Introduction to
Economic Analysis
Version 2.1

R. Preston McAfee;Tracy Lewis;Donald J. Dale

Introduction to Economic Analysis

1-1Introduction to Economic Analysis

1-2About the Authors
ABOUT R. PRESTON MCAFEE

R. Preston McAfee received his undergraduate degree in economics from the University of Florida, andmaster of science in mathematics, and a Ph.D in economics from Purdue University. McAfee is the J.
Stanley Johnson Professor of Business, Economics & Management at Caltech. He is on leave from
Caltech and currently is Chief Economist at Microsoft.
The author of many academic papers on auctions, McAfee was one of the designers of the Federal
Communication Commission’s ﬁrst auction of radio spectrum rights for cellular phones. Over $100 billion
worth of airwaves and other items have been sold using this auction design. He has run auctions in Mexico
and advised several governments on auction use.
McAfee served as an economic expert in a variety of antitrust cases, including Exxon-Mobil, BPArco, Lockheed Martin-Northrop Grumman, and Peoplesoft-Oracle. He also testiﬁed in the U.S. versus Rambus, and has testiﬁed before
three United States Senate committees on antitrust enforcement and gasoline pricing.

ABOUT TRACY R. LEWIS

Tracy R. Lewis is the Martin L Black Professor of Business Administration at the Fuqua School ofBusiness, Duke University, and Director of the Duke University Innovation Center.
Other positions held by Dr. Lewis include: James Walter Eminent Scholar in Economics, University
of Florida, and Associate Director of Energy Studies, Public Utilities Research Center, Director, Program
on Workable Energy Regulation (POWER), Professor of Economics, University of California, Davis,
Professor of Economics, University of British Columbia, Assistant Director, Program in Natural Resource
Economics, Visiting Associate Professor of Economics, California Institute of Technology, Associate
Professor of Economics, University of British Columbia, Brookings Fellow, Washington, DC, Visiting
Assistant Professor, University of British Columbia, Assistant Professor, University of Arizona.
In addition to the roles above, Dr. Lewis has served as Economic Advisor for the National ResearchCouncil, Academy of Sciences. He has been a consultant to numerous organizations including the Florida
Attorney General’s Office, the World Bank Project on Abatement of Greenhouse Gases, Florida Powerand Light Company, FTC, Department of Energy, the Rand Corporation, and many others.
Dr. Lewis has published two books, numerous articles, and has served as editor on a wide range of journals including: the Journalof Law Economics and Organization, The B. E. Journals in Industrial Organization, and Review of Network Economics–to name a few.
He has been awarded over 15 grants, fellowships and awards.
Tracy earned his BA and PhD at the University of California, San Diego.

ABOUT DONALD J. DALE

Donald J. Dale is Clinical Associate Professor of Economics at the Kellogg School of Management at
Northwestern University. The winner of several teaching awards, he has taught microeconomics for
24 years. He is interested in experimental economic methods for both research and pedagogy. Dr.
Dale has conference presentations and publications in the fields of game theory, experimental
economics, and experimental psychology. Dr. Dale received his undergraduate degree from the
University of Delaware, and his MS and Ph.D. from Princeton University.

Introduction to Economic Analysis

1-3Contents
1

2

3

4

5

6

WHAT IS ECONOMICS? ..................................... 1-8
1.1

NORMATIVE AND POSITIVE THEORIES ................................................................................................................................................ 1-8

1.2

OPPORTUNITY COST ....................................................................................................................................................................... 1-9

1.3

ECONOMIC REASONING AND ANALYSIS ............................................................................................................................................ 1-11

SUPPLY AND DEMAND.................................... 2-14
2.1

DEMAND AND CONSUMER SURPLUS................................................................................................................................................ 2-14

2.2

SUPPLY AND PROFIT ..................................................................................................................................................................... 2-19

2.3

MARKET DEMAND AND SUPPLY...................................................................................................................................................... 2-22

2.4

EQUILIBRIUM .............................................................................................................................................................................. 2-23

2.5

CHANGES IN DEMAND AND SUPPLY ................................................................................................................................................. 2-24

QUANTIFICATION ........................................... 3-28
3.1

ELASTICITY ................................................................................................................................................................................. 3-28

3.2

SUPPLY AND DEMAND CHANGES .................................................................................................................................................... 3-30

THE US ECONOMY .......................................... 4-33
4.1

BASIC DEMOGRAPHICS ................................................................................................................................................................. 4-33

4.2

EDUCATION ................................................................................................................................................................................ 4-39

4.3

HOUSEHOLDS AND CONSUMPTION.................................................................................................................................................. 4-41

4.4

PRODUCTION .............................................................................................................................................................................. 4-47

4.5

GOVERNMENT ............................................................................................................................................................................ 4-55

4.6

TRADE ....................................................................................................................................................................................... 4-63

4.7

FLUCTUATIONS............................................................................................................................................................................ 4-66

GOVERNMENT INTERVENTIONS ..................... 5-69
5.1

EFFECTS OF TAXES ....................................................................................................................................................................... 5-69

5.2

INCIDENCE OF TAXES .................................................................................................................................................................... 5-72

5.3

EXCESS BURDEN OF TAXATION ....................................................................................................................................................... 5-73

5.4

PRICE FLOORS AND CEILINGS ......................................................................................................................................................... 5-74

5.5

THE POLITICS OF PRICE CONTROLS .................................................................................................................................................. 5-79

5.6

PRICE SUPPORTS ......................................................................................................................................................................... 5-82

5.7

QUANTITY RESTRICTIONS AND QUOTAS ........................................................................................................................................... 5-83

TRADE............................................................. 6-85
6.1

PRODUCTION POSSIBILITIES FRONTIER ............................................................................................................................................. 6-85

6.2

COMPARATIVE AND ABSOLUTE ADVANTAGE ..................................................................................................................................... 6-88

6.3

FACTORS OF PRODUCTION ............................................................................................................................................................. 6-90

6.4

INTERNATIONAL TRADE ................................................................................................................................................................. 6-91

Introduction to Economic Analysis

1-4

7

8

9

EXTERNALITIES ............................................... 7-93
7.1

EXTERNAL EFFECTS....................................................................................................................................................................... 7-93

7.2

PIGOUVIAN TAXES ....................................................................................................................................................................... 7-97

7.3

QUOTAS .................................................................................................................................................................................... 7-98

7.4

TRADABLE PERMITS AND AUCTIONS ................................................................................................................................................ 7-99

7.5

COASIAN BARGAINING ................................................................................................................................................................ 7-100

7.6

FISHING AND EXTINCTION............................................................................................................................................................ 7-101

PUBLIC GOODS ............................................. 8-105
8.1

FREE-RIDERS ............................................................................................................................................................................ 8-105

8.2

PROVISION WITH TAXATION ......................................................................................................................................................... 8-107

8.3

LOCAL PUBLIC GOODS ................................................................................................................................................................ 8-108

PRODUCER THEORY: COSTS .......................... 9-110
9.1

TYPES OF FIRMS ........................................................................................................................................................................ 9-110

9.2

PRODUCTION FUNCTIONS............................................................................................................................................................ 9-112

9.3

PROFIT MAXIMIZATION............................................................................................................................................................... 9-115

9.4

THE SHADOW VALUE.................................................................................................................................................................. 9-119

9.5

INPUT DEMAND ........................................................................................................................................................................ 9-120

9.6

MYRIAD COSTS ......................................................................................................................................................................... 9-122

10 PRODUCER THEORY: DYNAMICS ................. 10-125
10.1

REACTIONS OF COMPETITIVE FIRMS........................................................................................................................................10-125

10.2

ECONOMIES OF SCALE AND SCOPE .........................................................................................................................................10-127

10.3

DYNAMICS WITH CONSTANT COSTS ........................................................................................................................................10-130

10.4

GENERAL LONG-RUN DYNAMICS ............................................................................................................................................10-135

11 INVESTMENT .............................................. 11-140
11.1

PRESENT VALUE ..................................................................................................................................................................11-140

11.2

INVESTMENT ......................................................................................................................................................................11-143

11.3

INVESTMENT UNDER UNCERTAINTY ........................................................................................................................................11-144

11.4

RESOURCE EXTRACTION .......................................................................................................................................................11-148

11.5

A TIME TO HARVEST ............................................................................................................................................................11-149

11.6

COLLECTIBLES.....................................................................................................................................................................11-151

11.7

SUMMER WHEAT ...............................................................................................................................................................11-155

12 CONSUMER THEORY ................................... 12-157
12.1

UTILITY MAXIMIZATION .......................................................................................................................................................12-157

12.2

BUDGET OR FEASIBLE SET .....................................................................................................................................................12-158

12.3

INDIFFERENCE CURVES .........................................................................................................................................................12-161

12.4

EXAMPLES .........................................................................................................................................................................12-164

12.5

SUBSTITUTION EFFECTS ........................................................................................................................................................12-166

12.6

INCOME EFFECTS ................................................................................................................................................................12-169

Introduction to Economic Analysis

1-5

12.7

MATHEMATICAL CLEANUP ....................................................................................................................................................12-172

13 APPLIED CONSUMER THEORY ..................... 13-174
13.1

LABOR SUPPLY ...................................................................................................................................................................13-174

13.2

URBAN REAL ESTATE PRICES .................................................................................................................................................13-178

13.3

DYNAMIC CHOICE ...............................................................................................................................................................13-181

13.4

RISK AVERSION...................................................................................................................................................................13-185

13.5

SEARCH.............................................................................................................................................................................13-189

14 GENERAL EQUILIBRIUM .............................. 14-192
14.1

EDGEWORTH BOXES ............................................................................................................................................................14-192

14.2

EQUILIBRIUM WITH PRICE SYSTEM .........................................................................................................................................14-195

14.3

GENERAL EQUILIBRIUM ........................................................................................................................................................14-199

15 MONOPOLY ................................................ 15-205
15.1

SOURCES OF MONOPOLY......................................................................................................................................................15-205

15.2

BASIC ANALYSIS ..................................................................................................................................................................15-206

15.3

EFFECT OF TAXES ................................................................................................................................................................15-209

15.4

PRICE DISCRIMINATION ........................................................................................................................................................15-210

15.5

WELFARE EFFECTS ..............................................................................................................................................................15-213

15.6

NATURAL MONOPOLY .........................................................................................................................................................15-214

15.7

PEAK LOAD PRICING ............................................................................................................................................................15-215

16 GAMES & STRATEGIC BEHAVIOR ................ 16-218
16.1

MATRIX GAMES .................................................................................................................................................................16-218

16.2

NASH EQUILIBRIUM.............................................................................................................................................................16-221

16.3

MIXED STRATEGIES .............................................................................................................................................................16-223

16.4

EXAMPLES .........................................................................................................................................................................16-226

16.5

SUBGAME PERFECTION ........................................................................................................................................................16-229

16.6

SUPERGAMES .....................................................................................................................................................................16-232

17 IMPERFECT COMPETITION .......................... 17-235
17.1

COURNOT OLIGOPOLY .........................................................................................................................................................17-235

17.2

COURNOT INDUSTRY PERFORMANCE ......................................................................................................................................17-237

17.3

HOTELLING DIFFERENTIATION................................................................................................................................................17-239

17.4

THE CIRCLE MODEL .............................................................................................................................................................17-241

18 INFORMATION............................................ 18-244
18.1

MARKET FOR LEMONS .........................................................................................................................................................18-244

18.2

MYERSON-SATTERTHWAITE THEOREM ....................................................................................................................................18-245

18.3

SIGNALING ........................................................................................................................................................................18-247

18.4

SEARCH AND PRICE DISPERSION .............................................................................................................................................18-248

19 AGENCY THEORY ........................................ 19-252
19.1

PRINCIPALS AND AGENTS......................................................................................................................................................19-252

Introduction to Economic Analysis

1-6

19.2

COST OF PROVIDING INCENTIVES ...........................................................................................................................................19-254

19.3

MULTI-TASKING..................................................................................................................................................................19-256

19.4

MULTI-TASKING WITHOUT HOMOGENEITY ...............................................................................................................................19-259

20 AUCTIONS................................................... 20-262
20.1

ENGLISH AUCTION ..............................................................................................................................................................20-262

20.2

SEALED-BID AUCTION ..........................................................................................................................................................20-263

20.3

DUTCH AUCTION ................................................................................................................................................................20-265

20.4

VICKREY AUCTION ...............................................................................................................................................................20-266

20.5

THE WINNER’S CURSE AND LINKAGE ......................................................................................................................................20-267

20.6

AUCTION DESIGN................................................................................................................................................................20-270

21 ANTITRUST ................................................. 21-272
21.1

SHERMAN ACT ...................................................................................................................................................................21-272

21.2

CLAYTON ACT ....................................................................................................................................................................21-273

21.3

PRICE-FIXING .....................................................................................................................................................................21-275

21.4

MERGERS ..........................................................................................................................................................................21-276

22 SOLUTIONS TO EXERCISES .......................... 22-280

Introduction to Economic Analysis

1-7

1

What is Economics?

Economics studies the allocation of scarce resources among people – examining what goods and services wind up in the hands ofwhich 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 the Chicago
Mercantile, but also farmer’s markets, auction markets like Christie’s or Sotheby’s (made famous in movies by people scratching theirnoses and inadvertently purchasing a Ming vase) or eBay, or more ephemeral markets, such as the market for music CDs in yourneighborhood. In addition, goods and services (which are scarce resources) are allocated by governments, using taxation as a meansof acquiring the items. Governments may be controlled by a political process, and the study of allocation by 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
the government, and such allocation methods nevertheless fall within the domain of economic analysis; the market for marijuanaremains vibrant despite interdiction by the governments of most nations. Other allocation methods include gifts and charity, lotteries
and gambling, and cooperative societies and clubs, all of which are studied by economists.
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 physical stores that
may or may not be next door to each other, and customers who search among the stores, purchasing when the customer finds anappropriate item at an acceptable price. When we buy bananas, we don’t typically go to a banana market and purchase from one of adozen or more banana sellers, but instead go to a grocery store. Nevertheless, in buying bananas, the grocery stores compete in amarket for our banana patronage, attempting to attract customers to their stores and inducing them to purchase bananas.
Price – exchange of goods and services for money – is an important allocation means, but price is hardly the only factor even inmarket exchanges. Other terms, such as convenience, credit terms, reliability, and trustworthiness are also valuable to the participantsin 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 still matter. For other products, like restaurant meals, camcorders bydifferent manufacturers, or air travel on distinct airlines, the products differ to some degree, and thus the qualities of the product arefactors 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.
Economic analysis is used in many situations. When British Petroleum sets the price for its Alaskan crude oil, it uses an estimateddemand 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 the demand 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 of Justice bothto understand Microsoft’s incentive to foreclose (eliminate from the market) rival Netscape and consumer behavior in the face ofalleged foreclosure. Stock market analysts use economic models to forecast the profits of companies in order to predict the price of
their stocks. When the government forecasts the budget deficit or considers 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

Normative and Positive Theories
Learning Objectives•

How is economics used?

•

What is an economic theory?

•

What is a market?

Economic analysis is used for two main purposes. The first is a scientific understanding of 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 a conclusion that a rule change is, on balance, sociallybeneficial. Such analyses combine positive analysis – predicting the effects of changes in rules – with value judgments, and are
known as normative analyses. For example, a gasoline tax used to build highways harms gasoline buyers (who pay higher prices), buthelps drivers (who face fewer potholes and less congestion). Since drivers and gasoline buyers are generally the same people, anormative analysis may suggest that everyone will benefit. This type of outcome, where everyone is made better off by a change, isrelatively uncontroversial.

Introduction to Economic Analysis

1-8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 the park, but
harms those who own property (although, by increasing property values, even non-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 the costs against thebenefits. In the case of the park, the costs are readily monetized (turned into dollars), because the costs to the tax-payers are just theamount of the tax. In contrast, the benefits are much more challenging to estimate. Conceptually, the benefits are the amount the park
users would be willing to pay to use the park if the park charged admission. However, if the park doesn’t charge admission, we would
have to estimate willingness-to-pay. In principle, the park provides greater benefits than costs if the benefits to the users exceed thelosses 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 accountnot just of the overall gains and losses, but also weighting those gains and losses by their effects on other social goals. For example, aproperty tax used to subsidize the opera might provide more value than costs, but the bulk of property taxes are paid by lower andmiddle 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 onbasic food items like milk and bread generally has a relatively greater benefit to the poor, who spend a much larger percentage of theirincome on food, than to the rich. Thus, such schemes may be considered desirable not so much for their overall effects but for theirredistribution effects. Economics is helpful not just in providing methods for determining the overall effects of taxes and programs,
but also the incidence of these taxes and programs, that is, who pays, and who benefits. What economics can’t do, however, is say
who ought to benefit.
Key Takeaways•

A positive analysis, analogous to the study of electromagnetism or molecular biology, involves only the attempt to understand theworld around us without value judgments.

•

Economic analyses employing value judgments are known as normative analyses. When everyone is made better off by achange, recommending that change is relatively uncontroversial.

•

A cost-benefit analysis totals the gains and losses to different individuals in dollars and suggests carrying out changes that provide
greater benefits than harm. A cost-benefit analysis is a normative analysis.

•

Welfare analysis posits social preferences and goals, permitting an optimization approach to social choice. Welfare analysis isnormative.

•

Economics helps inform society about the consequences of decisions, but the valuation of those decisions is a matter for society tochoose.
Key Terms•

Positive Analysis: A study intended to understand the world without value judgments•

Normative Analysis: A study making value judgments•

Cost-benefit analysis: A normative analysis that adds benefits and subtracts costs measured in dollars•

Willingness to Pay: The amount a customer is willing and able to pay for a good•

Welfare analysis: A normative analysis that trades off gains and losses to different individuals

1.2

Opportunity Cost
Learning Objectives•

What is opportunity cost?

•

How is it computed?

•

What is its relationship to the usual meaning of 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 our idiosyncratic 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 much enjoyment was lost – is part of the cost of education. However,some “costs” are not opportunity costs. Room and board would not generally be a cost because, after all, you are going to be living
Introduction to Economic Analysis

1-9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 they would be otherwise. Similarly, the expenditures on things you would have otherwise done – hang-gliding lessons,a trip to Europe – represent savings. However, the value of 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 time spent
shopping. The opportunity cost of a puppy includes not just the purchase price of the puppy, but also the food, veterinary bills, carpet
cleaning, and the value of the time spent dealing with the puppy. A puppy is a good example, because often the purchase price is anegligible 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 world is that people acquire puppies because the value they expect to get exceeds the opportunity
cost. That is, they acquire a puppy when the value of a puppy is higher than the value of what is foregone by the acquisition of apuppy.
Even though opportunity costs include lots of non-monetary costs, we will often monetize opportunity costs, translating the costs into
dollar terms for comparison purposes. Monetizing opportunity costs is clearly valuable, because it gives a means of comparison.
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 the defendant choose the sentence. Conceptually, we can use the same idea to find out the value of 30 days injail. Suppose you would choose to pay a fine of $750 to avoid the thirty days in jail, but wouldn’t pay $1,000 and instead would
choose time in the slammer. 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 a penny more you go to jail. That price – at which you are just indifferent tothe 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 the amount 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 the process, risk is valued, and riskier stocks and assets must sell for a lower price (or, equivalently, earn ahigher 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 of options, 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 valuingeach 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 the presence 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 be converted 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, youhave 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 a certainty. But suchan approach provides one means of estimating the value of the risk of death – an examination what people will, and will not, pay to
reduce that risk.
Key Takeaways•

The opportunity cost is the value of the best foregone alternative.

•

Opportunity cost of a purchase includes more than the purchase price but all of the costs associated with a choice.

•

The conversion of costs into dollar terms, while sometimes controversial, provides a convenient means of comparing costs.
Key Terms•

Opportunity cost: the value of the best forgone alternative•

Risk management: the science of hedging or minimizing risk•

Certainty equivalent: An amount of money that provides equal value to a person as a given gamble.

•

Risk Premium: The difference between the expected value of a gamble and the certainty equivalent•

Hedonic pricing: Estimating the value of something by summing the value of parts

Introduction to Economic Analysis

1-10

1.3

Economic Reasoning and Analysis
Learning Objectives•

How do economists reason?

•

What is comparative static?

•

What assumptions are commonly made by economists about human behavior?

•

What do economists mean by marginal?

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, the effect of a policy change – a government
program to educate unemployed workers, 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. Asan absurd and tortured example, government production of helium for (allegedly) military purposes reduces the cost of children’sbirthday 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 tolower admission fees to compete with circuses. Thus, were the government to stop subsidizing the manufacture of helium, theadmission fee of zoos would likely rise, even though zoos use no helium. This example is superficially reasonable, although theeffects 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, wewill often look at the effects of a change “other things 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 “other things equal” is to use Latin and say “ceteris paribus.” Part of your job as a student is to learn
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 most people we know. We model the choices thatpeople make, assuming that they make the choice 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.” That households are fairly selfish is more plausible perhaps than individuals being selfish.
Economics is pretty much silent on why consumers want things. You may want to make a lot of money so that you can build ahospital or endow a library, which would be altruistic things to do. Such motives are broadly consistent with self-interested behavior.
Corporations are often required to serve their shareholders by maximizing the share value, inducing self-interested behavior on thepart of the corporation. Even if corporations had no legal responsibility to act in the financial interest of 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 in their 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 fromtheir purchases, and firms maximize their profits. One objection to the economic methodology is that people rarely carry out thecalculations necessary to literally maximize anything. However, that is not a sensible objection to the methodology. People don’t
carry out the physics calculations to throw 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, even though no calculations are carried out. Some corporations in fact use
elaborate computer programs to minimize costs or maximize their profits, and the entire field of operations 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 a significant non-recoverable investment, there isa psychological tendency to invest more even when the return on the subsequent investment isn’t worthwhile. France and Britain
Introduction to Economic Analysis

1-11continued to invest in the Concorde (a supersonic aircraft no longer in production) 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 have exhibited the sunkcost 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 sunkcosts 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 in many 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 the average 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 this proliferation is reflected in this book.
Economists reason with models. Models help by removing 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 7.6). In all cases, the models are the simplest model that lets us understandthe question or phenomenon at hand. The purpose of the model is to illuminate connections between ideas. A typical implication of amodel is “when A increases, B falls.” This “comparative static” prediction lets us see how A affects B, and why, at least in thecontext of the model. The real world is always much more complex than the models 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 to isolate andunderstand 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 usually taught to students who have not yet studied calculus or can’t betrusted to remember even the most basic elements of it, economists tend to avoid using derivatives and instead talk about the value ofthe next unit purchased, or the cost of the next unit, and describe 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.
Key Takeaways•

It is often helpful to break economic effects into pieces.

•

A common strategy is to examine the effects of a change “other things equal,” that is, assuming nothing else changed, whichisolates the effect of the change. “Ceteris paribus” means “other things equal.”•

Economics frequently model the choices that people make by assuming that they make the best choice for them. People in amodel are known occasionally as “homo economicus.” Homo economicus is entirely selfish. The technical term is acting in
one’s self-interest.

•

Self-interested behavior is also described as “maximizing behavior,” where consumers maximize the net value they obtain fromtheir purchases, and firms maximize their profits.

•

Once one has made a significant non-recoverable investment, there is a psychological tendency to invest more even when the
return on the subsequent investment isn’t worthwhile, known as the sunk cost fallacy.

•

Economists reason with models. By stripping out extraneous detail, the model represents a lens to isolate and understand aspectsof the real world.

•

Marginal is just economist’s jargon for “the derivative of.” For example, marginal cost is the derivative of cost; marginal value isthe derivative of value.

Introduction to Economic Analysis

1-12Key Terms•

Homo economicus: A person who behaves according to standard economic theory – very selfishly•

Self-interested behavior: Following one’s own interests (as opposed to altruistic behavior)•

Maximizing behavior: Same as self-interested behavior•

Sunk cost fallacy: Tendency to invest in a bad project because of substantial past investments•

Comparative static: the effect of a change of one variable on another variable•

Marginal: the derivative of•Ceteris paribus: other things equal

Introduction to Economic Analysis

1-13

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 the weather iscolder 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, or dynamic random accessmemory, 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 9, which focuses on production, and Chapter 12 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

Demand and Consumer Surplus
Learning Objectives•

What is demand?

•

What is the value to buyers of their purchases?

•

What assumptions are commonly made about demand?

•

What causes demand to rise or fall?

•

What is a good that you buy only because you are poor called?

•

What are goods consumed together called?

•

How do the prices of one good influence demand for other goods?

Eating a French fry makes most people a little bit happier, and we are willing to give up something of value – a small amount ofmoney, a little bit of time – to eat one. What we are willing to give up measures the value – our personal value – of the French fry.
That value, expressed in dollars, is the willingness to pay for French fries. That is, if you are willing 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 of consumption 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 badvision, 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 theconsumer surplus associated with eyeglasses 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 a surplus of $2 in the purchase.
How much is a second order of French fries worth? For most of us, that first order is worth more than the second one. If a second
order is worth $2, we would still gain from buying it. Eating a third order of fries is worth less still, and at some point we’re unable orunwilling to eat any more fries even when they are free, which implies that at some point 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.
Many, but not all, goods have this feature of diminishing marginal value – the value of the last unit consumed declines as the number
consumed rises. If we consume a quantity 𝑞𝑞, it implies the marginal value 𝑣𝑣(𝑞𝑞) falls as the number of units rise.1 An example isillustrated in Figure 2.1.1. Here the value is a straight line, declining in the number of units.

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 isdecreasing.

Introduction to Economic Analysis

2-14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 price off thehorizontal axis, that is, given the value p on the vertical axis, thecorresponding value 𝑞𝑞0 on the horizontal axis is the quantity the
consumer will purchase.

value

It is often important to distinguish the demand curve itself – theentire relationship between price and quantity demanded – fromthe quantity demanded. Typically, “demand” refers to the entire
curve, while “quantity demanded” is a point on the curve.

v(q)v(q0), pqq0

Given a price p, a consumer will buy those units with 𝑣𝑣(𝑞𝑞) > 𝑝𝑝,
since those units are worth more than they cost. Similarly, a
consumer should not buy units for which 𝑣𝑣(𝑞𝑞) < 𝑝𝑝. Thus, thequantity 𝑞𝑞0 that solves the equation 𝑣𝑣(𝑞𝑞0 ) = 𝑝𝑝 gives the quantityof units the consumer will buy. This value is also illustrated in
Figure 2.1.1. Another way of summarizing this insight is that themarginal value curve is the inverse of demand function, where
the demand function gives the quantity demanded for any given
price. Formally, if 𝑥𝑥(𝑝𝑝) is the quantity a consumer buys given a
price of p, then 𝑣𝑣�𝑥𝑥(𝑝𝑝)� = 𝑝𝑝.

But what is the marginal value curve? Suppose the total value ofconsumption of the product, in dollar value, is given by 𝑢𝑢(𝑞𝑞).
Figure 2.1.1: A Demand Curve
That is, a consumer who pays 𝑢𝑢(𝑞𝑞) for the quantity q is justFigure 2.1.2 A Demand Curve
indifferent to getting nothing and paying nothing. For eachquantity, 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 willing to pay 𝑢𝑢(𝑞𝑞), any greater amount is more than the consumer should be willing topay.
The consumer facing a price p gets a net value or consumer surplus of 𝐶𝐶𝐶𝐶 = 𝑢𝑢(𝑞𝑞) − 𝑝𝑝𝑝𝑝 from consuming q units. In order to obtainthe maximal benefit, the consumer would then choose the level of q to maximize 𝑢𝑢(𝑞𝑞) − 𝑝𝑝𝑝𝑝. When the function 𝐶𝐶𝐶𝐶 is maximized, its
derivative is zero, which implies that, at the quantity that maximizes the consumer’s net value𝑑𝑑(𝑢𝑢(𝑞𝑞) − 𝑝𝑝𝑝𝑝) = 𝑢𝑢′(𝑞𝑞) − 𝑝𝑝 = 0
𝑑𝑑𝑑𝑑

Thus we see that 𝑣𝑣(𝑞𝑞) = 𝑢𝑢′(𝑞𝑞), that is, the marginal value ofthe good is the derivative of the total value.

value

Consumer surplus is the value of the consumption minus theamount paid, and represents the net value of the purchase to
the consumer. Formally, it is 𝐶𝐶𝐶𝐶 = 𝑢𝑢(𝑞𝑞) − 𝑝𝑝𝑝𝑝. A graphicalform of the consumer surplus is generated by the following
identity.
Consumer
surplus

𝑞𝑞0

𝐶𝐶𝐶𝐶 = max(𝑢𝑢(𝑞𝑞) − 𝑝𝑝𝑝𝑝) = 𝑢𝑢(𝑞𝑞0 ) − 𝑝𝑝𝑞𝑞0 = � (𝑢𝑢′(𝑥𝑥) − 𝑝𝑝)𝑑𝑑𝑑𝑑

v(q)

𝑞𝑞

v(q0), p𝑞𝑞0= � (𝑣𝑣(𝑥𝑥) − 𝑝𝑝)𝑑𝑑𝑑𝑑

0

0

q
q0
Figure 2.1.2: Consumer Surplus

Introduction to Economic Analysis

This expression shows that consumer surplus can be
represented as the area below the demand curve and above theprice, as is illustrated in Figure 2.1.2. The consumer surplus
represents the consumer’s gains from trade, the value ofconsumption to the consumer net of the price paid.
The consumer surplus can also be expressed using the demand
curve, by integrating from the price up. In this case, if 𝑥𝑥(𝑝𝑝) is
the demand, we have
2-15

∞

𝐶𝐶𝐶𝐶 = � 𝑥𝑥(𝑦𝑦)𝑑𝑑𝑑𝑑
𝑝𝑝

When you buy your first car, you experience an increase in demand for gasoline because gasoline is pretty useful for cars and not somuch 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 the marginal value v (movement up) for any given unit, or an increase in the number of units demanded for any given
price (movement to the right). Figure 2.1. illustrates a shift in demand.
Similarly, the reverse movement represents a decrease in demand. The beauty of the connection 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 a movement 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 aremostly purchased by people with high incomes. Few billionaires ride the bus. Economists aptly named goods whose demand doesn’t
increase with income inferior goods, with the idea that people substitute to better quality, more expensive goods as their incomes rise.
When demand for a good increases with income, the good is called a normal good. It would have been better to call such goods
superior, but it is too late to change such a widely accepted convention.
value

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 demand for printers, monitors andinternet access. Such goods are examples of complements. Formally,
for a given good X, a complement is a good whose consumption
increases the value of X. Thus, the use of computers increases thevalue of peripheral devices like printers and monitors. The
consumption of coffee increases the demand for cream for many
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 thevalue of the other. The complementarity relationship is symmetric – ifconsumption of X increases the value of Y, then consumption of Y
must increase the value of X.2 There are many complementary goods
and changes in the prices of complementary goods have predictableeffects on the demand of their complements. Such predictable effects
represent the heart of economic analysis.

v(q)

q

The opposite case of a complement is a substitute. Colas and root beeraresubstitutes, and a fall in the price of root beer (resulting in an
Figure 2.1.3: An Increase in Demand
increase in the consumption of root beer) will tend to decrease thedemand for colas. Pasta and ramen, computers and typewriters, movies (in theaters) and sporting events, restaurants and dining athome, spring break in Florida versus spring break in Mexico, marijuana and beer, economics courses and psychology courses, driving
and bicycling are all examples of substitutes for most 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 of marijuana, 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 theylike. 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 clothing style popularity to economic factors,3 by and large there is no coherent theory determining
fads and fashions beyond the observation that change is inevitable. As a result, 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 to understand the

2 The basis for this insight can be seen by denoting the total value in dollars of consuming goods x and y as 𝑢𝑢(𝑥𝑥, 𝑦𝑦). Then the demand𝜕𝜕𝜕𝜕for x is given by the partial derivative . The statement that y is a complement is the statement that the demand for x rises as yincreases, that is,x.

𝜕𝜕2 𝑢𝑢𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

𝜕𝜕𝜕𝜕> 0. But then with a continuous second derivative,

𝜕𝜕2 𝑢𝑢𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

> 0, which means the demand for y,

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

, increases with

3 Skirts are allegedly shorter during economic booms and lengthen during recessions.
Introduction to Economic Analysis

2-16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 for some of the effects of the increasing acceptance of tattoos through changes in the number of firms offering
tattooing, changes in the variety of products offered, and so on.
Key Takeaways•

Demand is the function that gives the number of units purchased as a function of the price.

•

The difference between your willingness to pay and the amount you pay is known as consumer surplus. Consumer surplus is thevalue in dollars of a good minus the price paid.

•

Many, but not all, goods have the feature of diminishing marginal value – the value of the last unit consumed declines as thenumber consumed rises.

•

Demand is usually graphed with price on the vertical axis and quantity on the horizontal axis.

•

Demand refers to the entire curve, while quantity demanded is a point on the curve.

•

The marginal value curve is the inverse of demand function.

•

Consumer surplus is represented in a demand graph by the area between demand and price.

•

An increase in demand is represented by a movement of the entire curve to the northeast (up and to the right), which represents anincrease in the marginal value v (movement up) for any given unit, or an increase in the number of units demanded for any given
price (movement to the right). Similarly, the reverse movement represents a decrease in demand.

•

Goods whose demand doesn’t increase with income are inferior goods, with the idea that people substitute to better quality, more
expensive goods as their incomes rise. When demand for a good increases with income, the good is called normal.

•

Demand is affected by the price of related goods.

•

For a given good X, a complement is a good whose consumption increases the value of X. The complementarity relationship is
symmetric – if consumption of X increases the value of Y, then consumption of Y must increase the value of X.

•

The opposite case of a complement is a substitute. An increase in the consumption of a substitute decreases the value for a good.
Key Terms•

Consumer surplus: net value in dollars of a consumer's purchase•

Diminishing marginal value: the value of the last unit consumed declines as the number consumed rises•

Demand: the function which gives the quantity purchased as a function of price•

Supply: the function which gives the quantity offered for sale as a function of price•Inferior good: a good whose demand falls as income rises•

Normal good: a good whose demand rises as income rises•

Complement: In demand, a good whose value rises as the consumption of another good rises; in supply a good whose cost falls as
the amount produced of another good rises•

Substitute: In demand, a good whose value falls as the consumption of another good rises; in supply a good whose cost rise as theamount produced of another good rises

Introduction to Economic Analysis

2-17

Exercises
2.1.1

A reservation price is the maximum willingness to pay for a good that 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.

2.1.2

Suppose the demand curve is given by 𝑥𝑥(𝑝𝑝) = 1 − 𝑝𝑝. The consumer’s expenditure is 𝑝𝑝𝑝𝑝(𝑝𝑝) = 𝑝𝑝(1 − 𝑝𝑝). Graph theexpenditure. What price maximizes the consumer’s expenditure?

2.1.3
2.1.4

2.1.5

2.1.6

For demand 𝑥𝑥(𝑝𝑝) = 1 − 𝑝𝑝, compute the consumer surplus function as a function of p.

For demand 𝑥𝑥(𝑝𝑝) = 𝑝𝑝 −𝜀𝜀 , where 𝜀𝜀 > 1, find the consumer surplus as a function of p. (Hint: recall that the consumer surplus∞
can be expressed as 𝐶𝐶𝐶𝐶 = ∫𝑝𝑝 𝑥𝑥(𝑦𝑦)𝑑𝑑𝑑𝑑 ).
Suppose the demand for wheat is given by 𝑞𝑞𝑑𝑑 = 3 − 𝑝𝑝, and the supply of wheat is given by 𝑞𝑞𝑠𝑠 = 2𝑝𝑝, where p is the price.
a.

