MODERN MICROECONOMICS Analysis and Applications

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1 MODERN MICROECONOMICS Analysis and Applications Second Edition DAVID N. HYMAN

2 CONTENTS PARTONE INTRODUCTION TO MICROECONOMICS 1 Modern Microeconomics and its Methodology,2 Scarcity and prices, 3 Scarcity, choice, and the tasks of the economy, 3 Application 1.1, Coping with scarcity: firewood and deforestation in the Third World,5 The role of prices in aliocating resources, 6 Economic transactions and markets, 7 The purpose and functions of markets, 7 Nonmarket activities, 8 Property rights: the prerequisites for market exchange, 9 Transaction costs, 10 Methodology of microeconomics: theories and modeis, 12 Model building, 13 The pursuit and maximization of net gain: a key behavioral assumption in microeconomic modeis, 14 Marginal analysis of net gains of transactions, 15 Positive vs. normative analysis, 16 Application 1.2, Can beer taxes and raising the legal drinking age save your life? Positive economic analysis in action, 17 Summary, 18 2 Market Interaction: Basic Supply and Demand Analysis and its Uses, 22 Market interaction: demand and supply, 23 The demand curve, 23 Changes in demand, 26 The supply curve, 28 Changes in supply, 31 Market equilibrium, 31 Changes in market equilibrium: comparative static analysis, 33 Market response to a change in demand, 33 Market response to a change in supply, 35 Applications of supply and demand analysis, 36 Analysis of the consequences of taxation, 36 Import quotas, tariffs, and the consequences of protecting domestic industries from foreign competition: a more complex application, 39 Rent controls: impact of a price ceiling, 41 Nonprice rationing of shortages caused by price controls, 42 Application 2.1, Rent regulation in practice: tenants' rights, warehousing of apartments, condominium conversions, and flipping in the Big Apple, 44 Minimum wages. the impact of a price floor, 45 xv

3 xvi Contents Government and the business of agriculrure,46 Application 2.2, How sweetening the pot for farmers in the United Srates and Eu- rope affects farmers in developing countries: the international impact of price supports, 50 Summary, 51 PART 1WO THE THEORY OF DEMAND 3 Preferences, Budgets, and Prices: The Theory of Consumer Behavior, 58 Preferences and choices, 59 Assumptions about consumer preferences, 59 The utilitv function and indifference curvesču The utilitv function, 61 Indifference curves, 61 Indifference maps, 63 Diminishing marginal rates of substitution and the curvature of indifference curves, 66 The cardinal approach: marginal utility and the slope of indifference curves, 68 Budgets and prices, 70 The budget constraint, 70 The economic significance of intercepts of the budget line with the axes, 7l The economic significance of the slope of the budget line, 73 Changes in income and prices, 74 Consumer equilibrium, 75 Maximization of utility subject to the budget constraint, 76 The equimarginal princip le, 79 Using indifference curve analysis to explain choices,80 Differences in tas tes among consumers,80 The choice nor to consume a good: corner equilibrium, 81 Nondirninishing marginal rates of substitution,82 Perfect complements, 84 Application 3.1, The choice to have children,85 Economic "bads,' 86 Further applications of the model of consumer choice, 89 Nonprice rationing, 89 Preferences for product arrributes: a business application for marketing products, 90 Application 3.2, Estimating the price of product attribures: how much will consumers pav for housing characteristics>, 94 Summary, 94 4 Indifference Curve Analysis and Applications, 100 Expanding the model: the choice between buying a product and spending on all other goods, 101 Diminishing marginal benefit of a good, 104 Incorne-consurnption curves and Engel curves, 104 Incorne-consurnption curves, 104 Normal vs. inferior goods, 105 Engel curves, 108 Price-consumption curves and derivation of de mand curves, 110 Income and substitution effects of price changes, 113 Income and substitution effects of a price decrease, 113 Income and substitution effects in general and the demand curve for normal goods,1l5

