The Pearson Series in Economics [563764]
TENTH EDITION
Principles of
Economics
The Pearson Series in Economics
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Macroeconomics
* denotes titles Log onto www.myeconlab.com to learn more.
Karl E. Case
Wellesley College
Ray C. Fair
Yale University
Sharon M. Oster
Yale University
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Principles of
Economics
Editor in Chief: Donna Battista
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Principles of economics / Karl E. Case, Ray C. Fair, Sharon M. Oster. — 10th ed.
p. cm.
Includes bibliographical references and index.ISBN-13: 978-0-13-255291-2ISBN-10: 0-13-255291-4
1. Economics. I. Fair, Ray C. II. Oster, Sharon M. III. Title.
HB171.5.C3123 2012330—dc22
2010049925Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear
on appropriate page within text.
Copyright © 2012, 2009, 2007, 2004, 2003, Pearson Education, Inc. All rights reserved. Manufactured in the United
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ISBN 13: 978-0-13-255291-2
ISBN 10: 0-13-255291-4Dedicated To
Professor Richard A. MusgraveandProfessor Robert M. SolowandProfessor Richard Caves
10 9 8 7 6 5 4 3 2 1
Karl E. Case is Professor of Economics Emeritus at Wellesley College where he has taught for 34
years and served several tours of duty as Department Chair. He is a Senior Fellow at the JointCenter for Housing Studies at Harvard University and a founding partner in the real estateresearch firm of Fiserv Case Shiller Weiss, which produces the S&P Case-Shiller Index of homeprices. He serves as a member of the Index Advisory Committee of Standard and Poor’s, and alongwith Ray Fair he serves on the Academic Advisory Board of the Federal Reserve Bank of Boston.
Before coming to Wellesley, he served as Head Tutor in Economics (director of undergradu-
ate studies) at Harvard, where he won the Allyn Y oung T eaching Prize. He was Associate Editor oftheJournal of Economic Perspectives and the Journal of Economic Education, and he was a member
of the AEA ’s Committee on Economic Education.
Professor Case received his B.A. from Miami University in 1968; spent three years on active
duty in the Army, and received his Ph.D. in Economics from Harvard University in 1976.
Professor Case’s research has been in the areas of real estate, housing, and public finance. He
is author or coauthor of five books, including Principles of Economics, Economics and Tax Policy ,
and Property Taxation: The Need for Reform , and he has published numerous articles in profes-
sional journals.
For the last 25 years, his research has focused on real estate markets and prices. He has authored
numerous professional articles, many of which attempt to isolate the causes and consequences ofboom and bust cycles and their relationship to regional and national economic performance.
Ray C. Fair is Professor of Economics at Y ale University. He is a member of the Cowles
Foundation at Y ale and a Fellow of the Econometric Society. He received a B.A. in Economicsfrom Fresno State College in 1964 and a Ph.D. in Economics from MIT in 1968. He taught atPrinceton University from 1968 to 1974 and has been at Y ale since 1974.
Professor Fair’s research has primarily been in the areas of macroeconomics and econometrics,
with particular emphasis on macroeconometric model building. He also has done work in the areasof finance, voting behavior, and aging in sports. His publications include Specification, Estimation,
and Analysis of Macroeconometric Models (Harvard Press, 1984); Testing Macroeconometric Models
(Harvard Press, 1994); and Estimating How the Macroeconomy Works (Harvard Press, 2004).
Professor Fair has taught introductory and intermediate macroeconomics at Y ale. He has
also taught graduate courses in macroeconomic theory and macroeconometrics.
Professor Fair’s U.S. and multicountry models are available for use on the Internet free of
charge. The address is http://fairmodel.econ.yale.edu. Many teachers have found that having stu-dents work with the U.S. model on the Internet is a useful complement to an introductorymacroeconomics course.
Sharon M. Oster is the Dean of the Y ale School of Management, where she is also the Frederic
Wolfe Professor of Economics and Management. Professor Oster joined Case and Fair as a coau-thor in the ninth edition of this book. Professor Oster has a B.A. in Economics from HofstraUniversity and a Ph.D. in Economics from Harvard University.
Professor Oster’s research is in the area of industrial organization. She has worked on problems of
diffusion of innovation in a number of different industries, on the effect of regulations on business,and on competitive strategy. She has published a number of articles in these areas and is the author ofseveral books, including Modern Competitive Analysis andThe Strategic Management of Nonprofits .
Prior to joining the School of Management at Y ale, Professor Oster taught for a number of
years in Y ale’s Department of Economics. In the department, Professor Oster taught introductoryand intermediate microeconomics to undergraduates as well as several graduate courses in indus-trial organization. Since 1982, Professor Oster has taught primarily in the Management School,where she teaches the core microeconomics class for MBA students and a course in the area of com-petitive strategy. Professor Oster also consults widely for businesses and nonprofit organizationsand has served on the boards of several publicly traded companies and nonprofit organizations.About the Authors
v
Brief Contents
PART I Introduction to Economics 1
1The Scope and Method of Economics 1
2The Economic Problem: Scarcity and Choice 25
3Demand, Supply, and Market Equilibrium 47
4Demand and Supply Applications 79
5Elasticity 97
PART II The Market System: Choices
Made by Households and Firms 117
6Household Behavior and Consumer Choice 121
7The Production Process: The Behavior of Profit-
Maximizing Firms 147
8Short-Run Costs and Output Decisions 167
9Long-Run Costs and Output Decisions 189
10 Input Demand: The Labor and Land Markets 215
11 Input Demand: The Capital Market and the
Investment Decision 233
12 General Equilibrium and the Efficiency of Perfect
Competition 253
PART III Market Imperfections and the
Role of Government 269
13 Monopoly and Antitrust Policy 269
14 Oligopoly 293
15 Monopolistic Competition 313
16 Externalities, Public Goods, and Social Choice 329
17 Uncertainty and Asymmetric Information 353
18 Income Distribution and Poverty 367
19 Public Finance: The Economics of Taxation 389
PART IV Concepts and Problems in
Macroeconomics 409
20 Introduction to Macroeconomics 409
21 Measuring National Output and National
Income 423
22 Unemployment, Inflation, and Long-Run
Growth 441PART V The Core of Macroeconomic
Theory 457
23 Aggregate Expenditure and Equilibrium Output 459
24 The Government and Fiscal Policy 477
25 The Money Supply and the Federal Reserve
System 501
26 Money Demand and the Equilibrium Interest
Rate 525
27 Aggregate Demand in the Goods and Money
Markets 541
28 Aggregate Supply and the Equilibrium Price
Level 559
29 The Labor Market In the Macroeconomy 581
PART VI Further Macroeconomics
Issues 599
30 Financial Crises, Stabilization, and Deficits 599
31 Household and Firm Behavior in the Macroeconomy:
A Further Look 615
32 Long-Run Growth 635
33 Alternative Views in Macroeconomics 649
PART VII The World Economy 663
34 International Trade, Comparative Advantage, and
Protectionism 663
35 Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates 687
36 Economic Growth in Developing and Transitional
Economies 713
Glossary 735
Index 751Photo Credits 781
vi
Contents
PART I Introduction To Economics 1
1The Scope and Method of
Economics 1
Why Study Economics? 2
T o Learn a Way of Thinking 2T o Understand Society 4T o Understand Global Affairs 5T o Be an Informed Citizen 5
ECONOMICS IN PRACTICE iPod and the World 6
The Scope of Economics 6
Microeconomics and Macroeconomics 6The Diverse Fields of Economics 7
ECONOMICS IN PRACTICE Trust and Gender 9
The Method of Economics 9
Descriptive Economics and Economic Theory 10Theories and Models 10Economic Policy 13
An Invitation 15
Summary 15 Review Terms and Concepts 16 Problems 16
Appendix: How to Read and Understand Graphs 17
2The Economic Problem: Scarcity
and Choice 25
Scarcity, Choice, and Opportunity Cost 26
Scarcity and Choice in a One-Person Economy 26Scarcity and Choice in an Economy of Two or
More 27
ECONOMICS IN PRACTICE Frozen Foods and
Opportunity Costs 28
The Production Possibility Frontier 33The Economic Problem 38
ECONOMICS IN PRACTICE Trade-Offs among the
Rich and Poor 39
Economic Systems and the Role of
Government 39
Command Economies 40Laissez-Faire Economies: The Free Market 40Mixed Systems, Markets, and Governments 42
Looking Ahead 42
Summary 43 Review Terms and Concepts 43 Problems 443Demand, Supply, and Market
Equilibrium 47
Firms and Households: The Basic Decision-
Making Units 47
Input Markets and Output Markets: The Circular
Flow 48
Demand in Product/Output Markets 50
Changes in Quantity Demanded versus Changes in
Demand 51
Price and Quantity Demanded: The Law of
Demand 51
Other Determinants of Household Demand 54
ECONOMICS IN PRACTICE Kindle in the College
Market? 55
Shift of Demand versus Movement Along a
Demand Curve 56
From Household Demand to Market Demand 58
Supply in Product/Output Markets 60
Price and Quantity Supplied: The Law of
Supply 61
Other Determinants of Supply 62Shift of Supply versus Movement Along a Supply
Curve 63
From Individual Supply to Market Supply 65
Market Equilibrium 66
Excess Demand 66Excess Supply 68Changes in Equilibrium 69
ECONOMICS IN PRACTICE High Prices for
Tomatoes 70
Demand and Supply in Product Markets: A
Review 72
Looking Ahead: Markets and the Allocation of
Resources 72
ECONOMICS IN PRACTICE Why Do the Prices of
Newspapers Rise? 73
Summary 74 Review Terms and Concepts 75 Problems 76
4Demand and Supply
Applications 79
The Price System: Rationing and Allocating
Resources 79
Price Rationing 79
vii
ECONOMICS IN PRACTICE Prices and Total
Expenditure: A Lesson From the Lobster Industry in2008–2009 81
Constraints on the Market and Alternative
Rationing Mechanisms 82
Prices and the Allocation of Resources 86Price Floor 86
Supply and Demand Analysis: An Oil Import
Fee 86
ECONOMICS IN PRACTICE The Price Mechanism at
Work for Shakespeare 87
Supply and Demand and Market Efficiency 89
Consumer Surplus 89Producer Surplus 90Competitive Markets Maximize the Sum of
Producer and Consumer Surplus 91
Potential Causes of Deadweight Loss From Under-
and Overproduction 92
Looking Ahead 93
Summary 93 Review Terms and Concepts 94 Problems 94
5Elasticity 97
Price Elasticity of Demand 98
Slope and Elasticity 98Types of Elasticity 99
Calculating Elasticities 100
Calculating Percentage Changes 100Elasticity Is a Ratio of Percentages 101The Midpoint Formula 101Elasticity Changes Along a Straight-Line Demand
Curve 103
Elasticity and T otal Revenue 105
The Determinants of Demand Elasticity 107
Availability of Substitutes 107The Importance of Being Unimportant 107
ECONOMICS IN PRACTICE Who Are the Elastic
Smokers? 108
The Time Dimension 108
ECONOMICS IN PRACTICE Elasticities at a
Delicatessen in the Short Run and Long Run 109
Other Important Elasticities 109
Income Elasticity of Demand 110Cross-Price Elasticity of Demand 110Elasticity of Supply 111
Looking Ahead 111
Summary 112 Review Terms and Concepts 112 Problems 113
Appendix: Point Elasticity (Optional) 115viii Contents
PART II The Market System: Choices Made by
Households and Firms 117
6Household Behavior and Consumer
Choice 121
Household Choice in Output Markets 121
The Determinants of Household Demand 122The Budget Constraint 122The Equation of the Budget Constraint 125
The Basis of Choice: Utility 126
Diminishing Marginal Utility 126Allocating Income to Maximize Utility 127The Utility-Maximizing Rule 129Diminishing Marginal Utility and Downward-
Sloping Demand 129
Income and Substitution Effects 130
The Income Effect 130The Substitution Effect 131
Household Choice in Input Markets 132
The Labor Supply Decision 132
ECONOMICS IN PRACTICE Substitution and Market
Baskets 133
The Price of Leisure 134Income and Substitution Effects of a Wage
Change 134
Saving and Borrowing: Present versus Future
Consumption 135
ECONOMICS IN PRACTICE What Happens When
the Cost of Self-Discovery Falls? 136
A Review: Households in Output and Input
Markets 137
Summary 138 Review Terms and Concepts 138 Problems 138
Appendix: Indifference Curves 141
7The Production Process: The
Behavior of Profit-MaximizingFirms 147
The Behavior of Profit-Maximizing Firms 148
Profits and Economic Costs 148Short-Run versus Long-Run Decisions 150The Bases of Decisions: Market Price of Outputs,
Available T echnology, and Input Prices 151
The Production Process 152
Production Functions: T otal Product, Marginal
Product, and Average Product 152
Production Functions with Two Variable Factors of
Production 155
Contents ix
Long-Run Adjustments to Short-Run
Conditions 200
ECONOMICS IN PRACTICE The Long-Run Average
Cost Curve: Flat or U-Shaped? 201
Short-Run Profits: Moves In and Out of
Equilibrium 201
ECONOMICS IN PRACTICE The Fortunes of the
Auto Industry 204
The Long-Run Adjustment Mechanism: Investment
Flows T oward Profit Opportunities 204
ECONOMICS IN PRACTICE Why Are Hot Dogs So
Expensive in Central Park? 205
Output Markets: A Final Word 206
Summary 206 Review Terms and Concepts 207 Problems 207
Appendix: External Economies and Diseconomies and the Long-Run
Industry Supply Curve 210
10Input Demand: The Labor and
Land Markets 215
Input Markets: Basic Concepts 215
Demand for Inputs: A Derived Demand 215
Inputs: Complementary and Substitutable 216Diminishing Returns 216
ECONOMICS IN PRACTICE Sometimes Workers Play
Hooky! 217
Marginal Revenue Product 217
Labor Markets 219
A Firm Using Only One Variable Factor of
Production: Labor 219
A Firm Employing Two Variable Factors of
Production in the Short and Long Run 222
ECONOMICS IN PRACTICE What is Denzel
Washington’s Marginal Revenue Product in Broadway’sFences ? 223
Many Labor Markets 224
Land Markets 224
Rent and the Value of Output Produced on
Land 225
ECONOMICS IN PRACTICE Time Is Money:
European High-Speed Trains 226
The Firm’s Profit-Maximizing Condition in Input
Markets 226
Input Demand Curves 227
Shifts in Factor Demand Curves 227
Looking Ahead 228
Summary 229 Review Terms and Concepts 230 Problems 230ECONOMICS IN PRACTICE Learning about Growing
Pineapples in Ghana 156
Choice of Technology 156
ECONOMICS IN PRACTICE How Fast Should a
Truck Driver Go? 157
Looking Ahead: Cost and Supply 158
Summary 158 Review Terms and Concepts 159 Problems 159
Appendix: Isoquants and Isocosts 162
8Short-Run Costs and Output
Decisions 167
Costs in the Short Run 168
Fixed Costs 168Variable Costs 169T otal Costs 175Short-Run Costs: A Review 177
ECONOMICS IN PRACTICE Average and Marginal
Costs at a College 178
Output Decisions: Revenues, Costs, and Profit
Maximization 179
Perfect Competition 179T otal Revenue and Marginal Revenue 180Comparing Costs and Revenues to Maximize
Profit 180
ECONOMICS IN PRACTICE Case Study in Marginal
Analysis: An Ice Cream Parlor 182
The Short-Run Supply Curve 184
Looking Ahead 185
Summary 185 Review Terms and Concepts 186 Problems 186
9Long-Run Costs and Output
Decisions 189
Short-Run Conditions and Long-Run
Directions 190
Maximizing Profits 190Minimizing Losses 192The Short-Run Industry Supply Curve 194Long-Run Directions: A Review 194
Long-Run Costs: Economies and Diseconomies of
Scale 195
Increasing Returns to Scale 196
ECONOMICS IN PRACTICE Economies of Scale in
the World Marketplace 197
ECONOMICS IN PRACTICE Economies of Scale in
Solar 198
Constant Returns to Scale 199Decreasing Returns to Scale 200U-Shaped Long-Run Average Costs 200
xContents
PART III Market Imperfections and the Role
of Government 269
13Monopoly and Antitrust
Policy 269
Imperfect Competition and Market Power: Core
Concepts 269
Forms of Imperfect Competition and Market
Boundaries 270
Price and Output Decisions in Pure Monopoly
Markets 271
Demand in Monopoly Markets 271Perfect Competition and Monopoly
Compared 276
Monopoly in the Long Run: Barriers to Entry 277
ECONOMICS IN PRACTICE Managing the Cable
Monopoly 280
The Social Costs of Monopoly 281
Inefficiency and Consumer Loss 281Rent-Seeking Behavior 282
Price Discrimination 283
Examples of Price Discrimination 285
Remedies for Monopoly: Antitrust Policy 285
Major Antitrust Legislation 285
ECONOMICS IN PRACTICE Antitrust Rules Cover
the NFL 287
Imperfect Markets: A Review and a Look
Ahead 287
Summary 288 Review Terms and Concepts 289 Problems 289
14Oligopoly 293
Market Structure in an Oligopoly 294
ECONOMICS IN PRACTICE Why Are Record Labels
Losing Key Stars Like Madonna? 296
Oligopoly Models 297
The Collusion Model 297The Price-Leadership Model 298The Cournot Model 299
Game Theory 300
Repeated Games 303A Game with Many Players: Collective Action Can
Be Blocked by a Prisoner’s Dilemma 304
ECONOMICS IN PRACTICE Price Fixing in Digital
Music 306
Oligopoly and Economic Performance 306
Industrial Concentration and T echnological
Change 30711Input Demand: The Capital
Market and the InvestmentDecision 233
Capital, Investment, and Depreciation 233
Capital 233
ECONOMICS IN PRACTICE Investment Banking,
IPOs, and Electric Cars 235
Investment and Depreciation 235
The Capital Market 236
Capital Income: Interest and Profits 237Financial Markets in Action 239Mortgages and the Mortgage Market 240
ECONOMICS IN PRACTICE Who Owns Stocks in the
United States? 241
Capital Accumulation and Allocation 241
The Demand for New Capital and the Investment
Decision 241
Forming Expectations 242
ECONOMICS IN PRACTICE Chinese Wind
Power 243
Comparing Costs and Expected Return 243
A Final Word on Capital 245
Summary 246 Review Terms and Concepts 246 Problems 247
Appendix: Calculating Present Value 248
12General Equilibrium and the
Efficiency of PerfectCompetition 253
Market Adjustment to Changes in Demand 254
Allocative Efficiency and Competitive
Equilibrium 256
Pareto Efficiency 256
ECONOMICS IN PRACTICE Ethanol and Land
Prices 257
Revisiting Consumer and Producer Surplus 258The Efficiency of Perfect Competition 259Perfect Competition versus Real Markets 262
The Sources of Market Failure 262
Imperfect Markets 262Public Goods 263Externalities 263Imperfect Information 264
Evaluating the Market Mechanism 264
Summary 264 Review Terms and Concepts 265 Problems 265
17Uncertainty and Asymmetric
Information 353
Decision Making Under Uncertainty: The
Tools 353
Expected Value 354Expected Utility 354Attitudes T oward Risk 356
Asymmetric Information 357
Adverse Selection 358
ECONOMICS IN PRACTICE Adverse Selection in the
Health Care Market 360
Market Signaling 360
ECONOMICS IN PRACTICE How to Read
Advertisements 361
Moral Hazard 362
Incentives 363
Labor Market Incentives 363
Summary 364 Review Terms and Concepts 365 Problems 365
18Income Distribution and
Poverty 367
The Sources of Household Income 367
Wages and Salaries 367Income from Property 369Income from the Government: Transfer
Payments 370
The Distribution of Income 370
Income Inequality in the United States 370The World Distribution of Income 372
ECONOMICS IN PRACTICE The New Rich
Work! 373
Causes of Increased Inequality 373Poverty 375The Distribution of Wealth 376
The Utility Possibilities Frontier 376The Redistribution Debate 377
Arguments Against Redistribution 378Arguments in Favor of Redistribution 378
Redistribution Programs and Policies 380
Financing Redistribution Programs: Taxes 380Expenditure Programs 381
ECONOMICS IN PRACTICE Does Price Matter in
Charitable Giving? 384
Government or the Market? A Review 385
Summary 385 Review Terms and Concepts 386 Problems 386The Role of Government 307
Regulation of Mergers 308A Proper Role? 310
Summary 310 Review Terms and Concepts 311 Problems 311
15Monopolistic Competition 313
Industry Characteristics 314Product Differentiation and Advertising 315
How Many Varieties? 315How Do Firms Differentiate Products? 316
ECONOMICS IN PRACTICE An Economist Makes
Tea 318
Advertising 318
ECONOMICS IN PRACTICE Can Information Reduce
Obesity? 321
Price and Output Determination in Monopolistic
Competition 322
Product Differentiation and Demand Elasticity 323Price/Output Determination in the Short Run 323Price/Output Determination in the Long Run 324
Economic Efficiency and Resource Allocation 326
Summary 326 Review Terms and Concepts 327 Problems 327
16Externalities, Public Goods, and
Social Choice 329
Externalities and Environmental Economics 329
Marginal Social Cost and Marginal-Cost
Pricing 330
ECONOMICS IN PRACTICE Ban on Oil Drillers 332
Private Choices and External Effects 333Internalizing Externalities 334
ECONOMICS IN PRACTICE Externalities Are All
Around Us 338
ECONOMICS IN PRACTICE Climate Change 341
Public (Social) Goods 341
The Characteristics of Public Goods 341Public Provision of Public Goods 342Optimal Provision of Public Goods 343Local Provision of Public Goods: Tiebout
Hypothesis 345
Social Choice 346
The Voting Paradox 346Government Inefficiency: Theory of Public
Choice 348
Rent-Seeking Revisited 348
Government and the Market 349
Summary 349 Review Terms and Concepts 350 Problems 350Contents xi
19Public Finance: The Economics
of Taxation 389
The Economics of Taxation 389
Taxes: Basic Concepts 389
ECONOMICS IN PRACTICE Calculating Taxes 392
Tax Equity 392What Is the “Best” Tax Base? 393
ECONOMICS IN PRACTICE The Yankees and the
Estate Tax 396
The Gift and Estate Tax 396
Tax Incidence: Who Pays? 396
The Incidence of Payroll Taxes 397The Incidence of Corporate Profits Taxes 400The Overall Incidence of Taxes in the United States:
Empirical Evidence 402
Excess Burdens and the Principle of
Neutrality 402
How Do Excess Burdens Arise? 402Measuring Excess Burdens 403Excess Burdens and the Degree of Distortion 404
The Principle of Second Best 405
Optimal Taxation 406
Summary 406 Review Terms and Concepts 407 Problems 407
PART IV Concepts and Problems in
Macroeconomics 409
20Introduction to
Macroeconomics 409
Macroeconomic Concerns 410
Output Growth 410Unemployment 411Inflation and Deflation 412
The Components of the Macroeconomy 412
The Circular Flow Diagram 413The Three Market Arenas 414The Role of the Government in the
Macroeconomy 415
A Brief History of Macroeconomics 415
ECONOMICS IN PRACTICE Macroeconomics in
Literature 417
The U.S. Economy Since 1970 417
ECONOMICS IN PRACTICE John Maynard
Keynes 419
Summary 420 Review Terms and Concepts 421 Problems 421xii Contents
21Measuring National Output and
National Income 423
Gross Domestic Product 423
Final Goods and Services 424Exclusion of Used Goods and Paper
Transactions 424
Exclusion of Output Produced Abroad by
Domestically Owned Factors of Production 425
Calculating GDP 425
The Expenditure Approach 426
ECONOMICS IN PRACTICE Where Does eBay Get
Counted? 427
The Income Approach 429
ECONOMICS IN PRACTICE GDP: One of the Great
Inventions of the 20th Century 431
Nominal versus Real GDP 432
Calculating Real GDP 432Calculating the GDP Deflator 434The Problems of Fixed Weights 434
Limitations of the GDP Concept 435
GDP and Social Welfare 435The Underground Economy 436Gross National Income per Capita 436
Looking Ahead 437
Summary 437 Review Terms and Concepts 438 Problems 439
22Unemployment, Inflation, and
Long-Run Growth 441
Unemployment 441
Measuring Unemployment 441Components of the Unemployment Rate 443
ECONOMICS IN PRACTICE A Quiet Revolution:
Women Join the Labor Force 445
The Costs of Unemployment 446
Inflation 447
The Consumer Price Index 448The Costs of Inflation 449
ECONOMICS IN PRACTICE The Politics of Cost-of-
Living Adjustments 450
Long-Run Growth 452
Output and Productivity Growth 452
Looking Ahead 454
Summary 455 Review Terms and Concepts 455 Problems 455
Contents xiii
PART V The Core of Macroeconomic
Theory 457
23Aggregate Expenditure and
Equilibrium Output 459
The Keynesian Theory of Consumption 460
Other Determinants of Consumption 463
ECONOMICS IN PRACTICE Behavioral Biases in
Saving Behavior 464
Planned Investment ( I) 464
The Determination of Equilibrium Output
(Income) 465
The Saving/Investment Approach to
Equilibrium 468
Adjustment to Equilibrium 469
The Multiplier 469
The Multiplier Equation 471
ECONOMICS IN PRACTICE The Paradox of
Thrift 472
The Size of the Multiplier in the Real World 473
Looking Ahead 473
Summary 474 Review Terms and Concepts 474 Problems 474
Appendix: Deriving the Multiplier Algebraically 476
24The Government and Fiscal
Policy 477
Government in the Economy 478
Government Purchases ( G), Net Taxes ( T), and
Disposable Income ( Yd) 478
The Determination of Equilibrium Output
(Income) 480
Fiscal Policy at Work: Multiplier Effects 482
The Government Spending Multiplier 482The Tax Multiplier 484The Balanced-Budget Multiplier 486
The Federal Budget 487
The Budget in 2009 488Fiscal Policy Since 1993: The Clinton, Bush, and
Obama Administrations 489
The Federal Government Debt 491
The Economy’s Influence on the Government
Budget 492
Automatic Stabilizers and Destabilizers 492
ECONOMICS IN PRACTICE Governments Disagree
on How Much More Spending Is Needed 493
Full-Employment Budget 493
Looking Ahead 494
Summary 494 Review Terms and Concepts 495 Problems 495Appendix A: Deriving the Fiscal Policy Multipliers 497
Appendix B: The Case in Which Tax Revenues Depend on
Income 497
25The Money Supply and the
Federal Reserve System 501
An Overview of Money 501
What Is Money? 501Commodity and Fiat Monies 502
ECONOMICS IN PRACTICE Dolphin Teeth as
Currency 503
Measuring the Supply of Money in the United
States 504
The Private Banking System 505
How Banks Create Money 505
A Historical Perspective: Goldsmiths 506The Modern Banking System 507The Creation of Money 508The Money Multiplier 510
The Federal Reserve System 511
Functions of the Federal Reserve 512Expanded Fed Activities Beginning in 2008 513The Federal Reserve Balance Sheet 513
How the Federal Reserve Controls the Money
Supply 515
The Required Reserve Ratio 515The Discount Rate 516Open Market Operations 517Excess Reserves and the Supply Curve for
Money 520
Looking Ahead 521
Summary 521 Review Terms and Concepts 521 Problems 522
26Money Demand and the
Equilibrium Interest Rate 525
Interest Rates and Bond Prices 525
ECONOMICS IN PRACTICE Professor Serebryakov
Makes an Economic Error 526
The Demand for Money 526
The Transaction Motive 527The Speculation Motive 530The T otal Demand for Money 530
ECONOMICS IN PRACTICE ATMs and the Demand
for Money 531
The Effect of Nominal Income on the Demand for
Money 531
The Equilibrium Interest Rate 532
Supply and Demand in the Money Market 532
xiv Contents
Changing the Money Supply to Affect the Interest
Rate 534
Increases in P•Yand Shifts in the Money Demand
Curve 534
Zero Interest Rate Bound 535
Looking Ahead: The Federal Reserve and
Monetary Policy 535
Summary 535 Review Terms and Concepts 536 Problems 536
Appendix A: The Various Interest Rates in the U.S. Economy 537
Appendix B: The Demand For Money: A Numerical Example 539
27Aggregate Demand in the Goods
and Money Markets 541
Planned Investment and the Interest Rate 542
Other Determinants of Planned Investment 542
ECONOMICS IN PRACTICE Small Business and the
Credit Crunch 543
Planned Aggregate Expenditure and the Interest
Rate 543
Equilibrium in Both the Goods and Money
Markets: The IS-LM Model 544
Policy Effects in the Goods and Money
Markets 545
Expansionary Policy Effects 545Contractionary Policy Effects 547The Macroeconomic Policy Mix 548
The Aggregate Demand ( AD) Curve 549
The Aggregate Demand Curve: A Warning 549Other Reasons for a Downward-Sloping Aggregate
Demand Curve 551
Shifts of the Aggregate Demand Curve from Policy
Variables 551
Looking Ahead: Determining the Price
Level 553
Summary 553 Review Terms and Concepts 554 Problems 554
Appendix: The IS-LM Model 555
28Aggregate Supply and the
Equilibrium Price Level 559
The Aggregate Supply Curve 559
The Aggregate Supply Curve: A Warning 559Aggregate Supply in the Short Run 560Shifts of the Short-Run Aggregate Supply
Curve 561
The Equilibrium Price Level 562The Long-Run Aggregate Supply Curve 563
ECONOMICS IN PRACTICE The Simple “Keynesian”
Aggregate Supply Curve 564
Potential GDP 564Monetary and Fiscal Policy Effects 565
Long-Run Aggregate Supply and Policy Effects 567
Causes of Inflation 567
Demand-Pull Inflation 567Cost-Push, or Supply-Side, Inflation 568Expectations and Inflation 568Money and Inflation 569
ECONOMICS IN PRACTICE Inflationary
Expectations in China 570
Sustained Inflation as a Purely Monetary
Phenomenon 571
The Behavior of the Fed 571
Targeting the Interest Rate 571The Fed’s Response to the State of the Economy 572
ECONOMICS IN PRACTICE Markets Watch the
Fed 573
Fed Behavior Since 1970 574Interest Rates Near Zero 575Inflation Targeting 576
Looking Ahead 576
Summary 576 Review Terms and Concepts 577 Problems 577
29The Labor Market In the
Macroeconomy 581
The Labor Market: Basic Concepts 581
The Classical View of the Labor Market 582
The Classical Labor Market and the Aggregate
Supply Curve 583
The Unemployment Rate and the Classical
View 583
Explaining the Existence of Unemployment 584
Sticky Wages 584Efficiency Wage Theory 585
ECONOMICS IN PRACTICE Does Unemployment
Insurance Increase Unemployment or Only Protect theUnemployed? 586
Imperfect Information 587Minimum Wage Laws 587An Open Question 587
The Short-Run Relationship Between the
Unemployment Rate and Inflation 588
The Phillips Curve: A Historical Perspective 589Aggregate Supply and Aggregate Demand Analysis
and the Phillips Curve 590
Expectations and the Phillips Curve 592Inflation and Aggregate Demand 592
The Long-Run Aggregate Supply Curve,
Potential Output, and the Natural Rate ofUnemployment 593
Contents xv
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU) 594
Looking Ahead 595
Summary 595 Review Terms and Concepts 596 Problems 596
PART VI Further Macroeconomics Issues 599
30Financial Crises, Stabilization,
and Deficits 599
The Stock Market, the Housing Market, and
Financial Crises 600
Stocks and Bonds 600Determining the Price of a Stock 600The Stock Market Since 1948 601
ECONOMICS IN PRACTICE Bubbles or Rational
Investors? 603
Housing Prices Since 1952 604Household Wealth Effects on the Economy 604Financial Crises and the 2008 Bailout 604Asset Markets and Policy Makers 605
ECONOMICS IN PRACTICE Financial Reform
Bill 606
Time Lags Regarding Monetary and Fiscal
Policy 606
Stabilization 607Recognition Lags 608Implementation Lags 608Response Lags 608Summary 609
Government Deficit Issues 610
Deficit Targeting 610
Summary 612 Review Terms and Concepts 613 Problems 613
31Household and Firm Behavior in
the Macroeconomy: A FurtherLook 615
Households: Consumption and Labor Supply
Decisions 615
The Life-Cycle Theory of Consumption 615The Labor Supply Decision 617Interest Rate Effects on Consumption 619Government Effects on Consumption and Labor
Supply: Taxes and Transfers 619
A Possible Employment Constraint on
Households 620
A Summary of Household Behavior 621The Household Sector Since 1970 621
ECONOMICS IN PRACTICE Household Reactions to
Winning the Lottery 622Firms: Investment and Employment
Decisions 624
Expectations and Animal Spirits 624Excess Labor and Excess Capital Effects 625Inventory Investment 625A Summary of Firm Behavior 627The Firm Sector Since 1970 627
Productivity and the Business Cycle 629The Short-Run Relationship Between Output and
Unemployment 630
The Size of the Multiplier 631
Summary 632 Review Terms and Concepts 633 Problems 633
32Long-Run Growth 635
The Growth Process: From Agriculture to
Industry 636
Sources of Economic Growth 637
Increase in Labor Supply 638Increase in Physical Capital 639Increase in the Quality of the Labor Supply
(Human Capital) 640
ECONOMICS IN PRACTICE Education and Skills in
the United Kingdom 641
Increase in the Quality of Capital (Embodied
T echnical Change) 641
Disembodied T echnical Change 642More on T echnical Change 642U.S. Labor Productivity: 1952 I–2010 I 643
Growth and the Environment and Issues of
Sustainability 644
Summary 646 Review Terms and Concepts 647 Problems 647
33Alternative Views in
Macroeconomics 649
Keynesian Economics 649
Monetarism 650
The Velocity of Money 650The Quantity Theory of Money 650Inflation as a Purely Monetary Phenomenon 652The Keynesian/Monetarist Debate 653
Supply-Side Economics 653
The Laffer Curve 654Evaluating Supply-Side Economics 654
New Classical Macroeconomics 655
The Development of New Classical
Macroeconomics 655
Rational Expectations 656
xvi Contents
ECONOMICS IN PRACTICE How Are Expectations
Formed? 657
Real Business Cycle Theory and New Keynesian
Economics 658
Evaluating the Rational Expectations
Assumption 659
Testing Alternative Macroeconomic Models 660
Summary 660 Review Terms and Concepts 661 Problems 661
PART VII The World Economy 663
34International Trade,
Comparative Advantage, andProtectionism 663
Trade Surpluses and Deficits 664
The Economic Basis for Trade: Comparative
Advantage 665
Absolute Advantage versus Comparative
Advantage 665
T erms of Trade 669Exchange Rates 670
The Sources of Comparative Advantage 672
The Heckscher-Ohlin Theorem 672Other Explanations for Observed Trade
Flows 673
Trade Barriers: Tariffs, Export Subsidies, and
Quotas 673
U.S. Trade Policies, GATT, and the WTO 674
ECONOMICS IN PRACTICE Tariff Wars 676
Free Trade or Protection? 676
The Case for Free Trade 676The Case for Protection 678
ECONOMICS IN PRACTICE A Petition 679
An Economic Consensus 682
Summary 682 Review Terms and Concepts 683 Problems 683
35Open-Economy
Macroeconomics: The Balanceof Payments and ExchangeRates 687
The Balance of Payments 688
The Current Account 688The Capital Account 690
ECONOMICS IN PRACTICE The Composition of
Trade Gaps 691
The United States as a Debtor Nation 691
Equilibrium Output (Income) in an Open
Economy 692
The International Sector and Planned AggregateExpenditure 692
Imports and Exports and the Trade Feedback
Effect 694
ECONOMICS IN PRACTICE The Recession Takes Its
Toll on Trade 695
Import and Export Prices and the Price Feedback
Effect 695
The Open Economy with Flexible Exchange
Rates 696
The Market for Foreign Exchange 696Factors That Affect Exchange Rates 699The Effects of Exchange Rates on the
Economy 701
ECONOMICS IN PRACTICE China’s Increased
Flexibility 702
ECONOMICS IN PRACTICE Losing Monetary Policy
Control 704
An Interdependent World Economy 705
Summary 705 Review Terms and Concepts 706 Problems 707
Appendix: World Monetary Systems Since 1900 708
36Economic Growth in
Developing and TransitionalEconomies 713
Life in the Developing Nations: Population and
Poverty 714
Economic Development: Sources and
Strategies 715
The Sources of Economic Development 716
ECONOMICS IN PRACTICE Corruption 718
Strategies for Economic Development 719
ECONOMICS IN PRACTICE Cell Phones Increase
Profits for Fishermen in India 722
Two Examples of Development: China and
India 723
Development Interventions 723
Random and Natural Experiments: Some New
T echniques in Economic Development 723
Education Ideas 724Health Improvements 725Population Issues 726
The Transition to a Market Economy 727
Six Basic Requirements for Successful Transition 727
Summary 731 Review Terms and Concepts 732 Problems 733
Glossary 735
Index 751Photo Credits 781
Our goal in the 10th edition, as it was in the first edition, is to instill in students a fascination
with both the functioning of the economy and the power and breadth of economics. Thefirst line of every edition of our book has been “The study of economics should begin with asense of wonder.” We hope that readers come away from our book with a basic understand-ing of how market economies function, an appreciation for the things they do well, and asense of the things they do poorly. We also hope that readers begin to learn the art and sci-ence of economic thinking and begin to look at some policy and even personal decisions in adifferent way.
What’s New in This Edition?
/L54263The years 2008–2009 became the fifth recession in the United States since 1970. One ofthe new features of this edition is a discussion of this recession in the context of theoverall history of the U.S. economy. This most recent recession, however, required morethan the usual revisions, both because of its severity and because of the unusual natureof both the events leading up to it and some of the remedies employed by the govern-ment to deal with it.
/L54263In June 2010, the balance sheet of the Federal Reserve had assets of $2.3 billion. Of theseassets, half, or just over $1.1 billion, was held in the form of mortgage-backed securities.In 2007, the Fed held no mortgage-backed securities. In June 2010, commercial banks inthe United States held more than $900 billion in excess reserves at the Fed. In the past,banks have held almost no excess reserves. These extraordinary changes at the Fed fol-low on the heels of interventions by the federal government in financial operations ofnumerous private banks like J.P . Morgan and Goldman Sachs, as well as in companieslike AIG and General Motors. These extraordinary actions required substantial changesthroughout the macroeconomic chapters of this book. New material describing theseinterventions appear in a number of chapters, both in the text itself and in the Economics
in Practice boxes. Revisions were also necessary in the background discussions of mone-
tary policy, since the existence of excess reserves considerably complicates the usualworkings of monetary policy.
/L54263In the microeconomics area, there has been a good deal of exciting new work in the areasof economic development, behavioral economics, and experimental economics. Thisedition has added material in various places throughout the microeconomics chaptersthat describe this work. A particular highlight is Chapter 36, which carefully lays out themethodological approach used by researchers doing randomized experiments in theeconomic development area and describes some of the results of that work.
/L54263This edition has augmented the current research focus of many of the Economics in
Practice boxes. Historically, the boxes have focused principally on newspaper excerpts
related to the subject of the chapter. Beginning last edition and pushed through morestrongly this edition, we have added boxes that we hope will demonstrate more clearlythe ideas that lie at the heart of economic thinking. Thus, two thirds of the boxes in themicroeconomics and macroeconomics chapters relate an economic principle either to apersonal observation (why does Denzel Washington get paid what he does?) or to arecent piece of economic research (new work by Emmanuel Saez on the fact that muchof modern wealth comes from wages rather than interest, Carola Frydman’s work onexecutive compensation, and Rachel Croson’s work on gender and trust). When possi-ble, we focus on work by younger scholars and on more recent research. It is our hopethat new students will be inspired by the wide breadth and exciting nature of theresearch currently going on in economics as they read these boxes.
xviiPreface
/L54263A number of the chapters have been reworked to improve their readability. On the
microeconomics side, Chapters 9, 12, and 18 have been most affected. On the macroeco-
nomics side, the growth chapter, Chapter 32, has been completely rewritten. The other
major changes concern the new discussion needed for the 2008–2009 recession and the
new policy initiatives.
/L54263We have added many new problems in the end-of-chapter materials, aiming for moretext-specific questions.
Economics is a social science. Its value is measured in part in terms of its ability to help
us understand the world around us and to grapple with some of the social issues of thetimes: How do markets work, and why are they so powerful? Why do firms earn profits, andhow are wages determined? Does it matter to consumers if there are many firms in an indus-try or only one? In 2006, the top 20 percent of the households in the United States earned48 percent of all income generated. Why do we see this income inequality, and why has itbeen growing? There is enormous poverty in many parts of the world. Are there ways tointervene, either at the country level or the individual level? In almost any marketplace inthe United States we see goods that were produced in countries from all over the world. U.S.goods also travel to far corners of the world to be sold to consumers in Europe, Asia, andLatin America. Why do we see the pattern we do? Across the globe, people are increasinglyworried about global warming. What tools can an economist bring to the table in helping tosolve this complex problem? These questions are microeconomic questions. T o answerthem, we need to learn how households and firms make decisions and how those decisionsare interconnected. As we begin to see the way in which market outcomes—like prices, prof-its, industry growth, and the like—emerge from the interplay of decisions made by a legionof households and firms, acting largely in their own interests, we hope that the reader’s senseof wonder will grow.
As we go to press in 2010, the U.S. economy is slowly recovering from a very difficult
downturn, with many people still unsuccessfully seeking work. What causes an economy to
falter and unemployment rates to grow? More generally, how do we measure and under-
stand economic growth? Are there government policies that can help prevent downturns orat least reduce their severity? In 2010, in the United States we hear increasing worries aboutthe growing size of the government debt. Where did this debt come from, and are peopleright to be worried? These question are macroeconomic questions. The years 2008–2010have been very challenging years in the macroeconomy for most of the world. In the UnitedStates the government has used policies never used before, and we have all—macroecono-mists and policy makers alike—struggled to figure out what works and what does not. Forsomeone studying macroeconomics, we are in the middle of an enormously exciting time.
The Foundation
The themes of Principles of Economics , 10th edition, are the same themes of the first nine edi-
tions. The purposes of this book are to introduce the discipline of economics and to providea basic understanding of how economies function. This requires a blend of economic theory,institutional material, and real-world applications. We have maintained a balance betweenthese ingredients in every chapter. The hallmark features of our book are its:
1.Three-tiered explanations of key concepts ( stories-graphs-equations )
2.Intuitive and accessible structure
3.International coverage
Three-Tiered Explanations: Stories-Graphs-Equations
Professors who teach principles of economics are faced with a classroom of students with
different abilities, backgrounds, and learning styles. For some students, analytical mater-ial is difficult no matter how it is presented; for others, graphs and equations seem tocome naturally. The problem facing instructors and textbook authors is how to conveythe core principles of the discipline to as many students as possible without selling thexviii Preface
better students short. Our approach to this problem is to present most core concepts in
the following three ways:
First, we present each concept in the context of a simple intuitive story or example in
words often followed by a table. Second, we use a graph in most cases to illustrate the story
or example. And finally, in many cases where appropriate, we use an equation to present the
concept with a mathematical formula.
Microeconomic Structure
The organization of the microeconomic chapters continues to reflect our belief that the bestway to understand how market economies operate—and the best way to understand basiceconomic theory—is to work through the perfectly competitive model first, including dis-cussions of output markets (goods and services) and input markets (land, labor, and capi-tal), and the connections between them before turning to noncompetitive market structuressuch as monopoly and oligopoly. When students understand how a simple, perfectly com-petitive system works, they can start thinking about how the pieces of the economy “fittogether.” We think this is a better approach to teaching economics than some of the moretraditional approaches, which encourage students to think of economics as a series of dis-connected alternative market models.
Learning perfect competition first also enables students to see the power of the market sys-
tem. It is impossible for students to discuss the efficiency of markets as well as the problemsthat arise from markets until they have seen how a simple, perfectly competitive market systemproduces and distributes goods and services. This is our purpose in Chapter 6 through 11.
Chapter 12, “General Equilibrium and the Efficiency of Perfect Competition,” is a piv-
otal chapter that links simple, perfectly competitive markets with a discussion of marketimperfections and the role of government. Chapter 13 through 15 cover three noncompeti-tive market structures—monopoly, monopolistic competition, and oligopoly. Chapter 16covers externalities, public goods, and social choice. Chapter 17, which is new to this edition,covers uncertainty and asymmetric information. Chapters 18 and 19 cover income distribu-tion as well as taxation and government finance. The visual at the top of the next page(Figure II.2 from page 118), gives you an overview of our structure.
Macroeconomic Structure
We remain committed to the view that it is a mistake simply to throw aggregate demand andaggregate supply curves at students in the first few chapters of a principles book. T o under-
stand the ASand ADcurves, students need to know about the functioning of both the goods
market and the money market. The logic behind the simple demand curve is wrong when itis applied to the relationship between aggregate demand and the price level. Similarly, thelogic behind the simple supply curve is wrong when it is applied to the relationship betweenaggregate supply and the price level.
Part of teaching economics is teaching economic reasoning. Our discipline is built
around deductive logic. Once we teach students a pattern of logic, we want and expect themto apply it to new circumstances. When they apply the logic of a simple demand curve or asimple supply curve to the aggregate demand or aggregate supply curve, the logic does notfit. We believe that the best way to teach the reasoning embodied in the aggregate demandand aggregate supply curves without creating confusion for students is to build up to thosetopics carefully.
In Chapter 23, “Aggregate Expenditure and Equilibrium Output,” and Chapter 24,
“The Government and Fiscal Policy,” we examine the market for goods and services. InChapter 25, “The Money Supply and the Federal Reserve System,” and Chapter 26, “MoneyDemand and the Equilibrium Interest Rate,” we examine the money market. We bring thetwo markets together in Chapter 27, “Aggregate Demand in the Goods and MoneyMarkets,” which explains the links between aggregate output ( Y) and the interest rate ( r)
and derives the ADcurve. In Chapter 28, “Aggregate Supply and the Equilibrium Price
Level,” we introduce the AScurve and determine the equilibrium price level ( P). We then
explain in Chapter 29, “The Labor Market in the Macroeconomy,” how the labor marketsPreface xix
fits into this macroeconomic picture. The figure at the top of the next page (Figure V .1
from page 457) gives you an overview of this structure.
One of the big issues in the organization of the macroeconomic material is whether
long-run growth issues should be taught before short-run chapters on the determination ofnational income and countercyclical policy. In the last three editions, we moved a significantdiscussion of growth to Chapter 22,“Unemployment, Inflation, and Long-Run Growth,” andhighlighted it. However, while we wrote Chapter 32, the major chapter on long-run growth,so that it can be taught before or after the short-run chapters, we remain convinced that it iseasier for students to understand the growth issue once they have come to grips with thelogic and controversies of short-run cycles, inflation, and unemployment.
International Coverage
As in previous editions, we continue to integrate international examples and applicationsthroughout the text. This probably goes without saying: The days in which an introductoryeconomics text could be written with a closed economy in mind have long since gone.
Tools for Learning
As authors and teachers, we understand the challenges of the principles of economics course.Our pedagogical features are designed to illustrate and reinforce key economic conceptsthrough real-world examples and applications.
Economics in Practice
As described earlier, the Economics in Practice feature presents a real-world personal observa-
tion, current research work, or a news article that supports the key concept of the chapterand helps students think critically about how economics is a part of their daily lives. Thexx Preface
CHAPTER 6
CHAPTERS 10–11CHAPTER 12CHAPTERS 13–19Household Behavior
• Demand in
output markets• Supply in input marketsCHAPTERS 8–9
Equilibrium
in CompetitiveOutput Markets
• Output prices
• Short run• Long run
Competitive
Input Markets
• Labor/land
– Wages/rents• Capital/Investment – Interest/profitsThe
CompetitiveMarket System
• General equilibrium
and efficiencyMarket
Imperfectionsand the Role ofGovernment
• Imperfect market
structures – Monopoly – Monopolistic competition – Oligopoly• Externalities, public goods, imperfect information, social choice• Income distribution and poverty• Public finance: the economics of taxationPerfectly Competitive Markets Market Imperfections
and the Role of
Government
CHAPTERS 7–8
Firm Behavior
• Choice of technology
• Supply in output markets• Demand in input markets
/L50304FIGURE II.2 Understanding the Microeconomy and the Role of Government
end-of-chapter problem sets include a question specific to each Economics in Practice feature.
Students can visit www.myeconlab.com for additional updated news articles and related
exercises.
Graphs
Reading and interpreting graphs is a key part of understanding economic concepts. TheChapter 1 Appendix, “How to Read and Understand Graphs,” shows readers how to interpretthe 200-plus graphs featured in this book. We use red curves to illustrate the behavior offirms and blue curves to show the behavior of households. We use a different shade of redand blue to signify a shift in a curve.Preface xxi
The Labor Market
• The supply of labor
• The demand for labor• Employment and unemploymentThe Goods-and-Services
Market
• Planned aggregate
expenditure Consumption (C)
Planned investment (I)
Government (G)
• Aggregate output (income) (Y)
The Money Market
• The supply of money
• The demand for money• Interest rate (r)Aggregate Supply
• Aggregate supply curve
• Equilibrium interest
rate (r*)
• Equilibrium output (income) (Y*)
• Equilibrium price level (P*)P
Y
Connections between
the goods-and-servicesmarket and the moneymarket
r YCHAPTERS 23–24
CHAPTER 27CHAPTER 28
CHAPTER 29
CHAPTERS 25–26
Aggregate Demand
• Aggregate demand
curve
P
Y
/L50304FIGURE V.1 The Core of Macroeconomic Theory
S
D
50,000 35,000 25,000 02.50
1.75Price of soybeans per bushel ($)
Bushels of soybeansEquilibrium point
Excess demand
= shortageP
Q/L50296FIGURE 3.9 Excess
Demand, or Shortage
At a price of $1.75 per bushel,
quantity demanded exceeds
quantity supplied. When excess
demand exists, there is a tendency
for price to rise. When quantity
demanded equals quantity sup-
plied, excess demand is elimi-
nated and the market is in
equilibrium. Here the equilib-
rium price is $2.50 and the equi-
librium quantity is 35,000
bushels.
Problems and Solutions
Each chapter and appendix ends with a problem set that asks students to think about and
apply what they’ve learned in the chapter. These problems are not simple memorization
questions. Rather, they ask students to perform graphical analysis or to apply economics to a
real-world situation or policy decision. More challenging problems are indicated by an aster-
isk. Additional questions specific to the Economics in Practice feature have been added.
Several problems have been updated. The solutions to all of the problems are available in theInstructor’s Manuals . Instructors can provide the solutions to their students so they can
check their understanding and progress.
MyEconLab
Both the text and supplement package provide ways for instructors and students to assesstheir knowledge and progress through the course. MyEconLab, the new standard in person-
alized online learning, is a key part of Case, Fair, and Oster’s integrated learning package forthe 10th edition.
For the Instructor
MyEconLab is an onlinecourse management, testing,and tutorial resource.Instructors can choose howmuch or how little time tospend setting up and usingMyEconLab. Each chaptercontains two Sample T ests,Study Plan Exercises, andTutorial Resources. Studentuse of these materials requiresno initial setup by their instructor. The online Gradebook records each student’s performanceand time spent on the T ests and Study Plan and generates reports by student or by chapter.Instructors can assign tests, quizzes, and homework in MyEconLab using four resources:
/L54263Preloaded Sample T ests
/L54263Problems similar to the end-of-chapter problems
/L54263T est Item File questions
/L54263Self-authored questions using Econ Exercise Builder
Exercises use multiple-choice, graph drawing, and free-response items, many of which
are generated algorithmically so that each time a student works them, a different variation ispresented. MyEconLab grades every problem, even those with graphs. When working home-work exercises, students receive immediate feedback with links to additional learning tools.
Customization and Communication MyEconLab in CourseCompass™ provides additional
optional customization and communication tools. Instructors who teach distance learningcourses or very large lecture sections find the CourseCompass format useful because theycan upload course documents and assignments, customize the order of chapters, and usecommunication features such as Digital Drop Box and Discussion Board.
Experiments in MyEconLab
Experiments are a fun and engaging way to promote active learning and mastery of important
economic concepts. Pearson’s experiments program is flexible and easy for instructors and stu-dents to use.
/L54263Single-player experiments allow your students to play an experiment against virtualplayers from anywhere at anytime with an Internet connection.
xxii Preface
Preface xxiii
/L54263Multiplayer experiments allow you to assign and manage a real-time experiment with
your class. In both cases, pre- and post-questions for each experiment are available for
assignment in MyEconLab.
For the Student
MyEconLab puts students in control of their learning through a collection of tests, practice, and
study tools tied to the online interactive version of the textbook, as well as other media resources.
Within MyEconLab’s structured environment, students practice what they learn, test their under-
standing, and pursue a personalized Study Plan generated from their performance on Sample
T ests and tests set by their instructors. At the core of MyEconLab are the following features:
/L54263Sample T ests, two per chapter
/L54263Personal Study Plan
/L54263Tutorial Instruction
/L54263Graphing T ool
Sample T ests Two Sample T ests for each chapter are
preloaded in MyEconLab, enabling students to practicewhat they have learned, test their understanding, andidentify areas in which they need further work. Studentscan study on their own, or they can complete assign-ments created by their instructor.
Personal Study Plan Based on a student’s performance
on tests, MyEconLab generates a personal Study Planthat shows where the student needs further study. TheStudy Plan consists of a series of additional practice exer-cises with detailed feedback and guided solutions thatare keyed to other tutorial resources.
Tutorial Instruction Launched from many of the exer-
cises in the Study Plan, MyEconLab provides tutorialinstruction in the form of step-by-step solutions andother media-based explanations.
Graphing T ool A graphing tool is integrated into the
T ests and Study Plan exercises to enable students to makeand manipulate graphs. This feature helps studentsunderstand how concepts, numbers, and graphs connect.
Additional MyEconLab T ools MyEconLab includes the
following additional features:
1. Economics in the News —This feature provides weekly
updates during the school year of news items with linksto sources for further reading and discussion questions.
2. eT ext —While students are working in the Study Plan
or completing homework assignments, one of thetutorial resources available is a direct link to the relevant page of the text so that studentscan review the appropriate material to help them complete the exercise.
3. Glossary —This searchable version of the textbook glossary provides additional examples
and links to related terms.
4. Glossary Flashcards —Every key term is available as a flashcard, allowing students to quiz
themselves on vocabulary from one or more chapters at a time.
5. Research Navigator (CourseCompass™ version only) —This feature offers extensive help
on the research process and provides four exclusive databases of credible and reliable sourcematerial, including the New York Times , the Financial Times , and peer-reviewed journals.
MyEconLab content has been created through the efforts of:
Charles Baum, Middle T ennessee State University; Sarah Ghosh, University of Scranton;
Russell Kellogg, University of Colorado–Denver; Bert G. Wheeler, Cedarville University; andNoel Lotz and Douglas A. Ruby, Pearson Education
Resources for the Instructor
The following supplements are designed to make teaching and testing flexible and easy.
Instructor’s Manuals
Two Instructor’s Manuals , one for Principles of Microeconomics and one for Principles of
Macroeconomics , were prepared by T ony Lima of California State University, East Bay
(Hayward, California). The Instructor’s Manuals are designed to provide the utmost teaching
support for instructors. They include the following content:
/L54263Detailed Chapter Outlines include key terminology, teaching notes, and lecture
suggestions.
/L54263Topics for Class Discussion provide topics and real-world situations that help ensure that
economic concepts resonate with students.
/L54263Unique Economics in Practice features that are not in the main text provide extra real-
world examples to present and discuss in class.
/L54263Teaching Tips provide tips for alternative ways to cover the material and brief reminders
on additional help to provide students. These tips include suggestions for exercises and
experiments to complete in class.
/L54263Extended Applications include exercises, activities, and experiments to help make eco-
nomics relevant to students.
/L54263Excel Workbooks , available for many chapters, make it easy to customize numerical
examples and produce graphs.
/L54263Solutions are provided for all problems in the book.
Six Test Item Files
We have tailored the T est Item Files to help instructors easily and efficiently assess student
understanding of economic concepts and analyses. T est questions are annotated with the fol-lowing information:
/L54263Difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis
/L54263Ty pe: Multiple-choice, true/false, short-answer, essay
/L54263T opic: The term or concept the question supports
/L54263Skill: Fact, definition, analytical, conceptual
/L54263AACSB: See description in the next section.
The T est Item Files include questions with tables that students must analyze to solve for
numerical answers. The T est Item Files also contain questions based on the graphs that appear inthe book. The questions ask students to interpret the information presented in the graph. Manyquestions require students to sketch a graph on their own and interpret curve movements.
Microeconomics T est Item File 1, by Randy Methenitis of Richland College: T est Item
File 1 (TIF1) includes over 2,700 questions. All questions are machine gradable and areeither multiple-choice or true/false. This T est Item File is for use with the 10th edition ofPrinciples of Microeconomics in the first year of publication. TIF1 is available in a computer-
ized format using T estGen EQ test-generating software and is included in MyEconLab.
Microeconomics T est Item File 2, by Randy Methenitis of Richland College: This additional
T est Item File contains another 2,700 machine-gradable questions based on the TIF1 but regener-ated to provide instructors with fresh questions when using the book the second year. This T estItem File is available in a computerized format using T estGen EQ test-generating software.
Microeconomics T est Item File 3, by Richard Gosselin of Houston Community College:
This third T est Item File includes 1,000 conceptual problems, essay questions, and short-
answer questions. Application-type problems ask students to draw graphs and analyze
tables. The Word files are available on the Instructor’s Resource Center(www.pearsonhighered.com/educator ).
Macroeconomics T est Item File 1, by Randy Methenitis of Richland College: T est Item
File 1 (TIF1) includes over 2,900 questions. All questions are machine gradable and are eitherxxiv Preface
multiple-choice or true/false. This T est Item File is for use with the 10th edition of Principles
of Macroeconomics in the first year of publication. This T est Item File is available in a comput-
erized format using T estGen EQ test-generating software and included in MyEconLab.
Macroeconomics T est Item File 2, by Randy Methenitis of Richland College: This additional
T est Item File contains another 2,900 machine-gradable questions based on the TIF1 but regener-ated to provide instructors with fresh questions when using the book the second year. This T estItem File is available in a computerized format using T estGen EQ test-generating software.
Macroeconomics T est Item File 3, by Richard Gosselin of Houston Community
College: This third T est Item File includes 1,000 conceptual problems, essay questions,and short-answer questions. Application-type problems ask students to draw graphs andanalyze tables. The Word files are available on the Instructor’s Resource Center(www.pearsonhighered.com/educator ).
The T est Item Files were checked for accuracy by the following professors:Leon J. Battista, Bronx Community College; Margaret Brooks, Bridgewater State College;
Mike Cohick, Collin County Community College; Dennis Debrecht, Carroll College; AmrikDua, California State Polytechnic University, Pomona; Mitchell Dudley, The College of William& Mary; Ann Eike, University of Kentucky; Connel Fullencamp, Duke University; Craig Gallet,California State University, Sacramento; Michael Goode, Central Piedmont CommunityCollege; Steve Hamilton, California State Polytechnic University; James R. Irwin, CentralMichigan University; Aaron Jackson, Bentley College; Rus Janis, University of Massachusetts,Amherst; Jonatan Jelen, The City College of New Y ork; Kathy A. Kelly, University of T exas,Arlington; Kate Krause, University of New Mexico; Gary F. Langer, Roosevelt University;Leonard Lardaro, University of Rhode Island; Ross LaRoe, Denison University; Melissa Lind,University of T exas, Arlington; Solina Lindahl, California State Polytechnic University; PeteMavrokordatos, Tarrant County College; Roberto Mazzoleni, Hofstra University; KimberlyMencken, Baylor University; Ida Mirzaie, Ohio State University; Shahruz Mohtadi, SuffolkUniversity; Mary Pranzo, California State University, Fresno; Ed Price, Oklahoma StateUniversity; Robert Shoffner, Central Piedmont Community College; James Swofford,University of South Alabama; Helen Tauchen, University of North Carolina, Chapel Hill; EricTaylor, Central Piedmont Community College; Henry T errell, University of Maryland; JohnT ommasi, Bentley College; Mukti Upadhyay, Eastern Illinois University; Robert Whaples, WakeForest University; and Timothy Wunder, University of T exas, Arlington.
The Association to Advance Collegiate Schools of Business (AACSB) The authors of the T est
Item File have connected select T est Item File questions to the general knowledge and skillguidelines found in the AACSB assurance of learning standards.
What Is the AACSB? AACSB is a not-for-profit corporation of educational institutions, corpo-
rations, and other organizations devoted to the promotion and improvement of higher educationin business administration and accounting. A collegiate institution offering degrees in businessadministration or accounting may volunteer for AACSB accreditation review. The AACSB makesinitial accreditation decisions and conducts periodic reviews to promote continuous qualityimprovement in management education. Pearson Education is a proud member of the AACSBand is pleased to provide advice to help you apply AACSB assurance of learning standards.
What Are AACSB Assurance of Learning Standards? One of the criteria for AACSB accredi-
tation is quality of the curricula. Although no specific courses are required, the AACSBexpects a curriculum to include learning experiences in areas such as the following:
/L54263Communication
/L54263Ethical Reasoning
/L54263Analytic Skills
/L54263Use of Information T echnology
/L54263Multicultural and Diversity
/L54263Reflective Thinking
Questions that test skills relevant to these guidelines are appropriately tagged. For exam-
ple, a question testing the moral questions associated with externalities would receive theEthical Reasoning tag.Preface xxv
How Can Instructors Use the AACSB T ags? Tagged questions help you measure whether
students are grasping the course content that aligns with the AACSB guidelines noted. Inaddition, the tagged questions may help instructors identify potential applications of theseskills. This in turn may suggest enrichment activities or other educational experiences tohelp students achieve these skills.
TestGen
The computerized T estGen package allows instructors to customize, save, and generate
classroom tests. The test program permits instructors to edit, add, or delete questions from
the T est Item Files; create new graphics; analyze test results; and organize a database of tests
and student results. This software allows for extensive flexibility and ease of use. It provides
many options for organizing and displaying tests, along with search and sort features. The
software and the T est Item Files can be downloaded from the Instructor’s Resource Center
(www.pearsonhighered.com/educator ).
PowerPoint®Lecture Presentations
Six sets of PowerPoint® slides, three for Principles of Microeconomics and three for Principles
of Macroeconomics , prepared by Fernando Quijano of Dickinson State University and his
assistant Shelly T efft, are available:
/L54263A comprehensive set of PowerPoint® slides that can be used by instructors for class pre-sentations or by students for lecture preview or review. The presentation includes allthe figures, photos, tables, key terms, and equations in the textbook. Two versions areavailable—the first is in step-by-step mode so that you can build graphs as you wouldon a blackboard, and the second is in automated mode, using a single click per slide.
/L54263A comprehensive set of PowerPoint® slides with Classroom Response Systems (CRS)questions built in so that instructors can incorporate CRS “clickers” into their classroomlectures. For more information on Pearson’s partnership with CRS, see the descriptionbelow. Instructors may download these PowerPoint presentations from the Instructor’sResource Center ( www.pearsonhighered.com/educator ).
/L54263Student versions of the PowerPoint presentations are available as .pdf files from the
book’s MyEconLab course. This version allows students to print the slides and bringthem to class for note taking.
Instructor’s Resource CD-ROM
The Instructor’s Resource CD-ROM contains all the faculty and student resources that sup-port this text. Instructors have the ability to access and edit the following three supplements:
/L54263Instructor’s Manuals
/L54263T est Item Files
/L54263PowerPoint® presentations
By clicking on a chapter or searching for a key word, faculty can access an interactive
library of resources. Faculty can pick and choose from the various supplements and exportthem to their hard drives.
Classroom Response Systems
Classroom Response Systems (CRS) is an exciting new wireless polling technology thatmakes large and small classrooms even more interactive because it enables instructors topose questions to their students, record results, and display the results instantly. Students cananswer questions easily by using compact remote-control transmitters. Pearson has partner-ships with leading providers of classroom response systems and can show you everythingyou need to know about setting up and using a CRS system. We provide the classroom hard-ware, text-specific PowerPoint® slides, software, and support; and we show you how yourstudents can benefit. Learn more at www.pearsonhighered.com/crs .xxvi Preface
Blackboard® and WebCT® Course Content
Pearson offers fully customizable course content for the Blackboard® and WebCT® Course
Management Systems.
Resources for the Student
The following supplements are designed to help students understand and retain the key con-cepts of each chapter.
MyEconLab
MyEconLab allows students to practice what they learn, test their understanding, and pursuea personalized Study Plan generated from their performance on Sample T ests and tests set by
their instructors. Here are MyEconLab’s key features. (See page xxii of this preface for more
details on MyEconLab.)
/L54263Sample T ests, two per chapter
/L54263Personal Study Plan
/L54263Tutorial Instruction
/L54263Graphing T ool
Study Guides
Two Study Guides, one for Principles of Microeconomics and one for Principles of
Macroeconomics , were prepared by Thomas M. Beveridge of Durham T echnical Community
College. They provide students with additional applications and exercises.
Each chapter of the Study Guides contains the following elements:
/L54263Point-by-Point Chapter Objectives A list of learning goals for the chapter. Each objec-
tive is followed up with a summary of the material, learning tips for each concept, andpractice questions with solutions.
/L54263Economics in Practice Questions A question that requires students to apply concepts of
the chapter to the Economics in Practice feature. The answer accompanies the question.
/L54263Practice T ests Approximately 20 multiple-choice questions and answers and applica-
tion questions that require students to use graphic or numerical analysis to solve eco-nomic problems.
/L54263Solutions Worked-out solutions to all questions in the Study Guide
/L54263Comprehensive Part Exams Multiple-choice and application questions to test stu-
dents’ overall comprehension. Solutions to all questions are also provided.
CourseSmart
CourseSmart is an exciting new choice for students looking to save money. As an alternative to
purchasing the print textbook, students can purchase an electronic version of the same con-tent and save up to 50 percent off the suggested list price of the print text. With a CourseSmarteT extbook, students can search the text, make notes online, print out reading assignments thatincorporate lecture notes, and bookmark important passages for later review. For more infor-mation or to purchase access to the CourseSmart eT extbook, visit www.coursesmart.com .
Student Subscriptions
Staying on top of current economic issues is critical to understanding and applying micro-
economic theory in and out of class. Keep students engaged by packaging, at a discount, asemester-long subscription to the Financial Times or Economist.com with each student text.
Contact your local Pearson Prentice Hall representative for more information about benefitsof these subscriptions and how to order them for your students.Preface xxvii
Acknowledgments
We are grateful to the many people who helped us prepare the 10th edition. We thank David
Alexander, our editor, and Lindsey Sloan and Melissa Pellerano, our project managers, for
their help and enthusiasm.
Lori DeShazo, Executive Marketing Manager, carefully crafted the marketing message.
Nancy Freihofer, production editor, and Nancy Fenton, our production managing editor,ensured that the production process of the book went smoothly. In addition, we also want tothank Marisa Taylor of GEX Publishing Services, who kept us on schedule, and DiahanneDowridge, who researched the many photographs that appear in the book.
We want to give special thanks to Patsy Balin, Murielle Dawdy, and Tracy Waldman for
their research assistance.
We also owe a debt of gratitude to those who reviewed and checked the 10th edition for
accuracy. They provided us with valuable insight as we prepared this edition and its supple-ment package.xxviii Preface
Reviewers of the Current
Edition
Mohsen Bahmani, University of
Wisconsin—Milwaukee
Klaus Becker, T exas T ech UniversityJeff Bookwalter, University of MontanaSuparna Chakraborty, City University of
New Y ork—Baruch
Scott Cunningham, Baylor UniversityElisabeth Curtis, DartmouthErwin Ehrhardt, University of CincinnatiBarbara Fischer, Cardinal Stritch
University
Bill Galose, Drake UniversityBrett Katzman, Kennesaw State UniversityHeather Kohls, Marquette UniversityDaniel Lawson, Drew UniversityMing Lo, St. Cloud State UniversityNathan Perry, University of UtahJoe Petry, University of Illinois-Urbana-
Champaign
Chris Phillips, Somerset Community
College
Jeff Phillips, Morrisville Community
College
David Spigelman, University of MiamiJohn Watkins, Westminster
Janice Weaver, Drake University
Reviewers of Previous
Editions
The following individuals were of
immense help in reviewing all or partof previous editions of this book andthe teaching/learning package in vari-ous stages of development:
Cynthia Abadie, Southwest Tennessee
Community College
Shawn Abbott, College of the Siskiyous
Fatma Abdel-Raouf, Goldey-Beacom
CollegeLew Abernathy, University of North T exas
Rebecca Abraham, Nova Southeastern
University
Basil Adams, Notre Dame de Namur
University
Jack Adams, University of MarylandDouglas K. Adie, Ohio UniversityDouglas Agbetsiafa, Indiana University,
South Bend
Sheri Aggarwal, University of VirginiaCarlos Aguilar, El Paso Community CollegeEhsan Ahmed, James Madison UniversityFerhat Akbas, T exas A&M UniversitySam Alapati, Rutgers UniversityT erence Alexander, Iowa State UniversityJohn W. Allen, T exas A&M UniversityPolly Allen, University of ConnecticutStuart Allen, University of North
Carolina at Greensboro
Hassan Aly, Ohio State UniversityAlex Anas, University at Buffalo, The
State University of New Y ork
David Anderson, Centre CollegeJoan Anderssen, Arapahoe Community
College
Jim Angresano, Hampton-Sydney CollegeKenneth S. Arakelian, University of
Rhode Island
Harvey Arnold, Indian River Community
College
Nick Apergis, Fordham UniversityBevin Ashenmiller, Occidental CollegeRichard Ashley, Virginia T echnical
University
Birjees Ashraf, Houston Community
College Southwest
Kidane Asmeron, Pennsylvania State
University
Musa Ayar, University of T exas, AustinJames Aylesworth, Lakeland Community
College
Moshen Bahmani, University of
Wisconsin-Milwaukee
Asatar Bair, City College of San FranciscoDiana Bajrami, College of AlamedaMohammad Bajwa, Northampton
Community College
Rita Balaban, University of North
Carolina, Chapel Hill
A. Paul Ballantyne, University of
Colorado, Colorado Springs
Richard J. Ballman, Jr., Augustana CollegeKing Banaian, St. Cloud State UniversityNick Barcia, Baruch CollegeHenry Barker, Tiffin UniversityRobin Bartlett, Denison UniversityLaurie Bates, Bryant UniversityKari Battaglia, University of North T exasLeon Battista, Bronx Community CollegeAmanda Bayer, Swarthmore CollegeKlaus Becker, T exas T ech UniversityRichard Beil, Auburn UniversityClive Belfield, Queens CollegeWillie J. Belton, Jr., Georgia Institute of
T echnology
Daniel K. Benjamin, Clemson UniversityCharles A. Bennett, Gannon UniversityEmil Berendt, Siena Heights UniversityDaniel Berkowitz, University of PittsburghKurt Beron, University of T exas, DallasDerek Berry, Calhoun Community CollegeTibor Besedes, Georgia Institute of
T echnology
Thomas Beveridge, Durham T echnical
Community College
Anoop Bhargava, Finger Lakes CCEugenie Bietry, Pace UniversityKelly Blanchard, Purdue UniversityMark Bock, Loyola College in MarylandHoward Bodenhorn, Lafayette CollegeBruce Bolnick, Northeastern UniversityFrank Bonello, University of Notre DameJeffrey Bookwalter, University of
Montana
Antonio Bos, Tusculum CollegeMaristella Botticini, Boston UniversityG. E. Breger, University of South CarolinaDennis Brennan, William Rainey Harper
Junior College
Preface xxix
Anne E. Bresnock, California State
Polytechnic University, Pomona, andthe University of California, Los Angeles
Barry Brown, Murray State UniversityBruce Brown, California State
Polytechnic University, Pomona
Jennifer Brown, Eastern Connecticut
State University
David Brownstone, University of
California, Irvine
Don Brunner, Spokane Falls Community
College
Jeff Bruns, Bacone CollegeDavid Bunting, Eastern Washington
University
Barbara Burnell, College of WoosterAlison Butler, Willamette UniversityCharles Callahan, III, State University of
New Y ork at Brockport
Fred Campano, Fordham UniversityDouglas Campbell, University of
Memphis
Beth Cantrell, Central Baptist CollegeKevin Carlson, University of
Massachusetts, Boston
Leonard Carlson, Emory UniversityArthur Schiller Casimir, Western New
England College
Lindsay Caulkins, John Carroll UniversityAtreya Chakraborty, Boston CollegeSuparna Chakraborty, Baruch College of
the City University of New Y ork
Winston W. Chang, University at Buffalo,
The State University of New Y ork
Janie Chermak, University of New MexicoDavid Ching, University of Hawaii –
Honolulu
Harold Christensen, Centenary CollegeDaniel Christiansen, Albion CollegeSusan Christoffersen, Philadelphia
University
Samuel Kim-Liang Chuah, Walla Walla
College
Dmitriy Chulkov, Indiana University,
Kokomo
David Colander, Middlebury CollegeDaniel Condon, University of Illinois at
Chicago; Moraine Valley CommunityCollege
Karen Conway, University of New
Hampshire
Cesar Corredor, T exas A&M UniversityDavid Cowen, University of T exas, AustinTyler Cowen, George Mason UniversityAmy Cramer, Pima Community College,
West Campus
Peggy Crane, Southwestern CollegeBarbara Craig, Oberlin CollegeJerry Crawford, Arkansas State UniversityJames Cunningham, Chapman UniversityJames D’Angelo, University of CincinnatiDavid Dahl, University of St. Thomas
Sheryll Dahlke, Lees-McRae CollegeJoseph Dahms, Hood CollegeSonia Dalmia, Grand Valley State
University
Rosa Lea Danielson, College of DuPageDavid Danning, University of
Massachusetts, Boston
Minh Quang Dao, Eastern Illinois
University
Amlan Datta, Cisco Junior CollegeDavid Davenport, McLennan
Community College
Stephen Davis, Southwest Minnesota
State University
Dale DeBoer, Colorado University,
Colorado Springs
Dennis Debrecht, Carroll CollegeJuan J. DelaCruz, Fashion Institute of
T echnology and Lehman College
Greg Delemeester, Marietta CollegeY anan Di, State University of New Y ork,
Stony Brook
Amy Diduch, Mary Baldwin CollegeTimothy Diette, Washington and Lee
University
Vernon J. Dixon, Haverford CollegeAlan Dobrowolksi, Manchester
Community College
Eric Dodge, Hanover CollegeCarol Dole, Jacksonville UniversityMichael Donihue, Colby CollegeShahpour Dowlatshahi, Fayetteville
T echnical Community College
Joanne M. Doyle, James Madison
University
Robert Driskill, Ohio State UniversityJames Dulgeroff, San Bernardino Valley
College
Kevin Duncan, Colorado State UniversityYvonne Durham, Western Washington
University
Debra Sabatini Dwyer, State University of
New Y ork, Stony Brook
Gary Dymski, University of Southern
California
David Eaton, Murray State UniversityJay Egger, T owson State UniversityAnn Eike, University of KentuckyEugene Elander, Plymouth State UniversityRonald D. Elkins, Central Washington
University
Tisha Emerson, Baylor University Michael Enz, Western New England CollegeErwin Erhardt III, University of CincinnatiWilliam Even, Miami UniversityDr. Ali Faegh, Houston Community
College, Northwest
Noel J. J. Farley, Bryn Mawr CollegeMosin Farminesh, T emple UniversityDan Feaster, Miami University of OhioSusan Feiner, Virginia Commonwealth
University
Getachew Felleke, Albright CollegeLois Fenske, South Puget Sound
Community College
William Field, DePauw UniversityDeborah Figart, Richard Stockton CollegeMary Flannery, Santa Clara UniversityBill Foeller, State University of New Y ork,
Fredonia
Fred Foldvary, Santa Clara UniversityRoger Nils Folsom, San Jose State
University
Mathew Forstater, University of
Missouri-Kansas City
Kevin Foster, The City College of New Y orkRichard Fowles, University of UtahSean Fraley, College of Mount Saint JosephJohanna Francis, Fordham UniversityRoger Frantz, San Diego State UniversityMark Frascatore, Clarkson UniversityAmanda Freeman, Kansas State UniversityMorris Frommer, Owens Community
College
Brandon Fuller, University of MontanaDavid Fuller, University of IowaMark Funk, University of Arkansas,
Little Rock
Alejandro Gallegos, Winona State
University
Craig Gallet, California State University,
Sacramento
N. Galloro, Chabot CollegeBill Ganley, Buffalo State CollegeMartin A. Garrett, Jr., College of William
and Mary
T om Gausman, Northern Illinois
University
Shirley J. Gedeon, University of VermontJeff Gerlach, Sungkyunkwan Graduate
School of Business
Lisa Giddings, University of Wisconsin,
La Crosse
Gary Gigliotti, Rutgers UniversityLynn Gillette, Spalding UniversityDonna Ginther, University of KansasJames N. Giordano, Villanova UniversityAmy Glass, T exas A&M UniversitySarah L. Glavin, Boston CollegeRoy Gobin, Loyola University, ChicagoBill Godair, Landmark CollegeBill Goffe, University of MississippiDevra Golbe, Hunter CollegeRoger Goldberg, Ohio Northern UniversityJoshua Goodman, New Y ork UniversityOphelia Goma, DePauw UniversityJohn Gonzales, University of San FranciscoDavid Gordon, Illinois Valley CollegeRichard Gosselin, Houston Community
College
xxx Preface
Eugene Gotwalt, Sweet Briar College
John W. Graham, Rutgers UniversityDouglas Greenley, Morehead State
University
Thomas A. Gresik, University of Notre
Dame
Lisa M. Grobar, California State
University, Long Beach
Wayne A. Grove, Le Moyne CollegeDaryl Gruver, Mount Vernon Nazarene
University
Osman Gulseven, North Carolina State
University
Mike Gumpper, Millersville UniversityBenjamin Gutierrez, Indiana University,
Bloomington
A. R. Gutowsky, California State
University, Sacramento
Anthony Gyapong, Penn State University,
Abington
David R. Hakes, University of Missouri,
St. Louis
Bradley Hansen, University of Mary
Washington
Stephen Happel, Arizona State UniversityMehdi Haririan, Bloomsburg University
of Pennsylvania
David Harris, Benedictine CollegeDavid Harris, San Diego State UniversityJames Hartley, Mount Holyoke CollegeBruce Hartman, California Maritime
Academy of California State University
Mitchell Harwitz, University at Buffalo,
The State University of New Y ork
Dewey Heinsma, Mt. San Jacinto CollegeSara Helms, University of Alabama,
Birmingham
Brian Hill, Salisbury UniversityDavid Hoaas, Centenary CollegeArleen Hoag, Owens Community CollegeCarol Hogan, University of Michigan,
Dearborn
Harry Holzer, Michigan State UniversityWard Hooker, Orangeburg-Calhoun
T echnical College
Bobbie Horn, University of TulsaJohn Horowitz, Ball State UniversityDaniel Horton, Cleveland State UniversityYing Huang, Manhattan CollegeJanet Hunt, University of GeorgiaE. Bruce Hutchinson, University of
T ennessee, Chattanooga
Creed Hyatt, Lehigh Carbon Community
College
Ana Ichim, Louisiana State UniversityAaron Iffland, Rocky Mountain CollegeFred Inaba, Washington State UniversityRichard Inman, Boston CollegeAaron Jackson, Bentley CollegeBrian Jacobsen, Wisconsin Lutheran
CollegeRussell A. Janis, University of
Massachusetts, Amherst
Jonatan Jelen, The City College of
New York
Eric Jensen, The College of William & MaryAaron Johnson, Missouri State UniversityDonn Johnson, Quinnipiac UniversityPaul Johnson, University of Alaska
Anchorage
Shirley Johnson, Vassar CollegeFarhoud Kafi, Babson CollegeR. Kallen, Roosevelt UniversityArthur E. Kartman, San Diego State
University
Hirshel Kasper, Oberlin CollegeBrett Katzman, Kennesaw State UniversityBruce Kaufman, Georgia State UniversityDennis Kaufman, University of
Wisconsin, Parkside
Pavel Kapinos, Carleton CollegeRussell Kashian, University of Wisconsin,
Whitewater
Amoz Kats, Virginia T echnical UniversityDavid Kaun, University of California,
Santa Cruz
Brett Katzman, Kennesaw State UniversityFred Keast, Portland State UniversityStephanie Kelton, University of Missouri,
Kansas City
Deborah Kelly, Palomar CollegeErasmus Kersting, T exas A&M UniversityRandall Kesselring, Arkansas State
University
Alan Kessler, Providence CollegeDominique Khactu, The University of
North Dakota
Gary Kikuchi, University of Hawaii, ManoaHwagyun Kim, State University of New
Y ork, Buffalo
Keon-Ho Kim, University of UtahKil-Joong Kim, Austin Peay State UniversitySang W. Kim, Hood CollegePhillip King, San Francisco State UniversityBarbara Kneeshaw, Wayne County
Community College
Inderjit Kohli, Santa Clara UniversityHeather Kohls, Marquette UniversityJanet Koscianski, Shippensburg UniversityVani Kotcherlakota, University of
Nebraska, Kearney
Barry Kotlove, Edmonds Community
College
Kate Krause, University of New MexicoDavid Kraybill, University of GeorgiaDavid Kroeker, Tabor CollegeStephan Kroll, California State University,
Sacramento
Joseph Kubec, Park UniversityJacob Kurien, Helzberg School of
Management
Rosung Kwak, University of T exas at AustinSally Kwak, University of Hawaii- Manoa
Steven Kyle, Cornell UniversityAnil K. Lal, Pittsburg State UniversityMelissa Lam, Wellesley CollegeDavid Lang, California State University,
Sacramento
Gary Langer, Roosevelt UniversityAnthony Laramie, Merrimack CollegeLeonard Lardaro, University of Rhode
Island
Ross LaRoe, Denison UniversityMichael Lawlor, Wake Forest UniversityPareena Lawrence, University of
Minnesota, Morris
Daniel Lawson, Drew UniversityMary Rose Leacy, Wagner CollegeMargaret D. Ledyard, University of T exas,
Austin
Jim Lee, Fort Hays State UniversityJudy Lee, Leeward Community CollegeSang H. Lee, Southeastern Louisiana
University
Don Leet, California State University,
Fresno
Robert J. Lemke, Lake Forest CollegeGary Lemon, DePauw UniversityAlan Leonard, Wilson T echnical
Community College
Mary Lesser, Iona CollegeDing Li, Northern State UniversityZhe Li, Stony Brook UniversityLarry Lichtenstein, Canisius CollegeBenjamin Liebman, Saint Joseph’s
University
Jesse Liebman, Kennesaw State UniversityGeorge Lieu, Tuskegee UniversityStephen E. Lile, Western Kentucky
University
Jane Lillydahl, University of Colorado at
Boulder
T ony Lima, California State University,
East Bay, Hayward, CA
Melissa Lind, University of T exas, ArlingtonAl Link, University of North Carolina
Greensboro
Charles R. Link, University of DelawareRobert Litro, U.S. Air Force AcademySamuel Liu, West Valley CollegeJeffrey Livingston, Bentley CollegeMing Chien Lo, St. Cloud State UniversityBurl F. Long, University of FloridaAlina Luca, Drexel UniversityAdrienne Lucas, Wellesley CollegeNancy Lutz, Virginia T echnical
University, Virginia T ech
Kristina Lybecker, Colorado CollegeGerald Lynch, Purdue UniversityKarla Lynch, University of North T exasAnn E. Lyon, University of Alaska
Anchorage
Bruce Madariaga, Montgomery College
Michael Magura, University of T oledo
Marvin S. Margolis, Millersville
University of Pennsylvania
Tim Mason, Eastern Illinois UniversityDon Mathews, Coastal Georgia
Community College
Don Maxwell, Central State UniversityNan Maxwell, California State University
at Hayward
Roberto Mazzoleni, Hofstra UniversityCynthia S. McCarty, Jacksonville State
University
J. Harold McClure, Jr., Villanova UniversityPatrick McEwan, Wellesley CollegeRick McIntyre, University of Rhode IslandJames J. McLain, University of New OrleansDawn McLaren, Mesa Community CollegeB. Starr McMullen, Oregon State UniversityK. Mehtaboin, College of St. RoseRandy Methenitis, Richland CollegeMartin Melkonian, Hofstra UniversityAlice Melkumian, Western Illinois
University
William Mertens, University of Colorado,
Boulder
Randy Methenitis, Richland CollegeArt Meyer, Lincoln Land Community
College
Carrie Meyer, George Mason UniversityMeghan Millea, Mississippi State UniversityJenny Minier, University of MiamiIda Mirzaie, The Ohio State UniversityDavid Mitchell, Missouri State UniversityBijan Moeinian, Osceola CampusRobert Mohr, University of New
Hampshire
Shahruz Mohtadi, Suffolk UniversityAmyaz Moledina, College of WoosterGary Mongiovi, St. John’s UniversityT erry D. Monson, Michigan
T echnological University
Barbara A. Moore, University of Central
Florida
Joe L. Moore, Arkansas T echnical
University
Myra Moore, University of GeorgiaRobert Moore, Occidental CollegeNorma C. Morgan, Curry CollegeW. Douglas Morgan, University of
California, Santa Barbara
David Murphy, Boston CollegeJohn Murphy, North Shore Community
College, Massachusetts
Ellen Mutari, Richard Stockton College of
New Jersey
Steven C. Myers, University of AkronVeena Nayak, University at Buffalo, The
State University of New Y ork
Ron Necoechea, Robert Wesleyan CollegeDoug Nelson, Spokane Community
CollegeRandy Nelson, Colby College
David Nickerson, University of British
Columbia
Sung No, Southern University and A&M
College
Rachel Nugent, Pacific Lutheran
University
Akorlie A. Nyatepe-Coo, University of
Wisconsin LaCrosse
Norman P . Obst, Michigan State UniversityWilliam C. O’Connor, Western Montana
College
Constantin Ogloblin, Georgia Southern
University
David O’Hara, Metropolitan State
University
Albert Okunade, University of MemphisRonald Olive, University of
Massachusetts, Lowell
Martha L. Olney, University of California,
Berkeley
Kent Olson, Oklahoma State UniversityJaime Ortiz, Florida Atlantic UniversityTheresa Osborne, Hunter CollegeDonald J. Oswald, California State
University, Bakersfield
Mete Ozcan, Brooklyn CollegeAlexandre Padilla, Metropolitan State
College of Denver
Aaron Pankratz, Fresno City CollegeNiki Papadopoulou, University of CyprusWalter Park, American UniversityCarl Parker, Fort Hays State UniversitySpiro Patton, Rasmussen CollegeAndrew Pearlman, Bard CollegeRichard Peck, University of Illinois at
Chicago
Don Peppard, Connecticut CollegeElizabeth Perry, Randolph CollegeNathan Perry, University of UtahJoseph A. Petry, University of IllinoisMary Ann Pevas, Winona State UniversityChris Phillips, Somerset Community
College
Frankie Pircher, University of Missouri,
Kansas City
T ony Pizelo, Spokane Community CollegeDennis Placone, Clemson UniversityMike Pogodzinski, San Jose State
University
Linnea Polgreen, University of IowaElizabeth Porter, University of North
Florida
Bob Potter, University of Central FloridaEd Price, Oklahoma State UniversityAbe Qastin, Lakeland CollegeKevin Quinn, St. Norbert CollegeRamkishen S. Rajan, George Mason
University
James Rakowski, University of Notre DameAmy Ramirez-Gay, Eastern Michigan
University
Paul Rappoport, T emple UniversityArtatrana Ratha, St. Cloud State UniversityMichael Rendich, Westchester
Community College
Lynn Rittenoure, University of TulsaBrian Roberson, Miami UniversityMichael Robinson, Mount Holyoke CollegeJuliette Roddy, University of Michigan,
Dearborn
Michael Rolleigh, University of MinnesotaBelinda Roman, Palo Alto CollegeS. Scanlon Romer, Delta CollegeBrian Rosario, University of California,
Davis
Paul Roscelli, Canada CollegeDavid C. Rose, University of Missouri-St.
Louis
Greg Rose, Sacramento City CollegeRichard Rosenberg, Pennsylvania State
University
Robert Rosenman, Washington State
University
Robert Rosenthal, Stonehill CollegeHoward Ross, Baruch CollegePaul Rothstein, Washington UniversityCharles Roussel, Louisiana State UniversityJeff Rubin, Rutgers UniversityMark Rush, University of FloridaDereka Rushbrook, Ripon CollegeJerard Russo, University of HawaiiLuz A. Saavedra, University of St. ThomasWilliam Samuelson, Boston University
School of Management
Allen Sanderson, University of ChicagoDavid Saner, Springfield College –
Benedictine University
Ahmad Saranjam, Bridgewater State
College
David L. Schaffer, Haverford CollegeEric Schansberg, Indiana University –
Southeast
Robert Schenk, Saint Joseph’s CollegeRamon Schreffler, Houston Community
College System (retired)
Adina Schwartz, Lakeland CollegeJerry Schwartz, Broward Community
College
Amy Scott, DeSales UniversityGary Sellers, University of AkronAtindra Sen, Miami UniversityChad Settle, University of TulsaJean Shackleford, Bucknell UniversityRonald Shadbegian, University of
Massachusetts, Dartmouth
Linda Shaffer, California State University,
Fresno
Dennis Shannon, Southwestern Illinois
College
Preface xxxi
xxxii Preface
Stephen L. Shapiro, University of North
Florida
Paul Shea, University of OregonGeoff Shepherd, University of
Massachusetts Amherst
Bih-Hay Sheu, University of T exas at AustinDavid Shideler, Murray State UniversityAlden Shiers, California Polytechnic State
University
Gerald Shilling, Eastfield CollegeDongsoo Shin, Santa Clara UniversityElias Shukralla, St. Louis Community
College, Meramec
Anne Shugars, Harford Community
College
Richard Sicotte, University of VermontWilliam Simeone, Providence CollegeScott Simkins, North Carolina Agricultural
and T echnical State University
Larry Singell, University of OregonPriyanka Singh, University of T exas, DallasSue Skeath, Wellesley CollegeEdward Skelton, Southern Methodist
University
Ken Slaysman, Y ork CollegeJohn Smith, New Y ork UniversityPaula Smith, Central State University,
Oklahoma
Donald Snyder, Utah State UniversityMarcia Snyder, College of CharlestonDavid Sobiechowski, Wayne State
University
John Solow, University of IowaAngela Sparkman, Itawamba Community
College
Martin Spechler, Indiana UniversityArun Srinivasa, Indiana University,
Southeast
David J. St. Clair, California State
University at Hayward
Sarah Stafford, College of William & MaryRichard Stahl, Louisiana State UniversityRebecca Stein, University of PennsylvaniaMary Stevenson, University of
Massachusetts, Boston
Susan Stojanovic, Washington University,
St. Louis
Courtenay Stone, Ball State UniversityErnst W. Stromsdorfer, Washington State
University
Edward Stuart, Northeastern Illinois
University
Chris Stufflebean, Southwestern
Oklahoma State University
Chuck Stull, Kalamazoo CollegeDella Sue, Marist CollegeAbdulhamid Sukar, Cameron UniversityChristopher Surfield, Saginaw Valley
State University
Rodney B. Swanson, University of
California, Los Angeles
James Swofford, University of AlabamaBernica Tackett, Pulaski T echnical CollegeMichael Taussig, Rutgers UniversitySamia Tavares, Rochester Institute of
T echnology
Timothy Taylor, Stanford UniversityWilliam Taylor, New Mexico Highlands
University
Sister Beth Anne T ercek, SND, Notre
Dame College of Ohio
Henry T errell, University of MarylandJennifer Thacher, University of New MexicoDonna Thompson, Brookdale
Community College
Robert T okle, Idaho State UniversityDavid T olman, Boise State UniversitySusanne T oney, Hampton UniversityKaren M. Travis, Pacific Lutheran
University
Jack Trierweler, Northern State UniversityBrian M. Trinque, University of T exas at
Austin
HuiKuan Tseng, University of North
Carolina at Charlotte
Boone Turchi, University of North
Carolina, Chapel HillKristin Van Gaasbeck, California State
University, Sacramento
Amy Vander Laan, Hastings CollegeAnn Velenchik, Wellesley CollegeLawrence Waldman, University of New
Mexico
Chris Waller, Indiana University,
Bloomington
William Walsh, University of St. ThomasChunbei Wang, University of St. ThomasBruce Webb, Gordon CollegeRoss Weiner, The City College of New Y orkElaine Wendt, Milwaukee Area T echnical
College
Walter Wessels, North Carolina State
University
Christopher Westley, Jacksonville State
University
Joan Whalen-Ayyappan, DeVry Institute
of T echnology
Robert Whaples, Wake Forest UniversityLeonard A. White, University of ArkansasAlex Wilson, Rhode Island CollegeWayne Winegarden, Marymount
University
Jennifer Wissink, Cornell UniversityArthur Woolf, University of VermontPaula Worthington, Northwestern
University
Bill Y ang, Georgia Southern UniversityBen Y oung, University of Missouri,
Kansas City
Darrel Y oung, University of T exasMichael Y oungblood, Rock Valley CollegeJay Zagorsky, Boston UniversityAlexander Zampieron, Bentley CollegeSourushe Zandvakili, University of
Cincinnati
Walter J. Zeiler, University of MichiganAbera Zeyege, Ball State UniversityJames Ziliak, Indiana University,
Bloomington
Jason Zimmerman, South Dakota State
University
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CHAPTER OUTLINE
1The Scope and
Method of Economics
The study of economics should
begin with a sense of wonder. Pausefor a moment and consider a typi-cal day in your life. It might startwith a bagel made in a local bakerywith flour produced in Minnesotafrom wheat grown in Kansas andbacon from pigs raised in Ohiopackaged in plastic made in NewJersey. Y ou spill coffee fromColombia on your shirt made inT exas from textiles shipped fromSouth Carolina.
After class you drive with a
friend on an interstate highway that is part of a system that took 20 years and billions of dollarsto build. Y ou stop for gasoline refined in Louisiana from Saudi Arabian crude oil brought to theUnited States on a supertanker that took 3 years to build at a shipyard in Maine.
Later you log onto the Web with a laptop assembled in Indonesia from parts made in China
and Skype with your brother in Mexico City, and you call a buddy on your iPhone with partsfrom a dozen countries. Y ou use or consume tens of thousands of things, both tangible and intan-gible, every day: buildings, music, staples, paper, toothpaste, tweezers, pizza, soap, digital watches,fire protection, banks, electricity, eggs, insurance, football fields, buses, rugs, subways, health ser-vices, sidewalks, and so forth. Somebody made all these things. Somebody organized men andwomen and materials to produce and distribute them. Thousands of decisions went into theircompletion. Somehow they got to you.
In the United States, over 139 million people—almost half the total population—work at
hundreds of thousands of different jobs producing over $14 trillion worth of goods and servicesevery year. Some cannot find work; some choose not to work. Some are rich; others are poor.
The United States imports over $200 billion worth of automobiles and parts and about
$300 billion worth of petroleum and petroleum products each year; it exports around $62 billionworth of agricultural products, including food. Every month the United States buys around $25 billion worth of goods and services from China, while China buys about $5 billion worthfrom the United States. High-rise office buildings go up in central cities. Condominiums andhomes are built in the suburbs. In other places, homes are abandoned and boarded up.
Some countries are wealthy. Others are impoverished. Some are growing. Some are not.
Some businesses are doing well. Others are going bankrupt. As the 10
thedition of our text goes to
press, the world is beginning to recover from a period during which many people felt the pain ofa major economic downturn. In the United States at the beginning of 2010 more than 15 millionpeople who wanted to work could not find a job. Millions around the world found themselveswith falling incomes and wealth.
At any moment in time, every society faces constraints imposed by nature and by previous
generations. Some societies are handsomely endowed by nature with fertile land, water, sunshine,Why Study
Economics? p. 2
To Learn a Way of
Thinking
To Understand Society
To Understand Global
Affairs
To Be an Informed Citizen
The Scope of
Economics p. 6
Microeconomics and
Macroeconomics
The Diverse Fields of
Economics
The Method of
Economics p. 9
Descriptive Economics and
Economic Theory
Theories and Models
Economic Policy
An Invitation p. 15
Appendix: How to
Read and UnderstandGraphs
p. 17
PART I INTRODUCTION TO ECONOMICS
1
2PART I Introduction to Economics
economics The study of how
individuals and societies
choose to use the scarceresources that nature and
previous generations have
provided.and natural resources. Others have deserts and few mineral resources. Some societies receive
much from previous generations—art, music, technical knowledge, beautiful buildings, and pro-ductive factories. Others are left with overgrazed, eroded land, cities leveled by war, or pollutednatural environments. Allsocieties face limits.
opportunity cost The best
alternative that we forgo, or
give up, when we make achoice or a decision.
scarce Limited.The purpose of this chapter and the next is to elaborate on this definition and to introduce
the subject matter of economics. What is produced? How is it produced? Who gets it? Why? Is theresult good or bad? Can it be improved?
Why Study Economics?
There are four main reasons to study economics: to learn a way of thinking, to understand soci-ety, to understand global affairs, and to be an informed citizen.
To Learn a Way of Thinking
Probably the most important reason for studying economics is to learn a way of thinking.Economics has three fundamental concepts that, once absorbed, can change the way you look ateveryday choices: opportunity cost, marginalism, and the working of efficient markets.
Opportunity Cost What happens in an economy is the outcome of thousands of individ-
ual decisions. People must decide how to divide their incomes among all the goods and servicesavailable in the marketplace. They must decide whether to work, whether to go to school, andhow much to save. Businesses must decide what to produce, how much to produce, how much tocharge, and where to locate. It is not surprising that economic analysis focuses on the process ofdecision making.
Nearly all decisions involve trade-offs. A key concept that recurs in analyzing the decision-
making process is the notion of opportunity cost . The full “cost” of making a specific choice
includes what we give up by not making the alternative choice. The best alternative that weforgo, or give up, when we make a choice or a decision is called the opportunity cost of
that decision.
When asked how much a movie costs, most people cite the ticket price. For an econo-
mist, this is only part of the answer: to see a movie takes not only a ticket but also time. Theopportunity cost of going to a movie is the value of the other things you could have donewith the same money and time. If you decide to take time off from work, the opportunitycost of your leisure is the pay that you would have earned had you worked. Part of the cost ofa college education is the income you could have earned by working full-time instead ofgoing to school. If a firm purchases a new piece of equipment for $3,000, it does so becauseit expects that equipment to generate more profit. There is an opportunity cost, however,because that $3,000 could have been deposited in an interest-earning account. T o a society,the opportunity cost of using resources to launch astronauts on a space shuttle is the value ofthe private/civilian or other government goods that could have been produced with the same resources.
Opportunity costs arise because resources are scarce. Scarce simply means limited.
Consider one of our most important resources—time. There are only 24 hours in a day, andwe must live our lives under this constraint. A farmer in rural Brazil must decide whether it is better to continue to farm or to go to the city and look for a job. A hockey player at theEconomics is the study of how individuals and societies choose to use the scarce
resources that nature and previous generations have provided. The key word in this def-inition is choose . Economics is a behavioral, or social, science. In large measure, it is the
study of how people make choices. The choices that people make, when added up, trans-late into societal choices.
CHAPTER 1 The Scope and Method of Economics 3
marginalism The process of
analyzing the additional orincremental costs or benefits
arising from a choice or
decision.University of Vermont must decide whether to play on the varsity team or spend more
time studying.
Marginalism A second key concept used in analyzing choices is the notion of marginalism .
In weighing the costs and benefits of a decision, it is important to weigh only the costs and bene-fits that arise from the decision. Suppose, for example, that you live in New Orleans and that youare weighing the costs and benefits of visiting your mother in Iowa. If business required that youtravel to Kansas City, the cost of visiting Mom would be only the additional, or marginal , time
and money cost of getting to Iowa from Kansas City.
Consider the video game business. It has been estimated that to create and produce a com-
plex multiplayer role-playing game like World of Warcraft (WOW) costs as much as $500 million.Once the game has been developed, however, the cost of selling and delivering it to another playeris close to zero. The original investment (by Activision) made to create WOW is considered asunk cost . Once the game has been developed, Activision cannot avoid these costs because they
have already been incurred. Activision’s business decisions about pricing and distributing WOWdepend not on the sunk costs of production, but on the incremental or marginal costs of produc-
tion. For Activision, those costs are close to zero.
There are numerous examples in which the concept of marginal cost is useful. For an air-
plane that is about to take off with empty seats, the marginal cost of an extra passenger is essen-tially zero; the total cost of the trip is roughly unchanged by the addition of an extra passenger.Thus, setting aside a few seats to be sold at big discounts through www.priceline.com or otherWeb sites can be profitable even if the fare for those seats is far below the average cost per seat ofmaking the trip. As long as the airline succeeds in filling seats that would otherwise have beenempty, doing so is profitable.
Efficient Markets—No Free Lunch Suppose you are ready to check out of a busy
grocery store on the day before a storm and seven checkout registers are open with severalpeople in each line. Which line should you choose? Usually, the waiting time is approximatelythe same no matter which register you choose (assuming you have more than 12 items). If oneline is much shorter than the others, people will quickly move into it until the lines are equal-ized again.
As you will see later, the term profit in economics has a very precise meaning. Economists,
however, often loosely refer to “good deals” or risk-free ventures as profit opportunities . Using
the term loosely, a profit opportunity exists at the checkout lines when one line is shorter thanthe others. In general, such profit opportunities are rare. At any time, many people are search-ing for them; as a consequence, few exist. Markets like this, where any profit opportunities areeliminated almost instantaneously, are said to be efficient markets . (We discuss markets , the
institutions through which buyers and sellers interact and engage in exchange, in detail inChapter 2.)
The common way of expressing the efficient markets concept is “there’s no such thing as a
free lunch.” How should you react when a stockbroker calls with a hot tip on the stock market?With skepticism. Thousands of individuals each day are looking for hot tips in the market. If aparticular tip about a stock is valid, there will be an immediate rush to buy the stock, which willquickly drive up its price. This view that very few profit opportunities exist can, of course, becarried too far. There is a story about two people walking along, one an economist and one not.The non-economist sees a $20 bill on the sidewalk and says, “There’s a $20 bill on the sidewalk.”The economist replies, “That is not possible. If there were, somebody would already have pickedit up.”
There are clearly times when profit opportunities exist. Someone has to be first to get the
news, and some people have quicker insights than others. Nevertheless, news travels fast, andthere are thousands of people with quick insights. The general view that large profit opportuni-ties are rare is close to the mark.efficient market A market in
which profit opportunities are
eliminated almost
instantaneously.
The study of economics teaches us a way of thinking and helps us make decisions.sunk costs Costs that
cannot be avoided because
they have already been
incurred.
4PART I Introduction to Economics
Industrial Revolution The
period in England during the
late eighteenth and earlynineteenth centuries in which
new manufacturing
technologies and improvedtransportation gave rise to the
modern factory system and a
massive movement of thepopulation from thecountryside to the cities.To Understand Society
Another reason for studying economics is to understand society better. Past and present eco-
nomic decisions have an enormous influence on the character of life in a society. The currentstate of the physical environment, the level of material well-being, and the nature and number ofjobs are all products of the economic system.
T o get a sense of the ways in which economic decisions have shaped our environment,
imagine looking out a top-floor window of an office tower in any large city. The workday isabout to begin. All around you are other tall glass and steel buildings full of workers. In thedistance, you see the smoke of factories. Looking down, you see thousands of commuterspouring off trains and buses and cars backed up on freeway exit ramps. Y ou see trucks carry-ing goods from one place to another. Y ou also see the face of urban poverty: Just beyond the freeway is a large public housing project and, beyond that, burned-out and boarded-upbuildings.
What you see before you is the product of millions of economic decisions made over hun-
dreds of years. People at some point decided to spend time and money building those buildingsand factories. Somebody cleared the land, laid the tracks, built the roads, and produced the carsand buses.
Economic decisions not only have shaped the physical environment but also have deter-
mined the character of society. At no time has the impact of economic change on a society beenmore evident than in England during the late eighteenth and early nineteenth centuries, aperiod that we now call the Industrial Revolution . Increases in the productivity of agriculture,
new manufacturing technologies, and development of more efficient forms of transportationled to a massive movement of the British population from the countryside to the city. At thebeginning of the eighteenth century, approximately 2 out of 3 people in Great Britain workedin agriculture. By 1812, only 1 in 3 remained in agriculture; by 1900, the figure was fewer than1 in 10. People jammed into overcrowded cities and worked long hours in factories. Englandhad changed completely in two centuries—a period that in the run of history was nothingmore than the blink of an eye.
It is not surprising that the discipline of economics began to take shape during this
period. Social critics and philosophers looked around and knew that their philosophies mustexpand to accommodate the changes. Adam Smith’s Wealth of Nations appeared in 1776. It
was followed by the writings of David Ricardo, Karl Marx, Thomas Malthus, and others.Each tried to make sense out of what was happening. Who was building the factories? Why?What determined the level of wages paid to workers or the price of food? What would hap-pen in the future, and what should happen? The people who asked these questions were the
first economists.
Similar changes continue to affect the character of life in more recent times. In fact, many
argue that the late 1990s marked the beginning of a new Industrial Revolution. As we turned thecorner into the new millennium, the “e” revolution was clearly having an impact on virtuallyevery aspect of our lives: the way we buy and sell products, the way we get news, the way we planvacations, the way we communicate with each other, the way we teach and take classes, and onand on. These changes have had and will clearly continue to have profound impacts on societiesacross the globe, from Beijing to Calcutta to New Y ork.
These changes have been driven by economics. Although the government was involved in
the early years of the World Wide Web, private firms that exist to make a profit (such asFacebook, Y ouTube, Y ahoo!, Microsoft, Google, Monster.com, Amazon.com, and E-Trade) cre-ated almost all the new innovations and products. How does one make sense of all this? Whatwill the effects of these innovations be on the number of jobs, the character of those jobs, thefamily incomes, the structure of our cities, and the political process both in the United Statesand in other countries?
During the last days of August 2005, Hurricane Katrina slammed into the coasts of Louisiana
and Mississippi, causing widespread devastation, killing thousands, and leaving hundreds ofthousands homeless. The economic impact of this catastrophic storm was huge. Thinking aboutvarious markets involved helps frame the problem.
For example, the labor market was massively affected. By some estimates, over 400,000 jobs
were lost as the storm hit. Hotels, restaurants, small businesses, and oil refineries, to name just a
CHAPTER 1 The Scope and Method of Economics 5
The study of economics is an essential part of the study of society.
To Understand Global Affairs
A third reason for studying economics is to understand global affairs. News headlines are filled
with economic stories. The environmental disaster associated with BP’s oil spill has the poten-tial to affect the future price of oil if deep sea drilling is banned, the price of fish, the extent oftourism, and tourist-related employment in the Gulf and numerous other markets. The dis-covery in 2010 of major new diamond deposits in Zimbabwe has implications for the futurestability of Mugabe’s government, with implications for developments in the rest of the region.China’s new position as a major trading partner of both the United States and Europe clearlyhas implications for political interactions among these nations. Greece’s economic struggles in2010 over its large debt is affecting the enthusiasm of the rest of Europe’s citizens for theEuropean Union.
In a relatively open, market-oriented world, it is impossible to understand political affairs with-
out a grounding in economics. While there is much debate about whether or not economic consider-ations dominate international relations, it is clear that they play a role as political leaders seek theeconomic well-being of their citizenry.
An understanding of economics is essential to an understanding of global affairs.few, were destroyed. All the people who worked in those establishments instantaneously lost their
jobs and their incomes. The cleanup and rebuilding process took time to organize, and it eventu-ally created a great deal of employment.
The storm created a major disruption in world oil markets. Loss of refinery capacity sent
gasoline prices up immediately, nearly 40 percent to over $4 per gallon in some locations. Theprice per gallon of crude oil rose to over $70 per barrel. Local governments found their taxbases destroyed, with no resources to pay teachers and local officials. Hundreds of hospitalswere destroyed, and colleges and universities were forced to close their doors, causing tens ofthousands of students to change their plans.
While the horror of the storm hit all kinds of people, the worst hit were the very poor, who
could not get out of the way because they had no cars or other means of escape. The storm raisedfundamental issues of fairness, which we will be discussing for years to come.
To Be an Informed Citizen
A knowledge of economics is essential to being an informed citizen. In 2009, most of the worldsuffered from a major recession, with diminished economic growth and high unemployment.Millions of people around the world lost their jobs. Governments from China to the UnitedKingdom to the United States all struggled to figure out policies to help their economies recover.Understanding what happens in a recession and what the government can and cannot do to helpin a recovery is an essential part of being an informed citizen.
Economics is also essential in understanding a range of other everyday government decisions
at the local and federal levels. Why do governments pay for public schools and roads, but not cellphones? In 2010, the federal government under President Obama moved toward universal healthcare for U.S. citizens. How do you understand the debate of whether this is or is not a good idea?In some states, scalping tickets to a ball game is illegal. Is this a good policy or not? Some govern-ments control the prices that firms can charge for some goods, especially essentials like milk andbread. Is this a good idea? Every day, across the globe, people engage in political decision makingaround questions like these, questions that depend on an understanding of economics.
T o be an informed citizen requires a basic understanding of economics.
6PART I Introduction to Economics
ECONOMICS IN PRACTICE
iPod and the World
It is impossible to understand the workings of an economy without
first understanding the ways in which economies are connected
across borders. The United States was importing goods and servicesat a rate of over $2 trillion per year in 2007 and was exporting at arate of over $1.5 trillion per year.
For literally hundreds of years, the virtues of free trade have been
the subject of heated debate. Opponents have argued that buying
foreign-produced goods costs Americans jobs and hurts Americanproducers. Proponents argue that there are gains from trade—that allcountries can gain from specializing in the production of the goodsand services they produce best.
In the modern world, it is not always easy to track where products
are made. A sticker that says “Made in China” can often be mislead-ing. Recent studies of two iconic U.S. products, the iPod and theBarbie doll, make this complexity clear.
The Barbie doll is one of Mattel’s best and longest selling prod-
ucts. The Barbie was designed in the United States. It is made of
plastic fashioned in Taiwan, which came originally from the Mideast
in the form of petroleum. Barbie’s hair comes from Japan, while thecloth for her clothes mostly comes from China. Most of the assemblyof the Barbie also is done in China, using, as we see, pieces fromacross the globe. A doll that sells for $10 in the United States carries
an export value when leaving Hong Kong of $2, of which only
35 cents is for Chinese labor, with most of the rest covering trans-portation and raw materials. Because the Barbie comes to the UnitedStates from assembly in China and transport from Hong Kong, somewould count it as being produced in China. Y et, for this Barbie, $8 of
its retail value of $10 is captured by the United States!
1
The iPod is similar. A recent study by three economists, Greg
Linden, Kenneth Kraemer, and Jason Dedrick, found that once oneincludes Apple’s payment for its intellectual property, distribution
costs, and production costs for some components, almost 80% ofthe retail price of the iPod is captured by the United States.
2
Moreover, for some of the other parts of the iPod, it is not easy to tell
exactly where they are produced. The hard drive, a relatively expen-
sive component, was produced in Japan by T oshiba, but some of thecomponents of that hard drive were actually produced elsewhere inAsia. Indeed, for the iPod, which is composed of many small parts, itis almost impossible to accurately tell exactly where each piece was
produced without pulling it apart.
So, next time you see a label saying “Made in China” keep in mind
that from an economics point of view one often has to dig a littledeeper to see what is really going on.
1For a discussion of the Barbie see Robert Feenstra, “Integration of Trade and
Disintegration of Production in the Global Economy,” Journal of Economic
Perspectives , Fall 1998, 31–50.
2Greg Linden, Kenneth Kraemer, and Jason Dedrick, “Who Profits from Innovation
in Global Value Chains?” Industrial and Corporate Change , 2010: 19(1), 81–116.
microeconomics The branch
of economics that examines
the functioning of individual
industries and the behavior ofindividual decision-makingunits—that is, firms andhouseholds.The Scope of Economics
Most students taking economics for the first time are surprised by the breadth of what they study.
Some think that economics will teach them about the stock market or what to do with theirmoney. Others think that economics deals exclusively with problems such as inflation and unem-ployment. In fact, it deals with all those subjects, but they are pieces of a much larger puzzle.
Economics has deep roots in and close ties to social philosophy. An issue of great importance
to philosophers, for example, is distributional justice. Why are some people rich and others poor?And whatever the answer, is this fair? A number of nineteenth-century social philosophers wres-tled with these questions, and out of their musings, economics as a separate discipline was born.
The easiest way to get a feel for the breadth and depth of what you will be studying is to
explore briefly the way economics is organized. First of all, there are two major divisions of eco-nomics: microeconomics and macroeconomics.
Microeconomics and Macroeconomics
Microeconomics deals with the functioning of individual industries and the behavior of individ-
ual economic decision-making units: firms and households. Firms’ choices about what to pro-duce and how much to charge and households’ choices about what and how much to buy help toexplain why the economy produces the goods and services it does.
Another big question addressed by microeconomics is who gets the goods and services that
are produced. Wealthy households get more than poor households, and the forces that determine
CHAPTER 1 The Scope and Method of Economics 7
The Diverse Fields of Economics
Individual economists focus their research and study in many diverse areas. Many of these spe-
cialized fields are reflected in the advanced courses offered at most colleges and universities. Someare concerned with economic history or the history of economic thought. Others focus on inter-national economics or growth in less developed countries. Still others study the economics ofcities (urban economics) or the relationship between economics and law. These fields are sum-marized in Table 1.2.this distribution of output are the province of microeconomics. Why does poverty exist? Who is
poor? Why do some jobs pay more than others?
Think again about what you consume in a day, and then think back to that view over a big city.
Somebody decided to build those factories. Somebody decided to construct the roads, build the hous-ing, produce the cars, and smoke the bacon. Why? What is going on in all those buildings? It is easy tosee that understanding individual microdecisions is very important to any understanding of society.
Macroeconomics looks at the economy as a whole. Instead of trying to understand what
determines the output of a single firm or industry or what the consumption patterns are of a sin-gle household or group of households, macroeconomics examines the factors that determinenational output, or national product. Microeconomics is concerned with household income;
macroeconomics deals with national income.
Whereas microeconomics focuses on individual product prices and relative prices, macro-
economics looks at the overall price level and how quickly (or slowly) it is rising (or falling).Microeconomics questions how many people will be hired (or fired) this year in a particularindustry or in a certain geographic area and focuses on the factors that determine how muchlabor a firm or an industry will hire. Macroeconomics deals with aggregate employment and
unemployment: how many jobs exist in the economy as a whole and how many people who arewilling to work are not able to find work.
T o summarize:macroeconomics The branch
of economics that examines
the economic behavior ofaggregates—income,employment, output, and so
on—on a national scale.
Microeconomics looks at the individual unit—the household, the firm, the industry. It
sees and examines the “trees.” Macroeconomics looks at the whole, the aggregate. It seesand analyzes the “forest.”
Table 1.1 summarizes these divisions of economics and some of the subjects with which they
are concerned.
TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns
Division of
Economics Production Prices Income Employment
Microeconomics Production/output
in individual indus-
tries and businessesHow much steelHow much officespace
How many carsPrices of individualgoods and services
Price of medicalcarePrice of gasolineFood prices
Apartment rentsDistribution ofincome and wealth
Wages in the autoindustryMinimum wageExecutive salaries
PovertyEmployment byindividual businesses
and industriesJobs in the steelindustryNumber of
employees in a firm
Number ofaccountants
Macroeconomics National
production/output
Total industrialoutputGross domesticproductGrowth of outputAggregate price level
Consumer prices
Producer pricesRate of inflationNational income
Total wages and
salariesTotal corporateprofitsEmployment and
unemployment in the
economyTotal numberof jobsUnemployment rate
8PART I Introduction to Economics
TABLE 1.2 The Fields of Economics
Behavioral economicsuses psychological theories relating to emotions and social context to help understand economic
decision making and policy. Much of the work in behavioral economics focuses on the biases that
individuals have that affect the decisions they make.
Comparative economic
systemsexamines the ways alternative economic systems function. What are the advantages anddisadvantages of different systems?
Econometrics applies statistical techniques and data to economic problems in an effort to test hypotheses and theo-
ries. Most schools require economics majors to take at least one course in statistics or econometrics.
Economic development focuses on the problems of low-income countries. What can be done to promote development inthese nations? Important concerns of development for economists include population growth
and control, provision for basic needs, and strategies for international trade.
Economic history traces the development of the modern economy. What economic and political events and scien-
tific advances caused the Industrial Revolution? What explains the tremendous growth and
progress of post—World War II Japan? What caused the Great Depression of the 1930s?
Environmental economics studies the potential failure of the market system to account fully for the impacts of produc-
tion and consumption on the environment and on natural resource depletion. Have alter-
native public policies and new economic institutions been effective in correcting thesepotential failures?
Finance examines the ways in which households and firms actually pay for, or finance, their purchases. It
involves the study of capital markets (including the stock and bond markets), futures and
options, capital budgeting, and asset valuation.
Health economics analyzes the health care system and its players: government, insurers, health care providers, and
patients. It provides insight into the demand for medical care, health insurance markets, cost-
controlling insurance plans (HMOs, PPOs, IPAs), government health care programs (Medicareand Medicaid), variations in medical practice, medical malpractice, competition versus regula-tion, and national health care reform.
The history of economic thought, which is grounded in philosophy, studies the development of economic ideas and theories over
time, from Adam Smith in the eighteenth century to the works of economists such as Thomas
Malthus, Karl Marx, and John Maynard Keynes. Because economic theory is constantly develop-ing and changing, studying the history of ideas helps give meaning to modern theory and puts itin perspective.
Industrial organization looks carefully at the structure and performance of industries and firms within an economy. How
do businesses compete? Who gains and who loses?
International economics studies trade flows among countries and international financial institutions. What are theadvantages and disadvantages for a country that allows its citizens to buy and sell freely in world
markets? Why is the dollar strong or weak?
Labor economics deals with the factors that determine wage rates, employment, and unemployment. How do peo-
ple decide whether to work, how much to work, and at what kind of job? How have the roles of
unions and management changed in recent years?
Law and economics analyzes the economic function of legal rules and institutions. How does the law change the
behavior of individuals and businesses? Do different liability rules make accidents and injuries
more or less likely? What are the economic costs of crime?
Public economics examines the role of government in the economy. What are the economic functions of
government, and what should they be? How should the government finance the services
that it provides? What kinds of government programs should confront the problems of poverty, unemployment, and pollution? What problems does government involve-ment create?
Urban and regional economics studies the spatial arrangement of economic activity. Why do we have cities? Why aremanufacturing firms locating farther and farther from the center of urban areas?
CHAPTER 1 The Scope and Method of Economics 9
positive economics An
approach to economics that
seeks to understand behaviorand the operation of systemswithout making judgments. It
describes what exists and how
it works.
normative economics An
approach to economics that
analyzes outcomes ofeconomic behavior, evaluatesthem as good or bad, and may
prescribe courses of action.
Also called policy economics .
ECONOMICS IN PRACTICE
Trust and Gender
As you study economics, you will see that economists study quite a
large range of topics. In the experimental area, this seems to be espe-
cially true. An interesting recent example is a paper on gender and trustby Nancy Buchan, Rachel Croson, and Sara Solnick.
1
While many transactions happen in anonymous markets in which
buyers and sellers don’t know one another, there are many other occa-
sions in which markets operate more effectively if individuals developsome trust in one another. Trust in the goodwill of your employer or ofthe staff of your local day care can make a big difference in the ways inwhich you transact business. What can economists say about who is oris not trustworthy?
T o answer this question, Buchan et al. used a game economists call
the Investment Game to explore the behavior of people when theyare not being observed. In this game, there are two players, a respon-der and a sender, and the game begins with each person receiving $10from the experimenter. The sender and responder are not known to
each other and are put in separate rooms. Sender begins and is toldhe or she can send any or all of the $10 to the responder. Whatever is
sent will be tripled by the experimenter. The responder then can sendany or all of the money back.
Clearly the sender–responder pair stand to gain the most if the
sender sends all $10 and has it tripled by the experimenter. In this way
the pair could turn a starting sum of $20 ($10 each) to $40 (the tripled$10 plus the responder’s original $10). As you will see in Chapter 14,economists who work on game theory expect no money to be sent ineither direction: Because the sender doesn’t trust the responder to
share, he or she sends nothing in the first place.What do Buchan et al. find? In experiments run at the University of
Wisconsin and the University of Miami, the experimenters found that
almost all subjects sent some money. Perhaps more interestingly, mensent significantly more than women did, but women returned signifi-cantly more than men. As the researchers conclude, “We find that men
trust more than women, and women are more trustworthy than men.”
1Nancy Buchan, Rachel Croson, and Sara Solnick. “Trust and Gender: An
Examination of Behavior, Biases, and Beliefs in the Investment Game.” Journal of
Economic Behavior and Organization , 2008: 68(3), 466–476.
Economists also differ in the emphasis they place on theory. Some economists specialize in
developing new theories, whereas other economists spend their time testing the theories of others.Some economists hope to expand the frontiers of knowledge, whereas other economists are moreinterested in applying what is already known to the formulation of public policies.
As you begin your study of economics, look through your school’s course catalog and talk to
the faculty about their interests. Y ou will discover that economics encompasses a broad range ofinquiry and is linked to many other disciplines.
The Method of Economics
Economics asks and attempts to answer two kinds of questions: positive and normative.Positive economics attempts to understand behavior and the operation of economic systems
without making judgments about whether the outcomes are good or bad. It strives to describe
what exists and how it works. What determines the wage rate for unskilled workers? What wouldhappen if we abolished the corporate income tax? The answers to such questions are the subjectof positive economics.
In contrast, normative economics looks at the outcomes of economic behavior and
asks whether they are good or bad and whether they can be made better. Normative eco-nomics involves judgments and prescriptions for courses of action. Should the governmentsubsidize or regulate the cost of higher education? Should medical benefits to the elderlyunder Medicare be available only to those with incomes below some threshold? Should the
variable A measure that can
change from time to time or
from observation to
observation.model A formal statement of
a theory, usually a mathematicalstatement of a presumed
relationship between two or
more variables.economic theory A
statement or set of relatedstatements about cause and
effect, action and reaction.United States allow importers to sell foreign-produced goods that compete with U.S.-made
products? Should we reduce or eliminate inheritance taxes? Normative economics is oftencalled policy economics .
Of course, most normative questions involve positive questions. T o know whether the govern-
ment should take a particular action, we must know first if it canand second what the conse-
quences are likely to be. (For example, if we lower import fees, will there be more competitionand lower prices?)
Some claim that positive, value-free economic analysis is impossible. They argue that ana-
lysts come to problems with biases that cannot help but influence their work. Furthermore, evenin choosing what questions to ask or what problems to analyze, economists are influenced bypolitical, ideological, and moral views.
Although this argument has some merit, it is nevertheless important to distinguish between
analyses that attempt to be positive and those that are intentionally and explicitly normative.Economists who ask explicitly normative questions should be required to specify their groundsfor judging one outcome superior to another.
Descriptive Economics and Economic Theory
Positive economics is often divided into descriptive economics and economic theory. Descriptive
economics is simply the compilation of data that describe phenomena and facts. Examples of
such data appear in the Statistical Abstract of the United States , a large volume of data published
by the Department of Commerce every year that describes many features of the U.S. economy.Massive volumes of data can now be found on the World Wide Web. As an example, look at www.bls.gov (Bureau of Labor Statistics).
Where do these data come from? The Census Bureau collects an enormous amount of raw
data every year, as do the Bureau of Labor Statistics, the Bureau of Economic Analysis, and non-government agencies such as the University of Michigan Survey Research Center. One importantstudy now published annually is the Survey of Consumer Expenditure , which asks individuals to
keep careful records of all their expenditures over a long period of time. Another is the National
Longitudinal Survey of Labor Force Behavior , conducted over many years by the Center for
Human Resource Development at the Ohio State University.
Economic theory attempts to generalize about data and interpret them. An economic theory
is a statement or set of related statements about cause and effect, action and reaction. One of thefirst theories you will encounter in this text is the law of demand , which was most clearly stated by
Alfred Marshall in 1890: When the price of a product rises, people tend to buy less of it; when theprice of a product falls, people tend to buy more.
Theories do not always arise out of formal numerical data. All of us have been observing
people’s behavior and their responses to economic stimuli for most of our lives. We may haveobserved our parents’ reaction to a sudden increase—or decrease—in income or to the loss of a job or the acquisition of a new one. We all have seen people standing in line waitingfor a bargain. Of course, our own actions and reactions are another important source of data.
Theories and Models
In many disciplines, including physics, chemistry, meteorology, political science, and economics,theorists build formal models of behavior. A model is a formal statement of a theory. It is usually
a mathematical statement of a presumed relationship between two or more variables.
Avariable is a measure that can change from time to time or from observation to observa-
tion. Income is a variable—it has different values for different people and different values for thesame person at different times. The rental price of a movie on a DVD is a variable; it has differentvalues at different stores and at different times. There are countless other examples.
Because all models simplify reality by stripping part of it away, they are abstractions. Critics
of economics often point to abstraction as a weakness. Most economists, however, see abstractionas a real strength.10 PART I Introduction to Economics
descriptive economics The
compilation of data that
describe phenomena and facts.
CHAPTER 1 The Scope and Method of Economics 11
Ockham’s razor The
principle that irrelevant detail
should be cut away.The easiest way to see how abstraction can be helpful is to think of a map. A map is a repre-
sentation of reality that is simplified and abstract. A city or state appears on a piece of paper as aseries of lines and colors. The amount of reality that the mapmaker can strip away before the maploses something essential depends on what the map will be used for. If you want to drive fromSt. Louis to Phoenix, you need to know only the major interstate highways and roads. Y ou loseabsolutely nothing and gain clarity by cutting out the local streets and roads. However, if youneed to get around Phoenix, you may need to see every street and alley.
Most maps are two-dimensional representations of a three-dimensional world; they show
where roads and highways go but do not show hills and valleys along the way. Trail maps for hikers,however, have “contour lines” that represent changes in elevation. When you are in a car, changes inelevation matter very little; they would make a map needlessly complex and more difficult to read.However, if you are on foot carrying a 50-pound pack, a knowledge of elevation is crucial.
Like maps, economic models are abstractions that strip away detail to expose only those
aspects of behavior that are important to the question being asked. The principle that irrelevantdetail should be cut away is called the principle of Ockham’s razor after the fourteenth-century
philosopher William of Ockham.
Be careful—although abstraction is a powerful tool for exposing and analyzing specific
aspects of behavior, it is possible to oversimplify. Economic models often strip away a good dealof social and political reality to get at underlying concepts. When an economic theory is used tohelp formulate actual government or institutional policy, political and social reality must often bereintroduced if the policy is to have a chance of working.
The key here is that the appropriate amount of simplification and abstraction depends on
the use to which the model will be put. T o return to the map example: Y ou do not want to walkaround San Francisco with a map made for drivers—there are too many very steep hills.
All Else Equal: Ceteris Paribus It is usually true that whatever you want to explain with a
model depends on more than one factor. Suppose, for example, that you want to explain the totalnumber of miles driven by automobile owners in the United States. The number of miles drivenwill change from year to year or month to month; it is a variable. The issue, if we want to under-stand and explain changes that occur, is what factors cause those changes.
Obviously, many things might affect total miles driven. First, more or fewer people may be
driving. This number, in turn, can be affected by changes in the driving age, by populationgrowth, or by changes in state laws. Other factors might include the price of gasoline, the house-hold’s income, the number and age of children in the household, the distance from home towork, the location of shopping facilities, and the availability and quality of public transport.When any of these variables change, the members of the household may drive more or less. Ifchanges in any of these variables affect large numbers of households across the country, the totalnumber of miles driven will change.
Very often we need to isolate or separate these effects. For example, suppose we want to know
the impact on driving of a higher tax on gasoline. This change would raise the price of gasoline atthe pump but would not (at least in the short run) affect income, workplace location, number ofchildren, and so on.
T o isolate the impact of one single factor, we use the device of ceteris paribus ,o r all else
equal . We ask, “What is the impact of a change in gasoline price on driving behavior, ceteris
paribus , or assuming that nothing else changes?” If gasoline prices rise by 10 percent, how much
less driving will there be, assuming no simultaneous change in anything else—that is, assumingthat income, number of children, population, laws, and so on, all remain constant? Using thedevice of ceteris paribus is one part of the process of abstraction. In formulating economic theory,
the concept helps us simplify reality to focus on the relationships that interest us.
Expressing Models in Words, Graphs, and Equations Consider the following
statements: Lower airline ticket prices cause people to fly more frequently. Higher interest ratesslow the rate of home sales. When firms produce more output, employment increases. Highergasoline prices cause people to drive less and to buy more fuel-efficient cars.ceteris paribus ,orall else
equal A device used to
analyze the relationship
between two variables whilethe values of other variables
are held unchanged.
12 PART I Introduction to Economics
post hoc, ergo propter hoc
Literally, “after this (in time),therefore because of this.” A
common error made in
thinking about causation: IfEvent A happens beforeEvent B, it is not necessarily
true that A caused B.Each of those statements expresses a relationship between two variables that can be quanti-
fied. In each case, there is a stimulus and a response, a cause and an effect. Quantitative relation-ships can be expressed in a variety of ways. Sometimes words are sufficient to express the essenceof a theory, but often it is necessary to be more specific about the nature of a relationship orabout the size of a response. The most common method of expressing the quantitative relation-ship between two variables is graphing that relationship on a two-dimensional plane. In fact, we
will use graphic analysis extensively in Chapter 2 and beyond. Because it is essential that you befamiliar with the basics of graphing, the appendix to this chapter presents a careful review ofgraphing techniques.
Quantitative relationships between variables can also be presented through equations .F o r
example, suppose we discovered that over time, U.S. households collectively spend, or consume,90 percent of their income and save 10 percent of their income. We could then write:
C= .90 Yand S= .10 Y
where Cis consumption spending, Yis income, and Sis saving. Writing explicit algebraic expres-
sions like these helps us understand the nature of the underlying process of decision making.Understanding this process is what economics is all about.
Cautions and Pitfalls In formulating theories and models, it is especially important to
avoid two pitfalls: the post hoc fallacy and the fallacy of composition.
The Post Hoc Fallacy Theories often make statements or sets of statements about cause and
effect. It can be quite tempting to look at two events that happen in sequence and assume that thefirst caused the second to happen. This is not always the case. This common error is called thepost hoc, ergo propter hoc (or “after this, therefore because of this”) fallacy.
There are thousands of examples. The Colorado Rockies have won seven games in a row. Last
night you went to the game and they lost. Y ou must have jinxed them. They lost because you went
to the game.
Stock market analysts indulge in what is perhaps the most striking example of the post hoc
fallacy in action. Every day the stock market goes up or down, and every day some analyst onsome national news program singles out one or two of the day’s events as thecause of some
change in the market: “T oday the Dow Jones industrial average rose 5 points on heavy trading;analysts say that the increase was due to progress in talks between Israel and Syria.” Research hasshown that daily changes in stock market averages are very largely random. Although major newsevents clearly have a direct influence on certain stock prices, most daily changes cannot be linkeddirectly to specific news stories.
Very closely related to the post hoc fallacy is the often erroneous link between correlation
and causation. Two variables are said to be correlated if one variable changes when the other
variable changes. However, correlation does not imply causation. Cities that have high crimerates also have many automobiles, so there is a very high degree of correlation between numberof cars and crime rates. Can we argue, then, that cars cause crime? No. The reason for the corre-
lation may have nothing to do with cause and effect. Big cities have many people, many peoplehave many cars; therefore, big cities have many cars. Big cities also have high crime rates formany reasons—crowding, poverty, anonymity, unequal distribution of wealth, and readily avail-able drugs, to mention only a few. However, the presence of cars is probably not one of them.
This caution must also be viewed in reverse. Sometimes events that seem entirely uncon-
nected actually areconnected. In 1978, Governor Michael Dukakis of Massachusetts ran for
reelection. Still quite popular, Dukakis was nevertheless defeated in the Democratic primary thatyear by a razor-thin margin. The weekend before, the Boston Red Sox, in the thick of the divisionchampionship race, had been badly beaten by the New Y ork Y ankees in four straight games. Somevery respectable political analysts believe that hundreds of thousands of Boston sports fansvented their anger on the incumbent governor the following Tuesday.
CHAPTER 1 The Scope and Method of Economics 13
The Fallacy of Composition T o conclude that what is true for a part is necessarily true for
the whole is to fall into the fallacy of composition . Suppose that a large group of cattle ranchers
graze their cattle on the same range. T o an individual rancher, more cattle and more grazingmean a higher income. However, because its capacity is limited, the land can support only somany cattle. If every cattle rancher increased the number of cattle sent out to graze, the landwould become overgrazed and barren; as a result, everyone’s income would fall. In short, theoriesthat seem to work well when applied to individuals or households often break down when theyare applied to the whole.
Testing Theories and Models: Empirical Economics In science, a theory is
rejected when it fails to explain what is observed or when another theory better explains what isobserved. The collection and use of data to test economic theories is called empirical economics .
Numerous large data sets are available to facilitate economic research. For example, econ-
omists studying the labor market can now test behavioral theories against the actual workingexperiences of thousands of randomly selected people who have been surveyed continuouslysince the 1960s. Macroeconomists continuously monitoring and studying the behavior of thenational economy at the National Bureau of Economic Research (NBER) pass thousands of items of data, collected by both government agencies and private companies, over the Internet.
In the natural sciences, controlled experiments, typically done in the lab, are a standard way
of testing theories. In recent years, economics has seen an increase in the use of experiments, bothin the field and in the lab, as a tool to test its theories. One economist, John List of Chicago, testedthe effect of changing the way an auction was run on bid prices for rare baseball cards with thehelp of the sports memorabilia dealers in trade show. (The experiment used a standard CalRipkin Jr. card.) Another economist, Keith Chen of Y ale, has used experiments with monkeys toinvestigate the deeper biological roots of human decision making. The Economics in Practice on
p. 9 describes another experiment on trust and gender.
Economic Policy
Economic theory helps us understand how the world works, but the formulation of economic
policy requires a second step. We must have objectives. What do we want to change? Why? What is
good and what is bad about the way the system is operating? Can we make it better?
Such questions force us to be specific about the grounds for judging one outcome superior
to another. What does it mean to be better? Four criteria are frequently applied in judging eco-nomic outcomes:
1.Efficiency
2.Equity
3.Growth
4.Stability
Efficiency In physics, “efficiency” refers to the ratio of useful energy delivered by a system to
the energy supplied to it. An efficient automobile engine, for example, is one that uses a smallamount of fuel per mile for a given level of power.
In economics, efficiency means allocative efficiency . An efficient economy is one that pro-
duces what people want at the least possible cost. If the system allocates resources to the produc-tion of goods and services that nobody wants, it is inefficient. If all members of a particularsociety were vegetarians and somehow half of all that society’s resources were used to producemeat, the result would be inefficient. It is inefficient when steel beams lie in the rain and rustbecause somebody fouled up a shipping schedule. If a firm could produce its product using25 percent less labor and energy without sacrificing quality, it too is inefficient.
The clearest example of an efficient change is a voluntary exchange. If you and I each
want something that the other has and we agree to exchange, we are both better off and noefficiency In economics,
allocative efficiency. An
efficient economy is one that
produces what people want atthe least possible cost.empirical economics The
collection and use of data to
test economic theories.fallacy of composition The
erroneous belief that what is
true for a part is necessarily
true for the whole.
one loses. When a company reorganizes its production or adopts a new technology that
enables it to produce more of its product with fewer resources, without sacrificing quality, ithas made an efficient change. At least potentially, the resources saved could be used to pro-duce more of something.
Inefficiencies can arise in numerous ways. Sometimes they are caused by government regula-
tions or tax laws that distort otherwise sound economic decisions. Suppose that land in Ohio isbest suited for corn production and that land in Kansas is best suited for wheat production. A lawthat requires Kansas to produce only corn and Ohio to produce only wheat would be inefficient.If firms that cause environmental damage are not held accountable for their actions, the incentiveto minimize those damages is lost and the result is inefficient.
Equity While efficiency has a fairly precise definition that can be applied with some degree of
rigor, equity (fairness) lies in the eye of the beholder. T o many, fairness implies a more equal dis-
tribution of income and wealth. Fairness may imply alleviating poverty, but the extent to whichthe poor should receive cash benefits from the government is the subject of enormous disagree-ment. For thousands of years, philosophers have wrestled with the principles of justice thatshould guide social decisions. They will probably wrestle with such questions for thousands ofyears to come.
Despite the impossibility of defining equity or fairness universally, public policy makers
judge the fairness of economic outcomes all the time. Rent control laws were passed becausesome legislators thought that landlords treated low-income tenants unfairly. Certainly, mostsocial welfare programs are created in the name of equity.
Growth As the result of technological change, the building of machinery, and the acqui-
sition of knowledge, societies learn to produce new goods and services and to produce oldones better. In the early days of the U.S. economy, it took nearly half the population to pro-duce the required food supply. T oday less than 2.0 percent of the country’s population worksin agriculture.
When we devise new and better ways of producing the goods and services we use now and
when we develop new goods and services, the total amount of production in the economyincreases. Economic growth is an increase in the total output of an economy. If output grows
faster than the population, output per capita rises and standards of living increase.Presumably, when an economy grows, it produces more of what people want. Rural and agrar-ian societies become modern industrial societies as a result of economic growth and rising percapita output.
Some policies discourage economic growth, and others encourage it. Tax laws, for example,
can be designed to encourage the development and application of new production techniques.Research and development in some societies are subsidized by the government. Building roads,highways, bridges, and transport systems in developing countries may speed up the process ofeconomic growth. If businesses and wealthy people invest their wealth outside their countryrather than in their country’s industries, growth in their home country may be slowed.
Stability Economic stability refers to the condition in which national output is growing
steadily, with low inflation and full employment of resources. During the 1950s and 1960s, theU.S. economy experienced a long period of relatively steady growth, stable prices, and low unem-ployment. Between 1951 and 1969, consumer prices never rose more than 5 percent in a singleyear, and in only 2 years did the number of unemployed exceed 6 percent of the labor force. Fromthe end of the Gulf War in 1991 to the beginning of 2001, the U.S. economy enjoyed price stabil-ity and strong economic growth with rising employment. It was the longest expansion inAmerican history.
The decades of the 1970s and 1980s, however, were not as stable. The United States expe-
rienced two periods of rapid price inflation (over 10 percent) and two periods of severe14 PART I Introduction to Economics
economic growth An
increase in the total output of
an economy.
stability A condition in which
national output is growing
steadily, with low inflation and
full employment of resources.equity Fairness.
unemployment. In 1982, for example, 12 million people (10.8 percent of the workforce) were
looking for work. The beginning of the 1990s was another period of instability, with a reces-sion occurring in 1990–1991. In 2008–2009 much of the world, including the United States,experienced a large contraction in output and rise in unemployment. This was clearly anunstable period.
The causes of instability and the ways in which governments have attempted to stabilize the
economy are the subject matter of macroeconomics.
An Invitation
This chapter has prepared you for your study of economics. The first part of the chapter invitedyou into an exciting discipline that deals with important issues and questions. Y ou cannot beginto understand how a society functions without knowing something about its economic historyand its economic system.
The second part of the chapter introduced the method of reasoning that economics requires
and some of the tools that economics uses. We believe that learning to think in this very powerfulway will help you better understand the world.
As you proceed, it is important that you keep track of what you have learned in earlier
chapters. This book has a plan; it proceeds step-by-step, each section building on the last. Itwould be a good idea to read each chapter’s table of contents at the start of each chapter andscan each chapter before you read it to make sure you understand where it fits in the big picture.CHAPTER 1 The Scope and Method of Economics 15
SUMMARY
1.Economics is the study of how individuals and societies
choose to use the scarce resources that nature and previousgenerations have provided.
WHY STUDY ECONOMICS? p. 2
2.There are many reasons to study economics, including (a) tolearn a way of thinking, (b) to understand society, (c) tounderstand global affairs, and (d) to be an informed citizen.
3.The best alternative that we forgo when we make a choice ora decision is the opportunity cost of that decision.
THE SCOPE OF ECONOMICS p. 6
4.Microeconomics deals with the functioning of individual
markets and industries and with the behavior of individualdecision-making units: business firms and households.
5.Macroeconomics looks at the economy as a whole. It deals
with the economic behavior of aggregates—national output,national income, the overall price level, and the general rateof inflation.
6.Economics is a broad and diverse discipline with many spe-cial fields of inquiry. These include economic history, inter-national economics, and urban economics.
THE METHOD OF ECONOMICS p.9
7.Economics asks and attempts to answer two kinds of ques-tions: positive and normative. Positive economics attempts
to understand behavior and the operation of economieswithout making judgments about whether the outcomes
are good or bad. Normative economics looks at the results of
economic behavior and asks whether they are good or badand whether they can be improved.
8.Positive economics is often divided into two parts. Descriptive
economics involves the compilation of data that accurately
describe economic facts and events. Economic theory attempts
to generalize and explain what is observed. It involves state-ments of cause and effect—of action and reaction.
9.An economic model is a formal statement of an economic
theory. Models simplify and abstract from reality.
10. It is often useful to isolate the effects of one variable onanother while holding “all else constant.” This is the device ofceteris paribus .
11. Models and theories can be expressed in many ways. The
most common ways are in words, in graphs, and in equations.
12. Because one event happens before another, the second eventdoes not necessarily happen as a result of the first. T o assumethat “after” implies “because” is to commit the fallacy of post
hoc, ergo propter hoc . The erroneous belief that what is true for a
part is necessarily true for the whole is the fallacy of composition .
13. Empirical economics involves the collection and use of data to
test economic theories. In principle, the best model is theone that yields the most accurate predictions.
14. T o make policy, one must be careful to specify criteria formaking judgments. Four specific criteria are used most oftenin economics: efficiency, equity, growth, and stability .
REVIEW TERMS AND CONCEPTS
ceteris paribus, or all else equal, p. 11
descriptive economics, p. 10
economic growth, p. 14
economic theory, p. 10
economics, p. 2
efficiency, p. 13
efficient market, p. 3
empirical economics, p. 13equity, p. 14
fallacy of composition, p. 13
Industrial Revolution, p. 4
macroeconomics, p. 7
marginalism, p. 3
microeconomics, p. 6
model, p. 10
normative economics, p. 9Ockham’s razor, p. 11
opportunity cost, p. 2
positive economics, p. 9
post hoc, ergo propter hoc, p. 12
scarce, p. 2
stability, p. 14
sunk costs, p. 3
variable, p. 1016 PART I Introduction to Economics
PROBLEMS
1.One of the scarce resources that constrain our behavior is time.
Each of us has only 24 hours in a day. How do you go about allo-
cating your time in a given day among competing alternatives?How do you go about weighing the alternatives? Once you choosea most important use of time, why do you not spend all your timeon it? Use the notion of opportunity cost in your answer.
2.In the summer of 2007, the housing market and the mortgage
market were both in decline. Housing prices in most U.S. cities
began to decline in mid-2006. With prices falling and theinventory of unsold houses rising, the production of newhomes fell to around 1.5 million in 2007 from 2.3 million in2005. With new construction falling dramatically, it was
expected that construction employment would fall and that this
would have the potential of slowing the national economy andincreasing the general unemployment rate. Go to www.bls.govand check out the recent data on total employment and con-
struction employment. Have they gone up or down from their
levels in August 2007? What has happened to the unemploy-ment rate? Go to www.fhfa.gov and look at the housing priceindex. Have home prices risen or fallen since August 2007?Finally, look at the latest GDP release at www.bea.gov. Look at
residential and nonresidential investment (Table 1.1.5) during
the last 2 years. Do you see a pattern? Does it explain theemployment numbers? Explain your answer.
3.Which of the following statements are examples of positive eco-
nomic analysis? Which are examples of normative analysis?
a.The inheritance tax should be repealed because it is unfair.
b.Allowing Chile to join NAFTA would cause wine prices in
the United States to drop.
c.The first priorities of the new regime in the Democratic
Republic of Congo (DRC, formerly Zaire) should be to rebuild
schools and highways and to provide basic health care.
4.Sarita signed up with Netflix for a fixed fee of $16.99 per month.For this fee, she can receive up to 3 DVDs at a time in the mail
and exchange each DVD as often as she likes. She also receives
unlimited instant access to movies being streamed from Netflix toher computer or TV . During the average month in 2010, Saritareceived and watched 6 movies sent to her through the mail andshe watched an additional 13 movies which were streamed to her
computer. What is the average cost of a movie to Sarita? What is
the marginal cost of an additional movie?5.A question facing many U.S. states is whether to allow casinogambling. States with casino gambling have seen a substantialincrease in tax revenue flowing to state government. This revenuecan be used to finance schools, repair roads, maintain social
programs, or reduce other taxes.
a.Recall that efficiency means producing what people want at
the least cost. Can you make an efficiency argument in favorof allowing casinos to operate?
b.What nonmonetary costs might be associated with gam-
bling? Would these costs have an impact on the efficiencyargument you presented in part a?
c.Using the concept of equity, argue for or against the legaliza-
tion of casino gambling.
6.For each of the following situations, identify the full cost(opportunity cost) involved:a.A worker earning an hourly wage of $8.50 decides to cut
back to part-time to attend Houston Community College.
b.Sue decides to drive to Los Angeles from San Francisco to
visit her son, who attends UCLA.
c.T om decides to go to a wild fraternity party and stays out all
night before his physics exam.
d.Annie spends $200 on a new dress.
e.The Confab Company spends $1 million to build a new branch
plant that will probably be in operation for at least 10 years.
f.Alex’s father owns a small grocery store in town. Alex works
40 hours a week in the store but receives no compensation.
7.[Related to the Economics in Practice onp. 6]Log onto www.
census.gov. Click on “Foreign Trade, ” then on “Statistics, ” andfinally on “State Export Data.” There you will find a list of theproducts produced in your state and exported to countries around
the world. In looking over that list, are you surprised by anything?
Do you know of any firms that produce these items? Search theWeb to find a company that does. Do some research and write aparagraph about your company: what it produces, how many peo-ple it employs, and whatever else you can learn about the firm. Y ou
might even call the company to obtain the information.
8.Explain the pitfalls in the following statements.
a.Whenever Jeremy decides to wash his car, the next day it
usually rain. Since Jeremy’s town is suffering from a severedrought, he decided to wash his car and, just as he expected,the next day the thunderstorms rolled in. Obviously it rainedbecause Jeremy washed his car.
All problems are available on www.myeconlab.com
CHAPTER 1 The Scope and Method of Economics 17
b.The principal of Hamilton High School found that requiring
those students who were failing algebra to attend an after-
school tutoring program resulted in a 30 percent averageincrease in their algebra grades. Based on this success, theprincipal decided to hire more tutors and require that allstudents must attend after-school tutoring, so everyone’s
algebra grades would improve.
c.People who drive hybrid automobiles recycle their trash
more than people who do not drive hybrids. Therefore,recycling trash causes people to drive hybrid automobiles.
9.Explain whether each of the following is an example of a macro-
economic concern or a microeconomic concern.a.Ford Motor Company is contemplating increasing the pro-
duction of full-size SUVs based on projected future con-sumer demand.b.Congress is debating the option of implementing a value-
added tax as a means to cut the federal deficit.
c.The Federal Reserve announces it is increasing the discount
rate in an attempt to slow the rate of inflation.
d.The Bureau of Labor Statistics projects a 22.5 percent
increase in the number or workers in the healthcare industryfrom 2008 to 2018.
10.On the Forbes 2010 list of the World’s Billionaires, Mexico’s Carlos
Slim Helu ranks at the top with a net worth of U.S. $53.5 billion.Does this “richest man in the world” face scarcity, or does scarcityonly affect those with more limited incomes and lower net worth?
Source: “The World’s Billionaires,” Forbes , March 10, 2010.
CHAPTER 1 APPENDIX
How to Read and Understand
Graphs
Economics is the most quantitative of the social sciences. If you
flip through the pages of this or any other economics text, youwill see countless tables and graphs. These serve a number ofpurposes. First, they illustrate important economic relation-ships. Second, they make difficult problems easier to understandand analyze. Finally, they can show patterns and regularities thatmay not be discernible in simple lists of numbers.
Agraph is a two-dimensional representation of a set of
numbers, or data. There are many ways that numbers can beillustrated by a graph.Time Series Graphs
It is often useful to see how a single measure or variablechanges over time. One way to present this information is toplot the values of the variable on a graph, with each value cor-responding to a different time period. A graph of this kind iscalled a time series graph. On a time series graph, time is
measured along the horizontal scale and the variable beinggraphed is measured along the vertical scale. Figure 1A.1 is atime series graph that presents the total disposable personalTotal disposable personal income
2,000
1,000
03,0004,0005,0006,0007,0008,0009,00010,000
2000 1995 1990 1985 1980 1975
Y ear200511,000 /L50296FIGURE 1A.1 Total
Disposable PersonalIncome in the UnitedStates: 1975–2009 (inbillions of dollars)
Source: See Table 1A.1.
18 PART I Introduction to Economics
income in the U.S. economy for each year between 1975 and
2009.1This graph is based on the data found in Table 1A.1. By
displaying these data graphically, we can see that (1) total dis-posable personal income has increased steadily since 1975 and(2) during certain periods, income has increased at a fasterrate than during other periods.
Graphing Two Variables on a Cartesian
Coordinate System
More important than simple graphs of one variable are graphs
that contain information on two variables at the same time.The most common method of graphing two variables is theCartesian coordinate system . This system is constructed by
drawing two perpendicular lines: a horizontal line, or X-axis ,
and a vertical line, or Y-axis . The axes contain measurement
scales that intersect at 0 (zero). This point is called the origin .
On the vertical scale, positive numbers lie above the horizontalaxis (that is, above the origin) and negative numbers lie belowit. On the horizontal scale, positive numbers lie to the right ofthe vertical axis (to the right of the origin) and negative num-bers lie to the left of it. The point at which the graph intersectstheY-axis is called the Y-intercept . The point at which the
graph intersects the X-axis is called the X-intercept .
When two variables are plotted on a single graph, each point
represents a pair of numbers. The first number is measured on theX-axis, and the second number is measured on the Y-axis. For
example, the following points (X, Y) are plotted on the set of axesTABLE 1A.1 Total Disposable Personal Income in the
United States, 1975–2009 (in billions of dollars)
YearTotal
DisposablePersonalIncome
YearTotalDisposablePersonal Income
1975 1,187.3 1993 4,921.6
1976 1,302.3 1994 5,184.3
1977 1,435.0 1995 5,457.0
1978 1,607.3 1996 5,759.6
1979 1,790.8 1997 6,074.6
1980 2,002.7 1998 6,498.9
1981 2,237.1 1999 6,803.3
1982 2,412.7 2000 7,327.2
1983 2,599.8 2001 7,648.5
1984 2,891.5 2002 8,009.7
1985 3,079.3 2003 8,377.8
1986 3,258.8 2004 8,889.4
1987 3,435.3 2005 9,277.3
1988 3,726.3 2006 9,915.7
1989 3,991.4 2007 10,403.1
1990 4,254.0 2008 10,806.4
1991 4,444.9 2009 10,923.6
1992 4,736.7
Source: U.S. Department of Commerce, Bureau of Economic Analysis.+
(4, 2)
X-axis–
– 1(– 3, 4)
(– 3, – 2)– 4 – 3 – 2 – 1
(2, –1)
–+Y-axis
– 2
– 3
– 44
3
1
1 34 22
/L50304FIGURE 1A.2 A Cartesian Coordinate System
A Cartesian coordinate system is constructed by drawing two perpendic-
ular lines: a vertical axis (the Y-axis) and a horizontal axis (the X-axis).
Each axis is a measuring scale.drawn in Figure 1A.2: (4, 2), (2, -1), (-3, 4), ( -3,-2). Most, but
not all, of the graphs in this book are plots of two variables whereboth values are positive numbers [such as (4, 2) in Figure 1A.2].On these graphs, only the upper-right quadrant of the coordinatesystem (that is, the quadrant in which all XandYvalues are posi-
tive) will be drawn.
Plotting Income and Consumption Data
For Households
Table 1A.2 presents data collected by the Bureau of Labor
Statistics (BLS). In a recent survey, 5,000 households wereasked to keep track of all their expenditures. This table showsaverage income and average spending for those households,
TABLE 1A.2 Consumption Expenditures and
Income, 2008
Average Income
Before TaxesAverageConsumptionExpenditures
Bottom fifth $ 10,263 $22,304
2nd fifth 27,442 31,751
3rd fifth 47,196 42,659
4th fifth 74,090 58,632
Top fifth 158,652 97,003
Source: Consumer Expenditures in 2008 , U.S. Bureau of Labor Statistics.
1The measure of income presented in Table 1A.1 and in Figure 1A.1 is disposable
personal income in billions of dollars. It is the total personal income received by allhouseholds in the United States minus the taxes that they pay.
CHAPTER 1 The Scope and Method of Economics 19
ranked by income. For example, the average income for the
top fifth (20 percent) of the households was $158,652. Theaverage spending for the top 20 percent was $97,003.
Figure 1A.3 presents the numbers from Table 1A.2
graphically using the Cartesian coordinate system. Along thehorizontal scale, the X-axis, we measure average income.
Along the vertical scale, the Y-axis, we measure average con-
sumption spending. Each of the five pairs of numbers fromthe table is represented by a point on the graph. Because allnumbers are positive numbers, we need to show only theupper right quadrant of the coordinate system.
T o help you read this graph, we have drawn a dotted line con-
necting all the points where consumption and income would beequal. This 45° line does not represent any data . Instead, it repre-
sents the line along which all variables on the X-axis correspond
exactly to the variables on the Y-axis, for example, (10,000,
10,000), (20,000, 20,000), and (37,000, 37,000). The heavy blueline traces the data; the purpose of the dotted line is to help youread the graph.
There are several things to look for when reading a graph.
The first thing you should notice is whether the line slopesupward or downward as you move from left to right. The blueline in Figure 1A.3 slopes upward, indicating that there seemsto be a positive relationship between income and spending:
The higher a household’s income, the more a household tendsto consume. If we had graphed the percentage of each groupreceiving welfare payments along the Y-axis, the line would
presumably slope downward, indicating that welfare paymentsare lower at higher income levels. The income level/welfarepayment relationship is thus a negative relationship .
Slope
Theslope of a line or curve is a measure that indicates whether
the relationship between the variables is positive or negativeand how much of a response there is in Y(the variable on thevertical axis) when X(the variable on the horizontal axis)
changes. The slope of a line between two points is the changein the quantity measured on the Y-axis divided by the change
in the quantity measured on the X-axis. We will normally use
(the Greek letter delta ) to refer to a change in a variable. In
Figure 1A.4, the slope of the line between points Aand Bis
divided by . Sometimes it is easy to remember slope as “therise over the run,” indicating the vertical change over the hori-zontal change.
T o be precise, between two points on a graph is
simply X
2minus X1,w h e r e X2is the Xvalue for the second
point and X1is the Xvalue for the first point. Similarly,
is defined as Y2minus Y1,w h e r e Y2is the Yvalue for the sec-
ond point and Y1is the Yvalue for the first point. Slope is
equal to
As we move from Ato Bin Figure 1A.4(a), both Xand Y
increase; the slope is thus a positive number. However, as wemove from Ato Bin Figure 1A.4(b), Xincreases [( X
2-X1) is
a positive number], but Ydecreases [( Y2-Y1) is a negative
number]. The slope in Figure 1A.4(b) is thus a negative num-ber because a negative number divided by a positive numberresults in a negative quotient.
T o calculate the numerical value of the slope between
points Aand Bin Figure 1A.3, we need to calculate and
. Because consumption is measured on the Y-axis,
is 9,447 [( Y
2-Y1) = (31,751 – 22,304)]. Because income is
measured along the X-axis, is 17,179 [( X2-X1) = (27,442
– 10,263)]. The slope between Aand Bis
= 9,447/17,179 = + 0.55.¢Y/¢X¢X¢Y ¢X¢Y¢Y
¢X=Y2-Y1
X2-X1¢Y¢X¢X¢Y¢
0$
20,00040,00060,000100,000120,000
80,00045/H11034 lineAverage consumption
AB
20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 $
Average income/L50298FIGURE 1A.3
Household
Consumption andIncome
A graph is a simple two-
dimensional geometric represen-
tation of data. This graph displays
the data from Table 1A.2. Alongthe horizontal scale ( X-axis), we
measure household income. Along
the vertical scale ( Y-axis), we mea-
sure household consumption.Note: At point A, consumption
equals $22,304 and income
equals $10,263. At point B, con-
sumption equals $31,751 andincome equals $27,442.
Source: See Table 1A.2.
Another interesting thing to note about the data graphed
in Figure 1A.3 is that all the points lie roughly along a straightline. (If you look very closely, however, you can see that theslope declines as you move from left to right; the line becomesslightly less steep.) A straight line has a constant slope. That is,if you pick any two points along it and calculate the slope, youwill always get the same number. A horizontal line has a zeroslope ( is zero); a vertical line has an “infinite” slope because
is too big to be measured.
Unlike the slope of a straight line, the slope of a curve is
continually changing. Consider, for example, the curves inFigure 1A.5. Figure 1A.5(a) shows a curve with a positiveslope that decreases as you move from left to right. The easi-est way to think about the concept of increasing or decreasing¢Y¢Y20 PART I Introduction to Economics
a. Positive slope b. Negative slope
00B
X X1X2Y2Y1
Y1Y2Y Y
/H9004Y /H9004Y
/H9004X /H9004XX1X2ABA
X
/L50304FIGURE 1A.4 A Curve with (a) Positive Slope and (b) Negative Slope
Apositive slope indicates that increases in Xare associated with increases in Yand that decreases in Xare
associated with decreases in Y. A negative slope indicates the opposite—when Xincreases, Ydecreases; and
when Xdecreases, Yincreases.
YYY
Y YX X X 0
00
00
0 X Xa. Slope: positive and decreasing b. Slope: positive and increasing c. Slope: negative and increasing
d. Slope: negative and decreasing e. Slope: positive, then negative f. Slope: negative, then positive
A
A
XY
/L50304FIGURE 1A.5 Changing Slopes Along Curves
CHAPTER 1 The Scope and Method of Economics 21
4,000
3,000
2,000
1,0007,0008,0009,00010,00011,000
6,000
5,000
1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000 13,0000
Aggregate national income (billions of dollars)Aggregate consumption (billions of dollars)19902000
1980 19701930
1960
194045/H11034 195045/H11034 line20052006 200720082009
/L50304FIGURE 1A.6 National Income and Consumption
It is important to think carefully about what is represented by points in the space defined by the axes of a
graph. In this graph, we have graphed income with consumption, as in Figure 1A.3, but here each observa-tion point is national income and aggregate consumption in different years , measured in billions of dollars.
Source: See Table 1A.3.Some Precautions
When you read a graph, it is important to think carefully
about what the points in the space defined by the axes rep-resent. Table 1A.3 and Figure 1A.6 present a graph ofconsumption and income that is very different from the oneslope is to imagine what it is like walking up a hill from left
to right. If the hill is steep, as it is in the first part ofFigure 1A.5(a), you are moving more in the Ydirection for
each step you take in the Xdirection. If the hill is less steep, as
it is further along in Figure 1A.5(a), you are moving less intheYdirection for every step you take in the Xdirection.
Thus, when the hill is steep, slope ( ) is a larger num-ber than it is when the hill is flatter. The curve inFigure 1A.5(b) has a positive slope, but its slope increases as
you move from left to right.
The same analogy holds for curves that have a negative
slope. Figure 1A.5(c) shows a curve with a negative slopethat increases (in absolute value) as you move from left toright. This time think about skiing down a hill. At first, thedescent in Figure 1A.5(c) is gradual (low slope), but as youproceed down the hill (to the right), you descend morequickly (high slope). Figure 1A.5(d) shows a curve with anegative slope that decreases (in absolute value) as you move
from left to right.
In Figure 1A.5(e), the slope goes from positive to negative
asXincreases. In Figure 1A.5(f), the slope goes from
negative to positive. At point Ain both, the slope is zero.
[Remember, slope is defined as . At point A,Yis not
changing ( = 0). Therefore, the slope at point A is zero.] ¢Y¢Y/¢X¢Y/¢X
TABLE 1A.3 Aggregate National Income and
Consumption for the United States,1930–2009 (in billions of dollars)
Aggregate National Income Aggregate Consumption
1930 82.9 70.1
1940 90.9 71.3
1950 263.9 192.2
1960 473.9 331.8
1970 929.5 648.3
1980 2,433.0 1,755.8
1990 5,059.8 3,835.5
2000 8,938.9 6,830.4
2005 11,273.8 8,819.0
2006 12,031.2 9,322.7
2007 12,448.2 9,826.4
2008 12,635.2 10,129.9
2009 12,280.0 10,089.1
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
APPENDIX SUMMARY
1.Agraph is a two-dimensional representation of a set of num-
bers, or data. A time series graph illustrates how a single vari-
able changes over time.
2.The most common method of graphing two variables on
one graph is the Cartesian coordinate system , which includes
anX(horizontal)- axis and a Y(vertical)- axis. The points at
which the two axes intersect is called the origin . The point at
which a graph intersects the Y-axis is called the Y-intercept .
The point at which a graph intersects the X-axis is called the
X-intercept .in Table 1A.2 and Figure 1A.3. First, each point in
Figure 1A.6 represents a different year; in Figure 1A.3, eachpoint represented a different group of households at thesame point in time (2008). Second, the points in Figure 1A.6
represent aggregate consumption and income for the whole
nation measured in billions of dollars; in Figure 1A.3, the
points represented average household income and consump-
tion measured in dollars.It is interesting to compare these two graphs. All points on
the aggregate consumption curve in Figure 1A.6 lie below the45° line, which means that aggregate consumption is alwaysless than aggregate income. However, the graph of averagehousehold income and consumption in Figure 1A.3 crosses the45° line, implying that for some households, consumption islarger than income.
3.The slope of a line or curve indicates whether the relation-
ship between the two variables graphed on a Cartesian coor-dinate system is positive or negative and how much of aresponse there is in Y(the variable on the vertical axis) when
X(the variable on the horizontal axis) changes. The slope of
a line between two points is the change in the quantity mea-sured on the Y-axis divided by the change in the quantity
measured on the X-axis.
APPENDIX REVIEW TERMS AND CONCEPTS
Cartesian coordinate system A common
method of graphing two variables that makes
use of two perpendicular lines against which
the variables are plotted. p. 18
graph A two-dimensional representation
of a set of numbers or data. p. 17
negative relationship A relationship
between two variables, Xand Y, in which a
decrease in Xis associated with an increase
inYand an increase in Xis associated with a
decrease in Y.p. 19
origin On a Cartesian coordinate system,
the point at which the horizontal and vertical
axes intersect. p. 18positive relationship A relationship
between two variables, Xand Y, in which a
decrease in Xis associated with a decrease
inY, and an increase in Xis associated with
an increase in Y.p. 19
slope A measurement that indicates
whether the relationship between variables
is positive or negative and how much of a
response there is in Y(the variable on the
vertical axis) when X(the variable on the
horizontal axis) changes. p. 19
time series graph A graph illustrating how
a variable changes over time. p. 17X-axis On a Cartesian coordinate system,
the horizontal line against which a variable is
plotted. p. 18
X-intercept The point at which a graph
intersects the X-axis. p. 18
Y-axis On a Cartesian coordinate system,
the vertical line against which a variable is
plotted. p. 18
Y-intercept The point at which a graph
intersects the Y-axis. p. 1822 PART I Introduction to Economics
APPENDIX PROBLEMS
1.Graph each of the following sets of numbers. Draw a line
through the points and calculate the slope of each line.2.For each of the graphs in Figure 1, determine whether the curve
has a positive or negative slope. Give an intuitive explanation forwhat is happening with the slope of each curve.
3.For each of the following equations, graph the line and calculate
its slope.a.P=1 0 -2q
D(Put qDon the X-axis.)
b.P= 100 -4qD(Put qDon the X-axis.)
c.P= 50 + 6 qS(Put qSon the X-axis.)
d.I= 10,000 -500r(Put Ion the X-axis.)1 2 3 4 5 6
X Y X Y X Y X Y X Y X Y
1 5 1 25 0 0 0 40 0 0 0.1 100
2 10 2 20 10 10 10 30 10 10 0.2 75
3 15 3 15 20 20 20 20 20 20 0.3 50
4 20 4 10 30 30 30 10 30 10 0.4 25
5 25 5 5 40 40 40 0 40 0 0.5 0
CHAPTER 1 The Scope and Method of Economics 23Price per unit
Taxes paid
Quantity of apples purchased
Days of sunshine Fastest time for
a 10K race
Tons of fertilizer
per acreHome sales
Bushels of corn
per acreBushels of corn
per acreAge 00
00
00 Income
Mortgage interest ratea. b. c.
d. e. f.
/L50304FIGURE 1
0B34
24A
Quantity 140 90Price
per
unit
45 2012
5Demand4.The following table shows the relationship between the price of
a dozen roses and the number of roses sold by Fiona’s Flowers.a.Is the relationship between the price of roses and the num-
ber of roses sold by Fiona’s Flowers a positive relationship or
a negative relationship? Explain.
b.Plot the data from the table on a graph, draw a line through
the points, and calculate the slope of the line.5.Calculate the slope of the demand curve at point Aand at point B
in the following figure.
PRICE PER
DOZENQUANTITY OF
ROSES (DOZENS) MONTH
$20 30 January
50 90 February
25 40 March
30 50 April
40 70 May
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CHAPTER OUTLINE
25The Economic
Problem: Scarcity
and Choice
Chapter 1 began with a very broad
definition of economics. Everysociety, no matter how small orlarge, no matter how simple orcomplex, has a system or processthat works to transform theresources that nature and previousgenerations provide into usefulform. Economics is the study ofthat process and its outcomes.
Figure 2.1 illustrates three
basic questions that must beanswered to understand the func-tioning of the economic system:
/L50766What gets produced?
/L50766How is it produced?
/L50766Who gets what is produced?
This chapter explores these questions in detail. In a sense, this entire chapter isthe defini-
tion of economics. It lays out the central problems addressed by the discipline and presents aframework that will guide you through the rest of the book. The starting point is the presump-tion that human wants are unlimited but resources are not . Limited or scarce resources force indi-
viduals and societies to choose among competing uses of resources—alternative combinationsof produced goods and services—and among alternative final distributions of what is producedamong households.
These questions are positive ordescriptive . That is, they ask how the system functions without
passing judgment about whether the result is good or bad. They must be answered first before weask more normative questions such as these:
/L50766Is the outcome good or bad?
/L50766Can it be improved?
The term resources is very broad. The sketch on the left side of Figure 2.1 shows several cate-
gories of resources. Some resources are the products of nature: land, wildlife, fertile soil, minerals,timber, energy, and even the rain and wind. In addition, the resources available to an economyinclude things such as buildings and equipment that have been produced in the past but are nowbeing used to produce other things. And perhaps the most important resource of a society is itshuman workforce with people’s talents, skills, and knowledge.
Things that are produced and then used in the production of other goods and services are
called capital resources, or simply capital . Buildings, equipment, desks, chairs, software, roads,
bridges, and highways are a part of the nation’s stock of capital.
The basic resources available to a society are often referred to as factors of production ,
or simply factors . The three key factors of production are land, labor, and capital. The
process that transforms scarce resources into useful goods and services is called production .
In many societies, most of the production of goods and services is done by private firms.2
Scarcity, Choice, and
Opportunity Cost
p. 26
Scarcity and Choice in a
One-Person Economy
Scarcity and Choice in an
Economy of Two or More
The Production Possibility
Frontier
The Economic Problem
Economic Systems
and the Role ofGovernment
p. 39
Command Economies
Laissez-Faire Economies:
The Free Market
Mixed Systems, Markets,
and Governments
Looking Ahead p. 42
capital Things that are
produced and then used inthe production of othergoods and services.
factors of production ( or
factors) The inputs into the
process of production.Another term f or resources.
production The process
that transforms scarce
resources into useful goods
and services.
26 PART I Introduction to Economics
/L50304FIGURE 2.1 The Three Basic Questions
Every society has some system or process that transforms its scarce resources into useful goods and services.
In doing so, it must decide what gets produced, how it is produced, and to whom it is distributed. The pri-
mary resources that must be allocated are land, labor, and capital.ResourcesProducersThe three basic questions:
Allocation of resources Distribution of outputMix of output
Households1. What gets produced? 2. How is it produced? 3. Who gets what is produced?
Private airlines in the United States use land (runways), labor (pilots and mechanics), and cap-
ital (airplanes) to produce transportation services. But in all societies, some production is doneby the public sector, or government. Examples of government-produced or government-provided goods and services include national defense, public education, police protection, andfire protection.
Resources or factors of production are the inputs into the process of production; goods and
services of value to households are the outputs of the process of production.
Scarcity, Choice, and Opportunity Cost
In the second half of this chapter we discuss the global economic landscape. Before you can
understand the different types of economic systems, it is important to master the basic economicconcepts of scarcity, choice, and opportunity cost.
Scarcity and Choice in a One-Person Economy
The simplest economy is one in which a single person lives alone on an island. Consider Bill, thesurvivor of a plane crash, who finds himself cast ashore in such a place. Here individual and soci-ety are one; there is no distinction between social and private. Nonetheless, nearly all the same
basic decisions that characterize complex economies must also be made in a simple economy . That is,
although Bill will get whatever he produces, he still must decide how to allocate the island’sresources, what to produce, and how and when to produce it.
First, Bill must decide what he wants to produce. Notice that the word needs does not appear
here. Needs are absolute requirements; but beyond just enough water, basic nutrition, and shelterto survive, needs are very difficult to define. What is an “absolute necessity” for one person maynot be for another person. In any case, Bill must put his wants in some order of priority and makesome choices.
Next, he must look at the possibilities . What can he do to satisfy his wants given the limits of
the island? In every society, no matter how simple or complex, people are constrained in whatthey can do. In this society of one, Bill is constrained by time, his physical condition, his knowl-edge, his skills, and the resources and climate of the island.
Given that resources are limited, Bill must decide how to best use them to satisfy his hierar-
chy of wants. Food would probably come close to the top of his list. Should he spend his timegathering fruits and berries? Should he hunt for game? Should he clear a field and plant seeds?inputs orresources
Anything provided by nature or
previous generations that canbe used directly or indirectly to
satisfy human wants.
outputs Goods and services
of value to households.
CHAPTER 2 The Economic Problem: Scarcity and Choice 27
The answers to those questions depend on the character of the island, its climate, its flora and
fauna ( arethere any fruits and berries?), the extent of his skills and knowledge (does he know
anything about farming?), and his preferences (he may be a vegetarian).
Opportunity Cost The concepts of constrained choice and scarcity are central to the disci-
pline of economics. They can be applied when discussing the behavior of individuals such as Billand when analyzing the behavior of large groups of people in complex societies.
Given the scarcity of time and resources, if Bill decides to hunt, he will have less time to
gather fruits and berries. He faces a trade-off between meat and fruit. There is a trade-offbetween food and shelter too. If Bill likes to be comfortable, he may work on building a niceplace to live, but that may require giving up the food he might have produced. As we noted inChapter 1, the best alternative that we give up, or forgo, when we make a choice is theopportunity cost of that choice.
Bill may occasionally decide to rest, to lie on the beach, and to enjoy the sun. In one sense,
that benefit is free—he does not have to buy a ticket to lie on the beach. In reality, however, relax-ing does have an opportunity cost. The true cost of that leisure is the value of the other things Billcould have produced, but did not, during the time he spent on the beach.
During 2010, more than a dozen cities, including Minneapolis, Los Angeles, and Houston,
were actively considering public funding for new football, soccer, and basketball arenas. Animportant part of that debate was the opportunity cost of the taxpayers’ dollars: What else couldtax dollars be spent on, and how much value would the alternatives bring to the local taxpayers?Perhaps without the new arena, taxes could be lower. Here the opportunity cost would includethe value taxpayers receive from goods and services they would consume with the earnings thatare no longer taxed. Most discussions of public expenditures at all levels of government includeactive considerations of opportunity costs.
In making everyday decisions, it is often helpful to think about opportunity costs. Should you
go to the dorm party or not? First, it costs $4 to attend. When you pay money for anything, yougive up the other things you could have bought with that money. Second, it costs 2 or 3 hours.Time is a valuable commodity for a college student. Y ou have exams next week, and you need tostudy. Y ou could go to a movie instead of the party. Y ou could go to another party. Y ou could sleep.Just as Bill must weigh the value of sunning on the beach against more food or better housing, soyou must weigh the value of the fun you may have at the party against everything else you mightotherwise do with the time and money.
Scarcity and Choice in an Economy of Two or More
Now suppose that another survivor of the crash, Colleen, appears on the island. Now that Billis not alone, things are more complex and some new decisions must be made. Bill’s andColleen’s preferences about what things to produce are likely to be different. They will proba-bly not have the same knowledge or skills. Perhaps Colleen is very good at tracking animals andBill has a knack for building things. How should they split the work that needs to be done?Once things are produced, the two castaways must decide how to divide them. How shouldtheir products be distributed?
The mechanism for answering these fundamental questions is clear when Bill is alone on
the island. The “central plan” is his; he simply decides what he wants and what to do about it.The minute someone else appears, however, a number of decision-making arrangementsimmediately become possible. One or the other may take charge, in which case that personwill decide for both of them. The two may agree to cooperate, with each having an equal say,and come up with a joint plan; or they may agree to split the planning as well as the produc-tion duties. Finally, they may go off to live alone at opposite ends of the island. Even if theylive apart, however, they may take advantage of each other’s presence by specializing and trading.
Modern industrial societies must answer the same questions that Colleen and Bill must
answer, but the mechanics of larger economies are more complex. Instead of two people livingtogether, the United States has over 300 million people. Still, decisions must be made about whatto produce, how to produce it, and who gets it.opportunity cost The best
alternative that we give up, or
forgo, when we make a choice
or decision.
28 PART I Introduction to Economics
absolute advantage
A producer has an absolute
advantage over another in the
production of a good orservice if he or she can producethat product using fewerresources.Specialization, Exchange, and Comparative Advantage The idea that mem-
bers of society benefit by specializing in what they do best has a long history and is one of themost important and powerful ideas in all of economics. David Ricardo, a major nineteenth-century British economist, formalized the point precisely. According to Ricardo’s theory of
comparative advantage , specialization and free trade will benefit all trading parties, even
when some are “absolutely” more efficient producers than others. Ricardo’s basic point appliesjust as much to Colleen and Bill as it does to different nations.
T o keep things simple, suppose that Colleen and Bill have only two tasks to accomplish each
week: gathering food to eat and cutting logs to burn. If Colleen could cut more logs than Bill in1 day and Bill could gather more nuts and berries than Colleen could, specialization would clearlylead to more total production. Both would benefit if Colleen only cuts logs and Bill only gathersnuts and berries, as long as they can trade.
Suppose that Bill is slow and somewhat clumsy in his nut gathering and that Colleen is bet-
ter at cutting logs and gathering food. At first, it might seem that since Colleen is better at every-
thing, she should do everything. But that cannot be right. Colleen’s time is limited after all, andeven though Bill is clumsy and not very clever, he must be able to contribute something.
One of Ricardo’s lasting contributions to economics has been his analysis of exactly this sit-
uation. His analysis, which is illustrated in Figure 2.2, shows both how Colleen and Bill shoulddivide the work of the island and how much they will gain from specializing and exchanging evenif, as in this example, one party is absolutely better at everything than the other party.
Suppose Colleen can cut 10 logs per day and Bill can cut only 4. Also suppose Colleen can
gather 10 bushels of food per day and Bill can gather only 8. A producer has an absolute
advantage over another in the production of a good or service if he or she can produce the
good or service using fewer resources, including time. Since Colleen can cut more logs per daythan Bill, we say that she has an absolute advantage in the production of logs. Similarly, Colleenhas an absolute advantage over Bill in the production of food.
ECONOMICS IN PRACTICE
Frozen Foods and Opportunity Costs
In 2007, $27 billion of frozen foods were sold in U.S. grocery
stores, one quarter of it in the form of frozen dinners and entrees.In the mid-1950s, sales of frozen foods amounted to only $1 bil-lion, a tiny fraction of the overall grocery store sales. One industryobserver attributes this growth to the fact that frozen food tastesmuch better than it did in the past. Can you think of anything elsethat might be occurring?
The growth of the frozen dinner entrée market in the last 50 years
is a good example of the role of opportunity costs in our lives. One ofthe most significant social changes in the U.S. economy in this periodhas been the increased participation of women in the labor force. In1950, only 24 percent of married women worked; by 2000, that frac-tion had risen to 61 percent. Producing a meal takes two basic ingre-dients: food and time. When both husbands and wives work, theopportunity cost of time for housework—including making meals—goes up. This tells us that making a home-cooked meal became moreexpensive in the last 50 years. A natural result is to shift people towardlabor-saving ways to make meals. Frozen foods are an obvious solu-tion to the problem of increased opportunity costs.
Another, somewhat more subtle, opportunity cost story is at work
encouraging the consumption of frozen foods. In 1960, the first
microwave oven was introduced. The spread of this device intoAmerica’s kitchens was rapid. The microwave turned out to be a quickway to defrost and cook those frozen entrées. So this technology low-ered the opportunity cost of making frozen dinners, reinforcing theadvantage these meals
had over home-cookedmeals. Microwaves
made cooking with
frozen foods cheaperonce opportunity costwas considered whilehome-cooked meals
were becoming more
expensive.
The entrepreneurs among you also might recognize that the rise
we described in the opportunity cost of the home-cooked mealcontributed in part to the spread of the microwave, creating a rein-
forcing cycle. In fact, many entrepreneurs find that the simple tools of
economics—like the idea of opportunity costs—help them anticipate
what products will be profitable for them to produce in the future.The growth of the two-worker family has stimulated many entrepre-neurs to search for labor-saving solutions to family tasks.
The public policy students among you might be interested to
know that some researchers attribute part of the growth in obesity in
the United States to the lower opportunity costs of making mealsassociated with the growth of the markets for frozen foods and themicrowave. (See David M.Cutler, Edward L. Glaeser, and Jesse M.Shapiro, ”Why Have Americans Become More Obese?” Journal of
Economic Perspectives , Summer 2003, 93–118.)
theory of comparative
advantage Ricardo’s theory
that specialization and free
trade will benefit all trading
parties, even those that may be“absolutely” more efficient
producers.
CHAPTER 2 The Economic Problem: Scarcity and Choice 29
Thinking just about productivity and the output of food and logs, you might conclude that
it would benefit Colleen to move to the other side of the island and be by herself. Since she ismore productive in cutting logs and gathering food, would she not be better off on her own? Howcould she benefit by hanging out with Bill and sharing what they produce?
T o answer that question we must remember that Colleen’s time is limited: This limit creates
opportunity cost. A producer has a comparative advantage over another in the production of
a good or service if he or she can produce the good or service at a lower opportunity cost. First,think about Bill. He can produce 8 bushels of food per day, or he can cut 4 logs. T o get 8 addi-tional bushels of food, he must give up cutting 4 logs. Thus, for Bill, the opportunity cost of
8 bushels of food is 4 logs . Think next about Colleen. She can produce 10 bushels of food per day,
or she can cut 10 logs. She thus gives up 1 log for each additional bushel; so for Colleen, the
opportunity cost of 8 bushels of food is 8 logs . Bill has a comparative advantage over Colleen in the
production of food because he gives up only 4 logs for an additional 8 bushels, whereas Colleengives up 8 logs.
Think now about what Colleen must give up in terms of food to get 10 logs. T o produce
10 logs she must work a whole day. If she spends a day cutting 10 logs, she gives up a day of gath-ering 10 bushels of food. Thus, for Colleen, the opportunity cost of 10 logs is 10 bushels of food . What
m u s tB i l lg i v eu pt og e t1 0l o g s ?T op r o d u c e4l o g s ,h em u s tw o r k1d a y .F o re a c hd a yh ec u t sl o g s ,he gives up 8 bushels of food. He thus gives up 2 bushels of food for each log; so for Bill, the
opportunity cost of 10 logs is 20 bushels of food . Colleen has a comparative advantage over Bill in the
production of logs since she gives up only 10 bushels of food for an additional 10 logs, whereasBill gives up 20 bushels.
Ricardo argues that two parties can benefit from specialization and trade even if one party
has an absolute advantage in the production of both goods. Suppose Colleen and Bill both wanta. Daily production
BillColleenWood
(logs)Food
(bushels)
10 10
48
b. Monthly production
with no trade
BillColleenWood
(logs)Food
(bushels)
150 150
80 80
Total 230 230c. Monthly production
after specialization
BillColleenWood
(logs)Food
(bushels)
270 30
0 240
Total 270 270
d. Monthly use
after trade
BillColleenWood
(logs)Food
(bushels)
170 170
100 100
Total 270 270/L50296FIGURE 2.2
Comparative Advantage
and the Gains from Trade
In this figure, (a) shows the
number of logs and bushels of
food that Colleen and Bill canproduce for every day spent atthe task and (b) shows how
much output they could produce
in a month, assuming theywanted an equal number of logsand bushels. Colleen would split
her time 50/50, devoting 15 days
to each task and achieving totaloutput of 150 logs and150 bushels of food. Bill would
spend 20 days cutting wood and
10 days gathering food. Asshown in (c) and (d), by special-izing and trading, both Colleen
and Bill will be better off. Going
from (c) to (d), Colleen trades100 logs to Bill in exchange for140 bushels of food.
comparative advantage A
producer has a comparative
advantage over another in the
production of a good orservice if he or she can produce
that product at a lower
opportunity cost .
30 PART I Introduction to Economics
A Graphical Presentation of Comparative Advantage and Gains from Trade Graphs
can also be used to show the benefits from specialization and trade in the example of Colleenand Bill. T o construct a graph reflecting Colleen’s production choices (Figure 2.3 [a]), we startwith the end points. If she were to devote an entire month (30 days) to log production,she could cut 300 logs—10 logs per day /H1100330 days. Similarly, if she were to devote an entire
month to food gathering, she could produce 300 bushels. If she chose to split her time evenly(15 days to logs and 15 days to food), she would have 150 bushels and 150 logs. Her produc-tion possibilities are illustrated by the straight line between Aand Band illustrate the trade-
off that she faces between logs and food: By reducing her time spent in food gathering,Colleen is able to devote more time to logs; and for every 10 bushels of food that she gives up,she gets 10 logs.
In Figure 2.3(b), we construct a graph of Bill’s production possibilities. Recall that Bill
can produce 8 bushels of food per day, but he can cut only 4 logs. Again, starting with theend points, if Bill devoted all his time to food production, he could produce 240 bushels—8 bushels of food per day /H1100330 days. Similarly, if he were to devote the entire 30 days to log
cutting, he could cut 120 logs—4 logs per day /H1100330 days. By splitting his time, with 20 days
spent on log cutting and 10 days spent gathering food, Bill could produce 80 logs and80 bushels of food. His production possibilities are illustrated by the straight line betweenDand E. By shifting his resources and time from logs to food, he gets 2 bushels for every log.
Figures 2.3(a) and 2.3(b) illustrate the maximum amounts of food and logs that Bill and
Colleen can produce acting independently with no specialization or trade, which is 230 logs and230 bushels. Now let us have each specialize in producing the good in which he or she has a com-parative advantage. Back in Figure 2.2 on p. 29, we showed that if Bill devoted all his time to foodproduction, producing 240 bushels (30 days /H110038 bushels per day), and Colleen devoted the vast
majority of her time to cutting logs (27 days) and just a few days to gathering food (3 days), theircombined total would be 270 logs and 270 bushels of food. Colleen would produce 270 logs and30 bushels of food to go with Bill’s 240 bushels of food.
Finally, we arrange a trade, and the result is shown in Figures 2.4(a) and 2.4(b). Bill trades
140 bushels of food to Colleen for 100 logs, and he ends up with 100 logs and 100 bushels of food,20 more of each than he would have had before the specialization and trade.equal numbers of logs and bushels of food. If Colleen goes off on her own, in a 30-day month she
can produce 150 logs and 150 bushels, devoting 15 days to each task. For Bill to produce equalnumbers of logs and bushels on his own requires that he spend 10 days on food and 20 days onlogs. This yields 80 bushels of food (10 days /H110038 bushels per day) and 80 logs (20 days /H110034 logs
per day). Between the two, they produce 230 logs and 230 bushels of food.
Let’s see if specialization and trade can work. If Bill spends all his time on food, he pro-
duces 240 bushels in a month (30 days /H110038 bushels per day). If Colleen spends 3 days on food
and 27 days on logs, she produces 30 bushels of food (3 days /H1100310 bushels per day) and
270 logs (27 days /H1100310 logs per day). Between the two, they produce 270 logs and 270 bushels
of food, which is more than the 230 logs and 230 bushels they produced when not specializ-ing. Thus, by specializing in the production of the good in which they enjoyed a comparativeadvantage, there are more of both goods. We see in this example how the fundamentalconcept of opportunity cost covered earlier in this chapter relates to the theory of compara-tive advantage.
Even if Colleen were to live at another place on the island, she could specialize, producing
30 bushels of food and 270 logs, then trading 100 of her logs to Bill for 140 bushels of food. Thiswould leave her with 170 logs and 170 bushels of food, which is more than the 150 of each shecould produce on her own. Bill would specialize completely in food, producing 240 bushels.Trading 140 bushels of food to Colleen for 100 logs leaves him with 100 of each, which is morethan the 80 of each he could produce on his own.
The simple example of Bill and Colleen should begin to give you some insight into why
most economists see value in free trade. Even if one country is absolutely better than anothercountry at producing everything, our example has shown that there are gains to specializingand trading.
CHAPTER 2 The Economic Problem: Scarcity and Choice 31
a. Colleen’s production possibilities (monthly output) b. Bill’s production possibilities (monthly output)
B300
150
0 150 300LogsA
C
Food bushelsD
F
E
8080
0120
240
Food bushelsLogs
/L50304FIGURE 2.3 Production Possibilities with No Trade
The figure in (a) shows all of the combinations of logs and bushels of food that Colleen can produce by
herself. If she spends all 30 days each month on logs, she produces 300 logs and no food (point A). If she
spends all 30 days on food, she produces 300 bushels of food and no logs (point B). If she spends 15 days
on logs and 15 days on food, she produces 150 of each (point C).
The figure in (b) shows all of the combinations of logs and bushels of food that Bill can produce by him-
self. If he spends all 30 days each month on logs, he produces 120 logs and no food (point D). If he
spends all 30 days on food, he produces 240 bushels of food and no logs (point E). If he spends 20 days
on logs and 10 days on food, he produces 80 of each (point F).
a. Colleen moves beyond her
original production possibilitiesb. Bill moves beyond his
original production possibilities
0300
150170
150 170 300CC´
Food bushelsLogs
80 080120
100
240 100FF´
Food bushelsLogs
/L50304FIGURE 2.4 Colleen and Bill Gain from Trade
By specializing and engaging in trade, Colleen and Bill can move beyond their own production possibilities.
If Bill spends all his time producing food, he will produce 240 bushels of food and no logs. If he can trade140 of his bushels of food to Colleen for 100 logs, he will end up with 100 logs and 100 bushels of food.The figure in (b) shows that he can move from point Fto point F'.
If Colleen spends 27 days cutting logs and 3 days producing food, she will produce 270 logs and 30 bushels
of food. If she can trade 100 of her logs to Bill for 140 bushels of food, she will end up with 170 logs and170 bushels of food. The figure in (a) shows that she can move from point Cto point C'.
Colleen ends up with 170 logs and 170 bushels, again 20 more of each than she would have
had before the specialization and trade. Both are better off. Both move beyond their individualproduction possibilities.
Weighing Present and Expected Future Costs and Benefits Very often we find
ourselves weighing benefits available today against benefits available tomorrow. Here, too, thenotion of opportunity cost is helpful.
32 PART I Introduction to Economics
While alone on the island, Bill had to choose between cultivating a field and just gathering
wild nuts and berries. Gathering nuts and berries provides food now; gathering seeds and clear-ing a field for planting will yield food tomorrow if all goes well. Using today’s time to farm maywell be worth the effort if doing so will yield more food than Bill would otherwise have in thefuture. By planting, Bill is trading present value for future value.
The simplest example of trading present for future benefits is the act of saving. When you put
income aside today for use in the future, you give up some things that you could have had today inexchange for something tomorrow. Because nothing is certain, some judgment about futureevents and expected values must be made. What will your income be in 10 years? How long arey o ul i k e l yt ol i v e ?
We trade off present and future benefits in small ways all the time. If you decide to study
instead of going to the dorm party, you are trading present fun for the expected future benefits ofhigher grades. If you decide to go outside on a very cold day and run 5 miles, you are trading dis-comfort in the present for being in better shape later.
Capital Goods and Consumer Goods A society trades present for expected future
benefits when it devotes a portion of its resources to research and development or to invest-ment in capital. As we said earlier in this chapter, capital in its broadest definition is anything
that has already been produced that will be used to produce other valuable goods or servicesover time.
Building capital means trading present benefits for future ones. Bill and Colleen might trade
gathering berries or lying in the sun for cutting logs to build a nicer house in the future. In amodern society, resources used to produce capital goods could have been used to produceconsumer goods —that is, goods for present consumption. Heavy industrial machinery does not
directly satisfy the wants of anyone, but producing it requires resources that could instead havegone into producing things that do satisfy wants directly—for example, food, clothing, toys, orgolf clubs.
Capital is everywhere. A road is capital. Once a road is built, we can drive on it or transport
goods and services over it for many years to come. A house is also capital. Before a new manufac-turing firm can start up, it must put some capital in place. The buildings, equipment, and inven-tories that it uses comprise its capital. As it contributes to the production process, this capitalyields valuable services over time.
In Chapter 1, we talked about the enormous amount of capital—buildings, factories, housing,
cars, trucks, telephone lines, and so on—that you might see from a window high in a skyscraper.Much of that capital was put in place by previous generations, yet it continues to provide valuableservices today; it is part of this generation’s endowment of resources. T o build every building, everyroad, every factory, every house, and every car or truck, society must forgo using resources to pro-duce consumer goods today. T o get an education, you pay tuition and put off joining the workforcefor a while.
Capital does not need to be tangible. When you spend time and resources developing skills or
getting an education, you are investing in human capital—your own human capital. This capitalwill continue to exist and yield benefits to you for years to come. A computer program producedby a software company and available online may cost nothing to distribute, but its true intangiblevalue comes from the ideas embodied in the program itself. It too is capital.
The process of using resources to produce new capital is called investment . (In everyday lan-
guage, the term investment often refers to the act of buying a share of stock or a bond, as in “I
invested in some Treasury bonds.” In economics, however, investment always refers to the cre-
ation of capital: the purchase or putting in place of buildings, equipment, roads, houses, and thelike.) A wise investment in capital is one that yields future benefits that are more valuable thanthe present cost. When you spend money for a house, for example, presumably you value itsfuture benefits. That is, you expect to gain more from living in it than you would from the thingsyou could buy today with the same money. Capital can also be intangible. Consider educationthat builds skills or knowledge in workers. Clearly education can yield decades of future “bene-fits” including higher wages. Because resources are scarce, the opportunity cost of every invest-ment in capital is forgone present consumption.
investment The process of
using resources to producenew capital.consumer goods Goods
produced for presentconsumption.