Solve for the equilibrium price and quantity.

b.

Graph the supply and demand curves. What are the consumer surplus and producer profits?

c.

Now suppose supply shifts to 𝑞𝑞𝑠𝑠 = 2𝑝𝑝 + 1. What are the new equilibrium price and quantity?

How will the following affect the price of a regular cup of coffee, and why?
a.

Droughts in Colombia and Costa Ricab.

A shift toward longer work daysc.

The price of milk fallsd.

A new study that shows many great health benefits of tea

2.1.7

A reservation price is the maximum willingness to pay for a good that most people buy one unit of. Suppose in a market of tshirts, 10 people have a reservation price of $10 and the 11th person has a reservation price of $5. What does the demand“curve” look like?

2.1.8

In exercise 2.1.7, what is the equilibrium price if there were 9 t-shirts available? What if there were 11 t-shirts available?
How about 10?

2.1.9

A consumer’s value for slices of pizza is given by the following table. Graph this person’s demand for slices of pizza.
Slices of pizza

Total value

0

0

1

4

2

7

3

10

4

12

5

11

Introduction to Economic Analysis

2-18

2.2

Supply and Profit
Learning Objectives•

What is supply?

•

What gains made by sellers called?

•

What assumptions are commonly made about supply?

•

What causes supply to rise or fall?

•

What are goods produced together called?

•

How do the prices of one good influence supply for other goods?
The supply curve gives the number of units, represented on thehorizontal axis, as a function of the price on the vertical axis, which will
be supplied for sale to the market. An example is illustrated in Figure
2.2.1: A Supply CurveFigure 2.2.1. Generally supply is upwardsloping, 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 thosesame 50 at a price of $11. The seller might choose to sell more than 50,
but if the first 50 weren’t worth keeping at a price of $10, that remains
true at $11.4pp

The seller who has a cost 𝑐𝑐(𝑞𝑞) for selling 𝑞𝑞 units obtains a profit, atprice 𝑝𝑝 per unit, of 𝑝𝑝𝑝𝑝 – 𝑐𝑐(𝑞𝑞). The quantity which maximizes profit forthe seller is the quantity 𝑞𝑞 ∗ satisfying
𝑑𝑑
𝑝𝑝𝑝𝑝 − 𝑐𝑐(𝑞𝑞) = 𝑝𝑝 − 𝑐𝑐′(𝑞𝑞 ∗ )𝑑𝑑𝑑𝑑

Thus, price equals marginal cost is a characteristic of profit
maximization; the seller sells all the units whose cost is less than price,q
and doesn’t sell the units whose cost exceeds price. In constructing theq0
demand curve, we saw that the demand curve was the inverse of themarginal value. There is an analogous property of supply: the supply
curve is the inverse function of marginal cost. Graphed with the
Figure 2.2.1: A Supply Curve
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 of the price and marginal costq*profit = max pq − c(q ) = pq * −c(q*) = ∫ ( p − c ′( x) )dx. This area is shaded in Figure 2.2.2.
q04This is a good point to remind the reader that the economists’ familiar assumption of “other things equal” is still in effect. If theincreased price is an indication that prices might rise still further, or a consequence of some other change that affects the sellers’ valueof items, then of course the higher price might not justify sale of the items. We hold other things equal to focus on the effects of pricealone, and then 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.

Introduction to Economic Analysis

2-19

The relationship of demand and marginal value exactly parallels therelationship of supply and marginal cost, for a somewhat hidden reason.
Supply is just negative demand, that is, a supplier is just the possessor of agood who doesn’t keep it but instead offers 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 thegood, that is, the marginal value of the good. Thus, with exchange, it ispossible to provide the theory of supply and demand entirely as a theory of
net demand, where sellers are negative demanders. There is somemathematical economy in this approach, and it fits certain circumstances
better than separating supply and demand. For example, when the price ofelectricity 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.

pProfitppq0Figure 2.2.2: Supplier profitq

However, the “net demand” approach obscures the likely outcomes ininstances 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 the equivalent
theory for demand, the nature of these complements and substitutes
tends to be different. For these reasons, and also for the purpose ofbeing consistent with common economic usage, we will distinguishsupply and demand.
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 is graphically represented by a curve thatis lower or to the right, or both, that is, to the south-east. This is
illustrated in Figure 2.2.3. A decrease in supply is the reverse case, ashift to the northwest.

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 is reduced, because wages are theinput price of labor. Labor accounts for about two-thirds of all inputqcosts, and thus wage increases create supply reductions (a higher price
Figure 2.2.3: An Increase in Supply
is necessary to provide the same quantity) for most goods andservices. Costs of materials of course increase the price of goods
using those materials. For example, the most important input into the manufacture of gasoline is crude oil, and an increase of $1 in theprice 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 wood chips and saw dust are useful in the manufactureof paper. An increase in the price of lumber tends to increase the quantity of trees sawn into boards, thereby increasing the supply ofwood 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 – the conditions that give rise to gold compounds also giverise to copper compounds. Thus, an increase in the price of gold tends to increase the number of people prospecting for 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 arecomplements 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 increasein the price of military aircraft will tend to divert resources used in the manufacture of aircraft toward military aircraft and away fromcivilian aircraft, thus reducing the supply of civilian aircraft. Wheat and corn are also substitutes in supply. An increase in the priceof 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
Introduction to Economic Analysis

2-20substitutes. Similarly, cars and trucks, tables and desks, sweaters and sweatshirts, horror movies and romantic comedies are examples
of substitutes in supply.
Complements and substitutes are important because they are common and have predictable effects on demand and supply. Changes in
one market spill over to the other market, through the mechanism of complements or substitutes.
Key Takeaways•

The supply curve gives the number of units as a function of the price which will be supplied for sale to the market.

•

Price equals marginal cost is an implication of profit maximization; the seller sells all the units whose cost is less than price, anddoesn’t sell the units whose cost exceeds price.

•

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.

•

Profit is given by the difference of the price and marginal cost•

Supply is negative demand.

•

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 ofunits. Thus, an increase in supply is graphically represented by a curve that is lower or to the right, or both, that is, to the southeast. A decrease in supply is the reverse case, a shift to the northwest.

•

Anything that increases costs of production will tend to increase marginal cost and thus reduce the supply.

•

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.

•

The opposite of a complement in supply is a substitute in supply.
Key Terms•

Supply: the function which gives the quantity offered for sale as a function of price•Complement: In demand, a good whose value rises as the consumption of another good rises; in supply a good whose cost falls as
the amount produced of another good rises•

Substitute: In demand, a good whose value falls as the consumption of another good rises; in supply a good whose cost rise as theamount produced of another good rises
Exercises

2.2.1.

A typist charges $30/hr and types 15 pages per hour. Graph the supply of typed pages.

2.2.2.

An owner of an oil well has two technologies for extracting oil. With one technology, the oil can be pumped out andtransported for $5,000 per day, 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 switchfrom one technology to the other? At what price would the producer shut down and spend nothing?)

2.2.3.

2.2.4.

An entrepreneur has a factory that produces 𝐿𝐿α widgets, where α < 1, when 𝐿𝐿 hours of labor is used. The cost of labor(wage and benefits) is 𝑤𝑤 per hour. If the entrepreneur maximizes profit, what is the supply curve for widgets?

Hint: The entrepreneur’s profit, as a function of the price, is 𝑝𝑝𝑝𝑝α – 𝑤𝑤𝑤𝑤. The entrepreneur chooses the amount of labor to
maximize profit. Find the amount of labor that maximizes, which is a function of 𝑝𝑝, 𝑤𝑤 and α. The supply is the amount of
output produced, which is Lα.

In the above exercise, suppose now that more than 40 hours entails a higher cost of labor (overtime pay). Let w be $20/hr for1
under 40 hours, and $30/hr for each hour over 40 hours, and α = . Find the supply curve.
2

2.2.5.

Hint: Let 𝐿𝐿(𝑤𝑤, 𝑝𝑝) be the labor demand when the wage is 𝑤𝑤 (no overtime pay) and the price is 𝑝𝑝. Now show that, if
𝐿𝐿(20, 𝑝𝑝) < 40, the entrepreneur uses 𝐿𝐿(20, 𝑝𝑝) hours. This is shown by verifying that profits are higher at 𝐿𝐿(20, 𝑝𝑝) than at
𝐿𝐿(30, 𝑝𝑝). If 𝐿𝐿(30, 𝑝𝑝) > 40, the entrepreneur uses 𝐿𝐿(30, 𝑝𝑝) hours. Finally, if 𝐿𝐿(20, 𝑝𝑝) > 40 > 𝐿𝐿(30, 𝑝𝑝), the entrepreneur
uses 40 hours. Labor translates into supply via 𝐿𝐿α.
In the previous exercise, for what range of prices does employment equal 40 hours? Graph the labor demanded by theentrepreneur. Hint: The answer involves √10

Introduction to Economic Analysis

2-212.2.6.

2.3

Suppose marginal cost, as a function of the quantity 𝑞𝑞 produced, is 𝑚𝑚𝑚𝑚. Find the producer’s profit as a function of the price𝑝𝑝.

Market Demand and Supply

Learning Objectives•

How are individual demands and supplies aggregated to create a 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.
Individual demand gives the quantity
purchased for each price. Analogously,
the market demand gives the quantity
Market Demandpurchased by all the market participants– the sum of the individual demands –for each price. This is sometimes calleda “horizontal sum” because thesummation is over the quantities forpeach price. An example is illustrated in
Figure 2.3.1. For a given price 𝑝𝑝, thequantity 𝑞𝑞1 demanded by one consumer,
and the quantity 𝑞𝑞2 demanded by asecond consumer are illustrated. The
sum of these quantities represents themarket demand, if the market has justthose two-participants. Since theconsumer 2 has a positive quantity
demanded for high prices, while
consumer
1 does not, the market
q1
q2
q1+ q2
demand coincides with consumer 2’s
demand when the price is sufficiently
Figure 2.3.1: Market Demandhigh. 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 𝑞𝑞1 = max {0, 10 – 𝑝𝑝}, and the demand of buyer 2 is given by 𝑞𝑞2 =max{0, 20 – 4𝑝𝑝} , what is market demand for the two-participants?

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 price between 5 and 10, market demand is buyer 1’s demand, or 10 – 𝑝𝑝. Finally, for a pricebetween zero and 5, the market quantity demanded is 10 – 𝑝𝑝 + 20 – 4𝑝𝑝 = 30 – 5𝑝𝑝.
Market supply is similarly constructed – the market supply is the horizontal (quantity) sum of all the individual supply curves.
Example: If the supply of firm 1 is given by 𝑞𝑞 = 2𝑝𝑝, and the supply of firm 2 is given by 𝑞𝑞 = max{0, 5𝑝𝑝 – 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 pricebetween zero and 2, market supply is firm 1’s supply, or 2𝑝𝑝. For 𝑝𝑝 > 2, market supply is 5𝑝𝑝 – 10 + 2𝑝𝑝 = 7𝑝𝑝 – 10.
Key Takeaways•

The market demand gives the quantity purchased by all the market participants – the sum of the individual demands – for each
price. This is sometimes called a “horizontal sum” because the summation is over the quantities for each price.

•

The market supply is the horizontal (quantity) sum of all the individual supply curves.
Key Terms•

Market demand: the horizontal sum of individual demand, giving the quantity demanded by all individuals as a function of price•Market supply: the horizontal sum of individual supply giving the quantity supplied by all market participants as a function of
price

Introduction to Economic Analysis

2-22

Exercises
2.3.1

Is the consumer surplus for market demand the sum of the consumer surpluses for the individual demands? Why or why
not? Illustrate your conclusion with a figure like Figure 2.3.1.

2.4

Equilibrium
Learning Objectives•

How are prices determined?

•

What happens when price is too low? Too high?

When will the price remain steady?
Economists use the term equilibrium in the same way as the word is used in physics, to represent a steady state in which opposing
forces are balanced, so that the current state of 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 for lower prices, and thus that the current state ofexchange between buyers and sellers can be expected to persist.
When the price is such that the quantity supplied of a good or service exceeds the quantity demanded, some sellers are unable to sellbecause fewer units are purchased than are offered. This condition is called a surplus. The sellers who fail to sell have an incentive tooffer 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 thequantity supplied equals the quantity demanded.
Similarly, when the price is low enough that the quantity demanded exceeds the quantity supplied, a shortage exists. In this case,some buyers fail to purchase, and these buyers have an incentive to accept a slightly higher price in order to be able to trade. 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 the quantity demanded and increase the quantity supplied, thereby eliminating the shortage. Again, the process
stops when the quantity supplied equals the quantity demanded.
This logic, which is illustrated in Figure 2.4.1, justifies theconclusion that the only equilibrium price is the price inwhich the quantity supplied equals the quantity demanded.
Any other price will tend to rise in a shortage, or fall in asurplus, until supply and demand are balanced. In Figure
2.4.1, a surplus arises at any price above the equilibrium
price 𝑝𝑝∗ , because the quantity supplied 𝑞𝑞𝑠𝑠 is larger than thequantity demanded 𝑞𝑞𝑑𝑑 . The effect of the surplus – leading tosellers with excess inventory – induces price cutting which isillustrated with three arrows pointing down.

pSupplySurplus: qd < qsp*Similarly, when the price is below 𝑝𝑝∗ , the quantity supplied
𝑞𝑞𝑠𝑠 is less than the quantity demanded 𝑞𝑞𝑑𝑑 . This causes somebuyers to fail to find goods, leading to higher asking prices
and higher bid prices by buyers. The tendency for the priceto rise is illustrated with the arrows pointing up. The only
price which doesn’t lead to price changes is 𝑝𝑝∗ , theequilibrium price in which the quantity supplied equals thequantity demanded.

Shortage: qs < qd
Demandqq*
Figure 2.4.1: Equilibrium

The logic of equilibrium in supply and demand is played out
daily in markets all over the world, from stock, bond andcommodity 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 realestate markets.
The equilibrium of supply and demand balances the quantity demanded and the quantity supplied, so that there is no excess of either.
Would it be desirable, from a social perspective, to force more trade, or to restrain trade below this level?

Introduction to Economic Analysis

2-23There are circumstances where the equilibrium level of trade has harmful consequences, and such circumstances are considered in thechapter on externalities. However, provided that the only people affected by a transaction are the buyer and seller, the equilibrium of
supply and demand maximizes the total gains from trade.
This proposition is quite easy to see. To maximize the gains from trade, clearly the highest 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 just by
diverting the good to the higher value buyer. Similarly, the lowest cost sellers must supply those goods; otherwise we can increase thegains from trade by replacing a higher cost seller with a lower cost seller. Thus, the only question is how many goods should betraded to maximize the gains from trade, since it will involve the lowest cost sellers selling to the highest value buyers. Adding a trade
increases the total gains from trade when that trade involves a buyer with value higher than the seller’s cost. Thus, the gains fromtrade are maximized by the set of transactions to the left of the equilibrium, with the high value buyers buying from the low costsellers.
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.
Key Takeaways•

The quantity supplied of a good or service exceeds the quantity demanded is called a surplus.

•

If the quantity demanded exceeds the quantity supplied, a shortage exists.

•

The equilibrium price is the price in which the quantity supplied equals the quantity demanded.

•

The equilibrium of supply and demand maximizes the total gains from trade.
Key Terms•

Equilibrium: In markets, the price where quantity supplied equals quantity demanded; see also Nash equilibrium•

Shortage: more units demanded than supplied•

Surplus: fewer units demanded than supplied•

Efficient: Cannot be re-arranged to provide more outputs
Exercises

2.4.1

If demand is given by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎 – 𝑏𝑏𝑏𝑏, and supply is given by 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑐𝑐𝑐𝑐, solve for the equilibrium price and quantity.
Find the consumer surplus and producer profits.

2.4.2

If demand is given by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 , and supply is given by 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑏𝑏𝑝𝑝𝜂𝜂 , where all parameters are positive numbers,
solve for the equilibrium price and quantity.

2.5

Changes in Demand and Supply
Learning Objectives•

What are the effects of changes in demand and supply?

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, and also spurred additional development, increasing the quantity of housing supplied as well. We seesuch a demand increase illustrated in Figure 2.5.1, which represents an increase 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 priceincreases from 𝑝𝑝1∗ to 𝑝𝑝2∗ , and the quantity rises from 𝑞𝑞1∗ to 𝑞𝑞2∗ .
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 the reverse 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 – VHS tapes were replaced by DVDs, vinyl records
replaced by CDs, cassette tapes replaced by CDs, 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.

Introduction to Economic Analysis

2-24

p

S

p2*
p1*

p

p1*

p2*

An increase in supply comes about from a fall in themarginal cost – recall that the supply curve is just themarginal cost of production. Consequently, an increased
supply is represented by a curve that is lower and to theright on the supply/demand graph, which is an endlesssource of confusion for many students. The reasoning –lower costs and greater supply are the same thing – is too
easily forgotten. The effects of an increase in supply areillustrated in Figure 2.5.2. The supply curve goes from S1
to S2, which represents a lower marginal cost. In thiscase, the quantity traded rises from 𝑞𝑞1∗ to 𝑞𝑞2∗ and price falls
from 𝑝𝑝1∗ to 𝑝𝑝2∗ .

D2 Computer equipment provides dramatic examples ofincreases in supply. Consider Dynamic Random Access
Memory, or DRAM. DRAMs are the chips in computers
and many other devices that store information on atemporary basis.5 Their cost has fallen dramatically,
D1
which is illustrated in Figure 2.5.3.6 Note that the pricesqin this figure reflect a logarithmic scale, so that a fixed
q1*
q2*
percentage decrease is illustrated by a straight line. Prices
of DRAMs fell to close to 1/1000th of their 1990 level by
Figure 2.5.1: An Increase in Demand
2004. The means by which these prices have fallen arethemselves quite interesting. The main reasons are shrinking the size of the chip (a “die shrink”), so that more chips fit on each silicondisk, 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 theS1solutions to thousands of engineering 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.
S2
An important source of supply and demand changes are changes in
the markets of complements. A decrease in the price of a demandcomplement 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 or complements. For example, when the price ofgasoline falls, the demand for automobiles (a complement) overall
should increase. As the price of automobiles rises, the demand forbicycles (a substitute in some circumstances) should rise. When theprice of computers falls, the demand for operating systems (acomplement) should rise. This gives an operating system seller likeD
Microsoft an incentive to encourage technical progress in the
q computer market, in order to make the operating system morevaluable.
q1*
q2*
Figure 2.5.2: An Increase in Supply

5 Information that will be stored on a longer term basis is generally embedded in flash memory or on a hard disk. Neither of theseproducts lose their information when power is turned off, unlike DRAM.
6 Used with permission of computer storage expert Dr. Edward Grochowski.
Introduction to Economic Analysis

2-25Figure 2.5.3: 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 tosuppliers), and similarly, a decrease in the price of 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 price of DVD-R discs (used for recording DVDs)
discourages investment in the manufacture of 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 natural gas, which is a complement in supply. However, since natural gas is also a demand substitutefor oil (both are used for heating homes), an increase in the price of oil also tends to increase the demand for natural gas. Thus, anincrease in the price of oil increases both the demand and the supply of natural gas. Both changes increase the quantity traded, but theincrease in demand tends to increase the price, while the increase 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.
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 or electric 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 bythis 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 13.4, but
only in a rudimentary way for this introductory text. Second, energy is a modest portion of the cost of owning and operating 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 ofthat device, an effect with the gobbledygook name of hysteresis. Third, a permanent increase in energy prices leads people to buy
more fuel efficient cars, and to replace the old gas guzzlers more quickly. That is, the effects of a change are larger over a larger timeinterval, which economists tend to call the long-run.
A striking example of such delay arose when oil quadrupled in price in 1973-4, caused by a reduction in sales by the cartel of oilproducing nations, OPEC, which stands for the Organization 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 thequantity 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, the North 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 the price 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 inproduction, 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 the resulting 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 to predictable patterns of prices and quantities over time.
Introduction to Economic Analysis

2-26

It turns out that direct estimates of demand and supply are less useful as quantifications than notions of percentage changes, whichhave the advantage of being unit-free. This observation gives rise to the concept of elasticity, the next topic.
Key Takeaways•

An increase in the demand increases both the price and quantity traded.

•

A decrease in demand implies a fall in both the price and the quantity traded.

•

An increase in the supply decreases the price and increases the quantity traded.

•

A decrease in the supply increases the price and decreases the quantity traded.

•

A supply change affects a price, which in turn affect the demand for both demand complements and substitutes.

•

People react less to temporary changes than to permanent changes. 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 called hysteresis.

•

Short-run and long-run effects represent a theme of economics, with the major conclusion that substitution doesn’t occur
instantaneously, which leads to predictable patterns of prices and quantities over time.
Key Terms•

Short-run: a time period where not all inputs can be changed•

Long-run: a time period long enough that all inputs can be changed•

Hysteresis: past choices influencing current decisions
Exercises

2.5.1

Video games and music CDs are substitutes in demand. What is the effect of an increase in supply of video games on theprice and quantity traded of music CDs? Illustrate your answer with diagrams for both markets.

2.5.2

Electricity is a major input into the production of aluminum, and aluminum is a substitute in supply for steel. What is theeffect of an increase in price of electricity on the steel market?

2.5.3

Concerns about terrorism reduced demand for air travel, and induced consumers to travel by car more often. What should
happen to the price of Hawaiian hotel rooms?

Introduction to Economic Analysis

2-27

3

Quantification

Practical use of supply and demand generally requires quantifying effects. If a hurricane wipes out a gasoline refinery, by how much
will the price rise, and for how long will it stay high? When the price of energy efficient lightbulbs falls, how long does it take toreplace 50% of our incandescent stock of bulbs? This chapter introduces the basic tools of quantification, the elasticities of demandand supply.

3.1

Elasticity
Learning Objectives•

What is the best way of measuring the responsiveness of demand?

•

What is the best way of measuring the responsiveness of supply?

Let 𝑥𝑥(𝑝𝑝) represent the quantity purchased when the price is 𝑝𝑝, so that the function 𝑥𝑥 represents demand. How responsive is demand to
price changes? One might be tempted to use the derivative 𝑥𝑥′ to measure the responsiveness of demand, since it measures directly
how much the quantity demanded changes in response to a small change in price. However, this measure has two problems. First, it issensitive to a change in units. If I measure the quantity of candy in kilograms rather than pounds, the derivative of demand for candywith respect to price changes even when demand itself has remained the same. Second, if I change price units, converting from one
currency to another, again the derivative of demand will change. So the derivative is unsatisfactory as a measure of responsivenessbecause it depends on units of measure. A common way of 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 in price. This is the notion of elasticity ofdemand.7 The elasticity of demand is the percentage 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
𝑑𝑑𝑑𝑑�

𝜀𝜀 = − 𝑑𝑑𝑑𝑑 𝑥𝑥 = −�𝑝𝑝

𝑝𝑝 𝑑𝑑𝑑𝑑

𝑥𝑥 𝑑𝑑𝑑𝑑=−

𝑝𝑝𝑝𝑝′(𝑝𝑝)𝑥𝑥(𝑝𝑝).

The minus sign is included to make the elasticity a positive number, since demand is decreasing. First, let’s verify that the elasticity is
in fact unit free. A change in the measurement of x cancels because the proportionality factor appears in both the numerator anddenominator. Similarly, if we change the units of measurement of price to replace the price p with r=ap, x(p) is replaced with x(r/a).
Thus, the elasticity is
𝑟𝑟 ′ 𝑟𝑟𝑟𝑟𝑑𝑑′
𝑥𝑥 � �
𝑥𝑥 � �
𝑎𝑎𝑎𝑎
𝑎𝑎 = − 𝑝𝑝𝑥𝑥 (𝑝𝑝)𝑑𝑑𝑑𝑑=−
𝜀𝜀 = −𝑟𝑟
𝑟𝑟
𝑥𝑥(𝑝𝑝)𝑥𝑥 � �
𝑥𝑥 � �
𝑎𝑎𝑎𝑎𝑟𝑟

which is independent of 𝑎𝑎, and therefore not affected by the change in units.

How does a consumer’s expenditure, also known as (individual) total revenue, react to a change in price? The consumer buys 𝑥𝑥(𝑝𝑝) ata price of 𝑝𝑝, and thus total expenditure or total revenue is 𝑇𝑇𝑇𝑇 = 𝑝𝑝𝑝𝑝(𝑝𝑝). Thus
𝑝𝑝𝑥𝑥 ′ (𝑝𝑝)𝑑𝑑
𝑝𝑝𝑝𝑝(𝑝𝑝) = 𝑥𝑥(𝑝𝑝) + 𝑝𝑝𝑥𝑥 ′ (𝑝𝑝) = 𝑥𝑥(𝑝𝑝) �1 +
� = 𝑥𝑥(𝑝𝑝)(1 − 𝜀𝜀)𝑥𝑥(𝑝𝑝)
𝑑𝑑𝑑𝑑
Therefore,

𝑑𝑑
𝑇𝑇𝑇𝑇
𝑑𝑑𝑑𝑑
= 1 − 𝜀𝜀1
𝑇𝑇𝑇𝑇
𝑝𝑝

Table 3.1.1: Various Demand Elasticities8
Productε

Product

ε7 The concept of elasticity was invented by Alfred Marshall, 1842-1924, in 1881 while sitting on his roof.
8 From http://www.mackinac.org/archives/1997/s1997-04.pdf; cited sources: Economics: Private and Public 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
Introduction to Economic Analysis

3-28

Salt

0.1

Movies0.9

Matches0.1

Shellfish, consumed at home

0.9

Toothpicks

0.1

Tires, short-run

0.9

Airline travel, short-run

0.1

Oysters, consumed at home

1.1

Residential natural gas, short-run

0.1

Private education

1.1

Gasoline, short-run

0.2

Housing, owner occupied, long-run

1.2

Automobiles, long-run

0.2

Tires, long-run

1.2

Coffee0.25

Radio and television receivers

1.2

Legal services, short-run

0.4

Automobiles, short-run

1.2-1.5

Tobacco products, short-run

0.45

Restaurant meals

2.3

Residential natural gas, long-run

0.5

Airline travel, long-run

2.4

Fish (cod) consumed at home

0.5

Fresh green peas

2.8

Physician services

0.6

Foreign travel, long-run

4.0

Taxi, short-run

0.6

Chevrolet automobiles

4.0

Gasoline, long-run

0.7

Fresh tomatoes

4.6

In words, the percentage change of total revenue resulting from a one percent change in price 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 of demand is greater than one, which is defined as
an elastic demand. The case of elasticity equal to one is called unitary elasticity, and total revenue is unchanged by a small pricechange. Moreover, that percentage increase in price will increase revenue by approximately 1 − ε percent. Because it is often
possible to estimate the elasticity of demand, the formulae can be readily used in practiceTable 3.1.1 provides estimates on demand elasticities for a variety of products.
price
a/b

Figure 3.1.1: Elasticities for Linear Demandε=∞When demand is linear, 𝑥𝑥(𝑝𝑝) = 𝑎𝑎 − 𝑏𝑏𝑏𝑏, the elasticity of demand has the
form
𝜀𝜀 =

ε=1

𝑏𝑏𝑏𝑏

𝑎𝑎−𝑏𝑏𝑏𝑏= 𝑎𝑎𝑝𝑝

�𝑏𝑏 −𝑝𝑝.

This case is illustrated in Figure 3.1.1.
If demand takes the form 𝑥𝑥(𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 , then demand has constantelasticity, and the elasticity is equal to ε.

ε=0
a

q

The elasticity of supply is analogous to the elasticity of demand, in that it
is a unit-free measure of the responsiveness of supply to a price change,
and is defined as the percentage increase in quantity supplied resulting
from a small percentage increase in price. Formally, if 𝑠𝑠(𝑝𝑝) gives thequantity supplied for each price 𝑝𝑝, the elasticity of supply, denoted η (theGreek letter “eta”, chosen because epsilon was already taken) is
𝜂𝜂 =

′
𝑑𝑑𝑑𝑑�
𝑠𝑠 𝑝𝑝 𝑑𝑑𝑑𝑑 𝑝𝑝𝑠𝑠 (𝑝𝑝)
=
=
.
𝑑𝑑𝑑𝑑�
𝑠𝑠(𝑝𝑝)
𝑠𝑠 𝑑𝑑𝑑𝑑𝑝𝑝

Again similar to demand, if supply takes the form 𝑠𝑠(𝑝𝑝) = 𝑎𝑎𝑝𝑝𝜂𝜂 , then supply has constant elasticity, and the elasticity is equal to η. A
special case of this form is linear supply, which occurs when the elasticity equals one.

Behavior (Baltimore: Johns Hopkins University Press, 1981); Hsaing-tai Cheng and Oral Capps, Jr., "Demand for Fish" American
Journal of Agricultural Economics, August 1988; and U.S. Department of Agriculture.
Introduction to Economic Analysis

3-29Key Takeaways•

The elasticity of demand is the percentage decrease in quantity that results from a small percentage increase in price, which is
generally denoted with the Greek letter epsilon ε.

•

The percentage change of total revenue resulting from a one percent change in price is one minus the elasticity of demand.

•

An elasticity of demand is less than one is defined as an inelastic demand. In this case increasing price increases total revenue.

•

A price increase will decrease total revenue when the elasticity of demand is greater than one, which is defined as an elastic
demand.

•The case of elasticity equal to one is called unitary elasticity, and total revenue is unchanged by a small price change.

•

If demand takes the form 𝑥𝑥(𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 , then demand has constant elasticity, and the elasticity is equal to ε.

••

The elasticity of supply is defined as the percentage increase in quantity supplied resulting from a small percentage increase in
price.
If supply takes the form 𝑠𝑠(𝑝𝑝) = 𝑎𝑎𝑝𝑝𝜂𝜂 , then supply has constant elasticity, and the elasticity is equal to η.
Key Terms•

Elasticity: the percentage change of one variable created by a small percentage change of another variable•

Elasticity of demand: the percentage change of the quantity demanded per unit of percentage change of price•

Elasticity of supply: the percentage change of the quantity supplied per unit of percentage change of price•Total revenue: price times quantity•

Total expenditure: price times quantity•

Elastic: elasticity greater than one•

Inelastic: elasticity less than one•

Unitary elastic: elasticity equal to one•

Constant elasticity: elasticity constant -- functional form proportional to p^elasticity
Exercises

3.1.1
3.1.2

Suppose a consumer has a constant elasticity of demand ε, and demand is elastic (ε > 1). Show that expenditure increases
as price decreases.

Suppose a consumer has a constant elasticity of demand ε, and demand is inelastic (ε < 1). What price makes expenditure
the greatest?

3.1.4

For a consumer with constant elasticity of demand ε > 1, compute the consumer surplus.

3.2

Supply and Demand Changes

3.1.3

For a producer with constant elasticity of supply, compute the producer profits.

Learning Objectives•

What are the effects of changes in supply and demand on price and quantity?

•

What is a useful approximation of these changes?

When something changes – the price of a complement, the demand for a good – what happens to the equilibrium? Such questions areanswered 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 theequilibrium level. Elasticities will help us quantify these changes.
How much do the price and quantity traded change in response to a change in demand? We begin by considering the constantelasticity case, which will let us draw conclusions for small changes in more general demand functions. We will denote the demand
function by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎𝑝𝑝 −𝜀𝜀 and supply function by 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑏𝑏𝑝𝑝𝜂𝜂 . The equilibrium price 𝑝𝑝∗ is given by the quantity supplied equal to
the quantity demanded, or the solution to the equation:
𝑞𝑞𝑑𝑑 (𝑝𝑝 ∗ ) = 𝑞𝑞𝑠𝑠 (𝑝𝑝 ∗ )Introduction to Economic Analysis

3-30Substituting the constant elasticity formulae,
𝑎𝑎𝑝𝑝 ∗ −𝜀𝜀 = 𝑞𝑞𝑑𝑑 (𝑝𝑝∗ ) = 𝑞𝑞𝑠𝑠 (𝑝𝑝 ∗ ) = 𝑏𝑏𝑝𝑝∗ 𝜂𝜂

Thus,
𝑎𝑎
= 𝑝𝑝∗ 𝜀𝜀+𝜂𝜂𝑏𝑏or

𝑎𝑎 1�𝜀𝜀+𝜂𝜂𝑝𝑝∗ = � �𝑏𝑏

The quantity traded, 𝑞𝑞 ∗ , can be obtained from either supply or demand and the price:𝑎𝑎

𝑞𝑞 ∗ = 𝑞𝑞𝑠𝑠 (𝑝𝑝 ∗ ) = 𝑏𝑏𝑝𝑝∗ 𝜂𝜂 = 𝑏𝑏 � �𝑏𝑏𝜂𝜂�𝜀𝜀+𝜂𝜂

𝜂𝜂𝜀𝜀= 𝑎𝑎 �𝜀𝜀+𝜂𝜂 𝑏𝑏 �𝜀𝜀+𝜂𝜂 .

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 𝑎𝑎. Suppose we increase 𝑎𝑎 by a fixed percentage, replacing
1
𝑎𝑎 by 𝑎𝑎(1 + ∆). Then price goes up by the multiplicative factor (1 + ∆) �𝜀𝜀+𝜂𝜂 and the change in price, as a proportion of the price, is
∆𝑝𝑝∗
𝑝𝑝∗

1

= (1 + ∆) �𝜀𝜀+𝜂𝜂 − 1.

Similarly, quantity rises by
∆𝑞𝑞 ∗
𝑞𝑞 ∗

𝜂𝜂

= (1 + ∆) �𝜀𝜀+𝜂𝜂 − 1.

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 can be addressed by considering small changes, that is, a small value of ∆. We make use of a trick
to simplify the formula. The trick is that, for small ∆,(1 + Δ)𝑟𝑟 ≈ 1 + 𝑟𝑟∆

The squiggly equals sign ≈ should be read “approximately equal to.”9 Applying this insight, we have that:
For a small percentage increase ∆ in demand, quantity rises by approximately𝜂𝜂∆percent and price rises by approximately

𝜀𝜀+𝜂𝜂

∆

percent.

𝜀𝜀+𝜂𝜂The beauty of this claim is that it holds even when demand and supply do not have constant elasticities, because the effect considered
is local, and locally, the elasticity is approximately constant if the demand is “smooth.”
Key Takeaways•

For a small percentage increase ∆ in demand, quantity rises by approximately
percent.

•

For a small percentage increase ∆ in supply, quantity rises by approximately
percent.

𝜂𝜂∆

percent and price rises by approximately𝜀𝜀∆percent and price falls by approximately

𝜀𝜀+𝜂𝜂

𝜀𝜀+𝜂𝜂

∆

𝜀𝜀+𝜂𝜂
∆

𝜀𝜀+𝜂𝜂

9 The more precise meaning of ≈ is that, as ∆ gets small, the size of the error of the formula is small even relative to ∆. That is,(1+∆)𝑟𝑟 −(1+𝑟𝑟∆)(1 + Δ)𝑟𝑟 ≈ 1 + 𝑟𝑟∆ means lim=0∆→0Introduction to Economic Analysis

∆

3-31

Exercises
3.2.1

Show that for a small percentage increase ∆ in supply, quantity rises by approximately
approximately

∆

𝜀𝜀+𝜂𝜂

percent.

𝜀𝜀∆

𝜀𝜀+𝜂𝜂

percent and price falls by

3.2.2

If demand is perfectly inelastic, what is the effect of a decrease in supply? Apply the formula and then graph the solution.

3.2.3

Suppose demand and supply have constant elasticity equal to 3. What happens to equilibrium price and quantity when the
demand increases by 3% and the supply decreases by 3%?

