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Introduction to Economic Analysis
byR. Preston McAfee
J. Stanley Johnson Professor of
Business, Economics & Management
California Institute of Technology

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Unstable Equilibrium

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McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006i

Dedication to this edition:
For Sophie. Perhaps by the time she goes to university, we’ll have won the war against
the publishers.

Disclaimer:This is the third draft. Please point out typos, errors or poor exposition, preferably byemail to intro@mcafee.cc. Your assistance matters.
In preparing this manuscript, I have received assistance from many people, including
Michael Bernstein, Steve Bisset, Grant Chang-Chien, Lauren Feiler, Alex Fogel, Ben
Golub, George Hines, Richard Jones, Jorge Martínez, Joshua Moses, Dr. John Ryan,
and Wei Eileen Xie. I am especially indebted to Anthony B. Williams for a careful,detailed reading of the manuscript yielding hundreds of improvements.

McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

ii

This work is licensed under the Creative Commons AttributionNonCommercial-ShareAlike License. To view a copy of this license, visit
http://creativecommons.org/licenses/by-nc-sa/2.0/
or send a letter to Creative Commons, 559 Nathan Abbott Way, Stanford, California
94305, USA.

Please email changes to intro@mcafee.cc.

Introduction to Economic Analysis
Version 2.0
by
R. Preston McAfee
J. Stanley Johnson Professor of
Business, Economics & Management
California Institute of Technology
Begun: June 24, 2004
This Draft: July 24, 2006
This book presents introductory economics (“principles”) material using standard
mathematical tools, including calculus. It is designed for a relatively sophisticatedundergraduate who has not taken a basic university course in economics. It also
contains the standard intermediate microeconomics material and some material that
ought to be standard but is not. The book can easily serve as an intermediate
microeconomics text. The focus of this book is on the conceptual tools and not on fluff.
Most microeconomics texts are mostly fluff and the fluff market is exceedingly overserved by $100+ texts. In contrast, this book reflects the approach actually adopted by
the majority of economists for understanding economic activity. There are lots ofmodels and equations and no pictures of economists.

McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

iii

Table of Contents
1
WHAT IS ECONOMICS? ..............................1-1
1.1.1
Normative and Positive Theories ..................1-2
1.1.2
Opportunity Cost ..........................................1-3
1.1.3
Economic Reasoning and Analysis................1-5
2
SUPPLY AND DEMAND...............................2-8
2.1
Supply and Demand.................................2-8
2.1.1
Demand and Consumer Surplus ...................2-8
2.1.2
Supply .........................................................2-13
2.2
The Market...............................................2-18
2.2.1
Market Demand and Supply .......................2-18
2.2.2
Equilibrium.................................................2-20
2.2.3
Efficiency of Equilibrium ............................2-22
2.3
Changes in Supply and Demand..........2-22
2.3.1
Changes in Demand ....................................2-22
2.3.2
Changes in Supply.......................................2-23
2.4
Elasticities................................................2-27
2.4.1
Elasticity of Demand...................................2-27
2.4.2
Elasticity of Supply .....................................2-30
2.5
Comparative Statics ...............................2-30
2.5.1
Supply and Demand Changes .....................2-30
2.6
Trade .........................................................2-32
2.6.1
Production Possibilities Frontier ................2-32
2.6.2
Comparative and Absolute Advantage ........2-36
2.6.3
Factors and Production...............................2-38
2.6.4
International Trade.....................................2-39
3
THE US ECONOMY .....................................3-41
3.1.1
Basic Demographics....................................3-41
3.1.2
Education....................................................3-47
3.1.3
Households and Consumption ....................3-49
3.1.4
Production ..................................................3-56
3.1.5
Government ................................................3-65
3.1.6
Trade...........................................................3-73
3.1.7
Fluctuations ................................................3-76
4
PRODUCER THEORY.................................4-79
4.1
The Competitive Firm............................4-79
4.1.1
Types of Firms ............................................4-79
4.1.2
Production Functions..................................4-81
4.1.3
Profit Maximization ....................................4-85
4.1.4
The Shadow Value.......................................4-91
4.1.5
Input Demand.............................................4-92
4.1.6
Myriad Costs ...............................................4-95
4.1.7
Dynamic Firm Behavior ..............................4-97
4.1.8
Economies of Scale and Scope ..................4-100
4.2
Perfect Competition Dynamics..........4-104
4.2.1
Long-run Equilibrium...............................4-104
4.2.2
Dynamics with Constant Costs..................4-105
4.2.3
General Long-run Dynamics .....................4-109
4.3
Investment .............................................4-114
4.3.1
Present value.............................................4-114
4.3.2
Investment................................................4-118
4.3.3
Investment Under Uncertainty .................4-120
4.3.4
Resource Extraction..................................4-125
4.3.5
A Time to Harvest .....................................4-127
4.3.6
Collectibles................................................4-130
4.3.7
Summer Wheat .........................................4-135

5
CONSUMER THEORY ............................. 5-139
5.1
Utility Maximization ........................... 5-139
5.1.1
Budget or Feasible Set .............................. 5-140
5.1.2
Isoquants ................................................. 5-143
5.1.3
Examples.................................................. 5-148
5.1.4
Substitution Effects .................................. 5-151
5.1.5
Income Effects.......................................... 5-155
5.2
Additional Considerations................. 5-158
5.2.1
Corner Solutions ...................................... 5-158
5.2.2
Labor Supply ............................................ 5-160
5.2.3
Compensating Differentials...................... 5-164
5.2.4
Urban Real Estate Prices .......................... 5-165
5.2.5
Dynamic Choice ....................................... 5-169
5.2.6
Risk .......................................................... 5-174
5.2.7
Search ...................................................... 5-178
5.2.8
Edgeworth Box ......................................... 5-181
5.2.9
General Equilibrium................................. 5-188
6
MARKET IMPERFECTIONS................... 6-195
6.1
Taxes....................................................... 6-195
6.1.1
Effects of Taxes ........................................ 6-195
6.1.2
Incidence of Taxes.................................... 6-199
6.1.3
Excess Burden of Taxation ....................... 6-200
6.2
Price Floors and Ceilings ................... 6-202
6.2.1
Basic Theory............................................. 6-203
6.2.2
Long- and Short-run Effects..................... 6-207
6.2.3
Political Motivations ................................ 6-209
6.2.4
Price Supports .......................................... 6-210
6.2.5
Quantity Restrictions and Quotas ............ 6-211
6.3
Externalities ......................................... 6-213
6.3.1
Private and Social Value, Cost .................. 6-214
6.3.2
Pigouvian Taxes ....................................... 6-217
6.3.3
Quotas...................................................... 6-218
6.3.4
Tradable Permits and Auctions ................ 6-219
6.3.5
Coasian Bargaining .................................. 6-220
6.3.6
Fishing and Extinction ............................. 6-221
6.4
Public Goods ......................................... 6-226
6.4.1
Examples.................................................. 6-226
6.4.2
Free-Riders .............................................. 6-227
6.4.3
Provision with Taxation ........................... 6-229
6.4.4
Local Public Goods ................................... 6-230
6.5
Monopoly............................................... 6-232
6.5.1
Sources of Monopoly ................................ 6-232
6.5.2
Basic Analysis........................................... 6-233
6.5.3
Effect of Taxes .......................................... 6-236
6.5.4
Price Discrimination ................................ 6-237
6.5.5
Welfare Effects ......................................... 6-240
6.5.6
Two-Part Pricing ...................................... 6-240
6.5.7
Natural Monopoly .................................... 6-241
6.5.8
Peak Load Pricing..................................... 6-242
6.6
Information .......................................... 6-245
6.6.1
Market for Lemons................................... 6-245
6.6.2
Myerson-Satterthwaite Theorem.............. 6-246
6.6.3
Signaling .................................................. 6-248
7
STRATEGIC BEHAVIOR ......................... 7-251
7.1
Games..................................................... 7-251
7.1.1
Matrix Games........................................... 7-251
7.1.2
Nash Equilibrium ..................................... 7-255
7.1.3
Mixed Strategies....................................... 7-257
7.1.4
Examples.................................................. 7-262
7.1.5
Two Period Games ................................... 7-265

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7.1.6
7.1.7
7.1.8
7.2
7.2.1
7.2.2
7.3
7.3.1
7.3.2
7.4
7.4.1
7.4.2
7.4.3
7.5
7.5.1
7.5.2
7.5.3
7.5.4
7.5.5

Subgame Perfection .................................. 7-266
Supergames .............................................. 7-268
The Folk Theorem .................................... 7-269
Cournot Oligopoly................................ 7-270
Equilibrium .............................................. 7-271
Industry Performance............................... 7-272
Search and Price Dispersion ............. 7-274
Simplest Theory........................................ 7-275
Industry Performance............................... 7-277
Hotelling Model.................................... 7-279
Types of Differentiation ............................ 7-279
The Standard Model ................................. 7-280
The Circle Model....................................... 7-280
Agency Theory ...................................... 7-283
Simple Model............................................ 7-284
Cost of Providing Incentives ..................... 7-286
Selection of Agent ..................................... 7-287
Multi-tasking ............................................ 7-288
Multi-tasking without Homogeneity......... 7-292

7.6
7.6.1
7.6.2
7.6.3
7.6.4
7.6.5
7.6.6
7.6.7
7.7
7.7.1
7.7.2
7.7.3
7.7.4

Auctions..................................................7-295
English Auction.........................................7-295
Sealed-bid Auction....................................7-296
Dutch Auction ...........................................7-298
Vickrey Auction.........................................7-299
Winner’s Curse..........................................7-301
Linkage .....................................................7-303
Auction Design..........................................7-304
Antitrust .................................................7-306
Sherman Act .............................................7-306
Clayton Act................................................7-308
Price-Fixing ..............................................7-309
Mergers.....................................................7-311

8
8.1
8.2

INDEX..........................................................8-315
List of Figures .......................................8-315
Index .......................................................8-317

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1 What is Economics?
Economics studies the allocation of scarce resources among people – examining what
goods and services wind up in the hands of which people. Why scarce resources?
Absent scarcity, there is no significant allocation issue. All practical, and many
impractical, means of allocating scarce resources are studied by economists. Markets
are an important means of allocating resources, so economists study markets. Markets
include stock markets like the New York Stock Exchange, commodities markets like theChicago Mercantile, but also farmer’s markets, auction markets like Christie’s orSotheby’s (made famous in movies by people scratching their noses and inadvertently
purchasing a Ming vase) or eBay, or more ephemeral markets, such as the market formusic CDs in your neighborhood. In addition, goods and services (which are scarce
resources) are allocated by governments, using taxation as a means of acquiring theitems. Governments may be controlled by a political process, and the study of allocationby the politics, which is known as political economy, is a significant branch of
economics. Goods are allocated by certain means, like theft, deemed illegal by thegovernment, and such allocation methods nevertheless fall within the domain of
economic analysis; the market for marijuana remains vibrant despite interdiction by thegovernments of most nations. Other allocation methods include gifts and charity,
lotteries and gambling, and cooperative societies and clubs, all of which are studied byeconomists.
Some markets involve a physical marketplace. Traders on the New York Stock Exchange
get together in a trading pit. Traders on eBay come together in an electronic
marketplace. Other markets, which are more familiar to most of us, involve physicalstores that may or may not be next door to each other, and customers who search among
the stores, purchasing when the customer finds an appropriate item at an acceptableprice. When we buy bananas, we don’t typically go to a banana market and purchasefrom one of a dozen or more banana sellers, but instead go to a grocery store.
Nevertheless, in buying bananas, the grocery stores compete in a market for our banana
patronage, attempting to attract customers to their stores and inducing them topurchase bananas.
Price – exchange of goods and services for money – is an important allocation means,but price is hardly the only factor even in market exchanges. Other terms, such as
convenience, credit terms, reliability, and trustworthiness are also valuable to theparticipants in a transaction. In some markets such as 36 inch Sony WEGA televisions,one ounce bags of Cheetos, or Ford Autolite spark plugs, the products offered by distinct
sellers are identical, and for such products, price is usually the primary factor
considered by buyers, although delivery and other aspects of the transaction may stillmatter. For other products, like restaurant meals, camcorders by different
manufacturers, or air travel on distinct airlines, the products differ to some degree, andthus the qualities of the product are factors in the decision to purchase. Nevertheless,different products may be considered to be in a single market if the products arereasonable substitutes, and we can consider a “quality-adjusted” price for these different
goods.

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Economic analysis is used in many situations. When British Petroleum sets the price for
its Alaskan crude oil, it uses an estimated demand model, both for gasoline consumers
and also for the refineries to which BP sells. The demand for oil by refineries isgoverned by a complex economic model used by the refineries and BP estimates thedemand by refineries by estimating the economic model used by refineries. Economic
analysis was used by experts in the antitrust suit brought by the U.S. Department ofJustice both to understand Microsoft’s incentive to foreclose (eliminate from themarket) rival Netscape and consumer behavior in the face of alleged foreclosure. Stockmarket analysts use economic models to forecast the profits of companies in order topredict the price of their stocks. When the government forecasts the budget deficit orconsiders a change in environmental regulations, it uses a variety of economic models.
This book presents the building blocks of the models in common use by an army of
economists thousands of times per day.

1.1.1 Normative and Positive Theories
Economic analysis is used for two main purposes. The first is a scientific understandingof how allocations of goods and services – scarce resources – are actually determined.
This is a positive analysis, analogous to the study of electromagnetism or molecularbiology, and involves only the attempt to understand the world around us. The
development of this positive theory, however, suggests other uses for economics.
Economic analysis suggests how distinct changes in laws, rules and other government
interventions in markets will affect people, and in some cases, one can draw aconclusion that a rule change is, on balance, socially beneficial. Such analyses combine
positive analysis – predicting the effects of changes in rules – with value judgments, andare known as normative analyses. For example, a gasoline tax used to build highways
harms gasoline buyers (who pay higher prices), but helps drivers (who face fewer
potholes and less congestion). Since drivers and gasoline buyers are generally the same
people, a normative analysis may suggest that everyone will benefit. This type ofoutcome, where everyone is made better off by a change, is relatively uncontroversial.
In contrast, cost-benefit analysis weighs the gains and losses to different individuals
and suggests carrying out changes that provide greater benefits than harm. For
example, a property tax used to build a local park creates a benefit to those who use thepark, but harms those who own property (although, by increasing property values, evennon-users obtain some benefits). Since some of the taxpayers won’t use the park, it
won’t be the case that everyone benefits on balance. Cost-benefit analysis weighs thecosts against the benefits. In the case of the park, the costs are readily monetized(turned into dollars), because the costs to the tax-payers are just the amount of the tax.
In contrast, the benefits are much more challenging to estimate. Conceptually, thebenefits are the amount the park users would be willing to pay to use the park if the parkcharged admission. However, if the park doesn’t charge admission, we would have toestimate willingness-to-pay. In principle, the park provides greater benefits than costs if
the benefits to the users exceed the losses to the taxpayers. However, the park also
involves transfers from one group to another.
Welfare analysis provides another approach to evaluating government intervention into
markets. Welfare analysis posits social preferences and goals, like helping the poor.
Generally a welfare analysis involves performing a cost-benefit analysis taking account

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not just of the overall gains and losses, but also weighting those gains and losses by theireffects on other social goals. For example, a property tax used to subsidize the opera
might provide more value than costs, but the bulk of property taxes are paid by lower
and middle income people, while the majority of opera-goers are rich. Thus, the opera
subsidy represents a transfer from relatively low income people to richer people, which
is not consistent with societal goals of equalization. In contrast, elimination of sales
taxes on basic food items like milk and bread generally has a relatively greater benefit to
the poor, who spend a much larger percentage of their income on food, than to the rich.
Thus, such schemes may be considered desirable not so much for their overall effects
but for their redistribution effects. Economics is helpful not just in providing methods
for determining the overall effects of taxes and programs, but also the incidence of thesetaxes and programs, that is, who pays, and who benefits. What economics can’t do,
however, is say who ought to benefit. That is a matter for society at large to decide.

1.1.2 Opportunity Cost
Economists use the idea of cost in a slightly quirky way that makes sense once you think
about it, and we use the term opportunity cost to remind you occasionally of ouridiosyncratic notion of cost. For an economist, the cost of something is not just the cash
payment, but all of the value given up in the process of acquiring the thing. For
example, the cost of a university education involves tuition, and text book purchases,
and also the wages that would have been earned during the time at university, but were
not. Indeed, the value of the time spent in acquiring the education – how muchenjoyment was lost – is part of the cost of education. However, some “costs” are notopportunity costs. Room and board would not generally be a cost because, after all, you
are going to be living and eating whether you are in university or not. Room and board
are part of the cost of an education only insofar as they are more expensive than theywould be otherwise. Similarly, the expenditures on things you would have otherwise
done – hang-gliding lessons, a trip to Europe – represent savings. However, the valueof these activities has been lost while you are busy reading this book.
The concept of opportunity cost can be summarized by a definition:
The opportunity cost is the value of the best foregone alternative.
This definition captures the idea that the cost of something is not just its monetary cost
but also the value of what you didn’t get. The opportunity cost of spending $17 on a CD
is what you would have done with the $17 instead, and perhaps the value of the timespent shopping. The opportunity cost of a puppy includes not just the purchase price ofthe puppy, but also the food, veterinary bills, carpet cleaning, and the value of the timespent dealing with the puppy. A puppy is a good example, because often the purchaseprice is a negligible portion of the total cost of ownership. Yet people acquire puppies all
the time, in spite of their high cost of ownership. Why? The economic view of the worldis that people acquire puppies because the value they expect to get exceeds theopportunity cost. That is, they acquire a puppy when the value of a puppy is higher thanthe value of what is foregone by the acquisition of a puppy.
Even though opportunity costs include lots of non-monetary costs, we will oftenmonetize opportunity costs, translating the costs into dollar terms for comparison

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purposes. Monetizing opportunity costs is clearly valuable, because it gives a means ofcomparison. What is the opportunity cost of 30 days in jail? It used to be that judges
occasionally sentenced convicted defendants to “thirty days or thirty dollars,” letting thedefendant choose the sentence. Conceptually, we can use the same idea to find out thevalue of 30 days in jail. Suppose you would choose to pay a fine of $750 to avoid thethirty days in jail, but wouldn’t pay $1,000 and instead would choose time in theslammer. Then the value of the thirty day sentence is somewhere between $750 and$1000. In principle, there exists a price where at that price you pay the fine, and at apenny more you go to jail. That price – at which you are just indifferent to the choice –is the monetized or dollar cost of the jail sentence.
The same idea as choosing the jail sentence or the fine justifies monetizing opportunity
costs in other contexts. For example, a gamble has a certainty equivalent, which is theamount of money that makes one indifferent to choosing the gamble versus the certain
amount. Indeed, companies buy and sell risk, and much of the field of risk
management involves buying or selling risky items to reduce overall risk. In theprocess, risk is valued, and riskier stocks and assets must sell for a lower price (or,equivalently, earn a higher average return). This differential is known as a risk
premium, and it represents a monetization of the risk portion of a risky gamble.
Home buyers considering various available houses are presented with a variety ofoptions, such as one or two story, building materials like brick or wood, roofing
materials, flooring materials like wood or carpet, presence or absence of swimming
pools, views, proximity to parks, and so on. The approach taken to valuing these items
is known as hedonic pricing, and corresponds to valuing each item separately – what
does a pool add to value on average? – and then summing the value of the components.
The same approach is used to value old cars, making adjustments to a base value for thepresence of options like leather interior, CD changer, and so on. Again, such a valuation
approach converts a bundle of disparate attributes into a monetary value.
The conversion of costs into dollars is occasionally controversial, and nowhere is it more
controversial than in valuing human life. How much is your life worth? Can it beconverted into dollars? A certain amount of insight into this question can be gleaned bythinking about risks. Wearing seatbelts and buying optional safety equipment reduce
the risk of death by a small but measurable amount. Suppose a $400 airbag option
reduces the overall risk of death by 0.01%. If you are indifferent to buying the option,
you have implicitly valued the probability of death at $400 per 0.01%, or $40,000 per
1%, or around $4,000,000 per life. Of course, you may feel quite differently about a
0.01% chance of death than a risk ten thousand times greater, which would be acertainty. But such an approach provides one means of estimating the value of the riskof death – an examination what people will, and will not, pay to reduce that risk.
Opportunity cost – the value of the best foregone alternative – is a basic building blockof economic analysis. The conversion of costs into dollar terms, while sometimes
controversial, provides a convenient means of comparing costs.

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1.1.3 Economic Reasoning and Analysis
What this country needs is some one-armed economists.
-Harry S Truman
Economic reasoning is rather easy to satirize. One might want to know, for instance,
what the effect of a policy change – a government program to educate unemployedworkers, an increase in military spending, or an enhanced environmental regulation –will be on people and their ability to purchase the goods and services they desire.
Unfortunately, a single change may have multiple effects. As an absurd and tortured
example, government production of helium for (allegedly) military purposes reduces thecost of children’s birthday balloons, causing substitution away from party hats and hired
clowns. The reduction in demand for clowns reduces clowns’ wages and thus reduces
the costs of running a circus. This cost reduction increases the number of circuses,
thereby forcing zoos to lower admission fees to compete with circuses. Thus, were thegovernment to stop subsidizing the manufacture of helium, the admission fee of zoos
would likely rise, even though zoos use no helium. This example is superficiallyreasonable, although the effects are miniscule.
To make any sense at all of the effects of a change in economic conditions, it is helpful to
divide up the effect into pieces. Thus, we will often look at the effects of a change “otherthings equal,” that is, assuming nothing else changed. This isolates the effect of thechange. In some cases, however, a single change can lead to multiple effects; even so,
we will still focus on each effect individually. A gobbledygook way of saying “otherthings equal” is to use Latin and say “ceteris paribus.” Part of your job as a student is tolearn economic jargon, and that is an example. Fortunately, there isn’t too much jargon.
We will make a number of assumptions that you may not find very easy to believe. Not
all of the assumptions are required for the analysis, and instead merely simplify the
analysis. Some, however, are required but deserve an explanation. There is a frequentassumption that the people we will talk about seem exceedingly selfish relative to mostpeople we know. We model the choices that people make, assuming that they make thechoice that is best for them. Such people – the people in the models as opposed to real
people – are known occasionally as “homo economicus.” Real people are indubitably
more altruistic than homo economicus, because they couldn’t be less: homo economicus
is entirely selfish. (The technical term is acting in one’s self-interest.) That doesn’tnecessarily invalidate the conclusions drawn from the theory, however, for at least four
reasons:• People often make decisions as families or households rather than individuals,
and it may be sensible to consider the household as the “consumer.” Thathouseholds are fairly selfish is more plausible perhaps than individuals being
selfish.
• Economics is pretty much silent on why consumers want things. You may wantto make a lot of money so that you can build a hospital or endow a library, which
would be altruistic things to do. Such motives are broadly consistent with selfinterested behavior.
• Corporations are often required to serve their shareholders by maximizing theshare value, inducing self-interested behavior on the part of the corporation.
Even if corporations had no legal responsibility to act in the financial interest of
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their shareholders, capital markets may force them to act in the self-interest of
the shareholders in order to raise capital. That is, people choosing investmentsthat generate a high return will tend to force corporations to seek a high return.
• There are many good, and some not-so-good, consequences of people acting intheir own self-interest, which may be another reason to focus on self-interested
behavior.
Thus, while there are limits to the applicability of the theory of self-interested behavior,
it is a reasonable methodology for attempting a science of human behavior.
Self-interested behavior will often be described as “maximizing behavior,” where
consumers maximize the value they obtain from their purchases, and firms maximize
their profits. One objection to the economic methodology is that people rarely carry out
the calculations necessary to literally maximize anything. However, that is not asensible objection to the methodology. People don’t carry out the physics calculations tothrow a baseball or thread a needle, either, and yet they accomplish these tasks.
Economists often consider that people act “as if” they maximize an objective, eventhough no calculations are carried out. Some corporations in fact use elaborate
computer programs to minimize costs or maximize their profits, and the entire field ofoperations research is used to create and implement such maximization programs.
Thus, while individuals don’t carry out the calculations, some companies do.
A good example of economic reasoning is the sunk cost fallacy. Once one has made asignificant non-recoverable investment, there is a psychological tendency to invest moreeven when the return on the subsequent investment isn’t worthwhile. France andBritain continued to invest in the Concorde (a supersonic aircraft no longer inproduction) long after it became clear that the project would generate little return. If
you watch a movie to the end, long after you become convinced that it stinks, you haveexhibited the sunk cost fallacy. The fallacy is the result of an attempt to make an
investment that has gone bad turn out to be good, even when it probably won’t. The
popular phrase associated with the sunk cost fallacy is “throwing good money after bad.”
The fallacy of sunk costs arises because of a psychological tendency to try to make an
investment pay off when something happens to render it obsolete. It is a mistake inmany circumstances.
The fallacy of sunk costs is often thought to be an advantage of casinos. People who lose
a bit of money gambling hope to recover their losses by gambling more, with the sunk
“investment” in gambling inducing an attempt to make the investment pay off. The
nature of most casino gambling is that the house wins on average, which means theaverage gambler (and even the most skilled slot machine or craps player) loses on
average. Thus, for most, trying to win back losses is to lose more on average.
The way economics is performed is by a proliferation of mathematical models, and thisproliferation is reflected in this book. Economists reason with models. Models help byremoving extraneous details from a problem or issue, letting one analyze what remains
more readily. In some cases the models are relatively simple, like supply and demand.
In other cases, the models are relatively complex (e.g. the over-fishing model of Section
6.3.6). In all cases, the models are the simplest model that lets us understand thequestion or phenomenon at hand. The purpose of the model is to illuminate

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connections between ideas. A typical implication of a model is “when A increases, B
falls.” This “comparative static” prediction lets us see how A affects B, and why, at leastin the context of the model. The real world is always much more complex than themodels we use to understand the world. That doesn’t make the model useless, indeed,exactly the opposite. By stripping out extraneous detail, the model represents a lens toisolate and understand aspects of the real world.
Finally, one last introductory warning before we get started. A parody of economists
talking is to add the word marginal before every word. Marginal is just economist’s
jargon for “the derivative of.” For example, marginal cost is the derivative of cost;
marginal value is the derivative of value. Because introductory economics is usuallytaught to students who have not yet studied calculus or can’t be trusted to remember
even the most basic elements of it, economists tend to avoid using derivatives andinstead talk about the value of the next unit purchased, or the cost of the next unit, anddescribe that as the marginal value or cost. This book uses the term marginal frequently
because one of the purposes of the book is to introduce the necessary jargon so that you
can read more advanced texts or take more advanced classes. For an economics student
not to know the word marginal would be akin to a physics student not knowing the word
mass. The book minimizes jargon where possible, but part of the job of a principles
student is to learn the jargon, and there is no getting around that.

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2 Supply and Demand
Supply and demand are the most fundamental tools of economic analysis. Most
applications of economic reasoning involve supply and demand in one form or another.
When prices for home heating oil rise in the winter, usually the reason is that theweather is colder than normal and as a result, demand is higher than usual. Similarly, a
break in an oil pipeline creates a short-lived gasoline shortage, as occurred in the
Midwest in the year 2000, which is a reduction in supply. The price of DRAM, ordynamic random access memory, used in personal computers falls when new
manufacturing facilities begin production, increasing the supply of memory.
This chapter sets out the basics of supply and demand, introduces equilibrium analysis,
and considers some of the factors that influence supply and demand and the effects of
those factors. In addition, quantification is introduced in the form of elasticities.
Dynamics are not considered, however, until Chapter 4, which focuses on production,
and Chapter 5 introduces a more fundamental analysis of demand, including a variety of
topics such as risk. In essence, this is the economics “quickstart” guide, and we will look
more deeply in the subsequent chapters.

2.1 Supply and Demand
2.1.1 Demand and Consumer Surplus
Eating a French fry makes most people a little bit happier, and we are willing to give up
something of value – a small amount of money, a little bit of time – to eat one. What weare willing to give up measures the value – our personal value – of the French fry. Thatvalue, expressed in dollars, is the willingness to pay for French fries. That is, if you arewilling to give up three cents for a single French fry, your willingness to pay is three
cents. If you pay a penny for the French fry, you’ve obtained a net of two cents in value.
Those two cents – the difference between your willingness to pay and the amount you do
pay – is known as consumer surplus. Consumer surplus is the value to a consumer ofconsumption of a good, minus the price paid.
The value of items – French fries, eyeglasses, violins – is not necessarily close to what
one has to pay for them. For people with bad vision, eyeglasses might be worth ten
thousand dollars or more, in the sense that if eyeglasses and contacts cost $10,000 at all
stores, that is what one would be willing to pay for vision correction. That one doesn’t
have to pay nearly that amount means that the consumer surplus associated witheyeglasses is enormous. Similarly, an order of French fries might be worth $3 to a
consumer, but because French fries are available for around $1, the consumer obtains asurplus of $2 in the purchase.
How much is a second order of French fries worth? For most of us, that first order isworth more than the second one. If a second order is worth $2, we would still gain frombuying it. Eating a third order of fries is worth less still, and at some point we’re unable
or unwilling to eat any more fries even when they are free, which implies that at somepoint the value of additional French fries is zero.
We will measure consumption generally as units per period of time, e.g. French fries
consumed per month.
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Many, but not all, goods have this feature of diminishing marginal value – the value ofthe last unit consumed declines as the number consumed rises. If we consume aquantity q, it implies the marginal value v(q) falls as the number of units rise.1 An
example is illustrated in Figure 2-1. Here the value is a straight line, declining in thenumber of units.
value

v(q0), p

v(q)

q0

q

Figure 2-1: The Demand Curve

Demand need not be a straight line, and indeed could be any downward-sloping curve.
Contrary to the usual convention, demand gives the quantity chosen for any given priceoff the horizontal axis, that is, given the value p on the vertical axis, the corresponding
value q0 on the horizontal axis is the quantity the consumer will purchase.
It is often important to distinguish the demand curve itself – the entire relationshipbetween price and quantity demanded – from the quantity demanded. Typically,“demand” refers to the entire curve, while “quantity demanded” is a point on the curve.
Given a price p, a consumer will buy those units with v(q)>p, since those units are worth
more than they cost. Similarly, a consumer should not buy units for which v(q)<p.
Thus, the quantity q0 that solves the equation v(q0)=p gives the quantity of units theconsumer will buy. This value is also illustrated in Figure 2-1.2 Another way of

1 When diminishing marginal value fails, which sometimes is said to occur with beer consumption,

constructing demand takes some additional effort, which isn’t of a great deal of consequence. Buyers will
still choose to buy a quantity where marginal value is decreasing.
2 We will treat units as continuous, even though in reality they are discrete units. The reason for treatingthem as continuous is only to simplify the mathematics; with discrete units, the consumer buys thoseunits with value exceeding the price, and doesn’t buy those with value less than the price, just as before.
However, since the value function isn’t continuous, much less differentiable, it would be an accident for

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summarizing this insight is that the marginal value curve is the inverse of demand
function, where the demand function gives the quantity demanded for any given price.
Formally, if x(p) is the quantity a consumer buys given a price of p, then v( x( p)) = p.

But what is the marginal value curve? Suppose the total value of consumption of the
product, in dollar value, is given by u(q). That is, a consumer who pays u(q) for thequantity q is just indifferent to getting nothing and paying nothing. For each quantity,
there should exist one and only one price that exactly makes the consumer indifferent
between purchasing it and getting nothing at all, because if the consumer is just willingto pay u(q), any greater amount is more than the consumer should be willing to pay.
The consumer facing a price p gets a net value or consumer surplus of CS = u(q) – pq
from consuming q units. In order to obtain the maximal benefit, the consumer would
then choose the level of q to maximize u(q) – pq. When the function CS is maximized,
its derivative is zero, which implies that, at the quantity that maximizes the consumer’s
net value0=d(u(q) − pq ) = u′(q) − p.
dq

Thus we see that v(q) = u′(q), that is, the marginal value of the good is the derivative ofthe total value.
Consumer surplus is the value of the consumption minus the amount paid, andrepresents the net value of the purchase to the consumer. Formally, it is u(q)-pq. A
graphical form of the consumer surplus is generated by the following identity.
CS = max(u(q) − pq ) = u(q0 ) − pq0 =
q

q0

q0

0

0

∫ (u′(x) − p)dx = ∫ (v(x) − p)dx.

This expression shows that consumer surplus can be represented as the area below thedemand curve and above the price, as is illustrated in Figure 2-2. The consumer surplus
represents the consumer’s gains from trade, the value of consumption to the consumer
net of the price paid.

marginal value to equal price. It isn’t particularly arduous to handle discreteness of the products, but it
doesn’t lead to any significant insight either, so we won’t consider it here.

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valueConsumer
Surplusv (q ) = u′(q )

v(q0)

q0

q

Figure 2-2: Consumer Surplus

The consumer surplus can also be expressed using the demand curve, by integratingfrom the price up. In this case, if x(p) is the demand, we have∞

CS = ∫ x( y) dy .
pWhen you buy your first car, you experience an increase in demand for gasoline because
gasoline is pretty useful for cars and not so much for other things. An imminent
hurricane increases the demand for plywood (to protect windows), batteries, candles,
and bottled water. An increase in demand is represented by a movement of the entire
curve to the northeast (up and to the right), which represents an increase in themarginal value v (movement up) for any given unit, or an increase in the number ofunits demanded for any given price (movement to the right). Figure 2-3 illustrates ashift in demand.
Similarly, the reverse movement represents a decrease in demand. The beauty of theconnection between demand and marginal value is that an increase in demand could in
principle have meant either more units demanded at a given price, or a higher
willingness to pay for each unit, but those are in fact the same concept – both create amovement up and to the right.
For many goods, an increase in income increases the demand for the good. Porsche
automobiles, yachts, and Beverly Hills homes are mostly purchased by people with highincomes. Few billionaires ride the bus. Economists aptly named goods whose demanddoesn’t increase with income inferior goods, with the idea that people substitute tobetter quality, more expensive goods as their incomes rise. When demand for a good

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increases with income, the good is called normal. It would have been better to call such
goods superior, but it is too late to change such a widely accepted convention.
value

v(q)

q
Figure 2-3: An Increase in Demand

Another factor that influences demand is the price of related goods. The dramatic fall in
the price of computers over the past twenty years has significantly increased the demandfor printers, monitors and internet access. Such goods are examples of complements.
Formally, for a given good X, a complement is a good whose consumption increases thevalue of X. Thus, the use of computers increases the value of peripheral devices likeprinters and monitors. The consumption of coffee increases the demand for cream formany people. Spaghetti and tomato sauce, national parks and hiking boots, air travel
and hotel rooms, tables and chairs, movies and popcorn, bathing suits and sun tan
lotion, candy and dentistry are all examples of complements for most people –consumption of one increases the value of the other. The complementarity relationshipis symmetric – if consumption of X increases the value of Y, then consumption of Y
must increase the value of X.3 There are many complementary goods and changes in theprices of complementary goods have predictable effects on the demand of theircomplements. Such predictable effects represent the heart of economic analysis.
The opposite case of a complement is a substitute. Colas and root beer are substitutes,
and a fall in the price of root beer (resulting in an increase in the consumption of rootbeer) will tend to decrease the demand for colas. Pasta and ramen, computers andtypewriters, movies (in theaters) and sporting events, restaurants and dining at home,spring break in Florida versus spring break in Mexico, marijuana and beer, economics
3 The basis for this insight can be seen by denoting the total value in dollars of consuming goods x and y asu(x, y). Then the demand for x is given by the partial ∂u . The statement that y is a complement is the∂xstatement that the demand for x rises as y increases, that is, ∂ 2u
second derivative, ∂ 2u

∂y∂x

∂x ∂y

> 0. But then with a continuous> 0 , which means the demand for y, ∂u ∂y , increases with x.

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courses and psychology courses, driving and bicycling are all examples of substitutes formost people. An increase in the price of a substitute increases the demand for a good,and conversely, a decrease in the price of a substitute decreases demand for a good.
Thus, increased enforcement of the drug laws, which tends to increase the price ofmarijuana, leads to an increase in the demand for beer.
Much of demand is merely idiosyncratic to the individual – some people like plaids,some like solid colors. People like what they like. Often people are influenced by others– tattoos are increasingly common not because the price has fallen but because of anincreased acceptance of body art. Popular clothing styles change, not because of income
and prices but for other reasons. While there has been a modest attempt to link clothingstyle popularity to economic factors,4 by and large there is no coherent theory
determining fads and fashions beyond the observation that change is inevitable. As aresult, this course, and economics more generally, will accept preferences for what they
are without questioning why people like what they like. While it may be interesting tounderstand the increasing social acceptance of tattoos, it is beyond the scope of this text
and indeed beyond most, but not all, economic analyses. We will, however, account forsome of the effects of the increasing acceptance of tattoos through changes in thenumber of firms offering tattooing, changes in the variety of products offered, and so on.
2.1.1.1 (Exercise)A reservation price is the maximum willingness to pay for a goodthat most people buy one unit of, like cars or computers. Graph the demand
curve for a consumer with a reservation price of $30 for a unit of a good.
2.1.1.2 (Exercise) Suppose the demand curve is given by x(p) = 1 – p. The consumer’s
expenditure is px(p) = p(1 – p). Graph the expenditure. What price maximizes
the consumer’s expenditure?
2.1.1.3 (Exercise)
For demand x(p) = 1 – p, compute the consumer surplus function as
a function of p.
2.1.1.4 (Exercise) For demand x(p) = p–ε, for ε > 1, find the consumer surplus as afunction of p. (Hint: recall that the consumer surplus can be expressed as∞

CS = ∫ x( y) dy .)p

2.1.2 Supply
The supply curve gives the number of units, represented on the horizontal axis, as afunction of the price on the vertical axis, which will be supplied for sale to the market.
An example is illustrated in Figure 2-4. Generally supply is upward-sloping, because if
it is a good deal for a seller to sell 50 units of a product at a price of $10, then it remains
a good deal to supply those same 50 at a price of $11. The seller might choose to sell

4 Skirts are allegedly shorter during economic booms and lengthen during recessions.

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more than 50, but if the first 50 weren’t worth keeping at a price of $10, that remains
true at $11.5

p

p

q0

q

Figure 2-4: The Supply Curve

The seller who has a cost c(q) for selling q units obtains a profit, at price p per unit, of pq– c(q). The quantity which maximizes profit for the seller is the quantity q* satisfying0=dpq − c(q) = p − c ′(q*).
dqThus, price equals marginal cost is a characteristic of profit maximization; the seller
sells all the units whose cost is less than price, and doesn’t sell the units whose costexceeds price. In constructing the demand curve, we saw that the demand curve was theinverse of the marginal value. There is an analogous property of supply: the supply
curve is the inverse function of marginal cost. Graphed with the quantity supplied on
the horizontal axis and price on the vertical axis, the supply curve is the marginal cost
curve, with marginal cost on the vertical axis.
Exactly in parallel to consumer surplus with demand, profit is given by the difference ofthe price and marginal cost

5 This is a good point to remind the reader that the economists’ familiar assumption of “other things

equal” is still in effect. If the increased price is an indication that prices might rise still further, or aconsequence of some other change that affects the sellers’ value of items, then of course the higher pricemight not justify sale of the items. We hold other things equal to focus on the effects of price alone, andthen will consider other changes separately. The pure effect of an increased price should be to increase
the quantity offered, while the effect of increased expectations may be to decrease the quantity offered.

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q*

Profit = max pq − c(q) = pq * −c(q*) = ∫ ( p − c ′( x ))dx.
q0This area is shaded in Figure 2-5.
pProfitpq0qFigure 2-5: Supplier Profits

The relationship of demand and marginal value exactly parallels the relationship of
supply and marginal cost, for a somewhat hidden reason. Supply is just negative
demand, that is, a supplier is just the possessor of a good who doesn’t keep it but insteadoffers it to the market for sale. For example, when the price of housing goes up, one of
the ways people demand less is by offering to rent a room in their house, that is, by
supplying some of their housing to the market. Similarly, the marginal cost of supplying
a good already produced is the loss of not having the good, that is, the marginal value ofthe good. Thus, with exchange, it is possible to provide the theory of supply anddemand entirely as a theory of net demand, where sellers are negative demanders.
There is some mathematical economy in this approach, and it fits certain circumstances
better than separating supply and demand. For example, when the price of electricity
rose very high in the western United States in 2003, several aluminum smelters resold
electricity they had purchased in long-term contracts, that is, demanders became
suppliers.
However, the “net demand” approach obscures the likely outcomes in instances where
the sellers are mostly different people, or companies, than the buyers. Moreover, while
there is a theory of complements and substitutes for supply that is exactly parallel to theequivalent theory for demand, the nature of these complements and substitutes tends tobe different. For these reasons, and also for the purpose of being consistent with
common economic usage, we will distinguish supply and demand.

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An increase in supply refers to either more units available at a given price, or a lower
price for the supply of the same number of units. Thus, an increase in supply isgraphically represented by a curve that is lower or to the right, or both, that is, to thesouth-east. This is illustrated in Figure 2-6. A decrease in supply is the reverse case, ashift to the northwest.
pq

Figure 2-6: An Increase in Supply

Anything that increases costs of production will tend to increase marginal cost and thus
reduce the supply. For example, as wages rise, the supply of goods and services isreduced, because wages are the input price of labor. Labor accounts for about twothirds of all input costs, and thus wage increases create supply reductions (a higher priceis necessary to provide the same quantity) for most goods and services. Costs ofmaterials of course increase the price of goods using those materials. For example, themost important input into the manufacture of gasoline is crude oil, and an increase of $1
in the price of a 42 gallon barrel of oil increases the price of gasoline about two cents –almost one-for-one by volume. Another significant input in many industries is capital,
and as we will see, interest is cost of capital. Thus, increases in interest rates increase
the cost of production, and thus tend to decrease the supply of goods.
Parallel to complements in demand, a complement in supply to a good X is a good Y
such that an increase in the price of Y increases the supply of X. Complements in supply
are usually goods that are jointly produced. In producing lumber (sawn boards), a large
quantity of wood chips and sawdust are also produced as a by-product. These woodchips and saw dust are useful in the manufacture of paper. An increase in the price of
lumber tends to increase the quantity of trees sawn into boards, thereby increasing the
supply of wood chips. Thus, lumber and wood chips are complements in supply.
It turns out that copper and gold are often found in the same kinds of rock – theconditions that give rise to gold compounds also give rise to copper compounds. Thus,
an increase in the price of gold tends to increase the number of people prospecting for

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gold, and in the process increases not just the quantity of gold supplied to the market,
but also the quantity of copper. Thus, copper and gold are complements in supply.
The classic supply-complement is beef and leather – an increase in the price of beef
increases the slaughter of cows, thereby increasing the supply of leather.
The opposite of a complement in supply is a substitute in supply. Military and civilian
aircraft are substitutes in supply – an increase in the price of military aircraft will tend
to divert resources used in the manufacture of aircraft toward military aircraft and awayfrom civilian aircraft, thus reducing the supply of civilian aircraft. Wheat and corn are
also substitutes in supply. An increase in the price of wheat will lead farmers whose
land is reasonably well-suited to producing either wheat or corn to substitute wheat for
corn, increasing the quantity of wheat and decreasing the quantity of corn. Agricultural
goods grown on the same type of land usually are substitutes. Similarly, cars and trucks,
tables and desks, sweaters and sweatshirts, horror movies and romantic comedies areexamples of substitutes in supply.
Complements and substitutes are important because they are common and havepredictable effects on demand and supply. Changes in one market spill over to the othermarket, through the mechanism of complements or substitutes.
2.1.2.1 (Exercise) A typist charges $30/hr and types 15 pages per hour. Graph the
supply of typed pages.
2.1.2.2 (Exercise) An owner of an oil well has two technologies for extracting oil.
With one technology, the oil can be pumped out and transported for $5,000 perday, and 1,000 barrels per day are produced. With the other technology, which
involves injecting natural gas into the well, the owner spends $10,000 per day
and $5 per barrel produced, but 2,000 barrels per day are produced. What is
the supply? Graph it.
(Hint: Compute the profits, as a function of the price, for each of the technologies. At
what price would the producer switch from one technology to the other? At what pricewould the producer shut down and spend nothing?)
2.1.2.3 (Exercise) An entrepreneur has a factory the produces Lα widgets, where α<1,
when L hours of labor is used. The cost of labor (wage and benefits) is w per
hour. If the entrepreneur maximizes profit, what is the supply curve forwidgets?
Hint: The entrepreneur’s profit, as a function of the price, is pLα – wL. The
entrepreneur chooses the amount of labor to maximize profit. Find the amount of laborthat maximizes, which is a function of p, w and α. The supply is the amount of output
produced, which is Lα.

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2.1.2.4 (Exercise) In the above exercise, suppose now that more than 40 hours entails
a higher cost of labor (overtime pay). Let w be $20/hr for under 40 hours, and$30/hr for each hour over 40 hours, and α = ½. Find the supply curve.
Hint: Let L(w, p) be the labor demand when the wage is w (no overtime pay) and theprice is p. Now show that, if L(20,p) < 40, the entrepreneur uses L(20,p) hours. This isshown by verifying that profits are higher at L(20,p) than at L(30,p). If L(30,p) > 40,
the entrepreneur uses L(30,p) hours. Finally, if L(20,p) > 40 > L(30,p), theentrepreneur uses 40 hours. Labor translates into supply via Lα.
2.1.2.5 (Exercise) In the previous exercise, for what range of prices does employment
equal 40 hours? Graph the labor demanded by the entrepreneur.
Hint: The answer involves

10 .

2.1.2.6 (Exercise) Suppose marginal cost, as a function of the quantity q produced, is
mq. Find the producer’s profit as a function of the price p.

2.2 The Market
Individuals with their own supply or demand trade in a market, which is where prices
are determined. Markets can be specific or virtual locations – the farmer’s market, the
New York Stock Exchange, eBay – or may be an informal or more amorphous market,
such as the market for restaurant meals in Billings, Montana or the market for roof
repair in Schenectady, New York.

2.2.1 Market Demand and Supply
Individual demand gives the quantity purchased for each price. Analogously, themarket demand gives the quantity purchased by all the market participants – the sumof the individual demands – for each price. This is sometimes called a “horizontal sum”
because the summation is over the quantities for each price. An example is illustrated in
Figure 2-7. For a given price p, the quantity q1 demanded by one consumer, and thequantity q2 demanded by a second consumer are illustrated. The sum of thesequantities represents the market demand, if the market has just those two-participants.
Since the consumer with subscript 2 has a positive quantity demanded for high prices,while the consumer with subscript 1 does not, the market demand coincides with
consumer 2’s demand when the price is sufficiently high. As the price falls, consumer 1
begins purchasing, and the market quantity demanded is larger than either individual
participant’s quantity, and is the sum of the two quantities.
Example: If the demand of buyer 1 is given by q = max {0, 10 – p}, and the demand of
buyer 2 is given by q = max {0, 20 – 4p}, what is market demand for the twoparticipants?
Solution: First, note that buyer 1 buys zero at a price 10 or higher, while buyer 2 buys
zero at a price of 5 or higher. For a price above 10, market demand is zero. For a pricebetween 5 and 10, market demand is buyer 1’s demand, or 10 – p. Finally, for a pricebetween zero and 5, the market quantity demanded is 10 – p + 20 – 4p = 30 – 5p.

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Market supply is similarly constructed – the market supply is the horizontal (quantity)
sum of all the individual supply curves.

Market Demand

p

q1

q2

q1+ q2

Figure 2-7: Market Demand

Example: If the supply of firm 1 is given by q = 2p, and the supply of firm 2 is given by q
= max {0, 5p – 10}, what is market supply for the two-participants?
Solution: First, note that firm 1 is in the market at any price, but firm 2 is in the market
only if price exceeds 2. Thus, for a price between zero and 2, market supply is firm 1’s
supply, or 2p. For p>2, market supply is 5p – 10 + 2p = 7p – 10.
2.2.1.1 (Exercise) Is the consumer surplus for market demand the sum of theconsumer surpluses for the individual demands? Why or why not? Illustrate
your conclusion with a figure like Figure 2-7.
2.2.1.2 (Exercise) Suppose the supply of firm i is αi p, when the price is p, where itakes on the values 1, 2, 3, … n. What is the market supply of these n firms?
2.2.1.3 (Exercise) Suppose consumers in a small town choose between two
restaurants, A and B. Each consumer has a value vA for A and a value vB for B,
each of which is a uniform random draw from the [0,1] interval. Consumers buy
whichever product offers the higher consumer surplus. The price of B is 0.2. In
the square associated with the possible value types, identify which consumers
buy from firm A. Find the demand (which is the area of the set of consumers
who buy from A in the picture below). Hint: Consumers have three choices:
Buy nothing (value 0), buy from A (value vA – pA) and buy from B, (value vB – pB

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= vB – 0.2). Draw the lines illustrating which choice has the highest value forthe consumer.
Value
of B

Price
of B
Buy Nothing
Price
of A

Value of A

2.2.2 Equilibrium
Economists use the term equilibrium in the same way as the word is used in physics, torepresent a steady state in which opposing forces are balanced, so that the current stateof the system tends to persist. In the context of supply and demand, equilibrium refers
to a condition where the pressure for higher prices is exactly balanced by a pressure forlower prices, and thus that the current state of exchange between buyers and sellers canbe expected to persist.
When the price is such that the quantity supplied of a good or service exceeds thequantity demanded, some sellers are unable to sell because fewer units are purchased
than are offered. This condition is called a surplus. The sellers who fail to sell have an
incentive to offer their good at a slightly lower price – a penny less – in order to succeed
in selling. Such price cuts put downward pressure on prices, and prices tend to fall. The
fall in prices generally reduces the quantity supplied and increases the quantity
demanded, eliminating the surplus. That is, a surplus encourages price cutting, which
reduces the surplus, a process that ends only when the quantity supplied equals thequantity demanded.
Similarly, when the price is low enough that the quantity demanded exceeds thequantity supplied, a shortage exists. In this case, some buyers fail to purchase, andthese buyers have an incentive to accept a slightly higher price in order to be able totrade. Sellers are obviously happy to get the higher price as well, which tends to put
upward pressure on prices, and prices rise. The increase in price tends to reduce thequantity demanded and increase the quantity supplied, thereby eliminating theshortage. Again, the process stops when the quantity supplied equals the quantity
demanded.

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p

Supplyds

Surplus: q < qp*

Shortage: qs < qdq*Demandq

Figure 2-8: Equilibration

This logic, which is illustrated in Figure 2-8, justifies the conclusion that the only
equilibrium price is the price in which the quantity supplied equals the quantity
demanded. Any other price will tend to rise in a shortage, or fall in a surplus, until
supply and demand are balanced. In Figure 2-8, a surplus arises at any price above theequilibrium price p*, because the quantity supplied qs is larger than the quantity
demanded qd. The effect of the surplus – leading to sellers with excess inventory –induces price cutting which is illustrated with three arrows pointing down.
Similarly, when the price is below p*, the quantity supplied qs is less than the quantity
demanded qd. This causes some buyers to fail to find goods, leading to higher asking
prices and higher bid prices by buyers. The tendency for the price to rise is illustrated
with the arrows pointing up. The only price which doesn’t lead to price changes is p*,
the equilibrium price in which the quantity supplied equals the quantity demanded.
The logic of equilibrium in supply and demand is played out daily in markets all over theworld, from stock, bond and commodity markets with traders yelling to buy or sell, toBarcelona fish markets where an auctioneer helps the market find a price, to Istanbul
gold markets, to Los Angeles real estate markets.
2.2.2.1 (Exercise) If demand is given by qd(p) = a – bp, and supply is given by qs(p) =cp, solve for the equilibrium price and quantity. Find the consumer surplus andproducer profits.

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2.2.2.2 (Exercise) If demand is given by qd(p) = ap-ε, and supply is given by qs(p) =bpη, where all parameters are positive numbers, solve for the equilibrium priceand quantity.

2.2.3 Efficiency of Equilibrium
The equilibrium of supply and demand balances the quantity demanded and thequantity supplied, so that there is no excess of either. Would it be desirable, from asocial perspective, to force more trade, or to restrain trade below this level?
There are circumstances where the equilibrium level of trade has harmful consequences,and such circumstances are considered in Chapter 6. However, provided that the only
people affected by a transaction are the buyer and seller, the equilibrium of supply anddemand maximizes the total gains from trade.
This proposition is quite easy to see. To maximize the gains from trade, clearly thehighest value buyers must get the goods. Otherwise, if there is a potential buyer that
doesn’t get the good with higher value than one who does, the gains from trade rise justby diverting the good to the higher value buyer. Similarly, the lowest cost sellers must
supply those goods; otherwise we can increase the gains from trade by replacing ahigher cost seller with a lower cost seller. Thus, the only question is how many goods
should be traded to maximize the gains from trade, since it will involve the lowest costsellers selling to the highest value buyers. Adding a trade increases the total gains fromtrade when that trade involves a buyer with value higher than the seller’s cost. Thus, thegains from trade are maximized by the set of transactions to the left of the equilibrium,with the high value buyers buying from the low cost sellers.
In the economist’s language, the equilibrium is efficient, in that it maximizes the gains
from trade, under the assumption that the only people affected by any given transaction
are the buyers and seller.

2.3 Changes in Supply and Demand
2.3.1 Changes in Demand
What are the effects of an increase in demand? As the population of California has
grown, the demand for housing has risen. This has pushed the price of housing up, andalso spurred additional development, increasing the quantity of housing supplied aswell. We see such a demand increase illustrated in Figure 2-9, which represents anincrease in the demand. In this figure, supply and demand have been abbreviated S and
D. Demand starts at D1 and is increased to D2. Supply remains the same. The
equilibrium price increases from p1* to p2*, and the quantity rises from q1* to q2*.

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p

S

p2*
p1*
D2

D1
q1*

q2*

q

Figure 2-9: An Increase in Demand

A decrease in demand – such as occurred for typewriters with the advent of computers,
or buggy whips as cars replaced horses as the major method of transportation – has thereverse effect of an increase, and implies a fall in both the price and the quantity traded.
Examples of decreases in demand include products replaced by other products – VHStapes were replaced by DVDs, vinyl records replaced by CDs, cassette tapes replaced byCDs, floppy disks (oddly named because the 1.44 MB “floppy,” a physically hard
product, replaced the 720KB, 5 ¼ inch soft floppy disk) replaced by CDs and flash
memory drives, and so on. Even personal computers experienced a fall in demand as
the market was saturated in the year 2001.

2.3.2 Changes in Supply
An increase in supply comes about from a fall in the marginal cost – recall that the
supply curve is just the marginal cost of production. Consequently, an increased supply
is represented by a curve that is lower and to the right on the supply/demand graph,
which is an endless source of confusion for many students. The reasoning – lower costs
and greater supply are the same thing – is too easily forgotten. The effects of anincrease in supply are illustrated in Figure 2-10. The supply curve goes from S1 to S2,
which represents a lower marginal cost. In this case, the quantity traded rises from q1*
to q2* and price falls from p1* to p2*.
Computer equipment provides dramatic examples of increases in supply. Consider
Dynamic Random Access Memory, or DRAM. DRAMs are the chips in computers andmany other devices that store information on a temporary basis.6 Their cost has fallen
dramatically, which is illustrated in Figure 2-11.7 Note that the prices in this figurereflect a logarithmic scale, so that a fixed percentage decrease is illustrated by a straightline. Prices of DRAMs fell to close to 1/1000th of their 1990 level by 2004. The means
6 Information that will be stored on a longer term basis is generally embedded in flash memory or on ahard disk. Neither of these products lose their information when power is turned off, unlike DRAM.
7 Used with permission of computer storage expert Dr. Edward Grochowski.

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by which these prices have fallen are themselves quite interesting. The main reasons areshrinking the size of the chip (a “die shrink”), so that more chips fit on each silicon disk,
and increasing the size of the disk itself, so that more chips fit on a disk. The
combination of these two, each of which required the solutions to thousands ofengineering and chemistry problems, has led to dramatic reductions in marginal costs
and consequent increases in supply. The effect has been that prices fell dramaticallyand quantities traded rose dramatically.
p

S1

S2

p1*
p2*

D
q1*

q2*

q

Figure 2-10: An Increase in Supply

An important source of supply and demand changes are changes in the markets ofcomplements. A decrease in the price of a demand-complement increases the demand
for a product, and similarly, an increase in the price of a demand-substitute increases
demand for a product. This gives two mechanisms to trace through effects fromexternal markets to a particular market via the linkage of demand substitutes orcomplements. For example, when the price of gasoline falls, the demand forautomobiles (a complement) overall should increase. As the price of automobiles rises,
the demand for bicycles (a substitute in some circumstances) should rise. When theprice of computers falls, the demand for operating systems (a complement) should rise.
This gives an operating system seller like Microsoft an incentive to encourage technicalprogress in the computer market, in order to make the operating system more valuable.

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Figure 2-11: Price of Storage

An increase in the price of a supply-substitute reduces the supply of a good (by making
the alternative good more attractive to suppliers), and similarly, a decrease in the priceof a supply complement reduces the supply of a good. By making the by-product lessvaluable, the returns to investing in a good are reduced. Thus, an increase in the priceof DVD-R discs (used for recording DVDs) discourages investment in the manufactureof CD-Rs, which are a substitute in supply, leading to a decrease in the supply of CD-Rs.
This tends to increase the price of CD-Rs, other things equal. Similarly, an increase in
the price of oil increases exploration for oil, tending to increase the supply of naturalgas, which is a complement in supply. However, since natural gas is also a demand
substitute for oil (both are used for heating homes), an increase in the price of oil also
tends to increase the demand for natural gas. Thus, an increase in the price of oil
increases both the demand and the supply of natural gas. Both changes increase thequantity traded, but the increase in demand tends to increase the price, while theincrease in supply tends to decrease the price. Without knowing more, it is impossible
to determine whether the net effect is an increase or decrease in the price.
2.3.2.1 (Exercise) Video games and music CDs are substitutes in demand. What is theeffect of an increase in supply of video games on the price and quantity traded ofmusic CDs? Illustrate your answer with diagrams for both markets.
2.3.2.2 (Exercise) Electricity is a major input into the production of aluminum, andaluminum is a substitute in supply for steel. What is the effect of an increase in
price of electricity on the steel market?

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2.3.2.3 (Exercise) Concerns about terrorism reduced demand for air travel, andinduced consumers to travel by car more often. What should happen to theprice of Hawaiian hotel rooms?
When the price of gasoline goes up, people curtail their driving to some extent, but don’t
immediately scrap their SUVs and rush out and buy more fuel-efficient automobiles orelectric cars. Similarly, when the price of electricity rises, people don’t replace their air
conditioners and refrigerators with the most modern, energy-saving models right away.
There are three significant issues raised by this kind of example. First, such changes
may be transitory or permanent, and people reasonably react differently to temporarychanges than to permanent changes. The effect of uncertainty is a very important topic
and will be considered in section 5.2.6, but only in a rudimentary way for thisintroductory text. Second, energy is a modest portion of the cost of owning andoperating an automobile or refrigerator, so it doesn’t make sense to scrap a large capital
investment over a small permanent increase in cost. Thus people rationally continue
operating “obsolete” devices until their useful life is over, even when they wouldn’t buy
an exact copy of that device, an effect with the gobbledygook name of hysteresis. Third,a permanent increase in energy prices leads people to buy more fuel efficient cars, andto replace the old gas guzzlers more quickly. That is, the effects of a change are larger
over a larger time interval, which economists tend to call the long-run.
A striking example of such delay arose when oil quadrupled in price in 1973-4, caused bya reduction in sales by the cartel of oil-producing nations, OPEC, which stands for theOrganization of Petroleum Exporting Countries. The increased price of oil (andconsequent increase in gasoline prices) caused people to drive less and to lower their
thermostats in the winter, thus reducing the quantity of oil demanded. Over time,
however, they bought more fuel efficient cars and insulated their homes more
effectively, significantly reducing the quantity demanded still further. At the same time,the increased prices for oil attracted new investment into oil production in Alaska, theNorth Sea between Britain and Norway, Mexico and other areas. Both of these effects(long-run substitution away from energy, and long-run supply expansion) caused theprice to fall over the longer term, undoing the supply reduction created by OPEC. In
1981, OPEC further reduced output, sending prices still higher, but again, additional
investment in production, combined with energy-saving investment, reduced prices
until they fell back to 1973 levels (adjusted for inflation) in 1986. Prices continued to fall
until 1990, when they were at all-time low levels and Iraq’s invasion of Kuwait and theresulting first Iraqi war sent them higher again.
Short-run and long-run effects represent a theme of economics, with the major
conclusion of the theme that substitution doesn’t occur instantaneously, which leads topredictable patterns of prices and quantities over time.
It turns out that direct estimates of demand and supply are less useful as quantifications
than notions of percentage changes, which have the advantage of being unit-free. Thisobservation gives rise to the concept of elasticity, the next topic.

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2.4 Elasticities
2.4.1 Elasticity of Demand
Let x(p) represent the quantity purchased when the price is p, so that the function x
represents demand. How responsive is demand to price changes? One might betempted to use the derivative x ′ to measure the responsiveness of demand, since itmeasures directly how much the quantity demanded changes in response to a smallchange in price. However, this measure has two problems. First, it is sensitive to achange in units. If I measure the quantity of candy in kilograms rather than pounds, thederivative of demand for candy with respect to price changes even when demand itself
has remained the same. Second, if I change price units, converting from one currency toanother, again the derivative of demand will change. So the derivative is unsatisfactory
as a measure of responsiveness because it depends on units of measure. A common wayof establishing a unit-free measure is to use percentages, and that suggests considering
the responsiveness of demand in percentage terms to a small percentage change inprice. This is the notion of elasticity of demand.8 The elasticity of demand is thepercentage decrease in quantity that results from a small percentage increase in price.
Formally, the elasticity of demand, which is generally denoted with the Greek letter
epsilon ε (chosen to mnemonically suggest elasticity) is

ε=−

dx

x = − p dx = − px ′( p) .
dpx dpx ( p)
p

The minus sign is included to make the elasticity a positive number, since demand isdecreasing. First, let’s verify that the elasticity is in fact unit free. A change in themeasurement of x cancels because the proportionality factor appears in both thenumerator and denominator. Similarly, if we change the units of measurement of priceto replace the price p with r=ap, x(p) is replaced with x(r/a). Thus, the elasticity isd1
x(r / a)rx ′(r / a)a = − px ′( p) ,ε == − dr=−x (r / a)x (r / a)x ( p)rwhich is independent of a, and therefore not affected by the change in units.
How does a consumer’s expenditure, also known as (individual) total revenue, react to achange in price? The consumer buys x(p) at a price of p, and thus expenditure is TR =px(p). Thus⎛dpx ′( p) ⎞⎟ = x ( p)(1 − ε ).
px( p) = x( p) + px ′( p) = x( p)⎜⎜ 1 +dpx( p) ⎟⎠⎝
Therefore,
8 The concept of elasticity was invented by Alfred Marshall, 1842-1924, in 1881 while sitting on his roof.

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d
TR
dp
= 1 − ε.
1TRpTable 2-1: Various Demand Elasticities9

Product
Salt
Matches
Toothpicks
Airline travel, short-run
Residential natural gas, short-run
Gasoline, short-run
Automobiles, long-run
CoffeeLegal services, short-run
Tobacco products, short-run
Residential natural gas, long-run
Fish (cod) consumed at home
Physician services
Taxi, short-run
Gasoline, long-run
MoviesShellfish, consumed at home
Tires, short-run
Oysters, consumed at home
Private education
Housing, owner occupied, long-run
Tires, long-run
Radio and television receivers
Automobiles, short-run
Restaurant meals
Airline travel, long-run
Fresh green peas
Foreign travel, long-run
Chevrolet automobiles
Fresh tomatoes

ε
0.1
0.1
0.1
0.1
0.1
0.2
0.2
0.25
0.4
0.45
0.5
0.5
0.6
0.6
0.7
0.9
0.9
0.9
1.1
1.1
1.2
1.2
1.2
1.2-1.5
2.3
2.4
2.8
4.0
4.0
4.6

9 From http://www.mackinac.org/archives/1997/s1997-04.pdf; cited sources: Economics: Private andPublic Choice, James D. Gwartney and Richard L. Stroup, eighth edition 1997, seventh edition 1995;
Hendrick S. Houthakker and Lester D. Taylor, Consumer Demand in the United States, 1929-1970(Cambridge: Harvard University Press, 1966,1970); Douglas R. Bohi, Analyzing Demand Behavior(Baltimore: Johns Hopkins University Press, 1981); Hsaing-tai Cheng and Oral Capps, Jr., "Demand forFish" American Journal of Agricultural Economics, August 1988; and U.S. Department of Agriculture.

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In words, the percentage change of total revenue resulting from a one percent change inprice is one minus the elasticity of demand. Thus, a one percent increase in price will
increase total revenue when the elasticity of demand is less than one, which is defined as
an inelastic demand. A price increase will decrease total revenue when the elasticity ofdemand is greater than one, which is defined as an elastic demand. The case ofelasticity equal to one is called unitary elasticity, and total revenue is unchanged by asmall price change. Moreover, that percentage increase in price will increase revenue by
approximately 1-ε percent. Because it is often possible to estimate the elasticity ofdemand, the formulae can be readily used in practiceTable 2-1 provides estimates on demand elasticities for a variety of products.
pricea/b ε=∞

ε=1

ε=0
q
a
Figure 2-12: Elasticities for Linear Demand

When demand is linear, x(p)=a-bp, the elasticity of demand has the form
ε=

bp
p
=
.
a − bp a − pbThis case is illustrated in Figure 2-12.
If demand takes the form x(p)=ap-ε, then demand has constant elasticity, and theelasticity is equal to ε.
2.4.1.1 (Exercise) Suppose a consumer has a constant elasticity of demand ε, anddemand is elastic (ε > 1). Show that expenditure increases as price decreases.
2.4.1.2 (Exercise) Suppose a consumer has a constant elasticity of demand ε, anddemand is inelastic (ε < 1). What price makes expenditure the greatest?

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2.4.1.3 (Exercise) For a consumer with constant elasticity of demand ε > 1, computethe consumer surplus.

2.4.2 Elasticity of Supply
The elasticity of supply is analogous to the elasticity of demand, in that it is a unit-freemeasure of the responsiveness of supply to a price change, and is defined as thepercentage increase in quantity supplied resulting from a small percentage increase in
price. Formally, if s(p) gives the quantity supplied for each price p, the elasticity ofsupply, denoted η (the Greek letter “eta”, chosen because epsilon was already taken) isη=dss = p ds = ps′( p) .
dps dps( p )p

Again similar to demand, if supply takes the form s(p)=apη, then supply has constantelasticity, and the elasticity is equal to η. A special case of this form is linear supply,
which occurs when the elasticity equals one.
2.4.2.1 (Exercise) For a producer with constant elasticity of supply, compute theproducer profits.

2.5 Comparative Statics
When something changes – the price of a complement, the demand for a good – what
happens to the equilibrium? Such questions are answered by comparative statics,
which are the changes in equilibrium variables when other things change. The use of
the term “static” suggests that such changes are considered without respect to dynamic
adjustment, but instead just focus on the changes in the equilibrium level. Elasticities
will help us quantify these changes.

2.5.1 Supply and Demand Changes
How much do the price and quantity traded change in response to a change in demand?
We begin by considering the constant elasticity case, which will let us draw conclusions
for small changes in more general demand functions. We will denote the demand
function by qd(p)=ap-ε and supply function by qs(p)=bpη. The equilibrium price p* isgiven by the quantity supplied equal to the quantity demanded, or the solution to theequation:qd ( p*) = qs ( p*).
Substituting the constant elasticity formulae,

ap * −ε = qd ( p*) = qs ( p*) = bp *η .
Thus,

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a
= p * ε+η ,bor1⎛ a ⎞ ε+η.
p* = ⎜ ⎟⎝b⎠
The quantity traded, q*, can be obtained from either supply or demand and the price:ηηε⎛ a ⎞ ε+ηq* = qs ( p*) = bp * = b⎜ ⎟= a ε+ηb ε+η .
b⎝ ⎠η

There is one sense in which this gives an answer to the question of what happens when
demand increases. An increase in demand, holding the elasticity constant, corresponds
to an increase in the parameter a. Suppose we increase a by a fixed percentage,
replacing a by a(1+∆). Then price goes up by the multiplicative factor (1 + ∆ )the change in price, as a proportion of the price, is

1

ε+η

and

1

ε+η
∆p *
= (1 + ∆ )−1.
p*Similarly, quantity rises by
η

ε+η
∆q *
= (1 + ∆ )−1 .
q*These formulae are problematic for two reasons. First, they are specific to the case of
constant elasticity. Second, they are moderately complicated. Both of these issues canbe addressed by considering small changes, that is, a small value of ∆. We make use of atrick to simplify the formula. The trick is that, for small ∆,r(1 + ∆ ) ≈ 1 + r∆.
The squiggly equals sign ≈ should be read “approximately equal to.”10 Applying thisinsight, we have that:

10 The more precise meaning of ≈ is that, as ∆ gets small, the size of the error of the formula is small evenrrelative to ∆. That is, (1 + ∆ ) ≈ 1 + r∆. means (1 + ∆ ) − (1 + r∆ ) ⎯⎯⎯→ 0.
∆→0∆r

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For a small percentage increase ∆ in demand, quantity rises bypercent and price rises by approximately ∆approximately η∆ε+η
ε+η
percent.
The beauty of this claim is that it holds even when demand and supply do not haveconstant elasticities, because the effect considered is local, and locally, the elasticity isapproximately constant if the demand is “smooth.”2.5.1.1 (Exercise)Show that for a small percentage increase ∆ in supply, quantity rises
by approximately ε∆percent and price falls by approximately ∆ε+η
ε+η
percent.
2.5.1.2 (Exercise)If demand is perfectly inelastic, what is the effect of a decrease insupply? Apply the formula and then graph the solution.

2.6 Trade
Supply and demand offers one approach to understanding trade, and it represents themost important and powerful concept in the toolbox of economists. However, for someissues, especially those of international trade, another related tool is very useful: theproduction possibilities frontier. Analysis using the production possibilities frontier was
made famous by the “guns and butter” discussions of World War II. From an economic
perspective, there is a tradeoff between guns and butter – if a society wants more guns,
it must give up something, and one thing to give up is butter. That getting more guns
might entail less butter often seems mysterious, because butter, after all, is made withcows, and indirectly with land and hay. But the manufacture of butter also involves steel
containers, tractors to turn the soil, transportation equipment, and labor, all of which
either can be directly used (steel, labor) or require inputs that could be used (tractors,
transportation) to manufacture guns. From a production standpoint, more guns entail
less butter (or other things).

2.6.1 Production Possibilities Frontier
Formally, the set of production possibilities is the collection of “feasible outputs” of anindividual, group or society or country. You could spend your time cleaning yourapartment, or you could study. The more of your time you devote to studying, thehigher your grades will be, but the dirtier your apartment will be. This is illustrated, fora hypothetical student, in Figure 2-13.
The production possibilities set embodies the feasible alternatives. If you spend all yourtime studying, you would obtain a 4.0 (perfect) grade point average (GPA). Spending anhour cleaning reduces the GPA, but not by much; the second hour reduces by a bit more,
and so on.
The boundary of the production possibilities set is known as the production possibilities
frontier. This is the most important part of the production possibilities set, because at

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any point strictly inside the production possibilities set, it is possible to have more ofeverything, and usually we would choose to have more.11 The slope of the production
possibilities frontier reflects opportunity cost, because it describes what must be given
up in order to acquire more of a good. Thus, to get a cleaner apartment, more time, or
capital, or both, must be spent on cleaning, which reduces the amount of other goods
and services that can be had. For the two-good case in Figure 2-13, diverting time tocleaning reduces studying, which lowers the GPA. The slope dictates how much lost
GPA there is for each unit of cleaning.
Grades
4.0

3.0

2.0

1.0

Cleanliness
Figure 2-13: The Production Possibilities Frontier

One important feature of production possibilities frontiers is illustrated in the Figure
2-13: they are concave toward the origin. While this feature need not be universallytrue, it is a common feature, and there is a reason for it that we can see in theapplication. If you are only going to spend an hour studying, you spend that hour doing
the most important studying that can be done in an hour, and thus get a lot of grades forthe hour’s work. The second hour of studying produces less value than the first, and thethird hour less than the second. This is the principle of diminishing marginal returns.
Diminishing marginal returns are like picking apples. If you are only going to pickapples for a few minutes, you don’t need a ladder because the fruit is low on the tree; themore time spent, the fewer apples per hour you will pick.

11 To be clear, we are considering an example with two goods, cleanliness and GPA. Generally there arelots of activities, like sleeping, eating, teeth-brushing, and the production possibilities frontierencompasses all of these goods. Spending all your time sleeping, studying and cleaning would still
represent a point on a three-dimensional frontier.

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Consider two people, Ann and Bob, getting ready for a party. One is cutting up
vegetables, the other is making hors d’oeuvres. Ann can cut up two ounces ofvegetables per minute, or make one hors d’oeuvre in a minute. Bob, somewhat inept
with a knife, can cut up one ounce of vegetables per minute, or make two hors d’oeuvres
per minute. Ann’s and Bob’s production possibilities frontiers are illustrated in the
Figure 2-14, given that they have an hour to work.
Since Ann can produce two ounces of chopped vegetables in a minute, if she spends her
entire hour on vegetables, she can produce 120 ounces. Similarly, if she devotes all her
time to hors d’oeuvres, she produces 60 of them. The constant translation between thetwo means that her production possibilities frontier is a straight line, which is illustrated
in the left side of Figure 2-14. Bob’s is the reverse – he produces 60 ounces ofvegetables, or 120 hors d’oeuvres, or something on the line in between.
Ounces ofvegetables
120

Ann’s
Production
Possibilities
Frontier

60

Ounces ofvegetables
120

Bob’s
Production
Possibilities
Frontier

60

60

hors
120 d’oeuvres

60

hors
120 d’oeuvres

Figure 2-14: Two Production Possibilities Frontiers

For Ann, the opportunity cost of an ounce of vegetables is half of one hors d’oeuvre – toget one extra ounce of vegetable, she must spend 30 extra seconds on vegetables.
Similarly, the cost of one hors d’oeuvres for Ann is two ounces of vegetables. Bob’s costs
are the inverse of Ann – an ounce of vegetables costs him two hors d’oeuvres.
What can Bob and Ann accomplish together? The important insight is that they should
use the low cost person in the manufacture of each good, when possible. This meansthat if fewer than 120 ounces of vegetables will be made, Ann makes them all. Similarly,
if fewer than 120 hors d’oeuvres are made, Bob makes them all. This gives a joint
production possibilities frontier illustrated in the Figure 2-15. Together, they can make180 of one and none of the other. If Bob makes only hors d’oeuvres, and Ann makes
only chopped vegetables, they will have 120 of each. With fewer than 120 ounces ofvegetables, the opportunity cost of vegetables is Ann’s, and is thus half an hors d’oeuvre,
but if more than 120 are needed, then the opportunity cost jumps to two.
Now change the hypothetical slightly – suppose that Bob and Ann are putting on
separate dinner parties, each of which will feature chopped vegetables and hors

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d’oeuvres in equal portions. By herself, Ann can only produce 40 ounces of vegetables
and 40 hors d’oeuvres if she must produce equal portions. She accomplishes this byspending 20 minutes on vegetables and 40 minutes on hors d’oeuvres. Similarly, Bob
can produce 40 of each, but using the reverse allocation of time.
Ounces ofvegetables
180
Joint
Production
Possibilities
Frontier

120

60

60

120

180

hors
d’oeuvres

Figure 2-15: Joint PPF

By working together, they can collectively have more of both goods. Ann specializes in
producing vegetables, and Bob specializes in producing hors d’oeuvres. This yields 120
units of each, which they can split equally, to have 60 of each. By specializing in theactivity in which they have lower cost, Bob and Ann can jointly produce more of eachgood.
Moreover, Bob and Ann can accomplish this by trading. At a “one for one” price, Bob
can produce 120 hors d’oeuvres, and trade 60 of them for 60 ounces of vegetables. Thisis better than producing the vegetables himself, which netted him only 40 of each.
Similarly, Ann produces 120 ounces of vegetables, and trades 60 of them for 60 horsd’oeuvres. This trading makes them both better off.
The gains from specialization are potentially enormous. The grandfather of economics,
Adam Smith, writes about specialization in the manufacture of pins:“…One man draws out the wire; another straights it; a third cuts it; afourth points it; a fifth grinds it at the top for receiving the head; to makethe head requires two or three distinct operations ; to put it on is a peculiar
business; to whiten the pins is another ; it is even a trade by itself to put
them into the paper ; and the important business of making a pin is, in this

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manner, divided into about eighteen distinct operations, which, in somemanufactories, are all performed by distinct hands, though in others thesame man will sometimes perform two or three of them.”12
Smith goes on to say that skilled individuals could produce at most twenty pins per day
acting alone, but that with specialization, ten people can produce 48,000 pins per day,
240 times as many pins.
2.6.1.1 (Exercise) The Manning Company has two factories, one that makes roof
trusses, and one that makes cabinets. With m workers, the roof factory
produces m trusses per day. With n workers, the cabinet plant produces

5 n . The Manning Company has 400 workers to use in the two factories.
Graph the production possibilities frontier. (Hint: Let T be the number oftrusses produced. How many workers are used making trusses?)
2.6.1.2 (Exercise) Alarm & Tint, Inc., has 10 workers working a total of 400 hours per
week. Tinting takes 2 hours per car. Alarm installation is complicated,
however, and performing A alarm installations requires A2 hours of labor.
Graph Alarm & Tint’s production possibilities frontier for a week.

2.6.2 Comparative and Absolute Advantage
Ann produces chopped vegetables because her opportunity cost of producing vegetables,
at ½ of one hors d’oeuvre, is lower than Bob’s. A lower opportunity cost is said to create
a comparative advantage. That is, Ann gives up less to produce chopped vegetables
than Bob, so in comparison to hors d’oeuvres, she has an advantage in the production ofvegetables. Since the cost of one good is the amount of another good foregone, acomparative advantage in one good implies a comparative disadvantage in another. If
you are better at producing butter, you are necessarily worse at something else, and inparticular the thing you give up less of to get more butter.
To illustrate this point, let’s consider another party planner. Charlie can produce onehors d’oeuvre, or one ounce of chopped vegetables, per minute. His production isstrictly less than Ann’s, that is, his production possibilities frontier lies inside of Ann’s.
However, he has a comparative advantage over Ann in the production of hors d’oeuvres,because he gives up only one ounce of vegetables to produce a hors d’oeuvres, while Ann
must give up two ounces of vegetables. Thus, Ann and Charlie can still benefit fromtrade if Bob isn’t around.
2.6.2.1 (Exercise) Graph the joint production possibilities frontier for Ann andCharlie, and show that collectively they can produce 80 of each if they need thesame number of each product. Hint: First show that Ann will produce some ofboth goods, by showing that if Ann specializes, there are too many ounces ofvegetables. Then show, if Ann devotes x minutes to hors d’oeuvres, that60 + x = 2(60 – x).
12 Adam Smith, “An Inquiry into the Nature and Causes of the Wealth of Nations,” originally published

1776, released by the Gutenberg project, 2002.