CHAPTER 2 The Economic Problem: Scarcity and Choice 33
production possibility
frontier (ppf) A graph that
shows all the combinations of
goods and services that can beproduced if all of society’sresources are used efficiently.
A
G
F
E
B800
550
Consumer goodsCapital goods
0
1,100 1,300D
/L50304FIGURE 2.5 Production Possibility Frontier
The ppf illustrates a number of economic concepts. One of the most important is opportunity cost . The opportu-
nity cost of producing more capital goods is fewer consumer goods. Moving from Eto F, the number of capi-
tal goods increases from 550 to 800, but the number of consumer goods decreases from 1,300 to 1,100.The Production Possibility Frontier
A simple graphic device called the production possibility frontier (ppf ) illustrates the princi-
ples of constrained choice, opportunity cost, and scarcity. The ppf is a graph that shows all thecombinations of goods and services that can be produced if all of a society’s resources are usedefficiently. Figure 2.5 shows a ppf for a hypothetical economy.
On the Y-axis, we measure the quantity of capital goods produced. On the X-axis, we mea-
sure the quantity of consumer goods. All points below and to the left of the curve (the shadedarea) represent combinations of capital and consumer goods that are possible for the societygiven the resources available and existing technology. Points above and to the right of the curve,such as point G, represent combinations that cannot be reached. If an economy were to end up
at point Aon the graph, it would be producing no consumer goods at all; all resources would be
used for the production of capital. If an economy were to end up at point B, it would be devot-
ing all its resources to the production of consumer goods and none of its resources to the forma-tion of capital.
While all economies produce some of each kind of good, different economies emphasize dif-
ferent things. About 17.1 percent of gross output in the United States in 2005 was new capital. InJapan, capital historically accounted for a much higher percent of gross output, while in theCongo, the figure was 7 percent. Japan is closer to point Aon its ppf, the Congo is closer to B, and
the United States is somewhere in between.
Points that are actually on the ppf are points of both full resource employment and pro-
duction efficiency. (Recall from Chapter 1 that an efficient economy is one that produces thethings that people want at the least cost. Production efficiency is a state in which a given mix
of outputs is produced at the least cost.) Resources are not going unused, and there is nowaste. Points that lie within the shaded area but that are not on the frontier represent eitherunemployment of resources or production inefficiency. An economy producing at point Din
Figure 2.5 can produce more capital goods and more consumer goods, for example, by mov-ing to point E. This is possible because resources are not fully employed at point Dor are not
being used efficiently.
34 PART I Introduction to Economics
B
A
0C
Bushels
of wheat
Wheat production Bushels
of corn
Corn production /L50298FIGURE 2.6
Inefficiency from
Misallocation of Land in Farming
Society can end up inside its ppf
at a point such as Aby using its
resources inefficiently. If, for
example, Ohio’s climate and soilwere best suited for corn produc-tion and those of Kansas were
best suited for wheat produc-
tion, a law forcing Kansas farm-ers to produce corn and Ohiofarmers to produce wheat would
result in less of both. In such a
case, society might be at point A
instead of point B.Unemployment During the Great Depression of the 1930s, the U.S. economy experienced
prolonged unemployment. Millions of workers found themselves without jobs. In 1933, 25 per-cent of the civilian labor force was unemployed. This figure stayed above 14 percent until 1940.More recently, between the end of 2007 and 2010, the United States lost over 8 million payrolljobs and unemployment rose to over 15 million.
In addition to the hardship that falls on the unemployed, unemployment of labor means
unemployment of capital. During economic downturns or recessions, industrial plants run at lessthan their total capacity. When there is unemployment of labor and capital, we are not producingall that we can.
Periods of unemployment correspond to points inside the ppf, points such as Din Figure 2.5.
Moving onto the frontier from a point such as Dmeans achieving full employment of resources.
Inefficiency Although an economy may be operating with full employment of its land, labor,
and capital resources, it may still be operating inside its ppf (at a point such as Din Figure 2.5). It
could be using those resources inefficiently .
Waste and mismanagement are the results of a firm operating below its potential. If you are
the owner of a bakery and you forget to order flour, your workers and ovens stand idle while youfigure out what to do.
Sometimes inefficiency results from mismanagement of the economy instead of misman-
agement of individual private firms. Suppose, for example, that the land and climate in Ohio arebest suited for corn production and that the land and climate in Kansas are best suited for wheatproduction. If Congress passes a law forcing Ohio farmers to plant 50 percent of their acreagewith wheat and Kansas farmers to plant 50 percent with corn, neither corn nor wheat productionwill be up to potential. The economy will be at a point such as Ain Figure 2.6—inside the ppf.
Allowing each state to specialize in producing the crop that it produces best increases the pro-duction of both crops and moves the economy to a point such as Bin Figure 2.6.
The Efficient Mix of Output T o be efficient, an economy must produce what people
want. This means that in addition to operating onthe ppf, the economy must be operating at the
right point on the ppf. This is referred to as output efficiency , in contrast to production efficiency.
Suppose that an economy devotes 100 percent of its resources to beef production and that thebeef industry runs efficiently using the most modern techniques. Also suppose that everyone inthe society is a vegetarian. The result is a total waste of resources (assuming that the society can-not trade its beef for vegetables produced in another country).
Points Band Cin Figure 2.6 are points of production efficiency and full employment.
Whether Bis more or less efficient than C, however, depends on the preferences of members of
society and is not shown in the ppf graph.
CHAPTER 2 The Economic Problem: Scarcity and Choice 35
TABLE 2.1 Production Possibility Schedule for Total Corn and Wheat Production in
Ohio and Kansas
Point on ppfTotal Corn Production
(Millions of Bushels per Year)Total Wheat Production
(Millions of Bushels per Year)
A 700 100
B 650 200
C 510 380
D 400 500
E 300 550
BA
C
D
E
0 100 200 380 500 550300400510650700
Bushels of wheat per year (millions)Bushels of corn per year (millions)/L50296FIGURE 2.7 Corn and
Wheat Production inOhio and Kansas
The ppf illustrates that the
opportunity cost of corn produc-
tion increases as we shift
resources from wheat produc-tion to corn production. Movingfrom point Eto D, we get an
additional 100 million bushels of
corn at a cost of 50 millionbushels of wheat. Movingfrom point Bto A, we get only
50 million bushels of corn at a
cost of 100 million bushels ofwheat. The cost per bushel of
corn—measured in lost wheat—
has increased.Negative Slope and Opportunity Cost As we have seen, points that lie on the ppf rep-
resent points of full resource employment and production efficiency. Society can choose only onepoint on the curve. Because a society’s choices are constrained by available resources and existingtechnology, when those resources are fully and efficiently employed, it can produce more capitalgoods only by reducing production of consumer goods. The opportunity cost of the additionalcapital is the forgone production of consumer goods.
The fact that scarcity exists is illustrated by the negative slope of the ppf. (If you need a
review of slope, see the Appendix to Chapter 1.) In moving from point Eto point Fin Figure 2.5,
capital production increases by 800 -550 = 250 units (a positive change), but that increase in
capital can be achieved only by shifting resources out of the production of consumer goods.Thus, in moving from point Eto point Fin Figure 2.5, consumer goods production decreases by
1,300 -1,100 = 200 units (a negative change). The slope of the curve, the ratio of the change in
capital goods to the change in consumer goods, is negative.
The value of the slope of a society’s ppf is called the marginal rate of transformation
(MRT) . In Figure 2.5, the MRT between points Eand Fis simply the ratio of the change in capi-
tal goods (a positive number) to the change in consumer goods (a negative number).
The Law of Increasing Opportunity Cost The negative slope of the ppf indicates the
trade-off that a society faces between two goods. We can learn something further about the shapeof the frontier and the terms of this trade-off. Let’s look at the trade-off between corn and wheatproduction in Ohio and Kansas. In a recent year, Ohio and Kansas together produced 510 millionbushels of corn and 380 million bushels of wheat. Table 2.1 presents these two numbers, plussome hypothetical combinations of corn and wheat production that might exist for Ohio andKansas together. Figure 2.7 graphs the data from Table 2.1.marginal rate of
transformation (MRT) The
slope of the productionpossibility frontier (ppf ).
36 PART I Introduction to Economics
Suppose that society’s demand for corn dramatically increases. If this happens, farmers
would probably shift some of their acreage from wheat production to corn production. Such ashift is represented by a move from point C(where corn = 510 and wheat = 380) up and to the
left along the ppf toward points Aand Bin Figure 2.7. As this happens, it becomes more difficult
to produce additional corn. The best land for corn production was presumably already in corn,and the best land for wheat production was already in wheat. As we try to produce more corn, theland is less well suited to that crop. As we take more land out of wheat production, we are takingincreasingly better wheat-producing land. In other words, the opportunity cost of more corn,measured in terms of wheat, increases.
Moving from point Eto D, Table 2.1 shows that we can get 100 million bushels of corn
(400 -300) by sacrificing only 50 million bushels of wheat (550 -500)—that is, we get
2 bushels of corn for every bushel of wheat. However, when we are already stretching the abilityof the land to produce corn, it becomes harder to produce more and the opportunity costincreases. Moving from point Bto A, we can get only 50 million bushels of corn (700 -650) by
sacrificing 100 million bushels of wheat (200 -100). For every bushel of wheat, we now get only
half a bushel of corn. However, if the demand for wheat were to increase substantially and we
were to move down and to the right along the ppf, it would become increasingly difficult to pro-duce wheat and the opportunity cost of wheat, in terms of corn, would increase. This is the law
of increasing opportunity cost .
If you think about the example we discussed earlier of Colleen and Bill producing logs and
food on an island, you will recognize that the production possibilities described were highlysimplified. In that example, we drew a downward slope, straight line ppf ; to make the problem
easier, we assumed constant opportunity costs. In a real economy, ppf’s would be expected tolook like Figure 2.5.
Although it exists only as an abstraction, the ppf illustrates a number of very important
concepts that we will use throughout the rest of this book: scarcity, unemployment, inefficiency,opportunity cost, the law of increasing opportunity cost, economic growth, and the gainsfrom trade.
It is important to remember that the ppf represents choices available within the constraints
imposed by the current state of agricultural technology. In the long run, technology mayimprove, and when that happens, we have growth .
Economic Growth Economic growth is characterized by an increase in the total output of
an economy. It occurs when a society acquires new resources or learns to produce more withexisting resources. New resources may mean a larger labor force or an increased capital stock. Theproduction and use of new machinery and equipment (capital) increase workers’ productivity.(Give a man a shovel, and he can dig a bigger hole; give him a steam shovel, and wow!) Improvedproductivity also comes from technological change and innovation , the discovery and application
of new, more efficient production techniques.
In the past few decades, the productivity of U.S. agriculture has increased dramatically. Based
on data compiled by the Department of Agriculture, Table 2.2 shows that yield per acre in cornproduction has increased fivefold since the late 1930s, while the labor required to produce it hasdropped significantly. Productivity in wheat production has also increased, at only a slightly lessremarkable rate: Output per acre has more than tripled, while labor requirements are downnearly 90 percent. These increases are the result of more efficient farming techniques, more andbetter capital (tractors, combines, and other equipment), and advances in scientific knowledgeand technological change (hybrid seeds, fertilizers, and so on). As you can see in Figure 2.8,increases such as these shift the ppf up and to the right.
Sources of Growth and the Dilemma of Poor Countries Economic growth
arises from many sources, the two most important over the years having been the accumulationof capital and technological advances. For poor countries, capital is essential; they must build thecommunication networks and transportation systems necessary to develop industries that func-tion efficiently. They also need capital goods to develop their agricultural sectors.
Recall that capital goods are produced only at a sacrifice of consumer goods. The same can
be said for technological advances. T echnological advances come from research and develop-ment that use resources; thus, they too must be paid for. The resources used to produce capitaleconomic growth An
increase in the total output ofan economy. It occurs when asociety acquires new resources
or when it learns to produce
more using existing resources.
CHAPTER 2 The Economic Problem: Scarcity and Choice 37
TABLE 2.2 Increasing Productivity in Corn and Wheat Production
in the United States, 1935–2009
Corn Wheat
Yield per Acre
(Bushels)Labor Hours per
100 BushelsYield per Acre
(Bushels)Labor Hours per
100 Bushels
1935–1939 26.1 108 13.2 67
1945–1949 36.1 53 16.9 34
1955–1959 48.7 20 22.3 17
1965–1969 78.5 7 27.5 11
1975–1979 95.3 4 31.3 9
1981–1985 107.2 3 36.9 7
1985–1990 112.8 NAa38.0 NAa
1990–1995 120.6 NAa38.1 NAa
1998 134.4 NAa43.2 NAa
2001 138.2 NAa43.5 NAa
2006 145.6 NAa42.3 NAa
2007 152.8 NAa40.6 NAa
2008 153.9 NAa44.9 NAa
2009 164.9 NAa44.3 NAa
aData not available.
Source: U.S. Department of Agriculture, Economic Research Service, Agricultural Statistics, Crop Summary.
2009
1975
1950
0Bushels of corn per year
Bushels of wheat per year/L50296FIGURE 2.8 Economic
Growth Shifts the PPFUp and to the Right
Productivity increases have
enhanced the ability of the
United States to produce both
corn and wheat. As Table 2.2shows, productivity increaseswere more dramatic for corn
than for wheat. Thus, the shifts
in the ppf were not parallel.
Note: The ppf also shifts if the
amount of land or labor in corn andwheat production changes. Althoughwe emphasize productivity increaseshere, the actual shifts between yearswere due in part to land and laborchanges.goods—to build a road, a tractor, or a manufacturing plant— and to develop new technologies
could have been used to produce consumer goods.
When a large part of a country’s population is very poor, taking resources out of the produc-
tion of consumer goods (such as food and clothing) is very difficult. In addition, in some coun-tries, people wealthy enough to invest in domestic industries choose instead to invest abroadbecause of political turmoil at home. As a result, it often falls to the governments of poor coun-tries to generate revenues for capital production and research out of tax collections.
38 PART I Introduction to Economics
All these factors have contributed to the growing gap between some poor and rich
nations. Figure 2.9 shows the result using ppf’s. On the left, the rich country devotes a largerportion of its production to capital while the poor country produces mostly consumergoods. On the right, you see the results: The ppf of the rich country shifts up and out fartherand faster.
The importance of capital goods and technological developments to the position of work-
ers in less developed countries is well illustrated by Robert Jensen’s study of South India’sindustry. Conventional telephones require huge investments in wires and towers and, as aresult, many less developed areas are without landlines. Mobile phones, on the other hand,require a less expensive investment; thus, in many areas, people upgraded from no phonesdirectly to cell phones. Jensen found that in small fishing villages, the advent of cell phonesallowed fishermen to determine on any given day where to take their catch to sell, resulting ina large decrease in fish wasted and an increase in fishing profits. The ability of newer commu-nication technology to aid development is one of the exciting features of our times. (SeeRobert Jensen, “The Digital Provide: Information T echnology, Market Performance, andWelfare in the South Indian Fisheries Sector,” Quarterly Journal of Economics , August 2007,
879–924.)
The Economic Problem
Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How isit produced? and (3) Who gets it?
When Bill was alone on the island, the mechanism for answering those questions was
simple: He thought about his own wants and preferences, looked at the constraints imposedby the resources of the island and his own skills and time, and made his decisions. As Bill setabout his work, he allocated available resources quite simply, more or less by dividing up hisavailable time. Distribution of the output was irrelevant. Because Bill was the society, he gotit all.
1990
1995
2010
1990
00
00
1995 2010a. Poor country
b. Rich countryConsumption ConsumptionCapital
Capital
Consumption ConsumptionCapital Capital/L50298FIGURE 2.9 Capital
Goods and Growth inPoor and Rich Countries
Rich countries find it easier than
poor countries to devote
resources to the production ofcapital, and the more resourcesthat flow into capital produc-
tion, the faster the rate of eco-
nomic growth. Thus, the gapbetween poor and rich countrieshas grown over time.
CHAPTER 2 The Economic Problem: Scarcity and Choice 39
ECONOMICS IN PRACTICE
Trade-Offs among the Rich and Poor
In all societies, for all people, resources are limited relative to peo-
ple’s demands. There are, however, quite large differences in thekinds of trade-offs individuals face in rich versus poor countries.
In 1990, the World Bank defined the extremely poor people of
the world as those earning less than $1 a day. Among developmenteconomists and policy makers, this figure continues to be used as arough rule of thumb. In a recent survey, Esther Duflo and Abhijit
Banerjee, two MIT economists, surveyed individuals living at thislevel in 13 countries across the world.
1What did they learn about
the consumption trade-offs faced by these individuals versus con-sumers in the United States?
It should not surprise you to learn that for the extremely poor,
food is a much larger component of the budget. On average over the
13 countries, between 56 percent and 78 percent of consumptionwas spent on food. In the United States just under 10 percent of theaverage budget goes to food. Even for the poorest consumers, how-ever, biological need is not all determining. The Banerjee and Duflostudy finds that in Udaipur, India, almost 10 percent of the typical
food budget goes to sugar and processed foods rather than more
nutritionally valuable grains. So even at these very low levels ofincome, some choice remains. Perhaps more interestingly, almost10 percent of the budget of those surveyed goes to weddings, funer-
als, and other festivals. In societies with very few entertainmentoutlets, Banerjee and Duflo suggest we may see more demand for
festivals, indicating that even in extremely poor societies, household
choice plays a role.
1Abhijit Banerjee and Esther Duflo, “The Economic Lives of the Poor,”
Journal of Economic Perspective , Winter 2007, 21(1), 141–167.
Introducing even one more person into the economy—in this case, Colleen—changed all
that. With Colleen on the island, resource allocation involves deciding not only how each personspends his or her time but also who does what; now there are two sets of wants and preferences.If Bill and Colleen go off on their own and form two separate self-sufficient economies, there willbe lost potential. Two people can do more things together than each person can do alone. Theymay use their comparative advantages in different skills to specialize. Cooperation and coordina-tion may give rise to gains that would otherwise not be possible.
When a society consists of millions of people, the problem of coordination and coopera-
tion becomes enormous, but so does the potential for gain. In large, complex economies, spe-cialization can go wild, with people working in jobs as different in their detail as animpressionist painting is from a blank page. The range of products available in a modernindustrial society is beyond anything that could have been imagined a hundred years ago, andso is the range of jobs.
The amount of coordination and cooperation in a modern industrial society is almost
impossible to imagine. Y et something seems to drive economic systems, if sometimes clumsilyand inefficiently, toward producing the goods and services that people want. Given scarceresources, how do large, complex societies go about answering the three basic economic ques-tions? This is the economic problem, which is what this text is about.
Economic Systems and the Role of
Government
Thus far we have described the questions that the economic system must answer. Now we turn to
the mechanics of the system. Here the basic debate concerns the role of government.
On the one hand, many favor leaving the economy alone and keeping the government at bay
while others believe that there are many circumstances in which the government may be able toimprove the functioning of the market.
40 PART I Introduction to Economics
In November 2008, President Barack Obama was elected during a period of turmoil in the
world economy. In the United States during the month of the election over 700,000 jobs werelost. A year later the unemployment rate was over 10 percent, and even into 2010, more than15 million were unemployed. At the same time, the banking system nearly collapsed when mas-sive home mortgage defaults led to bankruptcy filings by giants Bear Sterns and LehmannBrothers. The Federal Reserve System and the Treasury in response took action to save some bigbanks and big auto companies with the Troubled Asset Relief Program (TARP). While somecalled it a “bail out,” much of the federal expenditure on these troubled institutions was paid backwith interest.
In addition, during his first year, President Obama pushed hard for major reform of the
health care system, for much stronger government regulation of the financial markets, and for asystem designed to more effectively regulate energy consumption and protect the environment.
All of a sudden, the debate is all about the nature of the system. What should the govern-
ment be doing, and which decisions should be left to the free, private markets? Is it true thatthe government should save companies or banks in trouble on the grounds that they are “toobig to fail”?
Command Economies
During the long struggle between the United States and the Soviet Union it was an all or nothingproposition. The Soviet Union had a planned economy run by the government. In a purecommand economy , the basic economic questions are answered by a central government.
Through a combination of government ownership of state enterprises and central planning, thegovernment, either directly or indirectly, sets output targets, incomes, and prices.
While the extremes of central planning have been rejected, so too has the idea that “mar-
kets solve all problems.” The real debate is not about whether we have government at all, it isabout the extent and the character of a limited government role in the economy. One of themajor themes of this book is that government involvement, in theory, may improve the effi-ciency and fairness of the allocation of a nation’s resources. At the same time, a poorly func-tioning government can destroy incentives, lead to corruption, and result in the waste of asociety’s resources.
Laissez-Faire Economies: The Free Market
At the opposite end of the spectrum from the command economy is the laissez-faire economy .
The term laissez-faire , which translated literally from French means “allow [them] to do,” implies
a complete lack of government involvement in the economy. In this type of economy, individualsand firms pursue their own self-interest without any central direction or regulation; the sum totalof millions of individual decisions ultimately determines all basic economic outcomes. The cen-tral institution through which a laissez-faire system answers the basic questions is the market ,a
term that is used in economics to mean an institution through which buyers and sellers interactand engage in exchange.
The interactions between buyers and sellers in any market range from simple to complex.
Early explorers of the North American Midwest who wanted to exchange with Native Americansdid so simply by bringing their goods to a central place and trading them. T oday the Internet isrevolutionizing exchange. A jewelry maker in upstate Maine can exhibit wares through digitalphotographs on the Web. Buyers can enter orders or make bids and pay by credit card.Companies such as eBay facilitate the worldwide interaction of tens of thousands of buyers andsellers sitting at their computers.
In short:laissez-faire economy
Literally from the French:
“allow [them] to do.” Aneconomy in which individualpeople and firms pursue their
own self-interest without any
central direction or regulation.command economy An
economy in which a central
government either directly orindirectly sets output targets,incomes, and prices.
market The institution
through which buyers and
sellers interact and engage in
exchange.
Some markets are simple and others are complex, but they all involve buyers and sellers
engaging in exchange. The behavior of buyers and sellers in a laissez-faire economy deter-mines what gets produced, how it is produced, and who gets it.
CHAPTER 2 The Economic Problem: Scarcity and Choice 41
free enterprise The freedom
of individuals to start and
operate private businesses insearch of profits.The following chapters explore market systems in great depth. A quick preview is worthwhile
here, however.
Consumer Sovereignty In a free, unregulated market, goods and services are produced
and sold only if the supplier can make a profit. In simple terms, making a profit means selling
goods or services for more than it costs to produce them. Y ou cannot make a profit unlesssomeone wants the product that you are selling. This logic leads to the notion of consumer
sovereignty : The mix of output found in any free market system is dictated ultimately by the
tastes and preferences of consumers who “vote” by buying or not buying. Businesses rise andfall in response to consumer demands. No central directive or plan is necessary.
Individual Production Decisions: Free Enterprise Under a free market system,
individual producers must also determine how to organize and coordinate the actual produc-tion of their products or services. The owner of a small shoe repair shop must alone buy theneeded equipment and tools, hang signs, and set prices. In a big corporation, so many peopleare involved in planning the production process that in many ways, corporate planningresembles the planning in a command economy. In a free market economy, producers may besmall or large. One person who hand-paints eggshells may start to sell them as a business; aperson good with computers may start a business designing Web sites. On a larger scale, agroup of furniture designers may put together a large portfolio of sketches, raise several mil-lion dollars, and start a bigger business. At the extreme are huge corporations such asMicrosoft, Mitsubishi, and Intel, each of which sells tens of billions of dollars’ worth of prod-ucts every year. Whether the firms are large or small, however, production decisions in a mar-ket economy are made by separate private organizations acting in what they perceive to betheir own interests.
Often the market system is called a free enterprise system. Free enterprise means the free-
dom of individuals to start private businesses in search of profits. Because new businesses requirecapital investment before they can begin operation, starting a new business involves risk. A well-run business that produces a product for which demand exists is likely to succeed; a poorly runbusiness or one that produces a product for which little demand exists now or in the future islikely to fail. It is through free enterprise that new products and new production techniques findtheir way into use.
Proponents of free market systems argue that free enterprise leads to more efficient
production and better response to diverse and changing consumer preferences. If a producerproduces inefficiently, competitors will come along, fight for the business, and eventually takeit away. Thus, in a free market economy, competition forces producers to use efficienttechniques of production. It is competition, then, that ultimately dictates how output is produced.
Distribution of Output In a free market system, the distribution of output—who gets
what—is also determined in a decentralized way. The amount that any one household getsdepends on its income and wealth. Income is the amount that a household earns each year. It
comes in a number of forms: wages, salaries, interest, and the like. Wealth is the amount that
households have accumulated out of past income through saving or inheritance.
T o the extent that income comes from working for a wage, it is at least in part determined by
individual choice. Y ou will work for the wages available in the market only if these wages (and theproducts and services they can buy) are sufficient to compensate you for what you give up byworking. Y our leisure certainly has a value also. Y ou may discover that you can increase yourincome by getting more education or training. Y ou cannot increase your income, however, if you
acquire a skill that no one wants.
Price Theory The basic coordinating mechanism in a free market system is price. A price is
the amount that a product sells for per unit, and it reflects what society is willing to pay. Pricesof inputs—labor, land, and capital—determine how much it costs to produce a product. Pricesof various kinds of labor, or wage rates , determine the rewards for working in different jobs andconsumer sovereignty The
idea that consumers ultimately
dictate what will be produced
(or not produced) by choosingwhat to purchase (and what
not to purchase).
42 PART I Introduction to Economics
Mixed Systems, Markets, and Governments
The differences between command economies and laissez-faire economies in their pure forms are
enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense“mixed.” That is, individual enterprise exists and independent choice is exercised even ineconomies in which the government plays a major role.
Conversely, no market economies exist without government involvement and government
regulation. The United States has basically a free market economy, but government purchasesaccounted for just over 20 percent of the country’s total production in 2010. Governments in theUnited States (local, state, and federal) directly employ about 14 percent of all workers (15 per-cent including active duty military). They also redistribute income by means of taxation andsocial welfare expenditures, and they regulate many economic activities.
One of the major themes in this book, and indeed in economics, is the tension between the
advantages of free, unregulated markets and the desire for government involvement. Advocates offree markets argue that such markets work best when left to themselves. They produce only whatpeople want; without buyers, sellers go out of business. Competition forces firms to adopt effi-cient production techniques. Wage differentials lead people to acquire needed skills. Competitionalso leads to innovation in both production techniques and products. The result is quality andvariety, but market systems have problems too. Even staunch defenders of the free enterprise sys-tem recognize that market systems are not perfect. First, they do not always produce what peoplewant at the lowest cost—there are inefficiencies. Second, rewards (income) may be unfairly dis-tributed and some groups may be left out. Third, periods of unemployment and inflation recurwith some regularity.
Many people point to these problems as reasons for government involvement. Indeed, for
some problems, government involvement may be the only solution. However, government deci-sions are made by people who presumably, like the rest of us, act in their own self-interest. Whilegovernments may be called on to improve the functioning of the economy, there is no guaranteethat they will do so. Just as markets may fail to produce an allocation of resources that is perfectlyefficient and fair, governments may fail to improve matters. We return to this debate many timesthroughout this text.
Looking Ahead
This chapter described the economic problem in broad terms. We outlined the questions that alleconomic systems must answer. We also discussed very broadly the two kinds of economic sys-tems. In the next chapter, we analyze the way market systems work.In a free market system, the basic economic questions are answered without the help of acentral government plan or directives. This is what the “free” in free market means—thesystem is left to operate on its own with no outside interference. Individuals pursuingtheir own self-interest will go into business and produce the products and services thatpeople want. Other individuals will decide whether to acquire skills; whether to work; andwhether to buy, sell, invest, or save the income that they earn. The basic coordinatingmechanism is price.professions. Many of the independent decisions made in a market economy involve the weigh-
ing of prices and costs, so it is not surprising that much of economic theory focuses on the fac-tors that influence and determine prices. This is why microeconomic theory is often simplycalled price theory .
In sum:
CHAPTER 2 The Economic Problem: Scarcity and Choice 43
1.Every society has some system or process for transforming
into useful form what nature and previous generationshave provided. Economics is the study of that process andits outcomes.
2.Producers are those who take resources and transform them
into usable products, or outputs . Private firms, households,
and governments all produce something.
SCARCITY, CHOICE, AND OPPORTUNITY COST p. 26
3.All societies must answer three basic questions : What
gets produced? How is it produced? Who gets what is produced? These three questions make up the economic problem .
4.One person alone on an island must make the same basic
decisions that complex societies make. When a societyconsists of more than one person, questions of distribution,cooperation, and specialization arise.
5.Because resources are scarce relative to human wants in allsocieties, using resources to produce one good or serviceimplies notusing them to produce something else. This
concept of opportunity cost is central to an understanding
of economics.
6.Using resources to produce capital that will in turn produce
benefits in the future implies notusing those resources to
produce consumer goods in the present.
7.Even if one individual or nation is absolutely more efficientat producing goods than another, all parties will gain if theyspecialize in producing goods in which they have acomparative advantage .
8.Aproduction possibility frontier (ppf) is a graph that shows
all the combinations of goods and services that can be pro-duced if all of society’s resources are used efficiently. The ppfillustrates a number of important economic concepts:scarcity, unemployment, inefficiency, increasing opportunitycost, and economic growth.9.Economic growth occurs when society produces more,
either by acquiring more resources or by learning to pro-duce more with existing resources. Improved productivitymay come from additional capital or from the discoveryand application of new, more efficient techniques of production.
ECONOMIC SYSTEMS AND THE ROLE OF
GOVERNMENT p. 39
10. In some modern societies, government plays a big role in
answering the three basic questions. In pure command
economies , a central authority directly or indirectly sets out-
put targets, incomes, and prices.
11. Alaissez-faire economy is one in which individuals indepen-
dently pursue their own self-interest, without any centraldirection or regulation, and ultimately determine all basiceconomic outcomes.
12. Amarket is an institution through which buyers and sellers
interact and engage in exchange. Some markets involve sim-ple face-to-face exchange; others involve a complex series oftransactions, often over great distances or through elec-tronic means.
13. There are no purely planned economies and no pure laissez-faire economies; all economies are mixed. Individual enterprise,independent choice, and relatively free markets exist in centrallyplanned economies; there is significant government involve-ment in market economies such as that of the United States.
14. One of the great debates in economics revolves around thetension between the advantages of free, unregulated marketsand the desire for government involvement in the economy.Free markets produce what people want, and competitionforces firms to adopt efficient production techniques. Theneed for government intervention arises because free marketsare characterized by inefficiencies and an unequal distribu-tion of income, and experience regular periods of inflationand unemployment.SUMMARY
absolute advantage, p. 28
capital, p. 25
command economy, p. 40
comparative advantage, p. 29
consumer goods, p. 32
consumer sovereignty, p. 41
economic growth, p. 36factors of production ( orfactors), p. 25
free enterprise, p. 41
inputs orresources, p. 26
investment, p. 32
laissez-faire economy, p. 40
marginal rate of transformation
(MRT), p. 35market, p. 40
opportunity cost, p. 27
outputs, p. 26
production, p. 25
production possibility frontier (ppf), p. 33
theory of comparative advantage, p. 28REVIEW TERMS AND CONCEPTS
44 PART I Introduction to Economics
PROBLEMS
All problems are available on www.myeconlab.com
a.For Kristen and for Anna, what is the opportunity cost of a
pot holder? Who has a comparative advantage in the pro-
duction of pot holders? Explain your answer.
b.Who has a comparative advantage in the production of
wristbands? Explain your answer.
c.Assume that Kristen works 20 hours per week in the busi-
ness. Assuming Kristen is in business on her own, graph thepossible combinations of pot holders and wristbands that
she could produce in a week. Do the same for Anna.
d.If Kristen devoted half of her time (10 out of 20 hours) to
wristbands and half of her time to pot holders, how many ofeach would she produce in a week? If Anna did the same,how many of each would she produce? How many wrist-bands and pot holders would be produced in total?
e.Suppose that Anna spent all 20 hours of her time on
wristbands and Kristen spent 17 hours on pot holders and3 hours on wristbands. How many of each item would be produced?
f.Suppose that Kristen and Anna can sell all their wristbands
for $1 each and all their pot holders for $5.50 each. If each ofthem worked 20 hours per week, how should they split theirtime between wristbands and pot holders? What is theirmaximum joint revenue?
5.Briefly describe the trade-offs involved in each of the following
decisions. Specifically, list some of the opportunity costs associ-ated with each decision, paying particular attention to the trade-offs between present and future consumption.a.After a stressful senior year in high school, Sherice decides to
take the summer off instead of working before going to college.
b.Frank is overweight and decides to work out every day and
to go on a diet.
c.Mei is diligent about taking her car in for routine mainte-
nance even though it takes 2 hours of her time and costs
$100 four times each year.
d.Jim is in a hurry. He runs a red light on the way to work.
*6.The countries of Figistan and Blah are small island countries in
the South Pacific. Both produce fruit and timber. Each island
has a labor force of 1,200. The following table gives productionper month for each worker in each country.
a.Which country has an absolute advantage in the production
of fruit? Which country has an absolute advantage in theproduction of timber?
b.Which country has a comparative advantage in the produc-
tion of fruit? of timber?
c.Sketch the ppf’s for both countries.
d.Assuming no trading between the two, if both countries
wanted to have equal numbers of feet of timber and baskets
of fruit, how would they allocate workers to the two sectors?
e.Show that specialization and trade can move both countries
beyond their ppf’s.1.For each of the following, describe some of the potential oppor-
tunity costs:a.Studying for your economics test
b.Spending 2 hours playing computer games
c.Buying a new car instead of keeping the old one
d.A local community voting to raise property taxes to increase
school expenditures and to reduce class size
e.A number of countries working together to build a
space station
f.Going to graduate school
2.“As long as all resources are fully employed and every firm in
the economy is producing its output using the best availabletechnology, the result will be efficient.” Do you agree or disagreewith this statement? Explain your answer.
3.Y ou are an intern to the editor of a small-town newspaper in
Mallsburg, Pennsylvania. Y our boss, the editor, asks you towrite the first draft of an editorial for this week’s paper. Y our
assignment is to describe the costs and the benefits of buildinga new bridge across the railroad tracks in the center of town.
Currently, most people who live in this town must drive 2 miles through thickly congested traffic to the existing bridgeto get to the main shopping and employment center. The
bridge will cost the citizens of Mallsburg $25 million, which
will be paid for with a tax on their incomes over the next 20years. What are the opportunity costs of building this bridge?What are the benefits that citizens will likely receive if thebridge is built? What other factors might you consider in writ-
ing this editorial?
4.Kristen and Anna live in the beach town of Santa Monica.
They own a small business in which they make wristbands
and pot holders and sell them to people on the beach. Asshown in the table on the following page, Kristen can make15 wristbands per hour but only 3 pot holders. Anna is a bitslower and can make only 12 wristbands or 2 pot holders in
an hour.
OUTPUT PER HOUR
WRISTBANDS POT HOLDERS
Kristen 15 3
Anna 12 2BASKETS OF
FRUITBOARD FEET
OF TIMBER
Figistan workers 10 5
Blah workers 30 10
Productivity of one worker for one month
CHAPTER 2 The Economic Problem: Scarcity and Choice 45
*Note: Problems marked with an asterisk are more challenging.7.Suppose that a simple society has an economy with only one
resource, labor. Labor can be used to produce only two
commodities— X, a necessity good (food), and Y, a luxury
good (music and merriment). Suppose that the labor forceconsists of 100 workers. One laborer can produce either 5 unitsof necessity per month (by hunting and gathering) or 10 units
of luxury per month (by writing songs, playing the guitar,
dancing, and so on).a.On a graph, draw the economy’s ppf. Where does the ppf
intersect the Y-axis? Where does it intersect the X-axis? What
meaning do those points have?
b.Suppose the economy produced at a point inside the ppf.
Give at least two reasons why this could occur. What couldbe done to move the economy to a point onthe ppf?
c.Suppose you succeeded in lifting your economy to a point
on its ppf. What point would you choose? How might
your small society decide the point at which it wanted
to be?
d.Once you have chosen a point on the ppf, you still need
to decide how your society’s production will be divided.If you were a dictator, how would you decide? What
would happen if you left product distribution to the
free market?
*8.Match each diagram in Figure 1 with its description here.
Assume that the economy is producing or attempting to pro-
duce at point Aand that most members of society like meat
and not fish. Some descriptions apply to more than one dia-gram, and some diagrams have more than one description.a.Inefficient production of meat and fish
b.Productive efficiency
c.An inefficient mix of outputThese figures assume that a certain number of previously pro-
duced ovens are available in the current period for baking bread.a.Using the data in the table, graph the ppf (with ovens on the
vertical axis).
b.Does the principle of “increasing opportunity cost” hold in
this nation? Explain briefly. ( Hint: What happens to the
opportunity cost of bread—measured in number of ovens—
as bread production increases?)
c.If this country chooses to produce both ovens and bread,
what will happen to the ppf over time? Why?d.T echnological advances in the production of meat and fish
e.The law of increasing opportunity cost
f.An impossible combination of meat and fish
9.A nation with fixed quantities of resources is able to produce
any of the following combinations of bread and ovens:Fish
Fish
Meat 0
00
00
0FishFish
FishMeat
Meat Meat MeatMeat
Fisha. b. c.
d. e. f.AA
A
A
A
A
/L50304FIGURE 1 <LOAVES OF BREAD (MILLIONS) OVENS (THOUSANDS)
75 0
60 12
45 22
30 30
15 36
0 40
46 PART I Introduction to Economics
A B C D E
Turnips 100 90 70 40 0
Potatoes 0 10 20 30 40Now suppose that a new technology is discovered that allows
twice as many loaves of bread to be baked in each existing oven.
d.Illustrate (on your original graph) the effect of this new
technology on the ppf.
e.Suppose that before the new technology is introduced,
the nation produces 22 ovens. After the new technology
is introduced, the nation produces 30 ovens. What is
the effect of the new technology on the production ofbread? (Give the number of loaves before and after the change.)
10.[Related to the Economics in Practice onp. 28 ]An analysis of
a large-scale survey of consumer food purchases by Mark Aguiarand Erik Hurst indicates that retired people spend less for thesame market basket of food than working people do. Use theconcept of opportunity cost to explain this fact.
*11. Dr. Falk is a dentist who performs two basic procedures: filling
cavities and whitening teeth. Falk charges $50 per cavity filled, aprocess that takes him 15 minutes per tooth and requires no
help or materials. For tooth whitening, a process requiring
30 minutes, Falk charges $150 net of materials. Again, no help isrequired. Is anything puzzling about Falk’s pricing pattern?Explain your answer.
12.In 2010, the T exas Lottery Commission began selling $5 Dallas
Cowboys scratch-off game tickets. Prizes for winning ticketsincluded cash, team merchandise, and Cowboys’ season ticketsfor the 2010 season at their new $1.15 billion stadium. Suppose
you received one of these Cowboys’ scratch-off games as a birth-
day present and you won free season tickets for the 2010 season.Would there be a cost to you to attend the Cowboys’ games dur-ing the 2010 season?13.Describe a command economy and a laissez-faire economy. Do
any economic systems in the world reflect the purest forms ofcommand or laissez-faire economies? Explain.
14.The nation of Rougarou is able to produce turnips and potatoes
in combinations represented by the data in the following table.Each number represents thousands of bushels.
Plot this data on a production possibilities graph and explain
why the data shows that Rougarou experiences increasingopportunity costs.
15.Explain how each of the following situations would affect a
nation’s production possibilities curve.a.A technological innovation allows the nation to more effi-
ciently convert solar energy into electricity.
b.A prolonged recession increases the number of unemployed
workers in the nation.
c.A category 5 hurricane destroys over 40 percent of the
nation’s productive capacity.
d.The quality of education in the nation’s colleges and univer-
sities improves greatly.
e.The nation passes a law requiring all employers to give their
employees 16 weeks of paid vacation each year. Prior to thislaw, employers were not legally required to give employeesany paid vacation time.
Price and Quantity Supplied:
The Law of Supply
Other Determinants
of Supply
Shift of Supply versus
Movement Along the Supply Curve
From Individual Supply to
Market Supply
Market
Equilibrium p. 66
Excess Demand
Excess Supply
Changes in Equilibrium
Demand and Supply
in Product Markets: A Review
p. 72
Looking Ahead:Markets and theAllocation ofResources
p. 72
47CHAPTER OUTLINE Chapters 1 and 2 introduced the
discipline, methodology, and sub-ject matter of economics. We nowbegin the task of analyzing how amarket economy actually works.This chapter and the next presentan overview of the way individualmarkets work. They introducesome of the concepts needed tounderstand both microeconomicsand macroeconomics.
As we proceed to define terms
and make assumptions, it isimportant to keep in mind whatwe are doing. In Chapter 1 we explained what economic theory attempts to do. Theories areabstract representations of reality, like a map that represents a city. We believe that the modelspresented here will help you understand the workings of the economy just as a map helps youfind your way around a city. Just as a map presents one view of the world, so too does any giventheory of the economy. Alternatives exist to the theory that we present. We believe, however, thatthe basic model presented here, while sometimes abstract, is useful in gaining an understandingof how the economy works.
In the simple island society discussed in Chapter 2, Bill and Colleen solved the economic
problem directly. They allocated their time and used the island’s resources to satisfy their wants.Bill might be a farmer, Colleen a hunter and carpenter. He might be a civil engineer, she a doctor.Exchange occurred, but complex markets were not necessary.
In societies of many people, however, production must satisfy wide-ranging tastes and pref-
erences. Producers therefore specialize. Farmers produce more food than they can eat so that theycan sell it to buy manufactured goods. Physicians are paid for specialized services, as are attor-neys, construction workers, and editors. When there is specialization, there must be exchange,and markets are the institutions through which exchange takes place.
This chapter begins to explore the basic forces at work in market systems. The purpose of
our discussion is to explain how the individual decisions of households and firms together, with-out any central planning or direction, answer the three basic questions: What gets produced?How is it produced? Who gets what is produced? We begin with some definitions.3
Firms and Households:
The Basic Decision-Making Units
p. 47
Input Markets andOutput Markets: TheCircular Flow
p. 48
Demand inProduct/OutputMarkets
p. 50
Changes in Quantity
Demanded versusChanges in Demand
Price and Quantity
Demanded: The Law of Demand
Other Determinants of
Household Demand
Shift of Demand versus
Movement Along theDemand Curve
From Household Demand
to Market Demand
Supply in
Product/OutputMarkets
p. 60
Demand, Supply, and
Market Equilibrium
Firms and Households: The Basic Decision-
Making Units
Throughout this book, we discuss and analyze the behavior of two fundamental decision-
making units: firms —the primary producing units in an economy—and households —the con-
suming units in an economy. Both are made up of people performing different functions andplaying different roles. In essence, what we are developing is a theory of human behavior.
48 PART I Introduction to Economics
firm An organization that
transforms resources (inputs)
into products (outputs). Firms
are the primary producingunits in a market economy.
entrepreneur A person who
organizes, manages, andassumes the risks of a firm,
taking a new idea or a new
product and turning it into asuccessful business.
households The consuming
units in an economy.
product oroutput
markets The markets in
which goods and services areexchanged.
input orfactor markets
The markets in which theresources used to produce
goods and services are
exchanged.Afirm exists when a person or a group of people decides to produce a product or products
by transforming inputs —that is, resources in the broadest sense—into outputs , the products that
are sold in the market. Some firms produce goods; others produce services. Some are large,many are small, and some are in between. All firms exist to transform resources into goods andservices that people want. The Colorado Symphony Orchestra takes labor, land, a building,musically talented people, instruments, and other inputs and combines them to produce con-certs. The production process can be extremely complicated. For example, the first flautist in theorchestra uses training, talent, previous performance experience, score, instrument, conductor’sinterpretation, and personal feelings about the music to produce just one contribution to anoverall performance.
Most firms exist to make a profit for their owners, but some do not. Columbia University, for
example, fits the description of a firm: It takes inputs in the form of labor, land, skills, books, andbuildings and produces a service that we call education. Although the university sells that servicefor a price, it does not exist to make a profit; instead, it exists to provide education of the highestquality possible.
Still, most firms exist to make a profit. They engage in production because they can sell their
product for more than it costs to produce it. The analysis of a firm’s behavior that follows rests onthe assumption that firms make decisions in order to maximize profits . Sometimes firms suffer
losses instead of earning profits. In recent years this has occurred frequently. When firms sufferlosses, we will assume that they act to minimize those losses.
An entrepreneur is someone who organizes, manages, and assumes the risks of a firm. When
a new firm is created, someone must organize the new firm, arrange financing, hire employees,and take risks. That person is an entrepreneur. Sometimes existing firms introduce new products,and sometimes new firms develop or improve on an old idea, but at the root of it all is entrepre-neurship, which some see as the core of the free enterprise system.
The consuming units in an economy are households . A household may consist of any num-
ber of people: a single person living alone, a married couple with four children, or 15 unrelatedpeople sharing a house. Household decisions are presumably based on individual tastes and pref-erences. The household buys what it wants and can afford. In a large, heterogeneous, and opensociety such as the United States, wildly different tastes find expression in the marketplace. A six-block walk in any direction on any street in Manhattan or a drive from the Chicago Loop southinto rural Illinois should be enough to convince anyone that it is difficult to generalize aboutwhat people do and do not like.
Even though households have wide-ranging preferences, they also have some things in
common. All—even the very rich—have ultimately limited incomes, and all must pay in someway for the goods and services they consume. Although households may have some control overtheir incomes—they can work more hours or fewer hours—they are also constrained by theavailability of jobs, current wages, their own abilities, and their accumulated and inheritedwealth (or lack thereof).
Input Markets and Output Markets:
The Circular Flow
Households and firms interact in two basic kinds of markets: product (or output) markets
and input (or factor) markets. Goods and services that are intended for use by households are exchanged in product
oroutput markets . In output markets, firms supply and house-
holds demand .
T o produce goods and services, firms must buy resources in input orfactor markets .
Firms buy inputs from households, which supply these inputs. When a firm decides how muchto produce (supply) in output markets, it must simultaneously decide how much of each inputit needs to produce the desired level of output. T o produce automobiles, Ford Motor Companymust use many inputs, including tires, steel, complicated machinery, and many different kindsof labor.
CHAPTER 3 Demand, Supply, and Market Equilibrium 49
Firms
Supply in output markets
Demand in input markets
Input
(factor) markets
Labor
Capital
LandDEMAND SUPPLY DEMAND
SUPPLY
PAYMENT PAYMENT
PAYMENT
PAYMENT Households
Demand in output markets
Supply in input marketsOutput
(product) markets
Goods
Services
/L50304FIGURE 3.1 The Circular Flow of Economic Activity
Diagrams like this one show the circular flow of economic activity, hence the name circular flow diagram . Here
goods and services flow clockwise: Labor services supplied by households flow to firms, and goods and ser-
vices produced by firms flow to households. Payment (usually money) flows in the opposite (counterclock-
wise) direction: Payment for goods and services flows from households to firms, and payment for laborservices flows from firms to households.
Note: Color Guide—In Figure 3.1 households are depicted in blue and firms are depicted in red. From now on all diagrams
relating to the behavior of households will be blue or shades of blue and all diagrams relating to the behavior of firms willbe red or shades of red.labor market The
input/factor market in whichhouseholds supply workfor wages to firms thatdemand labor.
capital market The
input/factor market in whichhouseholds supply their
savings, for interest or
for claims to future profits,to firms that demand funds to
buy capital goods.
land market The input/factor
market in which householdssupply land or other real
property in exchange for rent.
factors of production
The inputs into the production
process. Land, labor, andcapital are the three key factors
of production.Figure 3.1 shows the circular flow of economic activity through a simple market economy.
Note that the flow reflects the direction in which goods and services flow through input andoutput markets. For example, real goods and services flow from firms to households throughoutput—or product—markets. Labor services flow from households to firms through input mar-kets. Payment (most often in money form) for goods and services flows in the opposite direction.
In input markets, households supply resources. Most households earn their incomes by
working—they supply their labor in the labor market to firms that demand labor and pay work-
ers for their time and skills. Households may also loan their accumulated or inherited savings tofirms for interest or exchange those savings for claims to future profits, as when a household buysshares of stock in a corporation. In the capital market , households supply the funds that firms
use to buy capital goods. Households may also supply land or other real property in exchange forrent in the land market .
Inputs into the production process are also called factors of production . Land, labor, and
capital are the three key factors of production. Throughout this text, we use the terms input
and factor of production interchangeably. Thus, input markets and factor markets mean the
same thing.
Early economics texts included entrepreneurship as a type of input, just like land, labor, and
capital. Treating entrepreneurship as a separate factor of production has fallen out of favor,however, partially because it is unmeasurable. Most economists today implicitly assume that
50 PART I Introduction to Economics
entrepreneurship is in plentiful supply. That is, if profit opportunities exist, it is likely that entre-
preneurs will crop up to take advantage of them. This assumption has turned out to be a goodpredictor of actual economic behavior and performance.
The supply of inputs and their prices ultimately determine household income. Thus, the
amount of income a household earns depends on the decisions it makes concerning what typesof inputs it chooses to supply. Whether to stay in school, how much and what kind of training toget, whether to start a business, how many hours to work, whether to work at all, and how toinvest savings are all household decisions that affect income.
As you can see:
Input and output markets are connected through the behavior of both firms and house-
holds. Firms determine the quantities and character of outputs produced and the types andquantities of inputs demanded. Households determine the types and quantities of productsdemanded and the quantities and types of inputs supplied.
1
The following analysis of demand and supply will lead up to a theory of how market prices
are determined. Prices are determined by the interaction between demanders and suppliers. T ounderstand this interaction, we first need to know how product prices influence the behavior ofdemanders and suppliers separately . Therefore, we discuss output markets by focusing first on
demanders, then on suppliers, and finally on their interaction.
Demand in Product/Output Markets
In real life, households make many decisions at the same time. T o see how the forces of demandand supply work, however, let us focus first on the amount of a single product that an individual
household decides to consume within some given period of time, such as a month or a year.
A household’s decision about what quantity of a particular output, or product, to demand
depends on a number of factors, including:
/L50766The price of the product in question.
/L50766The income available to the household.
/L50766The household’s amount of accumulated wealth .
/L50766The prices of other products available to the household.
/L50766The household’s tastes and preferences .
/L50766The household’s expectations about future income, wealth, and prices.
Quantity demanded is the amount (number of units) of a product that a household would buy
in a given period if it could buy all it wanted at the current market price . Of course, the amount of a
product that households finally purchase depends on the amount of product actually available in themarket. The expression if it could buy all it wanted is critical to the definition of quantity demanded
because it allows for the possibility that quantity supplied and quantity demanded are unequal.quantity demanded The
amount (number of units) of a
product that a household
would buy in a given period ifit could buy all it wanted at the
current market price.
1Our description of markets begins with the behavior of firms and households. Modern orthodox economic theory essentially com-
bines two distinct but closely related theories of behavior. The “theory of household behavior,” or “consumer behavior,” has its roo ts
in the works of nineteenth-century utilitarians such as Jeremy Bentham, William Jevons, Carl Menger, Leon Walras, Vilfredo Parcto,and F. Y. Edgeworth. The “theory of the firm” developed out of the earlier classical political economy of Adam Smith, David Ricardo,and Thomas Malthus. In 1890, Alfred Marshall published the first of many editions of his Principles of Economics . That volume pulled
together the main themes of both the classical economists and the utilitarians into what is now called neoclassical economics . While
there have been many changes over the years, the basic structure of the model that we build can be found in Marshall’s work.
CHAPTER 3 Demand, Supply, and Market Equilibrium 51
demand schedule A table
showing how much of a givenproduct a household would
be willing to buy at
different prices.
demand curve A graph
illustrating how much of a
given product a household
would be willing to buy atdifferent prices.Changes in Quantity Demanded versus
Changes in Demand
The most important relationship in individual markets is that between market price and quan-
tity demanded. For this reason, we need to begin our discussion by analyzing the likelyresponse of households to changes in price using the device of ceteris paribus , or “all else
equal.” That is, we will attempt to derive a relationship between the quantity demanded of agood per time period and the price of that good, holding income, wealth, other prices, tastes,and expectations constant.
It is very important to distinguish between price changes, which affect the quantity of a good
demanded, and changes in other factors (such as income), which change the entire relationshipbetween price and quantity. For example, if a family begins earning a higher income, it might buymore of a good at every possible price. T o be sure that we distinguish between changes in priceand other changes that affect demand, throughout the rest of the text, we will be very preciseabout terminology. Specifically:
Changes in the price of a product affect the quantity demanded per period. Changes in any
other factor, such as income or preferences, affect demand . Thus, we say that an increase in
the price of Coca-Cola is likely to cause a decrease in the quantity of Coca-Cola demanded .
However, we say that an increase in income is likely to cause an increase in the demand for
most goods.
Price and Quantity Demanded: The Law of Demand
Ademand schedule shows how much of a product a person or household is willing to purchase
per time period (each week or each month) at different prices. Clearly that decision is based onnumerous interacting factors. Consider Alex who just graduated from college with an entry-leveljob at a local bank. During her senior year, Alex got a car loan and bought a used Mini Cooper.The Mini gets 25 miles per gallon of gasoline. Alex lives with several friends in a house 10 milesfrom her workplace and enjoys visiting her parents 50 miles away.
How often Alex will decide to drive herself to work and parties, visit her family, or even go
joy riding depends on many things, including her income and whether she likes to drive. But theprice of gasoline also plays an important role, and it is this relationship between price and quan-tity demanded that we focus on in the law of demand. With a gasoline price of $3.00 a gallon,Alex might decide to drive herself to work every day, visit her parents once a week, and driveanother 50 miles a week for other activities. This driving pattern would add up to 250 miles aweek, which would use 10 gallons of gasoline in her Mini. The demand schedule in Table 3.1 thusshows that at a price of $3.00 per gallon, Alex is willing to buy 10 gallons of gasoline. We can seethat this demand schedule reflects a lot of information about Alex including where she lives andworks and what she likes to do in her spare time.
Now suppose an international crisis in the Middle East causes the price of gasoline at the
pump to rise to $5.00 per gallon. How does this affect Alex’s demand for gasoline, assuming thateverything else remains the same? Driving is now more expensive, and we would not be surprisedif Alex decided to take the bus some mornings or share a ride with friends. She might visit her par-ents less frequently as well. On the demand schedule given in Table 3.1, Alex cuts her desired con-sumption of gasoline by half to 5 gallons when the price goes to $5.00. If, instead, the price ofgasoline fell substantially, Alex might well spend more time driving, and that is in fact the patternwe see in the table. This same information presented graphically is called a demand curve . Alex’s
demand curve is presented in Figure 3.2. Y ou will note in Figure 3.2 that quantity (q) is measured
along the horizontal axis and price (P) is measured along the vertical axis. This is the convention
we follow throughout this book.
Demand Curves Slope Downward The data in Table 3.1 show that at lower prices, Alex
buys more gasoline; at higher prices, she buys less. Thus, there is a negative, or inverse, relationship
between quantity demanded and price . When price rises, quantity demanded falls, and when price
falls, quantity demanded rises. Thus, demand curves always slope downward. This negative rela-tionship between price and quantity demanded is often referred to as the law of demand ,a t e r m
first used by economist Alfred Marshall in his 1890 textbook.
Some people are put off by the abstraction of demand curves. Of course, we do not actu-
ally draw our own demand curves for products. When we want to make a purchase, we usuallyface only a single price and how much we would buy at other prices is irrelevant. However,demand curves help analysts understand the kind of behavior that households are likely to
exhibit if they are actually faced with a higher or lower price. We know, for example, that if theprice of a good rises enough, the quantity demanded must ultimately drop to zero. Thedemand curve is thus a tool that helps us explain economic behavior and predict reactions topossible price changes.52 PART I Introduction to Economics
TABLE 3.1 Alex’s Demand Schedule
for Gasoline
Price
(per Gallon)Quantity Demanded
(Gallons per Week)
$8.00 0
7.00 2
6.00 3
5.00 5
4.00 7
3.00 10
2.00 14
1.00 20
0.00 26
P
05 21 0 2 0 2 6 q
Gallons per weekPrice per gallon ($)8.00
6.00
4.00
2.005.00
3.007.00
1.00
/L50304FIGURE 3.2 Alex’s Demand Curve
The relationship between price ( P) and quantity demanded ( q) presented graphically is called a demand
curve. Demand curves have a negative slope, indicating that lower prices cause quantity demanded toincrease. Note that Alex’s demand curve is blue; demand in product markets is determined by house-
hold choice.law of demand The negative
relationship between price and
quantity demanded: As price
rises, quantity demandeddecreases; as price falls,quantity demanded increases.
Marshall’s definition of a social “law” captures the idea:
The term “law” means nothing more than a general proposition or statement of tenden-
cies, more or less certain, more or less definite …a social law is a statement of social ten-
dencies; that is, that a certain course of action may be expected from the members of asocial group under certain conditions.
2
It seems reasonable to expect that consumers will demand more of a product at a lower price
and less of it at a higher price. Households must divide their incomes over a wide range of goodsand services. At $3.00 per gallon and 25 miles to a gallon, driving the 20 miles round trip to workcosts Alex $2.40. At $5.00 per gallon, the trip now costs $4.00. With the higher prices, Alex mayhave to give up her morning latte if she drives, and that may turn out to be too big a sacrifice forher. As the price of gasoline rises, the opportunity cost of driving in terms of other types of con-sumption also rises and that is why Alex ends up driving less as the price of gasoline rises. Goodscompete with one another for our spending.
Economists use the concept of utility to explain the slope of the demand curve. Presumably,
we consume goods and services because they give us utility or satisfaction. As we consume more ofa product within a given period of time, it is likely that each additional unit consumed will yieldsuccessively less satisfaction. The utility you gain from a second ice cream cone is likely to be lessthan the utility you gained from the first, the third is worth even less, and so on. This law of
diminishing marginal utility is an important concept in economics. If each successive unit of a
good is worth less to you, you are not going to be willing to pay as much for it. Thus, it is reason-able to expect a downward slope in the demand curve for that good.
Thinking about the ways that people are affected by price changes also helps us see what is
behind the law of demand. Consider this example: Luis lives and works in Mexico City. Hiselderly mother lives in Santiago, Chile. Last year the airlines servicing South America got into aprice war, and the price of flying between Mexico City and Santiago dropped from 20,000 pesosto 10,000 pesos. How might Luis’s behavior change?
First, he is better off. Last year he flew home to Chile three times at a total cost of
60,000 pesos. This year he can fly to Chile the same number of times, buy exactly the same com-bination of other goods and services that he bought last year, and have 30,000 pesos left over.Because he is better off—his income can buy more—he may fly home more frequently. Second,the opportunity cost of flying home has changed. Before the price war, Luis had to sacrifice20,000 pesos worth of other goods and services each time he flew to Chile. After the price war,he must sacrifice only 10,000 pesos worth of other goods and services for each trip. The trade-off has changed. Both of these effects are likely to lead to a higher quantity demanded inresponse to the lower price.
In sum:
It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus , and to
expect quantity demanded to rise when price falls, ceteris paribus . Demand curves have a
negative slope.
Other Properties of Demand Curves Two additional things are notable about Alex’s
demand curve. First, it intersects the Y, or price, axis. This means that there is a price above
which she buys no gasoline. In this case, Alex simply stops driving when the price reaches $8 pergallon. As long as households have limited incomes and wealth, all demand curves will intersectthe price axis. For any commodity, there is always a price above which a household will not orcannot pay. Even if the good or service is very important, all households are ultimately con-strained, or limited, by income and wealth.CHAPTER 3 Demand, Supply, and Market Equilibrium 53
2Alfred Marshall, Principles of Economics , 8th ed. (New Y ork: Macmillan, 1948), p. 33. (The first edition was published in 1890.)
54 PART I Introduction to Economics
Second, Alex’s demand curve intersects the X, or quantity, axis. Even at a zero price, there is a
limit to how much she will drive. If gasoline were free, she would use 26 gallons, but not more.That demand curves intersect the quantity axis is a matter of common sense. Demand in a givenperiod of time is limited, if only by time, even at a zero price.
T o summarize what we know about the shape of demand curves:
1.They have a negative slope. An increase in price is likely to lead to a decrease in quantitydemanded, and a decrease in price is likely to lead to an increase in quantity demanded.
2.They intersect the quantity ( X-) axis, a result of time limitations and diminishing mar-
ginal utility.
3.They intersect the price ( Y-) axis, a result of limited income and wealth.
That is all we can say; it is not possible to generalize further. The actual shape of an individ-
ual household demand curve—whether it is steep or flat, whether it is bowed in or bowed out—depends on the unique tastes and preferences of the household and other factors. Somehouseholds may be very sensitive to price changes; other households may respond little to achange in price. In some cases, plentiful substitutes are available; in other cases, they are not.Thus, to fully understand the shape and position of demand curves, we must turn to the otherdeterminants of household demand.
Other Determinants of Household Demand
Of the many factors likely to influence a household’s demand for a specific product, we have consid-ered only the price of the product. Other determining factors include household income andwealth, the prices of other goods and services, tastes and preferences, and expectations.
Income and Wealth Before we proceed, we need to define two terms that are often con-
fused, income and wealth . A household’s income is the sum of all the wages, salaries, profits,
interest payments, rents, and other forms of earnings received by the household in a given
period of time . Income is thus a flow measure: We must specify a time period for it—income
per month orper year . Y ou can spend or consume more or less than your income in any given
period. If you consume less than your income, you save. T o consume more than your incomein a period, you must either borrow or draw on savings accumulated from previous periods.
Wealth is the total value of what a household owns minus what it owes. Another word for
wealth is net worth —the amount a household would have left if it sold all of its possessions and
paid all of its debts. Wealth is a stock measure: It is measured at a given point in time. If, in a given
period, you spend less than your income, you save; the amount that you save is added to yourwealth. Saving is the flow that affects the stock of wealth. When you spend more than yourincome, you dissave —you reduce your wealth.
Households with higher incomes and higher accumulated savings or inherited wealth can
afford to buy more goods and services. In general, we would expect higher demand at higher levelsof income/wealth and lower demand at lower levels of income/wealth. Goods for which demandgoes up when income is higher and for which demand goes down when income is lower are callednormal goods . Movie tickets, restaurant meals, telephone calls, and shirts are all normal goods.
However, generalization in economics can be hazardous. Sometimes demand for a good falls
when household income rises. Consider, for example, the various qualities of meat available.When a household’s income rises, it is likely to buy higher-quality meats—its demand for filetmignon is likely to rise—but its demand for lower-quality meats—chuck steak, for example—islikely to fall. Transportation is another example. At higher incomes, people can afford to fly.People who can afford to fly are less likely to take the bus long distances. Thus, higher incomemay reduce the number of times someone takes a bus. Goods for which demand tends to fall
when income rises are called inferior goods .
Prices of Other Goods and Services No consumer decides in isolation on the amount
of any one commodity to buy. Instead, each decision is part of a larger set of decisions that aremade simultaneously. Households must apportion their incomes over many different goods andservices. As a result, the price of any one good can and does affect the demand for other goods.This is most obviously the case when goods are substitutes for one another. For Alex the bus is analternative that she uses when gasoline gets expensive.income The sum of all a
household’s wages, salaries,profits, interest payments,
rents, and other forms of
earnings in a given period oftime. It is a flow measure.
wealth ornet worth The
total value of what a
household owns minus what itowes. It is a stock measure.
normal goods Goods for
which demand goes up when
income is higher and for which
demand goes down whenincome is lower.
inferior goods Goods for
which demand tends to fall
when income rises.
CHAPTER 3 Demand, Supply, and Market Equilibrium 55
When an increase in the price of one good causes demand for another good to increase (a
positive relationship), we say that the goods are substitutes .A fallin the price of a good causes
adecline in demand for its substitutes. Substitutes are goods that can serve as replacements for
one another.
T o be substitutes, two products do not need to be identical. Identical products are called
perfect substitutes . Japanese cars are not identical to American cars. Nonetheless, all have four
wheels, are capable of carrying people, and run on gasoline. Thus, significant changes in the priceof one country’s cars can be expected to influence demand for the other country’s cars.Restaurant meals are substitutes for meals eaten at home, and flying from New Y ork toWashington, D.C., is a substitute for taking the train.
Often two products “go together”—that is, they complement each other. Bacon and eggs are
complementary goods , as are cars and gasoline, and cameras and film. When two goods are
complements ,a decrease in the price of one results in an increase in demand for the other and vice
versa. The makers of Guitar Hero and Rock Band, two popular and competitive video games, under-stand that there is a strong connection between how many songs can be played on their operating plat-forms and how strong the demand is for their games. For iPods and Kindles as well, the availability ofcontent at low prices stimulates demand for the devices. The Economics in Practice above talks about
the complementarity between the Kindle and e-books.
Tastes and Preferences Income, wealth, and prices of goods available are the three factors
that determine the combinations of goods and services that a household is able to buy. Y ou know
that you cannot afford to rent an apartment at $1,200 per month if your monthly income is only$400, but within these constraints, you are more or less free to choose what to buy. Y our finalchoice depends on your individual tastes and preferences.
ECONOMICS IN PRACTICE
Kindle in the College Market?
Most of you are likely quite aware of the high price of text-
books. For some students, high prices lead to sharing texts orusing library copies. Jeff Bezos, who runs Amazon, the pro-ducer of the Kindle, thinks the high prices of printed textbooks provides an opportunity for his company to increasethe demand for the Kindle.
People buy Kindles so that they can read books on them.
Books are thus a complement to the Kindle. The cheaper theelectronic books you can buy are, the higher your demandfor the Kindle device. As the article here suggests, Amazon isworking with several universities and textbook publishers tomake textbooks available—for a much lower price—on theKindle. As the last line of the article tells us, this move isclearly intended to build demand for the Kindle itself. Thepresident of Amazon is well aware of the role of comple-ments in his business.
Amazon to Launch Kindle for Textbooks
The Wall Street Journal
Beginning this fall, some students at Case Western Reserve
University in Cleveland will be given large-screen Kindles with
textbooks for chemistry, computer science, and a freshmanseminar already installed, said Lev Gonick, the school’s chiefinformation officer. The university plans to compare the experi-
ences of students who get the Kindles and those who use tra-ditional textbooks, he said.
Amazon has worked out a deal with several textbook pub-
lishers to make their materials available for the device. Fiveother universities are involved in the Kindle project, according topeople briefed on the matter. They are Pace, Princeton, Reed,
Darden School at the University of Virginia, and Arizona State.
The moves are the latest by Amazon to promote the Kindle,which is the company’s first consumer-electronics device.
Source: The Wall Street Journal , excerpted from “Amazon to Launch
Kindle for T extbooks” by Geoffrey A. Fowler and Ben Worthen.Copyright 2009 by Dow Jones & Company, Inc. Reproduced with per-
mission of Dow Jones & Company, Inc. via Copyright Clearance Center .
substitutes Goods that can
serve as replacements for oneanother; when the price of one
increases, demand for the
other increases.
perfect substitutes
Identical products.
complements, complementary
goods Goods that “go
together”; a decrease in the
price of one results in an
increase in demand for theother and vice versa.
Changes in preferences can and do manifest themselves in market behavior. Thirty years
ago the major big-city marathons drew only a few hundred runners. Now tens of thousandsenter and run. The demand for running shoes, running suits, stopwatches, and other runningitems has greatly increased. For many years, people drank soda for refreshment. T oday conve-nience stores are filled with a dizzying array of iced teas, fruit juices, natural beverages, andmineral waters.
Within the constraints of prices and incomes, preference shapes the demand curve, but it is
difficult to generalize about tastes and preferences. First, they are volatile: Five years ago morepeople smoked cigarettes and fewer people had computers. Second, tastes are idiosyncratic:Some people like to text, whereas others still prefer to use e-mail; some people prefer dogs,whereas others are crazy about cats. Some eat fried cockroaches. The diversity of individualdemands is almost infinite.
One of the interesting questions in economics is why, in some markets, diverse con-
sumer tastes give rise to a variety of styles, while in other markets, despite a seeming diversityin tastes, we find only one or two varieties. All sidewalks in the United States are a similargray color, yet houses are painted a rainbow of colors. Y et it is not obvious on the face of itthat people would not prefer as much variety in their sidewalks as in their houses. T o answerthis type of question, we need to move beyond the demand curve. We will revisit this ques-tion in a later chapter.
Expectations What you decide to buy today certainly depends on today’s prices and your
current income and wealth. Y ou also have expectations about what your position will be in thefuture. Y ou may have expectations about future changes in prices too, and these may affect yourdecisions today.
There are many examples of the ways expectations affect demand. When people buy a house
or a car, they often must borrow part of the purchase price and repay it over a number of years. Indeciding what kind of house or car to buy, they presumably must think about their income today,as well as what their income is likely to be in the future.
As another example, consider a student in the final year of medical school living on a
scholarship of $12,000. Compare that student with another person earning $6 an hour at a full-time job, with no expectation of a significant change in income in the future. The two have virtu-ally identical incomes because there are about 2,000 working hours in a year (40 hours perweek /H1100350 work weeks per year). But even if they have the same tastes, the medical student is
likely to demand different goods and services, simply because of the expectation of a majorincrease in income later on.
Increasingly, economic theory has come to recognize the importance of expectations. We
will devote a good deal of time to discussing how expectations affect more than just demand. Forthe time being, however, it is important to understand that demand depends on more than justcurrent incomes, prices, and tastes.
Shift of Demand versus Movement Along a Demand Curve
Recall that a demand curve shows the relationship between quantity demanded and the price of a
good. Demand curves are derived while holding income, tastes, and other prices constant. Ifincome, tastes, or other prices change, we would have to derive an entirely new relationshipbetween price and quantity.
Let us return once again to Alex. (See Table 3.1 and Figure 3.2 on p. 52.) Suppose that
when we derived the demand curve in Figure 3.1 Alex was receiving a salary of $500 per weekafter taxes. If Alex faces a price of $3.00 per gallon and chooses to drive 250 miles per week, hertotal weekly expenditure works out to be $3.00 per gallon times 10 gallons of $30 per week.That amounts to 6.0 percent of her income.
Suppose now she were to receive a raise to $700 per week after taxes. Then if she continued
to buy only 10 gallons of gasoline a week it would absorb a smaller percentage of her income. The56 PART I Introduction to Economics
CHAPTER 3 Demand, Supply, and Market Equilibrium 57
higher income may well raise the amount of gasoline being used by Alex regardless of what she
was using before. Notice in Figure 3.3 that the entire curve has shifted to the right—at $3.00 a gal-lon the curve shows an increase in the quantity demanded from 10 to 15 gallons. At $5.00, thequantity demanded by Alex increases from 5 gallons to 10 gallons.
The fact that demand increased when income increased implies that gasoline is a normal good
to Alex.
P
05 1 5 10 20 30 26 q
Gallons per weekPrice per gallon ($)8.0010.00
6.00
5.00
3.007.00
1.004.00
2.009.00
24D0
D1
/L50304FIGURE 3.3 Shift of a Demand Curve Following a Rise in Income
When the price of a good changes, we move along the demand curve for that good. When any other factor
that influences demand changes (income, tastes, and so on), the relationship between price and quantity
is different; there is a shift of the demand curve, in this case from to . Gasoline is a normal good. D1 D0TABLE 3.2 Shift of Alex’s Demand Schedule Due to an Increase in Income
Schedule D0 Schedule D1
Price
(per Gallon)Quantity Demanded
(Gallons per Week at an Income
of $500 per Week)Quantity Demanded
(Gallons per Week at an
Income of $700 per Week)
$ 8.00 0 3
7.00 2 5
6.00 3 7
5.00 5 10
4.00 7 12
3.00 10 15
2.00 14 19
1.00 20 24
0.00 26 30
58 PART I Introduction to Economics
The conditions that were in place at the time we drew the original demand curve have now
changed. In other words, a factor that affects Alex’s demand for gasoline (in this case, her income)has changed, and there is now a new relationship between price and quantity demanded. Such achange is referred to as a shift of a demand curve .
It is very important to distinguish between a change in quantity demanded—that is, some
movement along a demand curve—and a shift of demand. Demand schedules and demand
curves show the relationship between the price of a good or service and the quantity demandedper period, ceteris paribus . If price changes, quantity demanded will change—this is a
movement along a demand curve . When any of the other factors that influence demand
change, however, a new relationship between price and quantity demanded is established—thisis a shift of a demand curve . The result, then, is a new demand curve. Changes in income, prefer-
ences, or prices of other goods cause a demand curve to shift:
Change in price of a good or service leads to
Change in quantity demanded (movement along a demand curve ).
Change in income, preferences, or prices of other goods or services leads to
Change in demand (shift of a demand curve ).
Figure 3.4 on the next page illustrates the differences between movement along a demand
curve and shifting demand curves. In Figure 3.4(a), an increase in household income causesdemand for hamburger (an inferior good) to decline, or shift to the left from to . (Becausequantity is measured on the horizontal axis, a decrease means a shift to the left .) In contrast,
demand for steak (a normal good) increases, or shifts to the right , when income rises.
In Figure 3.4(b), an increase in the price of hamburger from $1.49 to $3.09 a pound
causes a household to buy less hamburger each month. In other words, the higher pricecauses the quantity demanded to decline from 10 pounds to 5 pounds per month. This
change represents a movement along the demand curve for hamburger. In place of ham-
burger, the household buys more chicken. The household’s demand for chicken (a substitutefor hamburger) rises—the demand curve shifts to the right. At the same time, the demandfor ketchup (a good that complements hamburger) declines—its demand curve shifts to the left.
From Household Demand to Market Demand
Market demand is simply the sum of all the quantities of a good or service demanded per
period by all the households buying in the market for that good or service. Figure 3.5 showsthe derivation of a market demand curve from three individual demand curves. (Althoughthis market demand curve is derived from the behavior of only three people, most marketshave thousands, or even millions of demanders.) As the table in Figure 3.5 shows, when theprice of a pound of coffee is $3.50, both household A and household C would purchase 4 pounds per month, while household B would buy none. At that price, presumably, B drinkstea. Market demand at $3.50 would thus be a total of , or 8 pounds. At a price of $1.50 perpound, however, A would purchase 8 pounds per month; B, 3 pounds; and C, 9 pounds.Thus, at $1.50 per pound, market demand would be , or 20 pounds of coffee per month.
The total quantity demanded in the marketplace at a given price is simply the sum of all the
quantities demanded by all the individual households shopping in the market at that price .A
market demand curve shows the total amount of a product that would be sold at each price ifhouseholds could buy all they wanted at that price. As Figure 3.5 shows, the market demandcurve is the sum of all the individual demand curves—that is, the sum of all the individual quan-tities demanded at each price. Thus, the market demand curve takes its shape and position fromthe shapes, positions, and number of individual demand curves. If more people decide to shop in
8+3+94+4D1 D0movement along a demand
curve The change in quantity
demanded brought about by a
change in price.shift of a demand curve
The change that takes place ina demand curve correspondingto a new relationship between
quantity demanded of a goodand price of that good. The
shift is brought about by a
change in the original
conditions.
market demand The sum of
all the quantities of a good or
service demanded per period
by all the households buying inthe market for that good or
service.
CHAPTER 3 Demand, Supply, and Market Equilibrium 59
0
Pounds of hamburger per month
Pounds of hamburger per monthPrice per pound of hamburger ($)Price per pound of hamburger ($)
05 1 0 3.09
1.49 Demand for inferior good shifts left Demand for normal good shifts right
Demand for substitute good (chicken) shifts right
Demand for complementary good (ketchup) shifts left
Bottles of ketchup per monthPrice per bottle of ketchup ($)Pounds of chicken per monthPrice per pound of chicken ($)Pounds of steak per monthPrice per pound of steak ($)
0
0
0a. Income rises
b. Price of hamburger risesD0 D1D1 D0
D1
D0
D0 D1Quantity of hamburger demanded fallsP
qP
q
P
q
P
qP
q
/L50304FIGURE 3.4 Shifts versus Movement Along a Demand Curve
a.When income increases, the demand for inferior goods shifts to the left and the demand for normal goods
shifts to the right .b.If the price of hamburger rises, the quantity of hamburger demanded declines—this is a
movement along the demand curve. The same price rise for hamburger would shift the demand for chicken(a substitute for hamburger) to the right and the demand for ketchup (a complement to hamburger) tothe left.
60 PART I Introduction to Economics
a market, more demand curves must be added and the market demand curve will shift to the
right. Market demand curves may also shift as a result of preference changes, income changes, orchanges in the number of demanders.
An interesting fact about the market demand curve in Figure 3.5 is that at different
prices, not only the number of people demanding the product may change but also the type of
people demanding the product. When Apple halved the price of its iPhone in fall 2007, itannounced that it wanted to make the iPhone available to a broader group of people. Whenprices fall, people like those in household B in Figure 3.5 move into markets that are other-wise out of their reach.
As a general rule throughout this book, capital letters refer to the entire market and
lowercase letters refer to individual households or firms. Thus, in Figure 3.5, Qrefers to total
quantity demanded in the market, while qrefers to the quantity demanded by individ-
ual households.
Supply in Product/Output Markets
We turn now to explore the other half of markets, the firms that supply the goods and servicesconsumers want to purchase. What determines their willingness to produce and distribute thegoods and services that people want? How do we understand the supply part of the market?DC
DB
04 9 033.50
1.503.50
1.50
Pounds of coffee per monthPrice per pound ($)
Price per pound ($)
Pounds of coffee per monthPrice per pound ($)
DA + B + CPrice per pound ($)3.50
1.50
08 2 0Household B’s demand Household C’s demand
Market demand curvePounds of coffee per month04 83.50
1.50Household A’s demand
DA
Quantity ( q) Demanded byTotal Quantity
Demanded inthe Market ( Q) Price ABC
$3.50
1.504 + 0 + 4
8 + 3 + 9/H11005
/H110058
20
Pounds of coffee per monthP
q
P
QP
qP
q
/L50304FIGURE 3.5 Deriving Market Demand from Individual Demand Curves
Total demand in the marketplace is simply the sum of the demands of all the households shopping in a
particular market. It is the sum of all the individual demand curves—that is, the sum of all the individual
quantities demanded at each price.
CHAPTER 3 Demand, Supply, and Market Equilibrium 61
Firms build factories, hire workers, and buy raw materials because they believe they can sell
the products they make for more than it costs to produce them. In other words, firms supplygoods and services because they believe it will be profitable to do so. Supply decisions thusdepend on profit potential. Because profit is the difference between revenues and costs, supply is
likely to react to changes in revenues and changes in production costs. The amount of revenuethat a firm earns depends on what the price of its product in the market is and on how much itsells. Costs of production depend on many factors, the most important of which are (1) the kindsof inputs needed to produce the product, (2) the amount of each input required, and (3) theprices of inputs.
In later chapters, we will focus on how firms decide how to produce their goods and services
and explore the cost side of the picture more formally. For now, we will begin our examination offirm behavior by focusing on the output supply decision and the relationship between quantitysupplied and output price, ceteris paribus .
Price and Quantity Supplied: The Law of Supply
Quantity supplied is the amount of a particular product that firms would be willing and able to
offer for sale at a particular price during a given time period. A supply schedule shows how
much of a product firms will sell at alternative prices.
Let us look at an agricultural market as an example. Table 3.3 itemizes the quantities of soy-
beans that an individual representative farmer such as Clarence Brown might sell at variousprices. If the market paid $1.50 or less for a bushel for soybeans, Brown would not supply any soy-beans: When Farmer Brown looks at the costs of growing soybeans, including the opportunitycost of his time and land, $1.50 per bushel will not compensate him for those costs. At $1.75 perbushel, however, at least some soybean production takes place on Brown’s farm, and a priceincrease from $1.75 to $2.25 per bushel causes the quantity supplied by Brown to increase from10,000 to 20,000 bushels per year. The higher price may justify shifting land from wheat to soy-bean production or putting previously fallow land into soybeans, or it may lead to more intensivefarming of land already in soybeans, using expensive fertilizer or equipment that was not cost-justified at the lower price.
TABLE 3.3 Clarence Brown’s Supply
Schedule for Soybeans
Price
(per Bushel)Quantity Supplied
(Bushels per Year)
$1.50 0
1.75 10,000
2.25 20,000
3.00 30,000
4.00 45,000
5.00 45,000profit The difference between
revenues and costs.
quantity supplied The
amount of a particular product
that a firm would be willingand able to offer for sale at a
particular price during a given
time period.
supply schedule A table
showing how much of a
product firms will sell at
alternative prices.
Generalizing from Farmer Brown’s experience, we can reasonably expect an increase in
market price, ceteris paribus , to lead to an increase in quantity supplied for Brown and farmers
like him. In other words, there is a positive relationship between the quantity of a good sup-plied and price. This statement sums up the law of supply : An increase in market price will
lead to an increase in quantity supplied, and a decrease in market price will lead to a decreasein quantity supplied.law of supply The positive
relationship between price and
quantity of a good supplied:
An increase in market price willlead to an increase in quantity
supplied, and a decrease in
market price will lead to adecrease in quantity supplied.
62 PART I Introduction to Economics
The information in a supply schedule may be presented graphically in a supply curve .
Supply curves slope upward. The upward, or positive, slope of Brown’s curve in Figure 3.6 reflectsthis positive relationship between price and quantity supplied.
Note in Brown’s supply schedule, however, that when price rises from $4 to $5, quantity sup-
plied no longer increases. Often an individual firm’s ability to respond to an increase in price isconstrained by its existing scale of operations, or capacity, in the short run. For example, Brown’sability to produce more soybeans depends on the size of his farm, the fertility of his soil, and thetypes of equipment he has. The fact that output stays constant at 45,000 bushels per year suggeststhat he is running up against the limits imposed by the size of his farm, the quality of his soil, andhis existing technology.
In the longer run, however, Brown may acquire more land or technology may change, allow-
ing for more soybean production. The terms short run and long run have very precise meanings in
economics; we will discuss them in detail later. Here it is important only to understand that timeplays a critical role in supply decisions. When prices change, firms’ immediate response may bedifferent from what they are able to do after a month or a year. Short-run and long-run supplycurves are often different.
Other Determinants of Supply
Of the factors we have listed that are likely to affect the quantity of output supplied by a givenfirm, we have thus far discussed only the price of output. Other factors that affect supply includethe cost of producing the product and the prices of related products.
The Cost of Production For a firm to make a profit, its revenue must exceed its costs.
As an individual producer, like Farmer Brown, thinks about how much to supply at a particu-lar price, the producer will be looking at his or her costs. Brown’s supply decision is likely tochange in response to changes in the cost of production. Cost of production depends on asupply curve A graph
illustrating how much of a
product a firm will sell at
different prices.
Bushels of soybeans produced per yearPrice of soybeans per bushel ($)1.501.752.253.004.005.00
45,000 30,000 20,000 10,000 0P
q/L50298FIGURE 3.6 Clarence
Brown’s IndividualSupply Curve
A producer will supply more
when the price of output is
higher. The slope of a supply
curve is positive. Note that thesupply curve is red: Supply isdetermined by choices made
by firms.
number of factors, including the available technologies and the prices and quantities of the
inputs needed by the firm (labor, land, capital, energy, and so on).
T echnological change can have an enormous impact on the cost of production over time.
Consider agriculture. The introduction of fertilizers, the development of complex farm machin-ery, and the use of bioengineering to increase the yield of individual crops have all powerfullyaffected the cost of producing agricultural products. Farm productivity in the United States hasbeen increasing dramatically for decades. Yield per acre of corn production has increased fivefoldsince the late 1930s, and the amount of labor required to produce 100 bushels of corn has fallenfrom 108 hours in the late 1930s to 20 hours in the late 1950s to less than 2 hours today. (SeeTable 2.2 on p. 37.)
When a technological advance lowers the cost of production, output is likely to increase.
When yield per acre increases, individual farmers can and do produce more. The output of theFord Motor Company increased substantially after the introduction of assembly-line techniques.The production of electronic calculators, and later personal computers, boomed with the devel-opment of inexpensive techniques to produce microprocessors.
Cost of production is also directly affected by the price of the factors of production. In the
spring of 2008, the world price of oil rose to more than $100 per barrel from below $20 in 2002. Asa result, cab drivers faced higher gasoline prices, airlines faced higher fuel costs, and manufactur-ing firms faced higher heating bills. The result: Cab drivers probably spent less time drivingaround looking for customers, airlines cut a few low-profit routes, and some manufacturing plantsstopped running extra shifts. The moral of this story: Increases in input prices raise costs of pro-duction and are likely to reduce supply. The reverse occurred in 2009–2010 when oil prices fellback to $75 per barrel.
The Prices of Related Products Firms often react to changes in the prices of related
products. For example, if land can be used for either corn or soybean production, an increase insoybean prices may cause individual farmers to shift acreage out of corn production into soy-beans. Thus, an increase in soybean prices actually affects the amount of corn supplied.
Similarly, if beef prices rise, producers may respond by raising more cattle. However, leather
comes from cowhide. Thus, an increase in beef prices may actually increase the supply of leather.
T o summarize:
Assuming that its objective is to maximize profits, a firm’s decision about what quantity of
output, or product, to supply depends on:
1. The price of the good or service.
2. The cost of producing the product, which in turn depends on:
/L50766the price of required inputs (labor, capital, and land), and
/L50766the technologies that can be used to produce the product.
3. The prices of related products.CHAPTER 3 Demand, Supply, and Market Equilibrium 63
Shift of Supply versus Movement Along a Supply Curve
A supply curve shows the relationship between the quantity of a good or service supplied by a
firm and the price that good or service brings in the market. Higher prices are likely to lead to anincrease in quantity supplied, ceteris paribus . Remember: The supply curve is derived holding
everything constant except price. When the price of a product changes ceteris paribus , a change in
the quantity supplied follows—that is, a movement along a supply curve takes place. As you
have seen, supply decisions are also influenced by factors other than price. New relationshipsbetween price and quantity supplied come about when factors other than price change, and themovement along a supply
curve The change in quantity
supplied brought about by a
change in price.
result is a shift of a supply curve . When factors other than price cause supply curves to shift, we
say that there has been a change in supply .
Recall that the cost of production depends on the price of inputs and the technologies of
production available. Now suppose that a major breakthrough in the production of soybeanshas occurred: Genetic engineering has produced a superstrain of disease- and pest-resistantseed. Such a technological change would enable individual farmers to supply more soybeansat any market price. Table 3.4 and Figure 3.7 describe this change. At $3 a bushel, farmers
would have produced 30,000 bushels from the old seed (schedule in Table 3.4); with thelower cost of production and higher yield resulting from the new seed, they produce 40,000 bushels (schedule in Table 3.4). At $1.75 per bushel, they would have produced10,000 bushels from the old seed; but with the lower costs and higher yields, output rises to 23,000 bushels.
Increases in input prices may also cause supply curves to shift. If Farmer Brown faces higher
fuel costs, for example, his supply curve will shift to the left—that is, he will produce less at anyS
1S064 PART I Introduction to Economics
Bushels of soybeans produced per yearPrice of soybeans per bushel ($)S1 S0
10,000 30,000 23,000 40,000 01.753.00P
q
/L50304FIGURE 3.7 Shift of the Supply Curve for Soybeans Following Development of
a New Seed Strain
When the price of a product changes, we move along the supply curve for that product; the quantity supplied
rises or falls. When any other factor affecting supply changes, the supply curve shifts .shift of a supply curve
The change that takes place in
a supply curve corresponding
to a new relationship betweenquantity supplied of a good
and the price of that good. The
shift is brought about by achange in the originalconditions.
TABLE 3.4 Shift of Supply Schedule for Soybeans Following Development of a New
Disease-Resistant Seed Strain
Schedule S0 Schedule S1
Price
(per Bushel)Quantity Supplied
(Bushels per Year Using Old Seed)Quantity Supplied
(Bushels per Year Using New Seed)
$1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000
CHAPTER 3 Demand, Supply, and Market Equilibrium 65
given market price. If Brown’s soybean supply curve shifted far enough to the left, it would inter-
sect the price axis at a higher point, meaning that it would take a higher market price to induceBrown to produce any soybeans at all.
As with demand, it is very important to distinguish between movements along supply curves
(changes in quantity supplied) and shifts in supply curves (changes in supply):
Change in price of a good or service leads to
Change in quantity supplied (movement along a supply curve ).
Change in costs, input prices, technology, or prices of related goods and services leads to
Change in supply (shift of a supply curve ).
From Individual Supply to Market Supply
Market supply is determined in the same fashion as market demand. It is simply the sum of all
that is supplied each period by all producers of a single product. Figure 3.8 derives a market sup-ply curve from the supply curves of three individual firms. (In a market with more firms, totalmarket supply would be the sum of the amounts produced by each of the firms in that market.)As the table in Figure 3.8 shows, at a price of $3, farm A supplies 30,000 bushels of soybeans,
0 10,000 25,000 0 5,0003.00
1.751.75
Bushels of soybeans supplied per year0 10,000 30,0003.00
1.75Price of soybeans per bushel ($)Firm A’s supply
Quantity ( q) Supplied byTotal Quantity
Supplied inthe Market ( Q) Price AB C
$3.00
1.7530,000 + 10,000 + 25,000
10,000 + 5,000 + 10,000/H11005
/H1100565,000
25,000
Bushels of soybeans supplied per yearS
3.00
1.75
0 25,000 65,000Bushels of soybeans supplied per yearPrice of soybeans per bushel ($)
Price of soybeans per bushel ($)
Price of soybeans per bushel ($)Firm B’s supply
3.00
10,000Firm C’s supply
Bushels of soybeans supplied per year
Market supply curveSA
SA+B+CSB SCP
q
P
QP
qP
q
/L50304FIGURE 3.8 Deriving Market Supply from Individual Firm Supply Curves
Total supply in the marketplace is the sum of all the amounts supplied by all the firms selling in the market. It
is the sum of all the individual quantities supplied at each price.market supply The sum of all
that is supplied each period by
all producers of a single
product.
66 PART I Introduction to Economics
farm B supplies 10,000 bushels, and farm C supplies 25,000 bushels. At this price, the total
amount supplied in the market is , or 65,000 bushels. At a price of$1.75, however, the total amount supplied is only 25,000 bushels ( ).Thus, the market supply curve is the simple addition of the individual supply curves of all thefirms in a particular market—that is, the sum of all the individual quantities supplied ateach price.
The position and shape of the market supply curve depends on the positions and shapes of
the individual firms’ supply curves from which it is derived. The market supply curve alsodepends on the number of firms that produce in that market. If firms that produce for a par-ticular market are earning high profits, other firms may be tempted to go into that line of busi-ness. When the technology to produce computers for home use became available, literallyhundreds of new firms got into the act. The popularity and profitability of professional foot-ball has, three times, led to the formation of new leagues. When new firms enter an industry,the supply curve shifts to the right. When firms go out of business, or “exit” the market, thesupply curve shifts to the left.
Market Equilibrium
So far, we have identified a number of factors that influence the amount that householdsdemand and the amount that firms supply in product (output) markets. The discussion hasemphasized the role of market price as a determinant of both quantity demanded and quantitysupplied. We are now ready to see how supply and demand in the market interact to determinethe final market price.
We have been very careful in our discussions thus far to separate household decisions
about how much to demand from firm decisions about how much to supply. The operationof the market, however, clearly depends on the interaction between suppliers and deman-ders. At any moment, one of three conditions prevails in every market: (1) The quantitydemanded exceeds the quantity supplied at the current price, a situation called excess
demand ; (2) the quantity supplied exceeds the quantity demanded at the current price, a
situation called excess supply ; or (3) the quantity supplied equals the quantity demanded at
the current price, a situation called equilibrium . At equilibrium, no tendency for price to
change exists.
Excess Demand
Excess demand , or a shortage , exists when quantity demanded is greater than quantity
supplied at the current price. Figure 3.9, which plots both a supply curve and a demandcurve on the same graph, illustrates such a situation. As you can see, market demand at $1.75 per bushel (50,000 bushels) exceeds the amount that farmers are currently supplying(25,000 bushels).
When excess demand occurs in an unregulated market, there is a tendency for price to rise as
demanders compete against each other for the limited supply. The adjustment mechanisms maydiffer, but the outcome is always the same. For example, consider the mechanism of an auction.In an auction, items are sold directly to the highest bidder. When the auctioneer starts the biddingat a low price, many people bid for the item. At first, there is a shortage: Quantity demandedexceeds quantity supplied. As would-be buyers offer higher and higher prices, bidders drop outuntil the one who offers the most ends up with the item being auctioned. Price rises until quan-tity demanded and quantity supplied are equal.
At a price of $1.75 (see Figure 3.9 again), farmers produce soybeans at a rate of 25,000 bushels
per year, but at that price, the demand is for 50,000 bushels. Most farm products are sold to localdealers who in turn sell large quantities in major market centers, where bidding would push pricesup if quantity demanded exceeded quantity supplied. As price rises above $1.75, two things hap-pen: (1) The quantity demanded falls as buyers drop out of the market and perhaps choose a10,000 +5,000 +10,00030,000 +10,000 +25,000
equilibrium The condition
that exists when quantity
supplied and quantitydemanded are equal. At
equilibrium, there is no
tendency for price to change.
excess demand orshortage
The condition that exists when
quantity demanded exceedsquantity supplied at the
current price.
CHAPTER 3 Demand, Supply, and Market Equilibrium 67
substitute, and (2) the quantity supplied increases as farmers find themselves receiving a higher
price for their product and shift additional acres into soybean production.3
This process continues until the shortage is eliminated. In Figure 3.9, this occurs at
$2.50, where quantity demanded has fallen from 50,000 to 35,000 bushels per year and quan-tity supplied has increased from 25,000 to 35,000 bushels per year. When quantity demandedand quantity supplied are equal and there is no further bidding, the process has achieved anequilibrium, a situation in which there is no natural tendency for further adjustment .
Graphically, the point of equilibrium is the point at which the supply curve and the demandcurve intersect.
Increasingly, items are auctioned over the Internet. Companies such as eBay connect buyers
and sellers of everything from automobiles to wine and from computers to airline tickets.Auctions are occurring simultaneously with participants located across the globe. The principlesthrough which prices are determined in these auctions are the same: When excess demand exists,prices rise.
While the principles are the same, the process through which excess demand leads to
higher prices is different in different markets. Consider the market for houses in the hypothet-ical town of Boomville with a population of 25,000 people, most of whom live in single-familyhomes. Normally, about 75 homes are sold in the Boomville market each year. However, lastyear a major business opened a plant in town, creating 1,500 new jobs that pay good wages.This attracted new residents to the area, and real estate agents now have more buyers than thereare properties for sale. Quantity demanded now exceeds quantity supplied. In other words,there is a shortage.
Properties are sold very quickly, and housing prices begin to rise. Boomville sellers soon
learn that there are more buyers than usual, and they begin to hold out for higher offers. AsS
D
50,000 35,000 25,000 02.50
1.75Price of soybeans per bushel ($)
Bushels of soybeansEquilibrium point
Excess demand
= shortageP
Q
/L50304FIGURE 3.9 Excess Demand, or Shortage
At a price of $1.75 per bushel, quantity demanded exceeds quantity supplied. When excess demand exists, there is a
tendency for price to rise. When quantity demanded equals quantity supplied, excess demand is eliminated andthe market is in equilibrium. Here the equilibrium price is $2.50 and the equilibrium quantity is 35,000 bushels.
3Once farmers have produced in any given season, they cannot change their minds and produce more, of course. When we
derived Clarence Brown’s supply schedule in Table 3.3, we imagined him reacting to prices that existed at the time he decidedhow much land to plant in soybeans. In Figure 3.9, the upward slope shows that higher prices justify shifting land from othercrops. Final price may not be determined until final production figures are in. For our purposes here, however, we have ignoredthis timing problem. The best way to think about it is that demand and supply are flows ,o r rates , of production—that is, we are
talking about the number of bushels produced per production period . Adjustments in the rate of production may take place over
a number of production periods.
68 PART I Introduction to Economics
prices for Boomville houses rise, quantity demanded eventually drops off and quantity sup-
plied increases: (1) Encouraged by the high prices, builders begin constructing new houses,and (2) some people, attracted by the higher prices their homes will fetch, put their houses onthe market. Discouraged by higher prices, however, some potential buyers (demanders) maybegin to look for housing in neighboring towns and settle on commuting. Eventually, equilib-rium will be reestablished, with the quantity of houses demanded just equal to the quantity ofhouses supplied.
Although the mechanics of price adjustment in the housing market differ from the mechan-
ics of an auction, the outcome is the same:
When quantity demanded exceeds quantity supplied, price tends to rise. When the price in
a market rises, quantity demanded falls and quantity supplied rises until an equilibrium isreached at which quantity demanded and quantity supplied are equal.
This process is called price rationing . When a shortage exists, some people will be satisfied
and some will not. When the market operates without interference, price increases will dis-tribute what is available to those who are willing and able to pay the most. As long as there isa way for buyers and sellers to interact, those who are willing to pay more will make that factknown somehow. (We discuss the nature of the price system as a rationing device in detail inChapter 4.)
Excess Supply
Excess supply , or a surplus , exists when the quantity supplied exceeds the quantity demanded
at the current price. As with a shortage, the mechanics of price adjustment in the face of a sur-plus can differ from market to market. For example, if automobile dealers find themselves withunsold cars in the fall when the new models are coming in, you can expect to see price cuts.Sometimes dealers offer discounts to encourage buyers; sometimes buyers themselves simplyoffer less than the price initially asked. In any event, products do no one any good sitting indealers’ lots or on warehouse shelves. The auction metaphor introduced earlier can also beapplied here: If the initial asking price is too high, no one bids and the auctioneer tries a lowerprice. It is almost always true that certain items do not sell as well as anticipated during theChristmas holidays. After Christmas, most stores have big sales during which they lower theprices of overstocked items. Quantities supplied exceeded quantities demanded at the currentprices, so stores cut prices.
Figure 3.10 illustrates another excess supply/surplus situation. At a price of $3 per bushel,
suppose farmers are supplying soybeans at a rate of 40,000 bushels per year, but buyers aredemanding only 20,000. With 20,000 (40,000 minus 20,000) bushels of soybeans going unsold,the market price falls. As price falls from $3.00 to $2.50, quantity supplied decreases from40,000 bushels per year to 35,000. The lower price causes quantity demanded to rise from20,000 to 35,000. At $2.50, quantity demanded and quantity supplied are equal. For the datashown here, $2.50 and 35,000 bushels are the equilibrium price and quantity, respectively.
Although oil prices rose to record levels in 2008, back in 2001, crude oil production
worldwide exceeded the quantity demanded and prices fell significantly as competing pro-ducer countries tried to maintain their share of world markets. Although the mechanism bywhich price is adjusted is different for automobiles, housing, soybeans, and crude oil, the out-come is the same:
When quantity supplied exceeds quantity demanded at the current price, the price tends to
fall. When price falls, quantity supplied is likely to decrease and quantity demanded is likelyto increase until an equilibrium price is reached where quantity supplied and quantitydemanded are equal.excess supply orsurplus
The condition that exists when
quantity supplied exceeds
quantity demanded at thecurrent price.
CHAPTER 3 Demand, Supply, and Market Equilibrium 69
S
D
40,000 35,000 20,000Excess supply = surplus
03.00
2.50Price of soybeans per bushel ($)
Bushels of soybeansEquilibrium pointP
Q/L50296FIGURE 3.10 Excess
Supply, or Surplus
At a price of $3.00, quantity
supplied exceeds quantity
demanded by 20,000 bushels.
This excess supply will cause theprice to fall.Price of coffee per pound ($)
Billions of pounds of coffee per year0 6.6 9.9 13.21.202.40S1
S0
DInitial
equilibrium
Excess
demand (shortage)
at initial priceP
Q/L50296FIGURE 3.11
The Coffee Market:
A Shift of Supply and Subsequent Price Adjustment
Before the freeze, the coffee mar-
ket was in equilibrium at a price
of $1.20 per pound. At that
price, quantity demandedequaled quantity supplied. Thefreeze shifted the supply curve to
the left (from to ), increasing the
equilibrium price to $2.40.S
1 S0Changes in Equilibrium
When supply and demand curves shift, the equilibrium price and quantity change. The following
example will help to illustrate this point.
South America is a major producer of coffee beans. A cold snap there can reduce the coffee
harvest enough to affect the world price of coffee beans. In the mid-1990s, a major freeze hitBrazil and Colombia and drove up the price of coffee on world markets to a record $2.40 perpound. Severe hurricanes in the Caribbean caused a similar shift of supply in 2005.
Figure 3.11 illustrates how the freeze pushed up coffee prices. Initially, the market was in equilib-
rium at a price of $1.20. At that price, the quantity demanded was equal to quantity supplied (13.2 bil-lion pounds). At a price of $1.20 and a quantity of 13.2 billion pounds, the demand curve (labeled D)
intersected the initial supply curve (labeled ). (Remember that equilibrium exists when quantitydemanded equals quantity supplied—the point at which the supply and demand curves intersect.)
The freeze caused a decrease in the supply of coffee beans. That is, the freeze caused the sup-
ply curve to shift to the left. In Figure 3.11, the new supply curve (the supply curve that shows therelationship between price and quantity supplied after the freeze) is labeled .
At the initial equilibrium price, $1.20, there is now a shortage of coffee. If the price were to
remain at $1.20, quantity demanded would not change; it would remain at 13.2 billion pounds.S
1S0
70 PART I Introduction to Economics
However, at that price, quantity supplied would drop to 6.6 billion pounds. At a price of $1.20,
quantity demanded is greater than quantity supplied.
When excess demand exists in a market, price can be expected to rise, and rise it did. As the
figure shows, price rose to a new equilibrium at $2.40. At $2.40, quantity demanded is againequal to quantity supplied, this time at 9.9 billion pounds—the point at which the new supplycurve ( ) intersects the demand curve.
Notice that as the price of coffee rose from $1.20 to $2.40, two things happened. First, the
quantity demanded declined (a movement along the demand curve) as people shifted to substi-tutes such as tea and hot cocoa. Second, the quantity supplied began to rise, but within the limitsimposed by the damage from the freeze. (It might also be that some countries or areas with highcosts of production, previously unprofitable, came into production and shipped to the world mar-ket at the higher price.) That is, the quantity supplied increased in response to the higher pricealong the new supply curve, which lies to the left of the old supply curve. The final result was a
higher price ($2.40), a smaller quantity finally exchanged in the market (9.9 billion pounds), andcoffee bought only by those willing to pay $2.40 per pound.S
1
ECONOMICS IN PRACTICE
High Prices for Tomatoes
The winter of 2010 was a very cold one for Florida, where much of the
U.S. fresh fruit and vegetable supply is produced. The article below
describes the effect on the price of fresh tomatoes resulting from thefreeze. With fewer tomatoes around (the supply curve shifted left dueto the freeze), the price of tomatoes increased fivefold. What the
reporter calls a shortage, we economists simply note as a shift in the
supply curve!
Note the interesting comment by Mr. Brown, the executive vice
president of the Florida T omato Growers Exchange, when people
complained to him about the high price of tomatoes. “Doesn’t mat-ter,” he opined, “because there isn’t anything to sell.” It is precisely
because there is less to sell that the price has in fact risen!
Tomatoes Get Sliced From Menus
The Wall Street Journal
A shortage of tomatoes from weather-battered Florida
is forcing restaurants and supermarkets to ration supplies amid
soaring prices for America’s most popular fresh vegetable.
Fast-food restaurant chains such as Wendy’s have
stopped automatically including tomatoes in sandwiches; nowcustomers have to know to ask.
Even then, consumers might not get what they usually do.
At Lloyd’s, a white-table cloth restaurant across the streetfrom the Chicago Mercantile Exchange, signs went up thisweek warning that only plum tomatoes are available.
“People love having tomatoes in their salad and in
sandwiches, but we want people to know ahead of time
that the quality just isn’t what they are used to,” said Sam Berngard, president of Taste America RestaurantGroup LLC, which operates Lloyd’s and two Chicago
seafood restaurants.
Subway is continuing to offer tomatoes on its sand-
wiches, but the chain is using different varieties to ensure thatit has enough on hand.Fresh tomatoes are in short supply because of the
unusual spell of freezing temperatures that hugged Floridain January. The cold temperatures that dented citrus pro-duction also destroyed roughly 70% of the tomato crop in
Florida, which is the largest source of U.S.-grown fresh
tomatoes this time of year.
Reggie Brown, executive vice president of Florida Tomato
Growers Exchange, a Maitland, Florida, trade group, saidTuesday that a 25-pound box of tomatoes is trading for $30,
compared with $6.45 a year ago.
Some restaurants have been told they would have to
spend up to $45 for a box of tomatoes in recent days.“Doesn’t matter though, because there isn’t anything to sell,”said Mr. Brown, who calculates the state’s shipments are
running at about 30% of normal.
Source: The Wall Street Journal , excerpted from “T omatoes Get Sliced
from Menus” by Scott Kilman and Julie Jargon. Copyright 2010 by Dow
Jones & Company, Inc. Reproduced with permission of Dow Jones &
Company, Inc. via Copyright Clearance Center.
CHAPTER 3 Demand, Supply, and Market Equilibrium 71
S
0P1
P0
D1
D0
Q0 Q11. Increase in income:
X is a normal good
Quantity Quantity Quantity
PricePricePrice
Quantity Quantity Quantity
PricePricePrice
PricePrice
Quantity
Quantity QuantityQuantityPricePriceS
0P0
P1
D1D0
Q0 Q12. Increase in income:
X is an inferior good
S
0P1P0
D1D0
Q0 Q13. Decrease in income:
X is a normal good
S
0P0P1
D1 D0
Q0Q14. Decrease in income:
X is an inferior good
S
0P0P1
D1 D0
Q0 Q15. Increase in the price
of a substitute for X
S
0P1P0
D1D0
Q0 Q16. Increase in the price
of a complement for X
S
0P1P0
D1D0
Q0 Q17. Decrease in the price
of a substitute for X
S
0P0P1
D1D0
Q0 Q18. Decrease in the price
of a complement for Xa. Demand shifts
b. Supply shifts
0P0P1
D
Q0 Q19. Increase in the cost
of production of X
S1
S0
0P0
D
Q0 Q110. Decrease in the cost
of production of X
S1S0
P1
/L50304FIGURE 3.12 Examples of Supply and Demand Shifts for Product XSince many market prices are driven by the interaction of millions of buyers and sellers, it is
often difficult to predict how they will change. A series of events in the mid-1990s led to the left-ward shift in supply, thus driving up the price of coffee, but the opposite occurred more recently.T oday coffee beans are exported by over 50 countries, with Brazil being the largest producer withabout 30 percent of the market. Large increases in production have kept prices low. In July 2007,the average price per pound was $1.06.
Figure 3.12 summarizes the possible supply and demand shifts that have been discussed and
the resulting changes in equilibrium price and quantity. Study the graphs carefully to ensure thatyou understand them.
72 PART I Introduction to Economics
Demand and Supply in Product Markets:
A Review
As you continue your study of economics, you will discover that it is a discipline full of
controversy and debate. There is, however, little disagreement about the basic way thatthe forces of supply and demand operate in free markets. If you hear that a freeze in Floridahas destroyed a good portion of the citrus crop, you can bet that the price of orangeswill rise. If you read that the weather in the Midwest has been good and a record corncrop is expected, you can bet that corn prices will fall. When fishermen in Massachusetts goon strike and stop bringing in the daily catch, you can bet that the price of local fish willgo up.
Here are some important points to remember about the mechanics of supply and demand in
product markets:
1.A demand curve shows how much of a product a household would buy if it could buy all itwanted at the given price. A supply curve shows how much of a product a firm would sup-ply if it could sell all it wanted at the given price.
2.Quantity demanded and quantity supplied are always per time period—that is, per day, permonth, or per year.
3.The demand for a good is determined by price, household income and wealth, prices ofother goods and services, tastes and preferences, and expectations.
4.The supply of a good is determined by price, costs of production, and prices of relatedproducts. Costs of production are determined by available technologies of production andinput prices.
5.Be careful to distinguish between movements along supply and demand curves andshifts of these curves. When the price of a good changes, the quantity of that gooddemanded or supplied changes—that is, a movement occurs along the curve. When anyother factor changes, the curve shifts, or changes position.
6.Market equilibrium exists only when quantity supplied equals quantity demanded at thecurrent price.
Looking Ahead: Markets and the Allocation
of Resources
Y ou can already begin to see how markets answer the basic economic questions of what is pro-
duced, how it is produced, and who gets what is produced. A firm will produce what is prof-itable to produce. If the firm can sell a product at a price that is sufficient to ensure a profitafter production costs are paid, it will in all likelihood produce that product. Resources willflow in the direction of profit opportunities.
/L50766Demand curves reflect what people are willing and able to pay for products; demandcurves are influenced by incomes, wealth, preferences, prices of other goods, andexpectations. Because product prices are determined by the interaction of supply anddemand, prices reflect what people are willing to pay. If people’s preferences or incomeschange, resources will be allocated differently. Consider, for example, an increase in demand—a shift in the market demand curve. Beginning at an equilibrium,households simply begin buying more. At the equilibrium price, quantity demandedbecomes greater than quantity supplied. When there is excess demand, prices will rise,and higher prices mean higher profits for firms in the industry. Higher profits, in turn,
CHAPTER 3 Demand, Supply, and Market Equilibrium 73
ECONOMICS IN PRACTICE
Why Do the Prices of Newspapers Rise?
In 2006, the average price for a daily edition of a Baltimore newspa-
per was $0.50. In 2007, the average price had risen to $0.75. Threedifferent analysts have three different explanations for the higherequilibrium price.
Analyst 1: The higher price for Baltimore newspapers is good
news because it means the population is better informed aboutpublic issues. These data clearly show that the citizens ofBaltimore have a new, increased regard for newspapers.
Analyst 2: The higher price for Baltimore newspapers is bad
news for the citizens of Baltimore. The higher cost of paper, ink,and distribution reflected in these higher prices will furtherdiminish the population’s awareness of public issues.
Analyst 3: The higher price for Baltimore newspapers is an
unfortunate result of newspapers trying to make money as manyconsumers have turned to the Internet to access news coveragefor free.
As economists, we are faced with two tasks in looking at these
explanations: Do they make sense based on what we know abouteconomic principles? And if they do make sense, can we figure outwhich explanation applies to the case of rising newspaper pricesin Baltmore?
What is Analyst 1 saying? Her observation about consumers’
new increased regard for newspapers tells us something about thedemand curve. Analyst 1 seems to be arguing that tastes havechanged in favor of newspapers, which would mean a shift in thedemand curve to the right. With upward-sloping supply, such ashift would produce a price increase. So Analyst 1’s story is plausible.Analyst 2 refers to an increased cost of newsprint. This would
cause production costs of newspapers to rise, shifting the supplycurve to the left. A downward-sloping demand curve also results inincreased prices. So Analyst 2 also has a plausible story.
Since Analyst 1 and Analyst 2 have plausible stories based on
economic principles, we can look at evidence to see who is in factright. If you go back to the graphs in Figure 3.12 on p. 71, you willfind a clue. When demand shifts to the right (as in Analyst 1’s story)the price rises, but so does the quantity as shown in Figure (a).When supply shifts to the left (as in Analyst 2’s story) the pricerises, but the quantity falls as shown in Figure (b). So we wouldlook at what happened to newspaper circulation during this periodto see whether the price increase is from the demand side or thesupply side. In fact, in most markets, including Baltimore, quanti-ties of newspapers bought have been falling, so Analyst 2 is mostlikely correct.
But be careful. Both analysts may be correct. If demand shifts to
the right and supply shifts to the left by a greater amount, the pricewill rise and the quantity sold will fall.
What about Analyst 3? Analyst 3 clearly never had an economics
course! Free Internet access to news is a substitute for print media. Adecrease in the price of this substitute should shift the demand fornewspapers to the left. The result should be a lower price, not a priceincrease. The fact that the newspaper publishers are “trying to makemoney” faced with this new competition does not change the laws ofsupply and demand.Price of a newspaper
Quantity of newspapersP1
D1
D0P0
Q0 Q1a. Demand shifts to the right
S
Price of a newspaper
Quantity of newspapersS1
S0
D
Q0 Q1b. Supply shifts to the left
P1
P0
74 PART I Introduction to Economics
SUMMARY
1.In societies with many people, production must satisfy
wide-ranging tastes and preferences, and producers musttherefore specialize.
FIRMS AND HOUSEHOLDS: THE BASIC DECISION-
MAKING UNITS p. 47
2.Afirm exists when a person or a group of people decides to
produce a product or products by transforming resources, orinputs , into outputs —the products that are sold in the mar-
ket. Firms are the primary producing units in a marketeconomy. We assume that firms make decisions to try tomaximize profits.
3.Households are the primary consuming units in an economy.
All households’ incomes are subject to constraints.
INPUT MARKETS AND OUTPUT MARKETS: THE
CIRCULAR FLOW p. 48
4.Households and firms interact in two basic kinds of
markets: product oroutput markets and input orfactor
markets . Goods and services intended for use by house-
holds are exchanged in output markets. In outputmarkets, competing firms supply and competing house-
holds demand. In input markets, competing firmsdemand and competing households supply.
5.Ultimately, firms choose the quantities and character of outputs produced, the types and quantities of inputsdemanded, and the technologies used in production.Households choose the types and quantities of pro-ducts demanded and the types and quantities ofinputs supplied.
DEMAND IN PRODUCT/OUTPUT MARKETS p. 50
6.The quantity demanded of an individual product by an indi-vidual household depends on (1) price, (2) income, (3) wealth,(4) prices of other products, (5) tastes and preferences, and (6) expectations about the future.
7.Quantity demanded is the amount of a product that an indi-
vidual household would buy in a given period if it could buyall that it wanted at the current price.
8.Ademand schedule shows the quantities of a product
that a household would buy at different prices. The same information can be presented graphically in ademand curve .provide existing firms with an incentive to expand and new firms with an incentive
to enter the industry. Thus, the decisions of independent private firms responding toprices and profit opportunities determine what will be produced. No central direction
is necessary.
Adam Smith saw this self-regulating feature of markets more than 200 years ago:
Every individual …b y p u r s uing his own interest …p r o m o t e s that of society. He is led . . .
by an invisible hand to promote an end which was no part of his intention.
4
The term Smith coined, the invisible hand , has passed into common parlance and is still used
by economists to refer to the self-regulation of markets.
/L50766Firms in business to make a profit have a good reason to choose the best available technology—lower costs mean higher profits. Thus, individual firms determine how to produce their prod-
ucts, again with no central direction.
/L50766So far, we have barely touched on the question of distribution— who gets what is produced?
Y ou can see part of the answer in the simple supply and demand diagrams. When a good is inshort supply, price rises. As they do, those who are willing and able to continue buying do so;others stop buying.
The next chapter begins with a more detailed discussion of these topics. How, exactly, is the
final allocation of resources (the mix of output and the distribution of output) determined in amarket system?
4Adam Smith, The Wealth of Nations , Modern Library Edition (New Y ork: Random House, 1937), p. 456 (1st ed., 1776).
CHAPTER 3 Demand, Supply, and Market Equilibrium 75
9.The law of demand states that there is a negative relationship
between price and quantity demanded: As price rises, quan-tity demanded decreases and vice versa. Demand curvesslope downward.
10. All demand curves eventually intersect the price axis becausethere is always a price above which a household cannot orwill not pay. Also, all demand curves eventually intersect thequantity axis because demand for most goods is limited, ifonly by time, even at a zero price.
11. When an increase in income causes demand for a good torise, that good is a normal good . When an increase in
income causes demand for a good to fall, that good is aninferior good .
12. If a rise in the price of good X causes demand for good Y to
increase, the goods are substitutes . If a rise in the price of
X causes demand for Y to fall, the goods are complements .
13. Market demand is simply the sum of all the quantities of
a good or service demanded per period by all the house-holds buying in the market for that good or service. It isthe sum of all the individual quantities demanded at each price.
SUPPLY IN PRODUCT/OUTPUT MARKETS p. 60
14. Quantity supplied by a firm depends on (1) the price of the
good or service; (2) the cost of producing the product, whichincludes the prices of required inputs and the technologiesthat can be used to produce the product; and (3) the pricesof related products.15. Market supply is the sum of all that is supplied in
each period by all producers of a single product. It is the sum of all the individual quantities supplied at each price.
16. It is very important to distinguish between movements
along demand and supply curves and shifts of demand
and supply curves. The demand curve shows the rela-tionship between price and quantity demanded. Thesupply curve shows the relationship between price andquantity supplied. A change in price is a movement alongthe curve. Changes in tastes, income, wealth, expectations,or prices of other goods and services cause demandcurves to shift; changes in costs, input prices, technology,or prices of related goods and services cause supplycurves to shift.
MARKET EQUILIBRIUM p. 66
17. When quantity demanded exceeds quantity supplied at thecurrent price, excess demand (or a shortage ) exists and the
price tends to rise. When prices in a market rise, quantitydemanded falls and quantity supplied rises until an equilib-rium is reached at which quantity supplied and quantitydemanded are equal. At equilibrium , there is no further ten-
dency for price to change.
18. When quantity supplied exceeds quantity demanded at thecurrent price, excess supply (or a surplus ) exists and the price
tends to fall. When price falls, quantity supplied decreasesand quantity demanded increases until an equilibrium priceis reached where quantity supplied and quantity demandedare equal.
REVIEW TERMS AND CONCEPTS
capital market, p. 49
complements, complementary goods, p. 55
demand curve, p. 51
demand schedule, p. 51
entrepreneur, p. 48
equilibrium, p. 66
excess demand orshortage, p. 66
excess supply orsurplus, p. 68
factors of production, p. 49
firm, p. 48
households, p. 48
income, p. 54 inferior goods, p. 54
input orfactor markets, p. 48
labor market, p. 49
land market, p. 49
law of demand, p. 52
law of supply, p. 61
market demand, p. 58
market supply, p. 65
movement along a demand curve, p. 58
movement along a supply curve, p. 63
normal goods, p. 54
perfect substitutes, p. 55 product oroutput markets, p. 48
profit, p. 61
quantity demanded, p. 50
quantity supplied, p. 61
shift of a demand curve, p. 58
shift of a supply curve, p. 64
substitutes, p. 55
supply curve, p. 62
supply schedule, p. 61
wealth ornet worth, p. 54
76 PART I Introduction to Economics
PROBLEMS
1.Illustrate the following with supply and demand curves:
a.With increased access to wireless technology and lighter
weight, the demand for laptop computers has increased sub-stantially. Laptops have also become easier and cheaper toproduce as new technology has come online. Despite theshift of demand, prices have fallen.
b.Cranberry production in Massachusetts totaled 2.37 million
barrels in 2008, a 56 percent increase from the 1.52 million
barrels produced in 2007. Demand increased by even morethan supply, pushing 2008 prices to $56.70 per barrel from$49.80 in 2007.
c.During the high-tech boom in the late 1990s, San Jose office
space was in very high demand and rents were very high.With the national recession that began in March 2001, how-
ever, the market for office space in San Jose (Silicon Valley)was hit very hard, with rents per square foot falling. In 2005,the employment numbers from San Jose were rising slowlyand rents began to rise again. Assume for simplicity that no
new office space was built during the period.
d.Before economic reforms were implemented in the coun-
tries of Eastern Europe, regulation held the price of breadsubstantially below equilibrium. When reforms were
implemented, prices were deregulated and the price of
bread rose dramatically. As a result, the quantity of breaddemanded fell and the quantity of bread supplied rose sharply.
e.The steel industry has been lobbying for high taxes on
imported steel. Russia, Brazil, and Japan have been produc-ing and selling steel on world markets at $610 per metric
ton, well below what equilibrium would be in the UnitedStates with no imports. If no imported steel was permittedinto the country, the equilibrium price would be $970 per
metric ton. Show supply and demand curves for the United
States, assuming no imports; then show what the graphwould look like if U.S. buyers could purchase all the steelthat they wanted from world markets at $610 per metric
ton; show the quantity of imported steel.
2.On Sunday, August 19, the Detroit Tigers and the New Y ork
Y ankees played baseball at Y ankee Stadium. Both teams were inpursuit of league championships. Tickets to the game were sold
out, and many more fans would have attended if additional
tickets had been available. On that same day, the ClevelandIndians and the Tampa Bay Rays played each other and soldtickets to only 22,500 people in Tampa.
The Rays stadium, Tropicana Field, holds 43,772. Y ankee
Stadium holds 57,478. Assume for simplicity that tickets to all
regular-season games are priced at $40.a.Draw supply and demand curves for the tickets to each of
the two games. ( Hint: Supply is fixed. It does not change
with price.) Draw one graph for each game.
b.Is there a pricing policy that would have filled the ballpark
for the Tampa game? If the Rays adopted such a strategy,would it bring in more or less revenue?
c.The price system was not allowed to work to ration the
New Y ork tickets when they were initially sold to the
public. How do you know? How do you suppose the tickets
were rationed?
All problems are available on www.myeconlab.com
3.During the last 10 years, Orlando, Florida, grew rapidly,
with new jobs luring young people into the area. Despite
increases in population and income growth that expandeddemand for housing, the price of existing houses barelyincreased. Why? Illustrate your answer with supply anddemand curves.
4.Do you agree or disagree with each of the following statements?
Briefly explain your answers and illustrate each with supply anddemand curves.
a.The price of a good rises, causing the demand for another
good to fall. Therefore, the two goods are substitutes.
b.A shift in supply causes the price of a good to fall. The shift
must have been an increase in supply.
c.During 2009, incomes fell sharply for many Americans. This
change would likely lead to a decrease in the prices of both
normal and inferior goods.
d.Two normal goods cannot be substitutes for each other.
e.If demand increases and supply increases at the same time,
price will clearly rise.
f.The price of good A falls. This causes an increase in the price
of good B. Therefore, goods A and B are complements.
5.The U.S. government administers two programs that affect the
market for cigarettes. Media campaigns and labeling require-
ments are aimed at making the public aware of the health dan-gers of cigarettes. At the same time, the Department ofAgriculture maintains price supports for tobacco. Under thisprogram, the supported price is above the market equilibrium
price and the government limits the amount of land that can be
devoted to tobacco production. Are these two programs at oddswith the goal of reducing cigarette consumption? As part ofyour answer, illustrate graphically the effects of both policies onthe market for cigarettes.
6.During the period 2006 through 2010, housing production in
the United States fell from a rate of over 2.27 million housing
starts per year to a rate of under 500,000, a decrease of over
80 percent. At the same time, the number of new householdsslowed to a trickle. Students without a job moved in with theirparents, fewer immigrants came to the United States, andmore of those already here went home. If there are fewer
households, it is a decline in demand. If fewer new units are
built, it is a decline in supply.a.Draw a standard supply and demand diagram which shows
the demand for new housing units that are purchased eachmonth, and the supply of new units built and put on the
market each month. Assume that the quantity supplied and
quantity demanded are equal at 45,000 units and at a priceof $200,000.
b.On the same diagram show a decline in demand. What
would happen if this market behaved like most markets?
c.Now suppose that prices did not change immediately. Sellers
decided not to adjust price even though demand is belowsupply. What would happen to the number of homes for sale(the inventory of unsold new homes) if prices stayed thesame following the drop in demand?
CHAPTER 3 Demand, Supply, and Market Equilibrium 77
d.Now supposed that the supply of new homes put on the
market dropped, but price still stayed the same at $200,000.
Can you tell a story that brings the market back to equilib-rium without a drop in price?
e.Go to www.census.gov/newhomesales. Look at the current
press release, which contains data for the most recent month
and the past year. What trends can you observe?
7.The following sets of statements contain common errors.
Identify and explain each error:
a.Demand increases, causing prices to rise. Higher prices
cause demand to fall. Therefore, prices fall back to theiroriginal levels.
b.The supply of meat in Russia increases, causing meat prices
to fall. Lower prices always mean that Russian households
spend more on meat.
8.For each of the following statements, draw a diagram that
illustrates the likely effect on the market for eggs. Indicate
in each case the impact on equilibrium price and equilib-
rium quantity.a.A surgeon general warns that high-cholesterol foods cause
heart attacks.
b.The price of bacon, a complementary product, decreases.
c.An increase in the price of chicken feed occurs.
d.Caesar salads become trendy at dinner parties. (The dressing
is made with raw eggs.)
e.A technological innovation reduces egg breakage
during packing.
*9.Suppose the demand and supply curves for eggs in the United
States are given by the following equations:
where of dozens of eggs Americans would like to
buy each year; of dozens of eggs U.S. farms
would like to sell each year; and per dozen of eggs.
a.Fill in the following table:P=priceQ
s=millionsQd=millions Qs=10 + 40P Qd=100 -20Pb.Critics of housing vouchers (the demand-side strategy)
argue that because the supply of housing to low-incomehouseholds is limited and does not respond to higher rents,
demand vouchers will serve only to drive up rents and make
landlords better off. Illustrate their point with supply anddemand curves.
*11. .Suppose the market demand for pizza is given by
and the market supply for pizza is given by
, where (per pizza).
a.Graph the supply and demand schedules for pizza using
$5 through $15 as the value of P.
b.In equilibrium, how many pizzas would be sold and at
what price?
c.What would happen if suppliers set the price of pizza at $15?
Explain the market adjustment process.
d.Suppose the price of hamburgers, a substitute for pizza,
doubles. This leads to a doubling of the demand for pizza.
(At each price, consumers demand twice as much pizza asbefore.) Write the equation for the new market demandfor pizza.
e.Find the new equilibrium price and quantity of pizza.P=price Q
s=20P -100Qd=300 -20P
b.Use the information in the table to find the equilibrium
price and quantity.
c.Graph the demand and supply curves and identify the equi-
librium price and quantity.
*10.Housing policy analysts debate the best way to increase the
number of housing units available to low-income households.
One strategy—the demand-side strategy—is to provide peoplewith housing vouchers, paid for by the government, that can beused to rent housing supplied by the private market. Another—a supply-side strategy—is to have the government subsidize
housing suppliers or to build public housing.
a.Illustrate supply- and demand-side strategies using supply
and demand curves. Which results in higher rents?12.[Related to the Economics in Practice on p. 70 ]In the winter,
which is the peak season for coats, the price of coats is typicallyhigher than it is in the summer. In the case of strawberries,however, the reverse is true: The price of strawberries is lower inthe peak season than it is in the winter season. How do weexplain this seeming contradiction?
13.[Related to the Economics in Practice on p. 73 ]Analyst 1 sug-
gested that the demand curve for newspapers in Baltimoremight have shifted to the right because people were becoming
more literate. Think of two other plausible stories that would
result in this demand curve shifting to the right.
14.Explain whether each of the following statements describes a
change in demand or a change in quantity demanded, and spec-
ify whether each change represents an increase or a decrease.a.Baby Steps Footwear experiences a 40 percent increase in
sales of baby shoes during a 3-day, half-price sale.
b.Tabitha gets a promotion and 15 percent increase in her
salary and decides to reward herself by purchasing a new
3-D television.
c.When the price of peaches unexpectedly rises, many con-
sumers choose to purchase plums instead.
d.Due to potential problems with its breaking system, Asteriod
Motors has experienced a decline in sales of its Galacticaautomobile.
e.Antonio, an accountant working for the city of Santa Cristina,
decides to forego his annual vacation to Hawaii when wordleaks out that the city may be cu tting all employe es’ salaries by
10 percent at the end of the year.
15.For each of the five statements (a–e) in the previous question,
draw a demand graph representing the appropriate change in
quantity demanded or change in demand.
16.Until 2008, General Motors held the title of the world’s largest
automobile manufacturer for 78 years. The recession of
2007–2009 and its accompanying financial crisis saw GM
declare bankruptcy, receive over $50 billion in governmentbailout funds, and experience a significant decrease in demand
* Note: Problems marked with an asterisk are more challenging.PRICE
(PER DOZEN)QUANTITY
DEMANDED ( ) QdQUANTITY
SUPPLIED ( ) Qs
$ .50 _______ _______
$1.00 _______ _______
$1.50 _______ _______
$2.00 _______ _______
$2.50 _______ _______
78 PART I Introduction to Economics
for its products. One area where GM saw huge declines in
demand was its highly profitable large truck and SUV sector. In
response to the fall in demand, GM drastically reduced the pro-duction of large trucks and SUVs, including discontinuing itsHummer brand. Explain what determinants of householddemand contributed to the decision by GM to significantly
reduce production of its large trucks and SUVs.
17.The market for manicures is made up of five firms, and the
data in the following table represents each firm’s quantitysupplied at various prices. Fill in the column for the quantity
supplied in the market, and draw a supply graph showing themarket data.18.The following table represents the market for disposable digital
cameras. Plot this data on a supply and demand graph andidentify the equilibrium price and quantity. Explain what would
happen if the market price is set at $30, and show this on the
graph. Explain what would happen if the market price is set at$15, and show this on the graph.
Quantity supplied by:
PRICE FIRM A FIRM B FIRM C FIRM D FIRM E MARKET
$10 3 2 0 2 4
20 4 4 2 3 5
30 5 6 3 4 7
40 6 8 5 5 8PRICEQUANTITY
DEMANDEDQUANTITY
SUPPLIED
$ 5.00 15 0
10.00 13 3
15.00 11 6
20.00 9 9
25.00 7 12
30.00 5 15
35.00 3 18
79CHAPTER OUTLINE
Every society has a system of institutions that determines what is produced, how it is produced,
and who gets what is produced. In some societies, these decisions are made centrally, throughplanning agencies or by government directive. However, in every society, many decisions aremade in a decentralized way, through the operation of markets.
Markets exist in all societies, and Chapter 3 provided a bare-bones description of how markets
operate. In this chapter, we continue our examination of demand, supply, and the price system.
The Price System: Rationing and Allocating
Resources
The market system, also called the price system , performs two important and closely related func-
tions. First, it provides an automatic mechanism for distributing scarce goods and services. That is,it serves as a price rationing device for allocating goods and services to consumers when the quan-
tity demanded exceeds the quantity supplied. Second, the price system ultimately determines boththe allocation of resources among producers and the final mix of outputs.
Price Rationing
Consider the simple process by which the price system eliminates a shortage. Figure 4.1 showshypothetical supply and demand curves for wheat. Wheat is produced around the world, withlarge supplies coming from Russia and from the United States. Wheat is sold in a world marketand used to produce a range of food products, from cereals and breads to processed foods, whichline the kitchens of the average consumer. Wheat is thus demanded by large food companies asthey produce breads, cereals, and cake for households.
As Figure 4.1 shows, the equilibrium price of wheat was $160 per millions of metric tons in
the spring of 2010. At this price, farmers from around the world were expected to bring 61.7 mil-lion metric tons to market. Supply and demand were equal. Market equilibrium existed at a priceof $160 per millions of metric tons because at that price, quantity demanded was equal to quan-tity supplied. (Remember that equilibrium occurs at the point where the supply and demandcurves intersect. In Figure 4.1, this occurs at point C.)
In the summer of 2010, Russia experienced its warmest summer on record. Fires swept
through Russia, destroying a substantial portion of the Russia wheat crop. With almost a third ofthe world wheat normally produced in Russia, the effect of this environmental disaster on world4
The Price System:
Rationing andAllocatingResources
p. 79
Price Rationing
Constraints on the Market
and Alternative Rationing
Mechanisms
Prices and the Allocation
of Resources
Price Floors
Supply and Demand
Analysis: An OilImport Fee
p. 86
Supply and Demandand MarketEfficiency
p. 89
Consumer Surplus
Producer SurplusCompetitive Markets
Maximize the Sum of
Producer and Consumer
Surplus
Potential Causes of
Deadweight Loss fromUnder- andOverproduction
Looking Ahead p. 93
Demand and Supply
Applications
price rationing The process
by which the market system
allocates goods and services
to consumers when quantitydemanded exceeds quantity
supplied.
80 PART I Introduction to Economics
D
0247
160Price per millions of metric tons ($)
Millions of metric tons of wheatCB
A
35.0 41.5 61.7P
QSfall 2010 Sspring 2010
/L50304FIGURE 4.1 The Market for Wheat
Fires in Russia in the summer of 2010 caused a shift in the world's supply of wheat to the left, causing the
price to increase from $160 per millions of metric tons to $247. The equilibrium moved from C to B.
wheat supply was substantial. In the figure, the supply curve for wheat, which had been drawn in
expectation of harvesting all the wheat planted in Russia along with the rest of the world, nowshifted to the left, from S
spring 2010 to Sfall 2010 . This shift in the supply curve created a situation of
excess demand at the old price of $160. At that price, the quantity demanded is 61.7 millionmetric tons but the burning of much of the Russia supply left the world with only 35 millions ofmetric tons expected to be supplied. Quantity demanded exceeded quantity supplied at the orig-inal price by 26.7 million metric tons.
The reduced supply caused the price of wheat to rise sharply. As the price rises, the available sup-
ply is “rationed.” Those who are willing and able to pay the most get it. Y ou can see the market’srationing function clearly in Figure 4.1. As the price rises from $160, the quantity demanded declinesalong the demand curve, moving from point C (61.7 million tons) toward point B (41.5 million tons).The higher prices mean that prices for products like Pepperidge Farm bread and Shredded Wheatcereal, which use wheat as an essential ingredient, also rise. People bake fewer cakes, and begin to eatmore rye bread and switch from Shredded Wheat to Corn Flakes in response to the price changes.
As prices rise, wheat farmers also change their behavior, though supply responsiveness is limited
in the short term. Farmers outside of Russia, seeing the price rise, harvest their crops more carefully,getting more precious grains from each stalk. Perhaps some wheat is taken out of storage andbrought to market. Quantity supplied increases from 35 million metric tons (point A) to 41.5 milliontons (point B). The price increase has encouraged farmers who can to make up for part of the Russiawheat loss.
A new equilibrium is established at a price of $247 per millions of metric tons, with 41.5 mil-
lion tons transacted. The market has determined who gets the wheat: The lower total supply is
rationed to those who are willing and able to pay the higher price.
This idea of “willingness to pay” is central to the distribution of available supply, and willing-
ness depends on both desire (preferences) and income/wealth. Willingness to pay does not neces-sarily mean that only the very rich will continue to buy wheat when the price increases. Foranyone to continue to buy wheat at a higher price, his or her enjoyment comes at a higher cost interms of other goods and services.
In sum:
The adjustment of price is the rationing mechanism in free markets. Price rationing meansthat whenever there is a need to ration a good—that is, when a shortage exists—in a freemarket, the price of the good will rise until quantity supplied equals quantity demanded—that is, until the market clears.
CHAPTER 4 Demand and Supply Applications 81
S
D
1 0140,000,000Price ($)
Quantity of Jackson Pollock’s “No. 5, 1948”/L50296FIGURE 4.2 Market
for a Rare Painting
There is some price that will clear
any market, even if supply is
strictly limited. In an auction fora unique painting, the price (bid)will rise to eliminate excess
demand until there is only one
bidder willing to purchase thesingle available painting. Someestimate that the Mona Lisa
would sell for $600 million
if auctioned.There is some price that will clear any market you can think of. Consider the market for a
famous painting such as Jackson Pollock’s N o .5 ,1 9 4 8 , illustrated in Figure 4.2. At a low price,
there would be an enormous excess demand for such an important painting. The price wouldbe bid up until there was only one remaining demander. Presumably, that price would be veryhigh. In fact, the Pollock painting sold for a record $140 million in 2006. If the product is instrictly scarce supply, as a single painting is, its price is said to be demand-determined . That is,ECONOMICS IN PRACTICE
Prices and Total Expenditure: A Lesson From the Lobster
Industry in 2008–2009
It is very important to distinguish between the price of a product and
total expenditure from that product. A recent report on the lobster mar-
ket in New England shows how it can be confusing. See if you can fig-ure out what happened to the price and quantity of lobsters trapped in
Maine between 2008 and 2009.
The following short passage was taken from an Associated Press
article dated March 1, 2010.
Lobster Prices Plummet As Maine Fisherman
Catch Way Too Many
Business Insider
PORTLAND, Maine (AP)—Officials say Maine lobstermen had
a record harvest in 2009, but the value of the catch continued
to plunge amid the sour global economy.
The Department of Marine Resources announced
Monday that lobstermen caught 75.6 million pounds last
year, up 8 percent from 2008. But the value of the catch fell$23 million, to $221.7 million.
Source: Used with permission of The Associated Press. Copyright © 2010.
All rights reserved.
T otal revenue or expenditure in a market is simply the number of
units sold multiplied by the price. The author of this article seemssurprised that the total revenue in the lobster business (or value as
he calls it) has fallen despite an increase in the catch. But of course,when supply curves shift right, as has happened here, prices typically
fall, unless something has simultaneously happened to shift the
demand curve. With an increase in volume and a decrease in price,total revenue could go up or down. In 2009, in the lobster market,revenue apparently fell.
Incidentally, the data given in the article allows you to find
prices for 2008 and 2009 as well as quantities. (The price in 2008was $3.50 and in 2009, $2.93.) Make sure you see how these num-
bers are derived.
82 PART I Introduction to Economics
its price is determined solely and exclusively by the amount that the highest bidder or highest
bidders are willing to pay.
One might interpret the statement that “there is some price that will clear any market” to
mean “everything has its price,” but that is not exactly what it means. Suppose you own a smallsilver bracelet that has been in your family for generations. It is quite possible that you wouldnot sell it for any amount of money. Does this mean that the market is not working, or that
quantity supplied and quantity demanded are not equal? Not at all. It simply means that you
are the highest bidder. By turning down all bids, you must be willing to forgo what anybodyoffers for it.
Constraints on the Market and Alternative Rationing
Mechanisms
On occasion, both governments and private firms decide to use some mechanism other than the mar-
ket system to ration an item for which there is excess demand at the current price. Policies designed tostop price rationing are commonly justified in a number of ways.
The rationale most often used is fairness. It is not “fair” to let landlords charge high rents, not
fair for oil companies to run up the price of gasoline, not fair for insurance companies to chargeenormous premiums, and so on. After all, the argument goes, we have no choice but to pay—housing and insurance are necessary, and one needs gasoline to get to work. Although it is notprecisely true that price rationing allocates goods and services solely on the basis of income andwealth, income and wealth do constrain our wants. Why should all the gasoline or all the ticketsto the World Series go just to the rich?
Various schemes to keep price from rising to equilibrium are based on several percep-
tions of injustice, among them (1) that price-gouging is bad, (2) that income is unfairlydistributed, and (3) that some items are necessities and everyone should be able to buy themat a “reasonable” price. Regardless of the rationale, the following examples will make twothings clear:
1.Attempts to bypass price rationing in the market and to use alternative rationing devices aremore difficult and more costly than they would seem at first glance.
2.Very often such attempts distribute costs and benefits among households in unintended ways.
Oil, Gasoline, and OPEC One of the most important prices in the world is the price of crude
oil. Millions of barrels of oil are traded every day. It is a major input into virtually every product pro-duced. It heats our homes, and it is used to produce the gasoline that runs our cars. Its production hasled to massive environmental disasters as well as wars. Its price has fluctuated wildly, leading to majormacroeconomic problems. But oil is like other commodities in that its price is determined by the
basic forces of supply and demand. Oil provides a good example of how markets work and howmarkets sometimes fail.
The Organization of the Petroleum Exporting Countries (OPEC) is an organization of twelve
countries (Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the UnitedArab Emirates, and Venezuela) that together controlled about one-third of the known supply of oil inthe year 2010. In 1973 and 1974, OPEC imposed an embargo on shipments of crude oil to the
United States. What followed was a drastic reduction in the quantity of gasoline available atlocal gas pumps.
Had the market system been allowed to operate, refined gasoline prices would have
increased dramatically until quantity supplied was equal to quantity demanded. However, thegovernment decided that rationing gasoline only to those who were willing and able to pay themost was unfair, and Congress imposed a price ceiling , or maximum price, of $0.57 per gallon
of leaded regular gasoline. That price ceiling was intended to keep gasoline “affordable,” but italso perpetuated the shortage. At the restricted price, quantity demanded remained greater
price ceiling A maximum
price that sellers may charge
for a good, usually set bygovernment.
CHAPTER 4 Demand and Supply Applications 83
queuing Waiting in line as a
means of distributing goods
and services: a nonprice
rationing mechanism.
1Y ou can also show formally that the result is inefficient—that there is a resulting net loss of total value to society. First, the re
is the cost of waiting in line. Time has a value. With price rationing, no one has to wait in line and the value of that time issaved. Second, there may be additional lost value if the gasoline ends up in the hands of someone who places a lower value onit than someone else who gets no gas. Suppose, for example, that the market price of gasoline if unconstrained would rise to$2 but that the government has it fixed at $1. There will be long lines to get gas. Imagine that to motorist A, 10 gallons of gasis worth $35 but that she fails to get gas because her time is too valuable to wait in line. T o motorist B, 10 gallons is worthonly $15, but his time is worth much less, so he gets the gas. In the end, A could pay B for the gas and both would be betteroff. If A pays B $30 for the gas, A is $5 better off and B is $15 better off. In addition, A does not have to wait in line. Thus, theallocation that results from nonprice rationing involves a net loss of value. Such losses are called deadweight losses .S e e p .9 2
of this chapter.1.50
0.57
0 Quantity supplied Quantity demandedD1974S1974
Excess demand or shortage
Gallons per yearPrice per gallon ($)P
Q
/L50304FIGURE 4.3 Excess Demand (Shortage) Created by a Price Ceiling
In 1974, a ceiling price of $0.57 cents per gallon of leaded regular gasoline was imposed. If the price had
been set by the interaction of supply and demand instead, it would have increased to approximately $1.50 per gallon. At $0.57 per gallon, the quantity demanded exceeded the quantity supplied. Because the
price system was not allowed to function, an alternative rationing system had to be found to distribute the
available supply of gasoline.
than quantity supplied, and the available gasoline had to be divided up somehow among all
potential demanders.
Y ou can see the effects of the price ceiling by looking carefully at Figure 4.3. If the price had
been set by the interaction of supply and demand, it would have increased to approximately $1.50 per gallon. Instead, Congress made it illegal to sell gasoline for more than $0.57 per gallon.At that price, quantity demanded exceeded quantity supplied and a shortage existed. Because theprice system was not allowed to function, an alternative rationing system had to be found to dis-tribute the available supply of gasoline.
Several devices were tried. The most common of all nonprice rationing systems is queuing ,a
term that means waiting in line. During 1974, very long lines formed daily at gas stations, starting asearly as 5
A.M. Under this system, gasoline went to those people who were willing to pay the most, but
the sacrifice was measured in hours and aggravation instead of dollars.1
84 PART I Introduction to Economics
A second nonprice rationing device used during the gasoline crisis was that of favored
customers . Many gas station owners decided not to sell gasoline to the general public, but to
reserve their scarce supplies for friends and favored customers. Not surprisingly, many customerstried to become “favored” by offering side payments to gas station owners. Owners also chargedhigh prices for service. By doing so, they increased the real price of gasoline but hid it in serviceovercharges to get around the ceiling.
Y et another method of dividing up available supply is the use of ration coupons . It was sug-
gested in both 1974 and 1979 that families be given ration tickets or coupons that would entitlethem to purchase a certain number of gallons of gasoline each month. That way, everyone wouldget the same amount regardless of income. Such a system had been employed in the United Statesduring the 1940s when wartime price ceilings on meat, sugar, butter, tires, nylon stockings, andmany other items were imposed.
When ration coupons are used with no prohibition against trading them, however, the result
is almost identical to a system of price rationing. Those who are willing and able to pay the mostbuy up the coupons and use them to purchase gasoline, chocolate, fresh eggs, or anything elsethat is sold at a restricted price.
2This means that the price of the restricted good will effectively
rise to the market-clearing price. For instance, suppose that you decide not to sell your rationcoupon. Y ou are then forgoing what you would have received by selling the coupon. Thus, the“real” price of the good you purchase will be higher (if only in opportunity cost) than therestricted price. Even when trading coupons is declared illegal, it is virtually impossible tostop black markets from developing. In a black market
,illegal trading takes place at market-
determined prices.
Rationing Mechanisms for Concert and Sports Tickets Tickets for sporting
events such as the World Series, the Super Bowl, and the World Cup command huge prices in theopen market. In many cases, the prices are substantially above the original issue price. One of thehottest basketball tickets ever was one to the Boston Celtics and Los Angeles Lakers’ NBA finalseries in 2010 that LA won in seven games. The online price for a courtside seat to one of thegames in Los Angeles was $19,000. On September 16, 2007, Justin Timberlake performed at the
Staples Center in Los Angeles. The day before the concert, you could buy a front row ticket for$16,000 on the StubHub Web site.
Y ou might ask why a profit-maximizing enterprise would not charge the highest price it
could? The answer depends on the event. If the Chicago Cubs got into the World Series, the peo-ple of Chicago would buy all the tickets available for thousands of dollars each. But if the Cubsactually charged $2,000 a ticket, the hard-working fans would be furious: “Greedy Cubs Gouge
Fans” the headlines would scream. Ordinary loyal fans earning reasonable salaries would not beable to afford those prices. Next season, perhaps some of those irate fans would change loyalties,supporting the White Sox over the Cubs. In part to keep from alienating loyal fans, prices forchampionship games are held down. But not every concert promoter or sports team behaves thisway. In 2000, Barbra Streisand gave a concert in Sydney, Australia. Tickets were issued with a face
value of $1,530, a record for a concert that still stands today.
Let’s consider a concert at the Staples Center, which has 20,000 seats. The supply of tick-
ets is thus fixed at 20,000. Of course, there are good seats and bad seats, but to keep thingssimple, let’s assume that all seats are the same and that the promoters charge $50 per ticketfor all tickets. This is illustrated in Figure 4.4. Supply is represented by a vertical line at
2Of course, if you are assigned a number of tickets and you sell them, you are better off than you would be with price rationing.
Ration coupons thus serve as a way of redistributing income.favored customers Those
who receive special treatment
from dealers during situations
of excess demand.
ration coupons Tickets or
coupons that entitleindividuals to purchase acertain amount of a given
product per month.
black market A market in
which illegal trading takes
place at market-determined
prices.
CHAPTER 4 Demand and Supply Applications 85
300
20,000
Quantity
supplied
Tickets to a concert at the Staples Center38,000
Quantity
demandedPrice ($)
50 DSP
QExcess demand = shortage
/L50304FIGURE 4.4 Supply of and Demand for a Concert at the Staples Center
At the face-value price of $50, there is excess demand for seats to the concert. At $50 the quantity
demanded is greater than the quantity supplied, which is fixed at 20,000 seats. The diagram shows that
the quantity demanded would equal the quantity supplied at a price of $300 per ticket.
20,000. Changing the price does not change the supply of seats. In the figure the quantity
demanded at the price of $50 is 38,000, so at this price there is excess demand of 18,000.
Who would get to buy the $50 tickets? As in the case of gasoline, a variety of rationing
mechanisms might be used. The most common is queuing, waiting in line. The tickets wouldgo on sale at a particular time, and people would show up and wait. Now ticket sellers havevirtual waiting rooms online. Tickets for the World Series go on sale at a particular time inSeptember, and the people who log on to team Web sites at the right moment get into anelectronic queue and can buy tickets. Often tickets are sold out in a matter of minutes.
There are also, of course, favored customers. Those who get tickets without queuing are local
politicians, sponsors, and friends of the artist or friends of the players.
But “once the dust settles,” the power of technology and the concept of opportunity cost
take over. Even if you get the ticket for the (relatively) low price of $50, that is not the true cost.The true cost is what you give up to sit in the seat. If people on eBay, StubHub, or Ticketmasterare willing to pay $300 for your ticket, that’s what you must pay, or sacrifice, to go to the con-cert. Many people—even strong fans—will choose to sell that ticket. Once again, it is difficultto stop the market from rationing the tickets to those people who are willing and able to paythe most.
86 PART I Introduction to Economics
Prices and the Allocation of Resources
Thinking of the market system as a mechanism for allocating scarce goods and services among
competing demanders is very revealing, but the market determines more than just the distribu-tion of final outputs. It also determines what gets produced and how resources are allocatedamong competing uses.
Consider a change in consumer preferences that leads to an increase in demand for a specific
good or service. During the 1980s, for example, people began going to restaurants more fre-quently than before. Researchers think that this trend, which continues today, is partially theresult of social changes (such as a dramatic rise in the number of two-earner families) and par-tially the result of rising incomes. The market responded to this change in demand by shiftingresources, both capital and labor, into more and better restaurants.
With the increase in demand for restaurant meals, the price of eating out rose and the restau-
rant business became more profitable. The higher profits attracted new businesses and providedold restaurants with an incentive to expand. As new capital, seeking profits, flowed into therestaurant business, so did labor. New restaurants need chefs. Chefs need training, and the higherwages that came with increased demand provided an incentive for them to get it. In response tothe increase in demand for training, new cooking schools opened and existing schools began tooffer courses in the culinary arts. This story could go on and on, but the point is clear:
Price Floor
As we have seen, price ceilings, often imposed because price rationing is viewed as unfair, result in alternative rationing mechanisms that are inefficient and may be equally unfair.Some of the same arguments can be made for price floors. A price floor is a minimum price
below which exchange is not permitted. If a price floor is set above the equilibrium price, theresult will be excess supply; quantity supplied will be greater than quantity demanded.
The most common example of a price floor is the minimum wage , which is a floor
set for the price of labor. Employers (who demand labor) are not permitted under federal law topay a wage less than $7.25 per hour (in 2010) to workers (who supply labor). Critics argue thatsince the minimum wage is above equilibrium, the result will be wasteful unemployment. At thewage of $7.25, the quantity of labor demanded is less than the quantity of labor supplied.Whenever a price floor is set above equilibrium, there will be an excess supply.
Supply and Demand Analysis:
An Oil Import Fee
The basic logic of supply and demand is a powerful tool of analysis. As an extended example of
the power of this logic, we will consider a proposal to impose a tax on imported oil. The idea oftaxing imported oil is hotly debated, and the tools we have learned thus far will show us theeffects of such a tax.Price changes resulting from shifts of demand in output markets cause profits to rise orfall. Profits attract capital; losses lead to disinvestment. Higher wages attract labor andencourage workers to acquire skills. At the core of the system, supply, demand, andprices in input and output markets determine the allocation of resources and the ulti-mate combinations of goods and services produced.No matter how good the intentions of private organizations and governments, it is verydifficult to prevent the price system from operating and to stop people’s willingness to payfrom asserting itself. Every time an alternative is tried, the price system seems to sneak inthe back door. With favored customers and black markets, the final distribution may beeven more unfair than what would result from simple price rationing.
price floor A minimum price
below which exchange is notpermitted.
minimum wage A price floor
set for the price of labor.
CHAPTER 4 Demand and Supply Applications 87
ECONOMICS IN PRACTICE
The Price Mechanism at Work for Shakespeare
Every summer, New Y ork City puts on free performances of
Shakespeare in the Park. Tickets are distributed on a first-come-
first-serve basis at the Delacorte Theatre in the park beginning at1
P.M. on the day of the show. People usually begin lining up at
6A.M. when the park opens; by 10 A.M. the line has typically reached
a length sufficient to give away all available tickets.
When you examine the people standing in line for these tickets,
most of them seem to be fairly young. Many carry book bags identi-fying them as students in one of New Y ork’s many colleges. Ofcourse, all college students may be fervent Shakespeare fans, but canyou think of another reason for the composition of the line? Further,when you attend one of the plays and look around, the audienceappears much older and much sleeker than the people who werestanding in line. What is going on?
While the tickets are “free” in terms of financial costs, their true
price includes the value of the time spent standing in line. Thus, the
tickets are cheaper for people (for example, students) whose time
value is lower than they are for high-wage earners, like an invest-ment banker from Goldman Sachs. The true cost of a ticket is $0plus the opportunity cost of the time spent in line. If the averageperson spends 4 hours in line, as is done in the Central Park case, for
someone with a high wage, the true cost of the ticket might be very
high. For example, a lawyer who earns $300 an hour would be givingup $1,200 to wait in line. It should not surprise you to see more peo-ple waiting in line for whom the tickets are inexpensive.
What about the people who are at the performance? Think about
our discussion of the power of entrepreneurs. In this case, the stu-
dents who stand in line as consumers of the tickets also can play arole as producers. In fact, the students can produce tickets relatively
cheaply by waiting in line. They can then turn around and sell thosetickets to the high-wage Shakespeare lovers. These days eBay is a
great source of tickets to free events, sold by individuals with lowopportunity costs of their time who queued up. Craigslist even pro-
vides listings for people who are willing to wait in line for you.
Of course, now and again we do encounter a busy business-
person in one of the Central Park lines. Recently, one of the authors
encountered one and asked him why he was waiting in line rather
than using eBay, and he replied that it reminded him of when he wasyoung, waiting in line for rock concerts.
Consider the facts. Between 1985 and 1989, the United States increased its dependence on
oil imports dramatically. In 1989, total U.S. demand for crude oil was 13.6 million barrels perday. Of that amount, only 7.7 million barrels per day (57 percent) were supplied by U.S. pro-ducers, with the remaining 5.9 million barrels per day (43 percent) imported. The price of oilon world markets that year averaged about $18. This heavy dependence on foreign oil left theUnited States vulnerable to the price shock that followed the Iraqi invasion of Kuwait in August1990. In the months following the invasion, the price of crude oil on world markets shot up to$40 per barrel.
Even before the invasion, many economists and some politicians had recommended a stiff
oil import fee (or tax) that would, it was argued, reduce the U.S. dependence on foreign oil by(1) reducing overall consumption and (2) providing an incentive for increased domestic produc-tion. An added bonus would be improved air quality from the reduction in driving.
Supply and demand analysis makes the arguments of the import fee proponents easier to
understand. Figure 4.5(a) shows the U.S. market for oil. The world price of oil is assumed to be$18, and the United States is assumed to be able to buy all the oil that it wants at this price. This
means that domestic producers cannot charge any more than $18 per barrel. The curve labeledSupply
USshows the amount that domestic suppliers will produce at each price level. At a price
of $18, domestic production is 7.7 million barrels. U.S. producers will produce at point Aon
the supply curve. The total quantity of oil demanded in the United States in 1989 was 13.6 mil-lion barrels per day. At a price of $18, the quantity demanded in the United States is point Bon
the demand curve.
88 PART I Introduction to Economics
The difference between the total quantity demanded (13.6 million barrels per day) and
domestic production (7.7 million barrels per day) is total imports (5.9 million barrels per day).
Now suppose that the government levies a tax of 33 1/3 percent on imported oil.
Because the import price is $18, a tax of $6 (or .3333 /H11003$18) per barrel means that
importers of oil in the United States will pay a total of $24 per barrel ($18 + $6). This new,higher price means that U.S. producers can also charge up to $24 for a barrel of crude. Note,however, that the tax is paid only on imported oil. Thus, the entire $24 paid for domesticcrude goes to domestic producers.
Figure 4.5(b) shows the result of the tax. First, because of a higher price, the quantity
demanded drops to 12.2 million barrels per day. This is a movement along the demand curve
from point Bto point D. At the same time, the quantity supplied by domestic producers increased
to 9.0 million barrels per day. This is a movement along the supply curve from point Ato point C.18
18
9.0 0 12.224Price ($)Price ($)DemandUS
DemandUSMillions of barrels of
crude oil per dayImports = 5.97.7 0World
priceB A
B AC DSupplyUS
SupplyUS13.6
$6
Oil
import
feeb. Effects of an oil import fee
in the United Statesa. U.S. market, 1989
Millions of barrels of
crude oil per dayImports = 3.2P
Q
P
Q/L50298FIGURE 4.5 The U.S.
Market for Crude Oil,1989
At a world price of $18, domes-
tic production is 7.7 million bar-rels per day and the totalquantity of oil demanded in theUnited States is 13.6 million bar-rels per day. The difference istotal imports (5.9 million barrelsper day).
If the government levies a
33 1/3 percent tax on imports,
the price of a barrel of oil risesto $24. The quantity demandedfalls to 12.2 million barrels per
day. At the same time, the
quantity supplied by domesticproducers increases to 9.0 mil-lion barrels per day and the
quantity imported falls to
3.2 million barrels per day.
With an increase in domestic quantity supplied and a decrease in domestic quantity demanded,
imports decrease to 3.2 million barrels per day (12.2 – 9.0).3
The tax also generates revenues for the federal government. The total tax revenue collected is
equal to the tax per barrel ($6) times the number of imported barrels. When the quantityimported is 3.2 million barrels per day, total revenue is $6 /H110033.2 million, or $19.2 million per day
(about $7 billion per year).
What does all of this mean? In the final analysis, an oil import fee would (1) increase domes-
tic production and (2) reduce overall consumption. T o the extent that one believes thatAmericans are consuming too much oil, the reduced consumption may be a good thing.
Supply and Demand and Market Efficiency
Clearly, supply and demand curves help explain the way that markets and market prices work toallocate scarce resources. Recall that when we try to understand “how the system works,” we aredoing “positive economics.”
Supply and demand curves can also be used to illustrate the idea of market efficiency, an
important aspect of “normative economics.” T o understand the ideas, you first must understandthe concepts of consumer and producer surplus.
Consumer Surplus
The argument, made several times already, that the market forces us to reveal a great deal aboutour personal preferences is an extremely important one, and it bears repeating at least once morehere. If you are free to choose within the constraints imposed by prices and your income and youdecide to buy, for example, a hamburger for $2.50, you have “revealed” that a hamburger is worthat least $2.50 to you.
A simple market demand curve such as the one in Figure 4.6(a) illustrates this point quite
clearly. At the current market price of $2.50, consumers will purchase 7 million hamburgers permonth. There is only one price in the market, and the demand curve tells us how many hamburg-ers households would buy if they could purchase all they wanted at the posted price of $2.50.Anyone who values a hamburger at $2.50 or more will buy it. Anyone who does not value a ham-burger that highly will not buy it.
Some people, however, value hamburgers at more than $2.50. As Figure 4.6(a) shows, even if
the price were $5.00, consumers would still buy 1 million hamburgers. If these people were ableto buy the good at a price of $2.50, they would earn a consumer surplus . Consumer surplus is
the difference between the maximum amount a person is willing to pay for a good and its currentmarket price. The consumer surplus earned by the people willing to pay $5.00 for a hamburger isapproximately equal to the shaded area between point Aand the price, $2.50.
The second million hamburgers in Figure 4.6(a) are valued at more than the market price as
well, although the consumer surplus gained is slightly less. Point Bon the market demand curve
shows the maximum amount that consumers would be willing to pay for the second million ham-burgers. The consumer surplus earned by these people is equal to the shaded area between Band
the price, $2.50. Similarly, for the third million hamburgers, maximum willingness to pay is givenby point C; consumer surplus is a bit lower than it is at points Aand B, but it is still significant.
The total value of the consumer surplus suggested by the data in Figure 4.6(a) is roughly
equal to the area of the shaded triangle in Figure 4.6(b). T o understand why this is so, think aboutoffering hamburgers to consumers at successively lower prices. If the good were actually sold for$2.50, those near point Aon the demand curve would get a large surplus; those at point Bwould
get a smaller surplus. Those at point Ewould get no surplus.CHAPTER 4 Demand and Supply Applications 89
3These figures were not chosen randomly. It is interesting to note that in 1985, the world price of crude oil averaged about $24 a bar-
rel. Domestic production was 9.0 million barrels per day and domestic consumption was 12.2 million barrels per day, with imports of
only 3.2 million. The drop in the world price between 1985 and 1989 increased imports to 5.9 million, an 84 percent increase.consumer surplus The
difference between themaximum amount a person is
willing to pay for a good and
its current market price.
90 PART I Introduction to Economics
Producer Surplus
Similarly, the supply curve in a market shows the amount that firms willingly produce and supply
to the market at various prices. Presumably it is because the price is sufficient to cover the costs orthe opportunity costs of production and give producers enough profit to keep them in business.When speaking of cost of production, we include everything that a producer must give up inorder to produce a good.
A simple market supply curve like the one in Figure 4.7(a) illustrates this point quite
clearly. At the current market price of $2.50, producers will produce and sell 7 million ham-burgers. There is only one price in the market, and the supply curve tells us the quantity sup-plied at each price.
Notice, however, that if the price were just $0.75 (75 cents), although production would be
much lower—most producers would be out of business at that price—a few producers wouldactually be supplying burgers. In fact, producers would supply about 1 million burgers to themarket. These firms must have lower costs: They are more efficient or they have access to raw beefat a lower price or perhaps they can hire low-wage labor.
If these efficient, low-cost producers are able to charge $2.50 for each hamburger, they are
earning what is called a producer surplus . Producer surplus is the difference between the current
market price and the full cost of production for the firm. The first million hamburgers wouldgenerate a producer surplus of $2.50 minus $0.75, or $1.75 per hamburger: a total of $1.75 mil-lion. The second million hamburgers would also generate a producer surplus because the price of$2.50 exceeds the producers’ total cost of producing these hamburgers, which is above $0.75 butmuch less than $2.50.
The total value of the producer surplus received by producers of hamburgers at a price of
$2.50 per burger is roughly equal to the shaded triangle in Figure 4.7(b). Those producers justable to make a profit producing burgers will be near point Eon the supply curve and will earn
very little in the way of surplus.
producer surplus The
difference between the current
market price and the full cost
of production for the firm.DEA
B
C
05.00
2.50Price ($)
Millions of hamburgers
per month1234567 Qa. A simple market demand curve
for hamburgers
DEA
B
C
02.50Price ($)
Millions of hamburgers
per month1234567 Qb. Consumer surplus
Total consumer
surplus at price $2.50
/L50304FIGURE 4.6 Market Demand and Consumer Surplus
As illustrated in Figure 4.6(a), some consumers (see point A) are willing to pay as much as $5.00 each for
hamburgers. Since the market price is just $2.50, they receive a consumer surplus of $2.50 for each ham-burger that they consume. Others (see point B) are willing to pay something less than $5.00 and receive a
slightly smaller surplus. Since the market price of hamburgers is just $2.50, the area of the shaded triangle in
Figure 4.6(b) is equal to total consumer surplus.
CHAPTER 4 Demand and Supply Applications 91
Competitive Markets Maximize the Sum of Producer and
Consumer Surplus
In the preceding example, the quantity of hamburgers supplied and the quantity of hamburgers
demanded are equal at $2.50. Figure 4.8 shows the total net benefits to consumers and produc-ers resulting from the production of 7 million hamburgers. Consumers receive benefits in excessof the price they pay and equal to the blue shaded area between the demand curve andthe price line at $2.50; the area is equal to the amount of consumer surplus being earned.Producers receive compensation in excess of costs and equal to the red shaded area between theS
E
ABC
02.50
0.75Price ($)
Millions of hamburgers
per month1234567 Qa. A simple market supply
curve for hamburgers
S
E
ABC
02.50Price ($)
Millions of hamburgers
per month1234567 Qb. Producer surplus
Total producer
surplus at price $2.50
/L50304FIGURE 4.7 Market Supply and Producer Surplus
As illustrated in Figure 4.7(a), some producers are willing to produce hamburgers for a price of $0.75 each.
Since they are paid $2.50, they earn a producer surplus equal to $1.75. Other producers are willing to supply
hamburgers at a price of $1.00; they receive a producer surplus equal to $1.50. Since the market price of
hamburgers is $2.50, the area of the shaded triangle in Figure 4.7(b) is equal to total producer surplus.
DS
02.50Price ($)
Millions of hamburgers
per month1234567 Q
/L50304FIGURE 4.8 Total Producer and Consumer Surplus
Total producer and consumer surplus is greatest where supply and demand curves intersect at equilibrium.
92 PART I Introduction to Economics
supply curve and the price line at $2.50; the area is equal to the amount of producer surplus
being earned.
Now consider the result to consumers and producers if production were to be reduced
to 4 million burgers. Look carefully at Figure 4.9(a). At 4 million burgers, consumers arewilling to pay $3.75 for hamburgers and there are firms whose costs make it worthwhile tosupply at a price as low as $1.50, yet something is stopping production at 4 million. Theresult is a loss of both consumer and producer surplus. Y ou can see in Figure 4.9(a) that ifproduction were expanded from 4 million to 7 million, the market would yield more con-sumer surplus and more producer surplus. The total loss of producer and consumer surplusfrom underproduction and, as we will see shortly, from overproduction is referred to as a
deadweight loss . In Figure 4.9(a) the deadweight loss is equal to the area of triangle ABC
shaded in yellow.
Figure 4.9(b) illustrates how a deadweight loss of both producer and consumer surplus can
result from overproduction as well. For every hamburger produced above 7 million, consumers
are willing to pay less than the cost of production. The cost of the resources needed to producehamburgers above 7 million exceeds the benefits to consumers, resulting in a net loss of producerand consumer surplus equal to the yellow shaded area ABC .
Potential Causes of Deadweight Loss From Under- and
Overproduction
Most of the next few chapters will discuss perfectly competitive markets in which prices are
determined by the free interaction of supply and demand. As you will see, when supply anddemand interact freely, competitive markets produce what people want at the least cost, that
DSA
C
B
02.50
1.503.75Price ($)
Millions of hamburgers
per month1234567 QDeadweight
lossa. Deadweight loss from underproduction
DS
B
A
C
02.50Price ($)
Millions of hamburgers
per month123456789 1 0 QDeadweight
lossb. Deadweight loss from overproduction
/L50304FIGURE 4.9 Deadweight Loss
Figure 4.9(a) shows the consequences of producing 4 million hamburgers per month instead of
7 million hamburgers per month. Total producer and consumer surplus is reduced by the area oftriangle ABC shaded in yellow. This is called the deadweight loss from underproduction. Figure 4.9(b)
shows the consequences of producing 10 million hamburgers per month instead of 7 million
hamburgers per month. As production increases from 7 million to 10 million hamburgers, the full cost of production rises above consumers’ willingness to pay, resulting in a deadweight loss equal to the area of triangle ABC.deadweight loss The total
loss of producer and consumer
surplus from underproduction
or overproduction.
CHAPTER 4 Demand and Supply Applications 93
is, they are efficient. Beginning in Chapter 13, however, we will begin to relax assumptions
and will discover a number of naturally occurring sources of market failure. Monopolypower gives firms the incentive to underproduce and overprice, taxes and subsidies may dis-tort consumer choices, external costs such as pollution and congestion may lead to over- orunderproduction of some goods, and artificial price floors and price ceilings may have thesame effects.
Looking Ahead
We have now examined the basic forces of supply and demand and discussed themarket/price system. These fundamental concepts will serve as building blocks for whatcomes next. Whether you are studying microeconomics or macroeconomics, you will bestudying the functions of markets and the behavior of market participants in more detail inthe following chapters.
Because the concepts presented in the first four chapters are so important to your under-
standing of what is to come, this might be a good time for you to review this material.
THE PRICE SYSTEM: RATIONING AND ALLOCATING
RESOURCES
p. 79
1.In a market economy, the market system (or price system)
serves two functions. It determines the allocation ofresources among producers and the final mix of outputs.It also distributes goods and services on the basis of will-ingness and ability to pay. In this sense, it serves as a price
rationing device.
2.Governments as well as private firms sometimes decide
not to use the market system to ration an item for whichthere is excess demand. Examples of nonprice rationingsystems include queuing ,favored customers , and ration
coupons . The most common rationale for such policies
is “fairness.”
3.Attempts to bypass the market and use alternativenonprice rationing devices are more difficult and costlythan it would seem at first glance. Schemes that open up opportunities for favored customers, black markets,and side payments often end up less “fair” than the free market.SUPPLY AND DEMAND ANALYSIS: AN OIL
IMPORT FEE p. 86
4.The basic logic of supply and demand is a powerful
tool for analysis. For example, supply and demandanalysis shows that an oil import tax will reduce quantityof oil demanded, increase domestic production, andgenerate revenues for the government.
SUPPLY AND DEMAND AND MARKET
EFFICIENCY p. 89
5.Supply and demand curves can also be used to illustrate
the idea of market efficiency, an important aspect of nor-mative economics.
6.Consumer surplus is the difference between the maximum
amount a person is willing to pay for a good and the currentmarket price.
7.Producer surplus is the difference between the current market
price and the full cost of production for the firm.
8.At free market equilibrium with competitive markets,the sum of consumer surplus and producer surplusis maximized.
9.The total loss of producer and consumer surplus fromunderproduction or overproduction is referred to as adeadweight loss .SUMMARY
b.An increase in the price of chicken has an impact on the
price of hamburger.
c.Incomes rise, shifting the demand for gasoline. Crude oil
prices rise, shifting the supply of gasoline. At the new equi-
librium, the quantity of gasoline sold is less than it wasbefore. (Crude oil is used to produce gasoline.)
7.Illustrate the following with supply and/or demand curves:
a.A situation of excess labor supply (unemployment) caused
by a “minimum wage” law.
b.The effect of a sharp increase in heating oil prices on the
demand for insulation material.
8.Suppose that the world price of oil is $70 per barrel and that the
United States can buy all the oil it wants at this price. Suppose
also that the demand and supply schedules for oil in the United
States are as follows:94 PART I Introduction to Economics
black market, p. 84
consumer surplus, p. 89
deadweight loss, p. 92
favored customers, p. 84minimum wage, p. 86
price ceiling, p. 82
price floor, p. 86
price rationing, p. 79producer surplus, p. 90
queuing, p. 83
ration coupons, p. 84REVIEW TERMS AND CONCEPTS
PROBLEMS
All problems are available on www.myeconlab.com
1.Illustrate the following with supply and demand curves:
a.In the summer of 2010, Spanish artist Pablo Picasso’s
Portrait d’Angel Fernández de Soto was sold in London for
$51.6 million.
b.In 2010, hogs in the United States were selling for 81 cents
per pound, up from 58 cents per pound a year before. Thiswas due primarily to the fact that supply had decreased dur-ing the period.
c.Early in 2009, a survey of greenhouses indicated that the
demand for houseplants was rising sharply. At the sametime, large numbers of low-cost producers started grow-ing plants for sale. The overall result was a drop in theaverage price of houseplants and an increase in the num-
ber of plants sold.
2.Every demand curve must eventually hit the quantity axis
because with limited incomes, there is always a price so highthat there is no demand for the good. Do you agree or dis-agree? Why?
3.When excess demand exists for tickets to a major sporting event
or a concert, profit opportunities exist for scalpers. Explain
briefly using supply and demand curves to illustrate. Some
argue that scalpers work to the advantage of everyone and are“efficient.” Do you agree or disagree? Explain briefly.
4.In an effort to “support” the price of some agricultural goods,
the Department of Agriculture pays farmers a subsidy in cashfor every acre that they leave unplanted . The Agriculture
Department argues that the subsidy increases the “cost” of
planting and that it will reduce supply and increase the priceof competitively produced agricultural goods. Critics arguethat because the subsidy is a payment to farmers, it willreduce costs and lead to lower prices. Which argument is cor-
rect? Explain.
5.The rent for apartments in New Y ork City has been rising
sharply. Demand for apartments in New Y ork City has
been rising sharply as well. This is hard to explain because the law of demand says that higher prices should lead to lower demand. Do you agree or disagree? Explain your answer.
6.Illustrate the following with supply and/or demand curves:
a.The federal government “supports” the price of wheat
by paying farmers not to plant wheat on some oftheir land.PRICE
($ PER BARREL)U.S. QUANTITY
DEMANDEDU.S. QUANTITY
SUPPLIED
68 16 4
70 15 6
72 14 8
74 13 10
76 12 12
a.On graph paper, draw the supply and demand curves for the
United States.
b.With free trade in oil, what price will Americans pay for their
oil? What quantity will Americans buy? How much of thiswill be supplied by American producers? How much will beimported? Illustrate total imports on your graph of the U.S.
oil market.
c.Suppose the United States imposes a tax of $4 per barrel on
imported oil. What quantity would Americans buy? Howmuch of this would be supplied by American producers?How much would be imported? How much tax would the
government collect?
d.Briefly summarize the impact of an oil import tax by
explaining who is helped and who is hurt among the fol-lowing groups: domestic oil consumers, domestic oil pro-ducers, foreign oil producers, and the U.S. government.
CHAPTER 4 Demand and Supply Applications 95
9.Use the data in the preceding problem to answer the follow-
ing questions. Now suppose that the United States allows no
oil imports.a.What are the equilibrium price and quantity for oil in the
United States?
b.If the United States imposed a price ceiling of $74 per bar-
rel on the oil market and prohibited imports, would there
be an excess supply or an excess demand for oil? If so,how much?
c.Under the price ceiling, quantity supplied and quantity
demanded differ. Which of the two will determine howmuch oil is purchased? Briefly explain why.
10.Use the following diagram to calculate total consumer sur-
plus at a price of $8 and production of 6 million meals per
day. For the same equilibrium, calculate total producer
surplus. Assuming price remained at $8 but production wascut to 3 million meals per day, calculate producer surplusand consumer surplus. Calculate the deadweight loss from underproduction.
11.In early 2008, many predicted that in a relatively short period of
time, unleaded regular gasoline at the pump would be selling
for over $4. Do some research on the price of gasoline. Havethose dire predictions materialized? What is the price ofunleaded regular today in your city or town? If it is below $4 pergallon, what are the reasons? Similarly, if it is higher than $4,
what has happened to drive up the price? Illustrate with supply
and demand curves.
12.[Related to the Economics in Practice onp. 87 ]Many cruise
lines offer 5-day trips. A disproportionate number of these tripsleave port on Thursday and return late Monday. Why might thisbe true?
13.[Related to the Economics in Practice onp. 87 ]Lines for free
tickets to see Shakespeare in Central Park are often long. A local
politician has suggested that it would be a great service if the
park provided music to entertain those who are waiting in line.What do you think of this suggestion?DP
S
0Price per meal ($)
Millions of meals per day125
281114
345678 Q14.Suppose the market demand for burritos is given by Qd= 40 – 5 P
and the market supply for burritos is given by Qs= 10 P– 20,
where P= price (per burrito).
a.Graph the supply and demand schedules for burritos.
b.What is the equilibrium price and equilibrium quantity?
c.Calculate consumer surplus and producer surplus, and iden-
tify these on the graph.
15.On April 20, 2010, an oil-drilling platform owned by
British Petroleum exploded in the Gulf of Mexico, causing
oil to leak into the gulf at estimates of 1.5 to 2.5 million
gallons per day for well over two months. Due to the oil spill, the government closed over 25 percent of federalwaters, which has devastated the commercial fishing industryin the area. Explain how the reduction in supply from thereduced fishing waters will either increase or decrease
consumer surplus and producer surplus, and show thesechanges graphically.
16.The following graph represents the market for DVDs.
Supply
Demand
37
654
3
2
1
0Price of
DVDs
Quantity
of DVDs(millions)
6 9 12 15 18 21 24 27 30
a.Find the values of consumer surplus and producer surplus
when the market is in equilibrium, and identify these areas
on the graph.
b.If underproduction occurs in this market, and only
9 million DVDs are produced, what happens to theamounts of consumer surplus and producer surplus?
What is the value of the deadweight loss? Identify these
areas on the graph.
c.If overproduction occurs in this market, and 27 million
DVDs are produced, what happens to the amounts of con-sumer surplus and producer surplus? Is there a deadweight
loss with overproduction? If so, what is its value? Identify
these areas on the graph.
96 PART I Introduction to Economics
17.The following graph represents the market for wheat. The equi-
librium price is $20 per bushel and the equilibrium quantity is
14 million bushels.
Supply
Demand
230
2010
0Price of
wheat
(bushel)
Quantity
of wheat
(millions
of bushels)4 6 8 10 12 14 16 18 20 24 26 22a.Explain what will happen if the government establishes a
price ceiling of $10 per bushel of wheat in this market? What
if the price ceiling was set at $30?
b.Explain what will happen if the government establishes a
price floor of $30 per bushel of wheat in this market. What ifthe price floor was set at $10?
18.[Related to the Economics in Practice onp. 81 ]Go back
to the Economics in Practice on page 81. Using the numbers
in the newspaper article, find the total revenue, total catch,and market prices for lobsters in the years 2008 and 2009.
97In economics, simple logic often tells
us how a change in one variable, suchas the price of a good or an interestrate, is likely to affect behavior. It is asafe bet, for example, that when Barnes& Noble and Amazon.com both low-ered the price of their e-Readers in thesummer of 2010, sales increased. Whenmany universities lowered the price offootball tickets to students (many to aprice of zero), the schools did so in anattempt to increase the number of stu-dent fans in their stadiums. If the gov-ernment helps to raise the price ofcigarettes by increasing cigarette taxes, it is likely that tobacco sales will suffer.
The work we did in earlier chapters tells us the direction of the changes we would expect
to see from price changes in markets. But in each of the preceding examples and in most othersituations, knowing the direction of a change is not enough. What we really need to know tohelp us make the right decisions is how big the reactions are. How many more fans wouldcome to a football game if the price were lowered? Is the added team spirit worth the lostticket revenue? Would the university get more fans by charging students but giving them freehot dogs at the game? For profit-making firms, knowing the quantity that would be sold at alowered price is key. If sales increases following a price cut are large enough, revenues mayrise. T o answer these questions, we must know more than just direction; we must know some-thing about market responsiveness.
Understanding the responsiveness of consumers and producers in markets to price
changes is key to answering a wide range of economic problems. Should McDonald’s lowerthe price of its Big Mac? For McDonald’s, the answer depends on whether that price cutincreases or decreases its profits. The answer to that, in turn, depends on how its customersare likely to respond to the price cut. How many more Big Macs will be sold, and will the newsales come at the expense of the sandwiches sold at Subway or be a substitution ofMcDonald’s Chicken McNuggets for Big Macs? How many potential new smokers will bedeterred from smoking by higher cigarette prices the government has induced? Questionssuch as these lie at the core of economics. T o answer these questions, we need to measure themagnitude of market responses.
The importance of actual measurement cannot be overstated. Much of the research being
done in economics today involves the collection and analysis of quantitative data that measurebehavior. The ability to analyze large amounts of data increased enormously with the advent ofmodern computers.
Economists commonly measure responsiveness using the concept of elasticity . Elasticity is a
general concept that can be used to quantify the response in one variable when another variableCHAPTER OUTLINE
5
Price Elasticity of
Demand p. 98
Slope and Elasticity
Types of Elasticity
Calculating
Elasticities p. 100
Calculating Percentage
Changes
Elasticity Is a Ratio of
Percentages
The Midpoint Formula
Elasticity Changes Along
a Straight-Line Demand Curve
Elasticity and Total
Revenue
The Determinants of
Demand Elasticity p. 107
Availability of Substitutes
The Importance of Being
Unimportant
The Time Dimension
Other Important
Elasticities p. 109
Income Elasticity
of Demand
Cross-Price Elasticity
of Demand
Elasticity of Supply
Looking Ahead p. 111
Appendix: Point
Elasticity p. 115Elasticity
elasticity A general concept
used to quantify the response
in one variable when anothervariable changes.
98 PART I Introduction to Economics
0a. b.
0DDP1
P2P1
P2
Q1 Q2 Q1 Q2= 3
= 2= 3
= 2
= 5 = 10 = 80 = 160
/H9004Y P2 P1
/H9004X Q2 Q1=
== = ==/H9004Y P2 P1
/H9004X Q2 Q1Price per pound ($)
Price per pound ($)
Pounds of steak per month Ounces of steak per month
Slope: Slope:
2/H11002 3 2/H11002 3
10/H11002 5 160 /H11002 80/H110021
5/H11002 1
80/H11002/H11002
/H11002/H11002P
QP
Q/L50298FIGURE 5.1 Slope Is
Not a Useful Measure ofResponsiveness
Changing the unit of measure
from pounds to ounces changesthe numerical value of thedemand slope dramatically, butthe behavior of buyers in the two
diagrams is identical.changes. If some variable Achanges in response to changes in another variable B, the elasticity of
Awith respect to Bis equal to the percentage change in Adivided by the percentage change in B:
elasticity of A with respect to B=%¢A
%¢B
In the examples discussed previously, we often consider responsiveness or elasticity by look-
ing at prices: How does demand for a product respond when its price changes? This is known asthe price elasticity of demand. How does supply respond when prices change? This is the priceelasticity of supply. As in the McDonald’s example, sometimes it is important to know how theprice of one good—for example, the Big Mac—affects the demand for another good—Chicken
McNuggets. This is called the cross-price elasticity of demand.
But the concept of elasticity goes well beyond responsiveness to price changes. As we will see,
we can look at elasticities as a way to understand responses to changes in income and almost anyother major determinant of supply and demand in a market. We begin with a discussion of priceelasticity of demand.
Price Elasticity of Demand
Y ou have already seen the law of demand at work. Recall that ceteris paribus , when prices rise,
quantity demanded can be expected to decline. When prices fall, quantity demanded can beexpected to rise. The normal negative relationship between price and quantity demanded isreflected in the downward slope of demand curves.
Slope and Elasticity
The slope of a demand curve may in a rough way reveal the responsiveness of the quantitydemanded to price changes, but slope can be quite misleading. In fact, it is not a good formalmeasure of responsiveness.
Consider the two identical demand curves in Figure 5.1. The only difference between the two is
that quantity demanded is measured in pounds in the graph on the left and in ounces in the graphon the right. When we calculate the numerical value of each slope, however, we get very different
CHAPTER 5 Elasticity 99
00D
DPricePrice
Quantity of insulin demanded Quantity of wheat demandeda. Perfectly inelastic demand b. Perfectly elastic demand
P
QP
Q
/L50304FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves
Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity
demanded is fixed; it does not change at all when price changes. Figure 5.2(b) shows a perfectly elastic demand
curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectlyelastic demand implies that individual producers can sell all they want at the going market price but cannotcharge a higher price.answers. The curve on the left has a slope of -1/5, and the curve on the right has a slope of -1/80;
yet the two curves represent the exact same behavior . If we had changed dollars to cents on the
Y-axis, the two slopes would be -20 and -1.25, respectively. (Review the Appendix to Chapter 1 if
you do not understand how these numbers are calculated.)
The problem is that the numerical value of slope depends on the units used to measure the
variables on the axes. T o correct this problem, we must convert the changes in price and quantityto percentages. By looking at by how much the percent quantity demanded changes for a given
percent price change, we have a measure of responsiveness that does not change with the unit of
measurement. The price increase in Figure 5.1 leads to a decline of 5 pounds, or 80 ounces, in thequantity of steak demanded—a decline of 50 percent from the initial 10 pounds, or 160 ounces,whether we measure the steak in pounds or ounces.
We define price elasticity of demand simply as the ratio of the percentage of change in
quantity demanded to the percentage change in price.
Percentage changes should always carry the sign (plus or minus) of the change. Positive
changes, or increases, take a (+). Negative changes, or decreases, take a ( -). The law of demand
implies that price elasticity of demand is nearly always a negative number: Price increases (+) willlead to decreases in quantity demanded ( -), and vice versa. Thus, the numerator and denomina-
tor should have opposite signs, resulting in a negative ratio.
Types of Elasticity
The elasticity of demand can vary between 0 and minus infinity. An elasticity of 0 indicates thatthe quantity demanded does not respond at all to a price change. A demand curve with an elastic-
ity of 0 is called perfectly inelastic and is illustrated in Figure 5.2(a). A demand curve in which
even the smallest price increase reduces quantity demanded to zero is known as a perfectly elastic
demand curve and is illustrated in Figure 5.2(b). A good way to remember the difference betweenthe two perfect elasticities isprice elasticity of demand =% change in quantity demanded
% change in price
perfectly inelastic
demand Demand in which
quantity demanded does notrespond at all to a change
in price.price elasticity of
demand The ratio of the
percentage of change inquantity demanded to thepercentage of change in price;measures the responsiveness ofquantity demanded to changes
in price.
perfectly elastic demand
Demand in which quantity
drops to zero at the slightest
increase in price.
100 PART I Introduction to Economics
What type of good might have a perfectly elastic demand curve? Suppose there are two iden-
tical vendors selling Good Humor bars on a beach. If one vendor increased his price, all the buy-ers would flock to the second vendor. In this case, a small price increase costs the first vendor allhis business; the demand he faces is perfectly elastic. Products with perfectly inelastic demand areharder to find, but some life-saving medical products like insulin may be close, in that very highprice increases may elicit no response in terms of quantity demanded.
Of course, a lot of products have elasticities between the two extremes. When an elasticity is
over –1.0 in absolute value,
1we refer to the demand as elastic . In this case, the percentage change
in quantity is larger in absolute value than the percentage change in price. Here consumers areresponding a lot to a price change. When an elasticity is less than 1 in absolute value, it is referredto as inelastic . In these markets, consumers respond much less to price changes. The demand for
oil is inelastic, for example, because even with a price increase, it is hard to substitute oil for otherproducts. The demand for a Nestlé Crunch bar is much more elastic, in part because there are somany more substitutes.
A special case is one in which the elasticity of demand is minus one. Here, we say demand has
unitary elasticity . In this case, the percentage change in price is exactly equal to the percentage
change in quantity demanded, in absolute value terms. As you will see when we look at the rela-tionship between revenue and elasticities later in this chapter, unitary elastic demand curves havesome very interesting properties.
A warning: Y ou must be very careful about signs. Because it is generally understood that
demand elasticities are negative (demand curves have a negative slope), they are often reported anddiscussed without the negative sign. For example, a technical paper might report that the demandfor housing “appears to be inelastic with respect to price, or less than 1 (.6).” What the writer meansis that the estimated elasticity is –.6, which is between zero and –1. Its absolute value is less than 1.
Calculating Elasticities
Elasticities must be calculated cautiously. Return for a moment to the demand curves in Figure 5.1 onp. 98. The fact that these two identical demand curves have dramatically different slopes should beenough to convince you that slope is a poor measure of responsiveness. As we will see shortly, a givenstraight line, which has the same slope all along it, will show different elasticities at various points.
The concept of elasticity circumvents the measurement problem posed by the graphs in
Figure 5.1 by converting the changes in price and quantity to percentage changes. Recall that elas-ticity of demand is the percentage change in quantity demanded divided by the percentage change
in price.
Calculating Percentage Changes
Because we need to know percentage changes to calculate elasticity, let us begin our example bycalculating the percentage change in quantity demanded. Figure 5.1(a) shows that the quantity ofsteak demanded increases from 5 pounds ( Q
1) to 10 pounds ( Q2) when price drops from $3 to
$2 per pound. Thus, the change in quantity demanded is equal to Q2-Q1, or 5 pounds.
T o convert this change into a percentage change, we must decide on a base against which to calcu-
late the percentage. It is often convenient to use the initial value of quantity demanded ( Q1) as the base.
T o calculate percentage change in quantity demanded using the initial value as the base, the
following formula is used:
1Absolute value orabsolute size means ignoring the sign. The absolute value of -4 is 4.=Q2-Q1
Q1*100% % change in quantity demanded =change in quantity demanded
Q1*100%elastic demand A demand
relationship in which the
percentage change in quantity
demanded is larger than thepercentage change in price inabsolute value (a demand
elasticity with an absolute
value greater than 1).
unitary elasticity A demand
relationship in which the
percentage change in quantityof a product demanded is the
same as the percentage change
in price in absolute value (ademand elasticity of -1).inelastic demand Demand
that responds somewhat, butnot a great deal, to changes inprice. Inelastic demand always
has a numerical value between
zero and -1.
CHAPTER 5 Elasticity 101
In Figure 5.1, Q2= 10 and Q1= 5. Thus,
Expressing this equation verbally, we can say that an increase in quantity demanded from
5 pounds to 10 pounds is a 100 percent increase from 5 pounds. Note that you arrive at exactlythe same result if you use the diagram in Figure 5.1(b), in which quantity demanded is measuredin ounces. An increase from Q
1(80 ounces) to Q2(160 ounces) is a 100 percent increase.
We can calculate the percentage change in price in a similar way. Once again, let us use the
initial value of P—that is, P1—as the base for calculating the percentage. By using P1as the base,
the formula for calculating the percentage of change in Pis% change in quantity demanded =10-5
5*100% =5
5*100% =100%
=P2-P1
P1*100% % change in price =change in price
P1*100%
In Figure 5.1(a), P2equals 2 and P1equals 3. Thus, the change in P,o r P, is a negative
number: P2-P1= 2 -3 = -1. This is true because the change is a decrease in price. Plugging the
values of P1and P2into the preceding equation, we get
In other words, decreasing the price from $3 to $2 is a 33.3 percent decline.
Elasticity Is a Ratio of Percentages
Once the changes in quantity demanded and price have been converted to percentages, calculat-
ing elasticity is a matter of simple division. Recall the formal definition of elasticity:% change in price =2-3
3*100% =-1
3*100% =- 33.3%¢
price elasticity of demand =% change in quantity demanded
% change in price
If demand is elastic, the ratio of percentage change in quantity demanded to percentage
change in price will have an absolute value greater than 1. If demand is inelastic, the ratio willhave an absolute value between 0 and 1. If the two percentages are equal, so that a given percent-age change in price causes an equal percentage change in quantity demanded, elasticity is equal to-1; this is unitary elasticity.
Substituting the preceding percentages, we see that a 33.3 percent decrease in price leads to a
100 percent increase in quantity demanded; thus,
According to these calculations, the demand for steak is elastic when we look at the range
between $2 and $3.
The Midpoint Formula
Although simple, the use of the initial values of Pand Qas the bases for calculating percentage
changes can be misleading. Let us return to the example of demand for steak in Figure 5.1(a),where we have a change in quantity demanded of 5 pounds. Using the initial value Q
1as the base,
we calculated that this change represents a 100 percent increase over the base. Now suppose thatthe price of steak rises to $3 again, causing the quantity demanded to drop back to 5 pounds. Howprice elasticity of demand =+100%
-33.3%=- 3.0
102 PART I Introduction to Economics
much of a percentage decrease in quantity demanded is this? We now have Q1= 10 and Q2= 5.
With the same formula we used earlier, we get
Thus, an increase from 5 pounds to 10 pounds is a 100 percent increase (because the initial value
used for the base is 5), but a decrease from 10 pounds to 5 pounds is only a 50 percent decrease(because the initial value used for the base is 10). This does not make much sense because in bothcases, we are calculating elasticity on the same interval on the demand curve. Changing the“direction” of the calculation should not change the elasticity.
T o describe percentage changes more accurately, a simple convention has been adopted.
Instead of using the initial values of Qand Pas the bases for calculating percentages, we use the
midpoints of these variables as the bases. That is, we use the value halfway between P
1and P2for
the base in calculating the percentage change in price and the value halfway between Q1andQ2as
the base for calculating percentage change in quantity demanded.
Thus, the midpoint formula for calculating the percentage change in quantity demanded
becomes=5-10
10*100% =- 50%=Q2-Q1
Q1*100% % change in quantity demanded =change in quantity demanded
Q1*100%
=Q2-Q1
(Q1+Q2)>2*100% % change in quantity demanded =change in quantity demanded
(Q1+Q2)>2*100%
Substituting the numbers from the original Figure 5.1(a), we get
Using the point halfway between P1and P2as the base for calculating the percentage change
in price, we get% change in quantity demanded =10-5
(5+10)>2*100% =5
7.5*100% =66.7%
=P2-P1
(P1+P2)>2*100% % change in price =change in price
(P1+P2)>2*100%
Substituting the numbers from the original Figure 5.1(a) yields
We can thus say that a change from a quantity of 5 to a quantity of 10 is a +66.7 percent
change using the midpoint formula and that a change in price from $3 to $2 is a -40 percent
change using the midpoint formula.