3.2.4

Show that elasticity can be expressed as a constant times the change in the log of quantity divided by the change in log of

3.2.5

price. (That is, show 𝜀𝜀 = 𝐴𝐴

3.2.6

𝑑𝑑 ln 𝑥𝑥(𝑝𝑝)𝑑𝑑 ln 𝑝𝑝)). Find the constant A.

A car manufacturing company employs 100 workers and has two factories, one the produces sedans and one that makes
trucks. With 𝑚𝑚 workers, the sedan factory can make 𝑚𝑚2 sedans per day. With 𝑛𝑛 workers, the truck factory can make 5𝑛𝑛3
trucks per day. Graph the production possibilities frontier.

In exercise 3.2.5, assume sedans sell for $20,000 and trucks sell for $25,000. What assignment of workers maximizes
revenue?

Introduction to Economic Analysis

3-32

4

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 be ignorant of how we are changing, and how we arenot.10

4.1

Basic Demographics
Learning Objectives•

Who lives in the USA?

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 4.1.1: 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 overthe century, with the white population falling from 89% to 83%. The census is thought 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.

10 I apologize to those using the book in other countries; this chapter is about the US not because it is more important but because I
know it better. Encourage your professor to write a chapter on your country! 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/.
Introduction to Economic Analysis

4-33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 4.1.2: US Urban and White Population
The United States population has been aging significantly, with the proportion of seniors (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 and five 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 4.1.3: Population Proportions by Age GroupThe baby boom – a dramatic increase in births for the years 1946-1964, is visible in the Figure 4.1.3 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 oldbracket. There is a slight “echo” of the baby boom, most readily seen by looking at the 0-5 age bracket, as in Figure 4.1.4.

Introduction to Economic Analysis

4-34

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 4.1.4: Proportion of Population under Age Five
The aging of the American population is a consequence of greater life expectancy. When Social Security was created in 1935, theaverage American male lived to be slightly less than 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.
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 4.1.5: US Life Expectancy at BirthFigure 4.1.5 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 – is primarily 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.

Introduction to Economic Analysis

4-35

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 4.1.6: US Immigrant Population, in Percent, by Continent of Origin
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 United States, however, has been increasing after a long decline, and the fraction of the populationthat were born in other countries is about 11% -- one in nine.

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%
Canada, 7.3%

Africa , 1.5%
Caribbean , 7.6%

Mexico, 13.1%

Figure 4.1.7: National Origin of Immigrants, 1900-2000
The majority of immigrants during this century came from Europe, but immigration from Europe has been declining for most of the
century, while immigration from Asia and Latin America has grown substantially. Figure 4.1.7 aggregates the total country of origin
data over the century, to identify the major sources of immigrants.
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 population is actually a small fraction of the population in the United States.

Introduction to Economic Analysis

4-36

80.0
70.0

Percent

60.0
Never

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 4.1.8: Male Marital Status (Percentages)
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 4.1.9: 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 the proportion 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 thanprobably there are today.

Introduction to Economic Analysis

4-37

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 4.1.10: Percent of Births to Single 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 that involve a teenage mother.
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 4.1.11: Percent of Births to Women Age 19 or less

Introduction to Economic Analysis

4-38Key Takeaways•

No one in their right mind memorizes the takeaways of this chapter; the goal is to have a sense of one’s nation.

•

There are about three hundred million people in the United States, up from 76 million in 1900.

•

The US population has become primarily an urban population, growing from 40% to 80% urban in the past century.

•

The population is primarily white, with 12-13% African-American.

•

The United States population has aged, with the proportion of seniors (over 65 years old) tripling over the past century, and the
proportion of young people dropping by over a third.

•

The baby boom was a dramatic increase in births for the years 1946-1964.

•

The aging of the American population is a consequence of greater life expectancy.

•

About 11% of Americans were born in foreign countries.

•

The divorced population is about 10%.

•

Marriage rates have fallen, but primarily because the “never married” category has grown.
Key Terms•

Baby boom: a dramatic increase in births for the years 1946-1964

4.2

Education
Learning Objectives•

Who goes to school and how much?

Why are the western nations rich, and many other nations poor? What creates the wealth of the developed nations? Modern economic
analysis attributes much of the growth of the United States and other developed nations to its educated workforce, and not 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
50.0
40.0

<5
>12
>16

30.0
20.0
10.0

19
10
19
17
19
24
19
31
19
38
19
45
19
52
19
59
19
66
19
73
19
80
19
87
19
94
20
01

0.0

Figure 4.2.1: 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 ofelementary school has dropped from about a quarter of the population to a steady 1.6%. At least 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 high school.
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.
Introduction to Economic Analysis

4-39

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 4.2.2: Graduation Rates
There are several interesting things to see in Figure 4.2.2. First, high school completion dropped significantly during World War II(1940-45) but rebounded after. Second, after World War II, college graduation spiked, as many US soldiers were sent to university by
the government under a program called the “GI Bill.”11
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, high school
completion and university were in large part a sign of wealth. The creation of a large segment of the population who graduated fromhigh 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 the high rate of financial return to education in
the United States. Much of the reduction in completion 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 “General Equivalent Degree”) after
successfully passing examinations in five subject areas. Unfortunately, those people who obtain GED certification are not as
successful as high school graduates, even marginal graduates, and indeed the GED certification does not seem to help students
succeed, in comparison with high school graduation.12
Key Takeaways•

85% of the US population completes 12 years of schooling, not counting kindergarten.

•

A quarter of the population completes at least four years of university.

•

High school graduates comprised the bulk of the middle class.

•High school completion has been declining for thirty years. This is surprising given the high rate of financial return to educationin the United States.

11

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.
12 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.
Introduction to Economic Analysis

4-40

4.3

Households and Consumption
Learning Objectives•

How much do we spend?

There are approximately one hundred million households – a group of people sharing living quarters – in the United States. The
number of residents per household has consistently shrunk during this century, from over four to under three.
5

4

3

2

1

0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Figure 4.3.1: 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, even though 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 thesame number of men and women born – is accounted for by the greater female longevity already noted above.
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 4.3.2: 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 attached houses, such as “row houses.” Slightly over 7½ % live in mobile homes or trailers, and theremainder live in multi-unit housing, including apartments and duplexes. Two-thirds of American families own their own homes, up
from 43% in 1940. Slightly less than half a percent of the population is incarcerated in state and federal prisons. This represents afour-fold increase over 1925-1975.

Introduction to Economic Analysis

4-41

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 4.3.3: Percentage of Incarcerated Residents
Ten percent of households do not have an automobile, and 97.6% have a telephone. So-called “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 (or fifth) is a group of size 20%. Thus the top income quintile represents the top 20% ofincome earners, the next represents those ranking 60%-80%, and so on. Figure 4.3.4 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
54

19
47

0

Figure 4.3.4: Income Shares for Three Quintiles

Introduction to Economic Analysis

4-42180,000
160,000
140,000
95%

120,000

80%

100,000

60%

80,00040%

60,00020%

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 4.3.5: 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, infact families are getting richer, just not as fast as the top quintile.
250

200
150

20%
40%
60%

100

80%
95%

50

2001

1998

1995

1992

1989

1986

1983

1980

1977

1974

1971

1968

1965

1962

1959

1956

1953

1950

0

-50

Figure 4.3.6: Family Income, Cumulative Percentage Change
Figure 4.3.6Figure 4.3.5 shows the income, adjusted for inflation to be in 2001 dollars, for families at various points in the income
spectrum. For example, the 60% line indicates families for whom 40% of the families have higher income, and 60% have lower
income. Incomes of all groups has risen, although the richer families have seen their incomes rise faster than poorer families. That isreadily seen when percentage changes are plotted in Figure 4.3.6.
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 African-Americans fared? After World War II, AfricanAmericans families earned about 50% of white family income. This ratio has risen gradually, noticeably in the 1960s after the 1964
Civil Rights Act, legislation that prohibited segregation based on race in schools, public places, and employment, that is credited with

Introduction to Economic Analysis

4-43integrating workplaces throughout the southern United States. African-American family income lagged white income growth throughthe 1980s, but has been rising again.
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 4.3.7: Black Family Income as a Percentage of White Income
These income measures attempt to actually measure purchasing power, and thus adjust for 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),a price deflator which adjusts for what it costs to buy a “standard” bundle of food, clothing, housing, electricity and other items.
Figure 4.3.8 shows the CPI over most of past century, where 1982 is set as the reference year.
There have been three major inflations in the past century. Both World War I and World War II, with a large portion of the goods andservices diverted to military use, saw significant inflations. In addition, there was a substantial inflation during the 1970s, after theVietnam War in the 1960s. The price level fell during the Great Depression, a prolonged and severe economic downturn from 1929 to
1939. Falling price levels create investment problems, because inflation adjusted interest rates, which must adjust for a deflation, areforced to be high, since unadjusted interest rates cannot be negative.
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 4.3.8: Consumer Price Index (1982 = 100)Introduction to Economic Analysis

4-44

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 4.3.9: CPI Percent Changes
The cost of food has fallen quite dramatically over the past century. Figure 4.3.10 shows that the percentage of pre-tax householdincome spent on food has fallen from 25% to about 10%. This fall is a reflection of greater incomes, and of the fact that the real costof food has fallen.
Moreover, a much greater fraction of expenditures on food are spent away from home, a fraction that has risen from under 15% to
40%.
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 4.3.10: Food Expenditure as Percent of Income, and Proportion Spent Out
How do we spend our income? The major categories are food, clothing, housing, medical, household operation, transportation, andrecreation. The percentage of disposable income spent on these categories are shown, for the years 1929, 1965 and 2001, in Figure
4.3.11.

Introduction to Economic Analysis

4-4530.0%
25.0%
20.0%
1929
1965

15.0%

2001
10.0%
5.0%

n
R
ec
re
at
io

al
Tr
an
sp
or
ta
tio
n

ed
ic
M

g
H
ou
si
n

H
ou
se
ho
ld

g
th
in
C
lo

Fo
od

0.0%

Figure 4.3.11: After Tax Expenditure Shares
Food has shrunk substantially, but we enjoy more recreation, and spend a lot more staying healthy. (Spending on food is greater thanin Figure 4.3.10 because these figures use after tax disposable income, rather than pre-tax income). This is in part a consequence of
our aging population, but also of the increased technology available.
Key Takeaways•

There are approximately one hundred million households in the United States.

•

The number of residents per household has shrunk, from over four to under three, over the past 100 years.

•

About 60% of households live in single family detached homes.

•

Slightly less than half a percent of the population is incarcerated in state and federal prisons. This represents a four-fold increaseover 1925-1975.

•

Ten percent of households do not have an automobile, and 97.6% have a telephone.

•

Just under 99% of households have complete plumbing facilities (running water, bath or shower, flush toilet), up from 55% in
1940.

•

A quintile (or fifth) is a group of size 20%.

•

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.

•

Just after World War II, African-Americans families earned about 50% of white family income. This ratio has risen gradually,
noticeably in the 1960s after the 1964 Civil Rights Act.

•The consumer price index (CPI), which adjusts for what it costs to buy a “standard” bundle of food, clothing, housing, electricity
and other items, is the most common price index.

•

There have been three major inflations in the past century, associated World War I and World War II and the 1970s. The pricelevel fell during the Great Depression (1929-39).

•

The cost of food has fallen quite dramatically over the past century.

Introduction to Economic Analysis

4-46Key Terms•

Household: group of people sharing living quarters•

Quintiles: a fifth of the population•

1964 Civil Rights Act : legislation that prohibited segregation based on race in schools, public places, and employment•

Consumer price index (CPI): a price deflator which adjusts for what it costs to buy a “standard” bundle of food, clothing, housing,electricity and other items•

Great Depression: a prolonged and severe economic downturn from 1929 to 1939
Exercises

4.3.1

Have prices actually risen? Economists generally agree that the 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 change over time. Cars have goneup significantly in price, but are also more reliable. 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 to modern medicine, television,
electronics, refrigeration, highways, and many other technologies. If you made $40,000 annually in 1913, how would youlive and what would you buy? (Do some research.)

4.3.2

Compare a $40,000 income in 1980 to the present. What differences are there in available products? In the quality of
products? How rich does $40,000 make you in each time period? In which period would you choose to live, and why?

4.4

Production
Learning Objectives•

What do we make?

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 spend thateleven trillion on personal consumption of goods and services, savings, and government. This, by the way, is often expressed as 𝑌𝑌 =𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺, which states that income (𝑌𝑌) is spent on consumption (𝐶𝐶), investment (which comes from savings) and government.
One can consume imports as well, so the short-term constraint looks like 𝑌𝑌 + 𝑀𝑀 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑋𝑋, where 𝑀𝑀 is imports and 𝑋𝑋 isexports.

How much does the United States produce? Economists measure output with the gross domestic 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 neighbor pay
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 not measure 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 andreporting 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 4.4.1 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 the government’spurchases 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, notby the government. The cost of making the transfer payments (e.g. printing and mailing the checks), however, is included in the costof government.

Introduction to Economic Analysis

4-47

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 4.4.1: Output, Consumption, Investment and Government
It is often visually challenging to draw useful information from graphs like Figure 4.4.1, because economic activity is growing at aconstant percentage. Consequently, economists often use a logarithmic scale, rather than a dollar scale. A logarithmic scale has theuseful property that a straight line gives constant percentage growth. Consider a variable X that takes on values 𝑥𝑥𝑡𝑡 at time 𝑡𝑡. Define%∆𝑥𝑥 to be the percentage change:
𝑥𝑥𝑡𝑡 − 𝑥𝑥𝑡𝑡−1%∆𝑥𝑥 =
𝑥𝑥𝑡𝑡−1Then

𝑥𝑥𝑡𝑡
log 𝑥𝑥𝑡𝑡 = log 𝑥𝑥𝑡𝑡−1 + log �� = log 𝑥𝑥𝑡𝑡−1 + log(1 + %∆𝑥𝑥)𝑥𝑥𝑡𝑡−1Thus, if the percentage change is constant over time, log 𝑥𝑥𝑡𝑡 will be a straight line over time. Moreover, for small percentage changes:

log(1 + %∆𝑥𝑥) ≈ %∆𝑥𝑥

so that the slope is approximately the growth rate.13 Figure 4.4.2 shows these statistics with a logarithmic scale.
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 4.4.2: Major GDP Components in Log Scalelim

13 The meaning of ≈ throughout this book is ‘to the first order.’ Here that means %∆x →0log (1 + %∆x ) − %∆x=0%∆x. Moreover, in this casethe errors of the approximation are modest up to about 25% changes.
Introduction to Economic Analysis

4-48Immediately noticeable is the approximately constant growth rate from 1950 to the present, 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 volatility of 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.
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 we aren’t better off. How much are we producing per capita, and how much are we
consuming?
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 4.4.4.

35,00030,00025,00020,000Consumption

15,000GDP

10,000
5,000
0
1930

1940

1950

1960

1970

1980

1990

2000

Figure 4.4.3: Per Capita Income and Consumption
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 4.4.4: 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 World War 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 of government 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 a remarkable 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. Land use for
agriculture peaked in 1952, at 1,206 million acres, and has been dwindling ever since, especially in the northeast where farms are
Introduction to Economic Analysis

4-49being returned to forest through disuse. Figure 4.4.5 shows the output of agricultural products in the United States, adjusting to 1982
prices.
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 4.4.5: US Agricultural Output, 1982 constant dollars
The growth in output is more pronounced when viewed per worker involved in agriculture.
1000

100

Per Worker

10

Total

1999

1995

1991

1987

1983

1979

1975

1971

1967

1963

1959

1955

1951

1947

1

Figure 4.4.6: 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 fromcomputers to those little chef’s hats that are placed on turkey legs. Figure 4.4.7 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.

Introduction to Economic Analysis

4-50

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

RE
FI

O
th
er
S

Re
ta
il

e
W
ho
le
sa
l

T

&

PU

ur
in
g

an
uf
ac
t

ct
io
n
M

Co
ns
tru

M

in
in
g

0.0

Figure 4.4.7: Major Non-Agricultural Sectors of US Economy, percent of GDP
Mining has diminished as a major factor in the US economy, a consequence of the growth of other sectors, and the reduction in theprices for raw materials. Contrary to many popular predictions, the prices of raw materials have fallen even as output and population
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 – means that people expect a relative future abundance, either because of technological improvements in their use
or because of large as yet undiscovered pools of the resources. 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 was used 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 more manufactured goods than in the past. We produce more services. T& PU stands for transportation andpublic utilities, and includes electricity and telephone services and transportation including rail and air travel. This sector has shrunk
as a portion of the entire economy, although the components have grown in absolute terms. We take more airplane trips than we havehistorically.
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 4.4.8: Air Travel Per Capita
Electricity production has risen dramatically.

Introduction to Economic Analysis

4-51

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 4.4.9: Electricity Production (M kwh)
However, energy use more generally has not grown as much, just doubling over the post-war period.
80
70
60
50
40
30
20
10

1999

1994

1989

1984

1979

1974

1969

1964

1959

1954

1949

0

Figure 4.4.10: 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 more than ever, suggesting the change is actually an increase in the reliability of automobiles.

Introduction to Economic Analysis

4-52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

1920

1910

1930

0.0

1900

0

Miles

Figure 4.4.11: 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 so-called“service economy” that used to be in the news frequently, but is less so these days.
A bit more than 60% of the population works outside the home. The larger numbers in recent years are partially a reflection of thebaby 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 4.4.12: Percentage of Population Employed (Military & Prisoners Excluded)

Introduction to Economic Analysis

4-53

70
60
50
40

All
Married

30
20
10
0
1900

1920

1940

1960

1980

2000

Figure 4.4.13: Labor Force Participation Rates, All Women and Married Women
Female participation in the labor force has risen quite dramatically in the United States. Figure 4.4.13 shows female labor force
participation. The overall participation rate has roughly tripled during the century, and significantly exceeds 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 for single 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 disproportionately more likely to be widowed
rather than married or single, and who are less 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 thiscentury, 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 theSoviet Union led the United States to reduce military expenditures, in what was called the “peace dividend,” but again the effects weremodest.
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 4.4.14: Defense as a Percentage of GDP
Historically, defense represents the largest expenditure by the federal government. However, as we see, defense has become a muchsmaller part of the economy overall. However, the federal government plays many other roles in the modern US economy.

Introduction to Economic Analysis

4-54Key Takeaways•

Economists measure output with the gross domestic product (GDP), which is the value of traded goods and services produced
within the borders of the United States.

•

Importantly, GDP excludes non-traded goods and services. Thus, GDP is not a perfect measure of the production of our society.
It is just the best measure we have.

•

Economists often use a logarithmic scale, rather than a dollar scale. On a logarithmic scale, a straight line gives constantpercentage growth.

•

Economists divide production into goods and services. Goods are historically divided into mining, construction andmanufacturing.

•

The prices of raw materials have fallen even as output and population have grown.

•

Manufacturing has become less important, for several reasons. Many manufactured goods cost less, pulling down the overallvalue. In addition, we import more manufactured goods than in the past. We produce more services.

•Electricity production has risen dramatically.

•

The number of automobiles per capita in the United States peaked in the early 1980s, but we still drive more than ever, suggesting
the change is actually an increase in the reliability of automobiles.

•

The cost of selling goods – wholesale and retail costs – remains relatively stable, as does “FIRE” (finance, insurance, and realestate) costs. Other services have grown substantially.

•

A bit more than 60% of the population works.

•

Female participation in the labor force has risen quite dramatically in the United States.

•

Military expenditures peaked 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 the military, and less than 10% of GDP during
the Vietnam war. The military buildup during Ronald Reagan’s presidency (1980-1988) increased our military expenditures fromabout 5½% to 6½% of GDP – a large percentage change in military expenditures, but a small diversion of GDP.
Key Terms•

Gross domestic product (GDP): the value of traded goods and services produced within the borders of the United States•

Logarithmic scale: Scaling by the natural log; gives constant percentage changes

4.5

Government
Learning Objectives•

How big is government and what does the government spend money on?

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 4.5.1. Federal expenditures boomed during WorldWar 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 a percentage of GDP, continue to grow until Ronald
Reagan’s presidency in 1980, when they begin to shrink slightly after an initial growth. Figure 4.5.1 also shows federal revenues, andthe deficit – the difference between expenditures and revenues, is apparent, especially for World War II and 1970-1998.

Introduction to Economic Analysis

4-55

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 4.5.1: 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
post-war data, but the effect is very modest and long term. Most of the growth in state and local 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 4.5.2: Federal, State & Local and Total Government Receipts (% GDP)
Figure 4.5.2 sets out the taxation at both the federal and state and local (merged to be regional) level. Figure 4.5.3 shows expendituresof the same entities. Both figures are stated as a percentage of GDP. State and local taxation and expenditures doubled over the
postwar period. The two figures are very similar. The federal government’s expenditures have varied more significantly than its
revenues.

Introduction to Economic Analysis

4-56

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 4.5.3: 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 away 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 4.5.4: Federal Expenditures, On and Off Budget, Percent of GDP
During the 1980s, the public became aware of off-budget items. Political awareness made 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.

Introduction to Economic Analysis

4-57

20,000
18,00016,00014,000Executive
Military

12,00010,000Federal

8,000

Regional

6,000
4,000
2,000

01

20

98

95

19

19

92

89

19

86

19

83

19

80

19

19

77

74

19

71

19

19

68

65

19

19

19

62

0

Figure 4.5.5: Federal and Regional Government Employment (000s)
Federal employees includes two major categories, uniformed military personnel and the executive 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 Federal employees work for the US 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 4.5.6: Major Expenditures of the Federal Government

Introduction to Economic Analysis

4-58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 4.5.7: Major Transfer Payments (% of Federal Budget)
Transfers to individuals represent almost 50% of federal expenditures. These transfers are direct payments to individuals, in the formof a check. Such transfers include social security, Medicare, Medicaid, unemployment insurance, and veteran’s benefits. Transfers tostate 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, is primarily a consequence of increased costs of existing programs rather
than increases in benefit levels.

1,000,000
100,000
10,000
Revenue
Expenditure

1,000
100
10

1997

1991

1985

1979

1973

1967

1961

1955

1949

1943

1937

1

Figure 4.5.8: Social Security Revenue and Expenditure, $ millions
A question you may ask, quite reasonably, is whether the Social Security program can survive 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 4.5.8 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 a current value of approximately 1.5 trillion dollars,
which is a bit less than four times the current annual expenditure on social security. Unfortunately, this money is “invested” in thefederal 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

Introduction to Economic Analysis

4-59government can print money. The bad news is that 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 4.5.9: 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 4.5.1 that the
government runs a deficit, bringing in less than it spends. Interest has been as high as 15% of the cost of the federal government (seeFigure 4.5.6). How large is the debt, and how serious is it? Figure 4.5.9 gives the size of the federal debt, in absolute dollars and as apercent of GDP. The debt was increased dramatically during World War II (1940-45), but over the following 25 years, little wasadded 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’tstabilized until the 1990s, and then only because the economy grew at an extraordinary rate by historical standards. The expenditures
following the September 11, 2001 terrorist attacks, combined with a recession 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 right evaluation of the debt is as a percentage of GDP; viewed as a percentage, the size of the debt is ofmoderate size – serious but not critical. The serious side of the debt is the coming retirement of the baby boom generation, which islikely to put additional pressure on the government.
An important distinction in many economic activities is the distinction between a stock and a flow. Your bank account represents astock of money, the expenditures and income a flow. The national debt is a stock; the deficit is the addition to the debt and is a flow.
If you think about a lake with incoming water and evaporation, the amount of water in the lake is the stock of water, the incoming
stream minus evaporation the flow.

Introduction to Economic Analysis

4-60Table 4.5.1: Expenditures on Agencies as Percent of Non-Transfer Expenditures
Department or Agency

1977

1990

2002

Legislative

0.4

0.4

0.5

Judiciary

0.2

0.3

0.6

Agriculture

2.1

2.2

2.7

Commerce

3.2

0.7

0.7

Education

3.9

3.8

6.7

Energy

3.1

3.2

2.9

Health

3.7

4.6

8.3

Defense

43.8

59.2

46.9

Homeland Security

-

-

4.1

Housing & Urban Dev.

13.4

2.9

4.3

Interior

1.6

1.3

1.4

Justice

1.0

1.7

2.7

Labor

6.1

1.7

1.7

State

0.6

0.9

1.3

Transportation

2.2

2.6

2.1

Treasury

1.7

1.6

1.4

Veterans

2.3

2.6

3.3

Corps of Engineers

1.0

0.6

0.6

Environmental P.A.

1.1

1.1

1.1

Fed Emergency M.A.

0.2

0.4

0.0

GSA

0.2

0.5

0.0

Intl Assistance

2.8

2.7

1.9

NASA

1.6

2.5

2.0

NSF

0.3

0.4

0.7

Table 4.5.1 gives the expenditures on various agencies, as a percentage of the discretionary expenditures, where discretionary is aeuphemism for expenditures that 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 4.5.1 gives theexpenditures by the “Alphabet Soup” of federal agencies.
The National Science Foundation (NSF) provides funds for basic research. The general idea of government-funded research is that it
is useful for ideas to be in the public domain, 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 candeflect 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 of research. How much does thegovernment spend on R&D? Figure 4.5.10 shows the history of R&D expenditures. The 1960s “space race” competition between the
US and the Soviet Union led to the greatest federal expenditure on research and development, and it topped 2% of GDP. There was amodest increase during the Reagan presidency (1980-88) in defense R&D, which promptly returned to earlier levels.

Introduction to Economic Analysis

4-61

2.5
2.0
1.5

Military
Civilian

1.0

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 4.5.10: 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 4.5.11, the federal income tax currently
produces just under 50% of federal revenue. Social Security and Medicare taxes produce the next largest portion, with around 30-35%
of revenue. The rest comes from corporate profits taxes (about 10%), excise taxes like those imposed on cigarettes, liquor andcigarettes (under 5%) and other taxes like tariffs, 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 of the federal government’s attempt to insure thefuture viability of the program, in the face of severely adverse demographics in the form of the retirement of the baby boom
generation.
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 4.5.11: 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 the costs of doing business and are taxed on theirprofits, not on revenues. What is an allowable deduction, and what is not, make corporate profits complicated to administer.
Moreover, from an economic perspective, corporate taxes are paid by consumers, in the form of higher prices for goods, at least whenindustries are competitive.

Introduction to Economic Analysis

4-62Key Takeaways•

With a budget over two trillion dollars, the federal government represents just under 20% of the US economy.

•

Federal employees includes military personnel and the executive branch. State and Local government employment is much larger
than federal employment and has tripled in size since 1962.

•

Transfers to individuals represent almost 50% of federal expenditures. Such transfers include social security, Medicare,
Medicaid, unemployment insurance, and veteran’s benefits. Transfers are also known as entitlements and other expenditures arecalled discretionary spending.

•

The social security program has paid out approximately what it took in and is not an investment program.

•

The federal government runs deficits, spending more than it earned. 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 theeconomy grew at an extraordinary rate by historical standards. The expenditures following the September 11, 2001 terrorist
attacks, combined with a recession in the economy, have sent the debt rising dramatically.

•

The best way to evaluate the debt is as a percentage of GDP.

•

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 and income a flow. The national debt is a stock; the deficit is the addition to the debt and is a
flow.

•

Government funded research and development represents about 1% of GDP, divided about equally between military and civilian
research.

•

The federal income tax currently produces just under 50% of federal revenue. Social Security and Medicare taxes produce thenext largest portion, about a third of revenue. The rest comes from corporate profits taxes (about 10%), excise taxes like those
imposed on cigarettes, liquor and cigarettes (under 5%).
Key Terms•

Transfers to individuals: direct payments to individuals, in the form of a check. Such transfers include social security, Medicare,
Medicaid, unemployment insurance, and veteran’s benefits•

Stock : A amount which is increased or decreased like the national debt, as opposed to a flow•

Flow: the change to a stock•

Discretionary expenditures: government expenditures which are not transfers to individuals•

Entitlements: direct payments to individuals, in the form of a check. Such transfers include social security, Medicare, Medicaid,
unemployment insurance, and veteran’s benefits

4.6

Trade
Learning Objectives•

What do we trade with other nations?

The United States is a major trading nation. Figure 4.6.1 presents total US imports and exports, including foreign investment andearnings (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.

Introduction to Economic Analysis

4-63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 4.6.1: Total Imports and Exports as a Proportion of GDP
Figure 4.6.1 includes investment and earnings. When we think of trade, we tend to think of goods traded – American soybeans,movies and computers sold abroad, and automobiles, toys, shoes and wine purchased from foreign countries. Figure 4.6.2 shows thetotal trade in goods and services, as a percentage of US GDP. These figures are surprisingly similar, which shows that investment andearnings from investment are roughly balanced – the US invests abroad to a similar extent as foreigners invest in the US.
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 4.6.2: US Trade in Goods and Services
Figure 4.6.3 shows the earnings on US assets abroad, and the payments from US-based assets owned by foreigners. These forms of
exchange are known as capital accounts. These accounts are roughly in balance, while the US used to earn about 1% of GDP from its
ownership of foreign assets.

Introduction to Economic Analysis

4-644.00%
3.50%
3.00%
2.50%
Payments

2.00%

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 4.6.3: Income and Payments as a Percent of GDP
Table 4.6.1: Top US Trading Partners and Trade Volumes ($B)
Exports

Imports

Year-to-Date

Year-to-Date

All Countries

533.6

Top 15 Countries
1

Rank

Country

Total

Percent

946.6

1,480.2

100.0%

400.7

715.4

1,116.2

75.4%

Canada

123.1

167.8

290.9

19.7%

2

Mexico

71.8

101.3

173.1

11.7%

3

China

22.7

121.5

144.2

9.7%

4

Japan

36.0

85.1

121.0

8.2%

5

Germany

20.4

50.3

70.8

4.8%

6

United Kingdom

23.9

30.3

54.2

3.7%

7

Korea, South

17.5

29.6

47.1

3.2%

8

Taiwan

14.0

22.6

36.5

2.5%

9

France

13.4

20.0

33.4

2.3%

10

Italy

6.9

18.6

25.5

1.7%

11

Malaysia

7.2

18.0

25.2

1.7%

12

Ireland

5.2

19.3

24.5

1.7%

13

Singapore

13.6

10.1

23.7

1.6%

14

Netherlands

15.7

7.9

23.6

1.6%

15

Brazil

9.3

13.2

22.5

1.5%

Who does the US trade with? Table 4.6.1 details the top fifteen trading partners., and the share of trade. The US and Canada remain
the top trading countries of all pairs of countries. 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.
Introduction to Economic Analysis

4-65Key Takeaways•

The United States is a major trading nation, buying about 16% of GDP and selling about 12%, with a 4% trade deficit. Income
from investments abroad is roughly balanced with foreign earnings from US investments; these are known as the capital accounts.

•

The US and Canada remain the top trading countries of all pairs of countries. Mexico is the US’s second largest trading partner.
China and Japan are third and fourth. Together, the top fifteen account for three-quarters of US international trade.
Key Terms•

Capital accounts: In international trade, earnings on US assets abroad, and the payments from US-based assets owned byforeigners

4.7

Fluctuations
Learning Objectives•

What is a recession?

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, which keeps 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.
140
120

100
80

IP
Recession

60
40

20
0
1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

2001

Figure 4.7.1: Postwar Industrial Production and Recessions
Figure 4.7.1 shows the overall industrial production of the United States since World War 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 historically lasted a 1½ to two years, a pattern that continues. Indeed, the average recession since World War II has
been shorter than the average recession prior to that time.
These fluctuations in output are known as the business cycle, which is not an exactly periodic cycle but instead a random cycle.

Introduction to Economic Analysis

4-66

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 4.7.2: 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 than others. Investment varies very strongly with the business cycle, while overall employment varies
weakly. Interest rates, inflation, stock prices, unemployment and many other variables also vary systematically over the businesscycle. Recessions are clearly visible in the percentage of the population employed, illustrated in Figure 4.7.2.
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 4.7.3 shows thepercentage of industrial capacity utilized to produce manufactured goods. This series is more volatile than production itself, andresponds more strongly to economic 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 4.7.3: Industrial Factory Capacity Utilitzation (Source: FRED)
Most of the field of macroeconomics is devoted to understanding the determinants of growth and of fluctuations, but further
consideration of this important topic is beyond the scope of a microeconomics text.

Introduction to Economic Analysis

4-67Key Takeaways•

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, which keeps 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.

•

Prior to World War II, a normal boom lasted 2½ years and the longest was four years, but they have been much longer since1960. Recessions have historically lasted a 1½ to 2 years, a pattern that continues.

•

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

•

An important aspect of the business cycle is that many economic variables move together, or covary. Investment varies verystrongly with the business cycle, while overall employment varies weakly. Interest rates, inflation, stock prices, unemployment
and many other variables also vary systematically over the business cycle.

•

Some economic variables are much more variable than others. Investment, durable goods purchases, and utilization of production
capacity vary more dramatically over the business cycle than consumption and employment.
Key Terms•

Recession: a drop in gross domestic output.

•

Business cycle: correlated fluctuations in income, employment, investment and other economic variables•

Covary: to move together or be correlated

Introduction to Economic Analysis

4-68

5

Government Interventions

We have so far focused on unimpeded markets, and seen that markets may perform efficiently.14 In this and subsequent chapters, 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, impede efficiency in some circumstances, and government may
be used to mitigate the problems that arise.
This chapter analyzes taxes. There are a variety of types of taxes, such as income taxes, property taxes, ad valorem (percentage ofvalue) taxes, and excise taxes (taxes on a specific good like cigarettes or gasoline). 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 some other taxes.

5.1

Effects of Taxes
Learning Objectives•

How do taxes affect equilibrium prices and the gains from trade?

Consider first a fixed, per unit 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 a price 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 United States, sales taxes are generally imposed on thebuyer – 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 orthe buyer. The reason is that ultimately the buyer cares only about the total price paid, which is the amount the supplier gets plus thetax, and the supplier cares only about the net to the supplier, which is the total amount the buyer pays minus the tax. Thus, with atwenty 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 and additional
twenty cents in tax, or pays $2.00, produces the same outcome to both the buyer 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 thep
SAfter Tax
same profit.15
SBefore Tax
First, consider a tax imposed on the seller. At a given price 𝑝𝑝,
and tax 𝑡𝑡, each seller obtains 𝑝𝑝 − 𝑡𝑡, and thus supplies theamount associated with this net price. Taking the before tax
supply to be 𝑆𝑆𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑇𝑇𝑇𝑇𝑇𝑇 , the after tax supply is shifted up by theamount of the tax. This is the amount that covers the marginalvalue of the last unit, plus providing for the 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 5.1.1.

Amountof Taxq
Figure 5.1.1: A Tax on Supply

14 The standard term for an unimpeded market is a free market, which is free in the sense of “free of external rules and constraints.”
In this terminology, eBay is free market, even though it charges for the use of the market.
15 There are two minor issues here that won’t be considered further. First, the party who collects the tax has a legal responsibility andit could be that businesses have an easier time complying with taxes than individual consumers. The transaction costs associated withcollecting taxes could create a difference arising from who pays the tax. Such differences will be ignored in this book. Second, if thetax is percentage 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 imposedon the seller and taxes imposed on the buyer requires different percentages that produce the same effective tax level. In addition, there
is a political issue: imposing the tax on buyers makes the presence and size of taxes more transparent to voters.
Introduction to Economic Analysis

5-69Now consider the imposition of a tax on the buyer, illustrated in
Figure 5.1.2. In this case, the buyer pays the price of the good, 𝑝𝑝,
plus the tax, 𝑡𝑡. This reduces the willingness to pay for any given
unit by the amount of the tax, thus shifting down the demand curveby the amount of the tax.

p

In both cases, the effect of the tax on the supply-demandequilibrium is to shift the quantity toward a point where the before
tax demand minus the before tax supply is the amount of the tax.
This is illustrated in Figure 5.1.3. The quantity traded before a tax
was imposed was 𝑞𝑞𝐵𝐵∗ . When the tax is imposed, the price that thebuyer pays must exceed the price the sellers receive, by the amountequal to the tax. This pins down a unique quantity, denoted 𝑞𝑞𝐴𝐴∗ .
The price the buyer pays is denoted by 𝑝𝑝𝐷𝐷∗ and the sellers receivethat amount minus the tax, which is noted as 𝑝𝑝𝑆𝑆∗ . The relevant
quantities and prices are illustrated in Figure 5.1.3.