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When one production possibilities frontier lies outside another, the larger is said to havean absolute advantage – more total things are possible. In this case, Ann has an
absolute advantage over Charlie – she can, by herself, have more – but not over Bob.
Bob has an absolute advantage over Charlie, too, but again, not over Ann.
Diminishing marginal returns implies that the more of a good that a person produces,
the higher is the cost (in terms of the good given up). That is to say, diminishingmarginal returns means that supply curves slope upward; the marginal cost of
producing more is increasing in the amount produced.
Trade permits specialization in activities in which one has a comparative advantage.
Moreover, whenever opportunity costs differ, potential gains from trade exist. If person
1 has an opportunity cost of c1 of producing good X (in terms of Y, that is, for each unitof X that person 1 produces, person 1 gives up c1 units of Y), and person 2 has anopportunity cost of c2, then there are gains from trade whenever c1 is not equal to c2 andneither party has specialized.13 Suppose c1 < c2. Then by having person 1 increase theproduction of X by ∆, c1 ∆ less of the good Y is produced. Let person 2 reduce theproduction of X by ∆, so that the production of X is the same. Then there is c2 ∆ units of
Y made available, for a net increase of (c2-c1) ∆. The net changes are summarized inTable 2-2.
Table 2-2: Construction of the Gains From Trade

1
2 Net Change
Change in X +∆0-∆
Change in Y -c1 ∆ c2 ∆(c2-c1) ∆Whenever opportunity costs differ, there are gains from re-allocating production fromone producer to another, gains which are created by having the low cost producers
produce more, in exchange for greater production of the other good by the otherproducer, who is the low cost producer of this other good. An important aspect of thisre-allocation is that it permits production of more of all goods. This means there is little
ambiguity about whether it is a good thing to re-allocate production – it just means wehave more of everything we want.14
How can we guide the reallocation of production to produce more goods and services?
It turns out that under some circumstances, the price system does a superb job ofcreating efficient production. The price system posits a price for each good or service,
and anyone can sell at the common price. The insight is that such a price induces
efficient production. To see this, suppose we have a price p which is the number of units
13 If a party specialized in one product, it is a useful convention to say that the marginal cost of that

product is now infinite, since no more can be produced.
14 If you are worried that more production means more pollution or other bad things, rest assured.
Pollution is a bad, so we enter the negative of pollution (or environmental cleanliness) as one of the goods
we would like to have more of. The reallocation dictated by differences in marginal costs produces moreof all goods. Now with this said, we have no reason to believe that the reallocation will benefit everyone –there may be winners and losers.

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of Y one has to give to get a unit of X. (Usually prices are in currency, but we can thinkof them as denominated in goods, too.) If I have a cost c of producing X, which is thenumber of units of Y that I lose to obtain a unit of X, I will find it worthwhile to sell X if
p > c, because the sale of a unit of X, nets me p – c units of Y, which I can either
consume or resell for something else I want. Similarly, if c > p, I would rather buy X(producing Y to pay for it). Either way, only producers with costs less than p willproduce X, and those with costs greater than p will purchase X, paying for it with Y,
which they can produce more cheaply than its price. (The price of Y is 1/p – that is theamount of X one must give to get a unit of Y.)
Thus, a price system, with appropriate prices, will guide the allocation of production to
insure the low cost producers are the ones who produce, in the sense that there is no
way of re-allocating production to obtain more goods and services.
2.6.2.2 (Exercise) Using Manning’s production possibilities frontier in 2.6.1.1(Exercise), compute the marginal cost of trusses in terms of cabinets.
2.6.2.3 (Exercise) Using Alarm & Tint’s production possibilities frontier in 2.6.1.2(Exercise), compute the marginal cost of alarms in terms of window tints.

2.6.3 Factors and Production
Production possibilities frontiers provide the basis for a rudimentary theory ofinternational trade. To understand the theory, it is first necessary to consider that there
are fixed and mobile factors. Factors of production are jargon for inputs to the
production process. Labor is generally considered a fixed factor, because most countries
don’t have borders wide open to immigration, although of course some labor moves
across international borders. Temperature, weather, and land are also fixed – Canada isa high-cost citrus grower because of its weather. There are other endowments that
could be exported, but are expensive to export because of transportation costs, including
water and coal. Hydropower – electricity generated from the movement of water – ischeap and abundant in the Pacific Northwest, and as a result, a lot of aluminum issmelted there, because aluminum smelting requires lots of electricity. Electricity can betransported, but only with losses (higher costs), which gives other regions a
disadvantage in the smelting of aluminum. Capital is generally considered a mobile
factor, because plants can be built anywhere, although investment is easier in someenvironments than in others. For example, reliable electricity and other inputs arenecessary for most factories. Moreover, comparative advantage may arise from thepresence of a functioning legal system, the enforcement of contracts, and the absence ofbribery, because enforcement of contracts increases the return on investment by
increasing the probability the economic return to investment isn’t taken by others.
Fixed factors of production give particular regions a comparative advantage in the
production of some kinds of goods, and not in others. Europe, the United States andJapan have a relative abundance of highly skilled labor, and have a comparativeadvantage in goods requiring high skills, like computers, automobiles and electronics.
Taiwan, South Korea, Singapore and Hong Kong have increased the available laborskills, and now manufacture more complicated goods like VCRs, computer parts and thelike. Mexico has a relative abundance of middle-level skills, and a large number of

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assembly plants operate there, as well as clothing and shoe manufacturers. Lower
skilled Chinese workers manufacture the majority of the world’s toys. The skill levels ofChina are rising rapidly.
The basic model of international trade was first described by David Ricardo (1772-1823),
and suggests that nations, responding to price incentives, will specialize in the
production of goods in which they have a comparative advantage, and purchase thegoods in which they have a comparative disadvantage. In Ricardo’s description,
England has a comparative advantage of manufacturing cloth, and Portugal inproducing wine, leading to gains from trade from specialization.
The Ricardian theory suggests that the United States, Canada, Australia and Argentina
should export agricultural goods, especially grains that require a large land area for thevalue generated (they do). It suggests that complex technical goods should be produced
in developed nations (they are) and that simpler products and natural resources should
be exported by the lesser developed nations (they are). It also suggests that there should
be more trade between developed and underdeveloped nations than between developed
and other developed nations. The theory falters on this prediction – the vast majority oftrade is between developed nations. There is no consensus for the reasons for this, andpolitics plays a role – the North American Free Trade Act vastly increased the volume oftrade between the United States and Mexico, for example, suggesting that trade barriers
may account for some of the lack of trade between the developed and theunderdeveloped world. Trade barriers don’t account for the volume of trade between
similar nations, which the theory suggests should be unnecessary. Developed nations
sell each other mustard and tires and cell phones, exchanging distinct varieties of goods
they all produce.

2.6.4 International Trade
The Ricardian theory emphasizes that the relative abundance of particular factors of
production determines comparative advantage in output, but there is more to thetheory. When the United States exports a computer to Mexico, American labor, in theform of a physical product, has been sold abroad. When the United States exports
soybeans to Japan, American land (or at least the use of American land for a time) has
been exported to Japan. Similarly, when the United States buys car parts from Mexico,
Mexican labor has been sold to the United States, and similarly when the Americans buy
Japanese televisions, Japanese labor has been purchased. The goods that are tradedinternationally embody the factors of production of the producing nations, and it isuseful to think of international trade as directly trading the inputs through theincorporation of inputs into products.
If the set of traded goods is broad enough, the value of factors of production should beequalized through trade. The United States has a lot of land, relative to Japan, but by
selling agricultural goods to Japan, it is as if Japan had more land, by way of access to
US land. Similarly, by buying automobiles from Japan, it is as if a portion of theJapanese factories were present in the United States. With inexpensive transportation,
the trade equalizes the values of factories in the United States and Japan, and also
equalizes the value of agricultural land. One can reasonably think that soybeans aresoybeans, wherever they are produced, and that trade in soybeans at a common price

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forces the costs of the factors involved in producing soybeans to be equalized across the
producing nations. The purchase of soybeans by Japanese drives up the value ofAmerican land, and drives down the value of Japanese land by giving an alternative toits output, leading toward equalization of the value of the land across the nations.
This prediction, known as factor price equalization, of modern international trade
theory was first developed by Paul Samuelson (1915 – ) and generalized by Eli
Heckscher (1879 – 1952) and Bertil Ohlin (1899 – 1979). It has powerful predictions,
including the equalization of wages of equally skilled people after free trade between the
United States and Mexico. Thus, free trade in physical goods should equalize the priceof haircuts, and land, and economic consulting, in Mexico City and New York.
Equalization of wages is a direct consequence of factor price equalization because labor
is a factor of production. If economic consulting is cheap in Mexico, trade in goods
embodying economic consulting – boring reports, perhaps – will bid up the wages in the
low wage area, and reduce the quantity in the high wage area.
An even stronger prediction of the theory is that the price of water in New Mexico
should be the same as in Minnesota. If water is cheaper in Minnesota, trade in goods
that heavily use water – e.g. paper – will tend to bid up the value of Minnesota water,while reducing the premium on scarce New Mexico water.
It is fair to say that if factor price equalization works fully in practice, it works very, very
slowly. Differences in taxes, tariffs and other distortions make it a challenge to test thetheory across nations. On the other hand, within the United States, where we have full
factor mobility and product mobility, we still have different factor prices – electricity ischeaper in the Pacific Northwest. Nevertheless, nations with a relative abundance ofcapital and skilled labor export goods that use these intensively, nations with a relative
abundance of land export land-intensive goods like food, nations with a relative
abundance of natural resources export these resources, and nations with an abundanceof low-skilled labor export goods that make intensive use of this labor. The reduction of
trade barriers between such nations works like Ann and Bob’s joint production of party
platters: by specializing in the goods in which they have a comparative advantage, there
is more for all.

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3 The US Economy
An important aspect of economics is economic statistics, and an army of economists
collect and analyze these statistics. This chapter presents an overview of the economic
activity of the United States. How much do you need to know about these statistics? It
would be ridiculous to memorize them. At the same time, it would be undesirable to beignorant of how we are changing, and how we are not.15

3.1.1 Basic Demographics
There are about three hundred million people in the United States, up from 76 million
in 1900.
350,000
300,000

Population

250,000
200,000
150,000
100,000
50,000

19
00
19
06
19
12
19
18
19
24
19
30
19
36
19
42
19
48
19
54
19
60
19
66
19
72
19
78
19
84
19
90
19
96
20
02

0

Year

Figure 3-1: US Resident Population

During the last century, the US population has become primarily an urban population,
growing from 40% to 80% urban. The population is primarily white, with 12-13%
African-American and 4% classified as other. These proportions are relatively stable
over the century, with the white population falling from 89% to 83%. The census isthought to understate minority populations because of greater difficulties in contacting
minorities. The census does not attempt to classify people but instead accepts people’s
description of their own race.

15 I apologize to those using the book in foreign countries; this chapter is about the US not because it ismore important but because I know it better. Encourage your professor to write a chapter on yourcountry! All of the statistics in this chapter come from Fedstats, http://www.fedstats.gov/, from FRED,
http://research.stlouisfed.org/fred2/, and from the NBER, http://www.nber.org/.

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100.090.0
80.0

Percent

70.0
60.0

Urban

50.0

White

40.0
30.0
20.0
10.0
0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-2: US Urban and White Population

The United States population has been aging significantly, with the proportion ofseniors (over 65 years old) tripling over the past century, and the proportion of young
people dropping by over a third. Indeed, the proportion of children between zero andfive years old has dropped from 12.1% of the population to under 7%.

60.0
50.0

Percent

40.0
30.0
65+

20.0

0-24
25-44

10.0

45-64

0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-3: Population Proportions by Age GroupThe baby boom – a dramatic increase in births for the years 1946-1964, is visible in the
Figure 3-3 as the population in the 0-24 age group begins increasing in 1950, peaking in
1970 and then declining significantly as the baby boom moves into the 25-44 year old

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bracket. There is a slight “echo” of the baby boom, most readily seen by looking at the
0-5 age bracket, as in Figure 3-4.
14.0
12.0

Percent

10.0
8.0
6.0
4.0
2.0

20
02

20
00

19
90

19
80

19
70

19
60

19
50

19
40

19
30

19
20

19
10

19
00

0.0

Figure 3-4: Proportion of Population under Age Five

The aging of the American population is a consequence of greater life expectancy. Whensocial security was created in 1935, the average American male lived to be slightly lessthan sixty years old. The social security benefits, which didn’t start until age 65, thus
were not being paid to a substantial portion of the population.
Figure 3-5 shows life expectancy at birth, thus including infant mortality. The
significant drop in life expectancy in 1918 – to nearly 30 years old for non-whites – isprimarily a consequence of the great influenza, which killed about 2.5% of the people
who contracted it and killed more Americans in 1918 than did World War I. The Great
Depression (1932-39) also reduced life expectancy. The steady increase in life
expectancy is also visible, with white females now living eighty years on average.

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80.0
75.0
70.0
65.0
White Male

Years

60.0

White Female

55.0

Nonwhite Male

50.0

Nonwhite Female

45.0
40.0
35.0
1996

1988

1980

1972

1964

1956

1948

1940

1932

1924

1916

1908

1900

30.0

Figure 3-5: US Life Expectancy at Birth

It is said that the United States is a country of immigrants, and a large fraction of the
population had ancestors that came from elsewhere. Immigration into this UnitedStates, however, has been increasing after a long decline, and the fraction of the
population that were born in foreign countries is about 11% -- one in nine.
16.0

Population Percent

14.0
12.0
Europe

10.0

Asia

8.0

Latin Am

6.0

Total

4.0
2.0
0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-6: US Immigrant Population, in Percent, by Continent of Origin

The majority of immigrants during this century came from Europe, but immigrationfrom Europe has been declining for most of the century, while immigration from Asiaand Latin America has grown substantially. Figure 3-7 aggregates the total country oforigin data over the century, to identify the major sources of immigrants.

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Germany, 4.6%
Ireland, 1.9%
Italy , 9.4%
Norway , 0.8%
Sweden , 1.1%
Other, 39.0%

Soviet Union ,6.7%
UK , 4.8%
China, 2.2%

Africa , 1.5%
Caribbean , 7.6%

Canada, 7.3%
Mexico, 13.1%

Figure 3-7: National Origin of Immigrants, 1900-2000

One hears a lot about divorce rates in the United States, with statements like “fifty
percent of all marriages end in divorce.” Although it has grown, the divorced populationis actually a small fraction of the population in the United States.
80.0
70.0
60.0
Never

Percent

50.0

Married40.0

Widowed

30.0

Divorced

20.0
10.0
0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-8: Male Marital Status (Percentages)

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80.0
70.0
60.0
Never

Percent

50.0

Married40.0

Widowed

30.0

Divorced

20.0
10.0
0.0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-9: Female Marital Status (Percent)Marriage rates have fallen, but primarily because the “never married” category has
grown. Some of the “never married” probably represent unmarried couples, since theproportion of children from unmarried women has risen fairly dramatically. Even so,
marriage rates are greater than they were a century ago. However, a century ago there
were more unrecorded and common-law marriages than probably there are today.
40.0
35.0
30.0
25.0
20.0
15.0
10.0
5.0

2000

1997

1994

1991

1988

1985

1982

1979

1976

1973

1970

1967

1964

1961

1958

1955

1952

1949

1946

1943

1940

0.0

Figure 3-10: Percent of Births to Unwed Mothers

While we are on the subject, however, the much discussed crisis in teen-age pregnancy
doesn’t appear like such a crisis when viewed in terms of the proportion of all births thatinvolve a teenage mother.

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25%
20%
15%

10%
5%

2000

1997

1994

1991

1988

1985

1982

1979

1976

1973

1970

1967

1964

1961

1958

1955

1952

1949

1946

1943

1940

0%

Figure 3-11: Percent of Births to Women Age 19 or less

3.1.2 Education
Why are the western nations rich, and many other nations poor? What creates thewealth of the developed nations? Modern economic analysis attributes much of thegrowth of the United States and other developed nations to its educated workforce, andnot to natural resources. Japan, with a relative scarcity of natural resources but a highly
educated workforce, is substantially richer than Brazil, with its abundance of natural
resources.
90.0
80.0
70.0
60.0
<5

50.0

>12

40.0

>16

30.0
20.0
10.0

20
01

19
94

19
87

19
80

19
73

19
66

19
59

19
52

19
45

19
31
19
38

19
24

19
17

19
10

0.0

Figure 3-12: Educational Attainment in Years (Percent of Population)

Just less than 85% of the US population completes 12 years of schooling, not counting
kindergarten. Not all of these students graduate from high school, but they spent twelve
years in school. The proportion that completes only five or fewer years of elementary
school has dropped from about a quarter of the population to a steady 1.6%. At least

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four years of university now represents a bit more than a quarter of the population,
which is a dramatic increase. Slightly fewer women (25% versus 28%) complete four
years of university, although women are more likely to complete four years of highschool.
Graduation rates are somewhat below the number of years completed, so that slightly
less than three-quarters of the US population actually obtain their high school degree.
Of those obtaining a high school degree, nearly half obtain a university or college degree.
90
80
70
60
50

HS

40

U

30
20
10
1998

1991

1984

1977

1970

1963

1956

1949

1942

1935

1928

1921

1914

1907

1900

0

Figure 3-13: Graduation Rates

There are several interesting things to see in Figure 3-13. First, high school completion
dropped significantly during World War II (1940-45) but rebounded after. Second, afterWorld War II, college graduation spiked, as many US soldiers were sent to university by
the government under a program called the “GI Bill.”16
As the numbers of high school students rose, the portion of high school graduates going
to university fell, meaning a larger segment of the population became high school
educated. This increase represents the creation of the US middle class; previously, highschool completion and university were in large part a sign of wealth. The creation of alarge segment of the population who graduated from high school, but didn’t attend
university, led to a population with substantial skills and abilities, but no inherited
wealth, who became the middle class.
High school completion has been declining for thirty years. This is surprising given thehigh rate of financial return to education in the United States. Much of the reduction incompletion can be attributed to an increase in General Education Development, or GED,
certification, which is a program that grants diplomas (often erroneously thought to be a
16 The etymology of GI, as slang for US soldiers, is disputed, with candidates including “Government
Issue,” “General Infantry” and “Galvanized Iron,” the latter a reference to trash cans that looked like
German World War I artillery.

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“General Equivalent Degree”) after successfully passing examinations in five subject
areas. Unfortunately, those people who obtain GED certification are not as successful ashigh school graduates, even marginal graduates, and indeed the GED certification does
not seem to help students succeed, in comparison with high school graduation.17

3.1.3 Households and Consumption
There are approximately one hundred million households in the United States. The
number of residents per household has consistently shrunk during this century, fromover four to under three.
5

4

3

2

1

0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Figure 3-14: Household Occupancy

The shrinking size of households reflects a reduction not just in birthrates but also an
increase in the number of people living alone. More women live alone than men, eventhough four times as many families with a single adult member are headed by women.
This discrepancy – many more women both living on their own and living with children
and no partner, even though there are about the same number of men and women born
– is accounted for by the greater female longevity already noted above.

17 In performing this kind of analysis, economists are very concerned with adjusting for the type of person.

Smarter people are more likely to graduate from high school, but one doesn’t automatically become smart
by attending high school. Thus, care has been taken to hold constant innate abilities, measured by various
measures like IQ scores and performance on tests, so that the comparison is between similar individuals,
some of whom persevere to finish school, some of who don’t. Indeed, some studies use identical twins.

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100
90
80
70
Family60

Married50

Single Male

40

Single Female

30
20
10
2002

2001

2000

1995

1990

1985

1980

1975

1970

1965

1960

1955

1950

1947

0

Figure 3-15: Proportion of Households by Type

Where do we live? About 60% of households live in single family detached homes,
meaning houses that stand alone. Another 5% or so live in single family attachedhouses, such as “row houses.” Slightly over 7½ % live in mobile homes or trailers, andthe remainder live in multi-unit housing, including apartments and duplexes. Twothirds of American families own their own homes, up from 43% in 1940. Slightly lessthan half a percent of the population is incarcerated in state and federal prisons. This
represents a four-fold increase over 1925-1975.
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05

19
25
19
29
19
33
19
37
19
41
19
45
19
49
19
53
19
57
19
61
19
65
19
69
19
73
19
77
19
81
19
85
19
89
19
93
19
97

0

Figure 3-16: Percentage of Incarcerated Residents

Ten percent of households do not have an automobile, and 97.6% have a telephone. Socalled “land line” telephones may start to fall as apartment dwellers, especially students,
begin to rely exclusively on cell phones. Just under 99% of households have complete
plumbing facilities (running water, bath or shower, flush toilet), up from 54.7% in 1940.
How much income do these households make? What is the distribution of income? One
way of assessing the distribution is to use quintiles to measure dispersion. A quintile (orfifth) is a group of size 20%. Thus the top income quintile represents the top 20% of

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income earners, the next represents those ranking 60%-80%, and so on. Figure 3-17
shows the earnings of the top, middle and bottom quintiles.
60
50
40
Lowest 5th
Middle 5th30

Highest 5th
20
10

19
96

19
89

19
82

19
75

19
68

19
61

19
47

19
54

0

Figure 3-17: Income Shares for Three Quintiles

180,000
160,000
140,000
120,000
100,000
80,00060,000

95%
80%
60%
40%
20%

40,00020,000

19
47
19
51
19
55
19
59
19
63
19
67
19
71
19
75
19
79
19
83
19
87
19
91
19
95
19
99

0

Figure 3-18: Family Income

The earnings of the top quintile fell slightly until the late 1960s, when it began to rise.
All other quintiles lost income share to the top quintile starting in the middle 1980s.
Figures like these suggest that families are getting poorer, except for an elite few.
However, in fact families are getting richer, just not as fast as the top quintile.
Figure 3-18 shows the income, adjusted for inflation to be in 2001 dollars, for families atvarious points in the income spectrum. For example, the 60% line indicates families forwhom 40% of the families have higher income, and 60% have lower income. Incomes of
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3-51

all groups has risen, although the richer families have seen their incomes rise faster thanpoorer families. That is readily seen when percentage changes are plotted in Figure
3-19.
250
200
150

20%
40%

100

60%
80%
95%

50

2001

1998

1995

1992

1989

1986

1983

1980

1977

1974

1971

1968

1965

1962

1959

1956

1953

-50

1950

0

Figure 3-19: Family Income, Cumulative Percentage Change

Real income gains in percentage terms have been larger for richer groups, even though
the poor have also seen substantially increased incomes.
If the poor have fared less well than the rich in percentage terms, how have AfricanAmericans fared? After World War II, African-Americans families earned about 50% of
white family income. This has risen gradually, noticeably in the 1960s after the 1964
Civil Rights Act that is credited with integrating workplaces throughout the southern
United States. African-American family income lagged white income growth throughthe 1980s, but has been rising again.

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3-52

70%
60%
50%
40%
30%
20%
10%

19
47
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98

0%

Figure 3-20: Black Family Income as a Percentage of White Income

These income measures attempt to actually measure purchasing power, and thus adjustfor inflation. How much will $1 buy? This is a complicated question, because changes
in prices aren’t uniform – some goods get relatively cheaper, while others become more
expensive, and the overall cost of living is a challenge to calculate. The price index
typically used is the consumer price index (CPI), which adjusts for what it costs to buy a“standard” bundle of food, clothing, housing, electricity and other items. Figure 3-21
shows the CPI over most of past century, where 1982 is set as the reference year.
200
180
160
140
120
100
80
60
40
20

19
13
19
18
19
23
19
28
19
33
19
38
19
43
19
48
19
53
19
58
19
63
19
68
19
73
19
78
19
83
19
88
19
93
19
98

0

Figure 3-21: Consumer Price Index (1982 = 100)Have prices actually risen? Economists generally agree that the
3.1.3.1 (Exercise)meaning of “prices have risen” is that you would prefer past prices to current
prices. What makes this challenging is that the set of available products changeover time. Cars have gone up significantly in price, but are also more reliable.

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3-53

Would you be better off with your current income in 1913 than today? You
would be very rich with current average income in 1913, but not have access tomodern medicine, television, electronics, refrigeration, highways, and manyother technologies. If you made $40,000 annually in 1913, how would you live
and what would you buy? (Do some research.)
3.1.3.2 (Exercise) Compare a $40,000 income in 1980 to the present. Whatdifferences are there in available products? In the quality of products? Howrich does $40,000 make you in each time period? In which period would you
choose to live, and why?
There have been three major inflations in the past century. Both World War I andWorld War II, with a large portion of the goods and services diverted to military use,
saw significant inflations. In addition, there was a substantial inflation during the1970s, after the Vietnam War in the 1960s. The price level fell during the Great
Depression (1929-39). Falling price levels create investment problems, because
inflation adjusted interest rates, which must adjust for a deflation, are forced to be high,since unadjusted interest rates cannot be negative.

20
15
10
5
0
-5
-10

19
14
19
19
19
24
19
29
19
34
19
39
19
44
19
49
19
54
19
59
19
64
19
69
19
74
19
79
19
84
19
89
19
94
19
99

-15

Figure 3-22: CPI Percent Changes

The cost of food has fallen quite dramatically over the past century. Figure 3-23 showsthat the percentage of pre-tax household income spent on food has fallen from 25% toabout 10%. This fall is a reflection of greater incomes, and of the fact that the real costof food has fallen.

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45.0
40.0
35.0
30.0
25.0

Food

20.0

Eating Out

15.0
10.0
5.0

19
29
19
34
19
39
19
44
19
49
19
54
19
59
19
64
19
69
19
74
19
79
19
84
19
89
19
94
19
99

0.0

Figure 3-23: Food Expenditure as Percent of Income, and Proportion Spent Out

Moreover, a much greater fraction of expenditures on food are spent away from home, afraction that has risen from under 15% to 40%.
How do we spend our income? The major categories are food, clothing, housing,
medical, household operation, transportation, and recreation. The percentage ofdisposable income spent on these categories are shown, for the years 1929, 1965 and2001, in Figure 3-24.
30.0%
25.0%
20.0%

1929

15.0%

1965
2001

10.0%
5.0%

n
R
ec
re
at
io

n

Tr
an
sp
or
ta
tio

M
ed
ic
al

H
ou
se
ho
ld

H
ou
si
ng

C
lo
th
in
g

Fo
od

0.0%

Figure 3-24: After Tax Income Shares

Food has shrunk substantially, but we enjoy more recreation, and spend a lot more
staying healthy. (Food is larger than in Figure 3-23 because these figures use after tax
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3-55

disposable income, rather than pre-tax income.) This is in part a consequence of ouraging population, but also of the increased technology available.

3.1.4 Production
We learned something about where we live and what we buy. Where do we get our
income? Primarily we earn by providing goods and services. Nationally, we produce
about eleven trillion dollars worth of goods and services. Broadly speaking, we spendthat eleven trillion on personal consumption of goods and services, savings, andgovernment. This, by the way, is often expressed as Y = C + I + G, which states that
income (Y) is spent on consumption (C), investment (which comes from savings) andgovernment. One can consume imports as well, so the short-term constraint looks likeY + M = C + I + G + X, where M is imports and X is exports.
How much does the United States produce? Economists measure output with the grossdomestic product (GDP), which is the value of traded goods and services produced
within the borders of the United States. GDP measures what is produced within the
United States, and thus excludes output of Japanese factories owned by Americans, but
includes the output of US factories owned by Japanese.
Importantly, GDP excludes non-traded goods and services. Thus, unpaid housework is
not included. If you clean your own home, and your neighbor cleans his or her home,the cleaning does not contribute to GDP. On the other hand, if you and your neighborpay each other to clean each other’s homes, GDP goes up by the payments, even though
the actual production of goods and services remains unchanged. Thus, GDP does notmeasure our total output as a nation, because it neglects unpaid services. Why does it
neglect unpaid services? Primarily, because we can’t readily measure them. Data on
transactions is generated by tax information and reporting requirements imposed on
businesses. For the same reason, GDP neglects illegal activities as well, such as illegal
drug sales and pirated music sales. Thus, GDP is not a perfect measure of the
production of our society. It is just the best measure we have.
Figure 3-25 shows the growth in GDP, and its components of personal consumption,
government expenditures, and investment. The figures are expressed in constant 1996
dollars, that is, adjusted for inflation. The figure for government includes thegovernment’s purchases of goods and services – weapons, highways, rockets, pencils –but does not include transfer payments like social security and welfare programs.
Transfer payments are excluded from this calculation because the actual dollars are
spent by the recipient, not by the government. The cost of making the transfer
payments (e.g. printing and mailing the checks), however, is included in the cost of
government.

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10,000.0
9,000.08,000.0
7,000.0
GDP

6,000.0

Consumption

5,000.0

Investment

4,000.0

Government

3,000.0
2,000.0
1,000.0
1999

1994

1989

1984

1979

1974

1969

1964

1959

1954

1949

1944

1939

1934

1929

0.0

Figure 3-25: Output, Consumption, Investment and Government

It is often visually challenging to draw useful information from graphs like Figure 3-25,
because economic activity is growing at a constant percentage. Consequently,
economists often use a logarithmic scale, rather than a dollar scale. A logarithmic scale
has the useful property that a straight line gives constant percentage growth. Consider
a variable X that takes on values xt at time t. Define %∆x to be the percentage change:x − xt −1%∆x = t
.
xt −1
Then

⎛ x ⎞
log( xt ) = log( xt −1 ) + log⎜⎜ t ⎟⎟ = log( xt −1 ) + log (1 + %∆x )⎝ xt −1 ⎠Thus, if the percentage change is constant over time, log(xt) will be a straight line overtime. Moreover, for small percentage changes:

log (1 + %∆x ) ≈ %∆x
so that the slope is approximately the growth rate.18 Figure 3-26 shows these statistics
with a logarithmic scale.

18 The meaning of ≈ throughout this book is ‘to the first order.’ Here that meanslim% ∆x →0log (1 + %∆x ) − %∆x= 0 . Moreover, in this case the errors of the approximation are modest up to about% ∆x

25% changes.

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10,000.0

1,000.0
GDP
Consumption

100.0

Investment
Government

10.0

1999

1994

1989

1984

1979

1974

1969

1964

1959

1954

1949

1944

1939

1934

1929

1.0

Figure 3-26: Major GDP Components in Log Scale

Immediately noticeable is the approximately constant growth rate from 1950 to thepresent, because a straight line with a log scale represents a constant growth rate. In
addition, government has grown much more slowly (although recall that transfer
payments, another aspect of government, aren’t shown). A third feature is the volatilityof investment – it shows much greater changes than output and consumption. Indeed,
during the great depression (1929-39), income fell somewhat, consumption fell less,government was approximately flat, and investment plunged to 10% of its former level.
35,00030,00025,00020,000Consumption

15,000GDP

10,000
5,000
0
1930

1940

1950

1960

1970

1980

1990

2000

Figure 3-27: Per Capita Income and Consumption

Some of the growth in the American economy has arisen because there are more of us.
Double the number of people, and consume twice as many goods, and individually wearen’t better off. How much are we producing per capita, and how much are we
consuming?
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US output of goods and services, and consumption, have grown substantially over the
past 75 years. In addition, consumption has been a steady percentage of income. This is
more clearly visible when income shares are plotted in Figure 3-28.
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%

C/Y
I/Y
(X-M)/Y
G/Y

20.0%
10.0%
0.0%

19
29
19
34
19
39
19
44
19
49
19
54
19
59
19
64
19
69
19
74
19
79
19
84
19
89
19
94
19
99

-10.0%

Figure 3-28: Consumption, Investment and Government (% GDP)

Consumption was a very high portion of income during the Great Depression (1929-39),
because income itself fell. Little investment took place. The wartime economy of WorldWar II reduced consumption to below 50% of output, with government spending asimilar fraction as home consumers. Otherwise, consumption has been a relatively
stable 60-70% of income, rising modestly during the past twenty years, as the share ofgovernment shrank, and net imports grew. Net imports rose to 4% of GDP in 2001.
The most basic output of our economic system is food, and the US economy does aremarkable job producing food. The US has about 941 million acres under cultivation to
produce food, which represents 41½ % of the surface area of the United States. Landuse for agriculture peaked in 1952, at 1,206 million acres, and has been dwindling eversince, especially in the northeast where farms are being returned to forest throughdisuse. Figure 3-29 shows the output of agricultural products in the United States,
adjusting to 1982 prices.

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250
200
150
100
50

1998

1993

1988

1983

1978

1973

1968

1963

1958

1953

1948

1943

1938

1933

1928

1923

1918

1913

0

Figure 3-29: US Agricultural Output, 1982 constant dollars

The growth in output is more pronounced when viewed per worker involved inagriculture.
1000

100
Per Worker

10

Total

1999

1995

1991

1987

1983

1979

1975

1971

1967

1963

1959

1955

1951

1947

1

Figure 3-30: Agricultural Output, Total and Per Worker (1982 $, Log Scale)

Where do we work? Economists divide production into goods and services. Goods are
historically divided into mining, construction and manufacturing. Mining includes
production of raw materials of all kinds, including metals, oil, bauxite and gypsum.
Construction involves production of housing and business space. Manufacturing
involves the production of everything from computers to those little chef’s hats that areplaced on turkey legs. Figure 3-31 describes the major sectors of the US economy.
Because the data come from firms, agriculture is excluded, although goods and services
provided to farms would be included.

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40.0
35.0
30.0
25.0

1940

20.0

1970

15.0

2000

10.0
5.0

ce
s
G
ov
er
nm
en
t

er
vi

FI
RE

O
th
er
S

Re
ta
il

PU
W
ho
le
sa
le

&
T

ur
in
g

an
uf
ac
t

ct
io
n
M

Co
ns
tru

M

in
in
g

0.0

Figure 3-31: Major Non-Agricultural Sectors of US Economy, percent of GDP

Mining has diminished as a major factor in the US economy, a consequence of thegrowth of other sectors, and the reduction in the prices for raw materials. Contrary to
many popular predictions, the prices of raw materials have fallen even as output andpopulation have grown. We will see later in this book that the fall in prices of raw
materials – ostensibly in fixed supply given the limited capacity of the earth – meansthat people expect a relative future abundance, either because of technologicalimprovements in their use or because of large as yet undiscovered pools of theresources. An example of technological improvements is the substitution of fiber optic
cable for copper wires. An enormous amount of copper has been recovered from
telephone lines, and we can have more telephone lines and use less copper than wasused in the past.
Manufacturing has become less important, for several reasons. Many manufactured
goods cost less, pulling down the overall value. In addition, we import moremanufactured goods than in the past. We produce more services. T& PU stands fortransportation and public utilities, and includes electricity and telephone services andtransportation including rail and air travel. This sector has shrunk as a portion of theentire economy, although the components have grown in absolute terms. We take more
airplane trips than we have historically.

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2.5

2

1.5

1

0.5

19
28
19
32
19
36
19
40
19
44
19
48
19
52
19
56
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00

0

Figure 3-32: Air Travel Per Capita

Electricity production has risen dramatically.
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
1900

1920

1940

1960

1980

2000

Figure 3-33: Electricity Production (M kwh)

However, energy use more generally has not grown as much, just doubling over the
post-war period.

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80
70
60
50
40
30
20
10

1999

1994

1989

1984

1979

1974

1969

1964

1959

1954

1949

0

Figure 3-34: Energy Use (Quadrillion BTUs)

The number of automobiles per capita in the United States peaked in the early 1980s,
which looks like a reduction in transportation since then. However, we still drive morethan ever, suggesting the change is actually an increase in the reliability of automobiles.
12000

600.0

10000

500.0

8000

400.0

6000

300.0

4000

200.0

2000

100.0

Cars

2000

1990

1980

1970

1960

1950

1940

1930

1920

1910

0.0
1900

0

Miles

Figure 3-35: Cars Per Thousand Population and Miles Driven Per Capita

The cost of selling goods – wholesale and retail costs – remains relatively stable, as does
“FIRE,” which stands for finance, insurance, and real estate costs. Other services,
ranging from restaurants to computer tutoring, have grown substantially. This is the socalled “service economy” that used to be in the news frequently, but is less so these days.

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A bit more than 60% of the population works. The larger numbers in recent years are
partially a reflection of the baby boom’s entry into working years, reducing the
proportion of elderly and children in American society. However, it is partially areflection of an increased propensity for households to have two income earners.

66.0
64.0
62.0
60.0
58.0
56.0
54.0
52.0
50.0
2002

1999

1996

1993

1990

1987

1984

1981

1978

1975

1972

1969

1966

1963

1960

1957

1954

1951

1948

1946

1943

1940

48.0

Figure 3-36: Percentage of Population Employed (Military & Prisoners Excluded)

70
60
50
40

All
Married

30
20
10
0
1900

1920

1940

1960

1980

2000

Figure 3-37: Labor Force Participation Rates, All Women and Married Women

Female participation in the labor force has risen quite dramatically in the United States.
Figure 3-37 shows female labor force participation. The overall participation rate has
roughly tripled during the century, and significantly exceed the rate prevailing during
World War II, when many women went to work. In addition, participation of married
women has now risen above the level for unmarried women. The participation rate forsingle women is even higher, currently at 68% it is higher than the overall average
participation rate of all residents. The difference is primarily elderly women, who are

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disproportionately more likely to be widowed rather than married or single, and who areless likely to be working.
Another sector of the economy which has been much in the news is national defense.
How much do we spend on the military? In this century, the large expenditure occurred
during World War II, when about 50% of GDP was spent by the government, and 37% of
GDP went to the armed forces. During the Korean War, we spent about 15% of GDP on
military goods, and less than 10% of GDP during the Vietnam war. The military buildup
during Ronald Reagan’s presidency (1980-1988) increased our military expendituresfrom about 5½% to 6½% of GDP – a large percentage change in military expenditures,
but a small diversion of GDP. The fall of the Soviet Union led the United States toreduce military expenditures, in what was called the “peace dividend,” but again theeffects were modest.
40.0%
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1930

1940

1950

1960

1970

1980

1990

2000

Figure 3-38: Defense as a Percentage of GDP

Historically, defense represents the largest expenditure by the federal government.
However, as we see, defense has become a much smaller part of the economy overall.
However, the federal government plays many other roles in the modern US economy.

3.1.5 Government
With a budget over two trillion dollars, the federal government represents just under
20% of the US economy. It is one of the largest organizations in the world; only nations
are larger organizations, and only a handful of nations are larger.
The size of the federal government, as a percentage of GDP, is shown in Figure 3-39.
Federal expenditures boomed during World War II (1940-45), but shrank back to nearly
pre-war levels shortly afterward, with much of the difference attributable to veterans’
benefits and continuing international involvement. Federal expenditures, as apercentage of GDP, continue to grow until Ronald Reagan’s presidency in 1980, when
they begin to shrink slightly after an initial growth. Figure 3-39 also shows federal
revenues, and the deficit – the difference between expenditures and revenues, isapparent, especially for World War II and 1970-1998.

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50.0
45.0
40.0
35.0
30.0

Revenue
Expenditures

25.0
20.0
15.0
10.0
5.0
2000

1995

1990

1985

1980

1975

1970

1965

1960

1955

1950

1945

1940

1935

1930

0.0

Figure 3-39: Federal Expenditures and Revenues (Percent of GDP)

Much has been written about the federal government’s “abdication” of various services,which are pushed onto state and local government. Usually this behavior is attributed to
the Reagan presidency (1980-88). There is some evidence of this behavior in the postwar data, but the effect is very modest and long term. Most of the growth in state andlocal government occurred between 1947 and 1970, well before the Reagan presidency;
state and local government has been stable since then. Moreover, the expenditure of thefederal government, which shows ups and downs, has also been fairly stable. In any
event, such effects are modest overall.
35.0
30.0
25.0

Total

20.0

Federal

15.0

Regional

10.0
5.0
1999

1995

1991

1987

1983

1979

1975

1971

1967

1963

1959

1955

1951

1947

0.0

Figure 3-40: Federal, State & Local and Total Government Receipts (% GDP)

Figure 3-40 sets out the taxation at both the federal and state and local (merged to beregional) level. Figure 3-41 shows expenditures of the same entities. Both figures are
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stated as a percentage of GDP. State and local taxation and expenditures doubled overthe postwar period. The two figures are very similar. The federal government’s
expenditures have varied more significantly than its revenues.
35.0
30.0
25.0
Total

20.0

Federal

15.0

Regional

10.0
5.0
1999

1995

1991

1987

1983

1979

1975

1971

1967

1963

1959

1955

1951

1947

0.0

Figure 3-41: Federal, Regional and Total Expenditures as a Percent of GDP

A peculiarity of the US federal government is a penchant for “off-budget” expenditures.
Originally, such off-budget items involved corporations like Intelsat (which
commercialized satellite technology) and RCA (the Radio Corporation of America, which
commercialized radio) and other semi-autonomous and self-sustaining operations.
Over time, however, off-budget items became a way of hiding the growth of government,
through a process that became known as “smoke and mirrors.”
25.0
20.0
15.0

BudgetOff-Budget

10.0
5.0

1999

1995

1991

1987

1983

1979

1975

1971

1967

1963

1959

1955

1951

1947

0.0

Figure 3-42: Federal Expenditures, On and Off Budget, Percent of GDP

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During the 1980s, the public became aware of off-budget items. Political awarenessmade off-budget items cease to work as a device for evading balanced-budget
requirements, and few new ones were created, although they continue to be debated.
Sporadically there are attempts to push social security off-budget.
20,00018,00016,00014,000Executive
Military
FederalRegional

12,00010,000
8,000
6,000
4,000
2,000

19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
20
01

0

Figure 3-43: Federal and Regional Government Employment (000s)

Federal employees includes two major categories, uniformed military personnel and theexecutive branch. State and Local government is much larger and has tripled in size
since 1962. The biggest growth areas involve public school teachers, police, corrections(prisons) and hospitals. About 850,000 of the federal employees work for the postal
service.
90.0
80.0
70.0
DefenseTransfers
To Regional
Other Grants
Interest
Other

60.0
50.0
40.0
30.0
20.0
10.0
2000

1996

1992

1988

1984

1980

1976

1972

1968

1964

1960

1956

1952

1948

1944

1940

0.0

Figure 3-44: Major Expenditures of the Federal Government

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30.00%25.00%
20.00%

Social Security
Medical

15.00%

WelfareUnemployment

10.00%

Veterans

5.00%

2000

1996

1992

1988

1984

1980

1976

1972

1968

1964

1960

1956

1952

1948

0.00%

Figure 3-45: Major Transfer Payments (% of Federal Budget)

Transfers to individuals represent almost 50% of federal expenditures. These transfers
are direct payments to individuals, in the form of a check. Such transfers include social
security, Medicare, Medicaid, unemployment insurance, and veteran’s benefits.
Transfers to state and local governments are listed as regional. “Other grants” also
involve sending checks, usually with strings attached. The growth in social security
during the 1950s and 1960s is primarily a consequence of increasing benefit levels. The
growth in Medicare and Medicaid payments over the period 1970-90, in contrast, isprimarily a consequence of increased costs of existing programs rather than increases inbenefit levels.
1,000,000
100,000
10,000
Revenue

1,000

Expenditure

100

1997

1991

1985

1979

1973

1967

1961

1955

1949

1943

1

1937

10

Figure 3-46: Social Security Revenue and Expenditure, $ millions

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3-69

A question you may ask, quite reasonably, is whether the social security program cansurvive to the time when you retire. A common misunderstanding about social security
is that it is an investment program – that the taxes individuals paid in are invested andreturned at retirement. As Figure 3-46 makes clear, for most of its existence the social
security program has paid out approximately what it took in.
The social security administration has been ostensibly investing money and has acurrent value of approximately 1.5 trillion dollars, which is a bit less than four times thecurrent annual expenditure on social security. Unfortunately, this money is “invested”
in the federal government, and thus is an obligation of the federal government, as
opposed to an investment in the stock market. Consequently, from the perspective of
someone hoping to retire in, say, 2050, this investment isn’t much comfort, since theinvestment won’t make it easier for the federal government to make the social security
payments. The good news is that the government can print money. The bad news isthat when it prints a lot of it, and the obligations of the social security administration are
in the tens of trillions of dollars, it isn’t worth very much.
140.0

8,000

120.0

7,000
6,000

100.0

5,000

80.0

4,000
60.0

% GDP
Debt ($B)

3,000

40.0

2,000

20.0

1,000

0.0

0
00
20
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
19
50
19
45
19
40
19

Figure 3-47: Federal Debt, Total and Percent of GDP

The federal government runs deficits, spending more than it earned. In most of the past
75 years we see from Figure 3-39 that the government runs a deficit, bringing in lessthan it spends. Interest has been as high as 15% of the cost of the federal government(see Figure 3-44). How large is the debt, and how serious is it? Figure 3-47 gives thesize of the federal debt, in absolute dollars and as a percent of GDP. The debt wasincreased dramatically during World War II (1940-45), but over the following 25 years,
little was added to it, so that as a portion of growing GDP, the debt fell.
Starting in the late 1970s, the US began accumulating debt faster than we were growing,
and the debt began to rise. That trend wasn’t stabilized until the 1990s, and then only
because the economy grew at an extraordinary rate by historical standards. The
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expenditures following the September 11, 2001 terrorist attacks, combined with arecession in the economy, have sent the debt rising again.
The national debt isn’t out of control. At current 4% interest rates on federal borrowing,
we spend about 2½ % of GDP on interest servicing the federal debt. The rightevaluation of the debt is as a percentage of GDP; viewed as a percentage, the size of thedebt is of moderate size – serious but not critical. The serious side of the debt is thecoming retirement of the baby boom generation, which is likely to put additionalpressure on the government.
An important distinction in many economic activities is the distinction between a stock
and a flow. Your bank account represents a stock of money, the expenditures andincome a flow. The national debt is a stock; the deficit is the addition to the debt and isa flow. If you think about a lake with incoming water and evaporation, the amount ofwater in the lake is the stock of water, the incoming stream minus evaporation the flow.
Table 3-1: Expenditures on Agencies as Percent of Non-Transfer Expenditures
Department or
AgencyLegislative
Judiciary
Agriculture
Commerce
Education
EnergyHealthDefenseHomeland Security
Housing & Urban Dev.
Interior
Justice
Labor
StateTransportation
Treasury
Veterans
Corps of Engineers
Environmental P.A.
Fed Emergency M.A.
GSA
Intl Assistance
NASA
NSF

1977

1990

2002

0.4
0.2
2.1
3.2
3.9
3.1
3.7
43.8
13.4
1.6
1.0
6.1
0.6
2.2
1.7
2.3
1.0
1.1
0.2
0.2
2.8
1.6
0.3

0.4
0.3
2.2
0.7
3.8
3.2
4.6
59.2
2.9
1.3
1.7
1.7
0.9
2.6
1.6
2.6
0.6
1.1
0.4
0.5
2.7
2.5
0.4

0.5
0.6
2.7
0.7
6.7
2.9
8.3
46.9
4.1
4.3
1.4
2.7
1.7
1.3
2.1
1.4
3.3
0.6
1.1
0.0
0.0
1.9
2.0
0.7

Table 3-1 gives the expenditures on various agencies, as a percentage of the“discretionary” expenditures, where discretionary is a euphemism for expenditures that
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aren’t transfers. Transfers, which are also known as entitlements, include social
security, Medicare, aid to families with dependent children, unemployment insurance
and veteran’s benefits. In contrast, Table 3-1 gives the expenditures by the “Alphabet
Soup” of federal agencies.
The National Science Foundation (NSF) provides funds for basic research. The generalidea of government-funded research is that it is useful for ideas to be in the publicdomain, and moreover that some research isn’t commercially viable, but is valuable
nevertheless. Studying asteroids and meteors produces little if any revenue, but could,
perhaps, save humanity one day in the event that we can deflect a large incoming
asteroid. (Many scientists appear pessimistic about actually deflecting an asteroid.)
Similarly, research into nuclear weapons might be commercially viable but as a society,we don’t want firms selling nuclear weapons to the highest bidder. In addition to the
NSF, the National Institutes of Health, also a government agency, fund a great deal ofresearch. How much does the government spend on R&D? Figure 3-48 shows thehistory of R&D expenditures. The 1960s “space race” competition between the US andthe Soviet Union led to the greatest federal expenditure on research and development,
and it topped 2% of GDP. There was a modest increase during the Reagan presidency(1980-88) in defense R&D, which promptly returned to earlier levels.
2.5
2.0
1.5
1.0

Military
Civilian
Total

0.5

19
49
19
53
19
57
19
61
19
65
19
69
19
73
19
77
19
81
19
85
19
89
19
93
19
97
20
01

0.0

Figure 3-48: Federal Spending on R&D, as a Percent of GDP

Where does the government get the money to buy all these things? As we see in Figure
3-49, the federal income tax currently produces just under 50% of federal revenue.
Social Security and Medicare taxes produce the next largest portion, with around 3035% of revenue. The rest comes from corporate profits taxes (about 10%), excise taxes
like those imposed on cigarettes, liquor and cigarettes (under 5%) and other taxes liketariffs, fees, sales of property like radio spectrum and oil leases, and fines. The majorchange since World War II is the dramatic increase in social security, a consequence ofthe federal government’s attempt to insure the future viability of the program, in theface of severely adverse demographics in the form of the retirement of the baby boom
generation.

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60.0%
50.0%
40.0%

IncomeCorp

30.0%

Soc Sec
Excise

20.0%

Other

10.0%

19
34
19
39
19
44
19
49
19
54
19
59
19
64
19
69
19
74
19
79
19
84
19
89
19
94
19
99

0.0%

Figure 3-49: Sources of Federal Government Revenue

An important aspect of tax collection is that the income taxes, like the federal income
tax as well as Social Security and Medicare taxes, are very inexpensive to collect, relative
to sales taxes and excise taxes. Income taxes are straightforward to collect even relative
to corporate income taxes. Quite reasonably, corporations can deduct expenses and thecosts of doing business and are taxed on their profits, not on revenues. What is anallowable deduction, and what is not, make corporate profits complicated to administer.
Moreover, from an economic perspective, corporate taxes are paid by consumers, in theform of higher prices for goods, at least when industries are competitive.

3.1.6 Trade
The United States is a major trading nation. Figure 3-50 presents total US imports andexports, including foreign investment and earnings (for example, earnings from US
owned foreign assets). As is clear from this figure, the net trade surplus ended in the
1970s, and the US now runs substantial trade deficits, around 4% of GDP. In addition,
trade is increasingly important in the economy.

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20.00%18.00%
16.00%
14.00%
12.00%
10.00%
8.00%

Exports
Imports

6.00%
4.00%
2.00%

19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00

0.00%

Figure 3-50: Total Imports and Exports as a Proportion of GDP

Figure 3-50 includes investment and earnings. When we think of trade, we tend to
think of goods traded – American soybeans, movies and computers sold abroad, andautomobiles, toys, shoes and wine purchased from foreign countries. Figure 3-51 shows
the total trade in goods and services, as a percentage of US GDP. These figures are
surprisingly similar, which shows that investment and earnings from investment are
roughly balanced – the US invests abroad to a similar extent as foreigners invest in theUS.
16.00%
14.00%
12.00%
10.00%
8.00%

Exports
Imports

6.00%
4.00%
2.00%

19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00

0.00%

Figure 3-51: US Trade in Goods and Services

Figure 3-52 shows the earnings on US assets abroad, and the payments from US-based
assets owned by foreigners. These accounts are roughly in balance, while the US used toearn about 1% of GDP from its ownership of foreign assets.
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3-74

4.00%
3.50%
3.00%
2.50%
2.00%

Payments
Earnings

1.50%
1.00%
0.50%

19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00

0.00%

Figure 3-52: Income and Payments as a Percent of GDP

Who does the US trade with? Table 3-2 details the top fifteen trading partners., and theshare of trade. The US and Canada remain the top trading countries of all pairs ofcountries. Trade with Mexico has grown substantially since the enactment of the 1994
North American Free Trade Act (NAFTA), which extended the earlier US – Canada
agreement to include Mexico and Mexico is the US’s second largest trading partner.
Together, the top fifteen account for three-quarters of US foreign trade.

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3-75

Table 3-2: Top US Trading Partners and Trade Volumes ($B)

Rank

Country

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

All Countries
Top 15 Countries
CanadaMexicoChina
Japan
Germany
United Kingdom
Korea, South
TaiwanFranceItaly
Malaysia
IrelandSingapore
Netherlands
BrazilYear-to-Date

Year-to-Date

Imports

Total

Percent

533.6
400.7
123.1
71.8
22.7
36.0
20.4
23.9
17.5
14.0
13.4
6.9
7.2
5.2
13.6
15.7
9.3

946.6
715.4
167.8
101.3
121.5
85.1
50.3
30.3
29.6
22.6
20.0
18.6
18.0
19.3
10.1
7.9
13.2

1,480.2
1,116.2
290.9
173.1
144.2
121.0
70.8
54.2
47.1
36.5
33.4
25.5
25.2
24.5
23.7
23.6
22.5

100.0%
75.4%
19.7%
11.7%
9.7%
8.2%
4.8%
3.7%
3.2%
2.5%
2.3%
1.7%
1.7%
1.7%
1.6%
1.6%
1.5%

Exports

3.1.7 Fluctuations
The US economy has recessions, a term which refers to a drop in gross domestic output.
Recessions are officially called by the National Bureau of Economic Research, whichkeeps statistics on the economy and engages in various kinds of economic research.
Generally a recession is called whenever output drops for half of a year.
Figure 3-53 shows the overall industrial production of the United States since WorldWar II. Drops in output are clearly noticeable. The official recessions are also marked.
There are three booms that lasted about a decade; these are the longest booms in US
history and much longer than booms ordinarily lasted. Prior to World War II, a normal
boom lasted 2½ years and the longest was four years. Recessions have historicallylasted a 1½ to two years, a pattern that continues. Indeed, the average recession sinceWorld War II has been shorter than the average recession prior to that time.

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140
120
100
80

IP
Recession

60
40
20
0
1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

Figure 3-53: Postwar Industrial Production and Recessions

These fluctuations in output are known as the business cycle, which is not an exactly
periodic cycle but instead a random cycle.

66.0
64.0
62.0
60.0
58.0
56.0
54.0
52.0
50.0

19
40
19
43
19
46
19
48
19
51
19
54
19
57
19
60
19
63
19
66
19
69
19
72
19
75
19
78
19
81
19
84
19
87
19
90
19
93
19
96
19
99
20
02

48.0

Figure 3-54: Percentage of the Population Employed

An important aspect of the business cycle is that many economic variables move
together, or covary. Some economic variables vary less with the business cycle thanothers. Investment varies very strongly with the business cycle, while overall
employment varies weakly. Interest rates, inflation, stock prices, unemployment andmany other variables also vary systematically over the business cycle. Recessions areclearly visible in the percentage of the population employed, illustrated in Figure 3-54.

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Some economic variables are much more variable than others. For example,
investment, durable goods purchases, and utilization of production capacity vary more
dramatically over the business cycle than consumption and employment. Figure 3-55
shows the percentage of industrial capacity utilized to produce manufactured goods.
This series is more volatile than production itself, and responds more strongly toeconomic conditions.
90.0
88.0
86.0
84.0
82.0
80.0
78.0
76.0
74.0
72.0
Jan-03Jan-00Jan-97

Jan-94Jan-91Jan-88Jan-85Jan-82Jan-79Jan-76

Jan-73Jan-70Jan-6770.0

Figure 3-55: Industrial Factory Capacity Utilitzation (Source: FRED)

Most of the field of macroeconomics is devoted to understanding the determinants ofgrowth and of fluctuations, but further consideration of this important topic is beyond
the scope of a microeconomics text.

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4 Producer Theory
The most basic theory of the firm views the firm as a means of transforming things into
other, more valuable things, which is known as production. Thus, smelting of copper orgold removes impurities and makes the resulting product more valuable. Silicon valleytransforms silicon, which is the primary ingredient of sand, along with a thousand otherchemicals and metals, into computer chips used in everything from computers totoasters. Cooking transforms raw food, adding flavor and killing bacteria. Moving
things to locations where they have higher value is a form of production. Moving stone
to the location of a house where the stone can be installed in the exterior, or bringing theKing Tut museum exhibit temporarily to Chicago, or a basketball team to the playoffs,
are all examples of production. In this simplistic view, a firm is comprised of atechnology or set of technologies for transforming things and then chooses thetransformation to maximize the net profits. This “firm as a production function” view ofthe firm is adequate for some purposes, especially when products or services are
relatively standardized and technologies widely available, but fares poorly when theinternal organization of the firm matters a great deal. Nevertheless, the “firm as a
production function” model is a natural starting point in the investigation ofcompetition.

4.1 The Competitive Firm
4.1.1 Types of Firms
There are four major types of firms created in law, although these broad types have
many subtypes. At the smallest end is the proprietorship, in which a firm is owned by asingle individual (the proprietor) or perhaps a family, and operated by a relatively small
number of people. The family farm, many restaurants, convenience stores, andlaundromats are operated this way. Debts accrued by the proprietorship are thepersonal responsibility of the proprietor. Professionals like attorneys and accountants
are often organized as partnerships. Partnerships share profits according to a formula(some equally by partner, some assigning shares or points to partners so that‘rainmakers’ who generate more of the business obtain a larger share of the profits) andusually all are liable for losses incurred by the partnership. Thus, if a partner in a law
firm steals a client’s money and disappears, the other partners are generally responsible
for the loss. In contrast, a corporation is, by a legal fiction, a person, which means acorporation itself can incur debt and the responsibility for repayment of that debt is withthe corporation, not with the officers or owners of the corporation. When the energy
trader company Enron collapsed, the shareholders in Enron lost their investment in thestock, but were not responsible for the remaining debts of the corporation. Moreover,
executives of the company are also not financially responsible for debts of thecorporation, provided the executives act legally and carry out their responsibilities
appropriately. If a meteor strikes a manufacturing facility and bankrupts thecorporation, the executives are not personally responsible for the debts the corporation
fails to pay. On the other hand, breaking the law is not permitted, and executives at
Archer Daniels Midland, the large agriculture firm, who colluded in the fixing of theprice of lysine went to jail and were personally fined. The corporation was fined as well.

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Corporations shield company executives and shareholders from liability, and are said tooffer “limited liability.” So why would anyone in their right mind organize a firm as aproprietorship or a partnership? Corporations cost money to organize, about $1,000
per year at the time of this writing, and are taxed, which is why many small businesses
are organized as proprietorships: it is cheaper. Moreover, it may not be possible for a
corporation owned by a family to borrow money to open a restaurant: potential lenders
fear not being repaid in the event of bankruptcy, so insist on some personal liability on
the part of the owners. So why are professional groups organized as partnerships andnot corporations? The short answer is that a large variety of hybrid organizational
forms exist. The distinctions have been blurred and organizations like “Chapter S
Corporations” and “Limited Liability Partnerships” offer the advantages of partnerships(including avoidance of taxation) and corporations. The disadvantages to these forms isprimarily larger legal fees, and limitations on the nature of ownership and rules specificto individual states.
It is usually the case that proprietorships are smaller than partnerships, andpartnerships smaller than corporations, although there are some very large partnerships(e.g. the big four accounting firms) and some tiny corporations. The fourth kind can beof any size, for its distinction is not how it is organized internally but what it does withthe revenue. The non-profit firm is prohibited from distributing a profit to its owners.
Religious operations, academic associations, environmental groups, most zoos, industry
associations, lobbying groups, many hospitals, credit unions (a type of bank), labor
unions, private universities and charities are all organized as non-profit corporations.
The major advantage of non-profit firms is that the government doesn’t tax them. In
exchange for avoiding taxes, non-profits must be engaged in government-approved
activities, meaning generally that the non-profit operates for the benefit of somesegment of society. So why can’t you establish your own non-profit, that operates forthe benefit of you, and avoid taxes? Generally you alone aren’t enough of a sociallyworthy purpose to meet the requirements to form a non-profit.19 Moreover, you can’testablish a non-profit for a worthy goal and not serve that goal but just pay yourself all
the money the corporation raises, because non-profits are prohibited from overpaying
their managers, since overpaying the manager means not serving the worthy corporate
goal as well as possible. Finally, commercial activities of non-profits are taxable. Thus,
when the non-profit zoo sells stuffed animals in the gift-shop, generally the zoo collects
sales tax and is potentially subject to corporate taxes.
The modern corporation is a surprisingly recent invention. Prior to World War I,
companies were generally organized in a pyramid structure, with a president at the top,and vice-presidents who reported to him, etc. In a pyramid structure, there is a welldefined chain of command, and no one is ever below two distinct managers of the samelevel. The problem with a pyramid structure is that two retail stores that want tocoordinate have to contact their managers, and possibly their managers’ managers, andso on up the pyramid until a common manager is reached. There are circumstanceswhere such rigid decision-making is unwieldy, and the larger the operation of acorporation, the more unwieldy it gets.
19 Certainly some of the non-profit religious organizations created by televangelists suggest that the non-profit established for the benefit of a single individual isn’t far-fetched.

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4-80

Four companies – Sears, DuPont, General Motors and Standard Oil of New Jersey(Exxon) – found that the pyramid structure didn’t work well for them. Sears found thatits separate businesses of retail stores and mail order required a mix of shared inputs(purchased goods) but distinct marketing and warehousing of these goods.
Consequently, retail stores and mail order needed to be separate business units, butpurchasing had to answer to both of them. Similarly, DuPont’s military business (e.g.
explosives) and consumer chemicals were very different operations serving very
different kinds of customers, yet often selling the same things, so again the inputs
needed to be centrally produced and to coordinate with two separate corporate
divisions. General Motors’ many car divisions employ ‘friendly rivalry,’ in which
technology and parts are shared across the divisions but the divisions compete inmarketing their cars to consumers. Again, technology can’t be under just one division,
but instead is common to all. Finally, Standard Oil of New Jersey was attempting tocreate a company that managed oil products from oil exploration all the way throughpumping gasoline into automobile gas tanks. With such varied operations all over the
globe, Standard Oil of New Jersey required extensive coordination and found that theold business model needed to be replaced. These four companies independently
invented the modern corporation, which is organized into separate business units.
These business units run as semi-autonomous companies themselves, with one business
unit purchasing, at a negotiated price, inputs from another unit, and selling outputs to athird. The study of the internal organization of firms and its ramifications forcompetitiveness is fascinating, but beyond the scope of this book.20

4.1.2 Production Functions
The firm transforms inputs into outputs. For example, a bakery takes inputs like flour,
water, yeast, labor, and heat and makes loaves of bread. An earth-moving company
takes capital equipment, ranging from shovels to bulldozers, and labor and digs holes. A
computer manufacturer buys parts, generally “off-the-shelf” like disk-drives andmemory, along with cases and keyboards and other parts that may be manufactured
specially for the computer manufacturer, and uses labor to produce computers.
Starbucks takes coffee beans, water, some capital equipment, and labor and produces
brewed coffee.
Many if not all firms produce several outputs. However, we can view a firm producing
multiple outputs as using several distinct production processes, and thus it is useful tostart by looking at a firm that produces only one output. Generally, we can describe thisfirm as buying an amount x1 of the first input, x2 of the second input, and so on (we’ll
use xn to denote the last input) and producing an amount y of the output, that is, theproduction function is
y = f(x1, x2, … , xn).
Mostly we will focus on two inputs in this section, but carrying out the analysis for morethan two inputs is straightforward.

20 If you want to know more about organization theory, I happily recommend Competitive Solutions: The

Strategist’s Toolkit, by R. Preston McAfee, Princeton: Princeton University Press, 2002.

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4-81

Example: The Cobb-Douglas production function is the product of the x’s raised to
powers, and comes in the form:aaf ( x1 , x2 ,..., x n ) = a0 x1 1 x2 2 ... x nan
The constants a1 through an are positive numbers, generally individually less than one.
For example, with two goods, capital K and labor L, Cobb-Douglas can be expressed as
a0KaLb. We will use this example frequently. It is illustrated, for a0 = 1, a=1/3 andb=2/3, in Figure 4-1.
K
100
80
60
40
20
0.5

1

1.5

2

L

Figure 4-1: Cobb-Douglas Isoquants

Figure 4-1 shows three isoquants for the Cobb-Douglas production function. An
isoquant, meaning “equal quantity,” illustrates the input mixes that produce a given
output level. In this case, given a=1/3 and b=2/3, we can solve y = KaLb for K to obtain
K = y3 L-2. Thus, K = L-2 gives the combinations of inputs yielding an output of 1, andthat is what the dark, solid line represents. The middle, grey dashed line represents an
output of 2, and finally the dotted light-grey line represents an output of 3. Isoquants
are familiar contour plots used, for example, to show the height of terrain or
temperature on a map. Temperature isoquants are, not surprisingly, called isotherms.

Figure 4-2: The Production Function

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Isoquants provide a natural way of looking at production functions and are a bit more
useful to examine than 3-D plots like the one provided in Figure 4-2.
The fixed-proportions production function comes in the formf ( x1 , x2 ,..., x n ) = Min {a1 x1 , a2 x2 ,..., an x n }Figure 4-3: Fixed Proportions

The fixed proportions production function has the property that adding an input beyond
a necessary level does no good. For example, the productive value of having more than
one shovel per worker is pretty low, so that shovels and diggers are reasonably modeled
as producing holes using a fixed proportions production function. Moreover, without ashovel or other digging implement like a backhoe, a bare-handed worker produces solittle digging as to be nearly useless, so extra workers beyond the number of shovels
have little effect. Ultimately, the size of the holes is pretty much determined by Min{number of shovels, number of diggers}. The Figure 4-3 illustrates the isoquants for
fixed proportions. As we will see, fixed proportions makes the inputs “perfectcomplements.”
Two inputs K and L are perfect substitutes in a production function f if they enter as asum, that is, f(K, L, x3, … , xn) = g(K + cL, x3, … , xn), for a constant c. With anappropriate scaling of the units of one of the variables, all that matters is the sum of thetwo variables, not the individual values. In this case, the isoquants are straight linesthat are parallel to each other, as illustrated in the Figure 4-4.

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Figure 4-4: Perfect Substitutes

The marginal product of an input is just the derivative of the production function withrespect to that input.21 An important aspect of marginal products is that they areaffected by the level of other inputs. For example, in the Cobb-Douglas case with two
inputs22 and for constant A:

f ( K , L ) = AK α Lβ ,the marginal product of capital is∂f( K , L ) = αAK α −1 Lβ .
∂K
If α and β are between zero and one (the usual case), then the marginal product of
capital increases in the amount of labor, and decreases in the amount of capital. For
example, an extra computer is very productive in a situation with lots of workers andfew computers, but not so productive in a situation where there are lots of computersand few people to operate them.
The value of the marginal product of an input is just the marginal product times theprice of the output. If the value of the marginal product of an input exceeds the cost ofthat input, it is profitable to use more of the input.
Some inputs are more readily changed than others. It can take five years or more toorder and obtain new passenger aircraft, four years to build an electricity generation
21 This is a partial derivative, since it holds the other inputs fixed.

Partial derivatives are denoted with thesymbol ∂.
22 The symbol α is the Greek letter “alpha.” The symbol β is the Greek letter “beta.” These are the firsttwo letters of the Greek alphabet, and the word alphabet itself originates from these two letters.

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facility or a pulp and paper mill. Very skilled labor – experienced engineers, animators,
patent attorneys – is often hard to find and challenging to hire. It usually takes three tofive years to hire even a small number of academic economists. On the other hand, it ispossible to buy shovels, telephones, and computers and to hire a variety of temporary
workers quite rapidly, in a matter of a day or so. Moreover, additional hours of work
can be obtained by an existing labor force simply by hiring them “overtime,” at least on atemporary basis. The amount of water or electricity a production facility uses can bevaried second by second. If you run a restaurant, you can use more water tonight towash dishes if you need it. If you start in the morning, you can probably get a few
additional workers by that evening by paying overtime to those who aren’t scheduled towork. It will probably take a few days or more to hire additional waiters and waitresses,
and perhaps more than a few days to find a skilled chef. You can obtain moreingredients, generally the same day, and more plates and silverware pretty quickly. You
can lease more space, but it will probably take more than a month to actually occupy alarger space, what with finding the space for rent, renting it, remodeling it and obtaining
the necessary permits.
That some inputs or factors can be varied quickly, others only slowly, leads to thenotions of the long-run and short-run. In the short-run, only some inputs can be
adjusted, while in the long-run, all inputs can be adjusted. Traditionally, economists
viewed labor as quickly adjustable, and capital equipment as more difficult to adjust.
That is certainly right for airlines – obtaining new aircraft is a very slow process – andfor large complex factories, and for relatively low-skilled and hence substitutable labor.
On the other hand, obtaining workers with unusual skills is a slower process thanobtaining warehouse or office space. Generally speaking, the long-run inputs are thosethat are expensive to adjust quickly, while the short-run factors can be adjusted in a
relatively short time frame. What factors belong in which category is dependent on thecontext or application under consideration.
4.1.2.1 (Exercise) For the Cobb-Douglas production function, suppose there are two
inputs K and L, and the sum of the exponents is one. Show that if each input ispaid the value of the marginal product per unit of the input, the entire output isjust exhausted. That is, for this production function, show
K

∂f
∂f
+L
= f ( K , L) .
∂K
∂L

4.1.3 Profit Maximization
Consider an entrepreneur that would like to maximize profit, perhaps by running adelivery service. The entrepreneur uses two inputs, capital K (e.g. trucks) and labor L(e.g. drivers), and rents the capital at cost r per dollar of capital. The wage rate fordrivers is w. The production function is F(K, L), that is, given inputs K and L, theoutput is F(K, L). Suppose p is the price of the output. This gives a profit of:23
23 Economists often use the Greek letter π to stand for profit.

There is little risk of confusion because
economics doesn’t use the ratio of the circumference to the diameter of a circle very often. On the other
hand, the other two named constants, Euler’s e and i, the square root of -1, appear fairly frequently ineconomic analysis.

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π = pF ( K , L ) − rK − wL.
First, consider the case of a fixed level of K. The entrepreneur chooses L to maximize
profit. The value L* of L that maximizes the function π must satisfy:
0=

∂π
∂F
=p
( K , L*) − w.
∂L
∂L

This expression is known as a first order condition, because it says the first derivative of
the function is zero.24 The first order condition shows that we add workers to the
production process until reaching a worker who just pays his salary, in that the value ofthe marginal product for that worker is equal to the cost of the worker.

π
Slope zero at
maximum
Slopenegative toright ofmaximum

Slope positive
to left ofmaximum

L
L*
Figure 4-5: Profit-Maximizing Labor Input

In addition, a second characteristic of a maximum is that the second derivative isnegative (or non-positive). This arises because, at a maximum, the slope goes frompositive (since the function is increasing up to the maximum), to zero (at the
maximum), to a negative number (because the function is falling as the variable rises
past the maximum). This means that the derivative is falling, that is, the second
derivative is negative. This logic is illustrated in the Figure 4-5.
24 It is possible that L=0 is the best that entrepreneur can do.

In this case, the derivative of profit withrespect to L is not necessarily zero. The first order condition instead would be:
Either 0 =∂π∂π, or L=0 and 0 ≥. The latter pair of conditions reflects the logic that either the∂L∂Lderivative is zero and we are at a maximum, or L = 0, in which case a small increase in L must not cause π
to increase.

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The second property is known as the second order condition, because it is a conditionon the second derivative.25 It is expressed as:0≥∂2π(∂L )2=p∂2 F(∂L )2( K , L*).

This is enough of a mathematical treatment to establish comparative statics on the
demand for labor. Here, we treat the choice L* as a function of another parameter – theprice p, the wage w, or the level of capital K. For example, to find the effect of the wage
on the labor demanded by the entrepreneur, we can write:
0= p∂F( K , L * (w)) − w.
∂LThis expression recognizes that the choice L* that the entrepreneur makes satisfies thefirst order condition, and results in a value that depends on w. But how does it depend
on w? We can differentiate this expression to obtain:
0= p

∂2 F
(∂L )2( K , L * (w)) L *′ ( w) − 1,or1

L *′ (w) =
p

2

∂ F
(∂L )2≤ 0.

( K , L * ( w))

The second order condition lets the derivative be signed. This form of argument
assumes that the choice L* is differentiable, which is not necessarily true.
Digression: In fact, there is a revealed preference form of argument that makes
the point without calculus and makes it substantially more generally. Suppose w1< w2 are two wage levels, and that the entrepreneur chooses L1 when the wage is
w1 and L2 when the wage is w2. Then profit maximization requires that thesechoices are optimal. In particular, when the wage is w1, the entrepreneur earns
higher profit with L1 than with L2:
pf ( K , L1 ) − rK − w1 L1 ≥ pf ( K , L2 ) − rK − w1 L2 .
When the wage is w2, the entrepreneur earns higher profit with L2 than with L1.

25 The orders refer to considering small but positive terms ∆, which are sent to zero to reach derivatives.

The value ∆2, the “second order term” goes to zero faster than ∆, the first order term.

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pf ( K , L2 ) − rK − w2 L2 ≥ pf ( K , L1 ) − rK − w2 L1 .
The sum of the left hand sides of these two expressions is at least as large as thesum of the right hand side of the two expressions:pf ( K , L1 ) − rK − w1 L1 + pf ( K , L2 ) − rK − w2 L2 ≥pf ( K , L1 ) − rK − w2 L1 + pf ( K , L2 ) − rK − w1 L2

A large number of terms cancel, to yield− w1 L1 − w2 L2 ≥ − w2 L1 − w1 L2 .

This expression can be re-arranged to yield(w1 − w2 )( L2 − L1 ) ≥ 0.
This shows that the higher labor choice must be associated with the lower wage.
This kind of argument, sometimes known as a “revealed preference” kind ofargument because choices by consumers were the first place the type of argument
was applied, can be very powerful and general, because issues of differentiability
are avoided. However, we will use the more standard differentiability typeargument, because such arguments are usually more readily constructed.
The effect of an increase in the capital level K on the choice by the entrepreneur can becalculated by considering L* as a function of the capital level K.
0= p∂F( K , L * ( K )) − w.
∂L

Differentiating this expression with respect to K, we obtain

∂2 F
∂2 F
0= p
( K , L * ( K )) + p( K , L * ( K ))L *′ ( K ),∂K∂L(∂L )2or,∂2 F( K , L * ( K ))L *′ ( K ) = ∂K∂L.
∂2 F
( K , L * ( K ))(∂L )2−

We know the denominator of this expression is not positive, thanks to the second ordercondition, so the unknown part is the numerator. We then obtain the conclusion that:

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An increase in capital increases the labor demanded by the entrepreneur if

∂2 F
∂2 F
( K , L * ( K )) > 0 , and decreases the labor demanded if( K , L * ( K )) < 0.
∂K∂L
∂K∂L
This conclusion looks like gobbledygook but is actually quite intuitive. Note that

∂2 F
( K , L * ( K )) > 0 means that an increase in capital increases the derivative of output∂K∂L
with respect to labor, that is, an increase in capital increases the marginal product of∂2 F( K , L * ( K )) > 0 means∂K∂L
that labor and capital are complements in production – an increase in capital increases
the marginal productivity of labor. Thus an increase in capital will increase the demand
for labor when labor and capital are complements, and will decrease the demand forlabor when labor and capital are substitutes.

labor. But this is the definition of a complement! That is,

This is an important conclusion because different kinds of capital may be complements
or substitutes for labor. Are computers complements or substitutes for labor? Someeconomists consider that computers are complements to highly skilled workers,
increasing the marginal value of the most skilled, but substitute for lower skilledworkers. In academia, the ratio of secretaries to professors has fallen dramatically sincethe 1970s as more and more professors use machines to perform secretarial functions.
Computers are thought to have increased the marginal product of professors andreduced the marginal product of secretaries, so the number of professors rose and thenumber of secretaries fell.
The revealed preference version of the effect of an increase in capital is to posit two
capital levels, K1 and K2, with associated profit-maximizing choices L1 and L2. The
choices require, for profit maximization, thatpF ( K 1 , L1 ) − rK 1 − wL1 ≥ pF ( K 1 , L2 ) − rK 1 − wL2
andpF ( K 2 , L2 ) − rK 2 − wL2 ≥ pF ( K 2 , L1 ) − rK 2 − wL1 .
Again, adding the left-hand-sides together produces a result at least as large as thesum of the right hand sides:pF ( K 1 , L1 ) − rK 1 − wL1 + pF ( K 2 , L2 ) − rK 2 − wL2 ≥pF ( K 2 , L1 ) − rK 2 − wL1 + pF ( K 1 , L2 ) − rK 1 − wL2 .
Eliminating redundant terms yields
pF ( K 1 , L1 ) + pF ( K 2 , L2 ) ≥ pF ( K 2 , L1 ) + pF ( K 1 , L2 ),McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

4-89

or,
F ( K 2 , L2 ) − F ( K 1 , L2 ) ≥ F ( K 2 , L1 )−, F ( K 1 , L1 )
or,
K2

K

K1

K1

2
∂F
∂F
x
L
dx
≥
(
,
)
∫ ∂K 2∫ ∂K ( x , L1 )dx , 26

or
K2

∂F

∂F

∫ ∂K ( x, L2 ) − ∂K ( x , L1 )dx ≥ 0,

K1

and finally,
K 2 L2∫∂2 F∫ ∂K∂L ( x , y) dydx ≥ 0,

K 1 L1∂2 F( K , L ) > 0 for all K and L, then L2 ≥ L1, that is, with∂K∂L
complementary inputs, an increase in one input increases the optimal choice of thesecond input. In contrast, with substitutes, an increase in one input decreases theother input. While we still used differentiability of the production function to carryout the revealed preference argument, we did not need to establish that the choice
L* was differentiable to perform the analysis.
Thus, if K2 > K1 andExample: Labor Demand with the Cobb-Douglas production function. The CobbDouglas production function has the form F ( K , L ) = AK α Lβ , for constants A, α and β,
all positive. It is necessary for β<1 for the solution to be finite and well-defined. The
demand for labor satisfies
0= p∂F( K , L * ( K )) − w = pβAK α L *β−1 −w,∂Lor

26 Here we use the standard convention that

b

a

a

b

∫ ... dx = − ∫ ... dx.

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4-90

1

⎛ pβ AK α ⎞ 1−β⎟.
L* = ⎜⎜ w ⎟⎠⎝When α+β=1, L is linear in capital. Cobb-Douglas production is necessarily
complementary, that is, an increase in capital increases labor demanded by theentrepreneur.
For the fixed proportions production function Min {K, L}, find labor
4.1.3.1 (Exercise)demand (capital fixed at K).