Using these percentages to calculate elasticity yields
price elasticity of demand =% change in quantity demanded
% change in price=66.7%
-40.0%=- 1.67% change in price =2-3
(3+2)>2*100% =-1
2.5*100% =- 40.0%midpoint formula A more
precise way of calculatingpercentages using the valuehalfway between P
1and P2for
the base in calculating the
percentage change in price and
the value halfway between Q1
and Q2as the base for
calculating the percentage
change in quantity demanded.
Using the midpoint formula in this case gives a lower demand elasticity, but the demand remains
elastic because the percentage change in quantity demanded is still greater than the percentagechange in price in absolute size.
The calculations based on the midpoint approach are summarized in Table 5.1.CHAPTER 5 Elasticity 103
Elasticity Changes Along a Straight-Line Demand Curve
An interesting and important point is that elasticity changes from point to point along a demand
curve even when the slope of that demand curve does not change—that is, even along a straight-line demand curve. Indeed, the differences in elasticity along a demand curve can be quite large.
Before we go through the calculations to show how elasticity changes along a demand curve,
it is useful to think why elasticity might change as we vary price. Consider again McDonald’s deci-
sion to reduce the price of a Big Mac. Suppose McDonald’s found that at the current price of $3,a small price cut would generate a large number of new customers who wanted burgers. Demand,in short, was relatively elastic. What happens as McDonald’s continues to cut its price? As theprice moves from $2.50 to $2.00, for example, new customers lured in by the price cuts are likelyto decrease; in some sense, McDonald’s will be running out of customers who are interested in itsburgers at any price. It should come as no surprise that as we move down a typical straight-linedemand curve, price elasticity falls. Demand becomes less elastic as price is reduced. This lessonhas important implications for price-setting strategies of firms.
Consider the demand schedule shown in Table 5.2 and the demand curve in Figure 5.3.
Herb works about 22 days per month in a downtown San Francisco office tower. On the top floorTABLE 5.1 Calculating Price Elasticity with the Midpoint Formula
First, Calculate Percentage Change in Quantity Demanded (% /H9004QD):
Price elasticity compares the
percentage change in quantity demanded and the percentage change in price.
Demand is elastic.=Price elasticity of demand=- 1.67%¢Q
D
%¢P=66.7%
-40.0%% change in
quantity demanded=change in quantity demanded
(Q1+Q2)>2*100% =Q2-Q1
(Q1+Q2)>2*100%
By substituting the numbers from Figure 5.1(a):
% change in quantity demanded =10-5
(5+10)>2*100% =5
7.5*100% =66.7%
Next, Calculate Percentage Change in Price (% /H9004P):
% change in price =change in price
(P1+P2)>2*100% =P2-P1
(P1+P2)>2*100%
By substituting the numbers from Figure 5.1(a):
% change in price =2-3
(3+2)>2*100% =-1
2.5*100% =- 40.0%
TABLE 5.2 Demand Schedule for Office
Dining Room Lunches
Price (per Lunch)Quantity Demanded
(Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22
104 PART I Introduction to Economics
A
B
C
D
Q2Q1P1
P2$
11
10
9
8
76
54
3
2
1
0 2 4 6 8 1 01 21 4 1 61 82 02 2DemandPrice per lunch ($)
Number of lunches per month
at the office dining room/L50298FIGURE 5.3 Demand
Curve for Lunch at theOffice Dining Room
Between points Aand B, demand
is quite elastic at -6.4. Between
points Cand D, demand is quite
inelastic at -.294.
of the building is a nice dining room. If lunch in the dining room were $10, Herb would eat there
only twice a month. If the price of lunch fell to $9, he would eat there 4 times a month. (Herbwould bring his lunch to work on other days.) If lunch were only a dollar, he would eat there20 times a month.
Let us calculate price elasticity of demand between points Aand Bon the demand curve in
Figure 5.3. Moving from Ato B, the price of a lunch drops from $10 to $9 (a decrease of $1) and
the number of dining room lunches that Herb eats per month increases from two to four (anincrease of two). We will use the midpoint approach.
First, we calculate the percentage change in quantity demanded:
Substituting the numbers from Figure 5.3, we getNext, we calculate the percentage change in price:Substituting the numbers from Figure 5.3, we getFinally, we calculate elasticity by dividing
The percentage change in quantity demanded is 6.4 times larger than the percentage change in
price. In other words, Herb’s demand between points Aand Bis quite responsive; his demand
between points Aand Bis elastic.=66.7%
-10.5%=- 6.4elasticity of demand =% change in quantity demanded
% change in price% change in price =9-10
(10+9)>2*100% =-1
9.5*100% =- 10.5%% change in price =P2-P1
(P1+P2)>2*100%% change in quantity demanded =4-2
(2+4)>2*100% =2
3*100% =66.7%% change in quantity demanded =Q2-Q1
(Q1+Q2)>2*100%
CHAPTER 5 Elasticity 105
Now consider a different movement along the same demand curve in Figure 5.3. Moving
from point Cto point D, the graph indicates that at a price of $3, Herb eats in the office dining
room 16 times per month. If the price drops to $2, he will eat there 18 times per month. Thesechanges expressed in numerical terms are exactly the same as the price and quantity changesbetween points Aand Bin the figure—price falls $1, and quantity demanded increases by two
meals. Expressed in percentage terms, however, these changes are very different.
By using the midpoints as the base, the $1 price decline is only a 10.5 percent reduction when
price is around $9.50, between points Aand B. The same $1 price decline is a 40 percent reduc-
tion when price is around $2.50, between points Cand D. The two-meal increase in quantity
demanded is a 66.7 percent increase when Herb averages only 3 meals per month, but it is only an11.76 percent increase when he averages 17 meals per month. The elasticity of demand betweenpoints CandDis thus 11.76 percent divided by -40 percent, or -0.294. (Work these numbers out
for yourself by using the midpoint formula.)
The percentage changes between AandBare very different from those between CandD, and
so are the elasticities. Herb’s demand is quite elastic ( -6.4) between points AandB; a 10.5 percent
reduction in price caused a 66.7 percent increase in quantity demanded. However, his demand isinelastic ( -0.294) between points CandD; a 40 percent decrease in price caused only an 11.76 per-
cent increase in quantity demanded.
Again, it is useful to keep in mind the underlying economics as well as the mathematics. At
high prices, there is a great deal of potential demand for the dining room to capture. Hence,quantity is likely to respond well to price cuts. At low prices, everyone who is likely to come to thedining room already has.
Elasticity and Total Revenue
As we saw in Chapter 4, the oil-producing countries have had some success keeping oil priceshigh by controlling supply. T o some extent, reducing supply and driving up prices has increasedthe total oil revenues to the producing countries. We would not, however, expect this strategy towork for everyone. If the organization of banana-exporting countries (OBEC) had done the samething, the strategy would not have worked.
Why? Suppose OBEC decides to cut production by 30 percent to drive up the world price of
bananas. At first, when the quantity of bananas supplied declines, the quantity demanded isgreater than the quantity supplied and the world price rises. The issue for OBEC, however, is how
much the world price will rise. That is, how much will people be willing to pay to continue con-
suming bananas? Unless the percentage increase in price is greater than the percentage decrease in
output, the OBEC countries will lose revenues.
A little research shows us that the prospects are not good for OBEC. There are many reason-
able substitutes for bananas. As the price of bananas rises, people simply eat fewer bananas asthey switch to eating more pineapples or oranges. Many people are simply not willing to pay ahigher price for bananas. The quantity of bananas demanded declines 30 percent—to the newquantity supplied—after only a modest price rise, and OBEC fails in its mission; its revenuesdecrease instead of increase.
We have seen that oil-producing countries often can increase their revenues by restricting
supply and pushing up the market price of crude oil. We also argued that a similar strategy bybanana-producing countries would probably fail. Why? The quantity of oil demanded is not asresponsive to a change in price as is the quantity of bananas demanded. In other words, thedemand for oil is more inelastic than is the demand for bananas. One of the very useful featuresof elasticity is that knowing the value of price elasticity allows us to quickly see what happens toa firm’s revenue as it raises and cuts its prices. When demand is inelastic, raising prices will raiserevenues; when (as in the banana case) demand is elastic, price increases reduce revenues.
We can now use the more formal definition of elasticity to make more precise our argument
of why oil producers would succeed and banana producers would fail as they raise prices. In anymarket, P/H11003Qis total revenue ( TR) received by producers:
total revenue =price *quantityTR=P*Q
106 PART I Introduction to Economics
The oil producers’ total revenue is the price per barrel of oil ( P) times the number of barrels its
participant countries sell ( Q). T o banana producers, total revenue is the price per bunch times the
number of bunches sold.
When price increases in a market, quantity demanded declines. As we have seen, when price
(P) declines, quantity demanded ( QD) increases. This is true in all markets. The two factors, Pand
QD, move in opposite directions:
Pp:QDqon quantity demanded: andeffects of price changes Pq:QDp
Because total revenue is the product of Pand Q, whether TRrises or falls in response to a
price increase depends on which is bigger: the percentage increase in price or the percentagedecrease in quantity demanded. If the percentage decrease in quantity demanded is smallerthan the percentage increase in price, total revenue will rise. This occurs when demand isinelastic . In this case, the percentage price rise simply outweighs the percentage quantity
decline and P/H11003Q= (TR) rises:
If, however, the percentage decline in quantity demanded following a price increase is larger
than the percentage increase in price, total revenue will fall. This occurs when demand is elastic .
The percentage price increase is outweighed by the percentage quantity decline:
effect of price increase on
a product with elastic demand: qP*QDp=TRp
The opposite is true for a price cut. When demand is elastic, a cut in price increases total
revenues:
effect of price cut on a product
with elastic demand: pP*QDq=TRq
When demand is inelastic, a cut in price reduces total revenues:
effect of price cut on a product
with inelastic demand: pP*QDq=TRpeffect of price increase on
a product with inelastic demand: qP*QDp=TRq qq
pp
ppqq
CHAPTER 5 Elasticity 107
Review the logic of these equations to make sure you thoroughly understand the reasoning.
Having a responsive (or elastic) market is good when we are lowering price because it means thatwe are dramatically increasing our units sold. But that same responsiveness is unattractive as wecontemplate raising prices because now it means that we are losing customers. And, of course, thereverse logic works in the inelastic market. Note that if there is unitary elasticity, total revenue isunchanged if the price changes.
With this knowledge, we can now see why reducing supply by the oil-producing countries
was so effective. The demand for oil is inelastic. Restricting the quantity of oil available led to ahuge increase in the price of oil—the percentage increase was larger in absolute value than thepercentage decrease in the quantity of oil demanded. Hence, oil producers’ total revenues wentup. In contrast, a banana cartel would not be effective because the demand for bananas is elastic.A small increase in the price of bananas results in a large decrease in the quantity of bananasdemanded and thus causes total revenues to fall.
The Determinants of Demand Elasticity
Elasticity of demand is a way of measuring the responsiveness of consumers’ demand to changesin price. As a measure of behavior, it can be applied to individual households or to marketdemand as a whole. Y ou love peaches, and you would hate to give them up. Y our demand forpeaches is therefore inelastic. However, not everyone is crazy about peaches; in fact, the marketdemand for peaches is relatively elastic. Because no two people have exactly the same preferences,reactions to price changes will be different for different people, which makes generalizationsrisky. Nonetheless, a few principles do seem to hold.
Availability of Substitutes
Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes.Consider a number of farm stands lined up along a country road. If every stand sells fresh corn ofroughly the same quality, Mom’s Green Thumb will find it very difficult to charge a price muchhigher than the competition charges because a nearly perfect substitute is available just down theroad. The demand for Mom’s corn is thus likely to be very elastic: An increase in price will lead toa rapid decline in the quantity demanded of Mom’s corn.
In the oil versus banana example, the demand for oil is inelastic in large measure due to
the lack of substitutes. When the price of crude oil went up in the early 1970s, 130 millionmotor vehicles, getting an average of 12 miles per gallon and consuming over 100 billion gal-lons of gasoline each year, were on the road in the United States. Millions of homes wereheated with oil, and industry ran on equipment that used petroleum products. When the oil-producing countries (OPEC) cut production, the price of oil rose sharply. Quantitydemanded fell somewhat, but price increased over 400 percent. What makes the cases ofOPEC and OBEC different is the magnitude of the response in the quantity demanded to a
change of price.
The Importance of Being Unimportant
When an item represents a relatively small part of our total budget, we tend to pay little attentionto its price. For example, if you pick up a pack of mints once in a while, you might not notice anincrease in price from 25 cents to 35 cents. Y et this is a 40 percent increase in price (33.3 percentusing the midpoint formula). In cases such as these, we are not likely to respond very much tochanges in price and demand is likely to be inelastic.
108 PART I Introduction to Economics
The Time Dimension
When the oil-producing nations first cut output and succeeded in pushing up the price of crude
oil, few substitutes were immediately available. Demand was relatively inelastic, and prices rosesubstantially. During the last 30 years, however, there has been some adjustment to higher oilprices. Automobiles manufactured today get on average more miles per gallon, and some drivershave cut down on their driving. Millions of home owners have insulated their homes, most peoplehave turned down their thermostats, and some people have explored alternative energy sources.
Oil prices again rose dramatically during the weeks following Hurricane Katrina in 2005
because of the disruption to oil refineries and oil rigs. Once again, the response of demand to theresulting higher gasoline prices took place slowly over time. This time many former SUV driversswitched to hybrids.
All of this illustrates a very important point: The elasticity of demand in the short run may
be very different from the elasticity of demand in the long run. In the longer run, demand is likelyto become more elastic, or responsive, simply because households make adjustments over timeand producers develop substitute goods.
ECONOMICS IN PRACTICE
Who Are the Elastic Smokers?
In the United States, taxes are imposed on cigarettes at the state
level. As a result, there are large differences among states. As of July 1,
2010, three states had cigarette taxes in excess of $3.00 per pack:
Rhode Island, Connecticut, and Washington. Seven more had ratesbetween $2.00 and $3.00 (including the District of Columbia).Missouri had the lowest rate among the 50 states at $0.17 a pack.The following article describes a proposal to raise taxes by $1.00 per
pack in the state of Washington.
We would expect an increase in the tax on cigarettes to increase
their price to consumers. An interesting question from the point ofview of health and tax revenue is how much a price increase lowersdemand. One of the commentators in the article claims thatincreasing cigarette prices by 10 percent reduces youth smokers by
6–7 percent; this is an implied demand elasticity of –0.6 (6%/10%).
How do you think this compares to what we would expect fromadult smokers? Many people would argue that because more youngpeople are new smokers and because they have less money thanadults, their demand for cigarettes would be more elastic. On the
other hand, if peer pressure favors smoking, this could lower
demand elasticity for youths.
One problem that states face as they increase their cigarette
taxes is that people will seek cigarette substitutes from cheaperareas. In Washington, the state pressured Indian tribes to raise
the tribal tax rate on cigarettes to the overall state level. By mak-
ing these substitutes to state-taxed cigarettes more expensive,the loss of customers in response to the state tax increase wouldbe less.
Bill Aims to Raise Tax on Cigarettes
Seattle Times
OLYMPIA—If lawmakers pass a House bill raising the statecigarette tax to $2.50 a pack, Washington would be the sec-ond most expensive place in the country to buy cigarettes.The proposed tax would raise the current $1.425 a
pack by more than a dollar. The additional revenue would
generate an estimated $300 million in two years for thestate’s health-care fund, according to bill sponsors.Proponents also say the substantial tax would deter
people from smoking, saving nearly $1 billion in future
health-care costs.
Eric Lindblom, manager for policy research at
Campaign for Tobacco-Free Kids, said “raising cigaretteprices is one of the quickest, most effective ways to reduce
youth smoking.”
Every time a state increases cigarette taxes by 10 per-
cent, there is a 6 to 7 percent decrease in youth smokers, he said.
Source: Copyright 2005, Seattle Times Company. Used with permission.
CHAPTER 5 Elasticity 109
ECONOMICS IN PRACTICE
Elasticities at a Delicatessen in the Short Run and Long Run
Frank runs a corner delicatessen and decides one Monday morning
to raise the prices of his sandwiches by 10 percent. Because Frankknows a little economics, he expects that this price increase willcause him to lose some business, since demand curves slope down,
but he decides to try it anyway. At the end of the day, Frank discovers
that his revenue has, in fact, gone up in the sandwich department.Feeling pleased with himself, Frank hires someone to create signsshowing the new prices for the sandwich department. At the end ofthe month, however, he discovers that sandwich revenue is waydown. What is going on?
The first thing to notice about this situation is that it poses a
puzzle about what happens to revenue following a price increase.Seeing a linkage between price increases (or cuts) and revenueimmediately leads an economist to think about elasticity .W e
remember from earlier in the chapter that when demand is elastic ,
(that is, an absolute value greater than 1), price increases reduce
revenue because a small price increase will bring a large quantity
decrease, thus depressing revenue. Conversely, when demand isinelastic (that is, an absolute value less than 1), price increases dolittle to curb demand and revenues rise. In this case, Monday’s
price increase brings increases in revenue; therefore, this pattern
tells us that the demand from Frank’s customers appears to beinelastic. In the longer term, however, demand appears to be moreelastic (revenue is down after a month). Another way to pose thispuzzle is to ask why the monthly demand curve might have a dif-
ferent elasticity than the daily demand.
T o answer that question, you need to think about what deter-
mines elasticity. The most fundamental determinant of demandelasticity is the availability of substitutes. In this case, the productwe are looking at is sandwiches. At first, you might think that thesubstitutes for Monday’s sandwich would be the same as the sub-stitutes for the sandwiches for the rest of the month. But this is
not correct. Once you are in Frank’s store, planning to buy a
sandwich, your demand tends to be relatively inelastic becauseyour ability to substitute by going elsewhere or choosing a differ-ent lunch item is relatively limited. Y ou have already come to thepart of town where Frank’s Delicatessen is located, and you mayalready have chosen chips and a beverage to go along with yoursandwich. Once you know that Frank’s sandwiches are expensive,you can make different plans, and this broadening of your substi-tute choices increases your elasticity. In general, longer-termdemand curves tend to be more elastic than shorter-term curves
because customers have more choices.
The graph below shows the expected relationship between long-
run and short-run demand for Frank’s sandwiches. Notice if youraise prices above the current level, the expected quantity changeread off the short-run curve is less than that from the long-
run curve.
DSRDLR
Quantity of SandwichesCurrent Q New Q
inSRNew Q
inLRNew
Price
Current
PriceDLR/H11005 Long run
demand curve
DSR/H11005 Short run
demand curvePrice
Other Important Elasticities
So far, we have been discussing price elasticity of demand, which measures the responsive-
ness of quantity demanded to changes in price. However, as we noted earlier, elasticity is ageneral concept. If Bcauses a change in Aand we can measure the change in both, we can
calculate the elasticity of Awith respect to B. Let us look briefly at three other important
types of elasticity.
110 PART I Introduction to Economics
income elasticity of demand =% change in quantity demanded
% change in income
Measuring income elasticity is important for many reasons. Government policy makers
spend a great deal of time and money weighing the relative merits of different policies. Duringthe 1970s, for example, the Department of Housing and Urban Development (HUD) conducteda huge experiment in four cities to estimate the income elasticity of housing demand. In this“housing allowance demand experiment,” low-income families received housing vouchers overan extended period of time and researchers watched their housing consumption for severalyears. Most estimates, including the ones from the HUD study, put the income elasticity ofhousing demand between 0.5 and 0.8. That is, a 10 percent increase in income can be expectedto raise the quantity of housing demanded by a household by 5 percent to 8 percent.
Income elasticities can be positive or negative. During periods of rising income, people
increase their spending on some goods (positive income elasticity) but reduce their spending onother goods (negative income elasticity). The income elasticity of demand for jewelry is positive,while the income elasticity of demand for low-quality beef is negative. As incomes rise in manylow-income countries, the birth rate falls, implying a negative income elasticity of demand forchildren. Also, as incomes rise in most countries, the demand for education and health care rises,a positive income elasticity.
Cross-Price Elasticity of Demand
Cross-price elasticity of demand , which measures the response of quantity of one good
demanded to a change in the price of another good, is defined asIncome Elasticity of Demand
Income elasticity of demand , which measures the responsiveness of demand to changes in
income, is defined as
cross-price elasticity of demand =% change in quantity of Y demanded
% change in price of X
Like income elasticity, cross-price elasticity can be either positive or negative. A positive
cross-price elasticity indicates that an increase in the price of Xcauses the demand for Yto
rise. This implies that the goods are substitutes. For McDonald’s, Big Macs and ChickenMcNuggets are substitutes with a positive cross-price elasticity. In our earlier example, asMcDonald’s lowered the price of Big Macs, it saw a decline in the quantity of McNuggets soldas consumers substituted between the two meals. If cross-price elasticity turns out to benegative , an increase in the price of Xcauses a decrease in the demand for Y. This implies that
the goods are complements. Hot dogs and football games are complements with a negativecross-price elasticity.
As we have already seen, knowing the cross-price elasticity can be a very important part of a
company’s business strategy. Sony and T oshiba recently competed in the market for high-definitionDVD players: Sony’s Blu-ray versus T oshiba’s HD DVD. Both firms recognized that an impor-tant driver of a customer’s choice of a DVD player is movie price and availability. No one wantsa new high-definition player if there is nothing to watch on it or if the price of movies is expen-sive. Inexpensive and available movies are a key complement to new DVD players. The cross-price elasticity of
demand A measure of the
response of the quantity of one
good demanded to a change inthe price of another good.income elasticity of
demand A measure of the
responsiveness of demand to
changes in income.
CHAPTER 5 Elasticity 111
elasticity of supply =% change in quantity supplied
% change in price
elasticity of labor supply =% change in quantity of labor supplied
% change in the wage ratecross-price e lasticity of movies and high-definition DVD players is strong and negative.
Sony won, and some observers think that Sony’s ownership of a movie studio gave it an impor-tant advantage.
Elasticity of Supply
So far, we have focused on the consumer part of the market. But elasticity also matters on the pro-ducer’s side.
Elasticity of supply , which measures the response of quantity of a good supplied to a change
in price of that good, is defined as
In output markets, the elasticity of supply is likely to be a positive number—that is, a higher
price leads to an increase in the quantity supplied, ceteris paribus . (Recall our discussion of
upward-sloping supply curves in the preceding two chapters.)
The elasticity of supply is a measure of how easily producers can adapt to a price increase and
bring increased quantities to market. In some industries, it is relatively easy for firms to increasetheir output. Ballpoint pens fall into this category, as does most software that has already beendeveloped. For these products, the elasticity of supply is very high. In the oil industry, supply isinelastic, much like demand.
In input markets, however, some interesting problems arise in looking at elasticity. Perhaps
the most studied elasticity of all is the elasticity of labor supply , which measures the response of
labor supplied to a change in the price of labor. Economists have examined household labor sup-ply responses to government programs such as welfare, Social Security, the income tax system,need-based student aid, and unemployment insurance.
In simple terms, the elasticity of labor supply is defined as
It seems reasonable at first glance to assume that an increase in wages increases the quan-
tity of labor supplied. That would imply an upward-sloping supply curve and a positive laborsupply elasticity, but this is not necessarily so. An increase in wages makes workers better off:They can work the same number of hours and have higher incomes. One of the things workersmight like to “buy” with that higher income is more leisure time. “Buying” leisure simplymeans working fewer hours, and the “price” of leisure is the lost wages. Thus, it is quite possi-ble that to some groups, an increase in wages above some level will lead to a reduction in thequantity of labor supplied.
Looking Ahead
The purpose of this chapter was to convince you that measurement is important. If all we cansay is that a change in one economic factor causes another to change, we cannot say whetherthe change is important or whether a particular policy is likely to work. The most commonlyelasticity of supply A
measure of the response of
quantity of a good supplied to
a change in price of that good.Likely to be positive in output
markets.
elasticity of labor supply
A measure of the response of
labor supplied to a change inthe price of labor.
112 PART I Introduction to Economics
SUMMARY
1.Elasticity is a general measure of responsiveness that can
be used to quantify many different relationships. If onevariable Achanges in response to changes in another
variable B, the elasticity of Awith respect to Bis equal to
the percentage change in Adivided by the percentage
change in B.
2.The slope of a demand curve is an inadequate measure of
responsiveness because its value depends on the units ofmeasurement used. For this reason, elasticities are calculatedusing percentages.
PRICE ELASTICITY OF DEMAND p. 98
3.Price elasticity of demand is the ratio of the percentage
change in quantity demanded of a good to the percentagechange in price of that good.
4.Perfectly inelastic demand is demand whose quantity
demanded does not respond at all to changes in price; itsnumerical value is zero.
5.Inelastic demand is demand whose quantity demanded
responds somewhat, but not a great deal, to changes in price;its numerical value is between zero and –1.
6.Elastic demand is demand in which the percentage change
in quantity demanded is larger in absolute value than thepercentage change in price. Its numerical value is lessthan –1.
7.Unitary elasticity of demand describes a relationship in
which the percentage change in the quantity of a productdemanded is the same as the percentage change in price;unitary elasticity has a numerical value of –1.
8.Perfectly elastic demand describes a relationship in
which a small increase in the price of a product causes
the quantity demanded for that product to drop
to zero.CALCULATING ELASTICITIES p. 100
9.If demand is elastic, a price increase will reduce thequantity demanded by a larger percentage than the per-centage increase in price and total revenue ( P
/H11003Q) will
fall. If demand is inelastic, a price increase will increasetotal revenue.
10. If demand is elastic, a price cut will cause quantitydemanded to increase by a greater percentage than thepercentage decrease in price and total revenue will rise.If demand is inelastic, a price cut will cause quantity
demanded to increase by a smaller percentage than the percentage decrease in price and total revenue
will fall.
THE DETERMINANTS OF DEMAND ELASTICITY p. 107
11. The elasticity of demand depends on (1) the availability ofsubstitutes, (2) the importance of the item in individualbudgets, and (3) the time frame in question.
OTHER IMPORTANT ELASTICITIES p. 109
12. There are several important elasticities. Income elasticity
of demand measures the responsiveness of the quantity
demanded with respect to changes in income. Cross-price
elasticity of demand measures the response of the quantity
of one good demanded to a change in the price of another
good. Elasticity of supply measures the response of the
quantity of a good supplied to a change in the price ofthat good. The elasticity of labor supply measures the
response of the quantity of labor supplied to a change inthe price of labor.
REVIEW TERMS AND CONCEPTS
cross-price elasticity of demand, p. 110
elastic demand, p. 100
elasticity, p. 97
elasticity of labor supply, p. 111elasticity of supply, p. 111
income elasticity of demand, p. 110
inelastic demand, p. 100
midpoint formula, p. 102perfectly elastic demand, p. 99
perfectly inelastic demand, p. 99
price elasticity of demand, p. 99
unitary elasticity, p. 100used tool of measurement is elasticity, and the term will recur as we explore economics in
more depth.
We now return to the study of basic economics by looking in detail at household behavior.
Recall that households demand goods and services in product markets but supply labor and sav-
ings in input or factor markets.
CHAPTER 5 Elasticity 113
PROBLEMS
All problems are available on www.myeconlab.com
4.A sporting goods store has estimated the demand curve for a
popular brand of running shoes as a function of price. Use thediagram to answer the questions that follow.
a.Calculate demand elasticity using the midpoint formula
between points Aand B, between points Cand D, and
between points Eand F.b.If the store currently charges a price of $50, then increases
that price to $60, what happens to total revenue from shoesales (calculate P
/H11003Qbefore and after the price change)?
Repeat the exercise for initial prices being decreased to $40
and $20, respectively.
c.Explain why the answers to a. can be used to predict the
answers to b.
5.For each of the following scenarios, decide whether you agree or
disagree and explain your answer.
a.If the elasticity of demand for cocaine is -.2 and the Drug
Enforcement Administration succeeds in reducing supplysubstantially, causing the street price of the drug to rise by50%, buyers will spend less on cocaine.
b.Every year Christmas tree vendors bring tens of thousands of
trees from the forests of New England to New Y ork City andBoston. During the last two years, the market has been verycompetitive; as a result, price has fallen by 10 percent. If theprice elasticity of demand was -1.3, vendors would lose rev-
enues altogether as a result of the price decline.
c.If the demand for a good has unitary elasticity, or elasticity
is-1, it is always true that an increase in its price will lead to
more revenues for sellers taken as a whole.
6.For the following statements, decide whether you agree or dis-
agree and explain your answer.
a.The demand curve pictured here is elastic.1.Fill in the missing amounts in the following table:
2.Use the table in the preceding problem to defend your answers
to the following questions:a.Would you recommend that Ben & Jerry’s move forward
with a plan to raise prices if the company’s only goal is to
increase revenues?
b.Would you recommend that beer stands cut prices to
increase revenues at 49ers football games next year?
3.Using the midpoint formula, calculate elasticity for each of thefollowing changes in demand by a household.
70
60
50
40
30
20
10
0100 200 300 400 500 600
Shoe sales per weekDemandPrice per pair ($)A
B
C
D
E
FDemandSupply
Quantity 0PriceDemand
QuantityPrice
0
b.If supply were to increase slightly in the following diagram,
prices would fall and firms would earn less revenue.
7.Taxicab fares in most cities are regulated. Several years ago taxi-
cab drivers in Boston obtained permission to raise their fares
10 percent, and they anticipated that revenues would increase by
about 10 percent as a result. They were disappointed, however.When the commissioner granted the 10 percent increase, rev-enues increased by only about 5 percent. What can you inferP1P2Q1Q2
Demand for:
a. Long-distance
telephone service$0.25per min. $0.15 per min. 300 min. per month 400 min. per month
b. Orange juice 1.49 per qt 1.89 per qt 14 qt per month 12 qt per month
c. Big Macs 2.89 1.00 3 per week 6 per week
d. Cooked shrimp $9per lb $12per lb 2 lb per month 1.5 lb per month% CHANGE
IN PRICE% CHANGE
IN QUANTITY ELASTICITY
Demand for Ben & Jerry’s
Ice Cream+10% -12% a.
Demand for beer at San
Francisco 49ers football games-20% b. -.5
Demand for Broadway theater
tickets in New Yorkc. -15% -1.0
Supply of chickens +10% d. +1.2
Supply of beef cattle -15% -10% e.
114 PART I Introduction to Economics
13. Describe what will happen to total revenue in the follow-
ing situations.
a.Price decreases and demand is elastic.
b.Price decreases and demand is inelastic.
c.Price increases and demand is elastic.
d.Price increases and demand is inelastic.
e.Price increases and demand is unitary elastic.
f.Price decreases and demand is perfectly inelastic.
g.Price increases and demand is perfectly elastic.
14. The cross-price elasticity values for three sets of products are
listed in the table below. What can you conclude about the rela-tionships between each of these sets of products?about the elasticity of demand for taxicab rides? What were
taxicab drivers assuming about the elasticity of demand?
*8. Studies have fixed the short-run price elasticity of demand for
gasoline at the pump at -0.20. Suppose that international hos-
tilities lead to a sudden cutoff of crude oil supplies. As a result,U.S. supplies of refined gasoline drop 10 percent.a.If gasoline were selling for $2.60 per gallon before the cutoff,
how much of a price increase would you expect to see in the
coming months?
b.Suppose that the government imposes a price ceiling on gas
at $2.60 per gallon. How would the relationship betweenconsumers and gas station owners change?
9.Prior to 2005, it seemed like house prices always rose and never
fell. When the demand for housing increases, prices in the
housing market rise but not always by very much. For prices torise substantially, the supply of housing must be relativelyinelastic. That is, if the quantity supplied increases rapidlywhenever house prices rise, price increases will remain small.
Many have suggested government policies to increase the elas-
ticity of supply. What specific policies might hold prices downwhen demand increases? Explain.
10. For each of the following statements, state the relevant elasticity
and state what its value should be (negative, positive, greater
than one, zero, and so on).a.The supply of labor is inelastic but slightly backward-bending.
b.The demand for BMWs in an area increases during times of
rising incomes just slightly faster than income rises.
c.The demand for lobsters falls when lobster prices rise ( ceteris
paribus ), but the revenue received by restaurants from the
sale of lobsters stays the same.
d.Demand for many goods rise when the price of substi-
tutes rise.
e.Land for housing development near Y oungstown, Ohio, is in
plentiful supply. At the current price, there is essentially aninfinite supply.
11.[Related to the Economics in Practice onp. 108 ]A number
of towns in the United States have begun charging their resi-
dents for garbage pickup based on the number of garbage cansfilled per week. The town of Chase decided to increase its per-can price from 10 cents to 20 cents per week. In the first week,Chase found that the number of cans that were brought to the
curb fell from 550 to 525 (although the city workers com-
plained that the cans were heavier). The town economist ranthe numbers, informed the mayor that the demand for dis-posal was inelastic, and recommended that the city raise the
price more to maximize town revenue from the program. Six
months later, at a price of 30 cents per can, the number of canshas fallen to 125 and town revenues are down. What mighthave happened?
12.[Related to the Economics in Practice onp. 109 ]At Frank’s
Delicatessen, Frank noticed that the elasticity of customers dif-
fered in the short and longer term. Frank also noticed that hisincrease in the price of sandwiches had other effects on hisstore. In particular, the number of sodas sold declined whilethe number of yogurts sold went up. How might you explain
this pattern?PRODUCTS
A AND BPRODUCTS
C AND DPRODUCTS
E AND F
Cross-price
elasticity–8.7 +5.5 0.0
15. Income elasticity of demand measures the responsiveness of
demand to changes in income. Explain what is happening to
demand and what kind of good is being represented in the fol-lowing situations.a.Income is rising, and income elasticity of demand
is positive.
b.Income is rising, and income elasticity of demand
is negative.
16. Using the midpoint formula and the following graph, calculate
the price elasticity of demand and the price elasticity of supply
when the price changes from $4 to $9 and when the pricechanges from $9 to $15.
Supply
Demand
315
9
4
0Price
($)
Quantit y 51 0 1 6
*Note: Problems marked with an asterisk are more challenging.
CHAPTER 5 Elasticity 115
Total
revenue
0Total
revenue
Quantity
demanded17. Use the following total revenue graph to identify which sections
of the total revenue curve reflect elastic demand, inelastic
demand, and unitary elastic demand. Explain your answers.18. For each of the following products, explain whether demand is
likely to be elastic or inelastic.
a.Cigarettes
b.Tacos
c.Gasoline
d.Milk
e.Honda Accord automobiles
f.Newspapers
CHAPTER 5 APPENDIX
Point Elasticity (Optional)
Two different elasticities were calculated along the demand
curve in Figure 5.3 on p. 104. Between points Aand B,we dis-
covered that Herb’s demand for lunches in the fancy diningroom was very elastic: A price decline of only 10.5 percentresulted in his eating 66.7 percent more lunches in the diningroom (elasticity = -6.4). Between points Cand D,h o w e v e r ,o n
the same demand curve, we discovered that his demand formeals was very inelastic: A price decline of 40 percent resultedin only a modest increase in lunches consumed of 11.76 percent(elasticity = -0.294).
Now consider the straight-line demand curve in Figure 5A.1.
We can write an expression for elasticity at point Cas follows:
Q/Pis the reciprocal of the slope of the curve. Slope in
the diagram is constant along the curve, and it is negative. T ocalculate the reciprocal of the slope to plug into the previouselasticity equation, we take Q
1B,o r M1, and divide by minus
the length of line segment CQ1. Thus,
¢Q
¢P=M1
CQ 1¢¢elasticity =%¢Q
%¢P=¢Q
Q#100
¢P
P#100=¢Q
Q1
¢P
P1=¢Q
¢P#P1
Q1
Because the length of CQ1is equal to P1, we can write
¢Q
¢P=M1
P1Q1
M2 M1QC
B P
P1
0Price per unit
Demand
Units of output
/L50304FIGURE 5A.1 Elasticity at a Point Along a
Demand Curve
116 PART I Introduction to Economics
By substituting, we get
(The second equal sign uses the fact that Q1equals M2in
Figure 5A.1.)
Elasticity at point Cis simply the ratio of line segment M1
to line segment M2. It is easy to see that if we had chosen a point
to the left of Q1,M1would have been larger and M2would have
been smaller, indicating a higher elasticity. If we had chosen apoint to the right of Q
1,M1would have been smaller and M2
would have been larger, indicating a lower elasticity.
In Figure 5A.2, you can see that elasticity is unitary (equal
to -1) at the midpoint of the demand curve, Q3. At points to the
right, such as Q2, segment Q2C(M1from Figure 5A.1) is smaller
than segment 0 Q1(M2from Figure 5A.1). This means that the
absolute size of the ratio is less than 1 and that demand is inelastic
at point A. At points to the left, such as Q1, segment Q1C(M1) is
larger than segment 0 Q1(M2). This means that the absolute size
of the ratio is greater than 1 and that demand is elastic at point B.
Compare the results here with the results using the mid-
point formula for elasticity for Herb.elasticity =M1
P1#P1
Q1=M1
P1#P1
M2=M1
M2
Q3
MidpointQ2 Q1 QA
CB P
•
0 Price per unit
DemandInelasticUnitary elasticityElastic
Units of output
/L50304FIGURE 5A.2 Point Elasticity Changes Along a
Demand Curve
PARTII
The Market System
Choices Made by
Households and Firms
Now that we have discussed the basic forces of supply and demand, we can explore the
underlying behavior of the two fundamental decision-making units in the economy: house-holds and firms.
Figure II.1 presents a diagram of a simple competitive economy. The figure is an
expanded version of the circular flow diagram first presented in Figure 3.1 on p. 49. It isdesigned to guide you through Part II (Chapters 6 through 12) of this book. Y ou will see the
117Goods and services
markets
P
Q
Labor market
W
L
Capital market
(financial markets)
r
KFirms Households
Labor demand Labor supplyOutput supply Output demandOutput
(product) markets
Input markets
Capital stockWealthInvestment
(capital demand)Savings
(capital supply)
/L50304FIGURE II.1 Firm and Household Decisions
Households demand in output markets and supply labor and capital in input markets. To simplify our analy-
sis, we have not included the government and international sectors in this circular flow diagram. These topicswill be discussed in detail later.
big picture more clearly if you follow this diagram closely as you work your way through this
part of the book.
Recall that households and firms interact in two kinds of markets: output (product)
markets, shown at the top of Figure II.1, and input (factor) markets, shown at the bottom.Households demand outputs and supply inputs. In contrast, firms supply outputs and
demand inputs. Chapter 6 explores the behavior of households, focusing first on household
demand for outputs and then on household supply in labor and capital markets.
The remaining chapters in Part II focus on firms and the interaction between firms and
households. Chapters 7 through 9 analyze the behavior of firms in output markets in boththe short run and the long run. Chapter 10 focuses on the behavior of firms in input marketsin general, especially the labor and land markets. Chapter 11 discusses the capital market inmore detail. Chapter 12 puts all the pieces together and analyzes the functioning of a com-plete market system. Following Chapter 12, Part III of the book relaxes many assumptionsand analyzes market imperfections as well as the potential for and pitfalls of governmentinvolvement in the economy. The plan for Chapters 6 through 19 is outlined in Figure II.2.
Recall that throughout this book, all diagrams that describe the behavior of households
are drawn or highlighted in blue. All diagrams that describe the behavior of firms are drawn
or highlighted in red. Look carefully at the supply and demand diagrams in Figure II.1;
notice that in both the labor and capital markets, the supply curves are blue. The reason isthat labor and capital are supplied by households. The demand curves for labor and capitalare red because firms demand these inputs for production.
118CHAPTER 6
CHAPTERS 10–11CHAPTER 12CHAPTERS 13–19Household Behavior
• Demand in
output markets• Supply in input marketsCHAPTERS 8–9
Equilibrium
in Competitive
Output Markets
• Output prices
• Short run
• Long run
Competitive
Input Markets
• Labor/land
– Wages/rents• Capital/Investment – Interest/profitsThe
CompetitiveMarket System
• General equilibrium
and efficiencyMarket
Imperfections
and the Role of
Government
• Imperfect market
structures – Monopoly – Monopolistic competition – Oligopoly• Externalities, public goods, imperfect information, social choice• Income distribution and poverty• Public finance: the economics of taxationPerfectly Competitive Markets Market Imperfections
and the Role of
Government
CHAPTERS 7–8
Firm Behavior
• Choice of technology
• Supply in output markets• Demand in input markets
/L50304FIGURE II.2 Understanding the Microeconomy and the Role of Government
To understand how the economy works, it helps to build from the ground up. We start in Chapters 6–8
with an overview of household and firm decision making in simple perfectly competitive markets. In
Chapters 9–11, we see how firms and households interact in output markets (product markets) and input
markets (labor/land and capital) to determine prices, wages, and profits. Once we have a picture of how a
simple perfectly competitive economy works, we begin to relax assumptions. Chapter 12 is a pivotal chapter
that links perfectly competitive markets with a discussion of market imperfections and the role of govern-
ment. In Chapters 13–19, we cover the three noncompetitive market structures (monopoly, monopolisticcompetition, and oligopoly), externalities, public goods, uncertainty and asymmetric information, andincome distribution as well as taxation and government finance.
In Figure II.1, much of the detail of the real world is stripped away just as it is on a
highway map. A map is a highly simplified version of reality, but it is a very useful toolwhen you need to know where you are. Figure II.1 is intended to serve as a map to helpyou understand basic market forces before we add more complicated market structuresand government.
Before we proceed with our discussion of household choice, we need to make a few
basic assumptions. These assumptions pertain to Chapters 6 through 12.
We first assume that households and firms possess all the information they need to
make market choices. Specifically, we assume that households possess knowledge of thequalities and prices of everything available in the market. Firms know all that there is toknow about wage rates, capital costs, and output prices. This assumption is often called theassumption of perfect knowledge .
The next assumption is perfect competition . Perfect competition is a precisely defined
form of industry structure. (The word perfect here does not refer to virtue. It simply means
“total” or “complete.”) In a perfectly competitive industry, no single firm has control overprices. That is, no single firm is large enough to affect the market price of its product or theprices of the inputs that it buys. This follows from two characteristics of competitive indus-tries. First, a competitive industry is composed of many firms, each one small relative to thesize of the industry. Second, every firm in a perfectly competitive industry produces exactlythe same product; the output of one firm cannot be distinguished from the output of theothers. Products in a perfectly competitive industry are said to be homogeneous .
These characteristics limit the decisions open to competitive firms and simplify the
analysis of competitive behavior. Because all firms in a perfectly competitive industry pro-duce virtually identical products and because each firm is small relative to the market, per-fectly competitive firms have no control over the prices at which they sell their output. Bytaking prices as a given, each firm can decide only how much output to produce and how toproduce it.
Consider agriculture, the classic example of a perfectly competitive industry. A wheat
farmer in South Dakota has absolutely no control over the price of wheat. Prices are deter-mined not by the individual farmers, but by the interaction of many suppliers and manydemanders. The only decisions left to the wheat farmer are how much wheat to plant andwhen and how to produce the crop.
We finally assume that each household is small relative to the size of the market.
Households face a set of product prices that they individually cannot control. Prices againare set by the interaction of many suppliers and many demanders.
By the end of Chapter 10, we will have a complete picture of an economy, but it will be
based on this set of fairly restrictive assumptions. At first, this may seem unrealistic to you,but keep the following in mind. Much of the economic analysis in the chapters that followapplies to all forms of market structure. Indeed, much of the power of economic reasoningis that it is quite general. As we continue in microeconomics, in Chapters 13 and 14, we willdefine and explore several different kinds of market organization and structure, includingmonopoly, oligopoly, and monopolistic competition. Because monopolists, oligopolists,monopolistic competitors, and perfect competitors share the objective of maximizing prof-its, it should not be surprising that their behavior is in many ways similar. We focus here onperfect competition because many of these basic principles are easier to learn using the sim-plest of cases.
119perfect knowledge The
assumption that households
possess a knowledge of the
qualities and prices ofeverything available in the
market and that firms have all
available informationconcerning wage rates, capitalcosts, and output prices.perfect competition An
industry structure in whichthere are many firms, each
being small relative to the
industry and producingvirtually identical products,
and in which no firm is large
enough to have any controlover prices.homogeneous products
Undifferentiated outputs;products that are identical toor indistinguishable from one
another.
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121Every day people in a market econ-
omy make decisions. Some of thosedecisions involve the products theyplan to buy: Should you buy a Cokefor lunch, a bottle of tea, or justdrink water? Should you purchase alaptop computer or stick with yourold desktop? Some decisions areabout the labor market: Should youcontinue your schooling or go towork instead? If you do start work-ing, how much should you work?Should you work more when youget a raise or just take it easy? Manydecisions involve a time element. If you decide to buy a laptop, you may have to use your savingsor borrow money. That will leave you with fewer choices about what you can buy in the future. Onthe other hand, the laptop itself is an investment.
T o many people, the decisions listed in the previous paragraph seem very different from one
another. As you will see in this chapter, however, from an economics perspective, these decisions havea great deal in common. In this chapter, we will develop a set of principles that can be used to under-stand decisions in the product market and the labor market—decisions for today and for the future.
As you read this chapter, you might want to think about some of the following questions, ques-
tions that you will be able to answer by chapter’s end. Baseball, even when it was more popular than itis today, was never played year-round. Indeed, no professional sport has a year-round season. Is thisbreak necessary to give the athletes a rest, or is there something about household choice that helpsexplain this pattern? When the price of gasoline rises, people drive less, but one study suggests that theyalso switch from brand name products to generics or store brands.
1Why might this be? Studying
household choice will help you understand many decisions that underpin our market economy.
A constant theme that will run through the analysis is the idea of constrained choice . That is,
the decisions that we make we make under constraints that exist in the marketplace. Householdconsumption choices are constrained by income, wealth, and existing prices. Household deci-sions about labor supply and job choice are clearly constrained by the availability of jobs. Thiswas on everyone’s minds when the number of unemployed reached 15 million and the unem-ployment rate hovered at about 10 percent during the 2009–2010 period. In addition, the choiceswe make in the workforce are constrained by the existing structure of market wages.
Household Choice in Output Markets
Every household must make three basic decisions:
1.How much of each product, or output, to demand
2.How much labor to supply
3.How much to spend today and how much to save for the futureCHAPTER OUTLINE6
Household Choice in
Output Markets p. 121
The Determinants of
Household Demand
The Budget Constraint
The Equation of the Budget
Constraint
The Basis of Choice:
Utility p. 126
Diminishing Marginal
Utility
Allocating Income to
Maximize Utility
The Utility-Maximizing Rule
Diminishing Marginal
Utility and Downward-Sloping Demand
Income and
SubstitutionEffects
p. 130
The Income Effect
The Substitution Effect
Household Choice in
Input Markets p. 132
The Labor Supply Decision
The Price of Leisure
Income and Substitution
Effects of a Wage Change
Saving and Borrowing:
Present versus Future
Consumption
A Review: Households
in Output and InputMarkets
p. 137
Appendix:IndifferenceCurves
p. 141
Household Behavior
and Consumer Choice
1Dora Gicheva, Justine Hastings, and Sofia Villas-Boas, “Revisiting the Income Effect: Gasoline Prices and Grocery Purchases,”
NBER Working Paper No. 13614, October 2007.
As we begin our look at demand in output markets, you must keep in mind that the choices
underlying the demand curve are only part of the larger household choice problem. Closelyrelated decisions about how much to work and how much to save are equally important and mustbe made simultaneously with output–demand decisions.
The Determinants of Household Demand
As we saw in Chapter 3, several factors influence the quantity of a given good or servicedemanded by a single household:
/L50766The price of the product
/L50766The income available to the household
/L50766The household’s amount of accumulated wealth
/L50766The prices of other products available to the household
/L50766The household’s tastes and preferences
/L50766The household’s expectations about future income, wealth, and prices
Recall that demand schedules and demand curves express the relationship between quantity
demanded and price, ceteris paribus . A change in price leads to a movement along a demand
curve. Changes in income, in other prices, or in preferences shift demand curves to the left orright. We refer to these shifts as “changes in demand.” However, the interrelationship among thesevariables is more complex than the simple exposition in Chapter 3 might lead you to believe.122 PART II The Market System: Choices Made by Households and Firms
The Budget Constraint
Before we examine the household choice process, we need to discuss what choices are open and
not open to households. If you look carefully at the list of items that influence household demand,you will see that the first four actually define the set of options available. Information on house-hold income and wealth, together with information on product prices, makes it possible to distin-guish those combinations of goods and services that are affordable from those that are not.
2
Income, wealth, and prices thus define what we call household budget constraint . The bud-
get constraint facing any household results primarily from limits imposed externally by one ormore markets. In competitive markets, for example, households cannot control prices; they mustbuy goods and services at market-determined prices. A household has some control over itsincome: Its members can choose whether to work, and they can sometimes decide how manyhours to work and how many jobs to hold. However, constraints exist in the labor market too.The amount that household members are paid is limited by current market wage rates. Whetherthey can get a job is determined by the availability of jobs.
Although income does depend, at least in part, on the choices that households make, we will
treat it as a given for now. Later in this chapter, we will relax this assumption and explore laborsupply choices in more detail.
The income, wealth, and price constraints that surround choice are best illustrated with an
example. Consider Barbara, a recent graduate of a midwestern university who takes a job as anaccount manager at a public relations firm. Let us assume that she receives a salary of $1,000 permonth (after taxes) and that she has no wealth and no credit. Barbara’s monthly expenditures arelimited to her flow of income. Table 6.1 summarizes some of the choices open to her.budget constraint The limits
imposed on household choices
by income, wealth, andproduct prices.
2Remember that we drew the distinction between income and wealth in Chapter 3. Income is the sum of household earnings
within a given period; it is a flow variable. In contrast, wealth is a stock variable; it is what a household owns minus what it owes
at a given point in time.TABLE 6.1 Possible Budget Choices of a Person Earning $1,000 per Month after Taxes
Option Monthly Rent FoodOther
Expenses Total Available?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No
A careful search of the housing market reveals four vacant apartments. The least expensive is
a one-room studio with a small kitchenette that rents for $400 per month, including utilities(option A). If she lived there, Barbara could afford to spend $250 per month on food and stillhave $350 left over for other things.
About four blocks away is a one-bedroom apartment with wall-to-wall carpeting and a
larger kitchen. It has more space, but the rent is $600, including utilities. If Barbara took thisapartment, she might cut her food expenditures by $50 per month and have only $200 per monthleft for everything else.
In the same building as the one-bedroom apartment is an identical unit on the top floor of the
building with a balcony facing west toward the sunset. The balcony and view add $100 to the monthlyrent. T o live there, Barbara would be left with only $300 to split between food and other expenses.
Just because she was curious, Barbara looked at a town house in the suburbs that was renting
for $1,000 per month. Obviously, unless she could get along without eating or doing anythingelse that cost money, she could not afford it. The combination of the town house and any amountof food is outside her budget constraint.
Notice that we have used the information that we have on income and prices to identify dif-
ferent combinations of housing, food, and other items that are available to a single-person house-hold with an income of $1,000 per month. We have said nothing about the process of choosing.Instead, we have carved out what is called a choice set oropportunity set , the set of options that
is defined and limited by Barbara’s budget constraint.
Preferences, Tastes, Trade-Offs, and Opportunity Cost So far, we have identi-
fied only the combinations of goods and services that are and are not available to Barbara. Withinthe constraints imposed by limited incomes and fixed prices, however, households are free tochoose what they will and will not buy. Their ultimate choices are governed by their individualpreferences and tastes.
It will help you to think of the household choice process as a process of allocating income
over a large number of available goods and services. Final demand of a household for any singleproduct is just one of many outcomes that result from the decision-making process. Think, forexample, of a demand curve that shows a household’s reaction to a drop in the price of air travel.During certain periods when people travel less frequently, special fares flood the market andmany people decide to take trips that they otherwise would not have taken. However, if you live inFlorida and decide to spend $400 to visit your mother in Nashville, you cannot spend that $400on new clothes, dinners at restaurants, or a new set of tires.
A change in the price of a single good changes the constraints within which households choose,
and this may change the entire allocation of income. Demand for some goods and services may risewhile demand for others falls. A complicated set of trade-offs lies behind the shape and position ofa household demand curve for a single good. Whenever a household makes a choice, it is weighingthe good or service that it chooses against all the other things that the same money could buy.
Consider again our young account manager and her options listed in Table 6.1. If she hates
to cook, likes to eat at restaurants, and goes out three nights a week, she will probably trade offsome housing for dinners out and money to spend on clothes and other things. She will probablyrent the studio for $400. She may, however, love to spend long evenings at home reading, listen-ing to classical music, and sipping tea while watching the sunset. In that case, she will probablytrade off some restaurant meals, evenings out, and travel expenses for the added comfort of thelarger apartment with the balcony and the view. As long as a household faces a limited budget—and all households ultimately do—the real cost of any good or service is the value of the othergoods and services that could have been purchased with the same amount of money. The real costof a good or service is its opportunity cost, and opportunity cost is determined by relative prices.
The Budget Constraint More Formally Ann and T om are struggling graduate stu-
dents in economics at the University of Virginia. Their tuition is paid by graduate fellowships.They live as resident advisers in a first-year dormitory, in return for which they receive an apart-ment and meals. Their fellowships also give them $200 each month to cover all their otherexpenses. T o simplify things, let us assume that Ann and T om spend their money on only twothings: meals at a local Thai restaurant and nights at a local jazz club, The Hungry Ear. Thai mealsgo for a fixed price of $20 per couple. Two tickets to the jazz club, including espresso, are $10.
As Figure 6.1 shows, we can graphically depict the choices that are available to our dynamic
duo. The axes measure the quantities of the two goods that Ann and T om buy. The horizontal axisCHAPTER 6 Household Behavior and Consumer Choice 123
choice set oropportunity
set The set of options that is
defined and limited by a
budget constraint.
124 PART II The Market System: Choices Made by Households and Firms
measures the number of Thai meals consumed per month, and the vertical axis measures the
number of trips to The Hungry Ear. (Note that price is not on the vertical axis here.) Every pointin the space between the axes represents some combination of Thai meals and nights at the jazzclub. The question is this: Which of these points can Ann and T om purchase with a fixed budgetof $200 per month? That is, which points are in the opportunity set and which are not?
One possibility is that the students in the dorm are driving Ann and T om crazy. The two grad
students want to avoid the dining hall at all costs. Thus, they might decide to spend all theirmoney on Thai food and none of it on jazz. This decision would be represented by a point onthe
horizontal axis because all the points on that axis are points at which Ann and T om make no jazzclub visits. How many meals can Ann and T om afford? The answer is simple: When income is$200 and the price of Thai meals is $20, they can afford $200 /H11004$20 = 10 meals. This point is
labeled Aon the budget constraint in Figure 6.1.
Another possibility is that general exams are coming up and Ann and T om decide to relax at
The Hungry Ear to relieve stress. Suppose they choose to spend all their money on jazz and noneof it on Thai food. This decision would be represented by a point onthe vertical axis because all
the points on this axis are points at which Ann and T om eat no Thai meals. How many jazz clubvisits can they afford? Again, the answer is simple: With an income of $200 and with the price ofjazz/espresso at $10, they can go to The Hungry Ear $200 /H11004$10 = 20 times. This is the point
labeled Bin Figure 6.1. The line connecting points Aand Bis Ann and T om’s budget constraint.
What about all the points between AandBon the budget constraint? Starting from point B,s u p –
pose Ann and T om give up trips to the jazz club to buy more Thai meals. Each additional Thai meal“costs” two trips to The Hungry Ear. The opportunity cost of a Thai meal is two jazz club trips.
Point Con the budget constraint represents a compromise. Here Ann and T om go to the club
10 times and eat at the Thai restaurant 5 times. T o verify that point Cis on the budget constraint,
price it out: 10 jazz club trips cost a total of $10 /H1100310 = $100, and 5 Thai meals cost a total of
$20 /H110035 = $100. The total is $100 + $100 = $200.
The budget constraint divides all the points between the axes into two groups: those that can
be purchased for $200 or less (the opportunity set) and those that are unavailable. Point Don the
diagram costs less than $200; point Ecosts more than $200. (Verify that this is true.) The oppor-
tunity set is the shaded area in Figure 6.1.
Clearly, both prices and incomes affect the size of a household’s opportunity set. If a price or a set
of prices falls but income stays the same, the opportunity set gets bigger and the household is betteroff. If we define real income as the set of opportunities to purchase real goods and services, “real
income” will have gone up in this case even if the household’s money income has not. A consumer’sopportunity set expands as the result of a price decrease. On the other hand, when money incomeincreases and prices go up even more, we say that the household’s “real income” has fallen.
The concept of real income is very important in macroeconomics, which is concerned with
measuring real output and the price level.5
5B
C
E
D
A
Thai meals per monthBudget constraintOpportunity setJazz club visits per month
101020
0/L50298FIGURE 6.1 Budget
Constraint andOpportunity Set forAnn and Tom
A budget constraint separates
those combinations of goodsand services that are available,given limited income, fromthose that are not. The availablecombinations make up the
opportunity set.
real income The set of
opportunities to purchase realgoods and services available to
a household as determined by
prices and money income.
The Equation of the Budget Constraint
Y et another way to look at the budget constraint is to write the consumer’s problem as an equation.
In the previous example, the constraint is that total expenditure on Thai meals plus total expendi-ture on jazz club visits must be less than or equal to Ann and T om’s income. T otal expenditure onThai meals is equal to the price of Thai meals times the number, or quantity , of meals consumed.
T otal expenditure on jazz club visits is equal to the price of a visit times the number, or quantity ,o f
visits. That is,
$20 Thai meals + $10 jazz visits $200
If we let Xrepresent the number of Thai meals and we let Yrepresent the number of jazz club
visits and we assume that Ann and T om spend their entire income on either Xor Y, this can be
written as follows:
20X+ 10 Y= $200
This is the equation of the budget constraint—the line connecting points Aand Bin Figure 6.1.
Notice that when Ann and T om spend nothing at the jazz club, Y= 0. When you plug Y= 0 into the
equation of the budget constraint, 20 X= 200 and X= 10. Since Xis the number of Thai meals, Ann
and T om eat Thai food 10 times. Similarly, when X= 0, you can solve for Y, which equals 20. When
Ann and T om eat no Thai food, they can go to the jazz club 20 times.
In general, the budget constraint can be written
P
XX+ PYY= I,
where PX= the price of X,X= the quantity of Xconsumed, PY= the price of Y,Y= the quan-
tity of Yconsumed, and I= household income.3
Budget Constraints Change When Prices Rise or Fall Now suppose the Thai
restaurant is offering two-for-one certificates good during the month of November. In effect, thismeans that the price of Thai meals drops to $10 for Ann and T om. How would the budget con-straint in Figure 6.1 change?
First, point Bwould not change. If Ann and T om spend all their money on jazz, the price of
Thai meals is irrelevant. Ann and T om can still afford only 20 trips to the jazz club. What haschanged is point A, which moves to point A'in Figure 6.2. At the new lower price of $10, if Ann
and T om spent all their money on Thai meals, they could buy twice as many, $200 /H11004$10 = 20.
The budget constraint swivels , as shown in Figure 6.2.… * *CHAPTER 6 Household Behavior and Consumer Choice 125
3Y ou can calculate the slope of the budget constraint as – PX/PY, the ratio of the price of Xto the price of Y. This gives the trade-
off that consumers face. In the example, – PX/PY= –2, meaning to get another Thai meal, Ann and T om must give up two trips to
the jazz club.Initial opportunity set
Opportunity set after
decrease in price of Thai meals
New budget constraint
Thai meals per month10 2020Jazz club visits per monthB
A'
0AOriginal
budget constraintY
X/L50296FIGURE 6.2 The Effect
of a Decrease in Price onAnn and Tom’s BudgetConstraint
When the price of a good
decreases, the budget constraint
swivels to the right, increasing
the opportunities available andexpanding choice.
Notice that when the price of meals falls to $10, the equation of the budget constraint changes
to 10 X+1 0 Y= 200, which is the equation of the line connecting points A'andBin Figure 6.2.
The range of goods and services available in a modern society is as vast as consumer tastes
are variable, and this makes any generalization about the household choice process risky.Nonetheless, the theory of household behavior that follows is an attempt to derive some logicalpropositions about the way households make choices.
The Basis of Choice: Utility
Somehow, from the millions of things that are available, each of us manages to sort out a set ofgoods and services to buy. When we make our choices, we make specific judgments about the rel-ative worth of things that are very different.
During the nineteenth century, the weighing of values was formalized into a concept called util-
ity. Whether one item is preferable to another depends on how much utility , or satisfaction, it yields
relative to its alternatives. How do we decide on the relative worth of a new puppy or a stereo? a tripto the mountains or a weekend in New Y ork City? working or not working? As we make our choices,we are effectively weighing the utilities we would receive from all the possible available goods.
Certain problems are implicit in the concept of utility. First, it is impossible to measure util-
ity. Second, it is impossible to compare the utilities of different people—that is, we cannot saywhether person A or person B has a higher level of utility. Despite these problems, however, theidea of utility helps us better understand the process of choice.
Diminishing Marginal Utility
In making their choices, most people spread their incomes over many different kinds of goods.One reason people prefer variety is that consuming more and more of any one good reduces themarginal, or extra, satisfaction they get from further consumption of the same good. Formally,marginal utility ( MU)is the additional satisfaction gained by the consumption or use of one
more unit of a good or service.
It is important to distinguish marginal utility from total utility. Total utility is the total
amount of satisfaction obtained from consumption of a good or service. Marginal utility comesonly from the last unit consumed; total utility comes from allunits consumed.
Suppose you live next to a store that sells homemade ice cream that you are crazy about. Even
though you get a great deal of pleasure from eating ice cream, you do not spend your entireincome on it. The first cone of the day tastes heavenly. The second is merely delicious. The thirdis still very good, but it is clear that the glow is fading. Why? The answer is because the more ofany one good we consume in a given period, the less satisfaction, or utility, we get from each addi-tional, or marginal, unit. In 1890, Alfred Marshall called this “familiar and fundamental tendencyof human nature” the law of diminishing marginal utility .
Consider this simple example. Frank loves country music, and a country band is playing
seven nights a week at a club near his house. Table 6.2 shows how the utility he derives from theband might change as he goes to the club more frequently. The first visit generates 12 “utils,” orunits of utility. When Frank goes back another night, he enjoys it, but not quite as much as thefirst night. The second night by itself yields 10 additional utils. Marginal utility is 10, while the
total utility derived from two nights at the club is 22. Three nights per week at the club provide
28 total utils; the marginal utility of the third night is 6 because total utility rose from 22 to 28.Figure 6.3 graphs total and marginal utility using the data in Table 6.2. T otal utility increases up126 PART II The Market System: Choices Made by Households and Firms
marginal utility ( MU)The
additional satisfaction gained
by the consumption or use ofone more unit of a good or
service.utility The satisfaction a
product yields.
total utility The total amount
of satisfaction obtained from
consumption of a good
or service.
law of diminishing marginal
utility The more of any one
good consumed in a given
period, the less satisfaction
(utility) generated byconsuming each additional(marginal) unit of the same good.The new, flatter budget constraint reflects the new trade-off between Thai meals and Hungry
Ear visits. Now after the price of Thai meals drops to $10, the opportunity cost of a Thai meal isonly one jazz club visit. The opportunity set has expanded because at the lower price, more com-binations of Thai meals and jazz are available.
Figure 6.2 thus illustrates a very important point. When the price of a single good changes,
more than just the quantity demanded of that good may be affected. The household now faces anentirely different problem with regard to choice—the opportunity set has expanded. At the sameincome of $200, the new lower price means that Ann and T om might choose more Thai meals,more jazz club visits, or more of both. They are clearly better off. The budget constraint is definedby income, wealth, and prices. Within those limits, households are free to choose, and the house-hold’s ultimate choice depends on its own likes and dislikes.
CHAPTER 6 Household Behavior and Consumer Choice 127
30
2010
01 2 3 4 5 6 7Total utility
Marginal utility
8
06
210
41214
12 3 4 56 7Trips to club per week
Trips to club per weekMarginal utility Total utility/L50296FIGURE 6.3 Graphs of
Frank’s Total andMarginal Utility
Marginal utility is the additional
utility gained by consuming oneadditional unit of a commodity—
in this case, trips to the club.
When marginal utility is zero,total utility stops rising.through Frank’s fifth trip to the club but levels off on the sixth night. Marginal utility, which has
declined from the beginning, is now at zero.
Diminishing marginal utility helps explain the reason most sports have limited seasons. Even
rabid fans have had enough baseball by late October. Given this fact, it would be hard to sell outball games for a year-round season. While diminishing marginal utility is a simple and intuitiveidea, it has great power in helping us understand the economic world.
Allocating Income to Maximize Utility
How many times in one week would Frank go to the club to hear his favorite band? The answerdepends on three things: Frank’s income, the price of admission to the club, and the alternativesavailable. If the price of admission was zero and no alternatives existed, he would probably go toTABLE 6.2 Total Utility and Marginal Utility of Trips to the Club
Per Week
Trips to Club Total Utility Marginal Utility
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0
the club five nights a week. (Remember, the sixth night does not increase his utility, so why should
he bother to go?) However, Frank is also a basketball fan. His city has many good high school andcollege teams, and he can go to games six nights a week if he so chooses.
Let us say for now that admission to both the country music club and the basketball games is
free—that is, there is no price/income constraint. There is a time constraint, however, becausethere are only seven nights in a week. Table 6.3 lists Frank’s total and marginal utilities fromattending basketball games and going to country music clubs. From column 3 of the table, we canconclude that on the first night, Frank will go to a basketball game. The game is worth far more tohim (21 utils) than a trip to the club (12 utils).
On the second night, Frank’s decision is not so easy. Because he has been to one basketball
game this week, the second game is worth less (12 utils as compared to 21 for the first basketballgame). In fact, because it is worth the same as a first trip to the club, he is indifferent as to whetherhe goes to the game or the club. So he splits the next two nights: One night he sees ball gamenumber two (12 utils); the other night he spends at the club (12 utils). At this point, Frank hasbeen to two ball games and has spent one night at the club. Where will Frank go on evening four?He will go to the club again because the marginal utility from a second trip to the club (10 utils)is greater than the marginal utility from attending a third basketball game (9 utils).
Frank is splitting his time between the two activities to maximize total utility. At each succes-
sive step, he chooses the activity that yields the most marginal utility. Continuing with this logic,you can see that spending three nights at the club and four nights watching basketball producestotal utility of 76 utils each week (28 plus 48). No other combination of games and club trips canproduce as much utility.
So far, the only cost of a night of listening to country music is a forgone basketball game and
the only cost of a basketball game is a forgone night of country music. Now let us suppose that itcosts $3 to get into the club and $6 to go to a basketball game. Suppose further that after payingrent and taking care of other expenses, Frank has only $21 left to spend on entertainment.Typically, consumers allocate limited incomes, or budgets, over a large set of goods and services.Here we have a limited income ($21) being allocated between only two goods, but the principle isthe same. Income ($21) and prices ($3 and $6) define Frank’s budget constraint. Within that con-straint, Frank chooses to maximize utility.
Because the two activities now cost different amounts, we need to find the marginal utility
per dollar spent on each activity. If Frank is to spend his money on the combination of activities
lying within his budget constraint that gives him the most total utility, each night he must choosethe activity that gives him the most utility per dollar spent . As you can see from column 5 in
Table 6.3, Frank gets 4 utils per dollar on the first night he goes to the club (12 utils /H11004$3 = 4 utils
per dollar). On night two, he goes to a game and gets 3.5 utils per dollar (21 utils /H11004$6 = 3.5 utils
per dollar). On night three, it is back to the club. Then what happens? When all is said anddone—work this out for yourself—Frank ends up going to two games and spending three nightsat the club. No other combination of activities that $21 will buy yields more utility.128 PART II The Market System: Choices Made by Households and Firms
TABLE 6.3 Allocation of Fixed Expenditure per Week Between Two Alternatives
(1) Trips to Club
per Week (2) Total Utility(3) Marginal
Utility ( MU) (4) Price ( P)(5) Marginal
Utility per Dollar
(MU/P )
1 12 12 $3.00 4.0
2 22 10 3.00 3.3
3 28 6 3.00 2.0
4 32 4 3.00 1.3
5 34 2 3.00 0.7
6 34 0 3.00 0
(1) Basketball
Games per Week (2) Total Utility(3) Marginal
Utility ( MU) (4) Price ( P)(5) Marginal
Utility per Dollar
(MU/P )
1 21 21 $6.00 3.5
2 33 12 6.00 2.0
3 42 9 6.00 1.5
4 48 6 6.00 1.0
5 51 3 6.00 0.5
6 51 0 6.00 0
CHAPTER 6 Household Behavior and Consumer Choice 129
The Utility-Maximizing Rule
In general, utility-maximizing consumers spread out their expenditures until the following con-
dition holds:
where MUXis the marginal utility derived from the last unit of Xconsumed, MUYis the
marginal utility derived from the last unit of Yconsumed, PXis the price per unit of X, and
PYis the price per unit of Y.
T o see why this utility-maximizing rule is true, think for a moment about what would hap-
pen if it were nottrue. For example, suppose MUX/PXwas greater than MUY/PY; that is, suppose
a consumer purchased a bundle of goods so that the marginal utility from the last dollar spent onXwas greater than the marginal utility from the last dollar spent on Y. This would mean that the
consumer could increase his or her utility by spending a dollar less on Yand a dollar more on X.
As the consumer shifts to buying more Xand less Y, he or she runs into diminishing marginal
utility. Buying more units of X decreases the marginal utility derived from consuming additional
units of X. As a result, the marginal utility of another dollar spent on Xfalls. Now lessis being
spent on Y, and that means its marginal utility increases . This process continues until MU
X/PX=
MUY/PY. When this condition holds, there is no way for the consumer to increase his or her util-
ity by changing the bundle of goods purchased.
Y ou can see how the utility-maximizing rule works in Frank’s choice between country music
and basketball. At each stage, Frank chooses the activity that gives him the most utility per dollar.If he goes to a game, the utility he will derive from the next game—marginal utility—falls. If hegoes to the club, the utility he will derive from his next visit falls, and so on.
The principles we have been describing help us understand an old puzzle dating from the time
of Plato and familiar to economists beginning with Adam Smith. Adam Smith wrote about it in 1776:
The things which have the greatest value in use have frequently little or no value in
exchange; and on the contrary, those which have the greatest value in exchange have fre-quently little or no value in use. Nothing is more useful than water: but it will purchasescarce anything; scarce anything can be had in exchange for it. A diamond, on the con-trary, has scarce any value in use; but a very great quantity of other goods may fre-quently be had in exchange for it.
4
Although diamonds have arguably more than “scarce any value in use” today (for example,
they are used to cut glass), Smith’s diamond/water paradox is still instructive, at least where
water is concerned.
The low price of water owes much to the fact that it is in plentiful supply. Even at a price of
zero, we do not consume an infinite amount of water. We consume up to the point wheremarginal utility drops to zero. The marginal value of water is zero. Each of us enjoys an enormous
consumer surplus when we consume nearly free water. At a price of zero, consumer surplus is theentire area under the demand curve. We tend to take water for granted, but imagine what wouldhappen to its price if there were not enough for everyone. It would command a high price indeed.
Diminishing Marginal Utility and Downward-Sloping
Demand
The concept of diminishing marginal utility offers one reason people spread their incomes over a
variety of goods and services instead of spending all income on one or two items. It also leads usto conclude that demand curves slope downward.
T o see why this is so, let us return to our friends Ann and T om, the struggling graduate stu-
dents. Recall that they chose between meals at a Thai restaurant and trips to a jazz club. Nowthink about their demand curve for Thai meals, shown in Figure 6.4. When the price of a meal is$40, they decide not to buy any Thai meals. What they are really deciding is that the utility gainedutility-maximizing rule:
MU X
PX=MU Y
PYfor all goods,
4Adam Smith, The Wealth of Nations , Modern Library Edition (New Y ork: Random House, 1937), p. 28 (1st ed. 1776). The
cheapness of water is referred to by Plato in Euthydemus , 304 B.C.utility-maximizing rule
Equating the ratio of themarginal utility of a good to itsprice for all goods.
diamond/water paradox A
paradox stating that (1) thethings with the greatest value
in use frequently have little or
no value in exchange and (2)the things with the greatestvalue in exchange frequently
have little or no value in use.
from even that first scrumptious meal each month is not worth the utility that would come from
the other things that $40 can buy.
Now consider a price of $25. At this price, Ann and T om buy five Thai meals. The first, second,
third, fourth, and fifth meals each generate enough utility to justify the price. T om and Ann “reveal”this by buying five meals. After the fifth meal, the utility gained from the next meal is not worth $25.
Ultimately, every demand curve hits the quantity (horizontal) axis as a result of diminishing
marginal utility—in other words, demand curves slope downward. How many times will Annand T om go to the Thai restaurant if meals are free? Twenty-five times is the answer; and after 25 times a month, they are so sick of Thai food that they will not eat any more even if it is free.That is, marginal utility—the utility gained from the last meal—has dropped to zero. If you thinkthis is unrealistic, ask yourself how much water you drank today.
Income and Substitution Effects
Although the idea of utility is a helpful way of thinking about the choice process, there is anexplanation for downward-sloping demand curves that does not rely on the concept of utility orthe assumption of diminishing marginal utility. This explanation centers on income and substi-tution effects.
Keeping in mind that consumers face constrained choices, consider the probable response of
a household to a decline in the price of some heavily used product, ceteris paribus . How might a
household currently consuming many goods be likely to respond to a fall in the price of one ofthose goods if the household’s income, its preferences, and all other prices remained unchanged?The household would face a new budget constraint, and its final choice of all goods and servicesmight change. A decline in the price of gasoline, for example, may affect not only how muchgasoline you purchase but also what kind of car you buy, when and how much you travel, whereyou go, and (not so directly) how many movies you see this month and how many projectsaround the house you get done.
The Income Effect
Price changes affect households in two ways. First, if we assume that households confine theirchoices to products that improve their well-being, then a decline in the price of any product, ceteris
paribus , will make the household unequivocally better off. In other words, if a household contin-
ues to buy the same amount of every good and service after the price decrease, it will have income130 PART II The Market System: Choices Made by Households and Firms
40
25
15
0
51 0 2 5DPrice per meal ($)
Thai meals per month/L50298FIGURE 6.4
Diminishing Marginal
Utility and Downward-Sloping Demand
At a price of $40, the utility
gained from even the first Thai
meal is not worth the price.However, a lower price of $25lures Ann and Tom into the Thai
restaurant 5 times a month. (The
utility from the sixth meal is notworth $25.) If the price is $15,Ann and Tom will eat Thai meals
10 times a month—until the mar-
ginal utility of a Thai meal dropsbelow the utility they could gainfrom spending $15 on other
goods. At 25 meals a month, they
cannot tolerate the thought ofanother Thai meal even if it is free.
left over. That extra income may be spent on the product whose price has declined, hereafter called
good X, or on other products. The change in consumption of Xdue to this improvement in well-
being is called the income effect of a price change .
Suppose you live in Florida and four times a year you fly to Nashville to visit your mother.
Suppose further that last year a round-trip ticket to Nashville cost $400. Thus, you spend a totalof $1,600 per year on trips to visit Mom. This year, however, increased competition among theairlines has led one airline to offer round-trip tickets to Nashville for $200. Assuming the priceremains $200 all year, you can now fly home the same number of times and you will have spent$800 less for airline tickets than you did last year. Now that you are better off, you have additionalopportunities. Y ou can fly home a fifth time this year, leaving $600 ($800 $200) to spend onother things, or you can fly home the same number of times (four) and spend the extra $800 onother things. When the price of something we buy falls, we are better off . When the price of some-
thing we buy rises, we are worse off .
Look back at Figure 6.2 on p. 125. When the price of Thai meals fell, the opportunity set fac-
ing T om and Ann expanded—they were able to afford more Thai meals, more jazz club trips, ormore of both. They were unequivocally better off because of the price decline. In a sense, their“real” income was higher.
Now recall from Chapter 3 the definition of a normal good . When income rises, demand for
normal goods increases. Most goods are normal goods. Because of the price decline, T om andAnn can afford to buy more. If Thai food is a normal good, a decline in the price of Thai foodshould lead to an increase in the quantity demanded of Thai food.
The Substitution Effect
The fact that a price decline leaves households better off is only part of the story. When the priceof a product falls, that product also becomes relatively cheaper. That is, it becomes more attractive
relative to potential substitutes. A fall in the price of product Xmight cause a household to shift
its purchasing pattern away from substitutes toward X. This shift is called the substitution effect of
a price change .
Earlier we made the point that the “real” cost or price of a good is what one must sacrifice to
consume it. This opportunity cost is determined by relative prices. T o see why this is so, consideragain the choice that you face when a round-trip ticket to Nashville costs $400. Each trip that youtake requires a sacrifice of $400 worth of other goods and services. When the price drops to $200,the opportunity cost of a ticket has dropped by $200. In other words, after the price decline, youhave to sacrifice only $200 (instead of $400) worth of other goods and services to visit Mom.
T o clarify the distinction between the income and substitution, imagine how you would be
affected if two things happened to you at the same time. First, the price of round-trip air travelbetween Florida and Nashville drops from $400 to $200. Second, your income is reduced by $800.Y ou are now faced with new relative prices, but—assuming you flew home four times last year—you are no better off now than you were before the price of a ticket declined. The decrease in theprice of air travel has offset your decrease in income.
Y ou are still likely to take more trips home. Why? The opportunity cost of a trip home is now
lower, ceteris paribus , assuming no change in the prices of other goods and services. A trip to
Nashville now requires a sacrifice of only $200 worth of other goods and services, not the $400 worththat it did before. Thus, you will substitute away from other goods toward trips to see your mother.
Everything works in the opposite direction when a price rises, ceteris paribus .A p r i c e
increase makes households worse off. If income and other prices do not change, spending thesame amount of money buys less and households will be forced to buy less. This is the incomeeffect. In addition, when the price of a product rises, that item becomes more expensive relativeto potential substitutes and the household is likely to substitute other goods for it. This is thesubstitution effect.
What do the income and substitution effects tell us about the demand curve? Both the
income and the substitution effects imply a negative relationship between price and quantitydemanded—in other words, downward-sloping demand. When the price of something falls,ceteris paribus , we are better off and we are likely to buy more of that good and other goods
(income effect). Because lower price also means “less expensive relative to substitutes,” we arelikely to buy more of the good (substitution effect). When the price of something rises, we are-
CHAPTER 6 Household Behavior and Consumer Choice 131
worse off and we will buy less of it (income effect). Higher price also means “more expensive rela-
tive to substitutes,” and we are likely to buy less of it and more of other goods (substitution effect).5
Figure 6.5 summarizes the income and substitution effects of a price change of
gasoline prices.
If you recall the example of gasoline prices from early in the chapter, income and substitu-
tion effects help us answer the question posed. When gas prices rise, the income effects can causea fall in the demand for other goods. Since gas is a big part of many budgets, these income effectscan be very large. It is the income effect from gasoline price increases that some argue causesconsumers to switch away from high-priced brand name products.
Household Choice in Input Markets
So far, we have focused on the decision-making process that lies behind output demand curves.Households with limited incomes allocate those incomes across various combinations of goodsand services that are available and affordable. In looking at the factors affecting choices in theoutput market, we assumed that income was fixed, or given. We noted at the outset, however,that income is in fact partially determined by choices that households make in input markets.(Look back at Figure II.1 on p. 117.) We now turn to a brief discussion of the two decisions thathouseholds make in input markets: the labor supply decision and the saving decision.
The Labor Supply Decision
Most income in the United States is wage and salary income paid as compensation for labor.Household members supply labor in exchange for wages or salaries. As in output markets, house-holds face constrained choices in input markets. They must decide
1.Whether to work
2.How much to work
3.What kind of a job to work at132 PART II The Market System: Choices Made by Households and Firms
Household
buys more
RISESFALLS
Income
effectOpportunity
cost of the
good fallsHousehold is
better off
(Higher real income)
Household is
worse off
(Lower real income)Household
buys more
Household
buys lessSubstitution
effect
Opportunity
cost of the
good risesSubstitution
effectHousehold
buys lessIncome
effectPrice of a
good or service:/L50298FIGURE 6.5 Income
and Substitution Effectsof a Price Change
For normal goods, the income
and substitution effects work inthe same direction. Higher prices
lead to a lower quantity
demanded, and lower prices leadto a higher quantity demanded.
5For some goods, the income and substitution effects work in opposite directions. When our income rises, we may buy less of some
goods. In Chapter 3, we called such goods inferior goods . When the price of an inferior good rises, it is, like any other good, more expen-
sive relative to substitutes and we are likely to replace it with lower-priced substitutes. However, when we are worse off, we inc rease our
demand for inferior goods. Thus, the income effect could lead us to buy more of the good, partially offsetting the substitution eff ect.
Even if a good is “very inferior,” demand curves will slope downward as long as the substitution effect is larger than the
income effect. It is possible, at least in theory, for the income effect to be larger. In such a case, a price increase would actual ly
lead to an increase in quantity demanded. This possibility was pointed out by Alfred Marshall in Principles of Economics .
Marshall attributes the notion of an upward-sloping demand curve to Sir Robert Giffen; for this reason, the notion is oftenreferred to as Giffen’s paradox . Fortunately or unfortunately, no one has ever demonstrated that a Giffen good has existed.
CHAPTER 6 Household Behavior and Consumer Choice 133
ECONOMICS IN PRACTICE
Substitution and Market Baskets
In driving to work one day, one of the authors of this text heard the
following advertisement for a local grocery store, which we will call
Harry’s Food.
“Harry’s has the best prices in town, and we can prove it!
Y esterday we chose Mr. Smith out of our checkout line for a com-parison test. Mr. Smith is an average consumer, much like you and
me. In doing his weekly grocery shopping yesterday at Harry’s, he
spent $125. We then sent Mr. Smith to the neighboring competitorwith instructions to buy the same market basket of food. When hereturned with his food, he saw that his grocery total was $134. Y outoo will see that Harry’s can save you money!”
Advertisements like this one are commonplace. As you evalu-
ate the claims in the ad, several things may come to mind.
Perhaps Mr. Smith is not representative of consumers or is notmuch like you. That might make Harry’s a good deal for him butnot for you. (So your demand curve looks different from Mr. Smith’s demand curve.) Or perhaps yesterday was a sale day,
meaning yesterday was not typical of Harrys’ prices. But there is
something more fundamentally wrong with the claims in this adeven if you are just like Mr. Smith and Harry’s offers the sameprices every day. The fundamental error in this ad is revealed bythe work you have done in this chapter.
When Mr. Smith shopped, he presumably looked at the prices
of the various food choices offered at the market and tried to dothe best he could for his family given those prices and his family’stastes. If we go back to the utility-maximizing rule that youlearned in this chapter, we see that Mr. Smith was comparing the
marginal utility of each product he consumes relative to its pricein deciding what
bundle to buy. Inpragmatic terms, ifMr. Smith likes applesand pears about the
same, while he wasshopping in Harry’s,
he would have boughtthe cheaper of thetwo. When he wassent to the neighbor-
ing store, however, he
was constrained tobuy the same goodsthat he bought atHarry’s. (So he was
forced to buy pears
even if they weremore expensive justto duplicate the bun-dle.) When we artifi-
cially restrict Mr. Smith’s ability to substitute goods, we almost
inevitably give him a more expensive bundle. The real question isthis: Would Mr. Smith have been more happy or less happy withhis market basket after spending $125 at Harry’s or at its rival?Without knowing more about the shape of Mr. Smith’s utility
curve and the prices he faces, we cannot answer that question. The
dollar comparison in the ad doesn’t tell the whole story!
In essence, household members must decide how much labor to supply. The choices they
make are affected by:
1.Availability of jobs
2.Market wage rates
3.Skills they possess
As with decisions in output markets, the labor supply decision involves a set of trade-offs.
There are basically two alternatives to working for a wage: (1) not working and (2) doing unpaidwork. If you do not work, you sacrifice income for the benefits of staying home and reading,watching TV , swimming, or sleeping. Another option is to work, but not for a money wage. Inthis case, you sacrifice money income for the benefits of growing your own food, raising yourchildren, or taking care of your house.
As with the trade-offs in output markets, your final choice depends on how you value the
alternatives available. If you work, you earn a wage that you can use to buy things. Thus, thetrade-off is between the value of the goods and services you can buy with the wages you earn ver-sus the value of things you can produce at home—home-grown food, manageable children, cleanclothes, and so on—or the value you place on leisure. This choice is illustrated in Figure 6.6. Ingeneral, the wage rate can be thought of as the price—or the opportunity cost—of the benefits ofeither unpaid work or leisure. Just as you choose among different goods by comparing the mar-ginal utility of each relative to its price, you also choose between leisure and other goods by com-paring the marginal utility of leisure relative to its price (the wage rate) with the marginal utilityof other goods relative to their prices.
134 PART II The Market System: Choices Made by Households and Firms
Buys goods
and services
0W
LLeisure,
nonmarket production
(home-grown food,
child-raising, etc.)Wages
Maximum utility
HOUSEHOLDSPxProduct market
0Q
Labor market/L50298FIGURE 6.6 The
Trade-Off FacingHouseholds
The decision to enter the work-
force involves a trade-offbetween wages (and the goods
and services that wages will buy)
on the one hand and leisure andthe value of nonmarket produc-
tion on the other hand.
labor supply curve A curve
that shows the quantity oflabor supplied at different
wage rates. Its shape depends
on how households react tochanges in the wage rate.The Price of Leisure
In our analysis in the early part of this chapter, households had to allocate a limited budget
across a set of goods and services. Now they must choose among goods, services, and leisure .
When we add leisure to the picture, we do so with one important distinction. Trading one
good for another involves buying less of one and more of another, so households simply reallo-cate money from one good to the other. “Buying” more leisure, however, means reallocating time
between work and nonwork activities. For each hour of leisure that you decide to consume, yougive up one hour’s wages. Thus, the wage rate is the price of leisure .
Conditions in the labor market determine the budget constraints and final opportunity
sets that households face. The availability of jobs and these job wage rates determine thefinal combinations of goods and services that a household can afford. The final choicewithin these constraints depends on the unique tastes and preferences of each household.Different people place more or less value on leisure—but everyone needs to put food on the table.
Income and Substitution Effects of a Wage Change
A labor supply curve shows the quantity of labor supplied at different wage rates. The shape of
the labor supply curve depends on how households react to changes in the wage rate.
Consider an increase in wages. First, an increase in wages makes households better off. If they
work the same number of hours—that is, if they supply the same amount of labor—they willearn higher incomes and be able to buy more goods and services. They can also buy more leisure.If leisure is a normal good—that is, a good for which demand increases as income increases—anincrease in income will lead to a higher demand for leisure and a lower labor supply. This is theincome effect of a wage increase .
However, there is also a potential substitution effect of a wage increase . A higher wage rate
means that leisure is more expensive. If you think of the wage rate as the price of leisure, eachindividual hour of leisure consumed at a higher wage costs more in forgone wages. As a result, wewould expect households to substitute other goods for leisure. This means working more, or alower quantity demanded of leisure and a higher quantity supplied of labor.
Note that in the labor market, the income and substitution effects work in opposite
directions when leisure is a normal good. The income effect of a wage increase impliesbuying more leisure and working less; the substitution effect implies buying less leisure and working more. Whether households will supply more labor overall or less labor overallwhen wages rise depends on the relative strength of both the income and the substitu-tion effects.
If the substitution effect is greater than the income effect, the wage increase will increase
labor supply. This suggests that the labor supply curve slopes upward, or has a positive slope, likethe one in Figure 6.7(a). If the income effect outweighs the substitution effect, however, a higherwage will lead to added consumption of leisure and labor supply will decrease. This implies thatthe labor supply curve “bends back,” as the one in Figure 6.7(b) does.CHAPTER 6 Household Behavior and Consumer Choice 135
SWage rate
Units of labor0SWage rate
Units of labor0b. Income effect dominates a. Substitution effect dominates/L50296FIGURE 6.7 Two
Labor Supply CurvesDuring the early years of the Industrial Revolution in late eighteenth-century Great
Britain, the textile industry operated under what was called the “putting-out” system. Spinningand weaving were done in small cottages to supplement the family farm income—hence theterm cottage industry . During that period, wages and household incomes rose considerably.
Some economic historians claim that this higher income actually led many households to takemore leisure and work fewer hours; the empirical evidence suggests a backward-bending laborsupply curve.
Just as income and substitution effects helped us understand household choices in output
markets, they now help us understand household choices in input markets. The point here issimple: When leisure is added to the choice set, the line between input and output market deci-sions becomes blurred. In fact, households decide simultaneously how much of each good toconsume and how much leisure to consume.
Saving and Borrowing: Present versus Future
Consumption
We began this chapter by examining the way households allocate a fixed income over a large
number of goods and services. We then pointed out that, at least in part, choices made by house-holds determine income levels. Within the constraints imposed by the market, households decidewhether to work and how much to work.
So far, however, we have talked about only the current period—the allocation of current
income among alternative uses and the work/leisure choice today . Households can also (1) use
present income to finance future spending—they can save— or (2) use future income to finance
present spending—they can borrow .
When a household decides to save, it is using current income to finance future consumption.
That future consumption may come in 3 years, when you use your savings to buy a car; in 10 years,when you sell stock to put a deposit on a house; or in 45 years, when you retire and begin to receivemoney from your pension plan. Most people cannot finance large purchases—a house or condo-minium, for example—out of current income and savings. They almost always borrow money andsign a mortgage. When a household borrows, it is in essence financing a current purchase withfuture income. It pays back the loan out of future income.
Even in simple economies such as the two-person desert-island economy of Colleen and
Bill (see Chapter 2), people must make decisions about present versus future consumption .
Colleen and Bill could (1) produce goods for today’s consumption by hunting and gathering,(2) consume leisure by sleeping on the beach, or (3) work on projects to enhance future con-sumption opportunities. Building a house or a boat over a 5-year period is trading present
When the substitution effect
outweighs the income effect, the
labor supply curve slopesupward (a). When the incomeeffect outweighs the substitution
effect, the result is a “backward-
bending” labor supply curve: Thelabor supply curve slopes down-ward (b).
136 PART II The Market System: Choices Made by Households and Firms
consumption for future consumption. As with all of the other choices we have examined in this
chapter, the broad principle will be to look at marginal utilities and prices. How much doColleen and Bill value having something now versus waiting for the future? How much do theygain by waiting?
When a household saves, it usually puts the money into something that will generate
income. There is no sense in putting money under your mattress when you can make it work inso many ways: savings accounts, money market funds, stocks, corporate bonds, and so on—many of which are virtually risk-free. When you put your money in any of these places, you areactually lending it out and the borrower pays you a fee for its use. This fee usually takes theform of interest . The interest paid is the possible benefit Colleen and Bill get from forgoing cur-
rent consumption.
Just as changes in wage rates affect household behavior in the labor market, changes in inter-
est rates affect household behavior in capital markets. Higher interest rates mean that borrowingis more expensive—required monthly payments on a newly purchased house or car will behigher. Higher interest rates also mean that saving will earn a higher return: $1,000 invested in a5 percent savings account or bond yields $50 per year. If rates rise to 10 percent, the annual inter-est will rise to $100.
What impact do interest rates have on saving behavior? As with the effect of wage changes on
labor supply, the effect of changes in interest rates on saving can best be understood in terms ofincome and substitution effects. Suppose, for example, that I have been saving for a number ofyears for retirement. Will an increase in interest rates lead to an increase or a decrease in my sav-ing? The answer is not obvious. First, because each dollar saved will earn a higher rate of return,ECONOMICS IN PRACTICE
What Happens When the Cost of Self-Discovery Falls?
College graduates in 2009 and 2010 entered a difficult job market,
with fewer opportunities than their counterparts a few years earlier.
As the article below suggests, many ended up taking unpaid intern-ships. Why take an unpaid internship rather than continue to lookfor paid work?
Many new graduates are quite uncertain about what career to
pursue. A first job provides more than a paycheck. It provides an
opportunity to learn more about what a career in a particular arealooks like and whether it appeals to you. First jobs, in other words,provide a chance to learn about both the world and oneself. Whenjobs are plentiful, pursuing an unpaid internship in an area you areinterested in has a big opportunity cost: the lost wages associated
with a full-time job in what might be a less attractive industry. In a
world of few paying jobs, the opportunity cost of following yourheart in career terms is much lower.
New Experience: Interns Pay to Work
For-Profits Finding Flood of Candidates in Poor Job Market
The Boston Globe
Throughout her senior year at Boston College, Brynn
Merritt worked part time at Entercom Boston, which owns
four radio stations, including WEEI and WRKO. Sheblogged, called businesses to solicit merchandise forWEEI’s Web site, produced ad displays, and sent newslet-ter e-mail blasts.
For all of this, she was paid nothing.
“I did the same amount of work as a lot of people getting
paid did,’’ says Merritt, 22, who graduated this spring. But she’s
not complaining; in fact, she feels lucky. “I learned a ton,’’ says
Merritt, who received a course credit for the internship. “I feel Icould go into the business right now.’’
Unpaid internships have long been offered by nonprofits,
but for-profit businesses are increasingly taking advantage ofthe number of students who, in a tight job market, are willing toforgo a paycheck for practical experience.
Source: The Boston Globe by Bella English. Copyright 2010 by Globe
Newspaper Company – MA . Reproduced with permission of Globe
Newspaper Company – MA via Copyright Clearance Center.
CHAPTER 6 Household Behavior and Consumer Choice 137
financial capital market
The complex set of institutions
in which suppliers of capital
(households that save) and thedemand for capital (firms
wanting to invest) interact.
6Here in Chapter 6, we are looking at a country as if it were isolated from the rest of the world. Very often, however, capital
investment is financed by funds loaned or provided by foreign citizens or governments. For example, in recent years, a substan-tial amount of foreign savings has found its way into the United States for the purchase of stocks, bonds, and other financialinstruments. In part, these flows finance capital investment. Also, the United States and other countries that contribute funds tothe World Bank and the International Monetary Fund have provided billions in outright grants and loans to help developingcountries produce capital. For more information on these institutions, see Chapter 21.the “price” of spending today in terms of forgone future spending is higher. That is, each dollarthat I spend today (instead of saving) costs me more in terms of future consumption because mysaving will now earn a higher return. On this score, I will be led to save more , which is the substi-
tution effect at work.
However, higher interest rates mean more than that. Higher interest rates mean that it will
take less saving today to reach a specific target amount of savings tomorrow. I will not need tosave as much for retirement or future consumption as I did before. One hundred dollars put intoa savings account with 5 percent compound interest will double in 14 years. If interest was paid ata rate of 10 percent, I would have my $200 in just 7 years. Consequently, I may be led to save less,which is the income effect at work. Higher interest rates mean savers are better off; so higherinterest rates may lead to less saving. The final impact of a change in interest rates on savingdepends on the relative size of the income and substitution effects. Most empirical evidence indi-cates that saving tends to increase as the interest rate rises. In other words, the substitution effectis larger than the income effect.
Saving and investment decisions involve a huge and complex set of institutions, the financial
capital market , in which the suppliers of capital (households that save) and the demand for cap-
ital (firms that want to invest) interact. The amount of capital investment in an economy is con-strained in the long run by that economy’s saving rate. Y ou can think of household saving as the
economy’s supply of capital. When a firm borrows to finance a capital acquisition, it is almost asif households have supplied the capital in exchange for the fee we call interest. We treat capitalmarkets in detail in Chapter 11.
6
A Review: Households in Output and Input
Markets
In probing the behavior of households in both input and output markets and examining the
nature of constrained choice, we went behind the household demand curve using the simplifyingassumption that income was fixed and given. Income, wealth, and prices set the limits, orconstraints , within which households make their choices in output markets. Within those limits,
households make their choices on the basis of personal tastes and preferences.
The notion of utility helps explain the process of choice. The law of diminishing marginal
utility partly explains why people seem to spread their incomes over many different goods and
services and why demand curves have a negative slope. Another important explanation behindthe negative relationship between price and quantity demanded lies in income effects and
substitution effects .
As we turned to input markets, we relaxed the assumption that income was fixed and given.
In the labor market, households are forced to weigh the value of leisure against the value of goodsand services that can be bought with wage income. Once again, we found household preferencesfor goods and leisure operating within a set of constraints imposed by the market. Householdsalso face the problem of allocating income and consumption over more than one period of time.They can finance spending in the future with today’s income by saving and earning interest, orthey can spend tomorrow’s income today by borrowing.
We now have a rough sketch of the factors that determine output demand and input supply.
(Y ou can review these in Figure II.1 on p. 117.) In the next three chapters, we turn to firm behav-ior and explore in detail the factors that affect output supply and input demand.
REVIEW TERMS AND CONCEPTS138 PART II The Market System: Choices Made by Households and Firms
All problems are available on www.myeconlab.comSUMMARY
HOUSEHOLD CHOICE IN OUTPUT MARKETS p.121
1.Every household must make three basic decisions: (1) how
much of each product, or output, to demand; (2) how muchlabor to supply; and (3) how much to spend today and howmuch to save for the future.
2.Income, wealth, and prices define household budget constraint .
The budget constraint separates those combinations of goodsand services that are available from those that are not. All thepoints below and to the left of a graph of a household budgetconstraint make up the choice set ,o r opportunity set .
3.It is best to think of the household choice problem as one of
allocating income over a large number of goods and services.A change in the price of one good may change the entireallocation. Demand for some goods may rise, while demandfor others may fall.
4.As long as a household faces a limited income, the real costof any single good or service is the value of the next pre-ferred other goods and services that could have been pur-
chased with the same amount of money.
5.Within the constraints of prices, income, and wealth,household decisions ultimately depend on preferences—likes, dislikes, and tastes.
THE BASIS OF CHOICE: UTILITY p. 126
6.Whether one item is preferable to another depends on howmuch utility , or satisfaction, it yields relative to its alternatives.
7.The law of diminishing marginal utility says that the more of
any good we consume in a given period of time, the less sat-isfaction, or utility, we get out of each additional (or mar-ginal) unit of that good.
8.Households allocate income among goods and services tomaximize utility. This implies choosing activities that yieldthe highest marginal utility per dollar. In a two-good world,households will choose to equate the marginal utility perdollar spent on Xwith the marginal utility per dollar spent
onY. This is the utility-maximizing rule .
INCOME AND SUBSTITUTION EFFECTS p. 130
9.The fact that demand curves have a negative slope can be
explained in two ways: (1) Marginal utility for all goodsdiminishes. (2) For most normal goods, both the income and
the substitution effects of a price decline lead to more con-
sumption of the good.
HOUSEHOLD CHOICE IN INPUT MARKETS p.132
10. In the labor market, a trade-off exists between the value of
the goods and services that can be bought in the market orproduced at home and the value that one places on leisure.The opportunity cost of paid work is leisure and unpaidwork. The wage rate is the price, or opportunity cost, of thebenefits of unpaid work or leisure.
11. The income and substitution effects of a change in the wagerate work in opposite directions. Higher wages mean that(1) leisure is more expensive (likely response: people workmore —substitution effect) and (2) more income is earned
in a given number of hours, so some time may be spent onleisure (likely response: people work less—income effect).
12. In addition to deciding how to allocate its present income
among goods and services, a household may also decide tosave or borrow. When a household decides to save part of itscurrent income, it is using current income to finance futurespending. When a household borrows, it finances currentpurchases with future income.
13. An increase in interest rates has a positive effect on saving ifthe substitution effect dominates the income effect and anegative effect if the income effect dominates the substitu-tion effect. Most empirical evidence shows that the substitu-tion effect dominates here.
budget constraint, p. 122
choice set oropportunity set, p. 123
diamond/water paradox, p. 129
financial capital market, p. 137
homogeneous products, p. 119labor supply curve, p. 134
law of diminishing marginal utility, p. 126
marginal utility ( MU),p. 126
perfect competition, p. 119
perfect knowledge, p. 119real income, p. 124
total utility, p. 126
utility, p. 126
utility-maximizing rule, p. 129
PROBLEMS
1.For each of the following events, consider how you might react.
What things might you consume more or less of? Would you
work more or less? Would you increase or decrease your saving?Are your responses consistent with the discussion of householdbehavior in this chapter?a.Y ou have a very close friend who lives in another city, a
3-hour bus ride away. The price of a round-trip ticket risesfrom $20 to $45.
b.Tuition at your college is cut 25 percent.c.Y ou receive an award that pays you $300 per month for the
next 5 years.
d.Interest rates rise dramatically, and savings accounts are now
paying 10% interest annually.
e.The price of food doubles. (If you are on a meal plan,
assume that your board charges double.)
f.A new business opens up nearby offering part-time jobs at
$20 per hour.
2.The following table gives a hypothetical total utility schedule for
the Cookie Monster (CM):CHAPTER 6 Household Behavior and Consumer Choice 139
Calculate the CM’s marginal utility schedule. Draw a graph of
total and marginal utility. If cookies cost the CM 5 cents eachand CM had a good income, what is the maximum number of
cookies he would most likely eat in a day?
3.Kamika lives in Chicago but goes to school in Tucson, Arizona.
For the last 2 years, she has made four trips home each year.During 2010, the price of a round-trip ticket from Chicago to
Tucson increased from $350 to $600. As a result, Kamika
decided not to buy a new outfit that year and decided not todrive to Phoenix with friends for an expensive rock concert.a.Explain how Kamika’s demand for clothing and concert tick-
ets can be affected by an increase in air travel prices.
b.By using this example, explain why both income and substi-
tution effects might be expected to reduce Kamika’s numberof trips home.
4.Sketch the following budget constraints:effects were stronger than substitution effects. Do you agree or
disagree? Explain your answer.
7.Assume that Mei has $100 per month to divide between dinners
at a Chinese restaurant and evenings at Zanzibar, a local pub.Assume that going to Zanzibar costs $20 and eating at theChinese restaurant costs $10. Suppose Mei spends two evenings
at Zanzibar and eats six times at the Chinese restaurant.
a.Draw Mei’s budget constraint and show that she can afford
six dinners and two evenings at Zanzibar.
b.Assume that Mei comes into some money and can now
spend $200 per month. Draw her new budget constraint.
c.As a result of the increase in income, Mei decides to spend
eight evenings at Zanzibar and eat at the Chinese restaurantfour times. What kind of a good is Chinese food? What kindof a good is a night at Zanzibar?
d.What part of the increase in Zanzibar trips is due to the
income effect, and what part is due to the substitution effect?
Explain your answer.
8.Decide whether you agree or disagree with each of the following
statements and explain your reason:a.If the income effect of a wage change dominates the substitu-
tion effect for a given household and the household workslonger hours following a wage change, wages must have risen.
b.In product markets, when a price falls, the substitution effect
leads to more consumption; but for normal goods, the
income effect leads to less consumption.
9.Suppose the price of Xis $5 and the price of Yis $10 and a hypo-
thetical household has $500 to spend per month on goods XandY.
a.Sketch the household budget constraint.
b.Assume that the household splits its income equally between
Xand Y. Show where the household ends up on the budget
constraint.
c.Suppose the household income doubles to $1,000. Sketch the
new budget constraint facing the household.
d.Suppose after the change the household spends $200 on Y
and $800 on X. Does this imply that Xis a normal or an infe-
rior good? What about Y?
10.For this problem, assume that Joe has $80 to spend on books
and movies each month and that both goods must be purchased
whole (no fractional units). Movies cost $8 each, and books cost
$20 each. Joe’s preferences for movies and books are summa-rized by the following information:
a.Fill in the figures for marginal utility and marginal utility per
dollar for both movies and books.
b.Are these preferences consistent with the law of diminishing
marginal utility? Explain briefly.
c.Given the budget of $80, what quantity of books and what
quantity of movies will maximize Joe’s level of satisfaction?Explain briefly.5.On January 1, Professor Smith made a resolution to lose some
weight and save some money. He decided that he would strictlybudget $100 for lunches each month. For lunch, he has only twochoices: the faculty club, where the price of a lunch is $5, andAlice’s Restaurant, where the price of a lunch is $10. Every day
that he does not eat lunch, he runs 5 miles.
a.Assuming that Professor Smith spends the $100 each month
at either Alice’s or the club, sketch his budget constraint.Show actual numbers on the axes.
b.Last month Professor Smith chose to eat at the club 10 times
and at Alice’s 5 times. Does this choice fit within his budget
constraint? Explain your answer.
c.Last month Alice ran a half-price lunch special all month. All
lunches were reduced to $5. Show the effect on ProfessorSmith’s budget constraint.
6.During 2010, Congress debated the advisability of retaining
some or all of the tax cuts signed into law by former PresidentGeorge W. Bush in 2001 and 2003 and set to expire at the end of
2010. By reducing tax rates across the board, take-home pay for
all taxpaying workers would increase. The purpose, in part, wasto encourage work and increase the supply of labor. Householdswould respond the way the president hoped, but only if income# OF COOKIES PER DAY TOTAL UTILITY PER DAY
0 0
1 100
2 200
3 275
4 325
5 350
6 360
7 360
PXPY INCOME
a. $20 $50 $1,000
b. 40 50 1,000
c. 20 100 1,000
d. 20 50 2,000
e. 0.25 0.25 7.00
f. 0.25 0.50 7.00
g. 0.50 0.25 7.00
MOVIES BOOKS
NO. PER
MONTH TU MU MU/$NO. PER
MONTH TU MU MU/$
1 50 __ __ 1 22 __ __
2 80 __ __ 2 42 __ __
3 100 __ __ 3 52 __ __
4 110 __ __ 4 57 __ __
5 116 __ __ 5 60 __ __
6 121 __ __ 6 62 __ __
7 123 __ __ 7 63 __ __
140 PART II The Market System: Choices Made by Households and Firms
d.Draw the budget constraint (with books on the horizontal
axis) and identify the optimal combination of books and
movies as point A.
e.Now suppose the price of books falls to $10. Which of the
columns in the table must be recalculated? Do the requiredrecalculations.
f.After the price change, how many movies and how many
books will Joe purchase?
g.Draw the new budget constraint and identify the new opti-
mal combination of books and movies as point B.
h.If you calculated correctly, you found that a decrease in the
price of books caused Joe to buy more movies as well as
more books. How can this be?
11.[Related to the Economics in Practice on p. 133 ] John’s
New Y ork–based firm has sent him to work in its Paris office.
Recognizing that the cost of living differs between Paris andNew Y ork, the company wants to adjust John’s salary so thatJohn is as well off (or happy) in Paris as he was in New Y ork.John suggests that he submit a list of the things he bought
in New Y ork in a typical month. The firm can use the list
to determine John’s salary by figuring out how much thesame items cost in Paris. Is this a good idea? Explain your answer.
12.[Related to the Economics in Practice onp. 136 ]Using graphs,
show what you would expect to see happen to the labor supplycurve facing companies offering unpaid internships as the jobmarket starts to improve.
13.Thomas has allocated $48 per month for entertainment
expenses, which he uses either to go bowling or to playbilliards. One night of bowling costs Thomas $8, and one
night of billiards costs Thomas $4. Use the information in the
following graphs to determine how many nights Thomasshould spend bowling and how many nights he should playbilliards in order to maximize his utility. Explain your answer.
17.The table shows Regina’s marginal utility numbers for ham-
burgers and pizzas. Regina is trying to decide which item to
purchase first, a hamburger or a pizza, knowing that she wantsto receive the most utility for each dollar she spends. Assumingshe has enough money in her budget to purchase either item,which item should she purchase first?
MU
156
48
40
32
24
16
8
0Marginal
utility of
bowling
Bowling
(nights
per month)2 3 4 5 6 714.For most normal goods, the income effect and the substitution
effect work in the same direction; so when the price of a good
falls, both the income and substitution effects lead to a higherquantity demanded. How would this change if the good is aninferior good?
15.Explain why in product markets the substitution and income
effects work in the same direction for normal goods, but in thelabor market, the income and substitution effects work in oppo-site directions when leisure is considered a normal good.
16.Samantha has $7 to spend on apples and bananas and wants to
maximize her utility on her purchase. Based on the data in thetable, how many apples and bananas should Samantha pur-
chase, and what is her total utility from the purchase? Does the
utility-maximizing rule hold true for her purchase? Explain.MU
11416
12
10
8
64
2
0Marginal
utility of
billiards
Billiards
(nights
per month)2 3 4 5 6 78
APPLES $1.00 BANANAS $0.50
QUANTITY MU TU QUANTITY MU TU
1 28 28 1 12 12
2 24 52 2 10 22
3 20 72 3 8 30
4 16 88 4 6 36
5 12 100 5 4 40
6 8 108 6 2 42
7 4 112 7 0 42
8 0 112 8 –2 40
HAMBURGERS $4 PIZZAS $6
QUANTITY MU QUANTITY MU
1 12 1 18
2 8 2 14
3 4 3 8
CHAPTER 6 Household Behavior and Consumer Choice 141
18.Jake and Gonzalo are roommates and have saved a total of $360
to spend on summer entertainment. They have decided to use
this money on tickets to baseball games and on tickets to theirlocal amusement park. Their original budget constraint is shownin the graph below. Let Xrepresent amusement park tickets and
Yrepresent baseball tickets.
420
15
10
5
0Baseball
tickets
(Y)
Amusement
park tickets ( X)8 12 16 20Original
budget
constraintNew
budget
constrainta.What is the equation of the original budget constraint?
b.What is the price of an amusement park ticket? a baseball ticket?
c.Assume a price change occurs and Jake and Gonzalo now
face the new budget constraint. What is the equation of thenew budget constraint?
d.With the new budget constraint, what is the price of an
amusement park ticket? a baseball ticket?
CHAPTER 6 APPENDIX
Indifference Curves
Early in this chapter, we saw how a consumer choosing
between two goods is constrained by the prices of those goodsand by his or her income. This Appendix returns to that exam-ple and analyzes the process of choice more formally. (Beforewe proceed, carefully review the text under the heading “TheBudget Constraint More Formally,” p. 123)
Assumptions
We base the following analysis on four assumptions:
1.We assume that this analysis is restricted to goods thatyield positive marginal utility, or, more simply, that “moreis better.” One way to justify this assumption is to say thatwhen more of something makes you worse off, you cansimply throw it away at no cost. This is the assumption offree disposal.
2.The marginal rate of substitution is defined as MUX/MUY,
or the ratio at which a household is willing to substitute X
for Y. When MUX/MUYis equal to 4, for example, I would
be willing to trade 4 units of Yfor 1 additional unit of X.
We assume a diminishing marginal rate of substitution.
That is, as more of Xand less of Yare consumed, MUX/MUYdeclines. As you consume more of Xand less of Y,X
becomes less valuable in terms of units of Y,o r Ybecomes
more valuable in terms of X. This is almost but not precisely
equivalent to assuming diminishing marginal utility.
3.We assume that consumers have the ability to chooseamong the combinations of goods and services available.Confronted with the choice between two alternative com-binations of goods and services, Aand B, a consumer
responds in one of three ways: (1) She prefers Aover B,
(2) she prefers Bover A, or (3) she is indifferent between
Aand B—that is, she likes Aand Bequally.
4.We assume that consumer choices are consistent with a
simple assumption of rationality. If a consumer showsthat he prefers Ato Band subsequently shows that he
prefers Bto a third alternative, C, he should prefer Ato C
when confronted with a choice between the two.
Deriving Indifference Curves
If we accept these four assumptions, we can construct a “map”of a consumer’s preferences. These preference maps are madeup of indifference curves. An indifference curve is a set of
points, each point representing a combination of goods Xand
Y, all of which yield the same total utility.
142 PART II The Market System: Choices Made by Households and Firms
Figure 6A.1 shows how we might go about deriving an
indifference curve for a hypothetical consumer. Each point inthe diagram represents some amount of Xand some amount of Y.
Point Ain the diagram, for example, represents X
Aunits of Xand
YAunits of Y. Now suppose we take some amount of Yaway
from our hypothetical consumer, moving him or her to A'.A t A',
the consumer has the same amount of X—that is, XAunits—but
less Yand now has only YCunits of Y. Because “more is better,” our
consumer is unequivocally worse off at A'than at A.
T o compensate for the loss of Y, we begin giving our con-
sumer some more X. If we give the individual just a little, he or
she will still be worse off than at A. If we give this individual a
great deal of X, he or she will be better off. There must be some
quantity of Xthat will just compensate for the loss of Y. By giv-
ing the consumer that amount, we will have put together abundle, Y
Cand XC, that yields the same total utility as bundle
A. This is bundle Cin Figure 6A.1. If confronted with a choice
between bundles Aand C, our consumer will say, “Either one; I
do not care.” In other words, the consumer is indifferent
between Aand C. When confronted with a choice between
bundles Cand B(which represent XBand YBunits of Xand Y),
this person is also indifferent. The points along the curvelabeled iin Figure 6A.1 represent all the combinations of Xand
Ythat yield the same total utility to our consumer. That curve
is thus an indifference curve.
Each consumer has a whole set of indifference curves.
Return for a moment to Figure 6A.1. Starting at point Aagain,
imagine that we give the consumer a tiny bit more X and a tiny
bit more Y. Because more is better, we know that the new bun-
dle will yield a higher level of total utility and the consumerwill be better off. Now just as we constructed the first indiffer-ence curve, we can construct a second one. What we get is anindifference curve that is higher and to the right of the first
curve. Because utility along an indifference curve is constant atall points, every point along the new curve represents a higherlevel of total utility than every point along the first.
Figure 6A.2 shows a set of four indifference curves. The
curve labeled i
4represents the combinations of Xand YthatSlope: =
Units of XUnits of YA
CB
D
i1i2i3i4
0/H9004Y1MUX
/H9004Y2
/H9004X1/H9004X2/H9004Y1
/H9004X1=
MUY/H11002
/L50304FIGURE 6A.2 A Preference Map: A Family of
Indifference Curves
Each consumer has a unique family of indifference curves called a
preference map. Higher indifference curves represent higher levels of
total utility.Units of Y
Units of XA
C
B
iAYA
YC
YB
XA XC XB 0'
/L50304FIGURE 6A.1 An Indifference Curve
An indifference curve is a set of points, each representing a combina-
tion of some amount of good Xand some amount of good Y, that all
yield the same amount of total utility. The consumer depicted here isindifferent between bundles Aand B, Band C, and Aand C.
yield the highest level of total utility among the four. Many
other indifference curves exist between those shown on thediagram; in fact, their number is infinite. Notice that as youmove up and to the right, utility increases.
The shapes of the indifference curves depend on the pref-
erences of the consumer, and the whole set of indifferencecurves is called a preference map . Each consumer has a
unique preference map.
Properties of Indifference Curves
The indifference curves shown in Figure 6A.2 are drawn bow-ing in toward the origin, or zero point, on the axes. In otherwords, the absolute value of the slope of the indifference curvesdecreases, or the curves get flatter, as we move to the right.Thus, we say that indifference curves are convex toward theorigin. This shape follows directly from the assumption ofdiminishing marginal rate of substitution and makes sense ifyou remember the law of diminishing marginal utility.
T o understand the convex shape, compare the segment of
curve i
1between Aand Bwith the segment of the same curve
between Cand D. Moving from Ato B, the consumer is willing
to give up a substantial amount of Yto get a small amount of
X. (Remember that total utility is constant along an indiffer-
ence curve; the consumer is therefore indifferent between A
and B.) Moving from Cand D, however, the consumer is will-
ing to give up only a small amount of Yto get more X.
This changing trade-off makes complete sense when you
remember the law of diminishing marginal utility. Notice thatbetween Aand B, a great deal of Yis consumed and the marginal
utility derived from a unit of Yis likely to be small. At the same
time, though, only a little of Xis being consumed; so the marginal
utility derived from consuming a unit of Xis likely to be high.
Suppose, for example, that Xis pizza and Yis soda. Near A
and B, a thirsty, hungry football player who has 10 sodas in
front of him but only one slice of pizza will trade several sodas
CHAPTER 6 Household Behavior and Consumer Choice 143
for another slice. Down around Cand D, however, he has
20 slices of pizza and a single soda. Now he will trade severalslices of pizza to get an additional soda.
We can show how the trade-off changes more formally by
deriving an expression for the slope of an indifference curve.Let us look at the arc (that is, the section of the curve) betweenAand B. We know that in moving from Ato B, total utility
remains constant. That means that the utility lost as a result ofconsuming less Ymust be matched by the utility gained from
consuming more X. We can approximate the loss of utility by
multiplying the marginal utility of Y(MU
Y) by the number of
units by which consumption of Yis curtailed ( /H9004Y). Similarly,
we can approximate the utility gained from consuming more X
by multiplying the marginal utility of X(MUX) by the number
of additional units of Xconsumed ( /H9004X). Remember: Because
the consumer is indifferent between points Aand B, total util-
ity is the same at both points. Thus, these two must be equal inmagnitude—that is, the gain in utility from consuming more X
must equal the loss in utility from consuming less Y. Because
/H9004Yis a negative number (because consumption of Ydecreases
from Ato B), it follows that
When we divide both sides by MU
Yand by /H9004X, we obtain
Recall that the slope of any line is calculated by dividing the
change in Y—that is, /H9004Y—by the change in X—that is, /H9004X.
Thus, the slope of an indifference curve is the ratio of the mar-ginal utility of Xto the marginal utility of Y, and it is negative.
Now let us return to our pizza ( X) and soda ( Y) example.
As we move down from the A:Barea to the C:D area, our foot-
ball player is consuming less soda and more pizza. The marginalutility of pizza ( MU
X) is falling, and the marginal utility of soda
(MUY) is rising. That means that MUX/MUY(the marginal rate
of substitution) is falling and the absolute value of the slope ofthe indifference curve is declining. Indeed, it does get flatter.
Consumer Choice
As you recall, demand depends on income, the prices of goodsand services, and preferences or tastes. We are now ready to seehow preferences as embodied in indifference curves interactwith budget constraints to determine how the final quantitiesofXand Ywill be chosen.
In Figure 6A.3, a set of indifference curves is superim-
posed on a consumer’s budget constraint. Recall that the bud-get constraint separates those combinations of Xand Ythat are
available from those that are not. The constraint simply showsthose combinations that can be purchased with an income of I
at prices P
Xand PY. The budget constraint crosses the X-axis at
I/PX, or the number of units of Xthat can be purchased with I
if nothing is spent on Y. Similarly, the budget constraint
crosses the Y-axis at I/PY, or the number of units of Ythat can
be purchased with an income of Iif nothing is spent on X.T h e¢Y
¢X=- ¢MU X
MU Y≤MU X#¢X=- (MU Y#¢Y)Slope: =
Units of XUnits of YA
i1i2i3PX
PY/H11002
B
C
I
PXI
PY
X*Y*
/L50304FIGURE 6A.3 Consumer Utility-Maximizing
Equilibrium
Consumers will choose the combination of Xand Ythat maximizes
total utility. Graphically, the consumer will move along the budgetconstraint until the highest possible indifference curve is reached. Atthat point, the budget constraint and the indifference curve aretangent. This point of tangency occurs at X* and Y* (point B).
shaded area is the consumer’s opportunity set. The slope of a
budget constraint is – PX/PY.
Consumers will choose from among available combina-
tions of Xand Ythe one that maximizes utility. In graphic terms,
a consumer will move along the budget constraint until he orshe is on the highest possible indifference curve. Utility rises bymoving from points such as Aor C(which lie on i
1) toward B
(which lies on i2). Any movement away from point Bmoves the
consumer to a lower indifference curve—a lower level of utility.In this case, utility is maximized when our consumer buys X*
units of Xand Y*units of Y. At point B, the budget constraint is
just tangent to—that is, just touches—indifference curve i
2.A s
long as indifference curves are convex to the origin, utilitymaximization will take place at that point at which the indif-ference curve is just tangent to the budget constraint.
The tangency condition has important implications.
Where two curves are tangent, they have the same slope, whichimplies that the slope of the indifference curve is equal to theslope of the budget constraint at the point of tangency:
By multiplying both sides of this equation by MU
Yand divid-
ing both sides by PX, we can rewrite this utility-maximizing rule as
This is the same rule derived in our earlier discussion without
using indifference curves. We can describe this rule intuitively byMU X
PX=MU Y
PYslope of indifference curve =slope of budget constraint-MU X
MU Y =-PX
PYec
144 PART II The Market System: Choices Made by Households and Firms
A
BCUnits of Y
Units of X Units of XPrice per unit of X
Demandb. Demand curve
i1i2i3
I 00 X3I
PY
P 1
X
P 2
X
P 3
X
P 1
XI
P 3
XI
P 2
XX2 X1 X3 X2 X1a. Indifference curves and budget constraints
/L50304FIGURE 6A.4 Deriving a Demand Curve from Indifference Curves and
Budget Constraint
Indifference curves are labeled i1, i2, and i3; budget constraints are shown by the three diagonal lines from
to and Lowering the price of Xfrom to and then to swivels the budget con-
straint to the right. At each price, there is a different utility-maximizing combination of Xand Y. Utility is
maximized at point Aon i1, point Bon i2, and point Con i3. Plotting the three prices against the quantities of
Xchosen results in a standard downward-sloping demand curve.P3
X P2
X P1XI>P3
X. I>P1
X , I>P2
X, I>PY saying that consumers maximize their total utility by equating
the marginal utility per dollar spent on Xwith the marginal util-
ity per dollar spent on Y. If this rule did not hold, utility could be
increased by shifting money from one good to the other.
Deriving a Demand Curve from
Indifference Curves and Budget Constraints
We now turn to the task of deriving a simple demand curve
from indifference curves and budget constraints. A demandcurve shows the quantity of a single good, Xin this case, that a
consumer will demand at various prices. T o derive the demandcurve, we need to confront our consumer with several alterna-tive prices for Xwhile keeping other prices, income, and pref-
erences constant.
Figure 6A.4 shows the derivation. We begin with price .
At that price, the utility-maximizing point is A, where theP
1
Xconsumer demands X1units of X. Therefore, in the right-hand
diagram, we plot against X1. This is the first point on our
demand curve.
Now we lower the price of Xto Lowering the price
expands the opportunity set, and the budget constraintswivels to the right. Because the price of Xhas fallen, when
our consumer spends all of the income on X, he or she can
buy more of it. Our consumer is also better off because ofbeing able to move to a higher indifference curve. The newutility-maximizing point is B, where the consumer demands
X
2units of X. Because the consumer demands X2units of Xat
a price of we plot against X2in the right-hand diagram.
A second price cut to moves our consumer to point C, with
a demand of X3units of X, and so on. Thus, we see how the
demand curve can be derived from a consumer’s preferencemap and budget constraint.P
3
XP2XP2X
,P2
X.P1
X
APPENDIX SUMMARY
1.An indifference curve is a set of points, each point represent-
ing a combination of goods Xand Y, all of which yield the
same total utility. A particular consumer’s set of indifferencecurves is called a preference map .
2.The slope of an indifference curve is the ratio of the marginal
utility of Xto the marginal utility of Y, and it is negative.3.As long as indifference curves are convex to the origin, utility
maximization will take place at that point at which the indif-ference curve is just tangent to—that is, just touches—thebudget constraint. The utility-maximizing rule can also bewritten as MU
X/PX= MUY/PY.
CHAPTER 6 Household Behavior and Consumer Choice 145
Y Y
00 XX
0 100 200 300 30 140 180Units of Y
Units of X/L50304FIGURE ?1
/L50304FIGURE 2APPENDIX REVIEW TERMS AND CONCEPTS
Indifference curve A set of points, each
point representing a combination of goods X
and Y, all of which yield the same total utility.
p. 141Marginal rate of substitution MUX/MUY;
the ratio at which a household is willing tosubstitute good
Yfor good X.p. 141Preference map A consumer’s set of
indifference curves. p. 142
APPENDIX PROBLEMS
1.Which of the four assumptions made at the beginning of
the Appendix are violated by the indifference curves inFigure 1? Explain.
2..Assume that a household receives a weekly income of $100. If
Figure 2 represents the choices of that household as the price of
Xchanges, plot three points on the household demand curve.
3.If Ann’s marginal rate of substitution of Xfor Yis 5—that is,
MU
X/MUY= 5—the price of Xis $9, and the price of Yis $2,
she is spending too much of her income on Y. Do you agree or
disagree? Explain your answer using a graph.*4.Assume that Jim is a rational consumer who consumes only two
goods, apples ( A) and nuts ( N). Assume that his marginal rate of
substitution of apples for nuts is given by the following formula:
MRS = MUN/MUA= A/N
That is, Jim’s MRS is equal to the ratio of the number of apples
consumed to the number of nuts consumed.a.Assume that Jim’s income is $100, the price of nuts is $5, and
the price of apples is $10. What quantities of apples and nutswill he consume?
b.Find two additional points on his demand curve for nuts
(P
N= $10 and PN= $2).
c.Sketch one of the equilibrium points on an indifference
curve graph.
*Note: Problems marked with an asterisk are more challenging.
146 PART II The Market System: Choices Made by Households and Firms
SOFT-SHELL CRABS CHOCOLATE TRUFFLES
14 4
8 6
6 8
4 12
X1i1i2 i3Units of Y
Units of XX2 I
P1xX3I
P2xI
P3xI
PY
0AB
C5.Y olanda has $48 to spend on soft-shell crabs and chocolate truf-
fles, and the data in the following table represent an indifference
curve for these two products. If soft-shell crabs are $3 each andchocolate truffles are $4 each, draw a graph showing Y olanda’sindifference curve and her budget constraint, putting soft-shellcrabs on the vertical axis and chocolate truffles on the horizon-
tal axis. What combination of soft-shell crabs and chocolate
truffles will Y olanda purchase? Will this combination maximizeY olanda’s total utility? Explain.6.The following graph shows three indifference curves and the
accompanying budget constraints for products Xand Y.T h e
graph represents the price of product Xfalling from P
1xto P2x
and then to P3x. Explain how a demand curve for product Xcan
be derived from this graph and draw a graph showing the
demand curve for product X.
147CHAPTER OUTLINE7
The Behavior of
Profit-MaximizingFirms
p. 148
Profits and Economic Costs
Short-Run versus Long-
Run Decisions
The Bases of Decisions:
Market Price of Outputs,Available Technology, andInput Prices
The Production
Process p. 152
Production Functions:
Total Product, MarginalProduct, and AverageProduct
Production Functions with
Two Variable Factors of
Production
Choice of
Technology p. 156
Looking Ahead: Costand Supply
p. 158
Appendix: Isoquantsand Isocosts
p. 162The Production
Process: The Behavior
of Profit-Maximizing
Firms
In Chapter 6, we took a brief look
at the household decisions that liebehind supply and demand curves.We spent some time discussinghousehold choices: how much towork and how to choose amongthe wide range of goods and ser-vices available within the con-straints of prices and income. Wealso identified some of the influ-ences on household demand inoutput markets, as well as some ofthe influences on household sup-ply behavior in input markets.
We now turn to the other side of the system and examine the behavior of firms. Firms pur-
chase inputs to produce and sell outputs that range from computers to string quartet perfor-mances. In other words, they demand factors of production in input markets and supply goods
and services in output markets. In this chapter, we look inside the firm at the production processthat transforms inputs into outputs. Although Chapters 7 through 12 describe the behavior ofperfectly competitive firms, much of what we say in these chapters also applies to firms that arenot perfectly competitive. For example, when we turn to monopoly in Chapter 13, we will bedescribing firms that are similar to competitive firms in many ways. All firms, whether competi-tive or not, demand inputs, engage in production, and produce outputs. All firms have an incen-tive to maximize profits and thus to minimize costs.
Central to our analysis is production , the process by which inputs are combined, trans-
formed, and turned into outputs. Firms vary in size and internal organization, but they all takeinputs and transform them into goods and services for which there is some demand. For exam-ple, an independent accountant combines labor, paper, telephone and e-mail service, time, learn-ing, and a Web site to provide help to confused taxpayers. An automobile plant uses steel, labor,plastic, electricity, machines, and countless other inputs to produce cars. If we want to under-stand a firm’s costs, we first need to understand how it efficiently combines inputs to producegoods and services. Before we begin our discussion of the production process, however, we needto clarify some of the assumptions on which our analysis is based.
Although our discussions in the next several chapters focus on profit-making business
firms, it is important to understand that production and productive activity are not confined toprivate business firms. Households also engage in transforming factors of production (labor,capital, energy, natural resources, and so on) into useful things. When you work in your garden,you are combining land, labor, fertilizer, seeds, and tools (capital) into the vegetables you eatand the flowers you enjoy. The government also combines land, labor, and capital to producepublic services for which demand exists: national defense, homeland security, police and fireprotection, and education, to name a few.
production The process by
which inputs are combined,
transformed, and turned into
outputs.
148 PART II The Market System: Choices Made by Households and Firms
1.
How much
output to
supply2.
Which production
technology
to use3.
How much of
each input to
demand/L50298FIGURE 7.1 The Three
Decisions That All FirmsMust Make
The first and last choices are linked by the second choice. Once a firm has decided how much
to produce, the choice of a production method determines the firm’s input requirements. If asweater company decides to produce 5,000 sweaters this month, it knows how many productionworkers it will need, how much electricity it will use, how much raw yarn to purchase, and howmany sewing machines to run.
Similarly, given a technique of production, any set of input quantities determines the
amount of output that can be produced. Certainly, the number of machines and workersemployed in a sweater mill determines how many sweaters can be produced.
Changing the technology of production will change the relationship between input and out-
put quantities. An apple orchard that uses expensive equipment to raise pickers up into the treeswill harvest more fruit with fewer workers in a given period of time than an orchard in whichpickers use simple ladders. It is also possible that two different technologies can produce the samequantity of output. For example, a fully computerized textile mill with only a few workers run-ning the machines may produce the same number of sweaters as a mill with no sophisticatedmachines but many workers. A profit-maximizing firm chooses the technology that minimizes itscosts for a given level of output.
In this chapter, all firms in a given industry produce the same exact product and we are con-
cerned solely with production. In later chapters, these three basic decisions will be expanded toinclude the setting of prices and the determination of product quality.
Profits and Economic Costs
We assume that firms are in business to make a profit and that a firm’s behavior is guided by the goalof maximizing profits. What is profit? Profit is the difference between total revenue and total cost:
profit = total revenue -total cost
Total revenue is the amount received from the sale of the product; it is equal to the number of
units sold ( q) times the price received per unit ( P).Total cost is less straightforward to define. We
define total cost here to inclu de (1) out-of-pocket costs and (2) opportunity cost of all inputs or
factors of production. Out-of-pocket costs are sometimes referred to as explicit costs or
accounting costs . These refer to costs as an accountant w ould calculate them. Economic costs
include the opportunity cost of every input. These opportunity costs are often referred to asimplicit costs . The term profit will from here on refer to economic profit . So whenever we say profit
= total revenue -total cost, what we really mean is
economic profit = total revenue -total economic costPrivate business firms are set apart from other producers, such as households and govern-
ment, by their purpose. A firm exists when a person or a group of people decides to produce a
good or service to meet a perceived demand. Firms engage in production—that is, they trans-form inputs into outputs—because they can sell their products for more than it costs to pro-duce them.
The Behavior of Profit-Maximizing Firms
All firms must make several basic decisions to achieve what we assume to be their primary objective—maximum profits.
As Figure 7.1 states, the three decisions that all firms must make include:
1.How much output to supply (quantity of product)
2.How to produce that output (which production technique/technology to use)
3.How much of each input to demandfirm An organization that
comes into being when a
person or a group of people
decides to produce a good orservice to meet a perceived
demand.
profit (economic profit)
The difference between totalrevenue and total cost.
total revenue The amount
received from the sale of the
product ( q/H11003P).
total cost (total economic
cost) The total of (1) out-of-
pocket costs and (2)opportunity cost of all factorsof production.
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 149
The reason we take opportunity costs into account is that we are interested in analyzing the
behavior of firms from the standpoint of a potential investor or a potential new competitor. If Iam thinking about buying a firm or shares in a firm or entering an industry as a new firm, I needto consider the fullcosts of production. For example, if a family business employs three family
members but pays them no wage, there is still a cost: the opportunity cost of their labor. In eval-uating the business from the outside, these costs must be added if we want to figure out whetherthe business is successful.
The most important opportunity cost that is included in economic cost is the opportunity
cost of capital. The way we treat the opportunity cost of capital is to add a normal rate of return to
capital as part of economic cost.
Normal Rate of Return When someone decides to start a firm, that person must com-
mit resources. T o operate a manufacturing firm, you need a plant and some equipment. T ostart a restaurant, you need to buy grills, ovens, tables, chairs, and so on. In other words, youmust invest in capital. T o start an e-business, you need a host site, some computer equipment,some software, and a Web-site design. Such investment requires resources that stay tied up inthe firm as long as it operates. Even firms that have been around a long time must continue toinvest. Plant and equipment wear out and must be replaced. Firms that decide to expand mustput new capital in place. This is as true of proprietorships, where the resources come directlyfrom the proprietor, as it is of corporations, where the resources needed to make investmentscome from shareholders.
Whenever resources are used to invest in a business, there is an opportunity cost. Instead of
opening a candy store, you could put your funds into an alternative use such as a certificate ofdeposit or a government bond, both of which earn interest. Instead of using its retained earningsto build a new plant, a firm could earn interest on those funds or pay them out to shareholders.
Rate of return is the annual flow of net income generated by an investment expressed as a
percentage of the total investment. For example, if someone makes a $100,000 investment in cap-ital to start a small restaurant and the restaurant produces a flow of profit of $15,000 every year,we say the project has a “rate of return” of 15 percent. Sometimes we refer to the rate of return astheyield of the investment.
Anormal rate of return is the rate that is just sufficient to keep owners and investors satis-
fied. If the rate of return were to fall below normal, it would be difficult or impossible for managersto raise resources needed to purchase new capital. Owners of the firm would be receiving a rate ofreturn that was lower than what they could receive elsewhere in the economy, and they would haveno incentive to invest in the firm.
If the firm has fairly steady revenues and the future looks secure, the normal rate of
return should be very close to the interest rate on risk-free government bonds. A firm cer-tainly will not keep investors interested in it if it does not pay them a rate of return at least ashigh as they can get from a risk-free government or corporate bond. If a firm is rock solidand the economy is steady, it may not have to pay a much higher rate. However, if a firm is ina very speculative industry and the future of the economy is shaky, it may have to pay sub-stantially more to keep its shareholders happy. In exchange for a risk that the business may fal-ter or even fail, the shareholders will expect a higher return.
A normal rate of return is considered a part of the total cost of a business. Adding a normal
rate of return to total cost has an important implication: When a firm earns a normal rate ofreturn, it is earning a zero profit as we have defined profit. If the level of profit is positive, the firmis earning an above-normal rate of return on capital.
A simple example will illustrate the concepts of a normal rate of return being part of total
cost. Suppose that Sue and Ann decide to start a small business selling turquoise belts in theDenver airport. T o get into the business, they need to invest in a fancy pushcart. The price of thepushcart is $20,000 with all the displays and attachments included. Suppose that Sue and Annestimate that they will sell 3,000 belts each year for $10 each. Further assume that each belt costs$5 from the supplier. Finally, the cart must be staffed by one clerk, who works for an annual wageof $14,000. Is this business going to make a profit?
T o answer this question, we must determine total revenue and total cost. First, annual rev-
enue is $30,000 (3,000 belts /H11003$10). T otal cost includes the cost of the belts—$15,000 (3,000 belts
/H11003$5)—plus the labor cost of $14,000, for a total of $29,000. Thus, on the basis of the annual rev-
enue and cost flows, the firm seems to be making a profit of $1,000 ($30,000 -$29,000).normal rate of return A rate
of return on capital that is just
sufficient to keep owners andinvestors satisfied. Forrelatively risk-free firms, it
should be nearly the same as
the interest rate on risk-freegovernment bonds.
150 PART II The Market System: Choices Made by Households and Firms
What about the $20,000 initial investment in the pushcart? This investment is nota direct
part of the cost of Sue and Ann’s firm. If we assume that the cart maintains its value over time, the
only thing that Sue and Ann are giving up is the interest they might have earned had they not tied uptheir funds in the pushcart . That is, the only real cost is the opportunity cost of the investment,
which is the forgone interest on the $20,000.
Now suppose that Sue and Ann want a minimum return equal to 10 percent—which is, say,
the rate of interest that they could have gotten by purchasing corporate bonds. This implies a nor-mal return of 10 percent, or $2,000 annually (= $20,000 /H110030.10) on the $20,000 investment. As we
determined earlier, Sue and Ann will earn only $1,000 annually. This is only a 5 percent return ontheir investment. Thus, they are really earning a below-normal return. Recall that the opportunitycost of capital must be added to total cost in calculating profit. Thus, the total cost in this case is$31,000 ($29,000 + $2,000 in forgone interest on the investment). The level of profit is negative:$30,000 minus $31,000 equals –$1,000. These calculations are summarized in Table 7.1. Becausethe level of profit is negative, Sue and Ann are actually suffering a loss on their belt business.
When a firm earns a positive level of profit, it is earning more than is sufficient to retain the
interest of investors. In fact, positive profits are likely to attract new firms into an industry andcause existing firms to expand.
When a firm suffers a negative level of profit—that is, when it incurs a loss—it is earning at a
rate below that required to keep investors happy. Such a loss may or may not be a loss as anaccountant would measure it. Even if a firm is earning a rate of return of 10 percent, it is earninga below-normal rate of return, or a loss, if a normal return for its industry is 15 percent. Lossesmay cause some firms to exit the industry; others will contract in size. Certainly, new investmentwill not flow into such an industry.
Short-Run versus Long-Run Decisions
The decisions made by a firm—how much to produce, how to produce it, and what inputs todemand—all take time into account. If a firm decides that it wants to double or triple its output,it may need time to arrange financing, hire architects and contractors, and build a new plant.Planning for a major expansion can take years. In the meantime, the firm must decide how muchto produce within the constraint of its existing plant. If a firm decides to get out of a particularbusiness, it may take time to arrange an orderly exit. There may be contract obligations to fulfill,equipment to sell, and so on. Once again, the firm must decide what to do in the meantime.
A firm’s immediate response to a change in the economic environment may differ from its
response over time. Consider, for example, a small restaurant with 20 tables that becomes verypopular. The immediate problem for the owners is getting the most profit within the constraintof the existing restaurant. The owner might consider adding a few tables or speeding up serviceto squeeze in a few more customers. Some popular restaurants do not take reservations, forcingpeople to wait at the bar. This practice increases drink revenues and keeps tables full at all times.At the same time, the owner may be thinking of expanding the current facility, moving to a largerfacility, or opening a second restaurant. In the future, the owner might buy the store next doorand double the capacity. Such decisions might require negotiating a lease, buying new equip-ment, and hiring more staff. It takes time to make and implement these decisions.aThere is a loss of $1,000. TABLE 7.1 Calculating Total Revenue, Total Cost, and Profit
Initial Investment:
Market Interest Rate Available:$20,000
0.10, or 10%
Total revenue (3,000 belts /H11003$10 each) $30,000
Costs
Belts from supplier $15,000
Labor cost 14,000
Normal return/opportunity cost of capital ($20,000 /H110030.10) 2,000
Total Cost $31,000
Profit = total revenue -total cost -$1,000a
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 151
Because the character of immediate response differs from long-run adjustment, it is useful to
define two time periods: the short run and the long run. Two assumptions define the short run :
(1) a fixed scale (or a fixed factor of production) and (2) no entry into or exit from the industry.
First, the short run is defined as that period during which existing firms have some fixed factor of
production —that is, during which time some factor locks them into their current scale of opera-
tions. Second, new firms cannot enter and existing firms cannot exit an industry in the short run.Firms may curtail operations, but they are still locked into some costs even though they may be inthe process of going out of business.
Which factor or factors of production are fixed in the short run differs from industry to
industry. For a manufacturing firm, the size of the physical plant is often the greatest limitation.A factory is built with a given production rate in mind. Although that rate can be increased, out-put cannot increase beyond a certain limit in the short run. For a private physician, the limit maybe the capacity to see patients; the day has only so many hours. In the long run, the doctor mayinvite others to join the practice and expand; but for now, in the short run, this sole physician is
the firm, with a capacity that is the firm’s only capacity. For a farmer, the fixed factor may beland. The capacity of a small farm is limited by the number of acres being cultivated.
In the long run , there are no fixed factors of production. Firms can plan for any output level
they find desirable. They can double or triple output, for example. In addition, new firms can start
up operations (enter the industry) and existing firms can go out of business (exit the industry).
No hard-and-fast rule specifies how long the short run is. The point is that firms make two
basic kinds of decisions: those that govern the day-to-day operations of the firm and those thatinvolve longer-term strategic planning. Sometimes major decisions can be implemented inweeks. Often, however, the process takes years. In many large firms, different people often makethe short- and long-run decisions. A production manager might well be charged with trying todo the best she can with the plant and equipment that she has, while her boss, the division head,figures out whether expansion of the plant is a good idea. In a single proprietorship, one personmay wear both hats, thinking simultaneously about how to make the most out of the presentwhile taking steps to improve the future of the business.
The Bases of Decisions: Market Price of Outputs, AvailableTechnology, and Input Prices
As we said earlier, a firm’s three fundamental decisions are made with the objective of maximiz-ing profits. Because profits equal total revenues minus total costs, each firm needs to know howmuch it costs to produce its product and how much its product can be sold for.
T o know how much it costs to produce a good or service, a firm needs to know something
about the production techniques that are available and about the prices of the inputsrequired. T o estimate how much it will cost to operate a gas station, for instance, a firm needsto know equipment needs, number of workers, kind of building, and so on. The firm alsoneeds to know the going wage rates for mechanics and unskilled laborers, the cost of gaspumps, interest rates, the rents per square foot of land on high-traffic corners, and the whole-sale price of gasoline. Of course, the firm also needs to know how much it can sell gasolineand repair services for.
In the language of economics, a firm needs to know three things:
1.The market price of output
2.The techniques of production that are available
3.The prices of inputs
Output price determines potential revenues. The techniques available tell me how much of
each input I need, and input prices tell me how much they will cost. T ogether the availableproduction techniques and the prices of inputs determine costs.
The rest of this chapter and the next chapter focus on costs of production. We begin at the heart
of the firm, with the production process. Faced with a set of input prices, firms must decide on thebest, or optimal, method of production (Figure 7.2). The optimal method of production is the one
that minimizes cost. With cost determined and the market price of output known, a firm will make afinal judgment about the quantity of product to produce and the quantity of each input to demand.short run The period of time
for which two conditions hold:The firm is operating under afixed scale (fixed factor) of
production, and firms can
neither enter nor exit anindustry.
long run That period of time
for which there are no fixedfactors of production: Firms
can increase or decrease the
scale of operation, and newfirms can enter and existing
firms can exit the industry.
optimal method of
production The production
method that minimizes cost.
152 PART II The Market System: Choices Made by Households and Firms
Production techniques Price of output Input prices
Determine total
cost and optimal
method of productionDetermines
total revenue
Total revenue
– Total cost with optimal method
= Total profit/L50298FIGURE 7.2
Determining the
Optimal Method ofProduction
The Production Process
Production is the process through which inputs are combined and transformed into outputs.
Production technology relates inputs to outputs. Specific quantities of inputs are needed to pro-
duce any given service or good. A loaf of bread requires certain amounts of water, flour, and yeast;some kneading and patting; and an oven and gas or electricity. A trip from downtown New Y orkto Newark, New Jersey, can be produced with a taxicab, 45 minutes of a driver’s labor, some gaso-line, and so on.
Most outputs can be produced by a number of different techniques. Y ou can tear down an
old building and clear a lot to create a park in several ways, for example. Five hundred men andwomen could descend on the park with sledgehammers and carry the pieces away by hand; thiswould be a labor-intensive technology . The same park could be produced by two people with a
wrecking crane, a steam shovel, a backhoe, and a dump truck; this would be a capital-intensive
technology . Similarly, different inputs can be combined to transport people from Oakland to San
Francisco. The Bay Area Rapid Transit carries thousands of people simultaneously under SanFrancisco Bay and uses a massive amount of capital relative to labor. Cab rides to San Franciscorequire more labor relative to capital; a driver is needed for every few passengers.
In choosing the most appropriate technology, firms choose the one that minimizes the cost
of production. For a firm in an economy with a plentiful supply of inexpensive labor but notmuch capital, the optimal method of production will involve labor-intensive techniques. Forexample, assembly of items such as running shoes is done most efficiently by hand. That is whyNike produces virtually all its shoes in developing countries where labor costs are very low. Incontrast, firms in an economy with high wages and high labor costs have an incentive to substi-tute away from labor and to use more capital-intensive, or labor-saving, techniques. Suburbanoffice parks use more land and have more open space in part because land in the suburbs is moreplentiful and less expensive than land in the middle of a big city.
Production Functions: Total Product, Marginal Product,
and Average Product
The relationship between inputs and outputs—that is, the production technology—expressed
numerically or mathematically is called a production function (ortotal product function ). A
production function shows units of total product as a function of units of inputs.
Imagine, for example, a small sandwich shop. All the sandwiches made in the shop are
grilled, and the shop owns only one grill, which can accommodate only two workers comfortably.As columns 1 and 2 of the production function in Table 7.2 show, one person working alone canproduce only 10 sandwiches per hour in addition to answering the phone, waiting on customers,keeping the tables clean, and so on. The second worker can stay at the grill full-time and notworry about anything except making sandwiches. Because the two workers together can produce25 sandwiches, the second worker can produce 25 -10 = 15 sandwiches per hour. A third person
trying to use the grill produces crowding, but with careful use of space, more sandwiches can beproduction technology
The quantitative relationship
between inputs and outputs.
labor-intensive
technology Technology that
relies heavily on human labor
instead of capital.
capital-intensive
technology Technology that
relies heavily on capital instead
of human labor.
production function ortotal
product function A numerical
or mathematical expression of
a relationship between inputsand outputs. It shows units of
total product as a function of
units of inputs.
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 153
produced. The third worker adds 10 sandwiches per hour. Note that the added output from hir-
ing a third worker is less because of the capital constraint, notbecause the third worker is some-
how less efficient or hardworking. We assume that all workers are equally capable.
The fourth and fifth workers can work at the grill only while the first three are putting the
pickles, onions, and wrapping on the sandwiches they have made. Then the first three must waitto get back to the grill. Worker four adds five sandwiches per hour to the total, and worker fiveadds just two. Adding a sixth worker adds no output at all: The current maximum capacity of theshop is 42 sandwiches per hour.
Figure 7.3(a) graphs the total product data from Table 7.2. As you look at Table 7.2 and think
about marginal product, you should begin to see how important the nature of the productionfunction is to a firm. We see that the sandwich firm that hires a fourth worker will be expandingits sandwich production by five. Is it worth it? That will in turn depend on how much the workercosts and for how much the shop can sell the sandwich. As we proceed to analyze the firm’s deci-sion in the next few chapters, we will explore this further.
Marginal Product and the Law of Diminishing Returns Marginal product is
the additional output that can be produced by hiring one more unit of a specific input, holdingall other inputs constant. As column 3 of Table 7.2 shows, the marginal product of the first unit oflabor in the sandwich shop is 10 sandwiches; the marginal product of the second is 15; the third,10; and so on. The marginal product of the sixth worker is zero. Figure 7.3(b) graphs the mar-ginal product of labor curve from the data in Table 7.2.
01 2 3 4 5 610
Number of employees25354042
01 2 3 4 5 6
Number of employees251015Marginal productTotal producta. Production function
(Total product) b. Marginal product of labor
/L50304FIGURE 7.3 Production Function for Sandwiches
Aproduction function is a numerical representation of the relationship between inputs and outputs. In
Figure 7.3(a), total product (sandwiches) is graphed as a function of labor inputs. The marginal product of
labor is the additional output that one additional unit of labor produces. Figure 7.3(b) shows that the
marginal product of the second unit of labor at the sandwich shop is 15 units of output; the marginalproduct of the fourth unit of labor is 5 units of output.TABLE 7.2 Production Function
(1)
Labor Units
(Employees)(2)
Total Product
(Sandwiches per Hour)(3)
Marginal Product
of Labor(4)
Average Product of Labor
(Total Product ÷ Labor Units)
0 0 — —
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4
6 42 0 7.0
marginal product The
additional output that can beproduced by adding one moreunit of a specific input, ceteris
paribus .
154 PART II The Market System: Choices Made by Households and Firms
Thelaw of diminishing returns states that after a certain point, when additional units of a variable
input are added to fixed inputs (in this case, the building and grill), the marginal product of the variable
input (in this case, labor) declines . The British economist David Ricardo first formulated the law of
diminishing returns on the basis of his observations of agriculture in nineteenth-century England.Within a given area of land, he noted, successive “doses” of labor and capital yielded smaller andsmaller increases in crop output. The law of diminishing returns is true in agriculture because only somuch more can be produced by farming the same land more intensely. In manufacturing, diminish-ing returns set in when a firm begins to strain the capacity of its existing plant.
At our sandwich shop, diminishing returns set in when the third worker is added. The mar-
ginal product of the second worker is actually higher than the first [Figure 7.3(b)]. The firstworker takes care of the phone and the tables, thus freeing the second worker to concentrateexclusively on sandwich making. From that point on, the grill gets crowded. It is important tonote here that diminishing returns are setting in, not because the third worker is worse thanworkers one or two (we assume they are identical), but because as we add staff, each has a smalleramount of capital (here a grill) to work with.
Diminishing returns, or diminishing marginal product , begin to show up when more and
more units of a variable input are added to a fixed input, such as the scale of the plant. Recall thatwe defined the short run as that period in which some fixed factor of production constrains thefirm. It then follows that diminishing returns always apply in the short run and that in the shortrun, every firm will face diminishing returns. This means that every firm finds it progressivelymore difficult to increase its output as it approaches capacity production.
Marginal Product versus Average Product Average product is the average
amount produced by each unit of a variable factor of production. At our sandwich shop withone grill, that variable factor is labor. In Table 7.2, you saw that the first two workers togetherproduce 25 sandwiches per hour. Their average product is therefore 12.5 (25 ÷ 2). The thirdworker adds only 10 sandwiches per hour to the total. These 10 sandwiches are the marginal
product of labor. The average product of the first three units of labor, however, is 11.7 (the aver-
age of 10, 15, and 10). Stated in equation form, the average product of labor is the total product
divided by total units of labor:
Average product “follows” marginal product, but it does not change as quickly. If marginal
product is above average product, the average rises; if marginal product is below average product,the average falls. Suppose, for example, that you have had six exams and that your average is 86. Ifyou score 75 on the next exam, your average score will fall, but not all the way to 75. In fact, it willfall only to 84.4. If you score a 95 instead, your average will rise to 87.3. As columns 3 and 4 ofTable 7.2 show, marginal product at the sandwich shop declines continuously after the thirdworker is hired. Average product also decreases, but more slowly.
Figure 7.4 shows a typical production function and the marginal and average product curves
derived from it. The marginal product curve is a graph of the slope of the total product curve—that is, of the production function. Average product and marginal product start out equal, as theydo in Table 7.2. As marginal product climbs, the graph of average product follows it, but moreslowly, up to L
1(point A).
Notice that marginal product starts out increasing. (It did so in the sandwich shop as well.)
Most production processes are designed to be run well by more than one worker. Take an assem-bly line, for example. T o work efficiently, an assembly line needs a worker at every station; it’s acooperative process. The marginal product of the first workers is low or zero. As workers areadded, the process starts to run and marginal product rises.
At point A(L
1units of labor), marginal product begins to fall. Because every plant has a finite
capacity, efforts to increase production will always run into the limits of that capacity. At point B
(L2units of labor), marginal product has fallen to equal the average product, which has been
increasing. Between point Band point C(between L2andL3units of labor), marginal product falls
below average product and average product begins to follow it down . Average product is at its max-
imum at point B, where it is equal to marginal product. At L3, more labor yields no more output
and marginal product is zero—the assembly line has no more positions, the grill is jammed.average product of labor =total product
total units of laboraverage product The average
amount produced by each unitof a variable factor of
production.law of diminishing
returns When additional
units of a variable input areadded to fixed inputs, after acertain point, the marginal
product of the variable input
declines.
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 155
Production Functions with Two Variable Factors of
Production
So far, we have considered production functions with only one variable factor of production.
However, inputs work together in production. In general, additional capital increases the produc-tivity of labor. Because capital—buildings, machines, and so on—is of no use without people tooperate it, we say that capital and labor are complementary inputs .
A simple example will clarify this point. Consider again the sandwich shop. If the demand
for sandwiches began to exceed the capacity of the shop to produce them, the shop’s ownermight decide to expand capacity. This would mean purchasing more capital in the form of anew grill.
A second grill would essentially double the shop’s productive capacity. The new higher
capacity would mean that the sandwich shop would not run into diminishing returns as quickly.With only one grill, the third and fourth workers are less productive because the single grill getscrowded. With two grills, however, the third and fourth workers could produce 15 sandwiches perhour using the second grill. In essence, the added capital raises the productivity of labor—that is,
the amount of output produced per worker per hour.
Just as the new grill enhances the productivity of workers in the sandwich shop, new busi-
nesses and the capital they put in place raise the productivity of workers in countries such asMalaysia, India, and Kenya.
This simple relationship lies at the heart of worries about productivity at the national and
international levels. Building new, modern plants and equipment enhances a nation’s productiv-ity. In the last decade, China has accumulated capital (that is, built plants and equipment) at avery high rate. The result is growth in the average quantity of output per worker in China.A
B
C
L3 L2 L1L3 L2 L1
00
Average product
Marginal product
Units of labor, LOutput OutputTotal product/L50296FIGURE 7.4 Total
Average and MarginalProduct
Marginal and average product
curves can be derived from total
product curves. Average
product is at its maximum atthe point of intersection withmarginal product.
Choice of Technology
As our sandwich shop example shows, inputs (factors of production) are complementary. Capital
enhances the productivity of labor. Workers in the sandwich shop are more productive when theyare not crowded at a single grill. Similarly, labor enhances the productivity of capital. When moreworkers are hired at a plant that is operating at 50 percent of capacity, previously idle machinessuddenly become productive.
However, inputs can also be substituted for one another. If labor becomes expensive, firms
can adopt labor-saving technologies; that is, they can substitute capital for labor. Assembly linescan be automated by replacing human beings with machines, and capital can be substituted forland when land is scarce. If capital becomes relatively expensive, firms can substitute labor forcapital. In short, most goods and services can be produced in a number of ways through the useof alternative technologies. One of the key decisions that all firms must make is which technol-ogy to use.
Consider the choices available to the diaper manufacturer in Table 7.3. Five different tech-
niques of producing 100 diapers are available. T echnology Ais the most labor-intensive, requir-
ing 10 hours of labor and 2 units of capital to produce 100 diapers. (Y ou can think of units ofcapital as machine hours.) T echnology Eis the most capital-intensive, requiring only 2 hours of
labor but 10 hours of machine time.
TABLE 7.3 Inputs Required to Produce 100 Diapers Using
Alternative Technologies
Technology Units of Capital ( K) Units of Labor ( L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10 2
ECONOMICS IN PRACTICE
Learning about Growing Pineapples in Ghana
In this chapter we have focused on the way in which labor, capital,
and other inputs are used to produce outputs of various sorts. We
have described a somewhat abstract production function, linkingspecific combinations of inputs and output levels. In reading thischapter, you might have wondered where real people interested inproducing something learn about production functions. How does
an entrepreneur know what the ideal combination of inputs is to
produce a given output?
In a recent interesting article, Timothy Conley from Chicago and
Christopher Udry from Y ale asked precisely this question in thinkingabout the production of pineapples in Ghana. What they learnedhelps us think about the production process more generally.
In farming, as in manufacturing, we need a given combination
of labor and capital to produce output, here a crop. The capitaldoesn’t come in the form of a grill, as in the sandwich shop, buttractors, or plows, or shovels. Raw materials include seeds and fer-tilizer. There are clearly substitution possibilities among these
inputs; farmers can weed more and fertilize or water less, for
example. How does a farmer know what the right mix of inputs is,given input prices?
Ghana proved to be an interesting place to ask this question. In
the 1990s, an area of Ghana changed from an exclusive reliance on
maize as the agricultural crop to the development of pineapplefarms. This transformation hap-
pened slowly over time to variousneighborhoods. Conley and Udryfound that social learning waskey in the process of technologyadoption. For farmers in Ghana,the choice of how much fertilizerto use was highly dependent onhow much fertilizer their moresuccessful neighbor farmers used.
Social learning was especially
important for novice pineapplefarmers located near more vet-eran producers.
1
Social learning obviously plays
a role in the diffusion of manufac-
turing technology as well. It is no accident that many high-techentrepreneurs began their careers in other high-tech firms wherethey learned much about the right production techniques.
1Timothy Conley and Christopher Udry, “Learning About a New T echnology:
Pineapples in Ghana,” American Economic Review , March 2010, 35–69.156 PART II The Market System: Choices Made by Households and Firms
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 157
ECONOMICS IN PRACTICE
How Fast Should a Truck Driver Go?
The trucking business gives us an opportunity to think about choice
among technologies in a concrete way.
Suppose you own a truck and use it to haul merchandise for
retailers such as Target and Sears. Y our typical run is 200 miles, andyou hire one person to drive the truck at a cost of $20 per hour. Howfast should you instruct him to drive the truck? Consider the costper trip.
Notice that even with fixed inputs of one truck and one driver,
you still have some choices to make. In the language of this chapter,you can think of the choice as one of slow-drive technology (let’s say50 mph) versus fast-drive technology (say, 60 mph).
If the driver’s time were the only input, the problem would be
simple: Labor costs are minimized if you tell him to drive fast. At60 mph, a trip takes the driver only 3.33 hours (200 miles divided by60 mph) and costs you $66.67 given his $20 wage rate. However, at a
speed of 50 mph, it takes four hours and costs you $80. With one
variable input, the best technology is the one that uses that inputmost efficiently. In fact, with only one variable input, you would tellthe driver to speed regardless of his wage rate.
But, of course, trucks require not only drivers but also fuel,
which is where the question gets more interesting. As it turns out,
the fuel mileage that a truck gets diminishes with speed beyondabout 50 mph. Let’s say in this case that the truck gets 15 miles pergallon at 50 mph but only 12 miles per gallon at 60 mph. Now wehave a trade-off. When you tell the driver to go fast, your labor
costs are lower but your fuel costs are higher.
So what instructions do you give? It should be clear that your
instructions depend on the price of fuel. First suppose that fuel costs$3.50 per gallon. If the trucker drives fast, he will get 12 miles pergallon. Since the trucker has to drive 200 miles per trip, he burns
16.66 gallons (200 divided by 12) and total fuel cost is $58.31.
Driving fast, the trucker goes 60 miles per hour. Y ou have to pay himfor 3.33 hours (200 divided by 60), which at $20 per hour, is a totalof $66.67. The total for the trip is $124.98.
On the other hand, if your trucker drives slowly, he will get 15 miles
per gallon, which means you need only 13.33 gallons, which costs$46.67. But now it takes more time. He takes four hours, and youmust pay him 4 /H11003$20, or $80 per trip. T otal cost is now $126.67.
Thus, the cost-minimizing solution is to have him drive fast.
Now try a price of $4.50 per gallon. Doing the same calculations,
you should be able to show that when driving slowly, the total cost is$139.99; when driving fast, the cost is $141.63. Thus, the higher fuel
price means that you tell the driver to slow down.
Going one step further, you should be able to show that at a fuel
price of $4, the trip costs the same whether your trucker drives fast
or slowly.
In fact, you should be able to see that at fuel prices in excess of
$4 per gallon, you tell your driver to slow down, while at cheaperprices, you tell him to speed up. With more than one input, the choice
of technologies often depends on the unit cost of those inputs.
The observation that the optimal “technology” to use in truck-
ing depends on fuel prices is one reason we might expect accidentrates to fall with rises in fuel prices (in addition to the fact thateveryone drives less when fuel is expensive). Modern technology,
in the form of on-board computers, allows a modern trucking
firm to monitor driving speed and instruct drivers.
Here is a summary of the cost per trip.
T o choose a production technique, the firm must look to input markets to learn the current
market prices of labor and capital. What is the wage rate ( PL), and what is the cost per hour of capi-
tal (PK)? The right choice among inputs depends on how productive an input is and what its price is.
Suppose that labor and capital are both available at a price of $1 per unit. Column 4 of
Table 7.4 presents the calculations required to determine which technology is best. The winneris technology C. Assuming that the firm’s objective is to maximize profits, it will choose the
least-cost technology. Using technology C, the firm can produce 100 diapers for $8. All four of
the other technologies produce 100 diapers at a higher cost.
Now suppose that the wage rate ( P
L) were to rise sharply, from $1 to $5. Y ou might guess that
this increase would lead the firm to substitute labor-saving capital for workers, and you would beright. As column 5 of Table 7.4 shows, the increase in the wage rate means that technology Eis
now the cost-minimizing choice for the firm. Using 10 units of capital and only 2 units of labor,Fuel Price $3.50 $4.00 $4.50
Drive Fast $124.97 $133.33 $141.63
Drive Slowly $126.66 $133.33 $139.99
the firm can produce 100 diapers for $20. All other technologies are now more costly. Notice too
from the table that the firm’s ability to shift its technique of production softened the impact ofthe wage increase on its costs. The flexibility of a firm’s techniques of production is an importantdeterminant of its costs. Two things determine the cost of production: (1) technologies that areavailable and (2) input prices. Profit-maximizing firms will choose the technology that mini-mizes the cost of production given current market input prices.
Looking Ahead: Cost and Supply
So far, we have looked only at a single level of output. That is, we have determined how much it
will cost to produce 100 diapers using the best available technology when PK= $1 and PL= $1 or
$5. The best technique for producing 1,000 diapers or 10,000 diapers may be entirely different.The next chapter explores the relationship between cost and the level of output in some detail.One of our main objectives in that chapter is to determine the amount that a competitive firmwill choose to supply during a given time period.158 PART II The Market System: Choices Made by Households and Firms
SUMMARY
1.Firms vary in size and internal organization, but they all take
inputs and transform them into outputs through a processcalled production .
2.In perfect competition, no single firm has any control over
prices. This follows from two assumptions: (1) Perfectly com-petitive industries are composed of many firms, each smallrelative to the size of the industry, and (2) each firm in a per-
fectly competitive industry produces homogeneous products .
3.The demand curve facing a competitive firm is perfectly
elastic. If a single firm raises its price above the market price,it will sell nothing. Because it can sell all it produces at themarket price, a firm has no incentive to reduce price.
THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS p. 148
4.Profit-maximizing firms in all industries must make threechoices: (1) how much output to supply, (2) how to producethat output, and (3) how much of each input to demand.
5.Profit equals total revenue minus total cost. T otal cost (eco-
nomic cost) includes (1) out-of-pocket costs and (2) theopportunity cost of each factor of production, including anormal rate of return on capital.
6.Anormal rate of return on capital is included in total cost
because tying up resources in a firm’s capital stock has anopportunity cost. If you start a business or buy a share ofstock in a corporation, you do so because you expect to
make a normal rate of return. Investors will not invest theirmoney in a business unless they expect to make a normalrate of return.
7.A positive profit level occurs when a firm is earning anabove-normal rate of return on capital.
8.Two assumptions define the short run : (1) a fixed scale or fixed
factor of production and (2) no entry to or exit from the
industry. In the long run , firms can choose any scale of opera-
tions they want and firms can enter and leave the industry.
9.T o make decisions, firms need to know three things: (1) themarket price of their output, (2) the production techniquesthat are available, and (3) the prices of inputs.
THE PRODUCTION PROCESS p. 152
10. The relationship between inputs and outputs (the production
technology ) expressed numerically or mathematically is
called a production function ortotal product function .
11. The marginal product of a variable input is the additional
output that an added unit of that input will produce if allother inputs are held constant. According to the law of
diminishing returns , when additional units of a variable
input are added to fixed inputs, after a certain point, themarginal product of the variable input will decline.TABLE 7.4 Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)
Cost = ( L/H11003PL) + ( K/H11003PK)
(4) (5)
(1)
Technology(2)
Units of Capital (K)(3)
Units of Labor (L)PL= $1
PK= $1PL= $5
PK= $1
A 2 10 $12 52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 159
REVIEW TERMS AND CONCEPTS
average product, p. 154
capital-intensive technology, p. 152
firm, p. 148
labor-intensive technology, p. 152
law of diminishing returns, p. 154
long run, p. 151
marginal product, p. 153normal rate of return, p. 149
optimal method of production, p. 151
production, p. 147
production function ortotal product
function, p. 152
production technology, p. 152
profit (economic profit), p. 148short run, p. 151
total cost (total economic cost), p. 148
total revenue, p. 148
Average product of labor =total product
total units of laborProfit =total revenue -total costCHOICE OF TECHNOLOGY p. 156
14. One of the key decisions that all firms must make is which
technology to use. Profit-maximizing firms will choose thecombination of inputs that minimizes costs and thereforemaximizes profits.12. Average product is the average amount of product produced
by each unit of a variable factor of production. If marginalproduct is above average product, the average product rises;if marginal product is below average product, the averageproduct falls.
13. Capital and labor are at the same time complementary andsubstitutable inputs. Capital enhances the productivity oflabor, but it can also be substituted for labor.
PROBLEMS
All problems are available on www.myeconlab.com
1.Consider a firm that uses capital and labor as inputs and sells
5,000 units of output per year at the going market price of$10. Also assume that total labor costs to the firm are $45,000annually. Assume further that the total capital stock of thefirm is currently worth $100,000, that the return available to
investors with comparable risks is 10 percent annually, and
that there is no depreciation. Is this a profitable firm? Explainyour answer.
2.Two former Northwestern University students worked in an
investment bank at a salary of $60,000 each for 2 years afterthey graduated. T ogether they saved $50,000. After 2 years,they decided to quit their jobs and start a business designing
Web sites. They used the $50,000 to buy computer equipment,
desks, and chairs. For the next 2 years, they took in $40,000 inrevenue each year, paid themselves $10,000 annually each,and rented an office for $18,000 per year. Prior to the invest-ment, their $50,000 was in bonds earning interest at a rate of
10 percent. Are they now earning economic profits? Explain
your answer.
3.Suppose that in 2010, you became president of a small non-
profit theater company. Y our playhouse has 120 seats and a
small stage. The actors have national reputations, and demandfor tickets is enormous relative to the number of seats available;every performance is sold out months in advance. Y ou areelected because you have demonstrated an ability to raise funds
successfully. Describe some of the decisions that you must make
in the short run. What might you consider to be your “fixed fac-tor”? What alternative decisions might you be able to make inthe long run? Explain.LABOR TOTAL OUTPUT
0 0
1 5
2 9
3 12
4 14
5 154.The following table gives total output or total product as a func-
tion of labor units used.
a.Define diminishing returns.
b.Does the table indicate a situation of diminishing returns?
Explain your answer.
5.Suppose that widgets can be produced using two different
production techniques, Aand B. The following table provides
the total input requirements for each of five different totaloutput levels.
Q = 1 Q = 2 Q = 3 Q = 4 Q = 5
Tech. K L K L K L K L K L
A 2 5 1 10 5 14 6 18 8 20
B 5 2 8 3 11 4 14 5 16 6
a.Assuming that the price of labor ( PL) is $1 and the price of
capital ( PK) is $2, calculate the total cost of production for
each of the five levels of output using the optimal (least-
cost) technology at each level.
b.How many labor hours (units of labor) would be
employed at each level of output? How many machinehours (units of capital)?
160 PART II The Market System: Choices Made by Households and Firms
100 3002,000
1,000
0
Units of labor ( L)Total output ( Q)NUMBER OF WORKERS NUMBER OF REPAIRS
(PER WEEK)
0 0
1 8
2 20
3 35
4 45
5 52
6 57
7 60
a.Draw a graph of marginal product as a function of output.
(Hint: Marginal product is the additional number of units of
output per unit of labor at each level of output.)
b.Does this graph exhibit diminishing returns? Explain
your answer.
8.[Related to the Economics in Practice onp. 156 ]Identical
sweaters can be made in one of two ways. With a machinethat can be rented for $50 per hour and a person to run themachine who can be hired at $25 per hour, five sweaters
can be produced in an hour using $10 worth of wool.
Alternatively, I can run the machine with a less skilledworker, producing only four sweaters in an hour with thesame $10 worth of wool. (The less skilled worker is slower
and wastes material.) At what wage rate would I choose the
less skilled worker?
9.[Related to the Economics in Practice onp. 157 ]When the
price of fuel rises, we typically observe fewer accidents. Offer
two reasons this might be true.
10.A firm earning zero economic profits is probably suffering
losses from the standpoint of general accounting principles. Do
you agree or disagree with this argument? Explain why.
11.During the early phases of industrialization, the number of
people engaged in agriculture usually drops sharply, even as
agricultural output is growing. Given what you know aboutproduction technology and production functions, explain thisseeming inconsistency.
*Note: Problems marked with an asterisk are more challenging.12.The number of repairs produced by a computer repair shop
depends on the number of workers as follows:
Assume that all inputs (office space, telephone, and utilities)
other than labor are fixed in the short run.a.Add two additional columns to the table and enter the marginal
product and average product for each number of workers.
b.Over what range of labor input are there increasing
returns to labor? diminishing returns to labor? negativereturns to labor?
c.Over what range of labor input is marginal product greater
than average product? What is happening to average productas employment increases over this range?
d.Over what range of labor input is marginal product smaller
than average product? What is happening to average productas employment increases over this range?
13.Since the end of World War II, manufacturing firms in the United
States and in Europe have been moving farther and farther out-side of central cities. At the same time, firms in finance, insurance,and other parts of the service sector have been locating neardowntown areas in tall buildings. One major reason seems to be
that manufacturing firms find it difficult to substitute capital for
land, while service-sector firms that use office space do not.a.What kinds of buildings represent substitution of capital
for land?
b.Why do you think that manufacturing firms might find it
difficult to substitute capital for land?
c.Why is it relatively easier for a law firm or an insurance com-
pany to substitute capital for land?
d.Why is the demand for land likely to be very high near the
center of a city?
*e.One of the reasons for substituting capital for land near the
center of a city is that land is more expensive near the center.What is true about the relative supply of land near the centerof a city? ( Hint: What is the formula for the area of a circle?)
14.T ed Baxter runs a small, very stable newspaper company in
southern Oregon. The paper has been in business for 25 years.The total value of the firm’s capital stock is $1 million, which Ted
owns outright. This year the firm earned a total of $250,000
after out-of-pocket expenses. Without taking the opportunitycost of capital into account, this means that T ed is earning a 25 percent return on his capital. Suppose that risk-free bondsare currently paying a rate of 10 percent to those who buy them.
a.What is meant by the “opportunity cost of capital”?
b.Explain why opportunity costs are “real” costs even though
they do not necessarily involve out-of-pocket expenses.c.Graph total cost of production as a function of output. (Put
cost on the Y-axis and output, q, on the X-axis.) Again
assume that the optimal technology is used.
d.Repeat a. through c. under the assumption that the price of
labor ( P
L) rises from $1 to $3 while the price of capital ( PK)
remains at $2.
6.A female student who lives on the fourth floor of Bates Hall is
assigned to a new room on the seventh floor during her junioryear. She has 11 heavy boxes of books and “stuff” to move.Discuss the alternative combinations of capital and labor thatmight be used to make the move. How would your answer differif the move were to a new dorm 3 miles across campus and to anew college 400 miles away?
7.The following is a production function.
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 161
c.What is the opportunity cost of T ed’s capital?
d.How much excess profit is T ed earning?
15.A firm can use three different production technologies, with
capital and labor requirements at each level of output as follows:
TECHNOLOGY 1 TECHNOLOGY 2 TECHNOLOGY 3
Daily
Output K L K L K L
100 3 7 4 5 5 4
150 3 10 4 7 5 5
200 4 11 5 8 6 6
250 5 13 6 10 7 8
a.Suppose the firm is operating in a high-wage country, where
capital cost is $100 per unit per day and labor cost is $80 perworker per day. For each level of output, which technology is cheapest?
b.Now suppose the firm is operating in a low-wage country,
where capital cost is $100 per unit per day but labor cost isonly $40 per unit per day. For each level of output, whichtechnology is cheapest?
c.Suppose the firm moves from a high-wage to a low-wage
country but its level of output remains constant at 200 unitsper day. How will its total employment change?
16.An article on T echspot.com reported on the findings of the
marketing research firm iSuppli in its investigation of the cost ofthe components used to produce the Amazon Kindle 2: “Afterperforming a “teardown,” the firm concluded that each Kindle 2runs approximately $185.49 to produce in-total, or 52% less
than its [retail price] of $359.” Does this mean that Amazon is
making a profit of approximately $173 per Kindle 2?
Source: Matthew DeCarlo, “T eardown reveals production cost of Amazon’s
Kindle 2,” Techspot.com , April 22, 2009.
17.The following table represents data for Samantha’s Smoothies.
Draw a graph showing the total product, marginal product of
labor, and average product of labor. Identify where increasingreturns, diminishing returns and negative returns set in on thetotal product curve.
LABOR
UNITS
(EMPLOYEES)TOTAL PRODUCT
(SMOOTHIES
PER HOUR)MARGINAL
PRODUCT
OF LABORAVERAGE
PRODUCT
OF LABOR
0 0 — —
1 50 50 50.0
2 120 70 60.0
3 200 80 66.7
4 250 50 62.5
5 270 20 54.0
6 280 10 46.7
7 260 –20 37.1
18.Which of the following are short-run decisions and which are
long-run decisions?
a.General Motors decides to add a second shift to its
Arlington, T exas production plant.
b.Gotham Foods International chooses to exit the restaurant
industry to concentrate on its wholesale grocerysupply business.c.The Sahara Hotel and Casino in Las Vegas closes two of its
three hotel towers in response to low demand.
d.T ony Andretti, owner of T ony the Taxman, hires five new
CPAs to work at his tax preparation business.
e.German tool and appliance manufacturer Bosch enters the
electric bicycle industry in 2010.
f.General Electric builds a new offshore wind manufacturing
plant in the United Kingdom.
19.The data in the table represents annual costs and revenue for
Aurora’s Orchid Emporium. Aurora works 60 hours a week atthe Orchid Emporium. Aurora owns the building that housesthe Orchid Emporium, and if she closed the shop, she couldrent out the building for $40,000 per year and go to work for
Acme Flowers and earn a salary of $30,000 per year. Calculate
the economic profit and economic cost for Aurora’s OrchidEmporium. Are these figures the same as the accounting costand accounting profit? Explain.
Wages Paid $ 22,000
Interest Paid on Loans 8,000
Other Expenditures for Factors
of Production26,000
T otal Revenue 115,000
20.Assume that we have a production process that exhibits increas-
ing and then decreasing marginal productivity. That is, as we
increase output, the marginal product of labor starts at somelevel above zero, rises to a maximum, and then eventually fallsto zero. Which of the following statements is true? Brieflyexplain.
a.T otal product reaches its highest level where marginal prod-
uct is equal to average product.
b.Marginal product and average product are equal when mar-
ginal product is at its maximum.
c.When marginal product is equal to zero, average product
is rising.
d.When marginal product is above average product, average
product is rising.
e.When marginal product is equal to average product, output
is maximized.
21.Following is information on the production levels of three dif-
ferent firms.
Firm A is currently producing at a quantity where it is experi-
encing increasing returns.
Firm B is currently producing at a quantity where it is experi-
encing diminishing returns.
Firm C is currently producing at a quantity where it is experi-
encing negative returns.a.If each of the firms cut back on its labor force, what will
happen to its marginal product of labor? Why?
b.If each of the firms adds to its labor force, what will happen
to its marginal product of labor? Why?
162 PART II The Market System: Choices Made by Households and Firms
Isoquants and Isocosts
This chapter has shown that the cost structure facing a firm
depends on two key pieces of information: (1) input (factor)prices and (2) technology. This Appendix presents a more for-mal analysis of technology and factor prices and their relation-ship to cost.
New Look at Technology: Isoquants
Table 7A.1 is expanded from Table 7.3 to show the various com-binations of capital ( K) and labor ( L) that can be used to pro-
duce three different levels of output ( q). For example, 100 units
ofXcan be produced with 2 units of capital and 10 units of
labor, with 3 units of Kand 6 units of L, or with 4 units of Kand
4 units of L, and so on. Similarly, 150 units of Xcan be pro-
duced with 3 units of Kand 10 units of L, with 4 units of Kand
7 units of L, and so on.
point Fto point Galong the curve, less capital is employed
but more labor is used. An approximation of the amount ofoutput lost by using less capital is Ktimes the marginal
product of capital ( MP
K). The marginal product of capital is
the number of units of output produced by a single marginalunit of capital. Thus, K·MP
Kis the total output lost by
using less capital.
For output to remain constant (as it must because FandG
are on the same isoquant), the loss of output from using lesscapital must be matched by the added output produced byusing more labor. This amount can be approximated by L
times the marginal product of labor ( MP
L). Because the two
must be equal, it follows that
1
If we then divide both sides of this equation by Land
then by MPK, we arrive at the following expression for the
slope of the isoquant:
The ratio of MPLto MPKis called the marginal rate of
technical substitution . It is the rate at which a firm can sub-
stitute capital for labor and hold output constant.slope of isoquant:¢K
¢L=-MP L
MP K¢¢K#MP K=- ¢ L#MP L¢¢¢TABLE 7A.1 Alternative Combinations of Capital ( K)
and Labor ( L) Required to Produce 50,
100, and 150 Units of Output
QX= 50 QX= 100 QX= 150
K L K L K L
A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3
A graph that shows all the combinations of capital and
labor that can be used to produce a given amount of outputis called an isoquant . Figure 7A.1 graphs three isoquants,
one each for q
X= 50, qX= 100, and qX= 150 based on the
data in Table 7A.1. Notice that all the points on the graphhave been connected, indicating that there are an infinitenumber of combinations of labor and capital that can pro-duce each level of output. For example, 100 units of outputcan also be produced with 3.50 units of labor and 4.75 unitsof capital. (Verify that this point is on the isoquant labeledq
X= 100.)
Figure 7A.1 shows only three isoquants, but many more
are not shown. For example, there are separate isoquants forq
X= 101, qX= 102, and so on. If we assume that producing
fractions of a unit of output is possible, there must be an iso-quant for q
X= 134.57, for qX= 124.82, and so on. One could
imagine an infinite number of isoquants in Figure 7A.1. Thehigher the level of output, the farther up and to the right theisoquant will lie.
Figure 7A.2 derives the slope of an isoquant. Because
points Fand Gare both on the q
X= 100 isoquant, the two
points represent two different combinations of Kand Lthat
can be used to produce 100 units of output. In moving from
Units of capital ( K)
Units of labor ( L)qX= 150
qX= 100
qX= 50E
D
C
B
A10
9
8
7
6
5
4
3
2
1
01 2 3 4 5 6 7 8 9 1 0
/L50304FIGURE 7A.1 Isoquants Showing All
Combinations of Capital and Labor That Can BeUsed to Produce 50, 100, and 150 Units of Output
1We need to add the negative sign to Lbecause in moving from point Fto point
G,Kis a negative number and Lis a positive number. The minus sign is needed
to balance the equation.¢ ¢¢CHAPTER 7 APPENDIX
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 163
Slope: = =
qx= 100
Units of labor ( L)Units of capital ( K)F
0G/H9004K
/H9004LMPL
/H9004L/H9004KMPK/H11002
/L50304FIGURE 7A.2 The Slope of an Isoquant Is Equal
to the Ratio of MPLtoMPK
Factor Prices and Input Combinations:
Isocosts
A graph that shows all the combinations of capital and labor
that are available for a given total cost is called an isocost line .
(Recall that total cost includes opportunity costs and normalrate of return.) Just as there are an infinite number of isoquants(one for every possible level of output), there are an infinitenumber of isocost lines, one for every possible level of total cost.
Figure 7A.3 shows three simple isocost lines assuming that
the price of labor ( P
L) is $1 per unit and the price of capital
(PK) is $1 per unit. The lowest isocost line shows all the combi-
nations of Kand Lthat can be purchased for $5. For example,
$5 will buy 5 units of labor and no capital (point A), 3 units of
labor and 2 units of capital (point B), or no units of labor and
5 units of capital (point C). All these points lie along a straight
line. The equation of that straight line is
(PK·K) + ( PL·L) = TC
Substituting our data for the lowest isocost line into this
general equation, we get
($1 · K) + ($1 · L) = $5, or K+L= 5
Remember that the X- and Y-scales are units of labor and units
of capital, not dollars.
On the same graph are two additional isocosts showing
the various combinations of KandLavailable for a total cost of
$6 and $7. These are only three of an infinite number of iso-costs. At any total cost, there is an isocost that shows all thecombinations of Kand Lavailable for that amount.
Figure 7A.4 shows another isocost line. This isocost assumes
a different set of factor prices, P
L= $5 and PK= $1. The diagram
shows all the combinations of KandLthat can be bought for $25.
One way to draw the line is to determine the endpoints. For exam-ple, if the entire $25 were spent on labor, how much labor could bepurchased? The answer is, of course, 5 units ($25 divided by $5 perunit). Thus, point A, which represents 5 units of labor and no cap-
ital, is on the isocost line. Similarly, if all of the $25 were spent oncapital, how much capital could be purchased? The answer is25 units ($25 divided by $1 per unit). Thus, point B, which repre-
sents 25 units of capital and no labor, is also on the isocost line.Another point on this particular isocost is 3 units of labor and10 units of capital, point C.
The slope of an isocost line can be calculated easily if
you first find the endpoints of the line. In Figure 7A.4, wecan calculate the slope of the isocost line by taking K/L
between points Band A. Thus,
Plugging in the endpoints from our example, we get
Finding the Least-Cost Technology with
Isoquants and Isocosts
Figure 7A.5 superimposes the isoquant for qX= 50 on the iso-
cost lines in Figure 7A.3, which assume that PK= $1 and PL=
$1. The question now becomes one of choosing among thecombinations of Kand Lthat can be used to produce 50 units
of output. Recall that each point on the isoquant (labeled q
X=
50 in Figure 7A.5) represents a different technology—a differ-ent combination of Kand L.
We assume that our firm is a perfectly competitive, profit-
maximizing firm that will choose the combination that minimizesslope of line AB=-$5
$1=- 5slope of isocost line:¢K
¢L=-TC>PK
TC>PL=-PL
PK¢¢Units of capital ( K)
Units of labor ( L)10
109
9 8 7 6 5 4 3 2 1 08
7
6
5
4
3
2
1C
B
ATC = $7
TC = $6
TC = $5PK = $1 per unit
PL = $1 per unit
/L50304FIGURE 7A.3 Isocost Lines Showing the
Combinations of Capital and Labor Available for $5,$6, and $7
An isocost line shows all the combinations of capital and labor that
are available for a given total cost.
164 PART II The Market System: Choices Made by Households and Firms
cost. Because every point on the isoquant lies on some particular
isocost line, we can determine the total cost for each combinationalong the isoquant. For example, point D(5 units of capital and
2 units of labor) lies along the isocost for a total cost of $7. Noticethat 5 units of capital and 2 units of labor cost a total of $7.(Remember, P
K= $1 and PL= $1.) The same amount of output
(50 units) can be produced at lower cost. Specifically, by using3 units of labor and 3 units of capital (point C), total cost is
r e d u c e dt o$ 6 . No other combination of K and L along isoquant
qX=50 is on a lower isocost line . In seeking to maximize profits, the
firm will choose the combination of inputs that is least costly. Theleast costly way to produce any given level of output is indicated bythe point of tangency between an isocost line and the isoquantcorresponding to that level of output.
2
Units of capital ( K)
Units of labor ( L)10
109
9 8 7 6 5 4 3 2 1 08
7
6
5
4
3
2
1BD
CTC = $7
TC = $6
qX= 50PK= $1
PL= $1
TC = $5
/L50304FIGURE 7A.5 Finding the Least-Cost
Combination of Capital and Labor to Produce 50 Units of Output
Profit-maximizing firms will minimize costs by producing their chosen
level of output with the technology represented by the point at which
the isoquant is tangent to an isocost line. Here the cost-minimizingtechnology—3 units of capital and 3 units of labor—is represented by point C.
Figure 7A.7. The minimum cost of producing 50 units of X
is $6, the minimum cost of producing 100 units of Xis $8,
and the minimum cost of producing 150 units of Xis $10.
The Cost-Minimizing Equilibrium
Condition
At the point where a line is just tangent to a curve, the two have
the same slope. (We have already derived expressions for theslope of an isocost and the slope of an isoquant.) At each pointof tangency (such as at points A,B, and Cin Figure 7A.6), the
following must be true:
Thus,
Dividing both sides by P
Land multiplying both sides by
MPK,w e g e t
This is the firm’s cost-minimizing equilibrium condition.
This expression makes sense if you think about what it says.
The left side of the equation is the marginal product of laborMP L
PL=MP K
PKMP L
MP K=PL
PKslope of isoquant =-MP L
MP K=slope of isocost =-PL
PK
2This assumes that the isoquants are continuous and convex (bowed) toward
the origin.In Figure 7A.5, the least-cost technology of producing
50 units of output is represented by point C, the point at which
theqX= 50 isoquant is just tangent to—that is, just touches—
the isocost line.
Figure 7A.6 adds the other two isoquants from Figure 7A.1
to Figure 7A.5. Assuming that PK= $1 and PL= $1, the firm
will move along each of the three isoquants until it finds theleast-cost combination of Kand Lthat can be used to pro-
duce that particular level of output. The result is plotted in
Units of capital ( K)
510152025 =
TC/PK PLSlope: = /H11002 =/H11002TC/PL PKPL= $5
PK
TC= $1
= $25
ABTC
PK$25
$1=
Units of labor ( L)01 2 3 4 5 6
TC
PL== 5$25
$5C
/L50304FIGURE 7A.4 Isocost Line Showing All
Combinations of Capital and Labor Available for $25
One way to draw an isocost line is to determine the endpoints of that
line and draw a line connecting them.
CHAPTER 7 The Production Process: The Behavior of Profit-Maximizing Firms 165Units of capital ( K)
Units of labor ( L)qX= 150
qX= 100C
A10
9
8
7
6
5
4
3
2
1
01 2 34 56 7 89 10qX= 50BTC = $10
TC = $8
TC = $6
/L50304FIGURE 7A.6 Minimizing Cost of Production for
qX= 50, qX= 100, and qX= 150
Plotting a series of cost-minimizing combinations of inputs—shown in
this graph as points A,B, and C—on a separate graph results in a cost
curve like the one shown in Figure 7A.7.ABCTC
50 0 100 150123456789101112
Units of outputCost ($)
/L50304FIGURE 7A.7 A Cost Curve Shows the Minimum
Cost of Producing Each Level of Output
spent on labor was not equal to the product derived from the
last dollar spent on capital, the firm could decrease costs byusing more labor and less capital or by using more capital andless labor.
Look back to Chapter 6 and see if you can find a similar
expression and some similar logic in our discussion of house-hold behavior. In fact, there is great symmetry between the the-ory of the firm and the theory of household behavior.divided by the price of a unit of labor. Thus, it is the product
derived from the last dollar spent on labor. The right-hand sideof the equation is the product derived from the last dollarspent on capital. If the product derived from the last dollar
APPENDIX SUMMARY
1.An isoquant is a graph that shows all the combinations of
capital and labor that can be used to produce a givenamount of output. The slope of an isoquant is equal to -MP
L/MPK. The ratio of MPLto MPKis the marginal rate of
technical substitution . It is the rate at which a firm can substi-
tute capital for labor and hold output constant.
2.An isocost line is a graph that shows all the combinations of
capital and labor that are available for a given total cost. Theslope of an isocost line is equal to -P
L/PK.3.The least-cost method of producing a given amount of out-
put is found graphically at the point at which an isocostline is just tangent t o—that is, just touches—the isoquant
corresponding to that level of production. The firm’s cost-minimizing equilibrium condition is MP
L/PL=MPK/PK.
isocost line A graph that shows all the
combinations of capital and labor available
for a given total cost. p. 163
isoquant A graph that shows all the
combinations of capital and labor that can
be used to produce a given amount ofoutput.
p. 162marginal rate of technical substitution
The rate at which a firm can substitute
capital for labor and hold output constant.
p. 162
1. Slope of isoquant:
¢K
¢L=-MP L
MP K2. Slope of isocost line:
¢K
¢L=-TC>PK
TC>PL=-PL
PKAPPENDIX REVIEW TERMS AND CONCEPTS
166 PART II The Market System: Choices Made by Households and Firms
APPENDIX PROBLEMS
1.Assume that MPL= 5 and MPK= 10. Assume also that PL= $2
and PK= $5. This implies that the firm should substitute labor
for capital. Explain why.
2.In the isoquant/isocost diagram (Figure 1) suppose the firm isproducing 1,000 units of output at point Ausing 100 units of
labor and 200 units of capital. As an outside consultant, whatactions would you suggest to management to improve profits?What would you recommend if the firm were operating at point B, using 100 units of capital and 200 units of labor?
3.Using the information from the isoquant/isocost diagram
(Figure 2) and assuming that PL=PK= $2, complete Table 1.100 200200
100
0A
B
q= 1,000
Units of labor ( L)Units of capital ( K)
/L50304FIGURE 1
25 50 75 100 150255075100150
0
Units of labor ( L)Units of capital ( K)
q = 300
q = 200
q = 100
/L50304FIGURE 2TABLE 1
OUTPUT
UNITSTOTAL COSTOF OUTPUTUNITS OFLABORDEMANDED UNITS OFCAPITALDEMANDED
100
200
300
4.Each month a company can rent capital for $5,000 per unit and
can hire workers for $2,000 each. Currently, the company is
using 2 units of capital and 5 workers to produce 10,000 units ofoutput. This combination of capital and labor represents a cost-minimizing eq uilibrium. Draw an isoquant/isocost diagram to
illustrate this situation.
5.The Red Racer Company and the Blue Bomber Company are
each capable of minimizing cost and producing 4,000 bicy-
cles per month. Red Racer’s factory is located in an areawhere the cost of labor is significantly less and the cost ofcapital is significantly more than the costs of labor andcapital for Blue Bomber. Assume that each company has
access to the same technology to produce bicycles and draw
an isoquant/isocost diagram to illustrate why the cost-mini mizing
combinations of inputs for these companies are different. Besure to identify the isocost line, amount of capital, amount of labor, and cost-minimizing combination of inputs for
each company.
CHAPTER OUTLINE
1678
Costs in the Short
Run p. 168
Fixed Costs
Variable Costs
Total Costs
Short-Run Costs: A Review
Output Decisions:
Revenues, Costs, and ProfitMaximization
p. 179
Perfect Competition
Total Revenue and
Marginal Revenue
Comparing Costs and
Revenues to MaximizeProfit
The Short-Run Supply
Curve
Looking Ahead p. 185Short-Run Costs and
Output Decisions
This chapter continues our exami-
nation of the decisions that firmsmake in their quest for profits. Y ouhave seen that firms make threespecific decisions (Figure 8.1)involving their production. Thesedecisions are:
1.How much output to supply
2.How to produce that output—that is, which productiontechnique/technology to use
3.What quantity of each inputto demand
We have assumed so far that firms are in business to earn profits and that they make choices
to maximize those profits. (Remember that profit refers to economic profit, the difference
between revenues and costs—full economic costs.)
In the last chapter, we focused on the production process. This chapter focuses on the costs of
production. T o calculate costs, a firm must know two things: what quantity and combination ofinputs it needs to produce its product and how much those inputs cost. (Do not forget that eco-nomic costs include a normal return to capital—the opportunity cost of capital.)
Take a moment and look back at the circular flow diagram, Figure II.1 on p. 117. There you
can see where we are in our study of the competitive market system. The goal of this chapter isto look behind the supply curve in output markets. It is important to understand, however, thatproducing output implies demanding inputs at the same time. Y ou can also see in Figure II.1two of the information sources that firms use in their output supply and input demand deci-sions: Firms look to output markets for the price of output and to input markets for the prices
of capital and labor.