Amountof TaxDAfter Tax

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
DBefore Tax sellers obtain falls, but by less than the tax. These changes areq 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?

Figure 5.1.2: A Tax on Demand

There are two main effects of a tax: a fall in the quantity traded, anda diversion of revenue to the government. These are illustrated in
Figure 5.1.4. First, the revenue is just the 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 𝑞𝑞𝐴𝐴∗ because this is
the quantity traded once the tax is imposed.
p
In addition, a tax reduces the quantity traded, thereby reducing
SBefore Tax
some of the gains from trade. 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 arecaptured in the form of the tax, but there is a loss captured by noparty – the value of the units that would have been exchanged
p D*
were there no tax. The value of those units is given by thedemand, and the marginal cost of the units is given by theTax
supply. The difference, shaded in black in the diagram, is thelost gains from trade of units that aren’t traded because of the
pS*
tax. These lost gains from trade are known as a dead weightloss. That is, the dead weight loss is the buyers’ values minus
the sellers’ costs of units that are not economic 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 tosociety much the same as if resources were simply thrown awayqor lost. The dead weight loss is value that people don’t enjoy,q A* q B*
and in this sense can be viewed as an opportunity cost of
taxation. That is, to collect taxes, we have to take money away
Figure 5.1.3: Effect of a Tax on Equilibriumfrom 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 of collection like tax collectors and government agencies toadminister tax collection, and the 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 selection of activities and goods to tax in order to minimize the dead weight loss of taxation.
DBefore Tax

Introduction to Economic Analysis

5-70Without more quantification, only a little more can besaid about the effect of taxation. First, a small tax raises
revenue approximately equal to the tax level times thequantity, or 𝑡𝑡𝑡𝑡. Second, the drop in quantity is also
approximately proportional to the size of the tax. Third,
this means the size of the dead weight loss isapproximately proportional to the tax squared. Thus,
small taxes have an almost zero dead weight loss per
dollar of revenue raised, and the overhead of taxation,
as a percentage of the taxes raised, grows when the tax
Taxlevel is increased. Consequently, the cost of taxation
tends to rise in the tax level.

p
SBefore Tax
Dead
Tax

WeightRevenue

Loss

DBefore Tax

q
q A*

q B*

Figure 5.1.4: Dead Weight Loss
Key Takeaways•

Imposing a tax on the supplier or the buyer have the same effect on prices and quantity.

•

The effect of the tax on the supply-demand equilibrium is to shift the quantity toward a point where the before tax demand minus
the before tax supply is the amount of the tax.

•

A tax increases the price buyers pay by less than the tax. Similarly, the price the sellers obtain falls, but by less than the tax. The
relative effect on buyers and sellers is known as the incidence of the tax.

•

There are two main economic effects of a tax: a fall in the quantity traded, and a diversion of revenue to the government.

•

A tax causes consumer surplus to fall, and producer surplus (profit) to fall. Some of those losses are captured in the tax, but there
is a loss captured by no party – the value of the units that would have been exchanged, were there no tax. These lost gains fromtrade are known as a dead weight loss.

•

The dead weight loss is the buyers’ values minus the sellers’ costs of units that are not economic to trade only because of a tax (orother interference in the market efficiency).

•

The dead weight loss is important because it represents a loss to society much the same as if resources were simply thrown away
or lost.

•Small taxes have an almost zero dead weight loss per dollar of revenue raised, and the overhead of taxation, as a percentage of thetaxes raised, grows when the tax level is increased.
Key Terms•

Incidence of the tax: the amounts of a tax that are paid by various parties after adjusting for changes in behavior•

Dead weight loss: unrealized gains from trade

Introduction to Economic Analysis

5-71Exercises
5.1.1

Suppose demand is given by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 1 – 𝑝𝑝 and supply 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑝𝑝, with prices in dollars. If sellers pay a 10 cent tax, whatis the after tax supply? Compute the before tax equilibrium price and quantity, and the after tax equilibrium quantity, andbuyer’s price and seller’s price.

5.1.2

Suppose demand is given by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 1 – 𝑝𝑝 and supply 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑝𝑝, with prices in dollars. If buyers pay a 10 cent tax, whatis the after tax demand? Do the same computations as the previous exercise and show that the outcomes are the same.

5.1.3

Suppose demand is given by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 1 – 𝑝𝑝 and supply 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑝𝑝, with prices in dollars. Suppose a tax of t cents is
imposed, t ≤ 1. What is the equilibrium quantity traded, as a function of t? What is the revenue raised by the government,
and for what level of taxation is it highest?

5.2

Incidence of Taxes
Learning Objectives•

Who bears the largest burden of a tax, buyers or sellers?

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 be used to answer this question. To do so, we consider a percentage tax 𝑡𝑡 and employ themethodology introduced in Chapter 3 and assume constant elasticity of both demand and supply. Let the equilibrium price to theseller be 𝑝𝑝𝑠𝑠 and the equilibrium price to the buyer be 𝑝𝑝𝑏𝑏 . As before, we will denote the demand function by 𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 andsupply function by 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑏𝑏𝑝𝑝𝜂𝜂 . These prices are distinct because of the tax, and the tax determines the difference:
𝑝𝑝𝑏𝑏 = (1 + 𝑡𝑡) 𝑝𝑝𝑠𝑠 .

Equilibrium requires
𝑎𝑎𝑝𝑝𝑏𝑏 −𝜀𝜀 = 𝑞𝑞𝑑𝑑 (𝑝𝑝𝑏𝑏 ) = 𝑞𝑞𝑠𝑠 (𝑝𝑝𝑠𝑠 ) = 𝑏𝑏𝑝𝑝𝑠𝑠 𝜂𝜂
Thus,

−𝜀𝜀

𝑎𝑎�(1 + 𝑡𝑡)𝑝𝑝𝑠𝑠 �This solves for= 𝑎𝑎𝑝𝑝𝑏𝑏 −𝜀𝜀 = 𝑞𝑞𝑑𝑑 (𝑝𝑝𝑏𝑏 ) = 𝑞𝑞𝑠𝑠 (𝑝𝑝𝑠𝑠 ) = 𝑏𝑏𝑝𝑝𝑠𝑠 𝜂𝜂

𝑎𝑎 1�𝜀𝜀+𝜂𝜂−𝜀𝜀(1 + 𝑡𝑡) �𝜀𝜀+𝜂𝜂
𝑝𝑝𝑠𝑠 = � �
𝑏𝑏
and

𝑎𝑎

𝑞𝑞 ∗ = 𝑞𝑞𝑠𝑠 (𝑝𝑝𝑠𝑠 ) = 𝑏𝑏𝑝𝑝𝑠𝑠 𝜂𝜂 = 𝑏𝑏 � �𝑏𝑏𝜂𝜂�𝜀𝜀+𝜂𝜂
𝑎𝑎

Finally, 𝑝𝑝𝑏𝑏 = (1 + 𝑡𝑡) 𝑝𝑝𝑠𝑠 = � �𝑏𝑏(1 + 𝑡𝑡)

1�
𝜀𝜀+𝜂𝜂

−𝜀𝜀𝜀𝜀
�𝜀𝜀+𝜂𝜂
=𝜂𝜂

(1 + 𝑡𝑡) �𝜀𝜀+𝜂𝜂

Recall the approximation (1 + 𝑡𝑡)𝑟𝑟 ≈ 1 + 𝑟𝑟𝑟𝑟

𝜂𝜂

𝜀𝜀

−𝜀𝜀𝜀𝜀
�𝜀𝜀+𝜂𝜂

𝑎𝑎 �𝜀𝜀+𝜂𝜂 𝑏𝑏 �𝜀𝜀+𝜂𝜂 (1 + 𝑡𝑡)

Thus, a small proportional tax increases the price to the buyer by approximately
quantity falls by approximately𝜂𝜂𝜂𝜂𝜂𝜂

𝜂𝜂+𝜀𝜀

𝜂𝜂𝜂𝜂

𝜂𝜂+𝜀𝜀

, and decreases the price to the seller by

𝜀𝜀𝜀𝜀

𝜂𝜂+𝜀𝜀

. The

. Thus, the price effect is mostly on the “relatively inelastic party.” If demand is inelastic, ε issmall, then the price decrease to the seller will be small and the price increase to the buyer close to the entire tax. Similarly, if demandis very elastic, ε is very large, and the price increase to the buyer will be small and the price decrease to the seller close to the entiretax.
We can rewrite the quantity change as𝜂𝜂𝜂𝜂𝜂𝜂

𝜂𝜂+𝜀𝜀𝑡𝑡= 1 1 . Thus the effect of a tax on quantity is small if either the demand or the supply is
+

𝜀𝜀 𝜂𝜂

inelastic. To minimize the distortion in quantity, it is useful to impose taxes on goods that either have inelastic demand, or inelastic
supply.
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, but have large quantity distortions.

Introduction to Economic Analysis

5-72Key Takeaways•

A small proportional tax t increases the price to the buyer by approximately
quantity falls by approximately𝜂𝜂𝜂𝜂𝜂𝜂

𝜂𝜂+𝜀𝜀

𝜂𝜂𝜂𝜂

𝜂𝜂+𝜀𝜀

.

, and decreases the price to the seller by

𝜀𝜀𝜀𝜀

𝜂𝜂+𝜀𝜀

. The

•

The price effect is mostly on the “relatively inelastic party.”•

The effect of a tax on quantity is small if either the demand or the supply is inelastic. To minimize the distortion in quantity, it isuseful to impose taxes on goods that either have inelastic demand, or inelastic supply.
Exercises

5.2.1

For the case of constant elasticity (of both supply and demand), what tax rate maximizes the government’s revenue? How
does the revenue-maximizing tax rate change when demand becomes more inelastic?

5.3

Excess Burden of Taxation
Learning Objectives•

How does a tax affect the gains from trade?

The presence of the dead-weight loss implies that raising $1 in taxes costs society more than $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.
To start, we will denote the marginal cost of the quantity 𝑞𝑞 by 𝑐𝑐(𝑞𝑞) and the marginal value by 𝑣𝑣(𝑞𝑞). The elasticities of demand andsupply are given by the standard formulae:
𝑑𝑑𝑑𝑑�
𝑞𝑞

𝜀𝜀 = − 𝑑𝑑𝑑𝑑� = −𝑣𝑣

𝑣𝑣(𝑞𝑞)

𝑞𝑞𝑣𝑣 ′ (𝑞𝑞)

𝑑𝑑𝑑𝑑�
𝑞𝑞

and 𝜂𝜂 = − 𝑑𝑑𝑑𝑑� = −𝑐𝑐

𝑐𝑐(𝑞𝑞).

𝑞𝑞𝑐𝑐 ′ (𝑞𝑞)Consider an ad valorem tax that will be denoted by 𝑡𝑡. If sellers are charging 𝑐𝑐(𝑞𝑞), the ad valorem (at value) tax is 𝑡𝑡𝑡𝑡(𝑞𝑞), and thequantity 𝑞𝑞 ∗ will satisfy

𝑣𝑣(𝑞𝑞 ∗ ) = (1 + 𝑡𝑡)𝑐𝑐(𝑞𝑞 ∗ ).

From this equation, we immediately deduce
𝑑𝑑𝑞𝑞 ∗
𝑐𝑐(𝑞𝑞 ∗ )
= ′ ∗
=
𝑑𝑑𝑑𝑑
𝑣𝑣 (𝑞𝑞 ) − (1 + 𝑡𝑡)𝑐𝑐 ′ (𝑞𝑞)Tax revenue is given by−

𝑇𝑇 = 𝑡𝑡𝑡𝑡 ∗ 𝑐𝑐(𝑞𝑞 ∗ ).

𝑐𝑐(𝑞𝑞 ∗ )𝑣𝑣(𝑞𝑞 ∗ )𝑐𝑐(𝑞𝑞 ∗ )− (1 + 𝑡𝑡)∗
𝜀𝜀𝜀𝜀𝜀𝜀𝜀𝜀 ∗

=

𝑞𝑞 ∗

1 1
(1 + 𝑡𝑡) � + �
𝜀𝜀 𝜂𝜂

=

𝑞𝑞 ∗ 𝜀𝜀𝜀𝜀(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)The effect on taxes collected, 𝑇𝑇, of an increase in the tax rate 𝑡𝑡 is

𝑑𝑑𝑞𝑞 ∗
𝑑𝑑𝑞𝑞 ∗
1
𝑞𝑞 ∗ 𝜀𝜀𝜀𝜀
𝑑𝑑𝑑𝑑= 𝑞𝑞 ∗ 𝑐𝑐(𝑞𝑞 ∗ ) + 𝑡𝑡𝑡𝑡(𝑞𝑞 ∗ )+ 𝑡𝑡𝑞𝑞 ∗ 𝑐𝑐 ′ (𝑞𝑞 ∗ )= 𝑐𝑐(𝑞𝑞 ∗ ) �𝑞𝑞 ∗ − 𝑡𝑡 �1 + �
�
𝑑𝑑𝑑𝑑
𝑑𝑑𝑑𝑑
𝜂𝜂 (1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)
𝑑𝑑𝑑𝑑

𝑑𝑑𝑑𝑑
𝑐𝑐(𝑞𝑞 ∗ )𝑞𝑞 ∗𝑐𝑐(𝑞𝑞 ∗ )𝑞𝑞 ∗=�(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂) − 𝑡𝑡(1 + 𝜂𝜂)𝜀𝜀� =�𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)�
(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)
𝑑𝑑𝑑𝑑 (1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)Thus, tax revenue is maximized when the tax rate is 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 , given by𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 =𝜀𝜀 + 𝜂𝜂
𝜀𝜀
1 1
=
� + �
𝜂𝜂(𝜀𝜀 − 1) 𝜀𝜀 − 1 𝜀𝜀 𝜂𝜂𝜀𝜀The valueis the monopoly markup rate, which we will meet in Chapter 15. Here, it is applied to the sum of the inverse
𝜀𝜀−1elasticities.
The gains from trade for the good – that is, the total of the consumer surplus, the producer surplus, and the tax revenue, is thedifference between value and cost for the traded units, and thus is𝑞𝑞 ∗𝐺𝐺𝐺𝐺𝐺𝐺 = ∫0 �𝑣𝑣(𝑞𝑞) − 𝑐𝑐(𝑞𝑞)�𝑑𝑑𝑑𝑑.

Thus, the change in the gains from trade as taxes increase is given by
Introduction to Economic Analysis

5-73

𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕�𝜕𝜕𝜕𝜕
==𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕�
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝜕𝜕𝜕𝜕�𝑣𝑣(𝑞𝑞 ∗ ) − 𝑐𝑐(𝑞𝑞 ∗ )�𝑑𝑑𝑞𝑞 ∗
𝑑𝑑𝑑𝑑

𝑐𝑐(𝑞𝑞 ∗ )𝑞𝑞 ∗�𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)�
(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)=−�𝑣𝑣(𝑞𝑞 ∗ ) − 𝑐𝑐(𝑞𝑞 ∗ )�𝑞𝑞 ∗ 𝜀𝜀𝜀𝜀(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)𝑐𝑐(𝑞𝑞 ∗ )𝑞𝑞 ∗�𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)�
(1 + 𝑡𝑡)(𝜀𝜀 + 𝜂𝜂)𝑡𝑡
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑡𝑡𝑡𝑡(𝑞𝑞 ∗ )𝜀𝜀𝜀𝜀
𝜀𝜀𝜀𝜀𝜀𝜀
𝜀𝜀
=−
=−
=−
∗
(𝜀𝜀 − 1) (𝑡𝑡𝑚𝑚𝑎𝑎𝑎𝑎 − 𝑡𝑡)
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)
𝑐𝑐(𝑞𝑞 )�𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)�

The value 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 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 is composed of𝜀𝜀two components. First, there is the term (𝜀𝜀−1), which arises from the change 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 the dead 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 the current
level of taxation. The calculated value of 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 is value given the local elasticities; if elasticities are not constant, this value will notnecessarily be the actual value that maximizes the tax revenue. One can think of 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 as the projected value. It is sometimes more
useful to express the formula directly in terms of elasticities rather than in terms of the projected value of 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 , in order to avoid thepotential confusion between the projected (at current elasticities) and actual (at the elasticities relevant to 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 ) value of 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 . Thislevel can be read directly from the derivation above:𝜀𝜀𝜀𝜀𝜀𝜀
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑=−
𝜀𝜀 + 𝜂𝜂 − 𝑡𝑡𝑡𝑡(𝜀𝜀 − 1)
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

Key Takeaways•

The cost of taxation exceeds the taxes raised is known as the excess burden of taxation, or just the excess burden.

•

Tax revenue is maximized when the tax rate is 𝑡𝑡𝑚𝑚𝑚𝑚𝑚𝑚 = (𝜀𝜀−1) � + �

•

𝜀𝜀

1
𝜀𝜀

The change in the gains from trade as taxes increase is given by1

𝜂𝜂

𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

Key Terms𝜀𝜀= − (𝜀𝜀−1) (𝑡𝑡𝑡𝑡.

𝑚𝑚𝑚𝑚𝑚𝑚 −𝑡𝑡)•

Excess burden of taxation: the social cost of a tax -- the amount of the tax plus the dead weight loss of the tax•

Ad valorem tax: Tax on revenue rather than per unit
Exercises

5.3.1

5.3.2
5.3.3

5.4

Suppose both demand and supply are linear, 𝑞𝑞𝑑𝑑 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏 and 𝑞𝑞𝑠𝑠 = 𝑐𝑐 + 𝑑𝑑𝑑𝑑. A quantity tax is a tax that has a constant value
for every unit bought or sold. Determine the new equilibrium supply price 𝑝𝑝𝑠𝑠 and demand price 𝑝𝑝𝑏𝑏 when a quantity tax ofamount 𝑡𝑡 is applied.

An ad valorem tax is a proportional tax on value, like a sales tax. Repeat the previous exercise for an ad valorem tax 𝑡𝑡.
Let supply be given by 𝑝𝑝 = 𝑞𝑞 and demand 𝑝𝑝 = 1 – 𝑞𝑞. Suppose a per unit tax of 0.10 is applied.

a.

What is the change in quantity traded?

b.

Compute the tax revenue and dead weight loss.

Price Floors and Ceilings
Learning Objectives•

What happens when the government, and not a market, sets the price?

A price floor is a minimum price at which a product or service is permitted to sell. Many agricultural goods have price floors imposedby 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, the Screen Actors Guild imposes minimum rates forguild members, generally pushing up the price paid for actors above that which would prevail in an unconstrained market. (The wagesof big name stars aren’t generally affected by SAG, because these are individually negotiated.) The most important example of a pricefloor is the minimum wage, which imposes a minimum amount that a worker can be paid per hour.
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A price ceiling is a maximum price that can be charged for a product or service. Rent control imposes a maximum price onapartments (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, and again 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 cardcompanies are located in South Dakota. South Dakota was the first state to eliminate such laws. In addition, ticket prices for concerts
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.
The theory of price floors and ceilings is readily articulated with simple supply and demand analysis. Consider a price floor – aminimum 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 the price floor is higher than the equilibrium price,
there will be a surplus, because at the price floor, more units are supplied than are demanded. This surplus is illustrated in Figure
5.4.1.
In Figure 5.4.1, the price floor is illustrated with a horizontal line and is above the equilibrium price. Consequently, at the price floor,
a larger quantity is supplied than is demanded, 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 trade associated with these units, which is lost due to the price floor,
represent the dead weight 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 the price floor is imposed in order to be a benefit to sellers, we would not expect to see the priceincreased to the point where demand becomes elastic, for otherwise the sellers receive less revenue. Thus, for example, if theminimum wage is imposed in order to increase 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 the minimum wage is primarily to make low-skilledworkers a less effective substitute for union workers, and hence allow union workers to increase their wage demands, then we mightobserve a minimum wage which is in some sense “too high” to be of benefit to low-skilled workers.
p
S

Surplus

Price
Floor

D
q
qD

qS

Figure 5.4.1: A Price Floor

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p
S

Price
Floor
Dead
Weight
Loss

D
q
qD

qS

Figure 5.4.2: Dead weight Loss of a Price Floor
The dead weight loss illustrated in Figure 5.4.2 is the difference between the value of the units not traded, and value is given by thedemand curve, and the cost of producing these units. The triangular shaped region representing the difference between value and cost
is illustrated in the above diagram, in the shaded region.
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 thesecosts.
Example 5.1: 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, the equilibrium price and the equilibrium quantity, are both 1�2. A price floor of 𝑝𝑝 > 1�2
induces a quantity demanded of 1– 𝑝𝑝. How many units will suppliers offer, if a supplier’s chance of trading is random? Suppose 𝑞𝑞 ≥1−𝑝𝑝
. Thus, the marginal supplier (who has a marginal cost of 𝑞𝑞 by
1 − 𝑝𝑝 units are offered. A supplier’s chance of selling isassumption) has a probability

1−𝑝𝑝
𝑞𝑞

𝑞𝑞

of earning 𝑝𝑝, and a certainty of paying 𝑞𝑞. Exactly 𝑞𝑞 units will be supplied when this is a break-evenproposition for the marginal supplier, that is,
1−𝑝𝑝𝑞𝑞

𝑝𝑝 − 𝑞𝑞 = 0, or 𝑞𝑞 = �𝑝𝑝(1 − 𝑝𝑝)

The dead weight loss then includes not just the triangle illustrated in the previous picture, but also the cost of the �𝑝𝑝(1 − 𝑝𝑝) −(1 − 𝑝𝑝) unsold units.

The effects of a price floor include lost gains from trade, because too few units are traded (inefficient exchange), units produced thatare never consumed (wasted production), and more costly units produced than necessary (inefficient production)

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p
S

Price
Ceiling
Shortage

D
q
qS

qD

Figure 5.4.3: A Price Ceiling
A price ceiling is a maximum price. Analogous to a low price floor, a price ceiling that is larger than the equilibrium price has noeffect. Tell me that I can’t charge more than a billion dollars for a copy of this book (which is being given away free) and it won’t
affect the price charged or the quantity traded. Thus, the interesting case of a price ceiling is a price ceiling less than the equilibrium
price.
In this case, which should now look familiar, the price is forced below the equilibrium price, and fewer units are supplied, while alarger number are demanded, leading to a shortage. The dead weight loss is illustrated in Figure 5.4.3, and again represents the loss
associated with units that are valued more than they cost but aren’t produced.
Like the case of the price floor above, this is actually the lower bound for the dead weight loss of the price ceiling. In the absence ofthe price ceiling, equilibrium occurs where 𝑞𝑞𝑆𝑆 = 𝑞𝑞𝐷𝐷 ; at this point, all consumers whose value for the good is greater than theequilibrium price purchase the good, and all consumers whose value is less than the equilibrium price refrain from purchasing thegood. We can say that in this case, the price is the rationing mechanism that determines who obtains the good; this mechanism ensuresthat the consumers who value the good the most are the ones who obtain the good.
What happens when the price ceiling is imposed? Now, at the ceiling price, more consumers wish to purchase the good than units areavailable for sale; how is it decided who obtains the good? Suppose the recipients of the good are chosen by lottery; in this case, itwould be a miracle if the recipients of the good just happened to be those consumers with the highest reservation prices. But ourillustration in Figure 5.4.3 presumes exactly this! The deadweight loss will inevitably be greater than illustrated in Figure 5.4.3
because some consumers with low reservation prices will get lucky and obtain the good for the ceiling price, while other consumers
with higher values will go without. This situation tends 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 acommon strategy was to read the obituaries late at night, when the New York Times had just come out, hoping to find an apartmentthat would be vacant and available for rent.

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p
S

𝑝𝑝𝐷𝐷
Price
Ceiling
Shortage

D
q
qS

qD

Figure 5.4.4: A Price Ceiling with Queuing
Now suppose that instead of allocation by lottery, the good is allocated by queuing. That is, the 𝑞𝑞𝑆𝑆 units available are sold at theceiling price to the 𝑞𝑞𝐷𝐷 potential consumers by the simple mechanism of selling the good to the first consumers in line until the supply
is exhausted. Suppose further that all consumers value their time equally. With this assumption, we return to the outcome where theconsumers with the highest values are the ones who purchase the good, since those with the highest values will be sure to get in thequeue early enough to obtain the good at the ceiling price. Since queuing solves this allocation problem, one might be tempted toconclude that this yields the minimum dead weight loss illustrated in Figure 5.4.3. But in this case, we need to think more broadly
about the cost of acquiring the product – since the cost under this mechanism is not only money (the ceiling price) but time (the timespent standing in line). This is illustrated in Figure 5.4.4. Since the marginal consumer is willing to pay 𝑝𝑝𝐷𝐷 in money and/or time toobtain the 𝑞𝑞𝑆𝑆 th unit of the good, this is the price that the consumer will pay – and consequently, the deadweight loss associated withthis price ceiling is not only the traditional triangle, which represents mutually beneficial transactions that do not occur, but the redrectangle, which represents consumers’ time spent standing in line.
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 afree market, discrimination is costly – discrimination entails, for instance, not renting an apartment to the highest bidder, but thehighest bidder of the favored group. In contrast, with a price ceiling, there is a shortage, and sellers can discriminate at lower cost, oreven 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” among prospective tenants and still get the maximum legal rent. Thus a price ceiling has the undesirable byproduct of reducing the cost of discrimination.

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5-78Key Takeaways•

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. The most important example of a price floor is the minimum wage.

•

A price ceiling is a maximum price that can be charged for a product or service. Rent control imposes a maximum price onapartments in many U.S. cities.

•

If a price floor is low enough – below the equilibrium price – there are no effects. If the price floor is higher than the equilibrium
price, there will be a surplus.

•

The dead weight loss of a price floor is the difference between the value of the units not traded, and value is given by the demand
curve, and the cost of producing these units. This is the minimum loss to society associated with a price floor.

•

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. A price ceiling that is larger than the equilibrium price has no effect.

•

When the ceiling is below the equilibrium price, the price is forced below the equilibrium price and a shortage results.

•

In addition to underproduction, a price ceiling may also lead to inefficient allocation. Price ceilings tend to encourage illegal
trade and discrimination.
Key Terms•

Price floor: a minimum legal price•Price ceiling: a maximum legal price•Minimum wage: a price floor for wages•

Usury laws: price ceiling for interest rates
Exercises

5.4.1

In example 5.1, show that the quantity produced is less than the equilibrium quantity, which is ½. Compute the gains fromtrade, given the overproduction of suppliers. What is the dead weight loss of the price floor?

5.4.2

Suppose that units aren’t produced until after a buyer has agreed to purchase, as typically occurs with services. What is thedead weight loss in this case? (Hint: what potential sellers will offer their services? What is the average cost of supply ofthis set of potential sellers?)

5.4.3

Adapt the price floor example above to the case of a price ceiling, with 𝑝𝑝 < 1�2, and compute the lost gains from trade if

buyers willing to purchase are all able to purchase with probability

𝑞𝑞𝑠𝑠

𝑞𝑞𝑑𝑑

. (Hint: Compute the value of 𝑞𝑞𝑑𝑑 units; the value

realized by buyers collectively will be that amount times the probability of trade.)

5.5

The Politics of Price Controls
Learning Objectives•

Why does the government intervene in markets?

Both demand and supply tend to be more elastic in the long-run. This means that the quantity 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, such as
when property taxes increased. This law was softened in 1969 to be gradually replaced by a rent stabilization law that permitted
modest rent increases for existing tenants.

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p
SRS

LRS, initial

Rent
Control

D, initialq
Figure 5.5.1: 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 of apartments tends to be extremely inelastic, because one doesn’t tear down an apartment or convert itto a condominium (there were limitations on this) or abandon it without a pretty significant change in price. Demand also tends to berelatively 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 good substitute 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 more elastic than the short-run
supply, because in the long-run a price increase permits the creation of apartments from warehouses (lofts), rooms rented in houses,
etc. Thus, the apartment market in New York is characterized by inelastic short-run supply, much more elastic long-run supply, andinelastic demand. This is illustrated in Figure 5.5.1.
We start with a rent control law that has little or no immediate effect because it is set at current rents. Thus, in the near term, tenants’fears of price increases are eased and there is little change in the apartment rental market. This is not to say there is zero effect – somecompanies 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.

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LRS,

p
Old

later

SRS
LRS, initial
New
SRS
Rent
ControlD, laterD, initialq
Shortage
Figure 5.5.2: Rent Control, Long-Run EffectOver time, however, the demand for apartments grows as the city population and incomes 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 ashortage, but results in few apartments being lost because the short-run supply is very inelastic. Over time, however, apartments arewithdrawn from the market and the actual quantity falls, even as the demand rises, and the shortage gets worse and worse. Thesechanges are illustrated in Figure 5.5.2. The old values of demand, short-run supply and long-run supply are illustrated in dashed greylines. The new values, reflecting an increase in demand, 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 black lines.
The shortage is created by two separate factors – demand is increasing as incomes and population rise, and supply is decreasing as
costs rise. This reduces the quantity of available 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 wereabandoned by their owners, usually because the legal rent didn’t cover the property taxes and legally mandated maintenance. In somecases, tenants continued to inhabit the buildings even after the electricity and water 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?
The politics of rent control are straightforward. First, rent control involves a money transfer from landlords to tenants, because tenants
pay less than they would absent the law, and landlords obtain less revenue. In the short-run, due to the inelastic short-run supply, theeffect on the quantity of apartments is small, so rent control is primarily just a transfer from landlords to tenants.
In a city like New York, the majority of people rent. A tiny fraction of New Yorkers are landlords. 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 were renters 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 short-run, 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 effect on mostexisting New Yorkers, and thus isn’t a major impediment to getting voter support for rent control. The slow rate of harm to the city isimportant politically because the election cycle encourages a short time horizon – if successful at lower office, a politician hopes tomove on to higher office, and is unlikely to be blamed for the long-run 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 a minority. But there is another kind of political situation that is in some sense the reverse, wherea small number of people care a great deal about something, and the majority are only slightly harmed on an individual basis. No
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5-81political situation appears more extreme in this regard than that of refined sugar. There are few U.S. cane sugar producers (nine in1997), yet the U.S. imposes quotas that raise domestic prices much higher than world prices, in some years tripling the price
Americans pay for refined sugar. The domestic sugar producers benefit, while consumers are harmed. But consumers are harmed byonly a small amount each, perhaps twelve to fifteen cents per pound – which is not enough to build a consensus to defeat politicians
who accept donations from sugar producers. This is a case where concentrated benefits and diffused costs determine the politicaloutcome. 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 the domestic sugar price when they consume about
60 pounds per year of sugar.
Key Takeaways•

Both demand and supply tend to be more elastic in the long-run.

•

Rent control is usually imposed in the following way: as a prohibition or limitation on price increases. The nature of rent control
is that it begins with at most minor effects because it doesn’t bind until the equilibrium rent increases, thus the cost of rent control
tends to be in the future, and ill-effects worsen over time.

•

A candidate who runs on a rent control platform appeals to large portion of the voters as there are more renters than landlords.

•

Rent control is an example of a political situation sometimes called the tyranny of the majority, where a majority of people havean incentive to confiscate the wealth of a minority.

•

Concentrated benefits and diffused costs is the opposite of tyranny of the majority.
Key Terms•

Tyranny of the majority: In politics, a situation where a majority of people expropriate resources from a minority by voting•

Concentrated benefits and diffused costs: In politics, a situation where small number of people with strong incentives expropriate
a small amount per person from a large number

5.6

Price Supports
Learning Objectives•

How is a price support different from a price floor?

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

p
S

Gov’t
Purchase

Figure 5.6.1 illustrates the effect of a support program.
The government posts a price, called the support price,and purchases any excess production offered on themarket. The government purchases, which are thedifference between the quantity supplied and quantity
demanded, are illustrated on the diagram. The cost of the
program to the government is the support price times thisquantity purchased, which is the area of the rectangle
directly underneath the words “Gov’t Purchases.”

Support
Price

Dead

Figure 5.6.1: A Price Support

There are two kinds of dead weight loss in a price support
program. First, consumers who would like to buy at theequilibrium price are deterred by the higher prices,
resulting in the usual dead weight loss, illustrated with thevertical shading. In addition, however, there are goods
producedthat are then either destroyed or put inqwarehouses and not consumed, which means the costs ofproduction of those goods is also lost, resulting in asecond dead weight loss. That loss is the cost of
production, which is given by the supply curve, and thus

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Weight
Loss
D
qD

qS

is the area under the supply curve, for the government purchases. It is shaded in a horizontal fashion. The total dead weight loss ofthe price support is the sum of these two individual losses. Unlike the case of a price floor or ceiling, a price support creates noambiguity about what units are produced, or which consumers are willing and able to buy, and thus the rationing aspect of a pricefloor or ceiling is not present for a price support, nor is the incentive to create a black market other than that created by selling thewarehouse full of product.
Key Takeaways•

A price support is a combination of two programs – a price floor and government purchase of surplus. Excess production is aburden on the government.

•

A price support above the equilibrium price leads to a surplus.

•

The dead weight loss of price supports involves the usual dead weight loss plus the entire cost of unconsumed goods.
Key Terms•

Price support: a combination of a minimum price or price floor, and government purchase of any surplus•

Support price: The minimum price in a price support

5.7

Quantity Restrictions and Quotas
Learning Objectives•

What is a quota?

The final common way that governments intervene in market transactions is to impose a quota. A quota is a maximal production
quantity, usually set based on historical production. In tobacco, peanuts, hops, California oranges, and other products, producers haveproduction quotas based on their historical production. Tobacco quotas were established in the 1930s and today a tobacco farmer’squota is a percentage of the 1930s level of production. The percentage is set annually by the Secretary of Agriculture. Agricultural
products are not the only products with quotas. The right to drive a taxi in New York requires a medallion issued by the city, andthere 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 tothe cost 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 5.7.1. It works like a combination of a price floor and a prohibition on entry.
Generally, the immediate effects of a quota involve a transfer ofmoney from buyers to sellers. The inefficient production andsurplus of the price floor are avoided because a production
limitation created the price increase. This transfer has anundesirable and somewhat insidious attribute. Because the right toproduce is a capital good, it maintains a value, which must be
captured by the producer. For example, an individual who buys ataxi medallion today, and pays $300,000, makes no economic
profits – he captures the foregone interest on the medallion
through higher prices but no more than that. The individuals who
received the windfall gain were those who were driving taxis andwere grandfathered in to the system, and issued free medallions.
Those people – who were driving taxis 70 years ago and thus aremostly dead at this point – received a windfall gain from theestablishment of the system. Future generations pay for the
program, which provides no net benefits to the current generation;
all the benefits were captured by people long since retired.

p
S

Dead
Weight
L

D
q
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, elimination of the program would harm current medallion
owners.