4.1.4 The Shadow Value
When capital K can’t be adjusted in the short-run, it creates a constraint on the profit
available on the entrepreneur – the desire to change K reduces the profit available to theentrepreneur. There is no direct value of capital, because capital is fixed. That doesn’tmean we can’t examine its value, however, and the value of capital is called a shadow
value because it refers to the value associated with a constraint. Shadow value is wellestablished jargon.
What is the shadow-value of capital? Let’s return to the constrained, short-run
optimization problem. The profit of the entrepreneur is:

π = pF ( K , L ) − rK − wL.
The entrepreneur chooses the value L* to maximize profit, but is stuck in the short-run
with the level of capital inherited from a past decision. The shadow value of capital isthe value of capital to profit, given the optimal decision L*. Because
0=

∂π
∂F
=p
( K , L*) − w ,∂L∂L

the shadow value of capital isdπ( K , L*) ∂π( K , L*)∂F==p( K , L*) − r .
dK∂K∂KNote that this could be negative; the entrepreneur might like to sell some capital but
can’t, perhaps because it is installed in the factory.
Any constraint has a shadow value. The term refers to the value of relaxing a constraint.
The shadow value is zero when the constraint doesn’t bind; for example, the shadow
value of capital is zero when it is set at the profit-maximizing level. Technology binds
the firm; the shadow value of a superior technology is the increase in profit associatedwith it. For example, parameterize the production technology by a parameter a, so thataF(K, L) is produced. The shadow value of a given level of a is, in the short-run,

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dπ( K , L*) ∂π( K , L*)== pF ( K , L*).
da∂a
A term is vanishing in the process of establishing the shadow value. The desired value
L* varies with the other parameters like K and a, but the effect of these parameters on
L* doesn’t appear in the expression for the shadow value of the parameter because∂π0=at L*.
∂L

4.1.5 Input DemandOver a long period of time, an entrepreneur can adjust both the capital and the laborused at the plant. This lets the entrepreneur maximize profit with respect to bothvariables K and L. We’ll use a double star, **, to denote variables in their long-run
solution. The approach to maximizing profit over two variables is to maximize it
separately over each variable, thereby obtaining
0= p∂F( K **, L **) − w,
∂L

and
0= p

∂F
( K **, L **) − r.
∂K

We see for both capital and labor, the value of the marginal product is equal to purchaseprice of the input.
It is more of a challenge to carry out comparative statics exercises with two variables,
and the general method won’t be developed here.27 However, we can illustrate one
example as follows.
Example: The Cobb-Douglas production function implies choices of capital and labor
satisfying two first order conditions, one each for labor and capital.28
0= p∂F( K **, L **) − w = pβ AK ** α L **β−1 − w,
∂L

0= p

∂F
( K **, L **) − w = pαAK ** α −1 L **β −r.
∂K

To solve this expression, first rewrite to obtain
27 If you want to know more, the approach is to arrange the two equations as a vector with x = (K, L),z=(r/p, w/p), so that 0 = F ′( x **) − z , and then differentiate to obtain dx ** = (F′′( x **))−1 dz, which canthen be solved for each comparative static.
28

It is necessary for α+β<1 for the solution to be finite and well-defined.

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w = pβAK ** α L **β−1 and r = pαAK ** α −1 L **β , then divide the first by the second toyield
w βK **
αw=, or K ** =L ** . This can be substituted into either equation to obtainr αL **βr
1

1⎛ Apα αβ1−α ⎞ 1−α −β⎛ Apα1−βββ ⎞ 1−α −β⎟⎟
L ** = ⎜.
and K ** = ⎜⎜ r α w 1 −α ⎟⎜ r 1−β wβ ⎟⎝⎝⎠⎠While these expressions appear complicated, in fact the dependence on the output pricep, and the input prices r and w are quite straightforward.
How do equilibrium values of capital and labor respond to a change in input prices or
output price for the Cobb-Douglas production function? It is useful to cast thesechanges in percentage terms. It is straightforward to demonstrate that both capital andlabor respond to a small percentage change in any of these variables with a constantpercentage change.
4.1.5.1 (Exercise)

For the Cobb-Douglas production function F ( K , L ) = AK α Lβ , show

αw ∂L **1−α1r ∂L **p ∂L **
=−
,
=−
,
=
,
L ** ∂r1 − α − β L ** ∂w
1 − α − β L ** ∂p1 −α −βr ∂K **1 −βw ∂K **
βp ∂K **
1
=−
,
=−
=
and
.
K ** ∂r1 − α − β K ** ∂w
1 −α −βK ** ∂p1 −α −βAn important insight of profit maximization is that it implies minimization of costs ofyielding the chosen output, that is, profit-maximization entails efficient production.
The logic is straightforward. The profit of an entrepreneur is revenue minus costs, andthe revenue is price times output. For the chosen output, then, the entrepreneur earns
the revenue associated with the output, which is fixed since we are considering only thechosen output, minus the costs of producing that output. Thus, for the given output,
maximizing profits is equivalent to maximizing a constant (revenue) minus costs. Since
maximizing –C is equivalent to minimizing C, the profit-maximizing entrepreneur
minimizes costs. This is important because profit-maximization implies not being
wasteful in this regard: a profit-maximizing entrepreneur produces at least cost.

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4-93

K

q

L
Figure 4-6: Tangency and Isoquants

There are circumstances where the cost-minimization feature of profit maximization canbe used, and this is especially true when a graphical approach is taken. The graphicalapproach to profit-maximization is illustrated in Figure 4-6. The curve represents an
isoquant, which holds constant the output. The straight lines represent “isocost” lines,
which hold constant the expenditure on inputs. Isocost lines solve the problem
rK + wL = constantdKw= − . Isocost lines are necessarily parallel – they have thedLrsame slope. Moreover, the cost associated with an isocost line rises the further
northeast we go in the graph, or the further away from the origin.

and thus have slope

What point on an isoquant minimizes total cost? The answer is the point associatedwith the lowest (most southwest) isocost that intersects the isoquant. This point will betangent to the isoquant and is denoted by a star. At any lower cost, it isn’t possible toproduce the desired quantity. At any higher cost, it is possible to lower cost and still
produce the quantity.
That cost minimization requires a tangency between the isoquant and the isocost has auseful interpretation. The slope of the isocost is minus the ratio of input prices. The
slope of the isoquant measures the substitutability of the inputs in producing the output.
Economists call this slope the marginal rate of technical substitution, which is theamount of one input needed to make up for a decrease in another input and hold output
constant. Thus, one feature of cost minimization is that the input price ratio equals themarginal rate of technical substitution.
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4.1.6 Myriad Costs
How much does it cost to produce a given quantity q? We already have a detailed
answer to this question, but now need to focus less on the details and more on the “bigpicture.” First, let’s focus on the short-run, and suppose L is adjustable in the short-run,but K is not. Then the short-run total cost of producing q, given the capital level, is
SRTC(q|K) = min rK + wL , over all L satisfying F(K,L)≥q.
L

In words, this equation says the short-run total cost of the quantity q given the existinglevel K is the minimum cost, where L gets to vary (which is denoted by “min over L”),
where the L considered is large enough to produce q. The vertical line | is used toindicate a condition or conditional requirement; here |K indicates that K is fixed. The
minimum lets L vary but not K. Finally, there is a constraint F(K,L) ≥ q, which indicatesthat one has to be able to produce q with the mix of inputs because we are considering
the short-run cost of q.
The short-run total cost of q given K has a simple form. First, since we are minimizing
cost, the constraint F(K,L) ≥ q will be satisfied with equality, F(K,L) = q. This equation
determines L, since K is fixed, that is, F ( K , LS (q, K )) = q gives the short-run value of L,
LS(q,K). Finally, the cost is then rK + wL = rK + wLS(q,K).
The short-run marginal cost given K is just the derivative of total cost with respect to q.
To establish the short-run marginal cost, note that the equation F(K,L) = q gives∂F( K , LS (q, K )) dL = dq,
∂L
or
1
dL
.
=
dq F =q ∂F ( K , L (q, K ))S
∂L
The tall vertical line, subscripted with F=q, is used to denote the constraint F(K,L) = q
that is being differentiated. Thus, the short-run marginal cost is
SRMC(q|K) = SRTC ′(q) =

d
dL
w
=
(rK + wL ) = w.
dqdq F =q ∂F ( K , L (q, K ))S
∂L

There are two other short-run costs that will be needed to complete the analysis. First,
there is the notion of the short-run average cost of production, which we obtain bydividing the total cost by the quantity:

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4-95

SRAC (q | K ) =SRTC (q | K ).
qFinally, we need one more short-run cost: the short-run average variable cost. The
variable cost eliminates the fixed costs of operation, which in this case are rK. That is,
SRAVC (q | K ) =SRTC (q | K ) − SRTC (0 | K ) wLS (q | K )=.
qq

The short-run average variable cost is the average cost ignoring the investment in capital
equipment.
The short-run average cost could also be called the short-run average total cost, since itis the average of the total cost per unit of output, but “average total” is a bit of an
oxymoron.29 Consequently, when total, fixed or variable is not specified, the convention
is to mean total. Note that the marginal variable cost is the same as the marginal total
costs, because the difference between variable cost and total cost is a constant – the costof zero production, also known as the fixed cost of production.
At this point, we have identified four distinct costs, all relevant to the short-run. These
are the total cost, the marginal cost, the average cost, and the average variable cost. In
addition, all of these can be considered in the long-run as well. There are threedifferences in the long-run. First, the long-run lets all inputs vary, so the long-run total
cost is
LRTC(q) = min rK + wL , over all L and K combinations satisfying F(K,L) ≥ q.
L ,KSecond, since all inputs can vary, the long-run cost isn’t conditioned on K. Finally, thelong-run average variable cost is the same as the long-run average total cost. Because in
the long-run a firm could use no inputs and thus incur no costs, the cost of producing
zero is zero. Therefore, in the long-run, all costs are variable, and the long-run averagevariable cost is the long-run average total cost.
For the Cobb-Douglas production function F ( K , L ) = AK α Lβ , with
4.1.6.1 (Exercise)
α+β<1, with K fixed in the short-run but not in the long-run, and cost r ofcapital and w for labor, show1

⎛ q ⎞β⎟⎟ ,SRTC(q|K) = rK + w⎜⎜⎝ AK α ⎠29 An oxymoron is a word or phrase which is self-contradictory, like “jumbo shrimp,” “stationary orbit,”“virtual reality,” “modern tradition,” or “pretty ugly.” Oxymoron comes from the Greek oxy, meaning
sharp, and moros, meaning dull. Thus oxymoron is itself an oxymoron, so an oxymoron is selfdescriptive. Another word which is self-descriptive is “pentasyllabic.”

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4-96

SRAVC(q|K) = w

SRMC(q|K) = w

q

1−β
β

(

)

1
α β
AK

q

(

1−β
β

)

1
α β
β AK

,

,

β
α ⎞
1
β
α
⎛
⎜ ⎛ α ⎞ α+β ⎛ β ⎞ α +β ⎟
q
⎛
⎞
α
+β
.
+⎜ ⎟
LRTC(q|K) = ⎜ ⎜⎜ ⎟⎟⎟w α+β r α+β ⎜ ⎟⎝α⎠⎝ A⎠⎜⎜ ⎝ β ⎠⎟⎟⎝⎠Note that the easiest way to find the long-run total cost is to minimize the short-run
total cost over K. Since this is a function of one variable, it is straightforward to identify
the K that minimizes cost, and then plug that K into the expression for total cost.
One might want to distinguish the very short-run, from the short-run, from the medium
run, from the long-run, from the very long-run. But a better approach is to view
adjustment as a continuous process, with a gradual easing of the constraints. Fasteradjustment costs more. Continuous adjustment is a more advanced topic, requiring an
Euler equation approach.

4.1.7 Dynamic Firm Behavior
In this section, we consider a firm or entrepreneur that can’t affect the price of output or
the prices of inputs, that is, a competitive firm. How does such a competitive firm
respond to price changes? When the price of the output rises, the firm earns profits

π = pq − c(q | K ),where c(q|K) is the total cost of producing given that the firm currently has capital K.
Assuming the firm produces at all, the firm maximizes profits by choosing the quantity
qs satisfying 0 = p − c′(qs | K ) , that is, choosing the quantity where price equals marginalcost. However, this is a good strategy only if producing a positive quantity is desirable,c(qs | K ) − c(0, K ).
that is, if pqs − c(qs | K ) ≥ −c(0, K ), which can be rewritten as p ≥qs
The right-hand-side of this inequality is the average variable cost of production, andthus the inequality implies that a firm will produce provided price exceeds the averagevariable cost. Thus, the profit-maximizing firm produces the quantity qs where priceequals marginal cost, provided price is as large as minimum average variable cost. If
price falls below minimum average variable cost, the firm shuts down.

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The behavior of the competitive firm is illustrated in Figure 4-7. The thick line
represents the choice of the firm as a function of the price, which is on the vertical axis.
Thus, if the price is below the minimum average variable cost (AVC), the firm shuts
down. When price is above the minimum average variable cost, the marginal cost gives
the quantity supplied by the firm. Thus, the choice of the firm is composed of two
distinct segments – the marginal cost, where the firm produces the output where priceequals marginal cost, and shutdown, where the firm makes a higher profit, or loses lessmoney, by producing zero.
Figure 4-7 also illustrates the average total cost, which doesn’t affect the short term
behavior of the firm but does affect the long term behavior, because when price is below
average total cost, the firm is not making a profit, but instead would prefer to exit overthe long term. That is, when the price is between the minimum average variable cost
and the minimum average total cost, it is better to produce than to shut down, but thereturn on capital was below the cost of capital. With a price in this intermediate area, afirm would produce, but would not replace the capital, and thus would shut down in thelong-term if the price is expected to persist. As a consequence, minimum average total
cost is the long-run “shut down” point for the competitive firm. (Shutdown may refer toreducing capital rather that literally setting capital to zero.) Similarly, in the long term,
the firm produces the quantity where the price equals the long-run marginal cost.
p
MC
ATC

AVC

q
Figure 4-7: Short-Run Supply

Figure 4-7 illustrates one other fact: the minimum of average cost occurs at the pointthat marginal cost equals average cost. To see this, let C(q) be total cost, so that average
cost is C(q)/q. Then the minimum of average cost occurs at the point satisfying:

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0=

d C (q) C ′(q) C (q)
=
−
.
dq q
q
q2

But this can be rearranged to imply C ′(q) =C (q ), that is, marginal cost equals averageqcost at the minimum of average cost.
The long-run marginal cost has a complicated relationship to short-run marginal cost.
The problem in characterizing the relationship between long-run and short-run
marginal costs is that some costs are marginal in the long-run that are fixed in the shortrun, tending to make long-run marginal costs larger than short-run marginal costs.
However, in the long-run, the assets can be configured optimally, while some assets are
fixed in the short-run, and this optimal configuration tends to make long-run costs
lower.
Instead, it is more useful to compare the long-run average total costs and short-run
average total costs. The advantage is that capital costs are included in short-run average
total costs. The result is a picture like Figure 4-8.
p
SRMC
SRAC
LRATC
SRAVC

q
Figure 4-8: Average and Marginal Costs

In Figure 4-8, the short-run is unchanged – there is a short-run average cost, short-run
average variable cost, and short-run marginal cost. The long-run average total cost has
been added, in such a way that the minimum average total cost occurs at the same point
as the minimum short-run average cost, which equals the short-run marginal cost. Thisis the lowest long-run average cost, and has the nice property that long-run average costequals short-run average total cost equals short-run marginal cost. However, for a

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different output by the firm, there would necessarily be a different plant size, and thethree-way equality is broken. Such a point is illustrated in Figure 4-9.
In Figure 4-9, the quantity produced is larger than the quantity that minimizes long-run
average total cost. Consequently, as is visible in the picture, the quantity where shortrun average cost equals long-run average cost does not minimize short-run average cost.
What this means is that a factory designed to minimize the cost of producing aparticular quantity won’t necessarily minimize short-run average cost. Essentially,
because the long-run average total cost is increasing, larger plant sizes are getting
increasingly more expensive, and it is cheaper to use a somewhat “too small” plant andmore labor than the plant size with the minimum short-run average total cost.
However, this situation wouldn’t likely persist indefinitely, because, as we shall see,competition tend to force price to the minimum long-run average total cost, and at thatpoint, we have the three-way equality between long-run average total cost, short-run
average total cost, and short-run marginal cost.
p
SRMC
SRAC
LRATC
SRAVC

q
Figure 4-9: Increased Plant Sizeq2
, where capital
2K
K is fixed in the short-run. What is short-run average total cost and marginal
cost? Plot these curves. For a given quantity q0, what level of capital minimizes
total cost? What is the minimum average total cost of q0?

4.1.7.1 (Exercise)

Suppose a company has total cost given by rK +4.1.8 Economies of Scale and Scope
An economy of scale – that larger scale lowers cost – arises when an increase in output
reduces average costs. We met economies of scale, and their opposite, diseconomies of

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scale, in the previous section, with an example where long-run average total cost initiallyfell, then rose, as quantity was increased.
What makes for an economy of scale? Larger volumes of productions permit the
manufacture of more specialized equipment. If I am producing a million identical
automotive tail lights, I can spend $50,000 on an automated plastic stamping machineand only affect my costs by five cents each. In contrast, if I am producing 50,000 units,
the stamping machine increases my costs by a dollar each, and is much less economical.
Indeed, it is somewhat more of a puzzle as to what produces a diseconomy of scale. An
important source of diseconomies are managerial in nature – organizing a large,
complex enterprise is a challenge, and larger organizations tend to devote a larger
percentage of their revenues to management of the operation. A bookstore can be run
by a couple of individuals who rarely if ever engage in management activities, where a
giant chain of bookstores needs finance, human resource, risk management and other“overhead” type expenses just in order to function. Informal operation of small
enterprises is replaced by formal procedural rules in large organizations. This idea ofmanagerial diseconomies of scale is reflected in the aphorism that “A platypus is a duckdesigned by a committee.”
In his influential 1975 book The Mythical Man-Month, IBM software manager Fred
Books describes a particularly severe diseconomy of scale. Adding software engineers to
a project increases the number of conversations necessary between pairs of individuals.
If there are n engineers, there are ½ n (n – 1) pairs, so that communication costs rise at
the square of the project size. This is pithily summarized in Brooks’ Law: "Adding
manpower to a late software project makes it later."
Another related source of diseconomies of scale involves system slack. In essence, it iseasier to hide incompetence and laziness in a large organization than in a small one.
There are a lot of familiar examples of this insight, starting with the Peter Principle,
which states that people rise in organizations to the point of their own incompetence,
which means eventually people cease to do the jobs that they do well.30 That slack grows
as an organization grows implies an diseconomy of scale.
Generally, for many types of products, economies of scale from production technology
tend to reduce average cost, up to a point where the operation becomes difficult tomanage, at which point diseconomies tend to prevent the firm from economicallygetting larger. Under this view, improvements in information technologies over the past
twenty years have permitted firms to get larger and larger. While that seems logical, infact firms aren’t getting that much larger than they used to be, and the share of output
produced by the top thousand firms has been relatively steady. That is, the growth in
the largest firms just mirrors world output growth.
Related to an economy of scale is an economy of scope. An economy of scope is areduction in cost associated with producing several distinct goods. For example,
Boeing, which produces both commercial and military jets, can amortize some of its
R&D costs over both types of aircraft, thereby reducing the average costs of each. Scope
30 Laurence Johnston Peter (1919–1990).

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economies work like scale economies, except they account for advantages of producing
multiple products, where scale economies involve an advantage of multiple units of thesame product.
Economies of scale can operate at the level of the individual firm but can also operate at
an industry level. Suppose there is an economy of scale in the production of an input.
For example, there is an economy of scale in the production of disc drives for personal
computers. That means an increase in the production of PCs will tend to lower the priceof disc drives, reducing the cost of PCs, which is a scale economy. In this case, it doesn’t
matter to the scale economy whether one firm or many firms are responsible for theincreased production, and this is known as an external economy of scale or an industry
economy of scale, because the scale economy operates at the level of the industry rather
than in the individual firm. Thus, the long-run average cost of individual firms may beflat, while the long-run average cost of the industry slopes downward.
Even in the presence of an external economy of scale, there may be diseconomies ofscale at the level of the firm. In such a situation, the size of any individual firm is limitedby the diseconomy of scale, but nonetheless the average cost of production is decreasingin the total output of the industry, through the entry of additional firms. Generally there
is an external diseconomy of scale if a larger industry drives up input prices, for example
increasing land costs. Increasing the production of soybeans significantly requires using
land that isn’t so well suited for them, tending to increase the average cost of
production. Such a diseconomy is an external diseconomy rather than operating at theindividual farmer level. Second, there is an external economy if an increase in output
permits the creation of more specialized techniques and a greater effort in R&D to lower
costs. Thus, if an increase in output increases the development of specialized machine
tools and other production inputs, an external economy will be present.
An economy of scale arises when total average cost falls as the number of units produced
rises. How does this relate to production functions? We let y=f(x1,x2,…,xn) be theoutput when the n inputs x1, x2,…,xn are used. A rescaling of the inputs involves
increasing the inputs by a fixed percentage, e.g. multiplying them all by the constant λ(the Greek letter lambda), where λ>1. What does this do to output? If output goes up
by more than λ, we have an economy of scale (also known as increasing returns toscale): scaling up production increases output proportionately more. If output goes up
by less than λ, we have a diseconomy of scale or decreasing returns to scale. And
finally, if output rises by exactly λ, we have constant returns to scale. How does thisrelate to average cost? Formally, we have an economy of scale iff (λx1 , λx2 ,K, λx n ) > λf ( x1 , x2 ,K, x n ) if λ>1.
This corresponds to decreasing average cost. Let w1 be the price of input 1, w2 the priceof input 2, and so on. Then the average cost of producing y=f(x1,x2,…,xn) is
AVC =w1 x1 + w2 x2 + ... + wn x n.
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What happens to average cost as we scale up production by λ>1? Call this AVC(λ).
w1λx1 + w2λx2 + ... + wn λx n
w x + w2 x2 + ... + wn x n=λ 1 1f (λx1 , λx2 ,K, λx n )f (λx1 , λx2 ,K, λx n )λf ( x1 , x2 ,K, x n )=AVC (1)f (λx1 , λx2 ,K, λx n )AVC(λ) =Thus, average cost falls if there is an economy of scale and rises if there is a diseconomy
of scale.
Another insight about the returns to scale concerns the value of the marginal product of
inputs. Note that, if there are constant returns to scale:
x1

∂f
∂f
∂f
d
+ x2
+ ...x n=f (λx1 , λx2 ,K, λx n )
=
∂x1
∂x2
∂x n dλλ→1

f (λx1 , λx2 ,K, λx n ) − f ( x1 , x2 ,K, x n )= f ( x1 , x2 ,K, x n )
λ −1
λ→1
∂f
∂f
The valueis the marginal product of input x1, and similarlyis the marginal∂x1∂x2
product of input 2, and so on. Consequently, if the production function exhibits
constant returns to scale, it is possible to divide up output in such a way that each input∂fto the suppliers
receives the value of the marginal product. That is, we can give x1∂x1∂f
to the suppliers of input 2, and so on, and this exactly uses up the allof input 1, x2∂x2
the output. This is known as “paying the marginal product,” because each supplier ispaid the marginal product associated with the input.
= lim

If there is a diseconomy of scale, then paying the marginal product is feasible, but there
is generally something left over, too. If there are increasing returns to scale (aneconomy of scale), then it is not possible to pay all the inputs their marginal product,
∂f
∂f
∂f
+ x2
+ K xn> f ( x1 , x2 ,K, x n ).
that is, x1
∂x1
∂x2
∂x n

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4.1.8.1 (Exercise)

Given the Cobb-Douglas production functionaaf ( x1 , x2 ,..., x n ) = x1 1 x2 2 ... x nan , show there is constant returns to scale if
a1 + a2 + Kan = 1 , increasing returns to scale if a1 + a2 + Kan > 1 , anddecreasing returns to scale if a1 + a2 + Kan < 1 .
q2
4.1.8.2 (Exercise) Suppose a company has total cost given by rK +where capital
2K
K can be adjusted in the long-run. Does this company have an economy ofscale, diseconomy of scale, or constant returns to scale in the long-run?
4.1.8.3 (Exercise)A production function f is homogeneous of degree r iff (λx1 , λx2 ,K, λx n ) = λr f ( x1 , x2 ,K, x n ) . Consider a firm with a production
function that is homogeneous of degree r. Suppose further that the firm pays
the value of marginal product for all its inputs. Show that the portion ofrevenue left over is 1 – r.

4.2 Perfect Competition Dynamics
The previous section developed a detailed analysis of how a competitive firm responds
to price and input cost changes. In this section, we consider how a competitive market
responds to demand or cost changes.

4.2.1 Long-run Equilibrium
The basic picture of a long-run equilibrium is presented in Figure 4-10. There are three
curves, all of which are already familiar. First, there is demand, considered in the firstchapter. Here demand is taken to be the “per period” demand. Second, there is theshort-run supply, which reflects two components – a shut down point at minimum
average variable cost, and quantity such that price equals short-run marginal cost abovethat level. The short-run supply, however, is the market supply level, which means itsums up the individual firm effects. Finally, there is the long-run average total cost at
the industry level, thus reflecting any external diseconomy or economy of scale. As
drawn in Figure 4-10, there is no long-run scale effect. The long-run average total costis also the long-run industry supply.31
As drawn, the industry is in equilibrium, with price equal to P0, which is the long-run
average total cost, and also equating short-run supply and demand. That is, at the priceof P0, and industry output of Q0, no firm wishes to shut down, no firm can make positive
profits from entering, there is no excess output, and no consumer is rationed. Thus, nomarket participant has an incentive to change their behavior, so the market is in both
long-run and short-run equilibrium.

31 This may seem confusing, because supply is generally the marginal cost, not the average cost.

However, because a firm will quit producing in the long term if price falls below its minimum average
cost, the long-term supply is just the minimum average cost of the individual firms, because this is themarginal cost of the industry.

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SRS

p

P0

LRATC=LRSD
Q
Q0
Figure 4-10: Long-Run Equilibrium

4.2.2 Dynamics with Constant Costs
Now consider an increase in demand. Demand might increase because of population
growth, or because a new use for an existing product is developed, or because of income
growth, or because the product becomes more useful. For example, the widespread
adoption of the Atkins diet increased demand for high protein products like beef jerky
and eggs. Suppose that the change is expected to be permanent. This is importantbecause the decision of a firm to enter is based more on expectations of future demandthan on present demand.
Figure 4-11 reproduces the equilibrium figure, but with the curves “grayed out” toindicate a starting position, and a darker new demand curve, labeled D1.
The initial effect of the increased demand is that the price is bid up, because there isexcess demand at the old price P0. This is reflected by a change in both price andquantity to P1 and Q1, to the intersection of the short-run supply SRS and the new
demand curve. This is a short-run equilibrium, and persists temporarily because, in the
short-run, the cost of additional supply is higher.
At the new, short-run equilibrium, price exceeds the long-run supply cost. This higher
price attracts new investment in the industry. It takes some time for this newinvestment to increase the quantity supplied, but over time the new investment leads toincreased output, and a fall in the price, as illustrated in Figure 4-12.

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SRS

P
P1

P0

LRATC=LRS

D1
D0
Q
Q0

Q1

Figure 4-11: A Shift in Demand

SRS0

P

SRS2

P1

P0

LRATC=LRS

D1
D0
Q
Q0

Q1

Q2

Figure 4-12: Return to Long-Run Equilibrium

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As new investment is attracted into the industry, the short-run supply shifts to the right,
because with the new investment, more is produced at any given price level. This is
illustrated with the darker short-run supply, SRS2. The increase in price causes theprice to fall back to its initial level, and the quantity to increase still further to Q2.
It is tempting to think that the effect of a decrease in demand just retraces the steps ofan increase in demand, but that isn’t correct. In both cases, the first effect is theintersection of the new demand with the old short-run supply. Only then does theshort-run supply adjust to equilibrate the demand with the long-run supply. That is, theinitial effect is a short-run equilibrium, followed by adjustment of the short-run supply
to bring the system into long-run equilibrium. Moreover, a small decrease in demandcan have a qualitatively different effect in the short-run than a large decrease indemand, depending on whether the decrease is large enough to induce immediate exit offirms. This is illustrated in Figure 4-13.
P

SRS2

SRS0

LRS

D1
D0
Q
Figure 4-13: A Decrease in Demand

In Figure 4-13, we start at the long-run equilibrium where LRS and D0 and SRS0 all
intersect. If demand falls to D1, the price falls to the intersection of the new demand andthe old short-run supply, along SRS0. At that point, exit of firms reduces the short-run
supply and the price rises, following along the new demand D1.
If, however, the decrease in demand is large enough to push the industry to minimum
average variable cost, there is immediate exit. In Figure 4-14, the fall in demand from
D0 to D1 is sufficient to push the price to minimum average variable cost, which is the
shutdown point of suppliers. Enough suppliers have to shutdown to keep the price atthis level, which induces a shift in of the short-run supply, to SRS1. Then there is

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additional shutdown, shifting the short-run supply in still further, but driving up theprice (along the demand curve) until the long-term equilibrium is reached.
SRS1

P

SRS0

SRS2

LRS

D1

D0
Q

Figure 4-14: A Big Decrease in Demand

Consider an increase in the price of an input into production. For example, an increasein the price of crude oil increases the cost of manufacturing gasoline. This tends todecrease (shift up) both the long-run supply and the short-run supply, by the amount of
the cost increase. The effect is illustrated in Figure 4-15. The increased costs reduce
both the short-run supply (prices have to be higher to in order to produce the same
quantity) and the long-run supply. The short-run supply shifts upward to SRS1, and thelong-run supply to LRS2. The short-run effect is to move to the intersection of the shortrun supply and demand, which is at the price P1 and the quantity Q1. This price is below
the long-run average cost, which is the long-run supply, so over time some firms don’t
replace their capital and there is disinvestment in the industry. This disinvestment
causes the short-run supply to be reduced (move left) to SRS2.
The case of a change in supply is more challenging because both the long-run supply
and the short-run supply are shifted. But the logic – start at a long-run equilibrium,then look for the intersection of current demand and short-run supply, then look for theintersection of current demand and long-run supply – is the same whether demand or
supply has shifted.

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SRS2

SRS1
SRS0

P

P2
P1
P0

LRS2
LRS0

D0
Q2 Q1 Q0

Q

Figure 4-15: A Decrease in Supply

4.2.3 General Long-run Dynamics
The previous section made two simplifying assumptions that won’t hold in all
applications of the theory. First, it assumed constant returns to scale, so that long-run
supply is horizontal. A perfectly elastic long-run supply means that price always
eventually returns to the same point. Second, the theory didn’t distinguish long-run
from short-run demand. But with many products, consumers will adjust more over the
long-term than immediately. As energy prices rise, consumers buy more energyefficient cars and appliances, reducing demand. But this effect takes time to be seen, as
we don’t immediately scrap our cars in response to a change in the price of gasoline.
The short-run effect is to drive less in response to an increase in the price, while thelong-run effect is to choose the appropriate car for the price of gasoline.
To illustrate the general analysis, we start with a long-run equilibrium. Figure 4-16
reflects a long-run economy of scale, because the long-run supply slopes downward, sothat larger volumes imply lower cost. The system is in long-run equilibrium because theshort-run supply and demand intersection occurs at the same price and quantity as thelong-run supply and demand intersection. Both short-run supply and short-run
demand are less elastic than their long-run counterparts, reflecting greater substitution
possibilities in the long-run.

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SRS0

P

0

LRS

LRD0
SRD0

Q
Figure 4-16: Equilibrium with External Scale Economy

Now consider a decrease in demand, decreasing both short-run and long-run demand.
This is illustrated in Figure 4-17. To reduce the proliferation of curves, we color the olddemand curves very faintly, and mark the initial long-run equilibrium with a zero insidea small rectangle.32 The intersection of short-run supply and short-run demand ismarked with the number 1. Both long-run supply and long-run demand are more elastic
than their short-run counterparts, which has an interesting effect. The short-run
demand tends to shift down over time, because the price associated with the short-run
equilibrium is above the long-run demand price for the short-run equilibrium quantity.
However, the price associated with the short-run equilibrium is below the long-run
supply price at that quantity. The effect is that buyers see the price as too high, and are
reducing their demand, while sellers see the price as too low, and so are reducing their
supply. Both short-run supply and short-run demand fall, until a long-run equilibriumis achieved.
In this case, the long-run equilibrium involves higher prices, at the point labeled 2,
because of the economy of scale in supply. This economy of scale means that the
reduction in demand causes prices to rise over the long-run. The short-run supply anddemand eventually adjust to bring the system into long-run equilibrium, as Figure 4-18
illustrates. The new long-run equilibrium has short-run demand and supply curves
associated with it, and the system is in long-run equilibrium because the short-run
demand and supply, which determine the current state of the system, intersect at the
32 The short-run demand and long-run demand have been shifted down by the same amount, that is, bothreflect an equal reduction in value. This kind of shift might arise if, for instance, a substitute had become
cheaper, but the equal reduction is not essential to the theory. In addition, the fact of equal reductions
often isn’t apparent from the diagram, because of the different slopes – to most observers, it appears thatshort-run demand fell less than long-run demand. This isn’t correct, however, and one can see thisbecause the intersection of the new short-run demand and long-run demand occurs directly below theintersection of the old curves, implying both fell by equal amounts.

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same point as the long-run demand and supply, which determine where the system isheading.
SRS0

P

2
0

LRS

1

LRD0
SRD0
SRD1

LRD1
Q

Figure 4-17: Decrease in Demand

SRS2
SRS0

P

2
0

LRS

1

SRD2

LRD0
SRD0
SRD1

LRD1
Q

Figure 4-18: Long-run After a Decrease in Demand

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There are four basic permutations of the dynamic analysis – demand increase or
decrease, and a supply increase or decrease. Generally, it is possible for long-run supply
to slope down – this is the case of an economy of scale – and for long-run demand toslope up.33 This gives sixteen variations of the basic analysis. In all sixteen cases, theprocedure is the same. Start with a long-run equilibrium, shift both the short-run andlong-run levels of either demand or supply. The first stage is the intersection of theshort-run curves. The system will then go to the intersection of the long-run curves.
An interesting example of competitive dynamics concepts is the computer memory
market, which was discussed above. Most of the costs of manufacturing computer
memory are fixed costs. The modern DRAM plant costs several billion dollars; the costof other inputs – chemicals, energy, labor, silicon wafers – are modest in comparison.
Consequently, the short-run supply is vertical until prices are very, very low; at any
realistic price, it is optimal to run these plants 100% of the time.34 The nature of thetechnology has let manufacturers cut the costs of memory by about 30% per year overthe past forty years, demonstrating that there is a strong economy of scale inproduction. These two features – vertical short-run supply, strong economies of scale –are illustrated in the Figure 4-19. The system is started at the point labeled with thenumber 0, with a relatively high price, and technology which has made costs lower that
this price. Responding to the profitability of DRAM, short-run supply shifts out (newplants are built and die-shrinks permits increasing output from existing plants). The
increased output causes prices to fall, relatively dramatically because short-run demandis inelastic, and the system moves to the point labeled 1. The fall in profitability causes
DRAM investment to slow, which lets demand catch up, boosting prices to the pointlabeled 2. (One should probably think of Figure 4-19 as being in a logarithmic scale.)
The point labeled with the number 2 looks qualitatively similar to the point labeled 1.
The prices have followed a “saw-tooth” pattern, and the reason is due to the relatively
slow adjustment of demand compared to supply, as well as the inelasticity of short-run
demand, which creates great price swings as short-run supply shifts out. Supply can beincreased quickly, and is increased “in lumps” because a die-shrink (making the chips
smaller so that more fit on a given silicon wafer) tends to increase industry production
by a large factor. This process can be repeated starting at the point labeled 2. The
system is marching inexorably toward a long-run equilibrium in which electronic
memory is very, very cheap even by 2004 standards and used in applications thathaven’t yet been considered, but the process of getting there is a wild ride, indeed. The
saw-tooth pattern is illustrated in Figure 4-20, which shows DRAM industry revenues inbillions of dollars from 1992 to 2003, and projections of 2004 and 2005.35
33 The demand situation analogous to an economy of scale in supply is a network externality, in which theaddition of more users of a product increases the value of the product. Telephones are a clear example –suppose you were the only person with a phone – but other products like computer operating systems andalmost anything involving adoption of a standard represent examples of network externalities. When theslope of long-run demand is greater than the slope of long-run supply, the system will tend to beinefficient, because an increase in production produces higher average value and lower average cost. This
usually means there is another equilibrium at a greater level of production.
34 The plants are expensive in part because they are so clean, because a single speck of dust falling on achip ruins the chip. The Infineon DRAM plant in Virginia stopped operations only when a snow-storm
prevented workers and materials from reaching the plant.
35 Two distinct data sources were used, which is why there are two entries for each of 1998 and 1999.

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P
0

2

1

SRS0

SRS1

LRD

SRD0 SRD2LRS

Q

Figure 4-19: DRAM Market

$50
$40
$30
$20
$10
$0
1992

1994

1996

1998

2000

2002

2004

Figure 4-20: DRAM Revenue Cycle

4.2.3.1 (Exercise) Land close to the center of a city is in fixed supply, but it can beused more intensively by using taller buildings. When the population of a city
increases, illustrate the long- and short-run effects on the housing markets
using a graph.
4.2.3.2 (Exercise) Emus can be raised on a wide variety of ranch land, so that there
are constant returns to scale in the production of emus in the long-run. In the
short-run, however, the population of emus is limited by the number ofbreeding pairs of emus and the supply is essentially vertical. Illustrate the longand short-run effects of an increase in demand for emus. (In the late 1980s,

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there was a speculative bubble in emus, with prices reaching $80,000 per
breeding pair, in contrast to $2,000 or so today.)
4.2.3.3 (Exercise) There are long-run economies of scale in the manufacture ofcomputers and their components. There was a shift in demand away fromdesktop computers and toward notebook computers around the year 2001.
What are the short- and long-run effects? Illustrate your answer with two
diagrams, one for the notebook market and one for the desktop market.
Account for the fact that the two products are substitutes, so that if the price ofnotebook computers rises, some consumers shift to desktops. (To answer thisquestion, start with a time 0 and a market in long-run equilibrium. Shiftdemand for notebooks out and demand for desktops in. What happens in the
short-run? What happens in the long-run to the prices of each? What does thatprice effect do to demand for each?)

4.3 Investment
The distinction between the short-run supply and the long-run supply is governed by
the time that investment takes. Some of the difference between the short-run demand
and the long-run demand arises because we don’t scrap capital goods – cars, fridges,
and air conditioners – in response to price changes. In both cases, investment is an
important component of the responsiveness of supply and demand. In this section, we
take a first look at investment. We will take a second look at investment from asomewhat different perspective later when we consider basic finance tools near the endof the book. Investment goods require expenditures today to produce future value, so
we begin the analysis by examining the value of future payments.

4.3.1 Present value
The promise of $1 in the future is not worth $1 today. There are a variety of reasons why
a promise of future payments is not worth the face value today, some of which involverisk that the money may not be paid. Let’s set aside such risk for the moment; we’ll
consider risk separately later. Even when the future payment is perceived to occur withnegligible risk, nevertheless most people prefer $1 today to $1 payable a year hence.
One way of expressing this is that the present value – the value today – of a future
payment of a dollar is less than a dollar. From a present value perspective, future
payments are discounted.
From the individual perspective, one reason that you should value a future payment lessthan a current payment is due to arbitrage.36 Suppose you are going to need $10,000
one year from now, to put a down-payment on a house. One way of producing $10,000
is to buy a government bond that pays $10,000 a year from now. What will that bondcost you? At current interest rates, a secure bond37 will cost around $9700. This means
36 Arbitrage is the process of buying and selling in such a way to make a profit.

For example, if wheat isselling for $3 per bushel in New York, but $2.50 per bushel in Chicago, one can buy in Chicago and sell in
New York and profit by $0.50 per bushel, minus any transaction and transportation cost. Such arbitrage
tends to force prices to differ by no more than transaction costs. When these transaction costs are small,as with gold, prices will be about the same worldwide.
37 Economists tend to consider US federal government securities secure, because the probability of such a
default is very, very low.

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that no one should willing to pay $10,000 for a future payment of $10,000, because
instead one can have the future $10,000, by buying the bond, and have $300 left over tospend on cappuccinos or economics textbooks. In other words, if you will pay $10,000
for a secure promise to repay the $10,000 a year hence, then I can make a successful
business selling you the secure promise for $10,000, and pocketing $300.
This arbitrage consideration also suggests how to value future payments: discount themby the relevant interest rate.
Example (Auto loan): You are buying a $20,000 car, and you are offered the choice to
pay it all today in cash, or to pay $21,000 in one year. Should you pay cash (assuming
you have that much in cash) or take the loan? The loan is at a 5% annual interest rate,
because the repayment is 5% higher than the loan amount. This is a good deal for you if
your alternative is to borrow money at a higher interest rate, e.g. on (most) credit cards.
It is also a good deal if you have savings that pay more than 5% -- if buying the car withcash entails cashing in a certificate of deposit that pays more than 5%, then you would
be losing the difference. If, on the other hand, you are currently saving money that pays
less than 5% interest, paying off the car is a better deal.
The formula for present value is to discount by the amount of interest. Let’s denote theinterest rate for the next year as r1, the second year’s rate as r2, and so on. In thisnotation, a $1 invested would pay $1+r1 next year, or $(1+r1)×(1+r2) after 2 years, or$(1+r1)×(1+r2)×(1+r3) after 3 years. That is, ri is the interest rate that determines thevalue, at the end of year i, of $1 invested at the start of year i. Then, if we obtain astream of payments A0 immediately, A1 at the end of year 1, A2 at the end of year 2, andso on, the present value of that stream is
PV = A0 +

A1
A2
A2
+
+
+ ...
1 + r1 (1 + r1 )(1 + r2 ) (1 + r1 )(1 + r2 )(1 + r3 )Example (Consolidated annuities or Consols): What is the value of $1 paid at the end ofeach year forever, with a fixed interest rate r? Suppose the value is v. Then38
v=

1
1
1
1
1
+
+
+ ... =
−1 = .
1r
1 + r (1 + r )2 (1 + r )3
1−
1+r

At a 5% interest rate, $1 million per year paid forever is worth $20 million today. Bonds
that pay a fixed amount every year forever are known as consols; no current government
issues consols.
Example (Mortgages): Again, fix an interest rate r, but this time let r be the monthly
interest rate. A mortgage implies a fixed payment per month for a large number of

38 This development uses the formula, for -1<a<1, that

Note that this formula involves an infinite series.

1= 1 + a + a 2 + ... which is readily verified.
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months (e.g. 360 for a 30 year mortgage). What is the present value of these payments
over n months? A simple way to compute this is to use the consol value, because
M=

1
1
1
1
1
1
1
1
+
+
+ ... +
= −
−
−
....
1 + r (1 + r )2 (1 + r )3
(1 + r )n r (1 + r )n +1 (1 + r )n +2 (1 + r )n +3

=

⎛ 1
⎞
1
1
1
1
⎜
⎟
−
+
+
...
r (1 + r )n ⎜⎝ (1 + r ) (1 + r )2 (1 + r )3 ⎟⎠

=

⎞
1
1
1 1 ⎛⎜
1⎟.
−= ⎜1 −r (1 + r )n r r ⎝ (1 + r )n ⎟⎠Thus, at a monthly interest rate of ½%, paying $1 per month for 360 months produces a⎞1 ⎛⎜1⎟. = 166.79 Thus, to borrow $100,000, one
1−present value M of.005 ⎜⎝ (1.005)360 ⎟⎠$100,000= $599.55 per month. It is important to remember that awould have to pay
166.79different loan amount just changes the scale; borrowing $150,000 requires a payment of$150,000= $899.33 per month, because $1 per month generates $166.79 in present
166.79value.
Example (Simple and Compound Interest): In the days before calculators, it was achallenge to actually solve interest rate formulas, so certain simplifications were made.
One of these was “simple” interest, which means that daily or monthly rates aretranslated into annual rates by incorrect formulas. For example, with an annual rate of5%= .07692% . That this is incorrect can be seen
5%, the simple interest daily rate is
365
365

.05 ⎞
⎛
= 1.051267% Simple interest increases thefrom the calculation that ⎜ 1 +⎟⎝ 365 ⎠
annual rate, so it benefits lenders and harms borrowers. (Consequently, banks advertisethe accurate annual rate on savings accounts – when consumers like the number to belarger – and not on mortgages, although banks are required by law to disclose – but not
to advertise widely – actual annual interest on mortgages.)
Obligatory Lottery Example: You win the lottery, and the paper reports you’ve won $20
million. You’re going to be paid $20 million, but is it worth $20 million? In fact, you
get $1 million per year for 20 years. However, in contrast to our formula, you get thefirst million right off the bat, so the value is
PV = 1 +

⎞
1
1
1
1
1⎛
1
⎟.
+
+
+ ... +
= 1 + ⎜⎜ 1 −r ⎝ (1 + r )19 ⎟⎠1 + r (1 + r )2 (1 + r )3
(1 + r )19

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Table 3.1 computes the present value of our $20 million dollar lottery, listing the resultsin thousands of dollars, at various interest rates. At ten percent interest, the value of thelottery is less than half the “number of dollars” paid, and even at 5%, the value of thestream of payments is 65% of the face value.
r
3%
4%
5%
6%
7%
10%
PV (000s) $15,324 $14,134 $13,085 $12,158 $11,336 $9,365
The lottery example shows that interest rates have a dramatic impact on the value of
payments made in the distant future. Present value analysis is the number one tool used
in MBA programs, where it is known as Net Present Value or NPV analysis. It is
accurate to say that the majority of corporate investment decisions are guided by an
NPV analysis.
Example (Bond prices): A standard treasury bill has a fixed future value. For example it
may pay $10,000 in one year. It is sold at a discount off the face value, so that a oneyear $10,000 bond might sell for $9,615.39, producing a 4% interest rate. To computethe effective interest rate r, the formula relating the future value FV, the number ofyears n, and the price is(1 + r )n1

FV⎛ FV ⎞ n=, or r = ⎜⎟ − 1.
Price⎝ Price ⎠We can see from either formula that treasury bill prices move inversely to interest rates– an increase in interest rates reduces treasury prices. Bonds are a bit more
complicated. Bonds pay a fixed interest rate set at the time of issue during the life of thebond, generally collected semi-annually, and the face value is paid at the end of theterm. These bonds were often sold on long terms, as much as 30 years. Thus, a threeyear $10,000 bond at 5% with semi-annual payments would pay $250 at the end of eachhalf year for three years, and pay $10,000 at the end of the three years. The net present
value, with an annual interest rate r, is
NPV =

$250

+

$250

(1 + r ) 2 (1 + r )
1

1

+

$250
3

(1 + r ) 2

+

$250

(1 + r )

2

+

$250
5

(1 + r ) 2

+

$250

(1 + r )3+$10000(1 + r )3.

The net present value will be the price of the bond. Initially, the price of the bondshould be the face value, since the interest rate is set as a market rate. The U.S.
Treasury quit issuing such bonds in 2001, replacing them with bonds in which the facevalue is paid and then interest paid semi-annually.
At a 7% annual interest rate, what is the present value of $100 paid
4.3.1.1 (Exercise)at the end of one year, and $200 paid at the end of the second year?
4.3.1.2 (Exercise) Compute the NPV of the 3 year, $10,000 bond, with $250 payments
semi-annually, that was described above, at an interest rate of 4%.

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4.3.1.3 (Exercise) You can finance your $20,000 car with a straight 5% loan paid
monthly over 5 years, or get one year interest free, but then pay 7% over thefollowing four years. Which is a better deal? (Hint: In both cases, figure out the
fixed monthly payments that produce a net present value equal to $20,000.)
4.3.1.4 (Exercise) You win the lottery. At what interest rate should you accept $7
million today over twenty annual payments of $500,000?

4.3.2 Investment
A simple investment project involves spending an investment, I, and then reaping a
return over time. If you dig a mine, drill an oil well, build an apartment building or afactory, or buy a share of stock, you spend money now, in the hopes of earning money
subsequently. We will set aside the very important risk issue until the next subsection,
and ask how to make the decision to invest.
The NPV approach involves assigning a rate of return r that is reasonable for, andspecific to, the project and then computing the present value of the expected stream of
payments. Since the investment is initially expended, it is counted as negative revenue.
This gives an expression that looks like:
NPV = − I +

R3
R1
R2
+
+
+ ....
1 + r (1 + r )2 (1 + r )3

where R1 represents first year revenues, R2 represents second year revenues, etc.39 The
investment is then made when NPV is positive – since this would add to the net value ofthe firm.
Carrying out an NPV analysis essentially requires two things. First, investment andrevenues must be estimated. This is a challenge, especially for new products where
there is no direct way of estimating demand, or with uncertain outcomes like oil wells or
technological research.40 Second, an appropriate rate of return must be identified. The
rate of return is a problem, mostly because of risk associated with the payoffs to theinvestment, but also because of the incentives of project managers to inflate the payoffs
and minimize the costs to make the project look more attractive to upper management.
In addition, most investment undertaken by corporations is financed not withborrowing but with retained earnings, that is, with profits from previous activities. Thus
a company that undertakes one investment can’t carry out some other investment, andthe interest rate has to account for the internal corporate value of funds. As a result of
these factors, interest rates of 15%-20% are common for evaluating the NPV of projectsof major corporations.
39 The most common approach is to treat revenues within a year as if they are received at the midpoint,

and then discount appropriately for that mid-year point. The present discussion oversimplifies in thisregard.
40 The building of the famed Sydney Opera House, which looks like billowing sails over Sydney harbor,
was estimated to cost $7 million and actually cost $105 million. A portion of the cost overrun was due tothe fact that the original design neglected to install air conditioning. When this oversight was discovered,it was too late to install a standard unit, which would interfere with the excellent acoustics, so instead an
ice hockey floor was installed as a means of cooling the building.

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Example (Silver Mine): A company is considering whether to develop a silver mine in
Mexico. The company estimates that developing the mine (building roads and openinga large hole in the ground) would require $4 million per year for four years and norevenues would accrue during this time. Starting in year 5 the expenses fall to $2
million per year, and $6 million in net revenue is earned off the mined silver for each of
the subsequent 40 years. If the company values funds at 18%, should it develop themine?
The earnings from the mine are calculated in the following table. First, the NPV of theinvestment phase during years 0, 1, 2, and 3 isNPV = −4 +

−4
−4
−4
+
+
= −12.697.
2
1.18 (1.18)(1.18)3

A dollar earned in each of years 4 through 43 have a present value of
1(1 + r ) 4+

1(1 + r ) 5+

1(1 + r )6+ ... +

1
(1 + r ) 43

=

⎞
1⎛
1
⎟. = 13.377
× ⎜1 −
3 r⎜
40 ⎟(1 + r )⎝ (1 + r ) ⎠1

The mine is just profitable at 18%, in spite of the fact that its $4 million payments are
made in four years, after which point $4 million dollar revenues are earned for forty
years. The problem in the economics of mining is that 18% makes those future revenues
have quite modest present values.
Year Earnings ($M) / yr PV ($M)
0-3
-4-12.6974-43
413.377Net
0.810
There are other approaches to deciding whether to take an investment. In particular,
the Internal Rate of Return approach solves the equation NPV=0 for the interest rate,
and then the project is undertaken if the rate of return is sufficiently high. Thisapproach is flawed because the equation may have more than one solution, or nosolutions and it is not transparent what the right thing to do should be in these events.
Indeed, the IRR approach gets the profit-maximizing answer only if it agrees with NPV.
A second approach is the payback period, which asks how many years a project must be
run before profitability is reached. The problem with the payback period is deciding
between projects – if I can only do one of two projects, the one with the higher NPV
makes the most money for the company. The one with the faster payback may make aquite small amount of money very quickly; it isn’t apparent that this is a good choice.
When a company is in risk of bankruptcy, a short payback period might be valuable,
although this would ordinarily be handled by employing a higher interest rate in an NPV
analysis. NPV does a good job when the question is whether to undertake a project ornot, and it does better than other approaches to investment decisions. For this reason,
NPV has become the most common approach to investment decisions. Indeed, NPV
analysis is more common than all other approaches combined. NPV does a poor job,
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however, when the question is whether to undertake a project, or delay the project. Thatis, NPV answers “yes or no” to investment, but when the choice is “yes or wait,” NPV
requires amendment.
4.3.2.1 (Exercise) Suppose that, without a university education, you’ll earn $25,000
per year. A university education costs $20,000 per year, and you forgo the$25,000/year you would have earned for four years. However, you earn
$50,000 per year for the following forty years. At 7%, what is the NPV of theuniversity education?
4.3.2.2 (Exercise) Now that you’ve decided to go to university based on the previous
answer, suppose that you can attend East State U, paying $3,000 per year for
four years and earning $40,000 when you graduate, or North Private U, paying$22,000 per year for the four years and earning $50,000 when you graduate.
Which is the better deal at 7%?

4.3.3 Investment Under Uncertainty
Risk has a cost, and people, and corporations, buy insurance against financial risk.41
The standard approach to investment under uncertainty is to compute an NPV, with therevenues composed of expected values, and the interest rate used adjusted tocompensate for the risk.
For example, consider a project like oil exploration. The risks are enormous. Half of all
underwater tracts in the Gulf Coast near Louisiana and Texas that are leased are neverdrilled, because later information makes them a bad bet. Half of all the tracts that are
drilled are dry. So right off the bat, three-quarters of the tracts that are sold produce
zero or negative revenue, and positive costs. To see how the economics of such a risky
investment might be developed, suppose that the relevant rate of return for suchinvestments is 18%. Suppose further the tract can be leased for $500,000 and the initial
exploration costs $1 million. If the tract has oil (with a 25% probability), it produces $1
million per year for twenty years, and then runs dry. This gives an expected revenue of$250,000 per year. To compute the expected net present value, we first compute thereturns:
Table 4-1: Oil Tract Return

Expected revenue EPV
0-$1.5M-$1.5M
1-20 $0.25M$1.338M
Net-$0.162
At 18%, the investment is a loss – the risk is too great given the average returns.
A very important consideration for investment under uncertainty is the choice ofinterest rate. The most important thing to understand is that the interest rate is specific
41 For example, NBC spent $6 million in buying an insurance policy against US nonparticipation in the1980 Moscow summer Olympic games, and the US didn’t participate (because of the Soviet invasion of
Afghanistan), and NBC was paid $94 million from the policy.

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to the project, and not to the investor. This is perhaps the most important insight ofcorporate finance generally: the interest rate should adjust for the risk associated withthe project and not the investor. For example, suppose hamburger retailer McDonald’s
is considering investing in a cattle ranch in Peru. McDonald’s is overall a very low-risk
firm, but this particular project is quite risky, because of local conditions. McDonald’s
still needs to adjust for the market value of the risk it is undertaking, and that value is afunction of the project risk, not the risk of McDonald’s other investments.
This basic insight of corporate finance – the appropriate interest rate is determined by
the project, not the investor – is counter-intuitive to most of us because it doesn’t apply
to our personal circumstances. For individuals, the cost of borrowing money is mostly afunction of their own personal circumstances, and thus the decision of whether to pay
cash for a car or borrow the money is not so much a function of the car being purchased
but of the wealth of the borrower. Even so, personal investors borrow money at distinct
interest rates. Mortgage rates on houses are lower than interest rates on automobiles,
and interest rates on automobiles lower than on credit cards. This is because the“project” of buying a house has less risk associated for it: the percentage loss to thelender in event of borrower default is lower on a house than on a car. Credit cards carry
the highest interest rates because they are unsecured by any asset.
One way of understanding why the interest rate is project-specific but not investorspecific is to think about undertaking the project by creating a separate firm to make theinvestment. The creation of subsidiary units is a common strategy, in fact. Thissubsidiary firm created to operate a project has a value equal to the NPV of the projectusing the interest rate specific to the subsidiary, which is the interest rate for the project,independent of the parent. For the parent company, owning such a firm is a good thing
if the firm has positive value, and not otherwise.42
Investments in oil are subject to another kind of uncertainty: price risk. Prices of oil
fluctuate and aren’t constant. Moreover, oil pumped and sold today is not available forthe future. Should you develop and pump the oil you have today, or should you hold out
and sell in the future? This question, known as the option value of investment, isgenerally somewhat challenging and arcane, but a simple example provides a useful
insight.
To develop this example, let’s set aside some extraneous issues first. Consider a very
simple investment, in which either C is invested or not.43 If C is invested, a value V isgenerated. The cost C is a constant; it could correspond to drilling or exploration costs,
or in the case of a stock option, the strike price of the option, which is the amount one
pays to obtain the share of stock. The value V, in contrast, varies from time to time in arandom fashion. To simplify the analysis, we assume that V is uniformly distributed on
the interval [0,1], so that the probability of V falling in an interval [a, b] is b-a if0≤a≤b≤1. The option only has value if C<1, which we assume for the rest of this section.
42 It may seem that synergies between parent and subsidiary are being neglected here, but synergies
should be accounted for at the time they produce value, i.e. as part of the stream of revenues of thesubsidiary.
43 This theory is developed in striking generality by Avinash Dixit and Robert Pindyck, Investment Under
Uncertainty, Princeton University Press, 1994.

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The first thing to note is that the optimal rule to make the investment is cutoff value,that is, to set a level V0 and exercise the option if, and only if, V≥V0. This is because, if
you are willing to exercise the option and generate value V, you should be willing to
exercise the option and obtain even more value. The NPV rule simply says V0 = C, thatis, invest whenever it is profitable. The purpose of the example developed below is toprovide some insight into how far wrong the NPV rule will be when option values arepotentially significant.
Now consider the value of option to invest, given that the investment rule V≥V0 is
followed. Call this option value J(V0). If the realized value V exceeds V0, one obtains VC. Otherwise, one delays the investment, producing a discounted level of the samevalue. This logic says
⎛ 1 + V0⎞
⎛ 1⎞
J (V0 ) = (1 − V0 )⎜− C ⎟ + V0 ⎜J (V0 ) ⎟.
⎝1+r
⎠
⎝ 2
⎠
This expression for J(V0) arises as follows. First, the hypothesized distribution of V is
uniform on [0,1]. Consequently, the value of V will exceed V0 with probability 1- V0. In
this event, the expected value of V is the midpoint of the interval [V0, 1], which is½(V0+1). The value ½(V0+1) - C is the average payoff from the strategy of investing
whenever V≥ V0, which is obtained with probability 1- V0. Second, with probability V0,
the value falls below the cutoff level V0. in this case, no investment is made, and instead,we wait until the next period. The expected profits of the next period are J(V0) andthese profits are discounted in the standard way.
The expression for J is straightforward to solve:⎛ 1 + V0⎞−C ⎟(1 − V0 )⎜⎝ 2⎠.
J (V0 ) =
V
1− 0
1+r
Rudimentary calculus showsJ ′(V0 ) =1 + 2rC + V02 − 2(1 + r ) V0
V ⎞⎛2(1 + r )⎜ 1 − 0 ⎟⎝ 1+r ⎠

2.

First, note that J ′(C ) > 0 and J ′(1) < 0 , which together imply the existence of a
maximum at a value V0 between C and 1, satisfying J ′(V0 ) = 0 . Second, the solution
occurs at
V0 = (1 + r ) − (1 + r )2 − (1 + 2rC ) = (1 + r ) − r 2 + 2r(1 − C ) .

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The positive root of the quadratic has V0>1, which entails never investing, and hence is
not a maximum. The profit-maximizing investment strategy is to invest whenever thevalue exceeds V0 given by the negative root in the formula. There are a couple of notablefeatures about this solution. First, at r=0, V0 = 1. This is because r=0 corresponds to no
discounting, so there is no loss in holding out for the highest possible value. Second, asr→∞, V0 → C. As r→∞, the future is valueless, so it is worth investing if the return isanything over costs. These are not surprising findings, quite the opposite – they should
hold in any reasonable formulation of such an investment strategy. Moreover, theyshow that the NPV rule, which requires V0 = C, is correct only if the future is valueless.
How does this solution behave? The solution is plotted as a function of r, for C=0, 0.25
and 0.5, in Figure 4-21.
The horizontal axis represents interest rates, so this picture shows very high interest
rates by current standards, up to 200%. Even so, V0 remains substantially above C.
That is, even when the future has very little value because two-thirds of the value isdestroyed by discounting each period, the optimal strategy deviates significantly fromthe NPV strategy. Figure 4-22 shows a close-up of that picture for a more reasonable
range of interest rates, for interest rates of zero to ten percent
50

100

150

200

0.8

0.6

C=0.5

0.4

C=0.250.2

C=0Figure 4-21: Investment Strike Price Given Interest Rate r in Percent

Figure 4-22 shows the cutoff values of investment for three values of C, the cost of theinvestment. These three values are 0 (lowest curve), 0.25 (the middle dashed curve),
and 0.5, the highest, dotted line. Consider the lowest curve, with C=0. The NPV of thisproject is always positive – there are no costs and revenues are positive. Nevertheless,because the investment can only be made once, it pays to hold out for a higher level of
payoff, indeed, for 65% or more of the maximum payoff. The economics at an interest
rate of 10% is as follows. By waiting, there is a 65% chance that ten percent of thepotential value of the investment is lost. However, there is a 35% of an even higher
value. The optimum value of V0 trades these considerations off against each other.
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4-123

For C = 0.25, at 10% the cutoff value for taking an investment is 0.7, nearly three times
the actual cost of the investment. Indeed, the cutoff value incorporates two separate
costs: the actual expenditure on the investment C, and the lost opportunity to invest in
the future. The latter cost is much larger than the expenditure on the investment inmany circumstances, and in this example, can be quantitatively much larger than theactual expenditure on the investment.
Some investments can be replicated. There are over 13,000 McDonald’s restaurants in
the United States, and building another doesn’t foreclose building even more. For suchinvestments, NPV analysis gets the right answer, provided that appropriate interest
rates and expectations are used. Other investments are difficult to replicate or logically
impossible to replicate – having pumped and sold the oil from a tract, that tract is now
dry. For such investments, NPV is consistently wrong because it neglects the value ofthe option to delay the investment. A correct analysis adds a lost value for the option todelay the cost of the investment, a value which can be quantitatively large, as we have
seen.
2

4

6

8

10

0.95
0.9
0.85
0.8

C=0.5
0.75
0.7
0.65

C=0.25
C=0

Figure 4-22 Investment Strike Price Given Interest Rate r in Percent

Example: When should you refinance a mortgage? Suppose you are paying 10% on a$100,000 mortgage, and it costs $5,000 to refinance, but refinancing permits you tolock in a lower interest rate, and hence pay less. When is it a good idea? To answer thisquestion, we assume that the $5,000 cost of refinancing is built into the loan, so that inessence you borrow $105,000 at a lower interest rate when you refinance. This isactually the most common method of refinancing a mortgage.
To simplify the calculations, we will consider a mortgage that is never paid off, that is,
one pays the same amount per year forever. If the mortgage isn’t refinanced, one pays
ten percent of the $100,000 face value of the mortgage each year, or $10,000 per year.
If one refinances at interest rate r, one pays r × $105,000 per year, so the NPV ofrefinancing is

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NPV = $10,000 - r × $105,000.
Thus NPV is positive whenever r <10= 9.52% .
105

Should you refinance when the interest rate drops to this level? No. At that level, you
would exactly break even, but would also be carrying a $105,000 mortgage rather than a$100,000 mortgage, making it harder to benefit from any further interest rate
decreases. The only circumstance in which refinancing at 9.52% is sensible is if interest
rates can’t possibly fall further.
When should you refinance? That depends on the nature and magnitude of therandomness governing interest rates, preferences over money today versus money in the
future, and attitudes to risk. The model developed in this section is not a good guide toanswering this question, primarily because the interest rates are strongly correlated overtime. However, an approximate guide to implementing the option theory of investment
is to seek an NPV of twice the investment, which would translate into a refinance pointof around 8.5%.
4.3.3.1 (Exercise) You are searching for a job. The net value of jobs that arise isuniformly distributed on the interval [0,1]. When you accept a job, you muststop looking at subsequent jobs. If you can interview with one employer per
week, what jobs should you accept? Use a 7% annual interest rate.
Hint: Relate the job search problem to the investment problem, where accepting a job isequivalent to making the investment. What is c in the job search problem? What is theappropriate interest rate?

4.3.4 Resource Extraction
For the past sixty years, the world has been “running out of oil.” There are news stories
about the end of the reserves being only ten, fifteen or twenty years away. The tone ofthese stories is that, at that time, we will run out of oil completely and prices will be
extraordinarily high. Industry studies counter that more oil continues to be found andthat the world is in no danger of running out of oil.
If you believe that the world will run out of oil, what should you do? You should buy
and hold. That is, if the price of oil in twenty years is going to be $1,000 per barrel, then
you can buy oil at $40 and hold it for twenty years, and sell it at $1,000. The rate of
return from this behavior is the solution to(1 + r )20 =

1000
.
40

This equation solves for r = 17.46%, which represents a healthy rate of return on
investment. This substitution is part of a general conclusion known as the Ramsey44
44 The solution to this problem is known as Ramsey pricing, after the discoverer Frank Ramsey (1903-

1930).

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rule: for resources in fixed supply, prices rise at the interest rate. With a resource in
fixed supply, owners of the resource will sell at the point maximizing the present valueof the resource. Even if they do not, others can buy the resource at the low present valueof price point and resell at the high present value, and make money.
The Ramsey rule implies that prices of resources in fixed supply rise at the interest rate.
An example of the Ramsey rule in action concerns commodities that are temporarily
fixed in supply, such as grains, after the harvest. During the period between harvests,
these products rise in price on average at the interest rate, where the interest rate
includes storage and insurance costs, as well as the cost of funds.
Example: Let time run t = 0, 1, … and suppose the demand for a resource in fixed supply−1

has constant elasticity: p(Q ) = aQ ε . Suppose there is a total stock R of the resource,
and the interest rate is fixed at r. What is the price and consumption of the resource ateach time?
Solution: Let Qt represent the quantity consumed at time t. Then the arbitrage
condition requires:−1−1

aQ0 ε (1 + r )t = p(Q0 )(1 + r )t = p(Qt ) = aQt ε .
Thus, Qt = Q0 (1 + r )−tε .
Finally, the resource constraint implies() 1 − (1Q+0r)−ε .

R = (Q0 + Q1 + Q2 + ...) = Q0 1 + (1 + r )−ε + (1 + r )−2ε + ... =This solves for the initial consumption Q0. Consumption in future periods declines
geometrically, thanks to the constant elasticity assumption.
Market arbitrage insures the availability of the resource in the future, and drives theprice up to ration the good. The world runs out slowly, and the price of a resource in
fixed supply rises on average at the interest rate.
Resources like oil and minerals are ostensibly in fixed supply – there is only so much oil,or gold, or bauxite, or palladium in the earth. Markets, however, behave as if there is anunlimited supply, and with good reason. People are inventive, and find substitutes.
England’s wood shortage of 1651 didn’t result in England being cold permanently, nor
was England limited to the wood it could grow as a source of heat. Instead, coal was
discovered. The shortage of whale oil in the mid-nineteenth century led to thedevelopment of oil resources as a replacement. If markets expect that price increases
will lead to substitutes, then we rationally should use more today, trusting that

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technological developments will provide substitutes.45 Thus, while some believe we are
running out of oil, most investors are betting that we are not, and that energy will not bevery expensive in the future, either because of continued discovery of oil, or because of
the creation of alternative energy sources. If you disagree, why not invest and take the
bet? If you bet on future price increases, that will tend to increase the price today,
encouraging conservation today, and increase the supply in the future.
4.3.4.1 (Exercise) With an elasticity of demand of 2, compute the percentage of theresource that is used each year if the interest rate is 10%. If the interest rate
falls, what happens to the proportion quantity used?

4.3.5 A Time to Harvest
A tree grows slowly, but is renewable, so the analysis of Section 4.3.4 doesn’t help us
understand when it is most profitable to cut the tree down. Consider harvesting for pulp
and paper use. In this use, the amount of wood chips is what matters to the profitabilityof cutting down the tree, and the biomass of the tree provides a direct indication of this.
Suppose the biomass sells for a net price p, which has the costs of harvesting andreplanting deducted from it , and the biomass of the tree is b(t) when the tree is t years
old. It simplifies the analysis slightly to use continuous time discountingt⎛ 1 ⎞e −ρt = ⎜⎟ ,⎝1+r ⎠
where ρ = log(1 + r ) .
Consider the policy of cutting down trees when they are T years old. This induces a
cutting cycle of length T. A brand new tree will produce a present value of profits of:e−ρTpb(T ) + e−2ρTpb(T ) + e−3ρTpb(T ) + K =e −ρT pb(T )
1−e

−ρT

=

pb(T )e ρT − 1.

This profit arises because the first cut occurs at time T, with discounting e-ρT, andproduces a net gain of pb(T). The process then starts over, with a second tree cut down
at time 2T, and so on.
Profit maximization gives a first order condition on the optimal cycle length T of0=

d pb(T ) pb′(T ) pb(T )ρe ρT=−.
2dT e ρT − 1 e ρT − 1
ρT
e −1

(

)

This can be rearranged to yield:
45 Unlike oil and trees, whales were overfished and there was no mechanism for arbitraging them into the
future, that is, no mechanism for capturing and saving whales for later use. This problem, known as thetragedy of the commons, results in too much use and is taken up in Section 6.3.6. Trees have also been
over-cut, most notably on Easter Island.

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b′(T )
ρ=.
b(T ) 1 − e −ρT
The left hand side of this equation is the growth rate of the tree. The right hand side isapproximately the continuous-time discount factor, at least when T is large, as it tends
to be for trees, which are usually on a 20 to 80 year cycle, depending on the species.
This is the basis for a conclusion: cut down the tree slightly before it is growing at theinterest rate. The higher are interest rates, the shorter the cycle on which the trees
should be cut down.
The pulp and paper use of trees is special, because the tree is going to be ground up intowood chips. What happens when the object is to get boards from the tree, and larger
boards sell for more? In particular, it is more profitable to get a 4 × 4 than two 2 × 4s.
Doubling the diameter of the tree, which approximately raises the biomass by a factor ofsix to eight, more than increases the value of the timber by the increase in the biomass.
It turns out our theory is already capable of handling this case. The only adaptation is achange in the interpretation of the function b. Now, rather than representing thebiomass, b(t) must represent the value in boards of a tree that is t years old. (Theparameter p may be set to one.) The only amendment to the rule for cutting down trees
is that the most profitable point in time to cut down the tree occurs slightly before thetime when the value (in boards) of the tree is growing at the interest rate.
For example, lobsters become more valuable as they grow; the profit-maximizing timeto harvest lobsters is governed by the same equation, where b(T) is the value of a lobsterof age T. Prohibiting the harvest of lobsters under age T is a means of insuring the
profit-maximizing capture of lobsters, and preventing over-fishing, a topic considered in
section 6.3.6.
The implementation of the formula is illustrated in Figure 4-23. The dashed line
, while the solid line represents the discount rate,
represents the growth rate b′(T )b(T )which was set at 5%. Note that the best time to cut down the trees is when they areapproximately 28.7 years old, and at that time, they are growing at 6 ½ %. Figure 4-23
also illustrates another feature of the optimization – there may be multiple solutions to
the optimization problem, and the profit-maximizing solution involves b′(T )b(T )ρfrom above.
cutting
1 − e −ρT

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4-128

ρ

30

1 − e −ρT25

Growth
Rate

20
15
10
5
10

20

30

40

T

Figure 4-23: Optimal Solution for T

The U.S. Department of the Interior is in charge of selling timber rights on federal lands.
The Department uses the policy of maximum sustainable yield to determine the timethat the tree is cut down. Maximum sustainable yield maximizes the long-run averagevalue of the trees cut down, that is, it maximizes
b(T )
.
T
4.3.5.1 (Exercise) Show maximum sustainable yield results in cutting down the tree
when it is T years old, where T satisfiesb′(T ) 1= .
b(T ) T
Maximum sustainable yield is actually a special case of the policies considered here, andarises for a discount factor of 0. It turns out (thanks to a formula known variously as
L’Hôpital’s or L’Hospital’s rule) thatlimρ

ρ→0 1 − e −ρT

=

1
.
T

ρ
1
b′(T )=→ as ρ→0, and this is precisely the same rule that−ρTb(T ) 1 − eTarises under maximum sustainable yield.
Thus, the ruleThus, the Department of the Interior acts as if the interest rate is zero, when it is not.
The justification given is that the Department is valuing future generations at the samelevel as current generations, that is, increasing the supply for future generations, whileslightly harming the current generation of buyers. The major consequence of the

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Department’s policy of maximum sustainable yield is to force cutting of timber evenwhen prices are low during recessions.
b′(T )= te −t . Numerically
4.3.5.2 (Exercise) Suppose the growth rate of trees satisfiesb(T )approximate the efficient time to cut the tree if ρ=0.1. How does this compare
to the solution of maximum sustainable yield?

4.3.6 Collectibles
Many people purchase durable goods as investments, including Porsche Speedsters,
Tiffany lamps, antique telephones, postage stamps and coins, baseball cards, original
Barbie dolls, antique credenzas, autographs, original rayon Hawaiian shirts, oldpostcards, political campaign buttons, old clocks and even Pez dispensers. How is thevalue of, say, a 1961 Porsche Speedster or a $500 bill from the confederacy, whichcurrently sells for over $500, determined?

Figure 4-24: The Porsche Speedster

The theory of resource prices can be adapted to cover these items, which are in fixed
supply. There are four major differences that are relevant. First, using the item doesn’t
consume it; the goods are durable. I can own an “I Like Ike” campaign button for years,
then sell the same button. Second, these items may depreciate. Cars wear out evenwhen they aren’t driven, and the brilliant color of Pez dispensers fades. Every time astandard 27 ½ pound gold bar, like the kind in the Fort Knox depository, is moved,
approximately $5 in gold wears off the bar. Third, the goods may cost something tostore. Fourth, the population grows, and some of the potential buyers are not yet born.
To understand the determinants of the prices of collectibles, it turns out to create amajor simplification to perform the analysis in continuous time. Let t, ranging fromzero to infinity, be the continuous time variable. If the good depreciates at rate δ, and q0
is the amount available at time 0, the quantity available at time t isq(t ) = q0e −δt .
For simplicity, assume that there is constant elasticity of demand ε. If g is the
population growth rate, the quantity demanded, for any price p, is given by

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x d ( p,t ) = ae gt p −ε ,for a constant a which represents the demand at time 0. This represents demand for thegood for direct use, but neglects the investment value of the good – that the good can be
resold for a higher price later. In other words, xd captures the demand for looking at Pez
dispensers or driving Porsche Speedsters, but does not incorporate the value of being
able to resell these items.
The demand equation can be used to generate the lowest use value to a person owning
the good at time t. That marginal use value v arises from the equality of supply anddemand:q0e −δt = q(t ) = x d (v,t ) = ae gt v −εorvε =a (δ+ g)te.
q0

Thus, the use value to the marginal owner of the good at time t satisfies
1

δ+ g

t
⎛ a ⎞ εv = ⎜⎜ ⎟⎟ e ε .
⎝ q0 ⎠

An important aspect of this development is that the value to the owner is found without
reference to the price of the good. The reason this calculation is possible is that theindividuals with high values will own the good, and the number of goods and the valuesof people are assumptions of the theory. Essentially, we already know that the price will
ration the good to the individuals with high values, so computing the lowest value
individual who holds a good at time t is a straightforward “supply equals demand”
calculation. Two factors increase the marginal value to the owner – there are fewer
units available because of depreciation, and there are more high-value people
demanding them, because of population growth. Together, these factors make themarginal use value grow at the rate

δ+ g
.
ε

Assume that s is the cost of storage per unit of time and per unit of the good, so thatstoring x units for a period of length ∆ costs sx∆. This is about the simplest possible
storage cost technology.
The final assumption that we make is that all potential buyers use a common discountrate r, so that the discount of money or value received ∆ units of time in the future is e-r∆.
It is worth a brief digression why it is sensible to assume a common discount rate, when
it is evident that many people have different discount rates. Different discount rates
induce gains from trade in borrowing and lending, and create an incentive to have

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banks. While banking is an interesting thing to study, this section is concerned withcollectibles, not banks. If we have different discount factors, then we must also
introduce banks, which would complicate the model substantially. Otherwise, we wouldintermingle the theory of banking and the theory of collectibles. It is probably a goodidea to develop a joint theory of banking and collectibles given the investment potentialof collectibles, but it is better to start with the pure theory of either one before
developing the joint theory.
Consider a person who values the collectible at v. Is it a good thing for this person to
own a unit of the good at time t? Let p be the function that gives the price across time,so that p(t) is the price at time t. Buying the good at time t and then selling what
remains (recall that the good depreciates at rate δ) at time t+∆ gives a net value of
∆

∫e

−ru

( v − s )du − p(t ) + e −r∆ e −δ∆ p(t + ∆) .

0

For the marginal person, that is, the person who is just indifferent to buying or notbuying at time t, this must be zero at every moment in time, for ∆=0. If v represents thevalue to a marginal buyer (indifferent to holding or selling) holding the good at time t,then this expression should come out to be zero. Thus, dividing by ∆,∆1 −rup(t ) e −(r +δ)∆ p(t + ∆ )
−
−
+
e
(
v
s
)
du
∫
∆
∆
∆ →0 ∆

0 = lim

0= lim v − s +∆→0p(t + ∆) − p(t ) 1 − e −(r +δ)∆−p(t + ∆) = v − s + p′(t ) − (r + δ) p(t ) .
∆
∆
1

δ+ g

t
⎛ a ⎞ εRecall that the marginal value is v = ⎜⎜ ⎟⎟ e ε , which gives⎝ q0 ⎠
1

δ+ gt⎛ a ⎞ εp′(t ) = (r + δ) p(t ) + s − v = (r + δ) p(t ) + s − ⎜⎜ ⎟⎟ e ε .
⎝ q0 ⎠The general solution to this differential equation isδ+ g ⎞ ⎞⎛⎛−⎜ r +δ−⎟t
1⎜−(r +δ)tε ⎠ ⎟ε 1−e ⎝
⎛
⎞
e
a
−
1
⎟
⎜
p(t ) = e(r +δ)t ⎜ p(0) +s − ⎜⎜ ⎟⎟.
δ+g ⎟(r + δ)
q0 ⎠
⎝
r+δ−
⎟⎟
⎜⎜
ε
⎠
⎝

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δ+g
> 0 , for otherwise theεpresent value of the marginal value goes to infinity, so there is no possible finite initial
price. Provided demand is elastic and discounting is larger than growth rates (which isan implication of equilibrium in the credit market), this condition will be met.