DECISIONS INFORMATION are based on
1. The quantity of output
tosupply
2. How to produce that output
(which technique to use)
3. The quantity of each input
to demand1. The price of output
2. Techniques of
production available*
3. The price of inputs*
*Determines production costs/L50296FIGURE 8.1 Decisions
Facing Firms
168 PART II The Market System: Choices Made by Households and Firms
where TCdenotes total costs, TFC denotes total fixed costs, and TVC denotes total variable costs.
We will return to this equation after discussing fixed costs and variable costs in detail.
Fixed Costs
In discussing fixed costs, we must distinguish between total fixed costs and average fixed costs.
Total Fixed Cost ( TFC )T otal fixed cost is sometimes called overhead . If you operate a fac-
tory, you must heat the building to keep the pipes from freezing in the winter. Even if no produc-tion is taking place, you may have to keep the roof from leaking, pay a guard to protect thebuilding from vandals, and make payments on a long-term lease. There may also be insurancepremiums, taxes, and city fees to pay, as well as contract obligations to workers.
Fixed costs represent a larger portion of total costs for some firms than for others. Electric
companies, for instance, maintain generating plants, thousands of miles of distribution wires,poles, transformers, and so on. Usually, such plants are financed by issuing bonds to the public—that is, by borrowing. The interest that must be paid on these bonds represents a substantial partof the utilities’ operating cost and is a fixed cost in the short run, no matter how much (if any)electricity they are producing.
For the purposes of our discussion in this chapter, we will assume that firms use only two
inputs: labor and capital. Although this may seem unrealistic, virtually everything that we will sayabout firms using these two factors can easily be generalized to firms that use many factors of pro-duction. Recall that capital yields services over time in the production of other goods and services.It is the plant and equipment of a manufacturing firm and the computers, desks, chairs, doors, andwalls of a law office; it is the software of a Web-based firm and the boat that Bill and Colleen builton their desert island. It is sometimes assumed that capital is a fixed input in the short run and thatlabor is the only variable input. T o be more realistic, however, we will assume that capital has botha fixed anda variable component. After all, some capital can be purchased in the short run.
Consider a small consulting firm that employs several economists, research assistants, and
secretaries. It rents space in an office building and has a 5-year lease. The rent on the office spacecan be thought of as a fixed cost in the short run. The monthly electric and heating bills are alsoessentially fixed (although the amounts may vary slightly from month to month). So are thesalaries of the basic administrative staff. Payments on some capital equipment—a large copyingmachine and the main word-processing system, for instance—can also be thought of as fixed.
The same firm also has costs that vary with output. When there is a great deal of work, the
firm hires more employees at both the professional and research assistant levels. The capitalused by the consulting firm may also vary, even in the short run. Payments on the computersystem do not change, but the firm may rent additional computer time when necessary. The firmcan buy additional personal computers, network terminals, or databases quickly if needed. It mustpay for the copy machine, but the machine costs more when it is running than when it is not.
Total fixed costs ( TFC)oroverhead are those costs that do not change with output even if
output is zero. Column 2 of Table 8.1 presents data on the fixed costs of a hypothetical firm. Fixedcosts are $1,000 at all levels of output ( q). Figure 8.2(a) shows total fixed costs as a function of
total fixed costs ( TFC)or
overhead The total of all
costs that do not change withoutput even if output is zero.Costs in the Short Run
Our emphasis in this chapter is on costs in the short run only . Recall that the short run is that
period during which two conditions hold: (1) existing firms face limits imposed by some fixedfactor of production, and (2) new firms cannot enter and existing firms cannot exit an industry.
In the short run, all firms (competitive and noncompetitive) have costs that they must bear
regardless of their output. In fact, some costs must be paid even if the firm stops producing—thatis, even if output is zero. These costs are called fixed costs , and firms can do nothing in the short
run to avoid them or to change them. In the long run, a firm has no fixed costs because it canexpand, contract, or exit the industry.
Firms also have certain costs in the short run that depend on the level of output they have
chosen. These kinds of costs are called variable costs . T otal fixed costs and total variable costs
together make up total costs :
TC=TFC +TVC
total cost ( TC)Total fixed
costs plus total variable costs.fixed cost Any cost that does
not depend on the firms’ levelof output. These costs are
incurred even if the firm is
producing nothing. There areno fixed costs in the long run.
variable cost A cost that
depends on the level ofproduction chosen.
CHAPTER 8 Short-Run Costs and Output Decisions 169
TABLE 8.1 Short-Run Fixed Cost (Total and
Average) of a Hypothetical Firm
(1)
q(2)
TFC(3)
AFC (TFC/q)
0 $1,000 $ –
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200
1,000
0 123 4 5TFC
Units of outputTotal fixed cost ($)a. Total fixed cost
Average fixed cost ($)b. Average fixed cost
1,000
500
333
250
200AFC
Units of output0 123 4 5
/L50304FIGURE 8.2 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm
Average fixed cost is simply total fixed cost divided by the quantity of output. As output increases, average
fixed cost declines because we are dividing a fixed number ($1,000) by a larger and larger quantity.output. Because TFC does not change with output, the graph is simply a straight horizontal line
at $1,000. The important thing to remember here is that firms have no control over fixed costs inthe short run.
Average Fixed Cost ( AFC )Average fixed cost ( AFC)is total fixed cost ( TFC ) divided by
the number of units of output ( q):
AFC =TFC
qaverage fixed cost ( AFC)
Total fixed cost divided by thenumber of units of output; a
per-unit measure of fixed costs.
For example, if the firm in Figure 8.2 produced 3 units of output, average fixed costs would
be $333 ($1,000 /H110043). If the same firm produced 5 units of output, average fixed cost would be
$200 ($1,000 /H110045).Average fixed cost falls as output rises because the same total is being spread
over, or divided by, a larger number of units (see column 3 of Table 8.1). This phenomenon issometimes called spreading overhead .
Graphs of average fixed cost, like that in Figure 8.2(b) (which presents the average fixed cost
data from Table 8.1), are downward-sloping curves. Notice that AFC approaches zero as the
quantity of output increases. If output were 100,000 units, average fixed cost would equal only1 cent per unit in our example ($1,000 /H11004100,000 = $0.01). AFC never actually reaches zero.
Variable Costs
Total Variable Cost ( TVC )Total variable cost ( TVC)is the sum of those costs that vary
with the level of output in the short run. T o produce more output, a firm uses more inputs. Thecost of additional output depends directly on what additional inputs are required and how muchthey cost.spreading overhead The
process of dividing total fixedcosts by more units of output.
Average fixed cost declines as
quantity rises.
total variable cost ( TVC)
The total of all costs that varywith output in the short run.
170 PART II The Market System: Choices Made by Households and Firms
TABLE 8.2 Derivation of Total Variable Cost Schedule from Technology and
Factor Prices
ProduceUsing
TechniqueUnits of Input Required
(Production Function)
KLTotal Variable Cost Assuming
PK= $2, PL= $1
TVC = (K/H11003PK) + ( L/H11003PL)
1 unit of
outputA 4 4 (4/H11003$2) + (4 /H11003$1) = $12
B 2 6 (2/H11003$2) + (6 /H11003$1) = $10
2 units of
outputA 7 6 (7/H11003$2) + (6 /H11003$1) = $20
B 4 10 (4/H11003$2) + (10 /H11003$1) = $18
3 units of
outputA 9 6 (9/H11003$2) + (6 /H11003$1) = $24
B 6 14 (6/H11003$2) + (14 /H11003$1) = $26As you saw in Chapter 7, input requirements are determined by technology. Firms generally
have a number of production techniques available to them, and the option they choose isassumed to be the one that produces the desired level of output at the least cost. T o find out whichtechnology involves the least cost, a firm must compare the total variable costs of producing thatlevel of output using different production techniques.
This is as true of small businesses as it is of large manufacturing firms. Suppose, for example,
that you own a small farm. A certain amount of work has to be done to plant and harvest your120 acres. Y ou might hire four farmhands and divide up the tasks, or you might buy several piecesof complex farm machinery (capital) and do the work single-handedly. Y our final choice dependson a number of things. What machinery is available? What does it do? Will it work on small fieldssuch as yours? How much will it cost to buy each piece of equipment? What wage will you have topay farmhands? How many will you need to hire to get the job done? If machinery is expensiveand labor is cheap, you will probably choose the labor-intensive technology. If farm labor isexpensive and the local farm equipment dealer is going out of business, you might get a good dealon some machinery and choose the capital-intensive method.
Having compared the costs of alternative production techniques, the firm may be influenced
in its choice by the current scale of its operation. Remember, in the short run, a firm is locked intoafixed scale of operations. A firm currently producing on a small scale may find that a labor-
intensive technique is least costly whether or not labor is comparatively expensive. The same firmproducing on a larger scale might find a capital-intensive technique to be less costly.
Thetotal variable cost curve is a graph that shows the relationship between total variable cost
and the level of a firm’s output ( q). At any given level of output, total variable cost depends on (1) the
techniques of production that are available and (2) the prices of the inputs required by each techno-logy. T o examine this relationship in more detail, let us look at some hypothetical production figures.
Table 8.2 presents an analysis that might lie behind three points on a typical firm’s total variable
cost curve. In this case, there are two production techniques available, AandB, one somewhat more
capital-intensive than the other. We will assume that the price of labor is $1 per unit and the price ofcapital is $2 per unit. For the purposes of this example, we focus on variable capital— that is, on cap-
ital that can be changed in the short run. In practice, some capital (such as buildings and large, spe-cialized machines) is fixed in the short run. In our example, we will use Kto denote variable capital.
Remember, however, that the firm has other capital, capital that is fixed in the short run.
Analysis reveals that to produce 1 unit of output, the labor-intensive technique is least costly.
T echnique Arequires 4 units of both capital and labor, which would cost a total of $12. T echnique B
requires 6 units of labor but only 2 units of capital for a total cost of only $10. T o maximize prof-its, the firm would use technique Bto produce 1 unit. The total variable cost of producing 1 unit
of output would thus be $10.
The relatively labor-intensive technique Bis also the best method of production for 2 units of out-
put. By using B, the firm can produce 2 units for $18. If the firm decides to produce 3 units of output,
however, technique Ais cheaper. By using the least-cost technology ( A), the total variable cost of pro-
duction is $24. The firm will use 9 units of capital at $2 each and 6 units of labor at $1 each.
Figure 8.3 graphs the relationship between total variable cost and output based on the data
in Table 8.2, assuming the firm chooses the least-cost technology for each output. The totaltotal variable cost curve A
graph that shows the
relationship between totalvariable cost and the level of a
firm’s output.
CHAPTER 8 Short-Run Costs and Output Decisions 171
TVC
01 2 31018202430Total variable cost ($)
Units of output/L50296FIGURE 8.3 Total
Variable Cost Curve
In Table 8.2, total variable cost is
derived from production require-
ments and input prices. A totalvariable cost curve expresses therelationship between TVC and
total output.
TABLE 8.3 Derivation of Marginal Cost from Total Variable Cost
Units of Output Total Variable Costs ($) Marginal Costs ($)
0 0
1 10 10
2 18 8
3 24 6variable cost curve embodies information about both factor, or input, prices and technology. It
shows the cost of production using the best available technique at each output level given cur-rent factor prices.
Marginal Cost ( MC)The most important of all cost concepts is that of marginal cost
(MC), the increase in total cost that results from the production of 1 more unit of output. Let us
say, for example, that a firm is producing 1,000 units of output per period and decides to raise itsrate of output to 1,001. Producing the extra unit raises costs, and the increase—that is, the cost ofproducing the 1,001st unit—is the marginal cost. Focusing on the “margin” is one way of lookingat variable costs: marginal costs reflect changes in variable costs because they vary when outputchanges. Fixed costs do not change when output changes.
Table 8.3 shows how marginal cost is derived from total variable cost by simple subtraction.
The total variable cost of producing the first unit of output is $10. Raising production from 1 unitto 2 units increases total variable cost from $10 to $18; the difference is the marginal cost of thesecond unit, or $8. Raising output from 2 to 3 units increases total variable cost from $18 to $24.The marginal cost of the third unit, therefore, is $6.
It is important to think for a moment about the nature of marginal cost. Specifically, mar-
ginal cost is the cost of the added inputs, or resources, needed to produce 1 additional unit ofoutput. Look back at Table 8.2 and think about the additional capital and labor needed to gofrom 1 unit to 2 units. Producing 1 unit of output with technique Brequires 2 units of capital and
6 units of labor; producing 2 units of output using the same technique requires 4 units of capitaland 10 units of labor. Thus, the second unit requires 2 additional units of capital and 4 additional
units of labor. What, then, is the added, or marginal, cost of the second unit? Two units of capitalcost $2 each ($4 total) and 4 units of labor cost $1 each (another $4), for a total marginal cost of$8, which is the number we derived in Table 8.3. Although the easiest way to derive marginal costis to look at total variable cost and subtract, do not lose sight of the fact that when a firm increasesits output level, it hires or demands more inputs. Marginal cost measures the additional cost of
inputs required to produce each successive unit of output.marginal cost ( MC)The
increase in total cost that
results from producing 1 moreunit of output. Marginal costs
reflect changes in variable
costs.
172 PART II The Market System: Choices Made by Households and Firms
MC
0
Units of outputMarginal cost ($)
Units of laborMarginal product ( q)
0MP
/L50304FIGURE 8.4 Declining Marginal Product Implies That Marginal Cost Will
Eventually Rise with Output
In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminish-
ing returns (declining marginal product) and a limited capacity to produce. As that limit is approached, mar-ginal costs rise.The Shape of the Marginal Cost Curve in the Short Run The assumption of a
fixed factor of production in the short run means that a firm is stuck at its current scale of oper-ation (in our example, the size of the plant). As a firm tries to increase its output, it will eventu-ally find itself trapped by that scale. Thus, our definition of the short run also implies thatmarginal cost eventually rises with output . The firm can hire more labor and use more materials—
that is, it can add variable inputs—but diminishing returns eventually set in.
Recall from Chapter 7 the sandwich shop with one grill and too many workers trying to pre-
pare sandwiches on it. With a fixed grill capacity, more laborers could make more sandwiches,but the marginal product of each successive cook declined as more people tried to use the grill. Ifeach additional unit of labor adds less and less to total output, it follows that more labor is needed
to produce each additional unit of output . Thus, each additional unit of output costs more to
produce. In other words, diminishing returns, or decreasing marginal product, imply increasing
marginal cost as illustrated in Figure 8.4.
T o reiterate:
In the short run, every firm is constrained by some fixed input that (1) leads to diminish-ing returns to variable inputs and (2) limits its capacity to produce. As a firm approachesthat capacity, it becomes increasingly costly to produce successively higher levels of output.Marginal costs ultimately increase with output in the short run.
Graphing Total Variable Costs and Marginal Costs Figure 8.5 shows the total
variable cost curve and the marginal cost curve of a typical firm. Notice first that the shape of themarginal cost curve is consistent with short-run diminishing returns. At first, MC declines, but
eventually the fixed factor of production begins to constrain the firm and marginal cost rises. Upto 100 units of output, producing each successive unit of output costs slightly less than producingthe one before. Beyond 100 units, however, the cost of each successive unit is greater than the onebefore. (Remember the sandwich shop.)
More output costs more than less output. T otal variable costs ( TVC ), therefore, always
increase when output increases. Even though the cost of each additional unit changes, total vari-
able cost rises when output rises. Thus, the total variable cost curve always has a positive slope.
Y ou might think of the total variable cost curve as a staircase. Each step takes you out along
the quantity axis by a single unit, and the height of each step is the increase in total variable cost.
CHAPTER 8 Short-Run Costs and Output Decisions 173
100Marginal cost ($) Total variable cost ($)
100
Units of output00
MCTVC
/L50304FIGURE 8.5 Total Variable Cost and Marginal Cost for a Typical Firm
Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit.
Thus, the marginal cost curve shows how total variable cost changes with single-unit increases in total output.
As you climb the stairs, you are always going up, but the steps have different heights. At first, the
stairway is steep, but as you climb, the steps get smaller (marginal cost declines). The 100th stairis the smallest. As you continue to walk out beyond 100 units, the steps begin to get larger; thestaircase gets steeper (marginal cost increases).
Remember that the slope of a line is equal to the change in the units measured on the Y-axis
divided by the change in the units measured on the X-axis. The slope of a total variable cost curve
is thus the change in total variable cost divided by the change in output ( TVC /q). Because
marginal cost is by definition the change in total variable cost resulting from an increase in out-put of one unit ( q= 1), marginal cost actually is the slope of the total variable cost curve :
slope of TVC =¢TVC
¢q=¢TVC
1=¢ TVC =MC¢¢ ¢
Notice that up to 100 units, marginal cost decreases and the variable cost curve becomes flat-
ter. The slope of the total variable cost curve is declining—that is, total variable cost increases, butat a decreasing rate . Beyond 100 units of output, marginal cost increases and the total variable cost
curve gets steeper—total variable costs continue to increase, but at an increasing rate .
A more complete picture of the costs of a hypothetical firm appears in Table 8.4. Column 2 shows
total variable costs derived from information on input prices and technology. Column 3 derives mar-ginal cost by simple subtraction. For example, raising output from 3 units to 4 units increases variablecosts from $24 to $32, making the marginal cost of the fourth unit $8 ($32 – $24). The marginal costof the fifth unit is $10, the difference between $32 ( TVC ) for 4 units and $42 ( TVC ) for 5 units.
174 PART II The Market System: Choices Made by Households and Firms
TABLE 8.4 Short-Run Costs of a Hypothetical Firm
(1)
q(2)
TVC(3)
MC
(TVC ) ¢(4)
AVC
(TVC/q )(5)
TFC(6)
TC
(TVC +TFC )(7)
AFC
(TFC/q )(8)
ATC
(TC/q orAFC +AVC )
0 $ 0 $ – $ – $1,000 $1,000 $ – $ –
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509
3 24 6 8 1,000 1,024 333 341
4 32 8 8 1,000 1,032 250 258
5 42 10 8.4 1,000 1,042 200 208.4
— — — — — — — —
— — — — — — — —
— — — — — — — —
500 8,000 20 16 1,000 9,000 2 18
100 0 200
Units of output3.50MC
AVC
3.00
2.50Cost per unit ($)Minimum
point ofAVC/L50298FIGURE 8.6 More
Short-Run Costs
When marginal cost is below
average cost, average cost isdeclining. When marginal cost
isabove average cost, average
cost is increasing. Rising marginal cost intersects averagevariable cost at the minimum
point of AVC.average variable cost ( AVC)
Total variable cost divided by
the number of units of output.
In Table 8.4, we calculate AVC in column 4 by dividing the numbers in column 2 ( TVC ) by the num-
bers in column 1 ( q). For example, if the total variable cost of producing 5 units of output is $42, then
the average variable cost is $42 /H110045, or $8.40. Marginal cost is the cost of 1 additional unit .A v e r a g e
variable cost is the total variable cost divided by the total number of units produced.Average Variable Cost ( AVC )Average variable cost ( AVC)is total variable cost divided
by the number of units of output ( q):
AVC =TVC
q
Graphing Average Variable Costs and Marginal Costs The relationship between
average variable cost and marginal cost can be illustrated graphically. When marginal cost isbelow average variable cost, average variable cost declines toward it. When marginal cost is above
average variable cost, average variable cost increases toward it.
Figure 8.6 duplicates the bottom graph for a typical firm in Figure 8.5 but adds average vari-
able cost. As the graph shows, average variable cost follows marginal cost but lags behind. As we
move from left to right, we are looking at higher and higher levels of output per period. As weincrease production, marginal cost—which at low levels of production is above $3.50 per unit—falls as coordination and cooperation begin to play a role. At 100 units of output, marginal cost hasfallen to $2.50. Notice that average variable cost falls as well, but not as rapidly as marginal cost.
After 100 units of output, we begin to see diminishing returns. Marginal cost begins to
increase as higher and higher levels of output are produced. However, notice that average costis still falling until 200 units because marginal cost remains below it. At 100 units of output,marginal cost is $2.50 per unit but the average variable cost of production is $3.50. Thus,
even though marginal cost is rising after 100 units, it is still pulling the average of $3.50downward.
CHAPTER 8 Short-Run Costs and Output Decisions 175
At 200 units, however, marginal cost has risen to $3 and average cost has fallen to $3; mar-
ginal and average costs are equal. At this point, marginal cost continues to rise with higher out-put. From 200 units upward, MC isabove A VC and thus exerts an upward pull on the average
variable cost curve. At levels of output below 200 units, marginal cost is below average variablecost and average variable cost decreases as output increases. At levels of output above 200 units,MC is above AVC and AVC increases as output increases. If you follow this logic, you will see
that marginal cost intersects average variable cost at the lowest, or minimum, point of AVC .
An example using test scores should help you understand the relationship between MC and
AVC . Consider the following sequence of test scores: 95, 85, 92, 88. The average of these four
scores is 90. Suppose you get an 80 on your fifth test. This score will drag down your average to88. Now suppose you get an 85 on your sixth test. This score is higher than 80, but its still below
your 88 average. As a result, your average continues to fall (from 88 to 87.5) even though yourmarginal test score rose. If instead of an 85 you get an 89—just one point over your average—youhave turned your average around; it is now rising.
Total Costs
We are now ready to complete the cost picture by adding total fixed costs to total variable costs.Recall that
TC=TFC +TVC
T otal cost is graphed in Figure 8.7, where the same vertical distance (equal to TFC , which is con-
stant) is simply added to TVC at every level of output. In Table 8.4, column 6 adds the total fixed
cost of $1,000 to total variable cost to arrive at total cost.
Average Total Cost ( ATC )Average total cost ( ATC)is total cost divided by the number
of units of output ( q):
Column 8 in Table 8.4 shows the result of dividing the costs in column 6 by the quantities in col-
umn 1. For example, at 5 units of output, total cost is $1,042; average total cost is $1,042 /H110045, or
$208.40. The average total cost of producing 500 units of output is only $18—that is, $9,000 /H11004500.
Another, more revealing, way of deriving average total cost is to add average fixed cost and
average variable cost together:
ATC =AFC +AVC
For example, column 8 in Table 8.4 is the sum of column 4 ( AVC ) and column 7 ( AFC ).ATC =TC
q
1,000
TFCTVCTCCosts ($)
0
Units of output
/L50304FIGURE 8.7 Total Cost = Total Fixed Cost + Total Variable Cost
Adding TFCtoTVC means adding the same amount of total fixed cost to every level of total variable cost.
Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by anamount equal to TFC.average total cost ( ATC)
Total cost divided by the
number of units of output.
176 PART II The Market System: Choices Made by Households and Firms
MC
ATC
AVC
100 400 0Costs per unit ($) Costs per unit ($)
AFC
100$10$10
$2.50$2.50
400 0
Units of outputMinimum
point ofAVCMinimumpoint ofATC/L50298FIGURE 8.8 Average
Total Cost = AverageVariable Cost + AverageFixed Cost
To get average total cost, we add
average fixed and average vari-
able costs at all levels of output.
Because average fixed cost fallswith output, an ever-decliningamount is added to AVC. Thus,
AVC and ATC get closer together
as output increases, but the twolines never meet.Figure 8.8 derives average total cost graphically for a typical firm. The bottom part of the
figure graphs average fixed cost. At 100 units of output, average fixed cost is TFC/q = $1,000 /H11004
100 = $10. At 400 units of output, AFC = $1,000 /H11004400 = $2.50. The top part of Figure 8.8 shows
the declining AFC added to AVC at each level of output. Because AFC gets smaller and smaller,
ATC gets closer and closer to AVC as output increases, but the two lines never meet.
The Relationship Between Average Total Cost and Marginal Cost The rela-
tionship between average total cost and marginal cost is exactly the same as the relationship
between average variable cost and marginal cost. The average total cost curve follows the mar-
ginal cost curve but lags behind because it is an average over all units of output. The average totalcost curve lags behind the marginal cost curve even more than the average variable cost curvedoes because the cost of each added unit of production is now averaged not only with the variablecost of all previous units produced but also with fixed costs.
Fixed costs equal $1,000 and are incurred even when the output level is zero. Thus, the first
unit of output in the example in Table 8.4 costs $10 in variable cost to produce. The second unitcosts only $8 in variable cost to produce. The total cost of 2 units is $1,018; average total costof the two is ($1,010 + $8)/2, or $509. The marginal cost of the third unit is only $6. The totalcost of 3 units is thus $1,024, or $1,018 + $6, and the average total cost of 3 units is ($1,010 +$8 + $6)/3, or $341.
As you saw with the test scores example, marginal cost is what drives changes in average total
cost. If marginal cost is below average total cost, average total cost will decline toward marginal cost.
If marginal cost is above average total cost, average total cost will increase . As a result, marginal cost
CHAPTER 8 Short-Run Costs and Output Decisions 177
intersects average total cost at ATC’ s minimum point for the same reason that it intersects the aver-
agevariable cost curve at its minimum point.
Short-Run Costs: A Review
Let us now pause to review what we have learned about the behavior of firms. We know that firms
make three basic choices: how much product or output to produce or supply, how to producethat output, and how much of each input to demand to produce what they intend to supply. Weassume that these choices are made to maximize profits. Profits are equal to the differencebetween a firm’s revenue from the sale of its product and the costs of producing that product:profit = total revenue – total cost.
So far, we have looked only at costs, but costs are just one part of the profit equation. T o com-
plete the picture, we must turn to the output market and see how these costs compare with theprice that a product commands in the market. Before we do so, however, it is important to con-solidate what we have said about costs.
Before a firm does anything else, it needs to know the different methods that it can use to
produce its product. The technologies available determine the combinations of inputs that areneeded to produce each level of output. Firms choose the technique that produces the desiredlevel of output at the least cost. The cost curves that result from the analysis of all this informa-tion show the cost of producing each level of output using the best available technology.
Remember that so far, we have talked only about short-run costs. The curves we have drawn
are therefore short-run cost curves . The shape of these curves is determined in large measure by
the assumptions that we make about the short run, especially the assumption that some fixed fac-tor of production leads to diminishing returns. Given this assumption, marginal costs eventuallyrise and average cost curves are likely to be U-shaped. Table 8.5 summarizes the cost concepts thatwe have discussed.
After gaining a complete knowledge of how to produce a product and how much it will cost
to produce it at each level of output, the firm turns to the market to find out what it can sell itsproduct for. We now turn our attention to the output market.
TABLE 8.5 A Summary of Cost Concepts
Term Definition Equation
Accounting costs Out-of-pocket costs or costs as an
accountant would define them.
Sometimes referred to as explicit costs .—
Economic costs Costs that include the full opportunity
costs of all inputs. These include what
are often called implicit costs .—
Total fixed costs (TFC) Costs that do not depend on the quan-
tity of output produced. These must be
paid even if output is zero.—
Total variable costs (TVC) Costs that vary with the level of output. —
Total cost (TC) The total economic cost of all the
inputs used by a firm in production.TC=TFC +TVC
Average fixed costs (AFC) Fixed costs per unit of output. AFC =TFC/q
Average variable
costs (AVC)Variable costs per unit of output. AVC =TVC/q
Average total costs (ATC) Total costs per unit of output. ATC =TC/q ATC =AFC +AVC
Marginal costs (MC) The increase in total cost that results
from producing 1 additional unit of
output.MC= TC/ q¢ ¢
178 PART II The Market System: Choices Made by Households and Firms
Costs in Dollars
Students Total Fixed Cost Total Variable Cost Total Cost Average Total Cost
500 $60 million $ 20 million $ 80 million $160,000
1,000 60 million 40 million 100 million 100,000
1,500 60 million 60 million 120 million 80,000
2,000 60 million 80 million 140 million 70,000
2,500 60 million 100 million 160 million 64,000
500 1,000 1,500 2,000 2,500 3,00040,000160,000
100,000
80,000
70,000
64,000
0ATC
MCAverage total cost
Marginal cost
Number of students enrolled per yearECONOMICS IN PRACTICE
Average and Marginal Costs at a College
Pomona College in California has an annual operating budget of
$120 million. With this budget, the college educates and houses
1,500 students. So the average total cost of educating a Pomona stu-dent is $80,000 per year, some of which comes from the collegeendowment and gifts. Suppose college administrators are consider-ing a small increase in the number of students it accepts and believethey could do so without sacrificing quality of teaching and
research. Given that the level of tuition and room and board is con-
siderably less than $80,000, can the administrators make a financialcase to support such a move?
The key issue here is to recognize that for a college like
Pomona—and indeed for most colleges—the average total cost of
educating a student is higher than the marginal cost. For a very
small increase in the number of students, the course-relatedexpenses probably would not go up at all. These students couldlikely be absorbed into existing courses with no added expense for
faculty, buildings, or administrators. Housing might be more of aconstraint, but even in that regard administrators might find someflexibility. Thus, from a financial perspective, the key question
about expansion is not how the average total cost of educationcompares to the tuition, but how tuition compares to the marginal
cost. For this reason, many colleges would, in fact, find it financiallyadvantageous to expand student populations if they could do sowithout changing the quality and environment of the school.
Suppose that of Pomona’s $120 million budget, $60 million
was fixed costs: maintenance of the physical campus, basic
salaries, and other fixed operating costs. Suppose further that thefull marginal cost of providing the education was $40,000 per stu-dent and constant. Using these figures, one can easily create thefollowing table and draw the cost curves.
The cost curves also help us understand the downward spiral
that can affect colleges as their populations fall. In 2005, Antioch
College in Ohio announced that it would be phasing out its
undergraduate program. The culprit? Declining attendancecaused the average total cost of educating the remaining few stu-dents to skyrocket despite attempts to control costs. Given theinevitability of some fixed costs of education (to educate even a
modest student body requires facilities and a college president, forexample), as the number of students falls, the average total cost—
which is total cost divided by the number of students—rises. For
organizations such as colleges and museums, the numbers game isvery important to their survival.
CHAPTER 8 Short-Run Costs and Output Decisions 179
Output Decisions: Revenues, Costs, and
Profit Maximization
T o calculate potential profits, firms must combine their cost analyses with information on poten-
tial revenues from sales. After all, if a firm cannot sell its product for more than the cost of pro-duction, it will not be in business long. In contrast, if the market gives the firm a price that issignificantly greater than the cost it incurs to produce a unit of its product, the firm may have anincentive to expand output. Large profits might also attract new competitors to the market.
Let us now examine in detail how a firm goes about determining how much output to pro-
duce. We will begin by examining the decisions of a perfectly competitive firm.
Perfect Competition
Perfect competition exists in an industry that contains many relatively small firms producing
identical products. In a perfectly competitive industry, no single firm has any control over prices.In other words, an individual firm cannot affect the market price of its product or the prices ofthe inputs that it buys. This important characteristic follows from two assumptions. First, a com-petitive industry is composed of many firms, each small relative to the size of the industry.Second, every firm in a perfectly competitive industry produces homogeneous products , which
means that one firm’s output cannot be distinguished from the output of the others.
These assumptions limit the decisions open to competitive firms and simplify the analysis of
competitive behavior. Firms in perfectly competitive industries do not differentiate their prod-ucts and do not make decisions about price. Instead, each firm takes prices as given—that is, asdetermined in the market by the laws of supply and demand—and decides only how much toproduce and how to produce it.
The idea that competitive firms are “price-takers” is central to our discussion. Of course, we
do not mean that firms cannot affix price tags to their merchandise; all firms have this ability. Wemean that given the availability of perfect substitutes, any product priced over the market pricewill not be sold.
These assumptions also imply that the demand for the product of a competitive firm is per-
fectly elastic (Chapter 5). For example, consider the Ohio corn farmer whose situation is shownin Figure 8.9. The left side of the diagram represents the current conditions in the market. Cornis currently selling for $6.00 per bushel.
1The right side of the diagram shows the demand for corn
as the farmer sees it. If she were to raise her price, she would sell no corn at all; because there areperfect substitutes available, the quantity demanded of her corn would drop to zero. T o lower herprice would be silly because she can sell all she wants at the current price. (Remember, eachfarmer’s production is very small relative to the entire corn market.)perfect competition An
industry structure in which
there are many firms, eachsmall relative to the industry,producing identical products
and in which no firm is large
enough to have any controlover prices. In perfectly
competitive industries, new
competitors can freely enterand exit the market.
homogenous products
Undifferentiated products;
products that are identical to,
or indistinguishable from, oneanother.
1Capital letters refer to the entire market, and lowercase letters refer to representative firms. For example, in Figure 8.9, the mar-
ket demand curve is labeled Dand the demand curve facing the firm is labeled d.Bushels of corn per year Bushels of corn per year
Price per bushel ($)Price per bushel ($)6.00 6.00
00a. The market b. A representative perfectly competitive firm
DS
d/L50296FIGURE 8.9 Demand
Facing a Single Firm in aPerfectly CompetitiveMarket
If a representative firm in a per-
fectly competitive market raisesthe price of its output above$6.00, the quantity demanded of
that firm’s output will drop to
zero. Each firm faces a perfectlyelastic demand curve, d.
180 PART II The Market System: Choices Made by Households and Firms
total revenue ( TR)The total
amount that a firm takes in
from the sale of its product:
the price per unit times thequantity of output the firm
decides to produce ( P/H11003q).
Marginal revenue ( MR)is the added revenue that a firm takes in when it increases out-
put by 1 additional unit. If a firm producing 10,521 units of output per month increases thatoutput to 10,522 units per month, it will take in an additional amount of revenue eachmonth. The revenue associated with the 10,522nd unit is the amount for which the firm sellsthat 1 unit. Thus, for a competitive firm, marginal revenue is equal to the current market priceof each additional unit sold. In Figure 8.9, for example, the market price is $6.00. Thus, if therepresentative firm raises its output from 10,521 units to 10,522 units, its revenue willincrease by $6.00.
A firm’s marginal revenue curve shows how much revenue the firm will gain by raising out-
put by 1 unit at every level of output. The marginal revenue curve and the demand curve facing a
competitive firm are identical . The horizontal line in Figure 8.9(b) can be thought of as both the
demand curve facing the firm and its marginal revenue curve:
P*=d=MRmarginal revenue ( MR) The
additional revenue that a firmtakes in when it increasesoutput by one additional unit.
In perfect competition, P=MR.In perfect competition, we also assume easy entry—that firms can easily enter and exit the
industry. If firms in an industry are earning high profits, new firms are likely to spring up. Thereare no barriers that prevent a new firm from competing. Fast-food restaurants are quick tospring up when a new shopping center opens, and new gas stations appear when a housingdevelopment or a new highway is built. When it became clear a number of years ago that manypeople would be buying products online, thousands of e-commerce start-ups flooded the Webwith new online “shops.”
We also assume easy exit . When a firm finds itself suffering losses or earning low profits, one
option is to go out of business, or exit the industry. Everyone knows a favorite restaurant thatwent out of business. Changes in cost of production, falling prices from international or regionalcompetition, and changing technology may turn business profits into losses and failure.
The best examples of perfect competition are probably found in agriculture. In that
industry, products are absolutely homogeneous—it is impossible to distinguish one farmer’swheat from another’s—and prices are set by the forces of supply and demand in a hugenational market.
Total Revenue and Marginal Revenue
Profit is the difference between total revenue and total cost. Total revenue (TR) is the total
amount that a firm takes in from the sale of its product. A perfectly competitive firm sells eachunit of product for the same price, regardless of the output level it has chosen. Therefore, totalrevenue is simply the price per unit times the quantity of output that the firm decides to produce:
TR=P*qtotal revenue =price *quantity
Comparing Costs and Revenues to Maximize Profit
The discussion in the next few paragraphs conveys one of the most important concepts in all of
microeconomics. As we pursue our analysis, remember that we are working under two assump-tions: (1) that the industry we are examining is perfectly competitive and (2) that firms choosethe level of output that yields the maximum total profit.
The Profit-Maximizing Level of Output Look carefully at the graphs in Figure 8.10.
Once again, we have the whole market, or industry, on the left and a single, typical small firm on theright. And again the current market price is P*.
First, the firm observes the market price [Figure 8.10(a)] and knows that it can sell all that it
wants for P*= $5 per unit. Next, the firm must decide how much to produce. It might seem rea-
sonable for the firm to pick the output level where marginal cost is at its minimum point—in thiscase, at an output of 100 units. Here the difference between marginal revenue, $5.00, and mar-ginal cost, $2.50, is the greatest. As it happens, 100 units is notthe optimal production level.
CHAPTER 8 Short-Run Costs and Output Decisions 181
00 1,755,000 100 250
Units of output Units of outputq*300 340P* = 5 P* = MR= $5MC
MC =
$2.50MC =
$4MC = $5.70ATCS
DP* = 5Price per unit ($)a. The industry b. A representative firm
/L50304FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly
Competitive Firm
If price is above marginal cost, as it is at 100 and 250 units of output, profits can be increased by raising out-
put; each additional unit increases revenues by more than it costs to produce the additional output. Beyondq* = 300, however, added output will reduce profits. At 340 units of output, an additional unit of output
costs more to produce than it will bring in revenue when sold on the market. Profit-maximizing output is thus
q*, the point at which P* = MC.
Remember that a firm wants to maximize the difference between total revenue and total cost,
not the difference between marginal revenue and marginal cost. The fact that marginal revenue is
greater than marginal cost at a level of 100 indicates that profit is notbeing maximized. Think
about the 101st unit. Adding that single unit to production each period adds $5.00 to revenuesbut adds only about $2.50 to cost. Profits each period would be higher by about $2.50. Thus, theoptimal (profit-maximizing) level of output is clearly higher than 100 units.
Now look at an output level of 250 units. Here, once again, raising output increases
profit. The revenue gained from producing the 251st unit (marginal revenue) is still $5, andthe cost of the 251st unit (marginal cost) is only about $4. As long as marginal revenue isgreater than marginal cost, even though the difference between the two is getting smaller,added output means added profit. Whenever marginal revenue exceeds marginal cost, therevenue gained by increasing output by 1 unit per period exceeds the cost incurred by doingso. This logic leads us to 300 units of output. At 300 units, marginal cost has risen to $5. At300 units of output, P*=MR =MC = $5.
Notice that if the firm were to produce more than 300 units, marginal cost would rise above
marginal revenue. At 340 units of output, for example, the cost of the 341st unit is about $5.70 whilethat added unit of output still brings in only $5 in revenue, thus reducing profit. It simply does notpay to increase output above the point where marginal cost rises above marginal revenue becausesuch increases will reduce profit. The profit-maximizing perfectly competitive firm will produce up
to the point where the price of its output is just equal to short-run marginal cost—the level of out-put at which P*=MC. Thus, in Figure 8.10, the profit-maximizing level of output, q*, is 300 units.
Keep in mind, though, that all types of firms (not just those in perfectly competitive indus-
tries) are profit maximizers. The profit-maximizing output level for allfirms is the output level
where MR=MC. In perfect competition, however, MR=P, as shown earlier. Hence, for perfectly
competitive firms, we can rewrite our profit-maximizing condition as P=MC.
Important note: The key idea here is that firms will produce as long as marginal revenue exceeds
marginal cost. When marginal cost rises smoothly, as it does in Figure 8.10, the profit-maximizing
condition is that MR (orP)exactly equals MC . If marginal cost moves up in increments—as it
does in the following numerical example—marginal revenue or price may never exactly equalmarginal cost. The key idea still holds.
182 PART II The Market System: Choices Made by Households and Firms
ECONOMICS IN PRACTICE
Case Study in Marginal Analysis: An Ice Cream Parlor
The following is a description of the decisions made in 2000 by the
owner of a small ice cream parlor in Ohio. After being in business
for 1 year, this entrepreneur had to ask herself whether she shouldstay in business.
The cost figures on which she based her decisions are pre-
sented next. These numbers are real, but they do not include oneimportant item: the managerial labor provided by the owner. In
her calculations, the entrepreneur did not include a wage for her-
self, but we will assume an opportunity cost of $30,000 per year($2,500 per month).
FIXED COSTS
The fixed components of the store’s monthly costs include the following:
Rent (1,150 square feet) . . . . . . . . . . . . . . . . . . . . . . .$2,012.50
Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .325.00
Interest on loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .737.50
Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295.00T elephone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
65.00
T otal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$3,435.00
Not all the items on this list are strictly fixed, however. Electricity
costs, for example, would be slightly higher if the store producedmore ice cream and stayed open longer, but the added cost would
be minimal.
VARIABLE COSTS
The ice cream store’s variable costs include two components:(1) behind-the-counter labor costs and (2) cost of making ice cream.
The store hires employees at a wage of $5.15 per hour. Including theemployer’s share of the Social Security tax, the gross cost of labor is$5.54 per hour. Two employees work in the store at all times. The fullcost of producing ice cream is $3.27 per gallon. Each gallon contains
approximately 12 servings. Customers can add toppings free of
charge, and the average cost of the toppings taken by a customer isabout $.05:
Gross labor costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .$5.54/hour
Costs of producing one gallon of
ice cream (12 servings per gallon) . . . . . . . . . . . . . . . . .$3.27
Average cost of added toppings per serving . . . . . . . . . . . .$.05
REVENUES
The store sells ice cream cones, sundaes, and floats. The average
price of a purchase at the store is $1.45. The store is open 8 hours
per day, 26 days a month, and serves an average of 240 customersper day:
Average purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$1.45
Days open per month . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26Average number of customers per day . . . . . . . . . . . . . . . . .240
From the preceding information, it is possible to calculate the
store’s average monthly profit. T otal revenue is equal to 240 cus-tomers /H11003$1.45 per customer /H1100326 days open in an average month:
TR= $9,048 per month.PROFITS
The store sells 240 servings per day. Because there are 12 servings
of ice cream per gallon, the store uses exactly 20 gallons per day
(240 servings divided by 12). T otal costs are $3.27 /H1100320, or $65.40,
per day for ice cream and $12 per day for toppings (240 /H11003$.05).
The cost of variable labor is $5.54 /H110038 hours /H110032 workers, or
$88.64 per day. T otal variable costs are therefore $166.04 ($65.40 +$12.00 + $88.64) per day. The store is open 26 days a month, so
the total variable cost per month is $4,317.04.
Adding fixed costs of $3,435.00 to variable costs of $4,317.04,
we get a total cost of operation of $7,752.04 per month. Thus, thefirm is averaging a profit of $1,295.96 per month ($9,048.00 –$7,752.04). This is not an “economic profit” because we have not
accounted for the opportunity cost of the owner’s time and efforts. In
fact, when we factor in an implicit wage of $2,500 per month forthe owner, we see that the store is suffering losses of $1,204.04 per
month ($1,295.96 – $2,500.00).
T otal revenue ( TR) . . . . . . . . . . . . . . . . . . . . . . . . . . . .$9,048.00
T otal fixed cost ( TFC ) . . . . . . . . . . . . . . . . . . . . . . . . . .3,435.00
+ T otal variable cost ( TVC ) . . . . . . . . . . . . . . . . . . . . .
4,317.04
T otal costs ( TC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7,752.04
T otal profit ( TR – TC ) . . . . . . . . . . . . . . . . . . . . . . . . . .1,295.96
Adjustment for implicit wage . . . . . . . . . . . . . . . . . . 2,500.00
Economic profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .–1,204.04
Should the entrepreneur stay in business? If she wants to make
$2,500 per month and she thinks that nothing about her businesswill change, she must shut down in the long run. However, twothings keep her going: (1) a decision to stay open longer and (2) the
hope for more customers in the future.
OPENING LONGER HOURS: MARGINAL COSTS AND
MARGINAL REVENUES
The store’s normal hours of operation are noon until 8 P.M. On an
experimental basis, the owner extends its hours until 11 P.M.f o r
1 month. The following table shows the average number of addi-tional customers for each of the added hours:
Hours ( P.M.) Customers
8–9 41
9–10 20
10–11 8
CHAPTER 8 Short-Run Costs and Output Decisions 183
Hour ( P.M.) Marginal Revenue
(MR)Marginal Cost
(MC)Added Profit per Hour
(MR –MC)
8–9 $1.45 /H1100341 = $59.45 Ice cream: $0.32 /H1100341 = $13.12
Labor: 2 /H11003$5.54 = 11.08
Total $24.20$35.25
9–10 1.45 /H1100320 = $29.00 Ice cream: $0.32 /H1100320 = $6.40
Labor: 2 /H11003$5.54 = 11.08
Total $17 .48$11.52
10–11 1.45 /H110038 = $11.60 Ice cream: $0.32 /H110038 = $2.56
Labor: 2 /H11003$5.54 = 11.08
Total $13.64–$2.04Assuming that the late customers spend an average of $1.45, we
can calculate the marginal revenue and the marginal cost of staying
open longer. The marginal cost of one serving of ice cream is $3.27divided by 12 = $0.27 + .05 (for topping) = $0.32. (See the tablethat follows.)
Marginal analysis tells us that the store should stay open for
2 additional hours. Each day that the store stays open from 8
P.M.
to 9 P.M. it will make an added profit of $59.45 – $24.20, or $35.25.
Staying open from 9 P.M. to 10 P.M. adds $29.00 – $17.48, or
$11.52, to profit. Staying open the third hour, however, decreases
profits because the marginal revenue generated by staying openfrom 10 P.M. to 11 P.M. is less than the marginal cost. The entre-
preneur decides to stay open for 2 additional hours per day.
This adds $46.77 ($35.25 + 11.52) to profits each day, a total of$1,216.02 per month.
By adding the 2 hours, the store turns an economic loss of
$1,204.04 per month into a small ($11.98) profit after accounting
for the owner’s implicit wage of $2,500 per month.
The owner decided to stay in business. She now serves over
350 customers per day, and the price of a dish of ice cream has risento $2.50 while costs have not changed very much. In 2001, shecleared a profit of nearly $10,000 per month.
TABLE 8.6 Profit Analysis for a Simple Firm
(1) (2) (3) (4) (5) (6) (7) (8)
q TFC TVC MC P= M RTR
(P/H11003q)TC
(TFC +TVC )Profit
(TR–TC)
0 $10 $ 0 $– $15 $ 0 $10 $–10
1 10 10 10 15 15 20 –5
2 10 15 5 15 30 25 5
3 10 20 5 15 45 30 15
4 10 30 10 15 60 40 20
5 10 50 20 15 75 60 15
6 10 80 30 15 90 90 0A Numerical Example Table 8.6 presents some data for another hypothetical firm. Let us
assume that the market has set a $15 unit price for the firm’s product. T otal revenue in column 6is the simple product of P
/H11003q(the numbers in column 1 times $15). The table derives total, mar-
ginal, and average costs exactly as Table 8.4 did. Here, however, we have included revenues, andwe can calculate the profit, which is shown in column 8.
Column 8 shows that a profit-maximizing firm would choose to produce 4 units of output.
At this level, profits are $20. At all other output levels, they are lower. Now let us see if “marginal”reasoning leads us to the same conclusion.
First, should the firm produce at all? If it produces nothing, it suffers losses equal to $10. If it
increases output to 1 unit, marginal revenue is $15 (remember that it sells each unit for $15) andmarginal cost is $10. Thus, it gains $5, reducing its loss from $10 each period to $5.
Should the firm increase output to 2 units? The marginal revenue from the second unit is
again $15, but the marginal cost is only $5. Thus, by producing the second unit, the firm gains$10 ($15 – $5) and turns a $5 loss into a $5 profit. The third unit adds $10 to profits. Again, mar-ginal revenue is $15 and marginal cost is $5, an increase in profit of $10, for a total profit of $15.
184 PART II The Market System: Choices Made by Households and Firms
The fourth unit offers still more profit. Price is still above marginal cost, which means that
producing that fourth unit will increase profits. Price, or marginal revenue, is $15, and marginalcost is just $10. Thus, the fourth unit adds $5 to profit. At unit number five, however, diminishingreturns push marginal cost above price. The marginal revenue from producing the fifth unit is$15, while marginal cost is now $20. As a result, profit per period drops by $5, to $15 per period.Clearly, the firm will not produce the fifth unit.
The profit-maximizing level of output is thus 4 units. The firm produces as long as price
(marginal revenue) is greater than marginal cost. For an in-depth example of profit maximiza-tion, see “Case Study in Marginal Analysis: An Ice Cream Parlor” on p. 182.
The Short-Run Supply Curve
Consider how the typical firm shown in Figure 8.10 on p. 181 would behave in response to anincrease in price. In Figure 8.11(a), assume that something causes demand to increase (shift tothe right), driving price from $5 to $6 and finally to $7. When price is $5, a profit-maximizingfirm will choose an output level of 300 in Figure 8.11(b). T o produce any less, or to raise out-put above that level, would lead to a lower level of profit. At $6, the same firm would increaseoutput to 350, but it would stop there. Similarly, at $7, the firm would raise output to 400 unitsof output.
The MC curve in Figure 8.11(b) relates price and quantity supplied. At any market price, the
marginal cost curve shows the output level that maximizes profit. A curve that shows how muchoutput a profit-maximizing firm will produce at every price also fits the definition of a supplycurve. (Review Chapter 3 if this point is not clear to you.) Thus, the marginal cost curve of a com-petitive firm is the firm’s short-run supply curve.
As you will see, one very important exception exists to this general rule: There is some price
level below which the firm will shut down its operations and simply bear losses equal to fixedcosts even if price is above marginal cost. This important point is discussed in Chapter 9.
MCS
300 350 400 0 0ATC
d2= MR2
d1= MR1
d0= MR0
Units of output Units of output7
6
57
6
5Price per unit ($)D2
D1
D0a. The industry b. A representative firm
/L50304FIGURE 8.11 Marginal Cost Is the Supply Curve of a Perfectly Competitive Firm
At any market price,athe marginal cost curve shows the output level that maximizes profit. Thus, the mar-
ginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve.
aThis is true except when price is so low that it pays a firm to shut down—a point that will be discussed in Chapter 9.
CHAPTER 8 Short-Run Costs and Output Decisions 185
Looking Ahead
At the beginning of this chapter, we set out to combine information on technology, factor prices,
and output prices to understand the supply curve of a competitive firm. We have now accom-plished that goal.
Because marginal cost is such an important concept in microeconomics, you should care-
fully review any sections of this chapter that were unclear to you. Above all, keep in mind thatthemarginal cost curve carries information about both input prices and technology . The firm
looks to output markets for information on potential revenues, and the current market pricedefines the firm’s marginal revenue curve. The point where price (which is equal to marginalrevenue in perfect competition) is just equal to marginal cost is the perfectly competitive firm’sprofit-maximizing level of output. Thus, with one important exception, the marginal cost curveisthe perfectly competitive firm’s supply curve in the short run.
In the next chapter, we turn to the long run. What happens when firms are free to choose their
scale of operations without being limited by a fixed factor of production? Without diminishingreturns that set in as a result of a fixed scale of production, what determines the shape of cost curves?What happens when new firms can enter industries in which profits are being earned? How do indus-tries adjust when losses are being incurred? How does the structure of an industry evolve over time?
SUMMARY
1.Profit-maximizing firms make decisions to maximize profit
(total revenue minus total cost).
2.T o calculate production costs, firms must know two things:(1) the quantity and combination of inputs they need toproduce their product and (2) the cost of those inputs.
COSTS IN THE SHORT RUN p. 168
3.Fixed costs are costs that do not change with a firm’s output.
In the short run, firms cannot avoid fixed costs or changethem even if production is zero.
4.Variable costs are those costs that depend on the level of out-
put chosen. Fixed costs plus variable costs equal total costs
(TC=TFC +TVC ).
5.Average fixed cost (AFC ) is total fixed cost divided by the
quantity of output. As output rises, average fixed costdeclines steadily because the same total is being spread overa larger and larger quantity of output. This phenomenon iscalled spreading overhead .
6.Numerous combinations of inputs can be used to produce a
given level of output. Total variable cost (TVC ) is the sum of
all costs that vary with output in the short run.
7.Marginal cost (MC) is the increase in total cost that results
from the production of 1 more unit of output. If a firm is pro-ducing 1,000 units, the additional cost of increasing output to1,001 units is marginal cost. Marginal cost measures the costof the additional inputs required to produce each successiveunit of output. Because fixed costs do not change when out-put changes, marginal costs reflect changes in variable costs.
8.In the short run, a firm is limited by a fixed factor of pro-duction or a fixed scale of a plant. As a firm increases output,it will eventually find itself trapped by that scale. Because ofthe fixed scale, marginal cost eventually rises with output.
9.Marginal cost is the slope of the total variable cost curve.The total variable cost curve always has a positive slopebecause total costs always rise with output. However,increasing marginal cost means that total costs ultimately
rise at an increasing rate.
10. Average variable cost (AVC ) is equal to total variable cost
divided by the quantity of output.
11. When marginal cost is above average variable cost, averagevariable cost is increasing . When marginal cost is below aver-
age variable cost, average variable cost is declining . Marginal
cost intersects average variable cost at AVC ’ s minimum point.
12. Average total cost (ATC ) is equal to total cost divided by the
quantity of output. It is also equal to the sum of averagefixed cost and average variable cost.
13. When marginal cost is below average total cost, average totalcost is declining toward marginal cost. When marginal costis above average total cost, average total cost is increasing.Marginal cost intersects average total cost at ATC’ s mini-
mum point.
OUTPUT DECISIONS: REVENUES, COSTS, AND
PROFIT MAXIMIZATION p. 179
14. A perfectly competitive firm faces a demand curve that is a
horizontal line (in other words, perfectly elastic demand).
15. Total revenue (TR) is simply price times the quantity of out-
put that a firm decides to produce and sell. Marginal revenue
(MR) is the additional revenue that a firm takes in when it
increases output by 1 unit.
16. For a perfectly competitive firm, marginal revenue is equalto the current market price of its product.
17. A profit-maximizing firm in a perfectly competitive industrywill produce up to the point at which the price of its outputis just equal to short-run marginal cost: P=MC. The more
general profit-maximizing formula is MR=MC (P=MRin
perfect competition). The marginal cost curve of a perfectlycompetitive firm is the firm’s short-run supply curve, withone exception (discussed in Chapter 9).
186 PART II The Market System: Choices Made by Households and Firms
REVIEW TERMS AND CONCEPTS
average fixed cost ( AFC ),p. 169
average total cost ( ATC ),p. 175
average variable cost ( AVC ),p. 174
fixed cost, p. 168
homogeneous product, p. 179
marginal cost ( MC),p. 171
marginal revenue ( MR),p. 180
perfect competition, p. 179
spreading overhead, p. 169 total cost ( TC),p. 168
total fixed costs ( TFC )oroverhead, p. 168
total revenue ( TR),p. 180
total variable cost ( TVC ),p. 169
total variable cost curve, p. 170
variable cost, p. 168
1.TC=TFC +TVC
2.AFC =TFC/q3. Slope of TVC =MC
4.AVC =TVC/q
5.ATC =TC/q =AFC +AVC
6.TR=P/H11003q
7. Profit-maximizing level of output for
all firms: MR=M
8. Profit-maximizing level of output for
perfectly competitive firms: P=MC
PROBLEMS
1.Consider the following costs of owning and operating a car. A
$25,000 Ford Taurus financed over 60 months at 7 percent inter-est means a monthly payment of $495.03. Insurance costs $100 a
month regardless of how much you drive. The car gets 20 milesper gallon and uses unleaded regular gasoline that costs $3.50 pergallon. Finally, suppose that wear and tear on the car costs about
15 cents a mile. Which costs are fixed, and which are variable?
What is the marginal cost of a mile driven? In deciding whetherto drive from New Y ork to Pittsburgh (about 1,000 miles round-trip) to visit a friend, which costs would you consider? Why?
2.July 23, 2007 LONDON (Reuters)—The final volume of the Harry
Potter saga sold more than 11 million copies in the first 24 hours itwent on sale in the United States and Britain to become the fastest-
selling book in history, publishers said. In book publishing, fixed
costs are very high and marginal costs are very low and fairly con-stant. Suppose that the fixed cost of producing the new Harry Pottervolume is $30 million. What is the average fixed cost if the publisher
produces 5 million copies? 10 million copies? 20 million copies?
Now suppose that the marginal cost of a Harry Potter book is
$1.50 per book and is the same for each book up to 40 millioncopies. Assume that this includes all variable costs. Explain why inthis case marginal cost is a horizontal line, as is average variablecost. What is the average total cost of the book if the publisher
produces 5 million copies? 10 million copies? 20 million copies?
Sketch the average fixed cost curve and the average total cost
curve facing the publisher.
3.Do you agree or disagree with this statement? Firms minimize
costs; thus, a firm earning short-run economic profits will chooseto produce at the minimum point on its average total cost function.
4.Y ou are given the following cost data:
T otal fixed costs are 100.
All problems are available on www.myeconlab.com
q K L
0 0 0
1 2 5
2 4 9
3 6 12
4 8 15
5 10 19
6 12 24
7 14 30
8 16 37
9 18 45
10 20 54
a.Assuming that the price of labor ( PL) is $5 per unit and the
price of capital ( PK) is $10 per unit, compute and graph total
cost, marginal cost, and average variable cost for the firm.
b.Do the graphs have the shapes that you might expect? Explain.
c.Using the numbers here, explain the relationship between
marginal cost and average variable cost.
d.Using the numbers here, explain the meaning of “marginal
cost” in terms of additional inputs needed to produce a mar-
ginal unit of output.
e.If the output price was $57, how many units of output
would the firm produce? Explain.If the price of output is $15, how many units of output will this
firm produce? What is total revenue? What is total cost? Brieflyexplain using the concept of marginal cost. What do you think
the firm is likely to do in the short run? In the long run?
5.[Related to the Economics in Practice onp. 178 ]While charg-
ing admission most days of the week, the Museum of
Contemporary Art in Los Angeles offers free admission on
Thursday evenings. Why do museums often price this way? Whydo they choose Thursday rather than Saturday?
6.The following table gives capital and labor requirements for
10 different levels of production.
q TVC
0 0
1 5
2 10
3 20
4 40
5 65
6 95
CHAPTER 8 Short-Run Costs and Output Decisions 187
a.Complete the table.
b.Graph AVC ,ATC, and MC on the same graph. What is the
relationship between the MC curve and the ATC and
between MC and AVC ?
c.Suppose market price is $30. How much will the firm
produce in the short run? How much are total profits?
d.Suppose market price is $50. How much will the firm
produce in the short run? What are total profits?
9.A 2010 Georgia T ech graduate inherited her mother’s printing
company. The capital stock of the firm consists of threemachines of various vintages, all in excellent condition. All
machines can be running at the same time.7.Do you agree or disagree with each of the following statements?
Explain your reasons.
a.For a competitive firm facing a market price above average
total cost, the existence of economic profits means that thefirm should increase output in the short run even if price isbelow marginal cost.
b.If marginal cost is rising with increasing output, average cost
must also be rising.
c.Fixed cost is constant at every level of output except zero. When
a firm produces no output, fixed costs are zero in the short run.
8.A firm’s cost curves are given in the following table.
q TC TFC TVC AVC ATC MC
0 $100 $100 — — — —
1 130 100 — — — —
2 150 100 — — — —
3 160 100 — — — —
4 172 100 — — — —
5 185 100 — — — —
6 210 100 — — — —
7 240 100 — — — —
8 280 100 — — — —
9 330 100 — — — —
10 390 100 — — — —
COST OF PRINTING
AND BINDING
PER BOOKMAXIMUM TOTAL
CAPACITY (BOOKS)
PER MONTH
Machine 1 $1.00 100
Machine 2 2.00 200
Machine 3 3.00 500
a.Assume that “cost of printing and binding per book” includes
alllabor and materials, including the owner’s wages. Assume
further that Mom signed a long-term contract (50 years) with
a service company to keep the machines in good repair for a
fixed fee of $100 per month.(1) Derive the firm’s marginal cost curve.
(2) Derive the firm’s total cost curve.
b.At a price of $2.50, how many books would the company
produce? What would total revenues, total costs, and total
profits be?
10.The following is a total cost curve. Sketch the corresponding
marginal cost curve. If the price of output is $3 and there
are no fixed costs, what is the profit-maximizing level of output?600
100 0 300 200200$
qTC
Total product
Units of laborTotal output200
100
0 100 200 30011.The following curve is a production function for a firm that
uses just one variable factor of production, labor. It shows totaloutput, or product, for every level of input.a.Derive and graph the marginal product curve.
b.Suppose the wage rate is $4. Derive and graph the firm’s
marginal cost curve.
c.If output sells for $6, what is the profit-maximizing level of
output? How much labor will the firm hire?
PERIOD CATCH PER DAY (KILOGRAMS)
Prime fishing: 180 days 100
Month 7: 30 days 80
Month 8: 30 days 60
Rest of the year 4012.[Related to the Economics in Practice onp. 182 ]Elena and
Emmanuel live on the Black Sea in Bulgaria and own a small
fishing boat. A crew of four is required to take the boat out fish-ing. The current wage paid to the four crew members is a totalof 5,000 levs per day. (A lev is the Bulgarian unit of currency.)Assume that the cost of operating and maintaining the boat is
1,000 levs per day when fishing and zero otherwise. The follow-
ing schedule gives the appropriate catch for each period duringthe year.
The price of fish in Bulgaria is no longer regulated by the
government and is now determined in competitive markets.Suppose the price has been stable all year at 80 levs per kilogram.a.What is the marginal product of a day’s worth of fishing
during prime fishing season? during month 7? during
month 8?
b.What is the marginal cost of a kilogram of fish during prime
fishing season? during month 7, during month 8, and duringthe rest of the year?
c.If you were Elena and Emmanuel, how many months per
year would you hire the crew and go out fishing? Explainyour answer using marginal logic.
188 PART II The Market System: Choices Made by Households and Firms
13.For each of the following businesses, what is the likely fixed fac-
tor of production that defines the short run?
a.Potato farm of 160 acres
b.Chinese restaurant
c.Dentist in private practice
d.Car dealership
e.Bank
14.Explain which of the following is a fixed cost or a variable cost
for Southwest Airlines.a.The cost of jet fuel used in its airplanes.
b.The monthly rent on its Dallas, T exas headquarters.
c.The yearly lease payments on its current inventory of
Boeing 737 jets.
d.The cost of peanuts it serves to passengers.
e.The salary paid to Laura Wright, Southwest’s Senior Vice
President of Finance and Chief Financial Officer.
f.The gate rental fees it pays to McCarran International
Airport in Las Vegas, Nevada.
15.Use the information in the graph to find the values for the fol-
lowing costs at an output level of 500.
a.T otal fixed cost
b.T otal variable cost
c.T otal cost
d.Marginal cost16.Explain how the following events would affect the cost curves in
the graph from the previous question.a.Hourly wages for employees increase.
b.The company signs a new 3-year contract with its landlord
which lowers its monthly rent by 10 percent.
c.The company employs a new technology which lowers its
utility costs.
d.The company receives notice of a 5 percent increase in its
property insurance rate.
e.The company’s primary supplier of resources implements a
3 percent price increase for all of its supplies.
17.Fill in the columns in the following table. What quantity should
a profit-maximizing firm produce? Verify your answer withmarginal reasoning.
q TFC TVC MC P = MR TR TC Profit
0 $20 $0 $22
1 20 10 22
2 20 15 22
3 20 25 22
4 20 40 22
5 20 60 22
6 20 90 22
0 500
Units of output$35
1015Cost per unit ($)MC
ATC
AVC18.Use the information from your answer to the previous question
to construct a rough plot showing marginal revenue, marginal
cost, and average total cost. Also identify the profit-maximizingquantity of output on the graph. Y ou will have to calculate aver-age total cost from the information in the table.
19.Marginal cost represents the increase in total cost that results
from producing one more unit of output. Marginal productrepresents the additional output that can be produced by adding
one more unit of a specific input, holding all other inputs con-
stant. What does this imply about the relationship between mar-ginal cost and marginal product?
20.Evaluate the following statement. If the total variable cost of
production is the sum of the marginal cost of each additionalunit of output, we can calculate the marginal cost by taking thetotal variable cost of production and dividing it by the quantityof output produced.
CHAPTER OUTLINE
1899
Short-Run Conditions
and Long-RunDirections
p. 190
Maximizing Profits
Minimizing LossesThe Short-Run Industry
Supply Curve
Long-Run Directions:
A Review
Long-Run Costs:
Economies andDiseconomies ofScale
p. 195
Increasing Returns to Scale
Constant Returns to ScaleDecreasing Returns to ScaleU-Shaped Long-Run
Average Costs
Long-Run
Adjustments to Short-Run Conditions
p. 200
Short-Run Profits: Moves
In and Out ofEquilibrium
The Long-Run Adjustment
Mechanism: InvestmentFlows Toward ProfitOpportunities
Output Markets: A
Final Word p. 206
Appendix: ExternalEconomies andDiseconomies and theLong-Run IndustrySupply Curve
p. 210Long-Run Costs and
Output Decisions
The last two chapters discussed the
behavior of profit-maximizing competi-tive firms in the short run. Recall that allfirms must make three fundamentaldecisions: (1) how much output to pro-duce or supply, (2) how to produce thatoutput, and (3) how much of each inputto demand.
Firms use information on input
prices, output prices, and technology tomake the decisions that will lead to themost profit. Because profits equal rev-enues minus costs, firms must knowhow much their products will sell forand how much production will cost, using the most efficient technology.
In Chapter 8, we saw how cost curves can be derived from production functions and input
prices. Once a firm has a clear picture of its short-run costs, the price at which it sells its outputdetermines the quantity of output that will maximize profit. Specifically, a profit-maximizingperfectly competitive firm will supply output up to the point that price (marginal revenue) equalsmarginal cost. The marginal cost curve of such a firm is thus the same as its supply curve.
In this chapter, we turn from the short run to the long run. The condition in which firms find
themselves in the short run (Are they making profits? Are they incurring losses?) determines what islikely to happen in the long run. Remember that output (supply) decisions in the long run are lessconstrained than in the short run, for two reasons. First, in the long run, the firm can increase anyor all of its inputs and thus has no fixed factor of production that confines its production to a givenscale. Second, firms are free to enter industries to seek profits and to leave industries to avoid losses.
In thinking about the relationship between the short run and long run, it is useful to put
yourself in the position of a manager of a firm. At times, you will be making what we term short-
run decisions: Y ou are stuck with a particular factory and set of machines, and your decisions
involve asking how best to use those assets to produce output. At the same time, you or anothermanager at the firm will be doing more strategic long-run thinking: Should you be in this busi-
ness at all, or should you close up shop? In better times, you might consider expanding the oper-ation. In thinking about the long run, you will also have to reckon with other firms entering andexiting the industry. Managers simultaneously make short- and long-run decisions, making thebest of the current constraints while planning for the future.
In making decisions or understanding industry structure, the shape of the long-run cost
curve is important. As we saw in the short run, a fixed factor of production eventually causesmarginal cost to increase along with output. In the long run, all factors can be varied. In the ear-lier sandwich shop example, in the long run, we can add floor space and grills along with morepeople to make the sandwiches. Under these circumstances, it is no longer inevitable thatincreased volume comes with higher costs. In fact, as we will see, long-run cost curves need notslope up at all. Y ou might have wondered why there are only a few automobile and steel compa-nies in the United States but dozens of firms producing books and furniture. Differences in theshapes of the long-run cost curves in those industries do a good job of explaining these differ-ences in the industry structures.
190 PART II The Market System: Choices Made by Households and Firms
We begin our discussion of the long run by looking at firms in three short-run circum-
stances: (1) firms that earn economic profits, (2) firms that suffer economic losses but continueto operate to reduce or minimize those losses, and (3) firms that decide to shut down and bearlosses just equal to fixed costs. We then examine how these firms make their long-run decisions inresponse to conditions in their markets.
Although we continue to focus on perfectly competitive firms, allfirms are subject to the
spectrum of short-run profit or loss situations regardless of market structure . Assuming perfect
competition allows us to simplify our analysis and provides us with a strong background forunderstanding the discussions of imperfectly competitive behavior in later chapters.
Short-Run Conditions and Long-Run
Directions
Before beginning our examination of firm behavior, let us review the concept of profit. Recall
that a normal rate of return is included in the definition of total cost (Chapter 7). A normal rate
of return is a rate that is just sufficient to keep current investors interested in the industry.
Because we define profit as total revenue minus total cost and because total cost includes a nor-
mal rate of return, our concept of profit takes into account the opportunity cost of capital. Whena firm is earning an above-normal rate of return, it has a positive profit level; otherwise, it doesnot. When there are positive profits in an industry, new investors are likely to be attracted tothe industry.
When we say that a firm is suffering a loss, we mean that it is earning a rate of return that is
below normal. Such a firm may be suffering a loss as an accountant would measure it, or it maybe earning at a very low—that is, below normal—rate. Investors are not going to be attracted toan industry in which there are losses. A firm that is breaking even , or earning a zero level of
profit, is one that is earning exactly a normal rate of return. New investors are not attracted, butcurrent ones are not running away either.
With these distinctions in mind, we can say that for any firm, one of three conditions holds
at any given moment: (1) The firm is making positive profits, (2) the firm is suffering losses, or(3) the firm is just breaking even. Profitable firms will want to maximize their profits in the shortrun, while firms suffering losses will want to minimize those losses in the short run.
Maximizing Profits
The best way to understand the behavior of a firm that is currently earning profits is by way of example.
Example: The Blue Velvet Car Wash When a firm earns revenues in excess of costs
(including a normal rate of return), we say it is earning positive or excess profits. Let us consideras an example the Blue Velvet Car Wash. Looking at a few numbers will help you see how thespecifics of a business operation translate into economic graphs.
Car washes require a facility. In the case of Blue Velvet, suppose investors have put up $500,000 to
construct a building and purchase all the equipment required to wash cars. If the car wash closes, thebuilding and equipment can be sold for its original purchase price, but as long as the firm is in busi-ness, that capital is tied up. If the investors could get 10 percent return on their investment in anotherbusiness, then for them to keep their money in this business, they will also expect 10 percent from BlueVelvet. Thus, the annual cost of the capital needed for the business is $50,000 (10 percent of $500,000).
The car wash is currently servicing 800 cars a week and can be open 50 weeks a year (2 weeks are
needed for maintenance). The cost of the basic maintenance contract on the equipment is $50,000per year, and Blue Velvet has a contract to pay for those services for a year whether it opens the carwash or not. The fixed costs then for the car wash are $100,000 per year: $50,000 for the capital costsand $50,000 for the equipment contract. On a weekly basis, these costs amount to $2,000 per week. Ifthe car wash operates at the level of 800 cars per week, fixed costs are $2.50 per car ($2,000/800).
There are also variable costs associated with the business. T o run a car wash, one needs work-
ers and soap and water. Workers can be hired by the hour for $10.00 an hour, and at a customerlevel of 800 cars per week, each worker can wash 8 cars an hour. At this service level, then, BlueVelvet hires workers for 100 hours and has a wage bill of $1,000. The labor cost of each car wash,when Blue Velvet serves 800 customers, is $1.25 ($10/8).breaking even The situation
in which a firm is earning
exactly a normal rate of return.
CHAPTER 9 Long-Run Costs and Output Decisions 191
The number of cars each worker can service depends on the number of cars being worked
on. When there is too little business and few workers, no specialization is possible and carswashed per worker fall. With many cars to service, workers start getting in one another’s way. Wesaw that at 800 cars per week, workers could wash 8 each per hour. Later when we graph the oper-ation, we will assume that the number of cars washed per worker rises and then falls, reaching amaximum at a volume less than the current 800 cars.
Every car that is washed costs $0.75 in soap, adding $600 to the weekly bill if 800 car washes
are done. Table 9.1 summarizes the costs of Blue Velvet at the 800 washes per week level.
This car wash business is quite competitive, and the market price for this service at the
moment we are considering is $5. (Recall the perfectly elastic demand curve facing a competitivefirm we discussed in Chapter 8.) At a service level of 800 cars, as you see from the table, Blue Velvetis making a positive profit of $400 per week. For each car washed, it receives $5 and spends $4.50($2.50 in fixed costs + $1.25 in labor costs + $0.75 in soap), for an excess profit of $0.50 per car.
Graphic Presentation For Blue Velvet, we have seen a snapshot of the business as it oper-
ates with 800 cars serviced a week. We have also learned a little about the business, which we canuse to construct a graphical representation of Blue Velvet to help us see why the firm chose to ser-vice 800 cars. Figure 9.1 graphs the performance of Blue Velvet in this first period in which it ismaking money.
a. The industry b. Blue Velvet
S
D
0
Units of output, QPrice per unit ($)P* = 5 P* = 5
4.50
0 q*= 800Total
revenueTotalcostProfit
MC
ATC
AVCA
B
Units of output, qP*=MR
8,000
/L50304FIGURE 9.1 Firm Earning a Positive Profit in the Short Run
A profit-maximizing perfectly competitive firm will produce up to the point where P* = MC. Profit is the dif-
ference between total revenue and total cost. At q* = 800, total revenue is $5 /H11003800 = $4,000, total cost is
$4.50 /H11003800 = $3,600, and profit = $4,000 -$3,600 = $400.TABLE 9.1 Blue Velvet Car Wash Weekly Costs
TFC
Total Fixed CostTVC
Total Variable Cost
(800 Washes)TC
Total Cost
(800 Washes)TR
Total Revenue
(P= $5)
1. Normal return to
investors$1,000 1. Labor2. Soap $1,000
600TC=TFC +TVC
=$2,000 +$1,600
=$3,600TR=$5/H11003800
=$4,000
2. Other fixed costs
(maintenance contract)
1,000
$2,000$1,600 Profit =TR–TC
=$400
192 PART II The Market System: Choices Made by Households and Firms
The industry price is $5.00, and we have assumed that the total number of car washes done in
the market area in a week is 8,000; so there are 10 firms like Blue Velvet in this competitive market-place all earning economic profits. There are three key cost curves shown in the graph that repre-sents Blue Velvet. The average variable cost (AVC) curve shows what happens to the per unit costsof workers and the other variable factor, soap, as we change output. Initially as output increasesworkers can service more cars per hour as they work together, thus causing the AVC to decline, buteventually diminishing returns set in and A VC begins to rise. Now look at the average total cost(ATC) curve. The average total cost curve falls at first in response to the spreading of the fixed costsover more and more units and eventually begins to rise as the inefficiencies in labor take their toll.At the output of 800 washes, the ATC has a value of $4.50. Look back at Table 9.1. The total cost ofBlue Velvet at a service level of 800 cars is $3,600. The $4.50 comes from dividing this $3,600 by800 cars. Finally, we see the marginal cost (MC) curve, which rises after a certain point because ofthe fixed factor of the building and equipment.
With a price of $5.00, Blue Velvet is producing 800 units and making a profit (the gray box).
Blue Velvet is a perfectly competitive firm, and it maximizes profits by producing up to the pointwhere price equals marginal cost, here 800 car washes. Any units produced beyond 800 wouldadd more to cost than they would bring in revenue. Notice Blue Velvet is producing at a level thatis larger than the output that minimizes average costs. The high price in the marketplace hasinduced Blue Velvet to increase its service level even though the result is slightly less labor pro-ductivity and thus higher per unit costs.
Both revenues and costs are shown graphically. Total revenue (TR) is simply the product of
price and quantity: P*/H11003q* = $5 /H11003800 = $4,000. On the diagram, total revenue is equal to the
area of the rectangle P*Aq*0. (The area of a rectangle is equal to its length times its width.) At
output q*, average total cost is $4.50 (point B). Numerically, it is equal to the length of line seg-
ment q*B. Because average total cost is derived by dividing total cost by q, we can get back to total
cost by multiplying average total cost by q. That is,
and so
TC=ATC /H11003q
Total cost (TC), then, is $4.50 /H11003800 = $3,600, the area shaded blue in the diagram. Profit is sim-
ply the difference between total revenue ( TR) and total cost ( TC), or $400. This is the area that is
shaded gray in the diagram. This firm is earning positive profits.
A firm, like Blue Velvet, that is earning a positive profit in the short run and expects to con-
tinue doing so has an incentive to expand its scale of operation in the long run. Managers in thesefirms will likely be planning to expand even as they concentrate on producing 800 units. Weexpect greater output to be produced in the long run as firms react to profits they are earning.
Minimizing Losses
A firm that is not earning a positive profit or breaking even is suffering a loss. Firms sufferinglosses fall into two categories: (1) those that find it advantageous to shut down operationsimmediately and bear losses equal to total fixed costs and (2) those that continue to operate inthe short run to minimize their losses. The most important thing to remember here is that firmscannot exit the industry in the short run. The firm can shut down, but it cannot get rid of itsfixed costs by going out of business. Fixed costs must be paid in the short run no matter whatthe firm does.
Whether a firm suffering losses decides to produce or not to produce in the short run
depends on the advantages and disadvantages of continuing production. If a firm shuts down, itearns no revenue and has no variable costs to bear. If it continues to produce, it both earns rev-enue and incurs variable costs. Because a firm must bear fixed costs whether or not it shuts down,
its decision depends solely on whether total revenue from operating is sufficient to cover total
variable cost .ATC =TC
q
CHAPTER 9 Long-Run Costs and Output Decisions 193
/L50766If total revenue exceeds total variable cost, the excess revenue can be used to
offset fixed costs and reduce losses, and it will pay the firm to keep operating.
/L50766If total revenue is smaller than total variable cost, the firm that operates will suf-fer losses in excess of fixed costs. In this case, the firm can minimize its losses byshutting down.
Producing at a Loss to Offset Fixed Costs: Blue Velvet Revisited Suppose con-
sumers suddenly decide that car washing is a waste of money and demand falls. The price begins tofall, and Blue Velvet is no longer so profitable. We can see what Blue Velvet’s management will decideto do by looking back at Figure 9.1. With an upward-sloping marginal cost curve, as price begins tofall, the Blue Velvet management team first will choose to reduce the number of cars it services. Aslong as the price is greater than ATC (which is minimized at about $4.35 on the graph), Blue Velvetcontinues to make a profit. What happens if the price falls below this level, say to $3 per car?
Now Blue Velvet has to decide not only how many cars to wash but whether to be open at all.
If the car wash closes, there are no labor and soap costs. But Blue Velvet still has to pay for itsunbreakable year-long contract, and it still owns its building, which will take some time to sell. Sothe fixed costs of $2,000 per week remain. For Blue Velvet, the key question is can it do better thanlosing $2,000? The answer depends on whether the market price is greater or less than averagevariable costs—the costs per unit for the variable factors. If the price is greater than the averagevariable cost, then Blue Velvet can pay for its workers and the soap and have something left for theinvestors. It will still lose money, but it will be less than $2,000. If price is less than average vari-able cost, the firm will not only lose its $2,000 but also have added losses on every car it washes.So the simple answer for Blue Velvet is that it should stay open and wash cars as long as it coversits variable costs. Economists call this the shutdown point . At all prices above this shutdown
point, the marginal cost curve shows the profit-maximizing level of output. At all points belowthis point, optimal short-run output is zero.
We can now refine our earlier statement, from Chapter 8, that a perfectly competitive firm’s
marginal cost curve is its short-run supply curve. As we have just seen, a firm will shut downwhen the market price is less than the minimum point on the A VC curve. Also recall (or noticefrom the graph) that the marginal cost curve intersects the AVC at AVC’s lowest point. It thereforefollows that the short-run supply curve of a competitive firm is that portion of its marginal costcurve that lies above its average variable cost curve. For Blue Velvet, the firm will shut down at aprice of about $1.50 (reading off the graph).
Figure 9.2 shows the short-run supply curve for the general case of a perfectly competitive
firm like Blue Velvet.
0MC
ATC
AVC
Units of outputMarket
priceDollars
Shut-down pointShort-run
supply curve
/L50304FIGURE 9.2 Short-Run Supply Curve of a Perfectly Competitive Firm
At prices below average variable cost, it pays a firm to shutdown rather than continue operating. Thus, the
short-run supply curve of a competitive firm is the part of its marginal cost curve that lies above its average
variable cost curve.shutdown point The lowest
point on the average variable
cost curve. When price fallsbelow the minimum point on
AVC, total revenue is
insufficient to cover variablecosts and the firm will shut
down and bear losses equal to
fixed costs.
194 PART II The Market System: Choices Made by Households and Firms
The Short-Run Industry Supply Curve
Supply in a competitive industry is the sum of the quantity supplied by the individual firms in the
industry at each price level. The short-run industry supply curve is the sum of the individual
firm supply curves—that is, the marginal cost curves (above AVC ) of all the firms in the industry.
Because quantities are being added—that is, because we are finding the total quantity supplied inthe industry at each price level—the curves are added horizontally.
Figure 9.3 shows the supply curve for an industry with three identical firms.
1At a price of $6,
each firm produces 150 units, which is the output where P=MC. The total amount supplied on
the market at a price of $6 is thus 450. At a price of $5, each firm produces 120 units, for an indus-try supply of 360. Below $4.50, all firms shut down; Pis less than AVC .
Two things can cause the industry supply curve to shift. In the short run, the industry supply
curve shifts if something—a decrease in the price of some input, for instance—shifts the marginalcost curves of all the individual firms simultaneously. For example, when the cost of producingcomponents of home computers decreased, the marginal cost curves of all computer manufactur-ers shifted downward. Such a shift amounted to the same thing as an outward shift in their supplycurves. Each firm was willing to supply more computers at each price level because computerswere now cheaper to produce.
In the long run, an increase or decrease in the number of firms—and, therefore, in the num-
ber of individual firm supply curves—shifts the total industry supply curve. If new firms enterthe industry, the industry supply curve moves to the right; if firms exit the industry, the industrysupply curve moves to the left.
We return to shifts in industry supply curves and discuss them further when we take up
long-run adjustments later in this chapter.
Long-Run Directions: A Review
Table 9.2 summarizes the different circumstances that perfectly competitive firms may face asthey plan for the long run. Profit-making firms will produce up to the point where price andmarginal cost are equal in the short run. If there are positive profits, in the long run, there is anincentive for firms to expand their scales of plant and for new firms to enter the industry.=++Industry Firm 1 Firm 2 Firm 3
Units of output6
5SPrice per unit ($)
0 360 450AVC
Units of output6
5
4.5MC
0 120 150AVC
Units of output6
5
4.5MC
0 120 150AVC
Units of output6
5
4.5 4.5MC
0 120 150
/L50304FIGURE 9.3 The Industry Supply Curve in the Short Run Is the Horizontal
Sum of the Marginal Cost Curves (above AVC) of All the Firms in an Industry
If there are only three firms in the industry, the industry supply curve is simply the sum of all the products
supplied by the three firms at each price. For example, at $6 each firm supplies 150 units, for a total industrysupply of 450.
1Perfectly competitive industries are assumed to have many firms. Many is, of course, more than three. We use three firms here
simply for purposes of illustration. The assumption that all firms are identical is often made when discussing a perfectly com-petitive industry.short-run industry supply
curve The sum of the
marginal cost curves (above
AVC) of all the firms in an
industry.
CHAPTER 9 Long-Run Costs and Output Decisions 195
A firm suffering losses will produce if and only if revenue is sufficient to cover total variable
cost. Such firms, like profitable firms, will also produce up to the point where P=MC. If a firm
suffering losses cannot cover total variable cost by operating, it will shut down and bear lossesequal to total fixed cost. Whether a firm that is suffering losses decides to shut down in the shortrun or not, the losses create an incentive to contract in the long run. When firms are sufferinglosses, they generally exit the industry in the long run.
Thus, the short-run profits of firms cause them to expand or contract when opportuni-
ties exist to change their scale of plant. If expansion is desired because economic profits arepositive, firms must consider what their costs are likely to be at different scales or operation.(When we use the term “scale of operation,” you may find it helpful to picture factories ofvarying sizes.) Just as firms have to analyze different technologies to arrive at a cost structurein the short run, they must also compare their costs at different scales of plant to arrive atlong-run costs. Perhaps a larger scale of operations will reduce average production costs andprovide an even greater incentive for a profit-making firm to expand, or perhaps large firmswill run into problems that constrain growth. The analysis of long-run possibilities is evenmore complex than the short-run analysis because more things are variable—scale of plant isnot fixed, for example, and there are no fixed costs because firms can exit their industry in thelong run. In theory, firms may choose anyscale of operation; so they must analyze many pos-
sible options.
Now let us turn to an analysis of cost curves in the long run.
Long-Run Costs: Economies and
Diseconomies of Scale
The shapes of short-run cost curves follow directly from the assumption of a fixed factor of
production. As output increases beyond a certain point, the fixed factor (which we usuallythink of as fixed scale of plant) causes diminishing returns to other factors and thus increas-ing marginal costs. In the long run, however, there is no fixed factor of production.Firms can choose any scale of production. They can build small or large factories, double ortriple output, or go out of business completely.
The shape of a firm’s long-run average cost curve shows how costs vary with scale of opera-
tions. In some firms, production technology is such that increased scale, or size, reduces costs. Forothers, increased scale leads to higher per-unit costs. When an increase in a firm’s scale of produc-tion leads to lower average costs, we say that there are increasing returns to scale ,o r economies
of scale . When average costs do not change with the scale of production, we say that there are
constant returns to scale . Finally, when an increase in a firm’s scale of production leads to
higher average costs, we say that there are decreasing returns to scale, ordiseconomies of
scale . Because these economies of scale are a property of production characteristics of the indi-
vidual firm, they are considered internal economies of scale. In the Appendix to this chapter, we
talk about external economies of scale, which describe economies or diseconomies of scale on an
industry-wide basis.TABLE 9.2 Profits, Losses, and Perfectly Competitive Firm Decisions in the Long and
Short Run
Short-Run Condition Short-Run Decision Long-Run Decision
Profits TR/H11022TC P=MC: operate Expand: new firms enter
Losses 1.TR TVCÚ P=MC: operate Contract: firms exit
(loss /H11021 total fixed cost)
2. TR/H11021TVC Shut down: Contract: firms exit
loss = total fixed cost
increasing returns to scale, or
economies of scale An
increase in a firm’s scale of
production leads to lowercosts per unit produced.
constant returns to scale An
increase in a firm’s scale ofproduction has no effect on
costs per unit produced.
decreasing returns to scale, or
diseconomies of scale An
increase in a firm’s scale ofproduction leads to highercosts per unit produced.
196 PART II The Market System: Choices Made by Households and Firms
Increasing Returns to Scale
T echnically, the phrase increasing returns to scale refers to the relationship between inputs and out-
puts. When we say that a production function exhibits increasing returns, we mean that a givenpercentage of increase in inputs leads to a larger percentage of increase in the production of out-
put. For example, if a firm doubled or tripled inputs, it would more than double or triple output.
When firms can count on fixed input prices—that is, when the prices of inputs do not
change with output levels—increasing returns to scale also means that as output rises, averagecost of production falls. The term economies of scale refers directly to this reduction in cost per
unit of output that follows from larger-scale production.
The Sources of Economies of Scale Most of the economies of scale that immediately
come to mind are technological in nature. Automobile production, for example, would be morecostly per unit if a firm were to produce 100 cars per year by hand. In the early 1900s, HenryFord introduced standardized production techniques that increased output volume, reducedcosts per car, and made the automobile available to almost everyone. The new technology is notvery cost-effective at small volumes of cars, but at larger volumes costs are greatly reduced.Ford’s innovation provided a source of scale economics at the plant level of the auto firm.
Some economies of scale result not from technology but from firm-level efficiencies and bar-
gaining power that can come with size. Very large companies, for instance, can buy inputs in volumeat discounted prices. Large firms may also produce some of their own inputs at considerable sav-ings, and they can certainly save in transport costs when they ship items in bulk. Wal-Mart hasbecome the largest retailer in the United States in part because of scale economies of this type.Economics of scale have come from advantages of larger firm size rather than gains from plant size.
Economies of scale can be seen all around us. A bus that carries 50 people between
Vancouver and Seattle uses less labor, capital, and gasoline than 50 people driving 50 differentautomobiles. The cost per passenger (average cost) is lower on the bus. Roommates who share anapartment are taking advantage of economies of scale. Costs per person for heat, electricity, andspace are lower when an apartment is shared than if each person rents a separate apartment.
Example: Economies of Scale in Egg Production Nowhere are economies of scale
more visible than in agriculture. Consider the following example. A few years ago a majoragribusiness moved to a small Ohio town and set up a huge egg-producing operation. The newfirm, Chicken Little Egg Farms Inc., is completely mechanized. Complex machines feed the chick-ens and collect and box the eggs. Large refrigerated trucks transport the eggs all over the state daily.In the same town, some small farmers still own fewer than 200 chickens. These farmers collect theeggs, feed the chickens, clean the coops by hand, and deliver the eggs to county markets.
Table 9.3 presents some hypothetical cost data for Homer Jones’s small operation and for
Chicken Little Inc. Jones has his operation working well. He has several hundred chickens and
TABLE 9.3 Weekly Costs Showing Economies of Scale in Egg
Production
Jones Farm Total Weekly Costs
15 hours of labor (implicit value $8 per hour) $120
Feed, other variable costs 25
Transport costs 15
Land and capital costs attributable to egg
production17
$177
Total output 2,400 eggs
Average cost $0.074 per egg
Chicken Little Egg Farms Inc. Total Weekly Costs
Labor $ 5,128
Feed, other variable costs 4,115
Transport costs 2,431
Land and capital costs 19,230
$30,904
Total output 1,600,000 eggs
Average cost $0.019 per egg
CHAPTER 9 Long-Run Costs and Output Decisions 197
spends about 15 hours per week feeding, collecting, delivering, and so on. During the rest of his
time, he raises soybeans. We can value Jones’s time at $8 per hour because that is the wage hecould earn working at a local manufacturing plant. When we add up all Jones’s costs, including arough estimate of the land and capital costs attributable to egg production, we arrive at $177 perweek. T otal production on the Jones farm runs about 200 dozen, or 2,400, eggs per week, whichmeans that Jones’s average cost comes out to $0.074 per egg.
The costs of Chicken Little Inc. are much higher in total; weekly costs run over $30,000. A
much higher percentage of costs are capital costs—the firm uses a great many pieces of sophisti-cated machinery that cost millions to put in place. T otal output is 1.6 million eggs per week, andthe product is shipped all over the Midwest. The comparatively huge scale of plant has drivenaverage production costs all the way down to $0.019 per egg.
Although these numbers are hypothetical, you can see why small farmers in the United States
are finding it difficult to compete with large-scale agribusiness concerns that can realize signifi-cant economies of scale.
Many large firms have multiple plants or sites where they produce their goods and services.
In our discussion in this chapter, we will distinguish between cost changes that come aboutbecause a firm decides to build a large versus a small plant and cost changes that result from firmsadding volume to their production by building more plants. Coors originally produced its beer inColorado in what was, at the time, one of the largest U.S. brewing plants; the firm believed thatlarge size at the plant level brought cost savings. Most electronics companies, on the other hand,produce their output in multiple moderate-sized plants and hope to achieve cost savings throughfirm size. Both sources of scale economies are important in the economy.
Graphic Presentation A firm’s long-run average cost curve ( LRAC )shows the differ-
ent scales at which it can choose to operate in the long run. A given point on the LRAC tells us
the average cost of producing the associated level of output. At that point, the existing scale ofplant determines the position and shape of the firm’s short-run cost curves. The long-run aver-age cost curve shows the positions of the different sets of short-run curves among which thefirm must choose. In making the long-run strategic choice of plant scale, the firm thenconfronts an associated set of short-run cost curves. The long-run average cost curve is the“envelope” of a series of short-run curves; it “wraps around” the set of all possible short-runcurves like an envelope.
When the firm experiences economies of scale, its LRAC will decline with output. Figure 9.4
shows short-run and long-run average cost curves for a firm that realizes economies of scale up toabout 100,000 units of production and roughly constant returns to scale after that. The 100,000 unitoutput level in Figure 9.4 is sometimes called the minimum efficient scale (MES) of the firm. The
ECONOMICS IN PRACTICE
Economies of Scale in the World Marketplace
In this chapter we describe a range of possible long-run cost curves.
The form of the long-run production function and possible exis-tence of economies of scale in production have much to say aboutindustrial structure in ways we will explore further in a later chapter.
In a world economy in which trade occurs across geographical
boundaries, if economies of scale exist, it is possible to exploit thoseeconomies across a very large output base. The 2009 WorldDevelopment Report from the World Bank has an interesting chap-ter on scale economies with a few fascinating examples from aroundthe world.
Dongguan is a major manufacturing city in Southeast China,
lying between Guangzhou and Shenzhen. A single plant inDongguan produces more than 30 percent of the world’s magneticrecording heads used in hard disk drives. Another plant in the samecity produces 60 percent of the electronic learning devices sold inthe United States, while a third plant produces 30 million mobilephones, again all in one plant. Clearly, the scale economies in these
three sectors must be very large indeed. Notice in the case of all threeexamples that products are also light and easy to ship.
long-run average cost
curve ( LRAC )The
“envelope” of a series of short-run cost curves.
minimum efficient scale
(MES) The smallest size at
which the long-run averagecost curve is at its minimum.
198 PART II The Market System: Choices Made by Households and Firms
MES is the smallest size at which the long-run average cost curve is at its minimum. Essentially, it is
the answer to the question, how large does a firm have to be to have the best per-unit cost positionpossible? Consider a firm operating in an industry in which all of the firms in that industry face thelong-run average cost curve shown in Figure 9.4. If you want your firm to be cost-competitive in thatmarket, you need to produce at least 100,000 units. At smaller volumes, you will have higher coststhan other firms in the industry, which makes it hard for you to stay in the industry. Policy makers areoften interested in learning how large MES is relative to the total market for a product, since whenMES is large relative to the total market size, we typically expect fewer firms to be in the industry.And, as we will see in the next chapter, competition may be reduced.
Figure 9.4 shows three potential scales of operation, each with its own set of short-run cost
curves. Each point on the LRAC curve represents the minimum cost at which the associated out-
put level can be produced. Once the firm chooses a scale on which to produce, it becomes lockedinto one set of cost curves in the short run. If the firm were to settle on scale 1, it would not real-ize the major cost advantages of producing on a larger scale. By roughly doubling its scale of oper-ations from 50,000 to 100,000 units (scale 2), the firm reduces average costs per unit significantly.
Figure 9.4 shows that at every moment, firms face two different cost constraints. In the
long run, firms can change their scale of operation, and costs may be different as a result.ECONOMICS IN PRACTICE
Economies of Scale in Solar
Concerns about the environment and interest in sustainable energy
have greatly increased the excitement by both consumers andinvestors in alternative energies such as wind and solar power. Forboth alternatives, the price of more conventional energy sources, likeoil, is very important. As the price of oil rises, solar power, one of thesubstitutes for oil, becomes more viable. But there are also forces atwork on the cost side. As the article below discusses, the process ofproducing solar panels is subject to scale economies, so that as the useof solar panels increases, the long-run average cost of producingthem is likely to fall.
Utility Scale Solar Market Shares, Strategies,
and Forecasts, Worldwide, 2010–2016
PR Newswire
Solar energy market driving forces relate to the opportunity
to harness a cheap, long lasting, powerful energy source.Solar energy can be used to create electricity in huge quan-tity. Solar panels are mounted in a weatherproof frame and
then mounted in areas with direct exposure to the sun to
generate electricity from sunlight.
Solar power systems are composed of solar modules,
related power electronics, and other components. Solar
panels are used in residential, commercial, and industrial
applications. Solar compositions of arrays that make upelectric utility grids appear to be the wave of the future.Other solar systems are concentrating systems that lever-age thermal transport of heated fluids and utilize tradi-
tional steam generators. The demand for solar energy is
dependent on lower prices for solar and higher prices forpetroleum. A combination of economies of scale beingrealized in manufacturing along with increases in the cur-
rent prices for petroleum will drive solar energy adoption.
Large solar farms are more popular initially, but solar is
anticipated to be built out on commercial roof tops inincreased quantity. The electricity generated will be fed tolocal substations and distributed to homes from there.
There is growing global demand for cost-effective and
reliable solar power. Molten salt storage and solar electricitygeneration by use of steam turbines are poised to achievesignificant growth. The economies of scale have not yetkicked in and will do so after 100 projects have been built
out. The technology promises to be significant because the
projects generate so much electricity.
Source: Excerpted from press release “Utility Scale Solar Market Shares,
Strategies, and Forecasts, Worldwide, 2010–2016 Now Available atReportsandReports.com,” June 28, 2010.
CHAPTER 9 Long-Run Costs and Output Decisions 199
Units of outputScale 1
Scale 2Scale 3SRMC
SRAC
SRMC SRACSRMC
SRAC
LRAC
0 50,000 100,000 150,000Costs per unit ($)
/L50304FIGURE 9.4 A Firm Exhibiting Economies of Scale
The long-run average cost curve of a firm shows the different scales on which the firm can choose to operate
in the long run. Each scale of operation defines a different short run. Here we see a firm exhibiting economies
of scale; moving from scale 1 to scale 3 reduces average cost.
However, at any given moment, a particular scale of operation exists, constraining the firm’s
capacity to produce in the short run. That is why we see both short- and long-run curves inthe same diagram.
Constant Returns to Scale
T echnically, the term constant returns means that the quantitative relationship between input
and output stays constant, or the same, when output is increased. If a firm doubles inputs, itdoubles output; if it triples inputs, it triples output; and so on. Furthermore, if input prices arefixed, constant returns imply that average cost of production does not change with scale. Inother words, constant returns to scale mean that the firm’s long-run average cost curveremains flat.
The firm in Figure 9.4 exhibits roughly constant returns to scale between scale 2 and
scale 3. The average cost of production is about the same in each. If the firm exhibited con-stant returns at levels above 150,000 units of output, the LRAC would continue as a flat,
straight line.
Economists have studied cost data extensively over the years to estimate the extent to which
economies of scale exist. Evidence suggests that in most industries, firms do not have to be gigan-tic to realize cost savings from scale economies. In other words, the MES is moderate relative tomarket size. Perhaps the best example of efficient production on a small scale is the manufactur-ing sector in Taiwan. Taiwan has enjoyed very rapid growth based on manufacturing firms thatemploy fewer than 100 workers.
One simple argument supports the empirical result that most industries seem to exhibit
constant returns to scale (a flat LRAC ) after some level of output at least at the level of the
plant. Competition always pushes firms to adopt the least-cost technology and scale. If costadvantages result with larger-scale operations, the firms that shift to that scale will drive thesmaller, less efficient firms out of business. A firm that wants to grow when it has reached its“optimal” size can do so by building another identical plant. It thus seems logical to concludethat most firms face constant returns to scale at the plant level as long as they can replicate
their existing plants.
200 PART II The Market System: Choices Made by Households and Firms
SRMC
SRMCSRMC
SRAC
SRACSRACLRAC
0Costs per unit ($)
q*
Units of output/L50298FIGURE 9.5 A Firm
Exhibiting Economiesand Diseconomiesof Scale
Economies of scale push this
firm’s average costs down to q*.
Beyond q*, the firm experiences
diseconomies of scale; q* is the
level of production at lowest
average cost, using optimal scale.optimal scale of plant The
scale of plant that minimizesaverage cost.Decreasing Returns to Scale
When average cost increases with scale of production, a firm faces decreasing returns to scale ,o r
diseconomies of scale . The most often cited example of a diseconomy of scale is bureaucratic inef-
ficiency. As size increases beyond a certain point, operations tend to become more difficult to
manage. Large size often entails increased bureaucracy, affecting both managerial incentives and
control. The coordination function is more complex for larger firms than for smaller ones, and
the chances that it will break down are greater. Y ou can see that this diseconomy of scale is firm-level in type.
A large firm is also more likely than a small firm to find itself facing problems with organized
labor. Unions can demand higher wages and more benefits, go on strike, force firms to incur legal
expenses, and take other actions that increase production costs. (This does not mean that unionsare “bad,” but instead that their activities often increase costs.)
U-Shaped Long-Run Average Costs
As we have seen, the shape of a firm’s long-run average cost curve depends on how costs react tochanges in scale. Some firms do see economies of scale, and their long-run average cost curvesslope downward. Most firms seem to have flat long-run average cost curves. Still others encounter
diseconomies, and their long-run average cost curves slope upward.
Figure 9.5 describes a firm that exhibits both economies of scale and diseconomies of scale.
Average costs decrease with scale of plant up to q* and increase with scale after that. The
Economics in Practice on p. 201 discusses the history of the U-shaped curve.
The U-shaped average cost curve looks very much like the short-run average cost curves we
have examined in the last two chapters, but do not confuse the two. All short-run average costcurves are U-shaped because we assume a fixed scale of plant that constrains production and drives
marginal cost upward as a result of diminishing returns. In the long run, we make no such assump-
tion; instead, we assume that scale of plant can be changed and ask how costs change with scale.
It is important to note that economic efficiency requires taking advantage of economies of
scale (if they exist) and avoiding diseconomies of scale. The optimal scale of plant is the scale of
plant that minimizes average cost. In fact, as we will see next, competition forces firms to use the
optimal scale. In Figure 9.5, q*is the unique optimal scale.
Long-Run Adjustments to Short-Run
Conditions
We began this chapter by discussing the different short-run positions in which firms like Blue Velvet
may find themselves. Firms can be operating at a profit or suffering economic losses; they can beshut down or producing. The industry is not in long-run equilibrium if firms have an incentive to
CHAPTER 9 Long-Run Costs and Output Decisions 201
enter or exit in the long run. Thus, when firms are earning economic profits (profits above normal,
or positive) or are suffering economic losses (profits below normal, or negative), the industry is notat an equilibrium and firms will change their behavior. What firms are likely to do depends in parton costs in the long run. This is why we have spent a good deal of time discussing economies anddiseconomies of scale.
We can now put these two ideas together and discuss the actual long-run adjustments that
are likely to take place in response to short-run profits and losses.
Short-Run Profits: Moves In and Out of Equilibrium
Consider a competitive market in which demand and costs have been stable for some period andthe industry is in equilibrium. The market price is such that firms are earning a normal rate ofreturn and the flow of firms in and out of the industry balances out. Firms are producing as effi-ciently as possible, and supply equals demand. Figure 9.6 shows this situation at a price of $6 andan output of 200,000 units for an industry with a U-shaped long-run cost curve.
Now suppose demand increases. Perhaps this is the market for green tea, and there has been a
news report on the health benefits of the tea. What happens? Managers at the firms notice thedemand increase—they too read the paper! But each firm has a fixed capital stock—it owns a settea plantation, for example. Entry also is impossible in the short run. But existing firms can dosomething to meet the new demand, even within the constraints of their existing plant. They canhire overtime workers, for example, to increase yield. But this increases average costs. In Figure 9.7,firms will move up their SRMC curves as they produce output beyond the level of 2,000. Why do
firms do this? Because the increased demand has increased the price. The new higher price makesit worthwhile for the firms to increase their output even though in the short run it is expensive todo so. In fact, the firms increase output as long as the new price is greater than the short-run mar-ginal cost curve. We have noted the new short-run equilibrium in Figure 9.7.
ECONOMICS IN PRACTICE
The Long-Run Average Cost Curve: Flat or U-Shaped?
The long-run average cost curve has been a source of controversy in
economics for many years. A long-run average cost curve was firstdrawn as the “envelope” of a series of short-run curves in a classicarticle written by Jacob Viner in 1931.
1In preparing that article, Viner
gave his draftsman the task of drawing the long-run curve throughthe minimum points of all the short-run average cost curves.
In a supplementary note written in 1950, Viner commented:
… the error in Chart IV is left uncorrected so that future
teachers and students may share the pleasure of many of
their predecessors of pointing out that if I had known what
an envelope was, I would not have given my excellentdraftsman the technically impossible and economicallyinappropriate task of drawing an ACcurve which would
pass through the lowest cost points of all the ACcurves yet
not rise above any ACcurve at any point….
2
While this story is an interesting part of the lore of economics, a
more recent debate concentrates on the economic content of thiscontroversy. In 1986, Professor Herbert Simon of Carnegie-MellonUniversity stated bluntly in an interview for Challenge magazine that
most textbooks are wrong to use the U-shaped long-run cost curve
to predict the size of firms. Simon explained that studies show thefirm’s cost curves are not U-shaped but instead slope down to theright and then level off.
3What difference does it make if
the long-run average cost curve hasa long flat section with no upturn?In this case, there is no single pointon the long-run curve that is thebest. Once a firm achieves somescale, it has the same costs no mat-ter how much larger it gets. AsSimon tells us, this means we can’tpredict firm size. But we can still
predict industry size: In this situa-
tion, we still have forces of profitseeking causing firms to enter andexit until excess profits are zero. The unique industry output is the onethat corresponds to a price equal to long-run average cost that alsoequates supply and demand. Simon is right that this type of cost curve
means the economic theory doesn’t explain everything, but it still tellsus a good deal.
1Jacob Viner, “Cost Curves and Supply Curves,” Zeitschrift fur
Nationalokonomie, Vol. 3 (1–1931), 23–46. 2George J. Stigler and Kenneth E.
Boulding, eds., AEA Readings in Price Theory, V ol. 6 (Chicago: Richard D. Irwin,
1952), p. 227. 3Based on interview with Herbert A. Simon, “The Failure of
Armchair Economics,” Challenge, November–December, 1986, 23–24.
202 PART II The Market System: Choices Made by Households and Firms
610
SRAC
2,000 2,200
Units of output, qThe industry after a demand increase A representative firm after a demand increase*
S
D1
06
010
200,000 220,000
Units of output, QD2SRMC
SRACLRACPrice per unit ($)* # of firms = 100
/L50304FIGURE 9.7 Industry Response to an Increase in DemandAgain supply equals demand. But there are two important differences. First, and most
important, firms are making profits. The profits are noted in the gray-shaded rectangle inFigure 9.8 and are the difference between the new higher price and the new higher averagecost. Second, firms are also operating at too large an output level for minimum average cost.Managers in these firms are scrambling to get increased output from a plant designed for asmaller output level.SRMC
SRACLRACThe industry A representative firm*
S0
D0
0Price per unit ($)
0 200,000
Units of output, Q* # of firms = 100
2,000
Units of output, q66
/L50304FIGURE 9.6 Equilibrium for an Industry with U-shaped Cost Curves
The individual firm on the right is producing 2,000 units, and so we also know that the industry consists of
100 firms. All firms are identical, and all are producing at the uniquely best output level of 2,000 units.
CHAPTER 9 Long-Run Costs and Output Decisions 203
What happens next? Other entrepreneurs observing the industry see the excess profits and
enter. Each one enters at a scale of 2,000 because that is the optimal scale in this industry.Perhaps existing firms also build new plants. With each new entry, the industry supply curve(which is just the sum of all the individual firms’ supply curves) shifts to the right. More sup-ply is available because there are more firms. Price begins to fall. As long as the price is above$6, each of the firms, both old and new, is making excess profits and more entry will occur.Once price is back to $6, there are no longer excess profits and thus no further entry. Figure 9.8shows this new equilibrium where supply has shifted sufficiently to return the industry to theoriginal price of $6 at a new quantity level.
Again, notice the characteristics of the final equilibrium: Each individual firm chooses a scale
of operations that minimizes its long-run average cost. It operates this plant at an output levelthat minimizes short-run average cost. In equilibrium, each firm has
SRMC =SRAC =LRAC
Firms make no excess profits so that
P=SRMC =SRAC =LRAC
and there are enough firms so that supply equals demand.
Suppose instead of a positive demand shock, the industry experiences an unexpected cut in
demand. Precisely the same economic logic holds. When demand falls (shifts to the left), the pricefalls. In the short run, firms cannot shrink plants, nor can they exit. But with the lower price,firms begin to produce less in their plants than before. In fact, firms cut back production so longas the price they receive is less than their short-run marginal cost. At this point, firms earn lossesand are producing at too small a level and thus have higher average cost than before. Some firmsdrop out, and when they do so, the supply curve shifts to the left. How many firms leave? Enoughso that the equilibrium is restored with the price again at $6 and the industry output has fallenreduced to reflect the reduced demand for the product.6
2,000
Units of output, qA representative firm* The industry
* # of firms = 120
S1
D0
06
0 200,000 240,000
Units of output, QD1SRMC
SRACLRACS0Price per unit ($)
/L50304FIGURE 9.8 New Equilibrium with Higher Demand
204 PART II The Market System: Choices Made by Households and Firms
The Long-Run Adjustment Mechanism: Investment Flows
Toward Profit Opportunities
The central idea in our discussion of entry, exit, expansion, and contraction is this: In efficient
markets, investment capital flows toward profit opportunities. The actual process is complex andvaries from industry to industry.
We talked about efficient markets in Chapter 1. In efficient markets, profit opportunities are
quickly eliminated as they develop. T o illustrate this point, we described driving up to a toll boothand suggested that shorter-than-average lines are quickly eliminated as cars shift into those lines.Profits in competitive industries also are eliminated as new competing firms move into openslots, or perceived opportunities, in the industry.
In practice, the entry and exit of firms in response to profit opportunities usually involve the
financial capital market. In capital markets, people are constantly looking for profits. When firmsin an industry do well, capital is likely to flow into that industry in a variety of forms.Entrepreneurs start new firms, and firms producing entirely different products may join thecompetition to break into new markets. It happens all around us. The tremendous success of pre-mium ice cream makers Ben and Jerry’s and Häagen-Dazs spawned dozens of competitors. InECONOMICS IN PRACTICE
The Fortunes of the Auto Industry
In 2010 the majority shareholder in General Motors, once counted
among the top Fortune 500 firms, was the U.S. government. The
government bought its interest in General Motors as a “reluctantshareholder” to help the firm move out of the bankruptcy that itentered in 2009.
The article below describes the return of the firm to profitability
in mid-2010. We can use the tools of this chapter to dig into the
lessons of the article.
GM Reports First Quarterly Profit Since 2007
The Wall Street Journal
Ten months after emerging from a government-orchestrated
bankruptcy, General Motors Co. on Monday reported its first
quarterly profit in three years, driven by dramatic cost reduc-
tions and improved global sales.
GM made $863 million in the first three months of 2010,
compared with a $6 billion loss a year earlier, a performancethat surprised analysts who expected more modest results.
Revenue grew 40 percent to $31.5 billion, and the company
generated $1 billion in cash.
GM has managed to drive up prices by building fewer
vehicles and turning out cars and trucks more desirable toU.S. consumers, such as GM’s revamped Chevrolet Equinox
crossover, while tighter supply means the company doesn’t
have to rely on deals to clear out inventory. Another factor: In North America, GM’s factories are
operating at 84 percent of capacity, up from less than
40 percent a year ago. Underutilized factories are a majorcost drain for auto makers.
The company, meantime, has increased global sales by
24 percent amid rapid growth in emerging markets,
including China.
Cost reductions made possible by last year’s bankruptcy
were a major factor in GM’s profit.
Source: The Wall Street Journal , excerpted from “GM Reports First
Quarterly Profits Since 2007” by Sharon T erlep. Copyright 2010 by Dow
Jones & Company, Inc. Reproduced with permission of Dow Jones &
Company, Inc. via Copyright Clearance Center.
How has GM improved profits? First, demand for autos shifted right
as the recession eased and GM built vehicles “more desirable to U.S.
consumers,” as the article tells us. The demand shift allowed GM to raiseprices and allowed it to sell more vehicles. Improved sales also helped onthe cost side. The auto industry exhibits large economies of scale due inpart to the large capital investment of the assembly lines. In the
2008–2009 recession, the auto industry found itself with excess capacity
(the article tells us GM was operating at 40 percent capacity in thetrough) and the per unit costs of cars rocketed up. By using more of its
capacity, average costs fell, making for better profitability.
The demand shift is only part of the story, however. GM had also
taken other actions, both in terms of union wage negotiations andrestructuring, to reduce its costs. This had the effect of shifting down
the long-run average cost curve, further increasing profits. A hard
question now being asked is whether these cost reductions will be
long lived.
CHAPTER 9 Long-Run Costs and Output Decisions 205
ECONOMICS IN PRACTICE
Why Are Hot Dogs So Expensive in Central Park?
Recently, one of the authors of this textbook was walking in Central
Park in New Y ork City. Since it was lunchtime and she was hungry, shedecided to indulge her secret passion for good old-fashioned hot dogs.Because she did this frequently, she was well aware that the standardprice for a hot dog in New Y ork City was $1.50. So she was surprisedwhen she handed the vendor $2 that she received no change back. As itturned out, the price of a hot dog inside the park was $2.00, not the$1.50 vendors charged elsewhere in the city. Since she was trained asan economist, she wanted to know what caused the difference in price.
First, she looked to the demand side of the market. If hot dogs
are selling for $2.00 in the park but only $1.50 outside the park, peo-ple must be willing and able to pay more for them in the park. Why?
Perhaps hot dogs are more enjoyable to people when eaten whilewalking through Central Park. Hot dogs and “walking through thepark” may be complementary goods. Or maybe people who walk in
the park at noon are richer.
Y ou might ask, if hot dogs are available outside the park for $1.50,
why don’t people buy them there and bring them to the park? Thefact is that hot dogs are good only when they are hot, and they getcold very quickly. A hot dog purchased 5 minutes away from Central
Park will be stone cold by the time someone reaches the park.
But looking at the demand side is not enough to understand a
market. We also have to explain the behavior of the hot dog vendorswho comprise the supply side of the market. On the supply side, theauthor knew that the market for hot dogs was virtually perfectly com-
petitive outside the park. First, the product is homogeneous.
Essentially all vendors supply the same product: a standard quality-certified hot dog and two varieties of mustard. Second, there is freeentry. Since most vendors have wheels on their carts, if the price of hotdogs rises above $1.50 in one part of town, we would expect vendors
to move there. The added supply would then push prices back to Price
(P) = short-run marginal cost ( SRAC ) = long-run average cost
(LRAC ). At P= $1.50, individual vendors around the city must be
earning enough to cover average costs including a normal rate ofreturn (see the discussion in the text on p. 190). If the market price
produces excess profits, new vendors will show up to compete those
excess profits away.
All of this would suggest that the price of hot dogs should be the
same everywhere in New Y ork City. If a vendor is able to charge $2 inthe park and has the same costs as a vendor outside the park, hemust be earning above-normal profits. After all, the vendor makes$.50 more on each hot dog. Something must be preventing the out-
side vendors from rolling their carts into the park, which would
increase the supply of hot dogs and drive the price back to $1.50.
That something is a more expensive license. In New Y ork, you
need a license to operate a hot dog cart, and a license to operate inthe park costs more. Since hot dogs are $0.50 more in the park, theadded cost of a license each year must be roughly $0.50 per hot dogsold. In fact, in New Y ork City, licenses to sell hot dogs in the park
are auctioned off for many thousands of dollars, while licenses to
operate in more remote parts of the city cost only about $1,000.
one Massachusetts town of 35,000, a small ice cream store opened to rave reviews, long lines, and
high prices and positive profits. Within a year, there were four new ice cream/frozen yogurt stores,no lines, and lower prices. Magic? No, just the natural functioning of competition.
A powerful example of an industry expanding with higher prices and higher economic prof-
its is the housing sector prior to 2007. From the late 1990s until early 2006, the housing marketwas booming nationally. Demand was shifting to the right for a number of reasons. As it did,housing prices rose substantially and with them the profits being made by builders. As buildersresponded with higher output, the number of new units started (housing starts) increased toa near record level of over 2.2 million per year in 2005. Construction employment grew to over7.5 million.
Starting in 2006, housing demand shifted to the left. The inventory of unsold property began
to build, and prices started to fall. That turned profits into losses. Home builders cut their produc-tion, and many went out of business. These moves had major ramifications for the performanceof the whole economy. Go back and look at Figure 9.7 and Figure 9.8. Make sure you understandhow these diagrams explain both the expansion and contraction of the housing sector since 2000.
Many believe that part of the explosion of technology-based dot-com companies is due to
the ease of entering the sector. All it takes to start a company is an idea, a terminal, and Webaccess. The number of new firms entering the industry is so large that statistical agencies cannotkeep pace.
206 PART II The Market System: Choices Made by Households and Firms
Output Markets: A Final Word
In the last four chapters, we have been building a model of a simple market system under the
assumption of perfect competition. Let us provide just one more example to review the actualresponse of a competitive system to a change in consumer preferences.
Over the past two decades, Americans have developed a taste for wine in general and for
California wines in particular. We know that household demand is constrained by income,wealth, and prices and that income is (at least in part) determined by the choices that house-holds make. Within these constraints, households increasingly choose—or demand—wine.The demand curve for wine has shifted to the right, causing excess demand followed by anincrease in price.
With higher prices, wine producers find themselves earning positive profits. This increase
in price and consequent rise in profits is the basic signal that leads to a reallocation of society’sresources. In the short run, wine producers are constrained by their current scales of operation.
California has only a limited number of vineyards and only a limited amount of vat capacity,for example.
In the long run, however, we would expect to see resources flow in to compete for these
profits, and this is exactly what happens. New firms enter the wine-producing business. Newvines are planted, and new vats and production equipment are purchased and put in place.Vineyard owners move into new states—Rhode Island, T exas, and Maryland—and establishedgrowers increase production. Overall, more wine is produced to meet the new consumerdemand. At the same time, competition is forcing firms to operate using the most efficient tech-nology available.
What starts as a shift in preferences thus ends up as a shift in resources. Land is reallocated,
and labor moves into wine production. All this is accomplished without any central planning or direction.
Y ou have now seen what lies behind the demand curves and supply curves in competitive
output markets. The next two chapters take up competitive input markets and complete
the picture.
SUMMARY
1.For any firm, one of three conditions holds at any given
moment: (1) The firm is earning positive profits, (2) thefirm is suffering losses, or (3) the firm is just breakingeven—that is, earning a normal rate of return and thuszero profits.SHORT-RUN CONDITIONS AND LONG-RUN
DIRECTIONS p. 190
2.A firm that is earning positive profits in the short run and
expects to continue doing so has an incentive to expand inthe long run. Profits also provide an incentive for new firmsto enter the industry.When there is promise of positive profits, investments are made and output expands. When
firms end up suffering losses, firms contract and some go out of business. It can take quite awhile, however, for an industry to achieve long-run competitive equilibrium , the point at which
P=SRMC =SRAC =LRAC and profits are zero. In fact, because costs and tastes are in a constant
state of flux, very few industries ever really get there. The economy is always changing. There arealways some firms making profits and some firms suffering losses.
This, then, is a story about tendencies:
Investment—in the form of new firms and expanding old firms—will over time tend tofavor those industries in which profits are being made; and over time, industries in whichfirms are suffering losses will gradually contract from disinvestment.long-run competitive
equilibrium When P=SRMC
=SRAC =LRAC and profits
are zero.
CHAPTER 9 Long-Run Costs and Output Decisions 207
REVIEW TERMS AND CONCEPTS
breaking even, p. 190
constant returns to scale, p. 195
decreasing returns to scale ordiseconomies
of scale, p. 195
increasing returns to scale oreconomies of
scale, p. 195long-run average cost curve ( LRAC ),p. 197
long-run competitive equilibrium, p. 206
minimum efficient scale (MES), p. 197
optimal scale of plant, p. 200 short-run industry supply curve, p. 194
shutdown point, p. 193
long-run competitive equilibrium,
P=SRMC =SRAC =LRAC
PROBLEMS
1.For each of the following, decide whether you agree or disagree
and explain your answer:
a.Firms that exhibit constant returns to scale have U-shaped
long-run average cost curves.
b.A firm suffering losses in the short run will continue to
operate as long as total revenue at least covers fixed cost.
2.Ajax is a competitive firm operating under the following condi-
tions: Price of output is $5, the profit-maximizing level of out-put is 20,000 units of output, and the total cost (full economiccost) of producing 20,000 units is $120,000. The firm’s only
fixed factor of production is a $300,000 stock of capital (a
building). If the interest rate available on comparable risks is10 percent, should this firm shut down immediately in the short
run? Explain your answer.
3.Explain why it is possible that a firm with a production function
that exhibits increasing returns to scale can run into diminish-ing returns at the same time.
4.Which of the following industries do you think are likely to
exhibit large economies of scale? Explain why in each case.a.Home building
b.Electric power generation
c.Vegetable farming
d.Software development
e.Aircraft manufacturing3.In the short run, firms suffering losses are stuck in the
industry. They can shut down operations ( q= 0), but they
must still bear fixed costs. In the long run, firms sufferinglosses can exit the industry.
4.A firm’s decision about whether to shut down in the shortrun depends solely on whether its total revenue from operat-ing is sufficient to cover its total variable cost. If total rev-enue exceeds total variable cost, the excess can be used to paysome fixed costs and thus reduce losses.
5.Anytime that price is below the minimum point on theaverage variable cost curve, total revenue will be less thantotal variable cost, and the firm will shut down. The mini-mum point on the average variable cost curve (which isalso the point where marginal cost and average variablecost intersect) is called the shutdown point . At all prices
above the shutdown point, the MC curve shows the profit-
maximizing level of output. At all prices below it, optimalshort-run output is zero.
6.The short-run supply curve of a firm in a perfectly competi-
tive industry is the portion of its marginal cost curve thatlies above its average variable cost curve.
7.Two things can cause the industry supply curve to shift: (1) inthe short run, anything that causes marginal costs to changeacross the industry, such as an increase in the price of a par-ticular input, and (2) in the long run, entry or exit of firms.LONG-RUN COSTS: ECONOMIES AND
DISECONOMIES OF SCALE p. 195
8.When an increase in a firm’s scale of production leads to
lower average costs, the firm exhibits increasing returns to
scale ,o r economies of scale . When average costs do not
change with the scale of production, the firm exhibitsconstant returns to scale . When an increase in a firm’s scale of
production leads to higher average costs, the firm exhibitsdecreasing returns to scale ,o r diseconomies of scale .
9.A firm’s long-run average cost curve (LRAC ) shows the costs
associated with different scales on which it can choose tooperate in the long run.
LONG-RUN ADJUSTMENTS TO SHORT-RUN
CONDITIONS p. 200
10. When short-run profits exist in an industry, firms enter and
existing firms expand. These events shift the industry supplycurve to the right. When this happens, price falls and ulti-mately profits are eliminated.
11. When short-run losses are suffered in an industry, somefirms exit and some firms reduce scale. These events shift theindustry supply curve to the left, raising price and eliminat-ing losses.
12. Long-run competitive equilibrium is reached when P=SRMC
=SRAC =LRAC and profits are zero.
13. In efficient markets, investment capital flows toward profit
opportunities.
All problems are available on www.myeconlab.com
208 PART II The Market System: Choices Made by Households and Firms
A B C D E F
Total revenue 1,500 2,000 2,000 5,000 5,000 5,000
Total cost 1,500 1,500 2,500 6,000 7,000 4,000
Total fixed cost 500 500 200 1,500 1,500 1,500
q TFC TVC
0 12 0
1 12 5
2 12 9
3 12 14
4 12 20
5 12 28
6 12 385.For cases Athrough Fin the following table, would you
(1) operate or shut down in the short run and (2) expand your
plant or exit the industry in the long run?
b.Using the information in the table, fill in the following
supply schedule for this individual firm under perfect
competition and indicate profit (positive or negative) at
each output level. ( Hint: At each hypothetical price, what
is the MR of producing 1 more unit of output? Combine
this with the MC of another unit to figure out the quan-
tity supplied.)OUTPUT TFC TVC TC AVC ATC MC
0 $300 $0 __ __ __ __
1 __ 100 __ __ __ __
2 __ 150 __ __ __ __
3 __ 210 __ __ __ __
4 __ 290 __ __ __ __
5 __ 400 __ __ __ __
6 __ 540 __ __ __ __
7 __ 720 __ __ __ __
8 __ 950 __ __ __ __
9 __ 1,240 __ __ __ __
10 __ 1,600 __ __ __ __b.doubling up to reduce rent
c.farming
d.a single-family car versus public transit
e.a huge refinery
11.According to its Web site, Netflix is the world’s largest online
entertainment subscription service. It ships over 2 million
DVDs daily to its more than 15 million members. On its Website, Netflix indicates that its growth strategy is to “focus on sub-
scription growth in order to realize economies of scale.” In thisbusiness, where do you think scale economies come from?
12.From 2000 to 2005, the home building sector was expanding and
new housing construction as measured by housing starts wasapproaching an all-time high. (At www.census.gov, click“Housing,” then click “Construction data.”) Big builders such as
Lennar Corporation were making exceptional profits. The indus-
try was expanding. Existing home building firms invested inmore capacity and raised output. New home building firmsentered the industry. From 2006 to 2009, demand for new andexisting homes dropped. The inventory of unsold homes grewsharply. Home prices began to fall. Home builders suffered
losses, and the industry contracted. Many firms went out of busi-
ness, and many workers in the construction industry went bank-rupt. Use the Internet to verify that all of these events happened.Access www.bls.gov for employment data and www.bea.gov forinformation on residential construction as part of gross domes-
tic product. What has happened since the beginning of 2010?
Has the housing market recovered? Have housing starts stoppedfalling? If so, at what level? Write a short essay about whether thehousing sector is about to expand or contract.
13.[Related to the Economics in Practice onp. 205 ]St. Mark’s
Square is a beautiful plaza in Venice that is often frequented byboth tourists and pigeons. Ringing the piazza are many small,
privately owned cafes. In these cafes, a cappuccino costs 7 euros
despite the fact that an equally good cappuccino costs only3 euros a block a way. What is going on here?
14.The following problem traces the relationship between firm
decisions, market supply, and market equilibrium in a perfectlycompetitive market.a.Complete the following table for a single firm in the short run.
If the price of output is $7, how many units of output will this
firm produce? What is the total revenue? What is the total cost?Will the firm operate or shut down in the short run? in the long
run? Briefly explain your answers.
10.The concept of economies of scale refers to lower per-unit pro-
duction costs at higher levels of output. The easiest way to
understand this is to look at whether long-run average cost
decreases with output (economies of scale) or whether long-runaverage cost increases with output (diseconomies of scale). Ifaverage cost is constant as output rises, there is constant returnsto scale. But the concept of falling unit costs is all around us.
Explain how the concept of economies of scale helps shed light
on each of the following:a.car pooling6.[Related to the Economics in Practice onp. 201 ]Do you agree
or disagree with the following statements? Explain in a sentenceor two.
a.A firm will never sell its product for less than it costs to
produce it.
b.If the short-run marginal cost curve is U-shaped, the long-
run average cost curve is likely to be U-shaped as well.
7.The Smythe chicken farm outside Little Rock, Arkansas, pro-
duces 25,000 chickens per month. T otal cost of production atSmythe Farm is $28,000. Down the road are two other farms.
Faubus Farm produces 55,000 chickens a month, and total cost
is $50,050. Mega Farm produces 100,000 chickens per month, ata total cost of $91,000. These data suggest that there are signifi-cant economies of scale in chicken production. Do you agree ordisagree with this statement? Explain your answer.
8.Indicate whether you agree or disagree with the following state-
ments. Briefly explain your answers.a.Increasing returns to scale refers to a situation where an
increase in a firm’s scale of production leads to higher costs
per unit produced.
b.Constant returns to scale refers to a situation where an
increase in a firm’s scale of production has no effect on costsper unit produced.
c.Decreasing returns to scale refers to a situation where an
increase in a firm’s scale of production leads to lower costsper unit produced.
9.Y ou are given the following cost data:
CHAPTER 9 Long-Run Costs and Output Decisions 209
a.Use the data in the table and draw a graph for the represen-
tative firm in the industry when the industry demand curve
is represented by D1. What is the profit or loss for this firm?
Shade in the profit or loss area on the graph.
b.Draw a graph for the representative firm when the industry
demand curve falls to D2. What is the profit or loss for this
firm? Shade in the profit or loss area on the graph.
c.Draw a graph for the representative firm when the industry
demand curve falls to D3. What is the profit or loss for this
firm? Shade in the profit or loss area on the graph.
17.For each of the three scenarios in the previous question ( p* = 10,
p* = 6, and p* = 3), explain the long-run incentives for each
representative firm in the industry. Also explain what should
happen to the size of the industry as a whole.
18.Construct a graph with AVC ,ATC , and MC curves. On this
graph add a marginal revenue curve for a representative firm in
a perfectly competitive industry which is maximizing profits at aprice of p*
1. Add a second marginal revenue curve for a firm
which is minimizing losses but continues to produce when the
price is p*2. Add a third marginal revenue curve for a firm
which is shutting down when the price is p*3. Explain where you
decided to place each of the marginal revenue curves and iden-
tify the shutdown point on the graph.
19.The shape of a firm’s long-run average cost curve depends on
how costs vary with scale of operation. Draw a long-run average
cost curve for a firm which exhibits economies of scale, constantreturns to scale, and diseconomies of scale. Identify each ofthese sections of the cost curve and explain why each sectionexemplifies its specific type of returns to scale.
20.[Related to the Economics in Practice onp. 198 ]A new inno-
vation in computer technology is called “cloud computing.”With cloud computing, information and software are provided
to computers on an “as-needed” basis, much like utilities are
provided to homes and businesses. In a statement advocatingthe advantages of large, public cloud providers likeAmazon.com over smaller enterprise data centers, JamesHamilton, a vice president at Amazon claimed that “server,PRICE QUANTITY SUPPLIED PROFIT
$ 50 __ ____
70 __ ____
100 __ ____
130 __ ____
170 __ ____
220 __ ____
280 __ ____
350 __ ____
c.Now suppose there are 100 firms in this industry, all with
identical cost schedules. Fill in the market quantity supplied
at each price in this market.
d.Fill in the blanks: From the market supply and demand
schedules in c., the equilibrium market price for this good is____ and the equilibrium market quantity is ____. Eachfirm will produce a quantity of ____ and earn a ____
(profit/loss) equal to ____.
e.In d., your answers characterize the short-run equilibrium in
this market. Do they characterize the long-run equilibriumas well? If so, explain why. If not, explain why not (that is,
what would happen in the long run to change the equilib-
rium and why?).
*15. Assume that you are hired as an analyst at a major New Y ork
consulting firm. Y our first assignment is to do an industry
analysis of the tribble industry. After extensive research and twoall-nighters, you have obtained the following information:
/L50766Long-run costs :
Capital costs: $5 per unit of output
Labor costs: $2 per unit of output
/L50766No economies or diseconomies of scale
/L50766Industry currently earning a normal return to capital (profit
of zero)
/L50766Industry perfectly competitive, with each of 100 firms pro-ducing the same amount of output
/L50766Total industry output: 1.2 million tribbles
Demand for tribbles is expected to grow rapidly over the
next few years to a level twice as high as it is now, but (due toshort-run diminishing returns) each of the 100 existingfirms is likely to be producing only 50 percent more.
a.Sketch the long-run cost curve of a representative firm.
b.Show the current conditions by drawing two diagrams, one
showing the industry and one showing a representative firm.
c.Sketch the increase in demand and show how the industry is
likely to respond in the short run and in the long run.
16.The following graph shows the supply curve and three different
demand curves for a perfectly competitive industry. The tablerepresents cost data for a representative firm in the industry.PRICEMARKET QUANTITY
SUPPLIEDMARKET QUANTITY
DEMANDED
$ 50 __ 1,000
70 __ 900
100 __ 800
130 __ 700
170 __ 600
220 __ 500
280 __ 400
350 __ 300S
D1
0 Units of output, QP* = 10Price per
unit ($)
P* = 6
D3P* = 3D2
MARKET PRICE q* @ p* = MC ATC @p* = MC AVC @p* = MC
p* = 10 250 $8 $6
p* = 6 175 8 4
p* = 3 100 9 4
*Note: Problems marked with an asterisk are more challenging.
210 PART II The Market System: Choices Made by Households and Firms
networking and administration costs the average enterprise five
to seven times what it costs a large provider.” What does
Hamilton’s statement imply about the returns to scale in thecloud computing industry?
Source: James Urquhart, “James Hamilton on cloud economies of scale,”
cnet.com , April 28, 2010.
21.The long-run average cost curve for an industry is represented
in the following graph. Add short-run average cost curves and
short-run marginal cost curves for three firms in this industry,with one firm producing an output of 10,000 units, one firmproducing an output of 20,000, and one firm producing an out-put of 30,000. Label these as Scale 1, Scale 2, and Scale 3, respec-tively. What is likely to happen to the scale of each of these threefirms in the long run?22.On the following graph for a purely competitive industry, Scale 1
represents the short-run production for a representative firm.
Explain what is currently happening with firms in this industryin the short run and what will likely happen in the long run.
LRAC
0 Units of
output30,000Cost per
unit ($)
10,000 20,000LRAC
0 Units of
outputDollars ($)
SRAC
SRMCScale 1
9
P* = 4 P* = d = MR
5,000
CHAPTER 9 APPENDIX
External Economies and
Diseconomies and the Long-RunIndustry Supply Curve
Sometimes average costs increase or decrease with the size of
the industry, in addition to responding to changes in the size ofthe firm itself. When long-run average costs decrease as a resultof industry growth, we say that there are external economies .
When average costs increase as a result of industry growth, wesay that there are external diseconomies . (Remember the dis-
tinction between internal and external economies: Internal
economies of scale are found within firms, whereas external
economies occur on an industry-wide basis.)
The expansion of the home building sector of the econ-
omy between 2000 and 2005 illustrates how external disec-onomies of scale arise and how they imply a rising long-runaverage cost curve.
Beginning in 2000, the overall economy suffered a slow-
down as the dot-com exuberance turned to a bursting stockmarket bubble, and the events of 9/11 raised the specter ofinternational terrorism.
One sector, however, came alive between 2000 and 2005:
housing. Very low interest rates lowered the monthly cost ofhome ownership, immigration increased the number of
households, millions of baby boomers traded up and boughtsecond homes, and investors who had been burned by thestock market bust turned to housing as a “real” asset.
All of this increased the demand for single-family homes
and condominiums around the country. Table 9A.1 showswhat happened to house prices, output, and the costs of inputsduring the first 5 years of the decade.
First, house prices began to rise faster than other prices
while the cost of construction materials stayed flat. Profitabilityin the home building sector took off. Next, as existing buildersexpanded their operations, new firms started up. The numberof new housing units “started” stood at just over 1.5 millionannually in 2000 and then rose to over 2 million by 2005. All ofthis put pressure on the prices of construction materials such aslumber and wallboard. The table shows that construction mate-rials costs rose more than 8 percent in 2004. These input pricesincreased the costs of home building. The expanding industry
caused external diseconomies of scale.
The Long-Run Industry Supply Curve
Recall that long-run competitive equilibrium is achieved whenentering firms responding to profits or exiting firms fleeingfrom losses drive price to a level that just covers long-run average
CHAPTER 9 Long-Run Costs and Output Decisions 211
Source: Economy.com and the Office of Federal Housing Enterprise Oversight (OFHEO).
costs. Profits are zero, and P=LRAC =SRAC =SRMC .A tt h i s
point, individual firms are operating at the most efficient scale ofplant—that is, at the minimum point on their LRAC curve.
As we saw in the text, long-run equilibrium is not easily
achieved. Even if a firm or an industry does achieve long-runequilibrium, it will not remain at that point indefinitely.Economies are dynamic. As population and the stock of capitalgrow and as preferences and technology change, some sectorswill expand and some will contract. How do industries adjustto long-term changes? The answer depends on both internaland external factors.
The extent of internal economies (or diseconomies) deter-
mines the shape of a firm’s long-run average cost curve ( LRAC ).
If a firm changes its scale and either expands or contracts, itsaverage costs will increase, decrease, or stay the same along the
LRAC curve. Recall that the LRAC curve shows the relationship
between a firm’s output ( q) and average total cost ( ATC ). A firm
enjoying internal economies will see costs decreasing as itexpands its scale; a firm facing internal diseconomies will seecosts increasing as it expands its scale.However, external economies and diseconomies have noth-
ing to do with the size of individual firms in a competitive mar-
ket. Because individual firms in perfectly competitive industriesare very small relative to the market, other firms are affectedonly minimally when an individual firm changes its output orscale of operation. External economies and diseconomies arise
from industry expansions; that is, they arise when many firmsincrease their output simultaneously or when new firms enteran industry. If industry expansion causes costs to increase(external diseconomies), the LRAC curves facing individual
firms shift upward; costs increase regardless of the level of out-put finally chosen by the firm. Similarly, if industry expansioncauses costs to decrease (external economies), the LRAC curves
facing individual firms shift downward; costs decrease at allpotential levels of output.
An example of an expanding industry facing external
economies is illustrated in Figure 9A.1. Initially, the industryand the representative firm are in long-run competitive equi-librium at the price P
0determined by the intersection of the
initial demand curve D0and the initial supply curve S0.P0isTABLE 9A.1 Construction of New Housing and Construction Materials Costs, 2000–2005
YearHouse Prices % Over
the Previous YearHousing Starts
(Thousands)Housing Starts %
Change Over the
Previous YearConstruction
Materials Prices
% Change Over the
Previous YearConsumer Prices %
Change Over the
Previous Year
2000 — 1,573 — — —
2001 7.5 1,661 56% 0% 2.8%
2002 7.5 1,710 2.9% 1.5% 1.5%
2003 7.9 1,853 8.4% 1.6% 2.3%
2004 12.0 1,949 5.2% 8.3% 2.7%
2005 13.0 2,053 5.3% 5.4% 2.5%
P1
0 0a. The industry b. A representative firm
Units of output, Q Units of output, qP0
P2S0
S1
D1
D0LRISPrice per unit ($)P0
P2LRAC0
LRAC2
/L50304FIGURE 9A.1 A Decreasing-Cost Industry: External Economies
In a decreasing-cost industry, average cost declines as the industry expands. As demand expands from D0toD1, price rises from P0toP1.
As new firms enter and existing firms expand, supply shifts from S0toS1, driving price down. If costs decline as a result of the expansion
toLRAC2, the final price will be below P0atP2. The long-run industry supply curve ( LRIS) slopes downward in a decreasing-cost industry.
212 PART II The Market System: Choices Made by Households and Firms
the long-run equilibrium price; it intersects the initial long-
run average cost curve ( LRAC0) at its minimum point. At this
point, economic profits are zero.
Let us assume that as time passes, demand increases—that
is, the demand curve shifts to the right from D0toD1. This
increase in demand will push price all the way to P1. Without
drawing the short-run cost curves, we know that economicprofits now exist and that firms are likely to enter the industry tocompete for them. In the absence of external economies or dis-economies, firms would enter the industry, shifting the supplycurve to the right and driving price back to the bottom of thelong-run average cost curve, where profits are zero.Nevertheless, the industry in Figure 9A.1 enjoys externaleconomies. As firms enter and the industry expands, costsdecrease; and as the supply curve shifts to the right from S
0
toward S1, the long-run average cost curve shifts downward to
LRAC2. Thus, to reach the new long-run equilibrium level of
price and output, the supply curve must shift all the way to S1.
Only when the supply curve reaches S1i sp r i c ed r i v e nd o w nt o
the new equilibrium price of P2, the minimum point on the new
long-run average cost curve.
Presumably, further expansion would lead to even greater
savings because the industry encounters external economies.The red dashed line in Figure 9A.1(a) that traces out price and
total output over time as the industry expands is called thelong-run industry supply curve ( LRIS ). When an industry
enjoys external economies, its long-run supply curve slopesdown. Such an industry is called a decreasing-cost industry .
Figure 9A.2 shows the long-run industry supply curve for
an industry that faces external diseconomies . (These were suf-
fered in the construction industry, you will recall, whenincreased house building activity drove up lumber prices.) Asdemand expands from D
0toD1, price is driven up from P0to
P1. In response to the resulting higher profits, firms enter,
shifting the short-run supply schedule to the right and drivingprice down. However, this time, as the industry expands, thelong-run average cost curve shifts up to LRAC
2as a result of
external diseconomies. Now, price has to fall back only to P2
(the minimum point on LRAC2), not all the way to P0, to elim-
inate economic profits. This type of industry, whose long-runindustry supply curve slopes up to the right, is called anincreasing-cost industry .
It should not surprise you to know that industries in
which there are no external economies or diseconomies ofscale have flat, or horizontal, long-run industry supply curves.These industries are called constant-cost industries .
P1
0 0a. The industry b. A representative firm
Units of output, Q Units of output, qP2S0
S1
D1
D0LRISPrice per unit ($)P2LRAC0LRAC2
P0 P0
/L50304FIGURE 9A.2 An Increasing-Cost Industry: External Diseconomies
In an increasing-cost industry, average cost increases as the industry expands. As demand shifts from D0toD1, price rises from P0toP1. As new
firms enter and existing firms expand output, supply shifts from S0toS1, driving price down. If long-run average costs rise, as a result, to LRAC2,
the final price will be P2. The long-run industry supply curve ( LRIS) slopes up in an increasing-cost industry.
CHAPTER 9 Long-Run Costs and Output Decisions 213
APPENDIX SUMMARY
EXTERNAL ECONOMIES AND DISECONOMIES p. 210
1.When long-run average costs decrease as a result of industry
growth, we say that the industry exhibits external economies .
When long-run average costs increase as a result of industrygrowth, we say that the industry exhibits external
diseconomies .
THE LONG-RUN INDUSTRY SUPPLY CURVE p. 210
2.The long-run industry supply curve (LRIS ) is a graph that
traces out price and total output over time as an industryexpands. A decreasing-cost industry is an industry in whichaverage costs fall as the industry expands. It exhibits external
economies, and its long-run industry supply curve slopesdownward. An increasing-cost industry is an industry in
which average costs rise as the industry expands. It exhibitsexternal diseconomies, and its long-run industry supplycurve slopes upward. A constant-cost industry is an industry
that shows no external economies or diseconomies as theindustry grows. Its long-run industry supply curve is hori-zontal, or flat.
APPENDIX REVIEW TERMS AND CONCEPTS
constant-cost industry An industry that
shows no economies or diseconomies ofscale as the industry grows. Such industrieshave flat, or horizontal, long-run supplycurves.
p. 212
decreasing-cost industry An industry that
realizes external economies—that is,average costs decrease as the industrygrows. The long-run supply curve for suchan industry has a negative slope.
p. 212external economies and diseconomiesWhen industry growth results in a decreaseof long-run average costs, there are
external
economies ; when industry growth results in
an increase of long-run average costs, thereare
external diseconomies .p. 210 .increasing-cost industry An industry that
encounters external diseconomies—that is,
average costs increase as the industrygrows. The long-run supply curve for suchan industry has a positive slope.
p. 212
long-run industry supply curve ( LRIS)A
graph that traces out price and total outputover time as an industry expands.
p. 212
APPENDIX PROBLEMS
1.In deriving the short-run industry supply curve (the sum of
firms’ marginal cost curves), we assumed that input prices are
constant because competitive firms are price-takers. This sameassumption holds in the derivation of the long-run industrysupply curve. Do you agree or disagree? Explain.
2.Consider an industry that exhibits external diseconomies of
scale. Suppose that over the next 10 years, demand for thatindustry’s product increases rapidly. Describe in detail theadjustments likely to follow. Use diagrams in your answer.
3.A representative firm producing cloth is earning a normal profit
at a price of $10 per yard. Draw a supply and demand diagramshowing equilibrium at this price. Assuming that the industry is
a constant-cost industry, use the diagram to show the long-term
adjustment of the industry as demand grows over time. Explainthe adjustment m echanism.4.Evaluate the following statement. It is impossible for a firm fac-
ing internal economies of scale to be in an industry which is
experiencing external diseconomies.
5.Assume demand is decreasing in a contracting industry. Draw
three supply and demand diagrams which reflect this, with the
first representing an increasing-cost industry, the second repre-
senting a decreasing-cost industry, and the third representing aconstant-cost industry. Assume that prior to the decrease indemand, the industry is in competitive long-run equilibrium.Include the long-run industry supply curve in each diagram and
explain what is happening in each scenario. Specify whether each
diagram represents external economies or external diseconomies.
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In 2009 the average yearly wage for
a welder was $36,630, while theaverage yearly wage for a computerprogrammer was $74,690. Whatdetermines these wages? Why is the
price for an acre of land in T oledo,Ohio, less than it is in SanFrancisco, California? It should notsurprise you to learn that the sameforces of supply and demand thatdetermine the prices of the goodsand services we consume can alsobe used to explain what happens inthe markets for inputs like labor,land, and capital. These input markets are the subject of our next two chapters. In this chapter weset out a basic framework and discuss labor and land, while in Chapter 11 we tackle the morecomplicated topic of capital and investment.
Input Markets: Basic Concepts
As we begin to discuss the market for labor and land, four concepts will be important to under-stand: derived demand, complementary and substitutable inputs, diminishing returns, and mar-ginal revenue product. Once we outline these four concepts, we will be in a position to look atsupply and demand in input markets.
Demand for Inputs: A Derived Demand
When we looked at the Blue Velvet Car Wash in Chapter 9, we saw that the number and price of
car washes depended on, among other things, how much drivers liked getting their cars washed(the demand curve). If we want to explain the price of ice cream, knowing that most peoplehave a sweet tooth would be helpful. Now think about the demand for a welder. Why mightsomeone have a demand for a welder? In input markets, the reason we demand something isnot because it is itself useful, but because it can be used to produce something else that wewant. We demand a welder because he or she is needed to make a car and that car has value.The central difference between the demand for goods and services and the demand for aninput is that input demand is a derived demand . The higher the demand for cars, the higher
the demand for welders.CHAPTER OUTLINE
21510
Input Markets: Basic
Concepts p. 215
Demand for Inputs: A
Derived Demand
Inputs: Complementary
and Substitutable
Diminishing Returns Marginal Revenue Product
Labor Markets p. 219
A Firm Using Only One
Variable Factor ofProduction: Labor
A Firm Employing Two
Variable Factors of
Production in the Short
and Long Run
Many Labor Markets
Land Markets p. 224
Rent and the Value of
Output Produced on Land
The Firm’s Profit-
MaximizingCondition in InputMarkets
p. 226
Input DemandCurves
p. 227
Shifts in Factor Demand
Curves
Looking Ahead p. 228
Input Demand:
The Labor and
Land Markets
Inputs are demanded by a firm if and only if households demand the good or service pro-
vided by that firm.derived demand The
demand for resources
(inputs) that is dependenton the demand for the
outputs those resources can
be used to produce.
216 PART II The Market System: Choices Made by Households and Firms
productivity of an input The
amount of output producedper unit of that input.Valuing an input requires us to look at the output that the input is used to produce. The
productivity of an input is the amount of output produced per unit of that input. When a large
amount of output is produced per unit of an input, the input is said to exhibit high productivity .
When only a small amount of output is produced per unit of the input, the input is said to exhibitlow productivity .
In the press, we often read about conflicts between labor unions and manufacturing firms.
But understanding that labor demand is a derived demand shows us the common groundbetween labor and management: An increase in the demand for a product potentially improvesthe position not only of owners of the firm producing that good, but also the position of work-ers providing labor input.
Inputs: Complementary and Substitutable
Inputs can be complementary orsubstitutable . Two inputs used together may enhance, or comple-
ment, each other. For example, a new machine is often useless without someone to run it.Machines can also be substituted for labor, or—less often—labor can be substituted for machines.
All this means that a firm’s input demands are tightly linked to one another. An increase or
decrease in wages naturally causes the demand for labor to change, but it may also have an effecton the demand for capital or land. If we are to understand the demand for inputs, therefore, wemust understand the connections among labor, capital, and land.
Diminishing Returns
Recall that the short run is the period during which some fixed factor of production limits afirm’s capacity to expand. Under these conditions, the firm that decides to increase output willeventually encounter diminishing returns. Stated more formally, a fixed scale of plant means thatthe marginal product of variable inputs eventually declines.
Recall also that marginal product of labor (MP
L)is the additional output produced if a
firm hires 1 additional unit of labor. For example, if a firm pays for 400 hours of labor per week—10 workers working 40 hours each—and asks one worker to stay an extra hour, the product of the401st hour is the marginal product of labor for that firm.
In Chapter 7, we talked at some length about declining marginal product at a sandwich
shop. The first two columns of Table 10.1 reproduce some of the production data from thatshop. Y ou may remember that the shop has only one grill, at which only two or three peoplecan work comfortably. In this example, the grill is the fixed factor of production in the shortrun. Labor is the variable factor. The first worker can produce 10 sandwiches per hour, and thesecond worker can produce 15 (column 3 of Table 10.1). The second worker can produce morebecause the first worker is busy answering the phone and taking care of customers, as well asmaking sandwiches. After the second worker, however, marginal product declines. The thirdworker adds only 10 sandwiches per hour because the grill gets crowded. The fourth workercan squeeze in quickly while the others are serving or wrapping, but he or she adds only fiveadditional sandwiches each hour, and so on.marginal product of labor
(MPL)The additional
output produced by
1 additional unit of labor.
TABLE 10.1 Marginal Revenue Product per Hour of Labor in Sandwich Production
(One Grill)
(1)
Total Labor Units
(Employees)(2)
Total Product
(Sandwiches
per Hour)(3)
Marginal Product
of Labor ( MPL)
(Sandwiches
per Hour)(4)
Price ( PX)
(Value Added
per Sandwich)a(5)
Marginal
Revenue Product
(MPL/H11003PX)
(per Hour)
0 0 — — —
1 10 10 $0.50 $5.00
2 25 15 0.50 7.50
3 35 10 0.50 5.00
4 40 5 0.50 2.50
5 42 2 0.50 1.00
6 42 0 0.50 0.00
aThe “price” is essentially profit per sandwich; see discussion in text.
ECONOMICS IN PRACTICE
Sometimes Workers Play Hooky!
In this chapter we have described the connection between firm
demand for workers and the productivity of those workers. Inpractice, firms know that worker productivity is not always thesame each day. Monday mornings and Friday afternoons aresometimes less productive than the mid week, and employerstypically think of average productivity over a time period asthey contemplate hiring workers.
The article below describes the way in which the World Cup
matches, which occur every four years, tend to disrupt theusual worker productivity, especially in soccer-crazy countrieslike the United Kingdom. In the summer of 2010, the WorldCup was held in South Africa. Spain won, but in many firms,productivity took a hit!
World Cup Challenges Bosses
To Minimize Productivity Drop, They Juggle WorkerSchedules and Bring In TVs
The Wall Street Journal
The World Cup’s winner won’t be determined until July. But
there are already clear losers: bosses.
On Friday, managers on both sides of the Atlantic braced
for the quadrennial month-long productivity drain that soc-cer's global championship brings. The tournament lasts morethan four weeks, with many games scheduled in the middle of
the workday in the Americas and Europe.
In soccer-mad countries like the U.K., many companies
don’t even try to ban the matches. Some let employees watchgames at work. At others, managers juggle staffers’ sched-ules to accommodate game-watching.In Paraguay, President Fernando Lugo issued a decree giv-
ing public workers Monday afternoon off to watch Paraguay’sgame against Italy.
In past years, the U.S. was mostly immune to the contagion.
But this year, Americans’ growing World Cup curiosity sparked
scattered hooky outbreaks on Friday, the first day of play.
In the U.K., productivity losses tied to the World Cup could
total just under £1 billion ($1.45 billion), according to a survey bythe Chartered Management Institute. Just over half of working
men and 21 percent of working women intend to watch the
matches scheduled to take place during office hours as theyhappen, according to a PricewaterhouseCoopers LLP survey of1,000 U.K. workers.
Source: The Wall Street Journal , excerpted from “World Cup Challenges
Bosses” by Dana Mattioli and Javier Espinoza. Copyright 2010 by Dow
Jones & Company, Inc. Reproduced with permission of Dow Jones &
Company, Inc. via Copyright Clearance Center.
CHAPTER 10 Input Demand: The Labor and Land Markets 217
marginal revenue product
(MRP )The additional
revenue a firm earns byemploying 1 additional unit of
input, ceteris paribus .In this case, the grill’s capacity ultimately limits output. T o see how the firm might make a
rational choice about how many workers to hire, we need to know more about the value of thefirm’s product and the cost of labor.
Marginal Revenue Product
Themarginal revenue product ( MRP )of a variable input is the additional revenue a firm earns
by employing 1 additional unit of that input, ceteris paribus . If labor is the variable factor, for
example, hiring an additional unit will lead to added output (the marginal product of labor). The
sale of that added output will yield revenue. Marginal revenue product is the revenue produced by
selling the good or service that is produced by the marginal unit of labor. In a competitive firm,marginal revenue product is the value of a factor’s marginal product.
By using labor as our variable factor, we can state this proposition more formally by saying
that if MP
Lis the marginal product of labor and PXis the price of output, then the marginal rev-
enue product of labor is
MRPL=MPL/H11003PX
When calculating marginal revenue product, we need to be precise about what is being pro-
duced. A sandwich shop sells sandwiches, but it does not produce the bread, meat, cheese, mustard,
218 PART II The Market System: Choices Made by Households and Firms
MPL
MRPL/H11005MPL/H11003PX012345625Marginal product
(units of output) Marginal revenue product ($)1015
0123
Units of labor4565.00
2.50
1.007.50
/L50304FIGURE 10.1 Deriving a Marginal Revenue Product Curve from
Marginal Product
The marginal revenue product of labor is the price of output, PX, times the marginal product of labor, MPL.and mayonnaise that go into the sandwiches. What the shop is producing is “sandwich cooking
and assembly services.” The shop is “adding value” to the meat, bread, and other ingredients bypreparing and putting them all together in ready-to-eat form. With this in mind, let us assumethat each finished sandwich in our shop sells for $0.50 over and above the costs of its ingredients.Thus, the price of the service the shop is selling is $0.50 per sandwich, and the only variable cost of
providing that service is that of the labor used to put the sandwiches together. Thus, if Xis the
product of our shop, P
X= $0.50.
Table 10.1, column 5, calculates the marginal revenue product of each worker if the shop
charges $0.50 per sandwich over and above the costs of its ingredients. The first worker produces10 sandwiches per hour, which at $0.50 each, generates revenues of $5.00 per hour. The additionof a second worker yields $7.50 an hour in revenues. After the second worker, diminishingreturns drive MRP
Ldown. The marginal revenue product of the third worker is $5.00 per hour, of
the fourth worker is only $2.50, and so on.
Figure 10.1 graphs the data from Table 10.1. Notice that the marginal revenue product curve
has the same downward slope as the marginal product curve but that MRP is measured in dollars,
not units of output. The MRP curve shows the dollar value of labor’s marginal product.
CHAPTER 10 Input Demand: The Labor and Land Markets 219Wage rate ($)
MRPL
Units of labor560,000 100 210a. The labor market b. A representative firm
Units of laborW* /H11005 10 10 20
00DS/L50296FIGURE 10.2
Marginal Revenue
Product and FactorDemand for a FirmUsing One VariableInput (Labor)
A competitive firm using only
one variable factor of productionwill use that factor as long as itsmarginal revenue product
exceeds its unit cost. A perfectly
competitive firm will hire laboras long as MRP
Lis greater than
the going wage, W*. The hypo-
thetical firm will demand210 units of labor.Labor Markets
Let us begin our discussion of input markets by discussing a firm that uses only one variable fac-
tor of production.
A Firm Using Only One Variable Factor of Production: Labor
Demand for an input depends on that input’s marginal revenue product and its unit cost, or price.The price of labor, for example, is the wage determined in the labor market. (At this point, we arecontinuing to assume that the sandwich shop uses only one variable factor of production—labor.Remember that competitive firms are price-takers in both output and input markets. Such firmscan hire all the labor they want to hire as long as they pay the market wage.) We can think of thehourly wage at the sandwich shop as the marg inal cost of a unit of labor. A profit-maximizing
firm will add inputs—in the case of labor, it will hire workers—as long as the marginal revenueproduct of that input exceeds the market price of that input—in the case of labor, the wage.
Look again at the figures for the sandwich shop in Table 10.1, column 5. Now suppose the going
wage for sandwich makers is $4 per hour. A profit-maximizing firm would hire three workers. Thefirst worker would yield $5 per hour in revenue, and the second would yield $7.50, but they eachwould cost only $4 per hour. The third worker would bring in $5 per hour, but still cost only $4 inmarginal wages. The marginal product of the fourth worker, however, would not bring in enoughrevenue ($2.50) to pay this worker’s salary. T otal profit is thus maximized by hiring three workers.
Figure 10.2 presents this same concept graphically. The labor market appears in Figure 10.2(a);
Figure 10.2(b) shows a single firm that employs workers. This firm, incidentally, does not representjust the firms in a single industry. Because firms in many different industries demand labor, the rep-resentative firm in Figure 10.2(b) represents any firm in any industry that uses labor.
The firm faces a market wage rate of $10. We can think of this as the marginal cost of a unit of
labor. (Note that we are now discussing the margin in units of labor ; in previous chapters, we talked
about marginal units of output .) Given a wage of $10, how much labor would the firm demand?
Y ou might think that the firm would hire 100 units, the point at which the difference between
marginal revenue product and wage rate is greatest. However, the firm is interested in maximizing total
profit, not marginal profit. Hiring the 101st unit of labor generates $20 in revenue at a cost of only $10.
Because MRP
Lis greater than the cost of the input required to produce it, hiring 1 more unit of labor
adds to profit. This will continue to be true as long as MRPLremains above $10, which is all the way to
210 units. At that point, the wage rate is equal to the marginal revenue product of labor, or W* = MRPL
= 10. The firm will not demand labor beyond 210 units because the cost of hiring the 211th unit
of labor would be greater than the value of what that unit produces. (Recall that the fourth sandwichmaker, requiring a wage of $4 per hour, can produce only an extra $2.50 an hour in sandwiches.)
220 PART II The Market System: Choices Made by Households and Firms
Thus, the curve in Figure 10.2(b) tells us how much labor a firm that uses only one variable
factor of production will hire at each potential market wage rate. If the market wage falls, thequantity of labor demanded will rise. If the market wage rises, the quantity of labor demanded willfall. This description should sound familiar to you—it is, in fact, the description of a demandcurve. Therefore we can now say that when a firm uses only one variable factor of production, thatfactor’s marginal revenue product curve is the firm’s demand curve for that factor in the short run.
Comparing Marginal Revenue and Marginal Cost to Maximize Profits In
Chapter 8, we saw that a competitive firm’s marginal cost curve is the same as its supply curve.That is, at any output price, the marginal cost curve determines how much output a profit-maxi mizing firm will produce. We came to this concl usion by comparing the marginal revenue
that a firm would earn by producing one more unit of output with the marginal cost of produc-ing that unit of output.
There is no difference between the reasoning in Chapter 8 and the reasoning in this chapter.
The only difference is that what is being measured at the margin has changed. In Chapter 8, thefirm was comparing the marginal revenues and costs of producing another unit of output . Here the
firm is comparing the marginal revenues and costs of employing another unit of input . T o see this
similarity, look at Figure 10.3. When the only variable factor of production is labor, the conditionW=MRP
Lis the same condition as P=MC. The two statements say exactly the same thing.
In both cases, the firm is comparing the cost of production with potential revenues from the
sale of product at the margin . In Chapter 8, the firm compared the price of output ( P, which is
equal to MR in perfect competition) directly with cost of production ( MC), where cost was
derived from information on factor prices and technology. (Review the derivation of cost curvesin Chapter 8 if this is unclear.) Here information on output price and technology is contained inthe marginal revenue product curve, which the firm compares with information on input price todetermine the optimal level of input to demand.
The assumption of one variable factor of production makes the trade-off facing firms easy to
see. Figure 10.4 shows that, in essence, firms weigh the value of labor as reflected in the marketwage against the value of the product of labor as reflected in the price of output. Assuming thatlabor is the only variable input, if society values a good more than it costs firms to hire the work-ers to produce that good, the good will be produced. In general, the same logic also holds formore than one input. Firms weigh the value of outputs as reflected in output price against thevalue of inputs as reflected in marginal costs.
Deriving Input Demands For the small sandwich shop, calculating the marginal product of
a variable input (labor) and marginal revenue product was easy. Although it may be more complex,the decision process is essentially the same for both big corporations and small proprietorships.
When an airline hires more flight attendants, for example, it increases the quality of its ser-
vice to attract more passengers and thus to sell more of its product. In deciding how many flightattendants to hire, the airline must figure out how much new revenue the added attendants arelikely to generate relative to their wages.
• Output prices
• TechnologyMarginal revenue
product of a
unit of
input (labor)
Marginal cost
of a unit
of input (labor)
Firms will
hire until:
MRP L= WMarginal revenue
of a unit
of output
Marginal cost
of a unit
of output
Firms will
produce until:
P= MCInput pricesOutput price
• Technology
• Input prices/L50298FIGURE 10.3
The Two Profit-
Maximizing ConditionsAre Simply Two Viewsof the Same ChoiceProcess
CHAPTER 10 Input Demand: The Labor and Land Markets 221
At the sandwich shop, diminishing returns set in at a certain point. The same holds true for
an airplane. Once a sufficient number of attendants are on a plane, additional attendants add lit-tle to the quality of service, and beyond a certain level, they might even give rise to negative mar-ginal product. The presence of too many attendants could bother the passengers and make itdifficult to get to the restrooms.
In making your own decisions, you also compare marginal gains with input costs in the pres-
ence of diminishing returns. Suppose you grow vegetables in your yard. First, you save money atthe supermarket. Second, you can plant what you like, and the vegetables taste better fresh fromthe garden. Third, you simply like to work in the garden.
Like the sandwich shop and the airline, you also face diminishing returns. Y ou have only
625 square feet of garden to work with, and with land as a fixed factor in the short run, your mar-ginal product will certainly decline. Y ou can work all day every day, but your limited space willproduce only so many string beans. The first few hours you spend each week watering, fertilizing,and dealing with major weed and bug infestations probably have a high marginal product.However, after 5 or 6 hours, there is little else you can do to increase yield. Diminishing returnsalso apply to your sense of satisfaction. The farmers’ markets are now full of inexpensive freshproduce that tastes nearly as good as yours. Once you have been out in the garden for a few hours,the hot sun and hard work start to lose their charm. Although your gardening does not involve asalary (unlike the sandwich shop and the airline, which pay out wages), the labor you supply hasa value that must be weighed. Y ou must weigh the value of additional gardening time againstleisure and the other options available to you.
Less labor is likely to be employed as the cost of labor rises. If the competitive labor market
pushed the daily wage to $6 per hour, the sandwich shop would hire only two workers instead ofthree (Table 10.1). If you suddenly became very busy at school, the opportunity cost of your timewould rise and you would probably devote fewer hours to gardening.
We have recently seen an example of what may seem to be an exception to the rule that work-
ers will be hired only if the revenues they generate are equal to or greater than their wages. Manystart-up companies pay salaries to workers before the companies begin to take in revenue. Thishas been particularly true for Internet start-ups in recent years. How does a company pay work-ers if it is not earning any revenue? The answer is that the entrepreneur (or the venture capitalfund supporting the entrepreneur) is betting that the firm will earn substantial revenue in thefuture. Workers are hired because the entrepreneur expects that their current efforts will producefuture revenue greater than their wage costs.Marginal revenue product
MPL/H11003PXPx
0 0W
v QProduct market Labor market
Wage = cost of a
marginal unit of laborValue of labor’s
marginal product
Maximum profit
FIRMS/L50296FIGURE 10.4
The Trade-Off Facing
Firms
Firms weigh the cost of labor as
reflected in wage rates againstthe value of labor’s marginal
product. Assume that labor is the
only variable factor of produc-tion. Then, if society values agood more than it costs firms to
hire the workers to produce that
good, the good will be produced.
222 PART II The Market System: Choices Made by Households and Firms
A Firm Employing Two Variable Factors of Production in
the Short and Long Run
When a firm employs more than one variable factor of production, the analysis of input demand
becomes more complicated, but the principles stay the same. We shall now consider a firm thatemploys variable capital ( K) and labor ( L) inputs and thus faces factor prices P
Kand PL.1(Recall
that capital refers to plant, equipment, and inventory used in production. We assume that some
portion of the firm’s capital stock is fixed in the short run, but that some of it is variable—forexample, some machinery and equipment can be installed quickly.) Our analysis can be appliedto any two factors of production and can easily be generalized to three or more. It can also beapplied to the long run, when all factors of production are variable.
Y ou have seen that inputs can be complementary or substitutable. Land, labor, and capital are
used together to produce outputs. The worker who uses a shovel digs a bigger hole than another
worker with no shovel. Add a steam shovel and that worker becomes even more productive. Whenan expanding firm adds to its stock of capital, it raises the productivity of its labor, and vice versa.Thus, each factor complements the other. At the same time, though, land, labor, and capital canalso be substituted for one another. If labor becomes expensive, some labor-saving technology—
robotics, for example—may take its place.
In firms employing just one variable factor of production, a change in the price of that factor
affects only the demand for the factor itself. When more than one factor can vary, however, wemust consider the impact of a change in one factor price on the demand for other factors as well.
Substitution and Output Effects of a Change in Factor Price Table 10.2 pre-
sents data on a hypothetical firm that employs variable capital and labor. Suppose that the firmfaces a choice between two available technologies of production—technique A, which is capital
intensive, and technique B, which is labor intensive. When the market price of labor is $1 per
unit and the market price of capital is $1 per unit, the labor-intensive method of producingoutput is less costly. Each unit costs only $13 to produce using technique B, while the unit cost
of production using technique Ais $15. If the price of labor rises to $2, however, technique Bis
no longer less costly. Labor has become more expensive relative to capital. The unit cost rises to$23 for labor-intensive technique B, but to only $20 for capital-intensive technique A.
TABLE 10.2 Response of a Firm to an Increasing Wage Rate
TechnologyInput Requirements
per Unit of Output
KLUnit Cost if
PL= $1
PK= $1
(PL/H11003L) + ( PK/H11003K)Unit Cost if
PL= $2
PK= $1
(PL/H11003L) + ( PK/H11003K)
A(capital intensive) 10 5 $15 $20
B(labor intensive) 3 10 $13 $23
factor substitution
effect The tendency of firms
to substitute away from a
factor whose price has risenand toward a factor whose
price has fallen.Table 10.3 shows the effect of such an increase in the price of labor on both capital and labor
demand when a firm produces 100 units of output. When the price of labor is $1 and the price ofcapital is $1, the firm chooses technique Band demands 300 units of capital and 1,000 units of
labor. T otal variable cost is $1,300. An increase in the price of labor to $2 causes the firm to switchfrom technique Bto technique A. In doing so, the firm substitutes capital for labor. The amount of
labor demanded drops from 1,000 to 500 units. The amount of capital demanded increases from300 to 1,000 units, while total variable cost increases to $2,000.
The tendency of firms to substitute away from a factor whose relative price has risen and
toward a factor whose relative price has fallen is called the factor substitution effect . The factor
substitution effect is part of the reason that input demand curves slope downward . When an input,
1The price of labor, PL, is the same as the wage rate, W. We will often use the term PLinstead of Wto emphasize the symmetry
between labor and capital.
CHAPTER 10 Input Demand: The Labor and Land Markets 223
or factor of production, becomes less expensive, firms tend to substitute it for other factors and
thus buy more of it. When a particular input becomes more expensive, firms tend to substitute
other factors and buy lessof it.
The firm described in Table 10.2 and Table 10.3 continued to produce 100 units of output
after the wage rate doubled. An increase in the price of a production factor, however, also
means an increase in the costs of production. Notice that total variable cost increased from$1,300 to $2,000. When a firm faces higher costs, it is likely to produce less in the short run.When a firm decides to decrease output, its demand for all factors declines—including, of
ECONOMICS IN PRACTICE
What is Denzel Washington’s Marginal Revenue Product in
Broadway’s Fences ?
Denzel Washington is well known for his movie performances,
where he has been paid as much as $20 million for a film. In thespring and summer of 2010, Washington starred in August Wilson’s
Fences at the Cort Theater on Broadway in New Y ork. How would we
go about estimating Washington’s marginal revenue product in thatjob? What is the most the producers of Fences should be willing to
pay Washington?
In the case of Broadway theater, revenues come principally from
ticket revenues. The Cort Theater seats just over 1,000 people, and theaverage ticket price is $110. Fences has eight performances a week. So the
total maximum weekly “gate,” as it is called in the theater, is $880,000assuming the theater is fully sold out. How much of this should the pro-
ducers be willing to pay Washington to secure him in the role?
As with the sandwich workers, the key here is to figure out what
Washington adds to the gate. Given that all revenues come fromticket sales, we really need to know how many more peopleWashington can attract to the Cort Theater than could another
actor. Suppose the producer believed that Washington couldincrease demand for tickets by 10 percent, so that instead of selling
half the theater's seats in a week, or 4,000 tickets, as is common for aBroadway show, the theater sold 4,400 seats per week. That wouldadd $44,000 to the revenues over what would be achievable with
another actor. Moreover, in contrast to the sandwich shop,
Washington can add this revenue with no other added inputs; itcosts nothing more to play to a house three-fourths full than to onehalf full. In this case, the producer should be willing to pay
Washington as much as $44,000 per week over a lesser actor.Notice this salary is
considerably less thanWashington makes fora movie. Movies takeabout 3 months of act-
ing time. At $15 to
$20 million for amovie, that amountsto well over $1 millionper week. Why should
Washington’s acting
have an MRP of
$44,000 per weekwhen on the stage and$1 million per weekfor a movie? We are
back to the principle
of derived demand.Washington’s MRP is
higher in movies than
in the live theater because the earnings potential of the former is
higher. Movie audiences are not limited to 1,000 per week;Washington’s 2010 movie, Book of Eli , showed to more than
3 million people in its opening weekend, and most criticsthought that Washington was the primary audience draw. With
DVD sales in addition, it is easy to see how Washington’s MRP in
films might be quite high.
TABLE 10.3 The Substitution Effect of an Increase in Wages on a Firm Producing
100 Units of Output
To Produce 100 Units of Output
Total Capital
DemandedTotal Labor
DemandedTotal
Variable Cost
When PL= $1, PK= $1,
firm uses technology B300 1,000 $1,300
When PL= $2, PK= $1,
firm uses technology A1,000 500 $2,000
224 PART II The Market System: Choices Made by Households and Firms
demand-determined
price The price of a good
that is in fixed supply; it isdetermined exclusively by what
households and firms are
willing to pay for the good.
pure rent The return to any
factor of production that is in
fixed supply.course, the factor whose price increased in the first place. This is called the output effect of a
factor price increase .
Adecrease in the price of a factor of production, in contrast, means lower costs of produc-
tion. If their output price remains unchanged, firms will increase output. This, in turn, meansthat demand for all factors of production will increase. This is the output effect of a factor
price decrease .
The output effect helps explain why input demand curves slope downward. Output effects
and factor substitution effects work in the same direction. Consider, for example, a decline in thewage rate. Lower wages mean that a firm will substitute labor for capital and other inputs. Statedsomewhat differently, the factor substitution effect leads to an increase in the quantity of labordemanded. Lower wages mean lower costs, and lower costs lead to more output. This increase inoutput means that the firm will hire more of all factors of production, including labor. This is theoutput effect of a factor price decrease. Notice that both effects lead to an increase in the quantitydemanded for labor when the wage rate falls.
Many Labor Markets
Although Figure 10.1 depicts “ thelabor market,” many labor markets exist. There is a market for
baseball players, for carpenters, for chemists, for college professors, and for unskilled workers. Stillother markets exist for taxi drivers, assembly-line workers, secretaries, and corporate executives.Each market has a set of skills associated with it and a supply of people with the requisite skills. Iflabor markets are competitive, the wages in those markets are determined by the interaction ofsupply and demand. As we have seen, firms will hire additional workers only as long as the valueof their product exceeds the relevant market wage. This is true in all competitive labor markets.
Land Markets
Unlike labor and capital, land has a special feature that we have not yet considered: It is in strictlyfixed (perfectly inelastic) supply in total. The only real questions about land thus center aroundhow much it is worth and how it will be used.
Because land is fixed in supply, we say that its price is demand determined . In other words,
the price of land is determined exclusively by what households and firms are willing to pay for it.The return to any factor of production in fixed supply is called a pure rent .
Thinking of the price of land as demand determined can be confusing because all land is not
the same. Some land is clearly more valuable than other land. What lies behind these differences?As with any other factor of production, land will presumably be sold or rented to the user who iswilling to pay the most for it. The value of land to a potential user may depend on the character-istics of the land or on its location. For example, more fertile land should produce more farmproducts per acre and thus command a higher price than less fertile land. A piece of propertylocated at the intersection of two highways may be of great value as a site for a gas station becauseof the volume of traffic that passes the intersection daily.
A numerical example may help to clarify our discussion. Consider the potential uses of a cor-
ner lot in a suburb of Kansas City. Alan wants to build a clothing store on the lot. He anticipatesthat he can earn economic profits of $10,000 per year because of the land’s excellent location.Bella, another person interested in buying the corner lot, believes that she can earn $35,000 peryear in economic profit if she builds a pharmacy there. Because of the higher profit that she expectsto earn, Bella will be able to outbid Alan, and the landowner will sell (or rent) to the highest bidder.
Because location is often the key to profits, landowners are frequently able to “squeeze” their
renters. One of the most popular locations in the Boston area, for example, is Harvard Square.There are dozens of restaurants in and around the square, and most of them are full a good dealof the time. Despite this seeming success, most Harvard Square restaurant owners are not gettingrich. Why? Because they must pay very high rents on the location of their restaurants. A substan-tial portion of each restaurant’s revenues goes to rent the land that (by virtue of its scarcity) is thekey to unlocking those same revenues.
Although Figure 10.5 shows that the supply of land is perfectly inelastic (a vertical line), the
supply of land in a given use may not be perfectly inelastic or fixed. Think, for example, aboutoutput effect of a factor price
increase (decrease) When a
firm decreases (increases) its
output in response to a factorprice increase (decrease), this
decreases (increases) its
demand for all factors.
CHAPTER 10 Input Demand: The Labor and Land Markets 225
Supply
Demand
0
Land in acresR0Rent per acre/L50296FIGURE 10.5
The Rent on Land Is
Demand Determined
Because land in general (and
each parcel in particular) is infixed supply, its price is demand
determined. Graphically, a fixed
supply is represented by a verti-cal, perfectly inelastic supplycurve. Rent, R
0, depends exclu-
sively on demand—what peopleare willing to pay.
farmland available for housing developments. As a city’s population grows, housing developers
find themselves willing to pay more for land. As land becomes more valuable for development,some farmers sell out, and the supply of land available for development increases. This analysiswould lead us to draw an upward-sloping supply curve (not a perfectly inelastic supply curve) forland in the land-for-development category.
Nonetheless, our major point—that land earns a pure rent—is still valid. The supply of land
of a given quality at a given location is truly fixed in supply. Its value is determined exclusively by
the amount that the highest bidder is willing to pay for it. Because land cannot be reproduced,supply is perfectly inelastic.
Rent and the Value of Output Produced on Land
Because the price of land is demand determined, rent depends on what the potential users of theland are willing to pay for it. As we have seen, land will end up being used by whoever is willing topay the most for it. What determines this willingness to pay? Let us now connect our discussionof land markets with our earlier discussions of factor markets in general.
As our example of two potential users bidding for a plot of land shows, the bids depend on the
land’s potential for profit. Alan’s plan would generate $10,000 a year; Bella’s would generate $35,000a year. Nevertheless, these profits do not just materialize. Instead, they come from producing andselling an output that is valuable to households. Land in a popular downtown location is expensivebecause of what can be produced on it. Note that land is needed as an input into the production ofnearly all goods and services. A restaurant located next to a popular theater can charge a premiumprice because it has a relatively captive clientele. The restaurant must produce a quality product tostay in business, but the location alone provides a substantial profit opportunity.
It should come as no surprise that the demand for land follows the same rules as the
demand for inputs in general. A profit-maximizing firm will employ an additional factor ofproduction as long as its marginal revenue product exceeds its market price. For example, aprofit-maximizing firm will hire labor as long as the revenue earned from selling labor’s prod-uct is sufficient to cover the cost of hiring additional labor—which for perfectly competitivefirms, equals the wage rate. The same thing is true for land. A firm will pay for and use land aslong as the revenue earned from selling the product produced on that land is sufficient to coverthe price of the land. Stated in equation form, the firm will use land up to the point at whichMRP
A=PA,w h e r e Ais land (acres).
Just as the demand curve for labor reflects the value of labor’s product as determined in out-
put markets, so the demand for land depends on the value of land’s product in output markets.The profitability of the restaurant located next to the theater results from the fact that the mealsproduced there command a price in the marketplace.
226 PART II The Market System: Choices Made by Households and Firms
The allocation of a given plot of land among competing uses thus depends on the trade-off
between competing products that can be produced there. Agricultural land becomes developedwhen its value in producing housing or manufactured goods (or providing space for a mini-mall) exceeds its value in producing crops. A corner lot in Kansas City becomes the site of apharmacy instead of a clothing store because the people in that neighborhood have a greaterneed for a pharmacy.
One final word about land: Because land cannot be moved physically, the value of any one
parcel depends to a large extent on the uses to which adjoining parcels are put. A factory belchingacrid smoke will probably reduce the value of adjoining land, while a new highway that increasesaccessibility may enhance it.
The Firm’s Profit-Maximizing Condition in
Input Markets
Thus far, we have discussed the labor and land markets in some detail. Although we will put
off a detailed discussion of capital until the next chapter, it is now possible to generalize aboutcompetitive demand for factors of production. Every firm has an incentive to use variableinputs as long as the revenue generated by those inputs covers the costs of those inputs at themargin. More formally, firms will employ each input up to the point that its price equals itsmarginal revenue product. This condition holds for all factors at all levels of output.ECONOMICS IN PRACTICE
Time Is Money: European High-Speed Trains
In the past few years, many parts of Europe have invested in high-
speed trains. In the article that follows, we see the way in which these
trains increase land value. The rise in land value following the intro-duction of high-speed trains is another example of the importanceof the opportunity cost of time. As train speeds increase, the timecost of living far from one’s workplace decreases; the natural result is
an increased willingness to live far from one’s workplace and thus an
increase in outlying land values.
High-Speed Rail Give Short-Haul Air a Run
for the Money in Europe, With More FlexibleTravel, Greater Comfort, LowerEnvironmental Impact
Travel Industry News
While air travelers put up with longer delays, cancelled flights
and tedious security procedures, and drivers face rising gas
prices and ever-increasing congestion, life keeps gettingeasier for passengers on Europe’s expanding network ofhigh-speed trains. The latest developments and the far-reaching benefits of high-speed European train travel were
the topics of a press conference, “High-speed trains:
Changing the European Experience” held in New York today.Speakers included: CEO of the French National Railroads(SNCF), Guillaume Pepy; Commercial Director of the
Eurostar train, Nicholas Mercer; and High-Speed Director
of the Paris-based International Railway Association (UIC), Inaki Barron. Rail Europe— North America’s leading seller of
European rail travel—was the host of the conference.
Traveling at speed of 150 mph or higher (compared to reg-
ular trains going 100 mph or less), high-speed trains currentlyrun on 3,034 miles of track in 10 European countries. By2010, another 1,711 miles are scheduled to be in operation,and there are plans beyond that to add on average 346 mileseach year through 2020, according to the UIC’s Barron.
High-speed trains not only benefit travelers and the envi-
ronment, they also boost the economies of communitiesserved. In France, they call it the “TGV effect”—increases inproperty values, rents/real estate prices and number of
jobs/businesses in towns in or near high-speed rail lines.
Real estate prices in Avignon rose more than 30% in the
first three years following the launch of TGV Mediterranean. InVendome, near the TGV Atlantique line (Paris-Tours in theLoire region) real estate prices went up 50% in five years.
Source: Travel Industry Wire , March 24, 2008.
CHAPTER 10 Input Demand: The Labor and Land Markets 227
The profit-maximizing condition for the perfectly competitive firm is
where Lis labor, Kis capital, Ais land (acres), Xis output, and PXis the price of that output.
When all these conditions are met, the firm will be using the optimal, or least costly, combina-
tion of inputs. If all the conditions hold at the same time, it is possible to rewrite them another way:
Y our intuition tells you much the same thing that these equations do: The marginal product of the
last dollar spent on labor must be equal to the marginal product of the last dollar spent on capital,which must be equal to the marginal product of the last dollar spent on land, and so on. If this wasnot the case, the firm could produce more with less and reduce cost. Suppose, for example, thatMP
L/PL>MPK/PK. In this situation, the firm can produce more output by shifting dollars out of
capital and into labor. Hiring more labor drives down the marginal product of labor, and using lesscapital increases the marginal product of capital. This means that the ratios come back to equality asthe firm shifts out of capital and into labor.
So far, we have used very general terms to discuss the nature of input demand by firms in compet-
itive markets, where input prices and output prices are taken as given. The most important point isthat demand for a factor depends on the value that the market places on its marginal product.
2The rest
of this chapter explores the forces that determine the shapes and positions of input demand curves.
Input Demand Curves
In Chapter 5, we considered the factors that influence the responsiveness, or elasticity, of outputdemand curves. We have not yet talked about input demand curves in any detail, however, so we
now need to say more about what lies behind them.
Shifts in Factor Demand Curves
Factor (input) demand curves are derived from information on technology—that is, productionfunctions—and output price (see Figure 10.4 on p. 221). A change in the demand for outputs, achange in the quantity of complementary or substitutable inputs, changes in the prices of otherinputs, and technological change all can cause factor demand curves to shift. These shifts indemand are important because they directly affect the allocation of resources among alternativeuses as well as the level and distribution of income.
The Demand for Outputs A firm will demand an input as long as its marginal revenue
product exceeds its market price. Marginal revenue product, which in perfect competition is equal toa factor’s marginal product times the price of output, is the value of the factor’s marginal product:
MRP
L=MPL/H11003PX
The amount that a firm is willing to pay for a factor of production depends directly on the
value of the things the firm produces. It follows that if product demand increases, product pricewill rise and marginal revenue product (factor demand) will increase—the MRP curve will shift
to the right. If product demand declines, product price will fall and marginal revenue product(factor demand) will decrease—the MRP curve will shift to the left.MP L
PL=MP K
PK=MP A
PA=1
PXPA=MRP A=(MP A*PX)PK=MRP K=(MP K*PX)PL=MRP L=(MP L*PX)
2If you worked through the Appendix to Chapter 7, you saw this same condition derived graphically from an isocost/isoquant
diagram. Note: MPL/PL=MPK/PKMPL/MPK=PL/PK. :
228 PART II The Market System: Choices Made by Households and Firms
Go back and raise the price of sandwiches from $0.50 to $1.00 in the sandwich shop example
examined in Table 10.1 on p. 216 to see that this is so.
T o the extent that any input is used intensively in the production of some product, changes in the
demand for that product cause factor demand curves to shift and the prices of those inputs to change.Land prices are a good example. Forty years ago, the area in Manhattan along the west side of CentralPark from about 80th Street north was a run-down neighborhood full of abandoned houses. Thevalue of land there was virtually zero. During the mid-1980s, increased demand for housing causedrents to hit record levels. Some single-room apartments, for example, rented for as much as $1,400 permonth. With the higher price of output (rent), input prices increased substantially. By 2008, small one-bedroom apartments on 80th Street and Central Park West sold for well over $500,000, and thevalue of the land figures very importantly in these prices. In essence, a shift in demand for an output(housing in the area) pushed up the marginal revenue product of land from zero to very high levels.
The Quantity of Complementary and Substitutable Inputs In our discussion
thus far, we have kept coming back to the fact that factors of production complement oneanother. The productivity of, and thus the demand for, any one factor of production depends onthe quality and quantity of the other factors with which it works.
The effect of capital accumulation on wages is one of the most important themes in all of eco-
nomics. In general, the production and use of capital enhances the productivity of labor and nor-mally increases the demand for labor and drives up wages. Co nsider as an example transportation. In
a poor country such as Bangladesh, one person with an ox cart can move a small load over bad roadsvery slowly. By contrast, the stock of capital used by workers in the transportation industry in the UnitedStates is enormous. A truck driver in the United States works with a substantial amount of capital. Thetypical 18-wheel tractor trailer, for example, is a piece of capital worth over $100,000. The roads them-selves are capital that was put in place by the government. The amount of material that a single drivercan move between distant points in a short time is staggering relative to what it was just 50 years ago.
The Prices of Other Inputs When a firm has a choice among alternative technologies,
the choice it makes depends to some extent on relative input prices. Y ou saw in Table 10.2 onp. 222 and Table 10.3 on p. 223 that an increase in the price of labor substantially increased thedemand for capital as the firm switched to a more capital-intensive production technique.
During the 1970s, the large increase in energy prices relative to prices of other factors of produc-
tion had a number of effects on the demand for those other inputs. Insulation of new buildings,installation of more efficient heating plants, and similar efforts substantially raised the demand forcapital as capital was substituted for energy in production. It has also been argued that the energy cri-sis led to an increase in demand for labor. If capital and energy are complementary inputs—that is, iftechnologies that are capital-intensive are also energy-intensive—the argument goes, the higherenergy prices tended to push firms away from capital-intensive techniques toward more labor-intensive techniques. A new highly automated technique, for example, might need fewer workers, butit would also require a vast amount of electricity to operate. High electricity prices could lead a firmto reject the new techniques and stick with an old, more labor-intensive method of production.
Technological Change Closely related to the impact of capital accumulation on factor
demand is the potential impact of technological change —that is, the introduction of new methods of
production or new products. New technologies usually introduce ways to produce outputs with fewerinputs by increasing the productivity of existing inputs or by raising marginal products. Because mar-ginal revenue product reflects productivity, increases in productivity directly shift input demandcurves. If the marginal product of labor rises, for example, the demand for labor shifts to the right(increases). T echnological change can and does have a powerful influence on factor demands. As newproducts and new techniques of production are born, so are demands for new inputs and new skills.As old products become obsolete, so do the labor skills and other inputs needed to produce them.
Looking Ahead
We now have a complete, but simplified picture of household and firm decision making. We havealso examined some of the basic forces that determine the allocation of resources and the mix ofoutput in perfectly competitive markets.technological change
The introduction of new
methods of production or new
products intended to increasethe productivity of existing
inputs or to raise marginal
products.
CHAPTER 10 Input Demand: The Labor and Land Markets 229
In this competitive environment, profit-maximizing firms make three fundamental deci-
sions: (1) how much to produce and supply in output markets, (2) how to produce (which tech-nology to use), and (3) how much of each input to demand. Chapters 7 through 9 looked at thesethree decisions from the perspective of the output market. We derived the supply curve of a com-petitive firm in the short run and discussed output market adjustment in the long run. Derivingcost curves, we learned, involves evaluating and choosing among alternative technologies. Finally,we saw how a firm’s decision about how much product to supply in output markets implicitlydetermines input demands. Input demands, we argued, are also derived demands. That is, theyare ultimately linked to the demand for output.
T o show the connection between output and input markets, this chapter took these same
three decisions and examined them from the perspective of input markets. Firms hire up to thepoint at which each input’s marginal revenue product is equal to its price.
The next chapter takes up the complexity of what we have been loosely calling the “capital
market.” There we discuss the relationship between the market for physical capital and financialcapital markets and look at some of the ways that firms make investment decisions. Once weexamine the nature of overall competitive equilibrium in Chapter 12, we can finally begin relax-ing some of the assumptions that have restricted the scope of our inquiry—most importantly, theassumption of perfect competition in input and output markets.
SUMMARY
1.The same set of decisions that lies behind output supply
curves also lies behind input demand curves. Only the per-spective is different.
INPUT MARKETS: BASIC CONCEPTS p. 215
2.Demand for inputs depends on demand for the outputs thatthey produce; input demand is thus a derived demand .
Productivity is a measure of the amount of output produced
per unit of input.
3.In general, firms will demand workers as long as the value ofwhat those workers produce exceeds what they must bepaid. Households will supply labor as long as the wageexceeds the value of leisure or the value that they derivefrom nonpaid work.
4.Inputs are at the same time complementary and substitutable .
5.In the short run, some factor of production is fixed. This means
that all firms encounter diminishing returns in the short run.Stated somewhat differently, diminishing returns means that allfirms encounter declining marginal product in the short run.
6.The marginal revenue product (MRP ) of a variable input is
the additional revenue a firm earns by employing one addi-tional unit of the input, ceteris paribus .MRP is equal to the
input’s marginal product times the price of output.
LABOR MARKETS p. 219
7.Demand for an input depends on that input’s marginal revenueproduct. Profit-maximizing perfectly competitive firms will buyan input (for example, hire labor) up to the point where theinput’s marginal revenue product equals its price. For a firmemploying only one variable factor of production, the MRP
curve is the firm’s demand curve for that factor in the short run.
8.For a perfectly competitive firm employing one variable fac-tor of production, labor, the condition W=MRP
Lis exactly
the same as the condition P=MC. Firms weigh the value of
outputs as reflected in output price against the value ofinputs as reflected in marginal costs.9.When a firm employs two variable factors of production, achange in factor price has both a factor substitution effect and
anoutput effect .
10. A wage increase may lead a firm to substitute capital for labor
and thus cause the quantity demanded of labor to decline.This is the factor substitution effect of the wage increase .
11. A wage increase increases cost, and higher cost may lead to
lower output and less demand for all inputs, including labor.This is the output effect of the wage increase . The effect is the
opposite for a wage decrease.
LAND MARKETS p. 224
12. Because land is in strictly fixed supply, its price is demand
determined —that is, its price is determined exclusively by
what households and firms are willing to pay for it. Thereturn to any factor of production in fixed supply is calledapure rent . A firm will pay for and use land as long as the
revenue earned from selling the product produced on thatland is sufficient to cover the price of the land. The firmwill use land up to the point at which MRP
A=PA,w h e r e
Ais land (acres).
THE FIRM’S PROFIT-MAXIMIZING CONDITION IN
INPUT MARKETS p. 226
13. Every firm has an incentive to use variable inputs as long as
the revenue generated by those inputs covers the costs ofthose inputs at the margin. Therefore, firms will employeach input up to the point that its price equals its marginalrevenue product. This profit-maximizing condition holdsfor all factors at all levels of output.
INPUT DEMAND CURVES p. 227
14. A shift in a firm’s demand curve for a factor of productioncan be influenced by the demand for the firm’s product, thequantity of complementary and substitutable inputs, theprices of other inputs, and changes in technology.
If apples sell for $2 per bushel and workers can be hired in a
competitive labor market for $30 per day, how many workers
should be hired? What if workers unionized and the wagerose to $50? ( Hint: Create marginal product and marginal
revenue product columns for the table.) Explain youranswers clearly.
5.The following graph is the production function for a firm using
only one variable factor of production, labor.a.Graph the marginal product of labor for the firm as a func-
tion of the number of labor units hired.
b.Assuming the price of output, P
X, is equal to $6, graph the
firm’s marginal revenue product schedule as a function of
the number of labor units hired.
c.If the current equilibrium wage rate is $4 per hour, how
many hours of labor will you hire? How much output willyou produce?230 PART II The Market System: Choices Made by Households and Firms
REVIEW TERMS AND CONCEPTS
demand-determined price, p. 224
derived demand, p. 215
factor substitution effect, p. 222
marginal product of labor ( MPL),p. 216marginal revenue product ( MRP ),p. 217
output effect of a factor price increase
(decrease), p. 224
productivity of an input, p. 216 pure rent, p. 224
technological change, p. 228
Equations:
MRPL=MPL/H11003PX
UNITS OF LABOR UNITS OF CAPITAL
Process 1 4 1
Process 2 2 2
Process 3 1 3WORKERSTOTAL BUSHELS
OF APPLES PER DAY
0 0
1 40
2 70
3 90
4 100
5 105
6 102PROBLEMS
All problems are available on www.myeconlab.com
a.Assuming capital costs $3 per unit and labor costs $1 per
unit, which process will be employed?
b.Plot the three points on the firm’s TVC curve corresponding
to q= 10, q= 30, and q= 50.
c.At each of the three output levels, how much Kand Lwill
be demanded?
d.Repeat parts a. through c. assuming the price of capital is
$3 per unit and the price of labor has risen to $4 per unit.