Figure 5.7.1: A Quota

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 be bought and sold. Moreover, aIntroduction to Economic Analysis

5-83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 associatedwith 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 andMissouri, which only exist because of the value of the quota – if they could trade their quota to a farm 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 inefficient. Tradable quotas eliminate this particular problem, but continue to have the problem
that future generations are harmed with no benefits.
Key Takeaways•

A quota is a maximum production quantity, usually set based on historical production.

•

A quota restricts the quantity below that which would otherwise prevail, forcing the price up.

•

A quota transfers wealth from buyers to sellers. No surplus arises because of the production limitation. Future generations pay
for the program, which provides future sellers no benefits.

•

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 inefficient. Tradable quotas eliminate this particular problem, but continue to have theproblem that future generations are harmed with no benefits.
Key Terms•

Quota : a maximal production quantity, usually set based on historical production
Exercises

5.7.1

Suppose demand for a product is 𝑞𝑞𝑑𝑑 = 1 – 𝑝𝑝, and the marginal cost of production is 𝑐𝑐. A quota at level 𝑄𝑄 ≤ 1 – 𝑐𝑐 is
imposed. What is the value of the quota, per unit of production? Use this to derive the demand for the quota as a function 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?

Introduction to Economic Analysis

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6

Trade

Supply and demand offers one approach to understanding trade, and it represents the most important and powerful concept in the
toolbox of economists. However, for some issues, 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 moreguns, 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 with cows, 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 lessbutter (or other things).

6.1

Production Possibilities Frontier
Learning Objectives•

What can we produce and how does that relate to cost?

Formally, the set of production possibilities is the collection of “feasible outputs” of an individual, group or society or country. You
could spend your time cleaning your apartment, or you could study. The more of your time you devote to studying, the higher yourgrades will be, but the dirtier your apartment will be. This is illustrated, for a hypothetical student, in Figure 6.1.1.
The production possibilities set embodies the feasible alternatives. If you spend all your time studying, you would obtain a 4.0(perfect) grade point average (GPA). Spending an hour cleaning reduces the GPA, but not by much; the second hour reduces by a bit
more, and so on.
Grades
4.0

3.0

2.0

The boundary of the production possibilities set is known as
the production possibilities frontier. This is the mostimportant part of the production possibilities set, because atany point strictly inside the production possibilities set, it ispossible to have more of everything, and usually we would
choose to have more.16 The slope of the production
possibilities frontier reflects opportunity cost, because it
describes what must be given up in order to acquire more ofa 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 6.1.1, diverting time to cleaning
reduces studying, which lowers the GPA. The slope dictates
how much lost GPA there is for each unit of cleaning.

One important feature of production possibilities frontiers is
illustrated in Figure 6.1.1: they are concave toward the
1.0
origin. While this feature need not be universally true, it is acommon feature, and there is a reason for it that we can see
in the application. 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
Cleanliness grades for the hour’s work. The second hour of studying
produces less value than the first, and the third hour less than
the second. This is the principle of diminishing marginal
Figure 6.1.1: The Production Possibilities Frontier
returns. Diminishing marginal returns are like picking
apples. If you are only going to pick apples for a few minutes, you don’t need a ladder because the fruit is low on the tree; the moretime spent, the fewer apples per hour you will pick.
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 of vegetables per minute, or make one hors d’oeuvre in a minute. Bob, somewhat inept with a knife, can cut up

16 To be clear, we are considering an example with two goods, cleanliness and GPA. Generally there are lots of activities, likesleeping, eating, teeth-brushing, and the production possibilities frontier encompasses 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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one ounce of vegetables per minute, or make two hors d’oeuvres per minute. Ann’s and Bob’s production possibilities frontiers areillustrated in the Figure 6.1.2, 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 6.1.2. Bob’s is thereverse – he produces 60 ounces of vegetables, or 120 hors d’oeuvres, or something on the line in between.
Ounces of120

Ounces ofvegetables

120

Ann’s

vegetables

Bob’s
Production

Production

Possibilities

Possibilities

Frontier

Frontier

60

60

60

120

hors

60

d’oeuvres

120

hors
d’oeuvres

Figure 6.1.2: Two Production Possibilities Frontiers
For Ann, the opportunity cost of an ounce of vegetables is half of one hors d’oeuvre – to get 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.
Ounces ofvegetables
180

Joint
Production
120

Possibilities
Frontier

60

hors
60

120

180

d’oeuvres

Figure 6.1.3: Joint PPF
What can Bob and Ann accomplish together? The important insight is that they should use the low cost person in the manufacture ofeach good, when possible. This means that 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 6.1.3. Together, they can make 180 of one and none of the other. If Bob makes only hors d’oeuvres, and Ann makes only
Introduction to Economic Analysis

6-86chopped vegetables, they will have 120 of each. With fewer than 120 ounces of vegetables, the opportunity cost of vegetables isAnn’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 d’oeuvres in equal portions. By herself, Ann can only produce 40 ounces of vegetables and 40 horsd’oeuvres if she must produce equal portions. She accomplishes this by spending 20 minutes on vegetables and 40 minutes on horsd’oeuvres. Similarly, Bob can produce 40 of each, but using the reverse allocation of time.
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 each good.
Moreover, Bob and Ann can accomplish this by trading. At a “one for one” price, Bob can produce 120 hors d’oeuvres, and trade 60of them for 60 ounces of vegetables. This is 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 hors d’oeuvres. This trading makes them both betteroff.
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; a fourth points it; a fifth grinds it at the top for receiving the head;to make the 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 manner, divided into about eighteen
distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes
perform two or three of them.”17
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.
Key Takeaways•

The production possibilities set is the collection of “feasible outputs” of an individual or group.

•

The boundary of the production possibilities set is known as the production possibilities frontier.

•The principle of diminishing marginal returns implies that the production possibilities frontier is concave toward the origin, whichis equivalent to increasing opportunity cost.

•

Efficiencies created by specialization create the potential for gains from trade.
Key Terms•

Production possibilities: collection of feasible outputs of an individual, group or society or country•

Production possibilities frontier: boundard of the production possibilities set; no good can be increased without decreasing at least
one other•

Diminishing marginal returns: Spending more on something reduces the per unit value produced

17 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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Exercises
6.1.1

6.1.2

The Manning Company has two factories, one that makes roof trusses, and one that makes cabinets. With 𝑚𝑚 workers, theroof factory produces √𝑚𝑚 trusses per day. With n workers, the cabinet plant produces 5√𝑛𝑛. The Manning Company has 400
workers to use in the two factories. Graph the production possibilities frontier. (Hint: Let 𝑇𝑇 be the number of trusses
produced. How many workers are used making trusses?)
Alarm & Tint, Inc., has 10 workers working a total of 400 hours per week. Tinting takes 2 hours per car. Alarm installationis complicated, however, and performing 𝐴𝐴 alarm installations requires 𝐴𝐴2 hours of labor. Graph Alarm & Tint’s production
possibilities frontier for a week.
For questions 6.1.3 to 6.1.6 consider an orange juice factory that uses as inputs oranges and workers. If the factory uses x
pounds of oranges and y workers per hour, it produces 𝑇𝑇 = 20𝑥𝑥 0.25 𝑦𝑦 0.5 gallons of orange juice.

6.1.3

Suppose oranges cost $1 and workers cost $10, what relative proportion of oranges and workers should the factory use?

6.1.4

Suppose a gallon of orange juice sells for $1, how many units should be sold and what is the input mix to be used? What isthe profit?

6.1.5
6.1.6

Generalize the previous exercise for a price of $𝑝𝑝 per gallon of orange juice.

6.2

Comparative and Absolute Advantage

What is the supply elasticity?

Learning Objectives•

Who can produce more?

•

How does that relate to cost?

•

Can a nation be cheaper on all things?

Ann produces chopped vegetables because her opportunity cost of producing vegetables, at ½ of one hors d’oeuvre, is lower thanBob’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 of vegetables. Since the cost of one good is theamount of another good foregone, a comparative 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 in particular the thing you give up less of to get morebutter.
To illustrate this point, let’s consider another party planner. Charlie can produce one hors d’oeuvre, or one ounce of chopped
vegetables, per minute. His production is strictly 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 ofvegetables to produce a hors d’oeuvres, while Ann must give up two ounces of vegetables. Thus, Ann and Charlie can still benefit
from trade if Bob isn’t around.
When one production possibilities frontier lies outside another, the larger is said to have an 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 givenup). That is to say, diminishing marginal returns means that supply curves slope upward; the marginal cost of producing more isincreasing 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 𝑐𝑐1 of producing good X (in terms of Y, that is, for each unit of
X that person 1 produces, person 1 gives up 𝑐𝑐1 units of Y), and person 2 has an opportunity cost of 𝑐𝑐2 , then there are gains from trade
whenever 𝑐𝑐1 is not equal to 𝑐𝑐2 and neither party has specialized.18 Suppose 𝑐𝑐1 < 𝑐𝑐2 . Then by having person 1 increase theproduction of X by ∆, 𝑐𝑐1 ∆ less of the good Y is produced. Let person 2 reduce the production 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 (𝑐𝑐2 -𝑐𝑐1 ) ∆. The net changes are summarized in Table
6.2.1.

18

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 nomore can be produced.
Introduction to Economic Analysis

6-88Table 6.2.1: Construction of the Gains From Trade
1

2

Net Change

Change in X

+∆

-∆

0

Change in Y

-𝑐𝑐1 ∆

𝑐𝑐2 ∆(𝑐𝑐2 -𝑐𝑐1 ) ∆Whenever opportunity costs differ, there are gains from re-allocating production from one 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 other producer,
who is the low cost producer of this other good. An important aspect of this re-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 we have more ofeverything we want.19
How can we guide the reallocation of production to produce more goods and services? It turns out that under some circumstances, theprice system does a superb job of creating 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 𝑝𝑝
which is the number of units of Y one has to give to get a unit of X. (Usually prices are in currency, but we can think of them as
denominated in goods, too.) If I have a cost c of producing X, which is the number of units of Y that I lose to obtain a unit of X, I willfind it worthwhile to sell X if 𝑝𝑝 > 𝑐𝑐, because the sale of a unit of X, nets me 𝑝𝑝 – 𝑐𝑐 units of Y, which I can either consume or resell
for something else I want. Similarly, if 𝑐𝑐 > 𝑝𝑝, I would rather buy X (producing Y to pay for it). Either way, only producers withcosts less than p will produce X, and those with costs greater than p will purchase X, paying for it with Y, which they can produce
1more cheaply than its price. (The price of Y is – that is the amount of X one must give to get a unit of Y.)
𝑝𝑝

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.
Key Takeaways•

A lower opportunity cost creates a comparative advantage in production.

•

A comparative advantage in one good implies a comparative disadvantage in another.

•

It is not possible to have a comparative disadvantage in all goods.

•

An absolute advantage means the ability to produce more of all goods.

•

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, diminishing marginal 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.

•

Whenever opportunity costs differ, potential gains from trade exist.

••

Trade permits production of more of all goods.
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.
Key Terms•

Comparative advantage: a lower opportunity cost measured in another good••

Comparative disadvantage: opposite of a comparative advantage
Absolute advantage: The ability to produce more of all goods

19

If you are worried that more production means more pollution or other bad things, rest assured. Pollution is a bad, so we enter thenegative of pollution (or environmental cleanliness) as one of the goods we would like to have more of. The reallocation dictated bydifferences in marginal costs produces more of all goods. Now with this said, we have no reason to believe that the reallocation will
benefit everyone – there may be winners and losers.
Introduction to Economic Analysis

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Exercises
6.2.1

6.2.2

Graph the joint production possibilities frontier for Ann and Charlie, and show that collectively they can produce 80 of each
if they need the same number of each product. Hint: First show that Ann will produce some of both goods, by showing that
if Ann specializes, there are too many ounces of vegetables. Then show, if Ann devotes x minutes to hors d’oeuvres, that60 + 𝑥𝑥 = 2(60 – 𝑥𝑥).

6.2.3

Using Alarm & Tint’s production possibilities frontier in 6.1.2, compute the marginal cost of alarms in terms of window tints.

6.3

Factors of Production

Using Manning’s production possibilities frontier in 6.1.1, compute the marginal cost of trusses in terms of cabinets.

Learning Objectives•

How does the abundance or rarity of inputs to production affect the advantage of nations?

Production possibilities frontiers provide the basis for a rudimentary theory of international trade. To understand the theory, it is firstnecessary 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 is a 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 – is cheap and abundant in the
Pacific Northwest, and as a result, a lot of aluminum is smelted there, because aluminum smelting requires lots of electricity.
Electricity can be transported, but only with losses (higher costs), which gives other regions a disadvantage in the smelting ofaluminum. Capital is generally considered a mobile factor, because plants can be built anywhere, although investment is easier insome environments than in others. For example, reliable electricity and other inputs are necessary for most factories. Moreover,comparative advantage may arise from the presence 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 toinvestment 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 inothers. Europe, the United States and Japan have a relative abundance of highly skilled labor, and have a comparative advantage ingoods requiring high skills, like computers, automobiles and electronics. Taiwan, South Korea, Singapore and Hong Kong haveincreased the available labor skills, and now manufacture more complicated goods like VCRs, computer parts and the like. Mexico hasa relative abundance of middle-level skills, and a large number of 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 of China are rising
rapidly.
The basic model of international trade was first described by David Ricardo (1772-1823), and suggests that nations, responding toprice incentives, will specialize in the production of goods in which they have a comparative advantage, and purchase the goods inwhich they have a comparative disadvantage. In Ricardo’s description, England has a comparative advantage of manufacturing cloth,and Portugal in producing wine, leading to gains from trade from specialization.
The Ricardian theory suggests that the United States, Canada, Australia and Argentina should export agricultural goods, especiallygrains that require a large land area for the value generated (they do). It suggests that complex technical goods should be produced indeveloped nations (they are) and that simpler products and natural resources should be exported by the lesser developed nations (theyare). It also suggests that there should be more trade between developed and underdeveloped nations than between developed andother developed nations. The theory falters on this prediction – the vast majority of trade is between developed nations. There is noconsensus for the reasons for this, and politics plays a role – the North American Free Trade Act vastly increased the volume of trade
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 the underdeveloped world. Trade barriers don’t account for the volume of trade between similar nations, which thetheory suggests should be unnecessary. Developed nations sell each other mustard and tires and cell phones, exchanging distinct
varieties of goods they all produce.

Introduction to Economic Analysis

6-90Key Takeaways•

The term “factors of production” is jargon for inputs to the production process.

•Labor is generally considered a fixed or immobile factor, because most countries don’t have borders wide open to immigration.
Temperature, weather, and land are also fixed factors.

•

Fixed factors of production give particular regions a comparative advantage in the production of some kinds of goods, and not inothers.

•The basic model of international trade, known as the Ricardian theory, suggests that nations, responding to price incentives, will
specialize in the production of goods in which they have a comparative advantage, and purchase the goods in which they have acomparative disadvantage.
Key Terms•

Factors of production: inputs to the production process•

Fixed factors of production: Factors of production that are not readily moved•

Ricardian theory: Specialization in production according to comparative advantage

6.4

International Trade
Learning Objectives•

How does trade affect domestic prices for inputs and goods and services?

The Ricardian theory emphasizes that the relative abundance of particular factors of production determines comparative advantage in
output, but there is more to the theory. When the United States exports a computer to Mexico, American labor, in the form of aphysical 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 laborhas been sold to the United States, and similarly when the Americans buy Japanese televisions, Japanese labor has been purchased.
The goods that are traded internationally embody the factors of production of the producing nations, and it is useful to think ofinternational trade as directly trading the inputs through the incorporation of inputs into products.
If the set of traded goods is broad enough, the value of factors of production should be equalized 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 the Japanese 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 ofagricultural land. One can reasonably think that soybeans are soybeans, wherever they are produced, and that trade in soybeans at acommon price 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 of American land, and drives down the value of Japanese land by giving analternative to its 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 theequalization of wages of equally skilled people after free trade between the United States and Mexico. Thus, free trade in physicalgoods should equalize the price of 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 thequantity 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 ischeaper 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 andother distortions make it a challenge to test the theory 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 is cheaper in the Pacific Northwest.
Nevertheless, nations with a relative abundance of capital and skilled labor export goods that use these intensively, nations with arelative abundance of land export land-intensive goods like food, nations with a relative abundance of natural resources export theseresources, and nations with an abundance of 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.

Introduction to Economic Analysis

6-91Key Takeaways•

Goods that are traded internationally embody the factors of production of the producing nations.

•

It is useful to think of international trade as directly trading the inputs through the incorporation of inputs into products.

•

If the set of traded goods is broad enough, the value of factors of production should be equalized through trade. This prediction
is known as factor price equalization.
Key Terms•

Factor price equalization: Trade in outputs tends to equalize the prices of inputs

Introduction to Economic Analysis

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7

Externalities

When the person sitting next to you lights up a cigarette, he gets nicotine, and the cigarette 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, and the record company and stereo component companies get his money. You flunk out of college
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 the point that they catch fire like Cleveland’s Cuyahoga did, are all examples where a transaction 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 the smog 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 your neighbor. Inventions and creations, whether products or poetry, produce value for others. The
creator of a poem, or a mathematical theorem, provides a benefit to others.

7.1

External Effects
Learning Objectives•

How can society stop people from doing annoying things and encourage them to do pleasing things?

These effects are called external effects, or externalities. An externality is any effect on people not involved in a particulartransaction. Pollution is the classic example. When another person buys and smokes cigarettes, there is a transaction between thecigarette company and the smoker. But if you are sitting near the smoker, you are an affected party not directly compensated from thetransaction, at least before taxes were imposed on 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 a social perspective, absent a mechanism to
involve all the affected parties. Without such a 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 loudneighbor will play music much too late into the night. Externalities create a market failure, that is, a competitive market does not yield
the socially efficient outcome.
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 elect better
politicians.20 Educated individuals tend to make a society wealthy, an advantage to all of society’s members. As a consequence,
most societies subsidize education, in order 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 that you infect others with the disease.
Let’s consider pollution as a typical example. A paper mill produces paper, and a bad smell is an unfortunate by-product of theprocess. 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 inthis 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 7.1.1.

20This is a logical proposition, but there is scant evidence in favor of it. There is evidence that educated voters are more likely to vote,but little evidence that they vote for better candidates.
Introduction to Economic Analysis

7-93

p
Marginal
SocialCost

Marginal
External
Cost

Socially
Efficient

PrivatePi

Marginal
Competitive

Cost

Price
MarginalBfitqSocially

Competitive

Efficient

Quantity

Quantity
Figure 7.1.1: A Negative Externality
In Figure 7.1.1, the demand has been labeled “marginal benefit,” for reasons that will become apparent, but it is at this point just thestandard demand, the marginal value of the product. The paper mill’s costs have been labeled marginal private cost to reflect the factthat 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 the marginal 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,” arebad 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 created in the process ofmanufacturing paper.
The dead weight loss of these units is a shaded triangle. The loss arises because the marginal social cost of the units exceeds thebenefit, and the difference between the social 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 the costs are borne by others.

Introduction to Economic Analysis

7-94Marginal
SocialCostp

PrivateMarginal
Cost

Marginal
SocialBenefitMarginal
PrivateBenefitSocially
Efficient
QuantityqCompetitive
Quantity

Figure 7.1.2: External Costs and Benefits
Generally, a negative externality like pollution creates a marginal social cost higher than the marginal private cost. Similarly, a
positive externality like beautification creates a higher marginal social benefit than the marginal private benefit (demand). These areto some extent conventions – one could have incorporated a positive externality by a reduction in cost – but the convention remains.
An example of a product that produces both positive and negative externalities is illustrated in Figure 7.1.2. Street lights are an
example of a product that produces both externalities – most of us like lit streets, but they are terrible for astronomers. Similarly, large
highways produce benefits for commuters 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 thecompetitive quantity results from the intersection of these two. The marginal social benefit and the marginal social cost gives thevalue and cost from a social perspective; equating these two generates the socially efficient outcome. This can be either greater or lessthan the competitive outcome depending on which externality is larger.
Example (Tragedy of the Commons): Consider a town on a scenic bay filled with lobsters. The town members collect and eat
lobsters, and over time the size of the lobsters 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 to catch them.
The tragedy of the commons is a problem with a common resource, in this case the lobster bay. Catching lobsters creates anexternality, by lowering the productivity of other 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 nearly useless resource and potentially driving thelobsters into extinction. As a consequence, the lobster catch is usually regulated.

Introduction to Economic Analysis

7-95Key Takeaways•

An externality is any effect on people not involved in a particular transaction.

•

Pollution is the classic negative externality.

•

Externalities will generally cause competitive markets to behave inefficiently from a social perspective. Externalities create amarket failure, that is, a competitive market does not yield the socially efficient outcome.

•

Education is viewed as creating an important positive externality.

•

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 that you infect others with the disease.

•

Private costs are those borne by the parties to a transaction, external costs are costs borne by others not party to the transaction,and social costs and the sum of private and external costs.

•

Private benefits are those enjoyed by the parties to a transaction, external benefits are enjoyed by others not party to thetransaction, and social benefits and the sum of private and external benefits.

•

Demand is marginal private benefit; supply is marginal private cost.

•

The social optimum arises at the quantity where marginal social benefit equals marginal social cost. A different quantity than thesocial optimum creates a dead weight loss equal to the difference of marginal social benefit and cost.

•

The tragedy of the commons is overuse of a resource arising because users ignore the harmful effect of their use on other users.
Key Terms•

Externality: An effect on people not directly involved in a transaction•

Market failure: A situation where a competitive market fails to produce the socially efficient outcome, or a competitive market
can't exist•

Private cost: In theory of externalities, the costs borne by the supplier•

Private benefit: In theory of externalities, the benefits obtained by the buyer•

Social cost: In theory of externalities, the total costs for all parties•

Social benefit: In theory of externalities, the total benefits for all parties•

External cost: In theory of externalities, costs borne by third parties•

External benefit: bIn theory of externalities, benefits obtained by thid parties•

Tragedy of the commons: Overuse of a resource due to lack of ownership•

Common resource: A shared resource
Exercises

7.1.1

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 with your answer with a diagram
illustrating the negative marginal benefit of vaccination, and a horizontal axis representing the proportion of the population
vaccinated.

7.1.2

The total production from an oil field generally depends on the rate at which the oil is pumped, with faster rates leading tolower total production but earlier production. Suppose two different producers can pump from the field. Illustrate, using an
externality diagram where the horizontal axis is the rate of production for one of the producers, the difference between thesocially efficient outcome and the equilibrium outcome. Like many other states, Texas’ law requires that when multiple
people own land over a single oil field, the output is shared among the owners, with each owner obtaining a share equal toproportion of the field under their land. This process is called unitization. Does it solve the problem of externalities inpumping and yield an efficient outcome? Why or why not?

7.1.3

Imagine that many students are bothered by loud music playing at 7am near their dorm. Using economic analysis, how would
you improve the situation?

Introduction to Economic Analysis

7-96

7.2

Pigouvian Taxes
Learning Objectives•

Can society regulate annoying behavior with taxes?

Arthur Cecil Pigou, 1877-1959, proposed a solution to the problem of externalities that has 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 socially efficientquantity; this is known as a Pigouvian tax. Thus, if at the socially efficient quantity, the marginal external cost is a dollar, then a one
dollar per unit tax would lead to the right outcome. This is illustrated in Figure 7.2.1.
The tax that is added is the difference, at the socially efficient quantity, between the marginal social cost and the marginal private cost,which equals the marginal external cost. 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.
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

Marginal
BenefitSocially
Efficient
Quantityq

Figure 7.2.1: The Pigouvian Tax
Taxes and subsidies are fairly common instruments to control externalities. We subsidize higher education with state universities, andthe federal government provides funds for research and limited funds for the arts. Taxes on cigarettes and alcoholic beverages areused to discourage these activities, perhaps because smoking and drinking alcoholic beverages create negative externalities.
(Cigarettes and alcohol also have inelastic demands, which make them good candidates for taxation since there is only a small
distortion of the quantity.) However, while important in some arenas, taxes and subsidies are not the most common approach toregulation of externalities.
Key Takeaways•

A Pigouvian tax is a per-unit tax on a good generating negative externalities equal to the marginal externality at the sociallyefficient quantity.

•

Imposition of a Pigouvian tax leads to a competitive equilibrium, taking account of the tax, which is efficient.

•In the case of a positive externality, a subsidy can be used to obtain efficiency.

•

Taxes and subsidies are fairly common instruments to control externalities.
Key Terms•

Pigouvian tax: A tax equal to the marginal external cost at the socially efficient quantity

Introduction to Economic Analysis

7-97

Exercises
7.2.1

Identify the tax revenue produced by a Pigouvian tax in Figure 7.2.1. What is the relationship between the tax revenue andthe damage produced by the negative externality? Is the tax revenue sufficient to pay those damaged by the external effect anamount equal to their damage? Hint: Is the marginal external effect increasing or decreasing.

7.2.2

Identify on a diagram the Pigouvian subsidy needed to induce the efficient quantity in the case of a positive externality.
When is the subsidy expended smaller than the total external benefit?

7.2.3

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.

7.3

QuotasLearning Objectives•

Can society regulate annoying behavior by just telling people what to do?

The Pigouvian tax and subsidy approach to dealing with externalities has several problems. First, it requires knowing the marginalvalue or cost of the external effect, and this may be a challenge to estimate. Second, it requires the imposition of taxes and permits thepayment 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 the agency 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 been successfully articulated.
(The Canadian government, in contrast, sees externalities in film-making and railroads.)
An alternative to the Pigouvian tax or subsidy solution is to set a quota, which is a limit on 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 tozero). We set maximum amounts of 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 govern electricity and plumbing, designed to promote safety, and these tend to be “minimum standards.”
Quotas are a much more common regulatory strategy for dealing with externalities 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 or quantity restriction on pollution. If the positive externality of education means individuals in oursociety receive too little education from the social perspective, force them to go to school.
As noted, quotas have the advantage that they address the problem without letting the government spend more money, limiting thegovernment’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 for almost 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 to existing firms, and discourage the adoption of newtechnology. Indeed, the biggest polluters must stay with old technology in order to maintain their right to pollute.
Key Takeaways•

An alternative to the Pigouvian tax or subsidy solution is to set a quota. Quotas can be maxima or minima, depending on whether
the activity generates negative or positive externalities.

•

Quotas are a much more common regulatory strategy for dealing with externalities than taxes and subsidies.

•

The goal of a quota is to limit the quantity to the efficient level.

•

Quotas tend to harm new entrants compared to existing firms, and discourage the adoption of new technology.
Exercises

7.3.1

If a quota is set to the socially efficient level, how does the value of a quota right compare to the Pigouvian tax?

7.3.2

Speeding (driving fast) creates externalities by increasing the likelihood and severity of automobile accidents, and mostcountries put a limit on speed, but one could instead require fast drivers to buy a permit to speed. Discuss the advantages anddisadvantages of “speeding permits.”

Introduction to Economic Analysis

7-98

7.4

Tradable Permits and Auctions
Learning Objectives•

Is there a better way to regulate annoying behavior than either taxes or quotas?

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 theprice 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 on pollution, a tax whose level is determined by the quota supply and demand.

Figure 7.4.1: SO2 Permit Prices
The United States has permitted the trading of permits for some pollutants, like sulfur dioxide. Figure 7.4.1 shows the price of sulfur
dioxide permits over the past decade.21 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 ofsulfur 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 the total amount of pollution constant. Such exchange is efficient because it uses the pollution in
the manner creating the highest value, eliminating a bias toward “old” sources. Indeed, a low value polluter might sell its permits andjust shut down, if the price of pollution were high enough.
A somewhat unexpected advantage of tradable permits was the purchase of permits by environmental groups like the Sierra Club.
Environmental groups can buy permits and then 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 the environmental 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 ofpollution directly. This is especially valuable when the strategy is to set a quantity equal to the current quantity, and then gradually
reduce the quantity to reduce the effects of the pollution. The price of permits can be a very useful instrument is assessing theappropriate time to reduce the quantity, since high permit prices, relative to likely marginal external costs, suggests that the quantity ofthe quota is too low, while low prices suggest that the quantity is too large and should be reduced.

21

Source: Environmental Protection Agency, July 22, 2004, http://www.epa.gov/airmarkets/trading/so2market/alprices.html

Introduction to Economic Analysis

7-99Key Takeaways•

A solution to inefficiencies in the allocation of quota rights is to permit trading them.

•Tradable permits represent a hybrid of a quota system and a Pigouvian taxation system. The quota determines the overall quantityof pollution, while the purchase of pollution rights acts like a tax on pollution.

•

The United States has permitted the trading of permits for some pollutants, like sulfur dioxide.

•

The major advantage of a tradable permits system is that it creates the opportunity for efficient exchange.

•

A somewhat unexpected advantage of tradable permits was the purchase of permits by environmental groups, buying cleaner air.

•Tradable permits offer the advantages of a taxation scheme – efficient use of pollution – without needing to estimate the social
cost of pollution directly.

•

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 the quantity of the quota is too low, while low prices suggest thatthe quantity is too large and should be reduced.
Key Terms•

7.5

Tradable permits: Quotas that can be exchanged

Coasian Bargaining
Learning Objectives•

Can I just bribe my neighbor to stop being annoying?

The negative externality of a neighbor playing loud music late at night is not ordinarily solved with a tax or with a quota, but insteadthough an agreement. When there aren’t many individuals involved, the individuals may be able to solve the problem of externalities
without involving a government, but through negotiation. This insight was developed by Nobel laureate Ronald Coase (1910 – ), andis sometimes known as Coasian bargaining.
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 thefarm and eat the crops, rather than staying on the ranch. What happens next depends on property rights, which are the rights that comewith ownership.
One of three things might be efficient from a social perspective. It might be efficient to erect a fence to keep the cows away from thecrops. It might be efficient to close down 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 theranch, 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 efficient solution 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 in operation. 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 farm to the rancher. In all three cases, if the farmer has theproperty rights, the efficient outcome is reached.
Now suppose instead that the rancher has the rights, and that the farmer has no recourse 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 will build thefence to protect his crops. Finally, if shutting down the ranch is efficient, the farmer will buy the ranch from the rancher, in order tobe able to continue to operate the more valuable farm. In all cases, the efficient solution is reached through negotiation.
Coase argued that bargaining can generally solve problems of externalities, and that the real 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 andwouldn’t permit an inefficient level of pollution. 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 ofproblems, 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 of people are involved. When a large numberof people are potentially involved, as with air pollution, bargaining is unlikely to be successful in addressing the problem ofexternalities, and a different approach required.
Introduction to Economic Analysis

7-100Key Takeaways•

When there aren’t many individuals involved, the individuals may be able to solve the problem of externalities without involvinga government, but through negotiation.

•

Nobel Laureate Ronald Coase argued that bargaining can generally solve problems of externalities, and that the real problem is
ill-defined property rights.

•

Bargaining to solve the problem of externalities is often feasible when a small number of people 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
of externalities.
Key Terms•

Coasian bargaining: Solving problems of externalities through bargaining•

Property rights: Rights that come with ownership

7.6

Fishing and Extinction
Learning Objectives•

Is extinction really an economic phenomenon?

•

Why do we overfish?

Consider an unregulated fishing market like the lobster market considered above, and let S be the stock of fish. The purpose of thisexample 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 changeover time? Denote the change over time in the fish population by 𝑆𝑆̇ (𝑆𝑆̇ is notation for the derivative with respect to time, notation that
dates back to Sir Isaac Newton.) We assume that population growth follows the logistic equation 𝑆𝑆̇ = 𝑟𝑟𝑟𝑟(1 − 𝑆𝑆). This equationreflects two underlying assumptions. First, mating and reproduction is proportional to the stock of fish 𝑆𝑆. Second, survival is
proportional to the amount of available resources 1 − 𝑆𝑆, where 1 is set to be the maximum sustainable population. (Set the units of thenumber of fish so that 1 is the full population.)

The dynamics of the number of fish is illustrated in Figure 7.6.1. On the horizontal axis is the number of fish, and on the vertical axis
is the change in 𝑆𝑆. When 𝑆𝑆̇ > 0, 𝑆𝑆 is increasing over time, and the arrows on the horizontal axis reflect this. Similarly, if 𝑆𝑆̇ < 0, 𝑆𝑆 isdecreasing.

Absent fishing, the value 1 is a stable steady state of the fish population. It is a steady state because, if 𝑆𝑆 = 1, 𝑆𝑆̇ = 0, that is, there is
no change in the fish population. It is stable because the effect of a small perturbation – 𝑆𝑆 near but not exactly equal to 1 – is to returnto 1. (In fact, the fish population is very nearly globally stable – start with any population other than zero and the population returns to
1.)22

S

0.5
0.4
0.3
0.2
0.1

0.2

0.4

0.6

0.8

1

S

-0.1
-0.2
Figure 7.6.1: Fish Population Dynamics

22

It turns out that there is a closed form solution for the fish population: 𝑆𝑆(𝑡𝑡) =Introduction to Economic Analysis

𝑆𝑆(0)𝑆𝑆(0)+�1−𝑆𝑆(0)�𝑒𝑒 −𝑟𝑟𝑟𝑟

.
7-101

Now we introduce a human population and turn to the economics of fishing. Suppose that a boat costs 𝑏𝑏 to launch and operate, and−1
that it captures a fixed fraction 𝑎𝑎 of the total stock of fish 𝑆𝑆, that is, each boat catches 𝑎𝑎𝑎𝑎. Fish sell for a price 𝑝𝑝 = 𝑄𝑄 �𝜀𝜀 , where theprice arises from the demand curve, which in this case has constant elasticity ε, and 𝑄𝑄 is the quantity of fish offered for sale. Suppose
there be n boats launched; then the quantity of fish caught is 𝑄𝑄 = 𝑛𝑛𝑛𝑛𝑛𝑛. Fishers enter the market as long as profits are positive, which
𝑄𝑄

leads to zero profits for fishers, that is, 𝑏𝑏 = 𝑝𝑝(𝑄𝑄) � �. This equation makes a company just indifferent to launching an additional boat,𝑛𝑛because the costs and revenues are balanced. These two equations yield two equations in the two unknowns n and Q:
𝑛𝑛 =𝑄𝑄𝑄𝑄(𝑄𝑄)
𝑏𝑏

1

= 𝑄𝑄
𝑏𝑏

𝜀𝜀−1�
𝜀𝜀 , and

𝑄𝑄 = 𝑛𝑛𝑛𝑛𝑛𝑛. These two equations solve for the number of fish caught:
𝑄𝑄 = �

𝑎𝑎𝑎𝑎 𝜀𝜀�𝑏𝑏

and the number of boats 𝑛𝑛 =𝑎𝑎𝜀𝜀−1𝑏𝑏 𝜀𝜀𝑆𝑆 𝜀𝜀−1 .