4 Contents The case of inferior goods, 116 Using indifference curve analysis to understand the effects of business practices: inkind compensation and notched budget lines, 119 Frequem-flyer plans and notched budget lines, 119 Application 4.1, Why some airlines are having second thoughts about their frequent-flyer plans, 122 Compensating employees with fringe benefits instead of cash, 123 Using indifference curve analysis to understand the effects of government policies, 127 Income and substitution effects of a price increase: how a rebated tax can decrease consumption of the taxed good,127 In-kind subsidies: how policies can create natched budget lines and result in effects opposite to those intended, 128 Application 4.2, Food stamps and consumer choices, 131 Indifference curve analysis of the sale of nonpurchased goods and services, 132 Transaction costs and the incemive to sell, 132 Work, leisure, and the value of time, 134 Nonwage incame and work incentive, 136 Summary, Market Demand and its Elasticity, 144 Derivation of market demand curves, 145 Deterrninants of market demand, 146 Price elasticity of demand, 148 Calculating price elasticity of demand, 149 Elasticity vs. slope, 149 The range of variation of price elasticity of demand,150 Determinants of price elasticity of demand,151 'Ernpirical estimates of price elasticities of demand: how the sensitivity to price changes differs among goods, 152 J xvii Using price elasticities of demand to analyze consumer expenditures, 153 Price elasticity of demand and changes in total revenue, 155 Application 5.1, Maximizing revenue from the sale of tickets to sports events: whv pricing to fill the stadium is nat always the best policy, 156 Unit-elastic demand, 158 Application 5.2, The price of the dollar and the price elasticiry of demand for imported goods and USo exports, 160 Calculating price elasticity of demand for paims on a demand curve, 161 Price elasticity of demand as a ratio of distances at points on a demand curve, 161 Comparing point elasticity of two demand curves, 163 Calculating price elasticity from data corresponding to two paims on a de mand curve, 164 Other demand elasticities, 165 Incorne elasticiry of demand, 165 Cross elasticirv of demand, 166 Demand curves and consumer benefits, 168 Consumer surplus, 169 Using market demand curves to approximate consumer surplus, 171 Willingness to pay, availabilitv, and price, 172 Using consumer surplus to evaluate the burden of taxes, 173 Using consumer surplus to evaluate the gains from subsidies, 175 Some qualifications, 176 Estimating demand functions and elasticities, 177 Market experiments and surveys, 177 Statistical methods, 178 The identification problem, 179 Summary, 182 Appendix: Advanced topics in the theory of consumer choice and demand, 187 Evaluating willingness to pay, 187 Measuring changes in the cost of living, 193 " I

5 xviii Contenrs Taxes and economic welfare, 195 Subsidies and economic welfare, 197 Income elasticity of demand, budget con- straints, and expenditures, 199 Choices under uncertainty, 200 PART THREE PRODUCTION, COST, AND SUPPLY IN COMPETITIVE MARKETS 6 The Theory of Production, 208 Production, 209 Technology, 210 The production function, 210 Properties of production functions: The underlying assumptions of the theory of production, 210. Application 6.1, Improvements in technology: Some examples, 211 Isoquants, 212 Isoquant maps, 214 Application 6.2, An estimated production function for corn, 216 Production options in the short run: the law of diminishing marginal returns, 217 Total, ave rage, and marginal products of a variable input, 218 The tatai product curve, 220 The average product curve, 220 The marginal product curve, 222 The relationship between average and marginal product, 222 The law of diminishing marginal returns, 223 The stages of production, 224 A business application: management of a multidivision operation, 225 Input substitution, 227 Marginal rate of technical substitution and the curvature of isoquants, 227 How variation in the marginal products of inputs affects their marginal rates of technical substitution, 229 Substitution of capital for labor in business, 230 Input substitution and the shape of isoquants, 231 How changes in technology can affect isoquants, 232 Varying the scale of operations, 234 Using estimated production functions to measure returns to scale, 238 Summary, Cost and Output, 244 Measuring cost: economic cost vs. accounting cost, 245 Calculating economic cost: An example, 245 Cost and production, 247 Isocost lines, 248 The minimum cost input combination for a given output, 250 The princip le of least cost: equimarginal products per dollar of outlay on input services, 252 An expansion path, 253 Short-run cost, 254 Application 7.1, measuring fixed costs, 256 Average cost and marginal cost, 257 Short-run cost curves, 258 Average variable cost, average fixed cost, ave rage cost, and marginal cost curves, 260 Relationship between marginal cost, average variable cost, and ave rage cost, 262 Diminishing returns, costs, and the stages of production: more on the relationship between cost functions and production functions, 263 Application 7.2, Advanced technology, variable costs, and international competitiveness of the U.S. steel industry, 265

