Sharon M. Oster. Karl E. Case. Ray C. Fair. Principles of Microeconomics NINTH EDITION. Wellesley College. Yale University.

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1 NINTH EDITION Principles of Microeconomics Karl E. Case Wellesley College Ray C. Fair Yale University Sharon M. Oster Yale University Prentice Hall UPPER SADDLE RIVER, NJ 07458

2 Contents Preface ix PART I Introduction to Economics 1 1The Scope and Method of Economics 1 Why Study Economics? 2 To Learn a Way of Thinking 2 To Understand Society 4 To Understand Global Affairs 5 To Be an Informed Citizen 5 ECONOMICS IN PRACTICE ipod and the World 6 The Scope of Economics 7 Microeconomics and Macroeconomics 8 The Diverse Fields of Economics 9 The Method of Economics 10 Descriptive Economics and Economic Theory 10 Theories and Models 11 Economic Policy 14 An Invitation IS Summary 16 Review Terms and Concepts 16 Problems 17 Appendix: How to Read and Understand Graphs 18 2 The Economic Problem: Scarcity and Choice 25 Scarcity, Choice, and Opportunity Cost 26 Scarcity and Choice in a One-Person Economy 26 Scarcity and Choice in an Economy of Two or More 27 ECONOMICS IN PRACTICE Frozen Foods and Opportunity Costs 28 The Production Possibility Frontier 32 The Economic Problem 38 Economic Systems 38 Command Economies 39 Laissez-Faire Economies: The Free Market 39 Mixed Systems, Markets, and Governments 41 Looking Ahead 41 Summary 41 Review Terms and Concepts 42 Problems 42 3 Demand, Supply, and Market Equilibrium 45 Firms and Households: The Basic Decision-Making Units 45 Input Markets and Output Markets: The Circular Flow 46 Demand in Product/Output Markets 48 Changes in Quantity Demanded versus Changes in Demand 48 Price and Quantity Demanded: The Law of Demand 49 Other Determinants of Household Demand 51 Shift of Demand versus Movement Along a Demand Curve 53 From Household Demand to Market Demand 55 Supply in Product/Output Markets 57 Price and Quantity Supplied: The Law of Supply 57 Other Determinants of Supply 58 Shift of Supply versus Movement Along a Supply Curve 59 From Individual Supply to Market Supply 61 Market Equilibrium 62 Excess Demand 62 Excess Supply 63 Changes in Equilibrium 64 Demand and Supply in Product Markets: A Review 66 ECONOMICS IN PRACTICE Bad News for Orangejuice Fanatics 67 Looking Ahead: Markets and the Allocation of Resources 68 ECONOMICS IN PRACTICE Why Do the Prices of Newspapers Rise? 69 Summary 70 Review Terms and Concepts 71 Problems 71 4 Demand and Supply Applications 73 The Price System: Rationing and Allocating Resources 73 Price Rationing. 73 Constraints on the Market and Alternative Rationing Mechanisms 75 Prices and the Allocation of Resources 78 ECONOMICS IN PRACTICE The Price Mechanism at Work for Shakespeare 79 Price Floors 79 Supply and Demand Analysis: An Oil Import Fee 80 Supply and Demand and Market Efficiency 81 Consumer Surplus 81 Producer Surplus 82 Competitive Markets Maximize the Sum of Producer and Consumer Surplus 83 Potential Causes of Deadweight Loss From Under- and Overproduction 85 Looking Ahead 85 Summary 85 Review Terms and Concepts 86 Problems 86 \,J Elasticity 89 Price Elasticity of Demand 90 Slope and Elasticity 90 Types of Elasticity 91 Calculating Elasticities 92 Calculating Percentage Changes 93 Elasticity Is a Ratio of Percentages 93 The Midpoint Formula 94 Elasticity Changes Along a Straight-Line Demand Curve Elasticity and Total Revenue 97 The Determinants of Demand Elasticity 99 Availability of Substitutes 99 The Importance of Being Unimportant 99 The Time Dimension 99 ECONOMICS IN PRACTICE Who Are the Elastic Smokers? 100 ECONOMICS IN PRACTICE Elasticities at a Delicatessen in the Short Run and Long Run 101 Other Important Elasticities 102 Income Elasticity of Demand 102 Cross-Price Elasticity of Demand 102 Elasticity of Supply 103 Looking Ahead 103 Summary 103 Review Terms and Concepts 104 Problems 104 Appendix: Point Elasticity (Optional)