Subtracting the capture by humans from the growth in the fish population yields:
𝑎𝑎𝑎𝑎 𝜀𝜀�𝑏𝑏𝑆𝑆̇ = 𝑟𝑟𝑟𝑟(1 − 𝑆𝑆) − �

𝜀𝜀

𝑎𝑎𝑎𝑎
Thus, a steady state satisfies 𝑆𝑆̇ = 𝑟𝑟𝑟𝑟(1 − 𝑆𝑆) − � � = 0

S

𝑏𝑏

S
S*

Figure 7.6.2: 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 𝑆𝑆 near zero but positive, 𝑆𝑆̇ ≈ 𝑟𝑟𝑟𝑟 > 0, because the other terms
are small relative to the linear term. Thus, with elastic demand, there is always a steady state without extinction. (Extinction is also
an equilibrium, too, but over-fishing won’t get the system there.) This equilibrium is illustrated in Figure 7.6.2.
The dark curve represents 𝑆𝑆̇, and thus for 𝑆𝑆 between 0 and the point labeled 𝑆𝑆 ∗ , is positive and thus 𝑆𝑆 is increasing over time.
Similarly, to the right of 𝑆𝑆 ∗ , 𝑆𝑆 is decreasing. Thus, 𝑆𝑆 ∗ 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
𝑟𝑟𝑆𝑆

∗ (1

− 𝑆𝑆

∗)

𝑎𝑎𝑆𝑆 ∗ 𝜀𝜀
−�
� =0
𝑏𝑏

In contrast, if demand is inelastic, fishing may drive the fish to extinction. For example, if 𝑟𝑟 = 2 and 𝑎𝑎 = 𝑏𝑏 = 1, and ε = 0.7,
extinction is necessary, as is illustrated in
Figure 7.6.3.

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S
-0.01

0.1

0.2

0.3

0.4

0.5
S

-0.02
-0.03
-0.04
-0.05
-0.06

Figure 7.6.3: Fish Population Dynamics: Extinction
Figure 7.6.3 shows that, for the given parameters, the net growth of the fish population is negative for every value of the stock 𝑆𝑆.
Thus the population of fish consistently dwindles. This is a case when the fishing externality (overfishing today reduces the stock offish tomorrow) has particularly dire consequences. The reason why the elasticity of demand matters is that, with inelastic demand, thefall in the stock of fish increases the price by a large amount (enough so that total revenue rises). This, in turn, increases the numberof 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 of fish caught, and thus preventing extinction. We see this for the equation for the number of fishing boats𝑛𝑛 =𝑎𝑎𝜀𝜀−1 𝜀𝜀−1
𝑆𝑆
𝑏𝑏 𝜀𝜀

which reflects the fact that fishing effort rises as the stock falls if and only if demand is inelastic.
It is possible, even with inelastic demand, for there to be a stable fish population: not all parameter values lead to extinction. Using
the same parameters as before, but with ε = 0.9, we obtain a stable outcome illustrated in Figure 7.6.4.
0.02

S
S
0.1

-0.02

0.2

0.3

0.4

Unstable Equilibrium-0.04

Stable Equilibrium

Figure 7.6.4: Possibility of Multiple Equilibria
In addition to the stable equilibrium outcome, there is an unstable steady state, which might 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 near zero, thehigh demand price induced by inelasticity forces sufficient fishing to insure extinction.

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As a consequence of the fishing externality, nations attempt to regulate fishing, both by extending their own reach 200 miles into thesea, and by treaties limiting fishing in the open sea. These regulatory attempts have met with only modest success at preventing overfishing.
What is the efficient stock of fish? This is a challenging mathematical problem, but some insight can be gleaned via a steady state
analysis. A steady state arise when 𝑆𝑆̇ = 0. If a constant amount 𝑄𝑄 is removed, a steady state in the stock must occur at 0 = 𝑆𝑆̇ =1
1
𝑟𝑟𝑟𝑟(1 − 𝑆𝑆) − 𝑄𝑄. This maximum catch then occurs at 𝑆𝑆 = , and 𝑄𝑄 = 𝑟𝑟. This is not the efficient level, for it neglects the cost of
2
4boats, 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 7.6.1.
Conceptually, fishing is an example of the tragedy of the commons externality already discussed. However, the threat of a permanent
extinction and alluring possibility of solving dynamic models make it a particularly dramatic example.
Key Takeaways•

Extinction arises from the interaction of two systems, one biological, one economic.

•

When demand is elastic, extinction should not arise.

•

When demand is inelastic, population decreases reduce the quantity, which increase total revenue, which leads to moreinvestment in fishing. When demand is sufficiently inelastic, the heightened investment leads to proportionally more fish caught
and the fish go extinct.

•

Fishing is an example of the tragedy of the commons externality.
Key Terms•

Steady state: A situation where variables stay constant, forces are balaned
Exercises

7.6.1

Suppose ε = 1. For what parameter values are fish necessarily driven to extinction? Can you interpret this condition to saythat the demand for caught fish exceeds the production via reproduction?

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8

Public Goods

Consider a company offering a fireworks display. Pretty much anyone nearby can watch the fireworks, and people with houses in theright 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.

8.1

Free-Riders
Learning Objectives•

What are people who just use public goods without paying called and what is their effect on economic performance?

A public good has two attributes: nonexcludability, which means the producer can’t prevent the use of the good by others, andnonrivalry, which means that many people can use the good simultaneously.
The classic example of a public good is national defense. National defense is clearly non-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 ofa three story apartment on East Maple Street. Once we have kept our enemies out of our borders, we’ve protected everyone within theborders. Similarly, the defense of the national borders exhibits a fair degree of nonrivalry, especially insofar as the strategy of defense
is to deter an attack in the first place. That is, the same expenditure of resources protects all.
It is theoretically possible to exclude some from the use of a poem, or a mathematical theorem, but exclusion is generally quitedifficult. Both poems and theorems are nonrivalrous. Similarly, technological and software inventions are non-rivalrous, even thougha 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, butmainly 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 isessentially zero for a sizeable number of 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 unimpeded.23 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 areusually 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.)
Consider a neighborhood association which is considering buying land and building a park in the neighborhood. The value of the parkis going to depend on the size of the park, and we suppose for simplicity that the value in dollars of the park to each household in theneighborhood is 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 , where 𝑛𝑛 is the number of park users, 𝑆𝑆 is the size of the park and 𝑎𝑎 and 𝑏𝑏 a are parameters satisfying 0 < 𝑎𝑎 ≤𝑏𝑏 < 1. This functional form builds in the property that larger parks provide more value at a diminishing rate, but there is an effectfrom congestion. The functional form gives a reason for parks to be public – it is more efficient for a group of people to share a largepark than for each individual to possess a small park, at least if 𝑏𝑏 > 𝑎𝑎, because the gains from a large park exceed the congestion
effects. That is, there is a scale advantage – doubling the number of 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 thinkothers will contribute. Consider a single household, and suppose that household thinks the others will contribute 𝑆𝑆−1 to the building of
the park. Should the household contribute, and if so, how much? If the household contributes 𝑠𝑠, the park will have size 𝑆𝑆 = 𝑆𝑆−1 +𝑠𝑠, which the household values at (𝑆𝑆−1 + 𝑠𝑠)𝑏𝑏 𝑛𝑛−𝑎𝑎 . Thus, the net gain to a household that contributes s when the others contribute 𝑆𝑆−1
is −𝑠𝑠(𝑆𝑆−1 + 𝑠𝑠)𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑠𝑠.
Exercise 8.1.1 shows that individual residents gain from their marginal contribution if and only if the park is smaller than1
𝑆𝑆0 = (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏
Consequently, under voluntary contributions, the only equilibrium park size is 𝑆𝑆0 . That is, for any park size smaller than 𝑆𝑆0 , citizens
will voluntarily contribute to make the park larger. For any larger size, no one is willing to contribute.
23

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 thesame speed.
Introduction to Economic Analysis

8-105Under voluntary contributions, as the neighborhood grows in number, the size of the park shrinks. This makes sense – the benefits ofindividual contributions to the park mostly accrue to others, which reduces the payoff to any one contributor.
What park size is efficient? The total value of the park of size 𝑆𝑆 to the residents together is 𝑛𝑛 times the individual value, which gives acollective value of 𝑆𝑆 𝑏𝑏 𝑛𝑛1−𝑎𝑎 , and the park costs 𝑆𝑆, so from a social perspective the park should be sized to maximize 𝑆𝑆 𝑏𝑏 𝑛𝑛1−𝑎𝑎 − 𝑆𝑆, whichyields an optimal park of size
1
𝑆𝑆 ∗ = (𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏. Thus, as 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. Under individual contributions, the hope that others
contribute leads individuals not to contribute. Moreover, use of the park by others reduces the value of the park to each individual, sothat 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 grows, as the per capita park size is
1
𝑏𝑏−𝑎𝑎
𝑆𝑆 ∗
= 𝑏𝑏 1−𝑏𝑏 𝑛𝑛 1−𝑏𝑏𝑛𝑛
, which is an increasing function of 𝑛𝑛.24

The lack of incentive for individuals to contribute to a social good is known as a free-rider 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 to contribute to a public good is reduced by the contributions ofothers, and thus individual contributions tend to be smaller when the group is larger. Put another way, the size of the 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 under voluntary contributions is greater the larger is the community. In the theory presented, the optimal size of1
1
the public good is 𝑆𝑆 ∗ = (𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏 , and the actual size under voluntary contributions is 𝑆𝑆0 = (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 , a gap that gets verylarge as the number of people grows.

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 hard on the manuscript in order to get a good grade. Add a third author and it is a virtual 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 willcontribute 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, thefree-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 thealtruists.
Key Takeaways•

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

•

Examples of public goods include national defense, fireworks displays and mathematical theorems.

•

Nonexcludability implies that people don’t have to pay for the good; nonrivalry means that the efficient price is zero.

•

A free rider is someone who doesn’t pay for a public good.

•

Generally voluntary contributions lead to too little provision of public goods.

•

In spite of some altruism, the free-rider problem is very real and it gets worse the more people are involved.

24

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.
Introduction to Economic Analysis

8-106Key Terms•

Nonexcludability: Consumption can't be prevented•

Nonrivalry: Consumption by one doesn't prevent consumption by others•

Public good: A good satisfying nonexcludability and nonrivalry•Free-rider: Someone who doesn't contribute to the provision of a public good•

Free-rider problem: Underprovision of public goods due to free riders.
Exercises

8.1.1
8.1.2

8.1.3

1

Verify that individual residents gain from contributing to the park if 𝑆𝑆 < (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 and gain from reducing their1
contributions if 𝑆𝑆 > (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 .

For the model presented in this section, compute the elasticity of the optimal park size with respect to the number ofresidents, that is, the percent change in 𝑆𝑆 ∗ for a small percentage change in 𝑛𝑛. [Hint: use the linear approximation trick(1 + ∆)𝑟𝑟 ≈ 𝑟𝑟∆ for ∆ near zero.]

For the model of this section, show that an individual’s utility when the park is optimally sized and the expenses are sharedequally among the n individuals is 𝑢𝑢 = 𝑛𝑛larger communities?

8.1.4

𝑏𝑏−𝑎𝑎�
𝑏𝑏
1
1−𝑏𝑏 �𝑏𝑏 �1−𝑏𝑏 − 𝑏𝑏 �1−𝑏𝑏 �.

Does this model predict an increase in utility from

Suppose two people, person 1 and person 2, want to produce a playground to share between them. The value of theplayground of size 𝑆𝑆 to each person is √𝑆𝑆, where 𝑆𝑆 is the number of dollars spent building it. Show that under voluntary
contributions, the size of the playground is 1�4 and that the efficient size is 1.

8.1.5

For the previous exercise, now suppose person 1 offers “matching funds,” that is, offers to contribute an equal amount to thecontributions of the person 2. How large a playground will person 2 choose?

8.2

Provision with Taxation
Learning Objectives•

If people won’t pay for public goods, can society tax them instead?

Faced with the fact that voluntary contributions produce an inadequate park, the neighborhood turns to taxes. Many neighborhood
associations or condominium associations have taxing authority, and can compel individuals to contribute. Clearly in the 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 𝑛𝑛. Generally it is possible 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 𝑖𝑖 values the public good of size 𝑆𝑆 at 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 𝑣𝑣𝑖𝑖 in dollars. (It isuseful to assume that no two people have the same 𝑣𝑣 values to simplify arguments.) The optimal size of the park for the neighborhood
is
1
𝑛𝑛
1−𝑏𝑏
−𝑎𝑎
1−𝑎𝑎
1
= 𝑛𝑛1−𝑏𝑏 (𝑏𝑏𝑣𝑣̅ )1−𝑏𝑏
𝑆𝑆 ∗ = 𝑛𝑛1−𝑏𝑏 �𝑏𝑏 � 𝑣𝑣𝑖𝑖 �
𝑖𝑖=1, where 𝑣𝑣̅ = ∑𝑛𝑛𝑖𝑖=1 𝑣𝑣𝑖𝑖 is the average value. Again, taxes can be assessed to pay for an optimally-sized park, but some people (those withsmall 𝑣𝑣 values) will view that as a bad deal, while others (with large 𝑣𝑣) 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.25 With𝑆𝑆
equal taxes, an individual obtains 𝑣𝑣𝑖𝑖 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 − . If there are an odd number of people, 𝑛𝑛 can be written as 2𝑘𝑘 + 1. The median voter𝑛𝑛
is the person for whom 𝑘𝑘 have values 𝑣𝑣𝑖𝑖 larger than hers, and 𝑘𝑘 have values smaller. Consider increasing 𝑆𝑆. If the median voter likes
it, then so do all the people with higher 𝑣𝑣’s, and the proposition to increase 𝑆𝑆 passes. Similarly, a proposal to decrease 𝑆𝑆 will get amajority if the median voter likes it. If the median voter likes reducing 𝑆𝑆, all the individuals with smaller 𝑣𝑣𝑖𝑖 will vote for it as well.
Thus, we can see that voting maximizes the preferences of the median voter, and simple calculus shows that entails
25

The voting model used is that there is a status quo, which is a planned size of S. Anyone can propose to change the size of S, andthe neighborhood votes yes or no. If an S exists such that no replacement gets a majority vote, that S is an equilibrium under majority
voting.
Introduction to Economic Analysis

8-107

1−𝑎𝑎

1

𝑆𝑆 ∗ = 𝑛𝑛1−𝑏𝑏 (𝑏𝑏𝑣𝑣𝑘𝑘 )1−𝑏𝑏.

Unfortunately, voting does not result in an efficient outcome generally, and only does so when the average value equals the medianvalue. On the other hand, voting generally performs much better than voluntary contributions. The park size can either be larger orsmaller under median voting than is efficient.26
Key Takeaways•

Taxation – forced contribution – is a solution to the free-rider problem.

•

An optimal tax rate is the average marginal value of the public good.

•

Voting leads to a tax rate equal to the median marginal value, and hence does not generally lead to efficiency, although it
outperforms voluntary contributions.
Key Terms•

Median voter: The voter with preferences in the middle -- half to one side, half to the other
Exercises

8.2.1

For the model of this section, show that, under voluntary contributions, only one person contributes, and that person is the
person with the largest 𝑣𝑣𝑖𝑖 . How much do they contribute? [Hint: which individual 𝑖𝑖 is willing to contribute at the largest
park size? Given the park this individual desires, can anyone else benefit from contributing at all?]

8.2.2

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.

8.3

Local Public Goods
Learning Objectives•

If we disagree about the optimal level of public goods, what can we do about it?

The example in the previous section showed that there are challenges to a neighborhood’s provision of public goods created bydifferences in the preferences of the public good. Voting does not generally lead to the efficient provision of the public good, anddoes so only in special circumstances, like agreement of preferences.
A different solution was proposed by Tiebout27 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 thestreets, frequent garbage pickup, a first-rate fire department, extensive police protection and spectacular fireworks displays, and otherswith lower taxes and more modest provision of public goods. People will tend to move to the neighborhood that fits their preferences.
The result is neighborhoods that are relatively homogeneous with respect to the desire for public goods. That homogeneity, 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 the neighborhood provision of public goods more efficient. The “Tiebout theory” shows that local public goods willtend 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.
Key Takeaways•

When public goods are local in nature – people living nearby may or may not be excludable, but people living further away canbe excluded – the goods are called “local public goods.”•

Specialization by neighborhoods in distinct levels of public goods, combined with households choosing their neighborhoods, canlead to an efficient provision of public goods.

26
The general principle here is that the median voting will do better when the distribution of values is such 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.
27

Charles Tiebout, 1919-1962. His surname is pronounced “tee-boo.”

Introduction to Economic Analysis

8-108Key Terms•

Local public goods: Public goods that are produced and consumed in a small geographic area

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8-109

9

Producer Theory: Costs

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 or gold removes impurities and makes the resulting product more valuable. Silicon valleytransforms silicon, which is the primary ingredient of sand, along with a thousand other chemicals and metals, into computer chips
used in everything from computers to toasters. Cooking transforms raw food, adding flavor and killing bacteria. Moving things tolocations where they have higher value is a form of production. Moving stone to the location of a house where the stone can beinstalled in the exterior, or bringing the King 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 a technology or set of technologies for transforming things andthen chooses the transformation to maximize the net profits. This “firm as a production function” view of the firm is adequate forsome purposes, especially when products or services are relatively standardized and technologies widely available, but fares poorly
when the internal organization of the firm matters a great deal. Nevertheless, the “firm as a production function” model is a natural
starting point in the investigation of competition.

9.1

Types of Firms
Learning Objectives•

What kinds of companies are there?

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 a single individual (the proprietor) or perhaps a family, and operated by a relatively small
number of people. The family farm, many restaurants, convenience stores, and laundromats are operated this way. Debts accrued by
the proprietorship are the personal 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) and usually all are liable for losses incurredby 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 a corporation itself can incur debt and the
responsibility for repayment of that debt is with the 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 the stock, but were not responsible for theremaining 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 the corporation, the executives are not personally responsible for the debts the corporation fails to pay. On theother hand, breaking the law is not permitted, and executives at Archer Daniels Midland, the large agriculture firm, who colluded in
the fixing of the price of lysine went to jail and were personally fined. The corporation was fined as well.
Corporations shield company executives and shareholders from liability, and are said to offer “limited liability.” So why would
anyone in their right mind organize a firm as a proprietorship 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 and not 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 theadvantages of partnerships (including avoidance of taxation) and corporations. The disadvantages to these forms is primarily larger
legal fees, and limitations on the nature of ownership and rules specific to individual states.
It is usually the case that proprietorships are smaller than partnerships, and partnerships smaller than corporations, although there aresome very large partnerships (e.g. the big four accounting firms) and some tiny corporations. The fourth kind can be of any size, for
its distinction is not how it is organized internally but what it does with the 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 allorganized 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 forthe benefit of some segment of society. So why can’t you establish your own non-profit, that operates for the benefit of you, andavoid taxes? Generally you alone aren’t enough of a socially worthy purpose to meet the requirements to form a non-profit.28
Moreover, you can’t establish 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 the28

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.
Introduction to Economic Analysis

9-110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 well-defined
chain of command, and no one is ever below two distinct managers of the same level. The problem with a pyramid structure is that
two retail stores that want to coordinate have to contact their managers, and possibly their managers’ managers, and so on up the
pyramid until a common manager is reached. There are circumstances where such rigid decision-making is unwieldy, and the larger
the operation of a corporation, the more unwieldy it gets.
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 that its 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 separatebusiness units, but purchasing 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 in marketing theircars 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 to create a company that managed oil products from oil exploration all the way through pumping gasoline into
automobile gas tanks. With such varied operations all over the globe, Standard Oil of New Jersey required extensive coordination andfound that the old 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 a third. The study of the internalorganization of firms and its ramifications for competitiveness is fascinating, but beyond the scope of this book.29
Key Takeaways•

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.

•

A proprietorship is a firm is owned by a single individual (the proprietor) or perhaps a family, and operated by a relatively small
number of people. The family farm, many restaurants, convenience stores, and laundromats are operated this way. Debts accruedby the proprietorship are the personal responsibility of the proprietor.

•

Professionals like attorneys and accountants are often organized as partnerships. Partnerships share profits according to a formula
and usually all are liable for losses incurred by the partnership.

•

A corporation is, by a legal fiction, a person, which means a corporation itself can incur debt and the responsibility for repaymentof that debt is with the corporation, not with the officers or owners of the corporation.

•

A large variety of hybrid organizational forms exist.

•

The non-profit firm is prohibited from distributing a profit to its owners. 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 some segment ofsociety. Commercial activities of non-profits are taxable.

•

Large corporations are often organized into business units, which are semi-autonomous affiliated companies.
Key Terms•

Proprietorship: a firm is owned by a single individual (the proprietor)•

Partnerships: A firm owned by several individuals with a sharing rule for profits•

Corporation: A company in the form of a fictitious person owned by shareholders•

Non-profit firm: A firm operated for the public good, forgoing profits in exchange for avoiding taxes

29

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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9.2

Production Functions
Learning Objectives•

How is the output of companies modeled?

•

Are there any convenient functional forms?

The firm transforms inputs into outputs. For example, a bakery takes inputs like flour, water, yeast, labor, and heat and makes loavesof 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 and memory, along with cases and keyboards and otherparts 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 to start by looking at a firm that produces only one output. Generally, we can describe thisfirm as buying an amount 𝑥𝑥1 x1 of the first input, 𝑥𝑥2 of the second input, and so on (we’ll use 𝑥𝑥𝑛𝑛 to denote the last input) andproducing an amount y of the output, that is, the production function is𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )Mostly we will focus on two inputs in this section, but carrying out the analysis for more than two inputs is straightforward.

Example: The Cobb-Douglas production function is the product of the 𝑥𝑥’s raised to powers, and comes in the form:
𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = 𝑎𝑎0 𝑥𝑥1 𝑎𝑎1 𝑥𝑥2 𝑎𝑎2 … 𝑥𝑥𝑛𝑛 𝑎𝑎𝑛𝑛The constants 𝑎𝑎1 through 𝑎𝑎𝑛𝑛 are positive numbers, generally individually less than one. For example, with two goods, capital 𝐾𝐾 andlabor 𝐿𝐿, Cobb-Douglas can be expressed as 𝑦𝑦 = 𝑎𝑎0 𝐾𝐾 𝑎𝑎 𝐿𝐿𝑏𝑏 . We will use this example frequently. It is illustrated, for 𝑎𝑎0 = 1, 𝑎𝑎 = 1�3
and 𝑏𝑏 = 2�3 in Figure 9.2.1. This figure 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 𝑎𝑎 = 1�3 and 𝑏𝑏 = 2�3, we can solve
𝑦𝑦 = 𝐾𝐾 𝑎𝑎 𝐿𝐿𝑏𝑏 for 𝐾𝐾 to obtain 𝐾𝐾 = 𝑦𝑦 3 𝐿𝐿−2 . Thus, 𝐾𝐾 = 𝐿𝐿−2 gives the combinations of inputs yielding an output of 1, and that is what thedark, 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.

K
100
80
60
40
20
0.5

1

1.5

2

L

Figure 9.2.1: Cobb-Douglas Isoquants

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Figure 9.2.2: The Production Function
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 9.2.2.
The fixed-proportions production function comes in the form
𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = min{𝑎𝑎1 𝑥𝑥1 , 𝑎𝑎2 𝑥𝑥2 , … , 𝑎𝑎𝑛𝑛 𝑥𝑥𝑛𝑛 }Figure 9.2.3: Fixed Proportions and Perfect Substitutes
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 a shovel or other digging implement like abackhoe, a bare-handed worker produces so little digging as to be nearly useless, so extra workers beyond the number of shovels havelittle effect. Ultimately, the size of the holes is pretty much determined by Min {number of shovels, number of diggers}. The Figure
9.2.3 illustrates the isoquants for fixed proportions. As we will see, fixed proportions makes the inputs “perfect complements.”
Two inputs K and L are perfect substitutes in a production function if they enter as a sum, that is,𝑦𝑦 = 𝑓𝑓(𝐾𝐾, 𝐿𝐿, 𝑥𝑥3 , 𝑥𝑥4 , … , 𝑥𝑥𝑛𝑛 ) = 𝑔𝑔(𝑎𝑎1 𝐾𝐾 + 𝑎𝑎2 𝐿𝐿, 𝑥𝑥3 , 𝑥𝑥4 , … , 𝑥𝑥𝑛𝑛 ). In this case, the isoquants are straight lines that are parallel to each other, as
illustrated in Figure 9.2.3.

The marginal product of an input is just the derivative of the production function with respect to that input.30 An important aspect ofmarginal products is that they are affected by the level of other inputs. For example, in the Cobb-Douglas case with two inputs31 andfor constant 𝐴𝐴:
30

This is a partial derivative, since it holds the other inputs fixed. Partial derivatives are denoted with the symbol ∂.

The symbol α is the Greek letter “alpha.” The symbol β is the Greek letter “beta.” These are the first two letters of the Greekalphabet, and the word alphabet itself originates from these two letters.

31

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𝑦𝑦 = 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝑎𝑎 𝐿𝐿𝑏𝑏

the marginal product of capital is𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿)= 𝛼𝛼𝛼𝛼𝐾𝐾 𝑎𝑎−1 𝐿𝐿𝑏𝑏
𝜕𝜕𝜕𝜕

If α and β are between zero and one (the usual case), then the marginal product of capital increases in the amount of labor, anddecreases in the amount of capital. For example, an extra computer is very productive in a situation with lots of workers and few
computers, but not so productive in a situation where there are lots of computers and few people to operate them.
The value of the marginal product of an input is just the marginal product times the price of the output. If the value of the marginal
product of an input exceeds the cost of that 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 to order and obtain new passenger aircraft, four
years to build an electricity generation 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 to five years to hire even a small number of academic
economists. On the other hand, it is possible 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 byhiring them “overtime,” at least on a temporary basis. The amount of water or electricity a production facility uses can be varied
second by second. If you run a restaurant, you can use more water tonight to wash 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 to work. It willprobably 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 more ingredients, 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 a larger 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 the notions of the long-run and short-run. In the shortrun, 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 avery slow process – and for 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 than obtaining warehouse or office space. Generally speaking, the long-run
inputs are those that are expensive to adjust quickly, while the short-run factors can be adjusted in a relatively short time frame. Whatfactors belong in which category is dependent on the context or application under consideration.
Key Takeaways•

Firms transform inputs into outputs.

•

The functional relationship between inputs and outputs is the production function.

•

The Cobb-Douglas production function is the product of the inputs raised to powers, and comes in the form
𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = 𝑎𝑎0 𝑥𝑥1 𝑎𝑎1 𝑥𝑥2 𝑎𝑎2 … 𝑥𝑥𝑛𝑛 𝑎𝑎𝑛𝑛 for positive constants 𝑎𝑎1 , 𝑎𝑎2 , … , 𝑎𝑎𝑛𝑛 .

••An isoquant is a curve or surface that traces out the inputs leaving the output constant.

The fixed-proportions production function comes in the form
𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = min{𝑎𝑎1 𝑥𝑥1 , 𝑎𝑎2 𝑥𝑥2 , … , 𝑎𝑎𝑛𝑛 𝑥𝑥𝑛𝑛 }•Fixed proportions makes the inputs “perfect complements.”•

Two inputs K and L are perfect substitutes in a production function f if they enter as a sum, that is, 𝑦𝑦 = 𝑓𝑓(𝐾𝐾, 𝐿𝐿, 𝑥𝑥3 , 𝑥𝑥4 , … , 𝑥𝑥𝑛𝑛 ) =𝑔𝑔(𝑎𝑎1 𝐾𝐾 + 𝑎𝑎2 𝐿𝐿, 𝑥𝑥3 , 𝑥𝑥4 , … , 𝑥𝑥𝑛𝑛 )•The marginal product of an input is just the derivative of the production function with respect to that input. An important aspectof marginal products is that they are affected by the level of other inputs.

•

The value of the marginal product of an input is just the marginal product times the price of the output. If the value of themarginal product of an input exceeds the cost of that input, it is profitable to use more of the input.

•

Some inputs are more readily changed than others.

•

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.

•Generally speaking, the long-run inputs are those that are expensive to adjust quickly, while the short-run factors can be adjusted
in a relatively short time frame.

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Key Terms•

Production function: The mapping from inputs to an output or outputs•

Cobb-Douglas production function: The functional form proportional to the product of inputs raised to powers•

Isoquant : Curves along with a quantity is held constant•Fixed-proportions production function: A production function where output is produced only by inputs which combine in fixedproportions•

Perfect substitutes: Two goods are perfect substitutes if they substitute for each other at a constant ratio, hence enter additively
into a function•

Marginal product: The derivative of output with respect to an input•

Value of the marginal product: the output price times the marginal product
Exercises
For the Cobb-Douglas production function, suppose there are two inputs 𝐾𝐾 and 𝐿𝐿, and the sum of the exponents is 1. Show
that if each input is paid the value of the marginal product per unit of the input, the entire output is just exhausted. That is,for this production function, show

9.2.1

𝐾𝐾

9.3

𝜕𝜕𝜕𝜕

𝜕𝜕𝜕𝜕

+ 𝐿𝐿

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

= 𝑓𝑓(𝐾𝐾, 𝐿𝐿)

Profit Maximization
Learning Objectives•

If firms maximize profits, how will they behave?

Consider an entrepreneur that would like to maximize profit, perhaps by running a delivery service. The entrepreneur uses two inputs,
capital 𝐾𝐾 (e.g. trucks) and labor 𝐿𝐿 (e.g. drivers), and rents the capital at cost 𝑟𝑟 per dollar of capital. The wage rate for drivers is 𝑤𝑤.
The production function is 𝐹𝐹(𝐾𝐾, 𝐿𝐿), that is, given inputs 𝐾𝐾 and 𝐿𝐿, the output is 𝐹𝐹(𝐾𝐾, 𝐿𝐿). Suppose 𝑝𝑝 is the price of the output. This
gives a profit of:32
𝜋𝜋 = 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤𝑤𝑤

First, consider the case of a fixed level of 𝐾𝐾. The entrepreneur chooses 𝐿𝐿 to maximize profit. The value of 𝐿𝐿 that maximizes thefunction π must satisfy:𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )
𝜕𝜕𝜕𝜕
= 𝑝𝑝
− 𝑤𝑤 = 0𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕This expression is known as a first order condition, because it says the first derivative of the function is zero.33 The first ordercondition 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.

Economists often use the Greek letter π to stand for profit. There is little risk of confusion because economics doesn’t use the ratioof the circumference to the diameter of a circle very often. On the other hand, the other two named constants, Euler’s e and i, thesquare root of -1, appear fairly frequently in economic analysis.
32

It is possible that 𝐿𝐿 = 0 is the best that entrepreneur can do. In this case, the derivative of profit with respect to 𝐿𝐿 is not necessarily
zero. The first order condition instead would be:
33

𝜕𝜕𝜕𝜕

𝜕𝜕𝜕𝜕

Either = 0, or 𝐿𝐿 = 0 and ≥ 0. The latter pair of conditions reflects the logic that either the derivative 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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π
Slope zero at
maximum
Slope negative toright of maximum

Slope positive toleft of maximum

𝐿𝐿∗

L

Figure 9.3.1: Profit-Maximizing Labor Input
In addition, a second characteristic of a maximum is that the second derivative is negative (or non-positive). This arises because, at a
maximum, the slope goes from positive (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, thesecond derivative is negative. This logic is illustrated in the Figure 9.3.1.
The second property is known as the second order condition, because it is a condition on the second derivative.34 It is expressed as:
𝜕𝜕 2 𝜋𝜋𝜕𝜕 2 𝐹𝐹(𝐾𝐾, 𝐿𝐿∗ )=𝑝𝑝≤0(𝜕𝜕𝜕𝜕)2(𝜕𝜕𝜕𝜕)2
This is enough of a mathematical treatment to establish comparative statics on the demand for labor. Here, we treat the choice 𝐿𝐿∗ as afunction of another parameter – the price 𝑝𝑝, the wage 𝑤𝑤, or the level of capital 𝐾𝐾. For example, to find the effect of the wage on thelabor demanded by the entrepreneur, we can write:𝑝𝑝𝜕𝜕𝜕𝜕�𝐾𝐾, 𝐿𝐿∗ (𝑤𝑤)�
− 𝑤𝑤 = 0𝜕𝜕𝜕𝜕𝑝𝑝𝜕𝜕 2 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝑤𝑤)� ∗ ′𝐿𝐿 (𝑤𝑤) − 1 = 0(𝜕𝜕𝜕𝜕)2

This expression recognizes that the choice 𝐿𝐿∗ that the entrepreneur makes satisfies the first order condition, and results in a value that
depends on 𝑤𝑤. But how does it depend on 𝑤𝑤? We can differentiate this expression to obtain:or

𝐿𝐿∗ ′ (𝑤𝑤) =𝑝𝑝

1

𝜕𝜕 2 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝑤𝑤)�
(𝜕𝜕𝜕𝜕)2

𝜕𝜕2 𝐹𝐹The second order condition lets this relationship be signed, since by assumption (𝜕𝜕𝜕𝜕)2 < 0. This form of argument assumes that the

choice 𝐿𝐿∗ 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 substantiallymore generally. Suppose 𝑤𝑤1 < 𝑤𝑤2 are two wage levels, and that the entrepreneur chooses 𝐿𝐿1 when the wage is 𝑤𝑤1 and 𝐿𝐿2 when the

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.
34

Introduction to Economic Analysis

9-116wage is 𝑤𝑤2 . Then profit maximization requires that these choices are optimal. In particular, when the wage is 𝑤𝑤1 , the entrepreneur
earns higher profit with 𝐿𝐿1 than with 𝐿𝐿2 :𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿1 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤1 𝐿𝐿1 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤1 𝐿𝐿2When the wage is 𝑤𝑤2 , the entrepreneur earns higher profit with 𝐿𝐿2 than with 𝐿𝐿1 .

𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤2 𝐿𝐿2 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤2 𝐿𝐿1Adding these two expressions together, we obtain𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿1 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤1 𝐿𝐿1 + 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤2 𝐿𝐿2 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤1 𝐿𝐿2 + 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿2 ) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤2 𝐿𝐿1
A large number of terms cancel, to yield−𝑤𝑤1 𝐿𝐿1 − 𝑤𝑤2 𝐿𝐿2 ≥ −𝑤𝑤1 𝐿𝐿2 − 𝑤𝑤2 𝐿𝐿1This expression can be re-arranged to yield(𝑤𝑤1 − 𝑤𝑤2 )(𝐿𝐿1 − 𝐿𝐿2 ) ≥ 0This shows that the higher quantity of labor choice must be associated with the lower wage. This kind of argument, sometimes known
as a “revealed preference” kind of argument because choices by consumers were the first place the type of argument was applied, canbe very powerful and general, because issues of differentiability are avoided. However, we will use the more standard differentiability
type argument, because such arguments are usually more readily constructed.