6 Conrems Limiting the use of an input: a businessrelated application of cost functions, 266 Long-run cost, 268 Analysis of long-run costs: variation in plant size, 269 Return to scale and the shape of long-run cost curves, 271 Changes in input prices and technology, 274 Empirical studies of cost, 277 Summary, Profit Maximization and Short-run Supply in Perfectly Competitive Markets, 286 The business firm and perfect competition, 287 The social functions and internai organization of business firms, 287 The single-product profit-maximizing business firm, 288 Application 8.1, Vertical integration and business profits, 289 Perfect competition, 290 Demand as seen by a cornpetitive firm, 291 Profit maximization, 292 Tatai revenue, tatai cost, and economic profit, 292 A numerical example: outpur, cost, revenue, and profit, 293 Marginal analysis of profit maximization, 294 Graphic analysis of variation in profit as output increases over the short-run period,296 Price, marginal cost, average cost, and the profit-maximizing output, 298 Breaking even, 300 Minimizing losses when price is below the minimum possible average cost, 300 The decision to shut down operations in the short run, 303 Short-run supply, 306 The competitive firrn's short-run supply curve, 306 xix Short-run market supply and its deterrninants, 306 Short-run price elasticity of supply, 309 Applying the theory of short-run supply, 313 A reduction in the price of a variable input, 313 Change in the price of a fixed input: The short-run of license fees and fixed annual subsidies, 315 Using supply curves to calculate producer surplus, 317 Price changes and producer surplus, 318 Using the sum of producer and consumer surplus as a measure of gains and losses from economic policies, 319 Are markets competitive? 321 Application 8.2, Is US. agriculture cornpetitive?,322 Summary, Long-run Equilibrium and Supply in Perfectly Competitive Markets, 328 Firms, industries, and perfect cornpetition, 329 Long-run competitive equilibrium and supply, 330 Equilibrium of the industry, 330 Expansion of the firm in the long run, 331 Long-run competitive equilibrium, 332 Characteristics of long-run competitive equilibrium, 334 The paradox of profits, 334 Long-run supply, 335 Industry adjustment to an increase in demand,335 Industry adjustment to a decrease in demand,337 The long-run industry supply curve: the case of constant costs, 338 Increasing- and decreasing-costs industries and long-run industry supply curves, 339 Long-run supply vs. short-run supply, 342 Application 9.1, The impact of improved technology on long-run equilibrium in competitive rnarkets: international competition, 343

7 xx Contents Differences in firm size and costs under perfect competition, 344 Applications of the competitive model, 346 Long-run impact of a license fee, 346 The impact of government policies that limit entry of firms imo competitive markets, 347 The long-run impact of rent controls, 350 Application 9.2, The impact of rent control on housing quality: some evidence, 352 Taxing the output of a constant-costs industry,352 Subsidizing a competitive industry, 354 The competitive model as a benchmark, 357 Summary, 357 PART FOUR NONCOMPETITIVE MARKETS 10 Monopoly, 364 Pure monopoly and monopoly power, 365 Barriers to entry: how monopoly power is maintained, 366 Application 10.1, De Beers, diamonds and the central selling organization: some evidence, 367 The de mand for a monopolist's product, 371 The monopolist's marginal revenue, 371 Price, marginal revenue, and price elasticity of dernand, 374 Short-run profit maximization by monopoly firms,377 Short-run monopoly equilibrium: graphic analysis, 379 Monopoly equilibrium and price elasticiry of demand, 380 Long-run monopoly equilibrium, 381 A single-plant monopoly, 381 Multipiant monopoly, 382 Monopoly supply, 385 Monopoly equilibrium vs. competitive equilibrium, 386 The consequences of a monopoly takeover of a competitive industry, 387 The social cost of monopoly, 388 Application 10.2, Breaking up the Bell System, 389 Are there any benefits from monopolies that can offset the social cost of monopoly? 391 Monopoly reaction to price ceilings, taxes, and subsidies, 391 Price ceilings, 391 Monopoly reaction to taxes on its output,393 Monopoly reaction to subsidi es, 394 Price discrimination, 395 Price discrimination in segmented rnarkets, 398 Summary, Monopolistie Competition and Oligopoly, 404 Between pure monopoly and perfect cornpeti tion, 405 Monopolistic competition, 406 Defining the industry, 407 Short-run equilibrium of the firm under monopolistic competition, 408 Long-run equilibrium under monopolistic competition, 410 Comparison with the bench mark competitive equilibrium, 412 Implications of excess capacity under rnonopolistic competition, 414 Advertising and product development in monopolistically competitive markets, 414 Costs of nonprice cornpetition, 414 Selling costs, 415 Long-run equilibrium with advertising under monopolistic competition, 419 Oligopoly, 421 Conscious rivalry: oligopolistic price wars,423 Oligopoly strategies and the theory of games,425