3 PART II The Market System: Choices Made by Households and Firms Household Behavior and Consumer Choice 111 v Household Choice in Output Markets 111 The Determinants of Household Demand 112 The Budget Constraint 112 The Equation of the Budget Constraint 115 The Basis of Choice: Utility 116 Diminishing Marginal Utility 116 Allocating Income to Maximize Utility 117 The Utility-Maximizing Rule 119 Diminishing Marginal Utility and Downward-Sloping Demand 119 Income and Substitution Effects 120 The Income Effect 120 The Substitution Effect 121 Household Choice in Input Markets 122 The Labor Supply Decision 122 ECONOMICS IN PRACTICE Substitution and Market Baskets 123 The Price of Leisure 124 Income and Substitution Effects of a Wage Change 124 Saving and Borrowing: Present versus Future Consumption 125 ECONOMICS IN PRACTICE Google: Is It Work or Is It Leisure? 126 A Review: Households in Output and Input Markets 127 Summary 128 Review Terms and Concepts 128 Problems 129 Appendix: Indifference Curves The Production Process: The Behavior of Profit-Maximizing Firms 135 The Behavior of Profit-Maximizing Firms 136 Profits and Economic Costs 136 Short-Run Versus Long-Run Decisions 138 The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices 139 The Production Process 140 Production Functions: Total Product, Marginal Product, and Average Product 140 Production Functions with Two Variable Factors of Production 143 ECONOMICS IN PRACTICE UPS Technology Speeds Global Shipping 144 Choice of Technology 145 ECONOMICS IN PRACTICE How Fast Should a Truck Driver Go? 146 Looking Ahead: Cost and Supply 147 Summary 147 Review Terms and Concepts 147 Problems 148 Appendix: Isoquants and Isocosts Short-Run Costs and Output Decisions 155 Costs in the Short Run 156 Fixed Costs 156 Variable Costs 157 Total Costs 163 Short-Run Costs: A Review 165 ECONOMICS IN PRACTICE Average and Marginal Costs at a College 166 Output Decisions: Revenues, Costs, and Profit Maximization 167 Total Revenue and Marginal Revenue 168 Comparing Costs and Revenues to Maximize Profit 168 ECONOMICS IN PRACTICE Case Study in Marginal Analysis: An Ice Cream Parlor 170 The Short-Run Supply Curve 172 Looking Ahead 173 Summary 173 Review Terms and Concepts 174 Problems Long-Run Costs and Output Decisions 177 Short-Run Conditions and Long-Run Directions 178 Maximizing Profits 178 Minimizing Losses 180 The Short-Run Industry Supply Curve 183 Long-Run Directions: A Review 184 Long-Run Costs: Economies and Diseconomies of Scale 184 Increasing Returns to Scale 185 ECONOMICS IN PRACTICE Economies of Scale in Blood Banks 187 Constant Returns to Scale 188 Decreasing Returns to Scale 188 Long-Run Adjustments to Short-Run Conditions 189 ECONOMICS IN PRACTICE The Long-Run Average Cost Curve: Flat oru-shaped? 190 Short-Run Profits: Expansion to Equilibrium 191 Short-Run Losses: Contraction to Equilibrium 192 The Long-Run Adjustment Mechanism: Investment Flows Toward Profit Opportunities 193 ECONOMICS IN PRACTICE Why Are Hot Dogs So Expensive in Central Park? 194 Output Markets: A Final Word 195 Summary 195 Review Terms and Concepts 196 Problems 196 Appendix: External Economies and Diseconomies and the Long-Run Industry Supply Curve Input Demand: The Labor and Land Markets 203 Input Markets: Basic Concepts 203 Demand for Inputs: A Derived Demand 204 Inputs: Complementary and Substitutable 204 Diminishing Returns 204 Marginal Revenue Product 205 Labor Markets 206 A Firm Using Only One Variable Factor of Production: Labor 206 A Firm Employing Two Variable Factors of Production in the Short and Long Run 209 ECONOMICS IN PRACTICE Julia Roberts: Theater or the Movies? 211 Many Labor Markets 212 Land Markets 212 Rent and the Value of Output Produced on Land 213 ECONOMICS IN PRACTICE Time Is Money: European High-Speed Trains 214 The Firm's Profit-Maximizing Condition in Input Markets 215 Input Demand Curves 215 Shifts in Factor Demand Curves 215 Resource Allocation and the Mix of Output in Competitive Markets 217 The Distribution of Income 217 Looking Ahead 218 Summary 218 Review Terms and Concepts 219 Problems 219