3.During the two decades leading up to the new millennium,
wage inequality in the United States increased substantially.
That is, high-income workers saw their salaries increase sub-
stantially while wages of lower-income workers stagnated oreven fell. Using the logic of marginal revenue product, give anexplanation for this change in the distribution of income. Inyour explanation, you may want to consider the rise of the high-
technology, high-skill sector and the decline of industries
requiring low-skill labor.1.According to the Bureau of Labor Statistics, the average weekly
earnings of production and nonsupervisory employees in edu-cation and health services was $638 in January 2010, up from$440 in January 2000. All else equal, such an increase in wageswould be expected to reduce the demand for labor andemployment should fall. Instead, the quantity demanded for
labor has increased dramatically with more than 4 million jobs
being created between 2000 and 2010. How can you explainthis seeming discrepancy?
2.Assume that a firm that manufactures widgets can produce
them with one of three processes used alone or in combina-tion. The following table indicates the amounts of capitaland labor required by each of the three processes to produce
one widget.4.The following schedule shows the technology of production at
the Delicious Apple Orchard for 2010:
100
Units of labor (hours)Total product (output)
200 300 0100200
CHAPTER 10 Input Demand: The Labor and Land Markets 231
NUMBER OF
WORKERSNUMBER OF SHIRTS
PRODUCED PER DAY MPL TR MRPL
0 0 __ __ __
1 30 __ __ __
2 80 __ __ __
3 110 __ __ __
4 135 __ __ __
5 __ 20 __ __
6 170 __ __ __
7 __ __ __ 30
8 __ __ __ 15a.Fill in all the blanks in the table.
b.Verify that MRPLfor this firm can be calculated in two ways:
(1) change in TRfrom adding another worker and (2) MPL
times the price of output.
c.If this firm must pay a wage rate of $40 per worker
per day, how many workers should it hire? Briefly explain why.
d.Suppose the wage rate rises to $50 per worker. How many
workers should be hired now? Why?
e.Suppose the firm adopts a new technology that doubles out-
put at each level of employment and the price of shirtsremains at $3. What is the effect of this new technology onMP
Land on MRPL? At a wage of $50, how many workers
should the firm hire now?
12.[Related to Economics in Practice onp. 223 ]At some colleges,
the highest paid member of the faculty is the football coach.How would you explain this?
13.[Related to Economics in Practice onp. 226 ]In Orlando,
Florida, the land value went up dramatically when Disney built itstheme park there. How do you explain this land price increase?
*14. For a given firm, MRP
L= $50 and MRPK= $100 while PL= $10
and PK= $20.
a.Is the firm maximizing profits? Why or why not?
b.Identify a specific action that would increase this firm’s profits.
15.In 2007, the CEO of Harley-Davidson, James L. Ziemer,
earned $1,350,000 in total compensation (salary, bonuses,
and other compensation) and Roy Williams, the chief execu-tive with the non-profit Boy Scouts of America, earned$1,577,600. How can a non-profit organization like the BoyScouts justify compensating its chief executive at a similar
level to the CEO of a successful for-profit company like
Harley-Davidson?
Sources: Scott DeCarlo “CEO Compensation,” Forbes , April 30, 2008 and T eri
Sforza, “National Boy Scouts explain $1.6 million salary for top exec,” Orange
County Register , August 7, 2009.
16.On April 20, 2010, the Deepwater Horizon oil drilling rig
exploded in the Gulf of Mexico, causing one of the worst oil
spills in history. The oil spill was devastating to many gulfcoast industries, with one of the hardest-hit being the oyster-fishing industry. Explain the effect this oil spill will have onthe following:
a.Price of oysters
b.Marginal product of oyster fishermen
c.Demand for oyster fishermen
17.The price of land is said to be “demand-determined.”
Explain what this means and draw a graph to exemplify your explanation.
18.Houston, T exas, is the only major U.S. city with virtually no
zoning laws. This means that single-family homes, apartmentbuildings, shopping centers, high-rise buildings, and industrialcomplexes can all be built in the same neighborhood. Of the
major U.S. cities, Houston was also one of the least impacted by
the housing market crisis of 2008. In 2009, Houston issued42,697 building permits and was the top-ranked city in the listof healthiest housing markets. How might the lack of zoninglaws have played a part in Houston's healthy housing and build-
ing markets?
Sources: La Familia, “Zoning in on Zoning Laws,” El Gato , June 2, 2010.6.Describe how each of the following events would affect
(1) demand for construction workers and (2) construction wages
in Portland, Oregon. Illustrate with supply and demand curves.a.A sharp increase in interest rates on new-home mortgages
reduces the demand for new houses substantially.
b.The economy of the area booms. Office rents rise, creating
demand for new office space.
c.A change in the tax laws in 2010 made real estate develop-
ments more profitable. As a result, three major developersstart planning to build major shopping centers.
7.The demand for land is a derived demand. Think of a popular
location near your school. What determines the demand forland in that area? What outputs are sold by businesses locatedthere? Discuss the relationship between land prices and theprices of those products.
8.Many states provide firms with an “investment tax credit” that
effectively reduces the price of capital. In theory, these creditsare designed to stimulate new investment and thus create jobs.Critics have argued that if there are strong factor substitution
effects, these subsidies could reduce employment in the state.
Explain their arguments.
9.Doug’s farm in Idaho has four major fields that he uses to grow
potatoes. The productivity of each field follows:
ANNUAL YIELD, HUNDREDS OF POUNDS
Field 1 10,000
Field 2 8,000
Field 3 5,000
Field 4 3,000
Assume that each field is the same size and that the variablecosts of farming are $25,000 per year per field. The variable
costs cover labor and machinery time, which is rented.Doug must decide each year how many fields to plant. In2009, potato farmers received $6.35 per 100 pounds. Howmany fields did Doug plant? Explain. By 2011, the price of
potatoes had fallen to $4.50 per 100 pounds. How will this
price decrease change Doug’s decision? How will it affect hisdemand for labor? How will it affect the value of Doug’s land?
10.Assume that you are living in a house with two other people and
that the house has a big lawn that must be mowed. One of yourroommates, who dislikes working outdoors, suggests hiring aneighbor’s daughter to mow the grass for $40 per week insteadof sharing the work and doing it yourselves. How would you go
about deciding who will mow the lawn? What factors would you
raise in deciding? What are the trade-offs here?
11.Consider the following information for a T-shirt manufacturing
firm that can sell as many T-shirts as it wants for $3 per shirt.
232 PART II The Market System: Choices Made by Households and Firms
19.The Sunshine Shirt Manufacturing Company uses both capital
and labor as substitutable resources in the production of
shirts, and the price of capital used by Sunshine has justdecreased. What do the substitution and output effects suggestwill happen to the demand for capital and the demand forlabor at Sunshine?
20.For a perfectly competitive firm, the marginal cost curve
determines how much output a profit-maximizing firm willproduce. For input markets, the marginal revenue productcurve determines how much labor a profit-maximizing firmwill hire in a perfectly competitive labor market. Explain howthe reasoning behind these two concepts is related.21.[Related to the Economics in Practice onp. 217 ]Each year in
New Orleans, Carnival season begins on January 6 and culmi-nates with the city's biggest celebration of the year, Mardi
Gras. This wildly popular celebration attracts people from
around the world, and the city of New Orleans estimates thatover half a million visitors attended the festivities in 2010. TheTuesday on which Mardi Gras falls each year has been declareda state holiday in Louisiana, with banks, post offices, and manyprivate businesses closing for the day. On the basis of labor,
explain why you think Mardi Gras has been declared a stateholiday in Louisiana and why so many businesses in New
Orleans are closed on that day.
*Note: Problems marked with an asterisk are more challenging.
CHAPTER OUTLINE
23311
Capital, Investment,
and Depreciation p. 233
Capital
Investment and
Depreciation
The Capital
Market p. 236
Capital Income: Interest
and Profits
Financial Markets in Action
Mortgages and the
Mortgage Market
Capital Accumulation and
Allocation
The Demand for New
Capital and theInvestmentDecision
p. 241
Forming Expectations
Comparing Costs and
Expected Return
A Final Word on
Capital p. 245
Appendix: CalculatingPresent Value
p. 248In Chapter 10 we explored the labor and
land markets in some detail. In this chapter,we consider the capital market more fully.Transactions between households and firmsin the labor and land markets are direct. Inthe labor market, households offer theirlabor directly to firms in exchange forwages. In the land market, landowners rentor sell their land directly to firms inexchange for rent or an agreed-to price. Inthe capital market, though, householdsoften indirectly supply the financial
resources necessary for firms to purchasecapital. When households save and addfunds to their bank accounts, for example, firms can borrow those funds from the bank to financetheir capital purchases.
The importance of the movement of capital from individuals to firms in a market economy
cannot be overemphasized. For firms to enter new industries or produce new products, capital isrequired. In market capitalist systems, decisions about which enterprises to support via capital ismade by private citizens seeking private gain. The Economics in Practice on p. 235 describes this
process for one firm, T esla, maker of electric cars. These decisions are risky—it is hard to knowwhich new firms will succeed and which will fail. Understanding the institutions through whichcapital flows from households to firms is the subject of this chapter.
Capital, Investment, and Depreciation
Before we proceed with our analysis of the capital market, we need to review some basic eco-nomic principles and introduce some related concepts.
Capital
One of the most important concepts in all of economics is the concept of capital . Capital goods
are those goods produced by the economic system that are used as inputs to produce other goodsand services in the future. Capital goods thus yield valuable productive services over time. Thevalue of capital is only as great as the value of the services it renders over time.
Tangible Capital When we think of capital, we generally think of the physical, material capi-
tal employed by firms. The major categories of physical, ortangible, capital are (1) nonresidential
structures (for example, office buildings, power plants, factories, shopping centers, warehouses, anddocks) (2) durable equipment (for example, machines, trucks, sandwich grills, and automobiles),(3) residential structures, and (4) inventories of inputs and outputs that firms have in stock.
Most firms need tangible capital, along with labor and land, to produce their products. A
restaurant’s capital requirements include a kitchen, ovens and grills, tables and chairs, silverware,dishes, and light fixtures. These items must be purchased up front and maintained if the restau-rant is to function properly. A manufacturing firm must have a plant, specialized machinery,
Input Demand: The
Capital Market and the
Investment Decision
capital Those goods
produced by the economicsystem that are used as inputsto produce other goods and
services in the future.
physical, ortangible, capital
Material things used as inputs
in the production of future
goods and services. The majorcategories of physical capital
are nonresidential structures,
durable equipment, residentialstructures, and inventories.
234 PART II The Market System: Choices Made by Households and Firms
trucks, and inventories of parts. A winery needs casks, vats, piping, temperature-control equip-
ment, and cooking and bottling machinery.
The capital stock of a retail pharmacy is made up mostly of inventories. Pharmacies do not
produce the aspirin, vitamins, and toothbrushes that they sell. Instead, they buy those itemsfrom manufacturers and put them on display. The product actually produced and sold by apharmacy is convenience. Like any other product, convenience is produced with labor and cap-ital in the form of a store with many products, or inventory, displayed on the sales floor andkept in storerooms. The inventories of inputs and outputs that manufacturing firms maintainare also capital. T o function smoothly and meet the demands of buyers, for example, the FordMotor Company maintains inventories of both auto parts (tires, windshields, and so on) andcompleted cars.
An apartment building is also capital. Produced by the economic system, it yields valuable
services over time and it is used as an input to produce housing services, which are rented.
Social Capital: Infrastructure Some physical or tangible capital is owned by the public
instead of by private firms. Social capital, sometimes called infrastructure , is capital that pro-
vides services to the public. Most social capital takes the form of public works such as highways,roads, bridges, mass transit systems, and sewer and water systems. Police stations, fire stations,city halls, courthouses, and police cars are all forms of social capital that are used as inputs to pro-duce the services that government provides.
All firms use some forms of social capital in producing their outputs. Recent economic
research has shown that a country’s infrastructure plays a very important role in helpingprivate firms produce their products efficiently. When public capital is not properly caredfor—for example, when roads deteriorate or when airports are not modernized to accom-modate increasing traffic—private firms that depend on efficient transportation net-works suffer.
Intangible Capital Not all capital is physical. Some things that are intangible (nonmater-
ial) satisfy every part of our definition of capital. When a firm invests in advertising to establish abrand name, it is producing a form of intangible capital called goodwill. This goodwill yields
valuable services to the firm over time.
When a firm establishes a training program for employees, it is investing in its workers’ skills.
We can think of such an investment as the production of an intangible form of capital calledhuman capital . It is produced with labor (instructors) and capital (classrooms, computers, pro-
jectors, and books). Human capital in the form of new or augmented skills is an input—it willyield valuable productive services for the firm in the future.
When research produces valuable results, such as a new production process that reduces
costs or a new formula that creates a new product, the new technology can be considered capital.Furthermore, even ideas can be patented and the rights to them can be sold.
A large number of “new economy” start-up technology companies have responded to
the growth of the Internet. These dot-com and e-commerce companies generally start withlimited capital, and most of that capital is in the skills and knowledge of their employees:human capital.
Measuring Capital Labor is measured in hours, and land is measured in square feet or
acres. Because capital comes in so many forms, it is virtually impossible to measure itdirectly in physical terms. The indirect measure generally used is current market value .T h e
measure of a firm’s capital stock is the current market value of its plant, equipment, inven-
tories, and intangible assets. By using value as a measuring stick, business managers, accoun-tants, and economists can, in a sense, add buildings, barges, and bulldozers into a measure oftotal capital.
Capital is measured as a stock value. That is, it is measured at a point in time: The capital
stock of the XYZ Corporation on July 31, 2007, is $3,453,231. According to Department ofCommerce estimates, the capital stock of the U.S. economy in 2008 (in 2005 dollars) was about$44.2 trillion. Of that amount, $17.1 trillion was residential structures; $8.1 trillion was owned bythe federal, state, and local governments (for example, aircraft carriers and school buildings); and$6.3 trillion was equipment and software.social capital, or
infrastructure Capital that
provides services to the public.
Most social capital takes theform of public works (roads
and bridges) and public
services (police and fireprotection).
intangible capital
Nonmaterial things that
contribute to the output offuture goods and services.
human capital A form of
intangible capital that includes
the skills and other knowledgethat workers have or acquirethrough education and training
and that yields valuable services
to a firm over time.
capital stock For a single
firm, the current market
value of the firm’s plant,
equipment, inventories, andintangible assets.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 235
Although it is measured in terms of money, or value, it is very important to think of the actual
capital stock. When we speak of capital, we refer not to money or to financial assets such as bondsand stocks, but instead to the firm’s physical plant, equipment, inventory, and intangible assets.
Investment and Depreciation
Recall the difference between stock and flow measures discussed in earlier chapters. Stock measures are
valued at a particular point in time, whereas flow measures are valued over a period of time. The eas-
iest way to think of the difference between a stock and a flow is to think about a tub of water. The vol-ume of water in the tub is measured at a point in time and is a stock. The amount of water that flowsinto the tub per hour and the amount of water that evaporates out of the tub per day are flow mea-
sures. Flow measures have meaning only when the time dimension is added. Water flowing into thetub at a rate of 5 gallons per hour is very different from water flowing at a rate of 5 gallons per year.
Capital stocks are affected over time by two flows: investment and depreciation. When a firm
produces or puts in place new capital—a new piece of equipment, for example—it has invested.Investment is a flow that increases the stock of capital. Because it has a time dimension, we speak
of investment per period (by the month, quarter, or year).
As you proceed, keep in mind that the term investing isnotused in economics to describe the
act of buying a share of stock or a bond. Although people commonly use the term this way (“I investedin some Union Carbide stock” or “he invested in Treasury bonds”), the term investment when
used correctly refers only to an increase in capital .investment New capital
additions to a firm’s capital
stock. Although capital is
measured at a given point intime (a stock), investment is
measured over a period of time
(a flow). The flow ofinvestment increases thecapital stock.ECONOMICS IN PRACTICE
Investment Banking, IPOs, and Electric Cars
Automobile production is, as we noted in Chapter 9, subject to
economies of scale. Becoming a new car manufacturer requires con-siderable capital, well beyond what most individuals can puttogether. In the summer of 2010 T esla Motors, a new electric carmanufacturer, turned to the public to seek capital.
How did T esla do this? T esla decided to become a public company ,
with shares offered to the public on a stock exchange. The process ofdoing this is called an IPO (initial public offering). As the articleindicates, T esla initially offered the public 13.3 million shares, eachfor a price of $17, for a total increase in capital for the firm of
$226 million. In mounting its IPO T esla, like most other firms, reliedon investment banks to help figure out the right price and manage
the sales. In T esla’s case a number of firms were involved, includingGoldman Sachs, J.P . Morgan, and Morgan Stanley. Managing IPOs isone of the functions of investment banks, as they help move capital
from households to entrepreneurs with new ideas.
TSLA: What Does Tesla’s IPO Mean for the
Future of Electric Cars?
The Wall Street Journal
Tesla Motors today became the first American car company
to make an initial public offering since Ford did so in 1956.And one could argue the sleek, fast Tesla Roadster the com-pany has been selling is in some ways a bit like Ford’s old
Model T, which revolutionized assembly-line manufacturing.
Tesla seems poised to be part of the redefinition of the way
we drive. After all, the Palo Alto, California, electric-car makerhas in many ways been showing the rest of the auto industry
how electric cars are done. The sleek Tesla Roadster is an
emblem of electric cars’ potential in terms of power, speed, andrange. Without it I doubt many of the larger car makers wouldbe pursuing electric cars as vigorously as they are. Still, I worry
about Tesla’s endurance. Building cars is a difficult, expensiveendeavor that has broken many small manufacturers who havetried to bring innovation to the table, from John DeLorean toPreston Tucker.
For now the outlook is promising. Not only did the IPO
take place but it included more shares at a higher price thanexpected. The company boosted the number of shares toas much as 13.3 million and the price to $17 per share, for a
total value of $226 million. The company previously had said
it could sell up to 11.1 million shares at a price of $14 to $16 per share, or a total of $178 million. The increase in partreflects interest in electric cars that is greater than expectedand growing surprisingly fast. Tesla is trading on the Nasdaq
stock market under the symbol TSLA.
Source: The Wall Street Journal Online , “TSLA: What Does T esla’s IPO
Mean for the Future of Electric Cars?” by Jonathan Welsh. Copyright2010 by Dow Jones & Company, Inc. Reproduced with permission of
Dow Jones & Company, Inc. via Copyright Clearance Center.
236 PART II The Market System: Choices Made by Households and Firms
TABLE 11.1 Private Investment in the U.S. Economy, 2009
GDP =$14,256.3 billion
Billions of
Current DollarsAs a Percentage
of Total Gross
InvestmentAs a Percentage
of GDP
Nonresidential structures 480.0 29.5 3.4
Equipment and software 908.8 55.8 6.4
Change in private inventories —120.9 —7.4 —0.8
Residential structures 361.0 22.2 2.5
Total gross private investment 1,628.9 100.0 11.4
— depreciation -1,538.8 -94.5 -10.8
Net investment =
gross investment – depreciation 90.1 5.5 0.6Table 11.1 presents data on private investment in the U. S. economy in 2009. About half of the
total was equipment and software. Almost all the rest was investment in structures, both residen-tial (apartment buildings, condominiums, houses, and so on) and nonresidential (factories, shop-ping malls, and so on). Inventory investment was negative (sales exceeded production in 2009).Column 3 looks at private investment as a percent of gross domestic product (GDP), a measure ofthe total output of the economy.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Depreciation is the decline in an asset’s (resource’s) economic value over time. If you have
ever owned a car, you are aware that its resale value falls with age. Suppose you bought a newT oyota Prius for $30,500 and you decide to sell it 2 years and 25,000 miles later. Checking thenewspaper and talking to several dealers, you find out that, given its condition and mileage, youcan expect to get $22,000 for it. It has depreciated $8,500 ($30,500 -$22,000). Table 11.1 shows
that in 2009, private depreciation in the U.S. economy was $1,538.8 billion.
A capital asset can depreciate because it wears out physically or because it becomes obsolete.
Take, for example, a computer control system in a factory. If a new, technologically superior systemdoes the same job for half the price, the old system may be replaced even if it still functions well.The Prius depreciated because of wear and tear andbecause new models had become available.
The Capital Market
Where does capital come from? How and why is it produced? How much and what kinds of cap-
ital are produced? Who pays for it? These questions are answered in the complex set of institu-tions in which households supply their savings to firms that demand funds to buy capital goods.Collectively, these institutions are called the capital market .
Although governments and households make some capital investment decisions, most deci-
sions to produce new capital goods—that is, to invest—are made by firms. However, a firm cannotinvest unless it has the funds to do so. Although firms can invest in many ways, it is always the casethat the funds that firms use to buy capital goods come, directly or indirectly, from households.When a household decides not to consume a portion of its income, it saves. Investment by firms isthedemand for capital . Saving by households is the supply of capital . Various financial institutions
facilitate the transfer of households’ savings to firms that use them for capital investment.
Let us use a simple example to see how the system works. Suppose some firm wants to pur-
chase a machine that costs $1,000 and some household decides at the same time to save $1,000from its income. Figure 11.1 shows one way that the household’s decision to save might connectwith the firm’s decision to invest.
Either directly or through a financial intermediary (such as a bank), the household agrees to
loan its savings to the firm. In exchange, the firm contracts to pay the household interest at someagreed-to rate each period. Interest is the fee paid by a borrower to a lender or by a bank to adepositor for the use of funds. The interest rate is that fee paid annually, and it is expressed as apercentage of the loan or deposit. If the household lends directly to the firm, the firm gives thehousehold a bond , which is nothing more than a contract promising to repay the loan at some
specific time in the future. The bond also specifies the flow of interest to be paid in the meantime.depreciation The decline in
an asset’s economic value
over time.
capital market The market in
which households supply their
savings to firms that demand
funds to buy capital goods.
bond A contract between a
borrower and a lender, inwhich the borrower agrees topay the loan at some time inthe future, along with interestpayments along the way.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 237
Firms
Net worth
increases $1,000Capital stock
increases $1,000Capital market
(financial markets)Lends $1,000
Issues $1,000 bond
Buys
$1,000 machineInvestment decision
Saving decisionSaves $1,000
Issues $1,000 bond
Households
/L50304FIGURE 11.1 $1,000 in Savings Becomes $1,000 of Investment
The new saving adds to the household’s stock of wealth. The household’s net worth has increased
by the $1,000, which it holds in the form of a bond.1The bond represents the firm’s promise to repay
the $1,000 at some future date with interest. The firm uses the $1,000 to buy a new $1,000 machine,which it adds to its capital stock. In essence, the household has supplied the capital demanded by thefirm. It is almost as if the household bought the machine and rented it to the firm for an annual fee.Presumably, this investment will generate added revenues that will facilitate the payment of interestto the household. In general, projects are undertaken as long as the revenues likely to be realized fromthe investment are sufficient to cover the interest payments to the household.
Sometimes the transfer of household savings through the capital market into investment
occurs without a financial intermediary. An entrepreneur is one who organizes, manages, and
assumes the risk of a new firm. When entrepreneurs start a new business by buying capital withtheir own savings, they are both demanding capital and supplying the resources (that is, their sav-ings) needed to purchase that capital. No third party is involved in the transaction. Most invest-ment, however, is accomplished with the help of financial intermediaries (third parties such asbanks, insurance companies, and pension funds) that stand between the supplier (saver) and thedemander (investing firm). The part of the capital market in which savers and investors interactthrough intermediaries is often called the financial capital market .
Capital Income: Interest and Profits
It should now be clear to you how capital markets fit into the circular flow: They facilitate the move-
ment of household savings into the most productive investment projects. When households allowtheir savings to be used to purchase capital, they receive payments, and these payments (along withwages and salaries) are part of household incomes. Income that is earned on savings that have beenput to use through financial capital markets is called capital income . Capital income is received by
households in many forms, the two most important of which are interest andprofits .
Interest The most common form of capital income received by households is interest. In
simplest terms, interest is the payment made for the use of money. Banks pay interest to deposi-
tors, whose deposits are loaned out to businesses or individuals who want to make investments.2
Banks also charge interest to those who borrow money. Corporations pay interest to households
1Note that the act of saving increases the household’s wealth, not the act of buying the bond. Buying the bond simply transforms
one financial asset (money) into another (a bond). The household could simply have held on to the money.
2Although we are focusing on investment by businesses, households can and do make investments also. The most important
form of household investment is the construction of a new house, usually financed by borrowing in the form of a mortgage. Ahousehold may also borrow to finance the purchase of an existing house, but when it does so, no new investment is taking place.financial capital market The
part of the capital market in
which savers and investorsinteract through
intermediaries.
capital income Income
earned on savings that havebeen put to use through
financial capital markets.
interest The payments made
for the use of money.
238 PART II The Market System: Choices Made by Households and Firms
that buy their bonds. The government borrows money by issuing bonds, and the buyers of those
bonds receive interest payments.
Theinterest rate is almost always expressed as an annual rate. It is the annual interest pay-
ment expressed as a percentage of the loan or deposit. For example, a $1,000 bond (representinga $1,000 loan from a household to a firm) that carries a fixed 10 percent interest rate will pay thehousehold $100 per year ($1,000 /H11003.10) in interest. A savings account that carries a 5 percent
annual interest rate will pay $50 annually on a balance of $1,000.
The interest rate is usually agreed to at the time a loan or deposit is made. Sometimes bor-
rowers and lenders agree to periodically adjust the level of interest payments depending on mar-ket conditions. These types of loans are called adjustable orfloating-rate loans .(Fixed rate loans
are loans in which the interest rate never varies.) In recent years, there have even been adjustablerates of interest on savings accounts and certificates of deposit.
A loan’s interest rate depends on a number of factors. A loan that involves more risk will gen-
erally pay a higher interest rate than a loan with less risk. Similarly, firms that are considered badcredit risks will pay higher interest rates than firms with good credit ratings. Y ou have probablyheard radio or TV advertisements by finance companies offering to loan money to borrowers“regardless of credit history.” This means that they will loan to people or businesses that pose arelatively high risk of defaulting , or not paying off the loan. What they do not tell you is that the
interest rate will be quite high.
It is generally agreed that the safest borrower is the U.S. government. With the “full faith and
credit” of the U.S. government pledged to buyers of U.S. Treasury bonds and bills, most peoplebelieve that there is little risk that the government will not repay its loans. For this reason, the U.S.government can borrow money at a lower interest rate than any other borrower.
Profits Profits is another word for the net income of a firm: revenue minus costs of produc-
tion. Some firms are owned by individuals or partners who sell their products for more than itcosts to produce them. The profits of proprietors or partnerships generally go directly to the owneror owners who run the firm. Corporations are firms owned by shareholders who usually are nototherwise connected with the firms. Corporations are organized and chartered under state lawsthat grant limited liability status to their owners or shareholders. Essentially, that means that share-holders cannot lose more than they have invested if the company incurs liabilities it cannot pay.
A share of common stock is a certificate that represents the ownership of a share of a busi-
ness, almost always a corporation. For example, Lincoln Electric is a Cleveland-based companythat makes welding and cutting equipment. The company has 41 million shares of common stockthat are owned by tens of thousands of shareholders, some of whom are private individuals, someof whom are institutions such as Carlton College, and some of whom may be employees of thefirm. Shareholders are entitled to a share of the company’s profit. When profits are paid directlyto shareholders, the payment is called a dividend. Lincoln Electric made a profit of $54 million ina recent year, which was $1.31 per share, of which $0.43 was paid out to shareholders as dividendsand the rest retained for investment.
3
In discussing profit, it is important to distinguish between profit as defined by generally
accepting accounting practices and economic profits as we defined them in Chapter 7. Recall that
our definition of profit is total revenue minus total cost, where total cost includes the normal rateof return on capital. We defined profit this way because true economic cost includes the opportu-nity cost of capital.
Functions of Interest and Profit Capital income serves several functions. First, inter-
est may function as an incentive to postpone gratification. When you save, you pass up thechance to buy things that you want right now. One view of interest holds that it is the reward forpostponing consumption.
Second, profit serves as a reward for innovation and risk taking. Every year Forbes magazine
publishes the names of the richest people in the United States, and virtually every major fortunestock A share of stock is an
ownership claim on a firm,
entitling its owner to a profit share.
3Shares of common stock are traded openly on private stock exchanges or markets. Most of the billions of shares traded every
day are one shareholder selling shares to another. When shares are first issued, the proceeds are used to buy capital or to “buyout” the entrepreneurs who started the firm.interest rate Interest
payments expressed as apercentage of the loan.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 239
listed there is traceable to the founding of some business enterprise that “made it big.” In recent
years, big winners have included retail stores (the Walton family of Wal-Mart), high-tech companies(Bill Gates of Microsoft and Eric Schmidt of Google), and a real estate empire (the Pritzker family).
Many argue that rewards for innovation and risk taking are the essence of the U.S. free enter-
prise system. Innovation is at the core of economic growth and progress. More efficient produc-tion techniques mean that the resources saved can be used to produce new things. There is anotherside to this story, however: Critics of the free enterprise system claim that such large rewards arenot justified and that accumulations of great wealth and power are not in society’s best interests.
Financial Markets in Action
When a firm issues a fixed-interest-rate bond, it borrows funds and pays interest at an agreed-torate to the person or institution that buys the bond. Many other mechanisms, four of which areillustrated in Figure 11.2, also channel household savings into investment projects.
Case A: Business Loans As I look around my hometown, I see several ice cream stores
doing very well; but I think that I can make better ice cream than they do. T o go into the busi-ness, I need capital: ice cream-making equipment, tables, chairs, freezers, signs, and a store.Because I put up my house as collateral, I am not a big risk; so the bank grants me a loan at afairly reasonable interest rate. Banks have these funds to lend only because households deposittheir savings there.
Case B: Venture Capital A scientist at a leading university develops an inexpensive
method of producing a very important family of virus-fighting drugs, using microorganisms cre-ated through gene splicing. The business could very well fail within 12 months, but if it succeeds,the potential for profit is huge.
Our scientist goes to a venture capital fund for financing. Such funds take household savings
and put them into high-risk ventures in exchange for a share of the profits if the new businessessucceed. By investing in many different projects, the funds reduce the risk of going broke. Once
Households Firms
Investment
projects
Case A
Ice creamstore
Case B
Newbiotechnologycorporation
Case C
New autoassemblyplant (GM)
Case D
Peanutbusinessin AtlantaSavingBanks
Venture capital fundsRetained earningsStock market
Financial Markets/L50296FIGURE 11.2
Financial Markets Link
Household Saving andInvestment by Firms
240 PART II The Market System: Choices Made by Households and Firms
again, household funds make it possible for firms to undertake investments. If a venture succeeds,
those owning shares in the venture capital fund receive substantial profits.
Case C: Retained Earnings IBM decides in 2009 to build a new plant in Dubuque, Iowa,
and it discovers that it has enough funds to pay for the new facility. The new investment is thuspaid for through internal funds, or retained earnings .
The result is the same as if the firm had gone to households via some financial intermediary
and borrowed the funds. If IBM uses its profits to buy new capital, it does so only with the share-holders’ implicit consent. When a firm takes its own profit and uses it to buy capital assets insteadof paying it out to its shareholders, the total value of the firm goes up, as does the value of theshares held by stockholders. As in our other examples, IBM capital stock increases and so does thenet worth of households.
When a household owns a share of stock that appreciates , or increases in value, the apprecia-
tion is part of the household’s income. Unless the household sells the stock and consumes thegain, that gain is part of saving. In essence, when a firm retains earnings for investment purposes,it is actually saving on behalf of its shareholders.
Case D: The Stock Market A former high-ranking government official decides to start a
new peanut-processing business in Atlanta; he also decides to raise the funds needed by issuingshares of stock. Households buy the shares with income that they decide not to spend. Inexchange, they are entitled to a share of the peanut firm’s profits.
The shares of stock become part of households’ net worth. The proceeds from stock sales are
used to buy plant equipment and inventory. Savings flow into investment, and the firm’s capitalstock goes up by the same amount as household net worth. The Economics in Practice on p. 235
describes how T esla raised funds in this way.
Mortgages and the Mortgage Market
Most real estate in the United States is financed by mortgages. A mortgage, like a bond, is acontract in which the borrower promises to repay the lender in the future. Mortgages arebacked by real estate. When a household buys a home, it usually borrows most of the moneyby signing a mortgage in which it agrees to repay the money with interest often over as longas 30 years. While in recent years all kinds of exotic payment schemes have complicated themortgage market, the most common form of mortgage is the 30-year fixed rate mortgage.Almost all mortgage loans require a monthly payment. As an example, a home financed witha 30-year fixed rate mortgage loan of $250,000 at 6.4 percent will face a monthly payment of$1,563.76. If the borrower pays that amount each month for 30 years, he or she will have paidoff the loan while paying interest at a rate of 6.4 percent on the unpaid balance each month.
Until the last decade, most mortgage loans were made by banks and savings and loans. The
lenders used depositors’ money to make the loans, and the signed promissory notes were kept bythe lenders who collected the payment every month.
Recently, the mortgage market changed dramatically and became more complicated. Most
mortgages are now written by mortgage brokers or mortgage bankers who immediately sellthe mortgages to a secondary market. The secondary market is run by governmental agenciessuch as Fannie Mae and Freddie Mac and large investment banks. Loans in this market are“securitized,” which means that the mortgage documents are pooled and then mortgage-backed securities are sold to investors who want to take different degrees of risk.
The risk of owning mortgages is primarily the risk that the borrower will default on the
obligation. When default occurs, the house may be taken through foreclosure, a procedure inwhich the lender takes possession of the borrower’s house and sells it to get back at least some ofthe amount that the lender is owed.
In 2007, the mortgage market was hit by a dramatic increase in the number of defaults
and foreclosures. Lenders lost billions of dollars, and hundreds of thousands of homes wentinto foreclosure. The reasons were that home prices began falling for the first time in manyyears and that a large number of loans were made to buyers who could not make therequired payments.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 241
In modern industrial societies, investment decisions (capital production decisions) are
made primarily by firms. Households decide how much to save, and in the long run, sav-ings limit or constrain the amount of investment that firms can undertake. The capitalmarket exists to direct savings into profitable investment projects.
The Demand for New Capital and the
Investment Decision
We saw in Chapter 9 that firms have an incentive to expand in industries that earn positive
profits—that is, a rate of return above normal—and in industries in which economies of scalelead to lower average costs at higher levels of output. We also saw that positive profits in an indus-try stimulate the entry of new firms. The expansion of existing firms and the creation of newfirms both involve investment in new capital.
Even when there are no profits in an industry, firms must still do some investing. First,
equipment wears out and must be replaced if the firm is to stay in business. Second, firms areconstantly changing. A new technology may become available, sales patterns may shift, or thefirm may expand or contract its product line.
With these points in mind, we now turn to a discussion of the investment decision
process within the individual firm. In the end, we will see (just as we did in Chapter 10) that a
ECONOMICS IN PRACTICE
Who Owns Stocks in the United States?
In the text we describe how households buy shares of stock as a way to
invest in businesses and to generate hoped-for returns. In some caseshouseholds do this as individuals. There have always been individualswho have invested in stocks in specific companies through brokeragefirms. As the number of low-cost brokerage firms has grown, manymore people have begun trading this way. In the last decade, we haveseen the growth of day traders , individuals who buy and sell shares of
stock quickly in the hopes of making money. But, in terms of value,the bulk of the stock in the United States is held by householdsthrough institutions, pension funds, insurance companies, mutualfunds, and the like. For some companies, a large majority of their
stock is held by households through institutions. In the two chartsbelow, taken from Y ahoo Finance on June 23, 2010, we see the extent
of institutional holding in two companies: Microsoft and Activision,the producer of video games like Guitar Hero and World of Warcraft.Y ou can see that a more mature company like Microsoft has a much
higher rate of institutional holdings than does the newer Activision.Y ou can also see that for both firms, insiders (people who work for thecompany) hold quite a lot of the firm’s stock, and this is especially true
for the newer Activision.
Microsoft Data Share Statistics Activision Data Share Statistics
Avg Vol (3 month): 69,351,300 Avg Vol (3 month): 14,813,700
Avg Vol (10 day): 55,999,100 Avg Vol (10 day): 14,016,300
Shares Outstanding: 8.76B Shares Outstanding: 1.24B
% Held by Insiders: 12.25% % Held by Insiders: 58.03%
% Held by Institutions: 64.60% % Held by Institutions: 36.40%
Capital Accumulation and Allocation
Y ou can see from the preceding examples that various, and sometimes complex, connections
between households and firms facilitate the movement of savings into productive invest-ment. The methods may differ, but the results are the same. Industrialized or agrarian, smallor large, simple or complex, all societies exist through time and must allocate resources over time. In simple societies, investment and saving decisions are made by the same people. However:
242 PART II The Market System: Choices Made by Households and Firms
perfectly competitive firm invests in capital up to the point at which the marginal revenue
product of capital is equal to the price of capital.
Forming Expectations
We have already said that the most important dimension of capital is time. Capital producesuseful services over some period of time . In building an office tower, a developer makes an
investment that will be around for decades. In deciding where to build a branch plant, a man-ufacturing firm commits a large amount of resources to purchase capital that will be in placefor a long time.
It is important to remember, though, that capital goods do not begin to yield benefits until
they are used . Often the decision to build a building or purchase a piece of equipment must be
made years before the actual project is completed. Although the acquisition of a small businesscomputer may take only days, the planning process for downtown development projects in bigU.S. cities has been known to take decades.
The Expected Benefits of Investments Decision makers must have expectations
about what is going to happen in the future. A new plant will be very valuable—that is, it willproduce much profit—if the market for a firm’s product grows and the price of that productremains high. The same plant will be worth little if the economy goes into a slump or con-sumers grow tired of the firm’s product. The T esla’s success will depend not only on consumertastes for electric cars, but also on the government’s energy policy. The investment processrequires that the potential investor evaluate the expected flow of future productive services thatan investment project will yield.
An official of the General Electric Corporation (GE) once described the difficulty
involved in making such predictions. GE subscribes to a number of different economic fore-casting services. In the early 1980s, those services provided the firm with 10-year predictionsof new housing construction that ranged from a low of 400,000 new units per year to a highof 4 million new units per year. Because GE sells millions of household appliances to contrac-tors building new houses, condominiums, and apartments, the forecast was critical. If GEdecided that the high number was more accurate, it would need to spend billions of dollarson new plant and equipment to prepare for the extra demand. If GE decided that the lownumber was more accurate, it would need to begin closing several of its larger plants and dis-investing. In fact, GE took the middle road. It assumed that housing production would bebetween 1.5 and 2 million units—which, in fact, it was.
GE is not an exception. All firms must rely on forecasts to make sensible investment and pro-
duction decisions, but forecasting is an inexact science because so much depends on events thatcannot be foreseen.
The Expected Costs of Investments The benefits of any investment project
take the form of future profits. These profits must be forecast, but costs must also be evalu-ated. Like households, firms have access to financial markets, both as borrowers and as lenders. If a firm borrows, it must pay interest over time. If it lends, it will earn interest.
If the firm borrows to finance a project, the interest on the loan is part of the cost ofthe project.
Even if a project is financed with the firm’s own fund instead of through borrowing, an
opportunity cost is involved. A thousand dollars put into a capital investment project will gener-ate an expected flow of future profit; the same $1,000 put into the financial market (in essence,loaned to another firm) will yield a flow of interest payments. The project will not be undertakenunless it is expected to yield more than the market interest rate. The cost of an investment projectmay thus be direct or indirect because the ability to lend at the market rate of interest means thatthere is an opportunity cost associated with every investment project. The evaluation process thus
involves not only estimating future benefits but also comparing them with the possible alterna-tive uses of the funds required to undertake the project. At a minimum, those funds could earninterest in financial markets.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 243
expected rate of return The
annual rate of return that afirm expects to obtain through
a capital investment.
ECONOMICS IN PRACTICE
Chinese Wind Power
One of the most interesting investment phenomena in the last few
years has been the strong interest by the Chinese in wind power. As thearticle below indicates, by 2009 China had become the world’s largestwind power market. As we suggest in the text, investments—becausethey are long-lived—depend critically on future expectations. In thecase of wind power investments, investors have to make judgmentsabout government climate and energy policy, both in China and else-where, about tariff policy, about the future of substitute products likeoil, and about economic growth more generally. The uncertainty ofthese complex factors makes wind investing in China a risky business.
Gone With The Wind: Capital for China’s
Turbine Makers
The Wall Street Journal
“A great wind is blowing, and that gives you either imagination
or a headache.” Catherine the Great surely was referring tocapital raising for China’s wind turbine makers. As Dow JonesInvestment Banker reports, for them, a headache is more likely.
Last year was a good time for China when it became
the largest wind market by annual installed capacity at 13 gigawatts, according to the Global Wind Energy Council.
Unfortunately that growth heralds overcapacity for
Chinese turbine makers, suggesting a shake-out for somesmaller names after 2009’s aggressive build out. That should,
of course, play to survivors’ advantage in the long-term.
Favorable macro-tailwinds and preferential policy over
the last five years have helped China’s wind industry. Forexample, farm operators are aided by on-grid tariffs for wind
being higher than fossil fuels’, while local component-
makers gain from rules ensuring at least 70 percent of tur-bine components by purchase value are made domestically.
Source: Wall Street Journal Online , excerpted from “Gone With The
Wind: Capital for China’s Turbine Makers” by Jamie Miyazaki.Copyright 2010 by Dow Jones & Company, Inc. Reproduced with per-
mission of Dow Jones & Company, Inc. via Copyright Clearance Center.
Comparing Costs and Expected Return
Once expectations have been formed, firms must quantify them—that is, they must assign some
dollars-and-cents value to them. One way to quantify expectations is to calculate an expected
rate of return on the investment project. For example, if a new computer network that costs
$400,000 is likely to save $100,000 per year in data-processing costs forever after, the expected rateof return on that investment is 25 percent per year. Each year the firm will save $100,000 as a resultof the $400,000 investment. The expected rate of return will be less than 25 percent if the com-puter network wears out or becomes obsolete after a while and the cost saving ceases. The expectedrate of return on an investment project depends on the price of the investment, the expectedlength of time the project provides additional cost savings or revenue, and the expected amount ofrevenue attributable each year to the project.
Table 11.2 presents a menu of investment choices and expected rates of return that a
hypothetical firm faces. Because expected rates of return are based on forecasts of future
TABLE 11.2 Potential Investment Projects and Expected Rates of Return for a
Hypothetical Firm, Based on Forecasts of Future Profits Attributable tothe Investment
Project(1)
Total Investment
(Dollars)(2)
Expected Rate of
Return (Percent)
A. New computer network 400,000 25
B. New branch plant 2,600,000 20
C. Sales office in another state 1,500,000 15
D. New automated billing system 100,000 12
E. Ten new delivery trucks 400,000 10
F. Advertising campaign 1,000,000 7
G. Employee cafeteria 100,000 5
244 PART II The Market System: Choices Made by Households and Firms
profits attributable to the investments, any change in expectations would change all the
numbers in column 2.
Figure 11.3 graphs the total amount of investment in millions of dollars that the firm would
undertake at various interest rates. If the interest rate were 24 percent, the firm would fund onlyproject A, the new computer network. It can borrow at 24 percent and invest in a computer thatis expected to yield 25 percent. At 24 percent, the firm’s total investment is $400,000. The firstvertical red line in Figure 11.3 shows that at any interest rate above 20 percent and below 25 per-cent, only $400,000 worth of investment (that is, project A) will be undertaken.
If the interest rate were 18 percent, the firm would fund projects A and B, and its total
investment would rise to $3 million ($400,000 + $2,600,000). If the firm could borrow at 18 per-cent, the flow of additional profits generated by the new computer and the new plant wouldmore than cover the costs of borrowing, but none of the other projects would be justified. Therates of return on projects A and B (25 percent and 20 percent, respectively) both exceed the 18percent interest rate. Only if the interest rate fell below 5 percent would the firm fund all seveninvestment projects.
The investment schedule in Table 11.2 and its graphic depiction in Figure 11.3 describe the
firm’s demand for new capital, expressed as a function of the market interest rate. If we add thetotal investment undertaken by allfirms at every interest rate, we arrive at the demand for new
capital in the economy as a whole. In other words, the market demand curve for new capital is thesum of all the individual demand curves for new capital in the economy (Figure 11.4). In a sense,the investment demand schedule is a ranking of all the investment opportunities in the economyin order of expected yield. Only those investment projects in the economy that are expected toyield a rate of return higher than the market interest rate will be funded. At lower market interestrates, more investment projects are undertaken.
The most important thing to remember about the investment demand curve is that its shape
and position depend critically on the expectations of those making the investment decisions.
Because many influences affect these expectations, they are usually volatile and subject to fre-
quent change. Thus, although lower interest rates tend to stimulate investment and higher inter-est rates tend to slow it, many other hard-to-measure and hard-to-predict factors also affect thelevel of investment spending.
The Expected Rate of Return and the Marginal Revenue Product of
Capital The concept of the expected rate of return on investment projects is analogous to
the concept of the marginal revenue product of capital ( MRPK). Recall that we defined an
input’s marginal revenue product as the additional revenue a firm earns by employing oneadditional unit of that input, ceteris paribus .Interest rate
Total investment (millions of dollars)0. 41 2 3 4 5 6510152025/L50298FIGURE 11.3
Total Investment as a
Function of the MarketInterest Rate
The demand for new capital
depends on the interest rate.When the interest rate is low,
firms are more likely to invest in
new plant and equipment thanwhen the interest rate is high.This is so because the interestrate determines the direct cost
(interest on a loan) or the
opportunity cost (alternativeinvestment) of each project.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 245
Now think carefully about the return on an additional unit of new capital (the marginal rev-
enue product of capital). Suppose that the rate of return on an investment in a new machine is15 percent. This means that the investment project yields the same return as a bond yielding15 percent. If the current interest rate is less than 15 percent, the investment project will beundertaken because a perfectly competitive profit-maximizing firm will keep investing in newcapital up to the point at which the expected rate of return is equal to the interest rate. This isanalogous to saying that the firm will continue investing up to the point at which the marginalrevenue product of capital is equal to the price of capital, or MRP
K=PK, which is what we
learned in Chapter 10.
A Final Word on Capital
The concept of capital is one of the central ideas in economics. Capital is produced by the eco-nomic system itself. Capital generates services over time, and it is used as an input in the produc-tion of goods and services.
The enormous productivity of modern industrial societies is due in part to the tremen-
dous amount of capital that they have accumulated over the years. It may surprise you toknow that the average worker in the United States works with about $170,000 worth of capi-tal. Recall that in the United States, total investment (new capital) was 11.4 percent of GDP in2009 (Table 11.1). High rates of investment have had enormous impacts in countries such asChina and Malaysia. According to recent World Bank figures, capital goods represent 40 per-cent of China’s total output of goods and services, and in Malaysia the figure is 32 percent. In2009, China had a growth rate of output of over 9 percent and Malaysia had over 7 percent.
Most of this chapter described the institutions and processes that determine the amount and
types of capital produced in a market economy. Existing firms in search of increased profits,potential new entrants to the markets, and entrepreneurs with new ideas are continuously evalu-ating potential investment projects. At the same time, households are saving. Each year house-holds save some portion of their after-tax incomes. These new savings become part of their networth, and they want to earn a return on those savings. Each year a good portion of the savingsfinds its way into the hands of firms that use it to buy new capital goods.
Between households and firms is the financial capital market. Millions of people participate
in financial markets every day. There are literally thousands of financial managers, pension funds,mutual funds, brokerage houses, options traders, and banks whose sole purpose is to earn thehighest possible rate of return on people’s savings.
Brokers, bankers, and financial managers are continuously scanning the financial horizons for
profitable investments. What businesses are doing well? What businesses are doing poorly? Shouldwe lend to an expanding firm? All the analysis done by financial managers seeking to earn a highyield for clients, by managers of firms seeking to earn high profits for their stockholders, and byentrepreneurs seeking profits from innovation serves to channel capital into its most productiveuses. Within firms, the evaluation of individual investment projects involves forecasting costs andbenefits and valuing streams of potential income that will be earned only in future years.0
InvestmentInterest rate
D/L50296FIGURE 11.4
Investment Demand
Lower interest rates are likely to
stimulate investment in theeconomy as a whole, whereas
higher interest rates are likely to
slow investment.
246 PART II The Market System: Choices Made by Households and Firms
We have now completed our discussion of competitive input and output markets. We have
looked at household and firm choices in output markets, labor markets, land markets, and capi-tal markets.
We now turn to a discussion of the allocative process that we have described. How do all the
parts of the economy fit together? Is the result good or bad? Can we improve on it? All of this isthe subject of Chapter 12.
CAPITAL, INVESTMENT, AND DEPRECIATION
p. 233
1.In market capitalist systems, the decision to put capital to
use in a particular enterprise is made by private citizensputting their savings at risk in search of private gain. The setof institutions through which such transactions occur iscalled the capital market .
2.Capital goods are those goods produced by the economic
system that are used as inputs to produce other goods andservices in the future. Capital goods thus yield valuable pro-ductive services over time.
3.The major categories of physical ,o r tangible, capital are
nonresidential structures, durable equipment, residentialstructures, and inventories. Social capital (orinfrastructure )
is capital that provides services to the public. Intangible
(nonmaterial) capital includes human capital and goodwill.
4.The most important dimension of capital is that it exists
through time. Therefore, its value is only as great as the valueof the services it will render over time.
5.The most common measure of a firm’s capital stock is the
current market value of its plant, equipment, inventories,and intangible assets. However, in thinking about capital, itis important to focus on the actual capital stock instead of itssimple monetary value.
6.In economics, the term investment refers to the creation of
new capital, not to the purchase of a share of stock or abond. Investment is a flow that increases the capital stock.
7.Depreciation is the decline in an asset’s economic value over
time. A capital asset can depreciate because it wears outphysically or because it becomes obsolete.
THE CAPITAL MARKET p. 236
8.Income that is earned on savings that have been put to usethrough financial capital markets is called capital income .T h e
two most important forms of capital income are interest and
profits . Interest is the fee paid by a borrower to a lender.Interest rewards households for postponing gratification, and
profit rewards entrepreneurs for innovation and risk taking.
9.In modern industrial societies, investment decisions (capitalproduction decisions) are made primarily by firms.Households decide how much to save, and in the long run,saving limits the amount of investment that firms canundertake. The capital market exists to direct savings intoprofitable investment projects.
THE DEMAND FOR NEW CAPITAL AND THE
INVESTMENT DECISION p. 241
10. Before investing, investors must evaluate the expected flow of
future productive services that an investment project will yield.
11. The availability of interest to lenders means that there is anopportunity cost associated with every investment project.This cost must be weighed against the stream of earningsthat a project is expected to yield.
12. A firm will decide whether to undertake an investment projectby comparing costs with expected returns. The expected rate
of return on an investment project depends on the price of
the investment, the expected length of time the project pro-vides additional cost savings or revenue, and the expectedamount of revenue attributable each year to the project.
13. The investment demand curve shows the demand for capi-tal in the economy as a function of the market interestrate. Only those investment projects that are expected toyield a rate of return higher than the market interest ratewill be funded. Lower interest rates should stimulateinvestment.
14. A perfectly competitive profit-maximizing firm will keepinvesting in new capital up to the point at which theexpected rate of return is equal to the interest rate. This isequivalent to saying that the firm will continue investing upto the point at which the marginal revenue product of capi-tal is equal to the price of capital, or MRP
K=PK.SUMMARY
bond, p. 236
capital, p. 233
capital income, p. 237
capital market, p. 236
capital stock, p. 234
depreciation, p. 236expected rate of return, p. 243
financial capital market, p. 237
human capital, p. 234
intangible capital, p. 234
interest, p. 237interest rate, p. 238
investment, p. 235
physical, ortangible, capital, p. 233
social capital, orinfrastructure, p. 234
stock, p. 238REVIEW TERMS AND CONCEPTS
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 247
All problems are available on www.myeconlab.comPROBLEMS
1.Which of the following are capital, and which are not? Explain
your answers.
a.A video poker game machine at a local bar that takes quarters
b.A $10 bill
c.A college education
d.The Golden Gate Bridge
e.The shirts on the rack at Sears
f.A government bond
g.The Empire State Building
h.A savings account
i.The Washington Monument
j.A Honda plant in Marysville, Ohio
2.For each of the following, decide whether you agree or disagree
and explain your answer:a.Savings and investment are just two words for the same thing.
b.When I buy a share of Microsoft stock, I have invested; when
I buy a government bond, I have not.
c.Higher interest rates lead to more investment because those
investments pay a higher return.
3.Y ou and 99 other partners are offered the chance to buy a gas
station. Each partner would put up $10,000. The revenues fromthe operation of the station have been steady at $420,000 peryear for several years and are projected to remain steady into the
future. The costs (not including opportunity costs) of operating
the station (including maintenance and repair, depreciation,and salaries) have also been steady at $360,000 per year.Currently, 5-year Treasury bills are yielding 7.5 percent interest.Would you go in on the deal? Explain your answer.
4.The board of directors of the Quando Company in Singapore
was presented with the following list of investment projects forimplementation in 2010:7.From a newspaper such as The Wall Street Journal , from the
business section of your local daily, or from the Internet, lookup the prime interest rate, the corporate bond rate, and theinterest rate on 10-year U.S. government bonds today. List someof the reasons these three rates are different.
8.Explain what we mean when we say that “households supply
capital and firms demand capital.”
9.[Related to Economics in Practice onp. 243 ]Venture capital
funds have been very active in rapidly developing countries suchas China and India. Explain why this is so.
10.Describe the capital stock of your college or university. How
would you go about measuring its value? Has your school madeany major investments in recent years? If so, describe them.What does your school hope to gain from these investments?
11.In March 2008, the General Motors building, a skyscraper in
Manhattan, was up for bid. At the time, the skyscraper wasexpected to fetch more than $3 billion, a record for a singlebuilding. If you were a real estate investment company consid-
ering bidding on this building, what would you want to know
first? What specific factors would you need to form expecta-tions about? What information would you need to form those expectations?
12.On October 29, 2007, the Red Sox won the World Series. That
same day the stock market rose. The S&P 500 index (an index ofthe stock prices of the 500 largest corporations in the United
States) closed up at 1540.98. T en-year Treasury notes were pay-
ing 4.38% on 10-year obligations of the government. The Fedwas poised to announce a cut in the fed funds rate of a quarterof a percent to 4.75 percent.
Look up today’s S&P index, the 10-year treasury interest rate,
and the fed funds rate. Y ou can find them at http://money.cnn.com.
Provide an explanation for what has happened to those threenumbers since 2007.
13.Lending institutions charge different interest rates for
different classifications of mortgages. Two of these mort-gage types are Alt-A mortgages and subprime mortgages.Alt-A mortgages generally carry a higher interest rate than atypical “prime rate” mortgage, and subprime mortgage rates
are generally even higher than Alt-A rates. What is the likely
economic justification for the higher interest rates for thesetwo types of mortgages?
14.Celia, an analyst with a venture capital firm, is approached by
Wanda about financing her new business venture, a companywhich will build electricity-generating windmills for residentialuse. What information should Celia have before making a deci-sion about financing Wanda’s new company?
15.Draw a graph showing an investment demand curve and
explain the slope of the curve.
16.Bailey, Kaylee, Haley, and Joyce are sorority sisters who have dis-
covered an opportunity to purchase an Internet café. Each ofthe women would have to put up $80,000 to make the purchase.The revenue from the café is expected to remain constant at
$225,000 per year for the next several years. The costs (not
including the opportunity costs of the investment) of operatingthe café are expected to remain constant at $185,000 for the
PROJECTTOTAL COST
SINGAPORE
DOLLARSESTIMATED
RATE OF
RETURN
Factory in Kuala Lumpur $17,356,400 13%
Factory in Bangkok 15,964,200 15
A new company aircraft 10,000,000 12
A factory outlet store 3,500,000 18
A new computer network 2,000,000 20
A cafeteria for workers 1,534,000 7
Sketch total investment as a function of the interest rate (with
the interest rate on the Y-axis). Currently, the interest rate in
Singapore is 8 percent. How much investment would you rec-ommend to Quando’s board?
5.The Federal Reserve Board of Governors has the power to raise or
lower short-term interest rates. Between 2005 and 2006, the Fedaggressively increased the benchmark federal funds interest ratefrom 2.5 percent in February 2005 to 5.25 percent in June 2006.Assuming that other interest rates also increased, what effects do
you think that move had on investment spending in the economy?
Explain your answer. What do you think the Fed’s objective was?
6.Give at least three examples of how savings can be channeled
into productive investment. Why is investment so important foran economy? What do you sacrifice when you save today?
248 PART II The Market System: Choices Made by Households and Firms
TABLE 11A.1 Expected Profits from a $1,200
Investment Project
Year 1 $100
Year 2 100
Year 3 400
Year 4 500
Year 5 500
All later years 0
Total 1,600Recall that the interest rate is the amount of money that a
borrower agrees to pay a lender or a bank agrees to pay a depos-itor each year, expressed as a percentage of the deposit or theloan. For example, if I deposited $1,000 in an account paying10 percent interest, I would receive $100 per year for the term ofthe deposit. Sometimes we use the term rate of return to refer to
the amount of money that the lender receives from its invest-ment each year, expressed as a percentage of the investment.
The idea is that in deciding to do any project, you must
consider the opportunity costs: What are you giving up? If you
did not do this project but put the money to use elsewhere,would you do better?
Almost all investments that you might consider involve risks:
The project might not work out the way you anticipate, theeconomy may change, or market interest rates could go up ordown. T o assess the opportunity costs and to decide whetherthis project is worth it, you first have to think about those risksand decide on the rate of return that you require to compen-sate yourself for taking the risks involved.
If there were no risk, the opportunity cost of investing
in a project would be the government-guaranteed or bank-guaranteed interest rate. But in considering a project thatinvolves risk, you would want more profit in return for bearingthat risk. For example, you might invest in a sure deal if youreceived a 3 percent annual return comparable to what youmight earn with a bank account or certificate of deposit,whereas you might demand 15 percent or even 20 percent on avery risky investment.
Evaluating the opportunity costs of any investment project
requires taking the following steps:
Step 1: The first step in evaluating the opportunity costs of an
investment project is to look at the market. What areinterest rates today? What rates of interest are peopleearning by putting their money in bank accounts? Ifthere is risk that something could go wrong, whatinterest rate is the market paying to those who acceptthat risk? The discount rate used to evaluate an invest-
ment project is the interest rate that you could earn byinvesting a similar amount of money in an alternativeinvestment of comparable risk .
Let’s suppose that the investment project
described in Table 11A.1 involved some risk. Whileyou are quite certain that the expected flow of profitsCHAPTER 11 APPENDIX
Calculating Present Value
We have seen in this chapter that a firm’s major goal in mak-ing investment decisions is to evaluate revenue streams thatwill not materialize until the future. One way for the firm todecide whether to undertake an investment project is tocompare the expected rate of return from the investmentwith the current interest rate available (assuming compara-ble risk) in the financial market. We discussed this procedurein the text. The purpose of this Appendix is to present amore complete method of evaluating future revenue streamsthrough present-value analysis.
Present Value
Consider the investment project described in Table 11A.1. Weuse the word project in this example to refer to buying a
machine or a piece of capital for $1,200 and receiving the cashflow given in the right-hand column of the table. Would youdo the project? At first glance, you might answer yes. After all,the total flow of cash that you will receive is $1,600, which is$400 greater than the amount that you have to pay. But be care-ful: The $1,600 comes to you over a 5-year period, and your$1,200 must be paid right now. Y ou must consider the alterna-tive uses and opportunity costs of the $1,200. At the same time,you must consider the risks that you are taking.
What are these alternatives? At a bare minimum, the same
$1,200 could be put in a bank account, where it would earninterest. In addition, there are other things that you could dowith the same money. Y ou could buy Treasury bonds from thefederal government that guarantee you interest of 4 percent for5 years. Or you might find other projects with a similar degreeof risk that produce more than $1,600.next several years. The current market interest rate on enter-
prises with comparable risks is 9% per year. Should the four
sorority sisters purchase the café? Explain.
17.[Related to the Economics in Practice on p. 241 ]The text
states that in terms of value, the majority of stock in the United
States is held by households through institutions and the per-centage of institutional holding of stock (as well as the percent-age of insider holding) often varies based on the maturity of thecompany. Choose two publicly traded companies based in your
local area; one relatively new and the other relatively mature. Go
to www.finance.yahoo.com and enter each company in the
“GET QUOTES” dialog box, then click on “Key Statistics” tofind trading information. Look at the Share Statistics for eachcompany. Describe the variation in the percentage of shares heldby institutions and the percentage of shares held by insiders forthe two companies.
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 249
in years 1–5 ($100, $100, $400, and so on) is a very
good estimate, the future is always uncertain. Let’sfurther suppose that alternative investments of com-parable risks are paying a 10 percent rate of interest(rate of return). So you will not do this project unlessit earns at least 10 percent per year. We will thus use a10 percent discount rate in evaluating the project.
Step 2: Now comes the trick. Is your investment worth it? By
doing the project, you must consider the opportunitycost of the money. T o do this, imagine a bank that willpay 10 percent on deposits. The question that youmust answer is, how much would you have to put in abank paying 10 percent interest on deposits in orderto get the same flow of profits that you would get ifyou did the project?
If it turns out that you can replicate the flow of
profits for lessmoney up front than the project
costs—$1,200—you will notdo the project. The project
would be paying you less than a 10 percent rate ofreturn. On the other hand, if it turns out that youwould have to put more than $1,200 in the bank to
replicate the flow of profits from the project, the projectwould be earning more than 10 percent, and youwould do it.
The amount of money that you would have to
put in the imaginary bank to replicate the flow ofprofits from an investment project is called thepresent discounted value (PDV) or simply the
present value (PV) of the expected flow of profits
from the project. T o determine that flow, we have tolook at the flow 1 year at a time .
At the end of a year, you will receive $100 if you
do the project. T o receive $100 a year from now fromyour hypothetical bank, how much would you have todeposit now? The answer is clearly less than $100because you will earn interest. Let’s call the interestrate r. In the example, r= .10 (10 percent). T o get
back $100 next year, you need to deposit X,w h e r e X
plus a year’s interest on Xis equal to $100. That is,
X+rX= $100 or X(1 + r) = $100
And if we solve for X,w e g e t
and that means if r= .10,
or
X= $90.91
T o convince yourself that this is right, think of putting
$90.91 into your hypothetical bank and coming backin a year. Y ou get back your $90.91 plus interest of10 percent, which is $9.09. When you add the interest toX=$100
1.1X=$100
(1+r)the initial deposit, you get $90.91 + 9.09, or exactly
$100. We say that the present value of $100 a year from
now at a discount rate of 10 percent (r= .10) is$90.91.
Notice that if you paid more than $90.91 for the
$100 that you will receive from the project after ayear, you would be receiving less than a 10 percent
return . For example, suppose that you paid $95. If you
put $95 in an account and came back after a year andfound exactly $100, you would have received $5 ininterest. Since $5 is just about .0526 (or 5.26 percent)of $95, the interest rate that the bank paid you is only5.26 percent, not 10 percent.
What about the next year and the years after
that? At the end of year 2, you get another $100.How much would you have to put in the bank todayto be able to come back in 2years and take away
$100? Assume that you put amount X in the banktoday. Then at the end of year 1, you have X+rX,
which you keep in the account. At the end of year 2,you have X+rX plus interest on X+rX; so at the
end of year 2 you have
(X+rX) + r(X+rX)
which can be written
X(1 + r) + rX(1 + r)o r X(1 + r)(1 + r)o r X(1 + r)
2
Therefore,
is the amount you must deposit today to get back
$100 in 2 years.
Ifr= .10, then
T o convince yourself that this calculation is right,
if you put $82.65 in your hypothetical bank today andcame back to check the balance after a year, youwould have $82.65 plus interest of 10 percent, or$8.26, which is $90.91. But this time you leave it in thebank and receive 10 percent on the entire balanceduring the second year, which is $9.09. Adding theadditional 10 percent, you get back to $100. Thus, ifyou deposit $82.65 in an account and come back in2 years, you will have $100. The present value of$100 2 years from now is $82.65.
Now on to year 3. This time you receive a check
for $400, but you don’t get it until 3 years havepassed. Again, how much would you have to put inyour hypothetical bank to end up with $400?Without doing all the math, you can show that X,
the amount that you must deposit to get back $400in 3 years, is
X=$400
(1+r)3X=$100
(1.1)2 or X=$82.65X=$100
(1+r)2
250 PART II The Market System: Choices Made by Households and Firms
and if r= .10,
In general, the present value ( PV), or present dis-
counted value, of Rdollars to be received in tyears is
Step 3: Once you have looked at the project 1 year at a
time, you must add up the total present value to seewhat the whole project is worth. In Table 11A.2, theright-hand column shows the present value of eachyear’s return. If you add up the total, you havearrived at the amount that you would have to put inyour hypothetical bank (that pays interest ondeposits at 10 percent) today to receive the exactflow that is expected to come from the project. Thattotal is $1,126.06.
So if you go to the bank today and put in
$1,126.06, then come back in a year and withdraw$100, then come back after 2 years and withdrawanother $100, then come back in 3 years and with-draw $400, and so on, until 5 years have passed, whenyou show up to close the account at the end of thefifth year, there will be exactly $500 left to withdraw.Lo and behold, you have figured out that you canreceive the exact flow of profit that the project isexpected to yield for $1,126.06. If you were lookingfor a 10 percent yield, you would notspend $1,200 for
it. Y ou would not do the project.PV=R
(1+r)tX=$400
(1.1)3 or X=$300.53
What you have done is to convert an expected
flow of dollars from an investment project that comes
to you over some extended period of time to a single
number : the present value of the flow.
We can restate the point this way: If the present value of
the income stream associated with an investment is less thanthe full cost of the investment project, the investment shouldnot be undertaken. This is illustrated in Figure 11A.1.
It is important to remember that we are discussing
thedemand for new capital . Business firms must evaluate
potential investments to decide whether they are worthTABLE 11A.2 Calculation of Total Present Value of a
Hypothetical Investment Project(Assuming r=10 Percent)
END OF… $(r)DIVIDED
BY (1 + r)t=PRESENT
VALUE ($)
Year 1 100 (1.1) 90.91
Year 2 100 (1.1)282.64
Year 3 400 (1.1)3300.53
Year 4 500 (1.1)4341.51
Year 5 500 (1.1)5310.46
Total present value 1,126.05undertaking. This involves predicting the flow of potential
future profits arising from each project and comparingthose future profits with the return available in the financialmarket at the current interest rate. The present-valuemethod allows firms to calculate how much it would cost
today to purchase a contract for the same flow of earnings in
the financial market.
Lower Interest Rates, Higher Present Values
Now consider what would happen if you used a lower inter-est rate in calculating the present value of a flow of earn-ings. Y ou might use a lower rate in the analysis becauseinterest rates in general have gone down in financial mar-kets, making the opportunity cost of investment lower ingeneral. Y ou might also find out that the project is less riskythan you believed earlier. For whatever reason, let’s say thatyou would now do the project if it produced a return of5 percent.
In evaluating the present value, the firm now looks at
each year’s flow of profit and asks how much it would cost toearn that amount if it were able to earn exactly 5 percent onits money in a hypothetical bank. With a lower interest rate,the firm will have to pay more now to purchase the same
number of future dollars. Consider, for example, the presentvalue of $100 in 2 years. We saw that if the firm puts aside$82.65 at 10 percent interest, it will have $100 in 2 years—at a?Cost Deposit
New office
building
Year 1
Year 2
Year 3Year 4Year 1
Year 2
Year 3
Year 4Investment
project:Alternative:
Hypothetical
bank paying
interest rate r
Required
return
to cover
risk: r
Same flowFlow of
future rents
Can the flow of future
rents be obtained from
a hypothetical bank
for a smaller amount?Investment
decision
/L50304FIGURE 11A.1 Investment Project: Go or No? A
Thinking Map
CHAPTER 11 Input Demand: The Capital Market and the Investment Decision 251
10 percent interest rate, the present discounted value (or
current market price) of $100 in 2 years is $82.65. However,$82.65 put aside at a 5 percent interest rate would generateonly $4.13 in interest in the first year and $4.34 in the secondyear, for a total balance of $91.11 after 2 years. T o get $100 in2 years, the firm needs to put aside more than $82.65 now.Solving for Xas we did before,
When the interest rate falls from 10 percent to 5 percent,
the present value of $100 in 2 years rises by $8.05 ($90.70-$82.65).
Table 11A.3 recalculates the present value of the full
stream at the lower interest rate; it shows that a decrease in theinterest rate from 10 percent to 5 percent causes the total presentvalue to rise to $1,334.59. Because the investment project costsless than this (only $1,200), it should be undertaken. It is now abetter deal than can be obtained in the financial market. Underthese conditions, a profit-maximizing firm will make theinvestment. As discussed in the chapter, a lower interest rateleads to more investment.X=$100
(1+r)2=$100
(1.05)2=$90.70TABLE 11A.3 Calculation of Total Present Value of a
Hypothetical Investment Project(Assuming r=5 Percent)
END OF… $DIVIDED
BY (1 + r)t=PRESENT
VALUE ($)
Year 1 100 (1.05) 95.24
Year 2 100 (1.05)290.70
Year 3 400 (1.05)3345.54
Year 4 500 (1.05)4411.35
Year 5 500 (1.05)5391.76
Total present value 1,334.59
The basic rule is as follows:
If the present value of an expected stream of earnings
from an investment exceeds the cost of the investmentnecessary to undertake it, the investment should beundertaken. However, if the present value of an expectedstream of earnings falls short of the cost of the invest-ment, the financial market can generate the same streamof income for a smaller initial investment and the invest-ment should not be undertaken.
1.The present value ( PV) ofRdollars to be paid tyears in the
future is the amount you need to pay today, at currentinterest rates, to ensure that you end up with Rdollars
tyears from now. It is the current market value of receiving
Rdollars in tyears.2.If the present value of the income stream associated with an
investment is less than the full cost of the investment project,the investment project should not be undertaken. If the presentvalue of an expected stream of income exceeds the cost ofthe investment necessary to undertake it, the investmentshould be undertaken.APPENDIX SUMMARY
present discounted value (PDV) or
present value (PV) The present
discounted value of Rdollars to be paid t
years in the future is the amount you needto pay today, at current interest rates, to
ensure that you end up with Rdollars
tyears from now. It is the current market
value of receiving Rdollars in tyears. p. 249APPENDIX REVIEW TERMS AND CONCEPTS
PV=R
(1+r)t
APPENDIX PROBLEMS
1.Suppose you were offered $2,000 to be delivered in 1 year. Further
suppose you had the alternative of putting money into a safe cer-
tificate of deposit paying annual interest at 10 percent. Would youpay $1,900 in exchange for the $2,000 after 1 year? What is themaximum amount you would pay for the offer of $2,000? Suppose
the offer was $2,000, but delivery was to be in 2 years instead of
1 year. What is the maximum amount you would be willing to pay?
2.Y our Uncle Joe just died and left $10,000 payable to you when
you turn 30 years old. Y ou are now 20. Currently, the annual rateof interest that can be obtained by buying 10-year bonds is 6.5 per-
cent. Y our brother offers you $6,000 cash right now to sign over
your inheritance. Should you do it? Explain your answer.
3.A special task force has determined that the present discounted
value of the benefits from a bridge project comes to $23,786,000.
The total construction cost of the bridge is $25 million. Thisimplies that the bridge should be built. Do you agree with thisconclusion? Explain your answer. What impact could a substan-tial decline in interest rates have on your answer?
252 PART II The Market System: Choices Made by Households and Firms
TABLE 1
END OF YEAR A B C D E
1 $8 0 $8 0 $ 100 $ 100 $500
2 80 80 100 100 300
3 80 80 1,100 100 400
4 80 80 0 100 300
5 1,080 80 0 100 0
6 0 80 0 1,100 0
7 0 1,080 0 0 04.Calculate the present value of the income streams AtoEin
Table 1 at an 8 percent interest rate and again at a 10 percent rate.
Suppose the investment behind the flow of income in Eis a
machine that cost $1,235 at the beginning of year 1. Would youbuy the machine if the interest rate were 8 percent? if the inter-est rate were 10 percent?8.Assume that the present discounted value of an investment project
(commercial development) at a discount rate of 7 percent is
$234,756,000. Assume that the building just sold for $254 mil-
lion. Will the buyer earn a rate of return of more than 7 percent,exactly 7 percent, or less than 7 percent? Briefly explain.
9.Assume that I promise to pay you $100 at the end of each of the
next 3 years. Using the following formula,
X= 100/(1 + r) + 100/(1 + r)
2+ 100/(1 + r)3
ifr= 0.075, then X= $260.06.
Assuming that somebody of roughly comparable reliability
offers to pay out 7.5 percent on anything you let him or her bor-row from you, would you be willing to pay me $270 for mypromise? Explain your answer.
10.T eresa won the Florida lottery and was given the option of receiv-
ing $22 million immediately or $1,250,000 per year for 30 years.a.If T eresa opts for the 30 annual payments, how much in total
will she receive?
b.What is the present value of the 30 annual payments if the
interest rate is 4 percent? Based on this value, should T eresaopt for the up-front payment or the 30 installments?
c.What is the present value of the 30 annual payments if the
interest rate is 8 percent? Based on this value, should T eresaopt for the up-front payment or the 30 installments?
11.How would your answers to the previous question change if the
annual payments changed to $2,000,000 per year for 15 years?
12.Explain what will happen to the present value of money one
year from now if the market interest rate falls? What if the mar-ket interest rate rises?5.Determine what someone should be willing to pay for each of
the following bonds when the market interest rate for borrow-
ing and lending is 5 percent.a.A bond that promises to pay $3,000 in a lump-sum payment
after 1 year.
b.A bond that promises to pay $3,000 in a lump-sum payment
after 2 years.
c.A bond that promises to pay $1,000 per year for 3 years.
6.What should someone be willing to pay for each of the bonds in
question 5 if the interest rate is 10 percent?
7.Based on your answers to questions 5 and 6, state whether each
of the following is true or false:
a.Ceteris paribus , the price of a bond increases when the inter-
est rate increases.
b.Ceteris paribus , the price of a bond increases when any given
amount of money is received sooner rather than later.
CHAPTER OUTLINE
25312
Market Adjustment
to Changes inDemand
p. 254
Allocative Efficiencyand CompetitiveEquilibrium
p. 256
Pareto Efficiency
Revisiting Consumer and
Producer Surplus
The Efficiency of Perfect
Competition
Perfect Competition versus
Real Markets
The Sources of
Market Failure p. 262
Imperfect Markets
Public Goods
Externalities
Imperfect Information
Evaluating the Market
Mechanism p. 264 In the last nine chapters, we have built a model of a simple, perfectly competitive economy. Our dis-
cussion has revolved around the two fundamental decision-making units, households and firms ,
which interact in two basic market arenas, input markets andoutput markets . (Look again at the cir-
cular flow diagram, shown in Figure II.1 on p. 117.) By limiting our discussion to perfectly competi-tive firms, we have been able to examine how the basic decision-making units interact in the twobasic market arenas.
Households make constrained choices in both input and output markets. Household income, for
example, depends on choices made in input markets: whether to work, how much to work, whatskills to acquire, and so on. Input market choices are constrained by such factors as current wagerates, availability of jobs, and interest rates.
Firms are the primary producing units in a market economy. Profit-maximizing firms, to
which we have limited our discussion, earn their profits by selling products and services for morethan it costs to produce them. With firms, as with households, output markets and input marketscannot be analyzed separately. All firms make three specific decisions simultaneously: (1) howmuch output to supply, (2) how to produce that output—that is, which technology to use, and(3) how much of each input to demand.
In Chapters 7 through 9, we explored these three decisions from the viewpoint of output
markets. We saw that the portion of the marginal cost curve that lies above a firm’s averagevariable cost curve is the supply curve of a perfectly competitive firm in the short run. Implicitin the marginal cost curve is a choice of technology and a set of input demands. In Chapters 10and 11, we looked at the perfectly competitive firm’s three basic decisions from the viewpointof input markets.
Output and input markets are connected because firms and households make simultaneous
choices in both arenas, but there are other connections among markets as well. Firms buy in bothcapital and labor markets, for example, and they can substitute capital for labor and vice versa. Achange in the price of one factor can easily change the demand for other factors. Buying morecapital , for instance, usually changes the marginal revenue product of labor and shifts the labor
demand curve. Similarly, a change in the price of a single good or service usually affects house-hold demand for other goods and services, as when a price decrease makes one good more attrac-tive than other close substitutes. The same change also makes households better off when they
General Equilibrium
and the Efficiency of
Perfect Competition
254 PART II The Market System: Choices Made by Households and Firms
find that the same amount of income will buy more. Such additional “real income” can be spent
on any of the other goods and services that the household buys.
The point here is simple:
Input and output markets cannot be considered as if they were separate entities or as if theyoperated independently. Although it is important to understand the decisions of individualfirms and households and the functioning of individual markets, we now need to add it allup so we can look at the operation of the system as a whole.
Y ou have seen the concept of equilibrium applied both to markets and to individual
decision-making units. In individual markets, supply and demand determine an equilibriumprice. Perfectly competitive firms are in short-run equilibrium when price and marginal cost areequal ( P=MC). In the long run, however, equilibrium in a competitive market is achieved only
when economic profits are eliminated. Households are in equilibrium when they have equatedthe marginal utility per dollar spent on each good to the marginal utility per dollar spent on allother goods. This process of examining the equilibrium conditions in individual markets and forindividual households and firms separately is called partial equilibrium analysis .
Ageneral equilibrium exists when all markets in an economy are in simultaneous equilib-
rium. An event that disturbs the equilibrium in one market may disturb the equilibrium inmany other markets as well. The ultimate impact of the event depends on the way allmarkets
adjust to it. Thus, partial equilibrium analysis, which looks at adjustments in one isolated mar-ket, may be misleading.
Thinking in terms of a general equilibrium leads to some important questions. Is it possible for
all households and firms and all markets to be in equilibrium simultaneously? Are the equilibriumconditions that we have discussed separately compatible with one another? Why is an event that dis-turbs an equilibrium in one market likely to disturb many other equilibriums simultaneously?
In talking about general equilibrium in the beginning of this chapter, we continue our exer-
cise in positive economics —that is, we seek to understand how systems operate without making
value judgments about outcomes. Later in the chapter, we turn from positive economics tonormative economics as we begin to judge the economic system. Are its results good or bad? Can
we make them better?
In judging the performance of any economic system, you will recall, it is essential first to
establish specific criteria by which to judge. In this chapter, we use two such criteria: efficiency
and equity (fairness). First, we demonstrate the efficiency of the allocation of resources—that is,
the system produces what people want and does so at the least possible cost—if all the assump-tions that we have made thus far hold. When we begin to relax some of our assumptions, how-ever, it will become apparent that free markets may not be efficient. Several sources of
inefficiency naturally occur within an unregulated market system. In the final part of this chap-ter, we introduce the potential role of government in correcting market inefficiencies andachieving fairness.
Market Adjustment to Changes in Demand
All economies, particularly market systems, are dynamic: Change occurs all the time. Marketsexperience shifts of demand, both up and down; costs and technology change; and prices and out-puts change. We have spent a lot of time looking at how these changes affect individual markets.But markets are also connected to one another. If capital flows into one market, often that means itis flowing out of another market. If consumers ride trains, often that means they stay off the bus.How do we think about connections across markets?
As we look at the general case, you might find it helpful to keep an example in mind. In 2007,
Amazon introduced the Kindle, a small machine that allows a person to read e-books. We couldanalyze this product introduction in a partial equilibrium setting, considering the responsivenessof potential buyers to price or quality changes in the Kindle. But the introduction of the Kindle andsubsequent pricing decisions by Amazon affect other markets as well. E-books substitute in partfor printed books. The introduction of the Kindle and subsequent price reductions in the devicethus shift the demand for printed books to the left. When the demand for printed books falls,storefront booksellers like Barnes and Noble suffer profit losses. Likely their sales of other productspartial equilibrium analysis
The process of examining the
equilibrium conditions in
individual markets and forhouseholds and firms separately.
general equilibrium The
condition that exists when all
markets in an economy are insimultaneous equilibrium.
efficiency The condition in
which the economy is producing
what people want at leastpossible cost.
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 255
in the stores—complements to their book sales—also decline. Many printed books are ordered over
the Web, many in fact through Amazon itself. When demand for these books falls, shipping serviceslike UPS lose business. Printed books are produced using paper. When the demand for books falls, sodoes the demand for paper, and through that channel the demand for forest products falls.
Nor is the story over there. When Amazon prices the Kindle, it must take into account what is
going on in the marketplace for printed books. If Barnes and Noble responds to the shift in itsdemand by lowering prices of printed books, that move will influence the optimal price for theKindle. If the fall in demand for paper reduces the cost of paper, the costs of printing books will fall,and that too will lead to a lower price for printed books. Amazon will need to respond to that as well.In a general equilibrium analysis one needs to work through all the feedback loops and connectionsacross industries to get to a final answer.
Figure 12.1 beg ins our discussion of the more general case of market connections. In the fig-
ure we assume that there are two sectors in the economy, Xand Y, and that both are currently in
long-run equilibrium. T otal output in sector Xis the product is selling for a price of and
each firm in the industry produces up to where is equal to marginal At that point, cost— q
0
X. P0
XP0X, Q0
X,
S0
X
S1
X
D1
X
Q1
XQ0
XMCX
D0
XP0
XP1
X
0
S1
Y
D0
YP0
XP1
X
0 q1
Xq0
XQATCX
q
Units of XPrice per unit of X ($)Industry X
Industry YPrice per unit of Y ($)A representative firm in Y
MCYUnits of X
P1
YP0
Y
0 q0
Yq1
Yq 0 Q0
YQ1
YQS0
Y
D1
YATCYA representative firm in X
P1
YP0
Y
Units of Y Units of YProfits
Losses
/L50304FIGURE 12.1 Adjustment in an Economy with Two Sectors
Initially, demand for Xshifts from to This shift pushes the price of Xup to creating profits.
Demand for Yshifts down from to pushing the price of Ydown to and creating losses. Firms have
an incentive to leave sector Yand an incentive to enter sector X. Exiting sector Yshifts supply in that industry
to raising price and eliminating losses. Entry shifts supply in Xto thus reducing and eliminating profits.S1
X, S1
Y,P1
Y D1Y, D0
YP1X, D1
X. D0
X
256 PART II The Market System: Choices Made by Households and Firms
price is just equal to average cost and economic profits are zero. The same condition holds initially
in sector Y. The market is in zero profit equilibrium at a price of
Now assume that a change in consumer preferences (or in the age distribution of the popu-
lation or in something else) shifts the demand for Xout to the right from to That shift
drives the price up to If households decide to buy more X, without an increase in income,
they must buy lessof something else. Because everything else is represented by Yin this example,
the demand for Ymust decline and the demand curve for Yshifts to the left, from to
With the shift in demand for X, price rises to and profit-maximizing firms immediately
increase output to (the point where ). However, now there are positive profits in X.
With the downward shift of demand in Y, price falls to Firms in sector Ycut back to (the
point where ), and the lower price causes firms producing Yto suffer losses.
In the short run, adjustment is simple. Firms in both industries are constrained by their cur-
rent scales of plant. Firms can neither enter nor exit their respective industries. Each firm inindustry Xraises output somewhat, from to Firms in industry Ycut back from to
In response to the existence of profit in sector X, the capital market begins to take notice. In
Chapter 9, we saw that new firms are likely to enter an industry in which there are profits to beearned. Financial analysts see the profits as a signal of future healthy growth, and entrepreneursmay become interested in moving into the industry.
Adding all of this together, we would expect to see investment begin to favor sector X. This is
indeed the case: Capital begins to flow into sector X. As new firms enter, the short-run supply
curve in the industry shifts to the right and continues to do so until all profits are eliminated. Inthe top-left diagram in Figure 12.1, the supply curve shifts out from to a shift that drivesthe price back down to
We would also expect to see a movement out of sector Ybecause of losses. Some firms will
exit the industry. In the bottom-left diagram in Figure 12.1, the supply curve shifts back from to a shift that drives the price back up to At this point, all losses are eliminated.
Note that a new general equilibrium is not reached until equilibrium is reestablished in all
markets. If costs of production remain unchanged, as they do in Figure 12.1, this equilibriumoccurs at the initial product prices, but with more resources and production in Xand fewer in Y.
In contrast, if an expansion in Xdrives up the prices of resources used specifically in X, the cost
curves in Xwill shift upward and the final postexpansion zero-profit equilibrium will occur at a
higher price. Such an industry is called an increasing-cost industry .
Allocative Efficiency and Competitive
Equilibrium
As we have gone through and built models of a competitive economic system, we have often
referred to the efficiency of that system. How do we think about efficiency in a general equilib-rium world, in which many markets are interconnected?
Pareto Efficiency
In Chapter 1, we introduced several specific criteria used by economists to judge the perfor-mance of economic systems and to evaluate alternative economic policies. These criteria are(1) efficiency, (2) equity, (3) growth, and (4) stability. In Chapter 1, you also learned that anefficient economy is one that produces the things that people want at the least cost. The idea
behind the efficiency criterion is that the economic system exists to serve the wants and needsof people. If resources somehow can be reallocated to make people “better off,” then theyshould be. We want to use the resources at our disposal to produce maximum well-being. Thetrick is defining maximum well-being .
For many years, social philosophers wrestled with the problem of “aggregation,” or
“adding up.” When we say “maximum well-being,” we mean maximum for society . Societies are
made up of many people, and the problem has always been how to maximize satisfaction, orwell-being, for all members of society. What has emerged is the now widely accepted concept ofallocative efficiency , first developed by the Italian economist Vilfredo Pareto in the nineteenth
century. Pareto’s very precise definition of efficiency is often referred to as Pareto efficiency or
Pareto optimality .P
0
Y. S1
Y,S0
YP0X.S1
X, S0
Xq1Y. q0
Y q1X. q0
XP1Y=MC Yq1
Y P1Y.P1
X=MC X q1
XP1XD1Y. D0
YP1X.D1
X. D0
XP0Y.
Pareto efficiency orPareto
optimality A condition in
which no change is possiblethat will make some membersof society better off withoutmaking some other membersof society worse off.
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 257
ECONOMICS IN PRACTICE
Ethanol and Land Prices
As we see in the article, a number of markets are affected by the
ethanol subsidies. The increase in the demand for ethanol drives
up the demand for corn, which in turn increases the demand forland. Since the supply of land is finite, the price of land used toproduce corn rises. But what about the rest of the agriculturaleconomy? Increasing land prices increases the cost of other grains,
such as wheat. As you learned in Chapter 2, land is a key factor of
production. The increase in wheat costs shifts the supply curve to
the left, as in the figure below. Wheat prices thus also rise.Nebraska ethanol boom causing land prices
to soar
TheIndependent.com
Ethanol is not only pumping up the price of corn in Nebraska,
but also farm real estate market values and cash rent ratesvalues have seen a 14-percent increase, according to the pre-liminary results of the University of Nebraska-Lincoln’s annual
Farm Real Estate Market Development Survey.
According to the survey, Nebraska farmland’s average
value for the year ending Feb. 1 was $1,155 per acre, com-pared to $1,013 per acre at this time last year, said BruceJohnson, the UNL agricultural economist who conducts this
annual survey.
He said preliminary findings show this was the largest all-
land value increase in the past 19 years. It is also the fourthstraight year of what Johnson called “solid advances” in land
values. He said the state’s current all-land average value ismore than 50 percent higher than the 2003 level.
Higher prices for corn because of ethanol demand are
driving the sharp rise in land prices. By early 2008, Nebraska
should have about 25 ethanol plants online, producing 1.2 bil-
lion gallons of ethanol and using more than 425 millionbushels of corn.
“The demand from rapidly growing ethanol production
has tr iggered the commodity market advances, and, in turn,
worked into the agricultural land market dynamic, particu-
larly in the major corn-producing areas of the state,”
Johnson said.
Source: Robert Pore, robert.pore@theindependent.com. Reprinted
with permission.
P2
Q2 Q1 QWheat
per yearS1S2
D1P1
WheatP
P2
Q1 Q2 QCorn
per yearS1
D2
D1P1
CornThe U.S. government provides large subsidies for ethanol, a fuel produced from corn. Proponents of the ethanol subsidies suggest th at it is one
piece of a policy that can help the United States reduce its dependence on foreign oil. In part, as a result of these subsidies, the midwestern
United States has seen a large increase in corn production relative to other grains. The following article traces another of the general equilibrium
consequences of the ethanol subsidies: an increase in the price of agricultural land.
Specifically, a change is said to be efficient when it makes some members of society better off
without making other members of society worse off. An efficient, or Pareto optimal , system is one
in which no such changes are possible. An example of a change that makes some people better offand nobody worse off is a simple voluntary exchange. I have apples and you have nuts. I like nutsand you like apples. We trade. We both gain, and no one loses.
For such a definition to have any real meaning, we must answer two questions: (1) What do
we mean by “better off”? and (2) How do we account for changes that make some people betteroff and others worse off?
The answer to the first question is simple. People decide what “better off” and “worse off”
mean. I am the only one who knows whether I am better off after a change. If you and I exchange
258 PART II The Market System: Choices Made by Households and Firms
one item for another because I like what you have and you like what I have, we both “reveal” that
we are better off after the exchange because we agreed to it voluntarily. If everyone in the neigh-borhood wants a park and the residents all contribute to a fund to build one, they have con-sciously changed the allocation of resources and they all are better off for it.
The answer to the second question is more complex. Nearly every change that one can imag-
ine leaves some people better off and some people worse off. If some gain and some lose as theresult of a change, and it can be demonstrated that the value of the gains exceeds the value of thelosses, then the change is said to be potentially efficient . In practice, however, the distinction
between a potentially and an actually efficient change is often ignored and all such changes are
simply called efficient .
Example: Budget Cuts in Massachusetts Several years ago, in an effort to reduce state
spending, the budget of the Massachusetts Registry of Motor Vehicles was cut substantially. Amongother things, the state sharply reduced the number of clerks in each office. Almost immediatelyMassachusetts residents found themselves waiting in line for hours when they had to register theirautomobiles or get their driver’s licenses.
Drivers and car owners began paying a price: standing in line, which used time and energy
that could otherwise have been used more productively. However, before we can make sensibleefficiency judgments, we must be able to measure, or at least approximate, the value of both thegains and the losses produced by the budget cut. T o approximate the losses to car owners and dri-vers, we might ask how much people would be willing to pay to avoid standing in those long lines.
One office estimated that 500 people stood in line every day for about 1 hour each. If each
person were willing to pay just $2 to avoid standing in line, the damage incurred would be$1,000 (500 /H11003$2) per day. If the registry were open 250 days per year, the reduction in labor
force at that office alone would create a cost to car owners, conservatively estimated, of$250,000 (250 /H11003$1,000) per year.
Estimates also showed that taxpayers in Massachusetts saved about $80,000 per year by hav-
ing fewer clerks at that office. If the clerks were reinstated, there would be some gains and somelosses. Car owners and drivers would gain, and taxpayers would lose. However, because we canshow that the value of the gains would substantially exceed the value of the losses, it can beargued that reinstating the clerks would be an efficient change. Note that the only netlosers
would be those taxpayers who do not own a car and do not hold driver’s licenses.
1
Revisiting Consumer and Producer Surplus
In Chapter 4 we introduced the concept of consumer and producer surplus. Consumer surpluswas defined as the difference between the maximum amount that buyers are willing to pay for agood and its current market price. Y ou can think of a demand curve as defining a boundary thatshows maximum willingness to pay per unit at every quantity.
When you visit your favorite sandwich store, it will make you a sandwich and charge you a
fixed price. Say that the sandwich is priced at $7. If you really crave sandwiches made at thatplace, you may be gaining consumer surplus. Indeed, if you were willing to pay $12 for a sand-wich and it is selling for a price of $7, you earn a consumer surplus of $5 when you buy it.
Producer surplus is defined as the difference between the current market price of a good and
the full cost of producing it. It is, in a way, a measure of profitability.
If you go back to pages 89–91 and review the argument, you will see that demand and supply
curves, if left to their own natural adjustments, will lead the markets to an efficient equilibrium.Specifically, they will allocate demand across sectors in a way that maximizes the total surplus(consumer + producer) being generated by the exchange. Any change in quantity imposed on themarket will shift the curves (or one of the curves) to the left or the right, and the result will be“deadweight losses.”
1Y ou might wonder whether there are other gainers and losers. What about the clerks? In analysis like this, it is usually assumed
that the citizens who pay lower taxes spend their added income on other things. The producers of those other things need toexpand to meet the new demand, and they hire more labor. Thus, a contraction of 100 jobs in the public sector will open up100 jobs in the private sector. If the economy is fully employed, the transfer of labor to the private sector is assumed to create n o
net gains or losses to the workers.
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 259
T o really understand the argument that a perfectly competitive economy is economically effi-
cient and will lead to a Pareto efficient set of outcomes requires that we spend more time talkingabout some of the basic ideas.
The Efficiency of Perfect Competition
All societies answer these basic questions in the design of their economic systems:
1.What gets produced? What determines the final mix of output?
2.How is it produced? How do capital, labor, and land get divided up among firms? In other
words, what is the allocation of resources among producers?
3.Who gets what is produced? What determines which households get how much? What is the
distribution of output among consuming households?
The following discussion of efficiency uses these three questions and their answers to prove
informally that perfect competition is efficient. T o demonstrate that the perfectly competitive
system leads to an efficient, or Pareto optimal, allocation of resources, we need to show that nochanges are possible that will make some people better off without making others worse off.Specifically, we will show that under perfect competition, (1) resources are allocated among firmsefficiently, (2) final products are distributed among households efficiently, and (3) the systemproduces the things that people want.
Efficient Allocation of Resources Among Firms The simple definition of
efficiency holds that firms must produce their products using the best available—that is,lowest-cost—technology. If more output could be produced with the same amount of inputs,it would be possible to make some people better off without making others worse off.
The perfectly competitive model we have been using rests on several assumptions that assure
us that resources in such a system would indeed be efficiently allocated among firms. Mostimportant of these is the assumption that individual firms maximize profits. T o maximize profit,a firm must minimize the cost of producing its chosen level of output. With a full knowledge ofexisting technologies, firms will choose the technology that produces the output they want at theleast cost.
There is more to this story than meets the eye, however. Inputs must be allocated across firms
in the best possible way. If we find that it is possible, for example, to take capital from firm A andswap it for labor from firm B and produce more product in both firms, then the original allocationwas inefficient. Recall our example from Chapter 2. Farmers in Ohio and Kansas both producewheat and corn. The climate and soil in most of Kansas are best suited to wheat production, andthe climate and soil in Ohio are best suited to corn production. Kansas should produce most of thewheat, and Ohio should produce most of the corn. A law that forces Kansas land into corn produc-tion and Ohio land into wheat production would result in less of both—an inefficient allocation ofresources. However, if markets are free and open, Kansas farmers will naturally find a higher returnby planting wheat and Ohio farmers will find a higher return in corn. The free market, then,should lead to an efficient allocation of resources among firms. As you think back on Chapter 2,you should now see that societies operating on the production possibility frontier are efficientlyusing their inputs.
The same argument can be made more general. Misallocation of resources among firms is
unlikely as long as every single firm faces the same set of prices and trade-offs in input markets.Recall from Chapter 10 that perfectly competitive firms will hire additional factors of productionas long as their marginal revenue product exceeds their market price. As long as all firms haveaccess to the same factor markets and the same factor prices, the last unit of a factor hired will
produce the same value in each firm. Certainly, firms will use different technologies and factorcombinations, but at the margin, no single profit-maximizing firm can get more value out of afactor than that factor’s current market price. For example, if workers can be hired in the labormarket at a wage of $6.50, allfirms will hire workers as long as the marginal revenue product
(MRP
L) produced by the marginal worker (labor’s MRPL) remains above $6.50. Nofirms will hire
labor beyond the point at which MRPLfalls below $6.50. Thus, at equilibrium, additional work-
ers are not worth more than $6.50 to any firm, and switching labor from one firm to another will
260 PART II The Market System: Choices Made by Households and Firms
not produce output of any greater value to society. Each firm has hired the profit-maximizing
amount of labor. In short:
The assumptions that factor markets are competitive and open, that all firms pay the sameprices for inputs, and that all firms maximize profits lead to the conclusion that the alloca-tion of resources among firms is efficient.
We all know that people have different tastes and preferences and that they will buy verydifferent things in very different combinations. As long as everyone shops freely in the samemarkets, no redistribution of final outputs among people will make them better off. If youand I buy in the same markets and pay the same prices and I buy what I want and you buywhat you want, we cannot possibly end up with the wrong combination of things. Free andopen markets are essential to this result.Y ou should now have a greater appreciation for the power of the price mechanism in a market
economy. Each individual firm needs only to make decisions about which inputs to use by looking atits own labor, capital, and land productivity relative to their prices. But because all firms face identicalinput prices, the market economy achieves efficient input use among firms. Prices are the instrumentof Adam Smith’s “invisible hand,” allowing for efficiency without explicit coordination or planning.
Efficient Distribution of Outputs Among Households Even if the system is produc-
ing the right things and is doing so efficiently, these things still have to get to the right people. Just asopen, competitive factor markets ensure that firms do not end up with the wrong inputs, open, com-petitive output markets ensure that households do not end up with the wrong goods and services.
Within the constraints imposed by income and wealth, households are free to choose among all
the goods and services available in output markets. A household will buy a good as long as that goodgenerates utility, or subjective value, greater than its market price. Utility value is revealed in marketbehavior. Y ou do not go out and buy something unless you are willing to pay at least the market price.
Remember that the value you place on any one good depends on what you must give up to
have that good. The trade-offs available to you depend on your budget constraint. The trade-offsthat are desirable depend on your preferences. If you buy a $300 iPhone, you may be giving up atrip home. If I buy it, I may be giving up four new tires for my car. We have both revealed that theiPhone is worth at least as much to us as all the other things that $300 can buy. As long as we arefree to choose among all the things that $300 can buy, we will not end up with the wrong things;it is not possible to find a trade that will make us both better off. Again, the price mechanismplays an important role. Each of us faces the same price for the goods that we choose, and that inturn leads us to make choices that ensure that goods are allocated efficiently among consumers.
Producing What People Want: The Efficient Mix of Output It does no good to
produce things efficiently or to distribute them efficiently if the system produces the wrongthings. Will competitive markets produce the things that people want?
If the system is producing the wrong mix of output, we should be able to show that produc-
ing more of one good and less of another will make people better off. T o show that perfectly com-petitive markets are efficient, we must demonstrate that no such changes in the final mix ofoutput are possible.
The condition that ensures that the right things are produced is P=MC. That is, in both the
long run and the short run, a perfectly competitive firm will produce at the point where the priceof its output is equal to the marginal cost of production. As long as price is above marginal cost,it pays for a firm to increase output. The logic is this: When a firm weighs price and marginal cost,it weighs the value of its product to society at the margin against the value of the things that could
otherwise be produced with the same resources. Figure 12.2 summarizes this logic.
The argument is quite straightforward. First, price reflects households’ willingness to pay . By pur-
chasing a good, individual households reveal that it is worth at least as much as the other goods thatthe same money could buy. Thus, current price reflects the value that households place on a good.
Second, marginal cost reflects the opportunity cost of the resources needed to produce a good .I fa
firm producing Xhires a worker, it must pay the market wage. That wage must be sufficient to
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 261
The value placed on good X by
society through the market, or the social value of a marginal unit of X. PXMarket-determined value of resources
needed to produce a marginal unit of X.
MCX is equal to the opportunity cost of
those resources: lost production of other goods or the value of the resources left unemployed (leisure, vacant land, and so on).IfPX > MCX, society gains value by producing more X.
IfPX < MCX, society gains value by producing less X.
MCX
/L50304FIGURE 12.2 The Key Efficiency Condition: Price Equals Marginal Cost
attract that worker out of leisure or away from firms producing other goods. The same argument
holds for capital and land.
Thus, if the price of a good ends up greater than marginal cost, producing more of it will gen-
erate benefits to households in excess of opportunity costs, and society gains. Similarly,if the price of a good ends up below marginal cost, resources are being used to produce somethingthat households value less than opportunity costs. Producing less of it creates gains to society.
2
Society will produce the efficient mix of output if all firms equate price and marginal cost.
2It is important to understand that firms do not act consciously to balance social costs and benefits. In fact, the usual assumption is that
firms are self-interested private profit maximizers. It just works out that in perfectly competitive markets, when firms are weig hing pri-
vate benefits against private costs, they are actually (perhaps without knowing it) weighing the benefits and costs to society a s well.Figure 12.3 shows how a simple competitive market system leads individual households and
firms to make efficient choices in input and output markets. For simplicity, the figure assumesonly one factor of production, labor. Households weigh the market wage against the value of
0Px
QProduct market
Marginal revenue product MPL/H11003PX Buys goods and services
0W
LInput marketValue of leisure and
household productionWage
Maximum utility
HOUSEHOLDSWage = cost of a
marginal unit of laborValue of labor’s
marginal products
Maximum profit
FIRMS
/L50304FIGURE 12.3 Efficiency in Perfect Competition Follows from a Weighing of
Values by Both Households and Firms
262 PART II The Market System: Choices Made by Households and Firms
leisure and time spent in unpaid household production. However, the wage is a measure of
labor’s potential product because firms weigh labor cost (wages) against the value of the productproduced and hire up to the point at which W=MRP
L. Households use wages to buy market-
produced goods. Thus, households implicitly weigh the value of market-produced goods againstthe value of leisure and household production.
When a firm’s scale is balanced, it is earning maximum profit; when a household’s scale is
balanced, it is maximizing utility. Under these conditions, no changes can improve social welfare.
Perfect Competition versus Real Markets
So far, we have built a model of a perfectly competitive market system that produces an efficientallocation of resources, an efficient mix of output, and an efficient distribution of output. Theperfectly competitive model is built on a set of assumptions, all of which must hold for our con-clusions to be fully valid. We have assumed that all firms and households are price-takers in inputand output markets, that firms and households have perfect information, and that all firms max-imize profits.
These assumptions do not always hold in real-world markets . When this is the case, the conclu-
sion breaks down that free, unregulated markets will produce an efficient outcome. The remain-der of this chapter discusses some inefficiencies that occur naturally in markets and some of thestrengths, as well as the weaknesses, of the market mechanism. We also discuss the usefulness ofthe competitive model for understanding the real economy.
The Sources of Market Failure
In suggesting some of the problems encountered in real markets and some of the possible solu-tions to these problems, the rest of this chapter previews the next part of this book, which focuseson the economics of market failure and the potential role of government in the economy.
Market failure occurs when resources are misallocated, or allocated inefficiently. The result
is waste or lost value. In this section, we briefly describe four important sources of market failure:(1)imperfect market structure , or noncompetitive behavior; (2) the existence of public goods ;
(3) the presence of external costs and benefits ; and (4) imperfect information . Each condition
results from the failure of one of the assumptions basic to the perfectly competitive model, andeach is discussed in more detail in later chapters. Each also points to a potential role for govern-ment in the economy. The desirability and the extent of actual government involvement in theeconomy are hotly debated subjects.
Imperfect Markets
One of the elements of the efficiency of a perfectly competitive market that we described is the effi-cient mix of outputs. Society produces the right mix of goods given their costs and the preferencesof households in the economy. Efficient mix comes because products are sold at prices equal totheir marginal costs.
Think back to two goods, nuts and apples. For efficiency, we would like, in equilibrium, to
find that the relative prices of nuts and apples reflect their relative costs. If the marginal costs ofapples is twice that of nuts, efficiency means that consumption should be adjusted so that the rel-ative price of apples is twice that of nuts. Otherwise, society does better in using its resources dif-ferently. In a perfectly competitive market, this comes easily. If both goods are sold at prices equalto their marginal costs, then the ratio of the prices of the two goods will also equal the ratio of themarginal costs. Equilibrium in separate markets gives us efficiency in the general equilibrium set-ting. But suppose one of the two goods is priced for some reason at a level in excess of its mar-ginal costs. Now relative prices will no longer reflect relative costs.
So we can see that efficiency of output mix comes from marginal cost pricing. As we will
learn in the next few chapters, however, in imperfectly competitive markets, with fewer firmscompeting and limited entry by new firms, prices will not necessarily equal marginal costs. As aconsequence, in a market with firms that have some market power, where firms do not behave asprice-takers, we are not guaranteed an efficient mix of output.market failure Occurs when
resources are misallocated, or
allocated inefficiently. Theresult is waste or lost value.
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 263
Public Goods
A second major source of inefficiency lies in the fact that private producers may not find it in
their best interest to produce everything that members of society want because for one reason oranother they are unable to charge prices to reflect values people place on those goods. Morespecifically, there is a whole class of goods and services called public goods orsocial goods , that
will be underproduced or not produced at all in a completely unregulated market economy.
3
Public goods are goods and services that bestow collective benefits on society; they are, in a sense,
collectively consumed. The classic example is national defense, but there are countless others—policeprotection, homeland security, preservation of wilderness lands, and public health, to name a few.These things are “produced” using land, labor, and capital just like any other good. Some public goods,such as national defense, benefit the whole nation. Others, such as clean air, may be limited to smallerareas—the air may be clean in a Kansas town but dirty in a Southern California city. Pub lic goods are
consumed by everyone, not just by those who pay for them. The inability to exclude nonpayers fromconsumption of a public good makes it, not surprisingly, hard to charge people a price for the good.
If the provision of public goods were left to private profit-seeking producers with no power
to force payment, a serious problem would arise. Suppose, for example, you value some publicgood, X. If there were a functioning market for X, you would be willing to pay for X. Suppose you
are asked to contribute voluntarily to the production of X. Should you contribute? Perhaps you
should on moral grounds, but not on the basis of pure self-interest.
At least two problems can get in the way. First, because you cannot be excluded from using X
for not paying, you get the good whether you pay or not. Why should you pay if you do not haveto? Second, because public goods that provide collective benefits to large numbers of people areexpensive to produce, any one person’s contribution is not likely to make much difference to theamount of the good ultimately produced. Would the national defense suffer, for example, if youdid not pay your share of the bill? Probably not. Thus, nothing happens if you do not pay. Theoutput of the good does not change much, and you get it whether you pay or not. Private provi-sion of public goods fails. A completely laissez-faire market system will not produce everythingthat all members of a society might want. Citizens must band together to ensure that desiredpublic goods are produced, and this is generally accomplished through government spendingfinanced by taxes. Public goods are the subject of Chapter 16.
Externalities
A third major source of inefficiency is the existence of external costs and benefits. An externality
is a cost or benefit imposed or bestowed on an individual or a group that is outside, or external to,the transaction—in other words, something that affects a third party. In a city, external costs arepervasive. The classic example is air or water pollution, but there are thousands of others, such asnoise, congestion, and your house painted a color that the neighbors think is ugly. Global warm-ing is an externality at the level of the world.
Not all externalities are negative, however. For example, housing investment may yield bene-
fits for neighbors. A farm located near a city provides residents in the area with nice views and aless congested environment.
Externalities are a problem only if decision makers do not take them into account. The logic of
efficiency presented earlier in this chapter required that firms weigh social benefits against social costs.If a firm in a competitive environment produces a good, it is because the value of that good to societyexceeds the social cost of producing it—this is the logic of P=MC. If social costs or benefits are over-
looked or left out of the calculations, inefficient decisions result. In essence, if the calculation of eitherMCorPin the equation is “wrong,” equating the two will clearly not lead to an optimal result.
The effects of externalities can be enormous. For years, companies piled chemical wastes
indiscriminately into dump sites near water supplies and residential areas. In some locations,those wastes seeped into the ground and contaminated the drinking water. In response to the evi-dence that smoking damages not only the smoker but also others, governments have increasedprohibitions against smoking on airplanes and in public places.
3Although they are normally referred to as public goods , many of the things we are talking about are services .public goods, orsocial
goods Goods and services
that bestow collective benefitson members of society.
Generally, no one can be
excluded from enjoying theirbenefits. The classic example is
national defense.
externality A cost or benefit
imposed or bestowed on an
individual or a group that is
outside, or external to, thetransaction.
264 PART II The Market System: Choices Made by Households and Firms
Imperfect Information
The fourth major source of inefficiency is imperfect information on the part of buyers and sell-
ers. The conclusion that markets work efficiently rests heavily on the assumption that consumersand producers have full knowledge of product characteristics, available prices, and so on. Theabsence of full information can lead to transactions that are ultimately disadvantageous.
Some products are so complex that consumers find it difficult to judge the potential benefits
and costs of purchase. Buyers of life insurance have a very difficult time sorting out the terms ofthe more complex policies and determining the true “price” of the product. Consumers of almostany service that requires expertise, such as plumbing and medical care, have a hard time evaluat-ing what is needed, much less how well it is done. With imperfect information, prices may nolonger reflect individual preferences.
Some forms of misinformation can be corrected with simple rules such as truth-in-advertising
regulations. In some cases, the government provides information to citizens; job banks and con-sumer information services exist for this purpose. In certain industries, such as medical care, thereis no clear-cut solution to the problem of noninformation or misinformation. We discuss all thesetopics in detail in Chapter 16.
Evaluating the Market Mechanism
Is the market system good or bad? Should the government be involved in the economy, or shouldit leave the allocation of resources to the free market? So far, our information is mixed andincomplete. T o the extent that the perfectly competitive model reflects the way markets reallyoperate, there seem to be some clear advantages to the market system. When we relax the assump-tions and expand our discussion to include noncompetitive behavior, public goods, externalities,and the possibility of imperfect information, we see at least a potential role for government.
The market system may not provide participants with the incentive to weigh costs and
benefits and to operate efficiently. If there are no externalities or if such costs or benefits areproperly internalized, firms will weigh social benefits and costs in their production decisions.
Under these circumstances, the profit motive should provide competitive firms with an incentiveto minimize cost and to produce their products using the most efficient technologies. Likewise,competitive input markets should provide households with the incentive to weigh the value oftheir time against the social value of what they can produce in the labor force.
However, markets are far from perfect. Freely functioning markets in the real world do not
always produce an efficient allocation of resources, and this result provides a potential role for gov-ernment in the economy. Many have called for government involvement in the economy to correctfor market failure—that is, to help markets function more efficiently. As you will see, however,many believe that government involvement in the economy creates more inefficiency than it cures.
In addition, we have thus far discussed only the criterion of efficiency, but economic systems
and economic policies must be judged by many other criteria, not the least of which is equity ,o r
fairness. Indeed, some contend that the outcome of any free market is ultimately unfair becausesome become rich while others remain poor.
Part III, which follows, explores in greater depth the issue of market imperfections and gov-
ernment involvement in the economy.imperfect information The
absence of full knowledgeconcerning product
characteristics, available
prices, and so on.
SUMMARY
1.Both firms and households make simultaneous choices in
input and output markets. For example, input prices deter-mine output costs and affect firms’ output supply decisions.Wages in the labor market affect labor supply decisions,income, and ultimately the amount of output householdscan and do purchase.2.Ageneral equilibrium exists when all markets in an economy
are in simultaneous equilibrium. An event that disturbs theequilibrium in one market may disturb the equilibrium inmany other markets as well. Partial equilibrium analysis can
be misleading because it looks only at adjustments in oneisolated market.
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 265
MARKET ADJUSTMENT TO CHANGES IN DEMAND p. 254
3.General equilibrium is reached when equilibrium is estab-
lished in all markets.
ALLOCATIVE EFFICIENCY AND COMPETITIVE
EQUILIBRIUM p. 256
4.An efficient economy is one that produces the goods and ser-
vices that people want at the least possible cost. A change issaid to be efficient if it makes some members of society betteroff without making others worse off. An efficient, or Pareto
optimal , system is one in which no such changes are possible.
5.If a change makes some people better off and some people
worse off but it can be shown that the value of the gainsexceeds the value of the losses, the change is said to bepotentially efficient or simply efficient .
6.If all the assumptions of perfect competition hold, the result
is an efficient, or Pareto optimal, allocation of resources. T oprove this statement, it is necessary to show that resourcesare allocated efficiently among firms, that final products aredistributed efficiently among households, and that the sys-tem produces what people want.
7.The assumptions that factor markets are competitive andopen, that all firms pay the same prices for inputs, and thatall firms maximize profits lead to the conclusion that theallocation of resources among firms is efficient.
8.People have different tastes and preferences, and they buyvery different things in very different combinations. As longas everyone shops freely in the same markets, no redistribu-tion of outputs among people will make them better off.This leads to the conclusion that final products are distrib-uted efficiently among households.
9.Because perfectly competitive firms will produce as long asthe price of their product is greater than the marginal cost ofproduction, they will continue to produce as long as a gainfor society is possible. The market thus guarantees that theright things are produced. In other words, the perfectly com-
petitive system produces what people want.
THE SOURCES OF MARKET FAILURE p. 262
10. When the assumptions of perfect competition do not hold,the conclusion breaks down that free, unregulated marketswill produce an efficient allocation of resources.
11. An imperfectly competitive industry is one in which singlefirms have some control over price and competition. In allimperfectly competitive industries, output is lower and priceis higher than they would be in perfect competition. Imperfectcompetition is a major source of market inefficiency.
12. Public ,o r social ,goods bestow collective benefits on members
of society. Because the benefits of social goods are collective,people cannot, in most cases, be excluded from enjoyingthem. Thus, private firms usually do not find it profitable toproduce public goods. The need for public goods is thusanother source of inefficiency.
13. An externality is a cost or benefit that is imposed or
bestowed on an individual or a group that is outside, orexternal to, the transaction. If such social costs or benefitsare overlooked, the decisions of households or firms arelikely to be wrong or inefficient.
14. Market efficiency depends on the assumption that buyers haveperfect information on product quality and price and that firmshave perfect information on input quality and price. Imperfect
information can lead to wrong choices and inefficiency.
EVALUATING THE MARKET MECHANISM p. 264
15. Sources of market failure—such as imperfect markets, public
goods, externalities, and imperfect information—are consid-ered by many to justify the existence of government and gov-ernmental policies that seek to redistribute costs and incomeon the basis of efficiency, equity, or both.
efficiency, p. 254
externality, p. 263
general equilibrium, p. 254
imperfect information, p. 264market failure, p. 262
Pareto efficiency orPareto optimality, p. 256
partial equilibrium analysis, p. 254 public goods orsocial goods, p. 263
Key efficiency condition in perfect
competition: PX=MCXREVIEW TERMS AND CONCEPTS
1.Numerous times in history, the courts have issued consent
decrees requiring large companies to break up into smaller
competing companies for violating the antitrust laws. The twobest-known examples are American T elephone and T elegraph(AT&T) in the 1980s and Microsoft 20 years later. (AT&T wasbroken up into the “Baby Bells”; but the Microsoft breakup wassuccessfully appealed, and the breakup never occurred.)Many argue that breaking up a monopoly is a Pareto-efficient
change. This interpretation cannot be so because breaking up a
monopoly makes its owners (or shareholders) worse off. Do you
agree or disagree? Explain your answer.PROBLEMS
All problems are available on www.myeconlab.com
266 PART II The Market System: Choices Made by Households and Firms
2.[Related to the Economics in Practice onp. 257 ]The
Economics in Practice in this chapter describes the adjustment of
the corn and wheat markets to the massive U.S. subsidy given toethanol production. The subsidy drives up the prices of otheragricultural goods such as wheat and substantially raises thevalue of farmland. How would this story change if oil prices
were to rise extensively at the same time? if oil prices were to
fall? Trace these changes on the economy using supply anddemand curves.
3.For each of the following, tell a story about what is likely to hap-
pen in labor and capital markets using the model of the wholeeconomy that we developed over the first 11 chapters.a.A sharp drop in demand for automobiles raises the unem-
ployment rate in Flint, Michigan, and cuts into the profits oflocal gas stations where my nephew lost his job.
b.As the baby boomers age, many of them are moving back to
the city. They are also buying smaller units. This will have abig effect on owners of suburban homes who find theirhome values falling.
c.In 2007–2008, the mortgage markets crashed. This led to a
serious decline in the availability of credit to buyers who, a
couple of years ago, were able to borrow far more than
they needed.
4.A medium-sized bakery has just opened in Slovakia. A loaf of
bread is currently selling for 14 koruna (the Slovakian currency)
over and above the cost of intermediate goods (flour, yeast, andso on). Assuming that labor is the only variable factor of pro-duction, the following table gives the production function for
the bread.
WORKERS LOAVES OF BREAD
0 0
1 15
2 30
3 42
4 52
5 60
6 66
7 70
a.Suppose the current wage rate in Slovakia is 119 koruna per
hour. How many workers will the bakery employ?
b.Suppose the economy of Slovakia begins to grow, incomes
rise, and the price of a loaf of bread is pushed up to20 koruna. Assuming no increase in the price of labor, howmany workers will the bakery hire?
c.An increase in the demand for labor pushes up wages to
125 koruna per hour. What impact will this increase incost have on employment and output in the bakery at the20-koruna price of bread?
d.If all firms behaved like our bakery, would the allocation of
resources in Slovakia be efficient? Explain your answer.
5.Country A has soil that is suited to corn production and yields
135 bushels per acre. Country B has soil that is not suited for
corn and yields only 45 bushels per acre. Country A has soil
that is not suited for soybean production and yields 15 bushelsper acre. Country B has soil that is suited for soybeans andyields 35 bushels per acre. In 2004, there was no trade betweenA and B because of high taxes and both countries together pro-duced huge quantities of corn and soybeans. In 2005, taxeswere eliminated because of a new trade agreement. What is
likely to happen? Can you justify the trade agreement on the
basis of Pareto efficiency? Why or why not?
6.Do you agree or disagree with each of the following statements?
Explain your answer.
a.Housing is a public good and should be produced by the public
sector because private markets will fail to produce it efficiently.
b.Monopoly power is inefficient because large firms will pro-
duce too much product, dumping it on the market at artifi-
cially low prices.
c.Medical care is an example of a potentially inefficient market
because consumers do not have perfect information aboutthe product.
7.The point of scalping is to find someone who wants a ticket more
than the person who presently has it. Whenever two different pricesexist in a market, arbitrage opportunities (buy and then sell at ahigher price) are there. Professional scalpers buy up tickets whenthey are first offered to the public, while some buy them on the
street the night of the event. They can sell any ticket, even those in
short supply, at some price . When many people want to go to an
event that has a limited supply of tickets, the scalping price can bequite high. Go online and find scalping agencies like Stub-Hub andAce Tickets. See if you can find an event for which the scalpingprice is much higher than the original price. What determines
whether the event is worth the higher price?
It is argued that scalping is efficient. Explain that argument.
Others ask how could it be efficient “if only rich people can affordto go to most games?” Do you agree? Why or why not?
8.Which of the following are examples of Pareto-efficient
changes? Explain your answers.a.Cindy trades her laptop computer to Bob for his old car.
b.Competition is introduced into the electric industry, and
electricity rates drop. A study shows that benefits to con-sumers are larger than the lost monopoly profits.
c.A high tax on wool sweaters deters buyers. The tax is repealed.
d.A federal government agency is reformed, and costs are cut
23 percent with no loss of service quality.
9.A major source of chicken feed in the United States is
anchovies, small fish that can be scooped out of the ocean at
low cost. Every 7 years, when the anchovies disappear to
spawn, producers must turn to grain, which is more expensive,to feed their chickens. What is likely to happen to the cost ofchicken when the anchovies disappear? What are substitutesfor chicken? How are the markets for these substitutes
affected? Name some complements to chicken. How are the
markets for these complements affected? How might the allo-cation of farmland be changed as a result of the disappearanceof anchovies?
10.Suppose two passengers end up with a reservation for the last
seat on a train from San Francisco to Los Angeles. Two alterna-tives are proposed:a.T oss a coin
b.Sell the ticket to the highest bidder
Compare the two options from the standpoint of efficiency
and equity.
11.Assume that there are two sectors in an economy: goods ( G)
and services ( S). Both sectors are perfectly competitive, with
large numbers of firms and constant returns to scale. As income
rises, households spend a larger portion of their income on S
and a smaller portion on G. Using supply and demand curves
for both sectors and a diagram showing a representative firm in
CHAPTER 12 General Equilibrium and the Efficiency of Perfect Competition 267
each sector, explain what would happen to output and prices in
the short run and the long run in response to an increase in
income. (Assume that the increase in income causes demand forGto shift left and demand for Sto shift right.) In the long run,
what would happen to employment in the goods sector? in theservice sector? ( Hint: See Figure 12.2 on p. 261.)
12.Which of the following are actual Pareto-efficient changes?
Explain briefly.a.Y ou buy three oranges for $1 from a street vendor.
b.Y ou are near death from thirst in the desert and must pay a
passing vagabond $10,000 for a glass of water.
c.A mugger steals your wallet.
d.Y ou take a taxi ride in downtown Manhattan during rush hour.
13.Each instance that follows is an example of one of the four types
of market failure discussed in this chapter. In each case, identifythe type of market failure and defend your choice briefly.a.An auto repair shop convinces you that you need a $2,000
valve job when all you really need is an oil change.
b.Everyone in a neighborhood would benefit if an empty lot
were turned into a park, but no entrepreneur will come for-
ward to finance the transformation.
c.A bar opens next to your apartment building and plays loud
music on its patio every night until 4
A.M.
d.The only two airlines flying direct between St. Louis and
Atlanta make an agreement to raise their prices.
14.Two factories in the same town hire workers with the same
skills. Union agreements require factory A to pay its workers
$10 per hour, while factory B must pay $6 per hour. Each fac-tory hires the profit-maximizing number of workers. Is the allo-cation of labor between these two factories efficient? Explain
why or why not.15.Explain why resources are allocated efficiently among firms and
why output is distributed efficiently among households in per-fectly competitive markets.
16.Under what condition would society benefit from more of a
good being produced, and under what condition would societybenefit from less of a good being produced?
17.James lives on a cul-de-sac where he and all his neighbors park
on the street. After his car was vandalized, James decided toinstall motion-sensitive lighting on the front of his house. Nowany movement activates the lights, which shine across the entireparking area on the street. Explain why the installation of the
lights might lead to an inefficient outcome.
18.Briefly explain whether each of the following represents a pub-
lic good.
a.A chef salad sold at the cafeteria in the county courthouse
b.Palm trees planted along the median of the Pacific
Coast Highway
c.A Doppler radar station built at Chicago’s O’Hare
International Airport
d.A new roller coaster at Cedar Point, an amusement park in
Sandusky, Ohio
e.A new fleet of police cars for the Oklahoma City Police
Department
f.The Vietnam Memorial in Washington, D.C.
19.Explain the difference between a positive externality and a nega-
tive externality. Can both types of externalities result in marketfailure? Why or why not?
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PART III MARKET IMPERFECTIONS AND THE ROLE OF GOVERNMENT
CHAPTER OUTLINE
26913
Imperfect
Competition andMarket Power: CoreConcepts
p. 269
Forms of Imperfect
Competition and MarketBoundaries
Price and Output
Decisions in PureMonopolyMarkets
p. 271
Demand in Monopoly
Markets
Perfect Competition and
Monopoly Compared
Monopoly in the Long Run:
Barriers to Entry
The Social Costs of
Monopoly p. 281
Inefficiency and
Consumer Loss
Rent-Seeking Behavior
Price Discrimination
p. 283
Examples of Price
Discrimination
Remedies for
Monopoly: AntitrustPolicy
p. 285
Major Antitrust Legislation
Imperfect Markets: AReview and a LookAhead
p. 287In 1911 the U.S. Supreme Court found that Standard
Oil of New Jersey, the largest oil company in theUnited States, was a monopoly and ordered that it bedivided up. In 1999 a U.S. court similarly found thatMicrosoft had exercised monopoly power andordered it to change a series of its business practices.In 2010 the Federal Trade Commission—one of thegovernment agencies empowered to protectconsumers—argued that Google possessed monop-oly power and should also be restrained by the gov-ernment in its business practices. What do we mean by a monopoly, and why might the governmentand the courts try to control monopolists? Have our ideas on what constitutes a monopoly changedover time with new technology?
In earlier chapters, we described in some detail the workings and benefits of perfect
competition. Market competition among firms producing undifferentiated or homogeneousproducts limits the choices of firms. Firms decide how much to produce and how to pro-duce, but in setting prices, they look to the market. Moreover, because of entry and competi-tion, firms do no better than earn the opportunity cost of capital in the long run. For firmssuch as Google and Microsoft, economic decision making is richer and so is the potential forprofit making.
In the next three chapters, we explore markets in which competition is limited, either by the
fewness of firms or by product differentiation. After a brief discussion of market structure in gen-eral, this chapter will focus on monopoly markets. Chapter 14 will cover oligopolies, whileChapter 15 will deal with monopolistic competition.
Imperfect Competition and Market Power:
Core Concepts
In the competitive markets we have been studying all firms charge the same price. With many
firms producing identical or homogeneous products, consumers have many choices, and thosechoices constrain the pricing of individual firms. This same competition also means that firms inthe long run earn only a normal return on their capital. In imperfectly competitive markets, on
the other hand, the absence of numerous competitors or the existence of product differentiationcreates situations in which firms can at times raise their prices and not lose all their customers.These firms can be said to have market power . In these markets we may observe firms earning
excess profits, and we may see firms producing different variants of a product and charging dif-ferent prices for those variants. Studying these markets is especially interesting because we nowhave to think not only about pricing behavior, but also about how firms choose product qualityand type.
Monopoly and
Antitrust Policy
imperfectly competitive
industry An industry in
which individual firms have
some control over the price oftheir output.
market power An
imperfectly competitive firm’s
ability to raise price withoutlosing all of the quantitydemanded for its product.
270 PART III Market Imperfections and the Role of Government
Demand for beef 0 Price per unit ($)
Demand for meat 0 Price per unit ($)Demand for
Brand X hamburger0 Price per unit ($)
Demand for hamburger0 Price per unit ($)
Demand for food 0 Price per unit ($)/L50298FIGURE 13.1
The Boundary of a
Market and Elasticity
We can define an industry as
broadly or as narrowly as we like.The more broadly we define theindustry, the fewer substitutes
there are; thus, the less elastic
the demand for that industry’sproduct is likely to be. A monop-oly is an industry with one firm
that produces a product for
which there are no close substitutes .
The producer of Brand X ham-burger cannot properly be called
a monopolist because this pro-
ducer has no control over marketprice and there are many substi-tutes for Brand X hamburger.Forms of Imperfect Competition and Market Boundaries
Once we move away from perfectly competitive markets, with its assumption of many firms and
undifferentiated products, there is a range of other possible market structures. At one extremelies the monopoly. A monopoly is an industry with a single firm in which the entry of new firms
is blocked. An oligopoly is an industry in which there is a small number of firms, each large
enough so that its presence affects prices. Firms that differentiate their products in industrieswith many producers and free entry are called monopolistic competitors . We begin our discussion
in this chapter with monopoly.
What do we mean when we say that a monopoly firm is the only firm in the industry? In
practice, given the prevalence of branding, many firms, especially in the consumer products mar-kets, are alone in producing a specific product. Procter & Gamble (P&G), for example, is the onlyproducer of Ivory soap. Coca-Cola is the only producer of Coke Classic. And yet we would callneither firm monopolistic because for both, many other firms produce products that are close
substitutes . Instead of drinking Coke, we could drink Pepsi; instead of washing with Ivory, we
could wash with Dove. T o be meaningful, therefore, our definition of a monopolistic industrymust be more precise. We define a pure monopoly as an industry (1) with a single firm that pro-
duces a product for which there are no close substitutes and (2) in which significant barriers to
entry prevent other firms from entering the industry to compete for profits.
As we think about the issue of product substitutes and market power, it is useful to recall the
structure of the competitive market. Consider a firm producing an undifferentiated brand ofhamburger meat, Brand X hamburger. As we show in Figure 13.1 the demand this firm faces ishorizontal, perfectly elastic. The demand for hamburgers as a whole, however, likely slopes down.While there are substitutes for hamburgers, they are not perfect and some people will continue toconsume hamburgers even if they cost more than other foods. As we broaden the category we areconsidering, the substitution possibilities outside the category fall, and demand becomes quite
inelastic, as for example for food in general. If a firm were the only producer of Brand X ham-burger, it would have no market power: If it raised its price, people would just switch to Brand Zhamburger. A firm that produced all the hamburgers in the United States, on the other hand,might have some market power: It could perhaps charge more than other beef-product producersand still sell hamburgers. A firm that controlled all of the food in the United States would likelyhave substantial market power since we all must eat!
In practice, figuring out which products are close substitutes for one another to deter-
mine market power can be difficult. Are hamburgers and hot dogs close substitutes so that ahamburger monopoly would have little power to raise prices? Are debit cards and checks closepure monopoly An industry
with a single firm that producesa product for which there areno close substitutes and inwhich significant barriers to
entry prevent other firms fromentering the industry to
compete for profits.
CHAPTER 13 Monopoly and Antitrust Policy 271
substitutes for credit cards so that credit card firms have little market power? The courts in a
recent antitrust case said no. Is Microsoft a monopoly, or does it compete with Linux andApple for software users? These are questions that occupy considerable time for economists,lawyers, and the antitrust courts. The Economics in Practice on p. 287 discusses the antitrust
rules that pertain to the National Football League.
Price and Output Decisions in Pure
Monopoly Markets
Consider a market with a single firm producing a good for which there are few substitutes. How
does this profit-maximizing monopolist choose its output levels? At this point we assume themonopolist cannot price-discriminate. It sells its product to all demanders at the same price. ( Price
discrimination means selling to different consumers or groups of consumers at different prices and
will be discussed later in this chapter.)
Assume initially that our pure monopolist buys in competitive input markets. Even though
the firm is the only one producing for its product market, it is only one among many firms buy-ing factors of production in input markets. The local telephone company must hire labor like anyother firm. T o attract workers, the company must pay the market wage; to buy fiber-optic cable,it must pay the going price. In these input markets, the monopolistic firm is a price-taker.
On the cost side of the profit equation, a pure monopolist does not differ from a perfect
competitor. Both choose the technology that minimizes the cost of production. The cost curve ofeach represents the minimum cost of producing each level of output. The difference arises on therevenue, or demand, side of the equation, where we begin our analysis.
Demand in Monopoly Markets
A perfectly competitive firm, you will recall, can sell all it wants to sell at the market price. Thefirm is a small part of the market. The demand curve facing such a firm is thus a horizontal line.Raising the price of its product means losing all demand because perfect substitutes are available.The perfectly competitive firm has no incentive to charge a lower price either since it can sell all itwants at the market price.
A monopolist is different. It does not constitute a small part of the market; it isthe mar-
ket. The firm no longer looks at a market price to see what it can charge; it sets the marketprice. How does it do so? Even a firm that is a monopolist in its own market will neverthelesscompete with other firms in other markets for a consumer’s dollars. Even a monopolist thusloses some customers when it raises its price. The monopolist sets its price by looking at thetrade-off in terms of profit earned between getting more money for each unit sold versus sell-ing fewer units.
Shortly we will look at exactly how a monopolist thinks about this trade-off. But before
we become more formal, it is interesting to think about the business decisions of the com-petitive firm versus a monopolist. For a competitive firm, the market provides a lot of infor-mation; in effect, all the firm needs to do is figure out if, given its costs, it can make money atthe current market price. A monopolist needs to learn about the demand curve for its prod-uct. When the iPod first came out, Apple had to figure out how much individuals would bewilling to pay for this new product. What did its demand curve look like? Firms like Applehave quite sophisticated marketing departments that survey potential consumers, collect datafrom related markets, and even do a bit of trial and error to learn what their demand curvesreally look like.
Marginal Revenue and Market Demand We learned in Chapter 7 that the com-
petitive firm maximizes its profit by continuing to produce output so long as marginal rev-enue exceeds marginal cost. Under these conditions, incremental units add more to the plus,or revenue, side than they add to the minus, or cost, side. The same general rule is true for themonopolist: A monopolist too will maximize profits by expanding output so long as marginal
272 PART III Market Imperfections and the Role of Government
revenue exceeds marginal cost. The key difference in the two cases lies in the definition of
marginal revenue.
For a competitive firm marginal revenue is simply the price, as we discussed in Chapter 7.
Every unit that the firm sells, it sells at the going market price. The competitive firm is a verysmall part of the overall market, and its behavior has no effect on the overall market price. Sothe incremental or marginal revenue from each new unit sold is simply the price. In the case ofa monopolist, however, the monopolist is the market. If that firm decides to double its output,market output will double, and it is easy to see that the only way the firm will be able to sell twicethe output is to lower its price. The fact that a monopolist's output decisions influence marketprices means that price and marginal revenue will diverge. The simplest way to see this is via abit of arithmetic.
Consider the hypothetical demand schedule in Table 13.1. Column 3 lists the total revenue
that the monopoly would take in at different levels of output. If it were to produce 1 unit, thatunit would sell for $10, and total revenue would be $10. Two units would sell for $9 each, inwhich case total revenue would be $18. As column 4 shows, marginal revenue from the secondunit would be $8 ($18 minus $10). Notice that the marginal revenue from increasing output from1 unit to 2 units ($8) is lessthan the price of the second unit ($9).
TABLE 13.1 Marginal Revenue Facing a Monopolist
(1) (2) (3) (4)
Quantity Price Total Revenue Marginal Revenue
0 $11 0 —
1 10 $10 $10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0
7 4 28 -2
8 3 24 -4
9 2 18 -6
10 1 10 -8
Now consider what happens when the firm considers setting production at 4 units
instead of 3. The fourth unit would sell for $7, but because the firm cannot price discrimi-nate, it must sell all 4 units for $7 each. Had the firm chosen to produce only 3 units, it
could have sold those 3 units for $8 each. Thus, offsetting the revenue gain of $7 is a revenueloss of $3—that is, $1 for each of the 3 units that would have sold at the higher price. Themarginal revenue of the fourth unit is $7 minus $3, or $4, which is considerably below theprice of $7. (Remember, unlike a monopoly, a perfectly competitive firm does not have tocharge a lower price to sell more. Thus, P=MR in competition.) For a monopolist, an
increase in output involves not only producing more and selling it, but also reducing theoverall price of its output.
Marginal revenue can also be derived by looking at the change in total revenue as output
changes by 1 unit. At 3 units of output, total revenue is $24. At 4 units of output, total revenue is$28. Marginal revenue is the difference, or $4.
Moving from 6 to 7 units of output actually reduces total revenue for the firm. At 7 units,
marginal revenue is negative. Although it is true that the seventh unit will sell for a positiveprice ($4), the firm must sell all 7 units for $4 each (for a total revenue of $28). If output hadbeen restricted to 6 units, each would have sold for $5. Thus, offsetting the revenue gain of $4is a revenue loss of $6—that is, $1 for each of the 6 units that the firm would have sold at thehigher price. Increasing output from 6 to 7 units actually decreases revenue by $2. Figure 13.2
CHAPTER 13 Monopoly and Antitrust Policy 273
Demand
MR11
10
9
8
7
6
5
4
3
2
10
– 1
– 2
21
345 678 9
Units of out put, QPrice per unit ($)
/L50304FIGURE 13.2 Marginal Revenue Curve Facing a Monopolist
At every level of output except 1 unit, a monopolist’s marginal revenue ( MR) is below price. This is so
because (1) we assume that the monopolist must sell all its product at a single price (no price discrimina-
tion) and (2) to raise output and sell it, the firm must lower the price it charges. Selling the additional outputwill raise revenue, but this increase is offset somewhat by the lower price charged for all units sold. Therefore,the increase in revenue from increasing output by 1 (the marginal revenue) is less than the price.
1Recall from Chapter 4 that if the percentage change in Qis greater than the percentage change in Pas you move along a
demand curve, the absolute value of elasticity of demand is greater than 1. Thus, as we move along the demand curve inFigure 13.3 between point Aand point B, demand is elastic .graphs the marginal revenue schedule derived in Table 13.1. Notice that at every level of output
except 1 unit, marginal revenue is below price. Marginal revenue turns from positive to nega-
tive after 6 units of output. When the demand curve is a straight line, the marginal revenuecurve bisects the quantity axis between the origin and the point where the demand curve hitsthe quantity axis, as in Figure 13.3.
Look carefully at Figure 13.3. The marginal revenue curve shows the change in total revenue
that results as a firm moves along the segment of the demand curve that lies directly above it.Consider starting at a price in excess of point A per period in the top panel of Figure 13.3. Heretotal revenue (shown in the bottom panel) is zero because nothing is sold. T o begin selling, thefirm must lower the product price. Marginal revenue is positive, and total revenue begins toincrease. T o sell increasing quantities of the good, the firm must lower its price more and more.As output increases between zero and Q* and the firm moves down its demand curve from point A
to point B, marginal revenue remains positive and total revenue continues to increase. The quan-
tity of output ( Q) is rising, which tends to push total revenue ( P/H11003Q)up. At the same time, the
price of output ( P) is falling, which tends to push total revenue ( P/H11003Q)down . Up to point B, the
effect of increasing Qdominates the effect of falling Pand total revenue rises: Marginal revenue is
positive (above the quantity axis).
1
What happens as we look at output levels greater than Q*—that is, farther down the
demand curve from point Btoward point C? We are still lowering Pto sell more output, but at
levels greater than Q*, marginal revenue is negative, and total revenue in the bottom panel starts
to fall. Beyond Q*, the effect of cutting price on total revenue is larger than the effect of
274 PART III Market Imperfections and the Role of Government
Price per unit ($)
Marginal revenue
Units of output, QDemand
Total revenue+
0
– Q*CBA
=
0 Q*
Units of output, QTotal revenue ($)/L50298FIGURE 13.3
Marginal Revenue and
Total Revenue
A monopoly’s marginal revenue
curve bisects the quantity axis
between the origin and the pointwhere the demand curve hits thequantity axis. A monopoly’s MR
curve shows the change in total
revenue that results as a firmmoves along the segment of thedemand curve that lies exactly
above it.
2Beyond Q*, between points Band Con the demand curve in Figure 13.3, the decline in price must be bigger in percentage
terms than the increase in quantity. Thus, the absolute value of elasticity beyond point Bis less than 1: Demand is inelastic. At
point B, marginal revenue is zero; the decrease in Pexactly offsets the increase in Q, and elasticity is unitary or equal to -1.increasing quantity. As a result, total revenue ( P/H11003Q) falls. At point C, revenue once again is at
zero, this time because price has dropped to zero.2
The Monopolist’s Profit-Maximizing Price and Output We have spent much
time defining and explaining marginal revenue because it is an important factor in the monopo-list’s choice of profit-maximizing price and output. Figure 13.4 superimposes a demand curveand the marginal revenue curve derived from it over a set of cost curves. In determining price andoutput, a monopolistic firm must go through the same basic decision process that a competitivefirm goes through. Any profit-maximizing firm will raise its production as long as the added rev-enue from the increase outweighs the added cost. All firms, including monopolies, raise output aslong as marginal revenue is greater than marginal cost. Any positive difference between marginalrevenue and marginal cost can be thought of as marginal profit.
CHAPTER 13 Monopoly and Antitrust Policy 275
The optimal price/output combination for the monopolist in Figure 13.4 is Pm= $6 and
Qm= 5 units, the quantity at which the marginal revenue curve and the marginal cost curve
intersect. At any output below 5, marginal revenue is greater than marginal cost. At any outputabove 5, increasing output would reduce profits because marginal cost exceeds marginal rev-enue. This leads us to conclude that the profit-maximizing level of output for a monopolist isthe one at which marginal revenue equals marginal cost: MR =MC.
Because marginal revenue for a monopoly lies below the demand curve, the final price cho-
sen by the monopolist will be above marginal cost. ( P
m= $6.00 is greater than MC = $2.00.) At
5 units of output, price will be fixed at $6 (point Aon the demand curve), which is as much as the
market will bear, and total revenue will be Pm/H11003Qm= $6 /H110035 = $30 (area PmAQm0). T otal cost is
the product of average total cost and units of output, $4.50 /H110035 = $22.50 (area CBQm0). T otal
profit is the difference between total revenue and total cost, $30 -$22.50 = $7.50. In Figure 13.4,
total profit is the area of the gray rectangle PmABC .
Our discussion about the optimal output level for a monopolist points to a common mis-
conception. Even monopolists face constraints on the prices they can charge. Suppose a singlefirm controlled the production of bicycles. That firm would be able to charge more than could becharged in a competitive marketplace, but the power to raise prices has limits. As the bike pricerises, we will see more people buying inline skates or walking. A particularly interesting casecomes from monopolists who sell durable goods, goods that last for some period of time.Microsoft is the only producer for Windows, the operating system that dominates the personalcomputer (PC) market. But when Microsoft tries to sell a new version of that operating system(for example, Windows 7, which it introduced in 2010), its price is constrained by the fact thatmany of the potential consumers it seeks already have an old operating system. If the new price istoo high, consumers will stay with the older version. Some monopolists may face quite elasticdemand curves as a result of the characteristics of the product they sell.
The Absence of a Supply Curve in Monopoly In perfect competition, the supply
curve of a firm in the short run is the same as the portion of the firm’s marginal cost curve thatlies above the average variable cost curve. As the price of the good produced by the firm changes,the perfectly competitive firm simply moves up or down its marginal cost curve in choosing howmuch output to produce.
As you can see, however, Figure 13.4 contains nothing that we can point to and call a supply
curve. The amount of output that a monopolist produces depends on its marginal cost curve and
on the shape of the demand curve that it faces. In other words, the amount of output that amonopolist supplies is not independent of the shape of the demand curve. A monopoly firm hasno supply curve that is independent of the demand curve for its product.
T o see why, consider what a firm’s supply curve means. A supply curve shows the quantity of
output the firm is willing to supply at each price. If we ask a monopolist how much output she is0C
Qm= 5Pm= $6.00
ATC = $4.50
MC = $2.00A
B
Demand
MRATCMC
Units of output, QDollars ($)/L50296FIGURE 13.4 Price and
Output Choice for aProfit-MaximizingMonopolist
A profit-maximizing monopolist
will raise output as long as mar-
ginal revenue exceeds marginalcost. Maximum profit is at anoutput of 5 units per period and
a price of $6. Above 5 units of
output, marginal cost is greaterthan marginal revenue; increas-ing output beyond 5 units would
reduce profit. At 5 units, TR=
P
mAQm0,TC=CBQm0, and
profit = PmABC.
276 PART III Market Imperfections and the Role of Government
willing to supply at a given price, the monopolist will say that her supply behavior depends not
only on marginal cost but also on the marginal revenue associated with that price. T o know whatthat marginal revenue would be, the monopolist must know what her demand curve looks like.
In sum, in perfect competition, we can draw a firm’s supply curve without knowing anything
more than the firm’s marginal cost curve. The situation for a monopolist is more complicated: Amonopolist sets both price and quantity, and the amount of output that it supplies depends on itsmarginal cost curve and the demand curve that it faces.
Perfect Competition and Monopoly Compared
One way to understand monopoly is to compare equilibrium output and price in a perfectlycompetitive industry with the output and price that would be chosen if the same industry wereorganized as a monopoly. T o make this comparison meaningful, let us exclude from considera-tion any technological advantage that a single large firm might enjoy.
We begin our comparison with a perfectly competitive industry made up of a large number
of firms operating with a production technology that exhibits constant returns to scale in thelong run. (Recall that constant returns to scale means that average cost is the same whether the
firm operates one large plant or many small plants.) Figure 13.5 shows a perfectly competitiveindustry at long-run equilibrium, a condition in which price is equal to long-run average costsand in which there are no profits.
Suppose the industry were to fall under the control of a single price monopolist. The
monopolist now owns one firm with many plants. However, technology has not changed, onlythe location of decision-making power has. T o analyze the monopolist’s decisions, we mustderive the consolidated cost curves now facing the monopoly.
The marginal cost curve of the new monopoly will be the horizontal sum of the marginal
cost curves of the smaller firms, which are now branches of the larger firm. That is, to get thelarge firm’s MC curve, at each level of MC, we add together the output quantities from each sep-
arate plant. T o understand why, consider this simple example. Suppose there is perfect competi-tion and the industry is made up of just two small firms, A and B, each with upward-slopingmarginal cost curves. Suppose for firm A, MC = $5 at an output of 10,000 units and for firm B,
MC = $5 at an output of 20,000 units. If these firms were merged, what would be the marginal
cost of the 30,000th unit of output per period? The answer is $5 because the new larger firm
S
D
Q*= Sum of all
firm MC
curves
Units of output, Q0P*Price per unit ($)a. The industry b. A representative firm
MC
SRAC
LRAC
0P*
Units of output, qq*Price per unit ($)
/L50304FIGURE 13.5 A Perfectly Competitive Industry in Long-Run Equilibrium
In a perfectly competitive industry in the long run, price will be equal to long-run average cost. The market
supply curve is the sum of all the short-run marginal cost curves of the firms in the industry. Here weassume that firms are using a technology that exhibits constant returns to scale: LRAC is flat. Big firms
enjoy no cost advantage.
CHAPTER 13 Monopoly and Antitrust Policy 277
would produce 10,000 units in plant A and 20,000 in plant B. This means that the marginal cost
curve of the new firm is exactly the same curve as the supply curve in the industry when it was
competitively organized. (Recall from Chapter 9 that the industry supply curve in a perfectlycompetitive industry is the sum of the marginal cost curves [above average variable cost] of allthe individual firms in that industry.)
3
Figure 13.6 illustrates the cost curves, marginal revenue curve, and demand curve of the
consolidated monopoly industry. If the industry were competitively organized, total industryoutput would have been Q
c= 4,000 and price would have been Pc= $3. These price and output
decisions are determined by the intersection of the competitive supply curve, Sc, and the market
demand curve.
No longer faced with a price that it cannot influence, however, the monopolist can choose any
price/quantity combination along the demand curve. The output level that maximizes profits tothe monopolist is Q
m= 2,500—the point at which marginal revenue intersects marginal cost.
Output will be priced at Pm= $4. T o increase output beyond 2,500 units or to charge a price below
$4 (which represents the amount consumers are willing to pay) would reduce profit. Relative to aperfectly competitive industry, a monopolist restricts output, charges higher prices, and earns pos-itive profits. In the long run, the monopolist will close plants.
Also remember that all we did was transfer decision-making power from the individual small
firms to a consolidated owner. The new firm gains nothing technologically by being big.
Dollars ($)
Units of output, Q0 Qm = 2,500 Qc = 4,000Pm = $4
MRA
Pc= MCc = $3
MCm = $2
DemandATCSc = sum of firm MC curves = MCmonopoly
/L50304FIGURE 13.6 Comparison of Monopoly and Perfectly Competitive Outcomes
for a Firm with Constant Returns to Scale
In the newly organized monopoly, the marginal cost curve is the same as the supply curve that represented
the behavior of all the independent firms when the industry was organized competitively. Quantity producedby the monopoly will be less than the perfectly competitive level of output, and the monopoly price will be
higher than the price under perfect competition. Under monopoly, P=P
m= $4 and Q=Qm= 2,500. Under
perfect competition, P=Pc= $3 and Q=Qc= 4,000.
3The same logic will show that the average cost curve of the consolidated firm is the sum of the average cost curves of the indi-
vidual plants.Monopoly in the Long Run: Barriers to Entry
What will happen to a monopoly in the long run? Of course, it is possible for a monopolist to sufferlosses. Just because a firm is the only producer in a market does not guarantee that anyone will buy itsproduct. Monopolists can end up going out of business just like competitive firms. If, on the con-trary, the monopolist is earning positive profits (a rate of return above the normal return to capital),as in Figure 13.4, we would expect other firms to enter as they do in competitive markets. In fact,
278 PART III Market Imperfections and the Role of Government
many markets that end up competitive begin with an entrepreneurial idea and a short-lived monop-
oly position. In the mid-1970s, a California entrepreneur named Gary Dahl“invented”and marketedthe Pet Rock. Dahl had the market to himself for about 6 months, during which time he earned mil-lions before scores of competitors entered, driving down the price and profits. (In the end, this prod-uct, perhaps not surprisingly, disappeared). For a monopoly to persist, some factor or factors must
prevent entry . We turn now to a discussion of those factors, commonly termed barriers to entry .
Return for a moment to Figure 13.4 on p. 275. In that graph, we see that the monopolist is
earning a positive economic profit. Such profits can persist only if other firms cannot enter thisindustry and compete them away. The term barriers to entry is used to describe the set of factors
that prevent new firms from entering a market with excess profits. Monopoly can persist only inthe presence of entry barriers.
Economies of Scale In Chapter 9, we described production technologies in which average
costs fall with output increases. In situations in which those scale economies are very largerelative to the overall market, the cost advantages associated with size can give rise tomonopoly power.
Scale economies come in a number of different forms. Providing cable service requires laying
expensive cable; conventional telephones require the installation of poles and wires. For thesecases, there are clear cost advantages in having only one set of physical apparatuses. Once a firmhas laid the wire, providing service to one more customer is very inexpensive. The semiconductorindustry is another case in which production favors the large firms. In 2007, Intel, the world leaderin production of semiconductors for the PC, estimated that it would spend $6.2 billion for newproduction facilities and another $6 billion to support its research efforts to improve the speed ofits chips. For Intel, physical production and the importance of research favor the large firm.
In some cases, scale economies come from marketing and advertising. Breakfast cereal can be
produced efficiently on a small scale, for example; large-scale production does not reduce costs.However, to compete, a new firm would need an advertising campaign costing millions of dollars.The large front-end investment requirement in advertising is risky and likely to deter would-beentrants to the cereal market.
When scale economies are so large relative to the size of the market that costs are minimized
with only one firm in the industry, we have a natural monopoly .
Although Figure 13.7 presents an exaggerated picture, it does serve to illustrate our point.
One large-scale plant (Scale 2) can produce 500,000 units of output at an average unit cost of $1.If the industry were restructured into five firms, each producing on a smaller scale (Scale 1), theindustry could produce the same amount, but average unit cost would be five times as high ($5).Consumers potentially see a considerable gain when economies of scale are realized. The criticalpoint here is that for a natural monopoly to exist, economies of scale must be realized at a scalethat is close to total demand in the market.
ATCMC
LRAC
MC ATC
DemandScale 2
500,000 100,000 0$1$5$
Scale 1
Units of outputDollars ($)/L50298FIGURE 13.7
A Natural Monopoly
A natural monopoly is a firm in
which the most efficient scale is
very large. Here, average totalcost declines until a single firm isproducing nearly the entire
amount demanded in the mar-
ket. With one firm producing500,000 units, average total costis $1 per unit. With five firms
each producing 100,000 units,
average total cost is $5 per unit.natural monopoly An
industry that realizes such large
economies of scale in
producing its product thatsingle-firm production of that
good or service is most
efficient.barriers to entry Factors that
prevent new firms from
entering and competing inimperfectly competitiveindustries.
CHAPTER 13 Monopoly and Antitrust Policy 279
Notice in Figure 13.7 that the long-run average cost curve continues to decline until it almost
hits the market demand curve. If at a price of $1 market demand is 5 million units of output,
there would be no reason to have only one firm in the industry. T en firms could each produce500,000 units, and each could reap the full benefits of the available economies of scale.
Historically, natural monopolies in the United States have been regulated by the state. Public
utility commissions in each state monitor electric companies and locally operating telephonecompanies, regulating prices so that the benefits of scale economies are realized without the inef-ficiencies of monopoly power. The Economics in Practice on p. 280 describes the current debate
over the regulation of cable television.
Patents Patents are legal barriers that prevent entry into an industry by granting exclusive
use of the patented product or process to the inventor. Patents are issued in the United Statesunder the authority of Article I, Section 8, of the Constitution, which gives Congress the power to“promote the progress of science and the useful arts, by securing for limited times to authors andinventors the exclusive right to their respective writings and discoveries.” Patent protection in theUnited States is currently granted for a period of 20 years.
Patents provide an incentive for invention and innovation. New products and new processes
are developed through research undertaken by individual inventors and by firms. Researchrequires resources and time, which have opportunity costs. Without the protection that a patentprovides, the results of research would become available to the general public quickly. If researchdid not lead to expanded profits, less research would be done. On the negative side though,patents do serve as a barrier to competition and they slow down the benefits of research flowingthrough the market to consumers.
The expiration of patents after a given number of years represents an attempt to balance the
benefits of firms and the benefits of households: On the one hand, it is important to stimulateinvention and innovation; on the other hand, invention and innovation do society less goodwhen their benefits to the public are constrained.
4
In recent years, public attention has been focused on the high costs of health care. One factor con-
tributing to these costs is the high price of many prescription drugs. Equipped with newly developedtools of bioengineering, the pharmaceutical industry has been granted thousands of patents for newdrugs. When a new drug for treating a disease is developed, the patent holder can charge a high pricefor the drug. The drug companies argue that these rewards are justified by high research and develop-ment costs; others say that these profits are the result of a monopoly protected by the patent system.
Government Rules Patents provide one example of a government-enforced regulation
that creates monopoly. For patents, the justification for such intervention is to promote innova-tion. In some cases, governments impose entry restrictions on firms as a way of controlling activ-ity. In most parts of the United States, governments restrict the sale of alcohol. In fact, in somestates (Iowa, Maine, New Hampshire, and Ohio), liquor can be sold only through state-controlledand managed stores. Most states operate lotteries as monopolists. However, when largeeconomies of scale do not exist in an industry or when equity is not a concern, the arguments infavor of government-run monopolies are much weaker. One argument is that the state wants toprevent private parties from encouraging and profiting from “sin,” particularly in cases in whichsociety at large can be harmed. Another argument is that government monopolies are a conve-nient source of revenues.
Ownership of a Scarce Factor of Production Y ou cannot enter the diamond-
producing business unless you own a diamond mine. There are not many diamond mines in theworld, and most are already owned by a single firm, the DeBeers Company of South Africa. Atone time, the Aluminum Company of America (now Alcoa) owned or controlled virtually100 percent of the known bauxite deposits in the world and until the 1940s monopolized the pro-duction and distribution of aluminum. Obviously, if production requires a particular input andone firm owns the entire supply of that input, that firm will control the industry. Ownershipalone is a barrier to entry.
4Another alternative is licensing . With licensing, the new technology is used by all producers and the inventor splits the benefits with
consumers. Because forcing the non-patent-holding producers to use an inefficient technology results in waste, some analysts haveproposed adding mandatory licensing to the current patent system. A key question here involves determining the right licensing f ee.patent A barrier to entry that
grants exclusive use of thepatented product or process to
the inventor.
ECONOMICS IN PRACTICE
Managing the Cable Monopoly
Many people subscribe to cable television. Cable systems bundle a col-
lection of network and cable stations and offer them to viewers as
packages, ranging from a basic service with only a modest number ofofferings to much-expanded premium services. In the last 20 years,the cable system has grown to a multibillion dollar industry coveringmost of the country.
What you might not realize about the cable system is that it con-
sists of a network of local monopolies. In any given area, typicallyjust one cable company is in operation. Historically, this monopolywas justified as a natural monopoly, reflecting the expensive cablethat needed to be laid to serve the population and the fact that once
the cable was laid, the costs of providing service to a new consumer
was modest.
What you also may not realize is that when you pay your cable
bill, part of your payment goes to your home city. In fact, cities nego-tiate with the various cable companies to give one of them the rightto be the monopoly supplier of cable service in return for a fee that is
typically on the order of 5 percent of the cable revenues. Once a firm
has bought the right to be a local cable company, it must follow a setof rules, particularly with regard to the availability and price of thebasic cable.
One of the hot debates in 2008 was in the cable industry. Cable
companies offer programs bundled rather than à la carte programs.
Keith Martin, the commissioner of the Federal CommunicationsCommission, which oversees cable, pushed to have cable unbun-dled, largely in response to parents who were concerned about
inappropriate television shows coming into their homes as part of a
bundle. What economic logic would justify bundling programs inthis way?
Here it is helpful to think about costs again. Once a television
show is produced, distributing it to another customer has a zero
marginal cost up to the capacity level of the cable. Thus, from a
cable company’s point of view, having a large customer base forthe various shows is typically a profitable strategy. Suppose100 viewers valued doctor shows at $2 a week each and lawyer
shows at $1.50 each, while another 100 viewers had the oppositepreference. T o maximize revenue with à la carte pricing, the cable
company would charge $1.50 for each show, giving it 200 viewers
per show for a revenue of $600 (200 viewers /H110032 shows each
/H11003$1.50). If the cable company sells the bundle for $3.50, all view-
ers buy and it earns $700. If the cable company sells the bundle for
$3, its revenue is still the original $600 but now all of its customers
are better off and can watch two programs instead of one. Whenthe cost of distributing a good with high fixed costs is zero,bundling is often a way to make both producers and consumersbetter off.280 PART III Market Imperfections and the Role of Government
network externalities
The value of a product to aconsumer increases with the
number of that product being
sold or used in the market.
Network Effects How much value do you get from a telephone or a fax machine? It
will depend on how many other people own a machine that can communicate with yours.Products such as these, in which benefits of ownership are a function of how many otherpeople are part of the network, are subject to network externalities . For phones and faxes,
the network effects are direct. For products such as the Windows operating system and theXbox, network effects may be indirect. Having a large consumer base increases consumervaluation by encouraging the development of complementary goods. When many peopleown an Xbox, game developers have an incentive to create games for the system. Good gamesincrease the value of the system. In the case of online interactive games like Zygna’sFarmville, some observers have argued that the size of the playing community creates largenetwork effects.
How does the existence of network effects create a barrier to entry? In this situation, a firm
that starts early and builds a large product base will have an advantage over a newcomer.Microsoft’s dominant position in the operating system market reflects network effects in thisbusiness. The high concentration in the game console market (Microsoft, Nintendo, and Sonycontrol this market) also comes from network effects.
CHAPTER 13 Monopoly and Antitrust Policy 281
The Social Costs of Monopoly
So far, we have seen that a monopoly produces less output and charges a higher price than a com-
petitively organized industry if no large economies of scale exist for the monopoly. We have alsoseen the way in which barriers to entry can allow monopolists to persist over time. Y ou are prob-ably thinking at this point that producing less and charging more to earn positive profits is notlikely to be in the best interests of consumers, and you are right.
Inefficiency and Consumer Loss
In Chapter 12, we argued that price must equal marginal cost ( P = MC ) for markets to produce
what people want. This argument rests on two propositions: (1) that price provides a goodapproximation of the social value of a unit of output and (2) that marginal cost, in the absence ofexternalities (costs or benefits to external parties not weighed by firms), provides a good approx-imation of the product’s social opportunity cost. In a pure monopoly, price is above the productmarginal cost. When this happens, the firm is underproducing from society’s point of view.Society would be better off if the firm produced more and charged a lower price. Monopoly leadsto an inefficient mix of output.
A slightly simplified version of the monopoly diagram appears in Figure 13.8, which shows
how we might make a rough estimate of the size of the loss to social welfare that arises frommonopoly. (For clarity, we will ignore the short-run cost curves and assume constant returns toscale in the long run.) Under competitive conditions, firms would produce output up to Q
c=
4,000 units and price would ultimately settle at Pc= $2, equal to long-run average cost. Any price
above $2 will mean positive profits, which would be eliminated by the entry of new competingfirms in the long run. (Y ou should remember all this from Chapter 9.)
A monopoly firm in the same industry, however, would produce only Q
m= 2,000 units per
period and charge a price of Pm= $4 because MR =MC atQm= 2,000 units. The monopoly
would make a profit equal to total revenue minus total cost, or Pm/H11003Qmminus ATC /H11003Qm. Profit
D
A
B
C
Qc = 4,000 Qm= 2,000 0Pm = $4.00$6.00
= $2.00Pc= MC
MC = ATC
Demand
MR
Units of output, QDollars ($)
/L50304FIGURE 13.8 Welfare Loss from Monopoly
A demand curve shows the amounts that people are willing to pay at each potential level of output.
Thus, the demand curve can be used to approximate the benefits to the consumer of raising output
above 2,000 units. MCreflects the marginal cost of the resources needed. The triangle ABC roughly
measures the net social gain of moving from 2,000 units to 4,000 units (or the loss that results whenmonopoly decreases output from 4,000 units to 2,000 units).
282 PART III Market Imperfections and the Role of Government
to the monopoly is thus equal to the area PmACPc, or $4,000. [($4 /H110032,000) -($2/H110032,000) =
$8,000 -$4,000 = $4,000. Remember that Pc=ATC in this example.]
Now consider the gains and losses associated with increasing price from $2 to $4 and cutting
output from 4,000 units to 2,000 units. As you might guess, the winner will be the monopolistand the loser will be the consumer, but let us see how it works out.
At P
c= $2, the price under perfect competition, there are no profits. Consumers are paying a
price of $2, but the demand curve shows that many are willing to pay more than that. For exam-ple, a substantial number of people would pay $4 or more. Those people willing to pay more than$2 are receiving what we earlier called a consumer surplus . Consumer surplus is the difference
between what households are willing to pay for a product and the current market price. Thedemand curve shows approximately how much households are willing to pay at each level of out-put. Thus, the area of triangle DBP
cgives us a rough measure of the “consumer surplus” being
enjoyed by households when the price is $2. Consumers willing to pay exactly $4 get a surplusequal to $2. Those who place the highest value on this good—that is, those who are willing to paythe most ($6)—get a surplus equal to DP
c, or $4.
Now the industry is reorganized as a monopoly that cuts output to 2,000 units and raises price
to $4. The big winner is the monopolist, who ends up earning profits equal to $4,000. The big losersare the consumers. Their “surplus” now shrinks from the area of triangle DBP
cto the area of triangle
DAPm. Part of that loss (which is equal to DBPc–DAPm, or the area PmABPc) is covered by the
monopolist’s gain of PmACPc, but not all of it. The loss to consumers exceeds the gain to the monop-
oly by the area of triangle ABC (PmABPc–PmACPc), which roughly measures the net loss in social
welfare associated with monopoly power in this industry. Because the area of a triangle is half its basetimes its height, the welfare loss is 1/2 /H110032,000 /H11003$2 = $2,000. If we could push price back down to the
competitive level and increase output to 4,000 units, consumers would gain more than the monopo-list would lose and the gain in social welfare would approximate the area of ABC , or $2,000.
In this example, the presence of a monopoly also causes an important change in the distrib-
ution of real income. In Figure 13.8, area P
mACPcis a profit of $4,000 flowing every period to the
monopolist. If price were pushed down to $2 by competition or regulation, those profits wouldpass to consumers in the form of lower prices. Society may value this resource transfer on equitygrounds in addition to efficiency grounds.
Of course, monopolies may have social costs that do not show up on these graphs.
Monopolies, which are protected from competition by barriers to entry, may not face thesame pressures to cut costs and innovate as competitive firms do. A competitive firm thatdoes not use the most efficient technology will be driven out of business by firms that do.One of the significant arguments against tariffs and quotas to protect such industries as auto-mobiles and steel from foreign competition is that protection lessens the incentive to be effi-cient and competitive.
Rent-Seeking Behavior
Economists have another concern about monopolies. Triangle ABC in Figure 13.8 represents a
real net loss to society, but part of rectangle PmACPc(the $4,000 monopoly profit) may also end
up lost. T o understand why, we need to think about the incentives facing potential monopolists.
The area of rectangle PmACPcshows positive profits. If entry into the market were easy and
competition were open, these profits would eventually be competed to zero. Owners of businessesearning profits have an incentive to prevent this development. In fact, the graph shows how muchthey would be willing to pay to prevent it. A rational owner of a monopoly firm would be willingto pay any amount less than the entire rectangle. Any portion of profits left over after expenses isbetter than zero, which would be the case if free competition eliminated all profits.
Potential monopolists can do many things to protect their profits. One obvious approach is to
push the government to impose restrictions on competition. A classic example is the behavior oftaxicab driver organizations in New Y ork and other large cities. T o operate a cab legally in New Y orkCity, you need a license. The city tightly controls the number of licenses available. If entry into thetaxi business were open, competition would hold down cab fares to the cost of operating cabs.However, cab drivers have become a powerful lobbying force and have muscled the city into restrict-ing the number of licenses issued. This restriction keeps fares high and preserves monopoly profits.
CHAPTER 13 Monopoly and Antitrust Policy 283
There are countless other examples. The steel industry and the automobile industry spend
large sums lobbying Congress for tariff protection.5Some experts claim that establishment of
the now-defunct Civil Aeronautics Board in 1937 to control competition in the airline industryand extensive regulation of trucking by the I.C.C. prior to deregulation in the 1970s came aboutpartly through industry efforts to restrict competition and preserve profits.
This kind of behavior, in which households or firms take action to preserve positive profits,
is called rent-seeking behavior . Recall from Chapter 10 that rent is the return to a factor of pro-
duction in strictly limited supply. Rent-seeking behavior has two important implications.
First, this behavior consumes resources. Lobbying and building barriers to entry are not
costless activities. Lobbyists’ wages, expenses of the regulatory bureaucracy, and the like must bepaid. Periodically faced with the prospect that the city of New Y ork will issue new taxi licenses,cab owners and drivers have become so well organized that they can bring the city to a standstillwith a strike or even a limited job action. Indeed, positive profits may be completely consumedthrough rent-seeking behavior that produces nothing of social value; all it does is help to preservethe current distribution of income.
Second, the frequency of rent-seeking behavior leads us to another view of government. So
far, we have considered only the role that government might play in helping to achieve an effi-cient allocation of resources in the face of market failure—in this case, failures that arise fromimperfect market structure. Later in this chapter we survey the measures government might taketo ensure that resources are efficiently allocated when monopoly power arises. However, the ideaof rent-seeking behavior introduces the notion of government failure , in which the govern-
ment becomes the tool of the rent seeker and the allocation of resources is made even less effi-cient than before.
This idea of government failure is at the center of public choice theory , which holds that
governments are made up of people, just as business firms are. These people—politicians andbureaucrats—can be expected to act in their own self-interest, just as owners of firms do. We turnto the economics of public choice in Chapter 16.
Price Discrimination
So far in our discussion of monopoly, we have assumed that the firm faces a known downward-sloping demand curve and must choose a single price and a single quantity of output. Indeed, the
reason that price and marginal revenue are different for a monopoly and the same for a perfectlycompetitive firm is that if a monopoly decides to sell more output, it must lower price in orderto do so.
In the real world, however, there are many examples of firms that charge different prices to dif-
ferent groups of buyers. Charging different prices to different buyers is called price discrimination .
The motivation for price discrimination is fairly obvious: If a firm can identify those who are will-ing to pay a higher price for a good, it can earn more profit from them by charging a higher price.The idea is best illustrated using the extreme case where a firm knows what each buyer is willing topay. A firm that charges the maximum amount that buyers are willing to pay for each unit is prac-ticing perfect price discrimination .
Figure 13.9 is similar to Figure 13.8. For simplicity, assume a firm with a constant marginal
cost equal to $2 per unit. A non-price-discriminating monopolist would have to set one and onlyone price. That firm would face the marginal revenue curve shown in the diagram and wouldproduce as long as MRis above MC: Output would be Q
m, and price would be set at $4 per unit.
The firm would earn an economic profit of $2 per unit for every unit up to Qm. Consumers
would enjoy a consumer surplus equal to the shaded area. Consumer A, for example, is willing topay $5.75 but has to pay only $4.00.
Now consider what would happen if the firm could charge each consumer the maximum
amount that that consumer was willing to pay. In Figure 13.9(a), if the firm could charge con-sumer A a price of $5.75, the firm would earn $3.75 in profit on that unit and the consumerwould get no consumer surplus. Going on to consumer B, if the firm could determine B’srent-seeking behavior
Actions taken by households orfirms to preserve positive profits.
5A tariff is a tax on imports designed to give a price advantage to domestic producers.government failure Occurs
when the government becomesthe tool of the rent seeker and
the allocation of resources is
made even less efficient by theintervention of government.
public choice theory An
economic theory that the public
officials who set economicpolicies and regulate the playersact in their own self-interest,
just as firms do.
price discrimination
Charging different prices to
different buyers.
perfect price discrimination
Occurs when a firm charges
the maximum amount thatbuyers are willing to pay for
each unit.
284 PART III Market Imperfections and the Role of Government
maximum willingness to pay and charge $5.50, profit would be $3.50 and consumer surplus for B
would again be zero. This would continue all the way to point Con the demand curve, where total
profit would be equal to the entire area under the demand curve and above the MC =ATC line, as
shown in Figure 13.9(b).
Another way to look at the diagram in Figure 13.9(b) is to notice that the demand curve
actually becomes the same as the marginal revenue curve. When a firm can charge the maximumthat anyone is willing to pay for each unit , that price ismarginal revenue. There is no need to draw
a separate MR curve as there was when the firm could charge only one price to all consumers.
Once again, profit is the entire shaded area and consumer surplus is zero.
It is interesting to note that a perfectly price-discriminating monopolist will actually pro-
duce the efficient quantity of output— Q
cin Figure 13.9(b), which is the same as the amount that
would be produced had the industry been perfectly competitive. The firm will continue to pro-duce as long as benefits to consumers exceed marginal cost; it does not stop at Q
min
Figure 13.9(a). But when a monopolist can perfectly price discriminate, it reaps all the netbenefits from higher production. There is no deadweight loss, but there is no consumersurplus either.A
B
Qc = 4,000 Qm= 2,000 0$2.00$4.00a.Consumer surplus if the firm
charges a single price of $4 per unit.$6.00
$5.75
$5.50
MC = ATC
DemandDollars ($)
MR
Units of output, QC
Qc = 4,000MC = $2.00b.Profit for a perfectly price-
discriminating monopolist.$6.00
MC = ATC
Demand = MRDollars ($)
Units of output, QC
0/L50298FIGURE 13.9
Price Discrimination
In Figure 13.9(a), consumer A is
willing to pay $5.75. If the price-
discriminating firm can charge
$5.75 to A, profit is $3.75. Amonopolist who cannot pricediscriminate would maximizeprofit by charging $4. At a price
of $4.00, the firm makes $2.00 in
profit and consumer A enjoys aconsumer surplus of $1.75. InFigure 13.9(b), for a perfectly
price-discriminating monopolist,
the demand curve is the same asmarginal revenue. The firm willproduce as long as MR>MC, up
toQ
c. At Qc, profit is the entire
shaded area and consumer sur-
plus is zero.
CHAPTER 13 Monopoly and Antitrust Policy 285
Examples of Price Discrimination
Examples of price discrimination are all around us. It used to be that airlines routinely charged
those who stayed over Saturday nights a much lower fare than those who did not. Business trav-elers generally travel during the week, often are unwilling to stay over Saturdays, and generally arewilling to pay more for tickets.
Airlines, movie theaters, hotels, and many other industries routinely charge a lower price for
children and the elderly. The reason is that children and the elderly generally have a lower willing-ness to pay. T elephone companies have so many ways of targeting different groups that it is diffi-cult to know what they are really charging.
In each case, the objective of the firm is to segment the market into different identifiable
groups, with each group having a different elasticity of demand. Doing so requires firms to ensurethat different customers are kept separated, so that they cannot trade with one another. It can beshown, although we will not present the analysis here, that the optimal strategy for a firm that cansell in more than one market is to charge higher prices in markets with low demand elasticities.
Remedies for Monopoly: Antitrust Policy
As we have just seen, the exercise of monopoly power can bring with it considerable social costs.On the other hand, as our discussion of entry barriers suggested, at times, monopolies may bringwith them benefits associated with scale economies or innovation gains. Sometimes monopoliesresult from the natural interplay of market and technological forces, while at other times firmsactively and aggressively pursue monopoly power, doing their best to eliminate the competition.In the United States, the rules set out in terms of what firms can and cannot do in their marketsare contained in two pieces of antitrust legislation: the Sherman Act passed in 1890 and theClayton Act passed in 1914.
Major Antitrust Legislation
The following are some of the major antitrust legislation that have been passed in the United States.
The Sherman Act of 1890 The substance of the Sherman Act is contained in two
short sections:
Section 1 . Every contract, combination in the form of trust or otherwise, or conspiracy,
in restraint of trade or commerce among the several States, or with foreign nations, ishereby declared to be illegal….Section 2 . Every person who shall monopolize, or attempt to monopolize, or combine or
conspire with any other person or persons, to monopolize any part of the trade or com-merce among the several States, or with foreign nations, shall be deemed guilty of a mis-demeanor, and, on conviction thereof, shall be punished by fine not exceeding fivethousand dollars, or by imprisonment not exceeding one year, or by both said punish-ments, in the discretion of the court.
For our treatment of monopoly, the relevant part of the Sherman Act is Section 2, the rule
against monopolization or attempted monopolization. The language of the act is quite broad, soit is the responsibility of the courts to judge conduct that is legal and conduct that is illegal. As afirm competes in the hopes of winning business, what kind of behavior is acceptable hard compe-tition and what is not? Two different administrative bodies have the responsibility for initiatingactions on behalf of the U.S. government against individuals or companies thought to be in viola-tion of the antitrust laws. These agencies are the Antitrust Division of the Justice Department andthe Federal Trade Commission (FTC). In addition, private citizens can initiate antitrust actions.
In 1911, two major antitrust cases were decided by the Supreme Court. The two companies
involved, Standard Oil and American T obacco, seemed to epitomize the textbook definition ofmonopoly, and both appeared to exhibit the structure and the conduct outlawed by the ShermanAct. Standard Oil controlled about 91 percent of the refining industry, and although the exact figure
286 PART III Market Imperfections and the Role of Government
is still disputed, the American T obacco Trust probably controlled between 75 percent and 90 percent
of the market for all tobacco products except cigars. Both companies had used tough tactics to swal-low up competition or to drive it out of business. Not surprisingly, the Supreme Court found bothfirms guilty of violating Sections 1 and 2 of the Sherman Act and ordered their dissolution.
6
The Court made clear, however, that the Sherman Act did not outlaw every action that
seemed to restrain trade, only those that were “unreasonable.” In enunciating this rule of reason ,
the Court seemed to say that structure alone was not a criterion for unreasonableness. Thus, itwas possible for a near-monopoly not to violate the Sherman Act as long as it had won its marketusing “reasonable” tactics.
Subsequent court cases confirmed that a firm could be convicted of violating the Sherman Act
only if it had exhibited unreasonable conduct . Between 1911 and 1920, cases were brought against
Eastman Kodak, International Harvester, United Shoe Machinery, and United States Steel. The firstthree companies controlled overwhelming shares of their respective markets, and the fourth con-trolled 60 percent of the country’s capacity to produce steel. Nonetheless, all four cases were dis-missed on the grounds that these companies had shown no evidence of “unreasonable conduct.”
New technologies have also created challenges for the courts in defining reasonable con-
duct. Perhaps the largest antitrust case recently has been the case launched by the U.S.Department of Justice against Microsoft. By the 1990s, Microsoft had more that 90 percent ofthe market in operating systems for PCs. The government argued that Microsoft had achievedthis market share through illegal dealing, while Microsoft argued that the government failedto understand the issues associated with competition in a market with network externalitiesand dynamic competition. In the end, the case was settled with a consent decree in July 1994. A
consent decree is a formal agreement between a prosecuting government and defendants thatmust be approved by the courts. Such decrees can be signed before, during, or after a trial andare often used to save litigation costs. In the case of Microsoft, under the consent decree, itagreed to give computer manufacturers more freedom to install software from other softwarecompanies. In 1997, Microsoft found itself charged with violating the terms of the consentdecree and was back in court. In 2000, the company was found guilty of violating the antitrustlaws and a judge ordered it split into two companies. But Microsoft appealed; and the decisionto split the company was replaced with a consent decree requiring Microsoft to behave morecompetitively, including a provision that computer makers would have the ability to sell com-petitors’ software without fear of retaliation. In the fall of 2005, Microsoft finally ended itsantitrust troubles in the United States after agreeing to pay RealNetworks $761 million to set-tle one final lawsuit.
In 2005, Advanced Micro Devices (AMD) brought suit against Intel, which has an 80 per-
cent share of the x-86 processors used in most of the world’s PCs. AMD alleged anticompeti-tive behavior and attempted monopolization. At present in the United States, privateantitrust cases, brought by one firm against another, are 20-plus times more common thangovernment-led cases.
The Clayton Act and the Federal Trade Commission, 1914 Designed to
strengthen the Sherman Act and to clarify the rule of reason, the Clayton Act of 1914 outlawed
a number of specific practices. First, it made tying contracts illegal. Such contracts force a cus-
tomer to buy one product to obtain another. Second, it limited mergers that would “substan-tially lessen competition or tend to create a monopoly.” Third, it banned price
discrimination —charging different customers different prices for reasons other than changes in
cost or matching competitors’ prices.
TheFederal Trade Commission (FTC) , created by Congress in 1914, was established to
investigate “the organization, business conduct, practices, and management” of companies thatengage in interstate commerce. At the same time, the act establishing the commission addedanother vaguely worded prohibition to the books: “Unfair methods of competition in commerceare hereby declared unlawful.” The determination of what constituted “unfair” behavior was leftup to the commission. The FTC was also given the power to issue “cease-and-desist orders” whereit found behavior in violation of the law.rule of reason The criterion
introduced by the SupremeCourt in 1911 to determine
whether a particular action
was illegal (“unreasonable”) orlegal (“reasonable”) within the
terms of the Sherman Act.
6United States v. Standard Oil Co. of New Jersey , 221 U.S. 1 (1911); United States v. American Tobacco Co. , 221 U.S. 106 (1911).Clayton Act Passed by
Congress in 1914 to strengthen
the Sherman Act and clarify therule of reason, the actoutlawed specific monopolistic
behaviors such as tying
contracts, price discrimination,and unlimited mergers.
Federal Trade Commission
(FTC) A federal regulatory
group created by Congress in
1914 to investigate the structureand behavior of firms engaging
in interstate commerce, to
determine what constitutesunlawful “unfair” behavior, andto issue cease-and-desist ordersto those found in violation ofantitrust law.
ECONOMICS IN PRACTICE
Antitrust Rules Cover the NFL
Most people recognize that a sports league like the National Football
League is big business, but not everyone realizes that it is subject to
antitrust laws. But, as the article below indicates, one of the biggest
cases facing the Supreme Court in 2009–2010 involved the NFL.
The NFL’s practice had been to negotiate as a single unit with
apparel companies that wished to sell apparel like hats and T-shirtswith football logos. Of course this meant that apparel companies
could not play the New Y ork Giants against the Indianapolis Colts in
signing deals. American Needle, a large apparel company, sued. In itsdefense, the NFL argued that in its negotiations with companies likeReebok and American Needle, it faced competition from baseball andbasketball leagues that kept it from extracting too high a price for itslogos. In essence, the NFL argued that in the sports-logo hat market a
New Y ork Y ankees hat was a pretty good substitute for a New Y ork
Giants hat. The court saw it differently.
American Needle: High Court Delivers 9–0
Shutout Against NFL
The Wall Street Journal
Wow. Turns out the big antitrust case of the 2009–2010
Supreme Court term, American Needle v. NFL, didn’t provide
much of a matchup.
American Needle clobbered the league, in a unanimous
9-0 decision penned by Justice John Paul Stevens. We hadno dissents and no concurrences. This was an unadulterated
blowout. This was the 1940 NFL Championship game; the
1986 Super Bowl.
The case pitted American Needle, Inc., an apparel manu-
facturer, against the NFL. The dispute started back in 2000when the NFL signed an exclusive apparel licensing deal with
Reebok International, now a unit of Adidas AG.
American Needle, which had individual licensing deals
with NFL teams, sued, arguing the NFL’s exclusive dealwith Reebok violated antitrust rules. The NFL argued that
it is a single entity with 32 teams that compete with each other in football but not in business, where the teamscollectively compete with other sports and forms of enter-
tainment. American Needle countered by arguing that
the league was actually a collection of 32 independententities—i.e., all the teams.
The Seventh Circuit in 2008 ruled for the NFL, prompting
the appeal.
The Supreme Court on Monday essentially ruled that the
NFL is composed of 32 separate business entities.
Source: The Wall Street Journal , from “American Needle: High Court
Delivers 9–0 Shutout Against NFL” by Ashby Jones. Copyright 2010 by Dow
Jones & Company ,Inc. Reproduced with permission of Dow Jones &
Company ,Inc. via Copyright Clearance Center.CHAPTER 13 Monopoly and Antitrust Policy 287
Imperfect Markets: A Review and a
Look Ahead
A firm has market power when it exercises some control over the price of its output or the prices
of the inputs that it uses. The extreme case of a firm with market power is the pure monopolist.In a pure monopoly, a single firm produces a product for which there are no close substitutes inan industry in which all new competitors are barred from entry.
Our focus in this chapter on pure monopoly (which occurs rarely) has served a number
of purposes. First, the monopoly model describes a number of industries quite well. Second,the monopoly case illustrates the observation that imperfect competition leads to aninefficient allocation of resources. Finally, the analysis of pure monopoly offers insights into the more commonly encountered market models of monopolistic competition and
oligopoly, which we discussed briefly in this chapter and will discuss in detail in the next two chapters.Nonetheless, the legislation of 1914 retained the focus on conduct ; thus, the rule of reason
remained central to all antitrust action in the courts.
288 PART III Market Imperfections and the Role of Government
SUMMARY
1.A number of assumptions underlie the logic of perfect com-
petition. Among them: (1) A large number of firms andhouseholds are interacting in each market; (2) firms in agiven market produce undifferentiated, or homogeneous,products; and (3) new firms are free to enter industries andcompete for profits. The first two imply that firms have nocontrol over input prices or output prices; the third impliesthat opportunities for positive profit are eliminated in thelong run.
IMPERFECT COMPETITION AND MARKET POWER:
CORE CONCEPTS p. 269
2.A market in which individual firms have some control over
price is imperfectly competitive. Such firms exercise market
power . The three forms of imperfect competition are monop-
oly, oligopoly, and monopolistic competition.
3.Apure monopoly is an industry with a single firm that pro-
duces a product for which there are no close substitutes andin which there are significant barriers to entry .
4.Market power means that firms must make four decisions
instead of three: (1) how much to produce, (2) how to pro-duce it, (3) how much to demand in each input market, and(4)what price to charge for their output .
5.Market power does not imply that a monopolist can charge
any price it wants. Monopolies are constrained by marketdemand. They can sell only what people will buy and only ata price that people are willing to pay.
PRICE AND OUTPUT DECISIONS IN PURE
MONOPOLY MARKETS p. 271
6.In perfect competition, many firms supply homogeneous
products. With only one firm in a monopoly market, how-ever, there is no distinction between the firm and theindustry—the firm isthe industry. The market demand
curve is thus the firm’s demand curve, and the total quantitysupplied in the market is what the monopoly firm decides toproduce.
7.For a monopolist, an increase in output involves not justproducing more and selling it but also reducing the price ofits output to sell it. Thus, marginal revenue, to a monopolist,is not equal to product price, as it is in competition. Instead,marginal revenue is lower than price because to raise output1 unit and to be able to sell that 1 unit, the firm must lower
the price it charges to all buyers.
8.A profit-maximizing monopolist will produce up to thepoint at which marginal revenue is equal to marginal cost(MR=MC).
9.Monopolies have no identifiable supply curves. They simply
choose a point on the market demand curve. That is, theychoose a price and quantity to produce, which depend onboth the marginal cost and the shape of the demand curve.
10. In the short run, monopolists are limited by a fixed factor ofproduction, just as competitive firms are. Monopolies thatdo not generate enough revenue to cover costs will go out ofbusiness in the long run.11. Compared with a competitively organized industry, a monop-olist restricts output, charges higher prices, and earns positiveprofits. Because MRalways lies below the demand curve for a
monopoly, monopolists always charge a price higher than MC
(the price that would be set by perfect competition).
12. Barriers to entry prevent new entrants from competing awayindustry excess profits.
13. Forms of barriers to entry include economies of scale,patents, government rules, ownership of scarce factors, andnetwork effects.
14. When a firm exhibits economies of scale so large that aver-age costs continuously decline with output, it may be effi-cient to have only one firm in an industry. Such an industryis called a natural monopoly .
THE SOCIAL COSTS OF MONOPOLY p. 281
15. When firms price above marginal cost, the result is an ineffi-
cient mix of output. The decrease in consumer surplus islarger than the monopolist’s profit, thus causing a net loss insocial welfare.
16. Actions that firms take to preserve positive profits, such aslobbying for restrictions on competition, are called rentseeking. Rent-seeking behavior consumes resources and adds
to social cost, thus reducing social welfare even further.
PRICE DISCRIMINATION p. 283
17. Charging different prices to different buyers is called price
discrimination . The motivation for price discrimination is
fairly obvious: If a firm can identify those who are willing topay a higher price for a good, it can earn more profit fromthem by charging a higher price.
18. A firm that charges the maximum amount that buyers arewilling to pay for each unit is practicing perfect price
discrimination .
19. A perfectly price-discriminating monopolist will actually
produce the efficient quantity of output.
20. Examples of price discrimination are all around us. Airlines
routinely charge travelers who stay over Saturday nights amuch lower fare than those who do not. Business travelers gen-erally travel during the week, often are unwilling to stay overSaturdays, and generally are willing to pay more for tickets.
REMEDIES FOR MONOPOLY: ANTITRUST POLICY p. 285
21. Governments have assumed two roles with respect to imper-fectly competitive industries: (1) They promote competition
and restrict market power, primarily through antitrust lawsand other congressional acts; and (2) they restrict competi-
tion by regulating industries.
22. In 1914, Congress passed the Clayton Act , which was
designed to strengthen the Sherman Act and to clarify whatspecific forms of conduct were “unreasonable” restraints oftrade. In the same year, the Federal Trade Commission was
established and given broad power to investigate and regu-late unfair methods of competition.
CHAPTER 13 Monopoly and Antitrust Policy 289
REVIEW TERMS AND CONCEPTS
barrier to entry, p. 278
Clayton Act, p. 286
Federal Trade Commission (FTC), p. 286
government failure, p. 283
imperfectly competitive industry, p. 269market power, p. 269
natural monopoly, p. 278
network externalities, p. 280
patent, p. 279
perfect price discrimination, p. 283price discrimination, p. 283
public choice theory, p. 283
pure monopoly, p. 270
rent-seeking behavior, p. 283
rule of reason, p. 286
1.Do you agree or disagree with each of the following statements?
Explain your reasoning.a.For a monopoly, price is equal to marginal revenue because a
monopoly has the power to control price.
b.Because a monopoly is the only firm in an industry, it can
charge virtually any price for its product.
c.It is always true that when demand elasticity is equal to -1,
marginal revenue is equal to 0.
2.Explain why the marginal revenue curve facing a competitive
firm differs from the marginal revenue curve facing a monopolist.
3.Assume that the potato chip industry in the Northwest in 2009
was competitively structured and in long-run competitive equi-
librium; firms were earning a normal rate of return. In 2010,two smart lawyers quietly bought up all the firms and beganoperations as a monopoly called “Wonks.” T o operate efficiently,Wonks hired a management consulting firm, which estimated
long-run costs and demand. These results are presented in the
following figure.Justice concurs and prepares a civil suit. Suppose you work
in the White House and the president asks you to prepare a
brief memo (two or three paragraphs) outlining the issues.In your response, be sure to include:(1) The economic justification for action.(2) A proposal to achieve an efficient market outcome.
4.Willy’s Widgets, a monopoly, faces the following demand sched-
ule (sales in widgets per month):
$
0 QMC = /H20858MCii
AC
DPROBLEMS
All problems are available on www.myeconlab.com
(iMCi= the horizontal sum of the marginal cost curves of the
individual branches/firms.)
a.Indicate 2009 output and price on the diagram.
b.By assuming that the monopolist is a profit-maximizer, indi-
cate on the graph total revenue, total cost, and total profitafter the consolidation.
c.Compare the perfectly competitive outcome with the
monopoly outcome.
d.In 2010, an old buddy from law school files a complaint with
the Antitrust Division of the Justice Department claimingthat Wonks has monopolized the potato chip industry.©PRICE $20 $30 $40 $50 $60 $70 $80 $90 $100
QUANTITY DEMANDED 40 35 30 25 20 15 10 5 0
Calculate marginal revenue over each interval in the
schedule—for example, between q= 40 and q= 35. Recall that
marginal revenue is the added revenue from an additional unit
of production/sales and assume that MR is constant within
each interval.
If marginal cost is constant at $20 and fixed cost is $100,
what is the profit-maximizing level of output? (Choose one of
the specific levels of output from the schedule.) What is the
level of profit? Explain your answer using marginal cost andmarginal revenue.
Repeat the exercise for MC = $40.
5.The following diagram illustrates the demand curve facing
a monopoly in an industry with no economies or disec-onomies of scale and no fixed costs. In the short and long run MC =ATC . Copy the diagram and indicate
the following:
MC = ATC
Output, Q$
0D
290 PART III Market Imperfections and the Role of Government
a.Optimal output
b.Optimal price
c.T otal revenue
d.T otal cost
e.T otal monopoly profits
f.T otal “excess burden” or “welfare costs” of the monopoly
(briefly explain)
6.The following diagram shows the cost structure of a monopoly
firm as well as market demand. Identify on the graph and calcu-late the following:
a.Profit-maximizing output level
b.Profit-maximizing price
c.T otal revenue
d.T otal cost
e.T otal profit or loss
$
5
4
2
0 10,000
MRDATCMC
Q
Assuming 400 households are in the economy, draw the
market demand curve and the marginal revenue schedule
facing the monopolist.
c.What is the monopolist’s profit-maximizing output?
What is the monopolist’s price?
d.What is the “efficient price,” assuming no externalities?
e.Suppose the government “imposed” the efficient price by
setting a ceiling on price at the efficient level. What is thelong-run output of the monopoly?
f.Suggest an alternative approach for achieving an efficient
outcome.5
0 2.5 5.010
QP = 10 – 2Q P7.Consider the following monopoly that produces paperback books:
a.Draw the average total cost curve and the marginal cost
curve on the same graph.
b.Assume that all households have the same demand schedule
given by the following relationship:marginal cost =$1 (and is constant)fixed costs =$1,000*8.In Taiwan, there is only one beer producer, a government-
owned monopoly called Taiwan Beer. Suppose that the companywere run in a way to maximize profit for the government. Thatis, assume that it behaved like a private profit-maximizingmonopolist. Assuming demand and cost conditions are given on
the following diagram, at what level would Taiwan Beer target
output and what price would it charge?
Now suppose Taiwan Beer decided to begin competing in
the highly competitive American market. Assume furtherthat Taiwan maintains import barriers so that American pro-ducers cannot sell in Taiwan but that they are not immedi-
ately reciprocated. Assuming Taiwan Beer can sell all that it
can produce in the American market at a price P=P
USindi-
cate the following:
a.T otal output
b.Output sold in Taiwan
c.New price in Taiwan
d.T otal sold in the United States
e.T otal profits
f.T otal profits on U.S. sales
g.T otal profits on Taiwan sales
9.One of the big success stories of recent years has been Google.
Research the firm and write a memorandum to the head of the
Antitrust Division of the Justice Department presenting the
case for and against antitrust action against Google. In whatways has Google acted to suppress competition? What privatesuits have been brought? What are the benefits of a strong,
profitable Google?
10.[Related to the Economics in Practice onp. 280 ]When cable
television was first introduced, there were few substitutes for it,
particularly in areas with poor reception of network TV . In the
current environment, a number of companies from outside theindustry (for example, AT&T) have begun to develop new waysto compete with cable. What effect should we expect this to haveon the cable companies?
11.[Related to the Economics in Practice onp. 287 ]Explain how
the Supreme Court ruling in American Needle v. NFL exempli-fies the “rule of reason” provision of the Sherman Act of 1890.