It turns out that this equation only makes sense if r + δ −What is the initial price? It must be the case that the present value of the price is finite,
for otherwise the good would always be a good investment for everyone at time 0, using
the “buy and hold for resale” strategy. That is,lim e −rt p(t ) < ∞.

t →∞This condition implies
δ+ g ⎞ ⎞⎛⎛−⎜ r +δ−⎟t
1⎜−(r +δ)t
ε ⎠ ⎟
⎝
ε
⎛
⎞
−
−
e
a
e
1
1
⎜
⎟
s − ⎜⎜ ⎟⎟lim e δt ⎜ p(0) +
⎟<∞
δ
+
g
q0 ⎠
(r + δ)
t →∞
⎝
r+δ−
⎜⎜
⎟⎟
ε
⎝
⎠

and thus1⎛ a ⎞ ε11p(0) +s − ⎜⎜ ⎟⎟= 0.
(r + δ) ⎝ q0 ⎠ r + δ − δ + gεThis equation may take on two different forms. First, it may be solvable for a nonnegative price, which happens if
1⎛ a ⎞ ε11p(0) = ⎜⎜ ⎟⎟−s ≥0.
⎝ q0 ⎠ r + δ − δ + g (r + δ)εSecond, it may require destruction of some of the endowment of the good. Destruction
must happen if the quantity of the good q0 at time 0 satisfies
1⎛ a ⎞ ε
1
1
⎜⎜ ⎟⎟
−
s <0.
⎝ q0 ⎠ r + δ − δ + g (r + δ)εIn this case, there is too much of the good, and an amount must be destroyed to makethe initial price zero. Since the initial price is zero, the good is valueless at time zero,and destruction of the good makes sense – at the current quantity, the good is too costly

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to store for future profits. Enough is destroyed to insure indifference between holding
the good as a collectible and destroying it. Consider, for example, the $500 confederatebill pictured in Figure 4-25. Many of these bills were destroyed at the end of the US
Civil War, when the currency became valueless, burned as a source of heat. Now, an
uncirculated version retails for $900.
The amount of the good that must be destroyed is such that the initial price is zero. As
q0 is the initial (pre-destruction) quantity, the amount at time zero after the destructionis the quantity q(0) satisfying
1⎛ a ⎞ ε1
1⎟⎟0 = p(0) = ⎜⎜s.
−
⎝ q(0) ⎠ r + δ − δ + g (r + δ)εFigure 4-25: $500 Confederate States Bill

Given this construction, we have that1

⎛ a ⎞ ε11⎟⎟
= 0,p(0) +s − ⎜⎜(r + δ) ⎝ q(0) ⎠ r + δ − δ + gεwhere either q(0)=q0 and p(0)≥0, or q(0)<q0 and p(0)=0.
Destruction of a portion of the stock of a collectible, followed by price increases, isactually a quite common phenomenon. In particular, consider the “Model 500”
telephone by Western Electric illustrated in Figure 4-26. This ubiquitous classic phone
was retired as the US switched to tone dialing and push-button phones in the 1970s, andmillions of phones – perhaps over 100 million – wound up in landfills. Now, the phone
is a collectible and rotary phone enthusiasts work to keep them operational.

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Figure 4-26: Western Electric Model 500 Telephone

The solution for p(0) dramatically simplifies the expression for p(t):δ+ g ⎞ ⎞⎛⎛−⎜ r +δ−⎟t ⎟1⎜−(r +δ)tε⎠⎝ε⎛ a ⎞ 1−e
1−e
⎜
⎟
⎟⎟
p(t ) = e(r +δ)t ⎜ p(0) +s − ⎜⎜⎟
δ+g(r + δ)⎝ q(0) ⎠
r+δ−
⎜⎜
⎟⎟
ε
⎝
⎠
δ+ g ⎞ ⎞⎛⎛−⎜ r +δ−⎟t
1⎜ −(r +δ)t
ε ⎠ ⎟
⎝
ε
⎛
⎞
−
e
a
e
⎜
⎟
⎟⎟
= e(r +δ)t ⎜s + ⎜⎜
δ+g ⎟(r + δ)⎝ q(0) ⎠
r +δ−
⎜⎜
⎟
ε ⎟⎠
⎝
1

δ+ g
t
e ε

⎛ a ⎞ εs⎟⎟= ⎜⎜−⎝ q(0) ⎠ r + δ − δ + g r + δεThis formula lets us compare different collectibles. The first insight is that storage costs
enter linearly into prices, so that growth rates are approximately unaffected by storage
costs. That gold is easy to store, while stamps and art require control of humidity andtemperature to preserve value and are hence more expensive to store, affects the level ofprices but not the growth rate. However, depreciation and the growth of population
affect the growth rate, and they do so in combination with the demand elasticity. With
more elastic demand, prices grow more slowly and start at a lower level.

4.3.7 Summer Wheat
Typically, wheat harvested in the fall has to last until the following harvest. How shouldprices evolve over the season? If I know that I need wheat in January, should I buy it atharvest time and store it myself, or wait and buy it in January? We can use a theory
analogous to the theory of collectibles developed in Section 4.3.6 to determine theevolution of prices for commodities like wheat, corn, orange juice, and canola oil.

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Unlike collectibles, buyers need not hold for their personal use, since there is no value inadmiring the wheat in your home. Let p(t) be the price at time t and suppose that theyear has length T. Generally there is a substantial amount of uncertainty regarding thesize of wheat harvests and most countries maintain an excess inventory as a precaution.
However, if the harvest were not uncertain, there would be no need for a precautionary
holding, and instead we would consume the entire harvest over the course of a year, atwhich point the new harvest comes in. It is such a model that is investigated in thissection.
Let δ represent the depreciation rate (which for wheat includes the quantity eaten byrodents) and s be the storage cost. Buying at time t and reselling at t+∆ should be abreak-even proposition. If one purchases at time t, it costs p(t) to buy the good.
Reselling at t+∆, the storage cost is about s∆. (This is not the precisely relevant cost, butrather it is the present value of the storage cost, and hence the restriction to small valuesof ∆.) The good depreciates to only have e −δ∆ left to sell, and discounting reduces thevalue of that amount by the factor e −r∆ . For this to be a breakeven proposition, forsmall ∆,
0 = e −r∆ e −δ∆ p(t + ∆) − s∆ − p(t ) ,orp(t + ∆ ) − p(t ) 1 − e −(r +δ)∆p(t + ∆) − s .
=∆∆Taking the limit as ∆→0,p′(t ) = (r + δ) p(t ) − s .
This arbitrage condition insures that it is a break-even proposition to invest in the good;
the profits from the price appreciation are exactly balanced by depreciation, interest andstorage costs. We can solve the differential equation to obtain:⎛
1 − e −(r +δ)t ⎞⎟ (r +δ)te(r +δ)t − 1
p(t ) = e(r +δ)t ⎜ p(0) +s =ep(0) +
s.
⎜
⎟
r
r
+
δ
+
δ
⎝
⎠
The unknown is p(0). The constraint on p(0), however, is like the resource extraction
problem – p(0) is determined by the need to use up the harvest over the course of theyear.
Suppose demand has constant elasticity ε. Then the quantity used comes in the formx (t ) = ap(t )−ε . Let z(t) represent the stock at time t. Then the equation for theevolution of the stock is z ′(t ) = − x (t ) − δz(t ). This equation is obtained by noting that

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the flow out of stock is composed of two elements: depreciation δz and consumption x.
The stock evolution equation solves forz(t ) = e⎛⎞q(0) − ∫ e δu x(u)du ⎟ .
⎜
⎟
0
⎝
⎠
t

−δt ⎜

Thus, the quantity of wheat is consumed exactly ifTδu∫ e x(u)du = q(0) .

0

But this equation determines the initial price throughTq(0) = ∫ e
0

δu

T

δu

T

−ε

x(u)du = ∫ e ap(u) du = ∫
0

0

⎛
⎜
⎝

e
e δu a⎜ e(r +δ)u p(0) +(r +δ)u− 1 ⎞⎟
s
⎟
r+δ
⎠

−ε

du

This equation doesn’t lead to a closed form for p(0) but is readily estimated, which
provides a practical means of computing expected prices for commodities in temporarily
fixed supply.
Generally, the price equation produces a “saw-tooth” pattern, which is illustrated in
Figure 4-27. The increasing portion is actually an exponential, but of such a small
degree that it looks linear. When the new harvest comes in, prices drop abruptly as theinventory grows dramatically, and the same pattern is repeated.
0.4

0.3

0.2

0.1

1

2

3

4

Figure 4-27: Prices over a Cycle for Seasonal Commodities

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Log of Price of Gold versus Time

Log Gold Price

2.76
2.75
2.74
2.73
2.72
2.71
2.7
2.69
2.68
2.67
5/28/2005

10/10/2006

2/22/2008

7/6/2009

Date

Figure 4-28: Log of Price of Gold over Time

How well does the theory work? Figure 4-28 shows the log of the future price of gold
over time. The relevant data comes from a futures market which establishes, at one
moment in time, the price of gold for future delivery, and thus represents today’s
estimate of the future price of gold. These data, then, represent the expected future
price at a particular moment in time (the afternoon of October 11, 2005), and thus
correspond to the prices in the theory, since perceived risks are fixed. (Usually in thereal world, risk plays a salient role.) We can observe that prices are approximately an
exponential, because the log of prices is approximately linear. However, the estimate ofr+δ is surprisingly low, at an annual level of less than 0.03, or 3% for both discounting
and depreciation. Depreciation of gold is low, but this still represents a very low interest
rate.

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5 Consumer Theory
Consumer theory is to demand as producer theory is to supply. The major difference isthat producer theory assumes that sellers are motivated by profit, and profit issomething that one can usually directly measure. Moreover, the costs that enter into
profit arise from physical properties of the production process – how many coffee cups
come from the coffee cup manufacturing plant? In contrast, consumer theory is basedon what people like, so it begins with something that we can’t directly measure, butmust infer. That is, consumer theory is based on the premise that we can infer what
people like from the choices they make.
Now, inferring what people like from choices they make does not rule out mistakes. But
our starting point is to consider the implications of a theory in which consumers don’t
make mistakes, but make choices that give them the most satisfaction.
Economists think of this approach as analogous to studying gravitation in a vacuum
before thinking about the effects of air friction. There is a practical consideration that
dictates ignoring mistakes. There are many kinds of mistakes, e.g. “I meant to buy
toothpaste but forgot and bought a toothbrush,” a memory problem, “I thought thistoothpaste was better but it is actually worse,” a learning issue, and “I meant to buy
toothpaste but I bought crack instead,” a self-control issue. All of these kinds of
mistakes lead to distinct theories. Moreover, we understand these alternative theories
by understanding the basic theory first, and then seeing what changes these theories
lead to.

5.1 Utility Maximization
Economists use the term utility in a peculiar and idiosyncratic way. Utility refers not tousefulness but to the flow of pleasure or happiness that a person enjoys – some measureof the satisfaction a person experiences. Usefulness might contribute to utility, but sodoes style, fashion, or even whimsy.
The term utility is unfortunate not just because it suggests usefulness, but because it
makes the economic approach to behavior appear more limited than it actually is. We
will make very few assumptions about the form of utility that a consumer might have.
That is, we will attempt to avoid making value judgments about the preferences aconsumer holds – whether they like smoking cigarettes or eating only carrots, watching
Arnold Schwarzenegger movies or spending time with a hula hoop. Consumers likewhatever it is that they like; the economic assumption is that they attempt to obtain the
goods that they like. It is the consequences of the pursuit of happiness that comprise thecore of consumer theory.
In this chapter, we will focus on two goods. In many cases, the generalization to anarbitrary number of goods is straightforward. Moreover, in most applications it won’t
matter because we can view one of the goods as a “composite good” reflecting
consumption of a bunch of other goods.46
46 Thus, for example, savings for future consumption, or to provide for descendents, or to give to youralma mater, are all examples of consumption. Our consumer will, in the end, always spend all of her

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As a starting point, suppose the two goods are X and Y. To distinguish the quantity of
the good from the good itself, we’ll use capital letters to indicate the good and a lower
case letter to indicate the quantity consumed. If X is rutabagas, a consumer who ate
three of them would have x=3. How can we represent preferences for this consumer?
To fix ideas, suppose the consumer is both hungry and thirsty and the goods are beerand pizza. The consumer would like more of both, reflected in greater pleasure forgreater consumption. Items one might consume are generally known as “bundles,” as inbundles of goods and services, and less frequently as “tuples,” a short-form for the “ntuple,” meaning a list of n quantities. Since we will focus on two goods, both of theseterms are strained in the application; a bundle because a bundle of two things isn’tmuch of a bundle, and a tuple because what we have here is a “two-tuple,” also known asa pair. But part of the job of studying economics is to learn the language of economics,
and bundles it is.
One might naturally consider measuring utility on some kind of physical basis –production of dopamine in the brain, for example – but it turns out that the actual
quantities of utility don’t matter for the theory we develop. What matters is whether abundle produces more than another, or less, or the same. Let u(x, y) represent theutility a consumer gets from consuming x units of beer and y units of pizza. The
function u guides the consumer’s choice, in the sense that, if the consumer can choose
either (x1, y1) or (x2, y2), we expect him to choose (x1, y1) if u(x1, y1) > u(x2, y2).
But notice that a doubling of u would lead to the same choices, because
u(x1, y1) > u(x2, y2) if and only if 2u(x1, y1) > 2u(x2, y2).
Thus, doubling the utility doesn’t change the preferences of the consumer. But thesituation is more extreme than this. Even exponentiating the utility doesn’t change theconsumer’s preferences, because
u(x1, y1) > u(x2, y2) if and only if eu(x1, y1)> eu(x2, y2).
Another way to put this is that there are no natural units for utility, at least until suchtime as we are able to measure pleasure in the brain.
It is possible to develop the theory of consumer choice without supposing that a utility
function exists at all. However, it is expedient to begin with utility, to simplify the
analysis for introductory purposes.

5.1.1 Budget or Feasible Set
Suppose a consumer has a fixed amount of money to spend, M. There are two goods X
and Y, with associated prices pX and pY. The feasible choices the consumer can makesatisfy p X x + pY y ≤ M . In addition, we will focus on consumption and rule out
income, although this happens because we adopt a very broad notion of spending. In particular, savings
are “future spending.”

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negative consumption, so x≥0 and y≥0. This gives a budget set or feasible set illustrated
in Figure 5-1.
yM
pY
Budget Line

Budget Set

x

M
pX
Figure 5-1: Budget Set

In this diagram, the feasible set of purchases that satisfy the budget constraint are
illustrated with shading. If the consumer spends all her money on X, she can consume
M
M. Similarly, if she spends all of her money on Y, she consumes
the quantity x =pXpYunits of Y. The straight line between them, known as the budget line, represents thepmost of the goods she can consume. The slope of the budget line is − X .
pY
An increase in the price of one good pivots or rotates the budget line. Thus, if the priceMM
remains the same, but
falls. This is illustrated inof X increases, the endpoint
pY
pX
Figure 5-2.

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y

M
pY
Budget Line
PivotsM
pX

x

Figure 5-2: Effect of an Increase in Price on the Budget

y

M
pY

Budget Line
shifts out as
M risesM
pX

x

Figure 5-3: An Increase in Income

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M
M
and
pX
pY
proportionately. This means an increase in M shifts the budget line out (away from theorigin) in a parallel fashion, as in Figure 5-3.
The effect of increasing the available money M is to increase both

An increase in both prices by the same proportional factor has an effect identical to adecrease in income. Thus, one of the three financial values – the two prices and income– is redundant. That is, we can trace out all the possible budget lines with any two of thethree parameters. This can prove useful; we can arbitrarily set pX to be the number one
without affecting the generality of the analysis. When setting a price to one, that related
good is called the numeraire, and essentially all prices are denominated with respect tothat one good. A real world example of a numeraire occurred when the currency used
was based on gold so that the prices of other goods are denominated in terms of thevalue of gold.
Money is not necessarily the only constraint on the consumption of goods that a
consumer faces. Time can be equally important. One can own all the compact discs inthe world, but they are useless if one doesn’t actually have time to listen to them.
Indeed, when we consider the supply of labor, time will be a major issue – supplying
labor (working) uses up time that could be used to consume goods. In this case there
will be two kinds of budget constraints – a financial one and a temporal one. At a fixed
wage, time and money translate directly into one another and the existence of the time
constraint won’t present significant challenges to the theory. The conventional way tohandle the time constraint is to use as a baseline working “full out,” and then view
leisure as a good which is purchased at a price equal to the wage. Thus, if you earn
$20/hour, we would set your budget at $480/day, reflecting 24 hours of work, but thenpermit you to buy leisure time, during which eating, sleeping, brushing teeth and every
other non-work activity is accomplished at a price equal to $20 per hour.
5.1.1.1 (Exercise)
Graph the budget line for apples and oranges, with prices of $2 and$3 respectively and $60 to spend. Now increase the price of apples from $2 to$4 and draw the budget line.
5.1.1.2 (Exercise)
Suppose that apples cost $1 each. Water can be purchased for 0.5
cents per gallon up to 20,000 gallons, and 0.1 cent per gallon for each gallon
beyond 20,000 gallons. Draw the budget constraint for a consumer who spends$200 per month on apples and water.
5.1.1.3 (Exercise)
Graph the budget line for apples and oranges, with prices of $2 and$3 respectively and $60 to spend. Now increase expenditure to $90 and draw
the budget line.

5.1.2 IsoquantsWith two goods, we can graphically represent utility by considering the contour map ofutility. Utility contours are known as isoquants, meaning “equal quantity,” and are also
known as indifference curves, since the consumer is indifferent between points on theline. We have met this idea already in the description of production functions, where
the curves represented input mixes that produced a given output. The only difference

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here is that the output being produced is consumer “utility” instead of a single good orservice.
y
1

0.8

u=5
u=4

0.6

u=3

0.4

u=2
0.2

u=1
0
0

0.2

0.4

0.6

0.8

1

x

Figure 5-4: Utility Isoquants

Figure 5-4 provides an illustration of isoquants or indifference curves. Each curve
represents one level of utility. Higher utilities occur to the northeast, further away fromthe origin. As with production isoquants, the slope of the indifference curves has theinterpretation of the tradeoff between the two goods. The amount of Y that theconsumer is willing to give up to obtain an extra bit of X is the slope of the indifference
curve. Formally, the equationu(x, y) = u0
defines an indifference curve for the reference utility u0. Differentiating in such a way as
to preserve the equality, we obtain the slope of the indifference curve:
∂u
dy
∂u
∂u
dx + dy = 0 or
= − ∂x .
∂u
dx u=u∂x∂y0∂yThis slope is known as the marginal rate of substitution and reflects the tradeoff, fromthe consumer’s perspective, between the goods. That is to say, the marginal rate of
substitution (of Y for X) is the amount of Y the consumer is willing to lose to obtain an
extra unit of X.
An important assumption concerning isoquants is reflected in the diagram: “midpoints
are preferred to extreme points.” Suppose the consumer is indifferent between (x1, y1)

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and (x2, y2), that is, u(x1, y1) = u(x2, y2). Then we say preferences are convex if any pointon the line segment connecting (x1, y1) and (x2, y2) is at least as good as the extremes.
Formally, a point on the line segment connecting (x1, y1) and (x2, y2) comes in the form
(αx1 + (1 – α) x2, αy1 + (1 – α) y2),for α between zero and one. This is also known as a “convex combination” between thetwo points. When α is zero, the segment starts at (x2, y2) and proceeds in a linear
fashion to (x1,y1) at α equal to one. Preferences are convex if, for any α between 0 and 1,u(x1, y1) = u(x2, y2) implies u(αx1 + (1 – α) x2, αy1 + (1 – α) y2) ≥ u(x1, y1).
This property is illustrated in Figure 5-5. The line segment that connects two points on
the indifference curve lies to the northeast of the indifference curve, which means theline segment involves strictly more consumption of both goods than some points on theindifference curve, which means that it is preferred to the indifference curve. Convex
preferences mean that a consumer prefers a mix to any two equally valuable extremes.
Thus, if the consumer likes black coffee and also likes drinking milk, the consumer
prefers some of each (not necessarily mixed) to only drinking coffee or only drinking
milk. This sounds more reasonable if you think of the consumer’s choices on a monthly
basis; if you like drinking 60 cups of coffee, and no milk, per month the same as 30
glasses of milk and no coffee, convex preferences entails preferring 30 cups of coffee and
15 glasses of milk to either extreme.
y
1

0.8

0.6

0.4

0.2

0.2

0.4

0.6

0.8

1

x

Figure 5-5: Convex Preferences

How does a consumer choose which bundle to select? The consumer is faced with the
problem of maximizing u(x, y) subject to p X x + pY y ≤ M .
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We can derive the solution to the consumer’s problem as follows. First, “solve” theM − pX x. If Y is a good, thisbudget constraint p X x + pY y ≤ M for y, to obtain y ≤pYconstraint will be satisfied with equality and all the money will be spent. Thus, we canwrite the consumer’s utility as⎛ M − pX x ⎞⎟⎟.
u⎜⎜ x ,
pY⎝⎠
The first order condition for this problem, maximizing it over x, has0=d ⎛ M − p X x ⎞ ∂u p X ∂u⎟⎟ =−u⎜ x ,.
dx ⎜⎝pY⎠ ∂x pY ∂yThis can be re-arranged to obtain the marginal rate of substitution (MRS).
∂upXdy= ∂x = −= MRS .
pY ∂u
dx u=u0∂y
The first order condition requires that the slope of the indifference curve equals theslope of the budget line, that is, there is a tangency between the indifference curve andthe budget line. This is illustrated in Figure 5-6. Three indifference curves are drawn,
two of which intersect the budget line, but are not tangent. At these intersections, it ispossible to increase utility by moving “toward the center,” until the highest of the three
indifference curves is reached. At this point, further increases in utility are not feasible,
because there is no intersection between the set of bundles that produce a strictly higher
utility and the budget set. Thus, the large black dot is the bundle that produces thehighest utility for the consumer.
It will later prove useful to also state the second order condition, although we won’t use
this condition now:d2

2

⎛ M − p X x ⎞ ∂ 2u
p X ∂ 2u ⎛ p X ⎞ ∂ 2u
⎜
⎟
⎟⎟
−
0≥
u x,
+ ⎜⎜
.
⎟=
2 ⎜
2
2
∂
∂
p
p
x
y
p
(dx ) ⎝YY
⎠ (∂x )
⎝ Y ⎠ (∂y)⎛ ∂u ∂u ⎞Note that the vector (u1 , u2 ) = ⎜⎜ , ⎟⎟ is the gradient of u, and the gradient points in⎝ ∂x ∂y ⎠the direction of steepest ascent of the function u. Second, the equation whichcharacterizes the optimum,

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0 = pX∂u∂u ⎛ ∂u ∂u ⎞− pY
= ⎜ , ⎟ • ( − pY , p X ) ,∂y∂x ⎜⎝ ∂x ∂y ⎟⎠

y

M
pY

M
pX

x

Figure 5-6: Graphical Utility Maximization

where • is the “dot product” which multiplies the components of vectors and then adds
them, says that the vectors (u1, u2) and (-pY, pX) are perpendicular, and hence that therate of steepest ascent of the utility function is perpendicular to the budget line.
When does this tangency approach fail to solve the consumer’s problem? There arethree ways it can fail. First, the utility might not be differentiable. We will set aside thiskind of failure with the remark that fixing points of non-differentiability ismathematically challenging but doesn’t lead to significant alterations in the theory. The
second failure is that a tangency didn’t maximize utility. Figure 5-7 illustrates this case.
Here, there is a tangency, but it doesn’t maximize utility. In Figure 5-7, the dotted
indifference curve maximizes utility given the budget constraint (straight line). This isexactly the kind of failure that is ruled out by convex preferences. In Figure 5-7,
preferences are not convex, because if we connect two points on the indifference curves
and look at a convex combination, we get something less preferred, with lower utility,
not more preferred as convex preferences would require.

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y

x
Figure 5-7: “Concave” Preferences, Prefer Boundaries

The third failure is more fundamental: the derivative might fail to be zero because we’ve
hit the boundary of x=0 or y=0. This is a fundamental problem because in fact there aremany goods that we do buy zero of, so zeros for some goods are not uncommon
solutions to the problem of maximizing utility. We will take this problem up in a
separate section, but we already have a major tool to deal with it: convex preferences.
As we shall see, convex preferences insure that the consumer’s maximization problem is“well-behaved.”

5.1.3 Examples
The Cobb-Douglas utility function comes in the form u(x , y ) = x α y1−α . Since utility iszero if either of the goods is zero, we see that a consumer with Cobb-Douglas
preferences will always buy some of each good. The marginal rate of substitution for
Cobb-Douglas utility is
∂u
dy
αy
.
−
= ∂x =∂u(1 − α)xdx u=u0∂yThus, the consumer’s utility maximization problem yields
∂u
pX
dy
αy
.
=−
= ∂x =∂u(1 − α)xpY
dx u=u0∂yThus, using the budget constraint, (1 − α)xp X = αypY = α( M − xp X ).

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This yields x =αM(1 − α) M
, y=
.
pX
pY

Cobb-Douglas utility results in constant expenditure shares. No matter what the priceof X or Y, the expenditure xpX on X is αM. Similarly, the expenditure on Y is (1-α)M.
This makes the Cobb-Douglas utility very useful for computing examples and homework
exercises.
Consider a consumer with utility u( x , y) = xy . If the consumer
5.1.3.1 (Exercise)
has $100 to spend, and the price of X is $5 and the price of Y is $2, graph thebudget line, and then find the point that maximizes the consumer’s utility given
the budget. Draw the utility isoquant through this point. What are theexpenditure shares?

5.1.3.2 (Exercise)

Consider a consumer with utility u( x , y) = xy . Calculate the slopeof the isoquant directly, by solving u( x , y) = u0 for y as a function of x and theutility level u0. What is the slope −dy? Verify that it satisfies the formuladx u=u0

given above.
5.1.3.3 (Exercise) Consider a consumer with utility u( x , y) = ( xy)2 . Calculate theslope of the isoquant directly, by solving u( x , y) = u0 for y as a function of x andthe utility level u0. What is the slope −dy? Verify that the result is thedx u=u0

same as in the previous exercise. Why is it the same?
When two goods are perfect complements, they are consumed proportionately. The
utility that gives rise to perfect complements is in the form u(x, y) = min {x, βy} forsome constant β (the Greek letter beta). First observe that with perfect complements,
consumers will buy in such a way that x = βy. The reason is that, if x > βy, some
expenditure on x is a waste since it brings in no additional utility, and the consumer getshigher utility by decreasing x and increasing y. This lets us define a “composite good”
which involves buying some amount y of Y and also buying βy of X. The price of thisM
. In this way,composite commodity is βpX + pY, and it produces utility u =β p X + pY
perfect complements boil down to a single good problem.
The case of perfect substitutes arises when all that matters to the
5.1.3.4 (Exercise)consumer is the sum of the products – e.g. red shirts and green shirts for acolor-blind consumer. In this case, u(x, y) = x + y. Graph the isoquants for

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perfect substitutes. Show that the consumer maximizes utility by spending their
entire income on whichever product is cheaper.
If the only two goods available in the world were pizza and beer, it is likely that satiation
would set in at some point. How many pizzas can you eat per month? How much beer
can you drink? [Don’t answer that.]
y
1

0.8

u=120
0.6

u=100
u=50

0.4

u=40
u=30

0.2

u=20
u=10
0
0

0.2

0.4

0.6

0.8

1

x

Figure 5-8: Isoquants for a Bliss Point

What does satiation mean for isoquants? It means there is a point that maximizes
utility, which economists call a bliss point. An example is illustrated in Figure 5-8. Near
the origin, the isoquants behave as before. However, as one gets full of pizza and beer, apoint of maximum value is reached, illustrated by a large black dot. What does satiation
mean for the theory? First, if the bliss point isn’t within reach, the theory behaves as
before. With a bliss point within reach, consumption will stop at the bliss point. A
feasible bliss point entails having a zero value of money. There may be people with azero value of money, but even very wealthy people, who reach satiation in goods thatthey personally consume, often like to do other things with the wealth and appear not tohave reached satiation overall.
Suppose u(x , y ) = x α + y α for α<1. Show

5.1.3.5 (Exercise)x=M⎛ ⎛ p ⎞α ⎞p X ⎜⎜ 1 + ⎜⎜ Y ⎟⎟ ⎟⎟p⎝ ⎝ X⎠ ⎠, and y =M
⎛ ⎛ p ⎞α ⎞pY ⎜⎜ 1 + ⎜⎜ X ⎟⎟ ⎟⎟p⎝ ⎝ Y ⎠ ⎠.

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5.1.3.6 (Exercise) Suppose one consumer has the utility function u (which is always apositive number), and a second consumer has utility w. Suppose, in addition,that for any x, y, w(x, y) = (u(x, y))2, that is, the second person’s utility is thesquare of the first. Show that these consumers make the same choices – that is,u(xa, ya) ≥ u(xb, yb) if and only w(xa, ya) ≥ w(xb, yb).

5.1.4 Substitution Effects
It would be a simpler world if an increase in the price of a good always entailed buying
less of it. Alas, it isn’t so, as the following diagram illustrates. In this diagram, anincrease in the price of Y causes the budget line to pivot around the intersection on the X
axis, since the amount of X that can be purchased hasn’t changed. In this case, thequantity y of Y demanded rises.
yx
Figure 5-9: Substitution with an Increase in Price

At first glance, this increase in the consumption of a good in response to a price increasesounds implausible, but there are examples where it makes sense. The primary example
is leisure. As wages rise, the cost of leisure (forgone wages) rises. But as people feel
wealthier, they choose to work fewer hours. The other examples given, which are hotly
debated in the “tempest in a teapot” kind of way, involve people subsisting on a good
like potatoes but occasionally buying meat. When the price of potatoes rises, they canno longer afford meat and buy even more potatoes than before.
Thus, the logical starting point on substitution – what happens to the demand for a goodwhen the price of that good increases? – does not lead to a useful theory. As a result,economists have devised an alternative approach, based on the following logic. An
increase in the price of a good is really a composition of two effects: an increase in therelative price of the good, and a decrease in the purchasing power of money. As a result,
it is useful to examine these two effects separately. The substitution effect considers the

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change in the relative price, with a sufficient change in income to keep the consumer on
the same utility isoquant.47 The income effect changes only income.
yInitial
ChoiceCompensatedDemandpY ↑x
Figure 5-10: Substitution Effect

To graphically illustrate the substitution effect, consider Figure 5-10. The starting pointis the tangency between the isoquant and the budget line, denoted with a diamondshape and labeled “Initial Choice.” The price of Y rises, pivoting the budget line inward.
The new budget line is illustrated with a heavy, dashed line. To find the substitution
effect, increase income from the dashed line until the original isoquant is reached.
Increases in income shift the budget line out in a fashion parallel to the original. We
reach the original isoquant at a point labeled with a small circle, a point sometimes
called the compensated demand, because we have compensated the consumer for the
price increase by increasing income just enough to leave her unharmed, on the sameisoquant. The substitution effect is just the difference between these points – thesubstitution in response to the price change, holding constant the utility of theconsumer.
We can readily see that the substitution effect of a price increase in Y is to decrease theconsumption of Y and increase the consumption of X.48 The income effect is the change
in consumption resulting from the change in income. The effect of any change in pricecan be decomposed into the substitution effect, which holds utility constant and changes
the relative prices, and the income effect, which adjusts for the loss of purchasing powerarising from the price increase.
47 Some authors instead change the income enough to make the old bundle affordable.

This approach has
the virtue of being readily computed, but the disadvantage that the substitution effect winds up increasing
the utility of the consumer. Overall the present approach is more economical for most purposes.
48 To construct a formal proof, first show that if p rises and y rises, holding utility constant, the initialY
choice prior to the price increase is feasible after the price increase. Use this to conclude that after the
price increase it is possible to have strictly more of both goods, contradicting the hypothesis that utility
was held constant.

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Example (Cobb-Douglas): Recall that the Cobb-Douglas utility comes in the formu(x , y ) = x α y1−α . Solving for x, y we obtainx=MαM(1 − α) M.
, y=, and u(x , y ) = α α (1 − α)1−α
1 −α
pX
pY
pα
p
X Y

Thus, consider a multiplicative increase ∆ in pY, that is, multiplying pY by ∆>1. In orderto leave utility constant, M must rise by ∆1-α. Thus, x rises by the factor ∆1-α and y falls,
by the factor ∆-α < 1. This is the substitution effect.
What is the substitution effect of a small change in the price pY for any given utility
function, not necessarily Cobb-Douglas? To address this question, it is helpful tointroduce some notation. We will subscript the utility to indicate partial derivative, that
is,
u1 =

∂u
∂u
, u2 =.
∂y∂x

Note that, by the definition of the substitution effect, we are holding utility constant, sou(x, y) is being held constant. This means, locally, that0 = du = u1 dx + u2 dy .49
In addition, we have M = p X x + pY y, so
dM = p X dx + pY dy + ydpY

Finally, we have the optimality condition
∂u
pX
= ∂x
pY ∂u
∂y
which is convenient to write as p X u2 = pY u1 . Differentiating this equation, and letting
u11 =

∂ 2u
(∂x )2, u12 =∂ 2u
∂ 2u
and u22 =, we have
∂x∂y
(∂y)2

p X (u12 dx + u22dy) = u1 dpY + pY (u11 dx + u12 dy).

49 Writing dx for an unknown infinitesimal change in x can be put on a formal basis.

The easiest way to doso is to think of dx as representing the derivative of x with respect to a parameter, which will be pY.

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For a given dpY, we now have three equations in three unknowns dx, dy, and dM.
However, dM only appears in one of the three. Thus, the effect of a price change on x
and y can be solved by solving two equations:
0 = u1 dx + u2 dy andp X (u12 dx + u22dy) = u1 dpY + pY (u11 dx + u12 dy)
for the two unknowns dx and dy. This is straightforward and yields:
dx
pY u1
=−
and
2
dpY
p X u11 + 2 p X pY u12 + pY2 u22
dy
pY u2
=
.
dpY p2X u11 + 2 p X pY u12 + pY2 u22
These equations imply that x rises and y falls.50 We immediately see
dy
u
p
dpY
=− 1 =− X .
dx
u2
pY
dpY
Thus, the change in (x,y) follows the budget line locally. (This is purely a consequenceof holding utility constant.)
To complete the thought while we are embroiled in these derivatives, note thatp X u2 = pY u1 implies that p X dx + pY dy = 0 .
Thus, the amount of money necessary to compensate the consumer for the priceincrease, keeping utility constant, can be calculated from our third equation:dM = p X dx + pY dy + ydpY = ydpY .
The amount of income necessary to insure the consumer makes no losses from a priceincrease in Y is the amount that lets them buy the bundle they originally purchased, thatis, the increase in the amount of money is precisely the amount needed to cover theincreased price of y. This shows that locally there is no difference from a substitution
effect that keeps utility constant (which is what we explored) and one that provides
sufficient income to permit purchasing the previously purchased consumption bundle,
at least when small changes in prices are contemplated.

50 This is a consequence of the fact thatp2X u11 + 2 p X pY u12 + pY2 u22 < 0 , which follows from the alreadystated second order condition for a maximum of utility.

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5.1.5 Income Effects
Wealthy people buy more caviar than poor people. Wealthier people buy more land,
medical services, cars, telephones, and computers than poorer people, because they
have more money to spend on goods and services, and overall, buy more of them. But
wealthier people also buy fewer of some goods, too. Rich people buy fewer cigarettes
and processed cheese food. You don’t see billionaires waiting in line at McDonald’s, andthat probably isn’t because they have an assistant to wait for them. For most goods, at a
sufficiently high income, the purchase tends to trail off as income rises.
When an increase in income causes a consumer to buy more of a good that good is calleda normal good for that consumer. When the consumer buys less, the good is called aninferior good, which is an example of sensible jargon that is rare in any discipline. Thatis, an inferior good is any good whose quantity demanded falls as incomes rise. At asufficiently low income, almost all goods are normal goods, while at a sufficiently highincome, most goods become inferior. Even a Ferrari is an inferior good against somealternatives, such as Lear jets.
The curve that shows the path of consumption as incomes rise is known as an Engel
curve.51 An Engel curve graphs (x(M), y(M)) as M varies, where x(M) is the amount of X
chosen with income M, and similarly y(M) is the amount of is the amount of Y. An
example of an Engel curve is illustrated in Figure 5-11.
yx
Figure 5-11: Engel Curve

51 The Engel curve is named for Ernst Engel (1821-1896), a statistician, not for Friedrich Engels, whowrote with Karl Marx.

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αM
(1 − α) M, y=define thepY
pX
optimal consumption, the Engel curve is a straight line through the origin with slope(1 − α) p X.
α pY
Example (Cobb-Douglas): Since the equations x =Show that, in the case of perfect complements, the Engel curve
5.1.5.1 (Exercise)does not depend on prices.
An inferior good has the quantity fall as incomes rise. Note that, with two goods, at least
one is normal good – they can’t both be inferior goods, for otherwise when income rose,less of both would be purchased. An example of an inferior good is illustrated in Figure5-12. Here, as incomes rise, the consumption of x rises, reaches a maximum, thenbegins to decline. In the declining portion, X is an inferior good.
The definition of the substitution effect now permits us to decompose the effect of aprice change into a substitution effect and an income effect. This is illustrated in Figure
5-13.
What is the mathematical form of the income effect? This is actually morestraightforward to compute than the substitution effect computed above. As with thesubstitution effect, we differentiate the conditions M = px x + py y and px u2 = py u1 ,holding pX and pY constant, to obtain:dM = p X dx + pY dy and p X (u12 dx + u22dy) = pY (u11 dx + u12dy) .
yx
Figure 5-12: Backward Bending – Inferior Good

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y

Substitution
EffectIncomeEffectx
Figure 5-13: Income and Substitution Effects

The second condition can also be written as
dy pY u11 − p X u12=.
dx p X u22 − pY u12
This equation alone defines the slope of the Engel curve, without determining how largea change arises from a given change in M. The two conditions together can be solved forthe effects of M on X and Y. The Engel curve is given bydx
pY2 u11 − 2 p X u12 + p2X u22
dy pY2 u11 − 2 p X u12 + p2X u22
=
=
and
.
dM
p X u22 − pY u12
dM
pY u11 − p X u12
Note (from the second order condition) that good Y is inferior if pY u11 − p X u12 > 0 , or ifuu
u11 u12−> 0 , or 1 is increasing in x. Since 1 is locally constant when M increases,
u2
u2
u1 u2
u
equaling the price ratio, and an increase in y increases 1 (thanks to the second orderu2ucondition), the only way to keep 1 equal to the price ratio is for x to fall. This property
u2
characterizes an inferior good – an increase in the quantity of the good increases themarginal rate of substitution of that good for another good.

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5.1.5.2 (Exercise) Compute the substitution effect and income effect associated with amultiplicative price increase ∆ in pY, that is, multiplying pY by ∆>1, for the caseof Cobb-Douglas utility u(x , y ) = x α y1−α .

5.2 Additional Considerations
Let us revisit the maximization problem considered in this chapter. The consumer can⎛ M − pX x ⎞⎟⎟.
spend M on either or both of two goods. This yields a payoff of h( x ) = u⎜⎜ x ,pY⎝⎠When is this problem well behaved? First, if h is a concave function of x, which implies
h′′( x ) ≤ 0 ,52 then any solution to the first order condition is in fact a maximum. To see
this, note that h′′( x ) ≤ 0 entails h′(x ) decreasing. Moreover, if the point x* satisfies
h′( x *) = 0 , then for x≤x*, h′( x ) ≥ 0 , and for x≥x*, h′( x ) ≤ 0 , because h′(x ) gets smaller
as x gets larger, and h′( x *) = 0 . Now consider x≤x*. Since h′( x ) ≥ 0 , h is increasing as x
gets larger. Similarly, for x≥x*, h′( x ) ≤ 0 , which means h gets smaller as x gets larger.
Thus, h concave and h′( x *) = 0 means that h is maximized at x*.

Thus, a sufficient condition for the first order condition to characterize the maximum ofputility is that h′′( x ) ≤ 0 , for all x, pX, pY, and M. Letting z = X , this is equivalent topY
u11 − 2 zu12 + z 2 u22 ≤ 0 for all z>0.
In turn, we can see that this requires (i) u11≤0 (z=0) and (ii) u22≤0 (z →∞), and (iii)⎛⎞u⎟ . In addition, sinceu11 u22 − u12 ≥ 0 ⎜⎜ z = 11u22 ⎟⎠⎝() ( − u11 − z − u22 )2 + 2z ( u11u22 − u12 ),− u11 + 2 zu12 + z 2u22 =(i), (ii) and (iii) are sufficient for u11 + 2 zu12 + z 2u22 ≤ 0 .
Therefore, if (i) u11≤0 and (ii) u22≤0, and (iii) u11 u22 − u12 ≥ 0 , a solution to the firstorder conditions characterizes utility maximization for the consumer. We will assume
that these conditions are met for the remainder of this chapter.

5.2.1 Corner Solutions
When will a consumer specialize and consume zero of a good? A necessary condition forthe choice of x to be zero is that the consumer doesn’t benefit from consuming a verysmall x, that is, h′(0) ≤ 0 . This means

52 The definition of concavity is that h is concave if 0<a<1 and for all x, y, h(ax+(1-a)y)≥ah(x)+ (1-a)h(y).
It is reasonably straightforward to show this implies the second derivative of h is negative, and if h is twice
differentiable, the converse is true as well.

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⎞ − u ⎛ 0, M
⎞ pX
h′(0) = u1 ⎛⎜ 0, M
≤0,
⎟ 2⎜
⎟
p
p
pY
Y⎠
Y⎠
⎝
⎝
or
⎞
u1 ⎛⎜ 0, M
pY ⎟⎠ p X
⎝
≤
.
pY
⎞
u2 ⎛⎜ 0, M
pY ⎟⎠⎝Moreover, if the concavity of h is met, as assumed above, then this condition is sufficientto guarantee that the solution is zero. To see that, note that concavity of h implies h′ isdecreasing. Combined with h′(0) ≤ 0 , that entails h maximized at 0. An important classof examples of this behavior are quasilinear utility. Quasilinear utility comes in theform u(x, y) = y + v(x), where v is a concave function ( v′′( x ) ≤ 0 for all x).
5.2.1.1 (Exercise)

Demonstrate that the quasilinear consumer will consume zero X ifpand only if v′(0) ≤ x , and that the consumer instead consumes zero Y ifpy
⎞ ≥ p x . The quasilinear utility isoquants, for v( x ) = ( x + 0.03)0.3 , arev′⎛⎜ M⎟⎝ p X ⎠ py

illustrated in Figure 5-14. Note that even though the isoquants curve, they arenonetheless parallel to each other
y
1

u=80
0.8

u=70
u=60

0.6

u=50
0.4

u=40
u=30

0.2

u=20
u=10

0
0

0.2

0.4

0.6

0.8

1

x

Figure 5-14: Quasilinear Isoquants

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The procedure for dealing with corners is generally this. First, check concavity of the hfunction. If h is concave, we have a procedure to solve the problem; when h is notconcave, an alternative strategy must be devised. There are known strategies for somecases that are beyond the scope of this text. Given h concave, the next step is to checkthe endpoints, and verify that h′(0) > 0 (for otherwise x=0 maximizes the consumer’s⎞ < 0 (for otherwise y=0 maximizes the consumer’s utility).
utility) and that h′⎛⎜ M⎟p
X⎠⎝
Finally, at this point we seek the interior solution h′( x ) = 0 . With this procedure we caninsure we find the actual maximum for the consumer, rather than a solution to the firstorder conditions that doesn’t maximize the consumer’s utility.

5.2.2 Labor Supply
Consider a taxi driver who owns a car or convenience store owner, or anyone else who
can set his own hours. Working has two effects on this consumer – more goods
consumption, but less leisure consumption. To model this, we let x be the goods
consumption, L the amount of non-work time or leisure, and working time T – L, where
T is the amount of time available for activities of all kinds. The variable L includes a lotof activities that aren’t necessarily fun, like trips to the dentist and haircuts and sleeping,but for which the consumer isn’t paid, and which represent choices. One could argue
that sleeping isn’t really a choice, in the sense that one can’t choose zero sleep, but thiscan be handled by adjusting T to represent “time available for chosen behavior” so thatT – L is work time and L the chosen non-work activities. We set L to be leisure rather
than labor supply because it is leisure that is the good thing, whereas most of us view
working as something we are willing to do provided we’re paid for it.
Labor supply is different from other consumption because the wage enters the budget
constraint twice – first as the price of leisure and second as income from working. One
way of expressing this is to write the consumer’s budget constraint as
px + wL = M + wT.
Here, M represents non-work income, such as gifts, government transfers, and interest
income. We drop the subscript on the price of X, and use w as the wage. Finally, we use
a capital L for leisure because a small el looks like the number one. The somewhat
Dickensian idea is that the consumer’s maximal budget entails working the total
available hours T, and any non-worked hours are purchased at the wage rate w.
Alternatively, one could express the budget constraint so as to reflect that expenditures
on goods px equals the total money, which is the sum of non-work income M and work
income w(T – L), orpx = M + w(T – L).
These two formulations of the budget constraint are mathematically equivalent.
The strategy for solving the problem is also equivalent to the standard formulation,although there is some expositional clarity used by employing the budget constraint toeliminate x. That is, we write the utility u(x,L)

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⎛ M + w(T − L ) ⎞h( L ) = u⎜⎜, L ⎟⎟.
p⎝⎠
As before, we obtain the first order condition
0 = h′( L*) = −u1 ⎛⎜ w ⎞⎟ + u2
⎝ p⎠
⎛ M + w(T − L*)⎞, L * ⎟⎟ . Note that
where the partial derivatives u1 and u2 are evaluated at ⎜⎜p⎝⎠
the first order condition is the same as the standard two-good theory developed already.
This is because the effect so far is merely to require two components to income: M andwT, both of which are constant. It is only when we evaluate the effect of a wage increasethat we see a difference.
To evaluate the effect of a wage increase, differentiate the first order condition to obtain2⎛⎞ dL u1 ⎛ w ⎞
T −L
T −L
−
− ⎜⎜ ⎟⎟u11+ u12
0 = ⎜ u11 ⎛⎜ w ⎞⎟ − 2u12 ⎛⎜ w ⎞⎟ + u22 ⎟⎜⎟ dw p ⎝ p ⎠
⎝ p⎠
⎝ p⎠
p
p
⎝
⎠
2

Since u11 ⎛⎜ w ⎞⎟ − 2u12 ⎛⎜ w ⎞⎟ + u22 < 0 by the standard second order condition,
⎝ p⎠
⎝ p⎠
u ⎛w⎞
T −L
T −L
dL
− u12
< 0 , that is, these expressions are> 0 if, and only if, 1 + ⎜⎜ ⎟⎟u11p ⎝ p⎠ppdw
equivalent to one another. Simplifying the latter, we obtain
⎛w⎞
T −L
T −L
− ⎜⎜ ⎟⎟u11
+ u12
p
p
⎝ p⎠
> 1 , or,u1p⎛w⎞
− ⎜⎜ ⎟⎟u11 + u12p(T − L ) ⎝ ⎠> 1 , or,u11∂∂
Log(u1 ) >=−Log(T − L ) , or,
∂L
T −L
∂L
∂
∂
Log(u1 ) +Log(T − L ) > 0 , or,∂L∂L

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∂
Log(u1 (T − L )) > 0 .
∂LSince the logarithm is increasing, this is equivalent to u1 (T − L ) being an increasing
function of L. That is, L rises with an increase in wages, and hours worked falls, if themarginal utility of goods times the hours worked is an increasing function of L, holding
constant everything else, but evaluated at the optimal values. The value u1 is themarginal value of an additional good, while the value T-L is the hours worked. Thus, inparticular, if goods and leisure are substitutes, so that an increase in L decreases themarginal value of goods, then an increase in the wage must decrease leisure, and labor
supply increases in the wage. The case where the goods are complements holds a hopefor a decreasing labor supply, so we consider first the extreme case of complements.
Example (perfect complements): u(x, L)= Min {x, L}
In this case, the consumer will make consumption and leisure equal to maximize theutility, so
M + w(T − L*)
= L*
p
or

M + wT
M + wT
p
L* =
=
.
w
+
p
w
1+
p
Thus, L is increasing in the wage if pT>M, that is, if M is sufficiently small that one can’t
buy all one’s needs and not work at all. (This is the only reasonable case for this utility
function.) With strong complements between goods and leisure, an increase in the wage
induces fewer hours worked.
α⎛ M + w(T − L ) ⎞ 1−α⎟⎟ L .
Example (Cobb-Douglas): h( L ) = ⎜⎜p⎝⎠
The first order condition gives⎛ M + w(T − L ) ⎞⎟⎟0 = h′( L ) = −α⎜⎜
p
⎝
⎠

α −1

L

α

⎛ M + w(T − L ) ⎞ −α⎟⎟ L
+ (1 − α)⎜⎜pp⎝⎠1 −α wor

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αL

w
M + w(T − L )= (1 − α)ppw
M + wT
L = (1 − α)
p
p
⎛M
⎞
+T ⎟
or L = (1 − α)⎜⎝w⎠
If M is high enough, the consumer doesn’t work but takes L=T; otherwise, the equation
gives the leisure, and labor supply is given by

{

( w)}

T − L = Max 0, αT − (1 − α) M

Labor supply increases with the wage, no matter how high the wage goes.
5.2.2.1 (Exercise) Show that an increase in the wage increases the consumption of
goods, that is, x increases when the wage increases.

2003

2000

1997

1994

1991

1988

1985

1982

1979

1976

1973

1970

1967

40
39
38
37
36
35
34
33
32
31
1964

Hrs/wk

The wage affects not just the price of leisure, but also the income level; this makes it
possible that the income effect of a wage increase dominates the substitution effect.
Moreover, we saw that this is more likely when the consumption of goods takes time,that is, the goods and leisure are complements.

Year

Figure 5-15: Hours per Week

As a practical matter, for most developed nations, increases in wages are associated withfewer hours worked. The average workweek prior to 1950 was 55 hours, which fell to 40
hours by the mid-1950s. The workweek has gradually declined since then, as Figure
5-15 illustrates.

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Thought Question: Does a bequest motive – the desire to give money to others – change
the likelihood that goods and leisure are complements?

5.2.3 Compensating Differentials
A number of physicists have changed careers, to become researchers in finance or
financial economics. Research in finance pays substantially better than research inphysics, and yet requires many of the same mathematical skills like stochastic calculus.
Physicists who see their former colleagues driving Porsches and buying summer houses
are understandably annoyed that finance research – which is intellectually no moredifficult or challenging than physics – pays so much better. Indeed, some physicists saythat other fields – finance, economics, and law – “shouldn’t” pay more than physics.
The difference in income between physics researchers and finance researchers is an
example of a compensating differential. A compensating differential is income or costs
that equalize different choices. There are individuals who could become either
physicists or finance researchers. At equal income, too many choose physics and too few
choose finance, in the sense that there is a surplus of physicists, and a shortage offinance researchers. Finance salaries must exceed physics salaries in order to induce
some of the researchers capable of doing either one to switch to finance, which
compensates those individuals for doing the less desirable task.
Jobs that are dangerous or unpleasant must pay more than jobs requiring similar skills
but without the bad attributes. Thus, oil field workers in Alaska’s North Slope, well
above the Arctic Circle, earn a premium over workers in similar jobs in Houston, Texas.
The premium – or differential pay – must be such that the marginal worker isindifferent between the two choices – the extra pay compensates the worker for theadverse working conditions. This is why it is known in economics jargon by the phraseof a compensating differential.
The high salaries earned by professional basketball players are not compensating
differentials. These salaries are not created by a need to induce tall people to choosebasketball over alternative jobs like painting ceilings, but instead are payments thatreflect the rarity of the skills and abilities involved. Compensating differentials are
determined by alternatives, not by direct scarcity. Professional basketball players are
well-paid for the same reason that Picasso’s paintings are expensive: there aren’t very
many of them relative to demand.
A compensating differential is a feature of other choices as well as career choices. For
example, many people would like to live in California, for its weather and scenic beauty.
Given the desirability of California over, say, Lincoln, Nebraska or Rochester, New York,
there must be a compensating differential for living in Rochester, and two significant
ones are air quality and housing prices. Air quality worsens as populations rise, thus
tending to create a compensating differential. In addition, the increase in housing
prices also tends to compensate – housing is inexpensive in Rochester, at least
compared to California.53
53 There are other compensations besides housing to living in Rochester – cross-country skiing, proximity

to mountains and lakes. Generally employment is only a temporary factor that might compensate,

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Housing prices also compensate for location within a city. For most people, it is moreconvenient – both in commuting time and for services – to be located near the central
business district than in the outlying suburbs. The main compensating differentials areschool quality, crime rates, and housing prices. We can illustrate the ideas with a simple
model of a city.

5.2.4 Urban Real Estate Prices
An important point to understand is that the good in limited supply in cities is not
physical structures like houses, but the land on which the houses sit. The cost ofbuilding a house in Los Angeles is quite similar to the cost of building a house in
Rochester, New York. The big difference is the price of land. A $1 million house in Los
Angeles might be a $400,000 house sitting on a $600,000 parcel of land. The same
house in Rochester might be $500,000 – a $400,000 house on a $100,000 parcel ofland.
Usually, land is what fluctuates in value, rather than the price of the house that sits on
the land. When the newspaper reports that house prices rose, in fact what rose was land
prices, for the price of housing has changed only at a slow pace, reflecting increased
wages of house builders and changes in the price of lumber and other inputs. These dochange, but historically the changes have been small compared to the price of land.
We can construct a simple model of a city to illustrate the determination of land prices.
Suppose the city is constructed in a flat plane. People work at the origin (0,0). This
simplifying assumption is intended to capture the fact that a relatively small, central
portion of most cities involves business, with a large area given over to housing. The
assumption is extreme, but not unreasonable as a description of some cities.
Suppose commuting times are proportional to distance from the origin. Let c(t) be thecost to the person of a commute of time t, and let the time taken be t = λr, where r is the
distance. The function c should reflect both the transportation costs and the value oftime lost. The parameter λ accounts for the inverse of the speed in commuting, with ahigher λ indicating slower commuting. In addition, we assume that people occupy a
constant amount of land. This assumption is clearly wrong empirically, and we willconsider making house size a choice variable later.
A person choosing a house priced at p(r) at distance r thus pays c(λr) + p(r) for the
combination of housing and transportation. People will choose the lowest costalternative. If people have identical preferences about housing and commuting, thenhouse prices p will depend on distance, and will be determined by c(λr) + p(r) equal to a
constant, so that people are indifferent to the distance from the city center – decreased
commute time is exactly compensated by increased house prices.

because employment tends to be mobile, too, and move to the location the workers prefer, when that is
possible. It is not possible on Alaska’s North Slope.

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The remaining piece of the model is to figure out the constant. To do this, we need tofigure out the area of the city. If the total population is N, and people occupy an area of2, and thus
one per person, the city size rmax satisfies N = π rmax

rmax =Nπ

At the edge of the city, the value of land is given by some other use, like agriculture.
From the perspective of the determinant of the city’s prices, this value is approximately
constant. As the city takes more land, the change in agricultural land is a very small
portion of the total land used for agriculture. Let the value of agricultural land be v per
housing unit size. Then the price of housing p(rmax) = v, because that is the value of landat the edge of the city. This lets us compute the price of all housing in the city:⎛N ⎞⎟c(λr ) + p(r) = c(λrmax ) + p(rmax ) = c(λrmax ) + v = c⎜⎜ λ
+v
π ⎟⎠
⎝
or
⎛
N ⎞⎟
p(r) = c⎜⎜ λ+ v - c(λr ) .
π ⎟⎠⎝This equation produces housing prices like those illustrated in Figure 5-16, where thepeak is the city center. The height of the figure indicates the price of housing.

Figure 5-16: House Price Gradient

It is straightforward to verify that house prices increase in the population N and thecommuting time parameter λ, as one would expect. To quantify the predictions, weconsider a city with a population of 1,000,000, a population density of 10,000 per
square mile, and an agricultural use value of $6 million per square mile. To translatethese assumptions into the model’s structure, first note that a population density of
10,000 per square mile creates a fictitious “unit of measure” of about 52.8 feet, which
we’ll call a purlong, so that there is one person per square purlong (2788 square feet).
Then the agricultural value of a property is v = $600 per square purlong. Note that thisdensity requires a city of radius rmax equal to 564 purlongs, which is 5.64 miles.

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The only remaining structure to identify in the model is the commuting cost c. To
simplify the calculations, let c be linear. Suppose that the daily cost of commuting is $2
per mile (roundtrip), so that the present value of daily commuting costs in perpetuity is
about $10,000 per mile.54 This translates into a cost of commuting of $100.00 per
purlong. Thus, we obtain
⎛
⎛ N
⎞
N ⎞⎟
⎜
⎟ + $600 = $57,000 − $100r .
v
r
r
+
λ
=
−
p(r) = c⎜⎜ λ
c(
)
$
100
⎟
⎜ π
⎟
π
⎝
⎠
⎝
⎠
Thus, the same 2788 square foot property at the city edge sells for $600, versus $57,000
less than six miles away at the city center. With reasonable parameters, this model
readily creates dramatic differences in land prices, based purely on commuting time.
As constructed, a quadrupling of population approximately doubles the price of land in
the central city. This probably understates the change, since a doubling of the
population would likely increase road congestion, increasing λ and further increasing
the price of central city real estate.
As presented, the model contains three major unrealistic assumptions. First, everyone
lives in an identically-sized piece of land. In fact, however, the amount of land used
tends to fall as prices rise. At $53 per square foot, most of us buy a lot less land than attwenty cents per square foot. As a practical matter, the reduction of land per capita is
accomplished both through smaller housing units and through taller buildings, which
produce more housing floor space per acre of land. Second, people have distinct
preferences, and the disutility of commuting, as well as the value of increased space,vary with the individual. Third, congestion levels are generally endogenous – the more
people that live between two points, the greater the traffic density and consequently thelower the level of λ. The first two problems arise because of the simplistic nature of
consumer preferences embedded in the model, while the third is an equilibrium issue
requiring consideration of transportation choices.
This model can readily be extended to incorporate different types of people, different
housing sizes, and endogenous congestion. To illustrate such generalizations, consider
making the housing size endogenous. Suppose preferences are represented by the utility
function:u = H α − λr − p(r ) H ,where H is the house size that the person chooses, and r is the distance they choose.
This adaptation of the model reflects two issues. First, the transport cost has been set tobe linear in distance, for simplicity. Second, the marginal value of housing decreases in
the house size, but the value of housing doesn’t depend on distance from the center. For
54 Figure 250 working days per year, for an annual cost of about $500 per mile, yielding a present value at
5% interest of $10,000. See Section 4.3.1. With a time value of $25 per hour, and an average speed of 40
mph (1.5 minutes per mile), the time cost is 62.5 cents per minute. Automobile costs (gas, cardepreciation, insurance) are about 35-40 cents per mile. Thus the total is around $1 per mile, which
doubles with roundtrips.

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these preferences to make sense, α<1 (otherwise either zero or an infinite house size
emerges). A person with these preferences optimally would choose a house size of1⎛ α ⎞ 1 −α⎟⎟
H = ⎜⎜
p(r)⎝⎠

resulting in utility
1 ⎞
−α
⎛ α
⎜ 1 −α⎟u* = ⎜ α− α 1−α ⎟ p(r ) 1−α − λr
⎜
⎟
⎝
⎠
1 −α

1 ⎞ α
⎛ α
⎜ 1 −α⎟α− α 1 −α ⎟⎜= p(r ) .
Utility at every location is constant, so⎜ u * + λr ⎟⎜⎟⎝⎠A valuable attribute of the form of the equation for p is that the general form depends onthe equilibrium values only through the single number u*. This functional form
produces the same qualitative shapes as in Figure 5-16. Using the form, we can solve forthe housing size H.
11⎛ α ⎞ 1 −α⎟⎟
H (r ) = ⎜⎜⎝ p(r ) ⎠

1
1
⎞α
1 ⎛
⎜ u * + λr ⎟
⎞
⎛
u
r
α
*
+
λ
α
⎛
⎞α
⎟ = ⎜⎜⎟⎟ = ⎜(u * + λr ) ⎟ .
= α 1 −α ⎜
−
1
1
α
⎝1−α
⎠
⎜⎜
⎟⎟
⎝ α −1 ⎠⎝ α 1 −α − α 1 − α ⎠The space in the interval [r, r+∆] is π(2r∆+∆2). In this interval, there are approximately1π(2r∆ + ∆2 )⎛ 1 − α ⎞α= π(2r∆ + ∆2 )⎜⎟ people. Thus, the number of people within rmax
H (r )⎝ α(u * + λr ) ⎠of the city center is
rmax

⎛

1− α

1
⎞α

.

∫ 2π r ⎜⎜⎝ α(u * +λr ) ⎟⎟⎠ dr = N
0This equation, when combined with the value of land on the periphery:

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1 −α

1 ⎞ α
⎛ α
⎜ 1 −α⎟α− α 1 −α ⎟⎜v = p(rmax ) =⎜ u * + λrmax ⎟⎜⎟⎝⎠jointly determine rmax and u*.
5.2.4.1 (Exercise)rmax.

For the case of α= ½, solve for the equilibrium values of u* andWhen different people have different preferences, the people with the highest disutilityof commuting will tend to live closer to the city center. These tend to be people with thehighest wages, since one of the costs of commuting is time that could have been spentworking.

5.2.5 Dynamic Choice
The consumption of goods doesn’t take place in a single instance, but over time. How
does time enter into choice? We’re going to simplify the problem a bit, and focus only
on consumption and set aside working for the time being. Let x1 be consumption in thefirst period, x2 in the second period. Suppose the value of consumption is the same ineach period, so thatu(x1, x2) = v(x1) + δv(x2),where δ is called the rate of “pure” time preference. The consumer is expected to haveincome M1 in the first period and M2 in the second. There is a market for loaning andborrowing, which we assume has a common interest rate r.
The consumer’s budget constraint, then, can be written(1+r)(M1 – x1) = x2 – M2.
This equation says that the net savings in period 1, plus the interest on the net savings inperiod 1 equals the net expenditure in period 2. This is because whatever is saved inperiod 1 earns interest and can then be spent in period 2; alternatively, whatever isborrowed in period 1 must be paid back with interest in period 2. Rewriting theconstraint:(1+r)x1 + x2 = (1+r)M1 + M2.
This equation is known as the intertemporal budget constraint. It has two immediate
consequences. First, 1+r is the price of period 2 consumption in terms of period 1
consumption. Thus, the interest rate gives the relative prices. Second, the relevant
income is “permanent income” rather than “current income.” That is, a change inincomes that leaves the present value of income the same should have no effect on the
choice of consumption.

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Once again, as with the labor supply, a change in the interest rate affects not just theprice of consumption, but also the budget for consumption. Put another way, an
increase in the interest rate represents an increase in budget for net savers, but adecrease in budget for net borrowers.
As always, we rewrite the optimization problem to eliminate one of the variables, toobtainu = v( x1 ) + δv((1 + r )( M 1 − x1 ) + M 2 )Thus the first order conditions yield
0 = v′( x1 ) − (1 + r )δv′(x2 )This condition says that the marginal value of consumption in period 1, v′( x1 ) , equals
the marginal value of consumption in period 2, δv′(x2 ) , times the interest factor. Thatis, the marginal present values are equated. Note that the consumer’s private time
preference, δ, need not be related to the interest rate. If the consumer values period 1
consumption more than does the market, so δ(1+r) < 1, then v′( x1 ) < v′(x2 ) , that is, theconsumer consumes more in period 1 than in period 2.55 Similarly, if the consumer’s
discount of future consumption is exactly equal to the market discount, δ(1+r) = 1, theconsumer will consume the same amount in both periods. Finally, if the consumer
values period 1 consumption less than the market, δ(1+r) > 1, the consumer willconsume more in period 2. In this case, the consumer is more patient than the market.
x2(M1,M2)
Repayment

Period 1
Borrowing
x1
Figure 5-17: Borrowing and Lending
55 As usual, we are assuming that utility is concave, which in this instance means the second derivative of

v is negative, which means the derivative of v is decreasing. In addition, to insure an interior solution, it
is useful to require the Inada conditions: v′(0) = ∞, v′(∞ ) = 0 .

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Whether the consumer is a net lender or borrower depends not just on the preference
for earlier versus later consumption, but also on incomes. This is illustrated in Figure5-17. In this figure, the consumer’s income mostly comes in the second period. As aconsequence, the consumer borrows in the first period, and repays in the second period.
The effect of an interest rate increase is to pivot the budget constraint around the point(M1,M2). Note that this point is always feasible – that is, it is feasible to consume one’s
own endowment. The effect of an increase in the interest rate is going to depend onwhether the consumer is a borrower or a lender. As Figure 5-18 illustrates, the net
borrower borrows less in the first period – the price of first period consumption has
risen and the borrower’s wealth has fallen. It is not clear whether the borrower
consumes less in the second period because the price of second period consumption has
fallen even though wealth has fallen, too, two conflicting effects.
An increase in interest rates is a benefit to a net lender. The lender has more income,and the price of period 2 consumption has fallen. Thus the lender must consume morein the second period, but only consumes more in the first period (lends less) if theincome effect outweighs the substitution effect. This is illustrated in Figure 5-19.

x2(M1,M2)

x1
Figure 5-18: Interest Rate Change

The government from time to time will rebate a portion of taxes to “stimulate” theeconomy. An important aspect of the effects of such a tax rebate is the effect to which
consumers will spend the rebate, versus savings the rebate, because the stimulative
effects of spending are thought to be larger than the stimulative effects of savings.56 The

56 This belief shouldn’t be accepted as necessarily true; it was based on a model that has since been widely

rejected by the majority of economists. The general idea is that spending creates demand for goods, thus

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theory suggests how people will react to a “one-time” or transitory tax rebate, compared
to a permanent lowering of taxes. In particular, the budget constraint for the consumer
spreads lifetime income over the lifetime. Thus, for an average consumer that might
spend a present value of $750,000 over a lifetime, a $1,000 rebate is small potatoes. On
the other hand, a $1,000/year reduction is worth $20,000 or so over the lifetime, whichshould have twenty times the effect of the transitory change on the current expenditure.
Tax rebates are not the only way we receive one-time payments. Money can be found, or
lost, and we can have unexpected costs or windfall gifts. From an intertemporal budget
constraint perspective, these transitory effects have little significance, and thus thetheory suggests people shouldn’t spend much of a windfall gain in the current year, nor
cut back significantly when they have a moderately-sized unexpected cost.

x2(M1,M2)

x1
Figure 5-19: Interest Rate Increase on Lenders

As a practical matter, most individuals can’t borrow at the same rate at which they lend.
Many students borrow on credit cards at very high interest rates, and obtain a fractionof that in interest on savings. That is to say, borrowers and lenders face different
interest rates. This situation is readily explored with a diagram like Figure 5-20. The
cost of a first period loan is a relatively high loss of x2, and similarly the value of first
period savings is a much more modest increase in second period consumption. Sucheffects tend to favor “neither a borrower nor a lender be,” as Shakespeare recommends,
although it is still possible for the consumer to optimally borrow in the first period (e.g.
if M1=0) or in the second period (if M2 is small relative to M1).

encouraging business investment in production. However, savings encourage investment by producing
loanable funds, so it isn’t at all obvious whether spending or savings have a larger effect.

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x2

(M1,M2)

x1
Figure 5-20: Different Rates for Borrowing and Lending

Differences in interest rates causes transitory changes in income to have much larger
effects than the intertemporal budget constraint would suggest, and may go a long way
to explaining why people don’t save much of a windfall gain, and suffer a lot
temporarily, rather than a little for a long time, when they have unexpected expenses.
This is illustrated in Figure 5-21.

x2(M1,M2)

x1
Figure 5-21: The Effect of a Transitory Income Increase

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5.2.6 Risk
There are many risks in life, even if one doesn’t add to these risks by intentionallybuying lottery tickets. Gasoline prices go up and down, the demand for people trainedin your major fluctuates, house prices change. How do people value gambles? The
starting point for the investigation is the von Neumann-Morgenstern utility function.
The idea of a von Neumann-Morgenstern utility function for a given person is that foreach possible outcome x, there is a value v(x) assigned by the person, and the averagevalue of v is the value the person assigns to the risky outcome. This is a “state of theworld” approach, in the sense that each of the outcomes is associated with a state of theworld, and the person maximizes the expected value of the various possible states of theworld. Value here doesn’t mean a money value, but a psychic value or utility.
To illustrate the assumption, consider equal probabilities of winning $100 and winning$200. The expected outcome of this gamble is $150 – the average of $100 and $200.
However, the expected value of the outcome could be anything between the value of$100 and the value of $200. The von Neumann-Morgenstern utility is ½v($100) +½v($200).
The von Neumann-Morgenstern formulation has certain advantages, including the logic
that what matters is the average value of the outcome. On the other hand, in many tests,
people behave in ways not consistent with the theory.57 Nevertheless, the von Neumannapproach is the prevailing model of behavior under risk.
To introduce the theory, we will consider only money outcomes, and mostly the case of
two money outcomes. The person has a Neumann-Morgenstern utility function v ofthese outcomes. If the possible outcomes are x1, x2, … , xn and these occur withprobability π1, π2, … , πn respectively, the consumer’s utility isnu = π1 v( x1 ) + π2 v( x2 ) + ... + πn v( x n ) = ∑ πi v( x i )i =1This is the meaning of “having a von Neumann-Morgenstern utility function” – thatutility can be written in this weighted sum form.
The first insight that flows from this definition is that a individual dislikes risk if v isconcave. To see this, note that the definition of concavity posits that v is concave if, forall π in [0,1], and all values x1 and x2,v(πx1 + (1 − π)x2 ) ≥ πv( x1 ) + (1 − π)v( x2 )For smoothly differentiable functions, concavity is equivalent to a second derivative thatis not positive. Using induction, the definition of concavity can be generalized to show:

57 For example, people tend to react more strongly to very unlikely events than is consistent with thetheory.

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v(π1 x1 + π2 x2 + ... + πn x n ) ≥ π1 v( x1 ) + π2 v( x2 ) + ... + πn v( x n )That is, a consumer with concave value function prefers the average outcome to therandom outcome. This is illustrated in Figure 5-22. There are two possible outcomes, x1
and x2. The value x1 occurs with probability π and x2 with probability 1-π. This means
the average or expected outcome is πx1+(1-π)x2. The value v(πx1+(1-π)x2) is the value atthe expected outcome πx1+(1-π)x2, while πv(x1)+(1-π)v(x2) is the average of the value ofthe outcome. As is plainly visible in the picture, concavity makes the average outcome
preferable to the random outcome. People with concave von Neumann-Morgansternutility functions are known as risk averse people.

vv(πx1+(1-π)x2)

πv(x1)+(1-π)v(x2)x1 CE

πx1+(1-π)x2x2

xFigure 5-22: Expected Utility and Certainty Equivalents

A useful concept is the certainty equivalent of a gamble. The certainty equivalent is anamount of money that provides equal utility to the random payoff of the gamble. The
certainty equivalent is labeled CE in the diagram. Note that CE is less than the expected
outcome, if the person is risk averse. This is because risk averse individuals prefer the
expected outcome to the risky outcome.
The risk premium is defined to be the difference between the expected payoff (in thegraph, this is expressed as πx1 + (1 – π)x2) and the certainty equivalent. This is the costof risk – it is the amount of money an individual would be willing to pay to avoid risk.
This means as well that the risk premium is the value of insurance. How does the risk
premium of a given gamble change when the base wealth is increased? It can be shownthat the risk premium falls as wealth increases for any gamble if, and only if,58

58 R. Preston McAfee and Daniel Vincent, The Price Decline Anomaly, Journal of Economic Theory 60,

June, 1993, 191-212.

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−

v′′( x )is decreasing.
v′( x )

v′′( x )is known as the Arrow-Pratt59 measure of risk aversion, andv′( x )
also as the measure of absolute risk aversion. To get an idea why this measure matters,
consider a quadratic approximation to v. Let µ be the expected value and σ2 be theexpected value of (x – µ)2. Then we can approximate v(CE) two different ways.

The measure ρ( x ) = −v(µ) + v′(µ)(CE − µ) ≈ v(CE ) = E {v( x )} ≈ E {v(µ) + v′(µ)( x − µ) + ½v′′(µ)( x − µ)2 } ,thusv(µ) + v′(µ)(CE − µ) ≈ E {v(µ) + v′(µ)( x − µ) + ½v′′(µ)( x − µ)2 } .
Canceling v(µ) from both sides and noting that the average value of x is µ, so E(x–µ)=0,
we havev′(µ)(CE − µ) ≈ ½v′′(µ)σ2 .
Then, dividing by v′(x ) ,µ − CE ≈ −½

v ′′( µ ) 2
σ = ½ ρ ( µ )σ 2 .
v ′( µ )That is, the risk premium, the difference between the average outcome and the certainty
equivalent, is approximately equal to the Arrow-Pratt measure, times half the variance,at least when the variance is small.
5.2.6.1 (Exercise) Use a quadratic approximation on both sides to sharpen theestimate of the risk premium. First, notev(µ) + v′(µ)(CE − µ) + ½v′′(µ)(CE − µ)2 ≈ v(CE )= E {v( x )} ≈ E {v(µ) + v′(µ)( x − µ) + ½v′′(µ)( x − µ)2 } .
1Conclude that µ − CE ≈ ⎛⎜ 1 + ρ2σ2 − 1 ⎞⎟ . This approximation is exact to the secondρ⎝⎠order.
The translation of risk into dollars, by way of a risk premium, can be assessed even forlarge gambles if we are willing to make some technical assumptions. Suppose the utility

59 The measure was named after its discoverers Nobel laureate Kenneth Arrow and John Pratt.

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has constant absolute risk aversion or CARA, that is ρ = −v′′( x )is a constant. This turnsv′( x )

out to imply, after setting the utility of zero to zero, that1v( x ) = (1 − e −ρx ).
ρ(This formulation is derived by setting v(0)=0 handling the case of ρ=0 withappropriate limits.) Now also assume that the gamble x is normally distributed withmean µ and variance σ2. Then the expected value of v(x) is⎛ ρ ⎞⎛−ρ⎜ µ − σ 2 ⎟ ⎞⎟1⎜
Ev( x ) = ⎜ 1 − e ⎝ 2 ⎠ ⎟.
ρ⎜
⎟
⎝
⎠

It is an immediate result from this formula that the certainty equivalent, with CARAρ
preferences and normal risks, is µ − σ2 . Hence the risk premium of a normal
2ρ
distribution for a CARA individual is σ2 . This formulation will appear when we
2
consider agency theory and the challenges of motivating a risk averse employee whenoutcomes have a substantial random component.
An important aspect of CARA with normally distributed risks is that the preferences of
the consumer are linear in the mean of the gamble and the variance. In fact, given aρchoice of gambles, the consumer selects the one with the highest value of µ − σ2 . Such2
preferences are often called “mean variance preferences,” and they comprise thefoundation of modern finance theory.
5.2.6.2 (Exercise) Suppose u(x) = x0.95 for a consumer with a wealth level of $50,000.
Consider a gamble with equal probability of winning $100 and losing $100 andcompute the risk premium associated with the gamble.
5.2.6.3 (Exercise) Suppose u(x) = x0.99 for a consumer with a wealth level of$100,000. A lottery ticket costs $1 and pays $5,000,000 with the probability
1. Compute the certainty equivalent of the lottery ticket.
10,000,000
5.2.6.4 (Exercise) The return on U.S. government treasury investments isapproximately 3%. Thus, a $1 investment returns $1.03 after one year. Treat
this return as risk-free. The stock market (S&P 500) returns 7% on average andhas a variance that is around 16% (the variance of return on a $1 investment is$0.16). Compute the value of ρ for a CARA individual. What is the risk

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premium associated equal probabilities of a $100 gain or loss given the value ofρ?

5.2.7 Search
In most communities, every Wednesday grocery stores advertise sale prices in a
newspaper insert, and these prices vary from week to week. Prices can vary a lot fromweek to week and from store to store. The price of gasoline varies as much as fifteen
cents per gallon in a one mile radius. Decide you want a specific Sony television, andyou may see distinct prices at Best Buy, Circuit City, and other electronics retailers. For
many goods and services, there is substantial variation in prices, which implies that
there are gains for buyers to search for the best price.
The theory of consumer search behavior is just a little bit arcane, but the basic insightwill be intuitive enough. The general idea is that, from the perspective of a buyer, theprice that is offered is random, and has a probability density function f(p). If a
consumer faces a cost of search (e.g. if you have to visit a store, in person, telephonicallyor virtually, the cost includes your time and any other costs necessary to obtain a pricequote), the consumer will set a reservation price, which is a maximum price they will
pay without visiting another store. That is, if a store offers a price below p*, theconsumer will buy, and otherwise they will visit another store, hoping for a better price.
Call the reservation price p* and suppose that the cost of search is c. Let J(p*) represent
the expected total cost of purchase (including search costs). Then J must equalJ ( p*) = c +

∫

p*

0

∫

∞

pf ( p)dp + J ( p*) f ( p)dp .
p*This equation arises because the current draw (which costs c) could either result in a
price less than p*, in which case observed price, with density f, will determine the pricepaid p, or the price will be too high, in which case the consumer is going to take anotherdraw, at cost c, and on average get the average price J(p*). It is useful to introduce thexcumulative distribution function F, with F ( x ) = ∫ f ( p)dp . Note that something has to0

happen, so F(∞)=1.
We can solve the equality for J(p*),
p*∫ pf ( p)dp + c .
J ( p*) = 0
F ( p*)

This expression has a simple interpretation. The expected price J(p*) is composed off ( p)
p*
dp . This has thetwo terms. The first is the expected price, which is ∫ p
0
F ( p*)
interpretation of the average price conditional on that price being less than p*. This is

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f ( p)is in fact the density of the random variable which is the price given thatF ( p*)cthe price is less than p*. The second term is. This is the expected search costs,
F ( p*)
1and it arises because
is the expected number of searches. This arises because theF ( p*)
odds of getting a price low enough to be acceptable is F(p*). There is a general statisticalproperty underlying the number of searches. Consider a basketball player who
successfully shoots a free throw with probability y. How many throws on average musthe throw to sink one basket? The answer is 1/y. To see this, note that the probability
that exactly n throws are required is (1-y)n-1 y. This is because n are required means n-1
must fail (probability (1-y)n-1) and then the remaining one go in, with probability y.
Thus, the expected number of throws is
becausey + 2(1 - y)y + 3(1 - y) 2 y + 4 (1 - y) 3 y + …
= y(1 + 2(1 - y) + 3(1 - y) 2 + 4 (1 - y) 3 + …)(

= y (1 + (1 - y) + (1 - y)2 + (1 - y)3 + …) + (1 − y)(1 + (1 - y) + (1 - y)2 + (1 - y)3 + …)
+ (1 − y)2 (1 + (1 - y) + (1 - y)2 + (1 - y)3 + …) + (1 − y)3 (1 + (1 - y) + (1 - y)2 + …) + ...
⎛1
⎞ 1
1
1
1
= y ⎜⎜ + (1 − y) + (1 − y)2 + (1 − y)3 + ... ⎟⎟ = .
y
y
y
⎝y
⎠ y
Our problem has the same logic, where a successful basketball throw corresponds tofinding a price less than p*.
The expected total cost of purchase, given a reservation price p* is given byp*∫ pf ( p)dp + c .
J ( p*) = 0
F ( p*)

But what value of p* minimizes cost? Let’s start by differentiating:p*f ( p*) f ( p*)∫0 pf ( p)dp + c
J ′( p*) = p *−F ( p*)F ( p*)2

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p*
⎛
⎞
pf ( p)dp + c ⎟ f ( p*)∫f ( p*) ⎜0( p * − J ( p*)).
=
⎜ p*−
⎟=
F ( p*) ⎜F ( p*)⎟ F ( p*)⎝⎠Thus, if p*<J(p*), J is decreasing, and it lowers cost to increase p*. Similarly, if
p*>J(p*), J is increasing in p*, and it reduces cost to decrease p*. Thus, minimization
occurs at a point where p*=J(p*).
Moreover, there is only one such solution to the equation p*=J(p*) in the range where fis positive. To see this, note that at any solution to the equation p*=J(p*), J ′( p*) = 0
andJ ′′( p*) =d ⎛ f ( p*)⎜⎜( p * − J ( p*))⎞⎟⎟
dp * ⎝ F ( p*)⎠⎛ d f ( p*) ⎞f ( p*)f ( p*)⎟⎟( p * − J ( p*)) +
= ⎜⎜
> 0.
(1 − J ′( p*)) =F ( p*)F ( p*)⎝ dp * F ( p*) ⎠This means that J takes a minimum at this value, since its first derivative is zero and its
second derivative is positive, and that is true about any solution to p*=J(p*). Were
there to be two such solutions, J ′ would have to be both positive and negative on theinterval between them, since J is increasing to the right of the first (lower) one, anddecreasing to the left of the second (higher) one. Consequently, the equation p*=J(p*)
has a unique solution that minimizes the cost of purchase.
Consumer search to minimize cost dictates setting a reservation price equal to the
expected total cost of purchasing the good, and purchasing whenever the price offered islower than that level. That is, it is not sensible to “hold out” for a price lower than what
you expect to pay on average, although this might be well useful in a bargaining context
rather than in a store searching context.
Example (Uniform): Suppose prices are uniformly distributed on the interval [a,b]. For
p* in this interval,∫p*

J ( p*) = 0=

pf ( p)dp + c
F ( p*)p*=

dp∫a p b − a + c
p * −ab−a½( p *2 −a2 ) + c(b − a)c(b − a)= ½( p * + a) +.
p * −ap * −aThus, the first order condition for minimizing cost is

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0 = J ′( p*) = ½ −c(b − a), implying p* = a + 2c(b − a) .