4 11 Input Demand: The Capital Market and the Investment Decision 221 Capital, Investment, and Depreciation 221 Capital 221 Investment and Depreciation 223 The Capital Market 224 Capital Income: Interest and Profits 225 Financial Markets in Action 227 Mortgages and the Mortgage Market 228 Capital Accumulation and Allocation 229 The Demand for New Capital and the Investment Decision 229 Forming Expectations 229 ECONOMICS IN PRACTICE What Makes Venture Capital Green? 231 Comparing Costs and Expected Return 231 A Final Word on Capital 234 Summary 234 Review Terms and Concepts 235 Problems 235 Appendix: Calculating Present Value General Equilibrium and the Efficiency of Perfect Competition 241 General Equilibrium Analysis 242 An Early Technological Advance: The Electronic Calculator 242 Market Adjustment to Changes in Demand 244 Formal Proof of a General Competitive Equilibrium 245 Allocative Efficiency and Competitive Equilibrium 246 ECONOMICS IN PRACTICE Ethanol and Land Prices 247 Pareto Efficiency 248 The Efficiency of Perfect Competition 249 ECONOMICS IN PRACTICE Ticket Scalping in the Electronic Age 252 Perfect Competition versus Real Markets 254 The Sources of Market Failure 254 Imperfect Markets 254 Public Goods 255 Externalities 256 Imperfect Information 256 Evaluating the Market Mechanism 257 Summary 257 Review Terms and Concepts 258 Problems 258 PART III Market Imperfections and the Role of Government Monopoly and Antitrust Policy 261 Imperfect Competition and Market Power: Core Concepts 261 Forms of Imperfect Competition and Market Boundaries 262 Price and Output Decisions in Pure Monopoly Markets 263 Demand in Monopoly Markets 263 Perfect Competition and Monopoly Compared 268 Monopoly in the Long Run: Barriers to Entry 269 ECONOMICS IN PRACTICE Managing the Cable Monopoly 272 The Social Costs of Monopoly 273 Inefficiency and Consumer Loss 273 Rent-Seeking Behavior 274 Price Discrimination 275 Examples of Price Discrimination 277 Remedies for Monopoly: Antitrust Policy 277 Major Antitrust Legislation 277 ECONOMICS IN PRACTICE The Government Takes on Whole Foods 279 Imperfect Markets: A Review and a Look Ahead 279 Summary 280 Review Terms and Concepts 281 Problems Oligopoly 283 Market Structure in an Oligopoly 284 Contents Vll ECONOMICS IN PRACTICE Why Are Record Labels Losing Key Stars Like Madonna? 286 Oligopoly Models 287 The Collusion Model 287 The Price-Leadership Model 288 The Cournot Model 289 Game Theory 290 Repeated Games 293 A Game with Many Players: Collective Action Can Be Blocked by a Prisoner's Dilemma 294 ECONOMICS IN PRACTICE Price Fixing or Price Competition? 296 Oligopoly and Economic Performance 297 Industrial Concentration and Technological Change 297 The Role of Government 298 Regulation of Mergers 298 A Proper Role? 300 Summary 300 Review Terms and Concepts 301 Problems Monopolistic Competition 303 Industry Characteristics 304 Product Differentiation and Advertising 305 How Many Varieties? 305 How Do Firms Differentiate Products? 306 ECONOMICS IN PRACTICE An Economist Makes Tea 308 Advertising 309 ECONOMICS IN PRACTICE Can Information Reduce Obesity? 312 Price and Output Determination in Monopolistic Competition 313 Product Differentiation and Demand Elasticity 313 Price/Output Determination in the Short Run 313 Price/Output Determination in the Long Run 314 Economic Efficiency and Resource Allocation 316 Summary 316 Review Terms and Concepts 317 Problems Externalities, Public Goods, and Social Choice 319 Externalities and Environmental Economics 319 Marginal Social Cost and Marginal-Cost Pricing 320 Private Choices and External Effects 322 Internalizing Externalities 324 ECONOMICS IN PRACTICE Externalities Are All Around Us 326 ECONOMICS IN PRACTICE The Debate Over Global Warming 331 Public (Social) Goods 332 The Characteristics of Public Goods 332 Income Distribution as a Public Good? 333 Public Provision of Public Goods 333 Optimal Provision of Public Goods 334 Local Provision of Public Goods: Tiebout Hypothesis 337 Mixed Goods 337 Social Choice 337 The Voting Paradox 338 Government Inefficiency: Theory of Public Choice 339 Rent-Seeking Revisited 340 Government and the Market 341 Summary 341 Review Terms and Concepts 342 Problems 342