*Note: Problems marked with an asterisk are more challenging.MC
MRAC
Q$
PUS
DTaiwan
CHAPTER 13 Monopoly and Antitrust Policy 291
12.Black Eyed Peas was a rock band that stood at the top of the
charts for sales in 2010 when its song “I Gotta Feeling” was
downloaded over 7 million times. The path to success for a rockband involves reducing the elasticity of demand that it faces andbuilding barriers to entry. That sounds like economic babble,but it has a lot of meaning. Using the language of economics
and the concepts presented in this chapter, explain why lowering
the elasticity of demand and building barriers to entry areexactly what Black Eyed Peas is trying to do.
13.The diagram below shows a firm (industry) that earns a normal
return to capital if organized competitively. Price in the marketplace is P
cunder competition. We assume at first that marginal
cost is fixed at $50 per unit of output and that there are no
economies or diseconomies of scale. [The equation of thedemand curve facing the industry is P= 100 – 1/180 Q].Calculate the total revenue to the competitive firms, assum-
ing free entry. What is total cost under competition? Calculateconsumer surplus under competition.
Now assume that you bought all the firms in this industry,
combining them into a single-firm monopoly protected from
entry by a patent. Calculate the profit-maximizing price, P
m,
total revenue from the monopoly, total cost, profit, and con-
sumer surplus. Also compare the competitive and monopolyoutcomes. Calculate the dead weight loss from monopoly. Whatpotential remedies are available?
14.Explain why a monopoly faces no supply curve.
15.Suppose Gloria has the only franchise for a McDonald’s restau-
rant in Laughlin, Nevada, a city with a population of roughly
8,100. Does the fact that Gloria has the only McDonald’s in
town necessarily mean this represents a monopoly? Explain.
MC = ATC
Dm
MRm4,500 9,000 18,000 Units of output, Q0100
75
PC=M RC = 50Dollars ($)
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CHAPTER OUTLINE
29314
Market Structure in
an Oligopoly p. 294
Oligopoly Models p. 297
The Collusion Model
The Price-Leadership Model
The Cournot Model
Game Theory p. 300
Repeated Games
A Game with Many Players:
Collective Action Can BeBlocked by a Prisoner’sDilemma
Oligopoly and
EconomicPerformance
p. 306
Industrial Concentration
and Technological Change
The Role of
Government p. 307
Regulation of Mergers
A Proper Role?We have now examined two
“pure” market structures. At oneextreme is perfect competition ,a
market structure in which manyfirms, each small relative to thesize of the market, produce undif-ferentiated products and have nomarket power at all. Each com-petitive firm takes price as givenand faces a perfectly elasticdemand for its product. At theother extreme is pure monopoly ,a
market structure in which onlyone firm is the industry. Themonopoly holds the power to set price and is protected against competition by barriers toentry. Its market power would be complete if it did not face the discipline of the marketdemand curve. Even a monopoly, however, must produce a product that people want and arewilling to pay for.
Most industries in the United States fall somewhere between these two extremes. In the next
two chapters, we focus on two types of industries in which firms exercise some market power butat the same time face competition: oligopoly and monopolistic competition. In this chapter, wecover oligopolies, and in Chapter 15, we turn to monopolistic competition.
An oligopoly is an industry dominated by a few firms that, by virtue of their individual sizes,
are large enough to influence the market price. Oligopolies exist in many forms. Consider the fol-lowing cases:
In the United States, 90 percent of the music produced and sold comes from one of four stu-
dios: Universal, Sony, Warner, or EMI. The competition among these four firms is intense, butmost of it involves the search for new talent and the marketing of that talent. Although studioscompete less on price, Radiohead’s 2007 campaign to have consumers set their own price in buy-ing its new CD may result in a shake-up of the industry.
Stents are small metal devices used to prop open coronary arteries once they have been
unblocked by angioplasty surgery. In the United States, the $1 billion stent market is domi-nated by three firms: Boston Scientific, Johnson & Johnson, and Medtronic. Among the three,there is fierce competition in the area of research and development (R&D) as they try todevelop new, improved products. In 2007, Johnson & Johnson tried marketing its stentsdirectly to patients, with an advertisement during the Dallas Cowboys–New Y ork JetsThanksgiving Day football game. On the other hand, we see very little price competitionamong these firms.
Airlines are another oligopolistic industry, but price competition can be fierce. When
Southwest enters a new market, travelers often benefit from large price drops.
In 2010 Amazon found its position in the market for handheld readers threatened as the
Kindle was joined by both the Nook and the iPad.
What we see in these examples is the complexity of competition among oligopolists.
Oligopolists compete with one another not only in price but also in developing new products,marketing and advertising those products, and developing complements to use with the products.
Oligopoly
oligopoly A form of
industry (market) structure
characterized by a few
dominant firms. Productsmay be homogenous
or differentiated.
294 PART III Market Imperfections and the Role of Government
POTENTIAL
ENTRANTS
INDUSTRY
COMPETITORS
Rivalry Among
Existing FirmsBUYERS SUPPLIERS
SUBSTITUTES/L50298FIGURE 14.1
Forces Driving Industry
CompetitionAt times, in some industries, competition in any of these areas can be fierce; in the other industries,
there seems to be more of a “live and let live” attitude. The complex interdependence among oli-gopolists combined with the wide range of strategies that they use to compete makes them difficultto analyze. T o find the right strategy, firms need to anticipate the reactions of their customers andtheir rivals to what the firms do. If I raise my price, will my rivals follow me? If they do not, will mycustomers leave, or are they attracted enough to what I produce that they will continue to purchasefrom me? If Universal decides to dramatically cut prices of its music and redo its contracts withartists so that they earn more revenue from concerts, will Sony imitate that strategy? If Sony does,how will that affect Universal? As you can see, these are hard, although interesting, questions. Thischapter will introduce you to a range of different models from the fields of game theory and com-petitive strategy to help you answer these questions.
The four cases just described differ not only in how firms compete but also in some of the
fundamental features of their industries. Before we describe the formal models of the way oligop-oly firms interact, it is useful to provide a few tools that can be used to analyze the structure of the
industries to which those firms belong. Knowing more of the structure of an industry can help usfigure out which of the models we describe will be most helpful. For this exercise, we will rely onsome of the tools developed in the area of competitive strategy used in business schools and inmanagement consulting.
Market Structure in an Oligopoly
One of the standard models used in the competitive strategy area to look at the structure of anoligopoly industry is the Five Forces model developed by Michael Porter of Harvard University.
Figure 14.1 illustrates the model.
The five forces help us explain the relative profitability of an industry and identify in which
area firm rivalry is likely to be most intense.
The center box of the figure focuses on the competition among the existing firms in the
industry. In the competitive market, that box is so full of competitors that no individual firmneeds to think strategically about any other individual firm. In the case of monopoly, the centerbox has only one firm. In an oligopoly, there are a small number of firms and each of those firmswill spend time thinking about how it can best compete against the other firms.
What characteristics of the existing firms should we look at to see how that competition will
unfold? An obvious structural feature of an industry to consider is the number and size distributionof those firms. Do the top two firms have 90 percent of the market or only 20 percent? Is there onevery large firm and a few smaller competitors, or are firms similar in size? Table 14.1 shows the dis-tribution of market shares in a range of different U.S. industries, based on census data using value ofshipments. Market share can also be constructed using employment data. We can see that evenwithin industries that are highly concentrated , there are differences. Ninety percent of U.S. beer is
made by the top four firms (Anheuser-Busch itself produces 50 percent of the beer sold in theFive Forces model A model
developed by Michael Porterthat helps us understand the
five competitive forces that
determine the level ofcompetition and profitability
in an industry.
CHAPTER 14 Oligopoly 295
concentration ratio The
share of industry output in
sales or employmentaccounted for by the top firms.TABLE 14.1 Percentage of Value of Shipments Accounted for by the Largest Firms in
High-Concentration Industries, 2002
Industry Designation Four Largest Firms Eight Largest Firms Number of Firms
Primary copper 99 100 10
Cigarettes 95 99 15
Household laundry
equipment93 100 13
Cellulosic man-made fiber 93 100 8
Breweries 90 94 344
Electric lamp bulbs 89 94 57
Household refrigeratorsand freezers 85 95 18
Small arms ammunition 83 89 109
Cereal breakfast foods 82 93 45
Motor vehicles 81 91 308
Source: U.S. Department of Commerce, Bureau of the Census, 2002 Economic Census, Concentration Ratios: 2002 ECO2-315R-1,
May 2006.
United States), but there is a relatively large fringe of much smaller firms. In the copper industry, we
find only large firms. As we will see shortly in the models, with fewer firms, all else being equal com-petition is reduced.
We are also interested in the size distribution of firms among the top firms. Again, looking at
the beer industry, while Anheuser-Busch produces half of the U.S. beer consumed, MillerCoors (arecently merged pair) is now up to 30 percent of the market, giving us a two-firm concentration
ratio of 80 percent. In the market for conventional DVD players, Sony controls 20 percent of the
market, but the next three or four firms in the industry have similar shares. When we discuss theprice leadership model of oligopoly, we will highlight this question of size distribution. In ourdiscussion of government merger policy, we will discuss measures other than the concentrationratio that can be used to measure firm shares.
The final feature of existing firms that we want to look at is the amount of product differenti-
ation we see in the industry. Are the firms all making the same product, or are the products verydifferent from one another? This takes us back to the issue of how close products are as substitutes,a topic introduced in Chapter 13 in the description of monopoly. How different are Actavision’sGuitar Hero and Electronic Arts’ Rock Band? Does Farmville compete, or are there really differentmarkets for casual and dedicated gamers as some claim? The more differentiated products made byoligopolists are, the more their behavior will resemble that of the monopolist.
Now look at the boxes to the north and south of the competitive rivalry box in Figure 14.1.
T o the north, we see potential entrants. In the last chapter, we described the major sources ofentry barriers. When entry barriers are low, new firms can come in to compete away any excessprofits that existing firms are earning. In an oligopoly, we find that the threat of entry by newfirms can play an important role in how competition in the industry unfolds. In some cases, thethreat alone may be enough to make an industry with only a few firms behave like a perfectlycompetitive firm. Markets in which entry and exit are easy so that the threat of potential entryholds down prices to a competitive level are known as contestable markets .
Consider, for example, a small airline that can move its capital stock from one market to
another with little cost. Cape Air flies between Boston, Martha’s Vineyard, Nantucket, and CapeCod during the summer months. During the winter, the same planes are used in Florida, wherethey fly up and down that state’s west coast between Naples, Fort Meyers, Tampa, and other cities.A similar situation may occur when a new industrial complex is built at a fairly remote site and anumber of trucking companies offer their services. Because the trucking companies’ capital stockis mobile, they can move their trucks somewhere else at no great cost if business is not profitable.Existing firms in this market are continuously faced with the threat of competition. In con-testable markets, even large oligopolistic firms end up behaving like perfectly competitive firms.Prices are pushed to long-run average cost by competition, and positive profits do not persist.
T o the south of the competitor box, we see substitutes. For oligopolists—just like the
monopolists described in the last chapter—the availability of substitute products outside theindustry will limit the ability of firms to earn high profits.
contestable markets Markets
in which entry and exit are easy.
296 PART III Market Imperfections and the Role of Government
ECONOMICS IN PRACTICE
Why Are Record Labels Losing Key Stars Like Madonna?
How can we use the Five Forces model to help us understand the com-
petition record labels face? Notice first that the defectors from the
labels—Madonna, Radiohead, and Nine Inch Nails—are well-known
stars. For the record labels, these stars are suppliers. As these stars gainin popularity, they can drive harder bargains with the record labels.(This is one reason record labels sign artists to multiple record con-tracts, but no contract lasts forever.) While the supply of unknown
singers is likely quite elastic, the supply of branded stars like Madonna
is much more inelastic. Some people would argue that venues such asY ouTube reduce the power of the record labels, even for young artists,by providing low-cost exposure. Here, Y ouTube serves as a substitute
for the record labels from the perspective of the unknown artists.
Buyers are also gaining power. With easy access to downloaded music,
often pirated, listeners are willing to spend less on music and concertsplay a bigger role in generating revenue for artists. Most observersthink that the sum of these changes brought by new technology will benegative for record label profits.
Madonna (and the Internet) Disrupts
Another Business
Wall Street Journal
Madonna has always had a keen eye for the latest trends
and her new megadeal is no exception. But this time it’s not
due to the latest musical styles she’s embracing. It’s the factthat the Internet is disrupting traditional business models.
Rather than renewing her contract with her longtime
record label Warner Bros., the Material Girl is signing a
10-year, $120-million deal with a concert-promotion com-
pany, the Journal reports. The promoter, Live Nation,
probably won’t make that back by selling the three albumsworth of music Madonna’s agreed to record for them.Instead, it intends to make a profit by selling everything
from concert tickets to Madonna-brand perfumes to cor-
porate sponsorships.
It’s a textbook example of how the Internet is disrupting
an industry. The record labels used to be the key players in the
music industry. Getting music to fans meant negotiating acomplex supply chain that included printing records and deliv-
ering them to stores. Looking at it this way, the record labelsare more or less distribution companies. Yes, it’s a simplifiedview, but it also makes it easier to see the broader implications,because most successful companies have had to master two
skills: making stuff and distributing stuff.
The Internet is the world’s most efficient distribution
channel, which makes it a threat to any business whosebusiness model relies on getting product to customers. In
the case of the music industry, anyone can now distribute
their music over the Internet for little or no cost. This, in turn,changes the value of recorded music. Madonna and bandslike Radiohead and Nine Inch Nails realize that the best wayto make money is to use their music as a way to promote
their overall brands.
The music industry is just the most obvious example of
the way the Internet is changing the way an industrydistributes, values, and indeed defines its product.Newspapers—including the Business Technology Blog’s
employer—are going through their own version of this dis-
ruption right now. And it’s just a matter of time before itimpacts other industries.
Source: The Wall Street Journal, “Madonna (and the Internet) Disrupts
Another Business.” Copyright 2007 by Dow Jones & Company, Inc.
Reproduced with permission of Dow Jones & Company, Inc. via Copyright
Clearance Center .
Now take a look at the horizontal boxes in Figure 14.1. One of the themes in this book has
been the way in which input and output markets are linked. Firms that sell in the product marketalso buy in the input market. Conditions faced by firms in their input markets are described inthe left-hand box, suppliers. The circular flow diagram in Chapter 3 emphasizes this point. We seethis same point in the Five Forces horizontal boxes. Airlines, which have some market power inthe airline industry, face strong oligopolists when they try to buy or lease airplanes. In the air-plane market, Boeing and Airbus control almost the entire market for commercial airplanes. Inthe market for leasing planes, GE has a dominant position. When a firm with market power facesanother firm with market power in the input markets, interesting bargaining dynamics mayresult in terms of who ends up with the profits.
Finally, on the right side of the Five Forces diagram, we see the buyer or consumer—in some
ways the most important part of the schema. Buyer preferences, which we studied as we looked atindividual demand and utility functions—help to determine how successful a firm will be when it
CHAPTER 14 Oligopoly 297
tries to differentiate its products. Some buyers can also exert bargaining power, even when faced
with a relatively powerful seller. When people think of buyers, they usually think of the retailbuyer of consumer goods. These buyers typically have little power. But many products in the U.S.economy are sold to other firms, and in many of these markets firms face highly concentratedbuyers. Intel sells its processors to the relatively concentrated personal computer market, in whichDell has a large share. Proctor & Gamble (P&G) sells its consumer products to Wal-Mart, whichcurrently controls 25 percent of the retail grocery market. Wal-Mart’s power has enormous effectson how P&G can compete in its markets.
We have now identified a number of the key features of an oligopolistic industry.
Understanding these features will help us predict the strategies firms will use to compete withtheir rivals for business. We turn now to some of the models of oligopolistic behavior.
Oligopoly Models
Because many different types of oligopolies exist, a number of different oligopoly models havebeen developed. The following provides a sample of the alternative approaches to the behavior(or conduct) of oligopolistic firms. As you will see, all kinds of oligopolies have one thing in com-mon: The behavior of any given oligopolistic firm depends on the behavior of the other firms inthe industry composing the oligopoly.
The Collusion Model
In Chapter 13, we examined what happens when a perfectly competitive industry falls underthe control of a single profit-maximizing firm. We saw that when many competing firms actindependently, they produce more, charge a lower price, and earn less profit than if they hadacted as a single unit. If these firms get together and agree to cut production and increaseprice—that is, if firms can agree notto price compete—they will have a bigger total-profit
pie to carve up. When a group of profit-maximizing oligopolists colludes on price and out-put, the result is the same as it would be if a monopolist controlled the entire industry. Thatis, the colluding oligopoly will face market demand and produce only up to the point atwhich marginal revenue and marginal cost are equal ( MR =MC) and price will be set above
marginal cost.
A group of firms that gets together and makes price and output decisions jointly is called a
cartel . Perhaps the most familiar example of a cartel today is the Organization of Petroleum
Exporting Countries (OPEC). The OPEC cartel consists of 13 countries, including Saudi Arabiaand Kuwait, that agree on oil production levels. As early as 1970, the OPEC cartel began to cutpetroleum production. Its decisions in this matter led to a 400 percent increase in the price ofcrude oil on world markets during 1973 and 1974.
OPEC is a cartel of governments. Cartels consisting of firms, by contrast, are illegal under
U.S. antitrust laws described in Chapter 13. Price fixing has been defined by courts as anyagreement among individual competitors concerning prices. All agreements aimed at fixingprices or output levels, regardless of whether the resulting prices are high, are illegal. Moreover,price fixing is a criminal offense, and the penalty for being found guilty can involve jail time aswell as fines. In the 1950s, a group of 12 executives from five different companies in the electri-cal equipment industry were found guilty of a price-fixing scheme to rotate winning bidsamong the firms. All were fined and sentenced to jail. In 2005, a former executive from BayerAG, a major German pharmaceutical company, was sentenced to four months in jail and givena $50,000 fine for price fixing. In 2007, the U.S. government launched suits charging price fix-ing against a number of firms in industries ranging from car rentals to board game manu-facturers. Despite the clear illegality of price fixing, the lure of profits seems to attract someexecutives to agree on prices.
For a cartel to work, a number of conditions must be present. First, demand for the cartel’s
product must be inelastic. If many substitutes are readily available, the cartel’s price increases maybecome self-defeating as buyers switch to substitutes. Here we see the importance of understand-ing the substitutes box in Figure 14.1. Second, the members of the cartel must play by the rules. Ifcartel A group of firms that
gets together and makes jointprice and output decisions tomaximize joint profits.
298 PART III Market Imperfections and the Role of Government
a cartel is holding up prices by restricting output, there is a big incentive for members to cheat by
increasing output. Breaking ranks can mean huge profits.
Incentives of the various members of a cartel to “cheat” on the cartel rather than cooperate
highlights the role of the size distribution of firms in an industry. Consider an industry with onelarge firm and a group of small firms that has agreed to charge relatively high prices. For eachfirm, the price will be above its marginal cost of production. Gaining market share by sellingmore units is thus very appealing. On the other hand, if every firm drops prices to gain a marketshare, the cartel will collapse. For small players in an industry, the attraction of the added marketshare is often hard to resist, while the top firms in the industry have more to lose if the cartel col-lapses and have less added market share to gain. In most cartels, it is the small firms that beginpricing at below cartel prices.
Collusion occurs when price- and quantity-fixing agreements are explicit, as in a cartel. Tacit
collusion occurs when firms end up fixing prices without a specific agreement or when such
agreements are implicit. A small number of firms with market power may fall into the practice ofsetting similar prices or following the lead of one firm without ever meeting or setting down for-mal agreements. The fewer and more similar the firms, the easier it will be for tacit collusion tooccur. As we will see later in this chapter, antitrust laws also play a role in trying to discouragetacit collusion.
The Price-Leadership Model
In another form of oligopoly, one firm dominates an industry and all the smaller firms followthe leader’s pricing policy—hence its name price leadership . If the dominant firm knows that
the smaller firms will follow its lead, it will derive its own demand curve by subtracting fromtotal market demand the amount of demand that the smaller firms will satisfy at each poten-tial price.
The price-leadership model is best applied when the industry is made up of one large
firm and a number of smaller competitive firms. Under these conditions, we can think ofthe dominant firm as maximizing profit subject to the constraint of market demand and
subject to the behavior of the smaller competitive firms. Smaller firms then can essentiallysell all they want at this market price. The difference between the quantity demanded in themarket and the amount supplied by the smaller firms is the amount that the dominant firmwill produce.
Under price leadership, the quantity demanded in the market will be produced by a mix
of the smaller firms and the dominant firm. Contrast this situation with that of the monopo-list. For a monopolist, the only constraint it faces comes from consumers, who at some pricewill forgo the good the monopolist produces. In an oligopoly, with a dominant firm practic-ing price leadership, the existence of the smaller firms (and their willingness to produce out-put) is also a constraint. For this reason, the output expected under price leadership liesbetween that of the monopolist and the competitive firm, with prices also set between thetwo price levels.
The fact that the smaller firms constrain the behavior of the dominant firm suggests
that that firm might have an incentive to try to push those smaller firms out of the marketby buying up or merging with the smaller firms. We have already seen in the monopolychapter how moving from many firms to one firm can help a firm increase profits, even as itreduces social welfare. Antitrust rules governing mergers, discussed later in this chapter,reflect the potential social costs of such mergers. An alternative way for a dominant firm toreduce the number of smaller firms in its industry is through aggressive price setting. Ratherthan accommodate the small firms, as is done in the price-leadership situation, the domi-nant firm can try cutting prices aggressively until the smaller firms leave. The practice bywhich a large, powerful firm tries to drive smaller firms out of the market by temporarilyselling at an artificially low price is called predatory pricing .S u c hb e h a v i o rc a nb ev e r y
expensive for the larger firm and is often ineffective. Changing prices below average variablecosts to push other firms out of an industry in the expectation of later recouping throughprice increases is also illegal under antitrust laws.tacit collusion Collusion
occurs when price- and
quantity-fixing agreementsamong producers are explicit.
Tacit collusion occurs when such
agreements are implicit.
price leadership A form
of oligopoly in which onedominant firm sets prices
and all the smaller firms in
the industry follow its pricing policy.
CHAPTER 14 Oligopoly 299
duopoly A two-firm
oligopoly.
2,000 3,000 4,000 0$2Monopoly output q
Output of Firm A$4
Marginal cost
DemandMarginal
revenue
Output of Firm B2,000 1,333.33 4,000 02,000
1,333.33Firm B's
reaction function
Firm A's
reaction functionqA
qBa. Monopoly b. Duopoly
/L50304FIGURE 14.2 Graphical Depiction of the Cournot Model
The left graph shows a profit-maximizing output of 2,000 units for a monopolist with marginal cost of $2.
The right graph shows output of 1,333.33 units eachfor two duopolists with the same marginal cost of $2,
facing the same demand curve. Total industry output increases as we go from the monopolist to the Cournotduopolists, but it does not rise as high as the competitive output (here 4,000 units).The Cournot Model
A very simple model that illustrates the idea of interdependence among firms in an oligopoly is
the Cournot model, introduced in the 19th century by the mathematician Antoine AugustinCournot. The model is based on Cournot’s observations of competition between two producersof spring water. Despite the age of the model and some if its restrictive assumptions, the intuitionthat emerges from it has proven to be helpful to economists and policy makers.
The original Cournot model focused on an oligopoly with only two firms producing identi-
cal products and not colluding. A two-firm oligopoly is known as a duopoly . The key feature of
an oligopoly, compared to the competitive firm, is that a firm’s optimal decisions depend on theactions of the other individual firms in its industry. In a duopoly, the right output choice for eachof the two firms will depend on what the other firm does. Cournot provides us with one way tomodel how firms take each other’s behavior into account.
Return to the monopoly example that we used in the previous chapter in Figure 13.8 on
p. 281, reproduced here as Figure 14.2(a). Marginal cost is constant at $2, and the demand curve fac-ing the monopolist firm is the downward-sloping market demand curve. Recall that the marginalrevenue curve lies below the demand curve because in order to increase sales the monopoly firmmust lower its per-unit price. In this example, the marginal revenue curve hits zero at an output of3,000 units. In this market, the monopolist maximizes profits at a quantity of 2,000 units and aprice of $4 as we saw in the last chapter. What happens in this market if, instead of having onemonopoly firm, we have a Cournot duopoly? What does the duopoly equilibrium look like?
In choosing the optimal output, the monopolist had only to consider its own costs and the
demand curve that it faced. The duopolist has another factor to consider: how much output will itsrival produce? The more the rival produces, the less market is left for the other firm in the duopoly.In the Cournot model, each firm looks at the market demand, subtracts what it expects the rivalfirm to produce, and chooses its output to maximize its profits based on the market that is left.
Let’s illustrate the Cournot duopoly solution to this problem with two firms, Firm A and
Firm B. Recall the key feature of the duopoly: Firms must take each other’s output into accountwhen choosing their own output. Given this feature, it is helpful to look at how each firm’s optimaloutput might vary with its rival’s output. In Figure 14.2(b), we have drawn two reaction functions ,
showing each firm’s optimal, profit-maximizing output as it depends on its rival’s output. The Y-axis
shows levels of Firm A ’s output, denoted q
A, and the X-axis shows Firm B’s output, denoted as qB.
300 PART III Market Imperfections and the Role of Government
Several of the points along Firm A ’s reaction function should look familiar. Consider the
point where Firm A ’s reaction function crosses the vertical axis. At this point, Firm A ’s task is tochoose the optimal output assuming Firm B produces 0. But we know what this point is fromsolving the monopoly problem. If Firm B produces nothing, then Firm A is a monopolist and itoptimally produces 2,000 units. So ifFirm A expects Firm B to produce 0, it should produce 2,000
to maximize its profits.
Look at the point at which Firm A ’s reaction function crosses the horizontal axis. At this
point Firm B is producing 4,000 units. Look back at Figure 14.2(a). At an output level of 4,000 unitsthe market price is $2, which is the marginal cost of production. If Firm A expects Firm B to pro-duce 4,000 units, there is no profitable market left for Firm A and it will produce 0. If you startthere, where the output of Firm B (measured on the horizontal axis) is 4,000 units each period,and you let Firm B’s output fall moving to the left, Firm A will find it in its interest to increaseoutput. If you carefully figure out what Firms A ’s profit-maximizing output is at every possiblelevel of output for Firm B, you will discover that Firm A ’s reaction function is just a downward-sloping line between 2,000 on the Y-axis and 4,000 on the X-axis. The downward slope reflects
the way in which firm A chooses its output. It looks at the market demand, subtracts its rival’soutput, and then chooses its own optimal output. The more the rival produces, the less market isprofitably left for the other firm in the duopoly.
Next, we do the same thing for Firm B. How much will Firm B produce if it maximizes profit
and accepts Firm A ’s output as given? Since the two firms are exactly alike in costs and type ofproduct, Firm B’s reaction function looks just like Firm A ’s: When Firm B thinks it is alone in themarket (Firm A ’s output on the vertical axis is 0) it produces the monopoly output of 2,000; whenFirm B thinks Firm A is going to produce 4,000 units, it chooses to produce 0.
As you can see, the two reaction functions cross. Each firm’s reaction function shows what it
wants to do, conditional on the other firm’s output. At the point of intersection, each firm isdoing the best it can, given the actual output of the other firm. This point is sometimes called thebest response equilibrium . As you can see from the graph, the Cournot duopoly equilibrium to this
problem occurs when each firm is producing 1,333.33 units for an industry total of 2,666.66.This output is more than the original monopolist produced in this market, but less than the4,000 units that a competitive industry would produce.
It turns out that the crossing point is the only equilibrium point in Figure 14.2(b). T o see why,
consider what happens if you start off with a monopoly and then let a second firm compete.Suppose, for example, Firm A expected Firm B to stay out of the market, to produce nothing, leav-ing Firm A as a monopolist. With that expectation, Firm A would choose to produce 2,000 units.But now look at Firm B’s reaction function. If Firm A is now producing 2,000 units, Firm B’sprofit-maximizing output is not zero, it is 1,000 units. Draw a horizontal line from Firm A ’s out-put level of 2,000 to Firm B’s reaction function and then go down to the X-axis and you will dis-
cover that Firm B’s optimal output lies at 1,000 units. So an output level for Firm A of 2,000 unitsis not an equilibrium because it was predicated on a production level for Firm B that was incor-rect. Going one step further, with Firm B now producing 1,000 units, Firm A will cut back from2,000. This will in turn lead to a further increase in Firm B’s output and the process will go onuntil both are producing 1,333.33.
As we have seen, the output level predicted by the Cournot model is between that of the
monopoly and that of a perfectly competitive industry. Later extensions of the Cournot modeltell us that the more firms we have, behaving as Cournot predicted, the closer output (and thusprices) will be to the competitive levels. This type of intuitive result is one reason the Cournotmodel has been widely used despite its simplified view of firm interaction. The field of game the-ory, to which we now turn, offers a more sophisticated and complete view of firm interactions.
Game Theory
The firms in Cournot’s model do not anticipate the moves of the competition. Instead, they try toguess the output levels of their rivals and then choose optimal outputs of their own. But notice,the firms do not try to anticipate or influence what the rival firms will do in response to their ownactions. In many situations, it does not seem realistic for firms to just take their rival’s output as
CHAPTER 14 Oligopoly 301
game theory Analyzes the
choices made by rival firms,
people, and even governments
when they are trying tomaximize their own well-beingwhile anticipating and reacting
to the actions of others in their
environment.independent of their own. We might think that Intel, recognizing how important Advanced
Micro Devices (AMD) is in the processor market, would try to influence AMD’s business deci-sions. Game theory is a subfield of economics that analyzes the choices made by rival firms, peo-
ple, and even governments when they are trying to maximize their own well-being whileanticipating and reacting to the actions of others in their environment.
Game theory began in 1944 with the work of mathematician John von Neumann and econ-
omist Oskar Morgenstern who published path-breaking work in which they analyzed a set ofproblems, or games , in which two or more people or organizations pursue their own interests and
in which neither one of them can dictate the outcome. Game theory has become an increasinglypopular field of study and research. The notions of game theory have been applied to analyses offirm behavior, politics, international relations, nuclear war, military strategy, and foreign policy.In 1994, the Nobel Prize in Economic Science was awarded jointly to three early game theorists:John F. Nash of Princeton University, John C. Harsanyi of the University of California at Berkeley,and Reinhard Selten of the University of Bonn. Y ou may have seen the movie A Beautiful Mind
about John Nash and his contribution to game theory.
Game theory begins by recognizing that in all conflict situations, there are decision makers
(or players), rules of the game, and payoffs (or prizes). Players choose strategies without knowingwith certainty what strategy the opposition will use. At the same time, though, some informationthat indicates how their opposition may be “leaning” may be available to the players. Most cen-trally, understanding that the other players are also trying to do their best will be helpful in pre-dicting their actions.
Figure 14.3 illustrates what is called a payoff matrix for a simple game. Each of two firms, A
and B, must decide whether to mount an expensive advertising campaign. If each firm decidesnot to advertise, it will earn a profit of $50,000. If one firm advertises and the other does not, thefirm that does will increase its profit by 50 percent (to $75,000) while driving the competitioninto the loss column. If both firms decide to advertise, they will each earn profits of $10,000. Theymay generate a bit more demand by advertising, but not enough to offset the expense of theadvertising.
If firms A and B could collude (and we assume that they cannot), their optimal strategy
would be to agree not to advertise. That solution maximizes the joint profits to both firms. Ifboth firms do not advertise, joint profits are $100,000. If both firms advertise, joint profits areonly $20,000. If only one of the firms advertises, joint profits are $75,000 -$25,000 = $50,000.
We see from Figure 14.3 that each firm’s payoff depends on what the other firm does. In con-
sidering what firms should do, however, it is more important to ask whether a firm’s strategy
depends on what the other firm does. Consider A ’s choice of strategy. Regardless of what B does,it pays A to advertise. If B does not advertise, A makes $25,000 more by advertising than by notadvertising. Thus, A will advertise. If B does advertise, A must advertise to avoid a loss. The samelogic holds for B. Regardless of the strategy pursued by A, it pays B to advertise. A dominant
strategy is one that is best no matter what the opposition does. In this game, both players have a
dominant strategy, which is to advertise.
Do not advertise Advertise
A’s S t r a t e g yB’s Strategy
Do not advertise
AdvertiseB’s profit =
$50,000
A ’s profit =
$50,000
A ’s profit =
$10,000B’s profit =
$10,000
A ’s profit =
$75,000B’s loss =
$25,000B’s profit =
$75,000
A ’s loss =
$25,000/L50296FIGURE 14.3 Payoff
Matrix for AdvertisingGame
Both players have a dominant
strategy. If B does not advertise,A will because $75,000 beats
$50,000. If B does advertise, A
will also advertise because aprofit of $10,000 beats a loss of$25,000. A will advertise
regardless of what B does.
Similarly, B will advertise regard-less of what A does. If A does notadvertise, B will because $75,000
beats $50,000. If A does adver-
tise, B will too because a $10,000profit beats a loss of $25,000.dominant strategy In game
theory, a strategy that is
best no matter what the
opposition does.
302 PART III Market Imperfections and the Role of Government
prisoners’ dilemma A game
in which the players are
prevented from cooperating
and in which each has adominant strategy that leaves
them both worse off than if
they could cooperate.The result of the game in Figure 14.4 is an example of what is called a prisoners’ dilemma .
The term comes from a game in which two prisoners (call them Ginger and Rocky) are accusedof robbing the local 7-Eleven together, but the evidence is shaky. If both confess, they each get5 years in prison for armed robbery. If each one refuses to confess, they are convicted of a lessercharge, shoplifting, and get 1 year in prison each. The problem is that the district attorney hasoffered each of them a deal independently. If Ginger confesses and Rocky does not, Ginger goesfree and Rocky gets 7 years. If Rocky confesses and Ginger does not, Rocky goes free and Gingergets 7 years. The payoff matrix for the prisoners’ dilemma is given in Figure 14.4.
By looking carefully at the payoffs, you may notice that both Ginger and Rocky have dom-
inant strategies: to confess. That is, Ginger is better off confessing regardless of what Rocky doesand Rocky is better off confessing regardless of what Ginger does. The likely outcome is thatboth will confess even though they would be better off if they both kept their mouths shut.There are many cases in which we see games like this one. In a class that is graded on a curve, allstudents might consider agreeing to moderate their performance. But incentives to “cheat” bystudying would be hard to resist. In an oligopoly, the fact that prices tend to be higher thanmarginal costs provides incentives for firms to “cheat” on output—restricting agreements byselling additional units.
Is there any way out of this dilemma? There may be, under circumstances in which the game is
played over and over. Look back at Figure 14.3. The best joint outcome is not to advertise. But thepower of the dominant strategy makes it hard to get to the top-left corner. Suppose firms interactover and over again for many years. Now opportunities for cooperating are richer. Suppose firm Adecided not to advertise for one period to see how firm B would respond. If firm B continued toadvertise, A would have to resume advertising to survive. Suppose B decided to match A ’s strategy.In this case, both firms might—with no explicit collusion—end up not advertising after A figuresout what B is doing. We return to this in the discussion of repeated games, which follows.
There are many games in which one player does not have a dominant strategy, but in which
the outcome is predictable. Consider the game in Figure 14.5(a) in which C does not have a dom-inant strategy. If D plays the left strategy, C will play the top strategy. If D plays the right strategy, Cwill play the bottom strategy. What strategy will D choose to play? If C knows the options, it willsee that D has a dominant strategy and is likely to play that same strategy. D does better playing theright-hand strategy regardless of what C does. D can guarantee a $100 win by choosing right andis guaranteed to win nothing by playing left. Because D’s behavior is predictable (it will play theright-hand strategy), C will play bottom. When all players are playing their best strategy given what
their competitors are doing, the result is called a Nash equilibrium , named after John Nash. We
have already seen one example of a Nash equilibrium in the Cournot model.
Do not confess Confess
GingerRocky
Do not confess
ConfessRocky: 1 year
Ginger: 1 year
Ginger: 5 years Ginger: freeRocky: 5 years Rocky: 7 yearsRocky: free
Ginger: 7 years
/L50304FIGURE 14.4 The Prisoners’ Dilemma
Both players have a dominant strategy and will confess. If Rocky does notconfess, Ginger will because going
free beats a year in jail. Similarly, if Rocky doesconfess, Ginger will confess because 5 years in the slammer is
better than 7. Rocky has the same set of choices. If Ginger does notconfess, Rocky will because going free
beats a year in jail. Similarly, if Ginger doesconfess, Rocky also will confess because 5 years in the slammer is
better than 7. Both will confess regardless of what the other does.Nash equilibrium In game
theory, the result of all players’playing their best strategy
given what their competitors
are doing.
CHAPTER 14 Oligopoly 303
/L50304FIGURE 14.5 Payoff Matrixes for Left/Right–Top/Bottom Strategies
In the original game ( a), C does not have a dominant strategy. If D plays left, C plays top; if D plays right, C
plays bottom. D, on the other hand, doeshave a dominant strategy: D will play right regardless of what C
does. If C believes that D is rational, C will predict that D will play right. If C concludes that D will play right,
C will play bottom. The result is a Nash equilibrium because each player is doing the best that it can given
what the other is doing.In the new game (b), C had better be very sure that D will play right because if D plays left and C plays bot-tom, C is in big trouble, losing $10,000. C will probably play top to minimize the potential loss if the proba-
bility of D’s choosing left is at all significant.Left Right
C’s StrategyD’s Strategy
Top
BottomD wins no $
C wins $100
C wins $200D wins $100
C loses $100D wins no $D wins $100
C wins $100a. Original Game
Left Right
C’s StrategyD’s Strategy
Top
BottomD wins no $
C wins $100
C wins $200D wins $100
C loses $10,000D wins no $D wins $100
C wins $100b. New Game
maximin strategy In game
theory, a strategy chosen to
maximize the minimum gain
that can be earned.Now suppose the game in Figure 14.5(a) were changed. Suppose all the payoffs are the same
except that if D chooses left and C chooses bottom, C loses $10,000, as shown in Figure 14.5(b).While D still has a dominant strategy (playing right), C now stands to lose a great deal by choosingbottom on the off chance that D chooses left instead. When uncertainty and risk are introduced,the game changes. C is likely to play top and guarantee itself a $100 profit instead of playing bot-tom and risk losing $10,000 in the off chance that D plays left. A maximin strategy is a strategy
chosen by a player to maximize the minimum gain that it can earn. In essence, one who plays amaximin strategy assumes that the opposition will play the strategy that does the most damage.
Repeated Games
Clearly, games are not played once. Firms must decide on advertising budgets, investment strate-gies, and pricing policies continuously. Pepsi and Coca-Cola have competed against each otherfor 100 years, in countries across the globe. While explicit collusion violates the antitrust statutes,strategic reaction does not. Y et strategic reaction in a repeated game may have the same effect astacit collusion.
Consider the game in Figure 14.6. Suppose British Airways and Lufthansa were competing
for business on the New Y ork to London route during the off-season. T o lure travelers, they wereoffering low fares. The question is how much to lower fares. Both airlines were considering a deepreduction to a fare of $400 round-trip or a moderate one to $600. Suppose costs are such thateach $600 ticket produces profit of $400 and each $400 ticket produces profit of $200.
Clearly, demand is sensitive to price. Assume that studies of demand elasticity have deter-
mined that if both airlines offer tickets for $600, they will attract 6,000 passengers per week (3,000
for each airline) and each airline will make a profit of $1.2 million per week ($400 dollar profittimes 3,000 passengers). However, if both airlines offer deeply reduced fares of $400, they willattract 2,000 additional customers per week for a total of 8,000 (4,000 for each airline). Whilethey will have more passengers, each ticket brings in less profit and total profit falls to $800,000per week ($200 profit times 4,000 passengers). In this example, we can make some inferencesabout demand elasticity. With a price cut from $600 to $400, revenues fall from $3.6 million(6,000 passengers times $600) to $3.2 million (8,000 passengers times $400). We know fromChapter 5 that if a price cut reduces revenue, we are operating on an inelastic portion of the
demand curve.
304 PART III Market Imperfections and the Role of Government
What if the two airlines offer different prices? T o keep things simple, we will ignore brand
loyalty and assume that whichever airline offers the lowest fare gets all of the 8,000 passengers. IfBritish Airways offers the $400 fare, it will sell 8,000 tickets per week and make $200 profit each,for a total of $1.6 million. Since Lufthansa holds out for $600, it sells no tickets and makes noprofit. Similarly, if Lufthansa were to offer tickets for $400, it would make $1.6 million per weekwhile British Airways would make zero.
Looking carefully at the payoff matrix in Figure 14.6, do you conclude that either or both of the
airlines have a dominant strategy? In fact, both do. If Lufthansa prices at $600, British Airways willprice at the lower fare of $400, because $1.6 million per week is more than $1.2 million. On theother hand, if Lufthansa offers the deep price cut, British Airways must do so as well. If BritishAirways does not, it will earn nothing, and $800,000 beats nothing! Similarly, Lufthansa has a dom-inant strategy to offer the $400 fare because it makes more regardless of what British Airways does.
The result is that both airlines will offer the greatly reduced fare and each will make $800,000
per week. This is a classic prisoners’ dilemma. If they were permitted to collude on price, theywould both charge $600 per ticket and make $1.2 million per week instead—a 50 percent increase.
It was precisely this logic that led American Airlines President Robert Crandall to suggest to
Howard Putnam of Braniff Airways in 1983, “I think this is dumb as hell…to sit here and poundthe @#%* out of each other and neither one of us making a @#%* dime.” … “I have a suggestionfor you, raise your @#%* fares 20 percent. I’ll raise mine the next morning.”
Since competing firms are prohibited from even talking about prices, Crandall got into trouble
with the Justice Department when Putnam turned over a tape of the call in which these commentswere made. But could they have colluded without talking to each other? Suppose prices are announcedeach week at a given time. It is like playing the game in Figure 14.6 a number of times in succession, arepeated game. After a few weeks of making $800,000, British Airways raises its price to $600.Lufthansa knows that if it sits on its $400 fare, it will double its profit from $800,000 to $1.6 million perweek. But what is British Airways up to? It must know that its profit will drop to zero unlessLufthansa raises its fare too. The fare increase could just be a signal that both firms would be betteroff at the higher price and that if one leads and can count on the other to follow, they will both bebetter off. The strategy to respond in kind to a competitor is called a tit-for-tat strategy .
If Lufthansa figures out that British Airways will play the same strategy that Lufthansa is
playing, both will end up charging $600 per ticket and earning $1.2 million instead of charging$400 and earning only $800,000 per week even though there has been no explicit price fixing.
A Game with Many Players: Collective Action Can Be
Blocked by a Prisoner’s Dilemma
Some games have many players and can result in the same kinds of prisoners’ dilemmas as we
have just discussed. The following game illustrates how coordinated collective action in every-body’s interest can be blocked under some circumstances.tit-for-tat strategy A
repeated game strategy in
which a player responds in
kind to an opponent’s play.Price = $600 Price = $400
British AirwaysLufthansa Airlines
Price = $600
Price = $400Profit =
$1.2 million
Profit =
$1.2 million
Profit =
$800,000Profit =
$800,000
Profit =
$1.6 millionProfit = 0Profit =
$1.6 million
Profit = 0/L50298FIGURE 14.6
Payoff Matrix for
Airline Game
In a single play, both British
Airways (BA) and LufthansaAirlines (LA) have dominantstrategies. If LA prices at $600,
BA will price at $400 because
$1.6 million beats $1.2 million.If, on the other hand, LA pricesat $400, BA will again choose to
price at $400 because $800,000
beats zero. Similarly, LA willchoose to price at $400 regard-less of which strategy BA
chooses.
CHAPTER 14 Oligopoly 305
Suppose I am your professor in an economics class of 100 students. I ask you to bring $10 to
class. In front of the room I place two boxes marked Box A and Box B. I tell you that you mustput the sum of $10 split any way you would like in the two boxes. Y ou can put all $10 in Box Aand nothing in Box B. Y ou can put all $10 in Box B and nothing in Box A. On the other hand,you can put $2.50 in Box A and $7.50 in Box B. Any combination totaling $10 is all right, and Iam the only person who will ever know how you split up your money.
At the end of the class, every dollar put into Box A will be returned to the person who
put it in. Y ou get back exactly what you put in. But Box B is special. I will add 20 cents toBox B for every dollar put into it. That is, if there is $100 in the box, I will add $20. But hereis the wrinkle: The money that ends up in Box B, including my 20 percent contribution, will
be divided equally among everyone in the class regardless of the amount that an individualstudent puts in.
Y ou can think of Box A as representing a private market where we get what we pay for. We
pay $10, and we get $10 in value back. Think of Box B as representing something we want to docollectively where the benefits go to all members of the class regardless of whether they havecontributed. In Chapter 12, we discussed the concept of a public good . People cannot be
excluded from enjoying the benefits of a public good once it is produced. Examples includeclean air, a lower crime rate from law enforcement, and national defense. Y ou can think of Box Bas representing a public good.
Now where do you put your money? If you were smart, you would call a class meeting and
get everyone to agree to put his or her entire $10 in Box B. Then everybody would walk out with$12. There would be $1,000 in the box, I would add $200, and the total of $1,200 would be splitevenly among the 100 students.
But suppose you were not allowed to get together, in the same way that Ginger and Rocky
were kept in separate cells in the jailhouse? Further suppose that everyone acts in his or her bestinterest. Everyone plays a strategy that maximizes the amount that he or she walks out with. Ifyou think carefully, the dominant strategy for each class member is to put all $10 in Box A.Regardless of what anyone else does , you get more if you put all your money into Box A than you
would get from any other split of the $10. And if you put all your money into A, no one will walkout of the room with more money than you will!
How can this be? It is simple. Suppose everyone else puts the $10 in B but you put your $10
in A. Box B ends up with $990 plus a 20 percent bonus from me of $198, for a grand total of$1,188, just $12 short of the maximum possible of $1,200. What do you get? Y our share ofBox B—which is $11.88, plus your $10 back, for a total of $21.88. Pretty slimy but clearly opti-
mal for you. If you had put all your money into B, you would get back only $12. Y ou can do thesame analysis for cases in which the others split up their income in any way, and the optimalstrategy is still to put the whole $10 in Box A.
Here is another way to think about it is: What part of what you ultimately get out is linked
to or dependent upon what you put in? For every dollar you put in A, you get a dollar back. Forevery dollar you yourself put in B, you get back only 1 cent, one one-hundredth of a dollar,
because your dollar gets split up among all 100 members of the class.
Thus, the game is a classic prisoners’ dilemma, where collusion if it could be enforced would
result in an optimal outcome but where dominant strategies result in a suboptimal outcome.
How do we break this particular dilemma? We call a town meeting (class meeting) and pass
a law that requires us to contribute to the production of public goods by paying taxes. Then, ofcourse, we run the risk that government becomes a player. We will return to this theme inChapters 16 and 18.
T o summarize, oligopoly is a market structure that is consistent with a variety of behav-
iors. The only necessary condition of oligopoly is that firms are large enough to have somecontrol over price. Oligopolies are concentrated industries. At one extreme is the cartel, inwhich a few firms get together and jointly maximize profits—in essence, acting as a monop-olist. At the other extreme, the firms within the oligopoly vigorously compete for small,contestable markets by moving capital quickly in response to observed profits. In betweenare a number of alternative models, all of which emphasize the interdependence of oligopo-listic firms.
306 PART III Market Imperfections and the Role of Government
Oligopoly and Economic Performance
How well do oligopolies perform? Should they be regulated or changed? Are they efficient, or do
they lead to an inefficient use of resources? On balance, are they good or bad?
With the exception of the contestable-markets model, all the models of oligopoly we
have examined lead us to conclude that concentration in a market leads to pricing abovemarginal cost and output below the efficient level. When price is above marginal cost atequilibrium, consumers are paying more for the good than it costs to produce that good interms of products forgone in other industries. T o increase output would be to create valuethat exceeds the social cost of the good, but profit-maximizing oligopolists have an incentivenot to increase output.
Entry barriers in many oligopolistic industries also prevent new capital and other
resources from responding to profit signals. Under competitive conditions or in contestablemarkets, positive profits would attract new firms and thus increase production. This doesnot happen in most oligopolistic industries. The problem is most severe when entry barriersexist and firms explicitly or tacitly collude. The results of collusion are identical to the resultsof a monopoly. Firms jointly maximize profits by fixing prices at a high level and splitting upthe profits.ECONOMICS IN PRACTICE
Price Fixing in Digital Music
In 2010 the Second Circuit Court of Appeals decided to reinstate a
case from several years ago alleging that the major music labels
had colluded to keep the prices of digital downloads higher thanthey otherwise would be. Earlier cases had found no direct evi-dence of any price conspiracy. In contrast to some price fixingcases, there was no trail of secret meetings or phone calls, no
“smoking gun” as the lawyers often say. Instead, as the following
article makes clear, the court relied on economic evidence: thefailure of the major record labels to markedly reduce music pricesdespite the drastic reductions in costs associated with movingfrom compact discs to digital music.
RIAA Digital Music Price-Fixing
Case Reinstated
ZeroPaid.com
It’s been an open secret that record labels have long col-
luded with one another to ensure maximum profits with lim-ited competition and consumer choice. A group of plaintiffshas taken the RIAA to court over the matter, and after ini-
tially having to watch the case dismissed at the DistrictCourt level back in 2008, has now convinced a three-judge
panel at the Second Circuit Court of Appeals to reinstate
the case.
One of the major points of evidence of collusion is that
the price of digital music is still too similar to physical CDs
despite the obviously drastic reduction in price asso-
ciated with distributing it, something file-sharers haveargued all along.The judges note:
Moreover, the pricing of CDs accounted for costs such as
copying the compact discs; producing the CD case, labels
and anti-shoplifting packaging; shipping, both to the distribu-tor and then to record stores; labor, such as shelving CDs andstaffing cash registers; and damaged and unsold inventory. Allof these costs were eliminated with Internet Music. However,
these dramatic cost reductions were not accompanied by
dramatic price reductions for Internet Music, as would be expected in a competitive market.
In other words, an album that once fetched $15 on store
shelves should now cost much less being that the label has
much fewer costs to recoup.
Source: Reprinted with permission from Zeropaid, Inc.
CHAPTER 14 Oligopoly 307
1J. A. Schumpeter, Capitalism, Socialism, and Democracy (New Y ork: Harper, 1942); and J. K. Galbraith, American Capitalism
(Boston: Houghton Mifflin, 1952).On the other hand, it is useful to ask why oligopolies exist in an industry in the first place and
what benefits larger firms might bring to a market. When there are economies of scale, larger andfewer firms bring cost efficiencies even as they reduce price competition.
Vigorous product competition among oligopolistic competitors may produce variety and
lead to innovation in response to the wide variety of consumer tastes and preferences. The con-nection between market structure and the rate of innovation is the subject of some debate inresearch literature.
Industrial Concentration and Technological Change
One of the major sources of economic growth and progress throughout history has been techno-logical advance. Innovation, both in methods of production and in the creation of new and bet-ter products, is one of the engines of economic progress. Much innovation starts with R&Defforts undertaken by firms in search of profit.
Several economists, notably Joseph Schumpeter and John Kenneth Galbraith, argued in
works now considered classics that industrial concentration, where a relatively small number offirms control the marketplace, actually increases the rate of technological advance. AsSchumpeter put it in 1942:
As soon as we…inquire into the individual items in which progress was most conspicuous,
the trail leads not to the doors of those firms that work under conditions of comparativelyfree competition but precisely to the doors of the large concerns …and a shocking suspiciondawns upon us that big business may have had more to do with creating that standard oflife than keeping it down.
1
This interpretation caused the economics profession to pause and take stock of its theories. Theconventional wisdom had been that concentration and barriers to entry insulate firms from com-petition and lead to sluggish performance and slow growth.
The evidence concerning where innovation comes from is mixed. Certainly, most small busi-
nesses do not engage in R&D and most large firms do. When R&D expenditures are considered asa percentage of sales, firms in industries with high concentration ratios spend more on R&D thanfirms in industries with low concentration ratios.
Many oligopolistic companies do considerable research. In the opening segment of this
chapter, we noted three firms dominated the medical devices market—Johnson & Johnson,Boston Scientific, and Medtronic. Each of these firms spends more than 10 percent of its rev-enues on R&D. Johnson & Johnson alone spent $8 billion on R&D in 2007. Microsoft spends asimilar amount.
However, the “high-tech revolution” grew out of many tiny start-up operations. Companies
such as Sun Microsystems, Cisco Systems, and even Microsoft barely existed only a generationago. The new biotechnology firms that are just beginning to work miracles with genetic engi-neering are still tiny operations that started with research done by individual scientists in univer-sity laboratories.
Significant ambiguity on this subject remains. Indeed, there may be no right answer.
T echnological change seems to come in fits and starts, sometimes from small firms and some-times from large ones.
The Role of Government
As we suggested earlier, one way that oligopolies increase the market concentration is throughmergers. Not surprisingly, the government has passed laws to control the growth of market powerthrough mergers.
308 PART III Market Imperfections and the Role of Government
Celler-Kefauver Act
Extended the government’sauthority to control mergers.
Herfindahl-Hirschman Index
(HHI) An index of market
concentration found bysumming the square of
percentage shares of firms in
the market.
TABLE 14.2 Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical
Industries, Each with No More Than Four Firms
Percentage Share of:Herfindahl
Hirschman Index Firm 1 Firm 2 Firm 3 Firm 4
Industry A 50 50 – – 502+ 502= 5,000
Industry B 80 10 10 – 802+ 102+ 102= 6,600
Industry C 25 25 25 25 252+ 252+ 252+ 252= 2,500
Industry D 40 20 20 20 402+ 202+ 202+ 202= 2,800Regulation of Mergers
The Clayton Act of 1914 (as mentioned in Chapter 13) had given government the authority to
limit mergers that might “substantially lessen competition in an industry.” The Celler-Kefauver
Act(1950) enabled the Justice Department to monitor and enforce these provisions. In the early
years of the Clayton Act, firms that wanted to merge knew there was a risk of government oppo-sition. Firms could spend large amounts of money on lawyers and negotiation. Firms couldspend resources on negotiations only to have the government take the firms to court.
In 1968, the Justice Department issued its first guidelines designed to reduce uncertainty
about the mergers it would find acceptable. The 1968 guidelines were strict. For example, if thelargest four firms in an industry controlled 75 percent or more of a market, an acquiring firmwith a 15 percent market share would be challenged if it wanted to acquire a firm that controlledas little as an additional 1 percent of the market.
In 1982, the Antitrust Division—in keeping with President Reagan’s hands-off policy toward
big business—issued a new set of guidelines. Revised in 1984, they remain in place today. Thestandards are based on a measure of market structure called the Herfindahl-Hirschman Index
(HHI) . The HHI is calculated by expressing the market share of each firm in the industry as a
percentage, squaring these figures, and summing. For example, in an industry in which two firmseach control 50 percent of the market, the index is
50
2+ 502= 2,500 + 2,500 = 5,000
For an industry in which four firms each control 25 percent of the market, the index is
252+ 252+ 252+ 252= 625 + 625 + 625 + 625 = 2,500
Table 14.2 shows HHI calculations for several hypothetical industries. The Justice Department’s
courses of action, summarized in Figure 14.7, are as follows: If the Herfindahl-Hirschman Index is lessthan 1,000, the industry is considered unconcentrated and any proposed merger will go unchallengedby the Justice Department. If the index is between 1,000 and 1,800, the department will challenge any
HHIAntitrust division action
1,0001,800
0Concentrated
Challenge if Index is
raised by more than 50
points by the merger
Moderate Concentration
Challenge if Index is
raised by more than 100
points by the merger
Unconcentrated
No challenge/L50298FIGURE 14.7
Department of Justice
Merger Guidelines(revised 1984)
CHAPTER 14 Oligopoly 309
merger that would increase the index by over 100 points. Herfindahl indexes above 1,800 mean that
the industry is considered concentrated already, and the Justice Department will challenge any mergerthat pushes the index up more than 50 points.
Y ou should be able to see that the HHI combines two features of an industry that we identified as
important in our Five Forces discussion: the number of firms in an industry and their relative sizes.
In the previous arithmetic example, we looked at the share of the market controlled by each
of several firms. Before we can make these calculations, however, we have to answer anotherquestion: How do we define the market? What are we taking a share of? Think back to our dis-cussion of market power in Chapter 13. Coca-Cola has a “monopoly” in the production of Cokebut is one of several firms making cola products, one of many more firms making soda in gen-eral, and one of hundreds of firms making beverages. Coca-Cola’s market power depends onhow much substitutability there is among cola products, among sodas in general, and amongbeverages in general. Before the government can calculate an HHI, it must define the market ,a
task that involves figuring out which products are good substitutes for the products in question.
An interesting example of the difficulty in defining markets and the use of the HHI in merger
analysis comes from the 1997 opposition by the FTC to the proposed merger between Staples andOffice Depot. At that time, Office Depot and Staples were the number one and number two firms,respectively, in terms of market share in dedicated sales of office supplies. The FTC argued that insales of office supplies, office superstores such as Office Depot and Staples had a strong advantage inthe mind of the consumer. As a result of the one-stop shopping that they offered, it was argued thatother stores selling stationery were not good substitutes for the sales of these two stores. So the FTCdefined the market over which it intended to calculate the HHI to decide on the merger as the sale ofoffice supplies in office superstores. Practically, this meant that stationery sold in the corner shop or inWal-Mart was not part of the market, not a substantial constraint on the pricing of Office Depot orStaples. Using this definition, depending on where in the United States one looked, the HHI resultingfrom the proposed merger was between 5,000 and 10,000, clearly above the threshold. Economistsworking for Staples, on the other hand, argued that the market should include all sellers of office sup-plies. By that definition, a merger between Office Depot and Staples would result in a HHI well belowthe threshold since these two firms together controlled only 5 percent of the total market and the HHI
in the overall market was well below 1,000. In the end, the merger was not allowed.
In Table 14.3, we present HHIs for a few different markets. Notice in one case—Las Vegas
gaming—that the market has both a product and a geographic component. This definition,which was used by the government in one merger case, assumes that casinos in Las Vegas do noteffectively compete with casinos in Atlantic City, for example. Other markets (for example, beer)are national markets. In general, the broader the definition of the market, the lower the HHI.
TABLE 14.3
Industry Definition Some Sample HHIs
Beer 3,525
Ethanol 326
Las Vegas gaming 1,497
Critical care patient monitors 2,661
actions by a group of firms that are profitable for each of them only as the result of theaccommodating reactions of others. This behavior includes tacit or express collusion, andmay or may not be lawful in and of itself.
2In 1997, the Department of Justice and the FTC issued joint Horizontal Merger Guidelines ,
updating and expanding the 1984 guidelines. The most interesting part of the new provisions isthat the government examines each potential merger to determine whether it enhances the firms’power to engage in “coordinated interaction” with other firms in the industry. The guidelinesdefine “coordinated interaction” as
2U.S. Department of Justice, Federal Trade Commission, Horizontal Merger Guidelines , 2005.
310 PART III Market Imperfections and the Role of Government
A Proper Role?
Certainly, there is much to guard against in the behavior of large, concentrated industries.
Barriers to entry, large size, and product differentiation all lead to market power and to potentialinefficiency. Barriers to entry and collusive behavior stop the market from working toward anefficient allocation of resources.
For several reasons, however, economists no longer attack industry concentration with the
same fervor they once did. First, even firms in highly concentrated industries can be pushed toproduce efficiently under certain market circumstances. Second, the benefits of product differen-tiation and product competition are real. After all, a constant stream of new products and newvariations of old products comes to the market almost daily. Third, the effects of concentrationon the rate of R&D spending are, at worst, mixed. It is true that large firms do a substantialamount of the total research in the United States. Finally, in some industries, substantialeconomies of scale simply preclude a completely competitive structure.
In addition to the debate over the desirability of industrial concentration, there is a never-
ending debate concerning the role of government in regulating markets. One view is that high lev-els of concentration lead to inefficiency and that government should act to improve the allocationof resources—to help the market work more efficiently. This logic has been used to justify the lawsand other regulations aimed at moderating noncompetitive behavior.
An opposing view holds that the clearest examples of effective barriers to entry are those cre-
ated by government. This view holds that government regulation in past years has been ultimatelyanticompetitive and has made the allocation of resources less efficient than it would have beenwith no government involvement. Recall from Chapter 13 that those who earn positive profitshave an incentive to spend resources to protect themselves and their profits from competitors. Thisrent-seeking behavior may include using the power of government.
Complicating the debate further is international competition. Increasingly, firms are faced
with competition from foreign firms in domestic markets at the same time they are competingwith other multinational firms for a share of foreign markets. We live in a truly global economytoday. Thus, firms that dominate a domestic market may be fierce competitors in the interna-tional arena. This has implications for the proper role of government. Some contend that insteadof breaking up AT&T, the government should have allowed it to be a bigger, stronger interna-tional competitor. We will return to this debate in a later chapter.
SUMMARY
MARKET STRUCTURE IN AN OLIGOPOLY p. 294
1.An oligopoly is an industry dominated by a few firms that, by
virtue of their individual sizes, are large enough to influencemarket price. The behavior of a single oligopolistic firmdepends on the reactions it expects of all the other firms inthe industry. Industrial strategies usually are very compli-cated and difficult to generalize about.
2.The Five Forces model is a helpful way to organize economicknowledge about the structure of oligopolistic industries. Bygathering data on an industry’s structure in terms of theexisting rivals, new entrants, substitutes, and buyer and sup-plier characteristics, we can better understand the sources ofexcess profits in an industry.
OLIGOPOLY MODELS p. 297
3.When firms collude, either explicitly or tacitly, they jointlymaximize profits by charging an agreed-to price or by settingoutput limits and splitting profits. The result is the same as itwould be if one firm monopolized the industry: The firmwill produce up to the point at which MR=MC, and price
will be set above marginal cost.4.The price-leadership model of oligopoly leads to a result
similar but not identical to the collusion model. In thisorganization, the dominant firm in the industry sets a priceand allows competing firms to supply all they want at thatprice. An oligopoly with a dominant price leader will pro-duce a level of output between what would prevail undercompetition and what a monopolist would choose in thesame industry. An oligopoly will also set a price between themonopoly price and the competitive price.
5.The Cournot model of oligopoly is based on three assump-
tions: (1) that there are few firms in an industry, (2) thateach firm takes the output of the other as a given, and(3) that firms maximize profits. The model holds that aseries of output-adjustment decisions leads to a final level ofoutput between that which would prevail under perfectcompetition and that which would be set by a monopoly.
GAME THEORY p. 300
6.Game theory analyzes the behavior of firms as if their
behavior were a series of strategic moves and counter-moves. It helps us understand the problem of oligopoly
CHAPTER 14 Oligopoly 311
REVIEW TERMS AND CONCEPTS
cartel, p. 297
Celler-Kefauver Act, p. 308
concentration ratio, p. 295
contestable markets, p. 295
dominant strategy, p. 301
duopoly, p. 299Five Forces model, p. 294
game theory, p. 301
Herfindahl-Hirschman Index (HHI), p. 308
maximin strategy, p. 303
Nash equilibrium, p. 302
oligopoly, p. 293price leadership, p. 298
prisoners’ dilemma, p. 302
tacit collusion, p. 298
tit-for-tat strategy, p. 304
PROBLEMS
1.Which of the following industries would you classify as an oli-
gopoly? Which would you classify as monopolistically competi-tive? Explain your answer. If you are not sure, what informationdo you need to know to decide?
a.Athletic shoes
b.Restaurants
c.Watches
d.Aircraft
e.Ice cream
2.[Related to the Economics in Practice onp. 296 ]In the last
decade, many movie theaters have closed and others have seen afall in yearly revenues. Use the Five Forces apparatus to analyze
why this might have occurred.
3.Which of the following markets are likely to be perfectly con-
testable? Explain your answers.
a.Shipbuilding
b.Trucking
c.Housecleaning services
d.Wine production
4.Assume that you are in the business of building houses. Y ou
have analyzed the market carefully, and you know that at a priceof $120,000, you will sell 800 houses per year. In addition, youknow that at any price above $120,000, no one will buy your
houses because the government provides equal-quality houses
to anyone who wants one at $120,000. Y ou also know that forevery $20,000 you lower your price, you will be able to sell anadditional 200 units. For example, at a price of $100,000, youcan sell 1,000 houses; at a price of $80,000, you can sell1,200 houses; and so on.a.Sketch the demand curve that your firm faces.b.Sketch the effective marginal revenue curve that your
firm faces.
c.If the marginal cost of building a house is $100,000, how
many will you build and what price will you charge? What ifMC = $85,000?
5.The matrix in Figure 1 on the following page shows payoffs based
on the strategies chosen by two firms. If they collude and holdprices at $10, each firm will earn profits of $5 million. If A cheats
on the agreement, lowering its price, but B does not, A will get
75 percent of the business and earn profits of $8 million and B will lose $2 million. Similarly, if B cheats and A does not, B willearn $8 million and A will lose $2 million. If both firms cutprices, they will end up with $2 million each in profits.
Which strategy minimizes the maximum potential loss
for A and for B? If you were A, which strategy would youchoose? Why? If A cheats, what will B do? If B cheats, will Ado? What is the most likely outcome of such a game? Explain.
6.The payoff matrixes in Figure 2 on the following page show the
payoffs for two games. The payoffs are given in parentheses. Thefigure on the left refers to the payoff to A; the figure on the rightrefers to the payoff to B. Hence, (2, 25) means a $2 payoff to A
and a $25 payoff to B.
a.Is there a dominant strategy in each game for each player?
b.If game 1 were repeated a large number of times and you were
A and you could change your strategy, what might you do?
c.Which strategy would you play in game 2? Why?
7.Between 2008 and 2010, dozens of lawsuits were brought or
reinstated against U.S. firms for conspiracy to fix prices ofthings as diverse as pharmaceuticals, baby products, digitalmusic, and eggs. Choose one of these lawsuits or cases and
All problems are available on www.myeconlab.combut leaves us with an incomplete and inconclusive set of
propositions about the likely behavior of individual oli-gopolistic firms.
OLIGOPOLY AND ECONOMIC PERFORMANCE p. 306
7.Concentration in markets often leads to price above mar-ginal cost and output below the efficient level. Market con-centration, however, can also lead to gains from economiesof scale and may promote innovation.THE ROLE OF GOVERNMENT p. 307
8.The Clayton Act of 1914 (see Chapter 13) gave the govern-
ment the authority to limit mergers that might “substantiallylessen competition in an industry.” The Celler-Kefauver Act
(1950) enabled the Justice Department to move against aproposed merger. Currently, the Justice Department uses theHerfindahl-Hirschman Index to determine whether it will
challenge a proposed merger.
9.Some argue that the regulation of mergers is no longer aproper role for government.
312 PART III Market Imperfections and the Role of Government
Firm A Firm B
Price
high
Price
lowPrice high Price low
(2, 25)
(25, 2) (5, 5) (15, 15)
Ann (A) Bob (B)
Swerve
Do not
swerveSwerveDo not
swerve
(3, 10)
(10, 3) (–10, –10) (5, 5) Game 2: ChickenGame 1: Pricing
/L50304FIGURE 2a.Calculate the four-firm concentration ratio for this industry.
b.Calculate the Herfindahl-Hirschman Index (HHI) for
this industry.
c.Would the Justice Department consider this industry as uncon-
centrated, moderately concentrated, or concentrated? Why?describe the economic and legal issues. What are the details of
the case? What law was allegedly violated? How was the case set-
tled? Was justice done? Explain your answer.
8.Suppose we have an industry with two firms producing the
same product. Firm A produces 90 units, while firm B produces
10 units. The price in the market is $100, and both firms havemarginal costs of production of $50. What incentives do the twofirms have to lower prices as a way of trying to get consumers toswitch the firm they buy from? Which firm is more likely tolower its price?
9.For each of the following, state whether you agree or disagree.
Explain your reasoning.a.Oligopolies are always bad for society.
b.The beer industry has a few large firms and many small
firms. Therefore, we would not call it an oligopoly.
10.The following table represents the market share percentage for
each firm in a hypothetical industry.d.Suppose firms Eand Gwanted to merge. What would be
the value of the HHI following this merger? Would theJustice Department most likely challenge this merger? Whyor why not?
11.Bernie and Leona were arrested for money laundering and
were interrogated separately by the police. Bernie and Leonawere each presented with the following independent offers. Ifone confesses and the other doesn’t, the one who confesses willgo free and the other will receive a 20-year prison sentence; if
both confess, each will receive a 10-year prison sentence.Bernie and Leona both know that without any confessions, the
police only have enough evidence to convict them of the lessercrime of tax evasion, and each would then receive a 2-yearprison sentence.
a.Use the above information to construct a payoff matrix for
Bernie and Leona.
b.What is the dominant strategy for Bernie and for
Leona? Why?
c.Based on your response to the previous question, what
prison sentence will each receive?
12.Explain whether you agree or disagree with the following state-
ment. If all firms in an industry successfully engage in collusion,the resulting profit-maximizing price and output would be the
same as if the industry was a monopoly.
13.What is the Cournot model? How does the output decision in the
Cournot model differ from the output decision in a monopoly?
Firm A B C D E F G
Market Share 12 8 20 25 4 25 6
Stand by agreement Cheat
A’s S t r a t e g yB’s Strategy
Stand by
agreement
CheatB’s profit =
$5 million
A ’s profit =
$5 million
A ’s profit =
$2 millionB’s profit =
$2 million
A ’s profit =
$8 millionB’s profit =
–$2 millionB’s profit =
$8 million
A ’s profit =
–$2 million
/L50304FIGURE 1
CHAPTER OUTLINE
31315
Industry
Characteristics p. 314
ProductDifferentiation andAdvertising
p. 315
How Many Varieties?
How Do Firms
Differentiate Products?
Advertising
Price and Output
Determination inMonopolisticCompetition
p. 322
Product Differentiation
and Demand Elasticity
Price/Output
Determination in theShort Run
Price/Output
Determination in theLong Run
Economic Efficiency
and ResourceAllocation
p. 326We come now to our last broad type
of market structure: monopo listic
competition . Like perfect compe-
tition, a monopolistically com-petitive industry is an industry inwhich entry is easy and manyfirms are the norm. In contrast tothe perfectly competitive firm,however, firms in this industrytype do not produce homoge-neous goods. Rather, each firmproduces a slightly different ver-sion of a product. These productdifferences give rise to some mar-ket power. In the monopolistically competitive industry, a firm can charge a higher price thana competitor and not lose all of its customers. We will spend some time in this chapter look-ing at pricing in these industries.
But pricing is only one part of the story in these industries. When we look at firms in an
industry characterized by monopolistic competition, we naturally focus on how firms make deci-sions about what kinds of products to sell and how to market and advertise them. Why do we seea dozen different types of shampoo in a store? Is a dozen too many, too few, or just the rightamount? Why are beverages and automobiles advertised a great deal but semiconductors andeconomics textbooks are not? Advertising is expensive: Is it a waste of money, or does it servesome social function? In this chapter, we will also explore briefly some ideas from behavioral
economics . Can consumers ever be offered too many choices? Why does nutritional cereal sell bet-
ter in the extra large size while candy sells better by the bar?
By the end of this chapter, we will have covered the four basic types of market structure.
Figure 15.1 summarizes the four types: perfect competition, monopoly, oligopoly, andmonopolistic competition. The behavior of firms in an industry, the key decisions facingfirms, and the key policy issues government faces in dealing with those firms differ dependingon the market structure we are in. Although not every industry fits neatly into one of thesecategories, they do provide a useful and convenient framework for thinking about industrystructure and behavior.
Monopolistic
Competition
314 PART III Market Imperfections and the Role of Government
Industry Characteristics
Amonopolistically competitive industry has the following characteristics:
1.A large number of firms
2.No barriers to entry
3.Product differentiation
While pure monopoly and perfect competition are rare, monopolistic competition is com-
mon in the United States, for example, in the restaurant business. In a Y ahoo search ofSan Francisco restaurants, there are 8,083 listed in the area. Each produces a slightly differentproduct and attempts to distinguish itself in consumers’ minds. Entry to the market is notblocked. At one location near Union Square in San Francisco, five different restaurants openedand went out of business in 5 years. Although many restaurants fail, small ones can compete andsurvive because there are few economies of scale in the restaurant business.
The feature that distinguishes monopolistic competition from monopoly and oligopoly is
that firms that are monopolistic competitors cannot influence market price by virtue of their size.No one restaurant is big enough to affect the market price of a prime rib dinner even though allrestaurants can control their own prices. Instead, firms gain control over price in monopolistic
competition by differentiating their products. Y ou make it in the restaurant business by producing
a product that people want that others are not producing or by establishing a reputation for goodfood and good service. By producing a unique product or establishing a particular reputation, afirm becomes, in a sense, a “monopolist”—that is, no one else can produce the exact same good.
The feature that distinguishes monopolistic competition from pure monopoly is that good
substitutes are available in a monopolistically competitive industry. With 8,083 restaurants in theSan Francisco area, there are dozens of good Italian, Chinese, and French restaurants.San Francisco’s Chinatown, for example, has about 50 small Chinese restaurants, with over adozen packed on a single street. The menus are nearly identical, and they all charge virtually thesame prices. At the other end of the spectrum are restaurants, with established names and pricesfar above the cost of production, that are always booked. That is the goal of every restaurateurwho ever put a stockpot on the range.
Table 15.1 presents some data on nine national manufacturing industries that have the charac-
teristics of monopolistic competition. Each of these industries includes hundreds of individual firms,some larger than others, but all small relative to the industry. The top four firms in book printing, forexample, account for 33 percent of total shipments. The top 20 firms account for 68 percent of themarket, while the market’s remaining 41 percent is split among almost 540 separate firms.
Firms in a monopolistically competitive industry are small relative to the total market. New
firms can enter the industry in pursuit of profit, and relatively good substitutes for the firms’products are available. Firms in monopolistically competitive industries try to achieve a degree ofmarket power by differentiating their products—by producing something new, different, or bet-ter or by creating a unique identity in the minds of consumers. T o discuss the behavior of suchfirms, we begin with product differentiation and advertising.Number
of firmsProducts
differentiated
or homogeneousPrice a
decision
variableEasy
entryDistinguished
by Examples
Many Homogeneous No Y es Market sets price Wheat farmer
T extile firm
One One version or many
versions of a productYe s No Still constrained
by market demandPublic utility
Patented drug
Many Differentiated Y es, but
limitedYe s Price and
quality competitionRestaurants
Hand soap
Few Perfect
competition
Monopoly
Monopolistic
competition
Oligopoly Either Y es Limited Strategic
behaviorAutomobiles
Aluminum
/L50304FIGURE 15.1 Characteristics of Different Market Organizations
monopolistic competition
A common form of industry
(market) structure in the
United States, characterized bya large number of firms, no
barriers to entry, and product
differentiation.
CHAPTER 15 Monopolistic Competition 315
Product Differentiation and Advertising
Monopolistically competitive firms achieve whatever degree of market power they command
through product differentiation . But what determines how much differentiation we see in a
market and what form it takes?
How Many Varieties?
As you look around your neighborhood, notice the sidewalks that connect individual homes withthe common outside walk. In some areas, you will see an occasional brick or cobblestone walk,but in most places in the United States, these sidewalks are made of concrete. In almost everycase, that concrete is gray. Now look at the houses that these sidewalks lead up to. Except in devel-opments with tight controls, house colors vary across the palette. Why do we have one variety ofconcrete sidewalk while we have multiple varieties of house colors?
Whenever we see limited varieties of a product, a first thought might be that all consumers—
here homeowners—have similar preferences. Perhaps everyone has a natural affection for gray, atleast in concrete. The wide variety in the colors of the houses that these sidewalks lead up to mightmake you skeptical of this explanation, but it is possible. Another possible explanation for thecommon gray sidewalks might be a desire for coordination: Maybe everyone wants his or her side-walk to look like the neighbor’s, and the fact that the sidewalk connecting the houses—often pro-vided by the city—is gray serves to make gray a focal point. In fashion, for example, coordinationand conformity play an enormous role. There is no inherent reason that oversized jeans should bemore or less attractive than narrow-cut, low-rise jeans except that they are made so at certain timesby the fact that many people are wearing them. Again, you might wonder why conformity isimportant in sidewalk color but not in house color, something even more visible to the neighbors.
In explaining the narrow variety of concrete sidewalks, a better explanation may come from
a review of the material we covered in Chapter 8 when we looked at cost structures. As you know,concrete is made in large mixer trucks. The average capacity of these trucks is 9 or more cubicyards, well more than you would need for a sidewalk. An obvious way to color this concrete is tomix a coloring agent in the mixer truck along with the cement and other ingredients. When donethis way, however, we need to find several neighbors who want the same color cement that wewant at the same time—concrete is not storable. Even doing it this way is potentially problematicbecause the inside of the mixer unit can be affected, leaving a residue of our purple concrete, forexample, for the next customer. Alternatively, we could add dye after the concrete comes out ofthe truck, which is done in some places, but the resulting colors are limited, and the process isexpensive. So the lack of variety in concrete and not in houses may reflect the scale economies inhomogeneous production of concrete not found in house painting.
The example of the sidewalks versus the houses helps explain the wide variety in some prod-
uct areas and the narrowness in others. In some cases, consumers may have very different tastes .I t
should be no surprise that immigration brings with it an increase in the variety of restauranttypes in an area and in the food offerings at the local grocery store. Immigration typicallyproduct differentiation A
strategy that firms use to
achieve market power.
Accomplished by producingproducts that have distinct
positive identities in
consumers’ minds.TABLE 15.1 Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 2002
Industry DesignationFour Largest
FirmsEight Largest
FirmsTwenty Largest
FirmsNumber of
Firms
Travel trailers and campers 38 45 58 733
Games, toys 39 48 63 732
Wood office furniture 34 43 56 546
Book printing 33 54 68 560
Curtains and draperies 17 25 38 1,778
Fresh or frozen seafood 14 24 48 529
Women’s dresses 18 23 48 528
Miscellaneous plastic products 6 10 18 6,775
Source: U.S. Department of Commerce, Bureau of the Census, 2002 Census of Manufacturers, Concentration Ratios in Manufacturing .
Subject Ec02 315R, May 2006.
316 PART III Market Imperfections and the Role of Government
increases the heterogeneity of consumer tastes. Product variety is narrower when there are gains
to coordination. In Chapter 13, we described products in which there are network externalities.Here coordination needs can dramatically narrow product choice. For example, it will be more
important to most people to use the same word-processing program their friends use than to useone that suits them perfectly. Finally, scale economies that make producing different varietiesmore expensive than a single type can reduce variety. People prefer a relatively inexpensive stan-dardized good over a more expensive custom product that perfectly suits them. The development
of the Levitt house in the postwar period in Pennsylvania and New Y ork was a testament to thecost savings in housing that came from standardization, creating uniform tract houses for afford-able prices.
In sum, in well-working markets, the level of product variety reflects the underlying hetero-
geneity of consumers’ tastes in that market, the gains if any from coordination, and costeconomies from standardization. In industries that are monopolistically competitive, differencesin consumer tastes, lack of need for coordination, and modest or no scale economies from stan-dardization give rise to a large number of firms, each of which has a different product. Evenwithin this industry structure, however, these same forces play a role in driving levels of variety.
In recent years, quite a few people have taken up the sport of running. The market has
responded in a big way. Now there are numerous running magazines; hundreds of orthotic shoesdesigned specifically for runners with particular running styles; running suits of every color, cloth,and style; weights for the hands, ankles, and shoelaces; tiny radios to slip into sweatbands; and so on.Even physicians have differentiated their products: Sports medicine clinics have diets for runners,therapies for runners, and doctors specializing in shin splints or Morton’s toe.
Why has this increase in variety in the running market taken place? More runners—each
with a different body, running style, and sense of aesthetics—increase consumer heterogeneity.The increased market size also tells us that if you produce a specialized running product, it ismore likely you will sell enough to cover whatever fixed costs you had in developing the product.So market size allows for more variety. New Y ork has a wider range of ethnic restaurants thandoes Eden Prairie, Minnesota, not only because of the difference in the heterogeneity of the pop-ulations but also because of the sheer size of the two markets.
How Do Firms Differentiate Products?
We have learned that differentiation occurs in response to demands by consumers for productsthat meet their individual needs and tastes, constrained by the forces of costs of coordination andscale economies. We can go one step further and characterize the kinds of differentiation we seein markets.
Return to the restaurant example we brought up earlier. Of the 8,083 restaurants in San
Francisco, some are French, some are Chinese, and some are Italian. Economists would call thisform of differentiation across the restaurants horizontal differentiation . Horizontal differentia-
tion is a product difference that improves the product for some people but makes it worse forothers. If we were to poll San Francisco residents, asking for the best restaurant in town, we wouldundoubtedly get candidates from a number of different categories. Indeed, many people mightnot even consider this to be a legitimate question.
If you add sea salt and vinegar to potato chips, that makes them more attractive to some peo-
ple and less attractive to others. Horizontal differentiation creates variety to reflect differences inconsumers’ tastes in the market.
For some products, people choose a type and continue with it for a long time. For many of
us, breakfast cereals have this feature. Day after day we eat Cheerios or corn flakes. Brand prefer-ence for mayonnaise has the same stability. For dinner, however, most of us are variety-seeking .
Even small cities can support some variety in restaurant types because people get tired of eatingat the same place every week.
People who visit planned economies often comment on the lack of variety. Before the Berlin
Wall came down in 1989 and East and West Germany were reunited in 1990, those who wereallowed passed from colorful and exciting West Berlin into dull and gray East Berlin; varietyseemed to vanish. As the wall came down, thousands of Germans from the East descended on thedepartment stores of the West. Visitors to China since the economic reforms of the mid-1980shorizontal differentiation
Products differ in ways that
make them better for some
people and worse for others.
2The classic paper that describes the study reported here is I. Y engar and L. Epper, “When Choice Is Demotivating: Can One
Desire T oo Much of a Good Thing?” Journal of Personality and Social Psychology , 2000, 995–1006.CHAPTER 15 Monopolistic Competition 317
behavioral economics
A branch of economics that
uses the insights of psychology
and economics to investigatedecision making.
3The subsample of six brands was carefully selected to be neither the best nor the worst of the flavors, and to actually buy, con-
sumers had to go to a shelf that contained all the varieties of jam.
4Papers described in this paragraph include Klaus W. Ertenbroch, “Self-Rationing: Self-Control in Consumer Choice,” INSEAD
Working Paper, 2001, on the package size topic; Ulrike Malmendier and Stefano Della Vigna, “Paying Not to Go to the Gym,”AER , June 2006, 694–719, on health club memberships; and Sharon Oster and Fiona Scott Morton, “Behavioral Biases Meet the
Market,” BEPress Journal of Economic Advance and Policy, 2005, on magazines.claim that the biggest visible sign of change is the increase in the selection of products available to
the population.
Recent work in the area of behavioral economics suggests, however, that there may be times in
which too much variety is a bad thing.2Behavioral economics is a branch of economics that uses
the insight of psychology and economics to investigate decision making.
Researchers set up an experiment in an upscale grocery, Draeger’s, located in Menlo Park,
California. Draeger’s is known for its large selection, carrying, for example, 250 varieties ofmustard. A tasting booth was set up in the store on two consecutive Saturdays. On one day,consumers were offered one of six exotic jams to taste, while on the other day, 24 varietieswere offered. The results of the experiment were striking. While more customers approachedthe 24-jam booth for a taste than approached the booth with a limited selection, almost noneof the tasters at the 24-jam booth bought anything; in contrast, almost 30 percent of tasters atthe six-jam booth made a purchase.
3The researchers conclude that while some choice is
highly valued by people, too much choice can reduce purchases.
The jam experiment offers a case in which individuals react to a wide range of choices by
not making a choice at all. Behavioral economists also note that when the number of choices islarge, individuals may avoid the decision-making burden by using a rule of thumb or byreverting to the default option. In the area of retirement savings, for example, some studieshave found a tendency for people to allocate savings evenly across a range of investmentoptions without paying much attention to the earnings characteristics of those funds. In othercases, people appear to favor whatever option is the default designated by the governmentbody or by the firm offering the plan. For this reason, some economists have argued that oneway to increase consumer savings (if that is desirable) is to make participation rather than noparticipation the default in pension plans. In this way, individuals would be enrolled in aretirement plan unless they chose not to be. These plans are called opt-out plans rather thanopt-in plans.
Behavioral economics also has something to say about another form of horizontal
differentiation—package size and pricing form.
4Many consumer goods come in small, large,
and extra large packages. Many goods (for example, health club visits and magazines) can bebought per visit or issue or via membership or subscription. Many of us think of these differ-ences as matters of convenience. Firms can use these differences to create products targeted atconsumer types. Small households buy small boxes of cereals, and large families purchaseextra large sizes. Occasional readers buy Us Weekly on the newsstand, and fans subscribe to
the magazine. Clearly, these kinds of differences play a role. But behavioral economists havealso suggested that some of these differences survive in the market because some consumersare interested in trying to control their purchasing behavior. People buy small containers ofice cream but large bottles of vitamins. Why? Because they want to commit themselves to tak-
ing a vitamin every day but only occasionally eating ice cream. People buy memberships tohealth clubs as an incentive to work out; they make the marginal cost of a visit zero eventhough in the end, they may pay more than they would have by paying a per-visit fee. We sub-scribe to The Economist but buy Us Weekly on the newsstand at high per-issue prices in the
hopes that we will read more of The Economist and less of Us Weekly . Some students choose
classes that reward attendance as a way of ensuring that they go to class. Firms can be creativeabout using product differentiation to offer consumers commitment devices that help themcontrol their own impulses. A commitment device is an action taken by an individual now to
try to control his or her behavior in the future.
Behavioral economics is an exciting new field that is challenging and deepening our under-
standing of a number of areas of economics. New ideas from behavioral economics have enteredboth microeconomics and macroeconomics.
commitment device Actions
that individuals take in oneperiod to try to control their
behavior in a future period.
318 PART III Market Imperfections and the Role of Government
vertical differentiation A
product difference that, from
everyone’s perspective, makes aproduct better than rival
products.Products can be differentiated not only horizontally but also vertically . A new BMW with
GPS is better than one without for almost everyone. A hard drive with more capacity is betterthan one with less. The Hilton is better than a Motel 6 if they are located in the same place. Howcan a product survive in a competitive marketplace when another better product is available?The answer, of course, is in the price. The better products cost more, and only some people findit worthwhile to pay the higher price to get a better product. So differences among people alsogive rise to vertical differentiation. Some people value quality in a specific product more thanothers do and are willing to pay for that quality. If you are on a special date, it might be worth-while to go to the best restaurant in town. On the other hand, while at a casual dinner withfriends, watching your budget might be more important.
We have described the forces that help determine how much differentiation we will see in a
market and the major forms that differentiation can take. We turn now to advertising, whichplays a special role in the area of monopolistic competition.
Advertising
Advertising fits into the differentiation story in two different ways. One role advertising plays is toinform people about the real differences that exist among products. Advertising can also create or
contribute to product differentiation, creating a brand image for a product that has little to dowith its physical characteristics. We can all think of examples of each type.
ECONOMICS IN PRACTICE
An Economist Makes Tea
Y ou have probably seen Honest T ea, a slightly sweetened bottled iced
tea made from green, black, and herbal blends in your local grocery
store. It is probably not the only iced tea on the shelf. In addition tothe popular brands Lipton and Snapple, you may also see SoBe,Tazo, and Turkey Hill, depending on where you live. Bottled iced teais a classic example of a monopolistically competitive market. None
of the brands are exactly alike. Honest T ea, for example, prides itself
on being made with high-end tea leaves and only a hint of sweetener,while Snapple uses lower-quality leaves and a hefty dose of sweet-ener. Nor are the teas priced the same. In a typical store, the retailprice of Honest T ea and SoBe are likely to be about $1.89, whileSnapple would likely cost about $1.39. If you spend time in the bev-
erage aisle of a grocery store, you will notice that despite the higher
price of Honest T ea, some consumers choose it over the alternatives.What you may not know about Honest T ea is that it was started a
decade ago by Seth Goldman, an entrepreneur, and Barry Nalebuff,an economist. In figuring out how to differentiate his tea from oth-ers in the industry, Nalebuff used some of the economic theory that
we covered in Chapter 6 of this book. Look at the following graph,
which shows the placement of one of Honest T ea’s most popular fla-vors, Green Dragon. The graph shows how taste varies with sugar forGoldman and Nalebuff’s potential customers. T ea taste improves forthe first few grams of sugar, but shortly begins to flatten out and
then fall. Note that Green Dragon is somewhat to the left of the taste
peak. Some economists looking at this graph criticized Nalebuff forchoosing too little sugar content for his tea. What were the criticsthinking, and why were they wrong?
The critics clearly noticed that Green Dragon is not at the
peak of the taste curve. That is, a little more sugar would improve
the taste of the tea. Why did Nalebuff stop short of that point?
This is product differentiation at its best. Goldman and Nalebuffare out to produce a new product that will attract demand. Thatis, at a reasonable price they must attract consumers away fromother products. Goldman and Nalebuff discovered that sugar
beyond some point adds little taste, yet comes at a health cost—
more calories. Given consumers’ new awareness of healthy and
natural foods, Honest T ea became an overnight success. SinceNalebuff is an economist, he couldn’t resist a graph on the labelof the tea bottles
.Sugar
(grams per serving )Taste
0521 0Green Dragon
Liquid
candy
What
theycall tea20 30
CHAPTER 15 Monopolistic Competition 319
Recent Coca-Cola ads trumpeting the “Coke Side of Life” have little to do with Coke’s
taste, for example. The dancers in iPod’s ads create an image of hip and happy people ratherthan describe the technical features of the device. On the other hand, the advertising circularsin local newspapers carry specific information about what products are on sale that week inthe local grocery store.
In 2006, firms spent about $250 billion on advertising, as Table 15.2 shows. Advertising
reaches us through every medium of communication. Table 15.3 shows national advertisingexpenditures by major industrial category. The automobile industry leads the pack with expendi-tures of nearly $20 billion advertising in 2006. In 2008, 30 seconds of prime commercial advertis-ing time during Super Bowl XLII cost $2.7 million.
TABLE 15.2 Total Advertising
Expenditures in 2006
Billions of Dollars
Newspapers $49.0
Television 66.8
Direct mail 59.6
Yellow pages 14.4
Internet 15.0
Radio 19.1
Magazines 24.0
Total 247.9
Source: www.plunkettresearch.com
Many observers believe that the Internet is rapidly changing the way advertising works.
Traditionally, companies have targeted their advertisements in both print and media. Beercommercials are shown during televised sporting events, toy commercials air during chil-dren’s programs, and so on. The Internet has dramatically improved the ability of advertis-ing to target a specific market. Consider advertising on Google. Under Google’s AdWordssystem, which is a click-and-pay system, advertisers pay only when a Web surfer clicks
TABLE 15.3 Domestic Advertising Spending by Category
in 2006 in Billions of Dollars
Rank Category 2006
1 Automotive $19.8
2 Retail 19.1
3 Telecommunications 11.0
4 Medicine and Remedies 9.2
5 General services 8.7
6 Financial services 8.7
7 Food, beverages, and candy 7.2
8 Personal care 5.7
9 Airlines, hotels, car rental, travel 5.4
10 Movies, recorded video, and music 5.4
11 Restaurants 5.3
12 Media 5.1
13 Government, politics, religion 3.5
14 Insurance 3.5
15 Real estate 3.1
16 Apparel 2.9
17 Computers, software 2.5
18 Home furnishings 2.2
19 Beer, wine, and liquor 2.1
20 Education 1.9
Source: TNS Media Intelligence.
320 PART III Market Imperfections and the Role of Government
to their site. In this way, advertisers are sure that people who see their advertisements
are interested in the product. In 2006, Google earned over $6 billion from this form of tar-geted advertising.
Y ouTube, another new entrant into the advertising business, offers firms the opportu-
nity to actively interact with customers. In addition to the standard video ads, firms can cre-ate online contests and brand channels to learn from customers about their preferences.Advertising as information has become more of a transparent two-way street as a result ofthe Internet.
The effects of product differentiation in general (and advertising in particular) on the
allocation of resources have been hotly debated for years. Advocates claim that these forcesgive the market system its vitality and power. Critics argue that they cause waste and ineffi-ciency. Before we proceed to the models of monopolistic competition and oligopoly, let uslook at this debate.
The Case for Advertising For product differentiation to be successful, consumers
must know about product quality and availability. In perfect competition, where all productsare alike, we assume that consumers have perfect information; without it, the market fails toproduce an efficient allocation of resources. Complete information is even more importantwhen we allow for product differentiation. Consumers get this information through adver-tising, at least in part. The basic function of advertising, according to its proponents, is toassist consumers in making informed, rational choices. When we think of advertising, manyof us think of the persuasive ads shown on television geared to changing our image of aproduct. Over the years, Budweiser has developed a reputation for clever ads of this sort,especially those delivered during the Super Bowl. But much advertising is entirely informa-tional. In most parts of the country, one day a week the newspaper grows in size. On this day,stores advertise and promote their food sales. For many newspapers, advertisements are a bigsource of revenue; and it is all informational, helping consumers figure out where to buytheir orange juice and chicken, for example. During the holiday season, toy advertising, bothin print and on television, increases dramatically. For toys, which have a high rate of newproduct introduction, publicizing them is very important.
Supporters of advertising also note that it can promote competition. New products can com-
pete with old, established brands only when promoters can get their messages through to con-sumers. The standard of living rises when we have product innovation , when new and better
products come on the market. Think of all the products today that did not exist 20 years ago:iPods, video games like Guitar Hero, and hybrid cars, to name a few. When consumers areinformed about a wide variety of potential substitutes, their market choices help discipline olderfirms that may have lost touch with consumers’ tastes.
Even advertising that seems to function mostly to create and reinforce a brand image can
have efficiency effects. Creating a brand name such as Coca-Cola or Tide requires a huge invest-ment in marketing and advertising. The stronger the brand name and the more a firm hasinvested in creating that name, the more the firm will invest in trying to protect that name. Inmany cases, those investments provide benefits for consumers. In reacting to the 2007 news aboutlead in children’s toys made in China, large toy companies such as Hasbro and Mattel spentmillions in new testing of those toys. Restoring parental trust in the face of the toy recalls is vitalto the future of the firms.
Differentiated products and advertising give the market system its vitality and are the basis of
its power. Product differentiation helps to ensure high quality and variety, and advertising pro-vides consumers with valuable information on product availability, quality, and price that theyneed to make efficient choices in the marketplace.
The Case Against Product Differentiation and Advertising Product differenti-
ation and advertising waste society’s scarce resources, argue critics. They say enormous sums ofmoney are spent to create minute, meaningless differences among products.
CHAPTER 15 Monopolistic Competition 321
ECONOMICS IN PRACTICE
Can Information Reduce Obesity?
Coming to the Menu: Calorie Counts
The Wall Street Journal
Chowing down on calorie-laden food at chain restaurants is
going to become more of a guilt trip.
The health bill President Barack Obama signed into law
Tuesday requires that restaurant chains post calorie countsfor all the food items they sell. The law covers any chain with
at least 20 outlets, amounting to more than 200,000 restau-
rants nationwide.
“Dining out no longer has to be a nutritional guessing
game,” said Margo G. Wootan, director of nutrition policywith the Center for Science in the Public Interest, a nonprofit
health-advocacy group based in Washington. “People could
cut hundreds, thousands, of calories from their diet.”
Calorie counts must be listed on menus, menu boards,
drive-through displays and vending machines under the law.Additional information—such as sodium levels, carbohy-
drates and saturated fats—must be available on request.
Temporary specials and custom orders are exempted.
A growing number of state, county and local regulations
already require similar disclosures, and those rules will be
superceded by the federal law.
There has been debate about whether such menu
labeling actually affects consumers’ behavior. Some recentstudies have found that such labeling leads to healthier eat-ing: The New York City health department examined the
behavior of 12,000 customers of 13 chain restaurants in
275 locations in the city before and after menu labeling wasimplemented in the city in 2008.
Preliminary results show that one in six fast-food cus-
tomers report using the calorie-count information. Consumers
who said they used the information bought items with
106 fewer calories compared with those who didn’t see oruse the information. Separate studies have shown weak or inconsistent
effects of menu labeling on consumer behavior, according toa 2008 review of the literature published in the International
Journal of Behavioral Nutrition and Physical Activity .
“Calorie posting in and of itself is not going to change obe-
sity per se, but it’s all of these kinds of layering opportunitiesthat we’re doing for public health all across the country that aregoing to make the difference,” said Cathy Nonas, director ofphysical activity and nutrition for the health department in New
York City, a pioneer in adopting menu labeling.
The National Center for Health Statistics reported in
January that 34 percent of Americans age 20 and older wereobese in 2007–2008.
The restaurant industry is required to come up with a
labeling proposal in one year, but the bill leaves it to Foodand Drug Administration officials to determine specific reg-ulations, including the printing fonts and their sizes to beused in calorie displays. Ms. Wootan said it could take
three to four years before diners see the new information
in restaurants.
One concern about the rules is accuracy. Researchers
from Tufts University who looked into caloric disclosurefrom 29 quick-serve and sit-down restaurants found that
restaurants underreported calories by an average of
18 percent.
Some restaurant owners and groups have supported
labeling regulations, in part because they don’t think such dis-
closures deter patrons from ordering what they want.
Source: The Wall Street Journal , “Coming to the Menu: Calorie Counts”
by Jean Spencer and Shirley S. Wang. Copyright 2010 by Dow Jones &
Company, Inc. Reproduced with permission of Dow Jones & Company,
Inc. via Copyright Clearance Center.
Policy makers have been working to increase the level of informa-
tion that consumers have about products. In the early 1990s, theFood and Drug Administration passed rules requiring mostprocessed foods sold in grocery stores to carry nutrition labels.
The current hot topic in the labeling area involves restaurant
meals. With obesity growing in the United States, many policymakers think that one way to fight the problem is to require calo-rie and fat labeling in restaurants. The following article from The
Wall Street Journal discusses a recent law requiring chain restau-
rants to post calorie counts.
322 PART III Market Imperfections and the Role of Government
Drugs, both prescription and nonprescription, are an example. Companies spend mil-
lions of dollars to promote brand-name drugs that contain the same compounds as thoseavailable under the generic names. The antibiotics erythromycin and erythrocin have thesame ingredients, yet erythrocin is half as expensive as erythromycin. Aspirin is aspirin, yetwe pay twice the price for an advertised brand because the manufacturer has convinced usthat there is a tangible—or intangible—difference.
Do we really need 50 different kinds of soap, some of whose prices are increased by the
cost of advertising? For a firm producing a differentiated product, advertising is part ofthe everyday cost of doing business. Its price is built into the average cost curve and thusinto the price of the product in the short run and the long run. Thus, consumers pay tofinance advertising.
Critics also argue that the information content of advertising is minimal at best and deliber-
ately deceptive at worst. Advertising is meant to change our minds, to persuade us, and to createbrand images. Try to determine how much real information there is in the next 10 advertisementsyou see on television. U.S. firms spend about $250 billion a year on advertising. Critics argue thatfirms waste a substantial portion of this money if the advertising does not clearly convey infor-mation to consumers.
Competitive advertising can also easily turn into unproductive warfare. Suppose there are
five firms in an industry and one firm begins to advertise heavily. T o survive, the othersrespond in kind. Advertising of this sort may not increase demand for the product or improveprofitability for the industry. Instead, it is often a “zero sum game”—a game in which the sumof the gains equals the sum of the losses.
Advertising may also reduce competition by creating a barrier to the entry of new firms into
an industry. One famous case study taught at the Harvard Business School calculates the cost ofentering the brand-name breakfast cereal market. T o be successful, a potential entrant would haveto start with millions of dollars in an extensive advertising campaign to establish a brand namerecognized by consumers. Entry to the breakfast cereal game is not completely blocked, but suchfinancial requirements make entry very difficult.
Finally, some argue that advertising, by its very nature, imposes a cost on society. We
are continuously bombarded by bothersome jingles and obtrusive images. When drivinghome from school or work, we may pass 50 billboards and listen to 15 minutes of news and20 minutes of advertising on the radio. When we get home, we throw away 10 pieces ofunsolicited junk mail, glance at a magazine containing 50 pages of writing and 75 pages ofadvertisements, and perhaps watch a television show that is interrupted every 5 minutes fora “message.”
The bottom line, critics of product differentiation and advertising argue, is waste and ineffi-
ciency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differ-ences among products. Advertising raises the cost of products and frequently contains very littleinformation. Often, it is merely an annoyance. Advertising can lead to unproductive warfare andmay serve as a barrier to entry, thus reducing real competition.
Open Questions Y ou will see over and over as you study economics that many ques-
tions remain open. There are strong arguments on both sides of the advertising debate, andeven the empirical evidence yields to conflicting conclusions. Some studies show that adver-tising leads to concentration and positive profits; others, that advertising improves the func-tioning of the market.
Price and Output Determination in
Monopolistic Competition
Recall that monopolistically competitive industries are made up of a large number of firms, each
small relative to the size of the total market. Thus, no one firm can affect market price by virtueof its size alone. Firms do differentiate their products, however, in ways we have been discussing.By doing so, they gain some control over price.
CHAPTER 15 Monopolistic Competition 323
Demand curve facing a perfectly
competitive firm
Demand curve facing a monopolistically
competitive firm
Units of output0Price per unit ($)
/L50304FIGURE 15.2 Product Differentiation Reduces the Elasticity of Demand Facing
a Firm
The demand curve that a monopolistic competitor faces is likely to be less elastic than the demand curve that
a perfectly competitive firm faces. Demand is more elastic than the demand curve that a monopolist faces
because close substitutes for the products of a monopolistic competitor are available.Product Differentiation and Demand Elasticity
Perfectly competitive firms face a perfectly elastic demand for their product: All firms in a
perfectly competitive industry produce exactly the same product. If firm A tried to raiseprices, buyers would go elsewhere and firm A would sell nothing. When a firm can distin-guish its product from all others in the minds of consumers, as we assume it can undermonopolistic competition, it probably can raise its price without losing all quantitydemanded. Figure 15.2 shows how product differentiation might make demand somewhatless elastic for a hypothetical firm.
A monopoly is an industry with a single firm that produces a good for which there are
no close substitutes. A monopolistically competitive firm is like a monopoly in that it is theonly producer of its unique product. Only one firm can produce Cheerios or Wheat Thins orJohnson’s Baby Shampoo or Oreo cookies. However, unlike the product in a monopoly mar-ket, the product of a monopolistically competitive firm has many close substitutes compet-ing for the consumer’s favor. Although the demand curve that a monopolistic competitorfaces is likely to be less elastic than the demand curve that a perfectly competitive firm faces,it is likely to be more elastic than the demand curve that a monopoly faces.
Price/Output Determination in the Short Run
A profit-maximizing, monopolistically competitive firm behaves much like a monopolist in the short run. First, marginal revenue is not equal to price because the monopolisticallycompetitive firm is different enough from its rivals that small price increases over thoserivals do not eliminate all customers. This firm sees its price respond to its output decisions.The monopolistic competitor’s marginal revenue curve lies below its demand curve,
intersecting the quantity axis midway between the origin and the point at which the demandcurve intersects it. (If necessary, review Chapter 13 to make sure you understand this idea.) The firm chooses the output/price combination that maximizes profit. T o maximizeprofit, the monopolistically competitive firm will increase production until the marginalrevenue from increasing output and selling it no longer exceeds the marginal cost of producing it. This occurs at the point at which marginal revenue equals marginal cost:MR =MC.
324 PART III Market Imperfections and the Role of Government
In Figure 15.3(a), the profit-maximizing output is q0= 2,000, where marginal revenue
equals marginal cost. T o sell 2,000 units, the firm charges $6, which is the most it can chargeand still sell the 2,000 units. T otal revenue is P
0/H11003q0= $12,000, or the area of P0Aq00. T otal
cost is equal to average total cost times q0, which is $10,000, or CBq00. T otal profit is the dif-
ference, $2,000 (the gray-shaded area P0ABC ).
Nothing guarantees that a firm in a monopolistically competitive industry will earn positive
profits in the short run. Figure 15.3(b) shows what happens when a firm with similar cost curvesfaces a weaker market demand. Even though the firm does have some control over price, marketdemand is insufficient to make the firm profitable.
As in perfect competition, such a firm minimizes its losses by producing up to the point
where marginal revenue is equal to marginal cost. Of course, as in perfect competition, theprice that the firm charges must be sufficient to cover average variable costs. Otherwise, thefirm will shut down and suffer losses equal to total fixed costs instead of increasing losses byproducing more. In Figure 15.3(b), the loss-minimizing level of output is q
1= 1,000 at a price of
$5. T otal revenue is P1/H11003q1= $5,000, or P1Bq10. T otal cost is ATC /H11003q1= $6,000, or CAq10.
Because t otal cost is greater than revenue, the firm suffers a loss of $1,000, equal to the pink-
shaded area, CABP1.
Price/Output Determination in the Long Run
Under monopolistic competition, entry and exit are easy in the long run. Firms can enter an
industry when there are profits to be made, and firms suffering losses can go out of business.However, entry into an industry of this sort is somewhat different from entry into perfect compe-tition because products are differentiated in monopolistic competition. A firm that enters amonopolistically competitive industry is producing a close substitute for the good in question,but not the same good .
Let us begin with a firm earning positive profits in the short run, as shown on the left-hand
side of Figure 15.3. Those profits provide an incentive for new firms to enter the industry. Thisentry creates new substitutes for the profit-making firm, which, in turn, drives down demand forits product. For example, if several restaurants seem to be doing well in a particular location, oth-ers may start up and take business from the existing restaurants. While firms are not perfect sub-stitutes, they are similar enough to take business from one another.
a. A monopolistically competitive firm earning
short-run profitsb. A monopolistically competitive firm
suffering short-run losses
Marginal cost
Average total cost
Demand
Marginal revenue
Units of output0Losses = $1,000
A
B
q1= 1,000P1= $5ATC = $6Marginal cost
Average total cost
Demand
Marginal revenue
Units of output0Dollars ($)
Dollars ($)A
B
q0= 2,000P0= $6
ATC = $5CProfits = $2,000
C
/L50304FIGURE 15.3 Monopolistic Competition in the Short Run
In the short run, a monopolistically competitive firm will produce up to the point MR=MC. At q0= 2,000 in
panel a, the firm is earning short-run profits equal to P0ABC = $2,000. In panel b, another monopolistically
competitive firm with a similar cost structure is shown facing a weaker demand and suffering short-run lossesatq
1= 1,000, equal to CABP1= $1,000.
CHAPTER 15 Monopolistic Competition 325
MC
ATC
q*P*
Long-run
demand
MR Units of output0Dollars ($)
/L50304FIGURE 15.4
Monopolistically Competitive Firm at Long-Run Equilibrium
As new firms enter a monopolistically competitive industry in search of profits, the demand curves of existing
profit-making firms begin to shift to the left, pushing marginal revenue with them as consumers switch to thenew close substitutes. This process continues until profits are eliminated, which occurs for a firm when itsdemand curve is just tangent to its average total cost curve.In profitable markets, new firms continue to enter the market until profits are elimi-
nated. As the new firms enter, the demand curve facing each old firm begins to shift to theleft, pushing the marginal revenue curve along with it. With more entrants, less demand isleft for older firms. This shift continues until profits are eliminated, which occurs when thedemand curve slips down to the average total cost curve. Graphically, this is the point atwhich the demand curve and the average total cost curve are tangent (the point at which theyjust touch and have the same slope). Figure 15.4 shows a monopolistically competitiveindustry in long-run equilibrium. At q* and P*, price and average total cost are equal; so
there are no profits or losses.
Look carefully at the tangency, which in Figure 15.4, is at output level q*. The tangency
occurs at the profit-maximizing level of output. At this point, marginal cost is equal to marginalrevenue. At any level of output other than q*,ATC lies above the demand curve. This means that
at any other level of output, ATC is greater than the price that the firm can charge. (Recall that the
demand curve shows the price that can be charged at every level of output.) Hence, price equalsaverage total cost at q* and profits equal zero.
This equilibrium must occur at the point at which the demand curve is just tangent to the
average total cost curve. If the demand curve cuts across the average cost curve, intersecting it attwo points, the demand curve would be above the average total cost curve at some levels of out-
put. Producing at those levels of output would mean positive profits. Positive profits wouldattract entrants, shifting the market demand curve to the left and lowering profits. If thedemand curve were always below the average total cost curve, all levels of output would produce
losses for the firm. This would cause firms to exit the industry, shifting the market demandcurve to the right and increasing profits (or reducing losses) for those firms still in the industry.The firm’s demand curve must end up tangent to its average total cost curve for profits to equalzero. This is the condition for long-run equilibrium in a monopolistically competitive industry.
There is something else to notice about Figure 15.4: The monopolistically competitive firm is
not operating at the lowest point on its average total cost curve. It is producing at a scale smallerthan the one that minimizes its average total cost. In some ways this is the cost of product differ-entiation: The industry consists of firms that serve individualized tastes of customers, but servingthose different tastes results in higher production costs than we would see if everyone liked thesame thing. Remember our example of the gray sidewalks early in the chapter. Uniform gray side-walks allows us to lower costs, but the cost is a gray undifferentiated product. In other cases, wesee a rainbow of products, but the firms producing them are all operating at too small a scale.
326 PART III Market Imperfections and the Role of Government
INDUSTRY CHARACTERISTICS p. 314
1.A monopolistically competitive industry has the following
structural characteristics: (1) a large number of firms, (2) nobarriers to entry, and (3) product differentiation . Relatively
good substitutes for a monopolistic competitor’s productsare available. Monopolistic competitors try to achieve adegree of market power by differentiating their products.
PRODUCT DIFFERENTIATION AND
ADVERTISING p. 315
2.The amount of product differentiation in an industry
depends on a number of features of the industry. Howdifferent are customers’ tastes? Are there gains to customers
in buying a product that is identical to one bought by every-one else? Are there large-scale economies associated withmaking only one variety of a good? Industries with many dif-ferent products reflect strong heterogeneity of consumers,low gains from coordination, and small cost gains fromstandardization.
3.Products can be differentiated horizontally or vertically.Horizontal differentiation produces different types of agood with different appeals to different types of people. Invertical differentiation, people agree that one product is bet-ter than another; they just may not be willing to pay for thebetter good.Economic Efficiency and Resource
Allocation
We have already noted some of the similarities between monopolistic competition and perfect
competition. Because entry is easy and economic profits are eliminated in the long run, wemight conclude that the result of monopolistic competition is efficient. There are two prob-lems, however.
First, once a firm achieves any degree of market power by differentiating its product (as is the
case in monopolistic competition), its profit-maximizing strategy is to hold down productionand charge a price above marginal cost, as you saw in Figure 15.3 and Figure 15.4. Rememberfrom Chapter 12 that price is the value that society places on a good and that marginal cost is thevalue that society places on the resources needed to produce that good. By holding productiondown and price above marginal cost, monopolistically competitive firms prevent the efficient useof resources. More product could be produced at a resource cost below the value that consumersplace on the product.
Second, as Figure 15.4 shows, the final equilibrium in a monopolistically competitive firm is
necessarily to the left of the low point on its average total cost curve. That means a typical firm ina monopolistically competitive industry will not realize all the economies of scale available. (Inperfect competition, you will recall, firms are pushed to the bottom of their long-run average costcurves, and the result is an efficient allocation of resources.)
Suppose a number of firms enter an industry and build plants on the basis of initially prof-
itable positions. As more firms compete for those profits, individual firms find themselves withsmaller market shares; eventually, they end up with “excess capacity.” The firm in Figure 15.4 isnot fully using its existing capacity because competition drove its demand curve to the left. Inmonopolistic competition, we end up with many firms, each producing a slightly different prod-uct at a scale that is less than optimal. Would it not be more efficient to have a smaller number offirms, each producing on a slightly larger scale?
The costs of less-than-optimal production, however, need to be balanced against the gains
that can accrue from aggressive competition among products. If product differentiation leads tothe introduction of new products, improvements in old products, and greater variety, an impor-tant gain in economic welfare may counteract (and perhaps outweigh) the loss of efficiency frompricing above marginal cost or not fully realizing all economies of scale.
Most industries that comfortably fit the model of monopolistic competition are very com-
petitive. Price competition coexists with product competition, and firms do not earn incredibleprofits and do not violate any of the antitrust laws that we discussed in the last chapter.Monopolistically competitive firms have not been a subject of great concern among economicpolicy makers. Their behavior appears to be sufficiently controlled by competitive forces, and noserious attempt has been made to regulate or control them.
SUMMARY
CHAPTER 15 Monopolistic Competition 327
behavioral economics, p. 317
commitment device, p. 317 horizontal differentiation, p. 316
monopolistic competition, p. 314 product differentiation, p. 315
vertical differentiation, p. 318
1.For each of the following, state whether you agree or disagree.
Explain your answer.a.Monopolistically competitive firms produce their economic
profits protected by barriers to entry.
b.Monopolistically competitive firms are efficient because in
the long run, price falls to equal marginal cost.
2.Consider the local music scene in your area. Name some of the
local live bands that play in clubs and music halls, both on andoff campus. Look in your local newspaper for advertisements ofupcoming shows or performances. How would you characterizethe market for local musicians? Is there product differentiation?
In what specific ways do firms (individual performers or bands)
compete? T o what degree are they able to exercise marketpower? Are there barriers to entry? How profitable do you thinkthe musicians are?
3.Write a brief essay explaining this statement: The Beatles
were once a monopolistically competitive firm that became a monopolist.
4.In a market in which there is vertical differentiation, we always
see price differences among the products. In markets with hori-zontal differentiation, sometimes the products differ but pricesare very much the same. Why does vertical differentiation natu-rally bring with it price differences?5.[Related to Economics in Practice onp. 318 ]If you look at the
prices listed in the Economics in Practice on p. 318, you will see
that the more well-known brands are being sold for a lowerprice than the less well-known brands. Is this pattern always
true? Explain your answer.
6.[Related to Economics in Practice onp. 321 ]The news story
tells us that some restaurant owners oppose the labeling
requirement. Why? Since restaurants compete with one another,
would you not expect some of the healthier restaurants to comeout in favor of the rule? Explain.
7.The table shows the relationship for a hypothetical firm
between its advertising expenditures and the quantity of its out-put that it expects it can sell at a fixed price of $5 per unit.4.Behavioral economics suggests that there may be times when
too much variety reduces consumers’ purchases.
5.Behavioral economics also suggests that there may be timeswhen consumers prefer one form of a good over another as away to commit themselves to different actions in the futurethan they would otherwise take.
6.Advocates of free and open competition believe that dif-ferentiated products and advertising give the market sys-tem its vitality and are the basis of its power. Critics arguethat product differentiation and advertising are wastefuland inefficient.
PRICE AND OUTPUT DETERMINATION IN
MONOPOLISTIC COMPETITION p. 322
7.By differentiating their products, firms hope to be able to
raise prices without losing all demand. The demand curvefacing a monopolistic competitor is less elastic than thedemand curve faced by a perfectly competitive firm butmore elastic than the demand curve faced by a monopoly.8.T o maximize profit in the short run, a monopolistically
competitive firm will produce as long as the marginal rev-
enue from increasing output and selling it exceeds the mar-ginal cost of producing it.
9.When firms enter a monopolistically competitive industry,
they introduce close substitutes for the goods being pro-
duced. This attracts demand away from the firms already inthe industry. Demand faced by each firm shifts left, andprofits are ultimately eliminated in the long run. This long-run equilibrium occurs at the point where the demand curveis just tangent to the average total cost curve.
ECONOMIC EFFICIENCY AND RESCOURCE
ALLOCATION p. 326
10. Monopolistically competitive firms end up pricing above
marginal cost. This is inefficient, as is the fact that monop-
olistically competitive firms do not realize all economies ofscale available. There may be offsetting gains fromincreased variety.
REVIEW TERMS AND CONCEPTS
PROBLEMS
All problems are available on www.myeconlab.com
ADVERTISING
EXPENDITURES (MILLIONS) QUANTITY SOLD AT P=$5/IN
MILLION UNITS
$1 8
$1.2 9
$1.4 9.4
$1.6 9.6
$1.8 9.7
a.In economic terms, why might the relationship between
advertising and sales look the way it does?
MCATC
D
MR0
15 2020
15
1413
10
6Dollars ($)
Units of output328 PART III Market Imperfections and the Role of Government
b.Assume that the marginal costs of producing this product
(not including the advertising costs) are a constant $4. How
much advertising should this firm be doing? What economicprinciple are you using to make this decision?
8.In the area around a local university, a number of food vendors
gather each lunchtime to sell food to university students who
are tired of dorm food. The university and the town have nolicense fees that apply to food vendors, preferring to let the mar-ket dictate how many and which vendors show up.
Many different cuisines are represented on the street corner,
including a cart sponsored by Madame Defarge selling gumbo
and jambalaya. Madame Defarge sells a plate of either gumbo orjambalaya for $5. The food is made in the morning at hernearby restaurant, when the kitchen is otherwise unoccupied.Her crew of three, each of whom earns $15 per hour, takes2 hours to make the 100 meals required by Madame Defarge. In
creating these meals, they use ingredients equal to $100.
Madame Defarge hires another worker to load her cart withfood and sell it during the lunch hours. That worker costs$10 per hour and typically sells out the entire cart of 100 mealsin 2 hours. The cart is rented for $100 per 5-day week. (The
carts are not in operation on the weekends, when Madame
Defarge is too busy at her restaurant.)a.What market structure does this business most resemble?
What characteristics lead you to this conclusion?
b.What would you expect to see happen in this business? Use
the data in the problem to support your conclusions.
c.How would your calculations change if Madame Defarge
were to develop a weekday lunch business that used thekitchen’s capacity?
9.Conduct an online search for “Chicago restaurants.” Y ou will find
over 40 million entries. Now try “Chicago Chinese Restaurants.”Y ou will find nearly half a million entries. Try to estimate the totalnumber of Chinese restaurants in Chicago. Pick some random
locations and see how many are listed nearby. See if you can find
some advertisements with menus and prices. How much varia-tion does there seem to be in the price of standard spring rolls orfried rice? Make the case that the restaurant industry is or is not11.Explain the relationship between price and marginal revenue
for a purely competitive firm and for a monopolistically
competitive firm. Why is the relationship different for these markets?well described by the model of monopolistic competition pre-
sented in this chapter. Be specific.
10.The following diagram shows the structure of cost and demand
facing a monopolistically competitive firm in the short run.
a.Identify the following on the graph and calculate each one.
i. Profit-maximizing output levelii. Profit-maximizing priceiii. T otal revenueiv. T otal costv. T otal profit or loss
b.What is likely to happen in this industry in the long run?
CHAPTER OUTLINE
32916
Externalities and
EnvironmentalEconomics
p. 329
Marginal Social Cost and
Marginal-Cost Pricing
Private Choices and
External Effects
Internalizing Externalities
Public (Social)
Goods p. 341
The Characteristics of
Public Goods
Public Provision of Public
Goods
Optimal Provision of
Public Goods
Local Provision of Public
Goods: TieboutHypothesis
Social Choice p. 346
The Voting Paradox
Government Inefficiency:
Theory of Public Choice
Rent-Seeking Revisited
Government and the
Market p. 349In Chapters 6 through 12, we built a
complete model of a perfectly com-petitive economy under a set ofassumptions. By Chapter 12, we haddemonstrated that the allocation ofresources under perfect competitionis efficient and we began to relaxsome of the assumptions on whichthe perfectly competitive model isbased. We introduced the idea ofmarket failure , and in Chapters 13,
14, and 15, we talked about threekinds of imperfect markets: monop-oly, oligopoly, and monopolistic com-petition. We also discussed some of the ways government has responded to the inefficiencies ofimperfect markets and to the development of market power.
As we continue our examination of market failure, we look first at externalities as a source of
inefficiency. Often when we engage in transactions or make economic decisions, second or thirdparties suffer consequences that decision makers have no incentive to consider. For example,for many years, manufacturing firms and power plants had no reason to worry about the impactof smoke from their operations on the quality of the air we breathe. Now we know that airpollution—an externality—harms people.
Next, we consider a second type of market failure that involves products that private firms
find unprofitable to produce even if members of society want them. These products are calledpublic goods orsocial goods . Public goods yield collective benefits, and in most societies, govern-
ments produce them or arrange to provide them. The process of choosing what social goods toproduce is very different from the process of private choice.
Finally, while the existence of externalities and public goods are examples of market failure,
it is not necessarily true that government involvement always improves matters. Just as marketsfail, so too can governments. When we look at the incentives facing government decision makers,we find several reasons behind government failure.
Externalities and Environmental Economics
An externality exists when the actions or decisions of one person or group impose a cost or
bestow a benefit on second or third parties. Externalities are sometimes called spillovers or
neighborhood effects . Inefficient decisions result when decision makers fail to consider social costs
and benefits.
The presence of externalities is a significant phenomenon in modern life. Examples are
everywhere: Air, water, land, sight, and sound pollution; traffic congestion; automobile acci-dents; abandoned housing; nuclear accidents; and secondhand cigarette smoke are only a few.For most of the spring and summer of 2010, people watched as the oil spill from BP’s disastrouswell explosion spread throughout the Gulf. The study of externalities is a major concern ofenvironmental economics .
Externalities, Public
Goods, and Social
Choice
market failure Occurs when
resources are misallocated orallocated inefficiently.
externality A cost or benefit
imposed or bestowed on an
individual or a group that is
outside, or external to, thetransaction.
330 PART III Market Imperfections and the Role of Government
The growth of China and India has put increased pressure on the environment. As new
countries industrialize, strains on global air and water systems are inevitable. Problems of exter-nalities have increasingly become global problems.
Marginal Social Cost and Marginal-Cost Pricing
In the absence of externalities, when a firm weighs price and marginal cost to decide output, itis weighing the full benefits to society of additional production against the full costs to societyof that production. Those who benefit from the production of a product are the people orhouseholds who end up consuming it. The price of a product is a good measure of what anadditional unit of that product is “worth” because those who value it more highly already buyit. People who value it less than the current price are not buying it. If marginal cost includes allcosts—that is, all costs to society —of producing a marginal unit of a good, additional produc-
tion will be efficient, provided Pis greater than MC. Up to the point where P=MC, each unit
of production yields benefits in excess of cost. Figure 16.1(a) shows a firm and an industry inwhich no externalities exist.
Suppose, however, that the production of the firm’s product imposes external costs on soci-
ety as well. A firm producing detergent may dump wastewater into a local river as a by-product of its detergent production. If the firm does not factor those additional costs into itsdecisions, it is likely to overproduce. Figure 16.1(b) shows what happens graphically when weadd in those costs. The curve labeled MSC ,marginal social cost , is the sum of the marginal
costs of producing the product and the correctly measured damage costs imposed in the processof production.
If the firm is allowed to dump its wastewater and does not have to pay for resulting damage
costs, it will produce exactly the same level of output ( q*) as before and price ( P*) will continue to
reflect only the costs that the firm actually pays to produce its product. The firms in this industrywill continue to produce, and consumers will continue to consume their product, but the marketprice of the detergent will not reflect wastewater costs. At equilibrium ( q*), marginal social costs are
considerably greater than price . (Recall that price is a measure of the full value to consumers of a
unit of the product at the margin.)
Consider what happens as the detergent plant freely dumps untreated toxic waste into a
river. The waste imposes specific costs on people who live downstream: It kills the fish in theriver, it makes the river ugly to look at and rotten to smell, and it destroys the river for recre-ational use. There may also be health hazards depending on what chemicals the firm is dump-ing. Obviously, the plant’s product provides certain benefits. Its soap is valuable to consumerswho are willing and able to pay for it. The firm employs people and capital. The issue is howthenet benefits produced by the plant compare with the damage that it does. Y ou do not need
an economic model to know that someone should consider the costs of those damages.
Acid Rain and the Clean Air Act Acid rain is an excellent example of an externality
and of the issues and conflicts involved in dealing with externalities. When manufacturingfirms and power plants in the Midwest burn coal with a high sulfur content, smoke fromthose plants mixes with moisture in the atmosphere. The result is a dilute acid that is wind-blown north to Canada and east to New Y ork and New England, where it falls to Earth as rain.
How does the acid rain problem look to the different parties involved? For manufacturing
firms and public utilities generating the sulfur dioxide that creates acid rain, burning high-sulfur coal delivers cheap power and employment to residents of the Midwest. Paying to clean upthe damage or changing the fuel mix to reduce sulfur would result in higher electricity prices.Some firms would likely go out of business, and jobs would be lost. For residents in other parts ofthe United States and Canada, particularly those near wildlife areas, the burning of high-sulfurcoal and the resulting acid rain results in fish kills and deforestation. Often these citizens are farenough away from the power plants producing the sulfur dioxide that they are not even benefit-ing from the cheaper power. As in many areas of economics, the hard issue here is how to balancebenefits to one set of claimants with costs to another.
In complex cases of externalities, like acid rain, often governments get involved. The United
States began its work in reducing acid rain with the Clean Air Act in 1990. Since then, the Unitedmarginal social cost ( MSC)
The total cost to society of
producing an additional unitof a good or service. MSC is
equal to the sum of the
marginal costs of producingthe product and the correctlymeasured damage costs
involved in the process
of production.
CHAPTER 16 Externalities, Public Goods, and Social Choice 331
a. A profit-maximizing firm: No externalities
The industry A representative firm
b. A profit-maximizing firm: Externality
The industry A representative firmUnits of output Units of outputPrice per unit ($)
00P* P*
Q* q*MC
DS
Units of output Units of outputPrice per unit ($)
00P* P*
Q* q*DSMSC
MSCMC
External
cost/L50296FIGURE 16.1
Profit-Maximizing
Perfectly CompetitiveFirms Will Produce Upto the Point That PriceEquals Marginal Cost(P=MC)
If we assume that the current
price reflects what consumers
are willing to pay for a product
at the margin, firms that createexternal costs without weighingthem in their decisions are likelyto produce too much. At q*,
marginal social cost exceeds the
price paid by consumers.
States has made substantial progress in reducing the problem of acid rain, and many acidified
lakes and streams now once again support fish life. Recently, the United States has employed aninnovative “cap and trade” program to control emissions, which we will discuss later in this chap-ter. For acid rain, which travels across national boundaries, agreements between Canada and theUnited States have also played an important role.
Other Externalities Clearly, the most significant and hotly debated issue of externalities is
global warming. The 2007 Nobel Peace Prize was awarded to former Vice President Al Gore andthe Intergovernmental Panel on Climate Change, a group of 2,500 researchers from 130 nationsthat issued a number of reports linking human activity to the recent rise of the average tempera-ture on Earth. Although there is considerable disagreement, many people are convinced thatstrong measures must be taken to prevent major adverse consequences such as dramatically ris-ing sea levels. We will return to this topic later.
Individual actions can also create externalities. When I drive during rush hour, I increase
congestion faced by other drivers. If I smoke, your health may be compromised. Again the keyissue is weighing the costs and benefits to all parties.
Some Examples of Positive Externalities Thus far we have described a series of neg-
ative externalities. But externalities can also be positive. In some cases, when other people orfirms engage in an activity, there are side benefits from that activity. From an economics perspec-
tive, there are problems with positive externalities as well.
332 PART III Market Imperfections and the Role of Government
Ian Ayres and Steve Levitt have studied a fascinating example of a product with positive
externalities, LoJack. LoJack is a device that allows police to track a car when it is stolen. When acar has a LoJack device installed, the gains to stealing that car are sharply reduced. These devicesnot only help recover cars but also help catch car thieves. Suppose that 90 percent of the cars in acommunity had LoJack installed. If all LoJack cars were identified—the way houses are that haveburglar alarms—potential thieves could look for the unmarked cars. As it happens, LoJack doesnot come with any identifying mark. From a thief’s perspective, any car has a 90 percent chanceof having a LoJack installed. As a result, the benefits from stealing any car are reduced. With
reduced benefits, fewer thefts occur. Ayres and Levitt have found that the size of these positiveexternalities are very large; they estimate that the purchaser of a LoJack captures, as an individual,only 10 percent of the value of the device.
1
We also see positive externalities in the case of vaccinations. The more people who are vacci-
nated, the less likely a disease will become prevalent. But the less likely the disease, the lower theprivate benefits to people from getting a vaccination. With communicable diseases, health precau-tions taken by an individual have positive external benefits to the rest of the community.
The problem with positive externalities should now be clear. For this type of externality, the
individuals in charge have too little incentive to engage in the activity. T oo few LoJacks arebought; too few people wash their hands often; too few people would vaccinate their childrenunless forced to do so by school systems.
1Ian Ayres and Steve Levitt, “Measuring Positive Externalities from Unobservable Victim Precautions: An Empirical Analysis of
Lojack,” Quarterly Journal of Economics 108, (1), 1998.ECONOMICS IN PRACTICE
Ban on Oil Drillers
In April 2010, one of BP’s deep water wells exploded, killing 10 peo-
ple and creating what would become one of the largest environmen-
tal disasters in the United States. The article below describes whatwas known about the damage by the summer of 2010.
The effect of this disaster on economic and environmental
policy is likely to also be substantial. Oil still provides a substan-tial portion of U.S. energy, and many of the oil reserves lie off-shore. The recent disaster has made some of the trade-offsbetween environmental security and energy security consider-ably more salient.
New Ban Hits Oil Drillers
The Wall Street Journal
WASHINGTON—The Obama administration on Monday
issued a new order banning most new deepwater-drilling
activities until Nov. 30, setting up a fresh round of conflict withthe oil industry over when it will be safe to drill again offshore.
The latest round in the clash over the ban on new drilling
got under way as BP installed a new cap on its blown-out
undersea well that company and government officials hope
will capture all the spewing oil. BP officials have said theyare also aiming to finish drilling a relief well that will allowthem to permanently stanch the flow. Even after the well is
sealed, BP and the Gulf Coast face a lengthy process of
cleaning up the huge slick that has fouled beaches andwetlands from Texas to Florida.In moving to reinstate the drilling ban, President
Barack Obama again sided with environmental groupsand many voters in big coastal states such as Florida andCalifornia who support a halt to new deepwater drilling
until the causes of the catastrophic BP PLC well blowout
are known.
“We know that that is not without some economic conse-
quences to the region,” White House Press Secretary RobertGibbs said Monday. “But it's imperative that we have a sense
of what happened before we continue to do this again.”
But public officials and many residents of Gulf states
directly affected by the spill say the ban threatens thousandsof jobs in the offshore oil industry.
Source: The Wall Street Journal by Siobhan Hughes and Stephen Power.
Copyright 2011 by Dow Jones & Company ,Inc. Reproduced with permis-
sion of Dow Jones & Company ,Inc. via Copyright Clearance Center.
CHAPTER 16 Externalities, Public Goods, and Social Choice 333
Private Choices and External Effects
T o help us understand externalities and to see how one might make trade-offs in the situations we
have described, let us use a simple two-person example. Harry lives in a dormitory at a big publiccollege in the Southwest, where he is a first-year student. Harry is a serious gamer, with a partic-ular fondness for “Call of Duty,” a popular but noisy game. Unfortunately, the walls of Harry’sdorm are made of quarter-inch drywall over 3-inch aluminum studs. Y ou can hear people sleep-ing four rooms away. Because of a hearing loss after an accident on the Fourth of July some yearsago, Harry often does not notice the volume of his game. Jake, who lives next door to Harry, is apre-med student trying hard to steer clear of video games.
Let us assume that there are no further external costs or benefits to anyone other than Harry
and Jake from Harry’s play. Figure 16.2 illustrates the decision process that the two dorm resi-dents face. The downward-sloping curve labeled MBrepresents the value of the marginal benefits
that Harry derives from gaming. Of course, Harry does not sit down to draw this curve, any morethan anyone else (other than an economics student) sits down to draw actual demand curves.Curves like this are simply abstract representations of the way people behave. If you think aboutit, such a curve must exist. T o ask how much an hour of gaming is worth to you is to ask howmuch you would be willing to pay to have it. Start at $0.01 and raise the “price” slowly in yourmind. Presumably, you must stop at some point. Where you stop depends on your taste for gamesand your income.
Y ou can think about the benefits Harry derives from gaming as the maximum amount of
money that he would be willing to pay for an hour of play. For the first hour, for instance, thevalue for MB is $0.50. We assume diminishing marginal utility, of course. The more hours
Harry plays, the lower the additional benefits from each successive hour. As the graph shows,theMB curve falls below $0.05 per hour after 8 hours of playing.
We call the cost that Harry must pay for each additional hour of gaming the marginal
private cost , labeled MPC in Figure 16.2. In the present example, this cost is primarily the cost of
electricity. This cost is constant at $0.05 per hour.
Then there is Jake. Although Harry’s gaming does not poison Jake, give him lung cancer, or
even cause him to lose money, it damages him nonetheless: He gets a headache, loses sleep, andcannot concentrate on his work. Jake is harmed, and it is possible (at least conceptually) to mea-sure that harm in terms of the maximum amount that he would be willing to pay to avoid it. Thedamage, or cost, imposed on Jake is represented in Figure 16.2 by the curve labeled MDC .
Formally, marginal damage cost ( MDC )is the additional harm done by increasing the level of
an externality-producing activity by 1 unit. By assuming Jake would be willing to pay someamount of money to avoid the noise, it is reasonable to assume the amount increases each succes-sive hour. His headache gets worse with each additional hour he is forced to listen.
Harry’s MB (marginal benefit)
Harry’s MPC
(marginalprivate cost)MDC to Jake
(marginal
damage cost)MSC to the two-person society
of Harry and Jake (marginal
social cost)
01 5 8
Hours of time playing Call of Duty.50
.25
.20
.15
.05Dollars, cost, benefit/L50296FIGURE 16.2
Externalities in a College
Dormitory
The marginal benefits to Harry
exceed the marginal costs he
must bear to play his game
system for a period of up to8 hours. When the noise of thegame occurs, a cost is being
imposed on Jake. When we add
the costs borne by Harry to thedamage costs imposed on Jake,we get the full cost of the game
play to the two-person society
made up of Harry and Jake.Playing more than 5 hours isinefficient because the benefits
to Harry are less than the social
cost for every hour above 5. IfHarry considers only his privatecosts, he will play for too long atime from society’s point of view.marginal private cost ( MPC)
The amount that a consumer
pays to consume an additional
unit of a particular good.
marginal damage cost ( MDC )
The additional harm done byincreasing the level of an
externality-producing activity
by 1 unit. If producing product
Xpollutes the water in a river,
MDC is the additional cost
imposed by the added pollutionthat results from increasingoutput by 1 unit of Xper period.
334 PART III Market Imperfections and the Role of Government
In the simple society of Jake and Harry, it is easy to add up social benefits and costs. At every level
of output (playing time), total social cost is the sum of the private costs borne by Harry and the dam-age costs borne by Jake. In Figure 16.2, MPC (constant at $0.05 per hour) is added to MDC to get
MSC . The social optimum occurs where the marginal social benefit equals the marginal social cost.
Now consider what would happen if Harry simply ignored Jake.
2If Harry decides to continue
gaming, Jake will be damaged. As long as Harry gains more in personal benefits from an additionalhour of play than he incurs in costs, the system will stay on. He will play it for 8 hours (the pointwhere Harry’s MB=MPC ). This result is inefficient; for every hour of play beyond 5, the marginal
social cost borne by society—in this case, a society made up of Harry and Jake—exceeds the mar-ginal benefits to Harry—that is, MSC > Harry’s MB. It is generally true that when economic deci-
sions ignore external costs, whether those costs are borne by one person or by society, thosedecisions are likely to be inefficient. We will return to Harry and Jake to see how they deal with theirproblem. First, we need to discuss the general problem of correcting for externalities.
Internalizing Externalities
A number of mechanisms are available to provide decision makers with incentives to weigh theexternal costs and benefits of their decisions, a process called internalization . In some cases, exter-
nalities are internalized through bargaining and negotiation without government involvement. Inother cases, private bargains fail and the only alternative may be government action of some kind.
Five approaches have been taken to solving the problem of externalities: (1) private bargain-
ing and negotiation, (2) legal rules and procedures, (3) government-imposed taxes and subsidies,(4) sale or auctioning of rights to impose externalities, and (5) direct government regulation.While each is best suited for a different set of circumstances, all five provide decision makers withan incentive to weigh the external effects of their decisions.
Private Bargaining and Negotiation Return to Harry and Jake. Most of you have likely
been in this situation at one time or another. For most people in this situation, the first step is obv ious:
Knock on Harry’s door and ask him to turn down the volume or reduce his play time during yourstudy hours. In fact, good manners are a societal reaction to incipient externalities. As societiesincrease in population density, more and more activities fall under the category of “not done inpublic.” Consider what has happened over time to the social acceptability of smoking, for exam-ple. In 2010, in anticipation of its Expo, the Chinese government cracked down on the tendencyof its citizens in Shanghai to wear their pajamas outside the home, believing that this dress hasnegative externalities for their international guests.
Even when there are no social norms against an activity, private bargains and negotiation can
often solve an externality problem. The formal model describing how private negotiations workwas described first by Ronald Coase, in 1960.
3Indeed the Coase theorem describing the process
by which individual actions can solve externalities without government is a staple topic in bothlaw and economics classes around the world.
T o see how the Coase theorem works, let us return to Jake and Harry’s dorm rooms. Suppose Jake
has been unsuccessful in his mannerly plea to Harry. What next? At this point one might want to knowwhat the rules are. Indeed, Coase tells us that, while it does not matter what the rules are in situations
like this, it is very important that there be rules that are known to all parties. Negotiations are difficultwhen the two parties don’t agree on who has what rights. Let us assume, at least at first, that in this col-lege, there are no rules against video games and everyone in the dorm is aware of this lenient policy.Harry can play his games as much as he likes, which we see from Figure 16.2 is 8 hours a day. In a sys-tem with no rules and an unmannerly neighbor, does Jake have any recourse?
Look back at Figure 16.2 and put yourself in Jake’s position. With Harry playing his game
8 hours a day, the value of the last hour of play to Harry is pretty small. In fact, as you see at theeighth hour, playing is worth only $0.05 per hour. After 8 hours of listening to the sounds of bat-tle, however, Jake is going wild. He would pay more than $0.25 per hour for some relief. There isroom for a deal! As Harry cuts back on play, the value of the marginal hour of play goes up, andthe marginal damage to Jake of listening begins to fall. For hours of play in excess of 5, Jake’s
2It may be easier for individuals to ignore the social costs imposed by their actions when those costs fall on large numbers of
other people whom they do not have to look in the eye or they do not know personally. For the moment, however, we assumethat Harry takes no account of Jake.Coase theorem Under
certain conditions, whenexternalities are present,
private parties can arrive at the
efficient solution withoutgovernment involvement.
3See Ronald Coase, “The Problem of Social Cost,” Journal of Law and Economics , 1960.
CHAPTER 16 Externalities, Public Goods, and Social Choice 335
incremental damage exceeds Harry’s incremental value of playing. Again, look back at Figure 16.2.
As Coase would tell us, for all hours greater than 5 per day, Jake realizes enough benefits fromsilence to be able to bribe Harry into being quiet. Notice, however, what happens at 5 hours ofplay per day. T o cut back below 5 hours per day, Harry’s marginal benefit from play rises to above$0.25 per hour. Electricity costs him $0.05 per hour. So to make him stop, Jake would have tobribe him with at least $0.20. But as the graph shows, at less than 5 hours per day, Jake’s damageper hour is less than $0.20. Five hours is the efficient playing time. More hours or fewer hoursreduce total benefits to Harry and Jake.
Coase tells us that under certain conditions, private negotiations will push society to the right
level of output even with externalities. What features of the Harry–Jake situation matter for this typeof solution to work? First, as noted, the basic rights must be understood by all parties. In this situa-tion Jake knows he has to bribe Harry because Harry has the right to make noise if he wants to. Ifrights are not spelled out, arguments about who has what right interfere with the bargaining process.A second condition is that people must be able to bargain without impediment or costs. The fact thatJake and Harry lived next to each other made the bargaining a lot easier. Finally, private negotiationworks best when the number of parties involved is few in number. If one party to a bargain is a largegroup, such as all residents of a town or an area as in the earlier acid rain example, private negotia-tions work less well.
Coase also pointed out that bargaining will bring the contending parties to the right solution
regardless of where rights are initially assigned. Suppose that the dorm rules state that Jake has theright to silence. This being the case, Jake can go to the dorm administrators and have them enforcethe rule. Now when Harry plays the game and Jake asks him to turn it off, Harry must comply. Nowthe tables are turned. Accepting the dorm rules (as he must), Harry knocks on Jake’s door. Jake’sdamages from the first hour are only $0.15. This means that if Jake was compensated by morethan $0.15, he would allow the gaming. Now the stage is set for bargaining. Harry gets $0.45 innet benefit from the first hour of playing ($0.50 minus private cost of $0.05). Thus, he is willingto pay up to $0.45 for the privilege. If there are no impediments to bargaining, money willchange hands. Harry will pay Jake some amount between $0.15 and $0.45, and just as before,gaming will continue. Jake has, in effect, sold his right to have silence to Harry. As before, bar-gaining between the two parties will lead to 5 hours of gaming. At exactly 5 hours, Jake will stoptaking compensation and tell Harry to turn the system off. (Look again at Figure 16.2 to see thatthis is true.)
In both cases, the offer of compensation might be made in some form other than cash. Jake
may offer Harry goodwill, a favor or two, or the use of his Harley-Davidson for an hour. Indeed,in this example, if Harry has the right to play as much as he wants (our Case 1), Jake may offer to buyHarry a headset that allows him to game quietly. Jake’s willingness to do this would, of course,depend on how much a headset costs and how long Jake expected to live next door to Harry.
Coase’s critics are quick to point out that the conditions required for bargaining to produce
the efficient result are not always present. The biggest problem with Coase’s system is also a com-mon problem. Very often one party to a bargain is a large group of people, and our reasoning maybe subject to a fallacy of composition.
Suppose a power company in Pittsburgh is polluting the air. The damaged parties are the
100,000 people who live near the plant. Let us assume the plant has the right to pollute. TheCoase theorem predicts that the people who are damaged by the smoke will get together andoffer a bribe (as Jake offered a bribe to Harry). If the bribe is sufficient to induce the power plantto stop polluting or reduce the pollutants with air scrubbers, it will accept the bribe and cutdown on the pollution. If the bribe is not sufficient, the pollution will continue, but the firm willhave weighed all the costs (just as Harry did when he continued to play the game) and the resultwill be efficient.
However, not everyone will contribute to the bribe fund. First, each contribution is so
small relative to the whole that no single contribution makes much of a difference. Making acontribution may seem unimportant or unnecessary to some. Second, all people get to breathethe cleaner air whether they contribute to the bribe or not. Many people will not participatesimply because they are not compelled to, and the private bargain breaks down—the bribe thatthe group comes up with will be less than the full damages unless everyone participates. (Wediscuss these two problems—the drop-in-the-bucket and the free-rider —later in this chapter.)
When the number of damaged parties is large, government taxes or regulation may be the onlyavenue to a remedy.
336 PART III Market Imperfections and the Role of Government
Legal Rules and Procedures As we have just seen, for bargaining to result in an efficient
outcome, the initial assignment of rights must be clear to both parties. When rights are estab-lished by law, more often than not some mechanism to protect those rights is also built into thelaw. In some cases where a nuisance exists, for example, there may be legal remedies. In suchcases, the victim can go to court and ask for an injunction that forbids the damage-producing
behavior from continuing. If the dorm rules specifically give Jake the right to silence, Jake’s get-ting the resident adviser to speak to Harry is something like getting an injunction.
Injunctive remedies are irrelevant when the damage has already been done. Consider acci-
dents. If your leg has already been broken as the result of an automobile accident, enjoining thedriver of the other car from drinking and driving will not work—it is too late. In these cases,rights must be protected by liability rules , rules that require A to compensate B for damages
imposed. In theory, such rules are designed to do the same thing that taxing a polluter is designedto do: provide decision makers with an incentive to weigh all the consequences, actual andpotential, of their decisions. Just as taxes do not stop all pollution, liability rules do not stop allaccidents.
However, the threat of liability actions does induce people to take more care than they might
otherwise. Product liability is a good example. If a person is damaged in some way because aproduct is defective, the producing company is, in most cases, held liable for the damages, even ifthe company took reasonable care in producing the product. Producers have a powerful incentiveto be careful. If consumers know they will be generously compensated for any damages, however,they may not have as powerful an incentive to be careful when using the product.
Taxes and Subsidies When private negotiations fail, economists have traditionally advo-
cated marginal taxes and subsidies as a direct way of forcing firms to consider external costs orbenefits. When a firm imposes an external social cost, the reasoning goes, a per-unit tax should beimposed equal to the damages of each successive unit of output produced by the firm—the taxshould be exactly equal to marginal damage costs.
4
Figure 16.3 repeats Figure 16.1(b), but this time the damage costs are paid by the firm in the
form of a per-unit tax—that is, the tax = MDC . The firm now faces a marginal cost curve that is
the same as the marginal social cost curve ( MC1= MSC ). Remember that the industry supply
curve is the sum of the marginal cost curves of the individual firms. This means that as a result ofthe tax, the industry supply curve shifts to the left, driving up price from P
0to P1. The efficient
level of output is q1,w h e r e P= MC1. (Recall our general equilibrium analysis from Chapter 12.)injunction A court order
forbidding the continuation
of behavior that leads to damages.
liability rules Laws that
require A to compensate B for
damages imposed.
4As we discuss later in this chapter, damage costs are difficult to measure. It is often assumed that they are proportional to the
volume of pollutants discharged into the air or water. Instead of taxes, governments often impose effluent charges , which make
the cost to polluters proportional to the amount of pollution caused. We will use “tax” to refer to both taxes and effluent charge s.The industry A representative firmPrice per unit ($)
Units of output Units of output0 0P1S1
S0
P0P1
P0
Q1Q0q1q0DMC1 = MSCTax =
MDC
MC0/L50298FIGURE 16.3
Tax Imposed on a Firm
Equal to MarginalDamage Cost
If a per-unit tax exactly equal to
marginal damage costs isimposed on a firm, the firm will
weigh the tax, and thus the dam-
age costs, in its decisions. At thenew equilibrium price, P
1, con-
sumers will be paying an amount
sufficient to cover full resource
costs as well as the cost of dam-age imposed. The efficient levelof output for the firm is q
1.
CHAPTER 16 Externalities, Public Goods, and Social Choice 337
Because a profit-maximizing firm equates price with marginal cost, the new price to con-
sumers covers the resource costs of producing the product and the damage costs. The consumerdecision process is once again efficient at the margin because marginal social benefit as reflectedin market price is equal to the full social marginal cost of the product.
An interesting example of the use of taxes to reduce pollution is the tax that London has
placed on cars driving into the central part of the city. New Y ork’s Mayor Bloomberg considereda similar policy.
Measuring Damages The biggest problem with using taxes and subsidies is that damages
must be estimated in financial terms. For the detergent plant polluting the nearby river to beproperly taxed, the government must evaluate the damages done to residents downstream inmoney terms. This evaluation is difficult but not impossible. When legal remedies are pursued,judges are forced to make such estimates as they decide on compensation to be paid. Surveys of“willingness to pay,” studies of property values in affected versus nonaffected areas, and some-times the market value of recreational activities can provide basic data.
The monetary value of damages to health and loss of life is, naturally, more difficult to esti-
mate, and any measurement of such losses is controversial. Even here, policy makers frequentlymake judgments that implicitly set values on life and health. T ens of thousands of deaths and mil-lions of serious injuries result from traffic accidents in the United States every year, yet Americansare unwilling to give up driving or to reduce the speed limit to 40 miles per hour—the costs ofeither course of action would be too high. If most Americans are willing to increase the risk ofdeath in exchange for shorter driving times, the value we place on life has its limits.
Keep in mind that taxing externality-producing activities may not eliminate damages. Taxes
on these activities are not designed to eliminate externalities; they are simply meant to force deci-sion makers to consider the full costs of their decisions. Even if we assume that a tax correctlymeasures all the damage done, the decision maker may find it advantageous to continue causingthe damage. The detergent manufacturer may find it most profitable to pay the tax and go on pol-luting the river. It can continue to pollute because the revenues from selling its product are suffi-cient to cover the cost of resources used and to compensate the damaged parties fully .I n s u c h a
case, producing the product in spite of the pollution is “worth it” to society. It would be ineffi-cient for the firm to stop polluting. In our earlier example, the optimal level of Harry’s gamingwas 5 hours per day, not 0. Only if damage costs were very high would it make sense to have nopollution. Thus, you can see the importance of proper measurement of damage costs.
Reducing Damages to an Efficient Level Taxes also provide firms with an incentive to use
the most efficient technology for dealing with damage. If a tax reflects true damages and it isreduced when damages are reduced, firms may choose to avoid or reduce the tax by using a dif-ferent technology that causes less damage. Suppose our soap manufacturer is taxed $10,000 permonth for polluting the river. If the soap plant can ship its waste to a disposal site elsewhere at acost of $7,000 per month and thereby avoid the tax, it will do so. If a plant belching sulfides intothe air can install smoke scrubbers that eliminate emissions for an amount less than the taximposed for polluting the air, it will do so.
The Incentive to T ake Care and to Avoid Harm Y ou should understand that all externali-
ties involve at least two parties and that it is not always clear which party is “causing” the dam-age. Take our friends Harry and Jake. Harry enjoys games; Jake enjoys quiet. If Harry plays, heimposes a cost on Jake. If Jake can force Harry to stop, he imposes a cost on Harry.
Often, the best solution to an externality problem may not involve stopping the externality-
generating activity. Suppose Jake and Harry’s dormitory has a third resident, Pete. Pete hatessilence. The resident adviser on Harry’s floor arranges for Pete and Jake to switch rooms. Whatwas once an external cost has been transformed into an external benefit. Everyone is better off.Harry and Pete get to listen to sounds of war, and Jake gets his silence.
Sometimes the most efficient solution to an externality problem is for the damaged party to
avoid the damage. However, if full compensation is paid by the damager, damaged parties may haveno incentive to do so. Consider a laundry located next to the exhaust fans from the kitchen of aChinese restaurant. Suppose damages run to $1,000 per month because the laundry must use spe-cial air filters in its dryers so that the clothes will not smell of Szechuan spices. The laundry looksaround and finds a perfectly good alternative location away from the restaurant that rents for only$500 per month above its current rent. Without any compensation from the Chinese restaurant, the
338 PART III Market Imperfections and the Role of Government
ECONOMICS IN PRACTICE
Externalities Are All Around Us
Externalities arise from many sources. The most common examples
involve smoking factories and the automobile. But externalities areeverywhere. Here are two examples of externalities that you mayhave experienced.
THE CRYING BABY
Peter Scott, once employed as a research assistant on this book andnow a writer in Hollywood, wrote the following lines about cryingbabies on airplanes:
“The best example of this [an externality] is on airplanes. For
most of my life, a crying baby on an airplane felt like some kind oftorture method used to get spies to reveal national secrets. There was
actually a deleted scene in Goldfinger where Goldfinger locks James
Bond in a room with crying babies. The problem was that Bond thenshot himself, thus destroying the franchise. So they rewrote the sceneand had Goldfinger try and slice Bond in half with a laser. Bond
could easily escape from that because lasers are obviously less terri-
fying than crying babies.”
1
John Tierney wrote about the same externality in the New York
Times :2“If you think of a screaming child as an environmental dis-
turbance, then giving a child a discount is like offering subsidy to apolluter. A child should at least pay full fare, and the fairest policywould be to impose a surcharge.”
CHRISTMAS DECORATIONS
Abominable Snowmen: The War on Lawn
Decorations
Wall Street Journal
Jim McDilda’s holiday display last year included a 28-foot
lighted arch, 50-foot tree, 50,000 lights, and dozens of ani-mated silhouettes. The spectacle—he needed a crane toset it all up—lit up the sky and drew thousands of gawking
visitors to his Redding, Calif., house.But nearby neighbors weren’t so thrilled. Cars, limos,
and tour buses clogged the cul-de-sac, and trash wasstrewn across lawns. Christmas music blasting from Mr. McDilda’s display kept neighbors awake. They com-
plained to the city, which required that Mr. McDilda get a
special-events permit and demanded that he remove thenearby cargo containers he used to store the display mostof the year. After months of sniping between Mr. McDildaand the city, he decided to throw in the towel. This year, his
house is unadorned.
Source: The Wall Street Journal, excerpted from "Abominable
Snowmen: The War on Lawn Decorations" by Sara Schaefer Munoz.Copyright 2007 by Dow Jones & Company, Inc . Reproduced with per-
mission of Dow Jones & Company, Inc . via Copyright Clearance Center.
1Peter Scott ,There’s a Spouse in My House: A Humorous Journey Through the
First Years of Marriage. Copyright© 2007–2008 Peter Scott. All Rights Reserved.
2John Tierney ,“The Big City: Urban Menace Stalks Streets in Diapers,” The
New York Times ,June 24, 2000 .
laundry will move and the total damage will be the $500 per month extra rent that it must pay. But
if the restaurant compensates the laundry for damages of $1,000 a month, why should the laundrymove? Under these conditions, a move is unlikely even though it would be efficient.
Subsidizing External Benefits Sometimes activities or decisions generate external benefits
instead of costs, as in the case of Harry and Pete, or in the LoJack example. Real estate investmentprovides another example. Investors who revitalize a downtown area—an old theater district in abig city, for example—provide benefits to many people, both in the city and in surrounding areas.
Activities that provide such external social benefits may be subsidized at the margin to give
decision makers an incentive to consider them. Just as ignoring social costs can lead to inefficientdecisions, so too can ignoring social benefits. Government subsidies for housing and other devel-opment, either directly through specific expenditure programs or indirectly through tax exemp-tions, have been justified on such grounds.
Selling or Auctioning Pollution Rights We have already established that not all
externality-generating activities should be banned. Around the world, the private automobile hasbecome the clearest example of an externality-generating activity whose benefits (many believe)outweigh its costs.
CHAPTER 16 Externalities, Public Goods, and Social Choice 339
Many externalities are imposed when we drive our cars. First, congestion is an externality.
Even though the marginal “harm” imposed by any one driver is small, the sum total is a seriouscost to all who spend hours in traffic jams. Second, most of the air pollution in the United Statescomes from automobiles. The problem is most evident in Los Angeles, where smog loaded withharmful emissions (mostly from cars) blankets the city virtually every day. Finally, drivingincreases the likelihood of accidents, raising insurance costs to all.
While we do not ignore these costs from the standpoint of public policy, we certainly have
not banned driving. Athens, Greece, however, has instituted an even-odd system in which innercity driving is restricted to alternative days depending on a person’s license plate number. (In adevelopment that some economists predicted, however, this rule has led some people to buy twocars and simply switch off.) In many cases, we have also consciously opted to allow ocean dump-ing, river pollution, and air pollution within limits.
The right to impose environmental externalities is beneficial to the parties causing the
damage. In a sense, the right to dump in a river or to pollute the air or the ocean is a resource.Thinking of the privilege to dump in this way suggests an alternative mechanism for control-ling pollution: selling or auctioning the pollution rights to the highest bidder. The Clean AirAct of 1990 takes this cap-and-trade approach to controlling the emissions from our nation’spower plants. Emissions from each plant are capped; that is, emissions are limited to a specifiedlevel. The lower the level specified, the more air quality will improve. The plant is issued a per-mit allowing it to emit only at that level. This permit can be used or can be traded to anotherfirm in what has developed into a large auction market. For a firm with low costs of abatingpollution, it is often in the firm’s best interest to cut back below its permit levels and sell itsunused permits to a firm with higher abatement costs. In this way, the given level of emissionschosen by the government will be achieved at the lowest possible costs as a result of markettrades. Environmentalists can also buy up permits and leave them unused, resulting inimprovements in air quality beyond what the government mandated. These cap-and-tradeprograms are being used around the world in an attempt to reduce greenhouse gases responsi-ble for global warming.
A simple example will help illustrate the potential gains from a cap-and-trade system.
Table 16.1 shows the situation facing two firms, both of which are polluting. Assume that eachfirm emits 5 units of pollution and the government wants to reduce the total amount of pollutionfrom the current level of 10 to 4. T o do this, the government caps each firm’s allowed pollutionlevel at 2. Thus, each firm must pay to cut its pollution levels by 3 units. The process of reducingpollution is sometimes called pollution abatement . The table shows the marginal cost of abate-
ment for each firm and the total costs. For Firm A, for example, the first unit of pollution reducedor abated costs only $5. As the firm tries to abate more pollution, doing so becomes more diffi-cult; the marginal costs of reducing pollution rise. If Firm A wants to reduce its pollution levelsfrom 5 units to 2, as the government requires, it must spend $21, $5 for the first unit, $7 for thesecond unit, and $9 for the third unit. Firm B finds reducing pollution to be more difficult. If ittries to reduce pollution by 3 units, it will have costs of $45. A cap-and-trade policy gives each ofthese firms two permits and allows them to trade permits if they so choose. What will the firmswant to do?
Firm A can reduce its emissions from 2 units to 1 unit by spending $12 more on abate-
ment. It would then have a permit to sell to Firm B. How much would Firm B be willing to payfor this permit? At the moment, the firm is abating 3 units, and the marginal cost of that third
TABLE 16.1 Permit Trading
Firm A Firm A Firm A Firm B Firm B Firm B
Reduction of pollu-
tion by Firm A (in
units of pollution)MC of reducing
pollution for Firm ATC of reducing
pollution for Firm AReduction of pollu-
tion by Firm B (in
units of pollution)MC of reducing
pollution for Firm BTC of reducing
pollution for Firm B
1 $ 5 $ 5 1 $ 8 $ 8
2 7 12 2 14 22
3 9 21 3 23 45
4 12 33 4 35 80
5 17 50 5 50 130
340 PART III Market Imperfections and the Role of Government
unit is $23. This tells us that Firm B would be willing to pay up to $23 to buy a permit to allow
it to continue polluting up to a level of 3. So there is room for a deal. Indeed, the permit pricewill be somewhere between the $12 demanded by Firm A and the $23 that Firm B is willing tospend. Because Firm A ’s marginal costs of abatement are lower than Firm B’s, we expectFirm A to do more abatement and sell its extra permit to B. Y ou should be able to see from thenumbers that Firm A will not sell its last permit to B. T o abate another unit, Firm A wouldhave marginal costs of $17. T o avoid abatement, however, Firm B would pay only $14. There isno room for a deal. Once the trade of one permit by A to B has occurred, there are still only4 units of pollution, but now Firm A is emitting 1 unit and Firm B is emitting 3 units. Whatare the total costs of this pollution reduction? When both firms were reducing their emissionlevels equally, the total costs were $21 for Firm A and $45 for Firm B, for a total of $66. Nowcosts are $33 for A and $22 for B, for a total of $55. (Of course, A will also be receiving a pay-ment for the permit.)
Europe took the problem of global warming seriously by implementing the world’s first
mandatory trading scheme for carbon dioxide emissions in 2005. Carbon dioxide emissionsare a major source of global warming. The first phase of the plan, which was over at the end of2007, involved around 12,000 factories and other facilities. The participating firms were oilrefineries; power generation facilities; and glass, steel, ceramics, lime, paper, and chemical fac-tories. These 12,000 plants represented 45 percent of total European Union (EU) emissions.The EU set an absolute cap on carbon dioxide emissions and then allocated allowances to gov-ernments. The nations in turn distributed the allowances to the separate plants. In the secondphase from 2008 through 2012, a number of large sectors will be added, including agricultureand petrochemicals.
In both the United States and Europe, the allowances are given out to the selected plants
free of charge even though the allowances will trade at a high price once they are distributed.Many are now questioning whether the government should sell them in the market or collect afee from the firms. As it is, many of the firms that receive the allocations get a huge windfall.During the second phase in Europe, the governments are allowed to auction over 10 percent ofthe allowances issued.
Another example of selling externality rights comes from Singapore, where the right to buy a
car is auctioned each year. Despite very high taxes and the need for permits to drive in downtownareas, the roads in Singapore have become congested. The government decided to limit the num-ber of new cars on the road because the external costs associated with them (congestion and pol-lution) were becoming very high. With these limits imposed, the decision was made to distributecar ownership rights to those who place the highest value on them. It seems likely that taxi drivers,trucking companies, bus lines, and traveling salespeople will buy the licenses; families who drivefor convenience instead of taking public transportation will find the licenses too expensive.Congestion and pollution are not the only externalities that Singapore takes seriously: In 2005 thefine for littering was as high as $1,000; for failing to flush a public toilet, over $100; and for eatingon a subway, $300.
Direct Regulation of Externalities Taxes, subsidies, legal rules, and public auctions are
all methods of indirect regulation designed to induce firms and households to weigh the socialcosts of their actions against their benefits. The actual size of the external cost/benefit depends onthe reaction of households and firms to the incentives provided by the taxes, subsidies, and rules.
For obvious reasons, many externalities are too important to be regulated indirectly.
Dumping cancer-causing chemicals into the ground near a public water supply is simply illegal,and those who do it can be prosecuted and sent to jail.
Direct regulation of externalities takes place at federal, state, and local levels. The
Environmental Protection Agency (EPA) is a federal agency established by an act of Congress in1970. Since the 1960s, Congress has passed a great deal of legislation that sets specific standards forpermissible discharges into the air and water. Every state has a division or department chargedwith regulating activities that are likely to harm the environment. Most airports in the UnitedStates have landing patterns and hours that are regulated by local governments to minimize noise.
Many criminal penalties and sanctions for violating environmental regulations are like the
taxes imposed on polluters. Not all violations and crimes are stopped, but violators and criminalsface “costs.” For the outcome to be efficient, the penalties they expect to pay should reflect thedamage that their actions impose on society.
CHAPTER 16 Externalities, Public Goods, and Social Choice 341
ECONOMICS IN PRACTICE
Climate Change
Global warming has become one of the most difficult environmen-
tal policy challenges of our time. The science is complex, the effects
are long lasting, the nations involved are many, and the costs andbenefits to different nations are highly varied. Island nations in areasthat are already warm will experience very different effects fromlandlocked colder nations. Substantial reductions of greenhouse
gases are likely to be very expensive. For all these reasons, inter-
national accord has been hard to achieve. In December 2010 theinternational community tried again with a set of meetings inCancun, Mexico. The article below describes a meeting of the develop-ing nations (and leading up to the Cancun meeting) that took place inMay 2010 in C hina. The article illustrates some of the complex inter-
national issues in the global warming debate.
China, India Doubt Climate Deal Is Near
The Wall Street Journal
BEIJING—Top climate-change officials from China and Indiaexpressed pessimism at a Beijing conference this weekend
about reaching a binding global deal at a United NationsClimate Summit in Cancun, Mexico, at the end of the year.
China hosted the high profile global-warming forum that
brought together key negotiating blocs in the developing
world, including fellow basic group members Brazil, South
Africa, and India.
Beijing is trying to strengthen its role as leader of the
developing world in climate-change talks after accusations it
sabotaged efforts to reach a binding deal at a U.N.-backed
summit in Copenhagen last December. The composition ofthe forum participants served to send “a signal to the worldof the role China wants to play,” said Li Yan, a climate-change specialist at Greenpeace.
China’s climate-change czar said at the conference that a
binding pact on tackling global warming remains out ofreach until several big issues are settled, including how tohandle $100 billion in funds for developing nations to rein ingreenhouse gases over the next decade.The Beijing meeting didn’t result in any conclusive state-
ment, but it aimed to provide a channel to promote larger
climate-change talks, said former Chinese Vice PremierZeng Peiyan, who was in charge of the conference.
Analysts say Beijing also wanted to use the conference to
send a strong signal to the nation’s local governments that it
is serious about reaching energy-efficiency targets.
Such a signal is especially urgent after news that China’s
infrastructure and housing-led economic recovery increasedthe country’s energy intensity 3.2% in the first quarter com-pared with a year earlier, reversing a steady decline in the
amount of energy used to produce each dollar of gross
domestic product.
China, the world’s largest emitter of greenhouse gases in
absolute terms, has said it would cut energy intensity 20% by
the end of this year, a goal that is closely tied to the country’s
pledge to reduce its carbon intensity—the amount of carbonemitted per dollar of GDP—by 40% to 45% by 2020.
—Wan Xu contributed to this article .
Source: The Wall Street Journal , excerpted from “China, India Doubt
Climate Deal is Near” by Shai Oster. Copyright 2010 by Dow Jones &
Company ,Inc. Reproduced with permission of Dow Jones & Company ,
Inc. via Copyright Clearance Center.
Public (Social) Goods
Another source of market failure lies in public goods , often called social orcollective goods .
Public goods are defined by two closely related characteristics: They are nonrival in consumption,and/or their benefits are nonexcludable. As we will see, these goods represent a market failurebecause they have characteristics that make it difficult for the private sector to produce themprofitably. In an unregulated market economy with no government to see that they are produced,public goods would at best be produced in insufficient quantity and at worst not produced at all.
The Characteristics of Public Goods
A good is nonrival in consumption when A ’s consumption of it does not interfere with B’s con-
sumption of it. This means that the benefits of the goods are collective—they accrue to everyone.National defense, for instance, benefits us all. The fact that I am protected in no way detracts frompublic goods (social or
collective goods) Goods that
are nonrival in consumptionand/or their benefits are
nonexcludable.
nonrival in consumption
A characteristic of public goods:One person’s enjoyment of thebenefits of a public good doesnot interfere with another’sconsumption of it.
342 PART III Market Imperfections and the Role of Government
the fact that you are protected; every citizen is protected just as much as every other citizen. If the
air is cleaned up, my breathing that air does not interfere with your breathing it, and (under ordi-nary circumstances) that air is not used up as more people breathe it. Private goods, in contrast,are rival in consumption . If I eat a hamburger, you cannot eat it too.
Goods can sometimes generate collective benefits and still be rival in consumption. This
happens when crowding occurs. A park or a pool can accommodate many people at the sametime, generating collective benefits for everyone. However, when too many people crowd in on ahot day, they begin to interfere with each other’s enjoyment.
Most public goods are also nonexcludable . Once the good is produced, people cannot be
excluded for any reason from enjoying its benefits. Once a national defense system is established,it protects everyone.
Before we go on, it is very important to note that goods are either public or private by virtue
of their characteristics (nonrival and nonexcludable) and notby virtue of whether they are pro-
duced by the public sector. If the government decided to make it a law that hamburgers were anentitlement (that is, all people could have all the hamburgers they wanted at governmentexpense), that decision would not make hamburgers into public goods. It is an example of thegovernment’s providing a private good free of charge to all. The government’s decision not toexercise the power to exclude doesn’t change the nature of a hamburger.
The real problem with public goods is that private producers may simply not have any incentive
to produce them or to produce the right amount. For a private profit-making firm to produce a goodand make a profit, it must be able to withhold that good from those who do not pay. McDonald’s canmake money selling chicken sandwiches only because customers do not get the chicken sandwichunless they pay for it first. If payment were voluntary, McDonald’s would not be in business for long.
Consider an entrepreneur who decides to offer better police protection to the city of
Metropolis. Careful (and we assume correct) market research reveals that the citizens of Metropoliswant high-quality protection and are willing to pay for it. Not everyone is willing to pay the sameamount. Some can afford more, others less. People also have different preferences and different feel-ings about risk. Our entrepreneur hires a sales force and begins to sell his service. Soon he encoun-ters a problem. Because his company is private, payment is voluntary. He cannot force anyone topay. Payment for a hamburger is voluntary too, but a hamburger can be withheld for nonpayment.The good that our new firm is selling, however, is by nature a public good.
As a potential consumer of a public good, you face a dilemma. Y ou want more police protec-
tion, and let us say that you are even willing to pay $50 a month for it. But nothing is contingenton your payment. First, if the good is produced, the crime rate falls and all residents benefit. Y ouget that benefit whether or not you pay for it. Y ou get a free ride. That is why this dilemma iscalled the free-rider problem . Second, your payment is very small relative to the amount that
must be collected to provide the service. Thus, the amount of police protection actually producedwill not be significantly affected by how much you contribute or whether you contribute at all.This is the drop-in-the-bucket problem . Consumers acting in their own self-interest have no
incentive to contribute voluntarily to the production of public goods. Some will feel a moralresponsibility or social pressure to contribute, and those people indeed may do so. Nevertheless,the economic incentive is missing, and most people do not find room in their budgets for manyvoluntary payments. The public goods problem can also be thought of as a large-number, prison-ers’ dilemma game theory problem. (For a full discussion, see Chapter 14.)
Public Provision of Public Goods
All societies, past and present, have had to face the problem of providing public goods. When mem-bers of society get together to form a government, they do so to provide themselves with goods andservices that will not be provided if they act separately. Like any other good or service, a body of laws(or system of justice) is produced with labor, capital, and other inputs. Law and the courts yield socialbenefits, and they must be set up and administered by some sort of collective, cooperative effort.
Notice that we are talking about public provision , not public production . Once the government
decides what service it wants to provide, it often contracts with the private sector to produce the good.Much of the material for national defense is produced by private defense contractors. Highways, gov-ernment offices, data processing services, and so on, are usually produced by private firms.
One of the immediate problems of public provision is that it frequently leads to public dis-
satisfaction. It is easy to be angry at government. Part, but certainly not all, of the reason for thisdissatisfaction lies in the nature of the goods that government provides. Firms that produce or sellnonexcludable A
characteristic of most publicgoods: Once a good isproduced, no one can beexcluded from enjoying itsbenefits.
free-rider problem A problem
intrinsic to public goods:Because people can enjoy the
benefits of public goods whether
or not they pay for them, theyare usually unwilling to pay
for them.
drop-in-the-bucket problem
A problem intrinsic to publicgoods: The good or service is
usually so costly that its
provision generally does notdepend on whether any single
person pays.
CHAPTER 16 Externalities, Public Goods, and Social Choice 343
private goods post a price—we can choose to buy any quantity we want, or we can walk away with
nothing. It makes no sense to get angry at a shoe store because no one can force you to shop there.
Y ou cannot shop for collectively beneficial public goods. When it comes to national defense, the
government must choose one and only one kind and quantity of (collective) output to produce.Because none of us can choose how much should be spent or what it should be spent on, we are alldissatisfied. Even if the government does its job with reasonable efficiency, at any given time, abouthalf of us think we have too much national defense and about half of us think we have too little.
Optimal Provision of Public Goods
In the early 1950s, economist Paul Samuelson, building on the work of Richard Musgrave,demonstrated that there exists an optimal , or a most efficient , level of output for every public
good.
5The discussion of the Samuelson and Musgrave solution that follows leads us straight to
the thorny problem of how societies, as opposed to individuals, make choices.
The Samuelson–Musgrave Theory An efficient economy produces what people want.
Private producers, whether perfect competitors or monopolists, are constrained by the marketdemand for their products. If they cannot sell their products for more than it costs to producethem, they will be out of business. Because private goods permit exclusion, firms can withholdtheir products until households pay. Buying a product at a posted price reveals that it is “worth”at least that amount to you and to everyone who buys it.
Market demand for a private good is the sum of the quantities that each household decides
to buy (as measured on the horizontal axis) at each price. The diagrams in Figure 16.4 review thederivation of a market demand curve. Assume that society consists of two people, A and B. At aprice of $1, A demands 9 units of the private good and B demands 13. Market demand at a priceof $1 is 22 units. If price were to rise to $3, A ’s quantity demanded would drop to 2 units and B’swould drop to 9 units; market demand at a price of $3 is 2 + 9 = 11 units. The point is that theprice mechanism forces people to reveal what they want, and it forces firms to produce only whatpeople are willing to pay for, but it works this way only because exclusion is possible.
People’s preferences and demands for public goods are conceptually no different from their
preferences and demands for private goods. Y ou may want fire protection and be willing to pay forit in the same way you want to listen to a CD. T o demonstrate that an efficient level of productionexists, Samuelson assumes that we know people’s preferences. Figure 16.5 shows demand curves
5Paul A. Samuelson, “Diagrammatic Exposition of a Theory of Public Expenditure,” Review of Economics and Statistics , 37, 1955,
350–56. For Musgrave’s original version based on the work of Eric Lindahl, see “The Voluntary Exchange Theory of PublicEconomy,” Quarterly Journal of Economics 53 (2) , 213-237, February 1938.A B The market (A + B)
3
1
0
11 22 13 93
1
0
Units of output Units of output Units of output9 23
1
0Price per unit ($)
DADBDA + B
/L50304FIGURE 16.4 With Private Goods, Consumers Decide What Quantity to Buy;
Market Demand Is the Sum of Those Quantities at Each Price
At a price of $3, A buys 2 units and B buys 9 for a total of 11. At a price of $1, A buys 9 units and B buys 13
for a total of 22. We all buy the quantity of each private good that we want. Market demand is the horizontal
sum of all individual demand curves.
344 PART III Market Imperfections and the Role of Government
for buyers A and B. If the public good were available in the private market at a price of $6, A would
buy X1units. Put another way, A is willing to pay $6 per unit to obtain X1units of the public good.
B is willing to pay only $3 per unit to obtain X1units of the public good.
Remember, public goods are nonrival and/or nonexcludable—benefits accrue simultane-
ously to everyone. One and only one quantity can be produced, and that is the amount thateveryone gets. When X
1units are produced, A gets X1and B gets X1. When X2units are produced,
A gets X2and B gets X2.
T o arrive at market demand for public goods, we do not sum quantities. Instead, we add
the amounts that individual households are willing to pay for each potential level of output .
In Figure 16.5, A is willing to pay $6 per unit for X1units and B is willing to pay $3 per unit
forX1units. Thus, if society consists only of A and B, society is willing to pay $9 per unit for
X1units of public good X.F o r X2units of output, society is willing to pay a total of $4 per unit.
For private goods, market demand is the horizontal sum of individual demand curves—we
add the different quantities that households consume (as measured on the horizontal axis). For
public goods, market demand is the vertical sum of individual demand curves—we add the dif-ferent amounts that households are willing to pay to obtain each level of output (as measured on
the vertical axis).
A
B
The market (A + B)Price per unit ($)6
2
0 X1X2DAPrice per unit ($)3
2
X1X2Price per unit ($)9
4
X1X20
Units of outputDB
DA + B/L50298FIGURE 16.5
With Public Goods,
There Is Only One Levelof Output andConsumers Are Willingto Pay DifferentAmounts for Each Level
A is willing to pay $6 per unit for
X1units of the public good. B is
willing to pay only $3 for X1
units. Society—in this case A and
B—is willing to pay a total of $9for X
1units of the good. Because
only one level of output can bechosen for a public good, we
must add A’s contribution to B’s
to determine market demand.This means adding demandcurves vertically.
CHAPTER 16 Externalities, Public Goods, and Social Choice 345
Samuelson argued that once we know how much society is willing to pay for a public good,
we need only compare that amount to the cost of its production. Figure 16.6 reproduces A ’s andB’s demand curves and the total demand curve for the public good. As long as society (in thiscase, A and B) is willing to pay more than the marginal cost of production, the good should beproduced. If A is willing to pay $6 per unit of public good and B is willing to pay $3 per unit, soci-ety is willing to pay $9.
Given the MC curve as drawn in Figure 16.6, the efficient level of output is X
1units. If at that
level A is charged a fee of $6 per unit of Xproduced and B is charged a fee of $3 per unit of X,
everyone should be happy. Resources are being drawn from the production of other goods andservices only to the extent that people want the public good and are willing to pay for it. We havearrived at the optimal level of provision for public goods . At the optimal level, society’s total
willingness to pay per unit is equal to the marginal cost of producing the good.
The Problems of Optimal Provision One major problem exists, however. T o produce
the optimal amount of each public good, the government must know something that it cannotpossibly know—everyone’s preferences. Because exclusion is impossible, nothing forces house-holds to reveal their preferences. Furthermore, if we ask households directly about their willing-ness to pay, we run up against the same problem encountered by our protection-servicessalesperson mentioned earlier. If your actual payment depends on your answer, you have anincentive to hide your true feelings. Knowing that you cannot be excluded from enjoying the ben-efits of the good and that your payment is not likely to have an appreciable influence on the levelof output finally produced, what incentive do you have to tell the truth—or to contribute?
How does society decide which public goods to provide? We assume that members of society
want certain public goods. Private producers in the market cannot make a profit by producing thesegoods, and the government cannot obtain enough information to measure society’s demands accu-rately. No two societies have dealt with this dilemma in the same way. In some countries, dictatorssimply decide for the people. In other countries, representative political bodies speak for the people’spreferences. In still other countries, people vote directly. None of these solutions works perfectly. Wewill return to the problem of social choice at the end of the chapter.
Local Provision of Public Goods: Tiebout Hypothesis
In 1956, economist Charles Tiebout made this point: T o the extent that local governments areresponsible for providing public goods, an efficient market-choice mechanism may exist. Considera set of towns that are identical except for police protection. T owns that choose to spend a greatdeal of money on police are likely to have a lower crime rate. A lower crime rate will attract house-holds who are risk-averse and who are willing to pay higher taxes for a lower risk of being a crimevictim. Those who are willing to bear greater risk may choose to live in the low-tax/high-crime
MC
X10DADBDA + BPA + B = 9
PA = 6
PB = 3
Units of outputPrice per unit ($)/L50296FIGURE 16.6
Optimal Production of a
Public Good
Optimal production of a public
good means producing as long
as society’s total willingness topay per unit ( D
A+B) is greater
than the marginal cost of pro-
ducing the good.optimal level of provision for
public goods The level at
which society’s total willingnessto pay per unit is equal to the
marginal cost of producingthe good.
346 PART III Market Imperfections and the Role of Government
towns. Also, if some town is efficient at crime prevention, it will attract residents—given that each
town has limited space, property values will be bid up in this town. The higher home price in thistown is the “price” of the lower crime rate.
According to the Tiebout hypothesis , an efficient mix of public goods is produced when
local prices (in the form of taxes or higher housing costs) come to reflect consumer preferencesjust as they do in the market for private goods. What is different in the Tiebout world is that peo-ple exercise consumer sovereignty not by “buying” different combinations of goods in a market,but by “voting with their feet” (choosing among bundles of public goods and tax rates producedby different towns and participating in local government).
Social Choice
One view of government, or the public sector, holds that it exists to provide things that “societywants.” A society is a collection of individuals, and each has a unique set of preferences. Definingwhat society wants, therefore, becomes a problem of social choice —of somehow adding up, or
aggregating, individual preferences.
It is also important to understand that government is made up of individuals—politicians
and government workers—whose own objectives in part determine what government does. T o
understand government, we must understand the incentives facing politicians and public ser-vants, as well as the difficulties of aggregating the preferences of the members of a society.
The Voting Paradox
Democratic societies use ballot procedures to determine aggregate preferences and to make thesocial decisions that follow from them. If all votes could be unanimous, efficient decisions wouldbe guaranteed. Unfortunately, unanimity is virtually impossible to achieve when hundreds ofmillions of people, with their own different preferences, are involved.
The most common social decision-making mechanism is majority rule, but it is not perfect. In
1951, economist Kenneth Arrow proved the impossibility theorem
6—that it is impossible to devise
a voting system that respects individual preferences and gives consistent, nonarbitrary results.
One example of a seemingly irrational result emerging from majority-rule voting is the vot-
ing paradox. Suppose that faced with a decision about the future of the institution, the presidentof a major university opts to let its top three administrators vote on the following options: Shouldthe university (A) increase the number of students and hire more faculty, (B) maintain the cur-rent size of the faculty and student body, or (C) cut back on faculty and reduce the student body?Figure 16.7 represents the preferences of the three administrators diagrammatically.
The vice president for finance (VP1) wants growth, preferring A to B and B to C. The vice
president for development (VP2), however, does not want to rock the boat, preferring the main-tenance of the current size of the institution, option B, to either of the others. If the status quo isout of the question, VP2 would prefer option C. The dean believes in change, wanting to shakethe place up and not caring whether that means an increase or a decrease. The dean prefers C toA and A to B.social choice The problem of
deciding what society wants.The process of adding upindividual preferences to make
a choice for society as a whole.Tiebout hypothesis An
efficient mix of public goods isproduced when local land/
housing prices and taxes come
to reflect consumer preferencesjust as they do in the market
for private goods.
Option A Option B Option C
Hire more faculty No change Reduce the size of the faculty
Ranking
1
2
3X
X
XX
X
XX
X
XVP1 VP2
Dean/L50298FIGURE 16.7
Preferences of Three
Top University Officials
VP1 prefers A to B and B to C.
VP2 prefers B to C and C to A.The dean prefers C to A andAt oB .
6Kenneth Arrow, Social Choice and Individual Values (New Y ork: John Wiley, 1951).impossibility theorem A
proposition demonstrated by
Kenneth Arrow showing that nosystem of aggregating individual
preferences into social decisions
will always yield consistent,nonarbitrary results.
CHAPTER 16 Externalities, Public Goods, and Social Choice 347
Table 16.2 shows the results of the vote. When the three vote on A versus B, they vote in favor
of A—to increase the size of the university instead of keeping it the same size. VP1 and the deanoutvote VP2. Voting on B and C produces a victory for option B; two of the three would prefer tohold the line than to decrease the size of the institution. After two votes, we have the result that A(an increase) is preferred to B (no change) and that B (no change) is preferred to C (a decrease).
TABLE 16.2 Results of Voting on University’s Plans: The Voting
Paradox
Votes of:
Vote VP1 VP2 Dean Resulta
A versus B A B A A wins: A > B
B versus C B B C B wins: B > C
C versus A A C C C wins: C > A
aA > B is read “A is preferred to B.”
The problem arises when we have the three vote on A against C. Both VP2 and the dean vote
for C, giving it the victory; C is actually preferred to A. Nevertheless, if A beats B and B beats C,how can C beat A? The results are inconsistent.
Thevoting paradox illustrates several points. Most important is that when preferences for
public goods differ among individuals, any system for adding up, or aggregating, those prefer-ences can lead to inconsistencies. In addition, it illustrates just how much influence the personwho sets the agenda has. If a vote had been taken on A and C first, the first two votes might neverhave occurred. This is why rules committees in both houses of Congress have enormous power;they establish the rules under which, as well as the order in which, legislation will be considered.
Another problem with majority-rule voting is that it leads to logrolling. Logrolling occurs
when representatives trade votes—D helps get a majority in favor of E’s program; in exchange, Ehelps D get a majority on D’s program. It is not clear whether any bill could get through any leg-islature without logrolling. It is also not clear whether logrolling is, on balance, a good thing or abad thing from the standpoint of efficiency. On the one hand, a program that benefits one regionor group of people might generate enormous net social gains, but because the group of beneficia-ries is fairly small, it will not command a majority of delegates. If another bill that is likely to gen-erate large benefits to another area is also awaiting a vote, a trade of support between the twosponsors of the bills should result in the passage of two good pieces of efficient legislation. On theother hand, logrolling can also turn out unjustified, inefficient pork barrel legislation.
A number of other problems also follow from voting as a mechanism for public choice. For
one, voters do not have much of an incentive to become well informed. When you go out to buya car or, on a smaller scale, an MP3 player, you are the one who suffers the full consequences of abad choice. Similarly, you are the beneficiary of the gains from a good choice. This is not so invoting. Although many of us believe that we have a civic responsibility to vote, no one reallybelieves that his or her vote will actually determine the outcome of an election. The time andeffort it takes just to get to the polls are enough to deter many people. Becoming informedinvolves even more costs, and it is not surprising that many people do not do it.
Beyond the fact that a single vote is not likely to be decisive is the fact that the costs and benefits
of wise and unwise social choices are widely shared. If the congressperson whom you elect makes abig mistake and wastes a billion dollars, you bear only a small fraction of that cost. Even though thesums involved are large in aggregate, individual voters find little incentive to become informed.
Two additional problems with voting are that choices are almost always limited to bundles of pub-
licly provided goods and that we vote infrequently. Many of us vote for Republicans or Democrats. Wevote for president only every 4 years. We elect senators for 6-year terms. In private markets, we can lookat each item separately and decide how much of each item we want. We also can shop daily. In the pub-lic sector, though, we vote for a platform or a party that takes a particular position on a whole range ofissues. In the public sector it is very difficult, or impossible, for voters to unbundle issues.
There is, of course, a reason why bundling occurs in the sphere of public choice. It is difficult
enough to convince people to go to the polls once a year. If we voted separately on every appropri-ation bill, we would spend our lives at the polls. This is one reason for representative democracy.We elect officials who we hope will become informed and represent our interests and preferences.voting paradox A simple
demonstration of how
majority-rule voting can lead
to seemingly contradictory and inconsistent results. A
commonly cited illustration
of the kind of inconsistencydescribed in the impossibilitytheorem.
logrolling Occurs when
congressional representatives
trade votes, agreeing to help
each other get certain pieces oflegislation passed.
348 PART III Market Imperfections and the Role of Government
Government Inefficiency: Theory of Public Choice
Recent work in economics has focused not just on the government as an extension of individual
preferences but also on government officials as people with their own agendas and objectives.That is, government officials are assumed to maximize their own utility, not the social good. T ounderstand the way government functions, we need to look less at the preferences of individualmembers of society and more at the incentive structures that exist around public officials.
The officials whom we seem to worry about are the people who run government agencies—
the Social Security Administration, the Department of Housing and Urban Development, andstate registries of motor vehicles, for example. What incentive do these people have to produce agood product and to be efficient? Might such incentives be lacking?
In the private sector, where firms compete for profits, only efficient firms producing goods that
consumers will buy survive. If a firm is inefficient—if it is producing at a higher-than-necessarycost—the market will drive it out of business. This is not necessarily so in the public sector. If agovernment bureau is producing a necessary service or one that is mandated by law, it does notneed to worry about customers. No matter how bad the service is at the registry of motor vehi-cles, everyone with a car must buy its product.
The efficiency of a government agency’s internal structure depends on the way incentives
facing workers and agency heads are structured. If the budget allocation of an agency is based onthe last period’s spending alone, for example, agency heads have a clear incentive to spend moremoney, however inefficiently. This point is not lost on government officials, who have experi-mented with many ways of rewarding agency heads and employees for cost-saving suggestions.
However, critics say such efforts to reward productivity and punish inefficiency are rarely success-
ful. It is difficult to punish, let alone dismiss, a government employee. Elected officials are subject torecall, but it usually takes gross negligence to rouse voters into instituting such a measure. Also, electedofficials are rarely associated with problems of bureaucratic mismanagement, which they decry daily.
Critics of “the bureaucracy” argue that no set of internal incentives can ever match the disci-
pline of the market. They point to studies of private versus public garbage collection, airlineoperations, fire protection, mail service, and so on, all of which suggest significantly lower costsin the private sector. One theme of the Reagan and first Bush administrations was “privatization.”If the private sector can possibly provide a service, it is likely to do so more efficiently—so thepublic sector should allow the private sector to take over.
One concern regarding wholesale privatization is the potential effect it may have on distrib-
ution. Late in his administration, President Reagan suggested that the federal government sell itsentire stock of public housing to the private sector. Would the private sector continue to providehousing to poor people? The worry is that it would not because it may not be profitable to do so.
Like voters, public officials suffer from a lack of incentive to become fully informed and to make
tough choices. Consider an elected official. If the real objective of an elected official is to get reelected,then the real incentive must be to provide visible goods for that official’s constituency while hiding thecosts or spreading them thin. Self-interest may easily lead to poor decisions and public irresponsibility.
Looking at the public sector from the standpoint of the behavior of public officials and the poten-
tial for inefficient choices and bureaucratic waste rather than in terms of its potential for improvingthe allocation of resources has become quite popular. This is the viewpoint of what is called the public
choice field in economics that builds heavily on the work of Nobel laureate James Buchanan.
Rent-Seeking Revisited
Another problem with public choice is that special-interest groups can and do spend resources to
influence the legislative process. As we said before, individual voters have little incentive tobecome well informed and to participate fully in the legislative process. Favor-seeking special-interest groups have a great deal of incentive to participate in political decision making. We sawin Chapter 13 that a monopolist would be willing to pay to prevent competition from eroding itseconomic profits. Many—if not all—industries lobby for favorable treatment, softer regulation,or antitrust exemption. This, as you recall, is rent-seeking .
Rent-seeking extends far beyond those industries that lobby for government help in preserving
monopoly powers. Any group that benefits from a government policy has an incentive to use itsresources to lobby for that policy. Farmers lobby for farm subsidies, oil producers lobby for oil importtaxes, and the American Association of Retired Persons lobbies against cuts in Social Security.
In the absence of well-informed and active voters, special-interest groups assume an
important and perhaps critical role. But there is another side to this story. Some have argued
CHAPTER 16 Externalities, Public Goods, and Social Choice 349
that favorable leg islation is, in effect, for sale in the marketplace. Those willing and able to pay the
most are more successful in accomplishing their goals than those with fewer resources. Theory maysuggest that unregulated markets fail to produce an efficient allocation of resources. This should notlead you to the conclusion that government involvement necessarily leads to efficiency. There arereasons to believe that government attempts to produce the right goods and services in the rightquantities efficiently may fail.
Government and the Market
There is no question that government must be involved in both the provision of public goods and thecontrol of externalities. No society has ever existed in which citizens did not get together to protectthemselves from the abuses of an unrestrained market and to provide for themselves certain goodsand services that the market did not provide. The question is not whether we need government
involvement. The question is how much andwhat kind of government involvement we should have.
Critics of government involvement correctly say that the existence of an “optimal” level of
public-goods production does not guarantee that governments will achieve it. It is easy to showthat governments will generally fail to achieve the most efficient level. There is no reason tobelieve that governments are capable of achieving the “correct” amount of control over external-ities. Markets may fail to produce an efficient allocation of resources, but governments may makeit worse. Measurement of social damages and benefits is difficult and imprecise. For example,estimates of the costs of acid rain range from practically nothing to incalculably high amounts.
Just as critics of government involvement must concede that the market by itself fails to
achieve full efficiency, defenders of government involvement must acknowledge government’sfailures. Many on both sides agree that we get closer to an efficient allocation of resources by try-ing to control externalities and by doing our best to produce the public goods that people wantwith the imperfect tools we have than we would by leaving everything to the market.
SUMMARY
EXTERNALITIES AND ENVIRONMENTAL
ECONOMICS p. 329
1.Often when we engage in transactions or make economic deci-
sions, second or third parties suffer consequences that decisionmakers have no incentive to consider. These are calledexternalities . A classic example of an external cost is pollution.
2.When external costs are not considered in economic deci-
sions, we may engage in activities or produce products thatare not “worth it.” When external benefits are not consid-ered, we may fail to do things that are indeed “worth it.” Theresult is an inefficient allocation of resources.
3.A number of alternative mechanisms have been used to controlexternalities: (1) government-imposed taxes and subsidies, (2)private bargaining and negotiation, (3) legal remedies such asinjunctions andliability rules , (4) sale or auctioning of rights to
impose externalities, and (5) direct regulation.
PUBLIC (SOCIAL) GOODS p. 341
4.In an unfettered market, certain goods and services that peo-ple want will not be produced in adequate amounts. Thesepublic goods have characteristics that make it difficult or
impossible for the private sector to produce them profitably.
5.Public goods are nonrival in consumption (their benefits fall
collectively on members of society or on groups of mem-bers), and/or their benefits are nonexcludable (it is generally
impossible to exclude people who have not paid from enjoy-ing the benefits of public goods). An example of a publicgood is national defense.
6.One of the problems of public provision is that it leads topublic dissatisfaction. We can choose any quantity of privategoods that we want, or we can walk away without buying
any. When it comes to public goods such as national defense,the government must choose one and only one kind andquantity of (collective) output to produce.