( p * −a)2

There are a couple of interesting observations about this solution. First, notsurprisingly, as c→0, p*→a, that is, as the search costs go to zero, one holds out for thelowest possible price. This is sensible in the context of the model, but in the real searchsituations delay may also have a cost that isn’t modeled here. Second, p* < b, themaximum price, if 2c<(b – a). Put another way, if the most you can save by a search is
twice the search cost, don’t search, because the expected gains from search will be half
the maximum gains (thanks to the uniform distribution) and the search unprofitable.
The third observation, which is much more general than the specific uniform example, isthat the expected price is a concave function of the cost of search (second derivative
negative). That is in fact true for any distribution. To see this, define a functionp*pf ( p)dp + c∫.
H (c ) = min J ( p*) = min
0

p*

p*

F ( p*)

Since J ′( p*) = 0 ,H ′(c ) =∂1
J ( p*) =.
F ( p*)∂c

It then needs only a modest effort to show p* is increasing in c, from which it follows
that H is concave. This means that the effects of an increase in c are passed on at adecreasing rate. Moreover, it means that a consumer should rationally be risk averse
about the cost of search.
5.2.7.1 (Exercise) Suppose that there are two possible prices, 1 and 2, and that theprobability of the lower price 1 is x. Compute the consumer’s reservation price,which is the expected cost of searching, as a function of x and the cost of searchc. For what values of x and c should the consumer accept 2 on the first search,or continue searching until the lower price 1 is found?

5.2.8 Edgeworth Box
The Edgeworth60 box considers a two person, two good “exchange economy.” That is,
two people have utility functions of two goods and endowments (initial allocations) of
the two goods. The Edgeworth box is a graphical representation of the exchange
problem facing these people, and also permits a straightforward solution to theirexchange problem.

60 Francis Edgeworth, 1845-1926, introduced a variety of mathematical tools including calculus forconsidering economics and political issues, and was certainly among the first to use advanced
mathematics for studying ethical problems.

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The Edgeworth box is represented in Figure 5-23. Person 1 is “located” in the lower left
(southwest) corner, and person 2 in the upper right (northeast). The X good is given on
the horizontal axis, the Y good on the vertical. The distance between them is the total
amount of the good they have between them. A point in the box gives the allocation of
the good – the distance to the lower left to person 1, remainder to person 2. Thus, forthe point illustrated, person 1 obtains (x1, y1), and person 2 obtains (x2, y2). The total
amount of each good available to the two people will be fixed.

2

y2

y1

1
x1

x2

Figure 5-23: The Edgeworth Box

What points are efficient? The economic notion of efficiency is that an allocation isefficient if it is impossible to make one person better off without harming the other, thatis, the only way to improve 1’s utility is to harm 2, and vice versa. Otherwise, if theconsumption is inefficient, there is a re-arrangement that makes both parties better off,
and the parties should prefer such a point. Now, there is no sense of fairness embeddedin the notion, and there is an efficient point in which one person gets everything and theother nothing. That might be very unfair, but it could still be the case that improving 2
must necessarily harm 1. The allocation is efficient if there is no waste or slack in thesystem, even if it is wildly unfair. To distinguish this economic notion, it is sometimes
called Pareto Efficiency.61
We can find the Pareto-efficient points by fixing person 1’s utility and then asking what
point, on the indifference isoquant of person 1, maximizes person 2’s utility? At that
61 Vilfredo Pareto, 1848-1923, was a pioneer in replacing concepts of utility with abstract preferences,which was later adopted by the economics profession and remains the modern approach.

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point, any increase in person 2’s utility must come at the expense of person 1, and viceversa, that is, the point is Pareto-efficient. An example is illustrated in Figure 5-24.

2

u1

u2

1
Figure 5-24: An Efficient PointIn Figure 5-24, the isoquant of person 1 is drawn with a dark thick line. This utility levelis fixed. It acts like the “budget constraint” for person 2. Note that person 2’s isoquants
face the opposite way because a movement southwest is good for 2, since it gives him
more of both goods. Four isoquants are graphed for person 2, and the highest feasible
isoquant, which leaves person 1 getting the fixed utility, has the Pareto-efficient point
illustrated with a large dot. Such points occur at tangencies of the isoquants.
This process, of identifying the points that are Pareto-efficient, can be carried out forevery possible utility level for person 1. What results is the set of Pareto-efficient points,
and this set is also known as the contract curve. This is illustrated with the thick line in
Figure 5-25. Every point on this curve maximizes one person’s utility given the other,and they are characterized by the tangencies in the isoquants.
The contract curve need not have a simple shape, as Figure 5-25 illustrates. The main
properties are that it is increasing and goes from person 1 consuming zero of both goods
to person 2 consuming zero of both goods.

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2

1
Figure 5-25: The Contract Curve

Example: Suppose both people have Cobb-Douglas utility. Let the total endowment ofeach good be 1, so that x2 = 1 – x1. Then person 1’s utility can be written as
u1 = xα y1-α, and 2’s utility is u2 = (1-x)β (1-y)1-β. Then a point is Pareto-efficient if

∂u1
∂u2
αy
x
∂
∂x = β(1 − y) .
==∂u2
(1 − α)x ∂u1(1 − β)(1 − x )∂y∂yThus, solving for y, a point is on the contract curve ify=(1 − α)βxxx==.
(1 − β)α + (β − α) x (1 − β)α + β − α x⎛ (1 − β)α ⎞x + ⎜⎜⎟⎟(1 − x )(1 − α)β (1 − α)β⎝ (1 − α)β ⎠Thus, the contract curve for the Cobb-Douglas case depends on a single parameter(1 − β)α
. It is graphed for a variety of examples (α and β) in Figure 5-26.
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1

0.8

0.6

0.4

0.2

0
0

0.2

0.4

0.6

0.8

1

Figure 5-26: Contract Curves with Cobb-Douglas Utility

5.2.8.1 (Exercise) If two individuals have the same utility function concerning goods,
is the contract curve the diagonal? Why or why not?
5.2.8.2 (Exercise) For two individuals with Cobb-Douglas preferences, when is thecontract curve the diagonal?
The contract curve provides the set of efficient points. What point will actually bechosen? Let’s start with an endowment of the goods. An endowment is just a point in
the Edgeworth box, which gives the initial ownership of both goods for both people. The
endowment is marked with a triangle in Figure 5-27. Note that this point gives theendowment of both person 1 and 2, because it shows the shares of each.
Figure 5-27 also shows isoquants for persons 1 and 2 going through the endowment.
Note that the isoquant for 1 is concave toward the point labeled 1, and the isoquant for 2
is concave toward the point labeled 2. These utility isoquants define a reservation utility
level for each person – the utility they could get alone, without exchange. This “noexchange” state is known as autarky. There are a variety of efficient points that givethese people at least as much as they get under autarky, and those points are along thecontract curve but have a darker line.
In Figure 5-27, starting at the endowment, the utility of both players is increased bymoving in the general direction of the southeast, that is, down and to the right, until thecontract curve is reached. This involves person 1 getting more X (movement to theright) in exchange for giving up some Y (movement down). Thus, we can view theincrease in utility as a trade – 1 trades some of his Y for some of 2’s X.

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2

1
Figure 5-27: Individually Rational Efficient Points

In principle, any of the darker points on the contract curve, which give both people atleast as much as they achieve under autarky, might result from trade. The two people
get together and agree on exchange that puts them at any point along this segment of
the curve, depending on the bargaining skills of the players. But there is a particularpoint, or possibly a set of points, that result from exchange using a price system. A pricesystem involves a specific price for trading Y for X, and vice versa, that is available toboth parties. In this diagram, prices define a straight line, whose slope is the negative of
the Y for X price (the X for Y price is the reciprocal).
Figure 5-28 illustrates trade with a price system. The O in the center is the point on thecontract curve connected to the endowment (triangle) by a straight line (the price line),
in such a way that the straight line is tangent to both 1 and 2’s isoquants at the contract
curve. This construction means that, if each person took the price line as a budget
constraint, they would maximize their utility function by choosing the point labeled O.
That a price line that (i) goes through the endowment and (ii) goes through the contract
curve at a point tangent to both people’s utility exists is relatively easy to show.
Consider lines that satisfy property (ii) and let’s see if we can find one that goes throughthe endowment. Start on the contract curve at the point that maximizes 1’s utility given
2’s reservation utility, and you can easily see that the price line through that point
passes above and to the right of the endowment. The similar price line maximizing 2’s
utility given 1’s reservation utility passes below and to the left of the endowment. These
price lines are illustrated with dotted lines. Thus, by continuity, somewhere in between
is a price line that passes through the endowment.

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2

1
Figure 5-28: Equilibrium with a Price System

The point marked with the O represents an equilibrium of the price system, in the sensethat supply and demand are equated for both goods. Note that, given the endowment
and given the price through the endowment, both parties maximize utility by going to
the O. To see this, it may help to consider a version of the picture that only shows
person 2’s isoquants and the price line.
Figure 5-29 removes player 1’s isoquants, leaving only player 2’s isoquants and the priceline through the endowment. The price line through the endowment is the budget
facing each player at that price. Note that, given this budget line, player 2, who gets
more the less player 1 gets, maximizes utility at the middle isoquant, given the budget.
That is, taking the price as given, player 2 would choose the O given player 2’s
endowment. The logic for player 1 is analogous. This shows that, if both players believethat they can buy or sell as much as they like at the tradeoff of the price through the O,
both will trade to reach the O. This means that, if the players accept the price, a balanceof supply and demand emerges. In this sense, we have found an equilibrium price.

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2

1
Figure 5-29: Illustration of Price System Equilibrium

In the Edgeworth box, we see that, given an endowment, it is possible to reach some
Pareto-efficient point using a price system. Moreover, any point on the contract curvearises from as an equilibrium of the price system for some endowment. The proof ofthis proposition is startlingly easy. To show that a particular point on the contract curveis an equilibrium for some endowment, just start with an endowment equal to the pointon the contract curve. No trade can occur because the starting point is Pareto-efficient –any gain by one party entails a loss by the other.
Furthermore, if a point in the Edgeworth box represents an equilibrium using a pricesystem (that is, if the quantity supplied equals the quantity demanded for both goods), it
must be Pareto-efficient. At an equilibrium to the price system, each player’s isoquant istangent to the price line, and hence tangent to each other. This implies the equilibrium
is Pareto-efficient.
Two of these three propositions – any equilibrium of the price system is Pareto-efficient,
any Pareto-efficient point is an equilibrium of the price system for some endowment,
are known as the first and second welfare theorems of general equilibrium. They havebeen demonstrated by Nobel laureates Kenneth Arrow and Gerard Debreu, for an
arbitrary number of people and goods. They also demonstrated the third proposition,that for any endowment, there exists an equilibrium of the price system, with the samehigh level of generality.

5.2.9 General Equilibrium
We will illustrate general equilibrium, for the case when all consumers have CobbDouglas utility in an exchange economy. An exchange economy is an economy where
the supply of each good is just the total endowment of that good and there is no

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production. Suppose there are N people, indexed by n = 1, 2, …, N. There are G goods,
indexed by g = 1, 2, …, G. Person n has Cobb-Douglas utility, which we can represent
using exponents α(n,g), so that the utility of person n can be represented asG∏ x(n, g)α(n,g) , where x(n,g) is person n’s consumption of good g. Assume thatg=1

α(n,g)≥0 for all n and g, which amounts to assuming that the products are in fact goods.
Without any loss of generality, we can requireG∑ α(n, g) = 1 ,g=1

for each n. (To see this, note that maximizing the function U is equivalent tomaximizing the function Uβ for any positive β.)Let y(n,g) be person n’s endowment of good g. The goal of general equilibrium is to findprices p1, p2, …, pG for the goods, in such a way that demand for each good exactly equals
supply of the good. The supply of good g is just the sum of the endowments of that
good. The prices yield a wealth for person n equal toG

Wn = ∑ pg y(n, g) .
g=1

NWe will assume that ∑ α(n, g)y(n, i ) > 0 for every pair of goods g and i. Thisn =1

assumption states that for any pair of goods, there is at least one agent that values goodg and has an endowment of good i. The assumption insures that there is always
someone willing and able to trade if the price is sufficiently attractive. The assumption
is much stronger than necessary but useful for exposition. The assumption also insuresthe endowment of each good is positive.
Cobb-Douglas utility simplifies the analysis because of a feature that we already met in
the case of two goods, but which holds in general: the share of wealth for a consumer non good g equals the exponent α(n,g). Thus, the total demand for good g isNα(n, g)Wn
.
p
g
n =1

Xg = ∑The equilibrium conditions, then, can be expressed as saying supply (sum of theendowments) equals demand, or, for each good g,NNα(n, g)Wn
.
pg
n =1

∑ y(n, g) = X g = ∑n =1

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We can rewrite this expression, provided pg>0 (and it must be for otherwise demand isinfinite), to beNG∑ y(n, i )α(n, g)

pg − ∑ pi n =1
i =1

=0.

N

∑ y(n, g)n =1

Let B be the G × G matrix whose (g, i) term isN∑ y(n, i)α(n, g)

bgi = n =1

N.

∑ y(n, g)n =1

Let p be the vector of prices. Then we can write the equilibrium conditions as(I–B)p=0,
where 0 is the zero vector. Thus, for an equilibrium (other than p=0) to exist, B musthave an eigenvalue equal to 1, and a corresponding eigenvector p that is positive in eachcomponent. Moreover, if such an eigenvector, eigenvalue pair exists, it is anequilibrium, because demand is equal to supply for each good.
The actual price vector is not completely identified, because if p is an equilibrium pricevector, so is any positive scalar times p. Scaling prices doesn’t change the equilibrium
because both prices and wealth (which is based on endowments) rise by the scalar
factor. Usually economists assign one good to be a numeraire, which means all othergoods are indexed in terms of that good, and the numeraire’s price is artificially set to be
1. We will treat any scaling of a price vector as the same vector.
The relevant theorem is the Perron-Frobenius theorem.62 It states that if B is a positive
matrix (each component positive), then there is an eigenvalue λ>0 and an associatedpositive eigenvector p, and moreover λ is the largest (in absolute value) eigenvector of
B.63 This conclusion does most of the work of demonstrating the existence of an

62 Oskar Perron, 1880 - 1975 and Georg Frobenius, 1849 – 1917.

63 The Perron-Frobenius theorem, as usually stated, only assumes that B is non-negative and that B is

irreducible. It turns out that a strictly positive matrix is irreducible, so this condition is sufficient toinvoke the theorem. In addition, we can still apply the theorem even when B has some zeros in it,
provided that it is irreducible. Irreducibility means that the economy can’t be divided into two economies,
where the people in one economy can’t buy from the people in the second because they aren’t endowedwith anything the people in the first value. If B is not irreducible, then some people may wind up
consuming zero of things they value.

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equilibrium. The only remaining condition to check is that the eigenvalue is in fact 1, sothat (I–B)p=0.
Suppose the eigenvalue is λ. Then λp = Bp. Thus for each g,N∑ α(n, g)y(n, i )G

λpg = ∑ n =1
i =1

pi ,

N

∑ y(m, g)

m =1

or
N

G N

m =1

i =1 n =1

λpg ∑ y(m, g) = ∑ ∑ α(n, g)y(n, i )pi .
Summing both sides over g,
G

N

G G N

g=1

m =1

g=1i =1 n =1

λ ∑ pg ∑ y(m, g) = ∑∑ ∑ α(n, g)y(n, i )pi
G N G

G N

i =1 n =1g=1

i =1 n =1= ∑ ∑ ∑ α(n, g)y(n, i )pi = ∑ ∑ y(n, i )pi .
Thus λ=1 as desired.
The Perron-Frobenius theorem actually provides two more useful conclusions. First,
the equilibrium is unique. This is a feature of the Cobb-Douglas utility and does notnecessarily occur for other utility functions. Moreover, the equilibrium is readily
approximated. Denote by Bt the product of B with itself t times. Then for any positive
vector v, lim Bt v = p . While approximations are very useful for large systems (larget →∞numbers of goods), the system can readily be computed exactly with small numbers ofgoods, even with a large number of individuals. Moreover, the approximation can beinterpreted in a potentially useful manner. Let v be a candidate for an equilibrium pricevector. Use v to permit people to calculate their wealth, which for person n isG

Wn = ∑ vi y(n, i ) . Given the wealth levels, what prices clear the market? Demand for
i =1

good g is
N

G

N

n =1

i =1

n =1

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G

N

and the market clears, given the wealth levels, if pg = i =1

n =1
N

∑ vi ∑ α(n, g)y(n, i ), which is∑ y(n, g)n =1equivalent to p = Bv. This defines an iterative process. Start with an arbitrary pricevector, compute wealth levels, then compute the price vector that clears the market for
the given wealth levels. Use this price to recalculate the wealth levels, and then computea new market-clearing price vector for the new wealth levels. This process can be
iterated, and in fact converges to the equilibrium price vector from any starting point.
We finish this section by considering three special cases. If there are two goods, we canlet an = α(n, 1), and then conclude α(n, 2) = 1 – an. Then let
N

Yg = ∑ y(n, g)
n =1

be the endowment of good g. Then the matrix B is
⎛
⎞
1 N
1 N
⎜
y
(
n
,
1
)
a
y(n,2)an ⎟
∑
∑
n
⎜ Y1
⎟
Y1 n =1
n =1
B=⎜
⎟
N
1 N
⎜ 1
⎟
⎜ Y ∑ y(n,1)(1 − an ) Y ∑ y(n,2)(1 − an ) ⎟2 n =1⎝ 2 n =1
⎠
⎛
⎞
1 N
1 N
⎜
y(n,1)any(n,2)an ⎟∑∑⎜⎟Y1 n =1Y1 n =1
=⎜
⎟
N
⎞
1 N
⎜ 1 ⎛⎜⎟⎟⎜ Y ⎜ Y1 − ∑ y(n,1)an ⎟ 1 − Y ∑ y(n,2)an ⎟2 n =1
n =1
⎠
⎝ 2⎝
⎠

The relevant eigenvector of B is⎛ N⎞
⎜ ∑ y(n,2)a⎟n⎜ n =1⎟.
p=⎜ N⎟⎜ y(n,1)(1 − a ) ⎟n ⎟⎜∑⎝ n =1⎠The overall level of prices is not pinned down – any scalar multiple of p is also an
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N

∑ y(n,2)an
p1
.
n
=1
=
N
p2
∑ y(n,1)(1 − an )n =1

We can readily see that an increase in the supply of good 1, or a decrease in the supply of
good 2, decreases the price ratio. An increase in the preference for good 1 increases theprice of good 1. When people who value good 1 relatively highly are endowed with a lotof good 2, the correlation between preference for good 1 an and endowment of good 2 ishigher. The higher the correlation, the higher is the price ratio. Intuitively, if the people
who have a lot of good 2 want a lot of good 1, the price of good 1 is going to be higher.
Similarly, if the people who have a lot of good 1 want a lot of good 2, the price of good 1
is going to be lower. Thus, the correlation between endowments and preferences also
matters to the price ratio.
In our second special case, we consider people with the same preferences, but who startwith different endowments. Hypothesizing identical preferences sets aside thecorrelation between endowments and preferences found in the two good case. Since
people are the same, α(n, g) = Ag for all n. In this case,N∑ y(n, i)α(n, g)

bgi = n =1

N

∑ y(n, g)

Y= Ag i ,
Yg

n =1

N

where as before Yg = ∑ y(n, g) is the total endowment of good g. The matrix B has an =1

special structure, and in this case, pg =Ag
Ygis the equilibrium price vector. Prices areproportional to the preference for the good divided by the total endowment for thatgood.
Now consider a third special case, where no common structure is imposed on
preferences, but endowments are proportional to each other, that is, the endowment of
person n is a fraction wn of the total endowment. This implies that we can write y(n, g)= wn Yg, an equation assumed to hold for all people n and goods g. Note that byN

construction, ∑ wn = 1 , since the value wn represents n’s share of the total endowment.
n =1

In this case, we have

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N

∑ y(n, i )α(n, g)bgi= n =1N∑ y(n, g)Yi N=∑ wn α(n, g) .
Yg n =1n =1These matrices also have a special structure, and it is readily verified that theequilibrium price vector satisfies
pg =

1 N
∑ wn α(n, g) .
Yg n =1

This formula receives a similar interpretation – the price of good g is the strength ofpreference for good g, where strength of preference is a wealth-weighted average of theindividual preference, divided by the endowment of the good. Such an interpretation is
guaranteed by the assumption of Cobb-Douglas preferences, since these imply that
individuals spend a constant proportion of their wealth on each good. It also generalizes
the conclusion found in the two good case to more goods, but with the restriction thatthe correlation is now between wealth and preferences. The special case has the virtuethat individual wealth, which is endogenous because it depends on prices, can be readily
determined.
5.2.9.1 (Exercise)G

Consider a consumer with Cobb-Douglas utility,aU = ∏ xi i ,
i =1

G

G

i =1

i =1

where ∑ ai = 1 , and facing the budget constraint W = ∑ pi xi . Show that the consumeraW
for each good i. Hint: Express the budget
maximizes utility by choosing xi = i
pi
G −1
⎞
1 ⎛⎜
constraint as xG =W − ∑ pi x i ⎟ , and thus utility as
⎟
pG ⎜⎝
i =1
⎠
a

G −1
⎛ G −1 a ⎞⎛ 1 ⎛⎞⎞ G⎜i⎜ W − ∑ pi x i ⎟ ⎟ . This function can now be maximized in an
U = ⎜ ∏ xi ⎟⎟⎟⎟⎜ pG ⎜
⎜
i =1
⎝
⎠⎠
⎠⎝
⎝ i =1
unconstrained fashion. Verify that the result of the maximization can be expressed
G
G
a
p x
a
as pi x i = i pG xG , and thus W = ∑ pi xi = ∑ i pG xG = G G , which yields
aG
a
aG
i =1
i =1 Gpi x i = aiW .

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6 Market Imperfections
We have so far focused on unimpeded markets, and seen that markets may perform
efficiently.64 In this chapter, we examine impediments to the efficiency of markets.
Some of these impediments are imposed on otherwise efficiently functioning markets,as occurs with taxes. Others, such as monopoly or pollution, are problems that may
arise in some circumstances, and may require correction by the government.

6.1 Taxes
There are a variety of types of taxes, such as income taxes, property taxes, ad valorem(percentage of value) taxes, and excise taxes (taxes on a specific good like cigarettes orgasoline). Here, we are primarily concerned with sales taxes, which are taxes on goods
and services sold at retail. Our insights into sales taxes translate naturally into someother taxes.

6.1.1 Effects of Taxes
Consider first a fixed tax such as a twenty cent tax on gasoline. The tax could either be
imposed on the buyer or the supplier. It is imposed on the buyer if the buyer pays aprice for the good, and then also pays the tax on top of that. Similarly, if the tax is
imposed on the seller, the price charged to the buyer includes the tax. In the UnitedStates, sales taxes are generally imposed on the buyer – the stated price does not include
the tax – while in Canada, the sales tax is generally imposed on the seller.
An important insight of supply and demand theory is that it doesn’t matter – to anyone– whether the tax is imposed on the supplier or the buyer. The reason is that ultimately
the buyer cares only about the total price paid, which is the amount the supplier gets
plus the tax, and the supplier cares only about the net to the supplier, which is the total
amount the buyer pays minus the tax. Thus, with a twenty cent tax, a price of $2.00 to
the buyer is a price of $1.80 to the seller. Whether the buyer pays $1.80 to a seller andadditional twenty cents in tax, or pays $2.00, produces the same outcome to both thebuyer and seller. Similarly, from the seller’s perspective, whether the sellers charge$2.00 and then pay twenty cents to the government, or charges $1.80 and pay no tax,
leads to the same profit.65

64 The standard term for an unimpeded market is a free market, which is free in the sense of “free ofexternal rules and constraints.” In this terminology, eBay is free market, even though it charges for theuse of the market.
65 There are two minor issues here that won’t be considered further. First, the party who collects the tax
has a legal responsibility and it could be that businesses have an easier time complying with taxes than
individual consumers. The transaction costs associated with collecting taxes could create a difference
arising from who pays the tax. Such differences will be ignored in this book. Second, if the tax ispercentage tax, it won’t matter to the outcome but the calculations are more complicated, because a ten
percent tax on the seller at a seller’s price of $1.80 is different from a ten percent tax on a buyer’s price of$2.00. Then the equivalence between taxes imposed on the seller and taxes imposed on the buyer
requires different percentages that produce the same effective tax level. In addition, there is a politicalissue: imposing the tax on buyers makes the presence and size of taxes more transparent to voters.

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p

SAfter Tax

SBefore Tax

Amountof Taxq
Figure 6-1: Effect of a Tax on Supply

First, consider a tax imposed on the seller. At a given price p, and tax t, each seller
obtains p-t, and thus supplies the amount associated with this net price. Taking thebefore tax supply to be SBefore Tax, the after tax supply is shifted up by the amount of thetax. This is the amount that covers the marginal value of the last unit, plus providing forthe tax. Another way of saying this is that at any lower price, the sellers would reduce
the number of units offered. The change in supply is illustrated in Figure 6-1.

p

Amountof TaxDAfter Tax

DBefore TaxqFigure 6-2: Effect of a Tax on Demand

Now consider the imposition of a tax on the buyer, illustrated in Figure 6-2. In this case,the buyer pays the price of the good, p, plus the tax, t. This reduces the willingness to

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pay for any given unit by the amount of the tax, thus shifting down the demand curve by
the amount of the tax.

p

SBefore Tax

pD*
Tax
pS*

qA* qB*

DBefore TaxqFigure 6-3: Effect of a Tax on Equilibrium

In both cases, the effect of the tax on the supply-demand equilibrium is to shift thequantity toward a point where the before tax demand minus the before tax supply is theamount of the tax. This is illustrated in Figure 6-3. The quantity traded before a tax was
imposed was qB*. When the tax is imposed, the price that the buyer pays must exceed
the price the sellers receive, by the amount equal to the tax. This pins down a uniquequantity, denoted qA*. The price the buyer pays is denoted by pD* and the sellers receivethat amount minus the tax, which is noted as pS*. The relevant quantities and prices areillustrated in Figure 6-3.
Another thing notable from this picture is that the price that buyers pay rises, but
generally by less than the tax. Similarly, the price the sellers obtain falls, but by lessthan the tax. These changes are known as the incidence of the tax – is a tax mostly
borne by buyers, in the form of higher prices, or by sellers, in the form of lower prices
net of taxation?
There are two main effects of a tax: a fall in the quantity traded, and a diversion ofrevenue to the government. These are illustrated in Figure 6-4. First, the revenue is justthe amount of the tax times the quantity traded, which is the area of the shaded
rectangle. The tax raised of course uses the after tax quantity qA* because this is thequantity traded once the tax is imposed.

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p

SBefore Tax
Tax
Revenue

Dead
WeightLoss

Tax

qA* qB*

DBefore TaxqFigure 6-4: Revenue and Dead weight Loss

In addition, a tax reduces the quantity traded, thereby reducing some of the gains fromtrade. Consumer surplus falls because the price to the buyer rises, and producer surplus(profit) falls because the price to the seller falls. Some of those losses are captured in theform of the tax, but there is a loss captured by no party – the value of the units thatwould have been exchanged were there no tax. The value of those units is given by thedemand, and the marginal cost of the units is given by the supply. The difference,shaded in black in the diagram, is the lost gains from trade of units that aren’t tradedbecause of the tax. These lost gains from trade are known as a dead weight loss. Thatis, the dead weight loss is the buyers’ values minus the sellers’ costs of units that are noteconomic to trade only because of a tax or other interference in the market. The net lost
gains from trade, measured in dollars, of these lost units is illustrated by the black
triangular region in the diagram.
The dead weight loss is important because it represents a loss to society much the sameas if resources were simply thrown away or lost. The dead weight loss is value thatpeople don’t enjoy, and in this sense can be viewed as an opportunity cost of taxation.
That is, to collect taxes, we have to take money away from people, but obtaining a dollar
in tax revenue actually costs society more than a dollar. The costs of raising tax
revenues include the money raised (which the taxpayers lose), the direct costs ofcollection like tax collectors and government agencies to administer tax collection, andthe dead weight loss – the lost value created by the incentive effects of taxes, which
reduce the gains for trade. The dead weight loss is part of the overhead of collecting
taxes. An interesting issue, to be considered in the subsequent section, is the selectionof activities and goods to tax in order to minimize the dead weight loss of taxation.
Without more quantification, only a little more can be said about the effect of taxation.
First, a small tax raises revenue approximately equal to the tax level times the quantity,
or tq. Second, the drop in quantity is also approximately proportional to the size of the
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tax. Third, this means the size of the dead weight loss is approximately proportional to
the tax squared. Thus, small taxes have an almost zero dead weight loss per dollar ofrevenue raised, and the overhead of taxation, as a percentage of the taxes raised, grows
when the tax level is increased. Consequently, the cost of taxation tends to rise in the
tax level.
6.1.1.1 (Exercise)
Suppose demand is given by qd(p) = 1 – p and supply qs(p) = p, withprices in dollars. If sellers pay a 10 cent tax, what is the after tax supply?
Compute the before tax equilibrium price and quantity, and the after tax
equilibrium quantity, and buyer’s price and seller’s price.
6.1.1.2 (Exercise) Suppose demand is given by qd(p) = 1 – p and supply qs(p) = p, withprices in dollars. If buyers pay a 10 cent tax, what is the after tax demand? Do
the same computations as the previous exercise and show that the outcomes are
the same.
6.1.1.3 (Exercise)
Suppose demand is given by qd(p) = 1 – p and supply qs(p) = p, withprices in dollars. Suppose a tax of t cents is imposed, t ≤ 1. What is theequilibrium quantity traded, as a function of t? What is the revenue raised by
the government, and for what level of taxation is it highest?

6.1.2 Incidence of Taxes
How much does the quantity fall when a tax is imposed? How much does the buyer’s
price rise and the price to the seller fall? The elasticities of supply and demand can beused to answer this question. To do so, we consider a percentage tax t and employ themethodology introduced in Chapter 2 and assume constant elasticity of both demandand supply. Let the equilibrium price to the seller be ps and the equilibrium price to thebuyer be pb. As before, we will denote the demand function by qd(p)=ap-ε and supply
function by qs(p)=bpη. These prices are distinct because of the tax, and the tax
determines the difference:pb = (1+t) ps.
Equilibrium requires

apd−ε = qd ( pb ) = qs ( ps ) = bpsη .
Thus,a((1 + t ) ps )−ε = apd−ε = qd ( pb ) = qs ( ps ) = bpsη .
This solves for1−ε⎛ a ⎞ η+ε
ps = ⎜ ⎟(1 + t ) η+ε ,⎝b⎠

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and
η

⎛ a ⎞ η+ε
q* = qs ( ps ) = bpsη = b ⎜ ⎟(1 + t )
⎝b⎠

−εη

1

η+ε

η

=a

η+ε

ε

b

η+ε

−εη

(1 + t )

η+ε

.

η

⎛ a ⎞ η+ε
(1 + t ) η+ε .
Finally, pd = (1 + t ) ps = ⎜ ⎟b⎝ ⎠rRecall the approximation (1 + t ) ≈ 1 + rt .
ηt
,
ε+η
εt
ηεt
and decreases the price to the seller by. The quantity falls by approximately
.
ε+η
ε+η
Thus, the price effect is mostly on the “relatively inelastic party.” If demand is inelastic,
ε is small, then the price decrease to the seller will be small and the price increase to thebuyer close to the entire tax. Similarly, if demand is very elastic, ε is very large, and theprice increase to the buyer will be small and the price decrease to the seller close to theentire tax.
Thus, a small proportional tax increases the price to the buyer by approximately

ηεtt=. Thus the effect of a tax on quantity
1
1
ε+η
+
ε η
is small if either the demand or the supply is inelastic. To minimize the distortion inquantity, it is useful to impose taxes on goods that either have inelastic demand, or
inelastic supply.

We can rewrite the quantity change as

For example, cigarettes are a product with very inelastic demand and moderately elastic
supply. Thus a tax increase will generally increase the price almost the entire amount of
the tax. In contrast, travel tends to have relatively elastic demand, so taxes on travel –airport, hotel and rental car taxes – tend not to increase the final prices so much, buthave large quantity distortions.
6.1.2.1 (Exercise) For the case of constant elasticity (of both supply and demand),what tax rate maximizes the government’s revenue? How does the revenuemaximizing tax rate change when demand becomes more inelastic?

6.1.3 Excess Burden of Taxation
The presence of the dead-weight loss implies that raising $1 in taxes costs society morethan $1. But how much more? This idea – that the cost of taxation exceeds the taxes
raised – is known as the excess burden of taxation, or just the excess burden. We canquantify the excess burden with a remarkably sharp formula.

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To start, we will denote the marginal cost of the quantity q by c(q) and the marginalvalue by v(q). The elasticities of demand and supply are given by the standard
formulae:
dq

dq
v(q)
c(q )
q
ε=−
=−
and η ==.
dvdc
qv′(q)
qc ′(q)vcqConsider an ad valorem tax that will be denoted by t. If sellers are charging c(q), the advalorem (at value) tax is tc(q), and the quantity q* will satisfyv(q*) = (1 + t)c(q*).
From this equation, we immediately deduceq*q * εη
dq *
c(q*)
c(q*)
=
=
=−
=−
.
(
*)
(
*)
v
q
c
q
(
)
dt
v′(q*) − (1 + t )c ′(q*) −
(
1
+
t
)
ε
+
η
⎛
⎞
1
1
− (1 + t )(1 + t )⎜⎜ + ⎟⎟
εq *
ηq *
⎝ ε η⎠Tax revenue is given by
Tax = tc(q*)q * .
The effect on taxes collected, Tax, of an increase in the tax rate t is
⎛
⎛
dTax
dq *
1 ⎞ q * εη ⎞⎟= c(q*)q * +t (c(q*) + q * c ′(q*))= c(q*)⎜⎜ q * −t ⎜⎜ 1 + ⎟⎟
⎟
(
)
dt
dt
η
(
1
t
)
+
ε
+
η
⎝
⎠
⎝
⎠

=

c(q*)q *((1 + t )(ε + η) − t (1 + η)ε ) = c(q*)q * (ε + η − tη(ε − 1)) .
(1 + t )(ε + η)
(1 + t )(ε + η)

Thus, tax revenue is maximized when the tax rate is tmax, given byt max =ε+ηε ⎛1 1⎞⎜ + ⎟.
=
η(ε − 1) ε − 1 ⎜⎝ η ε ⎟⎠εis the monopoly markup rate, which we will meet in Section 6.5. Here, it
ε −1
is applied to the sum of the inverse elasticities.
The value

The gains from trade (including the tax) is the difference between value and cost for the
traded units, and thus is

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q*

GFT = ∫ v(q) − c(q) dq .
0Thus, the change in the gains from trade as taxes increase is given by
∂GFT

dGFT
∂t =
=
∂
Tax
dTax
∂t
=−

(v(q*) − c(q*)) dq *(v(q*) − c(q*))

q * εη
(1 + t )(ε + η)

dt=−c(q*)q *c(q*)q *(ε + η − tη(ε − 1))(ε + η − tη(ε − 1))(1 + t )(ε + η)
(1 + t )(ε + η)(tc(q*))εη
t
εηt
ε
.
=−
=−
ε + η − tη(ε − 1)c(q*)(ε + η − tη(ε − 1))
ε − 1 t max − t

The value tmax is the value of the tax rate t that maximizes the total tax take. This
remarkable formula permits the quantification of the cost of taxation. The minus sign
indicates it is a loss – the dead weight loss of monopoly, as taxes are raised, and it isεcomposed of two components. First, there is the term
, which arises from theε −1change in revenue as quantity is changed, thus measuring the responsiveness of revenue
to a quantity change. The second term provides for the change in the size of the welfare
loss triangle. The formula can readily be applied in practice to assess the social cost of
taxation, knowing only the tax rate and the elasticities of supply and demand.
The formula for the excess burden is a local formula – it calculates the increase in thedead weight loss associated with raising an extra dollar of tax revenue. All elasticities,
including those in tmax, are evaluated locally around the quantity associated with thecurrent level of taxation. The calculated value of tmax is value given the local elasticities;
if elasticities are not constant, this value will not necessarily be the actual value thatmaximizes the tax revenue. One can think of tmax as the projected value. It is sometimes
more useful to express the formula directly in terms of elasticities rather than in termsof the projected value of tmax, in order to avoid the potential confusion between the
projected (at current elasticities) and actual (at the elasticities relevant to tmax) value oftmax. This level can be read directly from the derivation above:
dGFT
εηt
.
=−
dTax
ε + η − η(ε − 1)t

6.2 Price Floors and Ceilings
A price floor is a minimum price at which a product or service is permitted to sell. Many
agricultural goods have price floors imposed by the government. For example, tobacco
sold in the United States has historically been subject to a quota and a price floor set by
the Secretary of Agriculture. Unions may impose price floors as well. For example, theScreen Actors Guild imposes minimum rates for guild members, generally pushing up
the price paid for actors above that which would prevail in an unconstrained market.

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(The wages of big name stars aren’t generally affected by SAG, because these areindividually negotiated.) The most important example of a price floor is the minimum
wage, which imposes a minimum amount that a worker can be paid per hour.
A price ceiling is a maximum price that can be charged for a product or service. Rent
control imposes a maximum price on apartments (usually set at the historical price plus
an adjustment for inflation) in many U.S. cities. Taxi fares in New York, Washington,
D.C. and other cities are subject to maximum legal fares. During World War II, andagain in the 1970s, the United States imposed price controls to limit inflation, imposing
a maximum price for legal sale of many goods and services. For a long time, most U.S.
states limited the legal interest rate that could be charged (these are called usury laws)
and this is the reason so many credit card companies are located in South Dakota.
South Dakota was the first state to eliminate such laws. In addition, ticket prices forconcerts and sporting events are often set below the equilibrium price. Laws prohibiting
scalping then impose a price ceiling. Laws preventing scalping are usually remarkably
ineffective in practice, of course.

6.2.1 Basic Theory
The theory of price floors and ceilings is readily articulated with simple supply anddemand analysis. Consider a price floor – a minimum legal price. If the price floor is
low enough – below the equilibrium price – there are no effects, because the same forcesthat tend to induce a price equal to the equilibrium price continue to operate. If theprice floor is higher than the equilibrium price, there will be a surplus, because at theprice floor, more units are supplied than are demanded. This surplus is illustrated in
Figure 6-5.
In Figure 6-5, the price floor is illustrated with a horizontal line and is above theequilibrium price. Consequently, at the price floor, a larger quantity is supplied than isdemanded, leading to a surplus. There are units that are socially efficient to trade but
aren’t traded – because their value is less than the price floor. The gains from tradeassociated with these units, which is lost due to the price floor, represent the deadweight loss.
The price increase created by a price floor will increase the total amount paid by buyers
when the demand is inelastic, and otherwise will reduce the amount paid. Thus, if theprice floor is imposed in order to be a benefit to sellers, we would not expect to see theprice increased to the point where demand becomes elastic, for otherwise the sellers
receive less revenue. Thus, for example, if the minimum wage is imposed in order toincrease the average wages to low-skilled workers, then we would expect to see the total
income of low-skilled workers rise. If, on the other hand, the motivation for theminimum wage is primarily to make low-skilled workers a less effective substitute forunion workers, and hence allow union workers to increase their wage demands, then wemight observe a minimum wage which is in some sense “too high” to be of benefit to
low-skilled workers.

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p

S

Surplus
Price
Floor

D
qD

q

qS

Figure 6-5: A Price Floor

p

S

Price
Floor
Dead
Weight
Loss

D
qD

qS

q

Figure 6-6: Dead weight Loss of a Price Floor

The dead weight loss illustrated in Figure 6-6 is the difference between the value of theunits not traded, and value is given by the demand curve, and the cost of producing
these units. The triangular shaped region representing the difference between value andcost is illustrated in the above diagram, in the shaded region.

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However, this is the minimum loss to society associated with a price floor. Generally
there will be other losses. In particular, the loss given above assumes that suppliers who
don’t sell don’t produce. As a practical matter, some suppliers who won’t in the end sell
may still produce because they hope to sell. In this case additional costs are incurred
and the dead weight loss will be larger to reflect these costs.
Example: Suppose both supply and demand are linear, with the quantity supplied equal
to the price, and the quantity demanded equal to one minus the price. In this case, theequilibrium price, and the equilibrium quantity, are both ½. A price floor of p > ½
induces a quantity demanded of 1–p. How many units will suppliers offer, if a supplier’s
chance of trading is random? Suppose q≥1–p units are offered. A supplier’s chance of
1− pselling is. Thus, the marginal supplier (who has a marginal cost of q by
q1− pof earning p, and a certainty of paying q. Exactly q
assumption) has a probabilityqunits will be supplied when this is a break-even proposition for the marginal supplier,that is,1− p
p − q = 0 , or q = p(1 − p).
q
The dead weight loss then includes not just the triangle illustrated in the previous
picture, but also the cost of the p(1 − p) − (1 − p) unsold units.
6.2.1.1 (Exercise)In this example, show that the quantity produced is less than theequilibrium quantity, which is ½. Compute the gains from trade, given the
overproduction of suppliers. What is the dead weight loss of the price floor?
6.2.1.2 (Exercise)
Suppose that units aren’t produced until after a buyer has agreed topurchase, as typically occurs with services. What is the dead weight loss in thiscase? (Hint: what potential sellers will offer their services? What is the average
cost of supply of this set of potential sellers?)
The Screen Actors Guild, a union of actors, has some ability to impose minimum prices(a price floor) for work on regular Hollywood movies. If the Screen Actors Guild would
like to maximize the total earnings of actors, what price should they set in the linear
demand and supply example?
The effects of a price floor include lost gains from trade, because too few units are traded(inefficient exchange), units produced that are never consumed (wasted production),and more costly units produced than necessary (inefficient production)
A price ceiling is a maximum price. Analogous to a low price floor, a price ceiling that islarger than the equilibrium price has no effect. Tell me that I can’t charge more than abillion dollars for this book (which is being given away free) and it won’t affect the price

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charged or the quantity traded. Thus, the important case of a price ceiling is a priceceiling less than the equilibrium price.
In this case, which should now look familiar, the price is forced below the equilibrium
price, and too few units are supplied, while a larger number are demanded, leading to ashortage. The dead weight loss is illustrated in Figure 6-7, and again represents the loss
associated with units that are valued more than they cost but aren’t produced.

p

S

Price
Ceiling
Shortage

D
qS

qD

q

Figure 6-7: A Price Ceiling

Analogous to the case of a price floor, there can be additional losses associated with aprice ceiling. In particular, some lower value buyers may succeed in purchasing,denying the higher value buyers the ability to purchase. This effect results in buyers
with high values failing to consume, and hence their value is lost.
6.2.1.3 (Exercise) Adapt the price floor example above to the case of a price ceiling,with p < ½, and compute the lost gains from trade if buyers willing to purchaseare all able to purchase with probability qS/qD. (Hint: Compute the value of qD
units; the value realized by buyers collectively will be that amount times theprobability of trade.)
In addition to the misallocation of resources (too few units, and units not allocated tothose who value them the most), price ceilings tend to encourage illegal trade as people
attempt to exploit the prohibited gains from trade. For example, it became common
practice in New York to attempt to bribe landlords to offer rent-controlled apartments,and such bribes could exceed $50,000. In addition, potential tenants expended a great
deal of time searching for apartments, and a common strategy was to read the obituaries

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late at night, when the New York Times had just come out, hoping to find an apartmentthat would be vacant and available for rent.
An important and undesirable by-product of price ceilings is discrimination. In a free or
unconstrained market, discrimination against a particular group, based on race,
religion, or other factors, requires transacting not based on price but on another factor.
Thus, in a free market, discrimination is costly – discrimination entails, for instance, notrenting an apartment to the highest bidder, but the highest bidder of the favored group.
In contrast, with a price ceiling, there is a shortage, and sellers can discriminate at lower
cost, or even at no cost. That is, if there are twice as many people seeking apartments as
there are apartments at the price ceiling, landlords can “pick and choose” amongprospective tenants and still get the maximum legal rent. Thus a price ceiling has theundesirable by-product of reducing the cost of discrimination.

6.2.2 Long- and Short-run Effects
Both demand and supply tend to be more elastic in the long-run. This means that thequantity effects of price floors and ceilings tend to be larger over time. An extreme
example of this is rent control, a maximum price imposed on apartments.
Rent control is usually imposed in the following way: as a prohibition or limitation on
price increases. For example, New York City’s rent control, imposed during World War
II, prevented landlords from increasing rent, even when their own costs increased, suchas when property taxes increased. This law was softened in 1969 to be graduallyreplaced by a rent stabilization law that permitted modest rent increases for existing
tenants.

p

SRS

LRS, initial

Rent
Control

D, initialq
Figure 6-8: Rent Control, Initial EffectThus the nature of rent control is that it begins with at most minor effects because it
doesn’t bind until the equilibrium rent increases. Moreover, the short-run supply ofapartments tends to be extremely inelastic, because one doesn’t tear down an apartment
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or convert it to a condominium (there were limitations on this) or abandon it without apretty significant change in price. Demand also tends to be relatively inelastic, because
one has to live somewhere and the alternatives to renting in the city are to live a long
distance away or buy (which is relatively expensive), neither of which is a very goodsubstitute for many consumers. Long-run demand and short-run demand are not very
different and are treated as being identical. Finally, the long-run supply is much moreelastic than the short-run supply, because in the long-run a price increase permits thecreation of apartments from warehouses (lofts), rooms rented in houses, etc. Thus, theapartment market in New York is characterized by inelastic short-run supply, much
more elastic long-run supply, and inelastic demand. This is illustrated in Figure 6-8.
We start with a rent control law that has little or no immediate effect because it is set atcurrent rents. Thus, in the near term, tenants’ fears of price increases are eased andthere is little change in the apartment rental market. This is not to say there is zero
effect – some companies considering building an apartment on the basis of an
expectation of higher future rents may be deterred, and a few marginal apartments may
be converted to other uses because the upside potential for the owner has been removed,
but such effects are modest at best.

LRS,
Old laterSRS

p

LRS, initial

Rent
Control

New
SRS

D, laterD, initialq
Shortage
Figure 6-9: Rent Control, Long-Run EffectOver time, however, the demand for apartments grows as the city population andincomes grow. Moreover, as the costs of operating an apartment rise due to property
tax increases, wage increases and cost of maintenance increases, the supply is reduced.
This has little effect on the short-run supply but a significant effect on the long-run
supply. The supply reduction and demand increases cause a shortage, but results in few
apartments being lost because the short-run supply is very inelastic. Over time,
however, apartments are withdrawn from the market and the actual quantity falls, even

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as the demand rises, and the shortage gets worse and worse. These changes areillustrated in Figure 6-9. The old values of demand, short-run supply and long-run
supply are illustrated in dashed grey lines. The new values, reflecting an increase indemand, a fall in long-run supply, and a reduction in the number available set ofapartments (where the rent control covers the long-run cost) are given in dark blacklines.
The shortage is created by two separate factors – demand is increasing as incomes andpopulation rise, and supply is decreasing as costs rise. This reduces the quantity ofavailable housing units supplied and increases the demand for those units.
How serious is the threat that units will be withdrawn from the market? In New York
City, over 200,000 apartment units were abandoned by their owners, usually because
the legal rent didn’t cover the property taxes and legally mandated maintenance. In
some cases, tenants continued to inhabit the buildings even after the electricity andwater were shut off. It is fair to say that rent control devastated large areas of New York
City, such as the Bronx. So why would New York, and so many other communities,
impose rent control on itself?

6.2.3 Political Motivations
The politics of rent control are straightforward. First, rent control involves a moneytransfer from landlords to tenants, because tenants pay less than they would absent thelaw, and landlords obtain less revenue. In the short-run, due to the inelastic short-run
supply, the effect on the quantity of apartments is small, so rent control is primarily justa transfer from landlords to tenants.
In a city like New York, the majority of people rent. A tiny fraction of New Yorkers arelandlords. Thus, it is easy to attract voters to support candidates who favor rent control– most renters will benefit, while landlords don’t. The numbers of course don’t tell thewhole story, because while landlords are small in numbers, they are wealthier on
average, and thus likely have political influence beyond the number of votes they cast.
However, even with their larger economic influence, the political balance favors renters.
In the 100ab zip codes of Manhattan (first three digits are 100), 80% of families wererenters in the year 2000. Thus, a candidate who runs on a rent control platform appeals
to large portion of the voters.
Part of the attraction of rent control is that there is little economic harm in the shortrun, and most of that harm falls on new residents to New York. As new residents
generally haven’t yet voted in New York, potential harm to them has only a small effecton most existing New Yorkers, and thus isn’t a major impediment to getting voter
support for rent control. The slow rate of harm to the city is important politicallybecause the election cycle encourages a short time horizon – if successful at lower office,a politician hopes to move on to higher office, and is unlikely to be blamed for the longrun damage to New York by rent control.
Rent control is an example of a political situation sometimes called the tyranny of the
majority, where a majority of people have an incentive to confiscate the wealth of aminority. But there is another kind of political situation that is in some sense the

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reverse, where a small number of people care a great deal about something, and the
majority are only slightly harmed on an individual basis. No political situation appears
more extreme in this regard than that of refined sugar. There are few U.S. cane sugar
producers (nine in 1997), yet the U.S. imposes quotas that raise domestic prices muchhigher than world prices, in some years tripling the price Americans pay for refinedsugar. The domestic sugar producers benefit, while consumers are harmed. But
consumers are harmed by only a small amount each, perhaps twelve to fifteen cents perpound – which is not enough to build a consensus to defeat politicians who accept
donations from sugar producers. This is a case where concentrated benefits anddiffused costs determine the political outcome. Because there aren’t many sugar
producers, it is straightforward for them to act as a single force. In contrast, it is pretty
hard for consumers to become passionate about twelve cents per pound increase in thedomestic sugar price when they consume about 60 pounds per year of sugar.

6.2.4 Price Supports
A price support is a combination of two programs – a minimum price or price floor, andgovernment purchase of any surplus. Thus, a price support is different from a pricefloor, because with a price floor, any excess production by sellers was a burden on thesellers. In contrast, with a price support, any excess production is a burden on thegovernment.
The U.S. Department of Agriculture operates a price support for cheese, and has
possessed warehouses full of cheese in the past. There are also price supports for milk
and other agricultural products.

p

S

Gov’t
Purchase
SupportPrice

Dead
Weight
Loss
D
qD

qS

q

Figure 6-10: Price Supports

Figure 6-10 illustrates the effect of a support program. The government posts a price,
called the support price, and purchases any excess production offered on the market.
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The government purchases, which are the difference between the quantity supplied andquantity demanded, are illustrated on the diagram. The cost of the program to thegovernment is the support price times this quantity purchased, which is the area of therectangle directly underneath the words “Gov’t Purchases.”
There are two kinds of dead weight loss in a price support program. First, consumers
who would like to buy at the equilibrium price are deterred by the higher prices,
resulting in the usual dead weight loss, illustrated with the vertical shading. In addition,
however, there are goods produced that are then either destroyed or put in warehouses
and not consumed, which means the costs of production of those goods is also lost,
resulting in a second dead weight loss. That loss is the cost of production, which is givenby the supply curve, and thus is the area under the supply curve, for the government
purchases. It is shaded in a horizontal fashion. The total dead weight loss of the pricesupport is the sum of these two individual losses. Unlike the case of a price floor or
ceiling, a price support creates no ambiguity about what units are produced, or which
consumers are willing and able to buy, and thus the rationing aspect of a price floor or
ceiling is not present for a price support, nor is the incentive to create a black market
other than that created by selling the warehouse full of product.

6.2.5 Quantity Restrictions and Quotas
The final common way that governments intervene in market transactions is to impose aquota. A quota is a maximal production quantity, usually set based on historical
production. In tobacco, peanuts, hops, California oranges, and other products,
producers have production quotas based on their historical production. Tobacco quotas
were established in the 1930s and today a tobacco farmer’s quota is a percentage of the
1930s level of production. The percentage is set annually by the Secretary ofAgriculture. Agricultural products are not the only products with quotas. The right todrive a tax in New York requires a medallion issued by the city, and there are a limited
number of medallions. This is a quota. Is it a restrictive quota? The current price of a
New York taxi medallion – the right to drive a taxi legally in New York City – is$300,000 (2004 number). This adds approximately $30,000-$40,000 annually to thecost of operating a taxi in New York, using a risk adjusted interest rate.
What are the effects of a quota? A quota restricts the quantity below that which would
otherwise prevail, forcing the price up, which is illustrated in Figure 6-11. It works like a
combination of a price floor and a prohibition on entry.
Generally, the immediate effects of a quota involve a transfer of money from buyers tosellers. The inefficient production and surplus of the price floor are avoided because a
production limitation created the price increase. This transfer has an undesirable andsomewhat insidious attribute. Because the right to produce is a capital good, it
maintains a value, which must be captured by the producer. For example, an individual
who buys a taxi medallion today, and pays $300,000, makes no economic profits – hecaptures the foregone interest on the medallion through higher prices but no more thanthat. The individuals who received the windfall gain were those who were driving taxis
and were grandfathered in to the system, and issued free medallions. Those people –who were driving taxis 70 years ago and thus are mostly dead at this point – received awindfall gain from the establishment of the system. Future generations pay for the

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program, which provides no net benefits to the current generation; all the benefits were
captured by people long since retired.

p

S

Dead
Weight
Loss

D
Quota

q

Figure 6-11: A Quota

Does this mean it is harmless to eliminate the medallion requirement? Unfortunately
not. The current medallion owners, who if they bought recently paid a lot of money for
their medallions, would see the value of these investments destroyed. Thus, eliminationof the program would harm current medallion owners.
If the right to produce is freely tradable, the producers will remain the efficient
producers, and the taxi medallions are an example of this. Taxi medallions can bebought and sold. Moreover, a medallion confers the right to operate a taxi, but doesn’t
require that the owner of the medallion actually drive the taxi. Thus, a “medallion
owning company” can lease the right to drive a taxi to an efficient driver, thereby
eliminating any inefficiency associated with who drives a taxi.
In contrast, because tobacco farming rights aren’t legally tradable across county lines,
tobacco is very inefficiently grown. The average size of a burley tobacco farm is less than
five acres, so some are much smaller. There are tobacco farms in Florida and Missouri,
which only exist because of the value of the quota – if they could trade their quota to afarm in North Carolina or Kentucky, which are much better suited to producing
cigarette tobacco, it would pay to do so. In this case, the quota, which locked in
production rights, also locked in production which gets progressively more inefficient as
the years pass.
Quotas based on historical production have the problem that they don’t evolve as
production methods and technology evolve, thus tending to become progressively more

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inefficient. Tradable quotas eliminate this particular problem, but continue to have theproblem that future generations are harmed with no benefits.
6.2.5.1 (Exercise) Suppose demand for a product is qd = 1 – p, and the marginal costof production is c. A quota at level Q ≤ 1 – c is imposed. What is the value of thequota, per unit of production? Use this to derive the demand for the quota as afunction of the level of quota released to the market. If the government wishes
to sell the quota, how much should they sell to maximize the revenue on the
product?

6.3 Externalities
When the person sitting next to you lights up a cigarette, he gets nicotine, and thecigarette company gets some of his money. You just suffer, with no compensation. If
your neighbor’s house catches fire because he fell asleep with that cigarette burning in
his hand, your house may burn to the ground. The neighbor on the other side who plays
very loud music late into the night before your big economics test enjoys the music, andthe record company and stereo component companies get his money. You flunk out ofcollege and wind up borrowing $300,000 to buy a taxi medallion. Drunk drivers, cell
phones ringing in movies, loud automobiles, polluted air, and rivers polluted to thepoint that they catch fire like Cleveland’s Cuyahoga did, are all examples where atransaction between two parties harmed other people. These are “external effects.”
But external effects are not necessarily negative. The neighbor who plants beautiful
flowers in her yard brightens your day. Another’s purchase of an electric car reduces thesmog you breathe. Your neighbor’s investment in making his home safe from fire
conveys a safety advantage to you. Indeed, even your neighbor’s investment in her own
education may provide an advantage to you – you may learn useful things from yourneighbor. Inventions and creations, whether products or poetry, produce value forothers. The creator of a poem, or a mathematical theorem, provides a benefit to others.
These effects are called external effects, or externalities. An externality is any effect on
people not involved in a particular transaction. Pollution is the classic example. Whenanother person buys and smokes cigarettes, there is a transaction between the cigarettecompany and the smoker. But if you are sitting near the smoker, you are an affected
party not directly compensated from the transaction, at least before taxes were imposedon cigarettes. Similarly, you pay nothing for the benefits you get from viewing yourneighbor’s flowers, nor is there a direct mechanism to reward your neighbor for her
efforts.
Externalities will generally cause competitive markets to behave inefficiently from asocial perspective, absent a mechanism to involve all the affected parties. Without sucha mechanism, the flower-planter will plant too few beautiful flowers, for she has no
reason to take account of your preferences in her choices. The odious smoker will
smoke too much, and too near others, and the loud neighbor will play music much toolate into the night. Externalities create a market failure, that is, a competitive market
does not yield the socially efficient outcome.

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Education is viewed as creating an important positive externality. Education generates
many externalities, including more and better employment, less crime, and fewer
negative externalities of other kinds. It is widely believed that educated voters electbetter politicians.66 Educated individuals tend to make a society wealthy, an advantage
to all of society’s members. As a consequence, most societies subsidize education, inorder to promote it.
A major source of externalities arises in communicable diseases. Your vaccination not
only reduces the likelihood that you contract a disease, but also makes it less likely thatyou infect others with the disease.

6.3.1 Private and Social Value, Cost
Let’s consider pollution as a typical example. A paper mill produces paper, and a badsmell is an unfortunate by-product of the process. Each ton of paper produced increases
the amount of bad smells produced. The paper mill incurs a marginal cost, associatedwith inputs like wood and chemicals and water. For the purposes of studying
externalities, we will refer to the paper mill’s costs as a private cost, the cost to the paper
mill itself. In addition, there are external costs, which are the costs borne by others,
which arise in this case from the smell. Adding the private costs and the external costs
yields the social costs. These costs, in their marginal form, are illustrated in Figure 6-12.

p
Marginal
SocialCost

Marginal
External
Cost

Socially
Efficient
Price

PrivateMarginal
Cost

Competitive
Price

Socially Competitive
Efficient Quantity
Quantity

Marginal
Benefitq

Figure 6-12: A Negative Externality

In Figure 6-12, the demand has been labeled “marginal benefit,” for reasons that will
become apparent, but it is at this point just the standard demand, the marginal value of
66 This is a logical proposition, but there is scant evidence in favor of it.

There is evidence that educatedvoters are more likely to vote, but little evidence that they vote for better candidates.

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the product. The paper mill’s costs have been labeled marginal private cost to reflect thefact that these costs are only the mill’s costs and don’t include the cost of the bad smell
imposed on others. The marginal social cost is obtained by adding the marginal external
cost to the marginal private cost. The marginal external cost isn’t graphed on the
diagram, but the size of it is illustrated at one quantity, and it is generally the difference
between marginal social cost and marginal private cost.
Left to its own devices, the paper market would equate the marginal private cost and themarginal benefit, to produce the competitive quantity sold at the competitive price.
Some of these units – all of those beyond the quantity labeled “Socially Efficient
Quantity,” are bad from a social perspective – they cost more to society than they
provide in benefits. This is because the social cost of these units includes pollution, but
paper buyers have no reason to worry about pollution or even to know it is being createdin the process of manufacturing paper.
The dead weight loss of these units is a shaded triangle. The loss arises because themarginal social cost of the units exceeds the benefit, and the difference between thesocial cost and the benefits yields the loss to society. This is a case where too much is
produced because the market has no reason to account for all the costs; some of thecosts are borne by others.
MarginalpSocialCost

PrivateMarginal
Cost

Marginal
SocialBenefitMarginal
PrivateBenefitq
Socially
Efficient
QuantityCompetitive
Quantity

Figure 6-13: External Costs and Benefits

Generally, a negative externality like pollution creates a marginal social cost higher thanthe marginal private cost. Similarly, a positive externality like beautification creates ahigher marginal social benefit than the marginal private benefit (demand). These are to

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some extent conventions – one could have incorporated a positive externality by areduction in cost – but the convention remains. An example of a product that produces
both positive and negative externalities is illustrated in Figure 6-13. Street lights are an
example of a product that produces both externalities – most of us like lit streets, butthey are terrible for astronomers. Similarly, large highways produce benefits forcommuters and harm to nearby residents.
The marginal private benefit and the marginal private cost give the demand and supply
of a competitive market, and hence the competitive quantity results from theintersection of these two. The marginal social benefit and the marginal social cost gives
the value and cost from a social perspective; equating these two generates the sociallyefficient outcome. This can be either greater or less than the competitive outcome
depending on which externality is larger.
Example (Tragedy of the Commons): Consider a town on a scenic bay filled withlobsters. The town members collect and eat lobsters, and over time the size of thelobsters collected falls, until they are hardly worth searching for. This situation persists
indefinitely; few large lobsters are caught and it is barely worth one’s time attempting tocatch them.
The tragedy of the commons is a problem with a common resource, in this case thelobster bay. Catching lobsters creates an externality, by lowering the productivity ofother lobster catchers. The externality leads to over-fishing, since individuals don’t take
into account the negative effect they have on each other, ultimately leading to a nearlyuseless resource and potentially driving the lobsters into extinction. As a consequence,
the lobster catch is usually regulated.
6.3.1.1 (Exercise)A child who is vaccinated against polio is more likely to contract
polio (from the vaccine) than an unvaccinated child. Does this fact imply that
programs forcing vaccination on schoolchildren are ill-advised? Include withyour answer with a diagram illustrating the negative marginal benefit ofvaccination, and a horizontal axis representing the proportion of the population
vaccinated.
6.3.1.2 (Exercise) The total production from an oil field generally depends on the rate
at which the oil is pumped, with faster rates leading to lower total production
but earlier production. Suppose two different producers can pump from thefield. Illustrate, using an externality diagram where the horizontal axis is therate of production for one of the producers, the difference between the sociallyefficient outcome and the equilibrium outcome. Like many other states, Texas’law requires that when multiple people own land over a single oil field, theoutput is shared among the owners, with each owner obtaining a share equal toproportion of the field under their land. This process is called unitization. Doesit solve the problem of externalities in pumping and yield an efficient outcome?
Why or why not?

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6.3.2 Pigouvian Taxes
Arthur Cecil Pigou, 1877-1959, proposed a solution to the problem of externalities thathas become a standard approach. This simple idea is to impose a per-unit tax on a good
generating negative externalities equal to the marginal externality at the sociallyefficient quantity. Thus, if at the socially efficient quantity, the marginal external cost isa dollar, then a one dollar per unit tax would lead to the right outcome. This is
illustrated in Figure 6-14.
The tax that is added is the difference, at the socially efficient quantity, between themarginal social cost and the marginal private cost, which equals the marginal externalcost. The tax level need not equal the marginal external cost at other quantities, and the
diagram reflects a marginal external cost that is growing as the quantity grows.
Nevertheless, the new supply curve created by the addition of the tax intersects demand(the marginal benefit) at the socially efficient quantity. As a result, the new competitive
equilibrium, taking account of the tax, is efficient.
6.3.2.1 (Exercise) Identify the tax revenue produced by a Pigouvian tax in Figure 6-14.
What is the relationship between the tax revenue and the damage produced by
the negative externality? Is the tax revenue sufficient to pay those damaged by
the external effect an amount equal to their damage? Hint: Is the marginalexternal effect increasing or decreasing.
The case of a positive externality is similar. In this case, a subsidy is needed to induce
the efficient quantity. It is left as an exercise.

Marginal
SocialCostp

PrivateMarginal
Cost +Tax
PrivateMarginal
Cost

Socially
Efficient
Price
Tax

Socially
Efficient
Quantity

Marginal
Benefitq

Figure 6-14: The Pigouvian Tax

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6.3.2.2 (Exercise) Identify on a diagram the Pigouvian subsidy needed to induce theefficient quantity in the case of a positive externality. When is the subsidy
expended smaller than the total external benefit?
6.3.2.3 (Exercise) Use the formulae for estimating the effect of a tax on quantity to
deduce the size of the tax needed to adjust for an externality when the marginal
social cost is twice the marginal private cost.
Taxes and subsidies are fairly common instruments to control externalities. We
subsidize higher education with state universities, and the federal government provides
funds for research and limited funds for the arts. Taxes on cigarettes and alcoholic
beverages are used to discourage these activities, perhaps because smoking and drinking
alcoholic beverages create negative externalities. (Cigarettes and alcohol also haveinelastic demands, which make them good candidates for taxation since there is only asmall distortion of the quantity.) However, while important in some arenas, taxes andsubsidies are not the most common approach to regulation of externalities.

6.3.3 Quotas
The Pigouvian tax and subsidy approach to dealing with externalities has several
problems. First, it requires knowing the marginal value or cost of the external effect,
and this may be a challenge to estimate. Second, it requires the imposition of taxes andpermits the payment of subsidies, which encourages what might be politely termed as“misappropriation of funds.” That is, once a government agency is permitted to tax
some activities and subsidize others, there will be a tendency to tax things people in theagency don’t like, and subsidize “pet” projects, using the potential for externalities as an
excuse rather than a real reason. U.S. politicians have been especially quick to see
positive externalities in oil, cattle and the family farm, externalities that haven’t beensuccessfully articulated. (The Canadian government, in contrast, sees externalities infilm-making and railroads.)
An alternative to the Pigouvian tax or subsidy solution is to set a quota, which is a limiton the activity. Quotas can be maxima or minima, depending on whether the activity
generates negative or positive externalities. We set maximum levels of many pollutants
rather than tax them, and ban some activities, like lead in gasoline or paint, or
chlorofluorocarbons (CFCs) outright (a quota equal to zero). We set maximum amountsof impurities, like rat feces, in foodstuffs. We impose minimum educational attainment(eighth grade or age 16, whichever comes first), minimum age to drive, minimum
amount of rest time for truck drivers and airline pilots. A large set of regulations governelectricity and plumbing, designed to promote safety, and these tend to be “minimum
standards.” Quotas are a much more common regulatory strategy for dealing withexternalities than taxes and subsidies.
The idea behind a quota is to limit the quantity to the efficient level. If a negative
externality in pollution means our society pollutes too much, then impose a limit orquantity restriction on pollution. If the positive externality of education means
individuals in our society receive too little education from the social perspective, force
them to go to school.

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As noted, quotas have the advantage that they address the problem without letting thegovernment spend more money, limiting the government’s ability to misuse funds. On
the other hand, quotas have the problem of identifying who should get the quota; quotas
will often misallocate the resource. Indeed, a small number of power plants account foralmost half of the man-made sulfur dioxide pollution emitted into the atmosphere,
primarily because these plants historically emitted a lot of pollution and their pollution
level was set by their historical levels. Quotas tend to harm new entrants compared toexisting firms, and discourage the adoption of new technology. Indeed, the biggest
polluters must stay with old technology in order to maintain their right to pollute.
6.3.3.1 (Exercise) If a quota is set to the socially efficient level, how does the value of aquota right compare to the Pigouvian tax?
6.3.3.2 (Exercise) Speeding (driving fast) creates externalities by increasing the
likelihood and severity of automobile accidents, and most countries put a limiton speed, but one could instead require fast drivers to buy a permit to speed.
Discuss the advantages and disadvantages of “speeding permits.”

6.3.4 Tradable Permits and Auctions
A solution to inefficiencies in the allocation of quota rights is to permit trading them.
Tradable permits for pollution create a market in the right to pollute, and thereby create
a tax on polluting: the emission of pollution requires the purchase of permits to pollute,and the price of these permits represents a tax on pollution. Thus, tradable permits
represent a hybrid of a quota system and a Pigouvian taxation system – a quota
determines the overall quantity of pollution as in a quota system, determining the
supply of pollution rights, but the purchase of pollution rights acts like a tax onpollution, a tax whose level is determined by the quota supply and demand.

Figure 6-15: SO2 Permit Prices

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The United States has permitted the trading of permits for some pollutants, like sulfur
dioxide. Figure 6-15 shows the price of sulfur dioxide permits over the past decade.67
Each permit conveys the right to emit one ton of sulfur dioxide into the air. The overall
pollution level is being reduced over time, which accounts for some of the increase in
prices. These prices represent significant taxes on large polluters, as a coal-fired power
plant, using coal with high sulfur content, can annually produce as much as 200,000
tons of sulfur dioxide.
The major advantage of a tradable permits system is that it creates the opportunity for
efficient exchange – one potential polluter can buy permits from another, leaving thetotal amount of pollution constant. Such exchange is efficient because it uses thepollution in the manner creating the highest value, eliminating a bias toward “old”
sources. Indeed, a low value polluter might sell its permits and just shut down, if theprice of pollution were high enough.
A somewhat unexpected advantage of tradable permits was the purchase of permits byenvironmental groups like the Sierra Club. Environmental groups can buy permits andthen not exercise them, as a way of cleaning the air. In this case, the purchase of thepermits creates a major positive externality on the rest of society, since theenvironmental group expends its own resources to reduce pollution of others.
Tradable permits offer the advantages of a taxation scheme – efficient use of pollution –without needing to estimate the social cost of pollution directly. This is especiallyvaluable when the strategy is to set a quantity equal to the current quantity, and thengradually reduce the quantity to reduce the effects of the pollution. The price of permits
can be a very useful instrument is assessing the appropriate time to reduce the quantity,
since high permit prices, relative to likely marginal external costs, suggests that thequantity of the quota is too low, while low prices suggest that the quantity is too large
and should be reduced.

6.3.5 Coasian Bargaining
The negative externality of a neighbor playing loud music late at night is not ordinarily
solved with a tax or with a quota, but instead though an agreement. When there aren’t
many individuals involved, the individuals may be able to solve the problem ofexternalities without involving a government, but through negotiation. This insight wasdeveloped by Nobel laureate Ronald Coase (1910 – ).
Coase offered the example of a cattle ranch next to a farm. There is a negative
externality, in that the cattle tend to wander over to the farm and eat the crops, rather
than staying on the ranch. What happens next depends on property rights, which are
the rights that come with ownership.
One of three things might be efficient from a social perspective. It might be efficient toerect a fence to keep the cows away from the crops. It might be efficient to close down
67 Source: Environmental Protection Agency, July 22, 2004,

http://www.epa.gov/airmarkets/trading/so2market/alprices.html

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the farm. Finally, it might be efficient to close down the ranch, if the farm is valuable
enough, and the fence costs more than the value of the ranch.
If the farmer has a right not to have his crops eaten, and can confiscate the cows if they
wander onto the farm, then the rancher will have an incentive to erect a fence to keep
the cows away, if that is the efficient solution. If the efficient solution is to close down
the ranch, then the rancher will do that, since the farmer can confiscate the cows if they
go to the farm and it isn’t worth building the fence by hypothesis. Finally, if the efficientsolution to the externality is to close down the farm, the rancher will have an incentive
to buy the farm in order to purchase the farm’s rights, so that he can keep the ranch inoperation. Since it is efficient to close down the farm only if the farm is worth less than
the ranch, there is enough value in operating the ranch to purchase the farm at its value
and still have money left over – that is there are gains from trade from selling the farmto the rancher. In all three cases, if the farmer has the property rights, the efficient
outcome is reached.
Now suppose instead that the rancher has the rights, and that the farmer has norecourse if the cows eat his crops. If shutting down the farm is efficient, the farmer has
no recourse but to shut down. Similarly, if building the fence is efficient, the farmer willbuild the fence to protect his crops. Finally, if shutting down the ranch is efficient, thefarmer will buy the ranch from the rancher, in order to be able to continue to operate
the more valuable farm. In all cases, the efficient solution is reached throughnegotiation.
Coase argued that bargaining can generally solve problems of externalities, and that thereal problem is ill-defined property rights. If the rancher and the farmer can’t transfer
their property rights, then the efficient outcome may not arise. In the Coasian view of
externalities, if an individual owned the air, air pollution would not be a problem,
because the owner would charge for the use and wouldn’t permit an inefficient level ofpollution. The case of air pollution demonstrates some of the limitations of the Coasianapproach, because ownership of the air, or even the more limited right to pollute into
the air, would create an additional set of problems, a case where the cure is likely worse
than the disease.
Bargaining to solve the problem of externalities is often feasible when a small number ofpeople are involved. When a large number of people are potentially involved, as with air
pollution, bargaining is unlikely to be successful in addressing the problem ofexternalities, and a different approach required.

6.3.6 Fishing and Extinction
Consider an unregulated fishing market like the lobster market considered above, and
let S be the stock of fish. The purpose of this example is illustrative of the logic, rather
than an exact accounting of the biology of fish populations, but is not unreasonable. Let
S be the stock of a particular species of fish. Our starting point is an environment
without fishing: how does the fish population change over time? Denote the changeover time in the fish population by S& ( S& is notation for the derivative with respect totime, notation that dates back to Sir Isaac Newton.) We assume that population growthfollows the logistic equation S& = rS (1 − S ). This equation reflects two underlying

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assumptions. First, mating and reproduction is proportional to the stock of fish S.
Second, survival is proportional to the amount of available resources 1-S, where 1 is set
to be the maximum sustainable population. (Set the units of the number of fish so that 1
is the full population.)
The dynamics of the number of fish is illustrated in Figure 6-16. On the horizontal axis
is the number of fish, and on the vertical axis is the change in S. When S& >0, S isincreasing over time, and the arrows on the horizontal axis reflect this. Similarly, if
S& <0, S is decreasing.
Absent fishing, the value 1 is a stable steady state of the fish population. It is a steadystate because, if S=1, S& =0, that is, there is no change in the fish population. It is stablebecause the effect of a small perturbation – S near but not exactly equal to 1 – is toreturn to 1. (In fact, the fish population is very nearly globally stable – start with any
population other than zero and the population returns to 1.)68

S&
0.5
0.4
0.3
0.2
0.1
S

0.2

0.4

0.6

0.8

1

-0.1
-0.2
Figure 6-16: Fish Population Dynamics

Now we introduce a human population and turn to the economics of fishing. Supposethat a boat costs b to launch and operate, and that it captures a fixed fraction a of the−1

total stock of fish S, that is, each boat catches aS. Fish sell for a price p = Q ε , where
the price arises from the demand curve, which in this case has constant elasticity ε, andQ is the quantity of fish offered for sale. Suppose there be n boats launched; then thequantity of fish caught is Q=naS. Fishers enter the market as long as profits are
positive, which leads to zero profits for fishers, that is, b = ⎛⎜ Q ⎞⎟ p(Q ) . This equation⎝ n⎠
68 It turns out that there is a closed form solution for the fish population:

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S (0 )
S (0) + (1 − S (0))e

−rt

.

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makes a company just indifferent to launching an additional boat, because the costs andrevenues are balanced. These two equations yield two equations in the two unknowns n
and Q:ε−1

Qp(Q ) 1 ε
n=
= Q
, and
b
b
Q=naS. These two equations solve for the number of fish caught:⎛ aS ⎞
Q=⎜
⎟
⎝ b ⎠

ε

a ε−1 ε−1S .
and the number of boats n =bεSubtracting the capture by humans from the growth in the fish population yields:
ε⎛ aS ⎞
S& = rS (1 − S ) − ⎜
⎟ .
⎝ b ⎠
ε

⎛ aS ⎞
Thus, a steady state satisfies 0 = S& = rS (1 − S ) − ⎜
⎟ .
⎝ b ⎠

S&

S
S*

Figure 6-17: Fish Population Dynamics with FishingWill human fishing drive the fish to extinction? Extinction must occur when the only
stable solution to the stock of fish is zero. Consider first the case when demand is elastic(ε>1). In this case, for S near zero but positive, S& ≈ rS > 0 , because the other terms are
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small relative to the linear term. Thus, with elastic demand, there is always a steadystate without extinction. (Extinction is also an equilibrium, too, but over-fishing won’t
get the system there.) This equilibrium is illustrated in Figure 6-17.
The dark curve represents S& , and thus for S between 0 and the point labeled S*, S& is
positive and thus S is increasing over time. Similarly, to the right of S*, S is decreasing.
Thus, S* is stable under small perturbations in the stock of fish and is an equilibrium.
We see that if demand for fish is elastic, fishing will not drive the fish to extinction.
Even so, fishing will reduce the stock of fish below the efficient level, because individual
fishers don’t take account of the externality they impose – their fishing reduces the stock
for future generations. The level of fish in the sea converges to S* satisfying
ε⎛ aS * ⎞0 = rS * (1 − S *) − ⎜
⎟ .
⎝ b ⎠

In contrast, if demand is inelastic, fishing may drive the fish to extinction. For example,
if r=2 and a=b=1, and ε=0.7, extinction is necessary, as is illustrated in Figure 6-18.