8 Contents Collusion and cartels, 428 Forming a cartel: directions, 428 A real cement cartel in action, 430 Advertising under oligopoly, 430 Application 11.1, The OPEC cartel, 431 Other oligopoly modeis, 433 Price rigidity and the kinked demand curve, 434 Price leadership, 435 Application 11.2, Pricing decisions in practice: cost-plus pricing rules 437 Entry-limit pricing, 438 Summary, 440 Appendix: The Cournot model of duopoly, 444 Reaction curves, Market Structure, Efficiency, and Regulation, 450 Efficiency, 451 Marginal eanditions for efficiency, 452 The efficient output of a good maximizes the sum of producer and consumer surplus, 453 Perfectly eampetitive markets and efficiency, 455 How the exercise of monopoly power can prevent the efficient output from being attained, 456 Diagnosing monopoly power, 457 Profits as a symptom of rnonopoly power, 457 Application 12.1, Rising concentration in the beer industry: the causes and consequences, 461 Contestable rnarkets: can the threat of entry prevent the exercise of monopolv power and guarantee efficient output levels? 462 Estimating the loss in efficiency from exercise of monopoly power, 464 Are there benefits from monopoly power? 457 Eeanomies of scale, 467 Technological progress, 467 Product variety and economizing on information costs, 468 Controlling monopoly power: antitrust po 1- icy,470 Controlling oligopolistic price fixing, 470 The rule of reason, 471 The relevant market, 471 Predatory pricing, 472 Recent cases, 472 Mergers, 474 Government regulation of pricing and entry in markets, 475 Regulating pricing of the output of a naturai monopoly, 475 Criticism of government regulation of pricing by natural monopolies, 476 Application 12.2, Peak-load pricing: what it is and why your electric company wants it approved, 477 Regulating pricing and entry in markets served by competing sellers, 479 The regulatory commissions, 479 Deregulation: the case of domestic air travel markets, 480 Summary, 482 xxi PART FIVE INPUT MARKETS 13 Competitive Input Markets and the Economics of Work and Wages, 488 Perfect competition in input rnarkets, 489 The marginal revenue product of an input: a measure of the marginal gain from hiring an input, 491 The hiring decision: weighing the marginal gain of additional input use against its marginal east, 493 A firrn's input demand curve, 494 What can cause a firm's input demand to change, 495

9 xxii Contents Industry and market de mand for an input, 496 Derivation of industry input demand curves, 496 Deterrninants of industry input demand elasticity, 499 Market demand, 499 Market supply of inputs and the economics of work, 501 Industry and market supply of inputs, 501 The work-leisure choice and labor supply of an individual worker, 501 Deriving a worker's labor supply curve, 503 Income and substitution effects of wage changes, 503 Backward-bending labor supply curves, 507 Market supply of labor services, 507 How cash-assistance welfare programs in the United States affect the labor supply of recipients, 508 Application 13.1, Labor supply in the United States, 509 The operation of competitive input markets, 512 Application 13.2, Minimum wages and ernployment: the case of teenagers, 514 Explaining differences in wages among occupations and jobs, 516 How differences in job quality give rise to wage differentials, 517 Economic rent, 520 Input mobility among market sectors, 523 Variable input supply, 526 Summary, Imperfectly Competitive Input Markets, Work, and Wages, 532 A monopolist's input demand, 533 Monopsony, 535 Marginal input cost for monopsony, 536 Hiring decisions in monopsonistic input markets, 539 Monopsony power paired with monopoly power in output markets, 541 Application 14.1, Monopsony power in the market for professional athletes: a case of collusion, 542 Monopoly power of input sellers, 543 Labor unions, 543 Union control over labor supply, 545 Impact of unions on wages, 546 The impact of unionization on labor productivity, 547 Application 14.2, Labor unions and wages, 548 Bilateral monopoly, 549 Union wages, minimum wages, and ernployment in monopsonistic labor rnarkets. some surprising conclusions, 551 Discrimination in labor markets, 553 Extreme discrimination: qualified workers are barred from entering the labor rnarket, 554 Less extreme discrirnination: entry into the market is permitted only if workers subject to discrimination accept lower wages,555 Profit maximization, competition, and the impact of these forces on discriminatory wage differentials, 556 Is discrimination actually practiced? 556 The issue of comparable worth, 557 Summary, Interest Rates, Rents, and the Creation of Capita1, 564 Capital, investment, and interest, 565 Capital flows and the capital stock, 565 Interest and the supply and demand of loanable funds, 566 How the interest rate affects investment decisions: a single-period investment, 566 Multiperiod investments, 571 Market demand for loanable funds, 573 The supply of savings, 574 Time preference, 574 Application 15.1, Human capital, 575 The inrerternporal budget constraint, 577 IntertemporaI equilibrium, 577