7.Theoretically, there exists an optimal level of provision for
each public good. At this level, society’s willingness to payper unit equals the marginal cost of producing the good. T odiscover such a level, we would need to know the preferencesof each individual citizen.
8.According to the Tiebout hypothesis , an efficient mix of pub-
lic goods is produced when local land/housing prices andtaxes come to reflect consumer preferences just as they do inthe market for private goods.
SOCIAL CHOICE p. 346
9.Because we cannot know everyone’s preferences about pub-lic goods, we are forced to rely on imperfect social choice
mechanisms such as majority rule.
10. The theory that unfettered markets do not achieve an effi-cient allocation of resources should not lead us to concludethat government involvement necessarily leads to efficiency.Governments also fail.
GOVERNMENT AND THE MARKET p. 349
11. Defenders of government involvement in the economyacknowledge its failures but believe we get closer to an effi-cient allocation of resources with government than withoutit. By trying to control externalities and by doing our best toprovide the public goods that society wants, we do betterthan we would if we left everything to the market.
350 PART III Market Imperfections and the Role of Government
REVIEW TERMS AND CONCEPTS
Coase theorem, p. 334
drop-in-the-bucket problem, p. 342
externality, p. 329
free-rider problem, p. 342
impossibility theorem, p. 346
injunction, p. 336
liability rules, p. 336 logrolling, p. 347
marginal damage cost ( MDC ),p. 333
marginal private cost ( MPC ),p. 333
marginal social cost ( MSC ),p. 330
market failure, p. 329
nonexcludable, p. 342
nonrival in consumption, p. 341 optimal level of provision for public goods,
p. 345
public goods (social orcollective goods),
p. 341
social choice, p. 346
Tiebout hypothesis, p. 346
voting paradox, p. 347
PROBLEMS
1.If government imposes on the firms in a polluting industry
penalties (taxes) that exceed the actual value of the damages
done by the pollution, the result is an inefficient and unfairimposition of costs on those firms and on the consumers oftheir products. Discuss that statement. Use a graph to show howconsumers are harmed.
2.It has been proposed that toll collection on the Massachusetts
Turnpike, a key commuter route into Boston from the west, bediscontinued. Proponents argue that tolls have long ago paid for
the cost of building the road; now they just provide cash for a
fat bureaucracy. A number of economists are opposing therepeal of tolls on the grounds that they serve to internalizeexternalities. Explain their argument briefly.
3.Many people are concerned with the problem of urban sprawl.
As the development of new housing tracts and suburban shop-ping malls continues over time, metropolitan areas have becomemore congested and polluted. Open space disappears, and thequality of life changes. Think of your own metropolitan area,
city, or town. Using the concept of externalities, consider the
issue of land use and development. What are the specific deci-sions made in the development process that lead to externali-ties? On whom are the externalities imposed? Do you think that
they are measurable? In what specific ways can decision makers
be given the incentive to consider them? One of the cities thathas paid the most attention to urban sprawl is Portland,Oregon. Search the Web to see what you can find out aboutPortland’s approach.
4.The existence of “public goods” is an example of potential mar-
ket failure and suggests that a government or public sector canimprove the outcome of completely free markets. Write a brief
summary of the arguments forgovernment provision of public
goods. (Make sure you consider the discussion of a prisoners’
dilemma in the last chapter.) The following three argumentssuggest that government may not improve the outcome as muchas we might anticipate.
a.Public goods theory: Because public goods are collective, the
government is constrained to pick a single level of outputfor all of us. National defense is an example. The govern-ment must pick one level of defense expenditure. Some willthink it is too much, some will think it is too little, and no
one is happy.b.Problems of social choice: It is impossible to choose collec-
tively in a rational way that satisfies voters/consumers ofpublic goods.
c.Public choice and public officials: Once elected or appointed,
public officials tend to act in accordance with their own
preferences and not out of concern for the public.
5.Which of the three arguments do you find to be most persuasive?
5.It has been argued that the following are examples of “mixed
goods.” They are essentially private but partly public. For eachexample, describe the private and public components and dis-cuss briefly why the government should or should not be
involved in their provision.
a.Elementary and secondary education
b.Higher education
c.Medical care
d.Air traffic control
6.A paper factory dumps polluting chemicals into the Snake River.
Thousands of citizens live along the river, and they bring suit,claiming damages. Y ou are asked by the judge to testify at the
trial as an impartial expert. The court is considering four possi-
ble solutions, and you are asked to comment on the potentialefficiency and equity of each. Y our testimony should be brief.a.Deny the merits of the case and affirm the polluter’s right to
dump. The parties will achieve the optimal solution without
government.
b.Find in favor of the plaintiff. The polluters will be held liable
for damages and must fully compensate citizens for all pastand future damages imposed.
c.Order an immediate end to the dumping, with no damages
awarded.
d.Refer the matter to the Environmental Protection Agency,
which will impose a tax on the factory equal to the mar-ginal damage costs. Proceeds will not be paid to the dam-aged parties.
7.[Related to the Economics in Practice on p. 338 ]The
Economics in Practice suggests that children impose negative
externalities. What does that imply about discounts for chil-
dren’s meals at restaurants and discount tickets for children at
museums? Provide three examples of activities that may, in fact,generate positive externalities.
All problems are available on www.myeconlab.com
CHAPTER 16 Externalities, Public Goods, and Social Choice 351
105
DA
DB100
100Price ($)Price ($)A’s Demand
X= 100 – 10 PXB’s Demand
Q BQ A
X= 100 – 20 PX0
0
/L50304FIGURE 18.Explain why you agree or disagree with each of the following
statements:
a.The government should be involved in providing housing
for the poor because housing is a “public good.”
b.From the standpoint of economic efficiency, an unregulated
market economy tends to overproduce public goods.
9.Society is made up of two individuals, A and B, whose demands
for public good X are given in Figure 1. Assuming that the pub-
lic good can be produced at a constant marginal cost of $6,
what is the optimal level of output? How much would you
charge A and B?
10.Government involvement in general scientific research has been
justified on the grounds that advances in knowledge are publicgoods—once produced, information can be shared at virtually
no cost. A new production technology in an industry could be
made available to all firms, reducing costs of production, dri-ving down price, and benefiting the public. The patent system,however, allows private producers of “new knowledge” toexclude others from enjoying the benefits of that knowledge.
Inventors would have little incentive to produce new knowledge
if there was no possibility of profiting from their inventions. Ifone company holds exclusive rights to an advanced productionprocess, it produces at lower cost but can use the exclusion toacquire monopoly power and hold price up.
a.On balance, is the patent system a good or bad thing?
Explain.
b.Is government involvement in scientific research a good
idea? Discuss.11.The Coase theorem implies that we never need to worry
about regulating externalities because the private individualsinvolved will reach the efficient outcome through negotia-tions. Is that statement true or false? Justify your answer and
use examples.
12.The recent economic growth resulting from government poli-
cies of newly industrializing nations such as India and China
has increased environmental strains on global air and water sys-
tems. The negative externalities associated with this economicgrowth demonstrate that the best economic system is one inwhich alleconomic decisions are made by individual house-
holds and firms without anygovernment involvement.
Comment briefly.
13.[Related to the Economics in Practice on p. 341 ]The
United Nations Climate Change Conference was scheduled to
be held in Cancun, Mexico, from November 29–December 10,
2010. Search the Internet to find information about this con-ference. Write a brief essay on any binding deals concerningglobal warming which were reached at the conference. If nodeals were reached, discuss which nations prevented any
binding resolutions and what issues stood in the way of
reaching these deals.
14.The following diagram represents the profit-maximizing
price and output for a firm in a perfectly competitive indus-
try with no externalities. Use this diagram to explain whatwill happen if the production of the product imposes exter-nal costs on society and these costs are not factored into pro-duction decisions.
q*Price per unit ($)
0P*
Units of outputMC
15.Refer to the previous question but assume that the
government has imposed a per-unit tax on this product
which is exactly equal to the marginal damage costs. Use the diagram to show what will happen to production, output,and price.
16.Suppose the nation of Valencia must decide which project to
fund: public transportation, construction of a seaport, or anational Wi-Fi network. The nation has the available funds tofinance only one of these projects, and the decision is up to
Valencia’s three-person finance committee. The order of pref-
erence of the finance committee members is shown in thetable. Explain whether the information in the table will lead toa voting paradox.
PROJECT DELIA ANDREW MALIKA
Public transportation 1 3 2
Seaport construction 2 1 3
Wi-Fi network 3 2 1
18.Sammy, a drummer in a local band, and Dean, a librarian at a
local university, share a condo in San Diego. Sammy enjoys
playing his drums at home, and Dean enjoys reading in silence.Dean is willing to pay Sammy $125 if he will stop playing thedrums at home. Sammy offers Dean $75 per week to find someplace else to read. If Dean has the right to read in silence,
explain why the condo will be free of drum playing. If Sammy
has the right to play his drums, explain why the condo will stillbe free of drum playing.352 PART III Market Imperfections and the Role of Government
CAPPCORE TRADIOLA
POLLUTION
REDUCTION,
UNITSMCOF
REDUCING
POLLUTIONTCOF
REDUCING
POLLUTIONPOLLUTION
REDUCTION,
UNITSMCOF
REDUCING
POLLUTIONTCOF
REDUCING
POLLUTION
1 $ 7 $7 1 $ 3 $ 3
2 10 17 2 4 7
3 14 31 3 6 13
4 19 50 4 9 22
5 26 76 5 14 36
6 35 111 6 21 5717.Two firms, Cappcore and Tradiola, are each emitting 6 units of
pollution, and the government wants to reduce the total level of
pollution from the current level of 12 to 4. T o do this, the gov-ernment caps each firm’s allowed pollution level at 2. Each firmmust now pay to cut pollution levels by 4 units. A cap-and-tradepolicy gives each of these firms two permits and allows them to
trade permits if they choose. Based on the table below which
represents the situation faced by these two firms, what will thefirms want to do?
CHAPTER OUTLINE
35317
Decision Making
Under Uncertainty:The Tools
p. 353
Expected Value
Expected Utility
Attitudes Toward Risk
Asymmetric
Information p. 357
Adverse Selection
Market Signaling
Moral Hazard
Incentives p. 363
Labor Market IncentivesIn previous chapters, we assumed
that consumers and firms madechoices based on perfect informa-tion. When consumers choosebetween two products, we assumethat they know the qualities ofthose products, and as a result theirchoices reveal their true prefer-ences. Similarly, when firms choosehow many workers to hire or howmuch capital to use, we assume thatthey know the productivity ofthose workers or that capital. Ofcourse, in many settings, perfectinformation seems to be a reason-able assumption to make. Every dayyou may choose whether to havecereal or eggs for breakfast. Everyevening you may decide what tohave for dinner and whether to goto the movies or stay home andstudy. Even for these choices, a littleuncertainty can creep in; perhaps anew cereal is on the market or a new movie has been released. But assuming that these choices aremade with perfect information does not seem too far a stretch.
In some markets, however, consumers and firms clearly make decisions with quite limited
information. When you decide to insure your car against theft, you don’t know whether the carwill be stolen. When you decide to buy a used car, it is not easy to figure out how good that carreally is. If you are choosing between a sales job that pays a flat salary and one that pays a commis-sion for every sale you make, you have to predict how good your sales skills will be to determinewhich is the better offer. In many markets, including some very important markets, consumers aswell as firms make decisions while having only some of the information they need. In this chap-ter, we will explore the economics of these markets. As we go through this chapter, you will seehow both the recent health care reform discussion and the 2008–2009 banking crisis can beunderstood using economic tools.
Decision Making Under Uncertainty:
The Tools
In Chapter 6, we laid out the fundamental principles of consumer choice assuming perfect infor-
mation. T o adapt this model to cases in which there is uncertainty, we need to develop a fewmore tools.
Uncertainty and
Asymmetric
Information
354 PART III Market Imperfections and the Role of Government
Expected Value
Suppose I offer you the following deal: Y ou flip a coin 100 times. Every time the coin is a head, you pay
me $1. Whenever the coin lands on tails, I pay you a dollar. We call the amount that one player—in thiscase, me—receives in each of the situations the payoff . Here my payoff is +$1 for heads and –$1 for
tails. In the case of a coin toss, the probability of heads is
1⁄2, as is the probability of tails. This tells us that
the financial value of this deal to me, or its expected value, is $0. Half the time I win a dollar, and halfthe time I lose a dollar. Formally, we define the expected value of an uncertain situation or deal as the
sum of the payoffs associated with each possible outcome multiplied by the probability that outcomewill occur. Again, in the case of a coin toss with the payoffs described, the expected value (EV) is
EV = 1/2 ($1) + 1/2 (–$1) = 0
The coin toss is an easy example, in part because there are only two outcomes. But the defin-
ition of expected value holds for any deal in which I can describe both the payoffs and the proba-bilities of all possible outcomes. If I play a game in which I receive $1 every time I roll a die andend up with an even number and I pay $1 every time the die comes up odd, this deal also has anexpected value of $0. Half the time (3 of 6 possible outcomes) I receive $1, and half the time (3 of6 possible outcomes) I pay $1.
The two games just described are known as fair games orfair bets . A fair game has an
expected value of $0. The expected financial gains from playing a fair game are equal to the finan-cial costs of that game. In the two fair games we described, the stakes are quite low. Supposeinstead of $1 payoffs, we made the payoffs $1,000 for heads and –$1,000 for tails. As you can see,the expected value of that deal is $0 just as it was in the $1 game. But we have learned in watchingpeople’s behavior that while some people might be willing to play a fair game with $1 payoffs,very few people will play $1,000-payoff fair games. What is it about people that makes themchange their minds about taking a fair bet when the stakes get high? We will explore this questionnext using some of the tools already covered in Chapter 6.
Expected Utility
Recall from Chapter 6 that consumers make choices to maximize utility. The idea of maximizing util-ity will also help us understand the way in which those consumers make choices in risky situations.
Chapter 6 introduced you to the idea of diminishing marginal utility —the more of any one
good consumed in a period, the less incremental satisfaction (utility) will be generated by eachadditional (marginal) unit of that good. Review Figure 6.3 on p. 127 and notice the form the util-ity curve takes when we have diminishing marginal utility for a good. The curve flattens as weincrease units of the good consumed. Now think about what happens to your utility level whenwe increase not the number of units of a particular good, but your overall income. Figure 17.1graphs the total utility of a typical consumer, Jacob, as a function of his income. On the Y-axis, we
have assigned units of total utility, while on the X-axis we have annual income. The shape of the
utility curve tells us that Jacob has diminishing marginal utility from income. The first $20,000 ofincome is very important to Jacob, moving him from a total utility level of 0 to 10; this first$20,000 might allow him to buy food and shelter, for example. Moving from $20,000 to $40,000brings an increase in well-being from 10 to 15. Notice that the second $20,000 adds 5 to the totalutility level, while the first $20,000 adds 10. And the pattern continues as we add $20,000 incre-ments to income. Each dollar increases total utility, but at a decreasing rate. The result is a curveas shown in Figure 17.1 that flattens as we move from left to right, with smaller gains in total util-ity from equal gains in income.
Y ou should see that the assumption of diminishing marginal utility of income reflects the dimin-
ishing marginal utility of goods that we talked about in Chapter 6. Income counts for less the more wehave because the value of what we can buy with that money on the margin falls as we buy more.
As you think about Figure 17.1, remember that we are describing the relationship between
utility and income for a given individual . The figure does not tell us that rich people get less util-
ity from an incremental dollar than do poor people. Indeed, it might be argued that one reasonsome rich people work so hard to make money is that they get a great deal of utility fromincreases in income relative to the average person. But rich or poor, Figure 17.1 tells us that asyour income increases, the marginal utility of another dollar falls.expected value The sum of
the payoffs associated with
each possible outcome of a
situation weighted by itsprobability of occurring.
diminishing marginal utility
The more of any one goodconsumed in a given period, the
less incremental satisfaction is
generated by consuming amarginal or incremental unit of
the same good.fair game orfair bet A game
whose expected value is zero.payoff The amount that
comes from a possibleoutcome or result.
CHAPTER 17 Uncertainty and Asymmetric Information 355
10
0
IncomeIncome
$20,000 $40,000 $60,000 $80,000151819Utility/L50296FIGURE 17.1 The
Relationship BetweenUtility and Income
The figure shows the way in
which utility increases withincome for a hypothetical per-
son, Jacob. Notice that utilityincreases with income but at adecreasing rate: the curve gets
flatter as income increases. This
curve shows diminishing mar-
ginal utility of income.
How does Figure 17.1 help us explain people’s unwillingness to play fair games with larger
stakes? Suppose Jacob, the individual whose preferences are shown in Figure 17.1, is currentlyearning $40,000. We see that $40,000 corresponds to a total utility level of 15. Now a firm offersJacob a different type of salary structure. Rather than earning $40,000 for sure, at the end of theyear, a manager will toss a coin. If it is heads, Jacob will earn $60,000; but if the coin turns up tails,his earnings will fall to $20,000. This is a high stakes game of the sort described earlier. Noticethat the expected value of the two salaries is the same. With one, Jacob earns $40,000 with cer-tainty. With the second, he earns $20,000 half the time and $60,000 half the time, for an expectedvalue of
EV = 1/2($20,000) + 1/2 (60,000) = $40,000
From an expected value perspective, the two salary offers are identical. So if we simply
looked at the expected values, we might expect Jacob to be indifferent between the two wageoffers. But if you put yourself in Jacob’s shoes, probably you would not find the coin-tossingsalary to be as attractive as the fixed $40,000 wage. If we think back to the model introduced inChapter 6, we can see why. Consumers make choices not to maximize income per se but to max-imize their utility levels. Figure 17.1 tells us that while utility increases with income, the relation-ship is not linear. So to decide what Jacob will do, we need to look at his utility under the twocontracts.
What can we say about Jacob’s utility under the two salary contracts? With a fixed $40,000
salary, total utility is at a level of 15, as we saw earlier. If his income falls to $20,000, that utilitylevel falls from 15 to 10, a substantial drop. With a possible earnings level of $60,000, the totalutility level goes up; but notice that it only increases from 15 to only 18. The drop in incomecauses a bigger loss in utility than comes from a gain in income. Of course, this results from thediminishing marginal utility of income. In fact, we can define expected utility as the sum of the
utilities coming from all possible outcomes of a deal, weighted by the probability of each occur-ring. Y ou can see that the expected utility is like the expected value, but the payoffs are in utilityterms rather than in dollars. In the coin-toss salary offer, if you look again at Figure 17.1, theexpected utility (EU) is
EU = 1/2 U($20,000) + 1/2 U(60,000), which reduces to
EU = 1/2 (10) + 1/2 (18) = 14
Since Jacob’s utility from a fixed salary of $40,000 is 15, he will not take the coin-toss salary
alternative.
Of course, in practice, workers are not paid wages based on the toss of a coin. Nevertheless,
many wage contracts contain some uncertainty. Many of you have probably had jobs where yourwages were uncertain in ways you could not control. Understanding the difference betweenexpected value maximization and expected utility maximization helps us understand these andother similar contracts.
In uncertain situations, consumers make choices to maximize their expected utility. Looking
at Figure 17.1, you should now see why people may take small fair bets but will avoid fair games
expected utility The sum of
the utilities coming from allpossible outcomes of a deal,
weighted by the probability of
each occurring.
356 PART III Market Imperfections and the Role of Government
with high stakes. For small games, people are making choices within a very small region of the
utility curve. The utility of gaining one more dollar or losing it is almost identical. When we com-pare outcomes at very different points on the utility curve, the differences in marginal utilitybecome more pronounced. This makes large fair bets quite unattractive.
Attitudes Toward Risk
We have now seen that diminishing marginal utility of income means that the typical individualwill not play a large stakes fair game. Individuals, like Jacob, who prefer a certain payoff to anuncertain payoff with an equal expected value are called risk-averse . Risk aversion thus comes
from the assumption of diminishing marginal utility of income and can be seen in the shape ofthe utility curve. Y ou are unwilling to take a risk because the costs of losing in terms of your well-being or utility exceed the gains of possibly winning. People who are willing to take a fair bet, onethat has an expected value of zero, are known as risk-neutral . For these individuals, the marginal
utility of income is constant so that the relationship between total utility and income in a graphlike Figure 17.1, for example, would be a straight, upward-sloping line. Again, we have seen thatsome people will be risk-neutral when the stakes are low. Finally, some people, in some circum-stances, may actually prefer uncertain games to certain outcomes. Individuals who pay to play agame with an expected value of zero or less are known as risk-loving . Since most people are risk-
averse in most situations, we will concentrate on this case.
The fact that people are, in general, risk-averse is seen in many markets. Most people who
own houses buy fire insurance even when not required to do so. In general, a fire insurancepolicy costs a homeowner more than it is worth in terms of expected value; this is how insur-ance companies make money. People pay for this insurance because they are risk-averse: Thepossible loss of their home is very important relative to the value of the premiums they have topay to protect it. When people invest in a risky business, there has to be some chance that theywill “make it big” to induce them to put up their money. The riskier the business in the sensethat it may fail, the bigger the upside potential needs to be. This too is an indication of riskaversion.
The presence of risk and uncertainty do not by themselves pose a problem for the workings
of the market. The risk that your house might burn down does not prevent you from buying ahouse; it simply encourages you, if you are risk-averse, to buy insurance. In fact, many marketsare designed to allow people to trade risk. Individuals who are risk-averse seek out other individ-uals (or more commonly firms) who are willing to take on those risks for a price.
Therisk premium is the maximum price a risk-averse person will pay to avoid taking a risk.
Figure 17.2 gives us another look at the same individual, Jacob, we examined in Figure 17.1.Suppose Jacob is currently earning $40,000 but faces a 50 percent chance of suffering an unpre-ventable disability that will reduce his income level to $0. Thus, the expected value of Jacob’sincome is
EV = .5($40,000) + .5($0) = $20,000
Suppose further that there are many individuals just like Jacob. On average, in any year, half
would become disabled and half would not. If an insurance company offered policies to all ofthem, offering to replace their $40,000 salaries should they become disabled, on average, thispolicy would cost the company $20,000 per person. In other words, the expected value tells uswhat, on average, it would cost a firm that pooled large numbers of identical people to offerthem insurance against an income loss of this size. If the individuals are willing to pay theinsurance company more than this expected value, there is a potential deal to be made. In fact,looking at Figure 17.2 shows us that the deal offered by the insurance company to cover earn-ings losses in the case of a disability is worth more than $20,000 to a risk-averse individual likeJacob. Uninsured, Jacob faces a 50 percent chance of earning $0 and a 50 percent chance ofearning $40,000. Looking at the graph, we see that the expected utility of Jacob in his uninsuredstate is
EU = .5 U ($0) + .5 U($40,000)
EU = .5(0) + .5(15) = 7.5risk-averse Refers to a
person’s preference of a certain
payoff over an uncertain onewith the same expected value.
risk-neutral Refers to a
person’s willingness to take a bet with an expected valueof zero.
risk-loving Refers to a
person’s preference for
an uncertain deal over a
certain deal with an equalexpected value.
risk premium The maximum
price a risk-averse person will
pay to avoid taking a risk.
CHAPTER 17 Uncertainty and Asymmetric Information 357
But a utility level of 7.5 corresponds, as we look at Figure 17.2, to a certain income level of x,
which is below the $20,000 level. In other words, Jacob would be indifferent between a certainincome of $ xand remaining uninsured. But notice that $ xis less than $20,000, which tells us that
Jacob is willing to pay more than $20,000 to avoid this disability risk. So there is room for a dealbetween the insurance company and risk-averse individuals. Because insurance companies canpool risks across many different people, they will be risk-neutral, willing to take on the risks ofindividuals for a price. In this example, the distance between $20,000, the expected value of therisk, and $ xtells us the risk premium.
Y ou may now be wondering how economists explain gambling. Every day people
throughout the United States buy lottery tickets even though they know that lotteries are nota fair bet. The Powerball lottery in Connecticut is one example. The winning number is gen-erated by choosing 5 numbers out of a pool of 49, then choosing another number from a poolof 42. The probability of getting all 6 numbers correct and winning the lottery’s top prize is 1in 80 million. The top prize in the lottery varies but is typically in the $10 million to $150 mil-lion range. The prize is taxable, and winning the top prize would push a winner into the toptax bracket with a tax rate of almost 40 percent. When the prize level is very high, many peo-ple play the lottery and there is a risk of multiple winners, with prize sharing. Thus, in almostall cases, the expected value of the typical lottery is highly negative. Playing the slots at acasino also has a negative expected value, as do all professional games of chance. If this werenot true, casinos would go out of business. Nevertheless, individuals buy lottery tickets andgamble in a range of forms. One explanation for this risk-taking behavior may, of course, bethat some people find gambling fun and gamble not just in the hopes of winning but for theexperience. For other people, gambling may be an addiction. Trying to understand more fullywhy people gamble while they seem to be risk-averse in most other ways remains an interest-ing research area in economics.
Asymmetric Information
In the discussion so far, we have described the way people behave in situations in which everyoneinvolved in the deal is equally uncertain. Again, the coin toss is a classic case. When you offer mea coin toss game, neither you nor I know how the coin will fall. It is an unknowable game ofchance. Under these situations, we have seen how to use the idea of expected utility to understandchoices and we have seen how markets arise to enable risk trading. In other situations, though,the playing field may be less even, with one party to the transaction having more information rel-evant to the transaction than the other party. Economists refer to these circumstances as ones ofasymmetric information . Asymmetric information creates possibilities of market failure by
making it harder for individuals to make deals that would otherwise be attractive.
We are surrounded by situations with asymmetric information. A homeowner has better
information than does his or her insurance company about how careful his or her family is,how often family members use candles, and whether anyone smokes. All of these factors are10
7.5
0
Income$20,000$x $40,000 $60,0001518Total utilityUtility/L50296FIGURE 17.2
Risk Aversion and
Insurance Markets
With a 50 percent chance of
earning $40,000 and a 50 per-
cent chance of becoming dis-
abled and earning $0, Jacob hasan EV of income of $20,000. Buthis expected utility is halfwaybetween the utility of $40,000
(15) and the utility of 0 (0), or
7.5. $ xis the amount of certain
earnings Jacob would accept toavoid a 50 percent chance of
earning $0.
asymmetric information One
of the parties to a transactionhas information relevant to thetransaction that the otherparty does not have.
358 PART III Market Imperfections and the Role of Government
important to an insurance company trying to set an insurance price. When you applied to
college, you likely knew more about your work ethic than did the colleges to which you applied.
In this section, we will explore several classic types of asymmetric situations. We will
look at the nature of the market failure that arises when we have asymmetric information,and we will consider some of the mechanisms that individuals and markets use to deal withthese problems.
Adverse Selection
A common saying in the car market is that once you drive a new car off the lot, it loses a sub-stantial part of its original value. Why might this be true? Physical depreciation is likely smallafter only a few miles, for example. The answer can be found in the theory of adverseselection, a theory whose development was cited by the Nobel Committee in its award toGeorge Akerlof in 2001. Adverse selection is a category of asymmetric information prob-
lems. In adverse selection, the quality of what is being offered in a transaction matters and isnot easily demonstrated. For example, consumers might be willing to pay for high-qualityused cars. But it is hard to tell which cars are good and which cars are not, and sellers will not,in general, have an incentive to be completely truthful. Insurance companies might be willingto offer inexpensive health insurance to people who take good care of themselves. But it is noteasy to figure out who those people are, and insurance buyers are not likely to want to tell thecompany about their bad habits. As we will see, under these conditions, high-quality productsand high-quality consumers are often squeezed out of markets, giving rise to the term adverse
selection . In the Economics in Practice on page 360, we will explore some issues in adverse selection
and genetic testing. But first we will explore the used car market, the setting Akerlof firstwrote about.
Adverse Selection and Lemons Suppose you were in the market for a slightly used car
of a particular make, perhaps from 2005. Having read a number of automotive magazines, youlearned that half of these cars are lemons (bad cars) and half are peaches (good cars). Given yourown tastes, a peach of this model year is worth $12,000 to you while a lemon is worth only $3,000.What would you pay if you were unable to tell a peach from a lemon?
One possible solution to this problem might involve thinking back to the lesson on expected
value. The data we described suggest that the expected value of this type of used car is $7,500,which we calculate as
1⁄2($12,000) + 1⁄2($3,000). From expected utility theory, you might conclude
that you would pay somewhat less than this—let’s say $7,000.
The problem with this calculation, however, is that you have forgotten that you will be trying
to buy this car from a rational, utility-maximizing car seller. Under these circumstances, it willnot be equally likely that the car offered will be a peach or a lemon. Let us see how a potentialseller of a used car sees the situation.
Suppose you offer current owners of a random 2005 car the $7,000 that we calculated. Which
owners will want to sell? Owners of cars likely know whether they have peaches or lemons. Afterall, they have been driving these cars for a while. The game we are playing here is very differentfrom the coin toss. Owners of the peaches will not, on average, find your offer attractive becausetheir cars are worth $12,000 and you are offering only $7,000. Owners of lemons, on the otherhand, will leap at the chance of unloading their cars at that price. In fact, with an offer of only$7,000, only lemon owners will offer their cars for sale. Over time, buyers come to understandthat the probability of getting a lemon on the used market is greater than the probability of get-ting a peach and the price of the used cars will fall. In fact, in this situation, since you know withcertainty that only lemons will be offered for sale, the most you will offer for the 2005 car is$3,000, the value to you of a lemon. In the end, Akerlof suggests, only lemons will be left in themarket. Indeed, Akerlof called his paper “The Market for Lemons.”
The used car example highlights the market failure associated with adverse selection.
Because one party to the transaction—the seller here—has better information than the otheradverse selection A situation
in which asymmetric
information results in high-quality goods or high-quality
consumers being squeezed
out of transactions becausethey cannot demonstrate
their quality.
CHAPTER 17 Uncertainty and Asymmetric Information 359
party and because people behave opportunistically, owners of high-quality cars will have
difficulty selling them. Buyers who are interested in peaches will find it hard to buy one becausethey cannot tell a lemon from a peach and thus are not willing to offer a high enough price tomake the transaction. Thus, while there are buyers who value a peachy car more than it is valuedby its current seller, no transaction will occur. The market, which is normally so good at movinggoods from consumers who place a lower value on a good to consumers with higher values, doesnot work properly.
Y ou should now see why the simple act of driving a car off the lot reduces its price dramati-
cally: Potential buyers assume you are selling the car because you must have bought a lemon, andit is hard for you to prove otherwise.
Adverse Selection and Insurance Adverse selection is a problem in a number of mar-
kets. Consider the very important market for insurance. We have already seen that risk aversioncauses people to want to buy health insurance. But individuals often know more about their ownhealth than anyone else, even with required medical exams. For a given premium level, those whoknow themselves to be most in need of medical care will be most attracted to the insurance. Asunhealthy people swell the ranks of the insured, premiums will rise. The higher the rates, the lessattractive healthy people will find such insurance. Similar problems are likely in markets forinsurance on auto theft and fire. As with used cars, it will be difficult for insurance companies totransact business with lower-risk (high-quality) individuals.
Reducing Adverse Selection Problems In practice, there are a number of ways in
which individuals and markets try to respond to adverse selection problems. Mechanics offerwould-be used car buyers an inspection service that levels the information playing field a bit.Of course, these inspection services have a price. Buyers can also look for other clues to quality.Some buyers have come to recognize that the best used cars to buy are from individuals whohave to relocate to another state. Many students buy used cars from graduating seniors forexample. People who need to relocate, like graduating seniors, often want to sell their cars evenif they are peaches, and they may be willing to do so at prices that do not quite reflect what theyknow to be the high quality of the car they are selling. If a car is being sold by a dealer, he or shecan offer a warranty that covers repairs for the first few years. The fact that a dealer is willing tooffer a warranty tells the potential buyer that the car is not likely to be a lemon. Dealers alsodevelop reputations for selling peaches or lemons. The government also plays a role in trying toreduce adverse selection problems in the used car market. All states have lemon laws that allowbuyers to return a used car for a full refund within a few days of purchase on the grounds thatsome major problems can be detected after modest driving.
Insurance markets also employ strategies to reduce the problem of adverse selection.
Companies require medical exams, for example, and often impose restrictions on their willing-ness to pay for treatment for preexisting conditions. Some companies offer better prices to peoplebased on verifiable health-related behavior such as not smoking.
Understanding the problem of adverse selection is also useful when we think about the pol-
icy issue of universal health coverage. In the United States, health coverage is provided by a mix ofthe private sector (through employers and private purchase) and by the government throughMedicare and Medicaid programs. Under the U.S. system currently in use, many people have achoice about what, if any, kind of health insurance they want to purchase given the premiumsthat insurers offer. By contrast, in some countries, including much of Western Europe, everyonereceives health insurance, typically through a government program. A government program inwhich everyone is covered, at least at some level, is known as universal health coverage . The Health
Care Reform Act of 2010 is moving the United States toward universal health coverage. Whilethere is considerable debate about the merits of moving to a universal health coverage system,most economists agree that universal coverage reduces problems of adverse selection. When indi-viduals can choose whether to be covered, on average, those who expect to most need medicalcare will be most attracted to the insurance offer. T o the extent that universal coverage reduceschoice, it reduces the adverse selection problem.
360 PART III Market Imperfections and the Role of Government
market signaling Actions
taken by buyers and sellers tocommunicate quality in a
world of uncertainty.Market Signaling
We have discussed how asymmetric information between buyers and sellers can lead to adverse
selection. However, there are many things that can be done to overcome or at least reduce theinformation problem. Michael Spence, who shared the Nobel Prize in Economics with GeorgeAkerlof and Joseph Stiglitz in 2001, defined the concept of market signaling to help explain how
buyers and sellers communicate quality in a world of uncertainty.
The college admission process is a good example of how signaling works. In the year
2008–2009, the age group applying to college in the United States peaked. This is the result of4.1 million births in 1990, record immigration, and an economy that provided young people withan incentive to get a good education. Thus, the demand for spaces at the top schools far exceededthe spaces available. Harvard University alone received over 27,000 applications for membershipin a class with fewer than 2,000 students. At the same time, many schools are far less selective andsome cannot even fill the chairs in their classrooms.
In selective admissions, the student is clearly “selling” in the admissions process and the col-
leges and universities are buying. Signaling results because the matching between students andcolleges involves communicating quality in a world of uncertainty.
The selective colleges and universities have uncertain information about the students that
they admit. While schools have concrete information such as test scores and grades, they do nothave concrete measures for other qualities that they are seeking. Thus, schools must look forsignals of those characteristics.
First, selective schools want students who are likely to be successful. They are seeking students
who are willing to work hard and who will do well academically. But schools also want studentswho will contribute to society by becoming good scientists, artists, humanists, dancers, musicians,businesspeople, and leaders. In their admissions forms, brochures, and Web sites, many selectivecolleges and universities explain that they are “seeking students who will make a difference.”
ECONOMICS IN PRACTICE
Adverse Selection in the Health Care Market
Health care is one area in which insurers worry about the problem of
adverse selection. A recent study on long-term care insurance andHuntington’s disease (HD) illustrates the issue.
1
Huntington’s disease is a degenerative neurological disorder. It
is caused by a genetic mutation and affects 1 in 10,000 individuals.Onset typically occurs between ages 30 and 50 and individualsbecome increasingly disabled as the disease progresses. Death typ-
ically occurs about 20 years after onset.
Given the inheritability of HD, any individual with a parent
who has the disease knows they have a 50 percent chance of hav-ing HD. Moreover, since 1993, there has been a test that perfectlypredicts HD. Thus, individuals—because they know their familyhistory and because they can be tested—have or could have sub-
stantial information about their likelihood of eventually suffering
from HD. Insurers, on the other hand, while they can and typi-cally do ask about health status, do not ask about family historyand are not at this point permitted to inquire about the results ofgenetic tests. The health care reform bill of 2010 similarly requires
the government to provide a long-term care option with premi-
ums based only on age, not family or genetic history. Thus wehave clear conditions of asymmetric information favoring poten-tial insurance buyers. As indicated, HD also results in a prolongedperiod of severe disability, so that there is considerable benefit to
owning insurance.
In a long-term study of HD patients, Oster et al. found that
individuals who carry the HD genetic mutation are up to fivetimes as likely as the general population to buy long-term care
insurance, indicating that adverse selection is both present andstrong. For this population, the study finds that at current premi-ums, long-term care insurance is a bargain: For an individual whoknows for sure that he or she will contract HD, the payout isalmost $4 for every $1 of premiums paid. As genetic testingincreases, situations of adverse selection in the health care area arelikely to increase and we will be confronted with harder choices onhow much genetic testing to reveal.
1Emily Oster, Kimberly Quaid, Ira Shoulson, E. Ray Dorsey, “Genetic
Adverse Selection: Evidence from Long-T erm Care Insurance andHuntington Disease,” Journal of Public Economics , forthcoming.
CHAPTER 17 Uncertainty and Asymmetric Information 361
ECONOMICS IN PRACTICE
How to Read Advertisements
Many high-end magazines, including alumni magazines for col-
leges, have a section at the back with advertisements for rentals ofvacation homes. Consider the following ad recently found in oneof those magazines.
St. Thomas Rental: “Lovely villa on the Caribbean island of St.
Thomas. Sleeps 6. Beautiful garden and pool area. Covered veranda
and barbecue. Available by the week or month.”
What conclusion should a discerning reader of this ad draw
about the property beyond what is written? The obvious conclusionto be drawn from this ad by anyone who has studied economics is
that the property is not on or even near the beach.
Why do we conclude this? Ads are designed by people who want to
attract customers. So a first step in our deduction is to recognize thatthe villa owner will mention any attractive and important positive fea-ture that the villa has. On a Caribbean island, beachfront is a key attrac-tion; thus, no mention of the beach tells us that this villa is not on ornear the beach. Recognizing that profit-seeking individuals place the adlets us draw conclusions about the information they do not provide.
This same logic can be used in a corporate setting. In 2002,
Congress and the president passed new accounting rules that requirefirms to inform shareholders of the stock options they give to theirexecutives and the effect of those options on the firms’ costs.
Information could be embedded in the financial statements orplaced in the footnotes. Not surprisingly, those firms—typically thedot-com firms—for whom options costs were large chose the lesstransparent method of putting the information in the footnotes,while more traditional firms, with fewer options to disclose, weremore forthcoming.
Sometimes the lack of information serves as a signal.
Developing a set of signals for identifying quality in admissions candidates is a difficult task,
but there are some generally accepted signals that the colleges and universities look at. Clearly,they look beyond grades and standardized tests. “Quality of the program” is a term used todescribe the difficulty of the classes that the applicant took in high school. How many advancedplacement courses did the student take? How many years of math, science, and foreign language?Did the student challenge himself or herself?
In addition to courses, extracurricular activities serve as a signal for future success.
Admissions professionals also see hours of practicing the violin or piano or soccer as signals ofstudents who dedicate energy to difficult challenges. Admissions professionals make theseassumptions about students because they have imperfect information.
Even without knowing about the theory of signals, most high school students recognize that
colleges reward extracurricular activities. Not surprisingly, this knowledge increases the incentiveof all students to engage in such activities. But how can extracurricular activities be a good signalof interests and productivity if everyone begins to do them? If every high school senior belongs tothe French Club, membership ceases to have a signaling effect.
For extracurricular activities to remain useful as a good signal, they must be more easily
done by well-rounded and productive students than by other students. If a student who is trulyinterested in writing and is well-organized about time management finds it easier to write for theschool paper, colleges can correctly infer that the newspaper writer is more likely to be interestedin writing and is a good manager. It would be too costly in terms of lost time and fun for some-one who dislikes writing and is disorganized to join the newspaper staff just to signal colleges. Forsignals to work, they must be costly and the cost of using them must be less for people who havethe trait that is valued. College admissions committees are, for this reason, beginning to thinkabout things like how many hours a given activity takes. Time-intensive activities are morepainful if a student does not really like the activity, and they involve more of a trade-off withother academic pursuits.
For a signal to reduce the problem of adverse selection, then, it must be less costly for the high
quality-type person to obtain. Extracurricular activities work as a signal when the most committedand brightest students are most able to do the activities and do well at school. Under those condi-tions, these activities are thought of as a strong signal . In the job market, education is a strong signal.
362 PART III Market Imperfections and the Role of Government
Of course, education improves your life in many ways, as a consumer, a citizen, and a worker.
Education can directly improve your productivity in most jobs. But it can also signal a potentialemployer that you are a productive person. Why is education a good signal? Education, likeextracurricular activities, is most easily attained by people who are disciplined, bright, and hard-working. All of those qualities are valued in the workplace but are hard to certify—hence, the needfor a signal.
Signals are everywhere. Return for a moment to the used car example and the discussion of
warranties. We argued that a car for which a dealer offered a warranty was likely to be a peach.Why? A warranty is a promise to pay for repairs for any defects. For a dealer, the warranty isexpensive to live up to only if the car is a lemon. Because a lemon will require more repairs thana peach, providing a warranty for it will end up costing the dealer more. So the fact that a selleroffers a warranty is a strong signal that the car is a peach.
Under some conditions, a firm’s name can signal quality to consumers. Many airports now
have nail salons offering manicures to travelers with spare time. On the surface, though, itappears that there might be a problem with adverse selection in the nail salon business. In a com-munity, a nail salon that does a poor job for the money it charges is likely to go out of business.The salon will have few return visitors, and word of mouth of its poor quality is likely to spread.In an airport salon, return business is infrequent; thus, one might think that low-quality nailsalons would not be forced out of business. Given that quality is more expensive in terms oflabor costs and that consumers do not know whether a salon is good before they have a mani-cure, one might expect bad salons to crowd out good salons in airports. Savvy consumers wouldcome to realize that only the desperate or those unconcerned with quality should get their nailsdone in an airport. In fact, there is an offset to this story about the crowding out of good salons.What we see in many airports is a shop that is part of a large chain of salons. The firm that ownsthe chain recognizes that providing good care in a shop at the Dallas-Fort Worth airport, forexample, will have positive reputation effects in the same-named shop at the St. Louis airport.This gives the firm an incentive to provide better quality care at each airport. As a result, airportvisitors can view the brand name of the salon as a signal of its quality. One of the economicadvantages of a chain is its ability to provide some assurance to customers who are not local of acommon level of product quality at different locations. Next time you are traveling along theinterstate, look at the hotel and food choices at the rest stops. Most are chains for the reasons wejust described.
Moral Hazard
Another information problem that arises in insurance markets is moral hazard . Often people
enter into contracts in which the result of the contract, at least in part, depends on one of the par-ties’ future behavior. A moral hazard problem arises when one party to a contract changes
behavior in response to that contract and thus passes the cost of its behavior on to the other partyto the contract. For example, accident insurance policies are contracts that agree to pay for repairsto your car if it is damaged in an accident. Whether you have an accident depends in part onwhether you drive cautiously. Similarly, apartment leases may specify that the landlord will per-form routine maintenance around the apartment. If you punch the wall every time you get angry,your landlord ultimately pays the repair bill.
Such contracts can lead to inefficient behavior. The problem is like the externality problem
in which firms and households have no incentive to consider the full costs of their behavior. Ifyour car is fully insured against theft, why should you lock it? If health insurance provides newglasses whenever you lose a pair, it is likely that you will be less careful.
In 2009, the U.S. government “bailed out” a number of firms in danger of failing: many
of the largest banks, AIG, and General Motors. Many economists who looked at these bailoutswarned about moral hazard. If the government is around to bail out banks when they fail,what will govern the risks those banks will take? If General Motors and AIG are kept frombankruptcy, will they too behave imprudently? “Moral hazard” became part of many head-lines in 2009.
Like adverse selection, the moral hazard problem is an information problem. Contracting
parties cannot always determine the future behavior of the person with whom they aremoral hazard Arises when
one party to a contractchanges behavior in response
to that contract and thus
passes on the costs of thatbehavior change to the other party.
CHAPTER 17 Uncertainty and Asymmetric Information 363
mechanism design A
contract or an institution thataligns the interests of twoparties in a transaction. A
piece rate, for example, creates
incentives for a worker to workhard, just as his or her superior
wants. A co-pay in the health
care industry encouragesmore careful use of health
care, just as the insurance
company wants.contracting. If all future behavior could be predicted, contracts could be written to try to
eliminate undesirable behavior. Sometimes this is possible. Life insurance companies do notpay off in the case of suicide during the first two years the policy is in force. Fire insurancecompanies will not write a policy unless you have smoke detectors. If you cause unreason-able damage to an apartment, your landlord can retain your security deposit. It is impossible to know everything about behavior and intentions. If a contract absolves one party ofthe consequences of his or her action and people act in their own self-interest, the result is inefficient.
Incentives
The discussion of moral hazard provides us with a number of examples in which individuals whobuy insurance may have the wrong incentives when they make decisions. Incentives play an
important role in other areas of life as well. When firms hire, they want to make sure that theirworkers have the incentive to work hard. Many employers provide bonuses for exemplary perfor-mance to create incentives for their employees. In class, teachers try to provide incentives in theform of positive feedback and grades to encourage students to learn the material. In designingpolicies to deal with unemployment, poverty, and even international relations, governments con-stantly worry about designing appropriate incentives.
In fact, most of our interest in incentives comes because of uncertainty. Because your
teacher or employer cannot always see how hard you are working, he or she wants to designincentives to ensure that you work even when no one is watching. Grades and salary bonusesplay this role. Because insurance companies cannot monitor whether you lock your car door,they would like to create incentives to encourage you to lock your doors even though you havetheft insurance.
Within economics, the area of mechanism design explores how transactions and contracts
can be designed so that, even under conditions of asymmetric information, self-interested peoplehave the incentive to behave properly. In 2007, Leonid Hurwicz, Roger Myerson, and Eric Maskinwon the Nobel Prize for their work in this area. While the field of mechanism design is a complexone, a simple idea in the field is that different incentive schemes can cause people to reveal thetruth about themselves. In the following discussion, we will look at a few examples in the labormarket and the health care market to see how incentives can help reduce both adverse selectionand moral hazard in this way.
Labor Market Incentives
In the section on expected utility versus expected value, we described an employee trying tochoose between a job that offered a wage of $40,000 versus a coin toss that could bring him either$20,000 or $60,000. We suggested that few employees would take such a deal, given risk aversion.And yet many people do have wage contracts that contain some uncertainty. For many CEOs oflarge U.S. companies, less than half of their compensation is in the form of a fixed salary. Most oftheir pay comes from bonuses based on the firm’s profits or its stock market performance. Manyfactory jobs pay piece wages that depend on how fast the worker is. Some of you may have hadsummer jobs selling magazines where wages were uncertain. Why do we see these contracts, giventhe risk aversion of most people?
These types of contracts occur because variable compensation can help firms get better
performance from their workforce. Suppose you are hiring one individual as a salesperson andhave two candidates, George and Harry. Both men seem to be affable, good with people, andhard-working. How can you tell who will be a better salesperson? In this case, incentives canplay a powerful role. Suppose you offer George and Harry the following deal: The base pay forthis job is $25,000, but for every sale made beyond a certain level, a large commission is paid.How valuable is this salary offer? That depends on how good George and Harry are as salespeo-ple. If George knows he is an excellent salesperson, while Harry recognizes that despite hisgood nature, he is lazy, only George will want to take this salary offer. The way the incentivepackage is designed has caused the right person, the better salesperson, to select into the job.
364 PART III Market Imperfections and the Role of Government
SUMMARY
DECISION MAKING UNDER UNCERTAINTY:
THE TOOLS p. 353
1.T o find the expected value of a deal, you identify all possible
outcomes of the deal and find the payoffs associated withthose outcomes. Expected value is the weighted average of
those payoffs where the weights are the probability of eachpayoff occurring.
2.In general, people do not accept uncertain deals with thesame expected value as certain deals.
3.Risk aversion exists when people prefer a certain outcome
to an uncertain outcome with an equal expected value.Risk-neutral people are indifferent between these two deals,
and risk-loving people prefer the uncertain deal to its certain
equivalent.
4.Most people are risk-averse unless the payoffs are very small.
5.Income is subject to diminishing marginal utility , and this
diminishing marginal utility helps explain risk aversion.
ASYMMETRIC INFORMATION p. 357
6.Choices made in the presence of imperfect information maynot be efficient. In the face of incomplete information, con-sumers and firms may encounter the problem of adverse
selection . When buyers or sellers enter into market exchanges
with other parties who have more information, low-qualitygoods are exchanged in greater numbers than high-qualitygoods. Moral hazard arises when one party to a contract
passes the cost of its behavior on to the other party to thecontract. If a contract absolves one party of the consequencesof its actions and people act in their own self-interest, theresult is inefficient. Asymmetric information occurs when one
of the parties to a transaction has information relevant to thetransaction that the other party does not have.
7.In many cases, the market provides solutions to informationproblems. Profit-maximizing firms will continue to gatherinformation as long as the marginal benefits from continuedsearch are greater than the marginal costs. Consumers willdo the same: More time is afforded to the information searchfor larger decisions. In other cases, government must becalled on to collect and disperse information to the public.
8.Market signaling is a process by which sellers can communi-cate to buyers their quality. For a signal to be meaningful, itmust be less expensive for high-quality types to acquire thesignal than for low-quality types.
INCENTIVES p. 363
9.Correct incentive design can improve the selection mecha-nism along with reducing the moral hazard problem.
10. Performance contracts in the labor market and co-pays inthe health insurance market are two examples of incentivecontracts.Notice that in contrast to the problem of adverse selection described earlier in this chapter, this
incentive scheme creates beneficial selection dynamics. One reason that many companies
design compensation with a component that varies with performance is that they want toattract the right kind of employees. In this case, the compensation scheme has screened out the
poor worker. Harry has revealed his own laziness by his job choice, as a result of the design ofthe incentive.
Performance compensation plays another role as well. Once George has taken the job, the
fact that some of his salary depends on his hard work will encourage him to work even harder. Ofcourse, it is important that his compensation depend on things he can, in part, control. This isone reason that in most companies, the CEO’s compensation is tied more to firm profitabilitythan is the salary of his or her executive assistant. Because the CEO has more control over prof-itability, he or she should face the strongest performance incentives.
At the top levels in the investment banking industry, most compensation is performance-
based. In 2008, just before the financial meltdown, Lloyd Blankfein, the CEO of Goldman Sachs,received $73 million in compensation. Of that, $600,000 was in base pay! Many have argued thatcompensation in the financial industry can be traced to excess risk taking.
In recent years, there have been efforts in some states to use more incentive compensa-
tion for public school teachers. In some cases, bonuses have been tied to student perfor-mance on standardized tests. In a related set of experiments, New Y ork City has a pilotprogram to reward students who earn good grades with gifts such as cell phones. There hasbeen a lot of debate about the efficacy of both programs. Some people think that publicschool teachers are already highly motivated and that monetary compensation is not likely tohave much effect. Others worry that teachers will “teach to the test,” suggesting that thewrong behavior will be stimulated. Some worry that incentive pay will screen out committedteachers, while other people believe it will improve retention of hard-working teachers. Inthe case of public school students, critics worry that these incentives will turn learning froma matter of love to one of commerce. These issues will likely be debated for some time to come.
CHAPTER 17 Uncertainty and Asymmetric Information 365
REVIEW TERMS AND CONCEPTS
adverse selection, p. 358
asymmetric information, p. 357
diminishing marginal utility, p. 354
expected utility, p. 355
expected value, p. 354 fair game orfair bet, p. 354
market signaling, p. 360
mechanism design, p. 363
moral hazard, p. 362
payoff, p. 354 risk-averse, p. 356
risk-loving, p. 356
risk-neutral, p. 356
risk premium, p. 356
PROBLEMS
All problems are available on www.myeconlab.com
1.Explain how imperfect information problems such as adverse
selection and moral hazard might affect the following markets
or situations:a.Workers applying for disability benefits from a company
b.The market for used computers
c.The market for customized telephone systems for college
offices and dorms
d.The market for automobile collision insurance
2.Figure 17.1 (p. 355) and Figure 17.2 (p. 357) show a utility curve
for a person who is risk-averse. Draw a similar curve for an indi-
vidual who is risk-neutral and for someone who is risk-loving.
*3.Y our current salary is a fixed sum of $50,625 per year. Y ou have
an offer for another job. The salary there is a flat $25,000 plus a
chance to earn $150,000 if the company does well. Assume that
your utility from income can be expressed as . So,for example, at an income level of $100, your utility level is 10;your utility level from the current salary of $50,625 is 225. How
high does the probability of success for the company have to be
to induce you to take this job?
4.Last January I bought life insurance; at the end of the year, I am
still alive. Was my purchase a mistake? Explain.
5.Many colleges offer pass/fail classes. Use the ideas of adverse selec-
tion and moral hazard to explain why teachers in these classes
find that pass/fail students rarely score at the top of the class.
6.Signals are also used in social settings. In a new place, what sig-
nals do you look for to find people who share your interests?
7.[Related to the Economics in Practice onp. 361 ]Find a prod-
uct advertisement in a magazine for which the missing informa-tion tells you something important about the product.
8.[Related to the Economics in Practice onp. 360 ]Do you think
companies that issue health insurance should be allowed to inquireabout family medical history and the results of genetic testing
before deciding to issue insurance policies? Why or why not?
9.Leopold Bloom runs a local United Parcel Service branch. At
present, he pays his workers an hourly wage. He is considering
changing to a piece rate, in which workers would be paid based
on how many packages they process during a day. Assume onany given day that there are more packages than the work staffcan handle. What effect would you expect this change in com-pensation to have on Bloom’s operations?
10.The fast-food restaurants located on major highways are typi-
cally part of national chains. Why might this be the case?
11.Mary’s local gym has two pricing options. If you pay by the day,
the charge is $10 per day. Alternatively, you can pay an annualmembership fee that allows you to exercise as often as you likeU=1Incomefor $1,000. On average, Mary predicts that she would use the
gym once a week and the value of the 50 times per year she
would go is not enough to warrant a membership. Instead,Mary decides to pay by the day.a.At the end of the year, Mary finds that she went to the gym
only 25 times rather than the 50 she had predicted. She isstill sure, however, that with a membership, she would go
50 times and insists that economic logic supports her predic-
tion. What principle is she thinking about?
b.Mary’s employer has read a new health study that suggests
that people who work out at least once a week perform bet-
ter at work. The firm decides to give Mary and her coworkers
a cash bonus of $40 per week to cover the costs of going tothe health club four times a month. Do you think this policywould be effective? If not, suggest an alternative that wouldachieve the firm’s goal.
12.Sondra wants to purchase a small, used car and sees a 2008
Honda Civic DX listed on Craigslist for $7,000. She is willing topay $9,000 if the car is reliable, but only $5,000 if the car is not
reliable. What additional information might Sondra find helpful
in making her decision about the purchase?
13.One way insurance companies reduce adverse selection prob-
lems is by offering group medical coverage to large firms and
requiring all employees to participate in the coverage. Explainhow this reduces adverse selection.
14.Most casino game dealers in Las Vegas are paid minimum wage,
and therefore rely on tips for a large portion of their income.Within the past few years, a majority of Las Vegas casinos haveinstituted tip-pooling policies for their dealers, whereby dealers
are not allowed to keep the tips they earn; instead, they must pool
all of their tips to be evenly distributed to all dealers. How wouldthe tip-pooling system affect the productivity of the dealers?
15.Video poker is a very popular form of gambling in casinos, sec-
ond only to slot machines. Some video poker games offer a “double-up” feature, where players receiving a paying hand areoffered the chance to double their winnings. If a player chooses toplay the double-up feature, the machine deals one card from a
52-card deck to the player and one to the “dealer.” If the player’s
card is higher than the dealer’s (with an ace being the highestcard), the player doubles his or her winnings. If the player’s card islower than the dealer’s card, the player loses his or her winnings. Ifboth are dealt cards of the same value (a push), the player keeps
his or her original bet. Explain whether the double-up feature is an
example of a fair game.
*Note: Problems with an asterisk are more challenging.
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CHAPTER OUTLINE
36718
The Sources of
HouseholdIncome
p. 367
Wages and Salaries
Income from Property
Income from the
Government: TransferPayments
The Distribution of
Income p. 370
Income Inequality in the
United States
The World Distribution of
Income
Causes of Increased
Inequality
Poverty
The Distribution of Wealth
The Utility
PossibilitiesFrontier
p. 376
The RedistributionDebate
p. 377
Arguments Against
Redistribution
Arguments in Favor of
Redistribution
Redistribution
Programs andPolicies
p. 380
Financing Redistribution
Programs: Taxes
Expenditure Programs
Government or the
Market? A Review p. 384Income Distribution
and Poverty
equity Fairness.What role should government play
in the economy? Thus far we havefocused only on actions the govern-ment might be called on to take toimprove market efficiency. Even ifwe achieved markets that are per-fectly efficient, would the result befair? We now turn to the question ofequity , or fairness.
Somehow the goods and ser-
vices produced in every society getdistributed among its citizens.Some citizens end up with man-sions in Palm Beach, ski trips toGstaad, and Ferraris; other citizens end up without enough to eat, and they live in shacks. Thischapter focuses on distribution. Why do some people get more than others? What are the sourcesof inequality? Should the government change the distribution generated by the market?
The Sources of Household Income
Why do some people and some families have more income than others? Before we turn to dataon the distribution of income, let us review what we already know about the sources ofinequality. Households derive their incomes from three basic sources: (1) from wages orsalaries received in exchange for labor; (2) from property—that is, capital, land, and so on; and(3) from government.
Wages and Salaries
More than half of personal income in the United States in 2007 was received in the form of wagesand salaries. If you add wage supplements, which include contributions for health insurance andpensions, the figure is 64 percent. Hundreds of different wage rates are paid to employees for theirlabor in thousands of different labor markets. As you saw in Chapter 10, perfectly competitivemarket theory predicts that all factors of production (including labor) are paid a return equal totheir marginal revenue product—the market value of what they produce at the margin. There arereasons why one type of labor might be more productive than another and why some householdshave higher incomes than others.
Required Skills, Human Capital, and Working Conditions Some people are born
with attributes that translate into valuable skills. LeBron James and Kevin Garnett are great bas-ketball players, partly because they happen to be very tall. They did not decide to go out and investin height; they were born with the right genes. Some people have perfect pitch and beautiful voices;others are tone deaf. Some people have quick mathematical minds; others cannot add 2 and 2.
The rewards of a skill that is in limited supply depend on the demand for that skill. Men’s
professional basketball is extremely popular, and the top NBA players make millions of dollars
368 PART III Market Imperfections and the Role of Government
per year. There are great women basketball players too, but because women’s professional basket-
ball has not become popular in the United States, these women’s skills go comparatively unre-warded. In tennis, however, people want to see women play, so women therefore earn prizemoney similar to the money that men earn.
Some people with rare skills can make enormous salaries in an unfettered market economy.
Luciano Pavarotti had a voice that millions of people were willing to pay to hear in person and onCDs. Some baseball players make tens of millions of dollars per year. Before Pablo Picasso died,he could sell small sketches for vast sums of money. Were they worth it? They were worth exactlywhat the highest bidder was willing to pay.
Not all skills are inborn. Some people have invested in training and schooling to improve
their knowledge and skills, and therein lies another source of inequality in wages. When we go toschool, we are investing in human capital that we expect to yield dividends, partly in the form
of higher wages, later on. Human capital, the stock of knowledge and skills that people possess,is also produced through on-the-job training. People learn their jobs and acquire “firm-specific”skills when they are on the job. Thus, in most occupations, there is a reward for experience. Payscale often reflects numbers of years on the job, and those with more experience earn higherwages than those in similar jobs with less experience.
Some jobs are more desirable than others. Entry-level positions in “glamour” industries
such as media tend to be low-paying. Because talented people are willing to take entry-level jobsin these industries at salaries below what they could earn in other occupations, there must beother, nonwage rewards. It may be that the job itself is more personally rewarding or that a low-paying apprenticeship is the only way to acquire the human capital necessary to advance. Incontrast, less desirable jobs often pay wages that include compensating differentials .O ft w o
jobs requiring roughly equal levels of experience and skills that compete for the same workers,the job with the poorer working conditions usually has to pay a slightly higher wage to attractworkers away from the job with the better working conditions.
Compensating differentials are also required when a job is very dangerous. Those who take
great risks are usually rewarded with high wages. High-beam workers on skyscrapers and bridgescommand premium wages. Firefighters in cities that have many old, run-down buildings are usu-ally paid more than firefighters in relatively tranquil rural or suburban areas.
Multiple Household Incomes Another source of wage inequality among households lies
in the fact that many households have more than one earner in the labor force. Second, and eventhird, incomes are becoming more the rule than the exception for U.S. families. In 1960, about37 percent of women over the age of 16 were in the labor force. By 1978, the figure had increasedto over 50 percent, and it continued to climb slowly but steadily to over 60 percent in 2007.
The Minimum Wage Controversy One strategy for reducing wage inequity that has been
used for almost 100 years in many countries is the minimum wage. (The minimum wage and pricefloors were discussed in Chapter 4.) A minimum wage is the lowest wage firms are permitted to pay
workers. The first minimum wage law was adopted in New Zealand in 1894. The United Statesadopted a national minimum wage with the passage of the Fair Labor Standards Act of 1938,although many individual states had laws on the books much earlier. The minimum wage was raisedto $7.25 in the summer of 2009.
In recent years, the minimum wage has come under increasing attack. Opponents argue that
minimum wage legislation interferes with the smooth functioning of the labor market and cre-ates unemployment. Proponents argue that it has been successful in raising the wages of thepoorest workers and alleviating poverty without creating much unemployment.
These arguments can best be understood with a simple supply and demand graph.
Figure 18.1 shows hypothetical demand and supply curves for unskilled labor. The equilibriumwage rate is $5.40. At that wage, the quantity of unskilled labor supplied and the quantity ofunskilled labor demanded are equal. Now suppose that a law is passed setting a minimum wageof $6.55. At that wage rate, the quantity of labor supplied increases from the equilibrium level,L
*,t o LS. At the same time, the higher wage reduces the quantity of labor demanded by firms,
from L*to LD. As a result, firms lay off L*-LDworkers.
It is true that those workers who remain on payrolls receive higher wages. With the mini-
mum wage in effect, unskilled workers receive $6.55 per hour instead of $5.40. But is it worth it?Some workers gain while others (including those who had been employed at the equilibriumwage) suffer unemployment.human capital The stock of
knowledge, skills, and talentsthat people possess; it can be
inborn or acquired through
education and training.
minimum wage The lowest
wage that firms are permitted
to pay workers.compensating differentials
Differences in wages that result
from differences in working
conditions. Risky jobs usuallypay higher wages; highlydesirable jobs usually pay
lower wages.
CHAPTER 18 Income Distribution and Poverty 369
In fact, the evidence on the extent to which the minimum wage causes jobs to be lost is
unclear. Professor Finis Welch at T exas A&M and two colleagues estimated in a recent study thateach 10 percent increase in the minimum wage produces job losses of about 1 percent of all min-imum wage workers, or about 60,000 workers in total at the time of the study. But other studiesfind little or no effect on the number of jobs lost when the minimum wage increases. Two earlierstudies by David Card of the University of California at Berkeley and one by Lawrence Katz ofHarvard and Alan Krueger of Princeton University found that an increase in the minimum wagehad virtually no effect on unemployment.
Unemployment Before turning to property income, we need to mention another cause of
inequality in the United States that is the subject of much discussion in macroeconomics:unemployment .
People earn wages only when they have jobs. In recent years, the United States has been through
three severe recessions (economic downturns). In 1975, the unemployment rate hit 9 percent andover 8 million people were unable to find work. In 1982, the unemployment rate was nearly 11 per-cent and over 12 million were jobless. More recently, the recovery from the milder recession of 1990to 1991 was slow at first. By 2000, the number of unemployed dropped below 5.5 million (an unem-ployment rate of 3.9 percent), but by 2008, it was back to 15.2 million, or 10 percent.
Unemployment hurts primarily those who are laid off, and thus its costs are narrowly dis-
tributed. For some workers, the costs of unemployment are lowered by unemployment compen-sation benefits paid out of a fund accumulated with receipts from a tax on payrolls.
Income from Property
Another source of income inequality is that some people have property income —from the own-
ership of real property and financial holdings—while many others do not. Some people own agreat deal of wealth, and some have no assets at all. Overall, about 22 percent of personal incomein the United States in 2007 came from ownership of property. The amount of property incomethat a household earns depends on (1) how much property it owns and (2) what kinds of assets itowns. Such income generally takes the form of profits, interest, dividends, and rents.
Households come to own assets through saving and through inheritance. Some of today’s
large fortunes were inherited from previous generations. The Rockefellers, the Kennedys, and theFords, to name a few, still have large holdings of property originally accumulated by previous gen-erations. Thousands of families receive smaller inheritances each year from their parents. (In2010, taxation of these estates was an important political issue.) Most families receive littlethrough inheritance; most of their wealth or property comes from saving.
Often fortunes accumulate in a single generation when a business becomes successful. The
late Sam Walton built a personal fortune estimated at over $70 billion on a chain of retail storesincluding Wal-Mart. Forbes magazine estimated that Bill Gates, founder of Microsoft, was worthUnits of labor, LWage ($)Unemployed
new entrants Layoffs
5.40
0 LD L*DS
LS6.55/L50296FIGURE 18.1
Effect of Minimum
Wage Legislation
If the equilibrium wage in the
market for unskilled labor is
below the legislated minimum
wage, the result is likely to beunemployment. The higher wagewill attract new entrants to the
labor force (quantity supplied
will increase from L* to L
S), but
firms will hire fewer workers
(quantity demanded will drop
from L* to LD).
property income Income
from the ownership of real
property and financial
holdings. It takes the form ofprofits, interest, dividends,
and rents.
370 PART III Market Imperfections and the Role of Government
over $53 billion in 2009. Karl and Theo Albrecht made $20 billion, beginning with their mother’s
corner store in Germany and expanding to 8,500 stores in 2009 in Germany and 10 other coun-tries. In the United States, they own the gourmet food-and-beverage chain Trader Joe’s. Forbes
estimated that there were over 1,011 billionaires in the world in 2009. The richest man in theworld in 2009 was Mexican tycoon Carlos Slim Helu with an estimated $53.5 billion in wealth.
Income from the Government: Transfer Payments
About 14 percent of personal income in 2007 came from governments in the form of transfer
payments . Transfer payments are payments made by government to people who do not supply
goods or services in exchange. Some, but not all, transfer payments are made to people withlow incomes precisely because they have low incomes. Transfer payments thus reduce theamount of inequality in the distribution of income. Not all transfer income goes to the poor.The biggest single transfer program at the federal level is Social Security. Transfer programs areby and large designed to provide income to those in need. They are part of the government’sattempts to offset some of the problems of inequality and poverty.
The Distribution of Income
Economic income is defined as the amount of money a household can spend during a given
period without increasing or decreasing its net assets. Economic income includes anything thatenhances your ability to spend—wages, salaries, dividends, interest received, proprietors’ income,transfer payments, rents, and so on. If you own an asset (such as a share of stock) that increases invalue, that gain is part of your income whether or not you sell the asset to “realize” the gain.Normally, we speak of “before-tax” income, with taxes considered a use of income.
Income Inequality in the United States
Table 18.1 presents some estimates of the distribution of several income components and of totalincome for households in 2006. The measure of income used to calculate these figures is verybroad; it includes both taxable and nontaxable items, as well as estimates of realized capital gains.transfer payments
Payments by government topeople who do not supply
goods or services in exchange.
economic income The
amount of money a household
can spend during a given
period without increasing ordecreasing its net assets.Wages, salaries, dividends,
interest income, transfer
payments, rents, and so on aresources of economic income.
TABLE 18.1 Distribution of Total Income and Components in the United States, 2006
(Percentages)
Households Total Income Labor Income Property Income Transfer Income
Bottom fifth 3.4 1.3 2.2 17.2
Second fifth 9.2 6.7 6.3 24.6
Third fifth 16.3 14.1 11.7 21.2
Fourth fifth 23.6 24.5 14.3 18.3
Top fifth 47.5 53.4 65.5 18.7
Top 1 percent 13.2 10.8 30.6 1.0
Source: Julie-Anne Cronin, U.S. Department of the Treasury, OTA paper 85, p. 19 and author’s calculations.
The data are presented by “quintiles”; that is, the total number of households is first ranked
by income and then split into five groups of equal size. In 2006, the top quintile earned 47.5 per-cent of total income while the bottom quintile earned just 3.4 percent. The top 1 percent (whichis part of the top quintile) earned more than the bottom 40 percent. Labor income was less evenlydistributed than total income.
Income from property is more unevenly distributed than wages and salaries. Property income
comes from owning things: Land earns rent, stocks earn dividends and appreciate in value, bonds anddeposit accounts earn interest, owners of small businesses earn profits, and so on. The top 20 percentof households earned 65.5 percent of property income, and the top 1 percent earned over 30 percent.
Transfer payments include Social Security benefits, unemployment compensation, and welfare
payments, as well as an estimate of nonmonetary transfers from the government to households—food stamps and Medicaid and Medicare program benefits, for example. Transfers flow to low-income households, but not solely to them. Social Security benefits, for example, which accountfor about half of all transfer payments, flow to everyone who participated in the system for the req uisite number of years and has reached the required age regardless of income.
CHAPTER 18 Income Distribution and Poverty 371
1The term household includes unmarried individuals living alone and groups of people living together who are not related by
blood, marriage, or adoption. In the United States in 2008, there was a total of 116.8 million households and 38.9 millionnonfamily households.Nonetheless, transfers represent a more impor tant income component at the bottom of the dis-
tribution than at the top. Although not shown in Table 18.1, transfers account for more than 80 percent of the income of the bottom 10 percent of households, but only about 3 percent ofincome among the top 10 percent of households.
Changes in the Distribution of Income Table 18.2 presents the distribution of
money income among U.S. households1at a number of points in time. Money income , the mea-
sure used by the Census Bureau in its surveys and publications, is slightly less complete than theincome measure used in the calculations in Table 18.1. The measure does not include noncashtransfer benefits, for example, and does not include capital gains.
0100
20 40 60 80 1003.412.026.649.8
Percentage of householdsPercentage of incomeA /L50296FIGURE 18.2
Lorenz Curve for the
United States, 2009
The Lorenz curve is the most
common way of presentingincome distribution graphically.The larger the shaded area, themore unequal the distribution. If
the distribution were equal, the
Lorenz curve would be the 45-degree line 0 A.TABLE 18.2 Distribution of Money Income of U.S. Households by Quintiles , 1967–2009
(Percentages)
1967 1975 1985 1995 2000 2009
Bottom fifth 4.0 4.3 3.9 3.7 3.6 3.4
Second fifth 10.8 10.4 9.8 9.1 8.9 8.6
Third fifth 17.3 17.0 16.2 15.2 14.8 14.6
Fourth fifth 24.2 24.7 24.4 23.3 23.0 23.2
Top fifth 43.6 43.6 45.6 48.7 49.8 50.3
Top 5% 17.2 16.4 17.6 21.6 22.1 21.7
Source: Bureau of the Census, Current Population Survey, Annual Social and Economic Supplements through 2010.
Since 1975, there has been a slow but steady drift toward more inequality. During those
years, the share of income going to the top 5 percent has increased from 16.4 percent to 21.7 per-cent while the share going to the bottom 40 percent has fallen from 14.8 percent to 12 percent.
The Lorenz Curve and the Gini Coefficient The distribution of income can
be graphed in several ways. The most widely used graph is the Lorenz curve , shown in
Figure 18.2. Plotted along the horizontal axis is the percentage of households, and along themoney income The measure
of income used by the CensusBureau. Because money
income excludes noncash
transfer payments and capitalgains income, it is less inclusive
than economic income.
Lorenz curve A widely used
graph of the distribution of
income, with cumulativepercentage of households
plotted along the horizontal
axis and cumulative percentageof income plotted along the
vertical axis.
372 PART III Market Imperfections and the Role of Government
Gini coefficient A commonly
used measure of the degree of
inequality of income derived
from a Lorenz curve. It can rangefrom 0 to a maximum of 1.vertical axis is the cumulative percentage of income. The curve shown here represents the
year 2009, using data from Table 18.2.
During that year, the bottom 20 percent of households earned only 3.4 percent of total
money income. The bottom 40 percent earned 12.0 percent (3.4 percent plus 8.6 percent), and soon. If income were distributed equally—that is, if the bottom 20 percent earned 20 percent of theincome, the bottom 40 percent earned 40 percent of the income, and so on—the Lorenz curvewould be a 45-degree line between 0 and 100 percent. More unequal distributions produceLorenz curves that are farther from the 45-degree line.
TheGini coefficient is a measure of the degree of inequality in a distribution. It is the ratio
of the shaded area in Figure 18.2 to the total triangular area below and to the right of the diago-nal line 0 A. If income is equally distributed, there is no shaded area (because the Lorenz curve
and the 45-degree line are the same) and the Gini coefficient is zero. The Lorenz curves for distri-butions with more inequality are farther down to the right, their shaded areas are larger, and theirGini coefficients are higher. The maximum Gini coefficient is 1. As the Lorenz curve shifts downto the right, the shaded area becomes a larger portion of the total triangular area below 0 A.I fo n e
family earned all the income (with no one else receiving anything), the shaded area and the trian-gle would be the same and the ratio would equal 1.
Differences Among African-American Households, White Households,
and Single-Person Households Looking just at households without differentiating
them in any way hides some needed distinctions. Income distribution differs significantlyamong African-American, Hispanic, and white households.
Table 18.3 presents data on the distribution of money income for different types of house-
holds. The differences among the groupings are dramatic. In 2008, the bottom 20 percent ofwhite households had a mean household income that was twice that of the bottom 20 percentof African-American households. For the middle 20 percent of households, mean income forwhite households was 65 percent higher than mean income for African-American households.For Hispanics, the figure was 42 percent. The top 5 percent of white households averaged$310,032 of income. For African-Americans, it was $199,353; for Hispanics, $218,396.
TABLE 18.3 Mean Household Income Received by the Top, Middle, and Bottom Fifth
of Households in 2008
White (non-Hispanic) African-American Hispanic
Bottom 20% $ 13,540 $ 6,675 $ 9,629
Middle 20% 54,521 33,067 38,271
Top 20% 180,341 118,259 129,265
Top 5% 310,032 199,353 218,396
Source: U.S. Census Bureau, www.census.gov, Historical Income Tables, Table H3, 2009.
The World Distribution of Income
Data on the distribution of income across rich and poor nations reveal much more inequality, as shown
in Table 18.4. The population of the world in 2008 was approximately 6.7 billion. Of that number, 1.0billion, or 15 percent, live in what the World Bank classifies as low-income countries. The averageincome per capita in those countries was $524 in 2008. The same year about 1.1 billion, or 15 percent,lived in high-income countries, where per-capita income was $39,345. When you look at total nationalincome, the rich countries with 15 percent of the population earn 73.0 percent of world income, w hile
the poor countries with 15 percent of the population get only 1.0 percent of world income. Thepoorest country in the world in 2008 was Burundi, with 8 million people and a per-capita incomeof $140 per year. The richest country was Norway, with 5 million people and a per-capita incomeof $87,070.
2
As we discussed earlier, income inequality has increased within the United States over the last
several decades. The evidence also suggests that income inequality is increasing in most otheradvanced countries as well as in Asia and Latin America. Among the advanced economies, only
2U.S. Bureau of the Census, www.census.gov.
CHAPTER 18 Income Distribution and Poverty 373
ECONOMICS IN PRACTICE
The New Rich Work!
Recent work by two economists, Thomas Piketty and Emmanuel
Saez, documents the rise in income inequality in the United Statesdescribed in the text and reports further that the bulk of the newinequality comes not from owners of capital, but from inequality inreturns to the workforce.
1As Piketty and Saez put it, “The working
rich have now replaced the coupon-clipping rentiers.”
In the recent recessionary period, there has been much media
and public interest in executive compensation that further calls our
attention to the returns to labor at the very top end of the work-
force, the executives who run our major banks and corporations.There is considerable evidence that executive compensation hasincreased across a wide swath of firms, while the real wage of theaverage worker has stagnated. There is less consensus, however, asto why wages of executives have risen. Within economics there is
debate about whether the rise in corporate pay comes from changes
in the market, like growth of average firm size and the importanceof scarce human capital, or from changes in corporate governanceand social norms.
One interesting recent study of executive compensation by
Carola Frydman at MIT traces the changes in executive compen-
sation in one iconic American firm, General Electric. The chartshows the dramatic increases in real executive pay over the post-war period.
Notes: Compensation is measured as the three-year moving-average for each
measure of pay for the three highest-paid executives as reported in GeneralElectric’s proxy statements. Salary and Bonus is defined as the level of salariesand current bonuses both awarded and paid out in the year. Long-T erm (L-T)Bonus measures the amount paid out in the year from long-term bonusesawarded in prior years. Stock Option Grants is defined as the Black-Scholesvalue of stock options granted in the given year. The real level of pay is calcu-lated in millions of $2000, using the CPI.
Source: Carola Frydman, “Learning from the Past: Trends in Executive
Compensation over the 20th Century,” CESifo Economic Studies , 2009,
volume 55: 458–481, by permission of Oxford University Press.Year1940 1950 1960 1970 1980 1990 200012040 Salary & Bonus + L-T Bonus + Stock Option Grants
Salary & Bonus + L-T Bonus10Log Compensation (Million $ 2000)The Real Level of Total Executive Compensation at General Electric
TABLE 18.4 Income and Income per Capita Across the World in 2008
Population Gross National Income Per-Capita Income
Billions % Trillions of $ % (Dollars)
World 6.7 100 57.6 100.0 8,613
Low-Income Countries 1.0 15 0.5 1.0 524
Middle-Income Countries 4.6 70 15.2 26.0 3,260
High-Income Countries 1.1 15 42.0 73.0 39,345
Source: World Bank, World Development Report 2010 , Key development indicators Table 1.
France has seen decreasing inequality. Inequality has increased everywhere in the developing
world except Africa and the Middle East.
Causes of Increased Inequality
The increased income inequality we see in the United States and in many other regions hasbecome the subject of much political debate. Much of the debate concerns what we as a nationand as a member of the world community should do to improve the position of the poorest ofour citizens. We will describe these economic issues in the next section of this chapter. Butequally debated is the question of what has caused the rise in inequality. Is it the forces of freetrade, immigration, and globalization all working together to worsen the position of the middle-income workers who find themselves competing with workers in lower-income countries? Is it the declining power of unions and deregulation that have opened up more labor markets tothe forces of competition? Some have argued that a major force in increasing inequality hasbeen technological change that has favored the well-educated worker at the expense ofunskilled labor.1Piketty, Thomas, and Emmanual Saez, “Income Inequality in the United States,
1913–1998,” Quarterly Journal of Economics , February 2003, 1–39.
374 PART III Market Imperfections and the Role of Government
3David Card, “The Impact of the Mariel Boat Lift on the Miami Labor Market,” Industrial and Labor Relations Review , January
1990, pp. 245–257.These are very difficult questions, questions that are becoming part of the political debate
across the world. Consider the role that immigration plays, for example. Most immigrants to theUnited States come from lower-income countries. Movement of labor from low-income areas tohigher-income areas is a natural economic phenomena, a manifestation of the forces of supplyand demand in labor markets. Unchecked, these movements have the capacity to reduce costs ofproduction in the high-wage country, increasing the return to capital, and to reduce worldincome inequality. Immigration also may play a role in increasing within-country inequality tothe extent that it brings a new group of less-skilled workers into a country, potentially competingfor jobs with the lower-income population already in the country.
Empirical evidence of the extent to which immigration has in fact reduced wages of lower-
income workers is mixed.
The Evidence: The Net Costs of Immigration T o determine whether the net bene-
fits of immigration outweigh its net costs, we must ask one important question: T o what extentdoes immigration reduce domestic wages and increase unemployment? A number of recent stud-ies have found that metropolitan areas with greater numbers of immigrants seem to have onlyslightly lower wages and only slightly higher unemployment rates.
An influential study by economist David Card of the University of California, Berkeley, looks
carefully at wages and employment opportunities in the Miami metropolitan area during andafter the Mariel boat lift of 1980. Almost overnight about 125,000 Cubans arrived in Florida andincreased the labor force in Miami by over 7 percent. Card looked at trends in wages and unem-ployment among Miami workers between 1980 and 1985 and found virtually no effect. In addi-tion, the data he examined mirrored the experience of workers in Los Angeles, Houston, Atlanta,and similar cities that were not hit by the same shock.
3
However, a more recent study by Borjas, Freeman, and Katz takes issue with much of the
work done to date. They argue that immigrants do not stay in the cities at which they arrive, butrather move within the United States in response to job opportunities and wage differentials.Thus, they argue that the effects of immigration on wages and unemployment must be analyzedat the national level, not the city level. Their study points to the large decline in the wages of highschool dropouts relative to workers with more education during the 1980s. Their results suggestthat a third of the drop in the relative wages of high school dropouts can be attributed to lower-skilled immigrants.
4
It is clear that immigration is not an issue simply for the United States. For someone in
Guatemala, Mexico offers new opportunities. Per-capita income in Guatemala is $2,640 and is$7,870 in Mexico. Haiti, one of the poorest countries in the world, sends people to the DominicanRepublic in search of work. In fact, the World Bank estimates that in 2007, 74 million migrantsmoved from one developing country to another. Here, too, there are lively debates about theeffects of this migration on incomes and inequality.
T echnological change also appears to play a role in the increases in inequality. In the last
several decades, technological advances have played a strong role in development. In theUnited States and the developing world, more work is conducted with the aid of computersand less work requires large inputs of unskilled labor. The result has been a wage premium forskilled workers.
5In fact, work by the International Monetary Fund (IMF) suggests that by look-
ing at the growth in inequality in regions around the world, the central force has been techno-logical change with its increased skill needs. The role of technology in increasing inequalityappears to be especially large in Asia. The opening up of economies to free trade has played amodest role relative to technology. In fact, the IMF finds that in the advanced countries, freetrade has decreased inequality by replacing low-paid manufacturing jobs with higher-paid jobsin the service sector.
The important role of technology in driving inequality suggests that going forward, educa-
tion may be key to reducing inequality in the United States and across the world.
4George Borjas, Richard Freeman, and Lawrence Katz, “On the Labor Market Effects of Immigration and Trade,” in Immigration
and the Work Force: Economic Consequences for the United States and Source Areas , eds. George Borjas and Richard Freeman
(Chicago: University of Chicago Press, 1992).
5Nancy Birdsall, 2007. “Discussion of the Impact of Globalization on the World’s Poor,” Brookings.
Poverty
Most of the government’s concern with income distribution and redistribution has focused on
poverty. Poverty is a very complicated word to define. In simplest terms, it means the condition of
people who have very low incomes. The dictionary defines the term simply as “lack of money ormaterial possessions,” but how low does your income have to be before you are classified as poor?
The Problem of Definition Philosophers and social policy makers have long debated
the meaning of “poverty.” One school of thought argues that poverty should be measured bydetermining how much it costs to buy the “basic necessities of life.” For many years, the Bureau ofLabor Statistics published “family budget” data designed to track the cost of specific “bundles” offood, clothing, and shelter that were supposed to represent the minimum standard of living.
Critics argue that defining bundles of necessities is a hopeless task. Although it might be pos-
sible to define a minimally adequate diet, what is a “minimum” housing unit? Is a car a necessity?What about medical care? In reality, low-income families end up using what income they have inan enormous variety of ways.
Some say that poverty is culturally defined and is therefore a relative concept, not an absolute
one. Poverty in Bangladesh is very different from poverty in the United States. Even within the UnitedStates, urban poverty is very different from rural poverty. If poverty is a relative concept, the definitionof it might change significantly as a society accumulates wealth and achieves higher living standards.
Although it is difficult to define precisely, the word poverty is one that we all understand
intuitively to some degree. It conveys images of run-down, overcrowded, rat-infested housing;homeless people; untreated illness; and so on. It is also a word that we have been forced to defineformally for purposes of keeping statistics and administering public programs.
The Official Poverty Line In the early 1960s, the U.S. government established an official
poverty line. Because poor families tend to spend about one-third of their incomes on food, theofficial poverty line has been set at a figure that is simply three times the cost of the Department
of Agriculture’s minimum food budget.
The minimum food budget was only calculated once, in 1963. It has been updated with the
Consumer Price Index since that year. Needless to say these figures are somewhat arbitrary, but they arestill used to determine the official poverty rate. For 2007, the threshold for a family of four was $21,027.
After years of study and debate, the Department of Health and Human Services began pub-
lishing an alternative measure of poverty now called the Poverty Guidelines. The new and some-what more complex methodology produces income limits that define eligibility for a number ofprograms including food stamps and Medicaid. The Department set the figure at $21,200 for afamily of four in 2008.
Poverty in the United States Since 1960 In 1962, Michael Harrington published The
Other America: Poverty in the United States , a book that woke the American people to the problem of
poverty and stimulated the government to declare a “war on poverty” in 1964. In 1960, official fig-ures had put the number of the poor in the United States at just under 40 million, or 22 percent ofthe total population. In his book, Harrington argued that the number had reached over 50 million.
By the late 1960s, the number living below the official poverty line had declined to about
25 million, where it stayed for over a decade. Between 1978 and 1983, the number of poorjumped nearly 45 percent, from 24.5 million to 35.3 million, the highest number since 1964. Thefigure stood at 43.6 million in 2009. As a percentage of the total population, the poor accountedfor between 11 percent and 12.6 percent of the population throughout the 1970s. That figureincreased sharply to 15.2 percent between 1979 and 1983. From 1983 to 1989, the rate dropped to12.8 percent, rising back to 14.5 percent in 1995. The rate rose to 14.3 in 2009.
While the official 2009 figures put the poverty rate at 14.3 percent of the population, they
also show that some groups in society experience more poverty than others. Table 18.5 showsthe official poverty count for 1964 and 2009 by demographic group. One of the problems withthe official count is that it considers only money income as defined by the census and is there-fore somewhat inflated. Many federal programs designed to help people out of poverty includenoncash benefits (sometimes called in-kind benefits ) such as food stamps and public housing. If
added to income, these benefits would reduce the number of those officially designated as belowthe poverty line to about 9 percent of the population.CHAPTER 18 Income Distribution and Poverty 375
poverty line The officially
established income level that
distinguishes the poor from
the nonpoor. It is set at three times the cost of the
Department of Agriculture’s
minimum food budget.
376 PART III Market Imperfections and the Role of Government
The poverty rate among African-Americans is more than twice as high as the poverty rate
among whites. Nearly one in four African-Americans live in poverty. In addition, a slightly lowerproportion of Hispanics than African-Americans had incomes below the poverty line in 2009.
The group with the highest incidence of poverty in 2009 was women living in households
with no husband present. In 1964, 45.9 percent of such women lived in poverty. By 2009, the fig-ure was still 29.9 percent. During the 1980s, there was increasing concern about the “feminizationof poverty,” a concern that continues today.
Poverty rates among the elderly have been reduced considerably over the last few decades,
dropping from 28.5 percent in 1964 to 8.9 percent in 2009. Certainly, Social Security, supplementalsecurity income, and Medicare have played a role in reducing poverty among the elderly. In 1964,20.7 percent of all children under 18 lived in poverty, and in 2009, the figure was 20.7 percent.
The Distribution of Wealth
Data on the distribution of wealth are not as readily available as data on the distribution of income.Periodically, however, the government conducts a detailed survey of the holdings that make up wealth.The results show that the top 10 percent of households held just under 70 percent of the total networth in the United States in 2004 while the bottom 40 percent of households held only 2.6 percent.
The distribution of wealth is more unequal than the distribution of income. Part of the reason is
that wealth is passed from generation to generation and accumulates. Large fortunes also accumulatewhen small businesses become successful large businesses. Some argue that an unequal distribution ofwealth is the natural and inevitable consequence of risk taking in a market economy: It provides theincentive necessary to motivate entrepreneurs and investors. Others believe that too much inequalitycan undermine democracy and lead to social conflict. Many of the arguments for and against incomeredistribution, discussed in the next section, apply equally well to wealth redistribution.
The Utility Possibilities Frontier
Ideally, in discussing distribution, we should talk not about the distribution of income orgoods and services, but about the distribution of well-being. In the nineteenth century,philosophers used the concept of utility as a measure of well-being. As they saw it, people make
choices among goods and services on the basis of the utility those goods and services yield.People act to maximize utility. If you prefer a night at the symphony to a rock concert, the rea-son is that you expect to get more utility from the symphony. If we extend this thinking, wemight argue that if household A gets more total utility than household B, A is better off than B.
Utility is not directly observable or measurable, but thinking about it as if it were can help us
understand some of the ideas that underlie debates about distribution. Suppose society consistedof two people, I and J. Next, suppose that the line PP/H11032in Figure 18.3 represents all the combina-
tions of I’s utility and J’s utility that are possible, given the resources and technology available intheir society. (This is an extension of the production possibilities frontier in Chapter 2.)
Any point inside PP/H11032, or the utility possibilities frontier , is inefficient because both I and J
could be better off. Ais one such point. Bis one of many possible points along PP/H11032that society
should prefer to Abecause both members are better off at Bthan they are at A.
While point Bis preferable to point Afrom everyone’s point of view, how does point Bcom-
pare with point C? Both BandCare efficient; I cannot be made better off without making J worse
off, and vice versa. All the points along PP/H11032are efficient, but they may not be equally desirable. IfTABLE 18.5 Percentage of Persons in Poverty by Demographic Group, 1964 and 2009
Official Measure 1964 Official Measure 2009
All 19.0 14.3
White (Non-Hispanic) 14.9 9.4
Black 49.6 25.8
Hispanic NA 25.3
Female householder—no husband present 45.9 29.9
Elderly (65 +) 28.5 8.9
Children under 18 20.7 20.7
Source: U.S. Census Bureau . Income, Poverty and Health Insurance Coverage in the U.S., 2009.
utility possibilities frontier
A graphic representation of atwo-person world that shows
all points at which I’s utility
can be increased only if J’sutility is decreased.
CHAPTER 18 Income Distribution and Poverty 377
all the assumptions of perfectly competitive market theory held, the market system would lead to
one of the points along PP/H11032. The actual point reached would depend on I’s and J’s initial endow-
ments of wealth, skills, and so on.
In practice, however, the market solution leaves some people out. The rewards of a market
system are linked to productivity, and some people in every society are simply not capable ofbeing very productive or have not had the opportunity to become more productive. All societiesmake some provision for the very poor. Most often, public expenditures on behalf of the poor arefinanced with taxes collected from the rest of society. Society makes a judgment that those whoare better off should give up some of their rewards so that those at the bottom can have morethan the market system would allocate to them. In a democratic state, such redistribution is pre-sumably undertaken because a majority of the members of that society think it is fair, or just.
Early economists drew analogies between social choices among alternative outcomes and
consumer choices among alternative outcomes. A consumer chooses on the basis of his or herown unique utility function, or measure of his or her own well-being. Society, economists said,chooses on the basis of a social welfare function that embodies the society’s ethics.
Such theoretical discussions of fairness and equity focus on the distribution and redistribution
of utility. Because utility is neither observable nor measurable, most discussions of social policy cen-ter on the distribution of income or the distribution of wealth as indirect measures of well-being, as we
have done. It is important that you remember, however, that income and wealth are imperfect mea-sures of well-being. Someone with a profound love of the outdoors may choose to work in a nationalpark for a low wage instead of a consulting firm in a big city for a high wage. The choice reveals thatshe is better off even though her measured income is lower. As another example, think about fivepeople with $1 each. Now suppose that one of those people has a magnificent voice, and that theother four give up their dollars to hear her sing. The exchange leads to inequality of measuredwealth—the singer has $5 and no one else has any—but all are better off than they were before.
Although income and wealth are imperfect measures we have of utility, they have no
observable substitutes and are therefore the measures we have used throughout this chapter.
The Redistribution Debate
Debates about the role of government in correcting for inequality in the distribution of incomerevolve around philosophical and practical issues. Philosophical issues deal with the “ideal.” What
should the distribution of income be if we could give it any shape we desired? What is “fair”?What is “just”? Practical issues deal with what is and what is not possible. Suppose we wanted zero
poverty. How much would it cost, and what would we sacrifice? When we take wealth or incomeaway from higher-income people and give it to lower-income people, do we destroy incentives?What are the effects of this kind of redistribution?
Policy makers must deal with both kinds of issues, but it seems logical to confront the philosoph-
ical issues first. If you do not know where you want to go, you cannot explain how to get there or howmuch it costs. Y ou may find that you do not want to go anywhere at all. Many respected economistsand philosophers argue quite convincingly that the government should notredistribute income.P
C
P´B
A
0 I’s utilityJ’s utility/L50296FIGURE 18.3
Utility Possibilities
Frontier
If society were made up of two
people, I and J, and all the
assumptions of perfect competi-tion held, the market systemwould lead to some point along
PP/H11032. Every point along PP/H11032is
efficient; it is impossible to makeI better off without making Jworse off, and vice versa. Which
point is best? Is Bbetter than C?
378 PART III Market Imperfections and the Role of Government
Arguments Against Redistribution
Those who argue against government redistribution believe that the market, when left to operate on
its own, is fair. This argument rests on the proposition that “one is entitled to the fruits of one’sefforts.”
6Remember that if market theory is correct, rewards paid in the market are linked to produc-
tivity. In other words, labor and capital are paid in accordance with the value of what they produce.
This view also holds that property income—income from land or capital—is no less justified
than labor income. All factors of production have marginal products. Capital owners receiveprofits or interest because the capital they own is productive.
The argument against redistribution also rests on the principles behind “freedom of contract”
and the protection of property rights. When you agree to sell your labor or to commit your capitalto use, you do so freely. In return, you contract to receive payment, which becomes your “property.”When a government taxes you and gives your income to someone else, that action violates those twobasic rights.
The more common arguments against redistribution are not philosophical. Instead, they
point to more practical problems. First, it is said that taxation and transfer programs interferewith the basic incentives provided by the market. Taxing higher-income people reduces theirincentive to work, save, and invest. Taxing the “winners” of the economic game also discouragesrisk taking. Furthermore, providing transfers to those at the bottom reduces their incentive towork as well. All of this leads to a reduction in total output that is the “cost” of redistribution.
Another practical argument against redistribution is that it does not work. Some critics see
the rise in the poverty rate during the early 1980s, again in the early 1990s, and yet again between2001 and 2004 as an indication that antipoverty programs simply drain money without reallyhelping the poor out of poverty. Whether these programs actually help people out of poverty, thepossibility of bureaucratic inefficiency in administration always exists. Social programs must beadministered by people who must be paid. The Department of Health and Human Servicesemploys over 120,000 people to run the Social Security system, process Medicaid claims, and soon. Some degree of waste and inefficiency is inevitable in any sizable bureaucracy.
Arguments in Favor of Redistribution
The argument most often used in favor of redistribution is that a society as wealthy as the UnitedStates has a moral obligation to provide all its members with the necessities of life. TheConstitution does carry a guarantee of the “right to life.” In declaring war on poverty in 1964,President Lyndon Johnson put it this way:
6Powerful support for this notion of “entitlement” can be found in the works of the seventeenth-century English philosophers
Thomas Hobbes and John Locke.There will always be some Americans who are better off than others. But it need not followthat the “poor are always with us.” …It is high time to redouble and to concentrate ourefforts to eliminate poverty….We know what must be done and this nation of abundancecan surely afford to do it.
7
Many people, often through no fault of their own, find themselves left out. Some are born
with mental or physical problems that severely limit their ability to “produce.” Then there arechildren. Even if some parents can be held accountable for their low incomes, do we want to pun-ish innocent children for the faults of their parents and thus perpetuate the cycle of poverty? Theelderly, without redistribution of income, would have to rely exclusively on savings to surviveonce they retire, and many conditions can lead to inadequate savings. Should the victims of badluck be doomed to inevitable poverty? Illness is perhaps the best example. The accumulated sav-ings of very few people can withstand the drain of extraordinary hospital and doctors’ bills andthe exorbitant cost of nursing home care.
Proponents of redistribution refute “practical” arguments against it by pointing to studies
that show little negative effect on the incentives of those who benefit from transfer programs. For
7Economic Report of the President , 1964.
CHAPTER 18 Income Distribution and Poverty 379
many—children, the elderly, the mentally ill—incentives are irrelevant, they say, and providing a
basic income to most of the unemployed does not discourage them from working when they havethe opportunity to do so. We now turn briefly to several more formal arguments.
Utilitarian Justice First put forth by the English philosophers Jeremy Bentham and John
Stuart Mill in the late eighteenth and early nineteenth centuries, the essence of the utilitarianargument in favor of redistribution is that “a dollar in the hand of a rich person is worth less thana dollar in the hand of a poor person.” The rich spend their marginal dollars on luxury goods. Itis easy to spend over $100 per person for a meal in a good restaurant in New Y ork or Los Angeles.The poor spend their marginal dollars on necessities—food, clothing, and medical care. If themarginal utility of income declines as income rises, the value of a dollar’s worth of luxury goodsis worth less than a dollar’s worth of necessities. Thus, redistributing from the rich to the poorincreases total utility. T o put this notion of utilitarian justice in everyday language: Through
income redistribution, the rich sacrifice a little and the poor gain a great deal.
The utilitarian position is not without problems. People have very different tastes and prefer-
ences. Who is to say that you value a dollar more or less than I do? Because utility is unobservableand unmeasurable, comparisons between individuals cannot be easily made. Nonetheless, manypeople find the basic logic of the utilitarians to be persuasive.
Social Contract Theory—Rawlsian Justice The work of Harvard philosopher John Rawls
has generated a great deal of recent discussion, both within the discipline of economics and betweeneconomists and philosophers.
8In the tradition of Hobbes, Locke, and Rousseau, Rawls argues that as
members of society, we have a contract with one another. In the theoretical world that Rawls imagines,an original social contract is drawn up and all parties agree to it without knowledge of who they are or
who they will be in society. This condition is called the “original position” or the “state of nature.”Withno vested interests to protect, members of society are able to make disinterested choices.
As we approach the contract, everyone has a chance to end up very rich or homeless. On the
assumption that we are all “risk-averse,” Rawls believes that people will attach great importance tothe position of the least fortunate members of society because anyone could end up there.Rawlsian justice is argued from the assumption of risk aversion. Rawls concludes that any con-
tract emerging from the original position would call for an income distribution that would “max-imize the well-being of the worst-off member of society.”
Any society bound by such a contract would allow for inequality, but only if that inequality
had the effect of improving the lot of the very poor. If inequality provides an incentive for peopleto work hard and innovate, for example, those inequalities should be tolerated as long as some ofthe benefits go to those at the bottom.
The Works of Karl Marx For decades, a rivalry existed between the United States and the
Soviet Union. At the heart of this rivalry was a fundamental philosophical difference of opinionabout how economic systems work and how they should be managed. At the center of the debatewere the writings of Karl Marx.
Marx did not write very much about socialism or communism. His major work, Das Kapital
(published in the nineteenth century), was a three-volume analysis and critique of the capitalistsystem that he saw at work in the world around him. We know what Marx thought was wrongwith capitalism, but he was not very clear about what should replace it. In one essay late in his life,he wrote, “from each according to his ability, to each according to his needs,”
9but he was not spe-
cific about the applications of this principle.
Marx’s view of capital income does have important implications for income distribution. In
the preceding chapters, we discussed profit as a return to a productive factor: Capital, like labor, isproductive and has a marginal product. However, Marx attributed all value to labor and none tocapital. According to Marx’s labor theory of value , the value of any commodity depends only on
the amount of labor needed to produce it. The owners of capital are able to extract profit, or “sur-plus value,” because labor creates more value in a day than it is paid for. Like any other good, laborpower is worth only what it takes to “produce” it. In simple words, this means that under capital-ism, labor is paid a subsistence wage.
8See John Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1972).
9Karl Marx, “Critique of the Gotha Program” (May 1875), in The Marx-Engels Reader , ed. Robert Tucker (New Y ork:
W. W. Norton), p. 388.utilitarian justice The idea
that “a dollar in the hand of arich person is worth less than a
dollar in the hand of a poor
person.” If the marginal utilityof income declines with
income, transferring income
from the rich to the poor willincrease total utility.
Rawlsian justice A theory
of distributional justice that
concludes that the socialcontract emerging from the“original position” would call
for an income distribution that
would maximize the well-beingof the worst-off member
of society.
labor theory of value
Stated most simply, the theory
that the value of a commodity
depends only on the amountof labor required to produce it.
380 PART III Market Imperfections and the Role of Government
Marx saw profit as an illegitimate expropriation by capitalists of the fruits of labor’s efforts.
It follows that Marxians see the property income component of income distribution as the pri-mary source of inequality in the United States today. Without capital income, the distribution ofincome would be more equal. (Refer again to Table 18.1 on p. 370.)
Income Distribution as a Public Good Those who argue that the unfettered market
produces a just income distribution do not believe private charity should be forbidden. Voluntaryredistribution does not involve any violation of property rights by the state.
In Chapter 16, however, you saw that there may be a problem with private charity. Suppose
people really do want to end the hunger problem. As they write their checks to charity, theyencounter the classic public-goods problem. First, there are free riders. If hunger and starvationare eliminated, the benefits—even the merely psychological benefits—flow to everyone whetherthey contributed or not. Second, any contribution is a drop in the bucket. One individual contri-bution is so small that it can have no real effect.
With private charity, as with national defense, nothing depends on whether you pay. Thus,
private charity may fail for the same reason that the private sector is likely to fail to producenational defense and other public goods. People will find it in their interest not to contribute.Thus, we turn to government to provide goods and services we want that will not be providedadequately if we act separately—in this case, help for the poor and hungry.
Redistribution Programs and Policies
The role of government in changing the distribution of income is hotly debated. The debate
involves not only what government programs are appropriate to fight poverty but also the char-acter of the tax system. Unfortunately, the quality of the public debate on the subject is low.Usually, the debate consists of a series of claims and counterclaims about what social programsdo to incentives instead of a serious inquiry into what our distributional goal should be.
In this section, we talk about the tools of redistribution policy in the United States. As we do
so, you will have a chance to assess for yourself some of the evidence about their effects.
Financing Redistribution Programs: Taxes
Redistribution always involves those who end up with less and those who end up with more.Because redistributional programs are financed by tax dollars, it is important to know who thedonors and recipients are—who pays the taxes and who receives the benefits of those taxes. Theissue of which households bear the burden of the taxes collected by government is quite complexand requires some analysis. Oftentimes households, firms, and markets react to the presence oftaxes in ways that shift burdens off of those on whom they were intended to fall and onto others.
A perfect example is the corporation tax. At both the federal and state levels in most states, a
special tax is levied on corporations in proportion to their profit or net income. Although this taxis levied on certain firms, the burden ultimately falls on households in one or more of a numberof ways. The tax may result in higher prices for corporate products. The tax may result in lowerwages for corporate employees, or the tax may result in lower profits for owners/shareholders ofcorporations. The ultimate impact of a tax, or set of taxes, on the distribution of income dependson which households end up bearing the burden after shifting has taken place.
The term incidence refers to the ultimate burden distribution of a tax. Chapter 19 illustrates
the way in which economic analysis can be used to estimate the ultimate incidence of taxes.
The mainstay of the U.S. tax system is the individual income tax, authorized in 1913 by the
Sixteenth Amendment to the Constitution. The income tax is progressive —those with higher
incomes pay a higher percentage of their incomes in taxes. Even though the tax is subject to manyexemptions, deductions, and so on that allow some taxpayers to reduce their tax burdens, all stud-ies of the income tax show that its burden as a percentage of income rises as income rises.
With the passage of the Tax Reform Act of 1986, Congress initiated a major change in income
tax rates and regulations. The reforms were to simplify the tax and make it easier for people tocomply with and harder to avoid. In addition, the act reduced the number of tax brackets and theoverall progressivity of the rates. The largest reduction was in the top rate, cut from 50 percent to28 percent in 1986. The Act also substantially reduced the tax burdens of those at the very bottomby increasing the amount of income a person can earn before paying any tax at all.
CHAPTER 18 Income Distribution and Poverty 381
In 1993, President Clinton signed into law a tax bill that increased the top rate to 36 percent
for families with taxable incomes over $140,000 and individuals with taxable incomes over$115,000. In addition, families with incomes of over $250,000 paid a surtax (a tax rate on a taxrate) of 10 percent, bringing the marginal rate for those families to 39.6 percent. Families withlow incomes received grants and credits under the plan. On May 28, 2003, President Bush signeda tax law that reduced the top rate to 35 percent and changed a number of other provisions of thetax code. (See Chapter 19 for details.)
The individual income tax is only one tax among many. More important to the individual is
theoverall burden of taxation, including all federal, state, and local taxes. Most studies of the
effect of taxes on the distribution of income, both before and after the Tax Reform Act, have con-cluded that the overall burden is roughly proportional. In other words, all people pay about thesame percentage of their income in total taxes.
Table 18.6 presents an estimate of effective tax rates paid in 2000 by families that have been
ranked by income. Although some progressivity is visible, it is very slight. The bottom 20 percentof the income earners pay 28 percent of their total incomes in tax. The top 1 percent pay 37.0 per-cent. We can conclude from these data that the tax side of the equation produces very littlechange in the distribution of income. (For more on taxes, see Chapter 19.)
TABLE 18.6 Effective Rates of Federal, State, and Local Taxes,
2000 (Taxes as a Percentage of Total Income)
Federal Total
Bottom 20% 5.9 28.1
Second 20 11.7 26.3
Third 20 17.4 29.2
Fourth 20 20.1 32.6
Top 20 24.6 33.9
Top 10 25.7 34.5
Top 5 26.6 34.9
Top 1 29.1 37.0
Source: Julie-Anne Cronin, U.S. Department of the Treasury, OTA paper 85, and authors’ estimate.
Expenditure Programs
Some programs designed to redistribute income or to aid the poor provide cash income to recip-
ients. Others provide benefits in the form of health care, subsidized housing, or food stamps. Stillothers provide training or help workers find jobs.
Social Security By far the largest income redistribution program in the United States is Social
Security. The Social Security system is three programs financed through separate trust funds. The
Old Age and Survivors Insurance (OASI) program , the largest of the three, pays cash benefits to retired
workers, their survivors, and their dependents. The Disability Insurance (DI) program pays cash ben-
efits to disabled workers and their dependents. The third, Health Insurance (HI) , or Medicare, pro-
vides medical benefits to workers covered by OASI and DI and the railroad retirement program. TheSocial Security system has been credited with substantially reducing poverty among the elderly.
Most workers in the United States must participate in the Social Security system. For many
years, federal employees and employees belonging to certain state and municipal retirement systemswere not required to participate, but federal employees are now being brought into the system.T oday, well over 90 percent of all workers in the United States contribute to Social Security.
Participants and their employers are required to pay a payroll tax to the Federal Insurance
Corporation Association (FICA) to finance the Social Security system. The tax in 2008 was 7.65 per-
cent paid by employers and 7.65 percent paid by employees on wages up to $102,000. Self-employedpeople assume the entire FICA burden themselves.
Y ou are entitled to Social Security benefits if you participate in the system for 10 years.
Benefits are paid monthly to you after you retire or, if you die, to your survivors. A complicatedformula based on your average salary while you were paying into the system determines yourbenefit level. Those who earned more receive a higher level of benefits, but there are maximumand minimum monthly benefits. By and large, low-salaried workers get more out of the systemSocial Security system
The federal system of social
insurance programs. It includes
three separate programs thatare financed through separate
trust funds: the Old Age and
Survivors Insurance (OASI)program, the Disability
Insurance (DI) program, and
the Health Insurance (HI), orMedicare program.
382 PART III Market Imperfections and the Role of Government
than they paid into it while they were working. High-salaried workers usually get out of the sys-
tem considerably less than they put in.
The Social Security system is self-financing, but it is different from funded retirement sys-
tems. In a funded system , deposits (by the employer, the employee, or both) are made to an
account in the employee’s name. Those funds are invested and earn interest or dividends thataccumulate until the employee’s retirement, when they are withdrawn. Funded retirement plansoperate very much like a savings plan that you might set up independently, except that you can-not touch the contents until you retire.
In the U.S. Social Security system, the tax receipts from today’s workers are used to pay bene-
fits to retired and disabled workers and their dependents today. Currently, the system is collectingmore than it is paying out, and the excess is accumulating in the trust funds. This is necessary tokeep the system solvent because after the year 2010, there will be a large increase in the number ofretirees and a relative decline in the number of workers. These demographic changes are the resultof a high birth rate between 1946 and 1964—the so-called baby boom. In 2007, 31.5 millionretired workers received Social Security benefits and 7.1 million received disability payments.
Public Assistance Next to Social Security, the biggest cash transfer program in the United
States is public assistance , more commonly called welfare . Aimed specifically at the poor, wel-
fare falls into two major categories.
Most welfare is paid in the form of temporary assistance for needy families . Benefit levels are
set by the states, and they vary widely. In January 2003, the maximum monthly payment to a one-parent family of three was $170 per month in Mississippi, $639 per month in Vermont, and $923per month in Alaska. The average monthly payment in the United States was $423. T o participate,a family must have a very low income and virtually no assets. In 2002, there were 5.1 millionrecipients of T emporary Assistance for Needy Families in the United States. Those who find jobsand enter the labor force lose benefits quickly as their incomes rise. This loss of benefits acts as atax on beneficiaries, and some argue that it discourages welfare recipients from seeking jobs.
No topics raise passions more than welfare and welfare reform. The issue has been a focal
point of “liberal/conservative” name-calling for more than three decades. In 1996, Congresspassed and President Clinton signed a major overhaul of the welfare system in the United States.The name of the program was changed to T emporary Assistance for Needy Families from its for-mer name, Aid to Families with Dependent Children, as of July 1997. The key change mandatedthat states limit most recipients to no more than five years of benefits over a lifetime. Some arguethat the result will be a disaster, with some families left with nothing. Others argue that the previ-ous system led to dependency and that there was no incentive to work.
The new legislation provides funds for added services to parents with young children but
leaves a great deal of discretion in states’ hands. Only time will tell how it turns out. However,remarkable declines in the T emporary Assistance for Needy Families program (TANF) caseloadsoccurred between 1994 and 2001. At the end of that year, the average monthly number of TANFrecipients was 5.5 million, or 56 percent lower than the Aid to Families with Dependent Children(AFDC) caseload in 1996. From its peak of 14.4 million in March 1994, the number dropped by64.6 percent to 5.1 million in 2002. Over three-fourths of the reduction in the U.S. averagemonthly number of recipients since March 1994 occurred following implementation of TANF.These are the largest caseload declines in the history of U.S. public assistance programs.
Supplemental Security Income The Supplemental Security Income program (SSI) is a
federal program that was set up under the Social Security Administration in 1974. The programis financed out of general revenues. That is, there is no trust fund and there are no earmarkedtaxes from which SSI benefits are paid out.
SSI is designed to take care of the elderly who end up very poor and have no or very low
Social Security entitlement. In 2009, 8 million people received SSI payments, about half of whomalso received some Social Security benefits. The average SSI payment was $498 per month. Aswith welfare, qualified recipients must have very low incomes and virtually no assets.
Unemployment Compensation In the first quarter of 2005, governments paid out over
$9.5 billion in benefits to 3.3 million recipients. The money to finance this benefit comes fromtaxes paid by employers into special funds. Companies that hire and fire frequently pay a highertax rate, while companies with relatively stable employment levels pay a lower tax rate. Tax andbenefit levels are determined by the states, within certain federal guidelines.public assistance, orwelfare
Government transfer programs
that provide cash benefits to:(1) families with dependent
children whose incomes and
assets fall below a very lowlevel and (2) the very poor
regardless of whether they
have children.
CHAPTER 18 Income Distribution and Poverty 383
Workers who qualify for unemployment compensation begin to receive benefit checks
soon after they are laid off. These checks continue for a period specified by the state. Mostunemployment benefits continue for 20 weeks. In times of recession, the benefit period is oftenextended on a state-by-state basis. Average unemployed workers receive only about 36 percent oftheir normal wages, and not all workers are covered. T o qualify for benefits, an unemployed per-son must have worked recently for a covered employer for a specified time for a given amount ofwages. Recipients must also demonstrate willingness and ability to seek and accept suitableemployment.
Unemployment benefits are not aimed at the poor alone, although many of the unemployed
are poor. Unemployment benefits are paid regardless of a person’s income from other sourcesand regardless of assets.
Health Care: Medicaid and Medicare The largest in-kind transfer programs in the
United States are Medicare and Medicaid. The Medicaid program provides health and hospitaliza-
tion benefits to people with low incomes. Although the program is administered by the states,about 57 percent of the cost is borne by the federal government. In fiscal year 2011, the federalshare was budgeted at $271 billion and growing rapidly. Both the federal share and the shares ofeach state are paid out of general revenue sources such as the income tax or the sales tax depend-ing on the state.
Medicare , which is run by the Social Security Administration, is a health insurance program
for the aged and certain disabled persons. Most U.S. citizens over age 65 receive Medicare hospi-tal insurance coverage regardless of their income. In addition, Medicare recipients are able topurchase supplemental policies that cover things like the cost of prescription drugs.
Medicare is financed with the revenues from the Social Security payroll tax discussed above.
Of the 7.65 percent flat rate tax paid by individuals who receive wages and salaries and an equalamount paid by their employers, 1.45 percent goes to Medicare. The self employed pay bothhalves or 15.3 percent. While the Social Security taxes apply only to income over a certain maxi-mum, the Medicare tax is paid on allincome without a cap. In fiscal year 2011, over $500 billion
was budgeted for Medicare benefits payable to nearly 50 million recipients.
A major problem facing the system is the aging of the baby boom generation. The oldest of
the baby boomers are now approaching the age of 65. Thus, a substantial numb er of people will be
eligible for Medicare benefits precisely during the years that they are likely to need them.Projections are that the payroll tax will be insufficient to cover benefits and the system will beinsolvent by the year 2020.
Despite the significant resources spent by the government, the Census Bureau reports that
the number of people without health insurance grew to 50.7 million in 2009 from 46.3 million in2008. The number of people covered by private insurance dropped during this period.
During the first term of the Obama administration the President put forward a major
package of health care reform legislation. The Congress passed the Affordable Care Act billby a razor thin vote in March 2010. The bill was designed to bring the United States closer touniversal coverage by mandating that everyone buy health insurance coverage and setting upa government sponsored plan. The bill also made it illegal to drop coverage of people whobecome ill or deny coverage to people with preexisting conditions. The bill is very complexand it will take years to phase in. In addition, there was a great deal of public opposition tothe reforms voiced during the mid-term elections of 2010. Much of the political oppositionfocused on the potential cost which would have to be added to an already high federal bud-get deficit.
Food Stamps The Food Stamp program is an antipoverty program fully funded out of gen-
eral federal tax revenues, with states bearing 50 percent of the program’s administrative costs.Food stamps are vouchers that have a face value greater than their cost and that can be used to
purchase food at grocery stores. The amount by which the face value of the stamps exceeds theircost depends on income and family size. Only low-income families and single people are eligible toreceive food stamps.
It is generally acknowledged that a thriving black market in food stamps exists. Families that
want or need cash can sell their food stamps to people who will buy them for less than face valuebut more than the original recipient paid for them.
In 2009, there were 40 million participants in the Food Stamp program. The total cost of the
program in 2009 was $54 billion.unemployment compensation
A state government transferprogram that pays cashbenefits for a certain period oftime to laid-off workers whohave worked for a specifiedperiod of time for a coveredemployer.
Medicaid andMedicare
In-kind government transferprograms that provide healthand hospitalization benefits:Medicare to the aged and theirsurvivors and to certain of thedisabled, regardless of income,and Medicaid to people withlow incomes.
food stamps Vouchers that
have a face value greater thantheir cost and that can be usedto purchase food at grocerystores.
384 PART III Market Imperfections and the Role of Government
ECONOMICS IN PRACTICE
Does Price Matter in Charitable Giving?
In the United States, one of the ways in which people try to help the
poor is through charity. Almost 90 percent of the population con-tributes each year to some charitable organization. Recent work inexperimental economics has explored the factors that lead people tomake these contributions. In experimental economics, experimentsare conducted in a laboratory or in the field by using control groupsto test economic theories. In some cases, the lessons learned havebeen put to use by charities as they try to raise funds.
One set of experiments looks at the effect of a matching gift on
giving.
1A matching gift is a commitment by a donor to give funds
conditioned on another person’s donation. A donor might say, for
example, “For every dollar you raise up to $20,000, I will match witha dollar of my own.” Why might an economist expect a matching gift
commitment to increase the likelihood that another person will give
to the charity?
There are at least two plausible explanations. In the previous chap-
ter of this book, we described signals . In this situation, by offering a
matching gift, in a public way, the original donor is telling otherpotential donors that he or she believes the charity to be worthy. If the
donor is a well-known member of the community, this signal can be a
powerful incentive to other givers.
Suppose that we think of “giving to charity” the same way we
think of buying a good or a service. That is, we do it because we
derive “utility” from it. If we do donate to charity, we are giving up
the other things that the donation would buy. Now think of the “priceof giving” as the amount you need to pay to deliver $10 in aid to acharity. With the matching grant, the price of giving falls to $5. If yougive $5, the charity gets $10. If you give $100, the charity gets $200. So
matching gifts are like reducing the “price” of a charitable gift.
Under the U.S. Income Tax, many taxpayers can deduct gifts to
qualifying charities from their income in calculating their taxeseach year. Suppose that a taxpayer were taxed at a marginal rate of25 percent. Then a gift of $100 results in a tax saving of $25. Thededuction reduces income by $100, and that $100 would have been
taxed at 25 percent. Thus, just as in the case of the matching grant,the “price of giving” is reduced, in this case the price of giving
$100 is reduced to $75. With deductibility, we reduce the price of
charity from Pto P(1- t) where tis the tax rate that applies to
increases or decreases in income. Do you see why?
Whether a reduction in “price” leads people to give more
depends on a lot of things. If it is a matching grant, you may give less
and deliver more charity due to the match or you may give more totake advantage of the match. In the Karlan and List experiments,matching gift programs increased rates of giving.
1Dean Karlan and John List, “Does Price Matter in Charitable Giving”
American Economics Review , 2008 .
Housing Programs Over the years, the federal government and state governments have
administered many different housing programs designed to improve the quality of housing forlow-income people. The biggest is the Public Housing program, financed by the federal govern-ment but administered by local public housing authorities. Public housing tenants pay rentsequal to no more than 30 percent of their incomes. In many cases, this means they pay nothing.The largest housing program, called “Section 8,” provides housing assistance payments to tenantsand slightly above-market rent guarantees to participating landlords.
In 2003, there were 33.5 million rental housing units in the United States, of which 1.9 mil-
lion were in public housing projects. Another 2.2 million received a government rent subsidy.
The Earned Income Tax Credit An important program that is not well understood by
most people is the earned income tax credit (EIC). The program is quite complex but essentiallyallows lower-income families with children a credit equal to a percentage of all wage and salaryincome against their income taxes. If the credit exceeds the amount of taxes due, the credit isrefundable. T o see roughly how the EIC works, consider a family made up of two adults and twochildren with an income of $11,000 per year, all earned as wages. After the standard deductionand exemptions, such a family would owe no taxes, but it would receive (subject to a number ofrestrictions) refundable credit of up to $3,800. That means the family would actually get a checkfor $3,800.
While not well known, the EIC program is very large. In 2009, the EIC was claimed by over
25 million households and totaled more than $57 billion.
Government or the Market? A Review
In Part II (Chapter 6 to 12), you were introduced to the behavior of households and firms in
input and output markets. Y ou learned that if all the assumptions of perfect competition held inthe real world, the outcome would be perfectly efficient.
As we began to relax the assumptions of perfect competition in Part III (Chapter 13 to
Chapter 19), we began to see a potential role for government in the economy. Some firms acquiremarket power and tend to underproduce and overprice. Unregulated markets give private deci-sion makers no incentives to weigh the social costs of externalities. Goods that provide collectivebenefits may not be produced in sufficient quantities without government involvement. As wesaw in this chapter, the final distribution of well-being determined by the unfettered market maynot be considered equitable by society.
Remember, however, that government is not a cure for all economic woes. There is no guar-
antee that public-sector involvement will improve matters. Many argue that government involve-ment may bring about even more inequity and inefficiency because bureaucrats are often drivenby self-interest, not public interest.CHAPTER 18 Income Distribution and Poverty 385
THE SOURCES OF HOUSEHOLD INCOME p. 367
1.Households derive their incomes from three basic sources:
(1) from wages or salaries received in exchange for labor (about64 percent), (2) from property such as capital and land (about22 percent), and (3) from government (about 14 percent).
2.Differences in wage and salary incomes across householdsresult from differences in the characteristics of workers(skills, training, education, experience, and so on) and fromdifferences in jobs (dangerous, exciting, glamorous, difficult,and so on). Household income also varies with the numberof household members in the labor force, and it can declinesharply if members become unemployed.
3.The amount of property income that a household earnsdepends on the amount and kinds of property it owns.Transfer income from governments flows substantially butnot exclusively to lower-income households. Except forSocial Security, transfer payments are by and large designedto provide income to those in need.
THE DISTRIBUTION OF INCOME p. 370
4.The 20 percent of families at the top of the income distribu-tion received 50.5 percent of the money income in theUnited States in 2006, while the bottom 20 percent earnedjust 3.4 percent. Income distribution in the United States hasremained basically stable over a long period of time.
5.The Lorenz curve is a commonly used graphic device fordescribing the distribution of income. The Gini coefficient isan index of income inequality that ranges from 0 for perfectequality to 1 for total inequality.
6.Poverty is very difficult to define. Nonetheless, the officialpoverty line in the United States is fixed at three times thecost of the Department of Agriculture’s minimum food bud-get. In 2006, the poverty line for a family of four was $17,628.
7.Between 1960 and 1970, the number of people officially clas-sified as poor fell from 40 million to 25 million. That num-ber did not change much between 1970 and 1978. Between1978 and 1983, the number of poor people increased bynearly 45 percent to 35.3 million. In 2006, the figure was36.5 million.8.Data on the distribution of wealth are not as readily avail-able as data on the distribution of income. The distributionof wealth in the United States is more unequal than the dis-tribution of income. The wealthiest 10 percent of house-holds own just under 70 percent of all household net worthin 2004.
THE UTILITY POSSIBILITIES FRONTIER p. 376
9.Even if all markets were perfectly efficient, the result mightnot be fair. Even in relatively unfettered market economies,governments redistribute income and wealth, usually in thename of fairness, or equity .
10. Because utility is neither directly observable nor measurable,
most policy discussions deal with the distributions ofincome and wealth as imperfect substitutes for the conceptof “the distribution of well-being.”
THE REDISTRIBUTION DEBATE p. 377
11. The basic philosophical argument against government redis-tribution rests on the proposition that one is entitled to thefruits of one’s efforts. The argument also rests on the princi-ples of freedom of contract and protection of property rights.More common arguments focus on the negative effects ofredistribution on incentives to work, save, and invest.
12. The basic philosophical argument in favor of redistributionis that a society as rich as the United States has a moralobligation to provide all its members with the basic necessi-ties of life. More formal arguments can be found in theworks of the utilitarians, Rawls, and Marx.
REDISTRIBUTION PROGRAMS AND POLICIES p. 380
13. In the United States, redistribution is accomplished throughtaxation and through a number of government transfer pro-grams. The largest of these programs are Social Security,public assistance, supplemental security, unemployment com-pensation, Medicare and Medicaid, food stamps, and varioushousing subsidy programs (including public housing).
14. The increase in poverty during the 1980s and 1990s is at thecenter of a great debate over the effectiveness of antipovertyprograms. One view holds that the best way to cure povertySUMMARY
386 PART III Market Imperfections and the Role of Government
1.One of the issues that is debated in virtually every election is
whether to raise the federal minimum wage, which stood at $7.25
per hour in 2010. Suppose that you are married with a child,working a 40 hour week in a minimum wage job. By assumingthat you pay taxes of about 10 percent of your total pay, howmuch do you “take home” each month? How much does it cost to
rent a “reasonable” apartment near where you live? How much
would you have left after paying rent? How much would it costfor other items such as food? Work out a hypothetical “budget”for this family.
2.By using the data in the following table, create two graphs. The first
graph should plot the Lorenz curves for African-American familiesand white families. The second graph should plot the Lorenz curvefor the 1980 “all” data and the Lorenz curve for the 1995 “all” data.
In each graph, which has the higher Gini coefficient? How
do you interpret the result?
3.Economists call education “an investment in human capital.”
Define capital . In what sense is education capital?
Investments are undertaken to earn a rate of return. Describethe return to an investment in a college education. How wouldyou go about measuring it? How would you decide if it is goodenough to warrant the investment?PERCENT OF INCOME
AFRICAN-AMERICAN WHITE1995
ALL1980
ALL
Lowest fifth 3.2 4.6 4.2 5.1
Second fifth 8.5 10.3 10.0 11.6
Third fifth 15.1 15.8 15.7 17.5
Fourth fifth 24.7 23.0 23.3 24.3
Highest fifth 48.7 46.3 46.9 41.6Computer programming $724.85
Heavy construction firms 535.29
Logging firms 447.02
Gas stations 218.13
Car washes 161.19PROBLEMS
All problems are available on www.myeconlab.com
4.Following is a list of establishment categories and average weekly
earnings for nonsupervisory employees in a recent year. Using
the concepts of “human capital” and “compensating differen-
tials,” explain why they might be expected to differ in these areas:economic growth. In addition, the rise in poverty is cited as
evidence that antipoverty programs do not work. The oppo-site view holds that without antipoverty programs, povertywould be much worse.is with economic growth. Poverty programs are expensive
and must be paid for with tax revenues. The high rates oftaxation required to support these programs have eroded theincentive to work, save, and invest, thus slowing the rate of
5.During the mid-1980s and again between 1995 and 2006,
house values and rents rose sharply in California and in the
northeastern United States. But starting in 2006, prices beganto fall. Homeowners, who have higher incomes on average thanrenters, benefit from house-price increases and are protectedfrom housing-cost increases. Falling house prices, on the other
hand, make housing more affordable but inflict pain on home-
owners. Renters experience rising rents and falling standards ofliving if incomes do not keep up with rents. Using theStatistical Abstract of the United States , other data sources,
www.census.gov, www.ofheo.gov, or http://macromarkets.com,
look up residential rent, home prices, and income levels foryour area. What has happened in the last 10 years? Do youthink the performance of the housing market in recent yearshas increased or decreased inequality in your area? Explain.
6.New PhDs in economics entering the job market find that acad-
emic jobs (jobs teaching at colleges and universities) pay about30 percent less than nonacademic jobs such as working at a
bank or a consulting firm. Those who take academic jobs are
clearly worse off than those who take nonacademic jobs. Do youagree? Explain your answer.compensating differentials, p. 368
economic income, p. 370
equity, p. 367
food stamps, p. 383
Gini coefficient, p. 372
human capital, p. 368
labor theory of value, p. 379 Lorenz curve, p. 371
Medicaid andMedicare, p. 383
minimum wage, p. 368
money income, p. 371
poverty line, p. 375
property income, p. 369
public assistance, orwelfare, p. 382 Rawlsian justice, p. 379
Social Security system, p. 381
transfer payments, p. 370
unemployment compensation, p. 383
utilitarian justice, p. 379
utility possibilities frontier, p. 376 REVIEW TERMS AND CONCEPTS
CHAPTER 18 Income Distribution and Poverty 387
14.Suppose the prevailing equilibrium wage in a labor market is
$10.00 per hour. What would be the impact of a minimum wage
law that sets the minimum wage in this market at $14.00 per
hour? What if the minimum wage was set at $8.00 per hour?
15.Explain how a state government transfer program such as
unemployment compensation may actually result in a higher
unemployment rate than would occur if the program didnot exist.
16.[Related to the Economics in Practice onp. 373 ]Executive
compensation remains a much-debated topic in the UnitedStates. Over the past three decades, compensation for CEOs ofU.S. corporations has risen dramatically, both in real dollars andin terms of worker’s earnings, where in 1980 the average CEO of
a major corporation earned 42 times the average pay of an
hourly worker. The debate has reached Washington, where in2009 President Obama imposed a pay limit of $500,000 forexecutives of companies that received federal bailout money.
Write a brief essay discussing executive compensation, explain-
ing whether you believe executive pay should be limited. Shouldthe government be involved in compensation decisions of pri-vate corporations? What has happened to the ratio of CEO payto hourly worker pay since 1980, and how does this compare to
other countries?PERSONANNUAL
INCOMESHARE OF
INCOMECUMULATIVE
SHARE OF
INCOME
Angus $15,000
Belinda 25,000
Coco 45,000
Darius 70,000
Eva 95,000
0100
20 40 60 80 10010205070
40608090
Percentage of householdsPercentage of incomeA
B
C20112010
30a.Explain whether the distribution of income was more equal
in 2010 or 2011.
b.If area A= 1,900 and area B= 300, what is the value of area C?
What is the value of the Gini coefficient for 2010 and for 2011?
13.The tiny island nation of Pong has five residents, and the table
below lists the annual income of each of these people. Fill in the
table and draw a Lorenz curve showing the distribution ofincome for the nation of Pong.7.Should welfare benefits be higher in California and New Y ork
than in Mississippi? Defend your answer.
8.Poverty among the elderly has been sharply reduced in the last
quarter-century. How has this reduction been accomplished?
9.“Income inequality is evidence that our economic system is
working well, not poorly.” Do you agree or disagree? Defendyour answer.
10.The official poverty line has been the subject of much debate
over the last few decades. On Google or another searchengine, look up and read the work of Molly Orshansky. Herwork focused on finding a measure of poverty that reflected abundle of goods that people in different circumstances mustbe able to purchase. Describe the debate and the resulting sys-
tem for setting the poverty thresholds. How would you
change them?
11.[Related to the Economics in Practice onp. 384 ]Some econo-
mists predict that an increase in the marginal income tax rate
would increase the amount of charitable giving that people doeven though this increase would require wealthier people to pay more taxes. Why do you think economists are predictingthis effect?
12.Refer to the following Lorenz curve to answer the questions.
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CHAPTER OUTLINE
389Public Finance: The
Economics of
Taxation
The previous chapters in Part III
have analyzed the potential role ofgovernment in the economy.T ogether those chapters discussmuch of the field of public
economics . In this chapter, we make
the transition to public finance .N o
matter what functions we end upassigning to government, to doanything at all, government mustfirst raise revenues. The primaryvehicle that the government uses tofinance itself is taxation.
Taxes may be imposed on
transactions, institutions, property,meals, and other things, but in the final analysis they are paid by individuals or households.
The Economics of Taxation
T o begin our analysis of the U.S. tax system, we need to clarify some terms. There are many kindsof taxes and tax analysts use a specific language to describe them.
Taxes: Basic Concepts
Every tax has two parts: a base and a rate structure . The tax base is the measure or value upon which
the tax is levied. In the United States, taxes are levied on a variety of bases, including income, sales,property, and corporate profits. The tax rate structure determines the portion of the tax base that
must be paid in taxes. A tax rate of 25 percent on income, for example, means that you pay a taxequal to 25 percent of your income.
Taxes on Stocks versus Taxes on Flows Tax bases may be either stock measures or
flow measures. The local property tax is a tax on the value of residential, commercial, or indus-trial property. A homeowner, for instance, is taxed on the current assessed value of his or herhome. Current value is a stock variable —that is, it is measured or estimated at a point in time.
Other taxes are levied on flows . Income is a flow. Most people are paid on a monthly basis, and
they have taxes taken out every month. Retail sales take place continuously, and a retail sales tax takesa portion of that flow. Figure 19.1 diagrams in simple form the important continuous payment flowsbetween households and firms and the points at which the government levies six different taxes.
Although the individual income tax remained around 45 percent of total taxes through 2000,
by 2009 it was down to 37.2 percent. The corporate tax has been around 10 percent since 1990.There has been a huge increase in the share of the social insurance tax, from 16.0 percent in 1960to 42.7 percent in 2009. It is now the largest component of federal tax receipts.19
The Economics of
Taxation p. 389
Taxes: Basic Concepts
Tax Equity
What Is the “Best” Tax Base?
The Gift and Estate Tax
Tax Incidence: Who
Pays? p. 396
The Incidence of Payroll
Taxes
The Incidence of Corporate
Profits Taxes
The Overall Incidence of
Taxes in the UnitedStates: Empirical Evidence
Excess Burdens and
the Principle ofNeutrality
p. 402
How Do Excess Burdens
Arise?
Measuring Excess Burdens
Excess Burdens and the
Degree of Distortion
The Principle of
Second Best p. 405
Optimal Taxation
tax base The measure
or value upon which a tax
is levied.
tax rate structure The
percentage of a tax base
that must be paid in taxes—
25 percent of income, for example.
390 PART III Market Imperfections and the Role of Government
Firms Households
Factor
marketsProduct
marketsConsumptionSales
Wages
DividendsIncomeProfits Rents
RentsWages123
4
56Personal income taxKey (counterclockwise)
1
Consumption tax (personal)2
Retail sales tax3
Payroll tax4
Profits (net income) tax5
Wage tax6
/L50304FIGURE 19.1 Taxes on Economic “Flows”
Most taxes are levied on measurable economic flows. For example, a profits, or net income, tax is levied on
the annual profits earned by corporations.
regressive tax A tax whose
burden, expressed as apercentage of income, falls asincome increases.proportional tax A tax whose
burden is the same proportion
of income for all households.
progressive tax A tax whose
burden, expressed as apercentage of income,
increases as income increases.Proportional, Progressive, and Regressive Taxes All taxes are ultimately paid out
of income. A tax whose burden is the same proportion of income for all households is aproportional tax . A tax of 20 percent on all forms of income, with no deductions or exclusions,
is a proportional tax.
A tax that exacts a higher percentage of income from higher-income households than from
lower-income households is a progressive tax . Because its rate structure increases with income,
the U.S. individual income tax is a progressive tax. Under current law, a family with a taxableincome of under $14,000 would pay a tax of 10 percent while a family with an income of$100,000 would pay about 19 percent.
A tax that exacts a lower percentage of income from higher-income families than from
lower-income families is a regressive tax .Excise taxes (taxes on specific commodities such as
gasoline and telephone calls) are regressive. The retail sales tax is also a regressive tax. SupposeTABLE 19.1 Federal Government Receipts 1960–2009 (billions of dollars)
Individual
Income TaxCorporation
Income TaxSocial Insurance
Payroll Taxes Excise TaxesOther
Receipts Total
1960 41.8 21.4 16.0 13.1 1.6 93.9
% 44.5 22.8 17.0 14.0 1.7 100
1970 88.9 30.6 45.5 18.1 3.0 186.1
% 47.8 16.4 24.4 9.7 1.6 100
1980 250.0 70.3 163.6 33.7 15.2 532.8
% 46.9 13.2 30.7 6.3 2.9 100
1990 470.1 118.1 402.0 50.9 41.7 1,082.8
% 43.4 10.9 37.1 4.7 3.9 100
2000 995.6 219.4 698.6 87.3 56.2 2,057.1
% 48.4 10.7 34.0 4.2 2.7 100
2009 828.7 231.0 949.1 92.3 123.8 2,224.9
% 37.2 10.4 42.7 4.1 5.6 100
Source: Bureau of Economic Analysis. Percentages may not add to 100 due to rounding.
CHAPTER 19 Public Finance: The Economics of Taxation 391
the retail sales tax in your state is 5 percent. Y ou might assume that it is a proportional tax
because everyone pays 5 percent. But all people do not spend the same fraction of theirincome on taxable goods and services. In fact, higher-income households save a larger frac-tion of their incomes. Even though they spend more on expensive things and may pay moretaxes in dollars than lower-income families, they end up paying a smaller proportion of their
incomes in sales tax.
Table 19.2 shows this principle at work in three families. The lowest-income family saves
20 percent of its $10,000 income, leaving $8,000 for consumption. With a hypothetical 5 percentsales tax, the household pays $400, or 4 percent of total income, in tax. The $50,000 family saves50 percent of its income, or $25,000, leaving $25,000 for consumption. With the 5 percent salestax, the household pays $1,250, only 2.5 percent of its total income, in tax.
Marginal versus Average Tax Rates When discussing a specific tax or taxes in general,
we should distinguish between average tax rate and marginal tax rates. Y our average tax rate is
the total amount of tax you pay divided by your total income. If you earned a total income of$15,000 and paid income taxes of $1,500, your average income tax rate would be 10 percent($1,500 divided by $15,000). If you paid $3,000 in taxes, your average rate would be 20 percent($3,000 divided by $15,000). Y our marginal tax rate is the tax rate you pay on any additional
income you earn.
Each year you must file a tax return with the Internal Revenue Service on or before April 15.
On that form, you first figure out the total tax you are responsible for paying. Next, you deter-mine how much was withheld from your income and sent to the IRS by your employer. If toomuch was withheld, you get a refund; if not enough was withheld, you have to write a check tothe government for the difference.
In figuring out the total amount of tax you must pay, you first add up all your income. Y ou are
then allowed to subtract certain items from it. Among the things that virtually all taxpayers can sub-tract are the personal exemption and the standard deduction . After everything is subtracted, you are left
with taxable income . Taxable income is then subject to a set of marginal rates that rise with income.
The Economics in Practice on p. 392 shows the income taxes that would be paid by two hypo-
thetical single people earning $100,000 and $125,000, respectively. The discussion uses the actual2009 U.S. tax rates. These calculations show that average and marginal tax rates are not the samein a progressive tax system. Which tax rate should you pay attention to? When talking abouttaxes, many people focus on average rates, the percent of one’s income that goes to the govern-ment. But for most decisions, the marginal rate is more relevant. If you are thinking of workingmore hours, you will be paying the marginal (higher) rate on the incremental income earned; sothat is the rate you should look at in thinking about whether to work. In thinking about whetherto donate money (which has the effect of lowering adjusted income), the marginal rate is againthe relevant one.
How Much Does a Deduction Save You in Taxes? As you saw in the Economics in
Practice , you were allowed to subtract $9,350 from your income as a single person before calculat-
ing taxes. However, you may be able to do better (that is, pay less tax) if you can come up with“itemized deductions” in excess of $9,350. Taxpayers may deduct income taxes paid to a state,charitable contributions to qualifying organizations, real estate taxes, and interest paid on amortgage to finance the purchase of a home, as well as other items.
Some people complain that high-income households receive a bigger benefit from deduc-
tions. For example, if a single person with very high income—let’s say over $400,000—gave aaverage tax rate Total
amount of tax paid divided bytotal income.
marginal tax rate The tax
rate paid on any additional
income earned.TABLE 19.2 The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households
with Different Incomes
Household IncomeSaving
Rate, % Saving Consumption5% Tax on
ConsumptionTax as a
% of Income
A $10,000 20 $ 2,000 $ 8,000 $ 400 4.0
B 20,000 40 8,000 12,000 600 3.0
C 50,000 50 25,000 25,000 1,250 2.5
392 PART III Market Imperfections and the Role of Government
contribution of $1,000, she would save $350 because her marginal tax rate is 35 percent, the high-
est marginal tax rate. If another person had a taxable income of $20,000, the same $1,000charitable contribution would save her only $150 because she would face a marginal tax rate of15 percent. Y ou can see that higher income households, facing higher marginal tax rates, havemore incentives to seek deductions of various sorts.
This discussion gives you a taste of the U.S. Individual Income Tax. It is a very complex tax,
and most people need help in figuring out how to comply with the law. One of the top prioritiesof each of the past five U.S. presidents has been to simplify the tax code, and while the Tax ReformAct of 1986 made some progress, the code seems to get more complex with every passing year.Shortly after being elected, President Obama appointed a task force headed by Paul Volcker tostreamline the tax code.
Tax Equity
One of the criteria for evaluating the economy that we defined in Chapter 1 (and returned to inChapter 18) was fairness, or equity . Everyone agrees that tax burdens should be distributed fairly,
that all of us should pay our “fair share” of taxes, but there is endless debate about what consti-tutes a fair tax system.
ECONOMICS IN PRACTICE
Calculating Taxes
One way to get a sense of the structure of the U.S. income tax system
is to actually calculate what you would owe assuming your income
was at one level or another. Suppose you are single with no depen-dents and you rent rather than own. Assume your charitable contri-butions are relatively modest as well. In that case, you are likely totake a “standard deduction” when filing your taxes.
Consider what happens to your tax payments as you go from
$100,000 per year to $125,000. We will use the 2009 tax schedule forthis calculation. In 2009, single filers who were not claimed on any-one else’s tax return (many students are still claimed on theirparents’ returns) and did not itemize were entitled to deduct $9,350from their gross income before calculating their taxes. In our exam-
ple, we will be comparing adjusted incomes of $90,650 versus
$115,650. Notice that both before and after this adjustment the pre-tax incomes differ by $25,000.
The 2009 tax table is reproduced below. As you see, the tax rate
increases with income, making it a progressive system. In the last two
columns we calculate the taxes owed at the two income levels.
Notice your average tax rate goes up with income given that the
tax system is progressive. Notice also that the marginal tax rate of28 percent is higher than the average tax rate. Of the added $25,000
you earn, 28 percent goes to the government, and you net only$18,000 more than you had at a salary level of $100,000. (If you do
the subtraction, you will see that your after-tax pay at $100,000 is$80,898, while at $125,000 it is $98,898.)
RateOn income
betweenAmount owed
on $100K
($90,650 taxed)Amount owed
on $125K
($115,650 taxed)
10% $0-$8,350 $835 $835
15% $8,350-$33,950 $3,840 $3,840
25% $33,950-$82,250 $12,075 $12,075
28% $82,250-$171,500 $2,352 $9,352
33% $171,500-$372,950 0 0
35% $372,950+ 0 0
Tax owed (Sum) $19,102 $26,102
Average tax rate (Tax/Income) 0.1910 0.2088
Marginal tax rate 0.28 0.28
CHAPTER 19 Public Finance: The Economics of Taxation 393
One theory of fairness is called the benefits-received principle . Dating back to the eighteenth-
century economist Adam Smith and earlier writers, the benefits-received principle holds that taxpay-ers should contribute to government according to the benefits they derive from public expenditures.This principle ties the tax side of the fiscal equation to the expenditure side. For example, the ownersand users of cars pay gasoline and automotive excise taxes, which are paid into the Federal HighwayTrust Fund to build and maintain the federal highway system. The beneficiaries of public highways arethus taxed in rough proportion to their use of those highways.
The difficulty with applying the benefits principle is that many public expenditures are for
public goods—national defense, for example. The benefits of public goods fall collectively on allmembers of society, and there is no way to determine what value individual taxpayers receivefrom them.
A different principle, and one that has dominated the formulation of tax policy in the United
States for decades, is the ability-to-pay principle . This principle holds that taxpayers should bear
tax burdens in line with their ability to pay. Here the tax side of the fiscal equation is viewed sep-arately from the expenditure side. Under this system, the problem of attributing the benefits ofpublic expenditures to specific taxpayers or groups of taxpayers is avoided.
Horizontal and Vertical Equity If we accept the idea that ability to pay should be the
basis for the distribution of tax burdens, two principles follow. First, the principle of horizontal
equity holds that those with equal ability to pay should bear equal tax burdens. Second, the prin-
ciple of vertical equity holds that those with greater ability to pay should pay more.
Although these notions seem appealing, we must have answers to two interdependent ques-
tions before they can be meaningful. First, how is ability to pay measured? What is the “best” taxbase? Second, if A has a greater ability to pay than B, how much more should A contribute?
What Is the “Best” Tax Base?
The three leading candidates for best tax base are income ,consumption , and wealth .B e f o r e w e
consider each as a basis for taxation, let us see what they mean.
Income —to be precise, economic income —is anything that enhances your ability to com-
mand resources. The technical definition of economic income is the value of what you consumeplus any change in the value of what you own:
This broad definition is essentially consumption + saving, but it includes many items
not counted by the Internal Revenue Service and some items the Census Bureau does notinclude in its definition of “money income.” Economic income includes all money receipts,whether from employment, interest on savings, dividends, profits, or transfers from the gov-ernment. It also includes the value of benefits not received in money form, such as medicalbenefits, employer retirement contributions, paid country club memberships, and so on.Increases or decreases in the value of stocks or bonds, whether or not they are “realized”through sale, are part of economic income. For income tax purposes, capital gains (increasesin the value of assets, like shares of stock) count as income only when they are realized, butfor purposes of defining economic income, all increases in asset values count, whether theyare realized or not.
A few other items that we do not usually think of as income are included in a comprehensive
definition of income. If you own your house outright and live in it rent free, income flows fromyour house just as interest flows from a bond or profit from a share of stock. By owning thehouse, you enjoy valuable housing benefits for which you would otherwise have to pay rent. Y ouare your own landlord, and you are, in essence, earning your own rent. Other components of eco-nomic income include any gifts and bequests received and food grown at home. In economicterms, income is income regardless of source and use.
Consumption is the total value of goods and services that a household consumes in a given period.
Wealth ,o r net worth , is the value of all the goods and services you own after your liabilities
are subtracted. If today you were to sell everything of value you own—stocks, bonds, houses, cars,benefits-received principle A
theory of fairness holding that
taxpayers should contribute to
government (in the form oftaxes) in proportion to the
benefits they receive from
public expenditures.
Economic Income = Consumption + Change in Net Worthability-to-pay principle
A theory of taxation holding
that citizens should bear taxburdens in line with their
ability to pay taxes.
394 PART III Market Imperfections and the Role of Government
and so on—at their current market prices and pay off all your debts—loans, mortgages, and so
on—you would end up with your net worth.
Remember, income and consumption are flow measures. We speak of income per month or
per year. Wealth and net worth are stock measures at a point in time.
For years, conventional wisdom among economists held that income was the best measure of
ability to pay taxes. Many who believe that consumption is a better measure have recently chal-lenged that assumption. The following arguments are not just arguments about fairness and abil-ity to pay; they are also arguments about the best base for taxation.
Remember as you proceed that the issue is which base is the best base, not which taxis the best tax
or whether taxes ought to be progressive or regressive. Sales taxes are regressive, but it is possible tohave a personal consumption tax that is progressive. Under such a system, individuals would reporttheir income as they do now, but all documented saving would be deductible. The difference betweenincome and saving is a measure of personal consumption that could be taxed with progressive rates.
Consumption as the Best Tax Base The view favoring consumption as the best tax base
dates back to at least the seventeenth-century English philosopher Thomas Hobbes, who arguedthat people should pay taxes in accordance with “what they actually take out of the common pot,not what they leave in.” The standard of living, the argument goes, depends not on income, but onhow much income is spent. If we want to redistribute well-being, therefore, the tax base should beconsumption because consumption is the best measure of well-being. The value-added tax (V AT)used by most developed economies other than the United States is essentially a tax on consumption.
A second argument with a distinguished history dates back to work done by Irving Fisher in
the early part of the last century. Fisher and many others have argued that a tax on income discour-ages saving by taxing savings twice. A story told originally by Fisher illustrates this theory nicely.
1
Suppose Alex builds a house for Frank. In exchange, Frank pays Alex $10,000 and gives him
an orchard containing 100 apple trees. Alex spends the $10,000 today, but he saves the orchard,and presumably he will consume or sell the fruit it bears every year in the future. At year’s end, thestate levies a 10 percent tax on Alex’s total income, which includes the $10,000 and the orchard.First, the government takes 10 percent of the $10,000, which is 10 percent of Alex’s consumption.Second, it takes 10 percent of the orchard—10 trees—which is 10 percent of Alex’s saving. If thisis all the government did, there would be no double taxation of saving. If, however, the incometax is also levied the following year, Alex will be taxed on the income generated by the 90 treesthat he still owns. If the income tax is levied in the year after that, Alex will again be taxed on theincome generated by his orchard, and so on. The income tax is thus taxing Alex’s saving morethan once. T o tax the orchard fairly, the system should take 10 percent of the trees or10 percent of
the fruit going forward— but not both! T o avoid the double taxation of savings, either the original
savings of 100 trees should not be taxed or the income generated from the after-tax number oftrees (90) should not be taxed.
The same logic can be applied to cash savings. Suppose the income tax rate is 25 percent and you
earn $20,000. Out of the $20,000, you consume $16,000 and save $4,000. At the end of the year, youowe the government 25 percent of your total income, or $5,000.Y ou can think of this as a tax of 25 per-cent on consumption ($4,000) and 25 percent on savings ($1,000). Why, then, do we say that theincome tax is a double tax on savings? T o see why, you have to think about the $4,000 that is saved.
If you save $4,000, you will no doubt put it to some use. Saving possibilities include putting
it in an interest-bearing account or buying a bond. If you do either, you will earn interest that youcan consume in future years. In fact, when we save and earn interest, we are spreading some ofour present earnings over future years of consumption. Just as the orchard yields future fruit, thebond yields future interest, which is considered income in the year it is earned and is taxed assuch. The only way you can earn that future interest income is by leaving your money tied up inthe bond or the account. Y ou can consume the $4,000 today, oryou can have the future flow of
interest; you can’t have both. Y et both are taxed!Net worth = Assets -Liabilities
1Irving Fisher and Herbert Fisher, Constructive Income Taxation: A Proposal for Reform (New Y ork: Harper, 1942), Ch. 8, p. 56.
CHAPTER 19 Public Finance: The Economics of Taxation 395
Taxing consumption is also more efficient than taxing income. As you will see later, a tax that
distorts economic choices creates excess burdens . By double-taxing savings, an income tax distorts
the choice between consumption and saving, which is really the choice between present con-sumption and future consumption. Double-taxing also tends to reduce the saving rate and therate of investment—and ultimately the rate of economic growth.
Income as the Best Tax Base Y our ability to pay is your ability to command resources,
and many argue that your income is the best measure of your capacity to command resourcestoday. According to proponents of income as a tax base, you should be taxed not on what youactually draw out of the common pot, but rather on the basis of your ability to draw from that
pot. In other words, your decision to save or consume is no different from your decision to buyapples, to go out for dinner, or to give money to your mother. It is your income that enables you
to do all these things, and it is income that should be taxed, regardless of its sources and regard-less of how you use it. Saving is just another use of income.
If income is the best measure of ability to pay, the double taxation argument doesn’t hold
true. An income tax taxes savings twice only if consumption is the measure used to gauge aperson’s ability to pay. It does not do so if income is the measure used. Acquisition of the orchardenhances your ability to pay today; a bountiful crop of fruit enhances your ability to pay when itis produced. Interest income is no different from any other form of income; it too enhances yourability to pay. Taxing both is thus fair.
Wealth as the Best Tax Base Still others argue that the real power to command resources
comes not from any single year’s income, but from accumulated wealth. Aggregate net worth inthe United States is many times larger than aggregate income.
If two people have identical annual incomes of $10,000 but one of them also has an accumu-
lated net worth of $1 million, is it reasonable to argue that these two people have the same abilityto pay or that they should pay equal taxes? Most people would answer no.
Those who promote a wealth-based system also argue that the only real way to redistribute
economic power is to tax the very high concentrations of wealth. Of course, it is important tonote that if income is already taxed, a wealth tax, in essence, taxes the same dollars again.
No Simple Answer Recall that these arguments are about the definition of “horizontal
equity”: What is the single best measure of ability to pay? In fact, policy debates about the systemof taxes in the United States or in any other country involve much more. Virtually every countryin the world has a system of taxation that taxes all three bases. In the United States, for example,there are sales and excise taxes (consumption taxes), the Federal Gift and Estate Tax (a wealthtax), the Individual Income Tax, and the local property tax (another wealth tax).
It is important to point out that for many U.S. taxpayers, the Individual Income Tax is prob-
ably closer to being a consumption tax than an income tax since much of household savings canbe deducted from income before the tax is figured. The tax code (or law) is full of subsidies andincentives. Among the most significant incentives built into the system are provisions designed toencourage people to save. For example, an important exclusion from income for purposes ofdefining the income tax base is employers’ contributions to employee pension accounts. For manyworkers, retirement is in part financed by payments from pension funds. As long as a person isworking, many employers will make deposits or match employee deposits to retirement or pen-sion accounts. Those contributions are part of a household’s economic income and part of house-hold savings, but they are not taxed. Recall that income is essentially consumption plus savings(change in net worth). In addition, deposits to specific kinds of accounts (such as IndividualRetirement Accounts, or IRAs) can be excluded from income for tax purposes. A good portion ofcapital gains income (increases in the value of things that a household owns), such as increases inthe value of corporate stocks or houses, is left out of the base or taxed at lower rates.
There is ongoing debate in the United States about whether it would be better to shift toward a
more comprehensive consumption tax. In the fall of 2005, President Bush’s Advisory Panel on FederalTax Reform presented its report on reforming and simplifying the nation’s tax code. The commissionstopped short of full implementation of a consumption tax such as a national sales tax or a version ofa national sales tax called a value-added tax (V AT) that is popular in Europe. But the panel did recom-
mend moving to a system that rewards saving and discourages consumption more than the currentone. An important goal of the commission was to recommend ways of simplifying the code.
396 PART III Market Imperfections and the Role of Government
The Gift and Estate Tax
One of the oldest and most common forms of taxation in the world is the taxation of property
held by an individual at the time of his or her death. The property owned at the time of a person’sdeath is called the person’s estate .A n estate tax is a tax on the total value of a person’s estate
regardless of how it is distributed. The United States levies a Gift and Estate Tax on gifts madeover a person’s lifetime and the value of the person’s estate, for estates over a certain level. TheFederal Gift and Estate Tax, which raises less than 2 percent of total tax revenues, was phased outfor one year in 2010 under a law passed by Congress in 2001. In 2011, without further action, thetax will revert to its original 2001 level. The Economics in Practice discusses the picture in 2010.
Tax Incidence: Who Pays?
When a government levies a tax, it writes a law assigning responsibility for payment to specific
people or specific organizations. T o understand a tax, we must look beyond those named in thelaw as the initial taxpayers.
First, remember the principle of tax analysis: The burden of a tax is ultimately borne by indi-
viduals or households; institutions such as business firms and colleges have no real taxpayingcapacity. Taxes paid by a firm ultimately fall on customers or owners or workers. Second, the bur-den of a tax is not always borne by those initially responsible for paying it. Directly or indirectly,tax burdens are often shifted to others. When we speak of the incidence of a tax , we are referring
to the ultimate distribution of its burden.estate The property that a
person owns at the time of his
or her death.
estate tax A tax on the total
value of a person’s estate.ECONOMICS IN PRACTICE
The Yankees and the Estate Tax
As we indicated in the text, under a tax change passed in 2001, the
gift and estate tax was phased out completely in 2010 for one year. By
the fall of 2010, Congress had not yet reversed this phasing out, andarticles began to appear about billionaires who had died in 2010 andwhose heirs appear to have avoided the tax. George Steinbrenner,legendary owner of the New Y ork Y ankees, was one.
How Steinbrenner Saved His Heirs a
$600 Million Tax Bill
The Wall Street Journal
Did George Steinbrenner save his heirs millions by dying
in 2010?
Forbes recently estimated the Yankees owner’s net worth
at $1.1 billion, largely from the YES network. The New YorkYankees, which he acquired in 1973 for $10 million, are nowworth $1.6 billion but are 95% leveraged due to debt from
the new Yankee Stadium, according to Forbes.
Because Steinbrenner died in a year when there is no fed-
eral estate tax, he potentially saved his heirs a 55% estate taxon his assets—or a tax bill of about $600 million. The 55% taxtakes effect on January 1, 2011. If Steinbrenner had died in
2009 when the estate tax rate was 45%, his estate tax bill
might have been nearer $500 million. Because the wealthyoften do elaborate planning, putting assets into trusts taxedseparately from the estate or into foundations that are tax-
exempt, it is unclear how large his estate will be. Estate taxes
may also be postponed on assets left to a spouse in yearswhen there is an estate tax.There is no estate tax this
year due to changes made byCongress in 2001. Those
changes eased the estate tax
over several years and culmi-nated with its repeal this year,followed by a return to high taxlevels in 2011. Experts say fewever expected the tax’s repeal,
and its 2011 reinstatement,
would actually take effect.Instead they believed lawmak-ers would smooth out the taxrates at some point between
2002 and the end of 2009.
Congress never got around
to it, and the tax lapsed this year. Many still hope lawmakerswill fix this year’s law, which actually raises taxes on heirs ofthe merely affluent (with assets between $1.3 and $4 million).
But they still haven’t acted and have little time to do so.
Because of the huge chasm separating 2010’s zero tax
rate from 2011’s 55% rate, some fear that Congress has pro-vided the wealthy with an incentive for dying—or their rela-tives with an incentive for making sure they die—before the
clock strikes midnight on Dec. 31.
Source: The Wall Street Journal Online, excerpted from “How Steinbrenner
Saved His Heirs a $600 Million Tax Bill” by Laura Saunders. Copyright2010 by Dow Jones & Company, Inc. Reproduced with permission of Dow
Jones & Company, Inc. via Copyright Clearance Center .
tax incidence The ultimate
distribution of a tax burden.
CHAPTER 19 Public Finance: The Economics of Taxation 397
The simultaneous reactions of many households and/or firms to the presence of a tax may cause
relative prices to change, and price changes affect households’ well-being. Households may feel theimpact of a tax on the sources side or on the uses side of the income equation. (We use the termincome equation because the amount of income from all sources must be equal to the amount of
income allocated to all uses—including saving—in a given period.) On the sources side , a household
is hurt when the net wages or profits that it receives fall; on the uses side , a household is hurt when
the prices of the goods and services that it buys rise. If your wages remain the same but the price ofevery item that you buy doubles, you are in the same position you would have been in if your wageshad been cut by 50 percent and prices hadn’t changed. In short, the imposition of a tax or a change ina tax can change behavior. Changes in behavior can affect supply and demand in markets and causeprices to change. When prices change in input or output markets, some households are made betteroff and some are made worse off. These final changes determine the ultimate burden of the tax.
Tax shifting takes place when households can alter their behavior and do something to avoid
paying a tax. Such shifting is easily accomplished when only certain items are singled out for taxation.Suppose a heavy tax were levied on bananas. Initially, the tax would make the price of bananas muchhigher, but there are many potential substitutes for bananas. Consumers can avoid the tax by not buy-ing bananas, and that is what many will do. But as demand drops, the market price of bananas falls andbanana growers lose money. The tax shifts from consumers to the growers, at least in the short run.
A tax such as the retail sales tax, which is levied at the same rate on allconsumer goods, is
harder to avoid. The only thing consumers can do to avoid such a tax is to consume less of every-thing. If consumers consume less, saving will increase, but otherwise there are few opportunitiesfor tax avoidance and therefore for tax shifting. Broad-based taxes are less likely to be shifted andmore likely to “stick” where they are levied than “partial taxes” are.
The Incidence of Payroll Taxes
In 2009, about 42.7 percent of federal revenues came from social insurance taxes, also called payroll
taxes . The revenues from payroll taxes go to support Social Security, unemployment compensation,
and other health and disability benefits for workers. Some of these taxes are levied on employers asa percentage of payroll, and some are levied on workers as a percentage of wages or salaries earned.
T o analyze the payroll tax, let us take a tax levied on employers and sketch the reactions that
are likely to follow. When the tax is first levied, firms find that the price of labor increases. Firmsmay react in two ways. First, they may substitute capital for the now more-expensive labor.Second, higher costs and lower profits may lead to a cut in production. Both reactions mean alower demand for labor. Lower demand for labor reduces wages, and part of the tax is thus passedon (or shifted to ) the workers, who end up earning less. The extent to which the tax is shifted to
workers depends on how workers can react to the lower wages.
We can develop a more formal analysis of this situation with a picture of the market before the tax
is levied. Figure 19.2 shows equilibrium in a hypothetical labor market with no payroll tax. Before weproceed, we should review the factors that determine the shapes of the supply and demand curves.sources side/uses side The
impact of a tax may be felt onone or the other or on both
sides of the income equation.
A tax may cause net income tofall (damage on the sources
side), or it may cause prices of
goods and services to rise sothat income buys less (damage
on the uses side).
tax shifting Occurs when
households can alter theirbehavior and do something to
avoid paying a tax.
Supply
(as a function
of workers’
take-home pay)
Demand
(as a function of
what firms pay)W0
L00
Units of labor, LWage rate ($)/L50296FIGURE 19.2
Equilibrium in a
Competitive LaborMarket—No Taxes
With no taxes on wages, the
wage that firms pay is the sameas the wage that workers take
home. At a wage of W
0, the
quantity of labor supplied andthe quantity of labor demanded
are equal.
398 PART III Market Imperfections and the Role of Government
Labor Supply and Labor Demand Curves in Perfect Competition: A
Review Recall that the demand for labor in perfectly competitive markets depends on its pro-
ductivity. As you saw in Chapter 10, a perfectly competitive, profit-maximizing firm will hirelabor up to the point at which the market wage is equal to labor’s marginal revenue product. Theshape of the demand curve for labor shows how responsive firms are to changes in wages.
Recall from Chapter 6 that household behavior and thus the shape of the labor supply curve
depend on the relative strengths of income and substitution effects. The labor supply curve repre-sents the reaction of workers to changes in the wage rate. Household behavior depends on theafter-tax wage that workers actually take home per hour of work. In contrast, labor demand is a
function of the full amount that firms must pay per unit of labor, an amount that may include a taxif it is levied directly on payroll, as it is in our example. Such a tax, when present, drives a “wedge”between the price of labor that firms face and take-home wages.
Imposing a Payroll Tax: Who Pays? In Figure 19.2, there were no taxes and the wage
that firms paid was the same as the wage that workers took home. At a wage of W0, quantity of labor
supplied and quantity of labor demanded were equal and the labor market was in equilibrium.2
But suppose employers must pay a tax of $ Tper unit of labor. Figure 19.3 shows a new curve that
is parallel to the supply curve but above it by a distance T. The new curve, S1, shows labor supply as a
function of what firms pay. Note that S1is not really a new supply curve. Supply is still determined by
what workers take home. S1simply adds Tto the supply curve. Regardless of how the ultimate burden
of the tax is shared, there is a difference between what firms pay and what workers take home.
If the initial wage is W0per hour, firms will face a price of W0+Tper unit of labor immedi-
ately after the tax is levied. Workers still receive only W0, however. The higher wage rate—that is,
the higher price of labor that firms now face—reduces the quantity of labor demanded from L0
toLd, and the firms lay off workers. Workers initially still receive W0, so that amount of labor
supplied does not change, and the result is an excess supply of labor equal to ( L0-Ld).
The excess supply applies downward pressure to the market wage, and wages fall, shifting
some of the tax burden onto workers. The issue is how far wages will fall. Figure 19.3 shows thata new equilibrium is achieved at W
1, with firms paying W1+T. When workers take home W1,
they supply L1units of labor. If firms must pay W1+T, they will demand L1units of labor, and
the market clears. Quantity supplied again equals quantity demanded.
In this case, then, employers and employees share the burden of the payroll tax. Initially, firms
paid W0; after the tax, they pay W1+T. Initially, workers received W0; after the tax, they end up with
2Although the supply curve has a positive slope, that slope implies nothing about the actual shape of the labor supply curve in
the United States.Supply
(as a function
of workers’
take-home pay)Supply
(as a function
of what firms pay)
Demand
(as a function of
what firms pay)W0
W1
L0 L1 Ld0
Units of labor, LWage rate ($)W0 + T
W1 + TWorkers’ shareFirms’ share
Total tax collectionS
T
TS01/L50298FIGURE 19.3
Incidence of a Per-Unit
Payroll Tax in a PerfectlyCompetitive LaborMarket
With a tax on firms of $ Tper unit
of labor hired, the market willadjust, shifting the tax partially to
workers. When the tax is levied,
firms must first pay W
0+T. This
reduces the labor demand to Ld.
The result is excess supply, whichpushes wages down to W
1and
passes some of the burden of thetax on to workers.
CHAPTER 19 Public Finance: The Economics of Taxation 399
the lower wage W1. T otal tax collections by the government are equal to T/H11003L1. Geometrically, tax
collections are equal to the entire shaded area in Figure 19.3. The workers’ share of the tax burden isthe lower portion, ( W
0-W1)/H11003L1. The firms’ share is the upper portion, [( W1+T)-W0]/H11003L1.
The relative sizes of the firms’ share and the workers’ share of the total tax burden depend on the
shapes of the demand and supply curves. Figure 19.4, parts a and b, show that the ultimate burden ofa payroll tax depends, at least in part, on the elasticity of labor supply . If labor supply is very elastic
(that is to say, responsive to price), take-home wages do not fall very much and workers bear only asmall portion of the tax. But if labor supply is inelastic, or unresponsive to price, most of the burden
is borne by workers. Workers bear the bulk of the burden of a payroll tax if labor supply is relativelyinelastic, and firms bear the bulk of the burden of a payroll tax if labor supply is relatively elastic.
Empirical studies of labor supply behavior in the United States suggest that for most of the work-
force, the elasticity of labor supply is close to zero. Therefore; most of the payroll tax in the UnitedStates is probably borne by workers. The result would be exactly the same if the tax were initially leviedon workers rather than on firms. Go back to the equilibrium in Figure 19.3 on p. 398, with wages atW
0. But now assume that the tax of $ Tper hour is levied on workers rather than firms. The burden
will end up being shared by firms and workers in the exact same proportions . Initially, take-home wages
will fall to W0-T. Workers will supply less labor, creating excess demand and pushing market wages
up. That shifts part of the burden back to employers. The “story” is different, but the result is the same.
Table 19.3 presents an estimate of the incidence of payroll taxes (Social Security taxes) in the
United States in 2007. This estimate assumes that both the employers’ share and employees’ shareof the payroll taxes are ultimately borne by employees .
The payroll tax is regressive at the top income levels for two reasons. First, in 2010, most of the tax
(6.2 percent of total wage and salary income levied on both employers and employees) did not applyto wages and salaries above $106,800. The remainder of the total 7.65 percent tax—1.45 percent—
W0
W1
L1S1 S0
LDD
0
Units of laborWage rate ($)W1 + TWorkers’ shareFirms’ shareTW0
W1
L1S1
S0
La.
b.0
Units of laborWage rate ($)W1 + T T/L50296FIGURE 19.4
Payroll Tax with Elastic
(a) and Inelastic(b) Labor Supply
The ultimate burden of a payroll
tax depends on the elasticities of
labor supply and labor demand.
For example, if supply is relativelyelastic, as in part a, the burdenfalls largely on employers; if the
supply is relatively inelastic, as in
part b, the burden falls largely on workers.
400 PART III Market Imperfections and the Role of Government
applied to all wage and salary income. Second, wages and salaries fell as a percentage of total income as
we move up the income scale. Those with higher incomes earn a larger portion of their incomes fromprofits, dividends, rents, and so on, and these kinds of income are not subject to the payroll tax.
Some economists dispute the conclusion that the payroll tax is borne entirely by wage earn-
ers. Even if labor supply is inelastic, some wages are set in the process of collective bargainingbetween unions and large firms. If the payroll tax results in a higher gross wage in the bargainingprocess, firms may find themselves faced with higher costs. Higher costs either reduce profits toowners or are passed on to consumers in the form of higher product prices.
The Incidence of Corporate Profits Taxes
Another tax that requires careful analysis is the corporate profits tax that is levied by the federalgovernment as well as by most states. The corporate profits tax orcorporation income tax , is a tax on
the profits of firms that are organized as corporations. Corporations are firms granted limited lia-
bility status by the government. Limited liability means that shareholders/owners can lose onlywhat they have invested. The owners of partnerships andproprietorships do not enjoy limited liabil-
ity and do not pay this tax; rather, they report their firms’ income directly on their individualincome tax returns.
We can think of the corporate tax as a tax on capital income , or profits, in one sector of the
economy. For simplicity, we assume that there are only two sectors of the economy, corporate andnoncorporate, and only two factors of production, labor and capital. Owners of capital receiveprofits, and workers (labor) are paid a wage.
Like the payroll tax, the corporate tax may affect households on the sources or the uses side
of the income equation. The tax may affect profits earned by owners of capital, wages earned byworkers, or prices of corporate and noncorporate products. Once again, the key question is howlarge these changes are likely to be.
When first imposed, the corporate profits tax initially reduces net (after-tax) profits in the
corporate sector. Assuming the economy was in long-run equilibrium before the tax was levied,firms in both the corporate and noncorporate sectors were earning a normal rate of return ; there
was no reason to expect higher profits in one sector than in the other. Suddenly, firms in the cor-porate sector become significantly less profitable as a result of the tax. (In 2009, for example, thetax rate applicable to most corporations was 35 percent.)
In response to these lower profits, capital investment begins to favor the nontaxed sector because
after-tax profits are higher there. Firms in the taxed sector contract in size or (in some cases) go outof business, while firms in the nontaxed sector expand and new firms enter its various industries. Asthis happens, the flow of capital from the taxed to the nontaxed sector reduces the profit rate in thenontaxed sector: More competition springs up, and product prices are driven down. Some of the taxburden shifts to capital income earners in the noncorporate sector, who end up earning lower profits.
As capital flows out of the corporate sector in response to lower after-tax profits, the
profit rate in that sector rises somewhat because fewer firms means less supply, which meanshigher prices, and so on. Presumably, capital will continue to favor the nontaxed sector untilthe after-tax profit rates in the two sectors are equal. Even though the tax is imposed on justone sector, it eventually depresses after-tax profits in all sectors equally.TABLE 19.3 Estimated Incidence of Payroll Taxes in the United
States in 2007
Population Ranked by Income Tax as a % of Total Income
Bottom 20% 7.5
Second 20% 9.9
Third 20% 10.6
Fourth 20% 11.4
Top 20% 8.0
Top 10% 6.3
Top 5% 5.1
Top 1% 2.5
Source: Authors’ estimate.
CHAPTER 19 Public Finance: The Economics of Taxation 401
Under these circumstances, the products of corporations will probably become more expen-
sive and products of proprietorships and partnerships will probably become less expensive. Butbecause almost everyone buys both corporate and noncorporate products, these excise effects
(that is, effects on the prices of products) are likely to have a minimal impact on the distributionof the tax burden. In essence, the price increases in the corporate sector and the price decreases inthe noncorporate sector cancel each other out.
Finally, what effect does the imposition of a corporate income tax have on labor? Wages
could actually rise or fall, but the effect is not likely to be large. Taxed firms will have an incentiveto substitute labor for capital because capital income is now taxed. This could benefit labor bydriving up wages. In addition, the contracting sector will use less labor and capital, but if the
taxed sector is the capital-intensive corporate sector, the bulk of the effect will be felt by capital.The price of capital will fall more than the price of labor.
The Burden of the Corporate Tax The ultimate burden of the corporate tax appears to
depend on several factors: the relative capital/labor intensity of the two sectors, the ease withwhich capital and labor can be substituted in the two sectors, and elasticities of demand for theproducts of each sector. In 1962, economist Arnold Harberger, then of the University of Chicago,analyzed this and concluded that owners of corporations, proprietorships, and partnerships allbear the burden of the corporate tax in rough proportion to profits, even though it is directlylevied only on corporations. Harberger also found that wage effects of the corporate tax weresmall and that excise effects, as we just noted, probably cancel each other out.
3
Much has been written about the incidence of the corporate tax since Harberger, but the
general conclusion that capital owners bear most of the tax burden is still viewed as correct bymost economists.
One exception to this conclusion is corporate taxation of a monopolist. Y ou might be
tempted to conclude that because monopolists can control market price, they will simply pass onthe profits tax in the form of higher prices to consumers of monopoly products. But theory pre-dicts just the opposite: that the tax burden will remain with the monopolist.
Remember that monopolists are constrained by market demand. That is, they choose the
combination of price and output that is consistent with market demand and that maximizesprofit. If a proportion of that profit is taxed, the choice of price and quantity will not change.Why not? Quite simply, if you behave so as to maximize profit and then I come and take half ofyour profit, you maximize your half by maximizing the whole, which is exactly what you woulddo in the absence of the tax. Thus, your price and output do not change, the tax is shifted, andyou end up paying the tax. In the long run, capital will not leave the taxed monopoly sector, as itdid in the competitive case. Even with the tax, the monopolist is earning higher profits than arepossible elsewhere.
Table 19.4 presents an estimate of the actual incidence of the U.S. corporate income tax in
2007. The burden of the corporate income tax is clearly progressive because profits and capitalincome make up a much bigger part of the incomes of high-income households.
3Arnold Harberger, “The Incidence of the Corporate Income Tax,” Journal of Political Economy , LXX, June 1962.TABLE 19.4 Estimated Burden of the U.S. Corporation Income Tax in 2007
Population Ranked by Income Corporate Tax Burden as a % of Total Income
Bottom 20% 1.2
Second 20% 1.1
Third 20% 1.5
Fourth 20% 1.6
Top 20% 4.7
Top 10% 5.6
Top 5% 7.3
Top 1% 9.0
Source: Authors’ estimate.
402 PART III Market Imperfections and the Role of Government
The Overall Incidence of Taxes in the United States:
Empirical Evidence
Many researchers have done complete analyses under varying assumptions about tax incidence, and in
most cases their results are similar. State and local taxes (with sales taxes playing a big role) seem as agroup to be mildly regressive. Federal taxes, dominated by the individual income tax but increasinglyaffected by the regressive payroll tax, are mildly progressive. The overall system is mildly progressive.
Excess Burdens and the Principle of Neutrality
Y ou have seen that when households and firms make decisions in the presence of a tax that differfrom decisions they would make in its absence, the burden of the tax can be shifted from those forwhom it was originally intended. Now we can take the same logic one step further. When taxesdistort economic conditions, they impose burdens on society that, in aggregate, exceed the rev-enue collected by the government.
The amount by which the burden of a tax exceeds the total revenue collected by the govern-
ment is called the excess burden of the tax. The total burden of a tax is the sum of the revenue
collected from the tax and the excess burden created by the tax. Because excess burdens are a formof waste, or lost value, tax policy should be written to minimize them. (Excess burdens are alsocalled deadweight losses .)
The size of the excess burden imposed by a tax depends on the extent to which economic
decisions are distorted. The general principle that emerges from the analysis of excess burdens istheprinciple of neutrality .Ceteris paribus , or all else equal,
4a tax that is neutral with respect to
economic decisions is preferred to one that distorts economic decisions.
In practice, all taxes change behavior and distort economic choices. A product-specific
excise tax raises the price of the taxed item, and people can avoid the tax by buying substitutes.An income tax distorts the choice between present and future consumption and between workand leisure. The corporate tax influences investment and production decisions—investment isdiverted away from the corporate sector, and firms may be induced to substitute labor for capital.
How Do Excess Burdens Arise?
The idea that a tax can impose an extra cost, or excess burden, by distorting choices can be illustratedby example. Consider a perfectly competitive industry that produces an output, X, using the technol-
ogy shown in Figure 19.5. Using technology A, firms can produce 1 unit of output with 7 units ofcapital ( K) and 3 units of labor ( L). Using technology B, the production of 1 unit of output requires
4 units of capital and 7 units of labor. A is thus the more capital-intensive technology.
If we assume labor and capital each cost $2 per unit, it costs $20 to produce each unit of out-
put with technology A and $22 to produce each unit of output with technology B. Firms willchoose technology A. Because we assume perfect competition, output price will be driven to costof production and the price of output will in the long run be driven to $20 per unit.
Now let us narrow our focus to the distortion of technology choice that is brought about by
the imposition of a tax. Assume that demand for the good in question is perfectly inelastic at
4The phrase ceteris paribus (all else equal) is important. In judging the merits of a tax or a change in tax policy, the degree of
neutrality is only one criterion among many, and it often comes into conflict with others. For example, tax A may impose alarger excess burden than tax B, but society may deem A more equitable.excess burden The amount
by which the burden of a tax
exceeds the total revenue
collected. Also calleddeadweight loss.
principle of neutrality
All else equal, taxes that are
neutral with respect to
economic decisions (that is,taxes that do not distort
economic decisions) are
generally preferable to taxesthat distort economicdecisions. Taxes that are not
neutral impose excess burdens.
$20K T echnologyPK= $2
PL= $2Input requirements
per unit of output XPer-unit cost of X
=K(PK) + L(PL)
Least costL
A
$22B73
47/L50298FIGURE 19.5
Firms Choose the
Technology ThatMinimizes the Cost ofProduction
If the industry is perfectly
competitive, long-run equilib rium
price will be $20 per unit of X. If
1,000 units of Xare sold,
consumers will pay a total of
$20,000 for X.
CHAPTER 19 Public Finance: The Economics of Taxation 403
1,000 units of output. That is, regardless of price, households will buy 1,000 units of the good. A
price of $20 per unit means consumers pay a total of $20,000 for 1,000 units of X.
Now suppose the government levies a tax of 50 percent on capital. This has the effect of rais-
ing the price of capital, PK, to $3. Figure 19.6 shows what would happen to unit cost of produc-
tion after the tax is imposed. With capital now more expensive, the firm switches to the morelabor-intensive technology B. With the tax in place, Xcan be produced at a cost of $27 per unit
using technology A but for $26 per unit using technology B.
If demand is perfectly inelastic, buyers continue to buy 1,000 units of Xregardless of its
price. (We shall ignore any distortions of consumer choices that might result from the impositionof the tax.) Recall that the tax is 50 percent, or $1 per unit of capital used. Because it takes 4 unitsof capital to produce each unit of output, firms—which are now using technology B—will pay atotal tax to the government of $4 per unit of output produced. With 1,000 units of output pro-duced and sold, total tax collections amount to $4,000.
But if you look carefully, you will see that the burden of the tax exceeds $4,000. After the tax,
consumers will be paying $26 per unit for the good. Twenty-six dollars is now the unit cost ofproducing the good using the best available technology in the presence of the capital tax.Consumers will pay $26,000 for 1,000 units of the good. This represents an increase of$6,000 over the previous total of $20,000. The revenue raised from the tax is $4,000, but its total
burden is $6,000. There is an excess burden of $2,000.
How did this excess burden arise? Look back at Figure 19.5. Y ou can see that technology B is
less efficient than technology A. (Unit costs of production are $2 higher per unit using technol-ogy B.) But the tax on capital has caused firms to switch to this less efficient, labor-intensivemode of production. The result is a waste of $2 per unit of output. The total burden of the tax isequal to the revenue collected plus the loss due to the wasteful choice of technology, and theexcess burden is $2 per unit times 1,000 units, or $2,000.
The same principle holds for taxes that distort consumption decisions. Suppose that you
prefer to consume bundle Xto bundle Ywhen there is no tax, but choose bundle Ywhen there is
a tax in place. Not only do you pay the tax, you also end up with a bundle of goods that is worthless than the bundle you would have chosen had the tax not been levied. Again, we have the burdenof an extra cost. The larger the distortion that a tax causes in behavior, the larger the excess bur-den of the tax. Taxes levied on broad bases tend to distort choices less and impose smaller excessburdens than taxes on more sharply defined bases. This follows from our discussion earlier in thischapter: The more partial the tax, the easier it is to avoid. An important part of the logic behindthe recommendation of the president’s tax reform commission in 2005 was that broader bases andlower rates reduce the distorting effects of the tax system and minimize excess burdens.
The only tax that has no excess burden is the lump-sum tax, where the tax you pay does not
depend on your behavior or your income or your wealth. Everyone pays the same amount; there is noway to avoid the tax. In 1990, the government of Prime Minister Margaret Thatcher of Great Britainreplaced the local property tax with a tax that was very similar to a lump-sum tax. Such a tax is highlyregressive, and the perceived unfairness of it led her successor, John Major, to call for its repeal in 1991.
Measuring Excess Burdens
It is possible to measure the size of excess burdens if we know something about how peoplerespond to price changes. Look at the demand curve in Figure 19.7. The product originally soldfor a price, P
0, equal to marginal cost (which, for simplicity, we assume is constant). Recall that
when input prices are determined in competitive markets, marginal cost reflects the real value ofthe resources used in producing the product.$27K T echnologyPK= $2 + $1 tax = $3
PL= $2Input requirements
per unit of output XPer-unit cost of X
=K(PK)+L(PL)
Least costL
A
$26B73
47/L50296FIGURE 19.6
Imposition of a Tax on
Capital Distorts theChoice of Technology
If the industry is perfectly com-
petitive, price will be $26 per
unit of Xwhen a tax of $1 per
unit of capital is imposed. Iftechnology B is used and if weassume that total sales remainat 1,000 units, total tax collec-
tions will be 1,000 /H110034/H11003$1=
$4,000. But consumers will paya total of $26,000 for thegood—$6,000 more than before
the tax. Thus, there is an excessburden of $2,000.
404 PART III Market Imperfections and the Role of Government
T o measure the total burden of the tax, we need to recall the notion of consumer surplus
from Chapter 4. At any price, some people pay less for a product than it is worth to them. All wereveal when we buy a product is that it is worth at least the price being charged. For example, if
only 1 unit of product Xwere auctioned, someone would pay a price close to Din Figure 19.7. By
paying only P
0, that person received a “surplus” equal to ( D–P0). (For a review of consumer sur-
plus and how it is measured, see Chapters 4 and 6.)
Consider what happens when an excise tax raises the price of Xfrom P0toP1=P0+T,
where Tis the tax per unit of X. First, the government collects revenue. The amount of revenue
collected is equal to Ttimes the number of units of Xpurchased ( X1). Y ou can see that T/H11003X1
is equal to the area of rectangle P1ABP0. Second, because consumers must now pay a price of P1,
the consumer surplus generated in the market is reduced from the area of triangle DCP0to the
area of the smaller triangle DAP1. The excess burden is equal to the original (pretax) consumer
surplus minus the after-tax surplus minus the total taxes collected by the government.
In other words, the original value of consumer surplus (triangle DCP0) has been broken
up into three parts: the area of triangle DAP1that is still consumer surplus, the area of rec-
tangle P1ABP0that is tax revenue collected by the government, and the area of triangle ACB
that is lost. Thus, the area ACB is an approximate measure of the excess burden of the tax.
The total burden of the tax is the sum of the revenue collected and the excess burden: thearea of P
1ACP0.
Excess Burdens and the Degree of Distortion
The size of the excess burden that results from a decision-distorting tax depends on the degree to
which decisions change in response to that tax. In the case of an excise tax, consumer behavior isreflected in elasticity of demand. The more elastic the demand curve, the greater the distortioncaused by any given tax rate.
Figure 19.8 shows how the size of the consumer response determines the size of the
excess burden. At price P
0, the quantity demanded by consumers is X0. Now suppose that the
government imposes a tax of $ Tper unit of X. The two demand curves ( D1and D2) illustrate
two possible responses by consumers. The change in quantity demanded along D1(from X0
to X1) is greater than the change in quantity demanded along D2(from X0to X2). In other
words, the response of consumers illustrated by D1is more elastic than the response of con-
sumers along D2.
The excess burdens that would result from the tax under the two assumptions about demand
elasticity are approximately equal to the areas of the shaded triangles in Figure 19.8. As you cansee, where demand is more responsive (more elastic), the excess burden is larger.
If demand were perfectly inelastic, no distortion would occur and there would be no excess
burden. The tax would simply transfer part of the surplus being earned by consumers to thegovernment. That is why some economists favor uniform land taxes over other taxes. BecauseX0 X1CAD
B
Demand
0Excess burden/
Deadweight loss
Units of good XPrice per unit ($)P1=P0 + T
P0 = MCT/L50298FIGURE 19.7
The Excess Burden of a
Distorting Excise Tax
A tax that alters economic deci-
sions imposes a burden that
exceeds the amount of taxes col-lected. An excise tax that raisesthe price of a good above mar-
ginal cost drives some consumers
to buy less desirable substitutes,reducing consumer surplus.
CHAPTER 19 Public Finance: The Economics of Taxation 405
principle of second best The
fact that a tax distorts aneconomic decision does not
always imply that such a tax
imposes an excess burden. Ifthere are previously existingdistortions, such a tax may
actually improve efficiency.P0P1
X1 X2X0D1
D2
0
Units of good XPrice per unit ($)D2Less elastic,
smaller excess burden
D
1More elastic,
larger excess
burden
T/L50296FIGURE 19.8
The Size of the Excess
Burden of a DistortingExcise Tax Depends onthe Elasticity of Demand
The size of the excess burden
from a distorting tax dependson the degree to which deci-sions or behaviors change in
response to it.
land is in perfectly inelastic supply, a uniform tax on all land uses distorts economic decisions
less than taxes levied on other factors of production that are in variable supply.
The Principle of Second Best
Now that we have established the connection between taxes that distort decisions and excess bur-dens, we can add more complexity to our earlier discussions. Although it may seem that distort-ing taxes always creates excess burdens, this is not necessarily the case. A distorting tax issometimes desirable when other distortions already exist in the economy. This is called theprinciple of second best . At least two kinds of circumstances favor nonneutral (that is, distort-
ing) taxes: the presence of externalities and the presence of other distorting taxes.
We already examined externalities at some length in Chapter 16. If some activity by a firm
or household imposes costs on society that are not considered by decision makers, firms andhouseholds are likely to make economically inefficient choices. Pollution is the classic exampleof an externality, but there are thousands of others. An efficient allocation of resources can berestored if a tax is imposed on the externality-generating activity that is equal to the value of thedamages caused by it. Such a tax forces the decision maker to consider the full economic cost ofthe decision.
Because taxing for externalities changes decisions that would otherwise be made, it does in a
sense “distort” economic decisions. But its purpose is to force decision makers to consider realcosts that they would otherwise ignore. In the case of pollution, for example, the distortioncaused by a tax is desirable. Instead of causing an excess burden, it results in an efficiency gain.(Review Chapter 16 if this is not clear.)
A distorting tax can also improve economic welfare when other taxes are present that
already distort decisions. Suppose there were only three goods, X,Y, and Z, and a 5 percent excise
tax on Yand Z. The taxes on Yand Zdistort consumer decisions away from those goods and
toward X. Imposing a similar tax on Xreduces the distortion of the existing system of taxes.
When consumers face equal taxes on all goods, they cannot avoid the tax by changing what theybuy. The distortion caused by imposing a tax on Xcorrects for a preexisting distortion—the taxes
onYand Z.
Let’s return to the example described earlier in Figure 19.5 on p. 402 and Figure 19.6 on p. 403.
Imposing the tax of 50 percent on the use of capital generated revenues of $4,000 but imposed aburden of $6,000 on consumers. A distortion now exists. But what would happen if the governmentimposed an additional tax of 50 percent, or $1 per unit, on labor? Such a tax would push our firm
406 PART III Market Imperfections and the Role of Government
back toward the more efficient technology A. In fact, the labor tax would generate a total revenue of
$6,000, but the burden it imposes on consumers would be only $4,000. (It is a good idea for you towork these figures out yourself.)
Optimal Taxation
The idea that taxes work together to affect behavior has led tax theorists to search for optimal tax-ation systems. Knowing how people will respond to taxes would allow us to design a system thatwould minimize the overall excess burden. For example, if we know the elasticity of demand forall traded goods, we can devise an optimal system of excise taxes that are heaviest on those goodswith relatively inelastic demand and lightest on those goods with relatively elastic demands.
Of course, it is impossible to collect all the information required to implement the optimal
tax systems that have been suggested. This point brings us full circle, and we end up where westarted, with the principle of neutrality : All else equal, taxes that are neutral with respect to eco-
nomic decisions are generally preferable to taxes that distort economic decisions. Taxes that arenot neutral impose excess burdens.
THE ECONOMICS OF TAXATION
p. 389
1.Public finance is one of the major subfields of applied eco-
nomics. A major interest within this subfield is the econom-ics of taxation.
2.Taxes are ultimately paid by people. Taxes may be imposedon transactions, institutions, property, and all kinds of otherthings, but in the final analysis, taxes are paid by individualsor households.
3.The base of a tax is the measure or value upon which the tax
is levied. The rate structure of a tax determines the portion of
the base that must be paid in tax.
4.A tax whose burden is a constant proportion of income forall households is a proportional tax . A tax that exacts a higher
proportion of income from higher-income households is aprogressive tax . A tax that enacts a lower proportion of
income from higher-income households is a regressive tax .I n
the United States, income taxes are progressive and sales andexcise taxes are regressive.
5.Y our average tax rate is the total amount of tax you paydivided by your total income. Y our marginal tax rate isthe tax rate that you pay on any additional income thatyou have earned. Marginal tax rates have the most influ-e n c eo nb e h a v i o r .
6.There is much disagreement over what constitutes a fair taxsystem. One theory contends that people should bear taxburdens in proportion to the benefits that they receive fromgovernment expenditures. This is the benefits-received
principle . Another theory contends that people should bear
tax burdens in line with their ability to pay. This ability-to-pay
principle has dominated U.S. tax policy.
7.The three leading candidates for best tax base are income,
consumption, and wealth.
TAX INCIDENCE: WHO PAYS? p. 396
8.As a result of behavioral changes and market adjustments,tax burdens are often not borne by those initially responsiblefor paying them. When we speak of the incidence of a tax ,w e
are referring to the ultimate distribution of its burden.9.Taxes change behavior, and changes in behavior can affectsupply and demand in markets, causing prices to change.When prices change in input markets or in output mar-kets, some people may be made better off and some worseoff. These final changes determine the ultimate burden ofa tax.
10. Tax shifting occurs when households can alter their behavior
and do something to avoid paying a tax. In general, broad-based taxes are less likely to be shifted and more likely tostick where they are levied than partial taxes are.
11. When labor supply is more elastic, firms bear the bulk of a tax imposed on labor. When labor supply is moreinelastic, workers bear the bulk of the tax burden. Becausethe elasticity of labor supply in the United States is closeto zero, most economists conclude that most of thepayroll tax in the United States is probably borne by workers.
12. The payroll tax is regressive at top incomes for two reasons.First, in 2009, most of the tax (6.2 percent of total incomelevied on both employers and employees) did not apply towages and salaries above $106,800. The remainder of the total7.65 percent—only 1.45 percent—applied to all wage andsalary income. Second, wages and salaries fall as a percentageof total income as we move up the income scale. Those withhigher incomes earn a larger portion of their incomes fromprofits, dividends, rents, and so on, and these kinds of incomeare not subject to the payroll tax.
13. The ultimate burden of the corporate tax appears to dependon several factors. One generally accepted study shows thatthe owners of corporations, proprietorships, and partner-ships all bear the burden of the corporate tax in rough pro-portion to profits, even though it is directly levied only oncorporations, that wage effects are small, and that exciseeffects are roughly neutral. However, there is still muchdebate about whom the corporate tax “hurts.” The burden ofthe corporate tax is progressive because profits and capitalincome make up a much bigger part of the incomes of thehigh-income households.SUMMARY
CHAPTER 19 Public Finance: The Economics of Taxation 407
14. Under a reasonable set of assumptions about tax shifting,
state and local taxes seem as a group to be mildly regressive.Federal taxes, dominated by the individual income tax butincreasingly affected by the regressive payroll tax, are mildlyprogressive. The overall system is mildly progressive.
EXCESS BURDENS AND THE PRINCIPLE OF
NEUTRALITY p. 402
15. When taxes distort economic decisions, they impose burdens
that, in aggregate, exceed the revenue collected by the gov-ernment. The amount by which the burden of a tax exceedsthe revenue collected by the government is called the excess
burden . The size of excess burdens depends on the degree to
which economic decisions are changed by the tax. Theprinciple of neutrality holds that the most efficient taxes are
broad-based taxes that do not distort economic decisions.
16. The excess burden imposed by a tax is equal to the pre-taxconsumer surplus minus the after-tax consumer surplusminus the total taxes collected by the government. The moreelastic the demand curve, the greater the distortion causedby any given tax rate.