S&
-0.01

0.1

0.2

0.3

0.4

S

0.5

-0.02
-0.03
-0.04
-0.05
-0.06

Figure 6-18: Fish Population Dynamics: Extinction

Figure 6-18 shows that, for the given parameters, the net growth of the fish population isnegative for every value of the stock S. Thus the population of fish consistently
dwindles. This is a case when the fishing externality (overfishing today reduces the stockof fish tomorrow) has particularly dire consequences. The reason why the elasticity ofdemand matters is that, with inelastic demand, the fall in the stock of fish increases theprice by a large amount (enough so that total revenue rises). This, in turn, increases thenumber of fishing boats, in spite of the fall in the catch. In contrast, with elastic
demand, the number of fishing boats falls as the stock falls, reducing the proportion offish caught, and thus preventing extinction. We see this for the equation for the numberof fishing boats

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n=

a ε−1 ε−1Sbεwhich reflects the fact that fishing effort rises as the stock falls if and only if demand isinelastic.
It is possible, even with inelastic demand, for there to be a stable fish population: not allparameter values lead to extinction. Using the same parameters as before, but with
ε=0.9, we obtain a stable outcome illustrated in Figure 6-19.
0.02

S&
S
0.1

-0.02

-0.04

0.2

0.3

0.4

Unstable Equilibrium

Stable Equilibrium

Figure 6-19: Possibility of Multiple Equilibria

In addition to the stable equilibrium outcome, there is an unstable steady state, whichmight either converge upward or downward. It is a feature of fishing with inelastic
demand that there is a region where extinction is inevitable, for when the stock is nearzero, the high demand price induced by inelasticity forces sufficient fishing to insure
extinction.
As a consequence of the fishing externality, nations attempt to regulate fishing, both byextending their own reach 200 miles into the sea, and by treaties limiting fishing in the
open sea. These regulatory attempts have met with only modest success at preventing
over-fishing.
What is the efficient stock of fish? This is a challenging mathematical problem, butsome insight can be gleaned via a steady state analysis. A steady state arise when S& = 0 .
If a constant amount Q is removed, a steady state in the stock must occur at
0 = S& = rS (1 − S ) − Q . This maximum catch then occurs at S = ½, and Q = ¼ r. This is
not the efficient level, for it neglects the cost of boats, and the efficient stock will actually
be larger. More generally, it is never efficient to send the population below the
maximum point on the survival curve plotted in Figure 6-16.

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Conceptually, fishing is an example of the tragedy of the commons externality alreadydiscussed. However, the threat of a permanent extinction and alluring possibility ofsolving dynamic models make it a particularly dramatic example.
6.3.6.1 (Exercise) Suppose ε = 1. For what parameter values are fish necessarily
driven to extinction? Can you interpret this condition to say that the demandfor caught fish exceeds the production via reproduction?

6.4 Public Goods
A public good has two attributes: nonexcludability, which means the producer can’t
prevent the use of the good by others, and nonrivalry, which means that many people
can use the good simultaneously.

6.4.1 Examples
Consider a company offering a fireworks display. Pretty much anyone nearby can watch
the fireworks, and people with houses in the right place have a great view of them. The
company that creates the fireworks can’t compel those with nearby homes to pay for the
fireworks, and so a lot of people get to watch them without paying. This will make it
difficult or impossible for the fireworks company to make a profit. In addition,
fireworks offer nonrivalry, in that one person’s viewing of the display doesn’t impinge
significantly on another’s viewing. Nonrivalry has the implication that the efficient priceis zero, since the marginal cost of another viewer is zero.
The classic example of a public good is national defense. National defense is clearlynon-excludable, for if we spend the resources necessary to defend our national borders,
it isn’t going to be possible to defend everything except one apartment on the second
floor of a three story apartment on East Maple Street. Once we have kept our enemies
out of our borders, we’ve protected everyone within the borders. Similarly, the defenseof the national borders exhibits a fair degree of nonrivalry, especially insofar as thestrategy of defense is to deter an attack in the first place. That is, the same expenditureof resources protects all.
It is theoretically possible to exclude some from the use of a poem, or a mathematicaltheorem, but exclusion is generally quite difficult. Both poems and theorems are
nonrivalrous. Similarly, technological and software inventions are non-rivalrous, eventhough a patent grants the right to exclude the use by others. Another good that permits
exclusion at a cost is a highway. A toll highway shows that exclusion is possible on the
highways. Exclusion is quite expensive, partly because the tollbooths require staffing,but mainly because of the delays imposed on drivers associated with paying the tolls –the time costs of toll roads are high. Highways are an intermediate case where exclusion
is possible only at a significant cost, and thus should be avoided if possible. Highways
are also rivalrous at high congestion levels, but nonrivalrous at low congestion levels.
That is, the marginal cost of an additional user is essentially zero for a sizeable numberof users, but then marginal cost grows rapidly in the number of users. With fewer than
700 cars per lane per hour on a four lane highway, generally the flow of traffic is

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unimpeded.69 As congestion grows beyond this level, traffic slows down and congestion
sets in. Thus, west Texas interstate highways are usually nonrivalrous, while Los
Angeles freeways are usually very rivalrous.
Like highways, recreational parks are nonrivalrous at low use levels, becoming rivalrous
as they become sufficiently crowded. Also like highways, it is possible but expensive to
exclude potential users, since exclusion requires fences and a means for admitting some
but not others. (Some exclusive parks provide keys to legitimate users, while others use
gatekeepers to charge admission.)

6.4.2 Free-Riders
Consider a neighborhood association which is considering buying land and building apark in the neighborhood. The value of the park is going to depend on the size of thepark, and we suppose for simplicity that the value in dollars of the park to eachhousehold in the neighborhood is S bn −a , where n is the number of park users, S is thesize of the park and a and b a are parameters satisfying 0<a≤b<1. This functional formbuilds in the property that larger parks provide more value at a diminishing rate, butthere is an effect from congestion. The functional form gives a reason for parks to be
public – it is more efficient for a group of people to share a large park than for eachindividual to possess a small park, at least if b > a, because the gains from a large park
exceed the congestion effects. That is, there is a scale advantage – doubling the numberof people and the size of the park increases each individual’s enjoyment.
How much will selfish individuals voluntarily contribute to the building of the park?
That of course depends on what they think others will contribute. Consider a single
household, and suppose that household thinks the others will contribute S-1 to thebuilding of the park. Should the household contribute, and if so, how much? If thehousehold contributes s, the park will have size S = S-1 + s, which the household valuesat ( S −1 + s )b n −a . Thus, the net gain to a household that contributes s when the others
contribute S-1 is ( S −1 + s )b n −a − s .
6.4.2.1 (Exercise)

Verify that individual residents gain from contributing to the park if

11−a 1−b−a 1−b
S < (bn )and gain from reducing their contributions if S > (bn ).

The previous exercise shows that individual residents gain from their marginal1−a 1−b. Consequently,
contribution if and only if the park is smaller than S0 = (bn )under voluntary contributions, the only equilibrium park size is S0. That is, for any park
size smaller than S0, citizens will voluntarily contribute to make the park larger. For any
larger size, no one is willing to contribute.

69 The effect of doubling the number of lanes from 2 to 4 is dramatic.

A two lane highway generally flows
at 60 mph or more provided there are fewer than 200 cars per lane per hour, while a four lane highway
can accommodate 700 cars per lane per hour at the same speed.

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Under voluntary contributions, as the neighborhood grows in number, the size of thepark shrinks. This makes sense – the benefits of individual contributions to the park
mostly accrue to others, which reduces the payoff to any one contributor.
How large should the park be? The total value of the park of size S to the residents
together is n times the individual value, which gives a collective value of S b n1−a , andthe park costs S, so from a social perspective the park should be sized to1
1−a 1−bb 1 −a− S , which yields an optimal park of size S * = (bn ). Thus, as
maximize S n
the neighborhood grows, the park should grow, but as we saw the park would shrink if
the neighborhood has to rely on voluntary contributions. This is because people
contribute individually as if they were building the park for themselves, and don’t
account for the value they provide to their neighbors when they contribute. Underindividual contributions, the hope that others contribute leads individuals not tocontribute. Moreover, use of the park by others reduces the value of the park to eachindividual, so that the size of the park shrinks as the population grows under individual
contributions. In contrast, the park ought to grow faster than the number of residents
1b −agrows, as the per capita park size is S * = b 1−b n 1−b , which is an increasing function ofnn.70
The lack of incentive for individuals to contribute to a social good is known as a freerider problem. The term refers to the individuals who don’t contribute, who are said to
free-ride on the contributions of others. There are two aspects of the free-rider problem
apparent in this simple mathematical model. First, the individual incentive tocontribute to a public good is reduced by the contributions of others, and thus individual
contributions tend to be smaller when the group is larger. Put another way, the size ofthe free-rider problem grows as the community grows larger. Second, as the community
grows larger, the optimal size of the public good grows. The market failure undervoluntary contributions is greater the larger is the community. In the theory presented,
the optimal size of the public good is S * = (bnvoluntary contributions is S0
people grows.

1
1−a 1−b), and the actual size under1−a 1−b= (bn )
, a gap that gets very large as the number of

The upshot is that people will voluntarily contribute too little from a social perspective,
by free-riding on the contributions of others. A good example of the provision of public
goods is a co-authored term paper. This is a public good because the grade given to thepaper is the same for each author, and the quality of the paper depends on the sum of
the efforts of the individual authors. Generally, with two authors, both work pretty hardon the manuscript in order to get a good grade. Add a third author and it is a virtual

70 Reminder: In making statements like should and ought, there is no conflict in this model because every
household agrees about the optimal size of the park, so that a change to a park size of S*, paid with equal
contributions, maximizes every household’s utility.

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certainty that two of the authors think the third didn’t work as hard and was a free-rider
on the project.
The term paper example also points to the limitations of the theory. Many people are
not as selfish as the theory assumed and will contribute more than would be privately
optimal. Moreover, with small numbers, bargaining between the contributors and thedivision of labor (each works on a section) may help reduce the free-rider problem.
Nevertheless, even with these limitations, the free-rider problem is very real and it gets
worse the more people are involved. The theory shows that if some individuals
contribute more than their share in an altruistic way, the more selfish individuals
contribute even less, undoing some of the good done by the altruists.
6.4.2.2 (Exercise) For the model presented in this section, compute the elasticity ofthe optimal park size with respect to the number of residents, that is, thepercent change in S* for a small percentage change in n. [Hint: use the linear
approximation trick (1 + ∆ )r ≈ r∆ for ∆ near zero.]
6.4.2.3 (Exercise) For the model of this section, show that an individual’s utility when
the park is optimally sized and the expenses are shared equally among the n
1 ⎞ b −a
⎛ b
⎟
⎜ 1−b
individuals is u = ⎜ b− b 1−b ⎟ n 1−b . Does this model predict an increase in⎜⎟⎝⎠utility from larger communities?
6.4.2.4 (Exercise) Suppose two people, person 1 and person 2, want to produce aplayground to share between them. The value of the playground of size S toeach person is S , where S is the number of dollars spent building it. Show
that under voluntary contributions, the size of the playground is ¼ and that theefficient size is 1.
6.4.2.5 (Exercise) For the previous exercise, now suppose person 1 offers “matchingfunds,” that is, offers to contribute an equal amount to the contributions of theperson 2. How large a playground will person 2 choose?

6.4.3 Provision with Taxation
Faced with the fact that voluntary contributions produce an inadequate park, theneighborhood turns to taxes. Many neighborhood associations or condominium
associations have taxing authority, and can compel individuals to contribute. Clearly inthe example from the previous section, and indeed a solution is to require each resident
to contribute the amount 1, resulting in a park that is optimally sized at n. Generally it ispossible in principle to provide the correct size of the public good using taxes to fund it.
However, it will be a challenge in practice, which can be illustrated with a slight
modification of the example.
Let individuals have different strengths of preferences, so that individual i values the
public good of size S at vi S bn −a in dollars. (It is useful to assume that no two people

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have the same v values to simplify arguments.) The optimal size of the park for the−aneighborhood is n 1−b ⎛⎜ b

⎝ ∑

1
1
1−a
1
n
⎞
b
−
1
v
= (bv) 1−b n 1−b , where v =i =1 i ⎟⎠nn∑i =1 vi is the averagevalue. Again, taxes can be assessed to pay for an optimally-sized park, but some people(those with small v values) will view that as a bad deal, while others (with large v) view it
as a good deal. What will the neighborhood choose?
If there are an odd number of voters in the neighborhood, the prediction is that the park
will serve the median voter the best.71 With equal taxes, an individual obtains
vi S b n −a − S . If there are an odd number of people, n can be written as 2k+1. Thenmedian voter is the person for whom k have values vi larger than hers, and k have values
smaller. Consider increasing S. If the median voter likes it, then so do all the people
with higher v’s, and the proposition to increase S passes. Similarly, a proposal todecrease S will get a majority if the median voter likes it. If the median voter likes
reducing S, all the individuals with smaller vi will vote for it as well. Thus, we can seethat voting maximizes the preferences of the median voter, and simple calculus shows1
1 −athat entails S = (bvk ) 1−b n 1−b .

Unfortunately, voting does not result in an efficient outcome generally, and only does sowhen the average value equals the median value. On the other hand, voting generally
performs much better than voluntary contributions. The park size can either be larger
or smaller under median voting than is efficient.72
6.4.3.1 (Exercise) For the model of this section, show that, under voluntary
contributions, only one person contributes, and that person is the person withthe largest vi. How much do they contribute? [Hint: which individual i is
willing to contribute at the largest park size? Given the park this individual
desires, can anyone else benefit from contributing at all?]
6.4.3.2 (Exercise) Show that if all individuals value the public good equally, voting on
the size of the good results in the efficient provision of the public good.

6.4.4 Local Public Goods
The example in the previous section showed that there are challenges to aneighborhood’s provision of public goods created by differences in the preferences of the
public good. Voting does not generally lead to the efficient provision of the public good,and does so only in special circumstances, like agreement of preferences.

71 The voting model used is that there is a status quo, which is a planned size of S.

Anyone can propose tochange the size of S, and the neighborhood votes yes or no. If an S exists such that no replacement gets amajority vote, that S is an equilibrium under majority voting.
72 The general principle here is that the median voting will do better when the distribution of values issuch that the average of n values exceeds the median, which in turn exceeds the maximum divided by n.
This is true for most empirically relevant distributions.

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A different solution was proposed by Tiebout73 in 1956. This solution works only when
the public goods are local in nature – people living nearby may or may not be
excludable, but people living further away can be excluded, and such goods are called“local public goods.” Schools are local – more distant people can readily be excluded.
Parks are harder to exclude from, but are still local in nature; few people will drive 30
miles to use a park.
Suppose that there are a variety of neighborhoods, some with high taxes, better schools,
big parks, beautifully maintained trees on the streets, frequent garbage pickup, a firstrate fire department, extensive police protection and spectacular fireworks displays, andothers with lower taxes and more modest provision of public goods. People will tend tomove to the neighborhood that fits their preferences. The result is neighborhoods thatare relatively homogeneous with respect to the desire for public goods. Thathomogeneity, in turn, makes voting work better. That is, the ability of people to choose
their neighborhoods to suit their preferences over taxes and public goods will make theneighborhood provision of public goods more efficient. The “Tiebout theory” shows that
local public goods will tend to be efficiently provided. In addition, even private goods
like garbage collection and schools can be efficiently provided publicly if they are local
goods, and there are enough distinct localities to offer a broad range of services.
6.4.4.1 (Exercise) Consider a baby-sitting cooperative, where parents rotate
supervision of the children of several families. Suppose that, if the sitting
service is available with frequency Y, the value placed by person i is vi Y and thecosts of contribution y is ½ ny2, where Y is the sum of the individual
contributions and n is the number of families. Rank v1 ≥ v2 ≥ … ≥ vn. (i) What is
the size of the service under voluntary contributions? (Hint: Let yi be thecontribution of family i. Identify the payoff of family j as

(

)

( )

v j y j + ∑ i ≠ j yi − ½n y j 2What value of yj maximizes this expression?)(ii) What contributions maximize the total social value
n
⎛ n
⎞⎛ n
⎞
⎜ v ⎟⎜ y ⎟ − ½n y 2 ? [Hint: Are the values of yi different for different
∑
∑
∑
j ⎟⎜
j⎟
j
⎜
i =1
⎝ j =1 ⎠⎝ j =1 ⎠
i?]

( )

(iii) Let µ =

n
1 n
2 1
v
σ
=
and
∑ j
∑ (v j − µ)2 . Conclude that, under voluntary
n j =1n j =1

contributions, the total value generated by the cooperative is

73 Charles Tiebout, 1919-1962.

(

)

n 2
µ − σ2 . (Hint:2

His surname is pronounced “tee-boo.”

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It helps to know that
1 n
1 n
2 n
1 n
1 n
σ2 = ∑ ( v j − µ)2 = ∑ v2j − ∑ µv j + ∑ µ2 = ∑ v2j − µ2 . )n j =1n j =1n j =1n j =1n j =1

6.5 Monopoly
We have spent a great deal of time on the competitive model, and we now turn to thepolar opposite case, that of monopoly. A monopoly is a firm that faces a downward
sloping demand, and has a choice about what price to charge – an increase in pricedoesn’t send most or all of the customers away to rivals.
There are very few pure monopolies. The U.S. post office has a monopoly in first-classmail, but faces competition by FedEx and other express mail companies, as well as byfaxes and email, in the broader “send documents to others” market. Microsoft has agreat deal of market power, but a small percentage of personal computer users choose
Apple or Linux operating systems. There is only one U.S. manufacturer of aircraft
carriers.
However, there are many firms that have market power or monopoly power, whichmeans that they can increase their price above marginal cost and sustain sales for a long
period of time.74 The theory of monopoly is applicable to such firms, although they may
face an additional and important constraint: a price increase may affect the behavior ofrivals. The behavior of rivals is the subject of the next chapter.
A large market share is not a proof of monopoly, nor is a small market share proof that afirm lacks monopoly power. U.S. Air dominated air traffic to Philadelphia andPittsburgh, but still lost money. Porsche has a small share of the automobile market, oreven the high-end automobile market, but still has monopoly power in that market.

6.5.1 Sources of Monopoly
There are three basic sources of monopoly. The most common source is to be granted amonopoly by the government, either through patents, in which case the monopoly is
temporary, or through a government franchise. Intelsat was a government franchisethat was granted a monopoly on satellite communications, a monopoly that ultimately
proved lucrative indeed. Many cities and towns license a single cable TV company ortaxi company, although usually basic rates and fares are set by the terms of the license
agreement. New drugs are granted patents that provide a monopoly for a period oftime. (Patents generally last twenty years, but pharmaceutical drugs have their own
patent laws.) Copyright also confers a monopoly for a supposedly limited period oftime. Thus, the Disney Corporation owns copyrights on Mickey Mouse, copyrights
which by law should have expired, but have been granted an extension by Congress eachtime they were due to expire. Copyrights create monopoly power over music as well as
cartoon characters, and Time-Warner owns the rights to the song “Happy Birthday to74 These terms are used somewhat differently by different authors.

Both require downward sloping
demand, and usually some notion of sustainability of sales. Some distinguish the terms by whether they
are “large” or not, others by how long the price increase can be sustained. We won’t need such
distinctions here.

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You,” and receives royalties every time it is played on the radio or other commercial
venue.75 Many of the Beatles songs which McCartney co-authored were purchased byMichael Jackson. This book is copyrighted under terms that expressly prohibitcommercial use but permit most other uses.
A second source of monopoly is a large economy of scale. The scale economy needs tobe large relative to the size of demand. If the average cost when a single firm serves theentire market is lower than when two or more firms serve the market, a monopoly canbe the result. For example, long distance telephone lines were expensive to install, andthe first company to do so, A.T. & T., wound up being the only provider of long distanceservice in the United States. Similarly, scale economies in electricity generation meantthat most communities had a single electricity provider prior to the 1980s, when newtechnology made relatively smaller scale generation more efficient.
The demand-side equivalent of an economy of scale is a network externality. A network
externality arises when others’ use of a product makes it more valuable to eachconsumer. Standards are a common source of network externality. That AA batteries
are standardized makes them more readily accessible, helps drive down their pricethrough competition and economies of scale, and thus makes the AA battery morevaluable. AA batteries are available everywhere, unlike proprietary batteries. Fax
machines are valuable only if others have similar machines. In addition to standards, asource of network externality is third-party products. Choosing Microsoft Windows as acomputer operating system means that there is more software available than for
Macintosh or Linux, as the widespread adoption of Windows has led a large variety ofsoftware to be written for it. The JVC Video Home System of VCRs came to dominate
the Sony Beta system, primarily because there were more movies to rent in the VHS
format than in the Beta format at the video rental store. In contrast, recordable DVD
has been hobbled by incompatible standards of DVD+R and DVD-R, a conflict not
resolved even as the next generation – 50GB discs such as Sony’s Blu-ray – start toreach the market. DVDs themselves were slow to be adopted by consumers, because few
discs were available for rent at video rental stores, which is a consequence of few
adoptions of DVD players. As DVD players became more prevalent, and the number ofdiscs for rent increased, the market tipped and DVDs came to dominate VHS.
The third source of monopoly is control of an essential, or a sufficiently valuable, input
to the production process. Such an input could be technology that confers a costadvantage. For example, software is run by a computer operating system, and needs tobe designed to work well with the operating system. There have been a series ofallegations that Microsoft kept secret some of the “application program interfaces” usedby Word as a means of hobbling rivals. If so, access to the design of the operating
system itself is an important input.

6.5.2 Basic Analysis
Even a monopoly is constrained by demand. A monopoly would like to sell lots of units
at very high prices, but higher prices necessarily lead to a loss in sales. So how does amonopoly choose its price and quantity?
75 Fair use provisions protect individuals with non-commercial uses of copyrighted materials.

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A monopoly can choose price, or a monopoly can choose quantity and let the demand
dictate the price. It is slightly more convenient to formulate the theory in terms ofquantity rather than price, because costs are a function of quantity. Thus, we let p(q) be
the demand price associated with quantity q, and c(q) be the cost of producing q. The
monopoly’s profits are

π = p(q)q − c(q) .
The monopoly earns the revenue pq and pays the cost c. This leads to the first ordercondition, for the profit-maximizing quantity qm:
0=∂π= p(qm ) + qm p′(qm ) − c ′(qm ) .
∂q

The term p(q) + qp′(q) is known as marginal revenue. It is the derivative of revenue pq
with respect to quantity. Thus, a monopoly chooses a quantity qm where marginal
revenue equals marginal cost, and charges the maximum price p(qm) the market willbear at that quantity. Marginal revenue is below demand p(q) because demand isdownward sloping. That is, p(q) + qp′(q) < p(q) .

p

MC
Dead
WeightLosspm
Monopoly
Profits

D

qm

q

qc
MR

Figure 6-20: Basic Monopoly Diagram

6.5.2.1 (Exercise) If demand is linear, p(q)=a – bq, what is marginal revenue? Plotdemand and marginal revenue, and total revenue qp(q) as a function of q.

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6.5.2.2 (Exercise)revenue?

For the case of constant elasticity of demand, what is marginal

6.5.2.3 (Exercise) If both demand and supply have constant elasticity, compute themonopoly quantity and price.
The choice of monopoly quantity is illustrated in Figure 6-20. The key points of thisdiagram are, first, that marginal revenue lies below the demand curve. This occurs
because marginal revenue is the demand p(q) plus a negative number. Second, themonopoly quantity equates marginal revenue and marginal cost, but the monopoly priceis higher than the marginal cost. Third, there is a dead weight loss, for the same reason
that taxes create a dead weight loss: the higher price of the monopoly prevents someunits from being traded that are valued more highly than they cost. Fourth, themonopoly profits from the increase in price, and the monopoly profit is shaded. Fifth,
since under competitive conditions supply equals marginal cost, the intersection of
marginal cost and demand corresponds to the competitive outcome. We see that themonopoly restricts output and charges a higher price than would prevail undercompetition.
We can rearrange the monopoly pricing formula to produce an additional insight.

p(qm ) − c ′(qm ) = −qm p′(qm )orp(qm ) − c ′(qm ) − qm p′(qm ) 1== .
p(qm )p(qm )εThe left hand side of this equation is known as the price-cost margin or Lerner Index.76
The right hand side is one over the elasticity of demand. This formula relates themarkup over marginal cost to the elasticity of demand. It is important because perfectcompetition forces price to equal marginal cost, so this formula provides a measure of
the deviation from competition, and in particular says that the deviation fromcompetition is small when the elasticity of demand is large, and vice versa.
Marginal cost will always be at least zero or larger. If marginal cost is less than zero, theleast expensive way to produce a given quantity is to produce more and throw someaway. Thus, the price-cost margin is no greater than one, and as a result, a monopolist
produces in the elastic portion of demand. One implication of this observation is that if
demand is everywhere inelastic (e.g. p(q) = q −a for a>1), the optimal monopoly
quantity is essentially zero, and in any event would be no more than one molecule of the
product.
76 Abba Lerner, 1903-1982.

Note thatdq
1which is used in the
qm
1
q
=−
=−
= ε,
− qm p′(qm )p′(qm )dppp(qm )p(qm )

derivation.

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In addition, the effects of monopoly are related to the elasticity of demand. If demand isvery elastic, the effect of monopoly on prices is quite limited. In contrast, if the demandis relatively inelastic, monopolies will increase prices by a large margin.
We can rewrite the formula to obtainp(qm ) =εc ′(qm ).
ε −1ε, at least when ε>1. Thisε −1formula is sometimes used to justify a “fixed markup policy,” which means a company
adds a constant percentage markup to its products. This is an ill-advised policy notjustified by the formula, because the formula suggests a markup which depends on the
demand for the product in question and thus not a fixed markup for all products acompany produces.
Thus, a monopolist marks up marginal cost by the factor

6.5.3 Effect of Taxes
A tax imposed on a seller with monopoly power performs differently than a tax imposedon a competitive industry. Ultimately a perfectly competitive industry must pass on allof a tax to consumers, because in the long-run the competitive industry earns zeroprofits. In contrast, a monopolist might absorb some portion of a tax even in the longrun.
To model the effect of taxes on a monopoly, consider a monopolist who faces a tax rate t
per unit of sales. This monopolist earns

π = p(q)q − c(q) − tq .
The first order condition for profit maximization yields
0=∂π= p(qm ) + qm p′(qm ) − c ′(qm ) − t .
∂qViewing the monopoly quantity as a function of t, we obtain:

dqm
1
=
< 0,
2 p′(qm ) + qm p′′(qm ) − c ′′(qm )dtwith the sign following from the second order condition for profit maximization. In
addition, the change in price satisfiesp′(qm )

dqm
p′(qm )=> 0.
2 p′(qm ) + qm p′′(qm ) − c ′′(qm )dt

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Thus, a tax causes a monopoly to increase its price. In addition, the monopoly pricedq
rises by less than the tax if p′(qm ) m < 1 , ordtp′(qm ) + qm p′′(qm ) − c ′′(qm ) < 0.
This condition need not be true, but is a standard regularity condition imposed byassumption. It is true for linear demand and increasing marginal cost. It is false forconstant elasticity of demand, ε>1 (which is the relevant case, for otherwise the second
order conditions fail) and constant marginal cost. In the latter case (constant elasticity
and marginal cost), a tax on a monopoly increases price by more than the amount of thetax.
6.5.3.1 (Exercise) Use a revealed preference argument to show that a per unit tax
imposed on a monopoly causes the quantity to fall. That is, hypothesize
quantities qb before the tax, and qa after the tax, and show that two facts – thebefore tax monopoly preferred qb to qa and the taxed monopoly made higher
profits from qb together imply the qb ≤ qa.
6.5.3.2 (Exercise) When both demand and supply have constant elasticity, use theresults of 6.5.2.3 (Exercise) to compute the effect of a proportional tax (i.e. a
portion of the price paid to the government).

6.5.4 Price Discrimination
Pharmaceutical drugs for sale in Mexico are generally priced substantially below their
U.S. counterparts. Pharmaceutical drugs in Europe are also cheaper than in the U.S.,
although not as inexpensive as in Mexico, with Canadian prices usually between the U.S.
and European prices. (The comparison is between identical drugs produced by the same
manufacturer.)
Pharmaceutical drugs differ in price across countries primarily because demandconditions vary. The formulap(qm ) =εc ′(qm ).
ε −1shows that a monopoly seller would like to charge a higher markup over marginal cost to
customers with less elastic demand than to customers with more elastic demand,εbecauseis a decreasing function of ε, for ε>1. Charging different prices for theε −1same product to different customers is known as price discrimination. In businesssettings, it is sometimes known as value-based pricing, which is a more palatable term
to tell to customers.
Computer software vendors often sell a “student” version of their software, usually at
substantially reduced prices, and requiring proof of being a student to qualify for the
lower price. Such student discounts are examples of price discrimination, and students

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have more elastic demand than business users. Similarly, the student and senior citizen
discounts at movies and other venues sell the same thing – a ticket to the show – fordifferent prices, and thus qualify as price discrimination.
In order for a seller to price-discriminate, the seller must be able to• identify (approximately) the demand of groups of customers• prevent arbitrage
Arbitrage is also known as “buying low and selling high,” and represents the act of being
an intermediary. Since price discrimination requires charging one group a higher pricethan another, there is potentially an opportunity for arbitrage, arising from members of
the low price group buying at the low price and selling at the high price. If the seller
can’t prevent arbitrage, arbitrage essentially converts a two-price system to sales at thelow price.
Why offer student discounts at the movies? You already know the answer to this –students have lower incomes on average than others, and lower incomes translate into alower willingness to pay for normal goods. Consequently a discount to a student makes
sense from a demand perspective. Arbitrage can be mostly prevented by requiring a
student identification card to be presented. Senior citizen discounts are a bit more
subtle. Generally seniors aren’t poorer than other groups of customers (in the UnitedStates, at least). However, seniors have more free time, and thus are able to substituteto matinee showings77 or drive to more distant locations should those offer discounts.
Thus seniors have relatively elastic demand more because of their ability to substitutethan because of their income.
Airlines commonly price discriminate, using “Saturday night stay-overs” and otherdevices. To see that such charges represent price discrimination, consider a passenger
who lives in Dallas but needs to spend Monday through Thursday in Los Angeles two
weeks in a row. This passenger could buy two round-trip tickets:
Trip One:First Monday: Dallas → Los AngelesFirst Friday: Los Angeles → Dallas
Trip Two:
Second Monday: Dallas → Los Angeles
Second Friday: Los Angeles → Dallas
At the time of this writing, the approximate combined cost of these two flights was
US$2,000. In contrast, another way of arranging exactly the same travel is to have tworound-trips, one of which originates in Dallas, while the other originates in Los Angeles:

77 Matinee showings are those early in the day, which are usually discounted.

These discounts are notprice discrimination because a show at noon isn’t the same product as a show in the evening.

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Trip One:First Monday: Dallas → Los Angeles
Second Friday: Los Angeles → Dallas
Trip Two:First Friday: Los Angeles → Dallas
Second Monday: Dallas → Los Angeles
This pair of round trips involves exactly the same travel as the first pair, but costs lessthan $500 for both (at the time of this writing). The difference is that the second pair
involves staying over Saturday night for both legs, and that leads to a major discount formost U.S. airlines. (American Airlines quoted the fares.)
How can airlines price discriminate? There are two major groups of customers:
business travelers and leisure travelers. Business travelers have the higher willingness
to pay overall, and the nature of their trips tends to be that they come home for the
weekend. In contrast, a leisure traveler will usually want to be away for a weekend, so aweekend stay-over is an indicator of a leisure traveler. It doesn’t work perfectly as anindicator – some business travelers must be away for the weekend – but it is sufficiently
correlated with leisure travel that it is profitable for the airline to price discriminate.
These examples illustrate an important distinction. Senior citizen and student discounts
are based on the identity of the buyer, and qualifying for the discount requires showing
an identity card. In contrast, airline price discrimination is not based on the identity ofthe buyer but on the choices by the buyer. The former is known as direct pricediscrimination, while the latter is known as indirect price discrimination.78
Two common examples of indirect price discrimination are coupons and quantity
discounts. Coupons offer discounts for products and are especially common in grocery
stores, where they are usually provided in a newspaper section available free at the frontof the store. Coupons discriminate on the basis of the cost of time. It takes time to findthe coupons for the products one is interested in buying, and thus those with a highvalue of time won’t find it worthwhile spending twenty minutes to save $5 (effectively a$15 per hour return), while those with a low value of time will find that returnworthwhile. Since those with a low value of time tend to be more price sensitive (moreelastic demand), coupons offer a discount available to all but used primarily bycustomers with a more elastic demand, and thus increase the profits of the seller.
Quantity discounts are discounts for buying more. Thus, the large size of milk, laundry
detergent and other items often cost less per unit than smaller sizes, and the differenceis greater than the savings on packaging costs. In some cases, the larger sizes entail
greater packaging costs; some manufacturers “band together” individual units, incurring
additional costs to create a larger size which is then discounted. Thus, the “twenty-fourpack” of paper towels sells for less per roll than the individual rolls; such large volumes
appeal primarily to large families, who are more price-sensitive on average.
78 The older and incoherent language for these concepts called direct price discrimination “third degree

price discrimination,” while indirect price discrimination was called second degree price discrimination.
In the older language, first degree price discrimination meant perfect third degree price discrimination.

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6.5.5 Welfare Effects
Is price discrimination a good thing, or a bad thing? It turns out that there is no
definitive answer to this question. Instead, it depends on circumstances. We illustrate
this conclusion with a pair of exercises.
6.5.5.1 (Exercise) Let marginal cost be zero for all quantities. Suppose there are two
equal-sized groups of customers, group 1 with demand q(p)=12-p, group 2 withdemand q(p)=8-p. Show that a non-discriminating monopolist charges a priceof 5 and the discriminating monopolist charges group 1 the price 6 and group 2
the price 4. Then calculate the gains from trade, with discrimination andwithout, and show that price discrimination reduces the gains from trade.
This exercise illustrates a much more general proposition: if a price-discriminating
monopolist produces less than a non-discriminating monopolist, then pricediscrimination reduced welfare. This proposition has an elementary proof. Consider
the price discriminating monopolist’s sales, and then allow arbitrage. The arbitrage
increases the gains from trade, since every transaction has gains from trade. Arbitrage,
however, leads to a common price like that charged by a non-discriminating monopolist.
Thus, the only way price discrimination can increase welfare is if it leads a seller to sellmore output than she would otherwise. This is possible, as the next exercise shows.
6.5.5.2 (Exercise) Let marginal cost be zero for all quantities. Suppose there are two
equal-sized groups of customers, group 1 with demand q(p)=12-p, group 2 withdemand q(p)=4-p. Show that a non-discriminating monopolist charges a priceof 6 and the discriminating monopolist charges group 1 the price 6 and group 2
the price 2. Then calculate the gains from trade, with discrimination andwithout, and show that price discrimination increases the gains from trade.
In this exercise, we see that price discrimination that brings in a new group of customers
may increase the gains from trade. Indeed, this example involves a Pareto
improvement: the seller and group 2 are better off, and group 1 no worse off, than
without price discrimination. (A Pareto improvement requires that no one is worse off
and at least one person is better off.)
Whether price discrimination increases the gains from trade overall depends on
circumstances. However, it is worth remembering that people with lower incomes tend
to have more elastic demand, and thus get lower prices under price discrimination thanabsent price discrimination. Consequently, a ban on price discrimination tends to hurt
the poor and benefit the rich no matter what the overall effect.

6.5.6 Two-Part Pricing
A common form of price discrimination is known as two-part pricing. Two-part pricing
usually involves a fixed charge and a marginal charge, and thus offers an ability for aseller to capture a portion of the consumer surplus. For example, electricity often comeswith a fixed price per month and then a price per kilowatt-hour, which is two-partpricing. Similarly, long distance and cellular telephone companies charge a fixed fee permonth, with a fixed number of “included” minutes, and a price per minute for additional

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minutes. Such contracts really involve three parts rather than two-parts, but are similarin spirit.
From the seller’s perspective, the ideal two-part price is to charge marginal cost plus a
fixed charge equal to the customer’s consumer surplus, or perhaps a penny less. By
setting price equal to marginal cost, the seller maximizes the gains from trade. By
setting the fixed fee equal to consumer surplus, the seller captures the entire gains fromtrade. This is illustrated in Figure 6-21.

pMCConsumer
Surplus =Fixed FeePrice=pc

Dqc

qFigure 6-21: Two-Part Pricing

6.5.7 Natural Monopoly
A natural monopoly arises when a single firm can efficiently serve the entire market
because average costs are lower with one firm than with two firms. An example isillustrated in Figure 6-22. In this case, the average total cost of a single firm is lower
than if two firms operate, splitting the output between them. The monopolist would liketo price at pm, which maximizes profits.79

79 The monopoly price may or may not be sustainable.

A monopoly price is not sustainable if it would
lead to entry, thereby undercutting the monopoly. The feasibility of entry, in turn, depends on whether
the costs of entering are not recoverable (“sunk”), and how rapidly entry can occur. If the monopoly priceis not sustainable, the monopoly may engage in limit pricing, which is jargon for pricing to deter (limit)
entry.

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P

MC
pm

ATC

p2
p1

D
q
Figure 6-22: Natural Monopoly

Historically, the United States and other nations have regulated natural monopolies likethose found in electricity, telephony and water service. An immediate problem withregulation is that the efficient price, that is, the price that maximizes the gains fromtrade, requires a subsidy from outside the industry. We see the need for a subsidy in
Figure 6-22 because the price that maximizes the gains from trade is p1, which sets thedemand (marginal value) equal to the marginal cost. At this price, however, the average
total cost exceeds the price, so that a firm with such a regulated price would lose money.
There are two alternatives. The product could be subsidized, and subsidies are usedwith postal service and passenger rail in the United States, and historically for many
more products in Canada and Europe including airlines and airplane manufacture.
Alternatively, regulation could be imposed that aims to limit the price to p2, the lowest
break-even price. This is the more common strategy in the United States.
There are two strategies toward limiting the price: price-cap regulation, which directly
imposes a maximum price, and rate of return regulation, that limits the profitability offirms. Both of these approaches induce some inefficiency of production. In both cases,
an increase in average cost may translate into additional profits for the firm, causing
regulated firms to engage in unnecessary activities.

6.5.8 Peak Load Pricing
Fluctuations in demand often require holding capacity which is used only a fraction of
the time. Hotels have off-seasons when most rooms are empty. Electric power plants
are designed to handle peak demand, usually hot summer days, with some of thecapacity standing idle on other days. Demand for trans-Atlantic airline flights is muchhigher in the summer than the rest of the year. All of these examples have the similaritythat an amount of capacity – hotel space, airplane seats, electric generation capacity –will be used over and over, which means it is used in both high demand and low demandstates. How should pricing be accomplished when demand fluctuates? This can be

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thought of as a question of how to allocate the cost of capacity across several time
periods when demand systematically fluctuates.
Consider a firm that experiences two kinds of costs – a capacity cost and a marginalcost. How should capacity be priced? This issue is applicable to a wide variety ofindustries, including pipelines, airlines, telephone networks, construction, electricity,
highways, and the internet.
The basic peak-load pricing problem, pioneered by Marcel Boiteux (1922 – ), considers
two periods. The firm’s profits are given by
π = p1 q1 + p2q2 − β max {q1 , q2 } − mc(q1 + q2 ).

Setting price equal to marginal costs is not sustainable, because a firm selling with priceequal to marginal cost would not earn a return on the capacity, and thus would losemoney and go out of business. Consequently, a capacity charge is necessary. The
question of peak load pricing is how the capacity charge should be allocated. This
question is not trivial because some of the capacity is used in both periods.
For the sake of simplicity, we will assume demands are independent, that is, q1 is
independent of p2 and vice versa. This assumption is often unrealistic, and generalizing
it actually doesn’t complicate the problem too much. The primary complication is incomputing the social welfare when demands are functions of two prices. Independence
is a convenient starting point.
Social welfare is
q1

q2

0

0

W = ∫ p1 ( x )dx + ∫ p2 ( x )dx − β max {q1 , q2 } − mc(q1 + q2 ).
The Ramsey problem is to maximize W subject to a minimum profit condition. A
technique for accomplishing this maximization is to instead maximize

L = W + λπ.
By varying λ, we vary the importance of profits to the maximization problem, which will
increase the profit level in the solution as λ increases. Thus, the correct solution to theconstrained maximization problem is the outcome of the maximization of L, for somevalue of λ.
A useful notation is 1A, which is known as the characteristic function of the set A. Thisis a function which is 1 when A is true, and zero otherwise. Using this notation, the firstorder condition for the maximization of L is:
0=

(

∂L
= p1 (qq ) − β 1q1 ≥q2 − mc + λ p1 (qq ) + q1 p1′ (q1 ) − β 1q1 ≥q2 − mc
∂q1

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)
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or,

p1 (q1 ) − β 1q1 ≥q2 − mc
p1

=

λ 1
λ + 1 ε1

where 1 q1 ≥q2 is the characteristic function of the event q1≥q2.
Similarly,

p2 (q2 ) − β 1q1 ≤q2 − mc
p2

=

λ 1
λ + 1 ε2Note as before that λ→∞ yields the monopoly solution.
There are two potential types of solution. Let the demand for good 1 exceed the demand
for good 2. Either q1>q2, or the two are equal.
Case 1: q1>q2.

p1 (q1 ) − β − mc
λ 1
p (q ) − mc
λ 1=
and 2 2=.
p1
λ + 1 ε1p2
λ + 1 ε2In case 1, with all of the capacity charge allocated to good 1, quantity for good 1 still
exceeds quantity for good 2. Thus, the peak period for good 1 is an extreme peak. In
contrast, case 2 arises when assigning the capacity charge to good 1 would reverse thepeak – assigning all of the capacity charge to good 1 would make period 2 the peak.
Case 2: q1=q2.
The profit equation can be written

p1(q) - mc + p2(q) – mc = βThis equation determines q, and prices are determined from demand.
The major conclusion from peak load pricing is that either the entire cost of capacity isallocated to the peak period, or there is no peak period in the sense that the two periods
have the same quantity demanded given the prices. That is, either the prices equalize
the quantity demanded, or the prices impose the entire cost of capacity only on one peak
period.
Moreover, the price (or, more properly, the markup over marginal cost) is proportional
to the inverse of the elasticity, which is known as Ramsey pricing.

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6.6 Information
An important advantage of the price system is that it economizes on information. A
typical consumer needs to know only the prices of goods and their own personal
preferences in order to make a sensible choice of purchases, and manufacturers only
need to know the prices of goods in order to decide what to produce. Such economies of
information are an advantage over centrally-planned economies, which attempt todirect production and consumption decisions using something other than prices, andcentrally-planned economies typically experience chronic shortages and occasional
surpluses. Shortages of important inputs to production may have dramatic effects andthe shortages aren’t remedied by the price of the input rising in a centrally planned
economy, and thus often persist for long periods of time.
There are, however, circumstances where the prices are not the only necessary
information required for firms and consumers to make good decisions. In suchcircumstances, information itself can lead to market failures.

6.6.1 Market for LemonsNobel laureate George Akerlof (1940 – ) examined the market for used cars andconsidered a situation where the sellers are better informed than the buyers. This isquite reasonable, as sellers have owned the car for a while and are likely to know its
quirks and potential problems. Akerlof showed that this differential information may
cause the used car market to collapse; that is, the information possessed by sellers ofused cars destroys the market.
To understand Akerlof’s insight, suppose that the quality of used cars lies on a 0 to 1
scale and that the population of used cars is uniformly distributed on the interval from 0
to 1. In addition, let that quality represent the value a seller places on the car, andsuppose buyers put a value that is 50% higher than the seller. Finally, the seller knows
the actual quality, while the buyer does not.
Can a buyer and seller trade in such a situation? First, note that trade is a good thing,because the buyer values the car more than the seller. That is, both the buyer and seller
know that they should trade. But can they agree on a price? Consider a price p. At thisprice, any seller who values the car less than p will be willing to trade. But because of
our uniform distribution assumption, this means the distribution of qualities of carsoffered for trade at price p will be uniform on the interval 0 to p. Consequently, theaverage quality of these cars will be ½ p, and the buyer values these cars 50% morewhich yields ¾ p. Thus, the buyer is not willing to pay the price p for the average caroffered at price p.
The effect of the informed seller, and uninformed buyer, produces a “lemons” problem.
At any given price, all the lemons and only a few of the good cars are offered, and thebuyer – not knowing the quality of the car – isn’t willing to pay as much as the actual
value of a high value car offered for sale. This causes the market to collapse; and only
the worthless cars trade at a price around zero. Economists call the differential
information an informational asymmetry.

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In the real world, of course, the market has found partial or imperfect solutions to thelemons problem identified by Akerlof. First, buyers can become informed and regularly
hire their own mechanic to inspect a car they are considering. Inspections reduce theinformational asymmetry but are costly in their own right. Second, intermediaries offer
warranties and certification to mitigate the lemons problem. The existence of both ofthese solutions, which involve costs in their own right, is itself evidence that the lemonsproblem is a real and significant problem, even though competitive markets find ways
to ameliorate the problems.
An important example of the lemons problem is the inventor who creates an idea that isdifficult or impossible to patent. Consider an innovation that would reduce the cost of
manufacturing computers. The inventor would like to sell it to a computer company,
but can’t tell the computer company what the innovation entails prior to pricenegotiations, because then the computer company could just copy the innovation.
Similarly, the computer company can’t possibly offer a price for the innovation inadvance of knowing what the innovation is. As a result, such innovations usuallyrequire the inventor to enter the computer manufacturing business, rather than sellingto an existing manufacturer, entailing many otherwise unnecessary costs.
6.6.1.1 (Exercise) In Akerlof’s market for lemons model, suppose it is possible tocertify cars, verifying that they are better than a particular quality q. Thus, amarket for cars “at least as good as q” is possible. What price or prices are
possible in this market? [Hint: sellers offer cars only if q ≤ quality ≤ p.] Whatquality maximizes the expected gains from trade?

6.6.2 Myerson-Satterthwaite Theorem
The lemons problem is a situation where the buyers are relatively uninformed and careabout the information held by sellers. Lemons problems are limited to situations where
the buyer isn’t well-informed and can be mitigated by making information public. In
many transactions, the buyer knows the quality of the product, so lemons concerns
aren’t a significant issue. There can still be a market failure, however, if there are alimited number of buyers and sellers.
Consider the case of one buyer and one seller bargaining over the sale of a good. The
buyer knows his own value v for the good, but not the seller’s cost. The seller knows her
own cost c for the good, but not the buyer’s value. The buyer views the seller’s cost as
uniformly distributed on the interval [0,1], and similarly the seller views the buyer’svalue as uniformly distributed on [0,1].80 Can efficient trade take place? Efficient traderequires that trade occurs whenever v>c, and the remarkable answer is that it is
impossible to arrange efficient trade if the buyer and seller are to trade voluntarily. This
80 The remarkable fact proved by Roger Myerson and Mark Satterthwaite (Efficient Mechanisms for

Bilateral Trade, Journal of Economic Theory, 28, 1983, 265-281) is that the distributions don’t matter;the failure of efficient trade is a fully general property. Philip Reny and Preston McAfee (CorrelatedInformation and Mechanism Design, Econometrica 60, No. 2, March 1992, 395-421) show the nature of
the distribution of information matters, and Preston McAfee (Efficient Allocation with Continuous
Quantities, Journal of Economic Theory 53, no. 1, February 1991: 51-74.) showed that continuous
quantities can overturn the Myerson-Satterthwaite theorem.

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is true even if a third party is used to help arrange trade, provided the third party
doesn’t subsidize the transaction.
The total gains from trade under efficiency are
1v

1 2

00

0

∫ ∫ v − c dc dv = ∫1v
dv = .
2
6

A means of arranging trade, or a mechanism, asks the buyer and seller for their value
and cost, respectively, and then orders trade if the value exceeds the cost, and dictates apayment p by the buyer to the seller. Buyers need not make honest reports to themechanism, however, and the mechanisms must be designed to induce the buyer andseller to report honestly to the mechanism, so that efficient trades can be arranged.81
Consider a buyer who actually has value v but reports a value r. The buyer trades withthe seller if the seller has a cost less than r, which occurs with probability r.

u(r,v) = vr – Ecp(r, c).
The buyer gets the actual value v with probability r, and makes a payment that depends
on the buyer’s report and the seller’s report, but we can take expectations over theseller’s report to eliminate it (from the buyer’s perspective), and this is denoted Ecp(r,c), which is just the expected payment given the report r. In order for the buyer tochoose to be honest, u must be maximized at r=v for every v, for otherwise some buyers
would lie and some trades would not be efficiently arranged. Thus, we can conclude82du( v, v) = u1 ( v, v) + u2 ( v, v) = u2 (v, v) = r
= v.
dv
r =v
The first equality is just the total derivative of u(v,v), because there are two terms; thesecond equality because u is maximized over the first argument r at r=v, and the firstorder condition insures u1 = 0. Finally, u2 is just r, and we are evaluating the derivativeat the point r = v. A buyer who has a value v + ∆, but who reports v, trades withprobability v and makes the payment Ecp(v, c). Such a buyer gets ∆v more in utility
than the buyer with value v. Thus a ∆ increase in value produces an increase in utility ofdat least ∆v, showing that u( v + ∆, v + ∆) ≥ u( v, v) + ∆v and hence thatu(v, v) ≥ v . A
dvsimilar argument considering a buyer with value v who reports v + ∆ shows that equality
occurs.

81

Inducing honesty is without loss of generality. Suppose that the buyer of type v reported the type z(v).
Then we can add a stage to the mechanism, where the buyer reports a type, which is converted via thefunction z to a report, and then that report given to the original mechanism. In the new mechanism,
reporting v is tantamount to reporting z(v) to the original mechanism.
82 We maintain an earlier notation that the subscript refers to a partial derivative, so that if we have afunction f, f1 is the partial derivative of f with respect to the first argument of f.

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The value u(v,v) is the gain accruing to a buyer with value v who reports having value v.
Since the buyer with value 0 gets zero, the total gain accruing to the average buyer canbe computed by integrating by parts1

1∫ u(v, v)dv = −(1 − v)u(v, v)

0

v=0

1

1

1
⎛ du ⎞+ ∫ (1 − v)⎜⎟dv = ∫ (1 − v)vdv = .
6⎝ dv ⎠
00

In the integration by parts, dv = d –(1–v) is used. The remarkable conclusion is that, if
the buyer is induced to truthfully reveal the buyer’s value, the buyer must obtain theentire gains from trade! This is actually a quite general proposition. If you offer theentire gains from trade to a party, they are induced to maximize the gains from trade.
Otherwise, they will want to distort away from maximizing the entire gains from trade,which will result in a failure of efficiency.
The logic with respect to the seller is analogous: the only way to get the seller to reporther cost honestly is to offer her the entire gains from trade.
6.6.2.1 (Exercise)

Let h(r, c) be the gains of a seller who has cost c and reports r,h(r, c) = p(v, r) – (1-r)c.
Noting that the highest cost seller (c=1) never sells and thus obtains zero profits,show that honesty by the seller implies the expected value of h is 1 .
6

The Myerson-Satterthwaite theorem shows that the gains from trade are insufficient to
induce honesty by both parties. (Indeed, they are half the necessary amount!) Thus,
any mechanism for arranging trades between the buyer and the seller must suffer someinefficiency. Generally this occurs because buyers act like they value the good less thanthey do, and sellers act like their costs are higher than they truly are.
It turns out that the worst case scenario is a single buyer and a single seller. As markets
get “thick,” the per capita losses converge to zero, and markets become efficient. Thus,
informational problems of this kind are a “small numbers” issue. However, manymarkets do in fact have small numbers of buyers or sellers. In such markets, it seems
likely that informational problems will be an impediment to efficient trade.

6.6.3 Signaling
An interesting approach to solving informational problems involves signaling.83
Signaling, in economic jargon, means expenditures of time or money whose purpose is
to convince others of something. Thus, people signal wealth by wearing Rolex watches,
driving expensive cars or sailing in the America’s Cup. They signal erudition by tossingout quotes from Kafka or Tacitus into conversations. They signal being chic by wearing
the right clothes and listening to cool music. Signaling is also rampant in the animal
83 Signaling was introduced by Nobel laureate Michael Spence in his dissertation, part of which was

reprinted in “Job Market Signaling,” Quarterly Journal of Economics 87, August 1973, 355-74.

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world, from peacock feathers to elk battles and the subject of a vibrant and related
research program.
A university education serves not just to educate, but also to signal the ability to learn.
Businesses often desire employees who are able to adapt to changing circumstances, andwho can easily and readily learn new strategies and approaches. Education signals suchabilities because it will easier for quick learners to perform well in university. A simple
model suffices to illustrate the point. Suppose there are two types of people. Type A has
a low cost cA of learning, and type B has a higher cost cB of learning. It is difficult todetermine from an interview whether someone is type A or not. Type A is worth more tobusinesses, and the competitive wage wA (expressed as a present value of lifetime
earnings) for type A’s is higher than the wage wB for type B’s.
A person can signal that they are a type A by taking a sufficient amount of education.
Suppose the person devotes an amount of time x to learning in university, thus incurring
the cost cA x. If x is large enough so thatwA – cA x > wB > wA – cB x,
it pays the type A to obtain the education, but not the type B, if education in fact signalsthat the student is type A. Thus, a level of education x in this case signals a trait (ease oflearning) that is valued by business, and it does so by voluntary choice – those with ahigh cost of learning choose not to obtain the education, even though they could do it.
This works as a signal because only type A would voluntarily obtain the education in
return for being perceived to be a type A.
There are several interesting aspects to this kind of signaling. First, the education
embodied in x need not be valuable in itself; the student could be studying astronomy orancient Greek, neither of which are very useful in most businesses, but are neverthelessstrong signals of the ability to learn. Second, the best subject matter for signaling is thatin which the difference in cost between the type desired by employers and the lessdesirable type is greatest, that is, where cB – cA is greatest. Practical knowledge issomewhat unlikely to make this difference great; instead, challenging abstract problemsolving may be a better separator. Clearly, it is desirable to have the subject matter be
useful, if it can still do the signaling job. But interpreting long medieval poems could
more readily signal the kind of flexible mind desired in management than studying
accounting, not because the desirable type is good at it, or that it is useful, but because
the less desirable type is so much worse at it.
Third, one interprets signals by asking “what kinds of people would make this choice?”while understanding that the person makes the choice hoping to send the signal.
Successful law firms have very fine offices, generally much finer than the offices of theirclients. Moreover, there are back rooms at most law firms, where much of the real work
is done, that aren’t nearly so opulent. The purpose of the expensive offices is to signal
success, essentially making the statement that
“we couldn’t afford to waste money on such expensive offices if we weren’t very
successful. Thus, you should believe we are successful.”

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The law firm example is similar to the education example. Here, the cost of theexpenditures on fancy offices is different for different law firms because more successful
firms earn more money and thus value the marginal dollar less. Consequently, more
successful firms have a lower cost of a given level of office luxury. What is interesting
about signaling is that it is potentially quite wasteful. A student spends four years
studying boring poems and dead languages in order to demonstrate a love of learning,
and a law firm pays $75,000 for a conference table that it rarely uses and gets nopleasure out of, in order to convince a client that the firm is extremely successful. In
both cases, it seems like a less costly solution should be available. The student can takestandardized tests, and the law firm could show its win-loss record to the potential
client. But standardized tests may measure test-taking skills rather than learning
ability, especially if what matters is the learning ability over a long time horizon. Winloss records can be “massaged,” and in the majority of all legal disputes, the case settles
and both sides consider themselves “the winner.” Consequently, statistics may not be agood indicator of success, and the expensive conference table a better guide.

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7 Strategic Behavior
Competitive theory studies price-taking consumers and firms, that is, people who can’t
individually affect the transaction prices. The assumption that market participants takeprices as given is justified only when there are many competing participants. We havealso examined monopoly, precisely because a monopoly by definition doesn’t have toworry about competitors. Strategic behavior involves the examination of theintermediate case, where there are few enough participants that they take each otherinto account and their actions individually matter, and where the behavior of any one
participant influences choices of the other participants. That is, participants are
strategic in their choice of action, recognizing that their choice will affect choices madeby others.
The right tool for the job of examining strategic behavior in economic circumstances isgame theory, the study of how people play games. Game theory was pioneered by themathematical genius John von Neumann (1903-1957). Game theory has also been very
influential in the study of military strategy, and indeed the strategy of the cold war
between the United States and the U.S.S.R. was guided by game theoretic analyses.84

7.1 Games
The theory of games provides a description of games that fits common games like poker
or the board game “Monopoly” but will cover many other situations as well. In any
game, there is a list of players. Games generally unfold over time; at each moment in
time, players have information, possibly incomplete, about the current state of play, anda set of actions they can take. Both information and actions may depend on the historyof the game prior to that moment. Finally, players have payoffs, and are assumed toplay in such a way as to maximize their expected payoff, taking into account their
expectations for the play of others. When the players, their information and available
actions, and payoffs have been specified, we have a game.

7.1.1 Matrix GamesThe simplest game is called a matrix payoff game with two players. In a matrix payoff
game, all actions are chosen simultaneously. It is conventional to describe a matrix
payoff game as played by a row player and a column player. The row player chooses a
row in a matrix; the column player simultaneously chooses a column. The outcome of
the game is a pair of payoffs where the first entry is the payoff of the row player and thesecond is the payoff of the column player. Table 7-1 provides an example of a “2 × 2”
matrix payoff game, the most famous game of all, which is known as the prisoner’s
dilemma.

84 An important reference for game theory is John von Neumann (1903-1957) and Oskar Morgenstern(1902-1977), Theory of Games and Economic Behavior, Princeton: Princeton University Press, 1944.
Important extensions were introduced by John Nash (1928 – ), the mathematician made famous by Sylvia
Nasar’s delightful book A Beautiful Mind (Simon & Schuster, 1998). Finally, applications in the militaryarena were pioneered by Nobel Laureate Thomas Schelling (1921 – ), The Strategy of Conflict,Cambridge: Cambridge University Press, 1960.

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Row

Table 7-1: The Prisoner’s Dilemma

ColumnConfess Don’t
Confess (-10,-10) (0,-20)
Don’t(-20,0)(-1,-1)In the prisoner’s dilemma, two criminals named Row and Column have been
apprehended by the police and are being questioned separately. They are jointly guiltyof the crime. Each player can choose either to confess or not. If Row confesses, we arein the top row of the matrix (corresponding to the row labeled Confess). Similarly, if
Column confesses, the payoff will be in the relevant column. In this case, if only one
player confesses, that player goes free and the other serves twenty years in jail. (Theentries correspond to the number of years lost to prison. The first entry is always Row’s
payoff, the second Column’s payoff.) Thus, for example, if Column confesses and Row
does not, the relevant payoff is the first column and the second row, in reverse color in
Table 7-2.

Row

Table 7-2: Solving the Prisoner's Dilemma

ColumnConfess Don’t
Confess (-10,-10) (0,-20)
Don’t(-20,0)(-1,-1)

If Column confesses and Row does not, Row loses twenty years, and Column loses noyears, that is, goes free. This is the payoff (-20,0) in reverse color in Table 7-2. If bothconfess, they are both convicted and neither goes free, but they only serve ten years
each. Finally, if neither confesses, there is a ten percent chance they are convictedanyway (using evidence other than the confession), in which case they average a year
lost each.
The prisoner’s dilemma is famous partly because it is readily solvable. First, Row has astrict advantage to confessing, no matter what Column is going to do. If Column
confesses, Row gets -10 from confessing, -20 from not, and thus is better off from
confessing. Similarly, if Column doesn’t confess, Row gets 0 from confessing, -1 fromnot confessing, and is better off confessing. Either way, no matter what Column does,
Row should choose to confess.85 This is called a dominant strategy, a strategy that is
optimal no matter what the other players do.
The logic is exactly similar for Column: no matter what Row does, Column shouldchoose to confess. That is, Column also has a dominant strategy, to confess. To
establish this, first consider what Column’s best action is, when Column thinks Row will
confess. Then consider Column’s best action when Column thinks Row won’t confess.
85 If Row and Column are friends are care about each other, that should be included as part of the payoffs.
Here, there is no honor or friendship among thieves, and Row and Column only care about what they
themselves will get.

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Either way, Column gets a higher payoff (lower number of years lost to prison) byconfessing.
The presence of a dominant strategy makes the prisoner’s dilemma particularly easy tosolve. Both players should confess. Note that this gets them ten years each in prison,and thus isn’t a very good outcome from their perspective, but there is nothing they can
do about it in the context of the game, because for each, the alternative to serving ten
years is to serve twenty years. This outcome is referred to as (Confess, Confess), where
the first entry is the row player’s choice, and the second entry is the column player’s
choice.
Consider an entry game, played by Microsoft (the row player) and Piuny (the column
player), a small start-up company. Both Microsoft and Piuny are considering entering a
new market for an online service. The payoff structure isMS

Table 7-3: An Entry GameEnter
Enter (2,-2)
Don’t (0,5)

Piuny
Don’t
(5,0)
(0,0)

In this case, if both companies enter, Microsoft ultimately wins the market, and earns 2,
and Piuny loses 2. If either firm has the market to itself, they get 5 and the other firmgets zero. If neither enters, both get zero. Microsoft has a dominant strategy to enter: itgets 2 when Piuny enters, 5 when Piuny doesn’t, and in both cases does better thanwhen Microsoft doesn’t enter. In contrast, Piuny does not have a dominant strategy:
Piuny wants to enter when Microsoft doesn’t, and vice-versa. That is, Piuny’s optimal
strategy depends on Microsoft’s action, or, more accurately, Piuny’s optimal strategy
depends on what Piuny believes Microsoft will do.
Piuny can understand Microsoft’s dominant strategy, if it knows the payoffs ofMicrosoft.86 Thus, Piuny can conclude that Microsoft is going to enter, and this meansthat Piuny should not enter. Thus, the equilibrium of the game is for MS to enter andPiuny not to enter. This equilibrium is arrived at by the iterated elimination of
dominated strategies, which sounds like jargon but is actually plain speaking. First, we
eliminated Microsoft’s dominated strategy in favor of its dominant strategy. Microsoft
had a dominant strategy to enter, which means the strategy of not entering is dominatedby the strategy of entering, so we eliminated the dominated strategy. That leaves a
simplified game in which Microsoft enters:

86 It isn’t so obvious that one player will know the payoffs of another player, and that often causes players

to try to signal that they are going to play a certain way, that is, to demonstrate commitment to aparticular advantageous strategy. Such topics are taken up in business strategy and managerial
economics.

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MS

Table 7-4; Eliminating a Dominated Strategy

Piuny
Enter
Don’t
Enter (2,-2)(5,0)

In this simplified game, after the elimination of Microsoft’s dominated strategy, Piuny
also has a dominant strategy: not to enter. Thus, we iterate and eliminate dominatedstrategies again, this time eliminating Piuny’s dominated strategies, and wind up with asingle outcome: Microsoft enters, and Piuny doesn’t. The iterated elimination of
dominated strategies solves the game.87
Here is another game, with three strategies for each player.

Row

Table 7-5: A 3 X 3 GameTop
MiddleLeft(-5,-1)(1,-3)

Bottom (0,10)

ColumnCenter Right
(2,2)
(3,3)
(1,2)
(1,1)
(0,0)

(0,-10)The process of iterated elimination of dominated strategies is illustrated by actuallyeliminating the rows and columns, as follows. A reverse color (white writing on black
background) indicates a dominated strategy.
Middle dominates bottom for Row, yielding:Row

Table 7-6: Eliminating a Dominated Strategy

Top
MiddleLeft(-5,-1)(1,-3)

Bottom (0,10)

ColumnCenter Right
(2,2)
(3,3)
(1,2)
(1,1)
(0,0)

(0,-10)With bottom eliminated, Left is now dominated for Column by either Center or Right,
which eliminates the left column.

87 A strategy may be dominated not by any particular alternate strategy but by a randomization over otherstrategies, which is an advanced topic not considered here.

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Row

Table 7-7: Eliminating Another Dominated Strategy

Top
MiddleLeft(-5,-1)(1,-3)

Bottom (0,10)

ColumnCenter Right
(2,2)
(3,3)
(1,2)
(1,1)
(0,0)

(0,-10)With Left and Bottom eliminated, Top now dominates Middle for Row.

Row

Table 7-8: Eliminating a Third Dominated Strategy

Top
MiddleLeft(-5,-1)(1,-3)

Bottom (0,10)

ColumnCenter Right
(2,2)
(3,3)
(1,2)
(1,1)
(0,0)

(0,-10)

Finally, Column chooses Right over Center, yielding a unique outcome after the iterated
elimination of dominated strategies, which is (Top, Right).

Row

Table 7-9: Game Solved

Top
MiddleLeft(-5,-1)(1,-3)

Bottom (0,10)

ColumnCenter Right
(2,2)
(3,3)
(1,2)
(1,1)
(0,0)

(0,-10)The iterated elimination of dominated strategies is a useful concept, and when it applies,
the predicted outcome is usually quite reasonable. Certainly it has the property that noplayer has an incentive to change their behavior given the behavior of others. However,there are games where it doesn’t apply, and these games require the machinery of aNash equilibrium, named for Nobel laureate John Nash (1928 – ).

7.1.2 Nash Equilibrium
In a Nash equilibrium, each player chooses the strategy that maximizes their expected
payoff, given the strategies employed by others. For matrix payoff games with two
players, a Nash equilibrium requires that the row chosen maximizes the row player’s
payoff, given the column chosen by the column player, and the column, in turn,maximizes the column player’s payoff given the row selected by the row player. Let us
consider first the prisoner’s dilemma, which we have already seen.

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Row

Table 7-10: Prisoner's Dilemma Again

ColumnConfess Don’t
Confess (-10,-10) (0,-20)
Don’t(-20,0)(-1,-1)Given that the row player has chosen to confess, the column player also chooses
confession because -10 is better than -20. Similarly, given that the column playerchooses confession, the row player chooses confession, because -10 is better than -20.
Thus, for both players to confess is a Nash equilibrium. Now let us consider whether
any other outcome is a Nash equilibrium. In any outcome, at least one player is notconfessing. But that player could get a higher payoff by confessing, so no other outcome
could be a Nash equilibrium.
The logic of dominated strategies extends to Nash equilibrium, except possibly for ties.
That is, if a strategy is strictly dominated, it can’t be part of a Nash equilibrium. On theother hand, if it involves a tied value, a strategy may be dominated but still part of aNash equilibrium.
The Nash equilibrium is justified as a solution concept for games as follows. First, if theplayers are playing a Nash equilibrium, no one has an incentive to change their play orre-think their strategy. Thus, the Nash equilibrium has a “steady state” aspect in that noone wants to change their own strategy given the play of others. Second, other potential
outcomes don’t have that property: if an outcome is not a Nash equilibrium, then atleast one player does have an incentive to change what they are doing. Outcomes thataren’t Nash equilibria involve mistakes for at least one player. Thus, sophisticated,
intelligent players may be able to deduce each other’s play, and play a Nash equilibrium
Do people actually play Nash equilibria? This is a controversial topic and mostly beyond
the scope of this book, but we’ll consider two well-known games: Tic-Tac-Toe (see, e.g.
http://www.mcafee.cc/Bin/tictactoe/index.html) and Chess. Tic-Tac-Toe is a relatively
simple game, and the equilibrium is a tie. This equilibrium arises because each player
has a strategy that prevents the other player from winning, so the outcome is a tie.
Young children play Tic-Tac-Toe and eventually learn how to play equilibrium
strategies, at which point the game ceases to be very interesting since it just repeats thesame outcome. In contrast, it is known that Chess has an equilibrium, but no one knows
what it is. Thus, at this point we don’t know if the first mover (White) always wins, orthe second mover (Black) always wins, or if the outcome is a draw (neither is able towin). Chess is complicated because a strategy must specify what actions to take given
the history of actions, and there are a very large number of potential histories of thegame thirty or forty moves after the start. So we can be quite confident that people arenot (yet) playing Nash equilibria to the game of Chess.
The second most famous game in game theory is the battle of the sexes. The battle ofthe sexes involves a married couple who are going to meet each other after work, buthaven’t decided where they are meeting. Their options are a baseball game or the ballet.

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Both prefer to be with each other, but the man prefers the baseball game and the woman
prefers the ballet. This gives payoffs something like this:Man

Table 7-11: The Battle of the Sexes

Woman
Baseball Ballet
Baseball (3,2)(1,1)
Ballet(0,0)(2,3)

The man would rather that they both go to the baseball game, and the woman that theyboth go to the ballet. They each get 2 payoff points for being with each other, and an
additional point for being at their preferred entertainment. In this game, iterated
elimination of dominated strategies eliminates nothing. You can readily verify that
there are two Nash equilibria: one in which they both go to the baseball game, and one
in which they both go to ballet. The logic is: if the man is going to the baseball game, thewoman prefers the 2 points she gets at the baseball game to the single point she would
get at the ballet. Similarly, if the woman is going to the baseball game, the man gets
three points going there, versus zero at the ballet. Thus, for both to go to the baseballgame is a Nash equilibrium. It is straightforward to show that for both to go to theballet is also a Nash equilibrium, and finally that neither of the other two possibilities,
involving not going to the same place, is an equilibrium.
Now consider the game of matching pennies. In this game, both the row player and thecolumn player choose heads or tails, and if they match, the row player gets the coins,while if they don’t match, the column player gets the coins. The payoffs are provided in
the next table.

Row

Table 7-12: Matching Pennies

ColumnHeads
Tails
Heads (1,-1)(-1,1)
Tails(-1,1)(1,-1)

You can readily verify that none of the four possibilities represents a Nash equilibrium.
Any of the four involves one player getting -1; that player can convert -1 to 1 by changing
his or her strategy. Thus, whatever the hypothesized equilibrium, one player can dostrictly better, contradicting the hypothesis of a Nash equilibrium. In this game, as
every child who plays it knows, it pays to be unpredictable, and consequently players
need to randomize. Random strategies are known as mixed strategies, because theplayers mix across various actions.

7.1.3 Mixed Strategies
Let us consider the matching pennies game again.

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Row

Table 7-13: Matching Pennies Again

ColumnHeads
Tails
Heads (1,-1)(-1,1)
Tails(-1,1)(1,-1)

Suppose that Row believes Column plays Heads with probability p. Then if Row plays
Heads, Row gets 1 with probability p and -1 with probability (1-p), for an expected valueof 2p – 1. Similarly, if Row plays Tails, Row gets -1 with probability p (when Column
plays Heads), and 1 with probability (1-p), for an expected value of 1 – 2p. This issummarized in the next table.

Row

Table 7-14: Mixed Strategy in Matching Pennies

ColumnHeads
Tails
Heads (1,-1)(-1,1)
Tails(-1,1)(1,-1)

1p + -1(1-p)=2p-1-1p + 1(1-p)=1-2p

If 2p – 1 > 1 – 2p, then Row is better off on average playing Heads than Tails. Similarly,
if 2p – 1 < 1 – 2p, Row is better off playing Tails than Heads. If, on the other hand, 2p –1 = 1 – 2p, then Row gets the same payoff no matter what Row does. In this case Row
could play Heads, could play Tails, or could flip a coin and randomize Row’s play.
A mixed strategy Nash equilibrium involves at least one player playing a randomized
strategy, and no player being able to increase their expected payoff by playing analternate strategy. A Nash equilibrium without randomization is called a pure strategy
Nash equilibrium.
Note that that randomization requires equality of expected payoffs. If a player is
supposed to randomize over strategy A or strategy B, then both of these strategies must
produce the same expected payoff. Otherwise, the player would prefer one of them, andwouldn’t play the other.
Computing a mixed strategy has one element that often appears confusing. Suppose
Row is going to randomize. Then Row’s payoffs must be equal, for all strategies Row
plays with positive probability. But that equality in Row’s payoffs doesn’t determine theprobabilities with which Row plays the various rows. Instead, that equality in Row’s
payoffs will determine the probabilities with which Column plays the various columns.
The reason is that it is Column’s probabilities that determine the expected payoff for
Row; if Row is going to randomize, then Column’s probabilities must be such that Row
is willing to randomize.
Thus, for example, we computed the payoff to Row of playing Heads, which was 2p – 1,
where p was the probability Column played Heads. Similarly, the payoff to Row ofplaying Tails was 1 – 2p. Row is willing to randomize if these are equal, which solves for
p=½.

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7.1.3.1 (Exercise)
Let q be the probability that Row plays Heads. Show that Column iswilling to randomize if, and only if, q = ½ . (Hint: First compute Column’s
expected payoff when Column plays Heads, and then Column’s expected payoff
when Column plays Tails. These must be equal for Column to randomize.)
Now let’s try a somewhat more challenging example, and revisit the battle of the sexes.

Man

Table 7-15: Mixed Strategy in Battle of the Sexes

Woman
Baseball Ballet
Baseball (3,2)(1,1)
Ballet(0,0)(2,3)

This game has two pure strategy Nash equilibria: (Baseball,Baseball) and (Ballet,Ballet).
Is there a mixed strategy? To compute a mixed strategy, let the Woman go to thebaseball game with probability p, and the Man go to the baseball game with probability
q. Table 7-16 contains the computation of the mixed strategy payoffs for each player.

Man

Table 7-16: Full Computation of the Mixed Strategy

Woman
Baseball (p)Ballet (1-p)
Man’s E Payoff
Baseball (prob q) (3,2)(1,1)
3p + 1(1-p)=1+2p
Ballet (prob 1-q)
(0,0)
(2,3)
0p + 2(1-p)=2-2p
Woman’s E Payoff 2q + 0(1-q)=2q 1q + 3(1-q)=3-2q

For example, if the Man (row player) goes to the baseball game, he gets 3 when the
Woman goes to the baseball game (probability p) and otherwise gets 1, for an expected
payoff of 3p + 1(1-p) = 1 + 2p. The other calculations are similar but you should
definitely run through the logic and verify each calculation.
A mixed strategy in the Battle of the Sexes game requires both parties to randomize(since a pure strategy by either party prevents randomization by the other). The Man’s
indifference between going to the baseball game and the ballet requires 1+2p = 2 – 2p,
which yields p = ¼ . That is, the Man will be willing to randomize which event heattends if the Woman is going to the ballet ¾ of the time, and otherwise to the baseballgame. This makes the Man indifferent between the two events, because he prefers to bewith the Woman, but he also likes to be at the baseball game; to make up for theadvantage that the game holds for him, the woman has to be at the ballet more often.
Similarly, in order for the Woman to randomize, the Woman must get equal payoffs
from going to the game and going to the ballet, which requires 2q = 3 – 2q, or q = ¾ .
Thus, the probability that the Man goes to the game is ¾, and he goes to the ballet ¼ ofthe time. These are independent probabilities, so to get the probability that both go to

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the game, we multiply the probabilities, which yields 3

16. The next table fills in theprobabilities for all four possible outcomes.

Man

Table 7-17: Mixed Strategy Probabilities

Woman
Baseball Ballet
Baseball 3
916
16
Ballet3
1
16
16Note that more than half the time, (Baseball, Ballet) is the outcome of the mixed
strategy, and the two people are not together. This lack of coordination is a feature of
mixed strategy equilibria generally. The expected payoffs for both players are readily
computed as well. The Man’s payoff was 1+2p = 2 – 2p, and since p = ¼, the Man
obtained 1 ½. A similar calculation shows the Woman’s payoff is the same. Thus, both
do worse than coordinating on their less preferred outcome. But this mixed strategy
Nash equilibrium, undesirable as it may seem, is a Nash equilibrium in the sense thatneither party can improve their payoff, given the behavior of the other party.
In the Battle of the sexes, the mixed strategy Nash equilibrium may seem unlikely, andwe might expect the couple to coordinate more effectively. Indeed, a simple call on thetelephone should rule out the mixed strategy. So let’s consider another game related to
the Battle of the Sexes, where a failure of coordination makes more sense. This is thegame of “Chicken.” Chicken is played by two drivers driving toward each other, trying toconvince the other to yield, which involves swerving into a ditch. If both swerve into theditch, we’ll call the outcome a draw and both get zero. If one swerves and the otherdoesn’t, the swerver loses and the other wins, and we’ll give the winner one point.88 The
only remaining question is what happens when both don’t yield, in which case a crash
results. In this version, that has been set at four times the loss of swerving, but you canchange the game and see what happens.

Row

Table 7-18: Chicken

ColumnSwerveDon’t
Swerve (0,0)(-1,1)
Don’t(1,-1)(-4,-4)This game has two pure strategy equilibria: (Swerve, Don’t) and (Don’t, Swerve). In
addition, it has a mixed strategy. Suppose Column swerves with probability p. Then
88 Note that adding a constant to a player’s payoffs, or multiplying that player’s payoffs by a positive
constant, doesn’t affect the Nash equilibria, pure or mixed. Therefore, we can always let one outcome foreach player be zero, and another outcome be one.

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Row gets 0p + -1(1-p) from swerving, 1p + (-4)(1-p) from not swerving, and Row will
randomize if these are equal, which requires p = ¾. That is, the probability that
Column swerves, in a mixed strategy equilibrium is ¾. You can verify that the Row
player has the same probability by setting the probability that Row swerves equal to q
and computing Column’s expected payoffs. Thus, the probability of a collision is 1 in16
the mixed strategy equilibrium.
The mixed strategy equilibrium is more likely in some sense in this game; if the players
already knew which player would yield, they wouldn’t actually need to play the game.
The whole point of the game is to find out who will yield, which means it isn’t known inadvance, which means the mixed strategy equilibrium is in some sense the morereasonable equilibrium.

Paper, Scissors, Rock is a child’s game in which two children simultaneously choose
paper (hand held flat), scissors (hand with two fingers protruding to look like scissors)or rock (hand in a fist). The nature of the payoffs is that paper beats rock, rock beats
scissors, and scissors beat paper. This game has the structure

Row

Table 7-19: Paper, Scissors, Rock

Paper
Paper
(0,0)
Scissors (1,-1)

ColumnScissors(-1,1)(0,0)

Rock(1,-1)(-1,1)

Rock(1,-1)(0,0)(-1,1)

7.1.3.2 (Exercise) Show that, in the Paper, Scissors, Rock game, there are no purestrategy equilibria. Show that playing all three actions with equal likelihood is amixed strategy equilibrium.
7.1.3.3 (Exercise)

Row

1

Row

2

Find all equilibria of the following games:

Column
Left
Right
Up
(3,2)
(11,1)
Down (4,5)(8,0)

Column
Left
Right
Up
(3,3)
(0,0)
Down (4,5)(8,0)

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Row

3

Row

4

Column
Left
Right
Up
(0,3)
(3,0)
Down (4,0)(0,4)

Column
Left
Right
Up
(7,2)
(0,9)
Down (8,7)
(8,8)

Row

5

Row

6

Left
Up
(1,1)
Down (4,1)

Column
Right
(2,4)
(3,2)

Column
Left
Right
Up
(4,2)
(2,3)
Down (3,8)(1,5)

7.1.4 Examples
Our first example concerns public goods. In this game, each player can either
contribute, or not. For example, two roommates can either clean their apartment, ornot. If they both clean, the apartment is nice. If one cleans, that roommate does all thework and the other gets half of the benefits. Finally, if neither clean, neither is very
happy. This suggests payoffs like:

Row

Table 7-20: Cleaning the Apartment

Column
Clean
Don’t
Clean (10,10)(0,15)
Don’t (15,0)(2,2)

You can verify that this game is similar to the prisoner’s dilemma, in that the only Nashequilibrium is the pure strategy in which neither player cleans. This is a game theoretic
version of the tragedy of the commons – even though the roommates would both bebetter off if both cleaned, neither do. As a practical matter, roommates do solve thisproblem, using strategies that we will investigate when we consider dynamic games.