The effect of an increase in the capital level 𝐾𝐾 on the choice by the entrepreneur can be calculated by considering 𝐿𝐿∗ as a function of
the capital level 𝐾𝐾.
𝑝𝑝𝜕𝜕𝜕𝜕�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)�
− 𝑤𝑤 = 0𝜕𝜕𝜕𝜕

Differentiating this expression with respect to 𝐾𝐾, we obtain𝑝𝑝

𝜕𝜕 2 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)� ∗ ′𝜕𝜕 2 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)�
+ 𝑝𝑝
𝐿𝐿 (𝐾𝐾) = 0(𝜕𝜕𝜕𝜕)2
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

or,𝜕𝜕 2 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)�
𝐿𝐿∗ ′ (𝐾𝐾) = 2 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
𝜕𝜕 𝐹𝐹�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)�
(𝜕𝜕𝜕𝜕)2−

We know the denominator of this expression is not positive, thanks to the second order condition, so the unknown part is thenumerator. We then obtain the conclusion that:
An increase in capital increases the labor demanded by the profit-maximizing entrepreneur if
demanded if

𝜕𝜕2 𝐹𝐹�𝐾𝐾,𝐿𝐿∗ (𝐾𝐾)�
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

<0

𝜕𝜕2 𝐹𝐹�𝐾𝐾,𝐿𝐿∗ (𝐾𝐾)�
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

> 0, and decreases the labor

𝜕𝜕2 𝐹𝐹�𝐾𝐾,𝐿𝐿∗ (𝐾𝐾)�

This conclusion looks like gobbledygook but is actually quite intuitive. Note that> 0 means that an increase in capital𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
increases the derivative of output with respect to labor, that is, an increase in capital increases the marginal product of labor. But this𝜕𝜕2 𝐹𝐹�𝐾𝐾,𝐿𝐿∗ (𝐾𝐾)�

> 0 means that labor and capital are complements in production – an increaseis the definition of a complement! That is,𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
in capital increases the marginal productivity of labor. Thus an increase in capital will increase the demand for labor when labor andcapital are complements, and will decrease the demand for labor when labor and capital are substitutes.
This is an important conclusion because different kinds of capital may be complements or substitutes for labor. Are computerscomplements or substitutes for labor? Some economists consider that computers are complements to highly skilled workers,
increasing the marginal value of the most skilled, but substitute for lower skilled workers. In academia, the ratio of secretaries toprofessors has fallen dramatically since the 1970s as more and more professors use machines to perform secretarial functions.
Computers are thought to have increased the marginal product of professors and reduced the marginal product of secretaries, so thenumber of professors rose and the number of secretaries fell.
The revealed preference version of the effect of an increase in capital is to posit two capital levels, 𝐾𝐾1 and 𝐾𝐾2 , with associated profitmaximizing choices 𝐿𝐿1 and 𝐿𝐿2 . The choices require, for profit maximization, that𝑝𝑝𝑝𝑝(𝐾𝐾1 , 𝐿𝐿1 ) − 𝑟𝑟𝐾𝐾1 − 𝑤𝑤𝐿𝐿1 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾2 , 𝐿𝐿1 ) − 𝑟𝑟𝐾𝐾2 − 𝑤𝑤𝐿𝐿1

andIntroduction to Economic Analysis

9-117𝑝𝑝𝑝𝑝(𝐾𝐾2 , 𝐿𝐿2 ) − 𝑟𝑟𝐾𝐾2 − 𝑤𝑤𝐿𝐿2 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾1 , 𝐿𝐿2 ) − 𝑟𝑟𝐾𝐾1 − 𝑤𝑤𝐿𝐿2

As above, we add these expressions together to obtain𝑝𝑝𝑝𝑝(𝐾𝐾1 , 𝐿𝐿1 ) − 𝑟𝑟𝐾𝐾1 − 𝑤𝑤𝐿𝐿1 + 𝑝𝑝𝑝𝑝(𝐾𝐾2 , 𝐿𝐿2 ) − 𝑟𝑟𝐾𝐾2 − 𝑤𝑤𝐿𝐿2 ≥ 𝑝𝑝𝑝𝑝(𝐾𝐾2 , 𝐿𝐿1 ) − 𝑟𝑟𝐾𝐾2 − 𝑤𝑤𝐿𝐿1 + 𝑝𝑝𝑝𝑝(𝐾𝐾1 , 𝐿𝐿2 ) − 𝑟𝑟𝐾𝐾1 − 𝑤𝑤𝐿𝐿2

This simplifies to𝑓𝑓(𝐾𝐾1 , 𝐿𝐿1 ) + 𝑓𝑓(𝐾𝐾2 , 𝐿𝐿2 ) ≥ 𝑓𝑓(𝐾𝐾2 , 𝐿𝐿1 ) + 𝑓𝑓(𝐾𝐾1 , 𝐿𝐿2 )or,𝑓𝑓(𝐾𝐾2 , 𝐿𝐿2 ) − 𝑓𝑓(𝐾𝐾1 , 𝐿𝐿2 ) ≥ 𝑓𝑓(𝐾𝐾2 , 𝐿𝐿1 ) − 𝑓𝑓(𝐾𝐾1 , 𝐿𝐿1 )

or

𝐾𝐾2

𝐾𝐾2

𝐾𝐾1

𝐾𝐾1

𝜕𝜕𝜕𝜕(𝑥𝑥, 𝐿𝐿1 )𝜕𝜕𝜕𝜕(𝑥𝑥, 𝐿𝐿2 )𝑑𝑑𝑑𝑑 ≥ �
𝑑𝑑𝑑𝑑
�
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

and finally
𝐿𝐿2 𝐾𝐾2

� �

𝐿𝐿1 𝐾𝐾1

𝜕𝜕 2 𝑓𝑓(𝑥𝑥, 𝑦𝑦)
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑 ≥ 0𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

𝜕𝜕2 𝑓𝑓(𝐾𝐾,𝐿𝐿)

Thus, if 𝐾𝐾2 > 𝐾𝐾1 andfor all 𝐾𝐾 and 𝐿𝐿, then 𝐿𝐿2 ≥ 𝐿𝐿1 , that is, with complementary inputs, an increase in one input increases the𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
optimal choice of the second input. In contrast, with substitutes, an increase in one input decreases the other input. While we stillused differentiability of the production function to carry out the revealed preference argument, we did not need to establish that the
choice 𝐿𝐿∗ was differentiable to perform the analysis.

Example: Labor Demand with the Cobb-Douglas production function. The Cobb-Douglas production function has the form
𝑦𝑦 = 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 for constants 𝐴𝐴, α and β, all positive. It is necessary for β < 1 for the solution to be finite and well-defined.
The demand for labor satisfies𝑝𝑝𝜕𝜕𝜕𝜕�𝐾𝐾, 𝐿𝐿∗ (𝐾𝐾)�
− 𝑤𝑤 = 𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 𝛼𝛼 𝐿𝐿∗ 𝛽𝛽−1 − 𝑤𝑤 = 0
𝜕𝜕𝜕𝜕

or

1

𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 𝛼𝛼 �1−𝛽𝛽�
𝐿𝐿∗ = �𝑤𝑤

When α + β = 1, 𝐿𝐿 is linear in capital. Cobb-Douglas production is necessarily complementary, that is, an increase in capitalincreases labor demanded by the entrepreneur.

Introduction to Economic Analysis

9-118

Key Takeaways•

Profit maximization arises when the derivative of the profit function with respect to an input is zero. This property is known as afirst order condition.

•

Profit maximization arises in an input when the value of the marginal product for that input is equal to its cost.

•

A second characteristic of a maximum is that the second derivative is negative (or non-positive). This property is known as thesecond order condition.

•

Differentiating the first order condition permits calculating the effect of a change in the wage on the amount of labor hired.

•

Revealed preference arguments permit calculating comparative statics without using calculus, under more general assumptions.

•

An increase in capital will increase the demand for labor when labor and capital are complements, and will decrease the demand
for labor when labor and capital are substitutes.

•

Cobb-Douglas production functions are necessarily complements, hence any one input increases in the others.
Key Terms•

First order condition: Mathematical condition for optimization stating that the first derivative is zero•Second order condition: Mathematical condition for maximization (minimization) stating that the second derivative is nonpositive (non-negative)•

Revealed preference: A form of proof that uses the fact that choice implies preference
Exercises

9.3.1
9.3.2

9.3.3

9.4

For the fixed proportions production function min{𝐾𝐾, 𝐿𝐿}, find labor demand (capital fixed at 𝐾𝐾).

A company that produces software needs two inputs, programmers (𝑥𝑥) at a rate of 𝑝𝑝 and computers (𝑦𝑦) at a price of 𝑟𝑟. The
11
output is given by 𝑇𝑇 = 4𝑥𝑥 �3 𝑦𝑦 �3, measured in pages of code.
a.

What is marginal cost?

b.

Now suppose each programmer needs two computers to do his job, what ratio of 𝑝𝑝 and 𝑟𝑟 would make this input mix
optimal?

A toy factory costs $2 million to construct and the marginal cost of the 𝑞𝑞th toy is max �10,a.

What are average total costs?

b.

What is short-run supply?

c.

What is the long-run competitive supply of toys?

𝑞𝑞 2�
1000�

The Shadow Value
Learning Objectives•

If a firm faces constraints on its behavior, how can we measure the costs of those constraints?

When capital 𝐾𝐾 can’t be adjusted in the short-run, it creates a constraint on the profit available on the entrepreneur – the desire tochange K reduces the profit available to the entrepreneur. 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 associatedwith a constraint. Shadow value is well-established jargon.
What is the shadow-value of capital? Let’s return to the constrained, short-run optimization problem. The profit of the entrepreneur is
𝜋𝜋 = 𝑝𝑝𝑝𝑝(𝐾𝐾, 𝐿𝐿) − 𝑟𝑟𝑟𝑟 − 𝑤𝑤𝑤𝑤

The entrepreneur chooses the value 𝐿𝐿∗ to maximize profit, but is stuck in the short-run with the level of capital inherited from a pastdecision. The shadow value of capital is the value of capital to profit, given the optimal decision 𝐿𝐿∗ . Because𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )
𝜕𝜕𝜕𝜕
= 𝑝𝑝
− 𝑤𝑤
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

the shadow value of capital isIntroduction to Economic Analysis

9-119𝑑𝑑𝑑𝑑(𝐾𝐾, 𝐿𝐿∗ ) 𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )
=
= 𝑝𝑝
− 𝑟𝑟
𝑑𝑑𝑑𝑑
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

Note that this could be negative; the entrepreneur might like to sell some capital but can’t, perhaps because it is installed in thefactory.
Any constraint has a shadow value. The term refers to the value of relaxing a constraint. The shadow value is zero when theconstraint 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 associated with it. For example, parameterize theproduction technology by a parameter 𝑎𝑎, so that 𝑎𝑎𝑎𝑎(𝐾𝐾, 𝐿𝐿) is produced. The shadow value of a given level of 𝑎𝑎 is, in the short-run,𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )𝑑𝑑𝑑𝑑(𝐾𝐾, 𝐿𝐿∗ ) 𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿∗ )
=
= 𝑝𝑝
𝑑𝑑𝑑𝑑
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

A term is vanishing in the process of establishing the shadow value. The desired value 𝐿𝐿∗ varies with the other parameters like K and𝜕𝜕𝜕𝜕
a, but the effect of these parameters on 𝐿𝐿∗ doesn’t appear in the expression for the shadow value of the parameter because = 0 at 𝐿𝐿∗ .
Key Takeaways

𝜕𝜕𝜕𝜕

•

When an input is fixed, its marginal value is called a shadow value.

•

A shadow value can be negative when an input is fixed at too high a level.

•

Every constraint has a shadow value. The term refers to the value of relaxing a constraint. The shadow value is zero when theconstraint doesn’t bind.

•

The effect of a constraint on terms that are optimized may be safely ignored in calculating the shadow value.
Key Terms•

Shadow value: The value of relaxing a constraint

9.5

Input Demand
Learning Objectives•

How much will firms buy?

•

How do they respond to input price changes?

Over a long period of time, an entrepreneur can adjust both the capital and the labor used at the plant. This lets the entrepreneur
maximize profit with respect to both variables 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 obtaining𝑝𝑝𝜕𝜕𝜕𝜕(𝐾𝐾 ∗∗ , 𝐿𝐿∗∗ )− 𝑤𝑤 = 0
𝜕𝜕𝜕𝜕

and
𝑝𝑝

𝜕𝜕𝜕𝜕(𝐾𝐾 ∗∗ , 𝐿𝐿∗∗ )− 𝑟𝑟 = 0𝜕𝜕𝜕𝜕

We see for both capital and labor, the value of the marginal product is equal to purchase price 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.35 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.36

If you want to know more, the approach is to arrange the two equations as a vector with 𝒙𝒙 = (𝐾𝐾, 𝐿𝐿), 𝒛𝒛 = (𝑟𝑟/𝑝𝑝, 𝑤𝑤/𝑝𝑝), so that−1
− z = 𝟎𝟎 and then differentiate to obtain 𝐝𝐝𝐝𝐝 = �𝐟𝐟 ′′ (𝐱𝐱 ∗∗ )� 𝐝𝐝𝐝𝐝 which can then be solved for each comparative static.
𝐟𝐟
35′ (𝐱𝐱 ∗∗ )36

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

Introduction to Economic Analysis

9-120𝜕𝜕𝜕𝜕(𝐾𝐾 ∗∗ , 𝐿𝐿∗∗ )− 𝑤𝑤 = 𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 ∗∗ 𝛼𝛼 𝐿𝐿∗∗ 𝛽𝛽−1 − 𝑤𝑤 = 0𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕(𝐾𝐾 ∗∗ , 𝐿𝐿∗∗ )− 𝑤𝑤 = 𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 ∗∗ 𝛼𝛼−1 𝐿𝐿∗∗ 𝛽𝛽 − 𝑟𝑟 = 0
𝑝𝑝
𝜕𝜕𝐾𝐾
𝑝𝑝

To solve this system of equations, first rewrite to obtain
𝑤𝑤 = 𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 ∗∗ 𝛼𝛼 𝐿𝐿∗∗ 𝛽𝛽−1 and 𝑟𝑟 = 𝑝𝑝𝑝𝑝𝑝𝑝𝐾𝐾 ∗∗ 𝛼𝛼−1 𝐿𝐿∗∗ 𝛽𝛽

Now we divide the first equation by the second to obtain𝛼𝛼𝛼𝛼 ∗∗
𝑤𝑤 𝛽𝛽𝐾𝐾 ∗∗=or 𝐾𝐾 ∗∗ =
𝐿𝐿
∗∗
𝛼𝛼𝐿𝐿
𝛽𝛽𝛽𝛽
𝑟𝑟
This can be substituted into either equation to obtain
1

1

𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽
𝐴𝐴𝐴𝐴𝛼𝛼 1−𝛽𝛽 𝛽𝛽 𝛽𝛽 1−𝛼𝛼−𝛽𝛽
𝐿𝐿 = � 𝛼𝛼 1−𝛼𝛼 �
and 𝐾𝐾 ∗∗ = � 1−𝛽𝛽 𝛽𝛽 �
𝑟𝑟 𝑤𝑤
𝑟𝑟 𝑤𝑤
∗∗

While these expressions appear complicated, in fact the dependence on the output price 𝑝𝑝, and the input prices 𝑟𝑟 and 𝑤𝑤 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 these changes in percentage terms. It is straightforward to demonstrate that both capital and labor
respond to a small percentage change in any of these variables with a constant percentage change.
An important insight of profit maximization is that it implies minimization of costs of yielding the chosen output, that is, profitmaximization entails efficient production.

The logic is straightforward. The profit of an entrepreneur is revenue minus costs, and the 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 – 𝐶𝐶 is equivalent to minimizing 𝐶𝐶, 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.
Kq

L
Figure 9.5.1: Tangency and Isoquants
There are circumstances where the cost-minimization feature of profit maximization can be used, and this is especially true when agraphical approach is taken. The graphical approach to profit-maximization is illustrated in Figure 9.5.1. The curve represents an
Introduction to Economic Analysis

9-121isoquant, which holds constant the output. The straight lines represent isocost lines, which hold constant the expenditure on inputs.
Isocost lines solve the problem
𝑑𝑑𝑑𝑑

𝑤𝑤

𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤 = 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

and thus have slope= . Isocost lines are necessarily parallel – they have the same slope. Moreover, the cost associated with an
𝑑𝑑𝑑𝑑
𝑟𝑟
isocost line rises the further northeast we go in the graph, or the further away from the origin.
What point on an isoquant minimizes total cost? The answer is the point associated with the lowest (most southwest) isocost thatintersects the isoquant. This point will be tangent 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 a useful interpretation. The slope of the isocost isminus 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 the amount of one input needed to make up for adecrease 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.
Key Takeaways•

In the long-run, all inputs can be optimized, which leads to multiple first order conditions.

•

The solution can be illustrated graphically and computed explicitly for Cobb Douglas production functions.

•

An important implication of profit maximization is cost minimization – output is produced by the most efficient means possible.

•

Cost minimization occurs where the ratio of the input prices equals the slope of the isocost curve, known as the marginal rate oftechnical substitution, which is the amount of one input needed to make up for a decrease in another input and hold output
constant.
Key Terms•

Isocost: lines that hold cost constant•Marginal rate of technical substitution: the amount of one input needed to make up for a small decrease in another input and holdoutput constant
Exercises
𝛼𝛼 𝛽𝛽For the Cobb-Douglas production function 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝐿𝐿 , show

9.5.1
9.5.2
9.5.3
9.5.4
9.5.5
9.5.6

9.6

𝑟𝑟 𝜕𝜕𝐿𝐿∗∗

𝐿𝐿∗∗ 𝜕𝜕𝜕𝜕

𝑤𝑤 𝜕𝜕𝐿𝐿∗∗

𝐿𝐿∗∗ 𝜕𝜕𝜕𝜕

𝑝𝑝 𝜕𝜕𝐿𝐿∗∗

𝐿𝐿∗∗ 𝜕𝜕𝜕𝜕

=

=−
=−

𝑟𝑟 𝜕𝜕𝐾𝐾 ∗∗𝐾𝐾 ∗∗ 𝜕𝜕𝜕𝜕𝑤𝑤 𝜕𝜕𝐾𝐾 ∗∗𝐾𝐾 ∗∗ 𝜕𝜕𝜕𝜕𝑝𝑝 𝜕𝜕𝐾𝐾 ∗∗𝐾𝐾 ∗∗ 𝜕𝜕𝜕𝜕−𝛼𝛼

1−𝛼𝛼−𝛽𝛽1−𝛼𝛼1−𝛼𝛼−𝛽𝛽11−𝛼𝛼−𝛽𝛽1−𝛽𝛽=−1−𝛼𝛼−𝛽𝛽=−1−𝛼𝛼−𝛽𝛽=−−𝛽𝛽1−𝛼𝛼−𝛽𝛽1

Myriad Costs
Learning Objectives•

What are the different ways of measuring costs and how are they related to the amount of time the firm has to change its
behavior?

How much does it cost to produce a given quantity 𝑞𝑞? We already have a detailed answer to this question, but now need to focus lesson the details and more on the “big picture.” First, let’s focus on the short-run, and suppose 𝐿𝐿 is adjustable in the short-run, but 𝐾𝐾 isnot. Then the short-run total cost of producing 𝑞𝑞, given the capital level, is

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) = min 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤 over all 𝐿𝐿 satisfying 𝑓𝑓(𝐾𝐾, 𝐿𝐿) ≥ 𝑞𝑞
𝐿𝐿

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In words, this equation says the short-run total cost of the quantity 𝑞𝑞 given the existing level 𝐾𝐾 is the minimum cost, where 𝐿𝐿 gets tovary (which is denoted by “min over 𝐿𝐿”), where the 𝐿𝐿 considered is large enough to produce 𝑞𝑞 when combined with the given 𝐾𝐾. The
vertical line | is used to indicate a condition or conditional requirement; here |𝐾𝐾 indicates that 𝐾𝐾 is fixed. The minimum lets 𝐿𝐿 vary
but not 𝐾𝐾. Finally, there is a constraint 𝑓𝑓(𝐾𝐾, 𝐿𝐿) ≥ 𝑞𝑞, which indicates that one has to be able to produce 𝑞𝑞 with the mix of inputs
because we are considering the short-run cost of 𝑞𝑞.
The short-run total cost of 𝑞𝑞 given 𝐾𝐾 has a simple form. First, since we are minimizing cost, the constraint 𝑓𝑓(𝐾𝐾, 𝐿𝐿) ≥ 𝑞𝑞 will besatisfied with equality, 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝑞𝑞. This equation determines 𝐿𝐿, since 𝐾𝐾 is fixed, that is, 𝑓𝑓�𝐾𝐾, 𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾)� = 𝑞𝑞 gives the short-run
value of 𝐿𝐿, 𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾). Finally, the cost is then 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾).

The short-run marginal cost given 𝐾𝐾 is just the derivative of total cost with respect to 𝑞𝑞. To establish the short-run marginal cost, notethat the equation 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝑞𝑞 gives

𝜕𝜕𝜕𝜕
1
𝜕𝜕𝜕𝜕
(𝐾𝐾, 𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾))𝑑𝑑𝑑𝑑 = 𝑑𝑑𝑑𝑑 or�=𝜕𝜕𝜕𝜕 𝑓𝑓=𝑞𝑞 𝜕𝜕𝜕𝜕 (𝐾𝐾,𝜕𝜕𝜕𝜕
𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾))𝜕𝜕𝜕𝜕

The tall vertical line, subscripted with 𝑓𝑓 = 𝑞𝑞, is used to denote the constraint 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝑞𝑞 that is being differentiated. Thus, theshort-run marginal cost is
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞) = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 ′ (𝑞𝑞) =

𝑑𝑑
𝜕𝜕𝜕𝜕
𝑤𝑤
(𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤) = 𝑤𝑤 �
=
𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑
𝜕𝜕𝜕𝜕 𝑓𝑓=𝑞𝑞(𝐾𝐾, 𝐿𝐿𝑆𝑆 (𝑞𝑞, 𝐾𝐾))𝜕𝜕𝜕𝜕

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 costof production, which we obtain by dividing the total cost by the quantity:
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) =𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾)
𝑞𝑞

Finally, we need one more short-run cost: the short-run average variable cost. The variable cost eliminates the fixed costs ofoperation, which in this case are 𝑟𝑟𝑟𝑟. That is,

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) =𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) − 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(0|𝐾𝐾) 𝑤𝑤𝐿𝐿𝑆𝑆 (𝑞𝑞|𝐾𝐾)=
𝑞𝑞
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 it is the average of the total cost per unit ofoutput, but “average total” is a bit of an oxymoron.37 Consequently, when total, fixed or variable is not specified, the convention is tomean 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 cost of zero production, also known as the short-run 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, theaverage 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
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿(𝑞𝑞) = min 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤 over all 𝐿𝐿 and 𝐾𝐾 combinations satisfying 𝑓𝑓(𝐾𝐾, 𝐿𝐿) ≥ 𝑞𝑞
𝐾𝐾,𝐿𝐿

Second, since all inputs can vary, the long-run cost isn’t conditioned on 𝐾𝐾. Finally, the long-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 zerois zero. Therefore, in the long-run, all costs are variable, and the long-run average variable cost is the long-run average total cost
divided by quantity.
Note that the easiest way to find the long-run total cost is to minimize the short-run total cost over 𝐾𝐾. Since this is a function of one
variable, it is straightforward to identify the 𝐾𝐾 that minimizes cost, and then plug that 𝐾𝐾 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. Faster adjustment costs
more. Continuous adjustment is a more advanced topic, requiring an Euler equation approach.

37

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 self-descriptive. Another word which is self-descriptive is “pentasyllabic.”
Introduction to Economic Analysis

9-123Key Takeaways•

The short-run total cost is the minimum cost of producing a given quantity, minimized over the inputs variable in the short-run.
Sometimes the word total is omitted.

•

The short-run fixed cost is the short-run total cost at a zero quantity.

••

The short-run marginal cost given 𝐾𝐾 is just the derivative of the short-run total cost with respect to quantity.

•

The short-run average variable cost is the short-run total cost minus the short-run fixed cost, all divided by quantity.

•

Marginal variable cost is the same as the marginal total costs, because the difference between total cost and variable cost is the
fixed cost of production, a constant.

•

The long-run total cost is the minimum cost of producing a given quantity, minimized over all inputs. Sometimes the word total
is omitted.

•

The long-run fixed cost is zero.

•

The long-run marginal cost the derivative of the long-run total cost with respect to quantity.

•

The long-run average cost is the long-run total cost divided by quantity.

•

The long-run average variable cost equals long-run average cost.

The short-run average cost is the short-run total cost divided by quantity.

Key Terms•

Short-run total cost: The total cost of output with only short-run factors varying•

Long-run total cost: The total cost of output with all factors varying•

Short-run average total cost: The short-run total cost divided by output•

Short-run marginal cost: The derivative of short-run total cost with respect to output•

Short-run variable cost: The short-run total cost minus the cost of zero output•

Short-run average variable cost: The short-run variable cost divided by output•

Short-run fixed cost: The short-run total cost of producing zero output•

Long-run average cost: The long-run total cost divided by output
Exercises

9.6.1

For the Cobb-Douglas production function 𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 with α + β < 1, with 𝐾𝐾 fixed in the short-run but not in thelong-run, and cost 𝑟𝑟 of capital and 𝑤𝑤 for labor, show
a.

b.

9.6.2

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) = 𝑟𝑟𝑟𝑟 + 𝑤𝑤 �
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) = 𝑤𝑤

𝑞𝑞

𝐴𝐴𝐾𝐾 𝛼𝛼

1−𝛽𝛽

𝑞𝑞 𝛽𝛽

�

1�
𝛽𝛽

1

�
(𝐴𝐴𝐾𝐾 𝛼𝛼 ) 𝛽𝛽c.

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆(𝑞𝑞|𝐾𝐾) = 𝑤𝑤d.

𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿(𝑞𝑞|𝐾𝐾) = �� �

1−𝛽𝛽

𝑞𝑞 𝛽𝛽

1

�
𝛽𝛽(𝐴𝐴𝐾𝐾 𝛼𝛼 ) 𝛽𝛽
𝛽𝛽

𝛼𝛼

𝛽𝛽

𝛼𝛼

1

𝛼𝛼 𝛼𝛼+𝛽𝛽𝛽𝛽 𝛼𝛼+𝛽𝛽
𝑞𝑞 𝛼𝛼+𝛽𝛽+ � � � 𝑤𝑤 𝛼𝛼+𝛽𝛽 𝑟𝑟 𝛼𝛼+𝛽𝛽 � �
𝛽𝛽
𝛼𝛼
𝐴𝐴

Consider a cost function of producing an output 𝑞𝑞 of the form 𝑐𝑐(𝑞𝑞) = 𝑞𝑞 2 + 2𝑞𝑞 + 16. Determine:a.

Marginal costb.

Average costc.

Average variable costd.

Graph the long-run supply curve assuming the cost function is for a single plant, and can be replicated without change.

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10

Producer Theory: Dynamics

How do shocks affect competitive markets?

10.1 Reactions of Competitive Firms
Learning Objectives•

How does a competitive firm respond to price changes?

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
𝜋𝜋 = 𝑝𝑝𝑝𝑝 − 𝑐𝑐(𝑞𝑞|𝐾𝐾)

where 𝑐𝑐(𝑞𝑞|𝐾𝐾) is the total cost of producing given that the firm currently has capital 𝐾𝐾. Assuming the firm produces at all, the firm
maximizes profits by choosing the quantity 𝑞𝑞𝑠𝑠 satisfying 𝑝𝑝 − 𝑐𝑐 ′ (𝑞𝑞|𝐾𝐾) = 0, that is, choosing the quantity where price equals marginalcost. However, this is a good strategy only if producing a positive quantity is desirable, that is, if 𝑝𝑝𝑞𝑞𝑠𝑠 − 𝑐𝑐(𝑞𝑞𝑠𝑠 |𝐾𝐾) ≥ −𝑐𝑐(0|𝐾𝐾) which
can be rewritten as 𝑝𝑝 ≥𝑐𝑐(𝑞𝑞𝑠𝑠 |𝐾𝐾)−𝑐𝑐(0|𝐾𝐾)
𝑞𝑞𝑠𝑠. The right-hand-side of this inequality is the average variable cost of production, and thus theinequality implies that a firm will produce provided price exceeds the average variable cost. Thus,

the profit-maximizing firm produces the quantity 𝑞𝑞𝑠𝑠 where price equals marginal cost, provided price is as large as minimum averagevariable cost. If price falls below minimum average variable cost, the firm shuts down.

The behavior of the competitive firm is illustrated in Figure 10.1.1. The thick line represents the choice of the firm as a function of theprice, 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 thefirm is composed of two distinct segments – the marginal cost, where the firm produces the output where price equals marginal cost,and shutdown, where the firm makes a higher profit, or loses less money, by producing zero.
Figure 10.1.1 also illustrates the average total cost, which doesn’t affect the short term behavior of the firm but does affect the longterm behavior, because when price is below average total cost, the firm is not making a profit, but instead would prefer to exit over thelong term. That is, when the price is between the minimum average variable cost and the minimum average total cost, it is better toproduce than to shut down, but the return on capital was below the cost of capital. With a price in this intermediate area, a firm would
produce, but would not replace the capital, and thus would shut down in the long-term if the price is expected to persist. As aconsequence, 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 priceequals the long-run marginal cost.
p

MC
ATC

AVC

q
Figure 10.1.1: Short-Run Supply
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Figure 10.1.1 illustrates one other fact: the minimum of average cost occurs at the point that marginal cost equals average cost. To see𝐶𝐶(𝑞𝑞). Then the minimum of average cost occurs at the point satisfying:
this, let 𝐶𝐶(𝑞𝑞) be total cost, so that average cost is𝑞𝑞

But this can be rearranged to yield 𝐶𝐶 ′ (𝑞𝑞) =𝐶𝐶(𝑞𝑞)𝑞𝑞

𝑑𝑑 𝐶𝐶(𝑞𝑞)𝐶𝐶 ′ (𝑞𝑞) 𝐶𝐶(𝑞𝑞)
�
�=0=
− 2
𝑑𝑑𝑑𝑑 𝑞𝑞
𝑞𝑞
𝑞𝑞, that is, marginal cost equals average cost 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 relationshipbetween long-run and short-run marginal costs is that some costs are marginal in the long-run that are fixed in the short-run, 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 capitalcosts are included in short-run average total costs. The result is a picture like Figure 10.1.2.
p

SRMC
SRAC
LRATC
SRAVC

q
Figure 10.1.2: Average and Marginal Costs
In Figure 10.1.2, the short-run is unchanged – there is a short-run average cost, short-run average variable cost, and short-run marginalcost. 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. This is the lowest long-run average cost, and has thenice property that long-run average cost equals short-run average total cost equals short-run marginal cost. However, for a different
output by the firm, there would necessarily be a different plant size, and the three-way equality is broken. Such a point is illustrated in
Figure 10.1.3.
In Figure 10.1.3, the quantity produced is larger than the quantity that minimizes long-run average total cost. Consequently, as isvisible in the picture, the quantity where short-run average cost equals long-run average cost does not minimize short-run averagecost. What this means is that a factory designed to minimize the cost of producing a particular 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 and more 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 that point, we have the three-way equality between long-run average total
cost, short-run average total cost, and short-run marginal cost.

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p
SRMC
SRAC

LRATC
SRAVC

q
Figure 10.1.3: Increased Plant Size
Key Takeaways•

The profit-maximizing firm produces the quantity where price equals marginal cost, provided price is as large as minimum
average variable cost. If price falls below minimum average variable cost, the firm shuts down.

•

When price falls below short-run average cost, the firm loses money. If price is above average variable cost, the firm loses lessmoney than it would by shutting down; once price falls below short-run average variable cost, shutting down entails smaller
losses than operating.

•

The minimum of average cost occurs at the point that marginal cost equals average cost.

•

If price is below long-run average cost, the firm exits in the long-run.

•Every point on long-run average total cost must be equal to a point on some short-run average total cost.

•

The quantity where short-run average cost equals long-run average cost need not minimize short-run average cost, if long-run
average cost isn’t constant.
Exercises

10.1.1

𝑞𝑞 2

Suppose a company has total cost given by 𝑟𝑟𝑟𝑟 + , where capital 𝐾𝐾 is fixed in the short-run. What is short-run average total
2𝐾𝐾
cost and marginal cost? Plot these curves. For a given quantity 𝑞𝑞0 , what level of capital minimizes total cost? What is theminimum average total cost of 𝑞𝑞0 ?

10.2 Economies of Scale and Scope

Learning Objectives•

When firms get bigger, when do average costs rise or fall?

•

How does size relate to profit?

An economy of scale – that larger scale lowers cost – arises when an increase in output reduces average costs. We met economies ofscale, and their opposite, diseconomies of 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 machine and only affect mycosts by five cents each. In contrast, if I am producing 50,000 units, the stamping machine increases my costs by a dollar each, and ismuch less economical.
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Indeed, it is somewhat more of a puzzle as to what produces a diseconomy of scale. An important source of diseconomies aremanagerial 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 everengage 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 inlarge organizations. This idea of managerial diseconomies of scale is reflected in the aphorism that “A platypus is a duck designed 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
𝑛𝑛(𝑛𝑛−1)
pairs, so that communication costs rise at the square of the project size. This is pithily
there are 𝑛𝑛 engineers, there are2summarized 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 is easier to hide incompetence and laziness in alarge organization than in a small one. There are a lot of familiar examples of this insight, starting with the Peter Principle, whichstates that people rise in organizations to the point of their own incompetence, which means eventually people cease to do the jobs thatthey do well.38 That slack grows as an organization grows implies a 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 to manage, at which point diseconomies tend to prevent the firm from economically getting
larger. Under this view, improvements in information technologies over the past twenty years have permitted firms to get larger andlarger. While that seems logical, in fact 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 a reduction 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 overboth types of aircraft, thereby reducing the average costs of each. Scope economies work like scale economies, except they accountfor advantages of producing multiple products, where scale economies involve an advantage of multiple units of the same 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 price of disc drives, reducing the cost ofPCs, 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 the increased production, and this is known as an external economy of scale or an industry economy of scale, because the scaleeconomy operates at the level of the industry rather than in the individual firm. Thus, the long-run average cost of individual firms
may be flat, 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 of scale at the level of the firm. In such a situation,
the size of any individual firm is limited by the diseconomy of scale, but nonetheless the average cost of production is decreasing in
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 the individual 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 thedevelopment 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 𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) be the output when the 𝑛𝑛 inputs 𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 are used. A rescaling of the inputs involves
increasing the inputs by a fixed percentage, e.g. multiplying them all by the constant 𝜆𝜆 (the Greek letter lambda), where 𝜆𝜆 > 1. What
does this do to output? If output goes up by more than 𝜆𝜆, we have an economy of scale (also known as increasing returns to scale):scaling up production increases output proportionately more. If output goes up by less than 𝜆𝜆, we have a diseconomy of scale ordecreasing returns to scale. And finally, if output rises by exactly 𝜆𝜆, we have constant returns to scale. How does this relate toaverage cost? Formally, we have an economy of scale if 𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) > 𝜆𝜆𝜆𝜆(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) if 𝜆𝜆 > 1.

This corresponds to decreasing average cost. Let 𝑤𝑤1 be the price of input 1, 𝑤𝑤2 the price of input 2, and so on. Then the average costof producing 𝑦𝑦 = 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) is
𝐴𝐴𝐴𝐴 =

𝑤𝑤1 𝑥𝑥1 + 𝑤𝑤2 𝑥𝑥2 + ⋯ + 𝑤𝑤𝑛𝑛 𝑥𝑥𝑛𝑛
𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )What happens to average cost as we scale up production by 𝜆𝜆 > 1? Call this 𝐴𝐴𝐴𝐴(𝜆𝜆).
38Laurence Johnston Peter (1919–1990).

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𝐴𝐴𝐴𝐴(𝜆𝜆) =𝑤𝑤1 𝜆𝜆𝜆𝜆1 + 𝑤𝑤2 𝜆𝜆𝑥𝑥2 + ⋯ + 𝑤𝑤𝑛𝑛 𝜆𝜆𝜆𝜆𝑛𝑛
𝑤𝑤1 𝑥𝑥1 + 𝑤𝑤2 𝑥𝑥2 + ⋯ + 𝑤𝑤𝑛𝑛 𝑥𝑥𝑛𝑛𝜆𝜆𝜆𝜆(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )
= 𝜆𝜆
=
𝐴𝐴𝐴𝐴
𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 )𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 )𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 )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:
𝑥𝑥1

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝑑𝑑
+ 𝑥𝑥2
+ ⋯ + 𝑥𝑥𝑛𝑛=𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 )|𝜆𝜆→1 =
𝜕𝜕𝑥𝑥1
𝜕𝜕𝑥𝑥2
𝜕𝜕𝑥𝑥𝑛𝑛 𝑑𝑑𝑑𝑑𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) − 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )= 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )𝜆𝜆→1𝜆𝜆 − 1lim

The value

𝜕𝜕𝜕𝜕

𝜕𝜕𝑥𝑥1

is the marginal product of input 1, and similarly

𝜕𝜕𝜕𝜕

𝜕𝜕𝑥𝑥2

is the marginal 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 receives the value
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
of the marginal product. That is, we can give 𝑥𝑥1
to the suppliers of input 1, 𝑥𝑥2
to the suppliers of input 2, and so on, and this
𝜕𝜕𝑥𝑥1

𝜕𝜕𝑥𝑥2

exactly uses up the all the output. This is known as “paying the marginal product,” because each supplier is paid the marginal productassociated with the input.