THE PRINCIPLE OF SECOND BEST p. 405
17. The principle of second best holds that a tax that distorts eco-
nomic decisions does not necessarily impose an excess bur-den. If previously existing distortions or externalities exist,such a tax may actually improve efficiency.
ability-to-pay principle, p. 393
average tax rate, p. 391
benefits-received principle, p. 393
estate, p. 396
estate tax, p. 396
excess burden, p. 402 marginal tax rate, p. 391
principle of neutrality, p. 402
principle of second best, p. 405
progressive tax, p. 390
proportional tax, p. 390
regressive tax, p. 390 sources side/uses side, p. 397
tax base, p. 389
tax incidence, p. 396
tax rate structure, p. 389
tax shifting, p. 397 REVIEW TERMS AND CONCEPTS
PROBLEMS
All problems are available on www.myeconlab.com
for people in the highest income groups. How did this debate turn
out? Did the federal system become more regressive or progressiveafter the dust settled in 2011? How serious was the gridlock?
4.A citizens’ group in the Pacific Northwest has the following
statement in its charter:
“Our goal is to ensure that large, powerful corporations pay
their fair share of taxes in this country.”
T o implement this goal, the group has recommended and
lobbied for an increase in the corporation income tax and areduction in the individual income tax. Would you support such
a petition? Explain your logic.
5.Taxes on necessities that have low demand elasticities impose
large excess burdens because consumers can’t avoid buying
them. Do you agree or disagree with that statement? Explain.
6.For each of the following statements, do you agree or dis-
agree? Why?
a.Economic theory predicts unequivocally that a payroll tax
reduction will increase the supply of labor.
b.Corporation income taxes levied on a monopolist are likely
to be regressive because the monopoly can pass on its bur-den to consumers.
c.All nonneutral taxes are undesirable.
7.In calculating total faculty compensation, the administration of
Doughnut University includes payroll taxes (Social Security taxes)
paid as a benefit to faculty. After all, those tax payments are earning
future entitlements for the faculty under Social Security. However,the American Association of University Professors has argued that,far from being a benefit, the employer’s contribution is simply atax and that its burden falls on the faculty even though it is paid bythe university. Discuss both sides of this debate.1.Suppose that in 2011, Congress passed and the president signed
a new simple income tax with a flat rate of 25 percent on all
income over $25,000 (no tax on the first $25,000). Assume that
the tax is imposed on every individual separately. For each ofthe following total income levels, calculate taxes due and com-pute the average tax rate. Plot the average tax rate on a graphwith income along the horizontal axis. Is the tax proportional,
progressive, or regressive? Explain why.
a.$25,000
b.$35,000
c.$45,000
d.$60,000
e.$80,000
f.$100,000
2.[Related to the Economics in Practice onp. 392 ]Using the tax
brackets and rates for 2009 on p. 392, compute the total tax foreach of the following income levels for a single taxpayer. In eachcase, calculate average and marginal tax rates. Assume that ineach case the taxpayer chooses the standard deduction and
qualifies for a single exemption.
a.Gross income = $30,000
b.Gross income = $50,000
c.Gross income = $100,000
d.Gross income = $190,000
3.During the debate over tax policy following the land slide victory
of the Republicans in the midterm elections in 2010, most thoughtthe Federal Government was headed for gridlock. Both the
Republicans and members of the new “T ea Party” favored tax pro-
visions primarily beneficial to high income tax payers, while theDemocrats tended to favored middle class tax cuts and increases
408 PART III Market Imperfections and the Role of Government
8.Developing countries rarely have a sophisticated income tax struc-
ture like that in the United States. The primary means of raising
revenues in many developing countries is through commoditytaxes. What problems do you see with taxing particular goods inthese countries? ( Hint: Think about elasticities of demand.)
9.Suppose a special tax was introduced that used the value of one’s
automobile as the tax base. Each person would pay taxes equal to10 percent of the value of his or her car. Would the tax be pro-portional, regressive, or progressive? What assumptions do youmake in answering this question? What distortions do you think
would appear in the economy if such a tax were introduced?
10.Y ou are given the following information on a proposed “restau-
rant meals tax” in the Republic of Olympus. Olympus collectsno other specific excise taxes, and all other government rev-
enues come from a neutral lump-sum tax. (A lump-sum tax is a
tax of a fixed sum paid by all people regardless of their circum-stances.) Assume further that the burden of the tax is fullyborne by consumers.
Now consider the following data:
/L50766Meals consumed before the tax: 12 million
/L50766Meals consumed after the tax: 10 million
/L50766Average price per meal: $15 (not including the tax)
/L50766Tax rate: 10 percent
Estimate the size of the excess burden of the tax. What is the
excess burden as a percentage of revenues collected from the tax?
11.[Related to Economics in Practice onp. 396 ]As of 2010,
Congress had not reversed the tax change of 2001 which phased
out the gift and estate tax. Do you think the gift and estate taxshould be reinstated? Why or why not? Using the key words“Federal Gift and Estate Tax” , search the Internet to find the cur-
rent status of this tax. Has the tax change now been reversed; if
so, what are the new rates? What amount of assets can be passedon to one’s children tax-free this year?
12.The graph below represents equilibrium in a competitive labor
market both before and after a payroll tax which is levied on theemployer has been implemented. Before the payroll tax, the equi-librium quantity of labor was 55 units. Supply curve S
1represents
supply as a function of what firms pay, including the tax. S0repre-
sents labor supply as a function of what workers take home.
a.What is the amount of the per-unit payroll tax?
b.What is the per-unit price of labor faced by firms immedi-
ately after the tax is levied?
c.What wage will workers receive immediately after the tax
is levied?d.What are the quantity of labor demanded and the quantity
of labor supplied immediately after the tax is levied?
e.If, after the tax is levied, the equilibrium quantity of labor
settles at 40 units, what will be the new equilibrium wage?
f.If, after the tax is levied, the equilibrium quantity of labor
settles at 40 units, what are the amounts of the workers’share of the tax burden, the firms’ share of the tax burden,and the total tax collection?
13.Assume that at a price of $5 per pound, the quantity of coffee
demanded is 20 pounds. Now assume that the governmentimposes an excise tax on coffee of $2 per pound. Draw a graphshowing demand when consumers are relatively responsive tothe tax and quantity demanded falls by 50 percent, and when
consumers are relatively nonresponsive to the tax and quantity
demanded falls by 10 percent. Calculate the amount of the excessburden of this tax for each situation and show this on the graph.
14.The market demand for product X is given by Q
d=8– 1/3 P
and the market supply for good X is given by Qs=P – 8, where
P= price per unit.
a.Draw a supply and demand graph with these curves. What
are the equilibrium price and the equilibrium quantity?
b.A per-unit excise tax is imposed on product X, and the mar-
ket supply with the tax is now given by Qs=P–12. Add this
supply curve to your graph and identify the new equilibrium
price and equilibrium quantity. What is the value of the per-unit tax? How much of this per-unit tax will be paid by con-sumers and how much will be paid by the producer? What isthe value of the excess burden of this tax? What is the value
of the tax revenue?
15.In the United States, 41 states have passed legislation to legalize
lotteries and the states use the lottery proceeds to raise revenue.
If you view the price of a lottery ticket as a tax, do you think itwould be a proportional, progressive, or regressive tax? Whatinformation would you need to definitively determine if it wasproportional, progressive, or regressive?
16.Each year around April 15, discussions heat up regarding the tax
system in the United States. A number of people are in favor ofreplacing the current federal income tax with either a flat tax or
a consumption tax. Explain whether the current federal income
tax is proportional, progressive, or regressive. Do the same for aflat tax and a consumption tax.
0 40 552428
Units of labor, LWage rate ($)S0 (as a function of workers’
take-home pay)
D (as a function of
what firms pay)16
3020S1 (as a function of
what firms pay)
Macroeconomics is part of our
everyday lives. If the macroecon-omy is doing well, jobs are easy tofind, incomes are generally rising,and profits of corporations arehigh. On the other hand, if themacroeconomy is in a slump, newjobs are scarce, incomes are notgrowing well, and profits are low.Students who entered the job mar-ket in the boom of the late 1990s inthe United States, on average, hadan easier time finding a job thandid those who entered in the reces-sion of 2008–2009. Given the large effect that the macroeconomy can have on our lives, it isimportant that we understand how it works.
We begin by discussing the differences between microeconomics and macroeconomics
that we glimpsed in Chapter 1. Microeconomics examines the functioning of individual
industries and the behavior of individual decision-making units, typically firms and house-holds. With a few assumptions about how these units behave (firms maximize profits; house-holds maximize utility), we can derive useful conclusions about how markets work and howresources are allocated.
Instead of focusing on the factors that influence the production of particular products and
the behavior of individual industries, macroeconomics focuses on the determinants of total
national output. Macroeconomics studies not household income but national income, not indi-
vidual prices but the overall price level. It does not analyze the demand for labor in the automo-
bile industry but instead total employment in the economy.
Both microeconomics and macroeconomics are concerned with the decisions of households
and firms. Microeconomics deals with individual decisions; macroeconomics deals with the sumof these individual decisions. Aggregate is used in macroeconomics to refer to sums. When we
speak of aggregate behavior , we mean the behavior of all households and firms together. We
also speak of aggregate consumption and aggregate investment, which refer to total consumptionand total investment in the economy, respectively.
Because microeconomists and macroeconomists look at the economy from different perspec-
tives, you might expect that they would reach somewhat different conclusions about the way theeconomy behaves. This is true to some extent. Microeconomists generally conclude that marketswork well. They see prices as flexible, adjusting to maintain equality between quantity supplied andquantity demanded. Macroeconomists, however, observe that important prices in the economy—for example, the wage rate (or price of labor)—often seem “sticky.” Sticky prices are prices that do
not always adjust rapidly to maintain equality between quantity supplied and quantity demanded.Microeconomists do not expect to see the quantity of apples supplied exceeding the quantity ofCHAPTER OUTLINE
40920
Macroeconomic
Concerns p. 410
Output Growth
Unemployment
Inflation and Deflation
The Components of
the Macroeconomy
p. 412
The Circular Flow Diagram
The Three Market Arenas
The Role of the
Government in theMacroeconomy
A Brief History of
Macroeconomics p. 415
The U.S. EconomySince 1970
p. 417Introduction to
MacroeconomicsPART IV CONCEPTS AND PROBLEMS IN MACROECONOMICS
microeconomics Examines
the functioning of individual
industries and the behavior of
individual decision-makingunits—firms and households.
macroeconomics Deals
with the economy as a whole.Macroeconomics focuses on
the determinants of total
national income, deals withaggregates such as aggregate
consumption and investment,
and looks at the overall level of prices instead of
individual prices.
aggregate behavior The
behavior of all households and
firms together.
sticky prices Prices that do
not always adjust rapidly to
maintain equality between
quantity supplied andquantity demanded.
410 PART IV Concepts and Problems in Macroeconomics
apples demanded because the price of apples is not sticky. On the other hand, macroeconomists—
who analyze aggregate behavior—examine periods of high unemployment, where the quantity oflabor supplied appears to exceed the quantity of labor demanded. At such times, it appears thatwage rates do not adjust fast enough to equate the quantity of labor supplied and the quantity oflabor demanded.
Macroeconomic Concerns
Three of the major concerns of macroeconomics are
/L50766Output growth
/L50766Unemployment
/L50766Inflation and deflation
Government policy makers would like to have high output growth, low unemployment, and low
inflation. We will see that these goals may conflict with one another and that an important pointin understanding macroeconomics is understanding these conflicts.
Output Growth
Instead of growing at an even rate at all times, economies tend to experience short-term ups anddowns in their performance. The technical name for these ups and downs is the business cycle .
The main measure of how an economy is doing is aggregate output , the total quantity of goods
and services produced in the economy in a given period. When less is produced (in other words,when aggregate output decreases), there are fewer goods and services to go around and the aver-age standard of living declines. When firms cut back on production, they also lay off workers,increasing the rate of unemployment.
Recessions are periods during which aggregate output declines. It has become conven-
tional to classify an economic downturn as a “recession” when aggregate output declines for twoconsecutive quarters. A prolonged and deep recession is called a depression , although econo-
mists do not agree on when a recession becomes a depression. Since the 1930s the United Stateshas experienced one depression (during the 1930s) and eight recessions: 1946, 1954, 1958,1974–1975, 1980–1982, 1990–1991, 2001, and 2008–2009. Other countries also experiencedrecessions in the twentieth century, some roughly coinciding with U.S. recessions and some not.
A typical business cycle is illustrated in Figure 20.1. Since most economies, on average, grow
over time, the business cycle in Figure 20.1 shows a positive trend—the peak (the highest point)
of a new business cycle is higher than the peak of the previous cycle. The period from a trough ,o r
bottom of the cycle, to a peak is called an expansion or a boom . During an expansion, output
and employment grow. The period from a peak to a trough is called a contraction ,recession ,o r
slump , when output and employment fall.
In judging whether an economy is expanding or contracting, note the difference between the
level of economic activity and its rate of change. If the economy has just left a trough (point Ain
Figure 20.1), it will be growing (rate of change is positive), but its level of output will still be low.If the economy has just started to decline from a peak (point B), it will be contracting (rate of
change is negative), but its level of output will still be high. In 2010 the U.S. economy wasexpanding—it had left the trough of the 2008–2009 recession—but the level of output was stilllow and many people were still out of work.
The business cycle in Figure 20.1 is symmetrical, which means that the length of an expan-
sion is the same as the length of a contraction. Most business cycles are not symmetrical, however.It is possible, for example, for the expansion phase to be longer than the contraction phase. Whencontraction comes, it may be fast and sharp, while expansion may be slow and gradual. Moreover,the economy is not nearly as regular as the business cycle in Figure 20.1 indicates. The ups anddowns in the economy tend to be erratic.
Figure 20.2 shows the actual business cycles in the United States between 1900 and 2009.
Although many business cycles have occurred in the last 110 years, each is unique. The economyis not so simple that it has regular cycles.
The periods of the Great Depression and World Wars I and II show the largest fluctuations in
Figure 20.2, although other large contractions and expansions have taken place. Note the expansionbusiness cycle The cycle of
short-term ups and downs inthe economy.
aggregate output The total
quantity of goods and services
produced in an economy in a
given period.
recession A period during
which aggregate output
declines. Conventionally, a
period in which aggregateoutput declines for two
consecutive quarters.
depression A prolonged and
deep recession.
expansion orboom The
period in the business cycle
from a trough up to a peakduring which output and
employment grow.
contraction, recession, or
slump The period in the
business cycle from a peakdown to a trough during which
output and employment fall.
CHAPTER 20 Introduction to Macroeconomics 411
in the 1960s and the five recessions since 1970. Some of the cycles have been long; some have been
very short. Note also that aggregate output actually increased between 1933 and 1937, even thoughit was still quite low in 1937. The economy did not come out of the Depression until the defensebuildup prior to the start of World War II. Note also that business cycles were more extreme beforeWorld War II than they have been since then.
Unemployment
Y ou cannot listen to the news or read a newspaper without noticing that data on the unemploy-ment rate are released each month. The unemployment rate —the percentage of the labor force
that is unemployed—is a key indicator of the economy’s health. Because the unemployment rateis usually closely related to the economy’s aggregate output, announcements of each month’s newfigure are followed with great interest by economists, politicians, and policy makers.TimeAggregate output
TroughTroughTrend
growthPeakRecession
Expansion
AB/L50296FIGURE 20.1 A Typical
Business Cycle
In this business cycle, the econ-
omy is expanding as it movesthrough point Afrom the trough
to the peak. When the economymoves from a peak down to atrough, through point B, the
economy is in recession.
1,000
30011,000
8,000
6,000
4,000
2,000
1900 1910 1920World
War IWorld
War IIKorean
War
Roaring
Twenties
The Great
DepressionVietnam
WarRecession
2001
First
oil shockSecond
oil shock
1930 1940 1950 1960 1970 1980 1990 2000 2009
Y earsAggregate output (real GDP) in billions of 2005 dollarsRecession
1974–1975Recession
1980–1982
Recession
1990–199115,000Recession
2008–2009
/L50304FIGURE 20.2 U.S. Aggregate Output (Real GDP), 1900–2009
The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output.unemployment rate The
percentage of the labor force
that is unemployed.
412 PART IV Concepts and Problems in Macroeconomics
Although macroeconomists are interested in learning why the unemployment rate has risen
or fallen in a given period, they also try to answer a more basic question: Why is there any unem-ployment at all? We do not expect to see zero unemployment. At any time, some firms may gobankrupt due to competition from rivals, bad management, or bad luck. Employees of such firmstypically are not able to find new jobs immediately, and while they are looking for work, they willbe unemployed. Also, workers entering the labor market for the first time may require a fewweeks or months to find a job.
If we base our analysis on supply and demand, we would expect conditions to change in
response to the existence of unemployed workers. Specifically, when there is unemploymentbeyond some minimum amount, there is an excess supply of workers—at the going wage rates,there are people who want to work who cannot find work. In microeconomic theory, theresponse to excess supply is a decrease in the price of the commodity in question and thereforean increase in the quantity demanded, a reduction in the quantity supplied, and the restorationof equilibrium. With the quantity supplied equal to the quantity demanded, the market clears.
The existence of unemployment seems to imply that the aggregate labor market is not in
equilibrium—that something prevents the quantity supplied and the quantity demanded fromequating. Why do labor markets not clear when other markets do, or is it that labor markets areclearing and the unemployment data are reflecting something different? This is another mainconcern of macroeconomists.
Inflation and Deflation
Inflation is an increase in the overall price level. Keeping inflation low has long been a goal of
government policy. Especially problematic are hyperinflations , or periods of very rapid increases
in the overall price level.
Most Americans are unaware of what life is like under very high inflation. In some countries
at some times, people were accustomed to prices rising by the day, by the hour, or even by theminute. During the hyperinflation in Bolivia in 1984 and 1985, the price of one egg rose from3,000 pesos to 10,000 pesos in 1 week. In 1985, three bottles of aspirin sold for the same price asa luxury car had sold for in 1982. At the same time, the problem of handling money became aburden. Banks stopped counting deposits—a $500 deposit was equivalent to about 32 millionpesos, and it just did not make sense to count a huge sack full of bills. Bolivia’s currency, printedin West Germany and England, was the country’s third biggest import in 1984, surpassed only bywheat and mining equipment.
Skyrocketing prices in Bolivia are a small part of the story. When inflation approaches rates
of 2,000 percent per year, the economy and the whole organization of a country begin to breakdown. Workers may go on strike to demand wage increases in line with the high inflation rate,and firms may find it hard to secure credit.
Hyperinflations are rare. Nonetheless, economists have devoted much effort to identifying
the costs and consequences of even moderate inflation. Does anyone gain from inflation? Wholoses? What costs does inflation impose on society? How severe are they? What causes inflation?What is the best way to stop it? These are some of the main concerns of macroeconomists.
A decrease in the overall price level is called deflation . In some periods in U.S. history and
recently in Japan, deflation has occurred over an extended period of time. The goal of policymakers is to avoid prolonged periods of deflation as well as inflation in order to pursue themacroeconomic goal of stability.
The Components of the Macroeconomy
Understanding how the macroeconomy works can be challenging because a great deal is goingon at one time. Everything seems to affect everything else. T o see the big picture, it is helpful todivide the participants in the economy into four broad groups: (1) households , (2) firms , (3) the
government , and (4) the rest of the world . Households and firms make up the private sector, the
government is the public sector, and the rest of the world is the foreign sector. These four groupsinteract in the economy in a variety of ways, many involving either receiving or paying income.inflation An increase in the
overall price level.
hyperinflation A period of
very rapid increases in theoverall price level.
deflation A decrease in the
overall price level.
CHAPTER 20 Introduction to Macroeconomics 413
The Circular Flow Diagram
A useful way of seeing the economic interactions among the four groups in the economy is a
circular flow diagram, which shows the income received and payments made by each group. A
simple circular flow diagram is pictured in Figure 20.3.
Let us walk through the circular flow step by step. Households work for firms and the gov-
ernment, and they receive wages for their work. Our diagram shows a flow of wages into house-
holds as payment for those services. Households also receive interest on corporate andgovernment bonds and dividends from firms. Many households receive other payments from thegovernment, such as Social Security benefits, veterans’ benefits, and welfare payments.Economists call these kinds of payments from the government (for which the recipients do notsupply goods, services, or labor) transfer payments . T ogether, these receipts make up the total
income received by the households.
Households spend by buying goods and services from firms and by paying taxes to the gov-
ernment. These items make up the total amount paid out by the households. The differencebetween the total receipts and the total payments of the households is the amount that the house-holds save or dissave. If households receive more than they spend, they save during the period. If
they receive less than they spend, they dissave . A household can dissave by using up some of its
previous savings or by borrowing. In the circular flow diagram, household spending is shown asa flow outof households. Saving by households is sometimes termed a “leakage” from the circu-
lar flow because it withdraws income, or current purchasing power, from the system.
Firms sell goods and services to households and the government. These sales earn revenue,
which shows up in the circular flow diagram as a flow into the firm sector. Firms pay wages, inter-
est, and dividends to households, and firms pay taxes to the government. These payments areshown flowing outof firms.
HouseholdsPurchasesofdomesticallymade
goodsandservicesbyforeigners(exports)
Firms GovernmentPurchasesofforeign-madePurchasesofgoodsandservices
TaxesPurchasesofgoods
Wages,interest,Taxes
Wages,interest,dividends,profits,andrentgoodsandservices(imports)RestoftheWorld
andservices
transferpayments/L50296FIGURE 20.3
The Circular Flow
of Payments
Households receive income from
firms and the government, pur-
chase goods and services from
firms, and pay taxes to the gov-ernment. They also purchaseforeign-made goods and services
(imports). Firms receive pay-
ments from households and thegovernment for goods and ser-vices; they pay wages, dividends,
interest, and rents to households
and taxes to the government.The government receives taxesfrom firms and households, pays
firms and households for goods
and services—including wages to government workers—andpays interest and transfers tohouseholds. Finally, people in
other countries purchase goods
and services produced domesti-cally (exports).
Note: Although not shown in this
diagram, firms and governments alsopurchase imports.circular flow A diagram
showing the income received
and payments made by each
sector of the economy.
transfer payments Cash
payments made by the
government to people who donot supply goods, services, orlabor in exchange for these
payments. They include Social
Security benefits, veterans’benefits, and welfare
payments.
414 PART IV Concepts and Problems in Macroeconomics
The government collects taxes from households and firms. The government also makes pay-
ments. It buys goods and services from firms, pays wages and interest to households, and makestransfer payments to households. If the government’s revenue is less than its payments, the gov-ernment is dissaving.
Finally, households spend some of their income on imports —goods and services produced in
the rest of the world. Similarly, people in foreign countries purchase exports —goods and services
produced by domestic firms and sold to other countries.
One lesson of the circular flow diagram is that everyone’s expenditure is someone else’s
receipt. If you buy a personal computer from Dell, you make a payment to Dell and Dell receivesrevenue. If Dell pays taxes to the government, it has made a payment and the government hasreceived revenue. Everyone’s expenditures go somewhere. It is impossible to sell something with-out there being a buyer, and it is impossible to make a payment without there being a recipient.Every transaction must have two sides.
The Three Market Arenas
Another way of looking at the ways households, firms, the government, and the rest of the worldrelate to one another is to consider the markets in which they interact. We divide the markets intothree broad arenas: (1) the goods-and-services market, (2) the labor market, and (3) the money(financial) market.
Goods-and-Services Market Households and the government purchase goods and services
from firms in the goods-and-services market . In this market, firms also purchase goods and services
from each other. For example, Levi Strauss buys denim from other firms to make its blue jeans. Inaddition, firms buy capital goods from other firms. If General Motors needs new robots on its assem-bly lines, it may buy them from another firm instead of making them. The Economics in Practice in
Chapter 1 describes how Apple, in constructing its iPod, buys parts from a number of other firms.
Firms supply to the goods-and-services market. Households, the government, and firms
demand from this market. Finally, the rest of the world buys from and sells to the goods-and-
services market. The United States imports hundreds of billions of dollars’ worth of automobiles,DVDs, oil, and other goods. In the case of Apple’s iPod, inputs come from other firms located incountries all over the world. At the same time, the United States exports hundreds of billions ofdollars’ worth of computers, airplanes, and agricultural goods.
Labor Market Interaction in the labor market takes place when firms and the government
purchase labor from households. In this market, households supply labor and firms and the gov-
ernment demand labor. In the U.S. economy, firms are the largest demanders of labor, although
the government is also a substantial employer. The total supply of labor in the economy dependson the sum of decisions made by households. Individuals must decide whether to enter the laborforce (whether to look for a job at all) and how many hours to work.
Labor is also supplied to and demanded from the rest of the world. In recent years, the labor
market has become an international market. For example, vegetable and fruit farmers in Californiawould find it very difficult to bring their product to market if it were not for the labor of migrantfarm workers from Mexico. For years, Turkey has provided Germany with “guest workers” who arewilling to take low-paying jobs that more prosperous German workers avoid. Call centers run bymajor U.S. corporations are sometimes staffed by labor in India and other developing countries.
Money Market In the money market —sometimes called the financial market —households
purchase stocks and bonds from firms. Households supply funds to this market in the expectation
of earning income in the form of dividends on stocks and interest on bonds. Households alsodemand (borrow) funds from this market to finance various purchases. Firms borrow to build
new facilities in the hope of earning more in the future. The government borrows by issuingbonds. The rest of the world borrows from and lends to the money market. Every morning thereare reports on TV and radio about the Japanese and British stock markets. Much of the borrow-ing and lending of households, firms, the government, and the rest of the world are coordinatedby financial institutions—commercial banks, savings and loan associations, insurance compa-nies, and the like. These institutions take deposits from one group and lend them to others.
When a firm, a household, or the government borrows to finance a purchase, it has an oblig-
ation to pay that loan back, usually at some specified time in the future. Most loans also involve
CHAPTER 20 Introduction to Macroeconomics 415
payment of interest as a fee for the use of the borrowed funds. When a loan is made, the borrower
usually signs a “promise to repay,” or promissory note , and gives it to the lender. When the federal
government borrows, it issues “promises” called Treasury bonds ,notes ,o r bills in exchange for
money. Firms can borrow by issuing corporate bonds .
Instead of issuing bonds to raise funds, firms can also issue shares of stock. A share of stock
is a financial instrument that gives the holder a share in the firm’s ownership and therefore theright to share in the firm’s profits. If the firm does well, the value of the stock increases and thestockholder receives a capital gain
1on the initial purchase. In addition, the stock may pay
dividends —that is, the firm may return some of its profits directly to its stockholders instead of
retaining the profits to buy capital. If the firm does poorly, so does the stockholder. The capitalvalue of the stock may fall, and dividends may not be paid.
Stocks and bonds are simply contracts, or agreements, between parties. I agree to loan you a cer-
tain amount, and you agree to repay me this amount plus something extra at some future date, or Iagree to buy part ownership in your firm, and you agree to give me a share of the firm’s future profits.
A critical variable in the money market is the interest rate . Although we sometimes talk
as if there is only one interest rate, there is never just one interest rate at any time. Instead,the interest rate on a given loan reflects the length of the loan and the perceived risk to thelender. A business that is just getting started must pay a higher rate than General Motorspays. A 30-year mortgage has a different interest rate than a 90-day loan. Nevertheless, inter-est rates tend to move up and down together, and their movement reflects general conditionsin the financial market.
The Role of the Government in the Macroeconomy
The government plays a major role in the macroeconomy, so a useful way of learning how themacroeconomy works is to consider how the government uses policy to affect the economy. Thetwo main policies are (1) fiscal policy and (2) monetary policy. Much of the study of macroeco-nomics is learning how fiscal and monetary policies work.
Fiscal policy refers to the government’s decisions about how much to tax and spend. The
federal government collects taxes from households and firms and spends those funds on goodsand services ranging from missiles to parks to Social Security payments to interstate highways.Taxes take the form of personal income taxes, Social Security taxes, and corporate profits taxes,among others. An expansionary fiscal policy is a policy in which taxes are cut and/or government
spending increases. A contractionary fiscal policy is the reverse.
Monetary policy in the United States is controlled by the Federal Reserve, the nation’s
central bank. The Fed, as it is usually called, determines the quantity of money in the economy,which in turn affects interest rates. The Fed’s decisions have important effects on the economy. Infact, the task of trying to smooth out business cycles in the United States is generally left to theFed (that is, to monetary policy). The chair of the Federal Reserve is sometimes said to be the sec-ond most powerful person in the United States after the president. As we will see later in the text,the Fed played a more active role in the 2008-2009 recession than it had in previous recessions.Fiscal policy, however, also played a very active role in the 2008-2009 recession.
A Brief History of Macroeconomics
The severe economic contraction and high unemployment of the 1930s, the decade of the Great
Depression , spurred a great deal of thinking about macroeconomic issues, especially unemployment.
Figure 20.2 earlier in the chapter shows that this period had the largest and longest aggregate outputcontraction in the twentieth century in the United States. The 1920s had been prosperous years for theU.S. economy. Virtually everyone who wanted a job could get one, incomes rose substantially, andprices were stable. Beginning in late 1929, things took a sudden turn for the worse. In 1929, 1.5 mil-lion people were unemployed. By 1933, that had increased to 13 million out of a labor force of51 million. In 1933, the United States produced about 27 percent fewer goods and servicesthan it had in 1929. In October 1929, when stock prices collapsed on Wall Street, billions of
1Acapital gain occurs whenever the value of an asset increases. If you bought a stock for $1,000 and it is now worth $1,500, you
have earned a capital gain of $500. A capital gain is “realized” when you sell the asset. Until you sell, the capital gain is accrued
but not realized .Treasury bonds, notes, and
bills Promissory notes issued
by the federal governmentwhen it borrows money.
corporate bonds Promissory
notes issued by firms when
they borrow money.
shares of stock Financial
instruments that give to the
holder a share in the firm’sownership and therefore
the right to share in the firm’s profits.
dividends The portion of a
firm’s profits that the firm pays
out each period to its
shareholders.
fiscal policy Government
policies concerning taxes and spending.
monetary policy The tools
used by the Federal Reserve
to control the quantity ofmoney, which in turn affects
interest rates.
Great Depression The period
of severe economic contractionand high unemployment that
began in 1929 and continued
throughout the 1930s.
416 PART IV Concepts and Problems in Macroeconomics
dollars of personal wealth were lost. Unemployment remained above 14 percent of the labor force
until 1940. (See the Economics in Practice , p. 417, “Macroeconomics in Literature,” for Fitzgerald’s and
Steinbeck’s take on the 1920s and 1930s.)
Before the Great Depression, economists applied microeconomic models, sometimes
referred to as “classical” or “market clearing” models, to economy-wide problems. For example,classical supply and demand analysis assumed that an excess supply of labor would drive downwages to a new equilibrium level; as a result, unemployment would not persist.
In other words, classical economists believed that recessions were self-correcting. As output
falls and the demand for labor shifts to the left, the argument went, the wage rate will decline,thereby raising the quantity of labor demanded by firms that will want to hire more workers at thenew lower wage rate. However, during the Great Depression, unemployment levels remained veryhigh for nearly 10 years. In large measure, the failure of simple classical models to explain theprolonged existence of high unemployment provided the impetus for the development of macro-economics. It is not surprising that what we now call macroeconomics was born in the 1930s.
One of the most important works in the history of economics, The General Theory of
Employment, Interest and Money , by John Maynard Keynes, was published in 1936. Building on
what was already understood about markets and their behavior, Keynes set out to construct a the-ory that would explain the confusing economic events of his time.
Much of macroeconomics has roots in Keynes’s work. According to Keynes, it is not prices
and wages that determine the level of employment, as classical models had suggested; instead, itis the level of aggregate demand for goods and services. Keynes believed that governments couldintervene in the economy and affect the level of output and employment. The government’s roleduring periods when private demand is low, Keynes argued, is to stimulate aggregate demandand, by so doing, to lift the economy out of recession. (Keynes was a larger-than-life figure, oneof the Bloomsbury group in England that included, among others, Virginia Woolf and Clive Bell.See the Economics in Practice , p. 419, “John Maynard Keynes.”)
After World War II and especially in the 1950s, Keynes’s views began to gain increasing influence
over both professional economists and government policy makers. Governments came to believethat they could intervene in their economies to attain specific employment and output goals.Theybegan to use their powers to tax and spend as well as their ability to affect interest rates and themoney supply for the explicit purpose of controlling the economy’s ups and downs. This view of gov-ernment policy became firmly established in the United States with the passage of the EmploymentAct of 1946. This act established the President’s Council of Economic Advisers, a group of econo-mists who advise the president on economic issues. The act also committed the federal governmentto intervening in the economy to prevent large declines in output and employment.
The notion that the government could and should act to stabilize the macroeconomy
reached the height of its popularity in the 1960s. During these years, Walter Heller, the chairmanof the Council of Economic Advisers under both President Kennedy and President Johnson,alluded to fine-tuning as the government’s role in regulating inflation and unemployment.
During the 1960s, many economists believed the government could use the tools available tomanipulate unemployment and inflation levels fairly precisely.
In the 1970s and early 1980s, the U.S. economy had wide fluctuations in employment, out-
put, and inflation. In 1974–1975 and again in 1980–1982, the United States experienced a severerecession. Although not as catastrophic as the Great Depression of the 1930s, these two recessionsleft millions without jobs and resulted in billions of dollars of lost output and income. In1974–1975 and again in 1979–1981, the United States also saw very high rates of inflation.
The 1970s was thus a period of stagnation and high inflation, which came to be called
stagflation. Stagflation is defined as a situation in which there is high inflation at the same time
there are slow or negative output growth and high unemployment. Until the 1970s, high inflationhad been observed only in periods when the economy was prospering and unemployment waslow. The problem of stagflation was vexing both for macroeconomic theorists and policy makersconcerned with the health of the economy.
It was clear by 1975 that the macroeconomy was more difficult to control than Heller’s words
or textbook theory had led economists to believe. The events of the 1970s and early 1980s had animportant influence on macroeconomic theory. Much of the faith in the simple Keynesian model
fine-tuning The phrase used
by Walter Heller to refer to thegovernment’s role in regulating
inflation and unemployment.
stagflation A situation of
both high inflation and high
unemployment.
CHAPTER 20 Introduction to Macroeconomics 417
ECONOMICS IN PRACTICE
Macroeconomics in Literature
As you know, the language of economics includes a heavy dose of
graphs and equations. But the underlying phenomena that econo-mists study are the stuff of novels as well as graphs and equations.The following two passages, from The Great Gatsby by F. Scott
Fitzgerald and The Grapes of Wrath by John Steinbeck, capture in
graphic, although not graphical, form the economic growth andspending of the Roaring Twenties and the human side of the unem-ployment of the Great Depression.
The Great Gatsby , written in 1925, is set in the 1920s, while The
Grapes of Wrath , written in 1939, is set in the early 1930s. If you look
at Figure 20.2 for these two periods, you will see the translation ofFitzgerald and Steinbeck into macroeconomics.
From The Great Gatsby
At least once a
fortnight a corpsof caterers camedown with sev-
eral hundred feet
of canvas andenough coloredlights to make a Christmas tree
of Gatsby’s enor-
mous garden.On buffet tables,garnished with
glistening hors d’œuvre, spiced baked hams crowded
against salads of harlequin designs and pastry pigs andturkeys bewitched to a dark gold. In the main hall a barwith a real brass rail was set up, and stocked with gins and liquors and with cordials so long forgotten that
most of his female guests were too young to know one
from another.By seven o’clock the orchestra has arrived—no thin five
piece affair but a whole pit full of oboes and trombones and
saxophones and viols and cornets and piccolos and low andhigh drums. The last swimmers have come in from the beach
now and are dressing upstairs; the cars from New York are
parked five deep in the drive, and already the halls and salonsand verandas are gaudy with primary colors and hair shorn instrange new ways and shawls beyond the dreams of Castile.
From The Grapes of Wrath
The moving,
questing peoplewere migrantsnow. Thosefamilies who
had lived on a
little piece ofland, who hadlived and diedon forty acres,
had eaten or
starved on theproduce of fortyacres, had now the whole West to rove in. And they scam-
pered about, looking for work; and the highways were
streams of people, and the ditch banks were lines of people.Behind them more were coming. The great highwaysstreamed with moving people.
Source: From The Grapes of Wrath by John Steinbeck, copyright 1939,
renewed © 1967 by John Steinbeck. Used by permission of Viking Penguin,a division of Penguin Group (USA) Inc. and Penguin Group (UK) Ltd.
and the “conventional wisdom” of the 1960s was lost. Although we are now 40 years past the
1970s, the discipline of macroeconomics is still in flux and there is no agreed-upon view of howthe macroeconomy works. Many important issues have yet to be resolved. This makes macroeco-nomics hard to teach but exciting to study.
The U.S Economy Since 1970
In the following chapters, it will be useful to have a picture of how the U.S. economy has per-formed in recent history. Since 1970, the U.S. economy has experienced five recessions and twoperiods of high inflation. The period since 1970 is illustrated in Figures 20.4, 20.5, and 20.6.These figures are based on quarterly data (that is, data for each quarter of the year). The firstquarter consists of January, February, and March; the second quarter consists of April, May, andJune; and so on. The Roman numerals I, II, III, and IV denote the four quarters. For example,1972 III refers to the third quarter of 1972.
418 PART IV Concepts and Problems in Macroeconomics
—Recessionary period
(1980 II–1982 IV)—Recessionary
period
(1974 I–
1975 I)
Recessionary period—
(1990 III–1991 I)Recessionary period—
(2001 I–2001 III)Recessionary period—
(2008 I–2009 II)
1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I4,0006,0008,00010,000
5,0007,0009,00011,00012,00013,00014,000
QuartersAggregate output (real GDP) in billions of 2005 dollars2010 I
/L50304FIGURE 20.4 Aggregate Output (Real GDP), 1970 I–2010 I
Aggregate output in the United States since 1970 has risen overall, but there have been five recessionary peri-
ods: 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II.
Figure 20.4 plots aggregate output for 1970 I–2010 I. The five recessionary periods are
1974 I–1975 I, 1980 II–1982 IV , 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II.2These
five periods are shaded in the figure. Figure 20.5 plots the unemployment rate for the same over-all period with the same shading for the recessionary periods. Note that unemployment rose inall five recessions. In the 1974–1975 recession, the unemployment rate reached a maximum of8.8 percent in the second quarter of 1975. During the 1980–1982 recession, it reached a maxi-mum of 10.7 percent in the fourth quarter of 1982. The unemployment rate continued to riseafter the 1990–1991 recession and reached a peak of 7.6 percent in the third quarter of 1992. Inthe 2008-2009 recession it reached a peak of 10.0 percent in the fourth quarter of 2009.
2Regarding the 1980 II–1982 IV period, output rose in 1980 IV and 1981 I before falling again in 1981 II.Given this fact, one
possibility would be to treat the 1980 II–1982 IV period as if it included two separate recessionary periods: 1980 II–1980 IIIand 1981 I–1982 IV . Because the expansion was so short-lived, however, we have chosen not to separate the period into twoparts. These periods are close to but are not exactly the recessionary periods defined by the National Bureau of EconomicResearch (NBER). The NBER is considered the “official” decider of recessionary periods. One problem with the NBER defini-tions is that they are never revised, but the macro data are, sometimes by large amounts. This means that the NBER periodsare not always those that would be chosen using the latest revised data. In November 2008 the NBER declared that a recessionbegan in December 2007. In September 2010 it declared that the recession ended in June 2009.Unemployment rate (percentage points)11.0
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0—Recessionary period
(1980 II–1982 IV)—Recessionary
period
(1974 I–
1975 I)
Recessionary period—
(1990 III–1991 I)
Quarters1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 IRecessionary period—
(2001 I–2001 III)Recessionary period—
(2008 I–2009 II)
2010 I
/L50304FIGURE 20.5 Unemployment Rate, 1970 I–2010 I
The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show
increases in the unemployment rate.
ECONOMICS IN PRACTICE
John Maynard Keynes
By 1933 the nation was virtually prostrate. On street corners,
in homes, in Hoovervilles (communities of makeshift shacks),
14 million unemployed sat, haunting the land….
It was the unemployment that was hardest to bear. The
jobless millions were like an embolism in the nation’s vitalcirculation; and while their indisputable existence arguedmore forcibly than any text that something was wrong with
the system, the economists wrung their hands and racked
their brains… but could offer neither diagnosis nor remedy.Unemployment—this kind of unemployment—was simplynot listed among the possible ills of the system: it wasabsurd, impossible, unreasonable, and paradoxical. But it
was there.
It would seem logical that the man who would seek to
solve this impossible paradox of not enough productionexisting side by side with men fruitlessly seeking work wouldbe a Left-winger, an economist with strong sympathies for
the proletariat, an angry man. Nothing could be further from
the fact. The man who tackled it was almost a dilettantewith nothing like a chip on his shoulder. The simple truthwas that his talents inclined in every direction. He had, forexample, written a most recondite book on mathematical
probability, a book that Bertrand Russell had declared
“impossible to praise too highly”; then he had gone on tomatch his skill in abstruse logic with a flair for makingmoney—he accumulated a fortune of £500,000 by way of
the most treacherous of all roads to riches: dealing in inter-
national currencies and commodities. More impressive yet,he had written his mathematics treatise on the side, as itwere, while engaged in Government service, and he piledup his private wealth by applying himself for only half an
hour a day while still abed.
But this is only a sample of his many-sidedness. He was an
economist, of course—a Cambridge don with all the dignityand erudition that go with such an appointment…. He man-aged to be simultaneously the darling of the Bloomsbury set,
the cluster of Britain’s most avant-garde intellectual brilliants,
and also the chairman of a life insurance company, a niche inlife rarely noted for its intellectual abandon. He was a pillar ofstability in delicate matters of
international diplomacy, buthis official correctness didnot prevent him from acquir-ing a knowledge of otherEuropean politicians thatincluded their… neuroses andfinancial prejudices…. He rana theater, and he came to bea Director of the Bank of
England. He knew Roosevelt
and Churchill and alsoBernard Shaw and PabloPicasso….
His name was John
Maynard Keynes, an old
British name (pronounced to rhyme with “rains”) that could betraced back to one William de Cahagnes and 1066. Keyneswas a traditionalist; he liked to think that greatness ran in fam-ilies, and it is true that his own father was John Neville Keynes,
an illustrious enough economist in his own right. But it took
more than the ordinary gifts of heritage to account for the son;it was as if the talents that would have sufficed half a dozenmen were by happy accident crowded into one person.
By a coincidence he was born in 1883, in the very year
that Karl Marx passed away. But the two economists who
thus touched each other in time, although each was toexert the profoundest influence on the philosophy of thecapitalist system, could hardly have differed from one
another more. Marx was bitter, at bay, heavy and disap-pointed; as we know, he was the draftsman of Capitalism
Doomed. Keynes loved life and sailed through it buoyant, atease, and consummately successful to become the archi-tect of Capitalism Viable.
Source: Reprinted with the permission of Simon & Schuster, Inc., from The
Worldly Philosophers 7thEdition by Robert L. Heilbroner. Copyright © 1953,
1961, 1967, 1972, 1980, 1986, 1999 by Robert L. Heilbroner. Copyright © 1953,1961, 1967, 1972, 1980, 1986, 1999 by Robert L. Heilbroner. All rights reserved.CHAPTER 20 Introduction to Macroeconomics419
Much of the framework of modern macroeconomics comes from
the works of John Maynard Keynes, whose General Theory of
Employment, Interest and Money was published in 1936. The following excerpt by Robert L. Heilbroner provides some insights
into Keynes’s life and work.
Figure 20.6 plots the inflation rate for 1970 I–2010 I. The two high inflation periods are
1973 IV–1975 IV and 1979 I–1981 IV , which are shaded. In the first high inflation period, theinflation rate peaked at 11.1 percent in the first quarter of 1975. In the second high inflationperiod, inflation peaked at 10.2 percent in the first quarter of 1981. Since 1983, the inflationrate has been quite low by the standards of the 1970s. Since 1994, it has been between about 1 and 3 percent.
420 PART IV Concepts and Problems in Macroeconomics
SUMMARY
1.Microeconomics examines the functioning of individual
industries and the behavior of individual decision-making units. Macroeconomics is concerned with the
sum, or aggregate, of these individual decisions—
the consumption of allhouseholds in the economy, the
amount of labor supplied and demanded by allindividu-
als and firms, and the total amount of allgoods and ser-
vices produced.
MACROECONOMIC CONCERNS p. 410
2.The three topics of primary concern to macroeconomistsare the growth rate of aggregate output; the level ofunemployment; and increases in the overall price level,orinflation .
THE COMPONENTS OF THE MACROECONOMY p. 412
3.The circular flow diagram shows the flow of income
received and payments made by the four groups in theeconomy—households, firms, the government, and the rest of the world. Everybody’s expenditure is someone else’s receipt—every transaction must have
two sides.4.Another way of looking at how households, firms, the gov-
ernment, and the rest of the world relate is to consider themarkets in which they interact: the goods-and-services market,labor market, and money (financial) market.
5.Among the tools that the government has available for influencing the macroeconomy are fiscal policy (deci-
sions on taxes and government spending) and monetary
policy (control of the money supply, which affects
interest rates).
A BRIEF HISTORY OF MACROECONOMICS p. 415
6.Macroeconomics was born out of the effort to explain the
Great Depression of the 1930s. Since that time, the disci-
pline has evolved, concerning itself with new issues as theproblems facing the economy have changed. Through thelate 1960s, it was believed that the government could
“fine-tune” the economy to keep it running on an even
keel at all times. The poor economic performance ofthe 1970s, however, showed that fine-tuning does not
always work.
THE U.S. ECONOMY SINCE 1970 p. 417
7.Since 1970, the U.S. economy has seen five recessions and two
periods of high inflation.1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 IHigh
inflation
period
(1973 IV
–1975 IV)High
inflation
period
(1979 I–
1981 IV)––Inflation rate (percentage change in the
GDP deflator, four-quarter average)
01.02.03.04.05.06.07.08.09.010.011.012.0
Quarters––
2010 I
/L50304FIGURE 20.6 Inflation Rate (Percentage Change in the GDP Deflator,
Four-Quarter Average), 1970 I–2010 I
Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between
1983 and 1992 was moderate. Since 1992, it has been fairly low.
In the following chapters, we will explain the behavior of and the connections among vari-
ables such as output, unemployment, and inflation. When you understand the forces at work increating the movements shown in Figures 20.4, 20.5, and 20.6, you will have come a long way inunderstanding how the macroeconomy works.
CHAPTER 20 Introduction to Macroeconomics 421
REVIEW TERMS AND CONCEPTS
aggregate behavior, p.409
aggregate output, p. 410
business cycle, p. 410
circular flow, p. 413
contraction, recession, orslump, p. 410
corporate bonds, p. 415
deflation, p. 412
depression, p. 410
dividends, p. 415expansion orboom, p. 410
fine-tuning, p. 416
fiscal policy, p. 415
Great Depression, p. 415
hyperinflation, p. 412
inflation, p. 412
macroeconomics, p. 409
microeconomics, p. 409 monetary policy, p. 415
recession, p. 410
shares of stock, p. 415
stagflation, p. 416
sticky prices, p. 409
transfer payments, p. 413
Treasury bonds, notes, andbills, p. 415
unemployment rate, p. 411
PROBLEMS
All problems are available on www.myeconlab.com
1.Define inflation. Assume that you live in a simple economy in
which only three goods are produced and traded: fish, fruit, and
meat. Suppose that on January 1, 2010, fish sold for $2.50 per
pound, meat was $3.00 per pound, and fruit was $1.50 per pound.At the end of the year, you discover that the catch was low and thatfish prices had increased to $5.00 per pound, but fruit pricesstayed at $1.50 and meat prices had actually fallen to $2.00. Can
you say what happened to the overall “price level”? How might you
construct a measure of the “change in the price level”? What addi-tional information might you need to construct your measure?
2.Define unemployment . Should everyone who does not hold a
job be considered “unemployed”? T o help with your answer,draw a supply and demand diagram depicting the labor market.What is measured along the demand curve? What factors deter-
mine the quantity of labor demanded during a given period?
What is measured along the labor supply curve? What factorsdetermine the quantity of labor supplied by households duringa given period? What is the opportunity cost of holding a job?
3.[Related to the Economics in Practice onp. 417 ]TheEconomics
in Practice describes prosperity and recession as they are depicted in
literature. In mid-2009, there was a debate about whether the U.S.economy had entered an economic expansion. Look at the data on
real GDP growth and unemployment and describe the pattern
since 2007. Y ou can find raw data on employment and unemploy-ment at www.bls.gov, and you can find raw data on real GDPgrowth at www.bea.gov. (In both cases, use the data described in
“Current Releases.”) Summarize what happened in mid-2009. Did
the United States enter an economic expansion? Explain.
4.A recession occurred in the U.S. economy during the first three
quarters of 2001. National output of goods and services fell dur-
ing this period. But during the fourth quarter of 2001, outputbegan to increase and it increased at a slow rate through the firstquarter of 2003. At the same time, between March 2001 andApril 2003, employment declined almost continuously with a
loss of over 2 million jobs. How is it possible that output rises
while at the same time employment is falling?
5.Describe the economy of your state. What is the most recently
reported unemployment rate? How has the number of payroll
jobs changed over the last 3 months and over the last year? Howdoes your state’s performance compare to the U.S. economy’sperformance over the last year? What explanations have beenoffered in the press? How accurate are they?6.Explain briefly how macroeconomics is different from microeco-
nomics. How can macroeconomists use microeconomic theoryto guide them in their work, and why might they want to do so?
7.During 1993 when the economy was growing very slowly,
President Clinton recommended a series of spending cuts andtax increases designed to reduce the deficit. These were passedby Congress in the Omnibus Budget Reconciliation Act of 1993.
Some who opposed the bill argue that the United States was
pursuing a “contractionary fiscal policy” at precisely the wrongtime. Explain their logic.
8.Many of the expansionary periods during the twentieth century
occurred during wars. Why do you think this is true?
9.In the 1940s, you could buy a soda for 5 cents, eat dinner at a
restaurant for less than $1, and purchase a house for $10,000.
From this statement, it follows that consumers today are worseoff than consumers in the 1940s. Comment.
10.[Related to Economics in Practice onp. 419 ]John Maynard
Keynes was the first to show that government policy could be usedto change aggregate output and prevent recessions by stabilizingthe economy. Describe the economy of the world at the timeKeynes was writing. Describe the economy of the United States
today. What measures were being proposed by the Presidential
candidates in the election of 2008 to prevent or end a recession in2008-2009? Where the actions taken appropriate from the stand-point of John Maynard Keynes? Did they have the desired effect?
11.In which of the three market arenas is each of the following
goods traded?a.U.S. Treasury Bonds
b.An Amazon Kindle
c.A Harley-Davidson Softail motorcycle
d.The business knowledge of Dallas Mavericks’ owner
Mark Cuban
e.Shares of Google stock
f.The crop-harvesting abilities of an orange picker in Florida
12.Assume that the demand for autoworkers declines significantly
due to a decrease in demand for new automobiles. Explain whatwill happen to unemployment using both classical and
Keynesian reasoning.
13.Explain why the length and severity of the Great Depression
necessitated a fundamental rethinking of the operations of themacroeconomy.
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CHAPTER OUTLINE
42321
Gross Domestic
Product p. 423
Final Goods and Services
Exclusion of Used Goods
and Paper Transactions
Exclusion of Output
Produced Abroad byDomestically OwnedFactors of Production
Calculating GDP p. 425
The Expenditure Approach
The Income Approach
Nominal versus Real
GDP p. 432
Calculating Real GDP
Calculating the GDP
Deflator
The Problems of Fixed
Weights
Limitations of the
GDP Concept p. 435
GDP and Social Welfare
The Underground
Economy
Gross National Income
per Capita
Looking Ahead p. 437Measuring National
Output and National
Income
We saw in the last chapter that three
main concerns of macroeconomicsare aggregate output, unemploy-ment, and inflation. In this chapter,we discuss the measurement ofaggregate output and inflation. Inthe next chapter, we discuss themeasurement of unemployment.Accurate measures of these vari-ables are critical for understandingthe economy. Without good mea-sures, economists would have ahard time analyzing how the econ-omy works and policy makerswould have little to guide them on which policies are best for the economy.
Much of the macroeconomic data are from the national income and product accounts ,
which are compiled by the Bureau of Economic Analysis (BEA) of the U.S. Department ofCommerce. It is hard to overestimate the importance of these accounts. They are, in fact, one ofthe great inventions of the twentieth century. (See the Economics in Practice , p. 431.) They not
only convey data about the performance of the economy but also provide a conceptual frame-work that macroeconomists use to think about how the pieces of the economy fit together. Wheneconomists think about the macroeconomy, the categories and vocabulary they use come fromthe national income and product accounts.
The national income and product accounts can be compared with the mechanical or wiring
diagrams for an automobile engine. The diagrams do not explain how an engine works, but theyidentify the key parts of an engine and show how they are connected. Trying to understand themacroeconomy without understanding national income accounting is like trying to fix an enginewithout a mechanical diagram and with no names for the engine parts.
There are literally thousands of variables in the national income and product accounts. In
this chapter, we discuss only the most important. This chapter is meant to convey the way thenational income and product accounts represent or organize the economy and the sizes of the
various pieces of the economy.
Gross Domestic Product
The key concept in the national income and product accounts is gross domestic product (GDP) .
gross domestic product
(GDP) The total market
value of all final goods andservices produced within a
given period by factors of
production located within a country.GDP is the total market value of a country’s output. It is the market value of all final goods
and services produced within a given period of time by factors of production locatedwithin a country.
U.S. GDP for 2009—the value of all output produced by factors of production in the United
States in 2009—was $14,256.3 billion.national income and product
accounts Data collected
and published by the
government describing the
various components ofnational income and output
in the economy.
424 PART IV Concepts and Problems in Macroeconomics
final goods and services
Goods and services producedfor final use.
intermediate goods Goods
that are produced by one firmfor use in further processing byanother firm.
value added The difference
between the value of goods
as they leave a stage ofproduction and the cost of
the goods as they enteredthat stage.
In calculating GDP , we can sum up the value added at each stage of production or we can
take the value of final sales. We do not use the value of total sales in an economy to measurehow much output has been produced.
Exclusion of Used Goods and Paper Transactions
GDP is concerned only with new, or current, production. Old output is not counted in currentGDP because it was already counted when it was produced. It would be double counting to countsales of used goods in current GDP . If someone sells a used car to you, the transaction is notcounted in GDP because no new production has taken place. Similarly, a house is counted inGDP only at the time it is built, not each time it is resold. In short:
GDP does not count transactions in which money or goods changes hands but in which nonew goods and services are produced.GDP is a critical concept. Just as an individual firm needs to evaluate the success or failure of
its operations each year, so the economy as a whole needs to assess itself. GDP , as a measure of thetotal production of an economy, provides us with a country’s economic report card. BecauseGDP is so important, we need to take time to explain exactly what its definition means.
Final Goods and Services
First, note that the definition refers to final goods and services . Many goods produced in the
economy are not classified as final goods, but instead as intermediate goods. Intermediate goods
are produced by one firm for use in further processing by another firm. For example, tires sold toautomobile manufacturers are intermediate goods. The parts that go in Apple’s iPod are alsointermediate goods. The value of intermediate goods is not counted in GDP .
Why are intermediate goods not counted in GDP? Suppose that in producing a car, General
Motors (GM) pays $200 to Goodyear for tires. GM uses these tires (among other components) toassemble a car, which it sells for $24,000. The value of the car (including its tires) is $24,000, not$24,000 + $200. The final price of the car already reflects the value of all its components. T o countin GDP both the value of the tires sold to the automobile manufacturers and the value of theautomobiles sold to the consumers would result in double counting.
Double counting can also be avoided by counting only the value added to a product by each
firm in its production process. The value added during some stage of production is the difference
between the value of goods as they leave that stage of production and the cost of the goods as theyentered that stage. Value added is illustrated in Table 21.1. The four stages of the production of agallon of gasoline are: (1) oil drilling, (2) refining, (3) shipping, and (4) retail sale. In the first stage,value added is the value of the crude oil. In the second stage, the refiner purchases the oil from thedriller, refines it into gasoline, and sells it to the shipper. The refiner pays the driller $3.00 per gallonand charges the shipper $3.30. The value added by the refiner is thus $0.30 per gallon. The shipperthen sells the gasoline to retailers for $3.60. The value added in the third stage of production is$0.30. Finally, the retailer sells the gasoline to consumers for $4.00. The value added at the fourthstage is $0.40; and the total value added in the production process is $4.00, the same as the value ofsales at the retail level. Adding the total values of sales at each stage of production ($3.00 + $3.30 +$3.60 + $4.00 = $13.90) would significantly overestimate the value of the gallon of gasoline.
TABLE 21.1 Value Added in the Production of a Gallon of
Gasoline (Hypothetical Numbers)
Stage of Production Value of Sales Value Added
(1) Oil drilling $3.00 $3.00
(2) Refining 3.30 0.30
(3) Shipping 3.60 0.30
(4) Retail sale 4.00 0.40
Total value added $4.00
CHAPTER 21 Measuring National Output and National Income 425
Sales of stocks and bonds are not counted in GDP . These exchanges are transfers of owner-
ship of assets, either electronically or through paper exchanges, and do not correspond to currentproduction. However, what if you sell the stock or bond for more than you originally paid for it?Profits from the stock or bond market have nothing to do with current production, so they arenot counted in GDP . However, if you pay a fee to a broker for selling a stock of yours to someoneelse, this fee is counted in GDP because the broker is performing a service for you. This service ispart of current production. Be careful to distinguish between exchanges of stocks and bonds formoney (or for other stocks and bonds), which do not involve current production, and fees forperforming such exchanges, which do.
Exclusion of Output Produced Abroad by Domestically
Owned Factors of Production
GDP is the value of output produced by factors of production located within a country .
The three basic factors of production are land, labor, and capital. The labor of U.S. citizens counts
as a domestically owned factor of production for the United States. The output produced by U.S. citi-zens abroad—for example, U.S. citizens working for a foreign company—is notcounted in U.S. GDP
because the output is not produced within the United States. Likewise, profits earned abroad by U.S.companies are not counted in U.S. GDP . However, the output produced by foreigners working in theUnited States is counted in U.S. GDP because the output is produced within the United States. Also,profits earned in the United States by foreign-owned companies are counted in U.S. GDP .
It is sometimes useful to have a measure of the output produced by factors of production
owned by a country’s citizens regardless of where the output is produced. This measure is calledgross national product (GNP) . For most countries, including the United States, the difference
between GDP and GNP is small. In 2009, GNP for the United States was $14,361.2 billion, whichis close to the $14,256.3 billion value for U.S. GDP .
The distinction between GDP and GNP can be tricky. Consider the Honda plant in
Marysville, Ohio. The plant is owned by the Honda Corporation, a Japanese firm, but most of theworkers employed at the plant are U.S. workers. Although all the output of the plant is includedin U.S. GDP , only part of it is included in U.S. GNP . The wages paid to U.S. workers are part ofU.S. GNP , while the profits from the plant are not. The profits from the plant are counted inJapanese GNP because this is output produced by Japanese-owned factors of production(Japanese capital in this case). The profits, however, are not counted in Japanese GDP becausethey were not earned in Japan.
Calculating GDP
GDP can be computed two ways. One way is to add up the total amount spent on all finalgoods and services during a given period. This is the expenditure approach to calculating
GDP . The other way is to add up the income—wages, rents, interest, and profits—received byall factors of production in producing final goods and services. This is the income approach to
calculating GDP . These two methods lead to the same value for GDP for the reason we dis-cussed in the previous chapter: Every payment (expenditure) by a buyer is at the same time a
receipt (income) for the seller . We can measure either income received or expenditures made,
and we will end up with the same total output.
Suppose the economy is made up of just one firm and the firm’s total output this year sells for
$1 million. Because the total amount spent on output this year is $1 million, this year’s GDP is $1 mil-lion. (Remember: The expenditure approach calculates GDP on the basis of the total amount spent onfinal goods and services in the economy.) However, every one of the million dollars of GDP either is
paid to someone or remains with the owners of the firm as profit. Using the income approach, we addup the wages paid to employees of the firm, the interest paid to those who lent money to the firm, andthe rents paid to those who leased land, buildings, or equipment to the firm. What is left over is profit,which is, of course, income to the owners of the firm. If we add up the incomes of all the factors of pro-duction, including profits to the owners, we get a GDP of $1 million.gross national product
(GNP) The total market
value of all final goods and
services produced within agiven period by factors of
production owned by a
country’s citizens, regardless ofwhere the output is produced.
expenditure approach
A method of computing GDP
that measures the total
amount spent on all finalgoods and services during a
given period.
income approach A method
of computing GDP that
measures the income—wages,
rents, interest, and profits—received by all factors ofproduction in producing final
goods and services.
426 PART IV Concepts and Problems in Macroeconomics
The Expenditure Approach
Recall from the previous chapter the four main groups in the economy: households, firms, the
government, and the rest of the world. There are also four main categories of expenditure:
/L50766Personal consumption expenditures ( C): household spending on consumer goods
/L50766Gross private domestic investment ( I): spending by firms and households on new capital,
that is, plant, equipment, inventory, and new residential structures
/L50766Government consumption and gross investment ( G)
/L50766Net exports ( EX-IM): net spending by the rest of the world, or exports ( EX) minus
imports ( IM)
The expenditure approach calculates GDP by adding together these four components of
spending. It is shown here in equation form:
GDP = C+I+G+ (EX-IM)
U.S. GDP was $14,256.3 billion in 2009. The four components of the expenditure approach
are shown in Table 21.2, along with their various categories.
TABLE 21.2 Components of U.S. GDP, 2009: The Expenditure Approach
Billions of Dollars Percentage of GDP
Personal consumption expenditures (C) 10,089.1 70.8
Durable goods 1,035.0 7.3
Nondurable goods 2,220.2 15.6
Services 6,833.9 47.9
Gross private domestic investment (I) 1,628.8 11.4
Nonresidential 1,388.8 9.7
Residential 361.0 2.5
Change in business inventories -120.9 -0.8
Government consumption and gross investment (G) 2,930.7 20.5
Federal 1,144.8 8.0
State and local 1,786.9 12.5
Net exports ( EX-IM) -392.4 -2.8
Exports ( EX) 1,564.2 11.0
Imports ( IM) 1,956.6 13.7
Gross domestic product 14,256.3 100.0
Note: Numbers may not add exactly because of rounding.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Personal Consumption Expenditures ( C)The largest part of GDP consists of
personal consumption expenditures ( C). Table 21.2 shows that in 2009, the amount of personal
consumption expenditures accounted for 70.8 percent of GDP . These are expenditures by con-sumers on goods and services.
There are three main categories of consumer expenditures: durable goods, nondurable
goods, and services. Durable goods , such as automobiles, furniture, and household appliances,
last a relatively long time. Nondurable goods , such as food, clothing, gasoline, and cigarettes, are
used up fairly quickly. Payments for services —those things we buy that do not involve the pro-
duction of physical items—include expenditures for doctors, lawyers, and educational institu-tions. As Table 21.2 shows, in 2009, durable goods expenditures accounted for 7.3 percent ofGDP , nondurables for 15.6 percent, and services for 47.9 percent. Almost half of GDP is now ser-vice consumption.personal consumption
expenditures ( C)
Expenditures by consumers on
goods and services.
durable goods Goods that
last a relatively long time, such
as cars and household
appliances.
nondurable goods Goods
that are used up fairly quickly,
such as food and clothing.
services The things we buy
that do not involve theproduction of physical things,such as legal and medicalservices and education.
CHAPTER 21 Measuring National Output and National Income 427
gross private domestic
investment ( I)Total
investment in capital—that is,
the purchase of new housing,
plants, equipment, andinventory by the private (or
nongovernment) sector.
nonresidential investment
Expenditures by firms formachines, tools, plants, and
so on.
residential investment
Expenditures by households
and firms on new houses and
apartment buildings.
change in business
inventories The amount by
which firms’ inventories change
during a period. Inventories arethe goods that firms produce
now but intend to sell later.
1The distinction between what is considered investment and what is considered consumption is sometimes fairly arbitrary. A
firm’s purchase of a car or a truck is counted as investment, but a household’s purchase of a car or a truck is counted as con-sumption of durable goods. In general, expenditures by firms for items that last longer than a year are counted as investmentexpenditures. Expenditures for items that last less than a year are seen as purchases of intermediate goods.Gross Private Domestic Investment ( I)Investment , as we use the term in economics,
refers to the purchase of new capital—housing, plants, equipment, and inventory. The economicuse of the term is in contrast to its everyday use, where investment often refers to purchases of
stocks, bonds, or mutual funds.
T otal investment in capital by the private sector is called gross private domestic inv estment ( I).
Expenditures by firms for machines, tools, plants, and so on make up nonresidential
investment .
1Because these are goods that firms buy for their own final use, they are part of “final
sales” and counted in GDP . Expenditures for new houses and apartment buildings constituteresidential investment . The third component of gross private domestic investment, the change
in business inventories , is the amount by which firms’ inventories change during a period.
Business inventories can be looked at as the goods that firms produce now but intend to sell later.In 2009, gross private domestic investment accounted for 11.4 percent of GDP . Of that, 9.7 per-cent was nonresidential investment, 2.5 percent was residential investment, and –0.8 percent waschange in business inventories.
Change in Business Inventories Why is the change in business inventories considered a
component of investment—the purchase of new capital? T o run a business most firms holdinventories. Publishing firms print more books than they expect to sell instantly so that they canship them quickly once they do get orders. Inventories—goods produced for later sale—arecounted as capital because they produce value in the future. An increase in inventories is anincrease in capital.ECONOMICS IN PRACTICE
Where Does eBay Get Counted?
eBay runs an online marketplace with over 220 million regis-
tered users who buy and sell 2.4 billion items a year, rangingfrom children’s toys to oil paintings. In December 2007, oneeBay user auctioned off a 1933 Chicago World’s Fair pen-nant. The winning bid was just over $20.
eBay is traded on the New Y ork Stock Exchange, employs
hundreds of people, and has a market value of about $40 bil-lion. With regard to eBay, what do you think gets counted aspart of current GDP?
That 1933 pennant, for example, does not get counted. The
production of that pennant was counted back in 1933. The manycartons of K’nex bricks sent from one home to another don’tcount either. Their value was counted when the bricks were firstproduced. What about a newly minted Scrabble game? One ofthe interesting features of eBay is that it has changed from beinga market in which individuals market their hand-me-downs to aplace that small and even large businesses use as a sales site. Thevalue of the new Scrabble game would be counted as part of thisyear’s GDP if it were produced this year.
So do any of eBay’s services count as part of GDP?
eBay’s business is to provide a marketplace for exchange.In doing so, it uses labor and capital and creates value. In
return for creating this value, eBay charges fees to thesellers that use its site. The value of these fees do enter intoGDP . So while the old knickknacks that people sell on eBaydo not contribute to current GDP , the cost of finding an interested buyer for those old goods does indeed get counted.
428 PART IV Concepts and Problems in Macroeconomics
Regarding GDP , remember that it is not the market value of total final sales during the
period, but rather the market value of total final production . The relationship between total pro-
duction and total sales is as follows:
GDP = Final sales + Change in business inventories
T otal production (GDP) equals final sales of domestic goods plus the change in business inventories.
In 2009, production in the United States was smaller than sales by $120.9 billion. The stock ofinventories at the end of 2009 was $120.9 billion smaller than it was at the end of 2008—the
change in business inventories was –$120.9 billion.
Gross Investment versus Net Investment During the process of production, capital (espe-
cially machinery and equipment) produced in previous periods gradually wears out. GDP doesnot give us a true picture of the real production of an economy. GDP includes newly producedcapital goods but does not take account of capital goods “consumed” in the production process.
Capital assets decline in value over time. The amount by which an asset’s value falls each
period is called its depreciation .
2A personal computer purchased by a business today may be
expected to have a useful life of 4 years before becoming worn out or obsolete. Over that period,the computer steadily depreciates.
What is the relationship between gross investment ( I) and depreciation? Gross investment
is the total value of all newly produced capital goods (plant, equipment, housing, and inven-tory) produced in a given period. It takes no account of the fact that some capital wears outand must be replaced. Net investment is equal to gross investment minus depreciation. Net
investment is a measure of how much the stock of capital changes during a period. Positive net
investment means that the amount of new capital produced exceeds the amount that wearsout, and negative net investment means that the amount of new capital produced is less thanthe amount that wears out. Therefore, if net investment is positive, the capital stock hasincreased, and if net investment is negative, the capital stock has decreased. Put another way,the capital stock at the end of a period is equal to the capital stock that existed at the beginningof the period plus net investment:depreciation The amount by
which an asset’s value falls in agiven period.
gross investment The total
value of all newly producedcapital goods (plant,
equipment, housing, and
inventory) produced in a given period.
net investment Gross
investment minus depreciation.
capitalend of period= capitalbeginning of period+ net investment
Government Consumption and Gross Investment ( G)Government
consumption and gross investment ( G)include expenditures by federal, state, and local
governments for final goods (bombs, pencils, school buildings) and services (military salaries,congressional salaries, school teachers’ salaries). Some of these expenditures are counted asgovernment consumption, and some are counted as government gross investment.Government transfer payments (Social Security benefits, veterans’ disability stipends, and soon) are not included in Gbecause these transfers are not purchases of anything currently pro-
duced. The payments are not made in exchange for any goods or services. Because interestpayments on the government debt are also counted as transfers, they are excluded from GDPon the grounds that they are not payments for current goods or services.
As Table 21.2 shows, government consumption and gross investment accounted for
$2,930.7 billion, or 20.5 percent of U.S. GDP , in 2009. Federal government consumption andgross investment accounted for 8.0 percent of GDP , and state and local government consump-tion and gross investment accounted for 12.5 percent.government consumption and
gross investment ( G)
Expenditures by federal, state,
and local governments for final
goods and services.
2This is the formal definition of economic depreciation. Because depreciation is difficult to measure precisely, accounting rules
allow firms to use shortcut methods to approximate the amount of depreciation that they incur each period. T o complicate mat-ters even more, the U.S. tax laws allow firms to deduct depreciation for tax purposes under a different set of rules.
CHAPTER 21 Measuring National Output and National Income 429
net exports ( EX–IM)The
difference between exports
(sales to foreigners of U.S.-
produced goods and services)and imports (U.S. purchases of
goods and services from
abroad). The figure can bepositive or negative.Net Exports ( EX-IM)The value of net exports ( EX-IM)is the difference between exports
(sales to foreigners of U.S.-produced goods and services) and imports (U.S. purchases of goods and
services from abroad). This figure can be positive or negative. In 2009, the United States exported lessthan it imported, so the level of net exports was negative ( -$392.4 billion). Before 1976, the United
States was generally a net exporter—exports exceeded imports, so the net export figure was positive.
The reason for including net exports in the definition of GDP is simple. Consumption, invest-
ment, and government spending ( C,I, and G, respectively) include expenditures on goods produced
at home and abroad. Therefore, C+I+Goverstates domestic production because it contains expen-
ditures on foreign-produced goods—that is, imports ( IM) ,w h i c hh a v et ob es u b t r a c t e df r o mG D P
to obtain the correct figure. At the same time, C+I+Gunderstates domestic production because
some of what a nation produces is sold abroad and therefore is not included in C,I,o rG—exports
(EX) have to be added in. If a U.S. firm produces computers and sells them in Germany, the comput-
ers are part of U.S. production and should be counted as part of U.S. GDP .
The Income Approach
We now turn to calculating GDP using the income approach, which looks at GDP in terms ofwho receives it as income rather than as who purchases it.
We begin with the concept of national income , which is defined in Table 21.3. National income
is the sum of eight income items. Compensation of employees , the largest of the eight items by far,
includes wages and salaries paid to households by firms and by the government, as well as varioussupplements to wages and salaries such as contributions that employers make to social insuranceand private pension funds. Proprietors’ income is the income of unincorporated businesses.
Rental income , a minor item, is the income received by property owners in the form of rent.
Corporate profits , the second-largest item of the eight, is the income of corporations. Net interest
is the interest paid by business. (Interest paid by households and the government is not counted inGDP because it is not assumed to flow from the production of goods and services.)
TABLE 21.3 National Income, 2009
Billions of
DollarsPercentage of
National Income
National income 12,280.0 100.0
Compensation of employees 7,783.5 63.4
Proprietors’ income 1,041.0 8.5
Rental income 268.1 2.2
Corporate profits 1,308.9 10.7
Net interest 788.2 6.4
Indirect taxes minus subsidies 964.3 7.9
Net business transfer payments 134.1 1.1
Surplus of government enterprises -8.1 -0.1
Source: See Table 21.2.
The sixth item, indirect taxes minus subsidies , includes taxes such as sales taxes, customs
duties, and license fees less subsidies that the government pays for which it receives no goods orservices in return. (Subsidies are like negative taxes.) The value of indirect taxes minus subsidiesis thus net income received by the government. Net business transfer payments are net transfer
payments by businesses to others and are thus income of others. The final item is the surplus of
government enterprises , which is the income of government enterprises. Table 21.3 shows that
this item was negative in 2009: government enterprises on net ran at a loss.
National income is the total income of the country, but it is not quite GDP . Table 21.4 shows
what is involved in going from national income to GDP . Table 21.4 first shows that in moving fromgross domestic product (GDP) to gross national product (GNP), we need to add receipts of factorincome from the rest of the world and subtract payments of factor income to the rest of the world.National income is income of the country’s citizens, not the income of the residents of the country.So we first need to move from GDP to GNP . This, as discussed earlier, is a minor adjustment.national income The total
income earned by the factorsof production owned by acountry’s citizens.
compensation of employees
Includes wages, salaries, andvarious supplements—employer
contributions to social
insurance and pension funds,for example—paid to
households by firms and by
the government.
proprietors’ income The
income of unincorporated
businesses.
rental income The income
received by property owners inthe form of rent.
corporate profits The
income of corporations.
net interest The interest paid
by business.
indirect taxes minus subsidies
Taxes such as sales taxes,customs duties, and license
fees less subsidies that the
government pays for which itreceives no goods or services in return.
net business transfer payments
Net transfer payments by
businesses to others.
surplus of government
enterprises Income of
government enterprises.
430 PART IV Concepts and Problems in Macroeconomics
TABLE 21.4 GDP, GNP, NNP, and National Income, 2009
Dollars
(Billions)
GDP 14,256.3
Plus: Receipts of factor income from the rest of the world +589.4
Less: Payments of factor income to the rest of the world -484.5
Equals: GNP 14,361.2
Less: Depreciation -1,864.0
Equals: Net national product (NNP) 12,497.2
Less: Statistical discrepancy -217.3
Equals: National income 12,280.0
Source: See Table 21.2
We then need to subtract depreciation from GNP , which is a large adjustment. GNP less depre-
ciation is called net national product (NNP) . Why is depreciation subtracted? T o see why, go back
to the example earlier in this chapter in which the economy is made up of just one firm and totaloutput (GDP) for the year is $1 million. Assume that after the firm pays wages, interest, and rent, ithas $100,000 left. Assume also that its capital stock depreciated by $40,000 during the year. Nationalincome includes corporate profits (see Table 21.3), and in calculating corporate profits, the $40,000depreciation is subtracted from the $100,000, leaving profits of $60,000. So national income doesnot include the $40,000. When we calculate GDP using the expenditure approach, depreciation isnot subtracted. We simply add consumption, investment, government spending, and net exports. Inour simple example, this is just $1 million. We thus must subtract depreciation from GDP (actuallyGNP when there is a rest-of-the-world sector) to get national income.
Table 21.4 shows that net national product and national income are the same except for a
statistical discrepancy ,a data measurement error
.If the government were completely accurate in its
data collection, the statistical discrepancy would be zero. The data collection, however, is not perfect,and the statistical discrepancy is the measurement error in each period. Table 21.4 shows that in 2009,this error was $217.3 billion, which is small compared to national income of $12,280.0 billion.
We have so far seen from Table 21.3 the various income items that make up total national
income, and we have seen from Table 21.4 how GDP and national income are related. A use-ful way to think about national income is to consider how much of it goes to households. Thetotal income of households is called personal income , and it turns out that almost all of
national income is personal income. Table 21.5 shows that of the $12,280.0 billion in nationalincome in 2009, $12,019.0 billion was personal income. Although not shown in Table 21.5,one of the differences between national income and personal income is the profits of corpora-tions not paid to households in the form of dividends, called the retained earnings of corpora-
tions. This is income that goes to corporations rather than to households, and so it is part ofnational income but not personal income.net national product (NNP)
Gross national product minus
depreciation; a nation’s total
product minus what is requiredto maintain the value of itscapital stock.
statistical discrepancy
Data measurement error.
personal income The total
income of households.
TABLE 21.5 National Income, Personal Income, Disposable
Personal Income, and Personal Saving, 2009
Dollars
(Billions)
National income 12,280.0
Less: Amount of national income not going to households -261.0
Equals: Personal income 12,019.0
Less: Personal income taxes -1,101.7
Equals: Disposable personal income 10,917.3
Less: Personal consumption expenditures -10,089.1
Personal interest payments -213.9
Transfer payments made by households -155.7
Equals: Personal saving 458.6
Personal saving as a percentage of disposable personal income: 4.2%
Source: See Table 21.2
ECONOMICS IN PRACTICE
GDP: One of the Great Inventions of the 20th Century
As the 20th century drew to a close, the U.S. Department of Commerce
embarked on a review of its achievements. At the conclusion of thisreview, the Department named the development of the national incomeand product accounts as “its achievement of the century.”
J. Steven Landefeld Director, Bureau of Economic Analysis
While the GDP and the rest of the national income accounts may
seem to be arcane concepts, they are truly among the great inven-tions of the twentieth century.
Paul A. Samuelson and William D. Nordhaus
GDP! The right concept of economy-wide output, accurately
measured. The U.S. and the world rely on it to tell where we are
in the business cycle and to estimate long-run growth. It is the
centerpiece of an elaborate and indispensable system of socialaccounting, the national income and product accounts. This issurely the single most innovative achievement of the CommerceDepartment in the 20th century. I was fortunate to become aneconomist in the 1930’s when Kuznets, Nathan, Gilbert, and Jaszi
were creating this most important set of economic time series. In
economic theory, macroeconomics was just beginning at thesame time. Complementary, these two innovations deserve muchcredit for the improved performance of the economy in the sec-ond half of the century.
James T obin
FROM THE SURVEY OF CURRENT BUSINESS
Prior to the development of the NIPAs [national income and prod-
uct accounts], policy makers had to guide the economy using lim-ited and fragmentary information about the state of the economy.The Great Depression underlined the problems of incomplete data
and led to the development of the national accounts:
One reads with dismay of Presidents Hoover and then Roosevelt
designing policies to combat the Great Depression of the 1930s on
the basis of such sketchy data as stock price indices, freight car load-ings, and incomplete indices of industrial production. The fact was
that comprehensive measures of national income and output didnot exist at the time. The Depression, and with it the growing role
of government in the economy, emphasized the need for such mea-
sures and led to the development of a comprehensive set of national
income accounts.
Richard T. Froyen
In response to this need in the 1930s, the Department of
Commerce commissioned Nobel laureate Simon Kuznets of theNational Bureau of Economic Research to develop a set of nationaleconomic accounts….Professor Kuznets coordinated the work of
researchers at the National Bureau of Economic Research in New
Y ork and his staff at Commerce. The original set of accounts waspresented in a report to Congress in 1937 and in a research report,National Income, 1929–35 ….
The national accounts have become the mainstay of modern
macroeconomic analysis, allowing policy makers, economists, and the
business community to analyze the impact of different tax and spend-ing plans, the impact of oil and other price shocks, and the impact ofmonetary policy on the economy as a whole and on specific compo-nents of final demand, incomes, industries, and regions….
Source: U.S. Department of Commerce, Bureau of Economics, “GDP: One of
the Great Inventions of the 20th Century,” Survey of Current Business ,
January 2000, pp. 6–9.CHAPTER 21 Measuring National Output and National Income 431
Personal income is the income received by households before they pay personal income taxes.
The amount of income that households have to spend or save is called disposable personal
income ,o r after-tax income . It is equal to personal income minus personal income taxes, as
shown in Table 21.5.
Because disposable personal income is the amount of income that households can spend
or save, it is an important income concept. Table 21.5 on p. 430 shows there are three cate-gories of spending: (1) personal consumption expenditures, (2) personal interest payments,and (3) transfer payments made by households. The amount of disposable personal incomeleft after total personal spending is personal saving . If your monthly disposable income is
$500 and you spend $450, you have $50 left at the end of the month. Y our personal saving is$50 for the month. Y our personal saving level can be negative: If you earn $500 and spend$600 during the month, you have dissaved $100. T o spend $100 more than you earn, you will
have to borrow the $100 from someone, take the $100 from your savings account, or sell anasset you own.disposable personal income or
after-tax income Personal
income minus personal income
taxes. The amount thathouseholds have to spend or save.
personal saving The amount
of disposable income that is
left after total personalspending in a given period.
432 PART IV Concepts and Problems in Macroeconomics
Thepersonal saving rate is the percentage of disposable personal income saved, an
important indicator of household behavior. A low saving rate means households are spendinga large fraction of their income. A high saving rate means households are cautious in theirspending. As Table 21.5 shows, the U.S. personal saving rate in 2009 was 4.2 percent. Savingrates tend to rise during recessionary periods, when consumers become anxious about theirfuture, and fall during boom times, as pent-up spending demand gets released. In 2005 the sav-ing rate got down to 1.4 percent.
Nominal versus Real GDP
We have thus far looked at GDP measured in current dollars , or the current prices we pay for
goods and services. When we measure something in current dollars, we refer to it as a nominal
value. Nominal GDP is GDP measured in current dollars—all components of GDP valued at
their current prices.
In most applications in macroeconomics, however, nominal GDP is not what we are
after. It is not a good measure of aggregate output over time. Why? Assume that there is onlyone good—say, pizza, which is the same quality year after year. In each year 1 and 2, 100 units(slices) of pizza were produced. Production thus remained the same for year 1 and year 2.Suppose the price of pizza increased from $1.00 per slice in year 1 to $1.10 per slice in year 2.Nominal GDP in year 1 is $100 (100 units /H11003$1.00 per unit), and nominal GDP in year 2 is
$110 (100 units /H11003$1.10 per unit). Nominal GDP has increased by $10 even though no more
slices of pizza were produced. If we use nominal GDP to measure growth, we can be misledinto thinking production has grown when all that has really happened is a rise in the pricelevel (inflation).
If there were only one good in the economy—for example, pizza—it would be easy to
measure production and compare one year’s value to another’s. We would add up all the pizzaslices produced each year. In the example, production is 100 in both years. If the number ofslices had increased to 105 in year 2, we would say production increased by 5 slices betweenyear 1 and year 2, which is a 5 percent increase. Alas, however, there is more than one good inthe economy.
The following is a discussion of how the BEA adjusts nominal GDP for price changes. As you
read the discussion, keep in mind that this adjustment is not easy. Even in an economy of justapples and oranges, it would not be obvious how to add up apples and oranges to get an overallmeasure of output. The BEA ’s task is to add up thousands of goods, each of whose price is changingover time.
In the following discussion, we will use the concept of a weight , either price weights or quantity
weights. What is a weight? It is easiest to define the term by an example. Suppose in your economicscourse there is a final exam and two other tests. If the final exam counts for one-half of the grade andthe other two tests for one-fourth each, the “weights” are one-half, one-fourth, and one-fourth. Ifinstead the final exam counts for 80 percent of the grade and the other two tests for 10 percent each,the weights are .8, .1, and .1. The more important an item is in a group, the larger its weight.
Calculating Real GDP
Nominal GDP adjusted for price changes is called real GDP . All the main issues involved in com-
puting real GDP can be discussed using a simple three-good economy and 2 years. Table 21.6 pre-sents all the data that we will need. The table presents price and quantity data for 2 years andthree goods. The goods are labeled A,B, and C, and the years are labeled 1 and 2. Pdenotes price,
and Qdenotes quantity. Keep in mind that everything in the following discussion, including the
discussion of the GDP deflation, is based on the numbers in Table 21.6. Nothing has beenbrought in from the outside. The table is the entire economy.
The first thing to note from Table 21.6 is that nominal output —in current dollars—in year 1
for good Ais the price of good Ain year 1 ($0.50) times the number of units of good Aproducedpersonal saving rate The
percentage of disposable
personal income that is saved.
If the personal saving rate islow, households are spending a
large amount relative to their
incomes; if it is high,households are spending
cautiously.
current dollars The current
prices that we pay for goods
and services.
nominal GDP Gross
domestic product measured incurrent dollars.
weight The importance
attached to an item within a
group of items.
CHAPTER 21 Measuring National Output and National Income 433
in year 1 (6), which is $3.00. Similarly, nominal output in year 1 is 7 /H11003$0.30 = $2.10 for good B
and 10 /H11003$0.70 = $7.00 for good C. The sum of these three amounts, $12.10 in column 5, is nom-
inal GDP in year 1 in this simple economy. Nominal GDP in year 2—calculated by using the year2 quantities and the year 2 prices—is $19.20 (column 8). Nominal GDP has risen from $12.10 inyear 1 to $19.20 in year 2, an increase of 58.7 percent.
3
Y ou can see that the price of each good changed between year 1 and year 2—the price of
good Afell (from $0.50 to $0.40) and the prices of goods Band Crose ( Bfrom $0.30 to
$1.00; Cfrom $0.70 to $0.90). Some of the change in nominal GDP between years 1 and 2 is
due to price changes and not production changes. How much can we attribute to pricechanges and how much to production changes? Here things get tricky. The procedure thatthe BEA used prior to 1996 was to pick a base year and to use the prices in that base year as
weights to calculate real GDP . This is a fixed-weight procedure because the weights used,
which are the prices, are the same for all years—namely, the prices that prevailed in the base year.
Let us use the fixed-weight procedure and year 1 as the base year, which means using year 1
prices as the weights. Then in Table 21.6, real GDP in year 1 is $12.10 (column 5) and real GDP inyear 2 is $15.10 (column 6). Note that both columns use year 1 prices and that nominal and realGDP are the same in year 1 because year 1 is the base year. Real GDP has increased from $12.10 to$15.10, an increase of 24.8 percent.
Let us now use the fixed-weight procedure and year 2 as the base year, which means using
year 2 prices as the weights. In Table 21.6, real GDP in year 1 is $18.40 (column 7) and real GDPin year 2 is $19.20 (column 8). Note that both columns use year 2 prices and that nominal andreal GDP are the same in year 2 because year 2 is the base year. Real GDP has increased from$18.40 to $19.20, an increase of 4.3 percent.
This example shows that growth rates can be sensitive to the choice of the base year—
24.8 percent using year 1 prices as weights and 4.3 percent using year 2 prices as weights. The oldBEA procedure simply picked one year as the base year and did all the calculations using theprices in that year as weights. The new BEA procedure makes two important changes. The first(using the current example) is to take the average of the two years’ price changes, in other words,to “split the difference” between 24.8 percent and 4.3 percent. What does “splitting the difference”mean? One way is to take the average of the two numbers, which is 14.55 percent. What the BEATABLE 21.6 A Three-Good Economy
(1) (2) (3) (4) (5) (6) (7) (8)
GDP in
Year 1
inGDP in
Year 2
inGDP in
Year 1
inGDP in
Year 2
in
Production Price per Unit Year 1 Year 1 Year 2 Year 2
Year 1 Year 2 Year 1 Year 2 Prices Prices Prices Prices
Q1Q2P1P2 P1/H11003Q1P1/H11003Q2P2/H11003Q1P2/H11003Q2
3The percentage change is calculated as [(19.20 -12.10)/12.10] /H11003100 = .587 /H11003100 = 58.7 percent.base year The year chosen
for the weights in a fixed-
weight procedure.
fixed-weight procedure A
procedure that uses weightsfrom a given base year.Good A 6 11 $0.50 $0.40 $3.00 $5.50 $2.40 $4.40
Good B 7 4 0.30 1.00 2.10 1.20 7.00 4.00
Good C 10 12 0.70 0.90 7.00 8.40 9.00 10.80
Total $12.10 $15.10 $18.40 $19.20
Nominal
GDP in
year 1Nominal
GDP in
year 2
434 PART IV Concepts and Problems in Macroeconomics
does is to take the geometric average, which for the current example is 14.09 percent.4These two
averages (14.55 percent and 14.09 percent) are quite close, and the use of either would give simi-lar results. The point here is not that the geometric average is used, but that the first change is tosplit the difference using some average. Note that this new procedure requires two “base” yearsbecause 24.8 percent was computed using year 1 prices as weights and 4.3 percent was computedusing year 2 prices as weights.
The second BEA change is to use years 1 and 2 as the base years when computing the per-
centage change between years 1 and 2, then use years 2 and 3 as the base years when computingthe percentage change between years 2 and 3, and so on. The two base years change as the calcu-lations move through time. The series of percentage changes computed this way is taken to be theseries of growth rates of real GDP . So in this way, nominal GDP is adjusted for price changes. T omake sure you understand this, review the calculations in Table 21.6, which provides all the datayou need to see what is going on.
Calculating the GDP Deflator
We now switch gears from real GDP , a quantity measure, to the GDP deflator, a price measure.One of economic policy makers’ goals is to keep changes in the overall price level small. For thisreason, policy makers not only need good measures of how real output is changing but alsogood measures of how the overall price level is changing. The GDP deflator is one measure ofthe overall price level. We can use the data in Table 21.6 to show how the BEA computes theGDP deflator.
In Table 21.6, the price of good Afell from $0.50 in year 1 to $0.40 in year 2, the price of
good Brose from $0.30 to $1.00, and the price of good Crose from $0.70 to $0.90. If we are
interested only in how individual prices change, this is all the information we need. However, ifwe are interested in how the overall price level changes, we need to weight the individual prices
in some way. The obvious weights to use are the quantities produced, but which quantities—those of year 1 or year 2? The same issues arise here for the quantity weights as for the priceweights in computing real GDP .
Let us first use the fixed-weight procedure and year 1 as the base year, which means using
year 1 quantities as the weights. Then in Table 21.6, the “bundle” price in year 1 is $12.10 (col-umn 5) and the bundle price in year 2 is $18.40 (column 7). Both columns use year 1 quantities.The bundle price has increased from $12.10 to $18.40, an increase of 52.1 percent.
Next, use the fixed-weight procedure and year 2 as the base year, which means using
year 2 q uantities as the weights. Then the bundle price in year 1 is $15.10 (column 6), and the
bundle price in year 2 is $19.20 (column 8). Both columns use year 2 quantities. The bundle pricehas increased from $15.10 to $19.20, an increase of 27.2 percent.
This example shows that overall price increases can be sensitive to the choice of the base
year: 52.1 percent using year 1 quantities as weights and 27.2 percent using year 2 quantitiesas weights. Again, the old BEA procedure simply picked one year as the base year and did allthe calculations using the quantities in the base year as weights. First, the new proceduresplits the difference between 52.1 percent and 27.2 percent by taking the geometric average,which is 39.1 percent. Second, it uses years 1 and 2 as the base years when computing thepercentage change between years 1 and 2, years 2 and 3 as the base years when computing thepercentage change between years 2 and 3, and so on. The series of percentage changes com-puted this way is taken to be the series of percentage changes in the GDP deflator, that is, aseries of inflation rates.
The Problems of Fixed Weights
T o see why the BEA switched to the new procedure, let us consider a number of problems usingfixed-price weights to compute real GDP . First, 1987 price weights, the last price weights the BEAused before it changed procedures, are not likely to be very accurate for, say, the 1950s. Many
4The geometric average is computed as the square root of 124.8 /H11003104.3, which is 114.09.
CHAPTER 21 Measuring National Output and National Income 435
structural changes have taken place in the U.S. economy in the last 40 to 50 years, and it seems
unlikely that 1987 prices are good weights to use for the 1950s.
Another problem is that the use of fixed-price weights does not account for the responses in the
economy to supply shifts. Perhaps bad weather leads to a lower production of oranges in year 2. Ina simple supply-and-demand diagram for oranges, this corresponds to a shift of the supply curve tothe left, which leads to an increase in the price of oranges and a decrease in the quantity demanded.As consumers move up the demand curve, they are substituting away from oranges. If technicaladvances in year 2 result in cheaper ways of producing computers, the result is a shift of the com-puter supply curve to the right, which leads to a decrease in the price of computers and an increasein the quantity demanded. Consumers are substituting toward computers. (Y ou should be able todraw supply-and-demand diagrams for both cases.) Table 21.6 on p. 433 shows this tendency. Thequantity of good Arose between years 1 and 2 and the price decreased (the computer case), whereas
the quantity of good Bfell and the price increased (the orange case). The computer supply curve has
been shifting to the right over time, due primarily to technical advances. The result has been largedecreases in the price of computers and large increases in the quantity demanded.
T o see why these responses pose a problem for the use of fixed-price weights, consider the data
in Table 21.6. Because the price of good Awas higher in year 1, the increase in production of good
Ais weighted more if we use year 1 as the base year than if we used year 2 as the base year. Also,
because the price of good Bwas lower in year 1, the decrease in production of good Bis weighted
less if we use year 1 as the base year. These effects make the overall change in real GDP larger if weuse year 1 price weights than if we use year 2 price weights. Using year 1 price weights ignores thekinds of substitution responses discussed in the previous paragraph and leads to what many believeare too-large estimates of real GDP changes. In the past, the BEA tended to move the base year for-ward about every 5 years, resulting in the past estimates of real GDP growth being revised down-ward. It is undesirable to have past growth estimates change simply because of the change to a newbase year. The new BEA procedure avoids many of these fixed-weight problems.
Similar problems arise when using fixed-quantity weights to compute price indexes. For
example, the fixed-weight procedure ignores the substitution away from goods whose prices areincreasing and toward goods whose prices are decreasing or increasing less rapidly. The proce-dure tends to overestimate the increase in the overall price level. As discussed in the next chapter,there are still a number of price indexes that are computed using fixed weights. The GDP deflatordiffers because it does not use fixed weights. It is also a price index for all the goods and servicesproduced in the economy. Other price indexes cover fewer domestically produced goods and ser-vices but also include some imported (foreign-produced) goods and services.
It should finally be stressed that there is no “right” way of computing real GDP . The economy
consists of many goods, each with its own price, and there is no exact way of adding together theproduction of the different goods. We can say that the BEA ’s new procedure for computing realGDP avoids the problems associated with the use of fixed weights, and it seems to be an improve-ment over the old procedure. We will see in the next chapter, however, that the consumer priceindex (CPI)—a widely used price index—is still computed using fixed weights.
Limitations of the GDP Concept
We generally think of increases in GDP as good. Increasing GDP (or preventing its decrease) isusually considered one of the chief goals of the government’s macroeconomic policy. Becausesome serious problems arise when we try to use GDP as a measure of happiness or well-being, wenow point out some of the limitations of the GDP concept as a measure of welfare.
GDP and Social Welfare
If crime levels went down, society would be better off, but a decrease in crime is not an increasein output and is not reflected in GDP . Neither is an increase in leisure time. Y et to the extent thathouseholds want extra leisure time (instead of having it forced on them by a lack of jobs in theeconomy), an increase in leisure is also an increase in social welfare. Furthermore, someincreases in social welfare are associated with a decrease in GDP . An increase in leisure during a
436 PART IV Concepts and Problems in Macroeconomics
time of full employment, for example, leads to a decrease in GDP because less time is spent on
producing output.
Most nonmarket and domestic activities, such as housework and child care, are not counted
in GDP even though they amount to real production. However, if I decide to send my children today care or hire someone to clean my house or drive my car for me, GDP increases. The salariesof day care staff, cleaning people, and chauffeurs are counted in GDP , but the time I spend doingthe same things is not counted. A mere change of institutional arrangements, even though nomore output is being produced, can show up as a change in GDP .
Furthermore, GDP seldom reflects losses or social ills. GDP accounting rules do not adjust
for production that pollutes the environment. The more production there is, the larger the GDP ,regardless of how much pollution results in the process.
GDP also has nothing to say about the distribution of output among individuals in a society.
It does not distinguish, for example, between the case in which most output goes to a few peopleand the case in which output is evenly divided among all people. We cannot use GDP to measurethe effects of redistributive policies (which take income from some people and give income to oth-ers). Such policies have no direct impact on GDP . GDP is also neutral about the kinds of goods aneconomy produces. Symphony performances, handguns, cigarettes, professional football games,Bibles, soda pop, milk, economics textbooks, and comic books all get counted similarly.
The Underground Economy
Many transactions are missed in the calculation of GDP even though, in principle, they should becounted. Most illegal transactions are missed unless they are “laundered” into legitimate business.Income that is earned but not reported as income for tax purposes is usually missed, althoughsome adjustments are made in the GDP calculations to take misreported income into account.The part of the economy that should be counted in GDP but is not is sometimes called theunderground economy .
Tax evasion is usually thought to be the major incentive for people to participate in the
underground economy. Studies estimate that the size of the U.S. underground economy, rangingfrom 5 percent to 30 percent of GDP ,
5is comparable to the size of the underground economy in
most European countries and probably much smaller than the size of the underground economyin the Eastern European countries. Estimates of Italy’s underground economy range from 10 per-cent to 35 percent of Italian GDP . At the lower end of the scale, estimates for Switzerland rangefrom 3 percent to 5 percent.
Why should we care about the underground economy? T o the extent that GDP reflects only a
part of economic activity instead of a complete measure of what the economy produces, it is mis-leading. Unemployment rates, for example, may be lower than officially measured if people workin the underground economy without reporting this fact to the government. Also, if the size ofthe underground economy varies among countries—as it does—we can be misled when we com-pare GDP among countries. For example, Italy’s GDP would be much higher if we considered itsunderground sector as part of the economy, while Switzerland’s GDP would change very little.
Gross National Income per Capita
Making comparisons across countries is difficult because such comparisons need to be madein a single currency, generally U.S. dollars. Converting GNP numbers for Japan into dollarsrequires converting from yen into dollars. Since exchange rates can change quite dramaticallyin short periods of time, such conversions are tricky. Recently, the World Bank adopted a newmeasuring system for international comparisons. The concept of gross national income (GNI)
is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. Figure 21.1 lists the gross national income per capitaunderground economy The
part of the economy in which
transactions take place and in
which income is generated thatis unreported and therefore
not counted in GDP.
5See, for example, Edgar L. Feige, “Defining and Estimating Underground and Informal Economies: The New Industrial
Economic Approach,” World Development 19(7), 1990, and “The Underground Economy in the United States,” Occasional Paper
No. 2, U.S. Department of Labor, September 1992.gross national income (GNI)
GNP converted into dollarsusing an average of currency
exchange rates over several
years adjusted for rates ofinflation.
CHAPTER 21 Measuring National Output and National Income 437SwitzerlandDenmark
Ireland
United StatesSweden
Netherlands
Finland
United Kingdom
Austria
JapanBelgium
Germany
FranceCanada
Australia
Italy
GreeceSpain
PortugalKorea, Rep. of
Czech Republic
Mexico
Turkey
South AfricaArgentinaRomania
ColumbiaBrazil
Jordan
China
IndonesiaPhilippines
PakistanIndia
Nepal
EthiopiaRwandaNorway
BangladeshChile
Egypt, Arab Rep.HungaryIsrael
KenyaLibyaNew Zealand
NigeriaRussian FederationSaudi Arabia
ThailandVenezuela, R.B.
VietnamU.S. dolla rs$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$1,000$90,000$80,000
/L50304FIGURE 21.1 Per Capita Gross National Income for Selected Countries, 2008
Source: World Bank.
SUMMARY
1.One source of data on the key variables in the macroeconomy
is the national income and product accounts . These accounts
provide a conceptual framework that macroeconomists use to
think about how the pieces of the economy fit together.
GROSS DOMESTIC PRODUCT p. 423
2.Gross domestic product (GDP ) is the key concept in national
income accounting. GDP is the total market value of all finalgoods and services produced within a given period by factors
of production located within a country. GDP excludes
intermediate goods . T o include goods when they are pur-
chased as inputs and when they are sold as final productswould be double counting and would result in an overstate-
ment of the value of production.
3.GDP excludes all transactions in which money or goods
change hands but in which no new goods and services are
produced. GDP includes the income of foreigners workingin the United States and the profits that foreign companiesearn in the United States. GDP excludes the income of U.S.citizens working abroad and profits earned by U.S. compa-nies in foreign countries.
4.Gross national product (GNP ) is the market value of all final
goods and services produced during a given period by fac-
tors of production owned by a country’s citizens.(GNI divided by population) for various countries in 2008. Norway had the highest per capita
GNI followed by Denmark, Switzerland, and Sweden. Ethiopia was estimated to have percapita GNI of only $280 in 2008. This compares to $87,340 for Norway.
Looking Ahead
This chapter has introduced many key variables in which macroeconomists are interested,including GDP and its components. There is much more to be learned about the data thatmacroeconomists use. In the next chapter, we will discuss the data on employment, unemploy-ment, and the labor force. In Chapters 25 and 26, we will discuss the data on money and interestrates. Finally, in Chapter 35, we will discuss in more detail the data on the relationship betweenthe United States and the rest of the world.
438 PART IV Concepts and Problems in Macroeconomics
CALCULATING GDP p. 425
5.The expenditure approach to GDP adds up the amount spent
on all final goods and services during a given period. The fourmain categories of expenditures are personal consumption
expenditures (C),gross private domestic investment (I),
government consumption and gross investment (G), and net
exports (EX-IM). The sum of these categories equals GDP .
6.The three main components of personal consumption
expenditures (C) are durable goods, nondurable goods , and
services .
7.Gross private domestic investment (I) is the total investment
made by the private sector in a given period. There arethree kinds of investment: nonresidential investment, residential
investment , and changes in business inventories . Gross
investment does not take depreciation —the decrease in the
value of assets—into account. Net investment is equal to
gross investment minus depreciation.
8.Government consumption and gross investment (G) include
expenditures by state, federal, and local governments forfinal goods and services. The value of net exports (EX-IM)
equals the differences between exports (sales to foreigners ofU.S.-produced goods and services) and imports (U.S. pur-chases of goods and services from abroad).
9.Because every payment (expenditure) by a buyer is a receipt(income) for the seller, GDP can be computed in terms ofwho receives it as income—the income approach to calculat-
ing gross domestic product.
10. GNP minus depreciation is net national product (NNP ).
National income is the total amount earned by the factors of
production in the economy. It is equal to NNP except for astatistical discrepancy. Personal income is the total income ofhouseholds. Disposable personal income is what households
have to spend or save after paying their taxes. The personal
saving rate is the percentage of disposable personal income
saved instead of spent.
NOMINAL VERSUS REAL GDP p. 432
11. GDP measured in current dollars (the current prices thatone pays for goods) is nominal GDP . If we use nominal
GDP to measure growth, we can be misled into thinkingthat production has grown when all that has happened is arise in the price level, or inflation. A better measure of pro-duction is real GDP , which is nominal GDP adjusted for
price changes.
12. The GDP deflator is a measure of the overall price level.
LIMITATIONS OF THE GDP CONCEPT p. 435
13. We generally think of increases in GDP as good, but someproblems arise when we try to use GDP as a measure ofhappiness or well-being. The peculiarities of GDPaccounting mean that institutional changes can changethe value of GDP even if real production has not changed.GDP ignores most social ills, such as pollution.Furthermore, GDP tells us nothing about what kinds ofgoods are being produced or how income is distributedacross the population. GDP also ignores many transac-tions of the underground economy .
14. The concept of gross national income (GNI ) is GNP con-
verted into dollars using an average of currency exchangerates over several years adjusted for rates of inflation.
REVIEW TERMS AND CONCEPTS
base year, p. 433
change in business inventories, p. 427
compensation of employees, p. 429
corporate profits, p. 429
current dollars, p. 432
depreciation, p. 428
disposable personal income, orafter-tax
income, p. 431
durable goods, p. 426
expenditure approach, p. 425
final goods and services, p. 424
fixed-weight procedure, p. 433
government consumption and gross
investment ( G),p. 428
gross domestic product (GDP), p. 423
gross investment, p. 428
gross national income (GNI), p. 436
gross national product (GNP), p. 425 gross private domestic investment ( I),p. 427
income approach, p. 425
indirect taxes minus subsidies, p. 429
intermediate goods, p. 424
national income, p. 429
national income and product accounts, p. 423
net business transfer payments, p. 429
net exports ( EX-IM),p. 429
net interest, p. 429
net investment, p. 428
net national product (NNP), p. 430
nominal GDP , p. 432
nondurable goods, p. 426
nonresidential investment, p. 427
personal consumption expenditures ( C),
p. 426
personal income, p. 430 personal saving, p. 431
personal saving rate, p. 432
proprietors’ income, p. 429
rental income, p. 429
residential investment, p. 427
services, p. 426
statistical discrepancy, p. 430
surplus of government enterprises, p. 429
underground economy, p. 436
value added, p. 424
weight, p. 432
Expenditure approach to GDP: GDP = C+
I+G+ (EX-IM)
GDP = Final sales +Change in business
inventories, p. 428
Net investment = Capital end of period –
Capital beginning of period, p. 428
CHAPTER 21 Measuring National Output and National Income 439
PROBLEMS
All problems are available on www.myeconlab.
1.[Related to the Economics in Practice onp. 427 ]In a simple
economy, suppose that all income is either compensation of
employees or profits. Suppose also that there are no indirecttaxes. Calculate gross domestic product from the following set
of numbers. Show that the expenditure approach and theincome approach add up to the same figure.
Consumption $5,000
Investment 1,000
Depreciation 600
Profits 900
Exports 500
Compensation of employees 5,300
Government purchases 1,000
Direct taxes 800
Saving 1,100
Imports 700
DATEGNP
(BILLIONS OF
DOLLARS)REAL GNP
(BILLIONS OF
DOLLARS)REAL GNP
(% CHANGE)GNP
DEFLATOR
(% CHANGE)
72:2 1,172 1,179 7.62 2.93
72:3 1,196 1,193 5.11 3.24
72:4 1,233 1,214 7.41 5.30
73:1 1,284 1,247 10.93 5.71
73:2 1,307 1,248 .49 7.20
73:3 1,338 1,256 2.44 6.92
73:4 1,377 1,266 3.31 8.58
74:1 1,388 1,253 -4.00 7.50
74:2 1,424 1,255 .45 10.32
74:3 1,452 1,247 -2.47 10.78
74:4 1,473 1,230 -5.51 12.03
75:1 1,480 1,204 -8.27 10.86
75:2 1,517 1,219 5.00 5.072.How do we know that calculating GDP by the expenditure
approach yields the same answer as calculating GDP by theincome approach?
3.As the following table indicates, GNP and real GNP were almost
the same in 1972, but there was a $300 billion difference bymid-1975. Explain why. Describe what the numbers here sug-
gest about conditions in the economy at the time. How do the
conditions compare with conditions today?
4.What are some of the problems in using fixed weights to com-
pute real GDP and the GDP price index? How does the BEA ’sapproach attempt to solve these problems?
5.Explain what double counting is and discuss why GDP is not
equal to total sales.
6.The following table gives some figures from a forecast of real GDP
(in 2005 dollars) and population done in mid-2010. According tothe forecast, approximately how much real growth will there bebetween 2010 and 2011? What is per capita real GDP projected tobe in 2010 and in 2011? Compute the forecast rate of change in
real GDP and per capita real GDP between 2010 and 2011.
Real GDP 2010 (billions) $13,406
Real GDP 2011 (billions) $13,792
Population 2010 (millions) 310.2
Population 2011 (millions) 313.2
7.Look at a recent edition of The Economist . Go to the section on
economic indicators. Go down the list of countries and make a
list of the ones with the fastest and slowest GDP growth. Lookalso at the forecast rates of GDP growth. Go back to the table ofcontents at the beginning of the journal to see if there are arti-cles about any of these countries. Write a paragraph or two
describing the events or the economic conditions in one of the
countries. Explain why they are growing or not growing rapidly.
8.During 2002, real GDP in Japan rose about 1.3 percent. During
the same period, retail sales in Japan fell 1.8 percent in real
terms. What are some possible explanations for retail sales to
consumers falling when GDP rises? ( Hint: Think of the compo-
sition of GDP using the expenditure approach.)
9.[Related to the Economics in Practice onp. 431 ]Which of the
following transactions would not be counted in GDP? Explainyour answers.a.General Motors issues new shares of stock to finance the
construction of a plant.
b.General Motors builds a new plant.
c.Company A successfully launches a hostile takeover of com-
pany B, in which company A purchases all the assets ofcompany B.
d.Y our grandmother wins $10 million in the lottery.
e.Y ou buy a new copy of this textbook.
f.Y ou buy a used copy of this textbook.
g.The government pays out Social Security benefits.
h.A public utility installs new antipollution equipment in its
smokestacks.
i.Luigi’s Pizza buys 30 pounds of mozzarella cheese, holds it in
inventory for 1 month, and then uses it to make pizza(which it sells).
j.Y ou spend the weekend cleaning your apartment.
k.A drug dealer sells $500 worth of illegal drugs.
10.If you buy a new car, the entire purchase is counted as consump-
tion in the year in which you make the transaction. Explain
briefly why this is in one sense an “error” in national incomeaccounting. ( Hint: How is the purchase of a car different from
the purchase of a pizza?) How might you correct this error?How is housing treated in the National Income and Product
Accounts? Specifically how does owner occupied housing enter
into the accounts? (Hint: Do some Web searching on “imputedrent on owner occupied housing.”)
11.Explain why imports are subtracted in the expenditure
approach to calculating GDP .
440 PART IV Concepts and Problems in Macroeconomics
12.GDP calculations do not directly include the economic costs of
environmental damage—for example, global warming and acid
rain. Do you think these costs should be included in GDP? Whyor why not? How could GDP be amended to include environ-mental damage costs?
13.Beginning in 2005, the housing market, which had been
booming for years, turned. Housing construction droppedsharply in 2006. Go to www.bea.gov. Look at the GDP releaseand at past releases from 2002–2010. In real dollars, howmuch private residential fixed investment (houses, apart-
ments, condominiums, and cooperatives) took place in each
quarter from 2002–2010? What portion of GDP did housingconstruction represent? After 2006, residential fixed invest-ment was declining sharply, yet GDP was growing until theend of 2007. What categories of aggregate spending keptthings moving between 2006 and the end of 2007?
14.By mid-2009, many economists believed that the recession had
ended and the U.S. economy had entered an economic expan-sion. Define recession and expansion . Go to www.bea.gov and
look at the growth of GDP during 2009. In addition, go to www.
bls.gov and look at payroll employment and the unemploymentrate. Had the recession ended and had the U.S. economy enteredan expansion? What do you see in the data? Can you tell byreading newspapers or watching cable news whether the coun-try had entered an expansion? Explain.
15.Jeannine, a successful real estate agent in San Francisco, occa-
sionally includes one of her home listings in the real estate sec-
tion on eBay. In December 2010, Jeannine listed a home built
in 1934 on eBay for $1.2 million, and she accepted an offerfrom a buyer in Copenhagen, Denmark, for $1.15 million inJanuary 2011. What part, if any, of this transaction will beincluded as a part of U.S. GDP in 2011?
16.Larson has started a home wine-making business and he buys
all his ingredients from his neighborhood farmers’ market and alocal bottle manufacturer. Last year he purchased $4,000 worth
of ingredients and bottles and produced 2,000 bottles of wine.
He sold all 2,000 bottles of wine to an upscale restaurant for $10each. The restaurant sold all the wine to customers for $45 each.For the total wine production, calculate the value added ofLarson and of the restaurant.
17.Artica is a nation with a simple economy that produces only
six goods: oranges, bicycles, magazines, paper, orange juice,and hats. Assume that half of all the oranges are used to pro-
duce orange juice and one-third of all the paper is used to pro-
duce magazines.a.Use the production and price information in the table to cal-
culate nominal GDP for 2011.b.Use the production and price information in the table to cal-
culate real GDP for 2009, 2010, and 2011 using 2009 as the
base year. What is the growth rate of real GDP from 2009 to2010 and from 2010 to 2011?
c.Use the production and price information in the table to cal-
culate real GDP for 2009, 2010, and 2011 using 2010 as thebase year. What is the growth rate of real GDP from 2009 to
2010 and from 2010 to 2011?
19.Evaluate the following statement: Even if the prices of a large
number of goods and services in the economy increase dramati-
cally, the real GDP for the economy can still fall.18.The following table contains nominal and real GDP data, in bil-
lions of dollars, from the U.S. Bureau of Economic Analysis for2008 and 2009. The data is listed per quarter, and the real GDPdata was calculated using 2005 as the base year. Fill in the columns
for the GDP deflator and for the percent increase in price level.
2009 2010 2011
PRODUCT QUANTITY PRICE QUANTITY PRICE QUANTITY PRICE
Oranges 180 $ 0.90 200 $ 1.00 200 $ 1.25
Bicycles 20 85.00 25 90.00 30 95.00
Magazines 175 3.50 150 3.50 150 3.25
Paper 675 0.60 600 0.50 630 0.50
Orange
juice 40 3.50 50 4.00 60 4.50
Hats 70 10.00 80 12.50 100 15.00
QUARTERNOMINAL
GDPREAL
GDPGDP
DEFLATORPERCENT
INCREASE
IN PRICE
LEVEL
2008q1 14,373.9 13,366.9
2008q2 14,497.8 13,415.3
2008q3 14,546.7 13,324.6
2008q4 14,347.3 13,141.9
2009q1 14,178.0 12,925.4
2009q2 14,151.2 12,901.5
2009q3 14,242.1 12,973.0
2009q4 14,453.8 13,149.5
CHAPTER OUTLINE
44122
Unemployment p. 441
Measuring Unemployment
Components of the
Unemployment Rate
The Costs of
Unemployment
Inflation p. 447
The Consumer Price Index
The Costs of Inflation
Long-Run Growth
p. 452
Output and Productivity
Growth
Looking Ahead p. 454 Unemployment,
Inflation, and
Long-Run Growth
Each month the U.S. Bureau of
Labor Statistics (BLS) announcesthe value of the unemployment ratefor the previous month. For exam-ple, on July 2, 2010, it announcedthat the unemployment rate forJune 2010 was 9.5 percent. Theunemployment rate is a key mea-sure of how the economy is doing.This announcement is widelywatched, and if the announcedunemployment rate is differentfrom what the financial marketsexpect, there can be large move-ments in those markets. It is thus important to know how the BLS computes the unemploymentrate. The first part of this chapter describes how the unemployment rate is computed and dis-cusses its various components.
Inflation is another key macroeconomic variable. The previous chapter discussed how the
GDP deflator, the price deflator for the entire economy, is computed. The percentage change inthe GDP deflator is a measure of inflation. There are, however, other measures of inflation, eachpertaining to some part of the economy. The most widely followed price index is the consumerprice index (CPI), and its measurement is discussed next in this chapter. The CPI is alsoannounced monthly by the BLS, and this announcement is widely followed by the financial mar-kets as well. For example, on June 17, 2010, the BLS announced that the percentage change in theCPI for May 2010 was –1.9 percent at an annual rate. After discussing the measurement of theCPI, this chapter discusses various costs of inflation.
The last topic considered in this chapter is long-run growth. Although much of macro-
economics is concerned with explaining business cycles, long-run growth is also a major concern.The average yearly growth rate of U.S. real GDP depicted in Figure 20.2 on p. 411 is 3.3 percent.So while there were many ups and downs during the 110 years depicted in Figure 20.2, on aver-age, the economy was growing at a 3.3 percent rate. In the last part of this chapter, we discuss thesources of this growth.
Keep in mind that this chapter is still descriptive. We begin our analysis of how the economy
works in the next chapter.
Unemployment
We begin our discussion of unemployment with its measurement.
Measuring Unemployment
The unemployment data released each month by the BLS are based on a survey of households.Each month the BLS draws a sample of 65,000 households and completes interviews with allbut about 2,500 of them. Each interviewed household answers questions concerning the work
442 PART IV Concepts and Problems in Macroeconomics
activity of household members 16 years of age or older during the calendar week that con-
tains the twelfth of the month. (The survey is conducted in the week that contains the twelfthof the month.)
If a household member 16 years of age or older worked 1 hour or more as a paid employee,
either for someone else or in his or her own business or farm, the person is classified as employed .
A household member is also considered employed if he or she worked 15 hours or more withoutpay in a family enterprise. Finally, a household member is counted as employed if the person helda job from which he or she was temporarily absent due to illness, bad weather, vacation, labor-management disputes, or personal reasons, regardless of whether he or she was paid.
Those who are not employed fall into one of two categories: (1) unemployed or (2) not in
the labor force. T o be considered unemployed , a person must be 16 years old or older, available
for work, and have made specific efforts to find work during the previous 4 weeks. A person notlooking for work because he or she does not want a job or has given up looking is classified as not
in the labor force . People not in the labor force include full-time students, retirees, individuals in
institutions, those staying home to take care of children, and discouraged job seekers.
The total labor force in the economy is the number of people employed plus the number
of unemployed:employed Any person
16 years old or older (1) who
works for pay, either for
someone else or in his or herown business for 1 or morehours per week, (2) who workswithout pay for 15 or morehours per week in a family
enterprise, or (3) who has a
job but has been temporarilyabsent with or without pay.
unemployed A person
16 years old or older who is
not working, is available forwork, and has made specific
efforts to find work during the
previous 4 weeks.
not in the labor force A
person who is not looking for
work because he or she does
not want a job or has given up looking.
labor force The number of
people employed plus the
number of unemployed.labor force = employed + unemployed
The total population 16 years of age or older is equal to the number of people in the labor force
plus the number not in the labor force:
population = labor force + not in labor force
With these numbers, several ratios can be calculated. The unemployment rate is the ratio of
the number of people unemployed to the total number of people in the labor force:
unemployment rate The
ratio of the number of people
unemployed to the total
number of people in the labor force.unemployment rate =unemployed
employed +unemployed
In June 2010, the labor force contained 153.741 million people, 139.119 million of whom were
employed and 14.623 million of whom were unemployed and looking for work. The unemploy-ment rate was 9.5 percent:
14.623
139.119 +14.623=9.5%
The ratio of the labor force to the population 16 years old or over is called the labor force
participation rate :labor force participation rate
The ratio of the labor force to
the total population 16 years
old or older.
labor force participation rate =labor force
population
In June 2010, the population of 16 years old or over was 237.690 million. So the labor force par-
ticipation rate was .65 (= 153.741/237.690).
Table 22.1 shows values of these variables for selected years since 1950. Although the
unemployment rate has gone up and down over this period, the labor force participationrate grew steadily between 1950 and 2000. Much of this increase was due to the growth in theparticipation rate of women between the ages of 25 and 54. Column 3 in Table 22.1 showshow many new workers the U.S. economy has absorbed in recent years. The number ofemployed workers increased by 40.4 million between 1950 and 1980 and by 40.6 millionbetween 1980 and 2009.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 443
TABLE 22.2 Unemployment Rates by Demographic Group, 1982 and 2010
Years November 1982 June 2010
Total 10.8 9.5
White 9.6 8.6
Men 20+ 9.0 8.9
Women 20+ 8.1 7.1
Both sexes 16–19 21.3 23.2
African American 20.2 15.4
Men 20+ 19.3 17.4
Women 20+ 16.5 11.8
Both sexes 16–19 49.5 39.9
Source : U.S. Department of Labor, Bureau of Labor Statistics. Data are seasonally adjusted.Components of the Unemployment Rate
The unemployment rate by itself conveys some but not all information about the unemployment
picture. T o get a better picture, it is useful to look at unemployment rates across groups of people,regions, and industries.
Unemployment Rates for Different Demographic Groups There are large dif-
ferences in rates of unemployment across demographic groups. Table 22.2 shows the unemploy-ment rate for November 1982—the worst month of the recession in 1982—and for June 2010—also
a month with high overall unemployment—broken down by race, sex, and age. In June 2010,when the overall unemployment rate hit 9.5 percent, the rate for whites was 8.6 percent while therate for African Americans was almost twice that—15.4 percent.
During the recessions in both 1982 and 2010, men fared worse than women. For African
Americans, 19.3 percent of men 20 years and over and 16.5 percent of women 20 years and overwere unemployed in 1982, while the comparable numbers in 2010 are 17.4 for African Americanmen and 11.8 for African American women. T eenagers between 16 and 19 years of age fared worst.African Americans between 16 and 19 experienced an unemployment rate of 39.9 percent in June2010. For whites between 16 and 19, the unemployment rate was 23.2 percent. The pattern wassimilar in November 1982.
Unemployment Rates in States and Regions Unemployment rates also vary by geo-
graphic location. For a variety of reasons, not all states and regions have the same level of unem-ployment. States and regions have different combinations of industries, which do not all growand decline at the same time and at the same rate. Also, the labor force is not completelymobile—workers often cannot or do not want to pack up and move to take advantage of jobopportunities in other parts of the country.TABLE 22.1 Employed, Unemployed, and the Labor Force, 1950–2009
(1) (2) (3) (4) (5) (6)
Population
16 Years
Old or Over
(Millions)Labor Force
(Millions)Employed
(Millions)Unemployed
(Millions)Labor Force
Participation
Rate
(Percentage
Points)Unemployment
Rate
(Percentage
Points)
1950 105.0 62.2 58.9 3.3 59.2 5.3
1960 117.2 69.6 65.8 3.9 59.4 5.5
1970 137.1 82.8 78.7 4.1 60.4 4.9
1980 167.7 106.9 99.3 7.6 63.8 7.1
1990 189.2 125.8 118.8 7.0 66.5 5.6
2000 212.6 142.6 136.9 5.7 67.1 4.0
2009 235.8 154.1 139.9 14.3 65.4 9.3
Note: Figures are civilian only (military excluded).
Source: Economic Report of the President, 2010, Table B-35.
444 PART IV Concepts and Problems in Macroeconomics
TABLE 22.3 Regional Differences in Unemployment, 1975, 1982, 1991, 2003, and 2010
1975 1982 1991 2003 2010
U.S. avg. 8.5 9.7 6.7 6.0 9.7
Cal. 9.9 9.9 7.5 6.7 12.4
Fla. 10.7 8.2 7.3 5.1 11.7
Ill. 7.1 11.3 7.1 6.7 10.8
Mass. 11.2 7.9 9.0 5.8 9.2
Mich. 12.5 15.5 9.2 7.3 13.6
N.J. 10.2 9.0 6.6 5.9 9.7
N.Y. 9.5 8.6 7.2 6.3 8.3
N.C. 8.6 9.0 5.8 6.5 10.3
Ohio 9.1 12.5 6.4 6.1 10.7
Tex. 5.6 6.9 6.6 6.8 8.3
Source: Statistical Abstract of the United States, various editions. 2010 data are for May.
Michigan is another interesting state. As you probably know, Michigan is highly dependent
on the automotive industry. Michigan has suffered unemployment rates above the national aver-age for decades as the American automobile industry has lost share to foreign competition, andthe state economy has been relatively slow to attract new industries. It should not surprise youthat Michigan has one of the highest unemployment rates in 2010, given the state of the U.S. autoindustry in the recent period.
Finally, consider T exas. T exas produces about 20 percent of the oil in the United States. (Alaska
is another large oil producer.) For most of the last 35 years oil has done well, and for most of thisperiod T exas has had relatively low unemployment rates. In Table 22.3, only in 2003 was T exas’unemployment rate greater than the national average.
Discouraged-Worker Effects Many people believe that the unemployment rate under-
estimates the fraction of people who are involuntarily out of work. People who stop looking forwork are classified as having dropped out of the labor force instead of being unemployed. Duringrecessions, people may become discouraged about finding a job and stop looking. This lowers theunemployment rate as calculated by the BLS because those no longer looking for work are nolonger counted as unemployed.
T o demonstrate how this discouraged-worker effect lowers the unemployment rate, suppose
there are 10 million unemployed out of a labor force of 100 million. This means an unemploymentrate of 10/100 = .10, or 10 percent. If 1 million of these 10 million unemployed people stoppedlooking for work and dropped out of the labor force, 9 million would be unemployed out of alabor force of 99 million. The unemployment rate would then drop to 9/99 = .091, or 9.1 percent.
The BLS survey provides some evidence on the size of the discouraged-worker effect.
Respondents who indicate that they have stopped searching for work are asked why they stopped.If the respondent cites inability to find employment as the sole reason for not searching, that per-son might be classified as a discouraged worker.
The number of discouraged workers seems to hover around 1 percent of the size of the labor
force in normal times. During the 1980–1982 recession, the number of discouraged workersincreased steadily to a peak of 1.5 percent. In June 2010 there were estimated to be 1.2 million dis-couraged workers, about 0.8 percent of the size of the labor force. Some economists argue thatAs Table 22.3 shows, in the last 35 years remarkable changes have occurred in the relative
prosperity of regions. In the 1970s Massachusetts was still quite dependent on its industrialbase. As textile mills, leather goods plants, and furniture factories closed in the face of competi-tion both from abroad and from lower wage southern states, Massachusetts experienced rela-tively high unemployment. By the 1980s, the state had moved into more high-technology areaswith the birth of firms like Wang Laboratories and Digital Equipment and later by biotech firmslike Genentech; state unemployment rates also were relatively low. In 2010 Massachusetts wasclose to the national average for unemployment.
discouraged-worker effect
The decline in the measured
unemployment rate that results
when people who want to workbut cannot find jobs grow
discouraged and stop looking,
thus dropping out of the ranksof the unemployed and thelabor force.
ECONOMICS IN PRACTICE
A Quiet Revolution: Women Join the Labor Force
Table 22.1 shows that the labor force participation rate in the
United States increased from 59.2 percent in 1950 to 65.4 percent in
2009. Much of this increase was due to the increased participationof women in the labor force. In 1955, the labor force participationrate of women was 36 percent. For married women, the rate waseven lower at 29 percent. By the 1990s, these numbers shifted con-
siderably. In 1996, the labor force participation rate was 60 percent
for all women and 62 percent for married women. The reasons forthese changes are complex. Certainly, in the 1960s, there was achange in society’s attitude toward women and paid work. In addi-tion, the baby boom became the baby bust as greater availability ofbirth control led to fewer births.
By comparison, the participation rate for men declined over this
period—from 85 percent in 1955 to 75 percent in 1996. Why thelabor force participation rate for men fell is less clear than why thewomen’s rate rose. No doubt, some men dropped out to assumemore traditional women’s roles, such as child care. Whatever the
causes, the economy grew in a way that absorbed virtually all the new
entrants during the period in question.
As women began joining the labor force in greater numbers in
the 1970s and 1980s, their wages relative to men’s wages actuallyfell. Most economists attribute this decline to the fact that less expe-
rienced women were entering the labor force, pointing out theimportance of correcting for factors such as experience and educa-
tion when we analyze labor markets.
At least some of the women entering the labor force at this time
hired housecleaners and child care workers to perform tasks theyhad once done themselves. As we learned in Chapter 21, the salariesof daycare staff and cleaning people are counted in GDP , while thevalue of these tasks when done by a husband or wife in a household
is not part of GDP .
If you are interested in learning more about the economic his-
tory of American women, read the book Understanding the Gender
Gap: An Economic History of American Women by Harvard
University economist Claudia Goldin.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 445
adding the number of discouraged workers to the number who are now classified as unemployed
gives a better picture of the unemployment situation.
The Duration of Unemployment The unemployment rate measures unemployment
at a given point in time. It tells us nothing about how long the average unemployed worker is outof work. With a labor force of 1,000 people and an annual unemployment rate of 10 percent, weknow that at any moment 100 people are unemployed. But a very different picture emerges if itturns out that the same 100 people are unemployed all year, as opposed to a situation in whicheach of the 1,000 people has a brief spell of unemployment of a few weeks during the year. Theduration statistics give us information on this feature of unemployment. Table 22.4 shows that
TABLE 22.4 Average Duration of Unemployment, 1970–2009
Weeks Weeks Weeks
1970 8.6 1984 18.2 1997 15.8
1971 11.3 1985 15.6 1998 14.5
1972 12.0 1986 15.0 1999 13.4
1973 10.0 1987 14.5 2000 12.6
1974 9.8 1988 13.5 2001 13.1
1975 14.2 1989 11.9 2002 16.6
1976 15.8 1990 12.0 2003 19.2
1977 14.3 1991 13.7 2004 19.6
1978 11.9 1992 17.7 2005 18.4
1979 10.8 1993 18.0 2006 16.8
1980 11.9 1994 18.8 2007 16.8
1981 13.7 1995 16.6 2008 17.9
1982 15.6 1996 16.7 2009 24.4
1983 20.0
Source : Economic Report of the President, 2010, Table B-44.
446 PART IV Concepts and Problems in Macroeconomics
frictional unemployment
The portion of unemployment
that is due to the normal
turnover in the labor market;used to denote short-run
job/skill-matching problems.during recessionary periods, the average duration of unemployment rises. Between 1979 and
1983, the average duration of unemployment rose from 10.8 weeks to 20.0 weeks. The slowgrowth following the 1990–1991 recession resulted in an increase in duration of unemploymentto 17.7 weeks in 1992 and to 18.8 weeks in 1994. In 2000, average duration was down to 12.6 we eks,
which then rose to 19.6 weeks in 2004. Between 2007 and 2009 average duration rose sharplyfrom 16.8 weeks to 24.4 weeks.
The Costs of Unemployment
In the Employment Act of 1946, Congress declared that it was the
continuing policy and responsibility of the federal government to use all practicable
means…to promote maximum employment, production, and purchasing power.
In 1978, Congress passed the Full Employment and Balanced Growth Act, commonly referred to
as the Humphrey-Hawkins Act , which formally established a specific unemployment rate target of
4 percent. Why should full employment be a policy objective of the federal government? Whatcosts does unemployment impose on society?
Some Unemployment Is Inevitable Before we discuss the costs of unemployment, we
must realize that some unemployment is simply part of the natural workings of the labor market.Remember, to be classified as unemployed, a person must be looking for a job. Every year thou-sands of people enter the labor force for the first time. Some have dropped out of high school,some are high school or college graduates, and still others are finishing graduate programs. At thesame time, new firms are starting up and others are expanding and creating new jobs while otherfirms are contracting or going out of business.
At any moment, there is a set of job seekers and a set of jobs that must be matched with one
another. It is important that the right people end up in the right jobs. The right job for a personwill depend on that person’s skills, preferences concerning work environment (large firm or small,formal or informal), location of the individual’s home, and willingness to commute. At the sametime, firms want workers who can meet the requirements of the job and grow with the company.
T o make a good match, workers must acquire information on job availability, wage rates,
location, and work environment. Firms must acquire information on worker availability andskills. Information gathering consumes time and resources. The search may involve travel, inter-views, preparation of a résumé, telephone calls, and hours going through the newspaper. T o theextent that these efforts lead to a better match of workers and jobs, they are well spent. As long asthe gains to firms and workers exceed the costs of search, the result is efficient.
When we consider the various costs of unemployment, it is useful to categorize unemploy-
ment into three types:
/L50766Frictional unemployment
/L50766Structural unemployment
/L50766Cyclical unemployment
Frictional, Structural, and Cyclical Unemployment When the BLS does its sur-
vey about work activity for the week containing the twelfth of each month, it interviews manypeople who are involved in the normal search for work. Some are either entering the laborforce or switching jobs. This unemployment is both natural and beneficial for the economy.The portion of unemployment due to the normal turnover in the labor market is calledfrictional unemployment . The frictional unemployment rate can never be zero. It may, how-
ever, change over time. As jobs become more differentiated and the number of required skillsincreases, matching skills and jobs becomes more complex and the frictional unemploymentrate may rise.
The concept of frictional unemployment is somewhat vague because it is hard to know what
“the normal turnover in the labor market” means. The industrial structure of the U.S. economy iscontinually changing. Manufacturing, for instance, has yielded part of its share of total employ-ment to services and to finance, insurance, and real estate. Within the manufacturing sector, thesteel and textile industries have contracted sharply, while high-technology sectors such as electronic
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 447
structural unemployment
The portion of unemployment
that is due to changes in the
structure of the economy thatresult in a significant loss ofjobs in certain industries.components have expanded. Although the unemployment that arises from such structural shifts
could be classified as frictional, it is usually called structural unemployment . The term frictional
unemployment is used to denote short-run job/skill-matching problems, problems that last a few
weeks. Structural unemployment denotes longer-run adjustment problems—those that tend to
last for years. Although structural unemployment is expected in a dynamic economy, it is painfulto the workers who experience it. In some ways, those who lose their jobs because their skills areobsolete experience the greatest pain. The fact that structural unemployment is natural andinevitable does not mean that it costs society nothing.
Economists sometimes use the term natural rate of unemployment to refer to the unem-
ployment rate that occurs in a normal functioning economy. This concept is also vague because itis hard to know what a “normal functioning economy” means. It is probably best to think of thenatural rate of unemployment as the sum of the frictional rate and the structural rate. Estimatesof the natural rate vary from 4 percent to 6 percent.
There are times when the actual unemployment rate appears to be above the natural rate.
Between 2007 and 2009 the actual unemployment rate rose from 4.6 percent to 9.3 percent, andit seems unlikely that all of this rise was simply due to a rise in frictional and structuralunemployment. Any unemployment that is above frictional plus structural is called cyclical
unemploy ment . It seems likely that much of the unemployment in 2009, during the 2008–2009
recession, was cyclical unemployment.
Social Consequences The costs of unemployment are neither evenly distributed across the
population nor easily quantified. The social consequences of the Depression of the 1930s are per-haps the hardest to comprehend. Few emerged from this period unscathed. At the bottom were thepoor and the fully unemployed, about 25 percent of the labor force. Even those who kept their jobsfound themselves working part-time. Many people lost all or part of their savings as the stock mar-ket crashed and thousands of banks failed.
Congressional committees heard story after story. In Cincinnati, where the labor force
totaled about 200,000, about 48,000 were wholly unemployed, 40,000 more were on short time,and relief payments to the needy averaged $7 to $8 per week:
Relief is given to a family one week and then they are pushed off for a week in the hope
that somehow or other the breadwinner may find some kind of work….We are payingno rent at all. That, of course, is a very difficult problem because we are continually hav-ing evictions, and social workers…are hard put to find places for people whose furniturehas been put out on the street.
1
From Birmingham, Alabama, in 1932:
…we have about 108,000 wage and salary workers in my district. Of that number, it is my
belief that not exceeding 8000 have their normal incomes. At least 25,000 men are altogetherwithout work. Some of them have not had a stroke of work for more than 12 months.Perhaps 60,000 or 70,000 are working from one to five days a week, and practically allhave had serious cuts in wages and many of them do not average over $1.50 per day.
2
Inflation
In a market economy like the U.S. economy, prices of individual goods continually change as sup-ply and demand shift. Indeed, a major concern of microeconomics is understanding the way inwhich relative prices change—why, for example, have computers become less expensive over timeand dental services more expensive? In macroeconomics, we are concerned not with relative pricechanges, but with changes in the overall price level of goods and services. Inflation is defined as an
increase in the overall price level, while deflation is a decrease in the overall price level.natural rate of unemployment
The unemployment rate that
occurs as a normal part of the
functioning of the economy.Sometimes taken as the sum
of frictional unemploymentrate and structural
unemployment rate.
cyclical unemployment
Unemployment that is above
frictional plus structural
unemployment.
1U.S. Senate Hearings before a subcommittee of the Committee of Manufacturers, 72nd Congress, first session (1931), p. 239.
Cited in Lester Chandler, America’s Greatest Depression, 1929–1941 (New Y ork: Harper & Row, 1970), p. 43.
2Senate Hearings, in Lester Chandler, America’s Greatest Depression, 1929–1941 (New Y ork: Harper & Row, 1970), p. 43.
448 PART IV Concepts and Problems in Macroeconomics
consumer price index (CPI)
A price index computed each
month by the Bureau of Labor
Statistics using a bundle that ismeant to represent the “market
basket” purchased monthly by
the typical urban consumer.
14.9%
Food and Beverages(breakfast cereal, milk, coffee,chicken, wine, full-service mealsand snacks)3.3%
Other Goods and Services(tobacco and smoking products,
haircuts and other personal services,
funeral expenses)6.1%
Education and Communication(college tuition, postage, telephoneservices, computer software andaccessories)
42.4%
Housing
(rent of primary residence,
owners’ equivalent rent,
fuel oil, bedroom furniture)5.6%
Recreation
(televisions, cable television,
pets and pet products,
sports equipment,
admissions)6.2%
Medical Care
(prescription drugs and medical
supplies, physicians’ services,
eyeglasses and eye care,
hospital services)
3.7%
Apparel
(men’s shirts and sweaters,
women’s dresses, jewelry)17.7%
Transportation
(new vehicles, airline fares,
gasoline, motor vehicle
insurance)/L50298FIGURE 22.1
The CPI Market Basket
The CPI market basket shows
how a typical consumer divideshis or her money among various
goods and services. Most of a
consumer’s money goes towardhousing, transportation, andfood and beverages.
Source: The Bureau of Labor
StatisticsThe fact that all prices for the multitude of goods and services in our economy do not rise and
fall together at the same rate makes measurement of inflation difficult. We have already exploredmeasurement issues in Chapter 21 in defining the GDP deflator, which measures the price level forall goods and services in an economy. We turn now to look at a second, commonly used measure ofthe price level, the consumer price index.
The Consumer Price Index
Theconsumer price index (CPI) is the most widely followed price index. Unlike the GDP defla-
tor, it is a fixed-weight index. It was first constructed during World War I as a basis for adjustingshipbuilders’ wages, which the government controlled during the war. Currently, the CPI is com-puted by the BLS each month using a bundle of goods meant to represent the “market basket”purchased monthly by the typical urban consumer. The quantities of each good in the bundlethat are used for the weights are based on extensive surveys of consumers. In fact, the BLS collectsprices each month for about 71,000 goods and services from about 22,000 outlets in 44 geo-graphic areas. For example, the cost of housing is included in the data collection by surveyingabout 5,000 renters and 1,000 homeowners each month. Figure 22.1 shows the CPI market bas-ket for December 2007.
Table 22.5 shows values of the CPI since 1950. The base period for this index is 1982–1984,
which means that the index is constructed to have a value of 100.0 when averaged across thesethree years. The percentage change for a given year in the table is a measure of inflation in thatyear. For example, from 1970 to 1971, the CPI increased from 38.8 to 40.5, a percentage change of4.9 percent. [The percentage change is (40.5 – 38.8)/38.8 times 100.] The table shows the highinflation rates in the 1970s and early 1980s and the fairly low inflation rates since 1992.
Since the CPI is a fixed-weight price index (with the current base period 1982–1984), it suf-
fers from the substitution problem discussed in the last chapter. With fixed weights, it does notaccount for consumers’ substitution away from high-priced goods. The CPI thus has a tendencyto overestimate the rate of inflation. This problem has important policy implications becausegovernment transfers such as Social Security payments are tied to the CPI. If inflation as mea-sured by percentage changes in the CPI is biased upward, Social Security payments will growmore rapidly than they would with a better measure: The government is spending more than itotherwise would.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 449
In response to the fixed-weight problem, in August 2002, the BLS began publishing a version
of the CPI called the Chained Consumer Price Index, which uses changing weights. Although thisversion is not yet the main version, it may be that within a few years the BLS completely movesaway from the fixed-weight version of the CPI. Remember, however, that even if this happens, theCPI will still differ in important ways from the GDP deflator, discussed in the last chapter. TheCPI covers only consumer goods and services—those listed in Figure 22.1—whereas the GDPdeflator covers all goods and services produced in the economy. Also, the CPI includes prices ofimported goods, which the GDP deflator does not.
Other popular price indexes are producer price indexes (PPIs) , once called wholesale price
indexes . These are indexes of prices that producers receive for products at all stages in the produc-
tion process, not just the final stage. The indexes are calculated separately for various stages in theproduction process. The three main categories are finished goods, intermediate materials , and
crude materials , although there are subcategories within each of these categories.
One advantage of some of the PPIs is that they detect price increases early in the production
process. Because their movements sometimes foreshadow future changes in consumer prices,they are considered to be leading indicators of future consumer prices. producer price indexes (PPIs)
Measures of prices thatproducers receive for
products at all stages in the
production process.
TABLE 22.5 The CPI, 1950–2009
Percentage Change Percentage Change
in CPI CPI in CPI CPI
1950 1.3 24.1 1980 13.5 82.4
1951 7.9 26.0 1981 10.3 90.9
1952 1.9 26.5 1982 6.2 96.5
1953 0.8 26.7 1983 3.2 99.6
1954 0.7 26.9 1984 4.3 103.9
1955 -0.4 26.8 1985 3.6 107.6
1956 1.5 27.2 1986 1.9 109.6
1957 3.3 28.1 1987 3.6 113.6
1958 2.8 28.9 1988 4.1 118.3
1959 0.7 29.1 1989 4.8 124.0
1960 1.7 29.6 1990 5.4 130.7
1961 1.0 29.9 1991 4.2 136.2
1962 1.0 30.2 1992 3.0 140.3
1963 1.3 30.6 1993 3.0 144.5
1964 1.3 31.0 1994 2.6 148.2
1965 1.6 31.5 1995 2.8 152.4
1966 2.9 32.4 1996 3.0 156.9
1967 3.1 33.4 1997 2.3 160.5
1968 4.2 34.8 1998 1.6 163.0
1969 5.5 36.7 1999 2.2 166.6
1970 5.7 38.8 2000 3.4 172.2
1971 4.4 40.5 2001 2.8 177.1
1972 3.2 41.8 2002 1.6 179.9
1973 6.2 44.4 2003 2.3 184.0
1974 11.0 49.3 2004 2.7 188.9
1975 9.1 53.8 2005 3.4 195.3
1976 5.8 56.9 2006 3.2 201.6
1977 6.5 60.6 2007 2.8 207.3
1978 7.6 72.6 2008 3.9 215.3
1979 11.3 65.2 2009 –0.4 214.5
Sources: Bureau of Labor Statistics, U.S. Department of Labor.
The Costs of Inflation
If you asked most people why inflation is bad, they would tell you that it lowers the overall standard of
living by making goods and services more expensive. That is, it cuts into people’s purchasing power.People are fond of recalling the days when a bottle of Coca-Cola cost a dime and a hamburger cost aquarter. Just think what we could buy today if prices had not changed. What people usually do not
ECONOMICS IN PRACTICE
The Politics of Cost-of-Living Adjustments
In the last few years many state governments in the United States
have begun to see the costs associated with retiring state workersescalate as the number of retirees has grown. For many of these
public-sector retirees, pensions have been tied to the cost of living.
In most years the CPI has gone up and pensions with it. But as yousaw in Table 22.5, in 2009 the CPI fell. The article below describesthe situation for state retirees in Maryland, in 2010, following the
CPI decline when no pension increases were forthcoming. As one
retiree points out, even if the overall rate of inflation is negative orlow, prices in the market basket a typical retiree purchases mayhave gone up. It is difficult to design the optimal policy underthese conditions.
No Cost-of-Living Increase for State
Retirees in July
The Baltimore Sun
More than 115,000 retirees and beneficiaries collecting state
pensions won’t see an increase in their checks next month—afirst since annual cost-of-living adjustments were put in place
in 1971.
Retirement payments were actually set to drop slightly
in lockstep with the Consumer Price Index, a common
measure of inflation that fell in 2009 after rising for more
than half a century. Instead, the General Assembly decidedto hold the benefits steady and plans to subtract from anyincrease next year the amount added this year to make up
for deflation.
Virginia Crespo, 63, understands the reasoning. Deflation
also kept her Social Security payment from rising in Januaryas it normally would. The trouble is, her cost of living has
gone up, not down, she says.
Health care is driving her expenses up, as is the case for
many retirees. The cost of her health insurance premiumincreased by $44 a month in December; at the same time,her co-pay for three months of blood-pressure medicine
jumped from $10 to $50.
“There’s going to be nothing to balance out that
amount in July,” said Crespo, a Millersville resident whoretired eight years ago from the Anne Arundel County pub-
lic school system. Teachers’ pensions are handled by the
state. “With less money in the check, you have to be muchmore cautious.”
Source: The Baltimore Sun, © June 13, 2010 The Baltimore Sun Company.
All rights reserved. Used by permission and protected by the CopyrightLaws of the United States. The printing, copying, redistribution, or retrans-mission of the Material without express written permission is prohibited.450 PART IV Concepts and Problems in Macroeconomics
think about is what their incomes were in the “good old days.” The fact that the cost of a Coke has
increased from 10 cents to a dollar does not mean anything in real terms if people who onceearned $5,000 now earn $50,000. During inflations, most prices—including input prices likewages—tend to rise together, and input prices determine both the incomes of workers and theincomes of owners of capital and land. So inflation by itself does not necessarily reduce ones
purchasing power.
Inflation May Change the Distribution of Income Whether you gain or lose dur-
ing a period of inflation depends on whether your income rises faster or slower than the prices ofthe things you buy. The group most often mentioned when the impact of inflation is discussed ispeople living on fixed incomes. If your income is fixed and prices rise, your ability to purchasegoods and services falls proportionately.
Although the elderly are often thought of as living on fixed incomes, many pension plans
pay benefits that are indexed to inflation, as we describe in the Economics in Practice on this page.
The benefits these plans provide automatically increase when the general price level rises. Ifprices rise 10 percent, benefits also rise 10 percent. The biggest source of income for the elderlyis Social Security. These benefits are fully indexed; when prices rise—that is, when the CPIrises—by 5 percent, Social Security benefits also increase by 5 percent.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 451
real interest rate The
difference between the interestrate on a loan and the
inflation rate.Wages are also sometimes indexed to inflation through cost of living adjustments (COLAs)
written into labor contracts. These contracts usually stipulate that future wage increases will belarger the larger is the rate of inflation. If wages are fully indexed, workers do not suffer a fall inreal income when inflation rises, although wages are not always fully indexed.
One way of thinking about the effects of inflation on the distribution of income is to distin-
guish between anticipated andunanticipated inflation. If inflation is anticipated and contracts are
made and agreements written with the anticipated value of inflation in mind, there need not beany effects of inflation on income distribution. Consider an individual who is thinking aboutretiring and has a pension that is not indexed to the CPI. If she knew what inflation was going tobe for the next 20 or 30 years of her retirement, there would be no problem. She would just waitto retire until she had enough money to pay for her anticipated growing expenses. The problemoccurs if after she has retired inflation is higher than she expected. At that point, she may face theprospect of having to return to work. Similarly, if I as a landlord expect inflation to be 2 percentper year over the next 3 years and offer my tenants a 3-year lease with a 2 percent rent increaseeach year, I will be in bad shape if inflation turns out to be 10 percent per year and causes all mycosts to rise by 10 percent per year.
For another example, consider debtors versus creditors. It is commonly believed that debtors
benefit at the expense of creditors during an inflation because with inflation they pay back less inthe future in real terms than they borrowed. But this is not the case if the inflation is anticipatedand the loan contract is written with this in mind.
Suppose that you want to borrow $100 from me to be paid back in a year and that we
both agree that if there is no inflation the appropriate interest rate is 5 percent. Suppose alsothat we both anticipate that the inflation rate will be 10 percent. In this case we will agree ona 15 percent interest rate—you will pay me back $115 at the end of the year. By charging you15 percent I have taken into account the fact that you will be paying me back with dollarsworth 10 percent less in real terms than when you borrowed them. I am then not hurt byinflation and you are not helped if the actual inflation rate turns out to equal our anticipatedrate. I am earning a 5 percent real interest rate —the difference between the interest rate on a
loan and the inflation rate.
Unanticipated inflation, on the other hand, is a different story. If the actual inflation rate
during the year turns out to be 20 percent, I as a creditor will be hurt. I charged you 15 percentinterest, expecting to get a 5 percent real rate of return, when I needed to charge you 25 percent toget the same 5 percent real rate of return. Because inflation was higher than anticipated, I got anegative real return of 5 percent. Inflation that is higher than anticipated benefits debtors; infla-tion that is lower than anticipated benefits creditors.
T o summarize, the effects of anticipated inflation on the distribution of income are likely to
be fairly small, since people and institutions will adjust to the anticipated inflation.Unanticipated inflation, on the other hand, may have large effects, depending, among otherthings, on how much indexing to inflation there is. If many contracts are not indexed and arebased on anticipated inflation rates that turn out to be wrong, there can be big winners andlosers. In general, there is more uncertainty and risk when inflation is unanticipated. Thisuncertainty may prevent people from signing long-run contracts that would otherwise be bene-ficial for both parties.
Administrative Costs and Inefficiencies There may be costs associated even with
anticipated inflation. One is the administrative cost associated with simply keeping up. Duringthe rapid inflation in Israel in the early 1980s, a telephone hotline was set up to give the hourlyprice index. Store owners had to recalculate and repost prices frequently, and this took time thatcould have been used more efficiently. In Zimbabwe, where the inflation rate in June 2008 wasestimated by some to be over 1 million percent at an annual rate, the government was forced toprint ever-increasing denominations of money.
More frequent banking transactions may also be required when anticipated inflation is high.
For example, interest rates tend to rise with anticipated inflation. When interest rates are high, theopportunity costs of holding cash outside of banks is high. People therefore hold less cash and needto stop at the bank more often. (We discuss this effect in more detail in the next part of this book.)
452 PART IV Concepts and Problems in Macroeconomics
Public Enemy Number One? Economists have debated the seriousness of the costs
of inflation for decades. Some, among them Alan Blinder, say, “Inflation, like every teenager,is grossly misunderstood, and this gross misunderstanding blows the political importance ofinflation out of all proportion to its economic importance.”
3Others such as Phillip Cagan
and Robert Lipsey argue, “It was once thought that the economy would in time make all the necessary adjustments [to inflation], but many of them are proving to be very difficult….For financial institutions and markets, the effects of inflation have been extremely unsettling.”
4
No matter what the real economic cost of inflation, people do not like it. It makes us uneasy
and unhappy. In 1974, President Ford verbalized some of this discomfort when he said, “Ourinflation, our public enemy number one, will unless whipped destroy our country, our homes,our liberties, our property, and finally our national pride, as surely as any well-armed wartimeenemy.”
5In this belief, our elected leaders have vigorously pursued policies designed to stop
inflation. In 2010, after many years of low inflation, some observers began to worry about pos-sible future increases in inflation.
Long-Run Growth
In discussing long-run growth, it will be useful to begin with a few definitions. Output
growth is the growth rate of the output of the entire economy. Per-capita output growth
is the growth rate of output per person in the economy. If the population of a country isgrowing at the same rate as output, then per-capita output is not growing: Output growth issimply keeping up with population growth. Not everyone in a country works, and so outputper worker is not the same as output per person. Output per worker is larger than output perperson, and it is called productivity. Productivity growth is thus the growth rate of output
per worker .
One measure of the economic welfare of a country is its per-capita output. Per-capita out-
put can increase because productivity increases, as each worker now produces more than he orshe did previously, or because there are more workers relative to nonworkers in the population.In the United States, both forces have been at work in increasing per-capita output.
Output and Productivity Growth
We have pointed out that aggregate output in the United States has grown at an annual rate of3.3 percent since 1900. Some years are better than this and some years worse, but, on average, thegrowth rate has been 3.3 percent. An area of economics called growth theory is concerned with the
question of what determines this rate. Why 3.3 percent and not 2 percent or 4 percent? We takeup this question in Chapter 32, but a few points are useful to make now.
In a simplified economy, machines (capital) and workers (labor) are needed to produce out-
put. Suppose that an economy consists of six machines and 60 workers, with 10 workers workingon each machine, and that the length of the workweek is 40 hours, with this workweek resultingin 50 units of output per month per machine. T otal output (GDP) for the month is thus 300 units(6 machines times 50 units per machine) in this simple economy.
How can output increase in this economy? There are a number of ways. One way is to add
more workers. If, for example, 12 workers are added, 2 extra per machine, more output can beproduced per machine per hour worked because there are more workers helping out on eachmachine. Another way is to add more machines. For example, if 4 machines are added, the
3Alan Blinder, Hard Heads, Soft Hearts: Tough-Minded Economics for a Just Society (Reading, MA: Addison-Wesley, 1987).
4Phillip Cagan and Robert Lipsey, “The Financial Effects of Inflation,” National Bureau of Economic Research (Cambridge, MA:
General Series No. 103, 1978), pp. 67–68.
5U.S. President, Weekly Compilation of Presidential Documents, vol. 10, no. 41, p. 1247. Cited in Blinder, Hard Heads .output growth The growth
rate of the output of the entire economy.
per-capita output growth
The growth rate of output per
person in the economy.
productivity growth The
growth rate of output
per worker.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 453Output per worker hour
(Constant-2005-dollars)
1955 I 1952 I 1960 I
Quarters1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I13.545.5
33.560.0
25.0
18.53.1%2.5%2.0%
1.4%
2010 ILine segments
Output per worker hour
/L50304FIGURE 22.2 Output per Worker Hour (Productivity), 1952 I–2010 I
Productivity grew much faster in the 1950s and 1960s than since.60 workers have a total of 10 machines to work with instead of 6 and more output can be pro-
duced per worker per hour worked. A third way is to increase the length of the workweek (forexample, from 40 hours to 45 hours). With workers and machines working more hours, moreoutput can be produced. Output can thus increase if labor or capital increases or if the amount oftime that labor and capital are working per week increases.
Another way for output to increase in our economy is for the quality of the workers to
increase. If, for example, the education of the workers increases, this may add to their skillsand thus increase their ability to work on the machines. Output per machine might then risefrom 50 units per month to some larger number per month. Also, if workers become morephysically fit by exercising more and eating less fat and more whole grains and fresh fruitsand vegetables, their greater fitness may increase their output on the machines. People aresometimes said to be adding to their human capital when they increase their mental or phys-
ical skills.
The quality of the machines may also increase. In particular, new machines that replace old
machines may allow more output to be produced per hour with the same number of workers. Inour example, it may be that 55 instead of 50 units of output can be produced per month per newmachine with 10 workers per machine and a 40-hour workweek. An obvious example is thereplacement of an old computer with a new, faster one that allows more to be done per minute ofwork on the computer.
T o summarize, output can increase when there are more workers, more skills per worker,
more machines, better machines, or a longer workweek.
Output per worker hour is called labor productivity or sometimes just productivity .O u t p u t p e r
worker hour is plotted in Figure 22.2 for the 1952 I–2010 I period. Two features are immediatelyclear from the figure. First, there is an upward trend. Second, there are fairly sizable short-run fluc-tuations around the trend. We will see in Chapter 31 why there are short-run fluctuations. This hasto do with the possibility that the employed workforce is not always fully utilized. For now, however,the main interest is the long-run trend.
T o smooth out the short-run fluctuations in Figure 22.2, we have added straight-line seg-
ments to the figure, where the segments roughly go through the high values. The slope ofeach line segment is the growth rate of productivity along the segment. The growth rates arelisted in the figure. The different productivity growth rates in the figure tell an interestingstory. From the 1950s through the mid-1960s, the growth rate was 3.1 percent. The rate then
fell to 2.5 percent in the last half of the 1960s and early 1970s. Between the early 1970s and
the early 1990s, the growth rate was much lower at 1.4 percent. Since the early 1990s, it hasbeen 2.0 percent.
Why are the growth rates positive in Figure 22.2? Why has the amount of output that a
worker can produce per hour risen in the last half century? Part of the answer is that the amountof capital per worker has increased. In Figure 22.3 capital per worker is plotted for the same 1952I–2010 I period. It is clear from the figure that the amount of capital per worker has generallybeen rising. Therefore, with more capital per worker, more output can be produced per worker.The other part of the answer is that the quality of labor and capital has been increasing. Both theaverage skill of workers and the average quality of capital have been increasing. This means thatmore output can be produced per worker for a given quantity of capital because both workersand capital are getting better.
A harder question to answer concerning Figure 22.2 is why the growth rate of produc-
tivity was much higher in the 1950s and 1960s than it has been since the early 1970s. Again,part of the answer is that the amount of capital per worker rose more rapidly in the 1950sand 1960s than it has since then. This can be seen in Figure 22.3. The other part of theanswer is, of course, that the quality of labor and capital must have increased more in the1950s and 1960s than later, although this, to some extent, begs the question. The key ques-tion is why the quality of labor and capital has grown more slowly since the early 1970s. Wetake up this question in Chapter 32, where we will see that there seems to be no oneobvious answer. An interesting question for the future is whether the continued growth ofthe Internet will lead to a much larger productivity growth rate, perhaps as large asthe growth rate in the 1950s and 1960s. In the present context, you can think about thegrowth of the Internet as an increase in physical capital (wires, servers, switchers, and soon) and an increase in the quality of capital (an increase in what can be done per minuteusing the Internet). Time will tell whether the Internet will lead to a “new age” of produc-tivity growth.
Looking Ahead
This ends our introduction to the basic concepts and problems of macroeconomics. The firstchapter of this part introduced the field; the second chapter discussed the measurement of national product and national income; and this chapter discussed unemployment, infla-tion, and long-run growth. We are now ready to begin the analysis of how the macroecon-omy works.454 PART IV Concepts and Problems in Macroeconomics
1955 I 1952 I 1960 ICapital per worker
(thousands of constant-2005-dollars)
Quarters1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I100.0
75.0
45.5
35.558.5
2005 I 2010 I
/L50304FIGURE 22.3 Capital per Worker, 1952 I–2010 I
Capital per worker grew until about 1980 and then leveled off somewhat.
CHAPTER 22 Unemployment, Inflation, and Long-Run Growth 455
SUMMARY
UNEMPLOYMENT p. 441
1.The unemployment rate is the ratio of the number of
unemployed people to the number of people in the labor
force . T o be considered unemployed and in the labor force, a
person must be looking for work.
2.Big differences in rates of unemployment exist across demo-graphic groups, regions, and industries. African Americans,for example, experience much higher unemployment ratesthan whites.
3.A person who decides to stop looking for work is consideredto have dropped out of the labor force and is no longer clas-sified as unemployed. People who stop looking because theyare discouraged about finding a job are sometimes calleddiscouraged workers .
4.Some unemployment is inevitable. Because new workers are
continually entering the labor force, because industries andfirms are continuously expanding and contracting, andbecause people switch jobs, there is a constant process of jobsearch as workers and firms try to match the best people tothe available jobs. This unemployment is both natural andbeneficial for the economy.
5.The unemployment that occurs because of short-runjob/skill-matching problems is called frictional
unemployment . The unemployment that occurs because of
longer-run structural changes in the economy is calledstructural unemployment . The natural rate of unemploymentis the sum of the frictional rate and the structural rate. The
increase in unemployment that occurs during recessions anddepressions is called cyclical unemployment .
INFLATION p. 447
6.The consumer price index (CPI) is a fixed-weight price index.
It represents the “market basket” purchased by the typicalurban consumer.
7.Whether people gain or lose during a period of inflationdepends on whether their income rises faster or slower thanthe prices of the things they buy. The elderly are more insu-lated from inflation than most people think because SocialSecurity benefits and many pensions are indexed to inflation.
8.Inflation is likely to have a larger effect on the distribution ofincome when it is unanticipated than when it is anticipated.
LONG-RUN GROWTH p. 452
9.Output growth depends on: (1) the growth rate of the capi-tal stock, (2) the growth rate of output per unit of the capitalstock, (3) the growth rate of labor, and (4) the growth rate ofoutput per unit of labor.
10. Output per worker hour (labor productivity) rose faster inthe 1950s and 1960s than it rose from the 1970s to 2007. Aninteresting question is whether labor productivity will risefaster in the future because of the Internet.
REVIW TERMS AND CONCEPTS
consumer price index (CPI), p. 448
cyclical unemployment, p. 447
discouraged-worker effect, p. 444
employed, p. 442
frictional unemployment, p. 446
labor force, p. 442
labor force participation rate, p. 442
natural rate of unemployment, p. 447
not in the labor force, p. 442
output growth, p. 452
per-capita output growth, p. 452producer price indexes (PPIs), p. 449
productivity growth, p. 452
real interest rate, p. 451
structural unemployment, p. 447unemployed, p. 442
unemployment rate, p. 442
1. labor force = employed + unemployed
2. population = labor force + not in labor force
3.
4. labor force participation rate =labor force
populationunemployment rate =unemployed
employed +unemployed
PROBLEMS
All problems are available on www.myeconlab.com
1.In late 2010 economists were debating whether the U.S. econ-
omy was in a recession. GDP seemed to be rising, yet the unem-ployment rate was stuck at close to 10 percent. In thinking
about the economic distress experienced during a recession
which is the most important: high unemployment or fallingGDP? Defend your answer.2.When an inefficient firm or a firm producing a product that
people no longer want goes out of business, people are unem-ployed, but that is part of the normal process of economic
growth and development. The unemployment is part of the
456 PART IV Concepts and Problems in Macroeconomics
GOODQUANTITY
CONSUMED2008
PRICES2009
PRICES2010
PRICES
X 100 $1.00 $1.50 $1.75
Y 150 1.50 2.00 2.00
Z 25 3.00 3.25 3.00natural rate and need not concern policy makers. Discuss that
statement and its relevance to the economy today.
3.What is the unemployment rate in your state today? What was it
in 1970, 1975, 1982, and 2008? How has your state done relative
to the national average? Do you know or can you determine why?
4.Suppose all wages, salaries, welfare benefits, and other sources of
income were indexed to inflation. Would inflation still be con-sidered a problem? Why or why not?
5.Go to www.bls.gov and click on the links for state and area
employment and unemployment. Look at your home state anddescribe what changes have taken place in the workforce. Has
the labor force participation rate gone up or down? Provide an
explanation for the rate change. Are your state’s experiences thesame as the rest of the country? Provide an explanation of whyyour state’s experiences are the same as or different from the restof the country.
6.What do the CPI and the PPI measure? Why do we need both of
these price indexes? (Think about what purpose you would useeach one for.)
7.The consumer price index (CPI) is a fixed-weight index. It com-
pares the price of a fixed bundle of goods in one year with theprice of the same bundle of goods in some base year. Calculatethe price of a bundle containing 100 units of good X, 150 units
of good Y, and 25 units of good Zin 2008, 2009, and 2010.
Convert the results into an index by dividing each bundle price
figure by the bundle price in 2008. Calculate the percentagechange in your index between 2008 and 2009 and again between2009 and 2010. Was there inflation between 2009 and 2010?
8.Consider the following statements:
a.More people are employed in Tappania now than at any time
in the past 50 years.
b.The unemployment rate in Tappania is higher now than it
has been in 50 years.
Can both of those statements be true at the same time? Explain.
9.Policy makers talk about the “capacity” of the economy to grow.
What specifically is meant by the “capacity” of the economy?How might capacity be measured? In what ways is capacity lim-ited by labor constraints and by capital constraints? What arethe consequences if demand in the economy exceeds capacity?
What signs would you look for?
10.What was the rate of growth in real GDP during the most recent
quarter? Y ou can find the answer in publications such as the
Survey of Current Business, The Economist , and Business Week .
Has growth been increasing or decreasing? What policies mightyou suggest for increasing the economy’s potential long-run rateof growth?11.Suppose the stock of capital and the workforce are both increas-
ing at 3 percent annually in the country of Wholand. At the
same time, real output is growing at 6 percent. How is that pos-sible in the short run and in the long run?
12.Suppose the number of employed people in an economy is
121,166,640. The unemployment rate in this economy is
10.4 percent, or .104, and the labor force participation rate is72.5 percent, or .725.a.What is the size of the labor force?
b.How many people are unemployed?
c.What is the size of the working-age population?
13.On average, nations in Europe pay higher unemployment bene-
fits for longer periods of time than does the United States. How
do you suppose this would impact the unemployment rates inthese nations? Explain which type of unemployment you think
is most directly affected by the size and duration of unemploy-ment benefits.
14.Consider the following four situations. In which situation
would a borrower be best off and in which situation would alender be best off?a.The nominal interest rate is 14 percent and the inflation rate
is 17 percent.
b.The nominal interest rate is 7 percent and the inflation rate
is 3 percent.
c.The nominal interest rate is 4 percent and the inflation rate
is –2 percent.
d.The real interest rate is 6 percent and the inflation rate is
2 percent.
15.In each of the following cases, classify the person as cyclically
unemployed, structurally unemployed, frictionally unemployed,
or not in the labor force. Explain your answers.
a.Maya just graduated from a top medical school and is cur-
rently deciding which hospital emergency room job shewill accept.
b.Hector lost his job as an assembly line worker at Chrysler
due to the recession.
c.Alejandro, an advertising executive in Seattle, quit his job
one month ago to look for a more prestigious advertising jobin New Y ork City. He is still looking for a job.
d.Yvonne got laid off from her job as a financial analyst 3 months
ago and has not looked for a new job since then.
e.Taylor lost his job as a welder due to the introduction of
robotic welding machines.
f.Ruby quit her job as a hotel concierge to become a full-time
student at a culinary school.
16.The consumer price index is 125 in year 1 and 160 in year 2. All
inflation is anticipated. If the Commerce Bank of Beverly Hills
charges an interest rate of 35 percent in year 2, what is the
bank’s real interest rate?
17.[Related to the Economics in Practice onp. 450 ]Evaluate the
following statement: Because the CPI is a fixed-weight price
index, it has a tendency to overestimate the rate of inflation.Therefore, if the CPI decreases, it must also have a tendency tounderestimate the rate of deflation.
457The Labor Market
• The supply of labor
• The demand for labor• Employment and
unemploymentThe Goods-and-Services
Market
• Planned aggregate
expenditure Consumption (C)
Planned investment (I)
Government (G)
• Aggregate output (income) (Y)
The Money Market
• The supply of money
• The demand for money• Interest rate (r)Aggregate Supply
• Aggregate supply curve
• Equilibrium interest
rate (r*)
• Equilibrium output
(income) (Y*)
• Equilibrium price level (P*)P
Y
Connections between
the goods-and-servicesmarket and the money
market
r YCHAPTERS 23–24
CHAPTER 27CHAPTER 28
CHAPTER 29
CHAPTERS 25–26
Aggregate Demand
• Aggregate demand
curve
P
Y
/L50304FIGURE V.1 The Core of Macroeconomic Theory
We build up the macroeconomy slowly. In Chapters 23 and 24, we examine the market for goods and ser-
vices. In Chapters 25 and 26, we examine the money market. Then in Chapter 27, we bring the two marketstogether, in so doing explaining the links between aggregate output ( Y) and the interest rate ( r), and derive
the aggregate demand curve. In Chapter 28, we introduce the aggregate supply curve and determine the pricelevel ( P). We then explain in Chapter 29 how the labor market fits into the macroeconomic picture.PARTV
The Core of
Macroeconomic
Theory
We now begin our discussion of the theory of how the macroeconomy works. We know how to
calculate gross domestic product (GDP), but what factors determine it? We know how to define
and measure inflation and unemployment, but what circumstances cause inflation and unem-
ployment? What, if anything, can government do to reduce unemployment and inflation?
Analyzing the various components of the macroeconomy is a complex undertaking.
The level of GDP , the overall price level, and the level of employment—three chief concernsof macroeconomists—are influenced by events in three broadly defined “markets”:
/L50766Goods-and-services market
/L50766Financial (money) market
/L50766Labor market
We will explore each market, as well as the links between them, in our discussion of macro-
economic theory. Figure V .1 presents the plan of the next seven chapters, which form the
458core of macroeconomic theory. In Chapters 23 and 24, we describe the market for goods and
services, often called the goods market . In Chapter 23, we explain several basic concepts and
show how the equilibrium level of output is determined in a simple economy with no gov-ernment and no imports or exports. In Chapter 24, we add the government to the economy.
In Chapters 25 and 26, we focus on the money market . Chapter 25 introduces the money
market and the banking system and discusses the way the U.S. central bank (the FederalReserve) controls the money supply. Chapter 26 analyzes the demand for money and the wayinterest rates are determined. Chapter 27 then examines the relationship between the goodsmarket and the money market and derives the aggregate demand curve. At the end ofChapter 27, the equilibrium values of aggregate output and the interest rate are determinedfor a given price level. Chapter 28 then uses the analysis from Chapter 27, adds the aggregatesupply curve, and determines the price level. Having then determined output, the interestrate, and the price level, we are ready to analyze the effects of fiscal and monetary policies onthe economy. This is done in the second half of Chapter 28. Finally, Chapter 29 discusses thesupply of and demand for labor and the functioning of the labor market in the macroecon-
omy. This material is essential to understanding employment and unemployment.
Before we begin our discussion of aggregate output and income, we need to emphasize
that production, consumption, and other activities that we will be discussing in the follow-ing chapters are ongoing activities. Nonetheless, it is helpful to think about these activities asif they took place in a series of production periods . A period might be a month long or
3 months long. During each period, output is produced, income is generated, and spendingtakes place. At the end of each period, we can examine the results. Was everything that wasproduced in the economy sold? What percentage of income was spent? What percentage wassaved? Is output (income) likely to rise or fall in the next period?
CHAPTER OUTLINE
459Aggregate
Expenditure and
Equilibrium Output
In the last several chapters we
described a number of features ofthe U.S. economy, including realGDP , inflation, and unemploy-ment, and we talked about howthey are measured. Now we beginthe analytical part of macroeco-nomics: we begin to explain how itis that the parts of the economyinteract to produce the time-profileof the American economy that wedescribed in the last few chapters.
We begin with the simplest
case, focusing on households andfirms. Once we understand how households and firms interact at the aggregate level, we will intro-duce government in Chapter 24. Our goal in this chapter is to provide you with a simplified modelthat will let you see what happens to the economy as a whole when there is an increase in invest-ment. If suddenly all the managers of firms in the economy decided to expand their plants, howwould that affect households and aggregate output? Because these are difficult questions, we startwith a simple model and then build up chapter by chapter.
As we work through our model of the economy, we will focus, at least initially, on understand-
ing movements in real gross domestic product (GDP), one of the central measures of macroeco-nomic activity. Because we are interested in tracking real changes in the level of economic activity,we focus on real, rather than nominal, output. So, while we will typically use dollars to measureGDP , you should think about this as dollars corrected for price level changes.
We saw earlier that GDP can be calculated in terms of either income or expenditures. We will
use the variable Yto refer to both aggregate output andaggregate income .
Aggregate output can also be considered the aggregate quantity supplied because it is the
amount that firms are supplying (producing) during a period. In the discussions that follow, weuse the term aggregate output (income ) instead of aggregate quantity supplied , but keep in mind
that the two are equivalent. Also remember that aggregate output means “real GDP .”
From the outset, you must think in “real terms.” For example, when we talk about output ( Y),
we mean real output, not nominal output. Although we discussed in Chapter 21 that the calcula-tion of real GDP is complicated, you can ignore these complications in the following analysis. T ohelp make things easier to read, we will frequently use dollar values for Y. But do not confuse Y
with nominal output. The main point is to think of Yas being in real terms—the quantities of
goods and services produced, not the dollars circulating in the economy.23
The Keynesian Theory
of Consumption p. 460
Other Determinants of
Consumption
Planned
Investment ( I)p. 464
The Determination of
Equilibrium Output(Income)
p. 465
The Saving/Investment
Approach to Equilibrium
Adjustment to Equilibrium
The Multiplier p. 469
The Multiplier EquationThe Size of the Multiplier
in the Real World
Looking Ahead p. 473
Appendix: Deriving
the MultiplierAlgebraically
p. 476
In any given period, there is an exact equality between aggregate output (production) and
aggregate income. Y ou should be reminded of this fact whenever you encounter the com-bined term aggregate output (income) ( Y).aggregate output The
total quantity of goods and
services produced (orsupplied) in an economy in agiven period.
aggregate income The
total income received by all
factors of production in agiven period.
aggregate output (income)
(Y)A combined term used
to remind you of the exact
equality between aggregateoutput and aggregateincome.
consumption function The
relationship betweenconsumption and income.
1John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New Y ork:
Harcourt Brace Jovanovich, 1964), p. 96.460 PART V The Core of Macroeconomic Theory
The Keynesian Theory of Consumption
In 2005, the average American family spent about $1,350 on clothing. For high-income families
earning more than $148,000, the amount spent on clothing was substantially higher, at $3,700. Weall recognize that for consumption as a whole, as well as for consumption of most specific cate-gories of goods and services, consumption rises with income. This relationship between con-sumption and income is central to Keynes’s model of the economy. While Keynes recognized thatmany factors, including wealth and interest rates, play a role in determining consumption levels inthe economy, in his classic The General Theory of Employment, Interest and Money , current income
played the key role:
The fundamental psychological law, upon which we are entitled to depend with great
confidence both a priori from our knowledge of human nature and from the detailed
facts of experience, is that men [and women, too] are disposed, as a rule and on average,to increase their consumption as their incomes increase, but not by as much as theincrease in their income
.1
Keynes is telling us two things in this quote. First, if you find your income going up, you willspend more than you did before. But Keynes is also saying something about how much more youwill spend: He predicts—based on his looking at the data and his understanding of people—thatthe rise in consumption will be less than the full rise in income. This simple observation plays alarge role in helping us understand the workings of the aggregate economy.
The relationship between consumption and income is called a consumption function .
Figure 23.1 shows a hypothetical consumption function for an individual household. The curveis labeled c(y), which is read “ cis a function of y,” or “consumption is a function of income.”
Note that we have drawn the line with an upward slope, reflecting that consumption increaseswith income. T o reflect Keynes’s view that consumption increases less than one for one withincome, we have drawn the consumption function with a slope of less than 1. The consumptionfunction in Figure 23.1 is a straight line, telling us that an increase in income of $1 leads to thesame increase in consumption regardless of the initial value of income. In practice, the con-sumption function may be curved, with the slope decreasing as income increases. This wouldtell us that the typical consumer spends less of the incremental income received as his or herincome rises.
The consumption function in Figure 23.1 represents an individual household. In macroeco-
nomics, however, we are interested in the behavior of the economy as a whole, the aggregate con-sumption of all households in the economy in relation to aggregate income. Figure 23.2 shows this
c(y)
Household income, yHousehold consumption, c
0/L50298FIGURE 23.1 A
Consumption Functionfor a Household
A consumption function for an
individual household shows thelevel of consumption at each
level of household income.
CHAPTER 23 Aggregate Expenditure and Equilibrium Output 461
aggregate consumption function, again using a straight line, or constant slope, for simplicity.
With a straight line consumption curve, we can use the following equation to describe the curve:
C=a+bY
Yis aggregate output (income), Cis aggregate consumption, and ais the point at which the con-
sumption function intersects the C-axis—a constant. The letter bis the slope of the line, in this
case /H9004C//H9004Y[because consumption ( C) is measured on the vertical axis and income ( Y) is mea-
sured on the horizontal axis].2Every time income increases (say by /H9004Y), consumption increases
by btimes /H9004Y. Thus, /H9004C=b/H11003/H9004 Yand/H9004C//H9004Y=b. Suppose, for example, that the slope of the
line in Figure 23.2 is .75 (that is, b= .75). An increase in income ( /H9004Y) of $1,000 would then
increase consumption by b/H9004Y= .75 /H11003$1,000, or $750.
Themarginal propensity to consume ( MPC )is the fraction of a change in income that is
consumed. In the consumption function here, bis the MPC .A n MPC of .75 means consumption
changes by .75 of the change in income. The slope of the consumption function is the MPC .A n
MPC less than 1 tells us that individuals spend less than 100 percent of their income increase, just
as Keynes suggested.C = a + bY
/H9004C
/H9004Y
/H9004C
/H9004YSlope =
Aggregate income, YAggregate consumption, C
0=ba/L50296FIGURE 23.2
An Aggregate
Consumption Function
The aggregate consumption
function shows the level ofaggregate consumption at each
level of aggregate income. The
upward slope indicates thathigher levels of income lead tohigher levels of consumption
spending.
marginal propensity to
consume ( MPC )That
fraction of a change in income
that is consumed, or spent.
aggregate saving ( S)The
part of aggregate income thatis not consumed.
identity Something that is
always true.
marginal propensity to save
(MPS)That fraction of a
change in income that is saved.Aggregate saving ( S)in the economy, denoted S, is the difference between aggregate
income and aggregate consumption:
The triple equal sign means that this equation is an identity , or something that is always true by defin-
ition. This equation simply says that income that is not consumed must be saved. If $0.75 of a $1.00 increase in income goes to consumption, $0.25 must go to saving. If income decreases by $1.00,consumption will decrease by $0.75 and saving will decrease by $0.25. The marginal propensity to
save ( MPS)is the fraction of a change in income that is saved: /H9004S//H9004Y,w h e r e /H9004Sis the change in sav-
ing. Because everything not consumed is saved, the MPC and the MPS must add up to 1.SKY-C
Because the MPC and the MPS are important concepts, it may help to review their defin-
itions. The marginal propensity to consume ( MPC ) is the fraction of an increase in income
that is consumed (or the fraction of a decrease in income that comes out of consumption).MPC +MPS /H110131
2The Greek letter /H9004(delta) means “change in.” For example, /H9004Y(read “delta Y”) means the “change in income.” If income ( Y) in
2007 is $100 and income in 2008 is $110, then /H9004Yfor this period is $110 -$100 = $10. For a review of the concept of slope, see
Appendix, Chapter 1.marginal propensity to consume Kslope of consumption function K¢C
¢Y
Aggregate consumption, C800
700
600
500
400
300
200
100
100 0 200 300 400 500 600 700 800 900 1000/H9004Y= 100
Aggregate income, Y/H9004C= 75C= 100 + .75 Y
/H9004C
/H9004YSlope = =75
100= .75 /L50298FIGURE 23.3
The Aggregate
Consumption FunctionDerived from theEquationC= 100 + .75 Y
In this simple consumption func-
tion, consumption is 100 at an
income of zero. As income rises,so does consumption. For every100 increase in income, con-
sumption rises by 75. The slope
of the line is .75.462 PART V The Core of Macroeconomic Theory
The marginal propensity to save ( MPS ) is the fraction of an increase in income that is saved
(or the fraction of a decrease in income that comes out of saving).
The numerical examples used in the rest of this chapter are based on the following consump-
tion function:
This equation is simply an extension of the generic C=a+bYconsumption function we have
been discussing, where ais 100 and bis .75. This function is graphed in Figure 23.3.
Since saving and consumption by definition add up to income, we can use the consump-
tion curve to tell us about both consumption and saving. We do this in Figure 23.4. In this fig-ure, we have drawn a 45° line from the origin. Everywhere along this line aggregateconsumption is equal to aggregate income. Therefore, saving is zero. Where the consumptioncurve is above the 45° line, consumption exceeds income and saving is negative. Where the con-
sumption function crosses the 45° line, consumption is equal to income and saving is zero.
Where the consumption function is below the 45° line, consumption is less than income and
saving is positive. Note that the slope of the saving function is /H9004S//H9004Y, which is equal to the
marginal propensity to save ( MPS ). The consumption function and the saving function are
mirror images of each other. No information appears in one that does not appear in the other.These functions tell us how households in the aggregate will divide income between consump-tion spending and saving at every possible income level. In other words, they embody aggregatehousehold behavior.C=100()*+.75"Y
ab
Aggregate Income, Y Aggregate Consumption, C
0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850
Other Determinants of Consumption
The assumption that consumption depends only on income is obviously a simplification. In prac-
tice, the decisions of households on how much to consume in a given period are also affected bytheir wealth, by the interest rate, and by their expectations of the future. Households with higherwealth are likely to spend more, other things being equal, than households with less wealth.
The boom in the U.S. stock market in the last half of the 1990s and the boom in housing
prices between 2003 and 2005, both of which increased household wealth substantially, led house-holds to consume more than they otherwise would have in these periods. In 2009–2010, after a fallin housing prices and the stock market, consumption was less than it otherwise would have been.CHAPTER 23 Aggregate Expenditure and Equilibrium Output 463Aggregate consumption, CC= 100 + .75 Y
Aggregate income, YAggregate income, YAggregate saving, S
200 400 800+100
+50
0
–50
–100S/H11013 Y – C800
700
400
250
200 400 800 Y200
045ș/L50296FIGURE 23.4
Deriving the Saving
Function from theConsumption Functionin Figure 23.3
Because S/H11013Y-C, it is easy to
derive the saving function fromthe consumption function. A
45° line drawn from the origin
can be used as a convenient toolto compare consumption andincome graphically. At Y= 200,
consumption is 250. The 45°
line shows us that consumptionis larger than income by 50.Thus, S/H11013Y-C=-50.
AtY= 800, consumption is
less than income by 100. Thus, S= 100 when Y= 800.
Y – C = S
Aggregate
IncomeAggregate
Consumption Aggregate
Saving
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
464 PART V The Core of Macroeconomic Theory
ECONOMICS IN PRACTICE
Behavioral Biases in Saving Behavior
This chapter has described how saving is related to income.
Economists have generally assumed that people make theirsaving decisions rationally, just as they make other decisionsabout choices in consumption and the labor market. Savingdecisions involve thinking about trade-offs between presentand future consumption. Recent work in behavioral economicshas highlighted the role of psychological biases in savingbehavior and has demonstrated that seemingly small changesin the way saving programs are designed can result in bigbehavioral changes.
Many retirement plans are designed with an opt-in fea-
ture. That is, you need to take some action to enroll. Typically,when you begin a job, you need to check yes on the retire-ment plan enrollment form. Recent work in economics byJames Choi of Y ale University and Bridget Madrian andDennis Shea of the University of Chicago suggests that simplychanging the enrollment process from the opt-in structurejust described to an opt-out system in which people are auto-matically enrolled unless they check the no box dramaticallyincreases enrollment in retirement pension plans. In onestudy, the change from an opt-in to an opt-out systemincreased pension plan enrollment after 3 months of workfrom 65 percent to 98 percent of workers.
Behavioral economists have administered a number of sur-
veys suggesting that people, on average, think they save too lit-tle of their income for retirement. Shlomo Benartzi, from theUniversity of California, Los Angeles, and Richard Thaler,
from the University of Chicago, devised a retirement programto try to increase saving rates. Under this plan, called SaveMore T omorrow, employees are offered a program that allowsthem to precommit to save more whenever they get a payraise. Behavioral economists argue that people find this optionattractive because it is easier for them to commit to makingsacrifices tomorrow than it is for them to make those sacrificestoday. (This is why many people resolve to diet some time inthe future but continue to overeat today.) The Save MoreT omorrow retirement plans have been put in place in a num-ber of companies, including Vanguard, T. Rowe Price, andTIAA-CREF. Early results suggest dramatic increases in thesaving rates of those enrolled, with saving rates quadruplingafter 4 years and four pay raises.
For many households, interest rates also figure in to consumption and saving decisions. Lower
interest rates reduce the cost of borrowing, so lower interest rates are likely to stimulate spending.(Conversely, higher interest rates increase the cost of borrowing and are likely to decrease spending.)Finally, as households think about what fraction of incremental income to consume versus save, theirexpectations about the future may also play a role. If households are optimistic and expect to do bet-ter in the future, they may spend more at present than if they think the future will be bleak.
Household expectations are also important regarding households’ responses to changes in
their income. If, for example, the government announces a tax cut, which increases after-taxincome, households’ responses to the tax cut will likely depend on whether the tax cut is expectedto be temporary or permanent. If households expect that the tax cut will be in effect for only twoyears, their responses are likely to be smaller than if they expect the tax cut to be permanent.
We examine these issues in Chapter 31, where we take a closer look at household behavior
regarding both consumption and labor supply. But for now, we will focus only on income asaffecting consumption.
Planned Investment ( I)
The output of an economy consists not only of goods consumed by households, but investments
made by firms. Some firms’ investments are in the form of plants and equipment. These are notvery different from consumption of households. In a given period, a firm might buy $500,000 ofnew machinery, which would be part of aggregate output for the period, as would the purchase ofautomobiles by households. In Chapter 21, you learned that firms’ investments also include
CHAPTER 23 Aggregate Expenditure and Equilibrium Output 465
I= 2560
50
40
30
20
10Planned investment, I
Aggregate income, Y0/L50296 FIGURE 23.5 The
Planned InvestmentFunction
For the time being, we will
assume that planned investment
is fixed. It does not change when
income changes, so its graph is ahorizontal line.
planned investment ( I)
Those additions to capital
stock and inventory that areplanned by firms.
actual investment The actual
amount of investment that
takes place; it includes itemssuch as unplanned changes in
inventories.inventories. Understanding how firms invest in inventories is a little more complicated, but it is
important for understanding the way the macroeconomy works.
A firm’s inventory is the stock of goods that it has awaiting sale. For many reasons, most
firms want to hold some inventory. It is hard to predict exactly when consumers will want topurchase a new refrigerator, and most customers are not patient. Sometimes it is cheaper toproduce goods in larger volumes than current demand requires, which leads firms to want to have inventory. From a macroeconomic perspective, however, inventory differs from othercapital investments in one very important way: While purchases by firms of machinery andequipment are always deliberate, sometimes inventories build up (or decline) without any
deliberate plan by firms. For this reason, there can be a difference between planned invest ment ,
which consists of the investments firms plan to make, and actual investment , which consists
of all of firms’ investments, including their unplanned changes in inventories.
Why are inventories sometimes different from what was planned? Recall that firms hold
planned inventories in anticipation of sales, recognizing that the exact timing of sales may beuncertain. If a firm overestimates how much it will sell in a period, it will end up with more ininventory than it planned to have. On other occasions, inventories may be lower than plannedwhen sales are stronger than expected.
We will use Ito refer only to planned investment. As we will see shortly, the economy is in equi-
librium only when planned investment and actual investment are equal. The determinants of
planned investment will be explored in later chapters. For the rest of this chapter we will assumethat firms’ planned investment is fixed and does not depend on income. We show this case inFigure 23.5, where planned investment is fixed at a level of 25.
The Determination of Equilibrium Output
(Income)
Thus far, we have described the behavior of firms and households. We now discuss the nature of
equilibrium and explain how the economy achieves equilibrium.
A number of definitions of equilibrium are used in economics. They all refer to the idea that
at equilibrium, there is no tendency for change. In microeconomics, equilibrium is said to exist ina particular market (for example, the market for bananas) at the price for which the quantitydemanded is equal to the quantity supplied. At this point, both suppliers and demanders are sat-isfied. The equilibrium price of a good is the price at which suppliers want to furnish the amountthat demanders want to buy.
T o define equilibrium for the macroeconomy, we start with a new variable, planned
aggregate expenditure ( AE). Planned aggregate expenditure is, by definition, consumption
plus planned investment:
AE/H11013C+Iequilibrium Occurs when
there is no tendency for
change. In the macroeconomicgoods market, equilibriumoccurs when planned
aggregate expenditure is equal
to aggregate output.
planned aggregate
expenditure ( AE)The total
amount the economy plans to
spend in a given period. Equalto consumption plus plannedinvestment: AE
/H11013C+I.
466 PART V The Core of Macroeconomic Theory
Note that Iis planned investment spending only. It does not include any unplanned increases or
decreases in inventory. Note also that this is a definition. Aggregate expenditure is always equal toC+I, and we write it with the triple equal sign.
The economy is defined to be in equilibrium when aggregate output ( Y) is equal to planned
aggregate expenditure ( AE).
Equilibrium: Y=AE
Because AEis, by definition, C+I, equilibrium can also be written:
Equilibrium: Y=C+I
It will help in understanding the equilibrium concept to consider what happens if the econ-
omy is out of equilibrium. First, suppose aggregate output is greater than planned aggregateexpenditure:
When output is greater than planned spending, there is unplanned inventory investment. Firms
planned to sell more of their goods than they sold, and the difference shows up as an unplannedincrease in inventories.
Next, suppose planned aggregate expenditure is greater than aggregate output:
When planned spending exceeds output, firms have sold more than they planned to. Inventory
investment is smaller than planned. Planned and actual investment are not equal. Only whenoutput is exactly matched by planned spending will there be no unplanned inventory investment.If there is unplanned inventory investment, this will be a state of disequilibrium. The mechanismby which the economy returns to equilibrium will be discussed later. Equilibrium in the goodsmarket is achieved only when aggregate output ( Y) and planned aggregate expenditure ( C+I)
are equal, or when actual and planned investment are equal.
Table 23.1 derives a planned aggregate expenditure schedule and shows the point of equi-
librium for our numerical example. (Remember, all our calculations are based on C= 100 +
.75Y). T o determine planned aggregate expenditure, we add consumption spending ( C)t o
planned investment spending ( I) at every level of income. Glancing down columns 1 and 4, we
see one and only one level at which aggregate output and planned aggregate expenditure areequal: Y= 500.planned aggregate expenditure 7aggregate outputC+I7Yaggregate output 7planned aggregate expenditureY7C+I
TABLE 23.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. The Figures in
Column 2 are Based on the Equation C= 100 + .75 Y.
(1) (2) (3) (4) (5) (6)
Aggregate Output
(Income) ( Y)Aggregate
Consumption ( C)Planned
Investment ( I)Planned Aggregate
Expenditure ( AE)
C+IUnplanned
Inventory Change
Y-(C+I)Equilibrium?
(Y=AE?)
100 175 25 200 -100 No
200 250 25 275 -75 No
400 400 25 425 -25 No
500 475 25 500 0 Yes
600 550 25 575 +25 No
800 700 25 725 +75 No
1,000 850 25 875 +125 No
CHAPTER 23 Aggregate Expenditure and Equilibrium Output 467
b.C = 100 + .75 Y
I = 25800
500
125
100
25
0 200 800 500Planned aggregate expenditure, C + I C + Ia.
800
725
600
500
275
200
125
200 500Planned aggregate
expenditure:
(AE/H11013C + I)
Unplanned
rise in
inventory:
output falls
Unplanned
fall in
inventory:
output
rises
Aggregate output, YPlanned aggregate expenditure, C + I
80045șEquilibrium
point:
Y = C + I
0/L50296FIGURE 23.6
Equilibrium Aggregate
Output
Equilibrium occurs when
planned aggregate expenditureand aggregate output are equal.
Planned aggregate expenditure
is the sum of consumptionspending and planned invest-ment spending.Figure 23.6 illustrates the same equilibrium graphically. Figure 23.6a adds planned invest-
ment, constant at 25, to consumption at every level of income. Because planned investment is aconstant, the planned aggregate expenditure function is simply the consumption function dis-placed vertically by that constant amount. Figure 23.6b shows the planned aggregate expenditurefunction with the 45° line. The 45° line represents all points on the graph where the variables onthe horizontal and vertical axes are equal. Any point on the 45° line is a potential equilibriumpoint. The planned aggregate expenditure function crosses the 45° line at a single point, where Y= 500. (The point at which the two lines cross is sometimes called the Keynesian cross .) At that
point, Y=C+I.
Now let us look at some other levels of aggregate output (income). First, consider Y= 800. Is
this an equilibrium output? Clearly, it is not. At Y= 800, planned aggregate expenditure is 725
(see Table 23.1). This amount is less than aggregate output, which is 800. Because output isgreater than planned spending, the difference ends up in inventory as unplanned inventoryinvestment. In this case, unplanned inventory investment is 75. In the aggregate, firms have moreinventory than desired. As a result, firms have an incentive to change their production plansgoing forward. In this sense, the economy will not be in equilibrium.
Next, consider Y= 200. Is this an equilibrium output? No. At Y= 200, planned aggregate
expenditure is 275. Planned spending ( AE) is greater than output ( Y), and there is an unplanned
fall in inventory investment of 75. Again, firms in the aggregate will experience a different resultfrom what they expected.
AtY= 200 and Y= 800, planned investment and actual investment are unequal. There is
unplanned investment, and the system is out of balance. Only at Y= 500, where planned aggregate
expenditure and aggregate output are equal, will planned investment equal actual investment.
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