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Row

Table 7-21: Driving on the Right

Column
Left
Right
Left
(1,1)
(0,0)
Right (0,0)(1,1)

The important thing about the side of the road the cars drive on is not that it is the rightside but that it is the same side. This is captured in the Driving on the Right game
above. If both players drive on the same side, then they both get one point, otherwise
they get zero. You can readily verify that there are two pure strategy equilibria,(Left,Left) and (Right,Right), and a mixed strategy equilibrium with equal probabilities.
Is the mixed strategy reasonable? With automobiles, there is little randomization. On
the other hand, people walking down hallways often seem to randomize whether they
pass on the left or the right, and sometimes do that little dance where they try to get pasteach other, one going left and the other going right, then both simultaneously reversing,unable to get out of each other’s way. That dance suggests that the mixed strategy
equilibrium is not as unreasonable as it seems in the automobile application.89

LA

Table 7-22: Bank Location GameNo Concession
Tax Rebate

NYC
No Concession
Tax Rebate(30,10)(10,20)(20,10)(20,0)

Consider a foreign bank that is looking to open a main office and a smaller office in the
United States. The bank narrows its choice for main office to either New York (NYC) or
Los Angeles (LA), and is leaning toward Los Angeles. If neither city does anything, LA
will get $30 million in tax revenue and New York ten million. New York, however, could
offer a $10 million rebate, which would swing the main office to New York, but now New
York would only get a net of $20 M. The discussions are carried on privately with thebank. LA could also offer the concession, which would bring the bank back to LA.

89 Continental Europe drove on the left until about the time of the French revolution. At that time, someindividuals began driving on the right as a challenge to royalty who were on the left, essentially playing
the game of chicken with the ruling class. Driving on the right became a symbol of disrespect for royalty.
The challengers won out, forcing a shift to driving on the right. Besides which side one drives on, anothercoordination game involves whether one stops or goes on red. In some locales, the tendency for a few
extra cars to go as a light changes from green to yellow to red forces those whose light changes to green to
wait, and such a progression can lead to the opposite equilibrium, where one goes on red and stops on
green. Under Mao Tse-tung, the Chinese considered changing the equilibrium to going on red andstopping on green (because ‘red is the color of progress’) but wiser heads prevailed and the plan was
scrapped.

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7.1.4.1 (Exercise)
Verify that the bank location game has no pure strategy equilibria,
and that there is a mixed strategy equilibrium where each city offers a rebatewith probability ½.

Dem

Table 7-23: Political Mudslinging

Republican
Clean
Mud
Clean (3,1)(1,2)
Mud (2,1)(2,0)

On the night before the election, a Democrat is leading the Wisconsin senatorial race.
Absent any new developments, the Democrat will win, and the Republican will lose.
This is worth 3 to the Democrat, and the Republican, who loses honorably, values thisoutcome at one. The Republican could decide to run a series of negative advertisements(“throwing mud”) against the Democrat, and if so, the Republican wins although loses
his honor, which he values at 1, and so only gets 2. If the Democrat runs negative ads,
again the Democrat wins, but loses his honor, so only gets 2. These outcomes are
represented in the Mudslinging game above.
7.1.4.2 (Exercise) Show that the only Nash equilibrium is a mixed strategy with equal
probabilities of throwing mud and not throwing mud.
7.1.4.3 (Exercise) Suppose that voters partially forgive a candidate for throwing mudwhen the rival throws mud, so that the (Mud, Mud) outcome has payoff (2.5,.5).
How does the equilibrium change?
You have probably had the experience of trying to avoid encountering someone, who wewill call Rocky. In this instance, Rocky is actually trying to find you. The situation isthat it is Saturday night and you are choosing which party, of two possible parties, toattend. You like party 1 better, and if Rocky goes to the other party, you get 20. If Rocky
attends party 1, you are going to be uncomfortable and get 5. Similarly, Party 2 is worth
15, unless Rocky attends, in which case it is worth 0. Rocky likes Party 2 better (thesedifferent preferences may be part of the reason you are avoiding him) but he is trying to
see you. So he values Party 2 at 10, party 1 at 5 and your presence at the party heattends is worth 10. These values are reflected in the following table.

You

Table 7-24: Avoiding Rocky

Rocky
Party 1
Party 2
Party 1 (5,15)(20,10)Party 2 (15,5)(0,20)

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7.1.4.4 (Exercise) (i) Show there are no pure strategy Nash equilibria in this game.
(ii) Find the mixed strategy Nash equilibria. (iii) Show that the probability you
encounter Rocky is 7 .
12
Our final example involves two firms competing for customers. These firms can either
price high or low. The most money is made if they both price high, but if one prices low,
it can take most of the business away from the rival. If they both price low, they makemodest profits. This description is reflected in the following table:

Firm 1

Table 7-25: Price Cutting Game

Firm 2High
Low
High (15,15)(0,25)
Low (25,0)(5,5)

7.1.4.5 (Exercise) Show that the firms have a dominant strategy to price low, so thatthe only Nash equilibrium is (Low, Low).

7.1.5 Two Period GamesSo far, we have considered only games that are played simultaneously. Several of thesegames, notably the price cutting and apartment cleaning games, are actually played over
and over again. Other games, like the bank location game, may only be played once but
nevertheless are played over time. Recall the bank location game:

LA

Table 7-26; Bank Location Revisited

No Concession
Tax Rebate

NYC
No Concession
Tax Rebate(30,10)(10,20)(20,10)(20,0)

If neither city offered a rebate, then LA won the bidding. So suppose instead of thesimultaneous move game, that first New York decided whether to offer a rebate, andthen LA could decide to offer a rebate. This sequential structure leads to a game thatlooks like Figure 7-1:
In this game, NYC makes the first move, and chooses Rebate (to the left) or No Rebate(to the right). If NYC chooses Rebate, LA can then choose Rebate or None. Similarly, if
NYC chooses No Rebate, LA can choose Rebate or None. The payoffs (using thestandard of (LA, NYC) ordering) are written below the choices.

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Rebate

NYC

LA
RebateNone(20,0)(10,20)

No Rebate

RebateLA(20,10)None(30,10)Figure 7-1 Sequential Bank Location (NYC payoff listed first)

What NYC would like to do depends on what NYC believes LA will do. What should
NYC believe about LA? (Boy does that rhetorical question suggest a lot of facetious
answers.) The natural belief is that LA will do what is in LA’s best interest. This idea –that each stage of a game is played in a maximizing way – is called subgame perfection.

7.1.6 Subgame Perfection
Subgame perfection requires each player to act in its best interest, independent of thehistory of the game.90 This seems very sensible and in most contexts it is sensible. In
some settings, it may be implausible. Even if I see a player make a particular mistake
three times in a row, subgame perfection requires that I must continue to believe that
player will not make the mistake again. Subgame perfection may be implausible insome circumstances, especially when it pays to be considered somewhat crazy.
In the example, subgame perfection requires LA to offer a rebate when NYC does (since
LA gets 20 by rebating versus 10), and not when NYC doesn’t. This is illustrated in thegame using arrows to indicate LA’s choices. In addition, the actions that LA won’t
choose have been re-colored in a light grey in Figure 7-2.
Once LA’s subgame perfect choices are taken into account, NYC is presented with the
choice of offering a rebate, in which case it gets 0, or not offering a rebate, in which caseit gets 10. Clearly the optimal choice for NYC is to offer no rebate, in which case LA
doesn’t either, and the result is 30 for LA, and 10 for NYC.
Dynamic games are generally “solved backward” in this way. That is, first establish what
the last player does, then figure out based on the last player’s expected behavior, what
the penultimate player does, and so on.

90 Subgame perfection was introduced by Nobel laureate Reinhart Selten (1930 – ).

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Rebate

NYC

LA
RebateNone(20,0)(10,20)

No Rebate

RebateLANone(20,10)(30,10)Figure 7-2: Subgame Perfection

We’ll consider one more application of subgame perfection. Suppose, in the game
“Avoiding Rocky,” Rocky is actually stalking you, and can condition his choice on yourchoice. Then you might as well go to the party you like best, because Rocky is going tofollow you wherever you go. This is represented in Figure 7-3.

Party 1

R

You

Party 2

Party 1

Party 1
Party 2

(5,15)(20,10)(15,5)

R
Party 2

(0,20)

Figure 7-3: Can’t Avoid Rocky

Since Rocky’s optimal choice eliminates your best outcomes, you make the best of a badsituation by choosing Party 1. Here, Rocky has a second mover advantage: Rocky’s
ability to condition on your choice meant he does better than he would do in asimultaneous game.
7.1.6.1 (Exercise)
Formulate the battle of the sexes as a sequential game, letting thewoman choose first. (This situation could arise if the woman can leave amessage for the man about where she has gone.) Show that there is only one

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subgame perfect equilibrium, and that the woman enjoys a first-moveradvantage over the man, and she gets her most preferred outcome.

7.1.7 Supergames
Some situations, like the pricing game or the apartment-cleaning game, are played over
and over. Such situations are best modeled as a supergame.91 A supergame is a gameplayed over and over again without end, where the players discount the future. The
game played each time is known as a stage game. Generally supergames are played intimes 1, 2, 3, …
Cooperation may be possible in supergames, if the future is important enough.
Consider the pricing game introduced above.

Firm 1

Table 7-27: Price Cutting, Revisited

Firm 2High
Low
High (15,15)(0,25)
Low (25,0)(5,5)

The dominant strategy equilibrium to this game is (Low, Low). It is clearly a subgame
perfect equilibrium for the players to just play (Low, Low) over and over again, because
if that is what Firm 1 thinks Firm 2 is doing, Firm 1 does best by pricing Low, and viceversa. But that is not the only equilibrium to the supergame.
Consider the following strategy, called a grim trigger strategy. Price high, until you see
your rival price low. After your rival has priced low, price low forever. This is called a
trigger strategy because an action of the other player (pricing low) triggers a change inbehavior. It is a grim strategy because it punishes forever.
If your rival uses a grim trigger strategy, what should you do? Basically, your only
choice is when to price low, because once you price low, your rival will price low, andthen your best choice is to also price low from then on. Thus, your strategy is to pricehigh up until some point t – 1, and then price low from time t on. Your rival will pricehigh through t, and price low from t + 1 on. This gives a payoff to you of 15 from period
1 through t – 1, 25 in period t, and then 5 in period t + 1 on. We can compute the payoff
for a discount factor δ.

Vt = 15(1 + δ + δ 2 + ... + δ t −1 ) + 25δ t + 5(δ t +1 + δ t + 2 + ...)= 15

1 − δt
15
15
δt
δt
δt
(15 − 25(1 − δ) − 5δ) =+ 25δ t + 5=−−(−10 + 20δ) .
1− δ
1− δ 1− δ 1− δ
1− δ 1− δ

91 The supergame was invented by Robert Aumann (1930 – ) in 1959.

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If -10 + 20δ < 0, it pays to price low immediately, at t=0, because it pays to price low
and the earlier the higher the present value. If -10 + 20δ > 0, it pays to wait forever toprice low, that is, t = ∞. Thus, in particular, the grim trigger strategy is an optimal
strategy for a player when the rival is playing the grim trigger strategy if δ≥½. In otherwords, cooperation in pricing is a subgame perfect equilibrium if the future is importantenough, that is, the discount factor δ is high enough.
The logic of this example is that the promise of future cooperation is valuable when the
future itself is valuable, and that promise of future cooperation can be used to induce
cooperation today. Thus, firm 1 doesn’t want to cut price today, because that would lead
firm 2 to cut price for the indefinite future. The grim trigger strategy punishes pricecutting today with future low profits.
Supergames offer more scope for cooperation than is illustrated in the pricing game.
First, more complex behavior is possible. For example, consider the following game:

Firm 1

Table 7-28: A Variation of the Price Cutting Game

Firm 2High
Low
High (10,10)(0,25)
Low (25,0)(5,5)

Here, again, the unique equilibrium in the stage game is (Low, Low). But the difference
between this game and the previous game is that the total profits of firms 1 and 2 arehigher in either (High, Low) or (Low, High) than in (High, High). One solution is toalternate between (High, Low) and (Low, High). Such alternation can also be supported
as an equilibrium, using the grim trigger strategy – that is, if a firm does anything otherthan what is it supposed to in the alternating solution, the firms instead play (Low, Low)
forever.
7.1.7.1 (Exercise)
Consider the game in Table 7-28, and consider a strategy in whichfirm 1 prices high in odd numbered periods, and low in even numbered periods,
while 2 prices high in even numbered periods, low in odd numbered periods. If
either deviate from these strategies, both price low from then on. Let δ be the25
25δ
discount factor. Show that these firms have a payoff of
or
,
2
1−δ
1 − δ2depending on which period it is. Then show that the alternating strategy is5δ
25δ
≤. This, in turn, is equivalent to δ ≥ 6 − 2.
sustainable if 10 +1 − δ 1 − δ2

7.1.8 The Folk Theorem
The folk theorem says that if the value of the future is high enough, any outcome that isindividually rational can be supported as an equilibrium to the supergame. Individual
rationality for a player in this context means that the outcome offers a present value of
profits at least as high as that offered in the worst equilibrium in the stage game fromthat player’s perspective. Thus, in the pricing game, the worst equilibrium of the stage
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game offered each player 5, so an outcome can be supported if it offers each player at
least a running average of 5.
The simple logic of the folk theorem is this. First, any infinite repetition of an
equilibrium of the stage game is itself a subgame perfect equilibrium. If everyone
expects this repetition of the stage game equilibrium, no one can do better than to playtheir role in the stage game equilibrium every period. Second, any other plan of action
can be turned into a subgame perfect equilibrium merely by threatening any agent who
deviates from that plan with an infinite repetition of the worst stage game equilibriumfrom that agent’s perspective. That threat is credible because the repetition of the stage
game equilibrium is itself a subgame perfect equilibrium. Given such a grim trigger typethreat, no one wants to deviate from the intended plan.
The folk theorem is a powerful result, and shows that there are equilibria to supergames
that achieve very good outcomes. The kinds of coordination failures we saw in the battleof the sexes, and the failure to cooperate in the prisoner’s dilemma, need not arise, andcooperative solutions are possible if the future is sufficiently valuable.
However, it is worth noting some assumptions that have been made in our descriptionsof these games, assumptions that matter and are unlikely to be true in practice. First,
the players know their own payoffs. Second, they know their rival’s payoffs. They
possess a complete description of the available strategies and can calculate theconsequences of these strategies, not just for themselves, but for their rivals. Third,
each player maximizes his or her expected payoff, and they know that their rivals do thesame, and they know that their rivals know that everyone maximizes, and so on. The
economic language for this is the structure of the game and the player’s preferences arecommon knowledge. Few real world games will satisfy these assumptions exactly.
Since the success of the grim trigger strategy (and other strategies we haven’t discussed)
generally depends on such knowledge, informational considerations may cause
cooperation to break down. Finally, the folk theorem shows us that there are lots ofequilibria to supergames, and provides no guidance on which one will be played. Theseassumptions can be relaxed, although they may lead to wars on the equilibrium path “byaccident,” and a need to recover from such wars, so that the grim trigger strategy
becomes sub-optimal.

7.2 Cournot Oligopoly
The Cournot92 oligopoly model is the most popular model of imperfect competition. It isa model in which the number of firms matters, and represents one way of thinking about
what happens when the world is neither perfectly competitive, nor a monopoly.
In the Cournot model, there are n firms, who choose quantities. We denote a typicalfirm as firm i and number the firms from i = 1 to i = n. Firm i chooses a quantity qi ≥ 0
to sell and this quantity costs ci(qi). The sum of the quantities produced is denoted by Q.
The price that emerges from the competition among the firms is p(Q) and this is thesame price for each firm. It is probably best to think of the quantity as really
92 Augustus Cournot, 1801-1877.

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representing a capacity, and competition in prices by the firms determining a market
price given the market capacity.
The profit that a firm i obtains is

πi = p(Q )qi − ci (qi ) .

7.2.1 Equilibrium
Each firm chooses qi to maximize profit. The first order conditions93 give:0=∂πi= p(Q ) + p′(Q )qi − ci′ (qi ) .
∂qiThis equation holds with equality provided qi > 0. A simple thing that can be done withthe first order conditions is to rewrite them to obtain the average value of the price-cost
margin:p(Q ) − ci′ (qi )p′(Q )qiQp′(Q ) qi si
= .
=−
=−
p(Q )
p(Q )
p(Q ) Q εq
Here si = i is firm i’s market share. Multiplying this equation by the market share andQsumming over all firms i = 1, … , n yieldsnp(Q ) − ci′ (qi )1 n 2 HHI=s
∑ p(Q)∑ si = ε ,
i
ε
i =1
i =1
n

where HHI = ∑ si2 is the Hirschman-Herfindahl Index.94 The HHI has the property
i =1

that if the firms are identical, so that si = 1/n for all i, then the HHI is also 1/n. For thisreason, antitrust economists will sometimes use 1/HHI as a proxy for the number offirms, and describe an industry with “2 ½ firms,” meaning an HHI of 0.4.95
We can draw several inferences from these equations. First, larger firms, those withlarger market shares, have a larger deviation from competitive behavior (price equal tomarginal cost). Small firms are approximately competitive (price nearly equals
marginal cost) while large firms reduce output to keep the price higher, and the amountof the reduction, in price/cost terms, is proportional to market share. Second, the HHI
reflects the deviation from perfect competition on average, that is, it gives the average
93 Bear in mind that Q is the sum of the firms’ quantities, so that when firm i increases its output slightly,

Q goes up by the same amount.
94 Named for Albert Hirschman (1918 – 1972), who invented it in 1945, and Orris Herfindahl (1915 – ),who invented it independently in 1950.
95 To make matters more confusing, antitrust economists tend to state the HHI using shares in percent, sothat the HHI is on a 0 to 10,000 scale.

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proportion by which price equal to marginal cost is violated. Third, the equation
generalizes the “inverse elasticity result” proved for monopoly, which showed that theprice – cost margin was the inverse of the elasticity of demand. The generalization
states that the weighted average of the price – cost margins is the HHI over the elasticity
of demand.
Since the price – cost margin reflects the deviation from competition, the HHI provides
a measure of how large a deviation from competition is present in an industry. A large
HHI means the industry “looks like monopoly.” In contrast, a small HHI looks likeperfect competition, holding constant the elasticity of demand.
The case of a symmetric (identical cost functions) industry is especially enlightening. In
this case, the equation for the first order condition can be restated as
0 = p(Q ) + p′(Q ) Qn− c ′⎛⎜ Q ⎞⎟
⎝ n⎠

or

p(Q ) =

εnc ′⎛⎜ Q ⎞⎟ .
εn − 1 ⎝ n ⎠Thus, in the symmetric model, competition leads to pricing as if demand were moreelastic, and indeed is a substitute for elasticity as a determinant of price.

7.2.2 Industry Performance
How does the Cournot industry perform? Let us return to the more general model, that
doesn’t require identical cost functions. We already have one answer to this question:
the average price – cost margin is the HHI divided by the elasticity of demand. Thus, if
we have an estimate of the demand elasticity, we know how much the price deviatesfrom the perfect competition benchmark.
The general Cournot industry actually has two sources of inefficiency. First, price isabove marginal cost, so there is the dead weight loss associated with unexploited gains
from trade. Second, there is the inefficiency associated with different marginal costs.
This is inefficient because a re-arrangement of production, keeping total output thesame, from the firm with high marginal cost to the firm with low marginal cost, would
reduce the cost of production. That is, not only is too little output produced, but what
output is produced is inefficiently produced, unless the firms are identical.
To assess the productive inefficiency, we let c1′ be the lowest marginal cost. The average
deviation from the lowest marginal cost, then, is
n

n

n

i =1

i =1

i =1

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n

= p − c1′ − p ∑ si
i =1

( p − ci′ )p np= p − c1′ − ∑ si2 = p − c1′ − HHI .
ε i =1εpThus, while a large HHI means a large deviation from price equal to marginal cost andhence a large level of monopoly power (holding constant the elasticity of demand), a
large HHI also tends to indicate greater productive efficiency, that is, less output
produced by high cost producers. Intuitively, a monopoly produces efficiently, even if it
has a greater reduction in total output than other industry structures.
There are a number of caveats worth mentioning in the assessment of industry
performance. First, the analysis has held constant the elasticity of demand, which could
easily fail to be correct in an application. Second, fixed costs have not been considered.
An industry with large economies of scale, relative to demand, must have very few firms
to perform efficiently and small numbers should not necessarily indicate the market
performs poorly even if price – cost margins are high. Third, it could be that entry
determines the number of firms, and that the firms have no long-run market power, justshort-run market power. Thus, entry and fixed costs could lead the firms to haveapproximately zero profits, in spite of price above marginal cost.
7.2.2.1 (Exercise) Suppose the inverse demand curve is p(Q) = 1 – Q, and that there
are n Cournot firms, each with constant marginal cost c, selling in the market.
n(1 − c )(i) Show that the Cournot equilibrium quantity and price are Q =
and
n +1
2

1 + nc⎛ 1−c ⎞p(Q ) =. (ii) Show each firm’s gross profits are ⎜⎟ .
n +1⎝ n +1⎠
Continuing with 7.2.2.1 (Exercise), suppose there is a fixed cost F to become a firm. The
number of firms n should be such that firms are able to cover their fixed costs, but add
one more and they can’t. This gives us a condition determining the number of firms n:22⎛ 1−c ⎞
⎛ 1−c ⎞⎜
⎟ ≥ F ≥⎜
⎟ .
⎝ n +1⎠
⎝n+2⎠
2

2

2

(2n + 3)(1 − c )2
⎛ 1−c ⎞
⎛ 1−c ⎞ ⎛ 1−c ⎞.
Thus, each firm’s net profits are ⎜⎟ −F ≤⎜⎟ −⎜⎟ =⎝ n +1⎠⎝ n +1⎠ ⎝ n +2⎠(n + 1)2 (n + 2)2
Note that the monopoly profits πm are ¼ (1-c)2. Thus, with free entry, net profits are(2n + 3)4n(2n + 3)4
less thanπ , and industry net profits are less than
πm .
2
2 m
( n + 1 ) ( n + 2)
(n + 1)2 (n + 2)2
Table 7-29 shows the performance of the constant cost, linear demand Cournot
industry, when fixed costs are taken into account, and when they aren’t. With two firms,
gross industry profits are 8/9ths of the monopoly profits, not substantially different
from monopoly. But when fixed costs sufficient to insure that only two firms enter are
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considered, the industry profits are at most 39% of the monopoly profits. This number– 39% -- is large because fixed costs could be “relatively” low, so that the third firm isjust deterred from entering. That still leaves the two firms with significant profits, eventhough the third firm can’t profitably enter. As the number of firms rises, gross industry
profits fall slowly toward zero. The net industry profits, on the other hand, fall
dramatically rapidly to zero. With ten firms, the gross profits are still about a third of
the monopoly level, but the net profits are only at most 5% of the monopoly level.
Table 7-29: Industry Profits as a Fraction of Monopoly Profits

Net
Number Gross
Industryof Firms Industry
Profits (%) Profits (%)
2
88.9
39.0
3
75.0
27.0
4
64.0
19.6
5
55.6
14.7
10
33.1
5.3
15
23.4
2.7
20
18.1
1.6
The Cournot model gives a useful model of imperfect competition, a model that readily
permits assessing the deviation from perfect competition. The Cournot model embodies
two kinds of inefficiency: the exercise of monopoly power, and technical inefficiency inproduction. In settings involving entry and fixed costs, care must be taken in applying
the Cournot model.

7.3 Search and Price Dispersion
Decades ago, economists used to make a big deal about the “Law of One Price,” whichstates that identical goods sell at the same price. The argument in favor of the law of
one price is theoretical. Well-informed consumers will buy identical goods from thelowest price seller. Consequently, the only seller to make any sales is the low-priceseller. This kind of consumer behavior forces all sellers to sell at the same price.
There are few markets where the law of one price is actually observed to hold.
Organized exchanges, like stock, bond and commodity markets, will satisfy the law of
one price. In addition, gas stations across the street from each other will often offer
identical prices, but often is not always.
Many economists considered that the internet would force prices of standardized goods– DVD players, digital cameras, MP3 players – to a uniform, and uniformly low, price.
However, this has not occurred. Moreover, it probably can’t occur, in the sense thatpure price competition would put the firms out of business, and hence can’t represent
equilibrium behavior.
There are many markets where prices appear unpredictable to consumers. The price ofairline tickets is notorious for unpredictability. The price of milk, soft drinks, paper

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towels and canned tuna varies 50% or more depending on whether the store has anadvertised sale of the item or not. Prices of goods sold on the internet varies
substantially from day to day.96 Such variation is known as price dispersion byeconomists. It is different from price discrimination, in that price dispersion entails agiven store quoting the same price to all customers; the variation is across stores, while
price discrimination is across customers.
Why are prices so unpredictable?

7.3.1 Simplest Theory
To understand price dispersion, we divide consumers into two types: shoppers and loyal
customers. Loyal customers won’t pay more than a price pm for the good, but they only
consult a particular store; if that store has the good for less than the price pm, the loyal
customer buys, and otherwise not. In contrast, the shoppers buy only from the store
offering the lowest price; shoppers are informed about the prices offered by all stores.
We let the proportion of shoppers be s. The loyal customers are allocated to the otherstores equally, so that, if there are n stores, each store gets a fraction (1 – s)/n of thecustomers. Let the marginal cost of the good be c, and assume c < pm. Both kinds ofcustomers buy only one unit.
For the purposes of this analysis, we will assume that prices can be chosen from thecontinuum. This makes the analysis more straightforward, but there is an alternate
version of the analysis (not developed here) that makes the more reasonable assumptionof prices that are an integer number of pennies.
First note that there is no pure strategy equilibrium. To see this, consider the lowest
price p charged by any firm. If that price is c, the firm makes no money, so would do
better by raising its price to pm and selling only to the loyal customers. Thus, the lowest
price p exceeds c. If there is a tie at p, it pays to break the tie by charging a billionth of acent less than p, and thereby capturing all the shoppers rather than sharing them withthe other firm charging p. So there can’t be a tie.
But no tie at p means the next lowest firm is charging something strictly greater than p,which means the lowest price firm can increase price somewhat and not suffer any lossof sales. This contradicts profit maximization for that firm. The conclusion is that firms
must randomize and no pure strategy equilibrium exists.
But how do they randomize? We are going to look for a distribution of prices. Each firm
will choose a price from the continuous distribution F, where F(x) is the probability thefirm charges a price less than x. What must F look like? We use the logic of mixed
strategies: the firm must get the same profits for all prices that might actually becharged under the mixed strategy, for otherwise it would not be willing to randomize.
A firm that charges price p ≤ pm always sells to its captive customers. In addition, it sells
to the shoppers if the other firms have higher prices, which occurs with probability(1 − F ( p))n −1 . Thus, the firm’s profits are
96 It is often very challenging to assess internet prices because of variation in shipping charges.

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⎛1−s
⎞
π( p) = ( p − c )⎜+ s(1 − F ( p))n −1 ⎟ .
⎝ n⎠
On each sale, the firm earns p – c. The firm always sells to its loyal customers, and in
addition captures the shoppers if the other firms price higher. Since no firm will exceed
pm, the profits must be the same as the level arising from charging pm, and this gives
1−s
⎛1−s
⎞
π( p) = ( p − c )⎜+ s(1 − F ( p))n −1 ⎟ = ( pm − c )
.
n
⎝ n
⎠
This equation is readily solved for F:⎛
F ( p) = ⎜⎜ 1 −⎝1( pm − p)(1 − s ) ⎞ n −1s( p − c )n

⎟⎟
⎠

.

The lower bound of prices arises at the point L where F(L)=0, or

L=c+( pm − c )

1−s
n .

1−s
+s
n

These two equations provide a continuous distribution of prices charged by each firm
which is an equilibrium to the pricing game. That is, each firm randomizes over theinterval [L, pm], according to the continuous distribution F. Any price in the interval[L,pm] produces the same profits for each firm, so the firms are willing to randomize
over this interval.
The loyal customers get a price chosen randomly from F, so we immediately see that the
shoppers make life better for the loyal customers, pushing average price down. (Anincrease in s directly increases F, which means prices fall – recall that F gives theprobability that prices are below a given level, so an increase in F is an increase in theprobability of low prices.)
Similarly loyal customers make life worse for shoppers, increasing prices on average to
shoppers. The distribution of prices facing shoppers is actually the distribution of theminimum price. Since all firms charge a price exceeding p with probability (1 – F(p))n,at least one charges a price less than p with probability 1 – (1 – F(p))n, and this is the
distribution of prices facing shoppers. That is, the distribution of prices charged to
shoppers isn⎛ ( p − p)(1 − s ) ⎞ n −1⎟⎟
1 − (1 − F ( p))n = 1 − ⎜⎜ m.
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7.3.2 Industry Performance
How does a price dispersed industry perform? First, average industry profits arenπ( p) = ( pm − c )(1 − s ).
An interesting aspect of this equation is that it doesn’t depend on the number of firms,
only on the number of loyal customers. Essentially, the industry profits are the samethat it would earn as if the shoppers paid marginal cost and the loyal customers paid themonopoly price, although that isn’t what happens in the industry, except in the limit as
the number of firms goes to infinity. Note that this formula for industry profits does notwork for a monopoly. In order to capture monopoly, one must set s=0, because
shoppers have no alternative under monopoly.
Price1

Expected price for loyal
customers

0.8

0.6

0.4

0.2

Expected price for shoppers

20

40

60

80

100

n

Figure 7-4: Expected Prices in Search Equilibrium

As the number of firms gets large, the price charged by any one firm converges to themonopoly price pm. However, the lowest price offered by any firm actually converges toc, marginal cost. Thus, in the limit as the number of firms get large, shoppers obtainprice equal to marginal cost and loyal firms pay the monopoly price.
The average price charged to shoppers and non-shoppers is a complicated object, so we
consider the case where there are n firms, s = ½, pm =1 and c = 0. Then the expected
prices for shoppers and loyal customers are given in Figure 7-4, letting the number offirms vary. Thus, with many firms, most of the gains created by the shoppers flow to
shoppers. In contrast, with few firms, a significant fraction of the gains created by
shoppers goes instead to the loyal customers.

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Similarly, we can examine the average prices for loyal customers and shoppers when the
proportion of shoppers varies. Increasing the proportion of shoppers has two effects.
First, it makes low prices more attractive, thus encouraging price competition, because
capturing the shoppers is more valuable. Second, it lowers industry profits, because theset of loyal customers is reduced. Figure 7-5 plots the average price for loyal customers
and shoppers, as the proportion of shoppers ranges from zero to one, when there are
five firms, pm = 1 and c = 0.
Price1
Expected price forloyal customers

0.8

0.6

0.4
Expected pricefor shoppers

0.2

0.2

0.4

0.6

0.8

1

s

Figure 7-5: Expected Prices (s=Proportion of Shoppers)

People who are price-sensitive and shop around convey a positive externality on otherbuyers by encouraging price competition. Similarly, people who are less price sensitiveand don’t shop around convey a negative externality on the other buyers. In markets
with dispersed information about the best prices, where some buyers are informed andsome are not, randomized prices are a natural outcome. That is, randomization ofprices, and the failure of the law of one price, is just a reflection of the different
willingness or ability to search on the part of consumers.
This difference in the willingness to search could arise simply because search is itself
costly. That is, the shoppers could be determined by their choice to shop, in such a waythat the cost of shopping just balances the expected gains from searching. The
proportion of shoppers may adjust endogenously to insure that the gains from searchingexactly equal the costs of searching. In this way, a cost of shopping is translated into arandomized price equilibrium in which there is a benefit from shopping and all
consumers get the same total cost of purchase on average.

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7.4 Hotelling Model
Breakfast cereals range from indigestible, unprocessed whole grains to cereals that arealmost entirely sugar with only the odd molecule or two of grain. Such cereals are
hardly good substitutes for each other. Yet similar cereals are viewed by consumers as
good substitutes, and the standard model of this kind of situation is the Hotellingmodel.97 Hotelling was the first to use a line segment to represent both the product thatis sold and the preferences of the consumers who are buying the products. In the
Hotelling model, there is a line, and preferences of each consumer is represented by apoint on this line. The same line is used to represent products. For example, movie
customers are differentiated by age, and we can represent moviegoers by their ages.
Movies, too, are designed to be enjoyed by particular ages. Thus a “pre-teen” movie isunlikely to appeal very much to a six year old or to a nineteen year old, while a Disney
movie appeals to a six year old, but less to a fifteen year old. That is, movies have atarget age, and customers have ages, and these are graphed on the same line.

High Fiber

Adult Cereals

Kid Cereals

Sugar Content
Figure 7-6: Hotelling Model for Breakfast Cereals

Breakfast cereal is a classic application of the Hotelling line, and this application is
illustrated in Figure 7-6. Breakfast cereals are primarily distinguished by their sugar
content, which ranges on the Hotelling line from low on the left to high on the right.
Similarly, the preferences of consumers also fall on the same line. Each consumer has a“most desired point,” and prefers cereals closer to that point than those at more distantpoints.

7.4.1 Types of Differentiation
There are two main types of differentiation, each of which can be modeled using the
Hotelling line. These types are quality and variety. Quality refers to a situation where
consumers agree what product is better; the disagreement among consumers concerns
whether higher quality is worth the cost. In automobiles, faster acceleration, betterbraking, higher gas mileage, more cargo capacity, more legroom, and greater durability
are all good things. In computers, faster processing, brighter screens, higher resolution
screens, lower heat, greater durability, more megabytes of RAM and more gigabytes of
hard drive space are all good things. In contrast, varieties are the elements about which
there is not widespread agreement. Colors and shapes are usually varietal rather thanquality differentiators. Some people like almond colored appliances, others choose
white, with blue a distant third. Food flavors are varieties, and while the quality ofingredients is a quality differentiator, the type of food is usually a varietal differentiator.
Differences in music would primarily be varietal.
Quality is often called vertical differentiation, while variety is horizontal
differentiation.
97 Hotelling Theory is named for Harold Hotelling, 1895-1973.

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7.4.2 The Standard Model
The standard Hotelling model fits two ice cream vendors on a beach. The vendors sell
the identical product, and moreover they can choose to locate wherever they wish. For
the time being, suppose the price they charge for ice cream is fixed at $1. Potential
customers are also spread randomly along the beach.
We let the beach span an interval from 0 to 1. People desiring ice cream will walk to theclosest vendor, since the price is the same. Thus, if one vendor locates at x and the otherat y, and x < y, those located between 0 and ½ (x + y) go to the left vendor, while therest go to the right vendor. This is illustrated in Figure 7-7.

Buy at x

0x

Buy at y½ (x + y)y

1

Figure 7-7: Sharing the Hotelling Market

Note that the vendor at x sells more by moving toward y, and vice versa. Such logic
forces profit maximizing vendors to both locate in the middle! The one on the left sells
to everyone left of ½, while the one on the right sells to the rest. Neither can capture
more of the market, so equilibrium locations have been found. (To complete thedescription of an equilibrium, we need to let the two “share” a point and still have oneon the right side, one on the left side of that point.)
This solution is commonly used as an explanation of why U.S. political parties often
seem very similar to each other – they have met in the middle in the process of chasing
the most voters. Political parties can’t directly buy votes, so the “price” is fixed; the only
thing parties can do is locate their platform close to voters’ preferred platform, on ascale of “left” to “right.” But the same logic that a party can grab the middle, without
losing the ends, by moving closer to the other party will tend to force the parties to sharethe same “middle of the road” platform.
7.4.2.1 (Exercise)
Suppose there are four ice cream vendors on the beach, andcustomers are distributed uniformly. Show that it is a Nash equilibrium for two
to locate at ¼, and two at ¾.
The model with constant prices is unrealistic for the study of the behavior of firms.
Moreover, the two-firm model on the beach is complicated to solve and has theundesirable property that it matters significantly whether the number of firms is odd oreven. As a result, we will consider a Hotelling model on a circle, and let the firms choose
their prices.

7.4.3 The Circle ModelIn this model, there are n firms evenly spaced around the circle whose circumference isone. Thus, the distance between any firm and each of its closest neighbors is 1/n.

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Consumers care about two things: how distant the firm they buy from is, and how muchthey pay for the good, and they minimize the sum of the price paid and t times the
distance between the consumer’s location (also on the circle) and the firm. Eachconsumer’s preference is uniformly distributed around the circle. The locations of firms
are illustrated in Figure 7-8.

length 1/n

Firm

length 1/n

Firm

Firm

Figure 7-8: A Segment of the Circle Model

We conjecture a Nash equilibrium in which all firms charge the price p. To identify p,
we look for what p must be to make any one firm choose to charge p, given that theothers all charge p. So suppose the firm in the middle of Figure 7-8 charges an alternate
price r, but every other firm charges p. A consumer who is x units away from the firmpays the price r + tx from buying at the firm, or p + t(1/n – x) from buying from therival. The consumer is just indifferent between the nearby firms if these are equal, thatis,r + tx* = p + t(1/n – x*)
where x* is the location of the consumer who is indifferent.

p+ t −r
1
p−r
n
x* =
=
+
.
2t
2n
2t
Thus, consumers who are closer than x* to the firm charging r buy from that firm, andconsumers who are further away than x* buy from the alternative firm. Demand for thefirm charging r is twice x* (because the firm sells to both sides), so profits are priceminus marginal cost times two x*, that is,⎛ 1 p−r ⎞(r − c )2 x * = (r − c )⎜ +
⎟.
t ⎠
⎝n
The first order condition98 for profit maximization is0=∂⎛ 1 p−r ⎞ ⎛ 1 p−r ⎞ r −c
(r − c )⎜ +
.
⎟=⎜ +
⎟−
∂r
t ⎠ ⎝nt ⎠t⎝n

98 Since profit is quadratic in r, we will find a global maximum.

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We could solve the first order condition for r. But remember that the concern is when is
p a Nash equilibrium price? The price p is an equilibrium price if the firm wants tochoose r = p. Thus, we can conclude that p is a Nash equilibrium price when

p=c+

t
.
n

This value of p insures that a firm facing rivals who charge p also chooses to charge p.
Thus, in the Hotelling model, price exceeds marginal cost by an amount equal to thevalue of the average distance between the firms, since the average distance is 1/n andthe value to a consumer of traveling that distance is t. The profit level of each firm istt, so industry profits are .
nn2
How many firms will enter the market? Suppose the fixed cost is F. We are going totake a slightly unusual approach and assume that the number of firms can adjust in acontinuous fashion, in which case the number of firms is determined by the zero profittcondition F =, or n = t .
2FnWhat is the socially efficient number of firms? The socially efficient number of firms
minimizes the total costs, which are the sum of the transportation costs and the fixed
costs. With n firms, the average distance a consumer travels is
1

n
−

1

2

2n
1
⎛ 1 ⎞
=
|
x
|
dx
2
n
∫
∫ xdx = n⎜⎝ 2n ⎟⎠ = 4n .
1
0
2n

2n

Thus, the socially efficient number of firms minimizes the transport costs plus the entryt
1 t+ nF . This occurs at n =. The socially efficient number of firms is half
costs
F
4n
2
the level that enter with free entry!
Too many firms enter in the Hotelling circle model. This extra entry arises because
efficient entry is determined by the cost of entry and the average distance of consumers,
while prices are determined by the marginal distance of consumers, or the distance ofthe marginal consumer. That is, competing firms’ prices are determined by the most
distant customer, and that leads to prices that are too high relative to the efficient level;
free entry then drives net profits to zero only by excess entry.
The Hotelling model is sometimes used to justify an assertion that firms will advertise
too much, or engage in too much R&D, as a means of differentiating themselves andcreating profits.

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7.5 Agency Theory
An agent is a person who works for, or on behalf of, another. Thus, an employee is anagent of a company. But agency extends beyond employee relationships. Independent
contractors are also agents. Advertising firms, lawyers and accountants are agents of
their clients. The CEO of a company is an agent of the board of directors of thecompany. A grocery store is an agent of the manufacturer of corn chips sold in the store.
Thus, the agency relationship extends beyond the employee into many different
economic relationships. The entity – person or corporation – on whose behalf an agent
works is called a principal.
Agency theory is the study of incentives provided to agents. Incentives are an issue
because agents need not have the same interests and goals as the principal. Employees
spend billions of hours every year browsing the web, emailing friends, and playing
computer games while they are supposedly working. Attorneys hired to defend a
corporation in a lawsuit have an incentive not to settle, to keep the billing flowing.
(Such behavior would violate the attorneys’ ethics requirements.) Automobile repair
shops have been known to use cheap or used replacement parts and bill for new, highquality parts. These are all examples of a conflict in the incentives of the agent and thegoals of the principal.
Agency theory focuses on the cost of providing incentives. When you rent a car, anagency relationship is created. Even though a car rental company is called an agency, it
is most useful to look at the renter as the agent, because it is the renter’s behavior that is
an issue. The company would like the agent to treat the car as if it were their own car.
The renter, in contrast, knows it isn’t their own car, and often drives accordingly.
"[T]here's a lot of debate on this subject---about what kind of car handles
best. Some say a front-engined car; some say a rear-engined car. I say arented car. Nothing handles better than a rented car. You can go faster, turncorners sharper, and put the transmission into reverse while going forward at
a higher rate of speed in a rented car than in any other kind." 99
How can the car rental company insure that you don’t put their car into reverse while
going forward at a high rate of speed? They could monitor your behavior, perhaps by
putting a company representative in the car with you. That would be a very expensive
and unpleasant solution to the problem of incentives. Instead, the company uses
outcomes – if damage is done, the driver has to pay for it. That is also an imperfectsolution, because some drivers who abuse the cars get off scot-free and others who don’t
abuse the car still have cars that break down, and are then mired in paperwork while
they try to prove their good behavior. That is, a rule that penalizes drivers based on
outcomes imposes risk on the drivers. Modern technology is improving monitoring withGPS tracking.

99 P. J. O'Rourke, Republican Party Reptile, Atlantic Monthly Press, 1987.

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7.5.1 Simple Model
To model the cost of provision of incentives, we consider an agent like a door-to-door
encyclopedia salesperson. The agent will visit houses, and sell encyclopedias to some
proportion of the households; the more work the agent does, the more sales that are
made. We let x represent the average dollar value of sales for a given level of effort; x isa choice the agent makes. However, x will come with risk to the agent, which we modelusing the variance σ2.
The firm will pay the agent a share s of the money generated by the sales. In addition,
the firm will pay the agent a salary y, which is fixed independently of sales. This scheme– a combination of salary and commission – covers many different situations. Realestate agents receive a mix of salary and commission. Authors receive an advance and aroyalty, which works like a salary and commission.
The monetary compensation of the agent is sx + y. In addition, the agent has a cost ofx2. Here a represents the ability of the agent: more able
2aagents, who have a higher value of a, have a lower cost of effort. Finally, there is a costof risk. The actual risk imposed on the agent is proportional to the degree they share in
the proceeds; if s is small, the agent faces almost no monetary risk, while if s is high,most of the risk is imposed on the agent. We use the “linear cost of risk” model
developed earlier, to impose a cost of risk which is sλσ2. Here, σ2 is the variance of themonetary risk, λ defines the agent’s attitude or cost of risk, and s is the share of the risk
imposed on the agent. This results in a payoff to the agent ofeffort, which we take to bex2
u = sx + y −− sλσ2 .
2a
The first two terms, sx + y, are the payments made to the agent. The next term is thecost of generating that level of x. The final term is the cost of risk imposed on the agent
by the contract.
The agency game works as follows. First, the principal offers a contract, which involves
a commission s and a salary y. The agent can either accept or reject the contract andaccepts if he obtains at least u0 units of utility, the value of his next best offer. Then theagent decides how much effort to expend, that is, the agent chooses x.
As with all subgame perfect equilibria, we work backwards to first figure out what x an
agent would choose. Because our assumptions make u quadratic in x, this is astraightforward exercise, and we conclude x=sa. This can be embedded into u, and we
obtain the agent’s optimized utility, u*, is(sa)2u* = s a + y −− sλσ2 = y + ½s 2a − sλσ2 .
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Incentive Compensation: A Percentage of What?
Most companies compensate their sales force based on the revenue generated. However, maximizing
revenue need not be the same thing as maximizing profit, which is generally the goal of the company. In
what follows, Steve Bisset discusses the difference.
“Many years ago I was CEO of a company called Megatest, founded by Howard Marshall and myself in
1975. Around 1987 we were selling test systems in the $1M+ price range. Every Monday morning we would
have a meeting with sales management and product marketing, mediated by myself. Individual salesmencame in to make their cases for how they just had to have a huge discount, else they would lose a particularsale. The meeting was part circus, with great performances, and part dogfight.
“I could visualize the sales guys spending their time in the car or the shower using their substantial creative
powers to dream up good justifications for their next plea for a huge discount. They knew that if we werewilling to bleed enough we could usually win the sale. I wanted to solve both the resultant profitability
problem and the problem of the unpleasant meeting.
“Commissions were traditionally a percentage of bookings (net of discount), with part held back until cash
was received. The percentage increased after a salesman met his individual quota for the quarter (theperformances at quota-setting time to sandbag the quota were even more impressive). The fact that a
discount reduced commission did not affect a salesman's behavior, because the difference in commission
was small. Better to buy the order by giving a big discount and then move on quickly to the next sale.
“Salesmen are "coin operated", and will figure out how to maximize their total commission. Most salesmen
I have met are quite good at math. Further, they have learned to “watch the hips, not the lips” – in otherwords, they judge management intentions by actions rather than words. They reason – and I agree withthem – that if management really wanted them to maximize margins rather than revenues, then they would
pay them more if they maximize margins.
“We decided to try a new scheme, against some howling from the sales department. We set a base "cost"for each product, approximately representing the incremental cost to manufacture and support the product.
Then we offered commission on the amount that the net sales price exceeded this base cost. The base cost
may have been as much as 80% of the list price (it was a very competitive market at the time). Then we
increased the commission rate by a factor of about six, so that if the salesman brought in an order at a pricenear list, then his commission was somewhat higher than before. If he started discounting, his commission
dropped sharply. We gave broad discretion to sales management to approve discounts.
“We still had sales guys claiming that a sale was massively strategic and had to be sold at or below cost,
and that they needed their commission anyway to justify the effort. In some cases we approved this, but
mostly we said that if it's strategic then you'll get your commission on the follow-on sales. While salesmen
have a strong preference for immediate cash, they will act so as to maximize income over time, and will
think and act strategically if financially rewarded for such.
“The results were that our margins increased significantly. Revenues were increasing too. It's hard to
attribute the revenue gain to the new commission plan, given the number of other variables, but I like tothink that it was a factor. Now our salesmen spent more of their creative energies devising ways to sell ourcustomers on the value of our products and company, instead of conspiring with sales management as tothe best tale of woe to present to marketing at the Monday pricing meeting.
“The Monday meetings became shorter and more pleasant, focused on truly creative ways to make eachsale. There certainly were steep discounts given in some cases, but they reflected the competitive situationand future sales potential at each account much more accurately.”(Source: private correspondence, quotation permission received)

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The agent won’t accept employment unless u*≥u0, the reservation utility. The principal
can minimize the cost of employing the agent by setting the salary such that u*=u0,
which results in
y = u0 − ½s 2a + sλσ 2 .

Observe that the salary has to be higher, the greater is the risk σ2. That is, the principal
has to cover the cost of risk in the salary term.

7.5.2 Cost of Providing Incentives
The principal obtains profits which are the remainder of the value after paying theagent, and minus the salary:
π = (1 − s ) x − y= (1 − s )sa − (u0 − ½s 2a + sλσ2 )= sa − u0 − ½s 2a − sλσ2 .
Note that the principal gets the entire output x = sa minus all the costs – the reservation
utility of the agent u0, the cost of providing effort, and the risk cost on the agent. Thatis, the principal obtains the full gains from trade – the value of production minus thetotal cost of production. However, the fact that the principal obtains the full gains fromtrade doesn’t mean the principal induces the agent to work extremely hard, because
there is no mechanism for the principal to induce the agent to work hard without
imposing more risk on the agent, and this risk is costly to the principal. Agents are
induced to work hard by tying their pay to their performance, and such a link
necessarily imposes risk on the agent, and risk is costly.100
We take the principal to be risk neutral. This is reasonable when the principal is“economically large” relative to the agent, so that the risks faced by the agent are small
to the principal. For example, the risks associated with any one car are small to a car
rental company. The principal who maximizes expected profits chooses s to maximize π,
which yields
s =1−

λ 2
σ .
a

This formula is interesting for several reasons. First, if the agent is neutral to risk,
which means λ=0, then s is 1. That is, the agent gets 100% of the marginal return toeffort, and the principal just collects a lump sum. This is reminiscent of some tenancy
contracts used by landlords and peasants; the peasant paid a lump sum for the right tofarm the land and then kept all of the crops grown. Since these peasants were unlikely
to be risk neutral, while the landlord was relatively neutral to risk, such a contract was
100 There is a technical requirement that the principal’s return π must be positive, for otherwise theprincipal would rather not contract at all. This amounts to an assumption that u0 is not too large.
Moreover, if s comes out less than zero, the model falls apart, and in this case, the actual solution is s=0.

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unlikely to be optimal. The contract with s=1 is known as “selling the agency” since theprincipal sells the agency to the agent for a lump sum payment. (Here, y will generally
be negative – the principal gets a payment rather than paying a salary.) The morecommon contract, however, had the landowner and the tenant farmer share theproceeds of farming, which gives rise to the name sharecropper.
Second, more risk or more risk aversion on the part of the agent decreases the share of
the proceeds accruing to the agent. Thus, when the cost of risk or the amount of risk ishigh, the best contract imposes less risk on the agent. Total output sa falls as the risk
costs rise.
Third, more able agents (higher a) get higher commissions. That is, the principal
imposes more risk on the more able agent because the returns to imposition of risk – inthe form of higher output – are greater, and thus worth the cost in terms of added risk.
Most real estate agencies operate on a mix of salary and commission, with commissions
paid to agents averaging about 50%. The agency RE/MAX, however, pays commissions
close to 100%, collecting a fixed monthly fee that covers agency expenses from theagents. RE/MAX claims that their formula is appropriate for better agents. The theory
developed suggests that more able agents should obtain higher commissions. But in
addition, RE/MAX’s formula also tends to attract more able agents, since able agents
earn a higher wage under the high commission formula. (There is a potential downside
to the RE/MAX formula, that it discourages agency-wide cooperation.)

7.5.3 Selection of Agent
Consider what contracts attract what kinds of agents. For a fixed salary y andcommission s, the agent’s utility, optimizing over x, is

u* = y + ½s 2a − sλσ2 .
The agent’s utility is increasing in a and decreasing in λ. Thus, more able agents gethigher utility, and less risk averse agents get higher utility.
How do the terms of the contract affect the pool of applicants? Let us suppose twocontracts are offered, one with a salary y1 and commission s1, the other with salary y2
and commission s2. We suppose y2 < y1 and s2 > s1. What kind of agent prefers contract
2, the high commission, low salary contract, over contract 1?

y2 + ½s22a − s2λσ2 ≥ y1 + ½s12a − s1λσ2 ,or, equivalently,()½a s22 − s12 − ( s2 − s1 )λσ2 ≥ y1 − y2 .
Thus, agents with high ability a or low level of risk aversion λ prefers the highcommission, low salary contract. A company that puts more of the compensation in theform of commission tends to attract more able agents, and agents less averse to risk.
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The former is a desirable feature of the incentive scheme, since more able agentsproduce more. The latter, the attraction of less risk averse agents, may or may not bedesirable but is probably neutral overall.
One important consideration is that agents who overestimate their ability will react thesame as people who have higher ability. Thus, the contract equally attracts those withhigh ability and those who overestimate their ability.
Agency theory provides a characterization of the cost of providing incentives. The
source of the cost is the link between incentives and risk. Incentives link pay andperformance; when performance is subject to random fluctuations, linking pay andperformance also links pay and the random fluctuations. Thus the provision of
incentives necessarily imposes risk on the agent, and if the agent is risk averse, this iscostly.
In addition, the extent to which pay is linked to performance will tend to affect the typeof agent who is willing to work for the principal. Thus, a principal must not only
consider the incentive to work hard created by the commission and salary structure, butalso the type of agent who would choose to accept such a contract.

7.5.4 Multi-tasking
Multi-tasking refers to performing several activities simultaneously. All of us multitask. We study while drinking a caffeinated beverage; we think about things in theshower; we talk all too much on cell phones and eat French fries while driving. In thecontext of employees, an individual employee will be assigned a variety of tasks andresponsibilities, and the employee must divide their time and efforts among the tasks.
Incentives provided to the employee must direct not only the total efforts of theemployee, but also the allocation of time and effort across activities. An important
aspect of multi-tasking is the interaction of incentives provided to employees, and theeffects of changes in one incentive on the behavior of the employee over many different
dimensions. In this section, we will establish conditions under which the problem of an
employer disaggregates, that is to say, the incentives on each individual task can be set
independently of the incentives applied to the others.
This section is relatively challenging and involves a number of pieces. To simplify thepresentation, some of the pieces are set aside as claims.
To begin the analysis, we consider a person who has n tasks or jobs. For convenience wewill index these activities with the natural numbers 1, 2, … , n. The level of activity,
which may also be thought of as an action, in task i will be denoted by xi. It will prove
convenient to denote the vector of actions by x = ( x1 , … , x n ) . We suppose the agent
bears a cost c(x) of undertaking the vector of actions x. We make four assumptions on
c:
•
•
•

c is increasing in each xi,
c has a continuous second derivative
c is strictly convex, andMcAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

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•

c is homogeneous101 of degree r.

For example, if there are two tasks (n=2), then all four of these assumptions are met by
the cost function c( x1 , x2 ) = x12 + x22 + ½x1 x2 . This function is increasing in x1 and x2,
has continuous derivatives, is strictly convex (more about this below) and ishomogeneous of degree 2.
It is assumed that c is increasing to identify the activities as costly. Continuity ofderivatives is used for convenience. Convexity of c will insure that a solution to the firstorder conditions is actually an optimum for the employee. Formally, it means that for
any vectors x ≠ y and scalar α between zero and one (0 ≤ α ≤ 1),αc( x ) + (1 − α)c( y ) ≥ c(αx + (1 − α) y ) .
One way of interpreting this requirement is that it is less costly to do the average of twothings than the average of the costs of the things. Intuitively, convexity requires thatdoing a medium thing is less costly than the average of two extremes. This is plausible
when extremes tend to be very costly. It also means the set of vectors which cost lessthan a fixed amount, {x | c(x) ≤ b}, is a convex set. Thus, if two points cost less than agiven budget, the line segment connecting them does, too. Convexity of the costfunction insures that the agent’s optimization problem is concave, and thus that the firstorder-conditions describe a maximum. When the inequality is strict for α satisfying 0 <α < 1, we refer to convexity as strict convexity.
The assumption of homogeneity dictates that scale works in a particularly simple
manner. Scaling up activities increases costs at a fixed rate r. Homogeneity has verystrong implications that are probably unreasonable in many settings. Nevertheless,homogeneity leads to an elegant and useful theory, as we shall see. Recall the definitionof a homogeneous function: c is homogeneous of degree r means that for any λ > 0,c(λx ) = λr c( x ) .

Claim: strict convexity implies that r > 1.
Proof of Claim: Fix any x and consider the two points x and λx. By convexity, for
0 < α <1,
(α + (1 − α)λr )c( x ) = αc( x ) + (1 − α)c(λx )> c(αx + (1 − α )λx )) = (α + (1 − α )λ )r c( x )which implies (α + (1 − α)λr ) > (α + (1 − α)λ)r .
Define a function k which is the left hand side minus the right hand side:

101 Homogeneous functions were defined in 4.1.8.3 (Exercise).

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k(α) = α + (1 − α)λr − (α + (1 − α)λ )r . Note that k(0)=k(1)=0. Moreover,k ′′(α) = −r(r − 1)(α + (1 − α)λ)r-2 (1 − λ )2 . It is readily checked that if a convex
function of one variable is twice differentiable, then the second derivative isgreater than zero. If r ≤ 1, k ′′(α) ≥ 0 , implying that k is convex, and hence, if 0 <α < 1,

k(α) = k((1 − α)0 + α1) ≤ (1 − α)k(0) + αk(1) = 0 .
Similarly, if r > 1, k is concave and k(α) > 0. This completes the proof, showingthat r≤1 is not compatible with the strict convexity of c.
How should our person behave? Consider linear incentives, which are also known as
piece rates. With piece rates, the employee gets a payment pi for each unit of xi
produced. The person then chooses x to maximizenu = ∑ pi x i − c( x ) = p • x − c( x ) .
i =1Here • is the dot product, which is the sum of the products of the components.
The agent chooses x to maximize u, resulting in n first order conditions∂u∂c( x )
= pi −= pi − ci ( x ) ,∂xi∂x i
where ci is the partial derivative of c with respect to the ith argument xi. This first ordercondition can be expressed more compactly as
0 = p − c′( x )where c′( x ) is the vector of partial derivatives of c. Convexity of c insures that any
solution to this problem is a global utility maximum, since the function u is concave, andstrict convexity insures that there is at most one solution to the first order conditions.102
One very useful implication of homogeneity is that incentives scale. Homogeneity has
the effect of turning a very complicated optimization problem into a problem that isreadily solved, thanks to this very scaling.
1r
Claim: If all incentives rise by a scalar factor α, then x rises by α −1 .

102 This description is slightly inadequate, because we haven’t considered boundary conditions.

Often arequirement like xi≥0 is also needed. In this case, the first order conditions may not hold with equality for
those choices where xi=0 is optimal.

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Proof of Claim: Note that differentiating c(λx ) = λr c( x ) with respect to xi yields
λci (λx ) = λr ci ( x ) , and thus c ′(λx ) = λr −1 c ′( x ) . That is, if c is homogeneous ofdegree r, c ′ is homogeneous of degree r – 1. Consequently, if 0 = p − c′( x ) ,1r
0 = αp − c ′(α −1 x ) . Thus, if the incentives are scaled up by α, the efforts rise by
1r
the scalar factor α −1 .

Now consider an employer with an agent engaging in n activities. The employer values
the ith activity at vi, and thus wishes to maximize
n

n

i =1

i =1

π = ∑ (vi − pi )x i = ∑ (vi − ci ( x )) xi .
This equation embodies a standard trick in agency theory. Think of the principal(employer) not as choosing the incentives p, but instead as choosing the effort levels x,
with the incentives as a constraint. That is, the principal can be thought of choosing x
and then choosing the p that implements this x. The principal’s expected profit isreadily differentiated with respect to each xj, yieldingn

0 = v j − c j ( x ) − ∑ cij ( x ))x i .
i =1

However, since cj(x) is homogeneous of degree r – 1,nd

∑ cij (x ))xi = dλ c j (λx )

i =1

=
λ =1

d r −1
λ c j (x)= (r − 1)c j ( x ) ,
dλ
λ =1

n

and thus 0 = v j − c j ( x ) − ∑ cij ( x ))x i = v j − rc j ( x ) .
i =1

This expression proves the main result of this section. Under the maintained
hypotheses (convexity and homogeneity), an employer of a multi-tasking agent uses
incentives which are a constant proportion of value, that is,
pj =

vj
r

,

where r is the degree of homogeneity of the agent’s costs. Recalling that r>1, theprincipal uses a sharing rule, sharing a fixed proportion of value with the agent.

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When agents have a homogeneous cost function, the principal has a very simple optimal
incentive scheme, requiring quite limited knowledge of the agent’s cost function (justthe degree of homogeneity). Moreover, the incentive scheme works through asomewhat surprising mechanism. Note that if the value of one activity, say activity 1,
rises, p1 rises and all the other payment rates stay constant. The agent responds byincreasing x1, but the other activities may rise or fall depending on how complementary
they are to activity 1. Overall, the agent’s substitution across activities given the new
incentive level on activity 1 implements the desired effort levels on other activities. The
remarkable implication of homogeneity is that, although the principal desires different
effort levels for all activities, only the incentive on activity 1 must change!

7.5.5 Multi-tasking without Homogeneity
In the previous section we saw, for example, that if the agent has quadratic costs, theprincipal pays the agent half the value of each activity. Moreover, the more rapidly costs
rise in scale, the lower the payments to the agent.
This remarkable theorem has several limitations. The requirement of homogeneity isitself an important limitation, although this assumption is reasonable in some settings.
More serious is the assumption that all of the incentives are set optimally for theemployer. Suppose, instead, that one of the incentives is set “too high,” at least from theemployer’s perspective. This might arise if, for example, the agent acquired all thebenefits of one of the activities. An increase in the power of one incentive will then tend
to “spill over” to the other actions, increasing for complements and decreasing for
substitutes. When the efforts are substitutes, an increase in the power of one incentive
will cause others to optimally rise, to compensate for the reduced supply of efforts ofthat type.103
We can illustrate the effects of cost functions that aren’t homogeneous in a relatively
straightforward way. Suppose the cost depends on the sum of the squared activity
levels:⎛ n 2⎞c( x ) = g⎜ ∑ xi ⎟ = g( x • x ) .
⎜⎟⎝ i =1 ⎠This is a situation where vector notation (dot-products) dramatically simplifies theexpressions. You may find it useful to work through the notation on a separate sheet, orin the margin, using summation notation to verify each step. At the moment, we won’t
be concerned with the exact specification of g, but instead use the first order conditions
to characterize the solution.
The agent maximizes
u = p • x − g( x • x ) .

103 Multi-tasking, and agency theory more generally, is a rich theory with many implications not discussed
here. For a challenging and important analysis, see Bengt Holmstrom and Paul Milgrom, "The Firm as an
Incentive System,” American Economic Review, Vol. 84, No. 4 (Sep., 1994), pp. 972-991.

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This gives a first order condition
0 = p − 2 g′( x • x )xIt turns out that a sufficient condition for this equation to characterize the agent’s utility
maximization is that g is both increasing and convex (increasing second derivative).
This is a particularly simple expression, because the vector of efforts, x, points in thesame direction as the incentive payments p. The scalar that gives the overall effort
levels, however, is not necessarily a constant, as occurs with homogeneous costfunctions. Indeed, we can readily see that x•x is the solution top • p = (2g′( x • x ))2 ( x • x ) .

Because x•x is a number, it is worth introducing notation for it: S = x•x. Then S is thesolution top • p = 4S ( g′( S ))2 .

The principal or employer chooses p to maximize
π = v • x − p • x = v • x − 2 g′( x • x )( x • x ) .

This gives the first order condition

0 = v − 4(g′( x • x ) + ( x • x )g′′( x • x ))x .
Thus, the principal’s choice of p is such that x is proportional to v, with constant ofproportionality g ′( x • x ) + x • xg ′′( x • x ) . Using the same trick (dotting each side of thefirst order condition v = 4(g ′( x • x ) + x • xg ′′( x • x ))x with itself), we obtain:v • v = 16(g ′(S *) + S * g ′′(S *))2 S * ,which gives the level of x•x=S* induced by the principal. Given S*, p is given by
⎞
⎛
⎟
⎜
v
1⎜
1
⎟v .
p = 2g′( x • x )x = 2g′( S *)=⎜′′S * g ( S *) ⎟4( g′( S *) + S * g′′( S *)) 2⎟⎜1 +g′( S *) ⎠⎝Note that this expression gives the right answer when costs are homogeneous. In thiscase, g(S) must be in the form Sr/2, and the formula gives

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p=

v
1⎛
1
⎞
⎟v =
⎜
2⎝1 +r −1⎠ras we already established.
The natural assumption to impose on the function g is that (g′( S ) + Sg′′( S ))2 S is anincreasing function of S. This assumption implies that as the value of effort rises, thetotal effort also rises.
Sg′′( S )is increasing in S. Then an increase in vi increases S, decreasing pj forg′( S )
j≠i. That is, when one item becomes more valuable, the incentives on the others are
reduced. Moreover, since p • p = 4S ( g′( S ))2 , an increase in S only occurs if p•pincreases.

Suppose

These equations together imply that an increase in any one vi increases the total effort(as measured by S* = x•x), increases the total incentives as measured by p•p, andSg′′( S )is adecreases the incentives on all activities other than activity i. In contrast, ifg′( S )
decreasing function of S, then an increase in any one vi causes all the incentives to rise.
Intuitively, the increase in vi directly causes pi to rise, since xi is more valuable. This
causes the agent to substitute toward activity i. This causes the relative cost of total
Sg′′( S )decreases), which induces a desire to increase the otheractivity to fall (sinceg′( S )
activity levels, which is accomplished by increase in the incentives on the otheractivities.
This conclusion generalizes readily and powerfully. Suppose that c(x) = g(h(x)), where
h is homogeneous of degree r and g is increasing. In the case just considered, h(x)=x•x.
dpi
is determined by the derivative ofThen the same conclusion, that the sign ofdv j
Sg′′( S ), holds. In the generalization, S now stands for h(x).
g′( S )

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7.6 Auctions
When we think of auctions, we tend to think of movies where people
scratch their ear and accidentally purchase a Faberge egg, like the one
pictured at left.104 However, stock exchanges, bond markets andcommodities markets are organized as auctions, too, and because of suchexchanges, auctions are the most common means of establishing prices.
Auctions are one of the oldest transactions means recorded in humanhistory, and were used by the Babylonians. The word auction comesfrom the Latin auctio, meaning to increase.
Auctions have been used to sell a large variety of things. Internet auction
house eBay is most famous for weird items that have been auctioned (e.g. one person’s
attempt to sell their soul), but in addition, many of the purchases of the U.S.
government are made by auction. The U.S. purchases everything from fighter aircraft to
French fries by auction, and the U.S. government is the world’s largest purchaser ofFrench fries. In addition, corporations are occasionally sold by auction.
Items that are usually sold by auction include prize bulls, tobacco, used cars, race
horses, coins, stamps, antiques, and fine art.
Information plays a significant role in bidding in auctions. The two major extremes in
information, which lead to distinct theories, are private values, which means bidders
know their own value, and common values, in which bidders don’t know their own
value, but have some indication or signal about the value. In the private values
situation, a bidder may be outbid by another bidder, but doesn’t learn anything fromanother bidder’s willingness to pay. The case of private values arises when the goodbeing sold has a quality apparent to all bidders, no hidden attributes, and no possibilityof resale. In contrast, the case of common values arises when bidders don’t know thevalue of the item for sale, but that value is common to all. The quintessential example is
an off-shore oil lease. No one knows for sure how much oil can be extracted from an offshore lease, and companies have estimates of the amount of oil. The estimates areclosely guarded because rivals could learn from them. Similarly, when antiques dealers
bid on an antique, the value they place on it is primarily the resale value. Knowing
rivals’ estimates of the resale value would influence the value each bidder placed on the
item.
The private values environment is unrealistic in most settings, because items for sale
usually have some element of common value. However, some situations approximate
the private values environment and these are the most readily understood.

7.6.1 English Auction
An English auction is the common auction form used for selling antiques, art, used carsand cattle. The auctioneer starts low, and calls out prices until no bidder is willing tobid higher than the current high price. The most common procedure is for a low price to104 Photo courtesy of Paris Jewelers, 107 East Ridgewood Ave. Ridgewood, New Jersey 07450.

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be called out, and a bidder accept it. A higher price is called out, and a different bidder
accepts it. When several accept simultaneously, the auctioneer accepts the first one
spotted. This process continues until a price is called out that no one accepts. At thatpoint the auction ends, and the highest bidder wins.
In a private values setting, a very simple bidding strategy is optimal for bidders: a biddershould keep bidding until the price exceeds the value a bidder places on it, at which
point the bidder should stop. That is, bidders should drop out of the bidding when theprice exceeds their value, because at that point, winning entails a loss. Every biddershould be willing to continue to bid and not let the item sell to someone else if the priceis less than their value. If you have a value v and another bidder is about to win at a
price pa < v, you might as well accept a price pb between the two, pa < pb < v, since apurchase at this price would provide profits. This strategy is a dominant strategy foreach private values bidder, because no matter what strategy other bidders adopt,bidding up to value is the strategy that maximizes the profits of a bidder.
The presence of a dominant strategy makes it straightforward to bid in the private
values environment. In addition, it makes an analysis of the outcome of the English
auction relatively simple.
Most auctioneers use a somewhat flexible system of bid increments. A bid increment isthe difference between successive price requests. The theory is simplest when the bid
increment, which we will denote as ∆, is very small. In this case, the bidder with thehighest value will win, and the price will be no more than the second-highest value, but
at least the second-highest value minus ∆, since if the price was less than this level, thebidder with the second-highest value would submit another bid. If we denote thesecond-highest value with the somewhat obscure (but standard) notation v(2), the final
price p satisfies

v(2) − ∆ ≤ p ≤ v(2) .
As the bid increment gets small, this nails down the price. The conclusion is that, whenbid increments are small and bidders have private values, the bidder with the highest
value wins the bidding at a price equal to the second-highest value. The notation for thehighest value is v(1), and thus the seller obtains v(2), and the winning bidder obtains
profits of v(1) – v(2).

7.6.2 Sealed-bid Auction
In a sealed-bid auction, each bidder submits a bid in an envelope. These are opened
simultaneously, and the highest bidder wins the item and pays his or her bid. Sealedbid auctions are used to sell off-shore oil leases, and used by governments to purchase awide variety of items. In a purchase situation, known often as a tender, the lowest
bidder wins and is paid the bid.
The analysis of the sealed-bid auction is more challenging because the bidders don’t
have a dominant strategy. Indeed, the best bid depends on what the other bidders are
bidding. The bidder with the highest value would like to bid a penny more than the next
highest bidder’s bid, whatever that might be.

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To pursue an analysis of the sealed-bid auction, we are going to make a variety ofsimplifying assumptions. These assumptions aren’t necessary to the analysis but are
made to simplify the mathematical presentation.
We suppose there are n bidders, and label the bidders 1,…,n. Bidder i has a private value
vi which is a draw from the uniform distribution on the interval [0,1]. That is, if
0 ≤ a ≤ b ≤ 1 , the probability that bidder i’s value is in the interval [a, b] is b – a. An
important attribute of this assumption is symmetry – the bidders all have the same
distribution. In addition, the formulation has assumed independence – the value one
bidder places on the object for sale is statistically independent from the value placed byothers. In addition, each bidder knows their own value, but doesn’t know the otherbidders’ values. Each bidder is assumed to bid in such a way as to maximize expected
profit, and we will look for a Nash equilibrium of the bidding game. Bidders are
permitted to submit any bid not less than zero.
To find an equilibrium, it is helpful to restrict attention to linear rules, in which a bidderbids a proportion of their value. Thus, we suppose each bidder bids λv when their value
is v, and examine under what conditions this is in fact Nash equilibrium behavior. We
have an equilibrium if, when all other bidders bid λv when their value is v, theremaining bidder will, too.
So fix a bidder and suppose that bidder’s value is vi. What bid should the bidderchoose? A bid of b wins the bidding if all other bidders bid less than b. Since the otherbidders, by hypothesis, bid λv when their value is v, our bidder wins when b ≥ λv j foreach other bidder j. This occurs when b ≥ v j for each other bidder j, and this in turnλoccurs with probability b .105 Thus, our bidder with value vi who bids b wins with
λ( λ)n−1 , since the bidder must beat all n-1 other bidders. That creates

probability b

expected profits for the bidder of( λ)n−1 .

π = (vi − b) b

The bidder chooses b to maximize expected profits. The first order condition requires⎛b⎞
0 = −⎜ ⎟⎝λ⎠n −1+ (vi − b)(n − 1)

bn −2
λn −1

.

The first order condition solves for

b=

n −1
v.
n

105 If b > λ , then in fact the probability is one.

You can show that no bidder would ever bid more than λ.

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But this is a linear rule! Thus, if λ =n −1, we have a Nash equilibrium.
nn −1of their value,n
and the highest value bidder wins at a price equal to that fraction of their value.

The nature of this equilibrium is that each bidder bids a fraction λ =In some cases, the sealed-bid auction produces regret. Regret means that a bidderwishes she had bid differently. Recall our notation for values: v(1) is the highest valuen −1
v(1) ,and v(2) is the second-highest value. Since the price in a sealed-bid auction isnn −1v(1) . In this case, thethe second-highest bidder will regret her bid when v(2) >nbidder with the second-highest value could have bid higher and won, if the bidder had
known the winning bidder’s bid. In contrast, the English auction is regret-free, in thatthe price rises to the point that the bidder with the second-highest value won’t pay.
How do the two auctions compare in prices? It turns out that statistical independenceof private values implies revenue equivalence, which means the two auctions produce
the same prices on average. Given the highest value v(1), the second-highest value hasn −1⎛ v(2) ⎞⎟distribution ⎜, since this is the probability that all n-1 other bidders have values⎜v ⎟⎝ (1) ⎠
less than v(2). But this gives an expected value of v(2) ofv(1 )v(n2−)20v(n1−) 1

Ev(2) = ∫ v(2) (n − 1)dv(2) =n −1v(1) .
nThus, the average price paid in the sealed-bid auction is the same as the average price inthe English auction.

7.6.3 Dutch Auction
The Dutch auction is like an English auction, except that prices start high and aresuccessively dropped until a bidder accepts the going price, at which point the auction
ends. The Dutch auction is so named because it is used to sell cut flowers in Holland, inthe enormous flower auctions.
A strategy in a Dutch auction is a price at which the bidder bids. Each bidder watches
the price decline, until such a point that either the bidder bids, or a rival bids, and theauction ends. Note that a bidder could revise their bid in the course of the auction, butthere isn’t any point. For example, suppose the price starts at $1,000, and a bidder
decides to bid when the price reaches $400. Once the price gets to $450, the bidder
could decide to revise and wait until $350. However, no new information has become
available and there is no reason to revise. In order for the price to reach the original

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planned bid of $400, it had to reach $450, meaning that no one bid prior to a price of$450. In order for a bid of $400 to wins, the price had to reach $450; if the pricereaching $450 means that a bid of $350 is optimal, than the original bid of $400 wasn’t
optimal.106
What is interesting about the Dutch auction is that it has exactly the same possible
strategies and outcomes as the sealed-bid auction. In both cases, a strategy for a bidder
is a bid, no bidder sees the others’ bids until after their own bid is formulated, and thewinning bidder is the one with the highest bid. This is called strategic equivalence.
Both games – the Dutch auction and the sealed-bid auction – offer identical strategies tothe bidders, and given the strategies chosen by all bidders, produce the same payoff.
Such games should produce the same outcomes.
The strategic equivalence of the Dutch auction and the sealed-bid auction is a very
general result, which doesn’t depend on the nature of the values of the bidders (private
versus common) or the distribution of information (independent versus correlated).
Indeed, the prediction that the two games should produce the same outcome doesn’t
even depend on risk aversion, although that is more challenging to demonstrate.

7.6.4 Vickrey Auction
The strategic equivalence of the Dutch and sealed-bid auction suggests another fact:
there may be more than one way of implementing a given kind of auction. Such logic led
Nobel laureate William Vickrey (1914-1996) to design what has become known as the
Vickrey auction, which is a “second-price sealed-bid” auction. This auction is mostfamiliar because it is the foundation of eBay’s auction design. The Vickrey auction is asealed-bid auction, but with a twist: the high bidder wins, but pays the second-highestbid. This is why the Vickrey auction is called a second-price auction: the price is not thehighest bid, but the second-highest bid.
The Vickrey auction underlies the eBay outcome because when a bidder submits a bid in
the eBay auction, the current “going” price is not the highest bid, but the second-highestbid, plus a bid increment. Thus, up to the granularity of the bid increment, the basic
eBay auction is a Vickrey auction run over time.
As in the English auction, bidders with private values in a Vickrey auction have adominant strategy. Fix a bidder, with value v, and let p be the highest bid of the otherbidders. If the bidder bids b, the bidder earns profits ofif b < p⎧ 0⎪.
⎨⎪v − p if b > p⎩

106 Of course, a bidder who thinks losing is likely may wait for a lower price to formulate the bid, aconsideration ignored here. In addition, because the Dutch auction unfolds over time, bidders who
discount the future will bid slightly higher in a Dutch auction as a way of speeding it along, another small
effect that is ignored for simplicity.

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It is profitable for the bidder to win if v > p, and lose if v < p. To win when v > p, andlose if v < p, can be assured by bidding v. Essentially, there is no gain to bidding lessthan your value, because your bid doesn’t affect the price, only the likelihood of winning.
Bidding less than value causes the bidder to lose when the highest rival bid falls between
the bid and the value, which is a circumstance that the bidder would like to win.
Similarly, bidding more than value only creates a chance of winning when the price ishigher than the bidder’s value, in which case the bidder would prefer to lose.
Thus, bidders in a Vickrey auction have a dominant strategy to bid their value. This
produces the same outcome as the English auction, however, because the payment madeis the second-highest value, which was the price in the English auction. Thus, theVickrey auction is a sealed-bid implementation of the English auction when bidders
have private values, producing the same outcome, which is that the highest value bidder
wins, but pays the second-highest value.
Because the Vickrey auction induces bidders to bid their value, it is said to be demand
revealing. Unlike the English auction, in which the bidding stops when the pricereaches the second-highest value and thus doesn’t reveal the highest value, the Vickrey
auction reveals the highest value. In a controlled, laboratory setting, demand revelation
is useful, especially when the goal is to identify buyer values. Despite its theoreticalniceties, the Vickrey auction can be politically disastrous. Indeed, New Zealand soldradio spectrum with the Vickrey auction on the basis of advice by a naïve economist, andthe Vickrey auction created a political nightmare when a nationwide cellular license
received a high bid of $110 million, and a second-highest bid of $11 million. The
political problem was that the demand revelation showed that the government received
only about 10% of the value of the license, making the public quite irate and dominatingnews coverage at the time.107 Some smaller licenses sold for tenths of a percent of thehighest bid.
In a private values setting, the Vickrey auction, or the English auction, are much easieron bidders than a regular sealed-bid auction, because of the dominant strategy. The
sealed-bid auction requires bidders to forecast their rivals’ likely bids, and produces therisks of either bidding more than necessary, or losing the bidding. Thus, the regularsealed-bid auction has undesirable properties. Moreover, bidders in the sealed-bid
auction have an incentive to bribe the auctioneer to reveal the best bid by rivals, becausethat is useful information in formulating a bid. Such (illegal) bribery occurs from time
to time in government contracting.
On the other hand, the regular sealed-bid auction has an advantage over the other twothat it makes price-fixing more difficult. A bidder can cheat on a conspiracy and not be
detected until after the current auction is complete.
Another disadvantage of the sealed-bid auction is that it is easier to make certain kindsof bidding errors. In the U.S. PCS auctions, in which rights to use the radio spectrum
107 The Vickrey auction generally produces higher prices than regular sealed-bid auctions if bidders are

symmetric (share the same distribution of values), but is a poor choice of auction format when bidders are
not symmetric. Since the incumbent telephone company was expected to have a higher value than others,
the Vickrey auction was a poor choice for that reason as well.