5 Vlll 17 Contents Uncertainty and Asymmetric Information 345 Decision Making Under Uncertainty: The Tools 345 Expected Value 346 Expected Utility 346 Attitudes Toward Risk 348 Asymmetric Information 349 Adverse Selection 350 ECONOMICS IN PRACTICE Recycled Lemons 352 Market Signaling 353 ECONOMICS IN PRACTICE How to Read Advertisements 354 Moral Hazard 355 Incentives 355 Labor Market Incentives 356 Incentives in Health Care 356 Summary 357 Review Terms and Concepts 358 Problems The Utility Possibilities Frontier 359 The Sources of Household Income 360 Wages and Salaries 361 Income from Property 363 Income from the Government: Transfer Payments 363 The Distribution of Income 363 Income Inequality in the United States 363 The World Distribution of Income 366 Causes of Increased Inequality 366 Poverty 367 The Distribution of Wealth 369 The Redistribution Debate 369 Arguments Against Redistribution 369 Arguments in Favor of Redistribution 370 Redistribution Programs and Policies 372 Financing Redistribution Programs: Taxes 372 Expenditure Programs 373 How Effective Are Antipoverty Programs? 375 ECONOMICS IN PRACTICE Does Price Matter in Charitable Giving? 376 Government or the Market? A Review 376 Summary 377 Review Terms and Concepts 378 Problems Income Distribution and Poverty 359 Public Finance: The Economics of Taxation 379 The Economics of Taxation 379 Taxes: Basic Concepts 379 Tax Equity 383 What is the "Best" Tax Base? 384 The Gift and Estate Tax 386 ECONOMICS IN PRACTICE The Gift and Estate Tax: A Call to Restore It in Tax Incidence: Who Pays? 387 The Incidence of Payroll Taxes 388 The Incidence of Corporate Profits Taxes 391 The Overall Incidence of Taxes in the United States: Empirical Evidence 393 Excess Burdens and the Principle of Neutrality 393 How Do Excess Burdens Arise? 393 The Principle of Second Best 395 ECONOMICS IN PRACTICE Federal Tax Reform 396 Measuring Excess Burdens 397 Excess Burdens and the Degree of Distortion 398 Summary 398 Review Terms and Concepts 399 Problems 400 PART IV The World Economy International Trade, Comparative Advantage, and Protectionism 401 Trade Surpluses and Deficits 402 The Economic Basis for Trade: Comparative Advantage 403 Absolute Advantage versus Comparative Advantage 403 Terms of Trade 407 Exchange Rates 408 The Sources of Comparative Advantage 410 The Heckscher-Ohlin Theorem 410 Other Explanations for Observed Trade Flows 411 Trade Barriers: Tariffs, Export Subsidies, and Quotas 411 U.S. Trade Policies, GATT, and the WTO 412 ECONOMICS IN PRACTICE Trade Barriers Take a Hit in Free Trade or Protection? 414 The Case for Free Trade 414 The Case for Protection 416 ECONOMICS IN PRACTICE A Petition 417 An Economic Consensus 420 Summary 420 Review Terms and Concepts 421 Problems Economic Growth in Developing and Transitional Economies 425 Life in the Developing Nations: Population and Poverty 426 Economic Development: Sources and Strategies 427 The Sources of Economic Development 427 ECONOMICS IN PRACTICE Corruption 430 Strategies for Economic Development 431 Growth Versus Development: The Policy Cycle 434 ECONOMICS IN PRACTICE Cell Phones Increase Profits for Fishermen in India 435 Two Examples of Development: China and India 435 Issues in Economic Development 436 Population Growth 436 The Transition to a Market Economy 438 Six Basic Requirements for Successful Transition 439 Summary 442 Review Terms and Concepts 443 Problems 443 Glossary 445 Index 451 Photo Credits 464

Sharon M. Oster PEARSON

Sharon M. Oster PEARSON ELEVENTH EDITION Principles of Microeconomics GLOBAL EDITION Karl E. Case Wellesley College Ray C. Fair Yale University Sharon M. Oster Yale University PEARSON Boston Columbus Indianapolis New York San