10 Conrenrs xxiii Incame and substitution effects of a change in the interest rate, 579 The market supply of savings, 579 Determination of the market rate of interest under perfect competition, 581 The market rate of interest and business investment, 582 The market rate of interest and the price of existing capital assets, 582 Application 15.2, Corporate takeovers and the relevance of the concept of present value, 584 Explaining differences in the return on investments and in lending rates, 586 Risk, 586 Taxes, 586 Differences in interest rates, 588 Land rnarkets, 589 Location, land use, and land rents, 589 Land price and rent differentials, 591 Summary, 591 PART SIX GENERAL EQUILIBRIUM, EFFICIENCY, AND PUBLIC GOODS 16 General Equilibrium Analysis and Efficiency, 598 Partial equilibrium analysis vs. general equilibrium analysis, 599 General equilibrium and efficiency, 601 The resource constraint, 601 Analysis of production with an Edgeworth box, 602 Productive efficiencv, 604 The production possibiliry curve, 605 The marginal rate of transfonnation, 606 General equilibrium in competitive input markets and efficiency, 607 Application 16.1, Are economic decisions within business firms efficient? The specter of X-inefficiency, 608 Exchange and allocative efficiency, 609 Efficiency in Production and Allocation of Products, 612 General equilibrium, perfect competition, and the distribution of welfare, 614 Prices, profit maximization, utility maximization, and efficiency, 614 The distribution of welfare in competitive markets, 616 Changes in the distribution of incame, 617 Efficiency vs. equiry, 618 Growth in resource availabiliry or productiviry, 620 Application 16.2, Free trade and efficiency: the net gains and redistributive effects of free international trade, 621 General equilibrium analysis of market distortions, 624 Monopoly power and losses in efficiency, 624 Tax-induced distortions, 625 Balancing distortions: the theory of seeand best, 626 Other distortions, 627 Summary, The Theory of Externalities, 632 Externalities, 633 Negative externalities, 634 Positive externalities, 638 Internalization of externalities: corrective taxes and subsidies, 640 Corrective taxes, 640 Corrective subsidi es, 641 Application 17.1, Use of corrective taxes and effluem charges, 642 Administering corrective taxes and subsidies: problems of measurement and idenrification, 643 What causes negative externalities? 644 Properry right disputes, 644 Transaction costs, 644 The Coase Theorem, 645

11 xxiv Contents Application 17.2, Evolution of property rights: grazing rights, 646 A numerical example, 647 Case 1: The emitter has the right to dump wastes, 649 Case 2: The emitter does not have the right to dump waste, 650 Additional alternatives and profits, 651 Significance of the Coase theorem, 652 Applications of the theory of externalities, 652 Pollution control policy, 652 Emissions standards: using regulations instead of charges to control pollution, 653 Pollution rights, 657 Summary, Public Goods, 664 Public goods vs. private goods, 665 Characteristics of pure public goods, 665 Public goods vs. government-supplied goods, 666 Positive externalities and the efficient output of pure public goods, 667 Application 18.1, Government expenditures in the United States, 667 The demand and supply of pure public goods, 670 The demand curve for pure public goods, 670 Cooperative supply of pure public goods,672 The free-rider problem, 673 The supply of public goods through political institutions, 676 Voting decisions, 676 Political equilibrium under majority rule, 678 Majority rule and efficient output of public goods, 680 Application 18.2, The demand for public goods, 681 Some qualifications, 682 Congestible and exc1udable public goods, 682 Congestible public goods, 683 Excludable public goods, 685 Summary, 686 Glossary, GI Answers to Even-Numbered Problems, Al

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