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for cellular phones was sold for around $20 billion, one bidder, intending to bid$200,000, inadvertently bid $200,000,000. Such an error isn’t possible in an English
auction, because prices rise at a measured pace. Such errors have little consequence in a
Vickrey auction, since getting the price wrong by an order of magnitude requires two
bidders to make such errors.

7.6.5 Winner’s Curse"I paid too much for it, but it's worth it."-Sam Goldwyn
The analysis so far has been conducted under the restrictive assumption of private
values. In most contexts, bidders are not sure of the actual value of the item being sold,and information held by others is relevant to the valuation of the item. If I estimate anantique to be worth $5,000, but no one else is willing to bid more than $1,000, I mightrevise my estimate of the value down. This revision leads bidders to learn from theauction itself what the item is worth.
The early bidders in the sale of oil lease rights in the Gulf of Mexico (the outer
continental shelf) were often observed to pay more than the rights were worth. Thisphenomenon came to be known as the winner’s curse. The winner's curse is the factthat the bidder who most overestimates the value of the object wins the bidding. Naïve
bidders, who don’t adjust for the winner’s curse, will tend to lose money because they
only win the bidding when they’ve bid too high.
0.4

0.3

0.2

0.1

v -4
– 4σ

v-2
– 2σ

v

2 σ
v+2

4σ
v+4

Figure 7-9: Normally Distributed Estimates

Auctions, by their nature, select optimistic bidders. Consider the case of an oil lease(right to drill for and pump oil) that has an unknown value v. Different bidders willobtain different estimates of the value, and we may view these estimates as draws from anormal distribution illustrated in Figure 7-9. The estimates are correct on average,
which is represented by the fact that the distribution is centered on the true value v.
Thus a randomly chosen bidder will have an estimate that is too high as often as it is too

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low, and the average estimate of a randomly selected bidder will be correct. However,
the winner of an auction will tend to be bidder with the highest estimate, not a randomly
chosen bidder. The highest of five bidders will have an estimate that is too large 97% of
the time. The only way the highest estimate is not too large is if all the estimates are
below the true value. With ten bidders, the highest estimate is larger than the true value
with probability 99.9%, because the odds that all the estimates are less than the true
value is (½)10 = 0.1%. This phenomenon – that auctions tend to select the bidder withthe highest estimate, and the highest estimate is larger than the true value most of thetime – is characteristic of the winner’s curse.
A savvy bidder corrects for the winner’s curse. Such a correction is actually quite
straightforward when a few facts are available, and here a simplified presentation is
given. Suppose there are n bidders for a common value good, and the bidders receive
normally distributed estimates that are correct on average. Let σ be the standard
deviation of the estimates.108 Finally, suppose that no prior information is given about
the likely value of the good.
In this case, it is a straightforward matter to compute a correction for the winner’s curse.
Because the winning bidder will generally be the bidder with the highest estimate ofvalue, the winner’s curse correction should be the expected amount by which the highest
value exceeds the average value. This can be looked up in a table for the normal
distribution. The values are given for selected numbers n in Table 7-30. This shows, asa function of the number of bidders, how much each bidder should reduce their estimateof value to correct for the fact that auctions select optimistic bidders. The units are
standard deviations.
Table 7-30: Winner's Curse Correctionn
WCC (σ)n
WCC (σ)

1
0
20
1.87

2
.56
25
1.97

3
.85
50
2.25

4
1.03
100
2.51

5
1.16
500
3.04

10
1.54
1000
3.24

15
1.74
10,0003.85

For example, with one bidder, there is no correction, since it was supposed that theestimates are right on average. With two bidders, the winner’s curse correction is theamount that the higher of two will be above the mean, which turns out to be 0.56σ, alittle more than half a standard deviation. This is the amount which should be
subtracted from the estimate to insure that, when the bidder wins, the estimated value ison average correct. With four bidders, the highest is a bit over a whole standard
deviation. As is apparent from the table, the winner’s curse correction increases
relatively slowly after ten or fifteen bidders. With a million bidders, it is 4.86σ.

108 The standard deviation is a measure of the dispersion of the distribution, and is the square root of theaverage of the square of the difference of the random value and its mean. The estimates are also assumed
to be independently distributed around the true value. Note that estimating the mean adds an additional
layer of complexity.

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The standard deviation σ measures how much randomness or noise there is in theestimates. It is a measure of the average difference between the true value and theestimated value, and thus the average level of error. Oil companies know from their
history of estimation how much error arises in the company estimates. Thus, they cancorrect their estimates to account for the winner’s curse using their historicalinaccuracies.
Bidders who are imperfectly informed about the value of an item for sale are subject tolosses arising from the way auctions select the winning bidder. The winning bidder isusually the bidder with the highest estimate, and that estimate is too high on average.
The difference between the highest estimate and the average estimate is known as thewinner’s curse correction. The size of the winner’s curse correction is larger the morebidders there are but tends to grow slowly beyond a dozen or so bidders.
If the bidders have the same information on a common value item, they will generally
not earn profits on it. Indeed, there is a general principle that it is the privacy of
information, rather than the accuracy of information, that leads to profits. Bidders earn
profits on the information that they hold that is not available to others. Information
held by others will be built into the bid price and therefore not lead to profits.

7.6.6 Linkage
The U.S. Department of the Interior, when selling off-shore oil leases, not only takes anupfront payment (the winning bid) but also takes 1/6 of the oil that is eventually
pumped. Such a royalty scheme links the payment made to the outcome, and in a way,
shares risk, since the payment is higher when there is more oil. Similarly, a bookcontract provides an author with an upfront payment and a royalty. Many U.S.
Department of Defense purchases of major weapons systems involve cost-sharing,where the payments made pick up a portion of the cost. Purchases of ships, for example,
generally involve 50% to 70% cost sharing, which means the DOD pays a portion of cost
overruns. The contract for U.S. television broadcast rights for the summer Olympics inSeoul, South Korea, involved payments that depended on the size of the U.S. audience.
Royalties, cost-sharing and contingent payments generally link the actual payment tothe actual value, which is unknown at the time of the auction. Linkage shares risk,
which is a topic already considered in Section 7.5. But linkage does something else, too.
Linkage reduces the importance of estimates in the auction, replacing the estimates withactual values. That is, the price a bidder pays for an object, when fully linked to the true
value, is just the true value. Thus, linkage reduces the importance of estimation in theauction by taking the price out of the bidder’s hands, at least partially.
The linkage principle109 states that, in auctions where bidders are buyers, the expected
price rises the more the price is linked to the actual value. (In a parallel fashion, theexpected price in an auction where bidders are selling falls.) Thus, linking price to value
generally improves the performance of auctions. While this is a mathematically deep
result, an extreme case is straightforward to understand. Suppose the government ispurchasing by auction a contract for delivery of 10,000 gallons of gasoline each week for
109 The linkage principle, and much of modern auction theory, was developed by Paul Milgrom (1948 – ).

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the next year. Suppliers face risk in the form of gasoline prices; if the government buys
at a fixed price, the suppliers’ bids will build in a cushion to compensate for the risk, andfor the winner’s curse. In addition, because their estimates of future oil prices will
generally vary, they will earn profits based on their private information about the value.
In contrast, if the government buys only delivery and then pays for the cost of thegasoline, whatever it might be, any profits that the bidders earned based on their ability
to estimate gasoline prices evaporates. The overall profit level of bidders falls, and theoverall cost of the gasoline supply can fall. Of course, paying the cost of the gasoline
reduces the incentive of the supplier to shop around for the best price, and that agency
incentive effect must be balanced against the reduction in bidder profits from theauction to select a supplier.

7.6.7 Auction Design
We saw above that the English auction tends to reduce regret relative to sealed-bid
auctions, and that the linkage principle suggests tying payments to value where possible.
These are examples of auction design, in which auctions are designed to satisfy
objectives of the auction designer. Proper auction design should match the rules of theauction to the circumstances of the bidders and the goal of the seller. Some of theprinciples of auction design include:
•
•
•
•
•

Impose an appropriate reserve price or minimum bid
Use ascending price (English) auctions rather than sealed-bid
Reveal information about the value of the item
Conceal information about the extent of competition
Handicap bidders with a known advantage

However, many of these precepts change if the seller is facing a cartel. For example, it iseasier for bidders to collude in a sealed-bid auction than in an English auction; andreserve prices should be made relatively high.
Reserve prices (minimum bid) have several effects. They tend to force marginal bidders
to bid a bit higher, which increases bids of all bidders, reducing bidder profits.
However, reserve prices also lead to a failure to sell on occasion, and the optimal reserve
trades off this failure to sell against the higher prices. In addition, reserve prices may
reduce the incentive of bidders to investigate the sale, reducing participation, which isan additional negative consideration for a high reserve price.

Ascending price auctions like the English auction have several advantages. Suchauctions reduce the complexity of the bidder’s problem, because bidder’s can stretch
their calculations out over time, and because bidders can react to the behavior of others
and not plan for every contingency in advance. In addition, because bidders in an
English auction can see the behavior of others, there is a linkage created – the price paidby the winning bidder is influenced not just by that bidder’s information but also by the
information held by others, tending to drive up the price, which is an advantage for theseller.
One caveat to the selection of the English auction is that risk aversion doesn’t affect theoutcome in the private values case. In contrast, in a sealed-bid auction, risk aversion

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works to the advantage of the seller, because bidders bid a little bit higher than theywould have otherwise, to reduce the risk of losing. Thus, in the private values case, risk
averse bidders will bid higher in the sealed-bid auction than in the English auction.
When considering the revelation of information, there is always an issue of lying andmisleading. In the long-run, lying and misleading is found out, and thus the standard
approach is to ignore the possibility of lying. Making misleading statements is, in thelong-run, the same thing as silence, since those who repeatedly lie or mislead are
eventually discovered, and then not believed. Thus, in the long-run, a repeat seller has achoice of being truthful or silent. Because of the linkage principle, the policy of
revealing truthful information about the value of the good for sale dominates the policyof concealing information, because the revelation of information links the payment tothe actual outcome.
In contrast, revealing information about the extent of competition may not increase theprices. Consider the case where occasionally there are three bidders, and sometimes
only one. If the extent of competition is concealed, bidders will bid without knowing theextent of competition. If the bidders are risk neutral, it turns out that the revelation
doesn’t matter and the outcomes are the same on average. If, in contrast, bidders arerisk averse, the concealment of information tends to increase the bid prices, because therisk created by the uncertainty about the extent of competition works to the advantageof the seller. Of course, it may be difficult to conceal the extent of competition in the
English auction, suggesting a sealed-bid auction instead.
Bidders with a large, known advantage have several deleterious effects. For example,
incumbent telephone companies generally are willing to pay more for spectrum in theirareas than outsiders are. Advantaged bidders discourage participation of others, since
the others are likely to lose. This can result in a bidder with an advantage facing nocompetition and picking up the good cheaply. Second, rivals don’t present muchcompetition to the advantaged bidder, even if the rivals do participate. Consequently,
when a bidder has a large advantage over rivals, it is advantageous to handicap theadvantaged bidder, favoring the rivals. This handicapping encourages participation andlevels the playing field, forcing the advantaged bidder to bid more competitively to win.
A common means of favoring disadvantaged bidders is by the use of bidder credits. For
example, with a 20% bidder credit for disadvantaged bidders, a disadvantaged bidder
only has to pay 80% of the face amount of the bid. This lets such a bidder bid 25% more(since a $100 payment corresponds to a $125 bid) than they would have otherwise,
which makes the bidder a more formidable competitor. Generally, the ideal bidder
credit is less than the actual advantage of the advantaged bidder.
Auction design is an exciting development in applied industrial organization, in which
economic theory and experience is used to improve the performance of markets. The
U.S. Federal Communications Commissions auctions of spectrum, were the first major
instance of auction design in an important practical setting, and the auction design wascredited with increasing the revenue raised by the government substantially.

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7.7 Antitrust
In somewhat archaic language, a trust was a group of firms acting in concert, which is
now known as a cartel. The antitrust laws made such trusts illegal, and were intended toprotect competition. In the United States, these laws are enforced by the Department ofJustice’s Antitrust Division, and by the Federal Trade Commission. The United States
began passing laws during a time when some European nations were actually passing
laws forcing firms to join industry cartels. By and large, however, the rest of the world
has since copied the U.S. antitrust laws in one version or another.

7.7.1 Sherman Act
The Sherman Act, passed in 1890, is the first significant piece of antitrust legislation. It
has two main requirements:
Section 1. Trusts, etc., in restraint of trade illegal; penalty
Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of tradeor commerce among the several States, or with foreign nations, is declared to be illegal. Every
person who shall make any contract or engage in any combination or conspiracy hereby declared
to be illegal shall be deemed guilty of a felony, and, on conviction thereof, shall be punished byfine not exceeding $10,000,000 if a corporation, or, if any other person, $350,000, or byimprisonment not exceeding three years, or by both said punishments, in the discretion of thecourt.
Section 2. Monopolizing trade a felony; penalty
Every person who shall monopolize, or attempt to monopolize, or combine or conspire with anyother person or persons, to monopolize any part of the trade or commerce among the several
States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shallbe punished by fine not exceeding $10,000,000 if a corporation, or, if any other person,$350,000, or by imprisonment not exceeding three years, or by both said punishments, in thediscretion of the court.110

The phrase “in restraint of trade” is challenging to interpret. Early enforcement of theSherman Act followed the “Peckham Rule,” named for noted Justice Rufus Peckham,
which interpreted the Sherman Act to prohibit contracts that reduced output or raised
prices, while permitting contracts that would increase output or lower prices.
In one of the most famous antitrust cases ever, the United States sued Standard Oil,which had monopolized the transportation of oil from Pennsylvania to the east coast
cities of the United States, in 1911.
The exact meaning of the Sherman Act had not been settled at the time of the Standard
Oil case. Indeed, Supreme Court Justice Edward White suggested that, because
contracts by their nature set the terms of trade and thus restrain trade to those terms
and Section 1 makes contracts restraining trade illegal, one could read the Sherman Act
to imply all contracts were illegal. Chief Justice White concluded that, since Congress
couldn’t have intended to make all contracts illegal, the intent must have been to makeunreasonable contracts illegal, and therefore concluded that judicial discretion isnecessary in applying the antitrust laws. In addition, Chief Justice White noted that the
110 The current fines were instituted in 1974; the original fines were $5,000, with a maximum

imprisonment of one year. The Sherman Act is 15 U.S.C. § 1.

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act makes monopolizing illegal, but doesn’t make having a monopoly illegal. Thus,
Chief Justice White interpreted the act to prohibit certain acts leading to monopoly, but
not monopoly itself.
The legality of monopoly was further clarified through a series of cases, starting with the1945 Alcoa case, in which the United States sued to break up the aluminum monopoly
Alcoa. The modern approach involves a two-part test. First, does the firm havemonopoly power in a market? If not, no monopolization has occurred and there is no
issue for the court. Second, if so, did the firm use illegal tactics to extend or maintainthat monopoly power? In the language of a later decision, did the firm engage in “thewillful acquisition or maintenance of that power as distinguished from growth ordevelopment as a consequence of superior product, business acumen or historic
accident?” (U.S. v. Grinnell, 1966.)
There are several important points that are widely misunderstood and even misreported
in the press. First, the Sherman Act does not make having a monopoly illegal. Indeed,
three legal ways of obtaining a monopoly – a better product, running a better business,or luck – are spelled out in one decision. It is illegal to leverage that existing monopoly
into new products or services, or to engage in anticompetitive tactics to maintain themonopoly. Moreover, you must have monopoly power currently to be found guilty ofillegal tactics.
When the Department of Justice sued Microsoft over the incorporation of the browser
into the operating system and other acts (including contracts with manufacturers
prohibiting the installation of Netscape), the allegation was not that Windows was anillegal monopoly. The DOJ alleged Microsoft was trying to use its Windows monopoly
to monopolize another market, the internet browser market. Microsoft’s defense was
two-fold. First, it claimed not to be a monopoly, citing the 5% share of Apple. (Linux
had a negligible share at the time.) Second, it alleged a browser was not a separate
market but an integrated product necessary for the functioning of the operating system.
This defense follows the standard “two-part test.”
Microsoft’s defense brings up the question of “what is a monopoly?” The simple answer
to this question depends on whether there are good substitutes in the minds ofconsumers – will they substitute to an alternate product in the event of some badbehavior by the seller? By this test, Microsoft had an operating system monopoly inspite of the fact that there was a rival, because for most consumers, Microsoft could
increase the price, tie the browser and MP3 player to the operating system, or evendisable Word Perfect, and the consumers would not switch to the competing operating
system. However, Microsoft’s second defense, that the browser wasn’t a separate
market, is a much more challenging defense to assess.
The Sherman Act provides criminal penalties, which are commonly applied in pricefixing cases, that is, when groups of firms join together and collude to raise prices.
Seven executives of General Electric and Westinghouse, who colluded in the late 1950s
to set the prices of electrical turbines, spent several years in jail each, and there was over$100 million in fines. In addition, Archer Daniels Midland executives went to jail after
their 1996 conviction for fixing the price of lysine, which approximately doubled the

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price of this common additive to animal feed. When highway contractors are convictedof bid-rigging, generally the conviction is under the Sherman Act, for monopolizing theirmarket.

7.7.2 Clayton Act
Critics of the Sherman Act, including famous “trust-buster” and President Teddy
Roosevelt, felt the ambiguity of the Sherman Act was an impediment to its use and that
the United States needed a more detailed law setting out a list of illegal activities. The
Clayton Act, 15 U.S.C. §§ 12-27, was passed in 1914 and it adds detail to the Sherman
Act. The same year, the FTC Act was passed, creating the Federal Trade Commission,
which has authority to enforce the Clayton Act, as well as engage in other consumer
protection activities.
The Clayton Act does not have criminal penalties, but does allow for monetary penalties
that are three times as large as the damage created by the illegal behavior.
Consequently, a firm, motivated by the possibility of obtaining a large damage award,
may sue another firm for infringement of the Clayton Act. A plaintiff must be directly
harmed to bring such a suit. Thus, customers who paid higher prices, or firms drivenout of business by exclusionary practices are permitted to sue under the Clayton Act.
When Archer Daniels Midland raised the price of lysine, pork producers who bought
lysine would have standing to sue, while final pork consumers who paid higher prices
for pork, but who didn’t directly buy lysine, would not.
Highlights of the Clayton Act include:•••

Section 2, which prohibits price discrimination that would lessen
competition,
Section 3, which prohibits exclusionary practices that lessen competition,such as tying, exclusive dealing and predatory pricing,
Section 7, which prohibits share acquisition or merger that would lessen
competition or create a monopoly

The language “lessen competition” is generally understood to mean that a significant
price increase becomes possible – that is, competition has been harmed if the firms in
the industry can successfully increase prices.
Section 2 is also known as ‘Robinson-Patman’ because of a 1936 amendment by thatname. It prohibits price discrimination that lessens competition. Thus, pricediscrimination to final consumers is legal under the Clayton Act; the only way pricediscrimination can lessen competition is if one charges different prices to different
businesses. The logic of the law was articulated in the 1948 Morton Salt decision, whichconcluded that lower prices to large chain stores gave an advantage to those stores, thus
injuring competition in the grocery market. The discounts in that case were not costbased, and it is permissible to charge different prices based on costs.
Section 3 rules out practices that lessen competition. A manufacturer who also offers
service for the goods it sells may be prohibited from favoring its own service
organization. Generally manufacturers may not require the use of the manufacturer’s

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own service. Moreover, an automobile manufacturer can’t require the use of
replacement parts made by the manufacturer, and many car manufacturers have lost
lawsuits on this basis. In an entertaining example, Mercedes prohibited Mercedes
dealers from buying Bosch parts directly from Bosch, even though Mercedes itself wasselling Bosch parts to the dealers. This practice was ruled illegal because the quality ofthe parts was the same as Mercedes (indeed, identical), so Mercedes’ action lessened
competition.
Predatory pricing involves pricing below cost in order to drive a rival out of business. It
is relatively difficult for a firm to engage in predation, simply because it only makes
sense if, once the rival is eliminated, the predatory firm can then increase its prices andrecoup the losses incurred. The problem is that once the prices go up, entry becomes
attractive; what keeps other potential entrants away? One answer is reputation: areputation for a willingness to lose money in order to dominate market could deter
potential entrants. Like various rare diseases that happen more often on TV than in thereal world (e.g. Tourette’s syndrome), predatory pricing probably happens more often in
textbooks than in the real world.111
The Federal Trade Commission also has authority to regulate mergers that would lessen
competition. As a practical matter, the Department of Justice and the Federal Trade
Commission divide responsibility for evaluating mergers. In addition, other agencies
may also have jurisdiction over mergers and business tactics. The Department of
Defense has oversight of defense contractors, using a threat of “we’re your only
customer.” The Federal Communications Commission has statutory authority overtelephone and television companies. The Federal Reserve Bank has authority overnational and most other banks.
Most states have antitrust laws as well, and can challenge mergers that would affectcommerce in the state. In addition, attorneys general of many states may join the
Department of Justice or the Federal Trade Commission is suing to block a merger or inother antitrust actions, or sue independently. For example, many states joined theDepartment of Justice in its lawsuit against Microsoft. Forty-two states jointly sued the
major record companies over their “minimum advertised prices” policies, which thestates argued resulted in higher compact disc prices. The “MAP” case settlement
resulted in a modest payment to compact disc purchasers. The Federal Trade
Commission had earlier extracted an agreement to stop the practice.

7.7.3 Price-Fixing
Price-fixing, which is called bid-rigging in a bidding context, involves a group of firms
agreeing to increase the prices they charge and restrict competition against each other.
The most famous example of price-fixing is probably the “Great Electrical Conspiracy”
in which GE and Westinghouse (and a smaller firm, Allis-Chalmers and many others)
fixed the prices of turbines used for electricity generation. Generally these turbines
were the subject of competitive (or in this case not-so-competitive) bidding, and one
way that the companies set the prices was to have a designated winner for each bidding
situation, and using a price book to provide identical bids by all companies. An amusing
111 Economists have argued that American Tobacco, Standard Oil and A.T. & T. each engaged in predationin their respective industries.

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element of the price-fixing scheme was the means by which the companies identified thewinner in any given competition: it used the phase of the moon. The phase of the moon
determined the winner and each company knew what to bid based on the phase of themoon. Executives from the companies met often to discuss terms of the price-fixing
arrangement, and the Department of Justice acquired a great deal of physical evidence
in the process of preparing its 1960 case. Seven executives went to jail and hundreds ofmillions of dollars in fines were paid.
Most convicted price-fixers are from small firms. The turbine conspiracy and the Archer
Daniels Midland lysine conspiracy are unusual. (There is evidence that large vitamins
manufacturers conspired in fixing the price of vitamins in many nations of the world.)
Far more common conspiracies involve highway and street construction firms,
electricians, water and sewer construction companies or other “owner operated”
businesses. Price-fixing seems most common when owners are also managers and there
are a small number of competitors in a given region.
As a theoretical matter, it should be difficult for a large firm to motivate a manager toengage in price-fixing. The problem is that the firm can’t write a contract promising themanager extraordinary returns for successfully fixing prices because such a contract
itself would be evidence and moreover implicate higher management. Indeed, Archer
Daniels Midland executives paid personal fines of $350,000 as well as each serving two
years in jail. Thus, it is difficult to offer a substantial portion of the rewards of pricefixing to managers, in exchange for the personal risks the managers would face fromengaging in price-fixing. Most of the gains of price-fixing accrue to shareholders of large
companies, while large risks and costs fall on executives. In contrast, for smaller
businesses in which the owner is the manager, the risks and rewards are borne by thesame person, and thus the personal risk more likely to be justified by the personal
return.
We developed earlier a simple theory of cooperation, in which the grim trigger strategy
was used to induce cooperation. Let us apply that theory to price-fixing. Suppose that
there are n firms, and that they share the monopoly profits πm equally if they collude. If
one firm cheats, that firm can obtain the entire monopoly profits until the others react.
This is clearly the most the firm could get from cheating. Once the others react, thecollusion breaks down and the firms earn zero profits (the competitive level) from thenon. The cartel is feasible if 1/n of the monopoly profits forever is better than the wholemonopoly profits for a short period of time. Thus, cooperation is sustainable if:πmπ= m (1 + δ + δ2 + ...) ≥ πm .
n(1 − δ)n
The left hand side gives the profits from cooperating – the present value of the 1/n shareof the monopoly profits. In contrast, if a firm chooses to cheat, it can take at most themonopoly profits, but only temporarily. How many firms will this sustain? The
1. Suppose the annual interest rate is 5% and theinequality simplifies to n ≤1−δreaction time is 1 week – that is, a firm that cheats on the cooperative agreement

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sustains profits for a week, after which time prices fall to the competitive level. In thiscase, 1-δ is a week’s worth of interest (δ is the value of money received in a week) and1

therefore δ = 0.95 52 = .999014 . According to standard theory, the industry with aweek-long reaction time should be able to support cooperation with up to a thousand
firms!
There are a large variety of reasons why this theory fails to work very well empirically,
including that some people are actually honest and don’t break the law, but we will focus
on one game-theoretic reason here. The cooperative equilibrium is not the only
equilibrium, and there are good reasons to think that full cooperation is unlikely topersist. The problem is the prisoner’s dilemma itself: generally the first participant toturn in the conspiracy can avoid jail. Thus, if one member of a cartel is uncertain
whether the other members of a price-fixing conspiracy are contacting the Departmentof Justice, that member may race to the DOJ – the threat of one confession may cause
them all to confess in a hurry. A majority of the conspiracies that are prosecuted arise
because someone – a member who feels guilty, a disgruntled ex-spouse of a member, or
perhaps a member who thinks another member is suffering pangs of conscience – turns
them in. Lack of confidence in the other members creates a self-fulfilling prophecy.
Moreover, cartel members should lack confidence in the other cartel members who are,after all, criminals.
On average, prosecuted conspiracies were about seven years old when they were caught.
Thus, there is about a 15% chance annually of a breakdown of a conspiracy, at least
among those that are eventually caught.

7.7.4 Mergers
The U.S. Department of Justice and the Federal Trade Commission share responsibility
for evaluating mergers. Firms with more than $50 million in assets are required underthe Hart-Scott-Rodino Act to file an intention to merge with the government. The
government then has a limited amount of time to either approve the merger or request
more information (called a second request). Once the firms have complied with thesecond request, the government again has a limited amount of time before it either
approves the merger or sues to block it. The agencies themselves don’t stop the merger,
but instead sue to block the merger, asking a federal judge to prevent the merger as a
violation of one of the antitrust laws. Mergers are distinct from other violations,because they have not yet occurred at the time the lawsuit is brought, so there is no
threat of damages or criminal penalties; the only potential penalty imposed on themerging parties is that the proposed merger may be blocked.
Many proposed mergers result in settlements. As part of the settlement associated with
GE’s purchase of RCA in 1986, a small appliance division was sold to Black & Decker,
thereby maintaining competition in the small kitchen appliance market. In the 1999
merger of oil companies Exxon and Mobil, a California refinery, shares in oil pipelines
connecting the gulf with the northeast, and thousands of gas stations were sold to othercompanies. The 1996 merger of Kimberley-Clark and Scott Paper would have resulted
in a single company with over 50% of the facial tissue and baby wipes markets, and inboth cases divestitures of production capacity and the “Scotties” brand name preserved

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competition in the markets. Large bank mergers, oil company mergers and other large
companies usually present some competitive concerns, and the majority of these cases
are solved by divestiture of business units to preserve competition.
A horizontal merger is a merger of competitors, such as Exxon and Mobil or two banks
located in the same city. In contrast, a vertical merger is a merger between an input
supplier and input buyer. The attempt by book retailer Barnes and Noble to purchasethe intermediary Ingram, a company that buys books from publishers and sells toretailers but didn’t directly sell to the public, would have resulted in a vertical merger.
Similarly, Disney is a company that sells programs to television stations (among otheractivities), so its purchase of TV network ABC was a vertical merger. The AOL--Time
Warner merger involved several vertical relationships. For example, Time Warner is alarge cable company, and cable represents a way for AOL to offer broadband services.
In addition, Time Warner is a content provider, and AOL delivers content to internet
subscribers.
Vertical mergers raise two related problems: foreclosure and raising rivals’ costs.
Foreclosure refers to denying access to necessary inputs. Thus, the AOL--Time Warnermerger threatened rivals to AOL internet service (like EarthLink) with an inability tooffer broadband services to consumers with Time Warner cable. This potentially injurescompetition in the internet service market, forcing Time Warner customers to use AOL.
In addition, by bundling Time Warner content and AOL internet service, users could beforced to purchase AOL internet service in order to have access to Time Warner content.
Both of these threaten foreclosure of rivals, and both were resolved to the government’s
satisfaction by promises that the merged firm would offer equal access to rivals.
Raising rivals’ costs is a softer version of foreclosure. Rather than deny access tocontent, AOL--Time Warner could instead make the content available underdisadvantageous terms. For example, American Airlines developed the Sabre
computerized reservation system, which was used by about 40% of travel agents. Thissystem charged airlines, rather than travel agents, for bookings. Consequently,
American Airlines had a mechanism for increasing the costs of its rivals, by increasing
the price of bookings on the Sabre system. The advantage to American was not justincreased revenue of the Sabre system but also the hobbling of airline rivals. Similarly,banks offer free use of their own automated teller machines (ATMs), but charge thecustomers of other banks. Such charges raise the costs of customers of other banks,
thus making other banks less attractive, and hence providing an advantage in thecompetition for bank customers.
The Department of Justice and the Federal Trade Commission periodically issue
horizontal merger guidelines, which set out how mergers will be evaluated. This is athree step procedure for each product that the merging companies have in common.
The procedure starts by identifying product markets. To identify a product market, startwith a product or products produced by both companies. Then ask if the merged parties
can profitably raise price by a small but significant and non-transitory increase in
price, also known as a “SSNIP,” pronounced ‘snip.’ A SSNIP is often taken to be a 5%
price increase, which must prevail for several years. If the companies can profitably

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increase price by a SSNIP, then they are judged to have monopoly power and consumers
will be directly harmed by the merger. (This is known as a unilateral effect, because themerging parties can increase price unilaterally after the merger is consummated.) If
they can’t increase prices, then an additional product has to be added to the group;
generally the best substitute is added. Ask whether a hypothetical monopoly seller ofthese three products can profitably raise price. If so, an antitrust market has been
identified; if not, yet another substitute product must be added. The process stops
adding products when enough substitutes have been identified which, if controlled by ahypothetical monopoly, would have their prices significantly increased.
The logic of product market definition is that, if a monopoly wouldn’t increase price in ameaningful way, that there is no threat to consumers – any price increase won’t be large
or won’t last. The market is defined by the smallest set of products for which consumers
can be harmed. The test is also known as the hypothetical monopoly test.
The second step is to identify a geographic market. The process starts with an area inwhich both companies sell, and asks if the merged company has an incentive to increaseprice by a SSNIP. If so, that geographic area is a geographic market. If not, it is becauseof buyers substituting outside the area to buy cheaply, and the area must be expanded.
For example, owning all the gas stations on a corner doesn’t let one increase priceprofitably because an increase in price leads to substitution to stations a few blocks
away. If one company owned all the stations in a half mile radius, would it be profitable
to increase price? Probably not, as there would still be significant substitution to moredistant stations. Suppose, instead, that one owned all the stations for a 15 mile radius.
Then an increase in price in the center of the area is not going to be thwarted by too
much substitution outside the area, and the likely outcome is that prices would be
increased by such a hypothetical monopoly. In this case, a geographic market has been
identified. Again, parallel to the product market definition, a geographic market is thesmallest area in which competitive concerns would be raised by a hypotheticalmonopoly. In any smaller area, attempts to increase price are defeated by substitution
to sellers outside the area.
The product and geographic markets together are known as a relevant antitrust market,
relevant for the purposes of analyzing the merger.
The third and last step of the procedure is to identify the level of concentration in eachrelevant antitrust market. The Hirschman-Herfindahl index, or HHI, is used for thispurpose. The HHI is the sum of the squared market shares of the firms in the relevant
antitrust market, and is justified because it measures the price – cost margin in the
Cournot model. Generally in practice the shares in percent are used, which makes thescale range from 0 to 10,000. For example, if one firm has 40%, one 30%, one 20% andthe remaining firm 10%, the HHI is402 + 302 + 202 + 102 = 3,000.
Usually, anything over 1800 is considered “very concentrated,” and anything over 1000
is “concentrated.”

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Suppose firms with shares x and y merge, and nothing in the industry changes besides
the combining of those shares. Then the HHI goes up by (x + y)2 – x2 – y2 = 2xy. Thisis referred to as the change in the HHI. The merger guidelines suggest the government
will likely challenge mergers with (i) a change of 100 and a concentrated post-merger
HHI, or (ii) a change of 50 and a very concentrated post-merger HHI. It is moreaccurate to understand the merger guidelines to say that the government likely won’t
challenge unless either (i) or (ii) is met. Even if the post-merger HHI suggests a very
concentrated industry, the government is unlikely to challenge is the change in the HHI
is less than 50.
Several additional factors affect the government’s decision. First, if the firms are
already engaging in price discrimination, the government may define quite small
geographic markets, and possibly as small as a single customer. Second, if one firm isvery small (less than a percent) and the other not too large (less than 35%) the merger
may escape scrutiny because the effect on competition is likely small. Third, if one firmis going out of business, the merger may be allowed as a means of keeping the assets in
the industry. Such was the case with Greyhound’s takeover of Trailways, a merger tomonopoly of the only intercity bus companies in the United States.
Antitrust originated in the United States and the United States remains the mostvigorous enforcer of antitrust laws. However, the European Union has recently taken amore aggressive antitrust stance and in fact blocked mergers that obtained tentative
U.S. approval, such as General Electric and Honeywell.
Antitrust is, in some sense, the applied arm of oligopoly theory. Because real situations
are so complex, the application of oligopoly theory to antitrust analysis is often
challenging, and we have only scratched the surface of many of the more subtle issues oflaw and economics in this text. For example, intellectual property, patents andstandards all have their own distinct antitrust issues.

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8 Index
8.1 List of Figures
FIGURE 2-1: THE DEMAND CURVE ...................................................................................................................................................................2-9
FIGURE 2-2: CONSUMER SURPLUS .................................................................................................................................................................2-11
FIGURE 2-3: AN INCREASE IN DEMAND .......................................................................................................................................................2-12
FIGURE 2-4: THE SUPPLY CURVE ....................................................................................................................................................................2-14
FIGURE 2-5: SUPPLIER PROFITS ......................................................................................................................................................................2-15
FIGURE 2-6: AN INCREASE IN SUPPLY ..........................................................................................................................................................2-16
FIGURE 2-7: MARKET DEMAND .......................................................................................................................................................................2-19
FIGURE 2-8: EQUILIBRATION...........................................................................................................................................................................2-21
FIGURE 2-9: AN INCREASE IN DEMAND .......................................................................................................................................................2-23
FIGURE 2-10: AN INCREASE IN SUPPLY ........................................................................................................................................................2-24
FIGURE 2-11: PRICE OF STORAGE ....................................................................................................................................................................2-25
FIGURE 2-12: ELASTICITIES FOR LINEAR DEMAND ..................................................................................................................................2-29
FIGURE 2-13: THE PRODUCTION POSSIBILITIES FRONTIER .................................................................................................................2-33
FIGURE 2-14: TWO PRODUCTION POSSIBILITIES FRONTIERS ..............................................................................................................2-34
FIGURE 2-15: JOINT PPF .....................................................................................................................................................................................2-35
FIGURE 3-1: US RESIDENT POPULATION ......................................................................................................................................................3-41
FIGURE 3-2: US URBAN AND WHITE POPULATION ...................................................................................................................................3-42
FIGURE 3-3: POPULATION PROPORTIONS BY AGE GROUP ....................................................................................................................3-42
FIGURE 3-4: PROPORTION OF POPULATION UNDER AGE FIVE ...........................................................................................................3-43
FIGURE 3-5: US LIFE EXPECTANCY AT BIRTH.............................................................................................................................................3-44
FIGURE 3-6: US IMMIGRANT POPULATION, IN PERCENT, BY CONTINENT OF ORIGIN ................................................................3-44
FIGURE 3-7: NATIONAL ORIGIN OF IMMIGRANTS, 1900-2000 ..............................................................................................................3-45
FIGURE 3-8: MALE MARITAL STATUS (PERCENTAGES) ...........................................................................................................................3-45
FIGURE 3-9: FEMALE MARITAL STATUS (PERCENT) ................................................................................................................................3-46
FIGURE 3-10: PERCENT OF BIRTHS TO UNWED MOTHERS ....................................................................................................................3-46
FIGURE 3-11: PERCENT OF BIRTHS TO WOMEN AGE 19 OR LESS .........................................................................................................3-47
FIGURE 3-12: EDUCATIONAL ATTAINMENT IN YEARS (PERCENT OF POPULATION) ....................................................................3-47
FIGURE 3-13: GRADUATION RATES ................................................................................................................................................................3-48
FIGURE 3-14: HOUSEHOLD OCCUPANCY ......................................................................................................................................................3-49
FIGURE 3-15: PROPORTION OF HOUSEHOLDS BY TYPE ..........................................................................................................................3-50
FIGURE 3-16: PERCENTAGE OF INCARCERATED RESIDENTS ................................................................................................................3-50
FIGURE 3-17: INCOME SHARES FOR THREE QUINTILES .........................................................................................................................3-51
FIGURE 3-18: FAMILY INCOME.........................................................................................................................................................................3-51
FIGURE 3-19: FAMILY INCOME, CUMULATIVE PERCENTAGE CHANGE .............................................................................................3-52
FIGURE 3-20: BLACK FAMILY INCOME AS A PERCENTAGE OF WHITE INCOME .............................................................................3-53
FIGURE 3-21: CONSUMER PRICE INDEX (1982 = 100) ...............................................................................................................................3-53
FIGURE 3-22: CPI PERCENT CHANGES ..........................................................................................................................................................3-54
FIGURE 3-23: FOOD EXPENDITURE AS PERCENT OF INCOME, AND PROPORTION SPENT OUT................................................3-55
FIGURE 3-24: AFTER TAX INCOME SHARES ................................................................................................................................................3-55
FIGURE 3-25: OUTPUT, CONSUMPTION, INVESTMENT AND GOVERNMENT ...................................................................................3-57
FIGURE 3-26: MAJOR GDP COMPONENTS IN LOG SCALE .......................................................................................................................3-58
FIGURE 3-27: PER CAPITA INCOME AND CONSUMPTION .......................................................................................................................3-58
FIGURE 3-28: CONSUMPTION, INVESTMENT AND GOVERNMENT (% GDP) .....................................................................................3-59
FIGURE 3-29: US AGRICULTURAL OUTPUT, 1982 CONSTANT DOLLARS ............................................................................................3-60
FIGURE 3-30: AGRICULTURAL OUTPUT, TOTAL AND PER WORKER (1982 $, LOG SCALE)...........................................................3-60
FIGURE 3-31: MAJOR NON-AGRICULTURAL SECTORS OF US ECONOMY, PERCENT OF GDP ......................................................3-61
FIGURE 3-32: AIR TRAVEL PER CAPITA .........................................................................................................................................................3-62
FIGURE 3-33: ELECTRICITY PRODUCTION (M KWH) ................................................................................................................................3-62
FIGURE 3-34: ENERGY USE (QUADRILLION BTUS) ...................................................................................................................................3-63
FIGURE 3-35: CARS PER THOUSAND POPULATION AND MILES DRIVEN PER CAPITA ..................................................................3-63
FIGURE 3-36: PERCENTAGE OF POPULATION EMPLOYED (MILITARY & PRISONERS EXCLUDED) ..........................................3-64
FIGURE 3-37: LABOR FORCE PARTICIPATION RATES, ALL WOMEN AND MARRIED WOMEN ....................................................3-64
FIGURE 3-38: DEFENSE AS A PERCENTAGE OF GDP .................................................................................................................................3-65
FIGURE 3-39: FEDERAL EXPENDITURES AND REVENUES (PERCENT OF GDP) ...............................................................................3-66
FIGURE 3-40: FEDERAL, STATE & LOCAL AND TOTAL GOVERNMENT RECEIPTS (% GDP) ..........................................................3-66
FIGURE 3-41: FEDERAL, REGIONAL AND TOTAL EXPENDITURES AS A PERCENT OF GDP ..........................................................3-67
FIGURE 3-42: FEDERAL EXPENDITURES, ON AND OFF BUDGET, PERCENT OF GDP.....................................................................3-67
FIGURE 3-43: FEDERAL AND REGIONAL GOVERNMENT EMPLOYMENT (000S) .............................................................................3-68
FIGURE 3-44: MAJOR EXPENDITURES OF THE FEDERAL GOVERNMENT ........................................................................................3-68
FIGURE 3-45: MAJOR TRANSFER PAYMENTS (% OF FEDERAL BUDGET)...........................................................................................3-69
FIGURE 3-46: SOCIAL SECURITY REVENUE AND EXPENDITURE, $ MILLIONS ...............................................................................3-69
FIGURE 3-47: FEDERAL DEBT, TOTAL AND PERCENT OF GDP ..............................................................................................................3-70
FIGURE 3-48: FEDERAL SPENDING ON R&D, AS A PERCENT OF GDP .................................................................................................3-72
FIGURE 3-49: SOURCES OF FEDERAL GOVERNMENT REVENUE..........................................................................................................3-73
FIGURE 3-50: TOTAL IMPORTS AND EXPORTS AS A PROPORTION OF GDP ......................................................................................3-74

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FIGURE 3-51: US TRADE IN GOODS AND SERVICES .................................................................................................................................. 3-74
FIGURE 3-52: INCOME AND PAYMENTS AS A PERCENT OF GDP .......................................................................................................... 3-75
FIGURE 3-53: POSTWAR INDUSTRIAL PRODUCTION AND RECESSIONS........................................................................................... 3-77
FIGURE 3-54: PERCENTAGE OF THE POPULATION EMPLOYED ........................................................................................................... 3-77
FIGURE 3-55: INDUSTRIAL FACTORY CAPACITY UTILITZATION (SOURCE: FRED) ........................................................................ 3-78
FIGURE 4-1: COBB-DOUGLAS ISOQUANTS ................................................................................................................................................... 4-82
FIGURE 4-2: THE PRODUCTION FUNCTION................................................................................................................................................ 4-82
FIGURE 4-3: FIXED PROPORTIONS ................................................................................................................................................................ 4-83
FIGURE 4-4: PERFECT SUBSTITUTES ............................................................................................................................................................ 4-84
FIGURE 4-5: PROFIT-MAXIMIZING LABOR INPUT .................................................................................................................................... 4-86
FIGURE 4-6: TANGENCY AND ISOQUANTS .................................................................................................................................................. 4-94
FIGURE 4-7: SHORT-RUN SUPPLY .................................................................................................................................................................. 4-98
FIGURE 4-8: AVERAGE AND MARGINAL COSTS ......................................................................................................................................... 4-99
FIGURE 4-9: INCREASED PLANT SIZE ......................................................................................................................................................... 4-100
FIGURE 4-10: LONG-RUN EQUILIBRIUM ................................................................................................................................................... 4-105
FIGURE 4-11: A SHIFT IN DEMAND ................................................................................................................................................................. 4-106
FIGURE 4-12: RETURN TO LONG-RUN EQUILIBRIUM ........................................................................................................................... 4-106
FIGURE 4-13: A DECREASE IN DEMAND ..................................................................................................................................................... 4-107
FIGURE 4-14: A BIG DECREASE IN DEMAND ............................................................................................................................................. 4-108
FIGURE 4-15: A DECREASE IN SUPPLY .......................................................................................................................................................... 4-109
FIGURE 4-16: EQUILIBRIUM WITH EXTERNAL SCALE ECONOMY .................................................................................................... 4-110
FIGURE 4-17: DECREASE IN DEMAND ......................................................................................................................................................... 4-111
FIGURE 4-18: LONG-RUN AFTER A DECREASE IN DEMAND ................................................................................................................ 4-111
FIGURE 4-19: DRAM MARKET ........................................................................................................................................................................ 4-113
FIGURE 4-20: DRAM REVENUE CYCLE ....................................................................................................................................................... 4-113
FIGURE 4-21: INVESTMENT STRIKE PRICE GIVEN INTEREST RATE R IN PERCENT.................................................................... 4-123
FIGURE 4-22 INVESTMENT STRIKE PRICE GIVEN INTEREST RATE R IN PERCENT .................................................................... 4-124
FIGURE 4-23: OPTIMAL SOLUTION FOR T ................................................................................................................................................. 4-129
FIGURE 4-24: THE PORSCHE SPEEDSTER.................................................................................................................................................. 4-130
FIGURE 4-25: $500 CONFEDERATE STATES BILL .................................................................................................................................... 4-134
FIGURE 4-26: WESTERN ELECTRIC MODEL 500 TELEPHONE ............................................................................................................ 4-135
FIGURE 4-27: PRICES OVER A CYCLE FOR SEASONAL COMMODITIES............................................................................................. 4-137
FIGURE 4-28: LOG OF PRICE OF GOLD OVER TIME ................................................................................................................................ 4-138
FIGURE 5-1: BUDGET SET ................................................................................................................................................................................ 5-141
FIGURE 5-2: EFFECT OF AN INCREASE IN PRICE ON THE BUDGET .................................................................................................. 5-142
FIGURE 5-3: AN INCREASE IN INCOME ...................................................................................................................................................... 5-142
FIGURE 5-4: UTILITY ISOQUANTS ................................................................................................................................................................ 5-144
FIGURE 5-5: CONVEX PREFERENCES .......................................................................................................................................................... 5-145
FIGURE 5-6: GRAPHICAL UTILITY MAXIMIZATION ............................................................................................................................... 5-147
FIGURE 5-7: “CONCAVE” PREFERENCES, PREFER BOUNDARIES ...................................................................................................... 5-148
FIGURE 5-8: ISOQUANTS FOR A BLISS POINT .......................................................................................................................................... 5-150
FIGURE 5-9: SUBSTITUTION WITH AN INCREASE IN PRICE ............................................................................................................... 5-151
FIGURE 5-10: SUBSTITUTION EFFECT ........................................................................................................................................................ 5-152
FIGURE 5-11: ENGEL CURVE ........................................................................................................................................................................... 5-155
FIGURE 5-12: BACKWARD BENDING – INFERIOR GOOD ...................................................................................................................... 5-156
FIGURE 5-13: INCOME AND SUBSTITUTION EFFECTS ........................................................................................................................... 5-157
FIGURE 5-14: QUASILINEAR ISOQUANTS................................................................................................................................................... 5-159
FIGURE 5-15: HOURS PER WEEK ................................................................................................................................................................... 5-163
FIGURE 5-16: HOUSE PRICE GRADIENT ..................................................................................................................................................... 5-166
FIGURE 5-17: BORROWING AND LENDING ................................................................................................................................................ 5-170
FIGURE 5-18: INTEREST RATE CHANGE ..................................................................................................................................................... 5-171
FIGURE 5-19: INTEREST RATE INCREASE ON LENDERS ....................................................................................................................... 5-172
FIGURE 5-20: DIFFERENT RATES FOR BORROWING AND LENDING ............................................................................................... 5-173
FIGURE 5-21: THE EFFECT OF A TRANSITORY INCOME INCREASE .................................................................................................. 5-173
FIGURE 5-22: EXPECTED UTILITY AND CERTAINTY EQUIVALENTS................................................................................................. 5-175
FIGURE 5-23: THE EDGEWORTH BOX ......................................................................................................................................................... 5-182
FIGURE 5-24: AN EFFICIENT POINT............................................................................................................................................................. 5-183
FIGURE 5-25: THE CONTRACT CURVE ........................................................................................................................................................ 5-184
FIGURE 5-26: CONTRACT CURVES WITH COBB-DOUGLAS UTILITY ................................................................................................. 5-185
FIGURE 5-27: INDIVIDUALLY RATIONAL EFFICIENT POINTS ............................................................................................................. 5-186
FIGURE 5-28: EQUILIBRIUM WITH A PRICE SYSTEM ............................................................................................................................ 5-187
FIGURE 5-29: ILLUSTRATION OF PRICE SYSTEM EQUILIBRIUM ....................................................................................................... 5-188
FIGURE 6-1: EFFECT OF A TAX ON SUPPLY ............................................................................................................................................... 6-196
FIGURE 6-2: EFFECT OF A TAX ON DEMAND ............................................................................................................................................ 6-196
FIGURE 6-3: EFFECT OF A TAX ON EQUILIBRIUM .................................................................................................................................. 6-197
FIGURE 6-4: REVENUE AND DEAD WEIGHT LOSS .................................................................................................................................. 6-198
FIGURE 6-5: A PRICE FLOOR .......................................................................................................................................................................... 6-204
FIGURE 6-6: DEAD WEIGHT LOSS OF A PRICE FLOOR .......................................................................................................................... 6-204
FIGURE 6-7: A PRICE CEILING ....................................................................................................................................................................... 6-206
FIGURE 6-8: RENT CONTROL, INITIAL EFFECT ....................................................................................................................................... 6-207
FIGURE 6-9: RENT CONTROL, LONG-RUN EFFECT ................................................................................................................................. 6-208
FIGURE 6-10: PRICE SUPPORTS..................................................................................................................................................................... 6-210

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FIGURE 6-11: A QUOTA ......................................................................................................................................................................................6-212
FIGURE 6-12: A NEGATIVE EXTERNALITY ..................................................................................................................................................6-214
FIGURE 6-13: EXTERNAL COSTS AND BENEFITS ......................................................................................................................................6-215
FIGURE 6-14: THE PIGOUVIAN TAX ..............................................................................................................................................................6-217
FIGURE 6-15: SO2 PERMIT PRICES .................................................................................................................................................................6-219
FIGURE 6-16: FISH POPULATION DYNAMICS ............................................................................................................................................6-222
FIGURE 6-17: FISH POPULATION DYNAMICS WITH FISHING ..............................................................................................................6-223
FIGURE 6-18: FISH POPULATION DYNAMICS: EXTINCTION ................................................................................................................6-224
FIGURE 6-19: POSSIBILITY OF MULTIPLE EQUILIBRIA..........................................................................................................................6-225
FIGURE 6-20: BASIC MONOPOLY DIAGRAM ..............................................................................................................................................6-234
FIGURE 6-21: TWO-PART PRICING ................................................................................................................................................................6-241
FIGURE 6-22: NATURAL MONOPOLY ...........................................................................................................................................................6-242
FIGURE 7-1 SEQUENTIAL BANK LOCATION (NYC PAYOFF LISTED FIRST) .......................................................................................7-266
FIGURE 7-2: SUBGAME PERFECTION ...........................................................................................................................................................7-267
FIGURE 7-3: CAN’T AVOID ROCKY .................................................................................................................................................................7-267
FIGURE 7-4: EXPECTED PRICES IN SEARCH EQUILIBRIUM .................................................................................................................7-277
FIGURE 7-5: EXPECTED PRICES (S=PROPORTION OF SHOPPERS) .....................................................................................................7-278
FIGURE 7-6: HOTELLING MODEL FOR BREAKFAST CEREALS .............................................................................................................7-279
FIGURE 7-7: SHARING THE HOTELLING MARKET...................................................................................................................................7-280
FIGURE 7-8: A SEGMENT OF THE CIRCLE MODEL ...................................................................................................................................7-281
FIGURE 7-9: NORMALLY DISTRIBUTED ESTIMATES ..............................................................................................................................7-301

8.2 Index
A
ABC, 7-312
ADM, 4-79, 7-307, 7-308, 7-310
Agency, 3-72, 5-177, 6-218, 7-283, 7-284, 7-286, 7287, 7-288, 7-291, 7-292, 7-293, 7-304
Akerlof, George, 6-245, 6-246
Alcoa, 7-307
Allocation, 1-1, 2-35, 2-37, 2-38, 5-182, 6-219, 7-

288

Ambiguity, 2-37, 6-211, 7-308
American Airlines, 6-239, 7-312
Analysis
Normative, 1-2
Positive, 1-2
Antitrust, 1-2, 7-271, 7-306, 7-309, 7-311, 7-313, 7-

314

Clayton Act, 7-308
FTC Act, 7-308
Market Power, 6-232, 7-273
Monopoly Power, 6-232, 6-236, 7-273, 7-274, 7307, 7-313
Peckham Rule, 7-306
Predatory Pricing, 7-308, 7-309
Robinson Patman, 7-308
Sherman Act, 7-306, 7-307, 7-308
SSNIP, 7-312, 7-313
Tying, 7-286, 7-304, 7-308
Vertical Merger, 7-312
AOL, 7-312
Arbitrage, 4-114, 4-115, 4-126, 4-136, 6-238, 6-240
Arbitrage Condition, 4-126, 4-136
Attitude, 7-284
Auction, 1-1, 7-295, 7-298, 7-299, 7-300, 7-301, 7302, 7-303, 7-304, 7-305
Bid-Increment, 7-296, 7-299
Common Values, 7-295, 7-302, 7-303

English, 7-295, 7-296, 7-298, 7-299, 7-300, 7301, 7-304, 7-305
Linkage Principle, 7-303, 7-304, 7-305
Sealed-Bid, 7-296, 7-297, 7-298, 7-299, 7-300,
7-304, 7-305
Vickrey, 7-299, 7-300, 7-301
Autarky, 5-185, 5-186
Availability, 4-126

B
Bargaining, 5-180, 5-186, 6-221, 6-229, 6-246
Basketball, 4-79, 5-164, 5-179
Beer, 2-9, 2-12, 5-140, 5-150
Benefit Concentrated, 6-210
Bliss Point, 5-150
Boeing, 4-101
Bosch, 7-309
Brands, 4-127, 7-311
British Petroleum, 1-2
Budget Line, 5-141, 5-143, 5-146, 5-147, 5-149, 5151, 5-152, 5-154, 5-187
Budget Set, 5-141, 5-146

C
Certainty Equivalent, 1-4, 5-175, 5-176, 5-177
Ceteris Paribus, 1-5
Coase, Ronald, 6-220, 6-221
Cobb-Douglas Production Function, 4-82, 4-84, 485, 4-90, 4-91, 4-92, 4-93, 4-96, 4-104, 5-148,
5-149, 5-153, 5-156, 5-158, 5-162, 5-184, 5-185,
5-188, 5-189, 5-191, 5-194
Compact Disc, 5-143, 7-309
Comparative Advantage, 2-36, 2-37, 2-38, 2-39, 2-

40Comparative Statics, 1-7, 2-30, 4-87, 4-92
Compensating Differential, 5-164, 5-165

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Competition
Imperfect, 7-270, 7-272, 7-273, 7-274, 7-313
Competitive Equilibrium, 6-217
Complement, 2-12, 2-15, 2-16, 2-17, 2-24, 2-25, 230, 4-83, 4-89, 4-90, 4-91, 5-149, 5-156, 5-162,
5-163, 5-164, 7-292
Concave, 2-33, 5-158, 5-159, 5-160, 5-170, 5-174,
5-175, 5-181, 5-185, 7-289, 7-290
Consols, 4-115
Consumer Surplus, 2-8, 2-10, 2-11, 2-13, 2-14, 2-19,
2-21, 2-30, 6-240, 6-241
Consumption, 2-8, 2-9, 2-10, 2-12, 3-56, 3-58, 3-59,
3-78, 4-126, 4-137, 5-139, 5-140, 5-143, 5-145,
5-150, 5-151, 5-152, 5-154, 5-155, 5-156, 5-160,
5-162, 5-163, 5-169, 5-170, 5-171, 5-172, 5-182,
5-189, 6-245
Contract Curve, 5-183, 5-184, 5-185, 5-186, 5-188
Contracts, 2-15, 2-38, 6-241, 7-286, 7-287, 7-306,

7-307

Convexity, 7-289, 7-290, 7-291
Cooperation, 7-269, 7-270, 7-287, 7-310, 7-311
Cartel, 2-26, 7-304, 7-306, 7-310, 7-311
Tacit Collusion, 7-310
Coordination, 4-81, 7-260, 7-263, 7-270
Corporate Finance, 4-121
Cost, 1-2, 1-3, 1-4, 1-5, 1-6, 1-7, 2-8, 2-9, 2-14, 2-15,
2-16, 2-17, 2-18, 2-22, 2-23, 2-26, 2-34, 2-35,
2-36, 2-37, 2-38, 3-53, 3-54, 3-56, 3-61, 3-63,
3-70, 4-80, 4-84, 4-85, 4-86, 4-93, 4-94, 4-95,
4-96, 4-97, 4-98, 4-99, 4-100, 4-101, 4-102, 4103, 4-104, 4-105, 4-107, 4-108, 4-109, 4-112,
4-114, 4-118, 4-120, 4-121, 4-123, 4-124, 4-126,
4-130, 4-131, 4-136, 5-143, 5-151, 5-165, 5-167,
5-172, 5-175, 5-178, 5-179, 5-180, 5-181, 6-199,
6-200, 6-201, 6-202, 6-204, 6-205, 6-206, 6207, 6-208, 6-211, 6-214, 6-215, 6-216, 6-217,
6-218, 6-220, 6-225, 6-226, 6-233, 6-234, 6235, 6-237, 6-238, 6-239, 6-241, 6-242, 6-243,
6-244, 6-246, 6-247, 6-248, 6-249, 6-250, 7-271,
7-272, 7-273, 7-277, 7-278, 7-279, 7-282, 7-283,
7-284, 7-286, 7-287, 7-288, 7-289, 7-292, 7293, 7-294, 7-303, 7-304, 7-308, 7-309
Fixed, 4-96, 4-112, 7-273, 7-274, 7-282
Long-Run, 4-96, 6-209
Marginal, 1-7, 2-14, 2-15, 2-16, 2-18, 2-23, 2-24,
2-37, 2-38, 4-95, 4-96, 4-97, 4-98, 4-99, 4100, 4-104, 6-198, 6-201, 6-205, 6-213, 6214, 6-226, 6-232, 6-234, 6-235, 6-236, 6237, 6-240, 6-241, 6-242, 6-243, 6-244, 7271, 7-272, 7-273, 7-275, 7-277, 7-281, 7-282
Opportunity, 1-3, 1-4, 2-33, 2-34, 2-36, 2-37, 6-

198

Short-Run, 4-95, 4-96
Variable, 4-96, 4-97, 4-98, 4-99, 4-104, 4-107
Cost-Benefit Analysis, 1-2
Cournot, 7-270, 7-272, 7-273, 7-274, 7-313

D
Damages, 7-311
Dead Weight Loss, 6-198, 6-199, 6-202, 6-203, 6204, 6-205, 6-206, 6-211, 6-215, 6-235, 7-272
DemandCompensated, 5-152
Constant Elasticity, 2-29, 2-30, 4-130, 6-235, 6-

237

Elasticity, 2-27, 2-29, 2-30, 4-127, 4-135, 6-200,
6-208, 6-218, 6-224, 6-225, 6-235, 6-236,
6-237, 6-238, 6-239, 6-240, 7-272, 7-273
Market, 2-18, 2-19
Perfect Substitute, 4-83, 5-149
Depreciation, 4-131, 4-135, 4-136, 4-137, 4-138, 5-

167

Differentiation, 7-279
Horizontal, 7-279
Vertical, 7-279
Diminishing Marginal Returns, 2-33, 2-37
Diminishing Marginal Value, 2-9
Discounting, 4-123, 4-127, 4-128, 4-129, 4-131, 4133, 4-136, 4-138, 7-268, 7-269
Disney, 6-232, 7-279, 7-312
Distribution, 3-50, 4-122, 5-178, 5-181, 6-230, 6245, 6-246, 7-275, 7-276, 7-297, 7-298, 7-299,
7-300, 7-301, 7-302
Dominant strategy, 7-252, 7-253, 7-254, 7-265, 7268, 7-296, 7-299, 7-300
DRAM, 2-8, 2-23, 4-112, 4-113
DuPont, 4-81
Durable Good, 3-78, 4-130
Dynamic Optimization, 5-169, 5-172, 5-173

E
eBay, 1-1, 2-18, 6-195, 7-295, 7-299
Economy of Scale, 4-100, 4-101, 4-102, 4-103, 4104, 4-109, 4-110, 4-112, 4-113, 4-114, 6-233, 7-273

Economy of Scope, 4-101
Edgeworth Box, 5-181, 5-182, 5-185, 5-188
Education, 1-3, 2-28, 3-48, 4-120, 6-213, 6-214, 6218, 6-249, 6-250
Efficiency, 2-22, 2-26, 2-37, 4-93, 4-109, 4-130, 5182, 5-183, 5-185, 5-188, 6-195, 6-203, 6-212,
6-213, 6-216, 6-217, 6-218, 6-219, 6-220, 6221, 6-224, 6-225, 6-226, 6-227, 6-229, 6-230,
6-231, 6-233, 6-242, 6-246, 6-247, 6-248, 7273, 7-282
Elasticity, 2-29, 4-109, 4-110, 4-133, 4-135, 6-200,
6-203, 6-207, 6-208, 6-223, 6-224, 6-235, 6236, 6-237, 6-238, 6-239, 6-240, 7-272
Demand, 2-27, 2-29, 2-30, 4-127, 6-224, 6-235,
6-236, 7-272, 7-273
Supply, 2-30
Unitary, 2-29
Engel Curve, 5-155, 5-156, 5-157

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Entrepreneur, 2-17, 2-18, 4-85, 4-86, 4-87, 4-88,
4-89, 4-91, 4-92, 4-93, 4-97
Entry, 3-64, 4-102, 6-211, 6-241, 7-251, 7-252, 7253, 7-273, 7-274, 7-282, 7-309
Equilibrium, 2-8, 2-20, 2-21, 2-22, 2-30, 4-93, 4104, 4-105, 4-107, 4-108, 4-109, 4-110, 4-112,
4-114, 4-133, 5-167, 5-168, 5-169, 5-187, 5-188,
5-189, 5-190, 5-191, 5-192, 5-193, 5-194, 6-197,
6-199, 6-203, 6-205, 6-206, 6-207, 6-211, 6216, 6-224, 6-225, 6-227, 6-230, 7-253, 7-255,
7-256, 7-257, 7-258, 7-260, 7-261, 7-262, 7263, 7-264, 7-265, 7-268, 7-269, 7-270, 7-273,
7-274, 7-275, 7-276, 7-278, 7-280, 7-281, 7-282,
7-297, 7-298, 7-311
Exclusive Dealing, 7-308
Expenditure Shares, 5-149
Externality, 4-112, 6-213, 6-214, 6-215, 6-216, 6217, 6-218, 6-219, 6-220, 6-221, 6-224, 6-225,
6-226, 6-233, 7-278
Common Resource, 6-216
Commons, 4-127, 6-216, 6-226, 7-262
Network, 4-112, 6-233
Extinction, 6-216, 6-223, 6-224, 6-225, 6-226
Exxon-Mobil, 4-81, 7-311, 7-312

F
Factor of Production, 2-40
Factor Price Equalization, 2-40
Factors of Production, 2-38, 2-39
FedEx, 6-232
Firm, 4-79, 4-97, 7-265, 7-268, 7-269, 7-270, 7292
Competitive, 4-97, 4-98, 4-104
Corporation, 1-5, 4-79, 4-80, 4-81, 7-283, 7-306
Non-Profit, 4-80
Partnership, 4-79, 4-80
Proprietorship, 4-79, 4-80
Fixed-Proportions, 4-83
Fluctuations, 3-77, 3-78, 7-288
Ford, 1-1
Foreclosure, 1-2, 7-312
Free Market, 6-195, 6-207
Free-Rider, 6-228, 6-229

G
Gains from Trade, 2-10, 2-22, 2-37, 2-39, 4-131, 6198, 6-201, 6-202, 6-203, 6-205, 6-206, 6-221,
6-240, 6-241, 6-242, 6-246, 6-247, 6-248, 7272, 7-286
Game Theory, 7-251, 7-256
Battle of the Sexes, 7-256, 7-259, 7-267, 7-270
Common Knowledge, 7-270
Elimination of Dominated Strategies, 7-253, 7254, 7-255, 7-257
Folk Theorem, 7-269, 7-270

Grim Trigger Strategy, 7-268, 7-269, 7-270, 7-

310

Mixed Strategy, 7-258, 7-259, 7-260, 7-261, 7263, 7-264, 7-265, 7-275
Pure Strategy, 7-258, 7-259, 7-260, 7-261, 7262, 7-263, 7-264, 7-265, 7-275
Second-Mover Advantage, 7-267
Strategic Behavior, 7-251
Subgame Perfection, 7-266, 7-267, 7-268, 7-269,
7-270, 7-284
Gasoline, 1-2, 2-8, 2-11, 2-16, 2-24, 2-26, 4-81, 4108, 4-109, 5-178, 6-195, 6-218, 7-303
General Electric, 7-309, 7-311
General Equilibrium, 5-188, 5-189
Welfare Theorems, 5-188
General Motors, 4-81
Chevrolet, 2-28
Goldwyn, Samuel, 7-301
Government, 1-1, 1-2, 1-5, 3-48, 3-56, 3-58, 3-59,
3-65, 3-66, 3-67, 3-68, 3-69, 3-70, 3-71, 3-72,
4-80, 4-114, 4-115, 5-160, 5-171, 5-177, 6-195,
6-197, 6-198, 6-199, 6-200, 6-202, 6-210, 6211, 6-213, 6-218, 6-219, 6-220, 6-232, 6-237,
7-295, 7-296, 7-300, 7-303, 7-305, 7-311, 7-312,

7-314

Greyhound, 7-314
Gross Domestic Product, 3-56, 3-58, 3-59, 3-61, 365, 3-66, 3-67, 3-70, 3-71, 3-72, 3-73, 3-74, 3-

75

H
Holmstrom, Bengt, 7-292
Homo Economicus, 1-5
Homogeneity, 6-231, 7-289, 7-290, 7-291, 7-292
Homogeneous Function, 4-104, 7-289, 7-291, 7-294
Hotelling Model, 7-279, 7-280, 7-282
Hotelling, Harold, 7-279
Hypothesis, 5-152, 6-221, 7-257, 7-297
Hysteresis, 2-26

I
IBM, 4-101
Identification, 6-238
Income, 1-3, 2-11, 2-13, 3-50, 3-51, 3-52, 3-53, 354, 3-55, 3-56, 3-58, 3-59, 3-64, 3-71, 3-72, 373, 4-105, 5-139, 5-143, 5-150, 5-152, 5-154, 5155, 5-156, 5-158, 5-160, 5-161, 5-163, 5-164, 5169, 5-171, 5-172, 5-173, 6-195, 6-203, 6-238
Income Effect, 5-152, 5-156, 5-158, 5-163, 5-171
Indifference Curve, 5-143, 5-144, 5-145, 5-146, 5-

147

Inferior Good, 2-11, 5-155, 5-156, 5-157
Information, 2-23, 3-56, 3-57, 4-101, 4-120, 6-245,
6-246, 7-251, 7-278, 7-295, 7-298, 7-299, 7300, 7-301, 7-302, 7-303, 7-304, 7-305, 7-311

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Intertemporal Budget Constraint, 5-169, 5-172, 5-O

Inventory, 2-21, 4-136, 4-137
Isocost, 4-94
Isoquant, 4-82, 4-94, 5-149, 5-152, 5-182, 5-183,
5-185, 5-187, 5-188

Ohlin, Bertil, 2-40
Oil, 1-2, 2-8, 2-16, 2-17, 2-25, 2-26, 3-60, 3-72, 481, 4-108, 4-118, 4-120, 4-121, 4-124, 4-125, 4126, 4-127, 4-135, 5-164, 6-216, 6-218, 7-295,
7-296, 7-301, 7-303, 7-304, 7-306, 7-311
Oligopoly, 7-270, 7-314
OPEC, 2-26
Opportunity Cost, 1-3, 1-4, 2-33, 2-34, 2-36, 2-37,

173

M
Managers, 4-80, 4-101, 7-310
Marginal Product, 4-84, 4-89, 4-103, 4-104
Value of, 4-84, 4-85, 4-86, 4-92, 4-103
Marginal Rate of Substitution, 5-144, 5-146, 5-148,

5-157

Marginal Rate of Technical Substitution, 4-94
Marginal Returns, Diminishing, 2-33, 2-37
Marginal Revenue, 6-234, 6-235
Marginal Value, Diminishing, 2-9Market for Lemons, 6-246
Marketing, 4-81
Markets, 1-1, 1-2, 1-6, 2-21, 2-24, 2-25, 4-113, 4126, 6-195, 6-213, 6-246, 6-248, 7-274, 7-278,
7-295, 7-305, 7-311, 7-312, 7-313, 7-314
Maximum Sustainable Yield, 4-129, 4-130
McAfee, R. Preston, i, iii, 4-81, 5-175, 6-246
Mercedes, 7-309
Merger, 7-308, 7-309, 7-311, 7-312, 7-313, 7-314
Horizontal, 7-312
Microsoft, 1-2, 2-24, 6-232, 6-233, 7-253, 7-254, 7307, 7-309
Milgrom, Paul, 7-292, 7-303
Monopoly, 6-195, 6-201, 6-202, 6-232, 6-233, 6234, 6-235, 6-236, 6-237, 6-241, 6-244, 7-251,
7-270, 7-272, 7-273, 7-274, 7-277, 7-307, 7308, 7-310, 7-313, 7-314
Monopoly Power, 6-232, 6-236, 7-273, 7-274, 7307, 7-313
Morgenstern, Oskar, 7-251
Mortgage, 4-115, 4-116, 4-124, 4-125
Multi-Tasking, 7-288, 7-291
Myerson, Roger, 6-246, 6-248
Myerson-Satterthwaite Theorem, 6-246, 6-248

NNash, John, 7-251, 7-255
Netscape, 1-2, 7-307
Network, 4-112, 6-233, 7-312
Newton, Sir Isaac, 6-221
Nonexcludability, 6-226
Nonrivalry, 6-226
Normal Good, 5-155, 5-156, 6-238
Northwest, 2-38, 2-40
NPV, 4-117, 4-118, 4-119, 4-120, 4-121, 4-122, 4123, 4-124, 4-125
Numeraire, 5-143, 5-190

6-198

Option Value of Investment, 4-121
Options, 1-4, 4-121, 4-122, 4-124, 4-125
O'Rourke, P. J., 7-283

P
Pareto Efficiency, 5-182, 5-183, 5-184, 5-188
Partnership, 4-79, 4-80
Patent, 4-85, 6-232, 6-246
Perron-Frobenius Theorem, 5-190, 5-191
Peter Principle, 4-101
Pigou, Arthur Cecil, 6-217
Porsche, 2-11, 4-130, 4-131, 6-232
Post Office, US, 6-232
Preferences, 1-2, 2-13, 4-125, 5-139, 5-140, 5-145,
5-147, 5-148, 5-165, 5-167, 5-168, 5-169, 5-177,
5-182, 5-185, 5-193, 5-194, 6-213, 6-229, 6230, 6-231, 6-245, 7-264, 7-270, 7-279
Present Value, 4-114, 4-115, 4-116, 4-117, 4-118, 4119, 4-120, 4-126, 4-127, 4-133, 4-136, 5-167, 5169, 5-170, 5-172, 6-249, 7-269, 7-310
Price
Ceiling, 6-203, 6-205, 6-206, 6-207
Hedonic, 1-4
Law of One, 7-274, 7-278
Peak Load, 6-243, 6-244
Reservation, 2-13, 5-178, 5-179, 5-180, 5-181
Price – Cost Margin, 7-272, 7-273, 7-313
Price Discrimination, 6-237, 6-238, 6-239, 6-240,
7-275, 7-308, 7-314
Coupons, 6-239
Direct, 6-239
Indirect, 6-239
Quantity Discount, 6-239
Price Dispersion, 7-275
Price Floor, 6-202, 6-203, 6-205, 6-206, 6-207, 6210, 6-211
Price Support, 6-210, 6-211
Price System, 2-37, 2-38, 5-186, 5-187, 5-188, 6238, 6-245
Price-Cost Margin, 6-235, 7-271
Pricing
Ramsey, 4-125, 4-126, 6-244
Private Values, 7-295, 7-296, 7-297, 7-298, 7-299,
7-300, 7-301, 7-304
Production Possibilities Frontier, 2-32, 2-33, 2-34,
2-35, 2-36, 2-37, 2-38
Property Rights, 6-220, 6-221

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Proprietorship, 4-79, 4-80
Public Good, 6-226, 6-228, 6-229, 6-230, 6-231, 7-

262

Q
Quintiles, 3-50, 3-51

Spence, Michael, 6-248
Standard Oil, 4-81, 7-306, 7-309
Standardization, 4-79, 6-233, 6-250, 7-274
Statistics, 3-41, 3-57, 3-76, 6-250
Correlation, 5-193, 5-194
Normal Distribution, 5-177, 7-301, 7-302
Steady State, 2-20, 6-222, 6-223, 6-224, 6-225, 7-

256

R
Raising Rivals’ Cost, 7-312
Ramsey Pricing, 4-125, 6-244
Ramsey, Frank, 4-125
RE/MAX, 7-287
Reagan, Ronald, 3-65
Regulation
Price-Cap, 6-242
Rent Control, 6-207, 6-208, 6-209
Rents, 4-85, 6-208
Research and Development, 3-72, 4-101, 4-102, 7282
Reservation Price, 2-13, 5-178, 5-179, 5-180, 5-181
Revealed Preference, 4-87, 4-88, 4-89, 4-90, 6-237
Revenue equivalence, 7-298
Risk, 1-4, 2-8, 4-85, 4-101, 4-114, 4-118, 4-119, 4120, 4-121, 4-125, 4-138, 5-174, 5-175, 5-176, 5177, 5-181, 6-211, 7-283, 7-284, 7-286, 7-287, 7288, 7-299, 7-303, 7-304, 7-305, 7-310
Certainty Equivalent, 1-4, 5-175, 5-176, 5-177
Risk Management, 1-4, 4-101
Risk Aversion, 5-176, 5-177, 7-287, 7-299, 7-304
Risk Premium, 1-4, 5-175, 5-176, 5-177, 5-178
Rivalry, 4-81
Roosevelt, Teddy, 7-308

S

Strategy, 4-97, 4-121, 4-122, 4-123, 4-133, 5-160,
6-206, 6-218, 6-220, 6-226, 6-242, 7-251, 7252, 7-253, 7-254, 7-255, 7-256, 7-257, 7-258,
7-259, 7-260, 7-261, 7-263, 7-268, 7-269, 7270, 7-296, 7-298, 7-299, 7-310
Substitute, 2-11, 2-12, 2-17, 2-24, 2-25, 4-89, 4110, 6-203, 6-208, 6-238, 7-272, 7-294, 7-307,

7-313

Supergames, 7-268, 7-269
Supply, 1-6, 2-8, 2-13, 2-14, 2-15, 2-16, 2-17, 2-18,
2-19, 2-20, 2-21, 2-22, 2-23, 2-24, 2-25, 2-26,
2-30, 2-31, 2-32, 2-37, 3-61, 4-103, 4-104, 4105, 4-107, 4-108, 4-109, 4-110, 4-112, 4-113, 4114, 4-126, 4-129, 4-130, 4-131, 4-137, 5-139, 5143, 5-160, 5-162, 5-163, 5-165, 5-170, 5-187, 5188, 5-189, 5-190, 5-193, 6-195, 6-196, 6-197, 6198, 6-199, 6-200, 6-201, 6-202, 6-203, 6-205,
6-207, 6-208, 6-209, 6-211, 6-216, 6-217, 6219, 6-235, 6-237, 7-292, 7-304
Complement, 2-16, 2-17, 2-25
Constant Elasticity, 2-30
Elasticity, 2-30, 6-200
Increase in, 2-16, 2-23, 2-25
Market, 2-19, 4-104
Substitute, 2-17, 2-25
Surplus, 2-8, 2-10, 2-13, 2-20, 2-21, 3-73, 5-164, 6198, 6-203, 6-210, 6-211, 6-241

T

S&P 500, 5-177
Samuelson, Paul, 2-40
Satiation, 5-150
Satterthwaite, Mark, 6-246
Saving, 2-26, 4-115, 4-127
Scale Economy, 4-102, 6-233
Schelling, Thomas, 7-251
Schwarzenegger, Arnold, 5-139
Sears, 4-81
Second-Price Auction, 7-299
Self-Interest, 1-5, 1-6
Selten, Reinhart, 7-266
Service, 2-20, 2-37, 3-63, 3-68, 4-85, 5-144, 6202, 6-203, 6-231, 6-233, 6-242, 7-253, 7-308,

Tax
Ad Valorem, 6-195, 6-201
Excess Burden of, 6-200, 6-202
Excise, 3-72, 3-73, 6-195
Income, 3-72, 3-73, 6-195
Sales, 1-3, 3-73, 4-80, 6-195
Time preference, 5-169, 5-170
Trailways, 7-314
Transaction Costs, 4-114, 6-195
Truman, Harry, 1-5
Tyranny of the Majority, 6-209

Shadow Value, 4-91, 4-92
Sharecropper, 7-287
Shortage, 2-8, 2-20, 2-21, 4-126, 5-164, 6-206, 6207, 6-208, 6-209
Signaling, 6-248, 6-249, 6-250
Smith, Adam, 2-35, 2-36
Sony, 1-1, 5-178, 6-233

U. S. Federal Trade Commission, 7-306, 7-308, 7309, 7-311, 7-312
U.S. Department of Justice, 1-2, 7-306, 7-307, 7309, 7-310, 7-311, 7-312
Uncertainty, 2-26, 4-120, 4-121, 4-136, 7-305
Unitization, 6-216

U

7-312

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Utility, 5-139, 5-140, 5-143, 5-144, 5-146, 5-147, 5148, 5-149, 5-150, 5-151, 5-152, 5-153, 5-154, 5158, 5-159, 5-160, 5-162, 5-167, 5-168, 5-170, 5174, 5-175, 5-176, 5-181, 5-182, 5-183, 5-184, 5185, 5-186, 5-187, 5-188, 5-189, 5-191, 5-194, 6228, 6-229, 6-247, 7-284, 7-286, 7-287, 7-290,
7-293
Compensated Demand, 5-152
Convex Preferences, 5-145, 5-147, 5-148
Indifference Curve, 5-143, 5-144, 5-145, 5-146, 5-

Marginal, 1-7, 2-9, 2-10, 2-9, 2-11, 2-14, 2-15, 489, 4-131, 4-132, 4-133, 5-162, 5-167, 5-170,
6-196, 6-201, 6-214, 6-218, 6-242
Vickrey, William, 7-299
Video Home System, 2-23, 6-233
Vincent, Daniel, 5-175
von Neumann, John, 7-251
VotingMedian Voter, 6-230

147

Quasilinear, 5-159
Satiation, 5-150
von Neumann-Morgenstern, 5-174

V

W
Warranties, 6-246
Welfare Analysis, 1-2Western Electric, 4-134, 4-135
Willingness To Pay, 1-2, 2-8, 2-11, 2-13, 6-197, 6238, 6-239, 7-295

Value

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