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 (an economy of scale), then it is not possible to pay all the inputs their marginal product, that is,
𝑥𝑥1

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
+ 𝑥𝑥2
+ ⋯ + 𝑥𝑥𝑛𝑛
> 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )
𝜕𝜕𝑥𝑥1
𝜕𝜕𝑥𝑥2
𝜕𝜕𝑥𝑥𝑛𝑛•An economy of scale arises when an increase in output reduces average costs.

•

Specialization may produce economies 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.

•

An economy of scope is a reduction in cost associated with producing several related goods.

•

Economies of scale can operate at the level of the individual firm but can also operate at an industry level. At the industry level
scale economies are known as an external economies of scale or an industry economies of scale.

•

The long-run average cost of individual firms may be flat, while the long-run average cost of the industry slopes downward.

•

Generally there is an external diseconomy of scale if a larger industry drives up input prices. There is an external economy if anincrease in output permits the creation of more specialized techniques and a greater effort in R&D to lower costs.

••

A production function has increasing returns to scale if an increase in all inputs by a constant factor 𝜆𝜆 increases output by morethan 𝜆𝜆.

•The production function exhibits increasing returns to scale if and only if the cost function has an economy of scale.

Key Takeaways

A production function has decreasing returns to scale if an increase in all inputs by a constant factor 𝜆𝜆 increases output by lessthan 𝜆𝜆.

•

When there is an economy of scale, the sum of the values of the marginal product exceeds the total output. Consequently, it is notpossible to pay all inputs their marginal product.

•

When there is a diseconomy of scale, the sum of the values of the marginal product is less than the total output. Consequently, it
is possible to pay all inputs their marginal product, and have something left over for the entrepreneur.

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Key Terms•

Economy of scale: Larger scale lowers average cost•

Economy of scope: Producing more related goods lowers average cost•

External economy of scale: An economy of scale that operates at the industry level, not the individual firm level•

Industry economy of scale: An economy of scale that operates at the industry level, not the individual firm level•

Increasing returns to scale: Increasing all inputs by the same scalar factor increases output by more than the scalar factor•

Decreasing returns to scale: Increasing all inputs by the same scalar factor increases output by less than the scalar factor•

Constant returns to scale: Increasing all inputs by the same scalar factor increases output by that scalar factor
Exercises

10.2.1 Given the Cobb-Douglas production function 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = 𝑥𝑥1 𝑎𝑎1 𝑥𝑥2 𝑎𝑎2 … 𝑥𝑥𝑛𝑛 𝑎𝑎𝑛𝑛 , show there are constant returns to scale if
𝑎𝑎1 + 𝑎𝑎2 + ⋯ 𝑎𝑎𝑛𝑛 = 1, increasing returns to scale if 𝑎𝑎1 + 𝑎𝑎2 + ⋯ 𝑎𝑎𝑛𝑛 > 1, and decreasing returns to scale if 𝑎𝑎1 + 𝑎𝑎2 + ⋯ 𝑎𝑎𝑛𝑛 <1.
𝑞𝑞 2

10.2.2 Suppose a company has total cost given by 𝑟𝑟𝑟𝑟 + where capital 𝐾𝐾 can be adjusted in the long-run. Does this company have
2𝐾𝐾
an economy of scale, diseconomy of scale, or constant returns to scale in the long-run?
10.2.3 A production function 𝑓𝑓 is homogeneous of degree 𝑟𝑟 if 𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = 𝜆𝜆𝑟𝑟 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ). Consider a firm with aproduction function that is homogeneous of degree 𝑟𝑟. Suppose further that the firm pays the value of marginal product for all
its inputs. Show that the portion of revenue left over is 1 − 𝑟𝑟.

10.3 Dynamics with Constant Costs

Learning Objectives•

How do changes in demand or cost affect the short and long-run prices and quantities traded?

Having understood how a competitive firm responds to price and input cost changes, we consider how a competitive market responds
to demand or cost changes.
The basic picture of a long-run equilibrium is presented in Figure 10.3.1. There are three curves, all of which are already familiar.
First, there is demand, considered in the first chapter. Here demand is taken to be the “per period” demand. Second, there is the shortrun supply, which reflects two components – a shutdown point at minimum average variable cost, and quantity such that price equals
short-run marginal cost above that level. The short-run supply, however, is the market supply level, which means it sums up theindividual 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 10.3.1, there is no long-run scale effect. The long-run average total cost is also the long-run
industry supply.39
As drawn, the industry is in equilibrium, with price equal to 𝑃𝑃0 , which is the long-run average total cost, and also equating short-run
supply and demand. That is, at the price of 𝑃𝑃0 , and industry output of 𝑄𝑄0 , 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, no market participant has an incentive to change
their behavior, so the market is in both long-run and short-run equilibrium. In a long-run equilibrium, long-run demand equals longrun supply and short-run demand equals short-run supply, so the market is also in short-run equilibrium, where short-run demand
equals short-run supply.

39

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 theindividual firms, because this is the marginal cost of the industry.
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pP0
LRATC=LRSD
Q
Q0
Figure 10.3.1: Long-Run Equilibrium
Now consider an increase in demand. Demand might increase because of population growth, or because a new use for an existingproduct 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 important because the decision of a firm to enter is based more on expectations of future demand than on
present demand.
Figure 10.3.2 reproduces the equilibrium figure, but with the curves “grayed out” to indicate a starting position, and a darker new
demand curve, labeled 𝐷𝐷1 .

The initial effect of the increased demand is that the price is bid up, because there is excess demand at the old price 𝑃𝑃0 . This isreflected by a change in both price and quantity to 𝑃𝑃1 and 𝑄𝑄1 , 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 new investment to increase the quantity supplied, but over time the new investment leads to increased output,
and a fall in the price, as illustrated in Figure 10.3.3.

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SRS

P
P1

P0
LRATC=LRS

D1
D0
Q
Q0

Q1

Figure 10.3.2: A Shift in Demand
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 the price tofall back to its initial level, and the quantity to increase still further to Q2.

SRS0

P

SRS2

P1

P0
LRATC=LRS

D1
D0
Q
Q0

Q1

Q2

Figure 10.3.3: Return to Long-Run Equilibrium

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It is tempting to think that the effect of a decrease in demand just retraces the steps of an increase in demand, but that isn’t correct. In
both cases, the first effect is the intersection of the new demand with the old short-run supply. Only then does the short-run supply
adjust to equilibrate the demand with the long-run supply. That is, the initial effect is a short-run equilibrium, followed by adjustmentof the short-run supply to bring the system into long-run equilibrium. Moreover, a small decrease in demand can have a qualitatively
different effect in the short-run than a large decrease in demand, depending on whether the decrease is large enough to induce
immediate exit of firms. This is illustrated in Figure 10.3.4.
In Figure 10.3.4, 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 and the 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.
P

SRS2

SRS0

LRS

D1
D0
Q
Figure 10.3.4: A Decrease in DemandIf, however, the decrease in demand is large enough to push the industry to minimum average variable cost, there is immediate exit.
In Figure 10.3.5, 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 at this level, which induces a shift in of the shortrun supply, to SRS1. Then there is additional shutdown, shifting the short-run supply in still further, but driving up the price (along
the demand curve) until the long-term equilibrium is reached.
Consider an increase in the price of an input into production. For example, an increase in the price of crude oil increases the cost of
manufacturing gasoline. This tends to decrease (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 10.3.6. The increased costs reduce both the short-run supply (prices have to be higher to inorder to produce the same quantity) and the long-run supply. The short-run supply shifts upward to SRS1, and the long-run supply to
LRS2. The short-run effect is to move to the intersection of the short-run 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 capitaland there is disinvestment in the industry. This disinvestment causes the short-run supply to be reduced (move left) to SRS2.

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SRS1

P

SRS0

SRS2

LRS

D1
D0
Q
Figure 10.3.5: A Big Decrease in Demand
The case of a change in supply is more challenging because both the long-run supply and the short-run supply are shifted. But thelogic – 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.
SRS2

SRS1
SRS0

P

P2

LRS2

P1
P0

LRS0

D0
Q
Q2 Q1 Q0
Figure 10.3.6: A Decrease in Supply

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Key Takeaways•

A long-run equilibrium occurs at a price and quantity when the demand equals the long-run supply, and the number of firms issuch that the short-run supply equals the demand.

•

At long-run equilibrium prices, no firm wishes to shut down, no firm can make positive profits from entering, there is no excess
output, and no consumer is rationed.

•

An increase in demand to a system in long-run equilibrium first causes a short-run increase in output and a price increase. Then,because entry is profitable, firms enter. Entry shifts out short-run supply until the system achieves long-run equilibrium,
decreasing prices back to their original level and increasing output.

•

A decrease in demand creates a short-run equilibrium where existing short-run supply equals demand, with a fall in price andoutput. If the price fall is large enough (to average variable cost) some firms shut down. Then as firms exit, supply contracts,
prices rise, and quantity contracts further.

•

The case of a change in supply is more challenging because both the long-run supply and the short-run supply are shifted.
Key Terms•

Short-run equilibrium: The point where short-run demand equals short-run supply•

Long-run equilibrium: The point where both long-run demand equals long-run supply and short-run demand equals short-run
supply10.4 General Long-run Dynamics
Learning Objectives•

If long-run costs aren’t constant, how do changes in demand or costs affect short and long-run prices and quantities traded.

The previous section made two simplifying assumptions that won’t hold in all applications of the theory. First, it assumed constantreturns 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 energy-efficient 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 ofgasoline. The short-run effect is to drive less in response to an increase in the price, while the long-run effect is to choose theappropriate car for the price of gasoline.
To illustrate the general analysis, we start with a long-run equilibrium. Figure 10.4.1 reflects a long-run economy of scale, because
the long-run supply slopes downward, so that 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 the long-run supply and demand intersection. Bothshort-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 10.4.1: Equilibrium with External Scale Economy
SRS0

P

2
0
LRS

1

LRD0
SRD0
SRD1

LRD1
Q

Figure 10.4.2: Decrease in Demand
Now consider a decrease in demand, decreasing both short-run and long-run demand. This is illustrated in Figure 10.4.2. To reduce
the proliferation of curves, we color the old demand curves very faintly, and mark the initial long-run equilibrium with a zero inside asmall rectangle.40 The intersection of short-run supply and short-run demand is marked 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-

40
The short-run demand and long-run demand have been shifted down by the same amount, that is, both reflect an equal reduction invalue. This kind of shift might arise if, for instance, a substitute had become cheaper, but the equal reduction is not essential to thetheory. In addition, the fact of equal reductions often isn’t apparent from the diagram, because of the different slopes – to mostobservers, it appears that short-run demand fell less than long-run demand. This isn’t correct, however, and one can see this because
the intersection of the new short-run demand and long-run demand occurs directly below the intersection of the old curves, implying
both fell by equal amounts.

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run equilibrium quantity. However, the price associated with the short-run equilibrium is below the long-run supply price at thatquantity. The effect is that buyers see the price as too high, and are reducing their demand, while sellers see the price as too low, andso are reducing their supply. Both short-run supply and short-run demand fall, until a long-run equilibrium is achieved.
SRS2
SRS0

P

2
0
LRS

1

LRD0
SRD2

SRD0
SRD1

LRD1
Q

Figure 10.4.3: Long-run After a Decrease in Demand
In this case, the long-run equilibrium involves higher prices, at the point labeled 2, because of the economy of scale in supply. Thiseconomy of scale means that the reduction in demand causes prices to rise over the long-run. The short-run supply and demand
eventually adjust to bring the system into long-run equilibrium, as Figure 10.4.3 illustrates. The new long-run equilibrium has shortrun 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 same point as the long-run demand and supply, which determine
where the system is heading.
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.41 This gives sixteen variations of the basic analysis. In all sixteen cases, the procedure is the same. Start with a long-run
equilibrium, shift both the short-run and long-run levels of either demand or supply. The first stage is the intersection of the short-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 thecosts of manufacturing computer memory are fixed costs. The modern DRAM plant costs several billion dollars; the cost of 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.42 The nature of the technology has
let manufacturers cut the costs of memory by about 30% per year over the past forty years, demonstrating that there is a strong
economy of scale in production. These two features – vertical short-run supply, strong economies of scale – are illustrated in the
Figure 10.4.4. The system is started at the point labeled with the number 0, with a relatively high price, and technology which has

41

The demand situation analogous to an economy of scale in supply is a network externality, in which the addition 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 – butother products like computer operating systems and almost anything involving adoption of a standard represent examples of network
externalities. When the slope of long-run demand is greater than the slope of long-run supply, the system will tend to be inefficient,because an increase in production produces higher average value and lower average cost. This usually means there is anotherequilibrium at a greater level of production.
42

The plants are expensive in part because they are so clean, because a single speck of dust falling on a chip ruins the chip. The
Infineon DRAM plant in Virginia stopped operations only when a snow-storm prevented workers and materials from reaching theplant.
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made costs lower that this price. Responding to the profitability of DRAM, short-run supply shifts out (new plants are built and dieshrinks permits increasing output from existing plants). The increased output causes prices to fall, relatively dramatically because
short-run demand is 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 point labeled 2. (One should probably think of Figure 10.4.4 as being in alogarithmic 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 be increased 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 inwhich electronic memory is very, very cheap even by 2004 standards and used in applications that haven’t yet been considered, but
the process of getting there is a wild ride, indeed. The saw-tooth pattern is illustrated in Figure 10.4.5, which shows DRAM industry
revenues in billions of dollars from 1992 to 2003, and projections of 2004 and 2005.43
P
0

2

1

LRD
SRS0

SRS1

SRD0

SRD2
LRS

Q

Figure 10.4.4: DRAM Market

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

1994

1996

1998

2000

2002

2004

Figure 10.4.5: DRAM Revenue Cycle

43

Two distinct data sources were used, which is why there are two entries for each of 1998 and 1999.

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Key Takeaways•

In general both demand and supply may have long and short-run curves. In this case, when something changes, initially thesystem moves to the intersections of the current short-run supply and demand for a short-run equilibrium, then to the intersectionof the long-run supply and demand. The second change involves shifting short-run supply and demand curves.
Exercises

10.4.1 Land close to the center of a city is in fixed supply, but it can be used 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.
10.4.2 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 thelong-run. In the short-run, however, the population of emus is limited by the number of breeding pairs of emus and the supply isessentially vertical. Illustrate the long- and short-run effects of an increase in demand for emus. (In the late 1980s, there was a
speculative bubble in emus, with prices reaching $80,000 per breeding pair, in contrast to $2,000 or so today.)10.4.3 There are long-run economies of scale in the manufacture of computers and their components. There was a shift in demandaway from desktop 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 thatthe two products are substitutes, so that if the price of notebook computers rises, some consumers shift to desktops. (To answer
this question, start with a time 0 and a market in long-run equilibrium. Shift demand 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 that price effect do to demandfor each?)

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10-13911

Investment

The distinction between the short-run supply and the long-run supply is governed by the time that investment takes. Some of thedifference 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 anddemand. In this section, we take a first look at investment. We will take a second look at investment from a somewhat different
perspective later when we consider basic finance tools near the end of the book. Investment goods require expenditures today to
produce future value, so we begin the analysis by examining the value of future payments.

11.1 Present value
Learning Objectives•

How is a stream of payments or liabilities evaluated?

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 involve risk 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 with negligible 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 less than a current payment is due to arbitrage.44
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 tobuy a government bond that pays $10,000 a year from now. What will that bond cost you? At current interest rates, a secure bond45
will cost around $9700. This means 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 to spend on cappuccinos or economics textbooks. In otherwords, 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 them by 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 ahigher 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 carwith cash 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 the interest rate for the next year as 𝑟𝑟1 , the second
year’s rate as 𝑟𝑟2 , and so on. In this notation, a $1 invested would pay $1 + 𝑟𝑟1 next year, or $(1 + 𝑟𝑟1 )(1 + 𝑟𝑟2 ) after 2 years, or$(1 + 𝑟𝑟1 )(1 + 𝑟𝑟2 )(1 + 𝑟𝑟3 ) after 3 years. That is, 𝑟𝑟𝑖𝑖 is the interest rate that determines the value, at the end of year 𝑖𝑖, of $1 invested at
the start of year 𝑖𝑖. Then, if we obtain a stream of payments 𝐴𝐴0 immediately, 𝐴𝐴1 at the end of year 1, 𝐴𝐴2 at the end of year 2, and so on,
the present value of that stream is
𝑃𝑃𝑃𝑃 = 𝐴𝐴0 +

𝐴𝐴1
𝐴𝐴2
+
+⋯
(1 + 𝑟𝑟1 ) (1 + 𝑟𝑟1 )(1 + 𝑟𝑟2 )Example (Consolidated annuities or Consols): What is the value of $1 paid at the end of each year forever, with a fixed interest rate
𝑟𝑟? Suppose the value is 𝑣𝑣. Then
𝑣𝑣 =

1
1
+
+⋯
1 + 𝑟𝑟 (1 + 𝑟𝑟)2

(1 + 𝑟𝑟)𝑣𝑣 = 1 +11++ ⋯ = 1 + 𝑣𝑣
1 + 𝑟𝑟 (1 + 𝑟𝑟)2

44

Arbitrage is the process of buying and selling in such a way to make a profit. For example, if wheat is selling 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 thesetransaction costs are small, as with gold, prices will be about the same worldwide.
45

Economists tend to consider US federal government securities secure, because the probability of such a default is very, very low.

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𝑣𝑣 =

1
𝑟𝑟

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.
Annuities: Again, fix an interest rate 𝑟𝑟. What is the present value of 𝑇𝑇 payments, each of amount 𝐶𝐶, with the first payment due 1
period from today? This is the sum of the present values of each of the 𝑇𝑇 payments:
𝑣𝑣 =

𝐶𝐶
𝐶𝐶
𝐶𝐶
+
+ ⋯+
(1 + 𝑟𝑟)𝑇𝑇
1 + 𝑟𝑟 (1 + 𝑟𝑟)2

It follows that𝑣𝑣(1 + 𝑟𝑟) = 𝐶𝐶 +

𝐶𝐶
𝐶𝐶
+⋯+
(1 + 𝑟𝑟)𝑇𝑇−1
1 + 𝑟𝑟

Subtracting the first expression from the second, we obtain
𝑣𝑣(1 + 𝑟𝑟) − 𝑣𝑣 = 𝐶𝐶 −

𝑣𝑣 =

𝐶𝐶
(1 + 𝑟𝑟)𝑇𝑇

𝐶𝐶
1
�1 −
�
(1 + 𝑟𝑟)𝑇𝑇
𝑟𝑟

There are many applications of this formula. A mortgage usually implies a fixed payment per month for a large number of months(e.g. 360 for a 30 year mortgage). What is the present value of these payments over 𝑛𝑛 months? At an interest rate of 1�2 % per month,a monthly payment of $600 for 360 months has a present value of $100,075. This means that the payment on a mortgage of $100,075
will be $600, if the loan is at an interest rate of 1�2 % per month and is financed over 360 months
Example (Simple and Compound Interest): In the days before calculators, it was a challenge to actually solve interest rate formulas, so
certain simplifications were made. One of these was simple interest, which means that daily or monthly rates are translated into5%
= 0.07692% . Thatannual rates by incorrect formulas. For example, with an annual rate of 5%, the simple interest daily rate is

this is incorrect can be seen from the calculation that �1 +

5% 365

365

�

365

= 1.051267, for an effective (compound) interest rate of 5.1267%.

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 the firstmillion right off the bat, so the value is

𝑃𝑃𝑃𝑃 = 1 +

1
1
1
1
+ ⋯+
= 1 + �1 −
�(1 + 𝑟𝑟)19(1 + 𝑟𝑟)19
𝑟𝑟
1 + 𝑟𝑟Table 11.1.1 computes the present value of our $20 million dollar lottery, listing the results in thousands of dollars, at various interest
rates. At ten percent interest, the value of the lottery is less than half the “number of dollars” paid, and even at 5%, the value of thestream of payments is 65% of the nominal face value.
Table 11.1.1: Present Value at different interest rates
r

3%

4%

5%

6%

7%

10%

PV (000s)$15,324$14,134$13,085$12,158$11,336$9,365The 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 $1000 in one year. It is sold at a
discount off the face value, so that a one-year $1000 bond might sell for $961.54, producing a 4% interest rate. To compute theeffective interest rate 𝑟𝑟, the formula relating the future value 𝐹𝐹𝐹𝐹, the number of periods 𝑛𝑛, and the price 𝑃𝑃 is(1 + 𝑟𝑟)𝑛𝑛 =

𝐹𝐹𝐹𝐹
𝑃𝑃

𝐹𝐹𝐹𝐹

or 𝑟𝑟 = � �
𝑃𝑃

1�
𝑛𝑛

−1

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 the bond, generallycollected semi-annually, and the face value is paid at the end of the term. These bonds were often sold on long terms, as much as 30
Introduction to Economic Analysis

11-141years. Thus, a three-year $1000 bond at a coupon rate of 5% with semi-annual payments would pay $25 at the end of each half year
for three years, and pay $1000 at the end of the three years. The net present value, with an annual interest rate 𝑟𝑟, is

𝑁𝑁𝑁𝑁𝑁𝑁 =

$25
$25
$25
$25
$25
$1000
$25
+
+
+
+
+
+
0.5
1
1.5
2
2.5
3
(1 + 𝑟𝑟)(1 + 𝑟𝑟)(1 + 𝑟𝑟)(1 + 𝑟𝑟)(1 + 𝑟𝑟)(1 + 𝑟𝑟)3(1 + 𝑟𝑟)

The net present value will be the price of the bond. Initially, the price of the bond should 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 face value is paid andthen interest paid semi-annually.
Key Takeaways•

Capital goods change slowly in part because they are durable.

•

The acquisition of goods that will be used over time, whether factories, homes, or televisions, is known as investment.

•

The promise of $1 in the future is not worth $1 today. The difference is a discount on future payments.

•

Arbitrage involves buying and selling in a way that leaves money left over.

•

Arbitrage is possible unless future payments are discounted by the appropriate interest rate.

•“Simple” interest means that daily, monthly or annual rates are translated into daily, monthly or annual rates by incorrect
formulas. Accurate calculations are known as compound interest.

•

A standard treasury bill has a fixed future value. Treasury bill prices move inversely to interest rates – an increase in interest rates
reduces treasury prices.

•

Bonds pay a fixed interest rate set at the time of issue during the life of the bond, generally collected semi-annually, and the facevalue is paid at the end of the term.
Key Terms•

Present value: Value today of a stream of future payments•

Future value: Value at some point in the future jof a stream of payments•

Discount: In investment, to adjust for interest rates•

Arbitrage: Buying and reselling to make a profit•

Consols: A bond that makes a fixed payment each time period forever•

Treasury bill: A bond which has a fixed future value•

Simple interest: An incorrect interest rate which estimates a subperiod rate by dividing the period rate by the number of periods•

Compound interest: The correct calculation of interest•

Net Present Value: The present value of a stream of net payments•

NPV: Net Present Value
Exercises

11.1.1 At a 7% annual interest rate, what is the present value of $100 paid at the end of one year, and $200 paid at the end of thesecond year?
11.1.2 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%.
11.1.3 You can finance your $20,000 car with a straight 5% loan paid monthly over 5 years, or get one year interest free, but thenpay 7% over the following 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.)
11.1.4

You win the lottery. At what interest rate should you accept $7 million today over twenty annual payments of $500,000?

11.1.5 An investor discounts future profits at 5% per year. Suppose a stock pays $1 in dividends after one year, growing 1% eachyear thereafter. How much should the stock be worth today?
11.1.6 You are buying a $20,000 car. If you make monthly payments of $1000, how long does it take you to pay off the debt if theinterest rate is 1% per month? How does this change when the interest rate drops to ½%?

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11.2 Investment
Learning Objectives•

How do I evaluate an investment opportunity?

A simple investment project involves spending an investment, I, and then reaping a return over time. If you dig a mine, drill an oilwell, build an apartment building or a factory, 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 𝑟𝑟 that is reasonable for, and specific to, the project and then computing thepresent 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:
𝑁𝑁𝑁𝑁𝑁𝑁 = −𝐼𝐼 +

𝑅𝑅2
𝑅𝑅1
+
+⋯
1 + 𝑟𝑟 (1 + 𝑟𝑟)2

where 𝑅𝑅1 represents first year revenues, 𝑅𝑅2 represents second year revenues, etc.46 The investment is then made when NPV is
positive – since this would add to the net value of the firm.

Carrying out an NPV analysis essentially requires two things. First, investment and revenues 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.47 Second, an appropriate rate of return must be identified. The rate of return is a problem, mostly because ofrisk associated with the payoffs to the investment, but also because of the incentives of project managers to inflate the payoffs andminimize the costs to make the project look more attractive to upper management. In addition, most investment undertaken bycorporations is financed not with borrowing 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, and the 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 projects of major
corporations.
Example (Silver Mine): A company is considering whether to develop a silver mine in Mexico. The company estimates thatdeveloping the mine (building roads and opening a large hole in the ground) would require $4 million per year for four years, starting
now, and no revenues would accrue during this time. Starting in year 4 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 the investment phase during years 0, 1, 2, and 3 is
𝑃𝑃𝑃𝑃 = −4 +

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

The mine earns a net of $4 million per year in years 4 through 43. This adds up to
𝑃𝑃𝑃𝑃 =

4
4
4++⋯+= 13.507(1.18)43(1.18)5 (1.18)6

So the net present value of the investment is 13.507 − 12.697 = $0.81 million. The mine is just profitable at 18%, in spite of the factthat 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.
There are other approaches to deciding whether to take an investment. In particular, the Internal Rate of Return approach solves theequation 𝑁𝑁𝑁𝑁𝑁𝑁 = 0 for the interest rate, and then the project is undertaken if the rate of return is sufficiently high. This approach isflawed because the equation may have more than one solution, or no solutions and it is not transparent what the right thing to doshould 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 withthe payback period is deciding between projects – if I can only do one of two projects, the one with the higher NPV makes the mostmoney for the company. The one with the faster payback may make a quite small amount of money very quickly; it isn’t apparent that46

The most common approach is to treat revenues within a year as if they are received at the midpoint, and then discountappropriately for that mid-year point. The present discussion oversimplifies in this regard.
47

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 to the 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.
Introduction to Economic Analysis

11-143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 toundertake a project or not, and it does better than other approaches to investment decisions. For this reason, NPV has become themost common approach to investment decisions. Indeed, NPV analysis is more common than all other approaches combined. NPV
does a poor job, however, when the question is whether to undertake a project, or delay the project. That is, NPV answers “yes or no”
to investment, but when the choice is “yes or wait,” NPV requires amendment.
Key Takeaways•

The NPV approach involves assigning a rate of return r that is reasonable for, and specific to, the project and then computing thepresent value of the expected stream of payments. The investment is then made when NPV is positive – since this would add tothe net value of the firm.

•

Carrying out an NPV analysis requires estimating investment and revenues and identifying an appropriate rate of return.

•Interest rates of 15%-20% are common for evaluating the NPV of projects of major corporations.
Key Terms•

Internal Rate of Return: Solve the equation 𝑁𝑁𝑁𝑁𝑁𝑁 = 0 for the interest rate
Exercises

11.2.1

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 the university education?

11.2.2

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 thefour years and earning $50,000 when you graduate. Which is the better deal at 7%?

11.2.3A bond is a financial instrument that pays a fixed amount, called the face value at a maturity date. Bonds can also pay out
fixed payments called coupons in regular intervals up until the maturity date. Suppose a bond with face value $1,000 sells for$900 on the market and has annual coupon payments starting a year from today up until its maturity date 10 years from now.
What is the coupon rate? Assume 𝑟𝑟 = 10%.

11.2.4

The real return on stocks averages about 4% annually. Over 40 years, how much will $1000 invested today grow?

11.2.5You have invented something. You can sell it now for $1M, and work at something else, producing $75,000 per year for ten
years. (Treat this income as received at the start of the year.) Alternatively, you can develop your invention, which requires
working for ten years, and will net $5 million ten years hence. For what interest rates are you better off selling now? (Pleaseapproximate the solution.)

11.2.6

A company is evaluating a project with a start-up fee of $50,000, but pays $2,000 every second year, starting two years fromnow. Suppose the company is indifferent about taking on the project or not. What discount rate is the company using?

11.3 Investment Under Uncertainty
Learning Objectives•

What is the effect of risk on investment?

•

What is an option?

Risk has a cost, and people, and corporations, buy insurance against financial risk.48 The standard approach to investment under
uncertainty is to compute an NPV, with the revenues composed of expected values, and the interest rate used adjusted to compensate
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 never drilled, 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 such investments 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%

48

For example, NBC spent $6 million in buying an insurance policy against US nonparticipation in the 1980 Moscow summer
Olympic games, and the US didn’t participate (because of the Soviet invasion of Afghanistan), and NBC was paid $94 million fromthe policy.
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11-144

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 the returns:
Table 11.3.1: Oil Tract Return
Expected revenue

EPV0-$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 of interest rate. The most important thing to understandis that the interest rate is specific to the project, and not to the investor. This is perhaps the most important insight of corporate financegenerally: the interest rate should adjust for the risk associated with the 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 a function of the project risk, not the risk of McDonald’s other investments.
This basic insight of corporate finance (the study of funding of operations of companies) – the appropriate interest rate is determinedby 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 a function of their own personal circumstances, and thus the decision of whether topay 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. Evenso, 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 associatedfor it: the percentage loss to the lender 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 investor-specific is to think about undertaking the project by
creating a separate firm to make the investment. The creation of subsidiary units is a common strategy, in fact. This subsidiary firm
created to operate a project has a value equal to the NPV of the project using the interest rate specific to the subsidiary, which is theinterest 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.49
Investments in oil are subject to another kind of uncertainty: price risk. Prices of oil fluctuate and aren’t constant. Moreover, oilpumped and sold today is not available for the 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, is generally somewhat challenging and arcane, but asimple example provides a useful insight. An option is the right to buy or sell at a price determined in advance.
To develop this example, let’s set aside some extraneous issues first. Consider a very simple investment, in which either 𝐶𝐶 is invested
or not.50 If 𝐶𝐶 is invested, a value 𝑉𝑉 is generated. The cost 𝐶𝐶 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 𝑉𝑉, incontrast, varies from time to time in a random fashion. To simplify the analysis, we assume that 𝑉𝑉 is uniformly distributed on theinterval [0,1], so that the probability of 𝑉𝑉 falling in an interval [𝑎𝑎, 𝑏𝑏][a, b] is 𝑏𝑏 − 𝑎𝑎b-a if 0 ≤ 𝑎𝑎 ≤ 𝑏𝑏 ≤ 1. The option only has value if
𝐶𝐶 ≤ 1, which we assume for the rest of this section.

The first thing to note is that the optimal rule to make the investment is a cutoff value, that is, to set a level 𝑉𝑉0 V0 and exercise theoption if, and only if, 𝑉𝑉 ≥ 𝑉𝑉0 . This is because, if you are willing to exercise the option and generate value 𝑉𝑉, you should be willing to
exercise the option and obtain even more value. The NPV rule simply says 𝑉𝑉0 = 𝐶𝐶, that is, invest whenever it is profitable. The
purpose of the example developed below is to provide 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 𝑉𝑉 ≥ 𝑉𝑉0 is followed. Call this option value 𝐽𝐽(𝑉𝑉0 ). If therealized value 𝑉𝑉 exceeds 𝑉𝑉0 , one obtains 𝑉𝑉 − 𝐶𝐶. Otherwise, one delays the investment, producing a discounted level of the samevalue. This logic says

49

It may seem that synergies between parent and subsidiary are being neglected here, but synergies should be accounted for at thetime they produce value, i.e. as part of the stream of revenues of the subsidiary.
50

This theory is developed in striking generality by Avinash Dixit and Robert Pindyck, Investment Under Uncertainty, Princeton
University Press, 1994.

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1 + 𝑉𝑉0
𝐽𝐽(𝑉𝑉0 )− 𝐶𝐶� + 𝑉𝑉0 ��
2
1 + 𝑟𝑟𝐽𝐽(𝑉𝑉0 ) = (1 − 𝑉𝑉0 ) �This expression for 𝐽𝐽(𝑉𝑉0 ) arises as follows. First, the hypothesized distribution of 𝑉𝑉 is uniform on[0,1]. Consequently, the value of 𝑉𝑉
will exceed 𝑉𝑉0 with probability 1 − 𝑉𝑉0 . In this event, the expected value of 𝑉𝑉 is the midpoint of the interval [𝑉𝑉0 , 1], which is1
1(𝑉𝑉0 + 1). The value (𝑉𝑉0 + 1) − 𝐶𝐶 is the average payoff from the strategy of investing whenever 𝑉𝑉 ≥ 𝑉𝑉0 , which is obtained with2
2
probability 1 − 𝑉𝑉0 . Second, with probability 𝑉𝑉0 , the value falls below the cutoff level 𝑉𝑉0 . in this case, no investment is made, andinstead, we wait until the next period. The expected profits of the next period are 𝐽𝐽(𝑉𝑉0 ) and these profits are discounted in thestandard way.
The expression for 𝐽𝐽(𝑉𝑉0 ) is straightforward to solve:
𝐽𝐽(𝑉𝑉0 ) =1 + 𝑉𝑉0
− 𝐶𝐶�
2
𝑉𝑉
1− 0
1 + 𝑟𝑟(1 − 𝑉𝑉0 ) �

Rudimentary calculus shows
𝐽𝐽′ (𝑉𝑉0 ) =1 + 2𝑟𝑟𝑟𝑟 + 𝑉𝑉0 2 − 2(1 + 𝑟𝑟)𝑉𝑉02(1 + 𝑟𝑟) �1 −𝑉𝑉0 2
�
1 + 𝑟𝑟First, note that 𝐽𝐽′ (𝐶𝐶) > 0 and 𝐽𝐽′ (1) < 0, which together imply the existence of a maximum at a value 𝑉𝑉0 between 𝐶𝐶 and 1, satisfying
𝐽𝐽′ (𝑉𝑉0 ) = 0. Second, the solution occurs at
𝑉𝑉0 = (1 + 𝑟𝑟) − �(1 + 𝑟𝑟)2 − (1 + 2𝑟𝑟𝑟𝑟) = (1 + 𝑟𝑟) − �𝑟𝑟 2 − 2𝑟𝑟(1 − 𝐶𝐶)

The positive root of the quadratic has 𝑉𝑉0 > 1, which entails never investing, and hence is not a maximum. The profit-maximizing
investment strategy is to invest whenever the value exceeds 𝑉𝑉0 given by the negative root in the formula. There are a couple ofnotable features about this solution. First, at 𝑟𝑟 = 0, 𝑉𝑉0 = 1. This is because 𝑟𝑟 = 0 corresponds to no discounting, so there is no loss inholding out for the highest possible value. Second, as 𝑟𝑟 → ∞, 𝑉𝑉0 → 𝐶𝐶. As 𝑟𝑟 → ∞, the future is valueless, so it is worth investing if the
return is anything over costs. These are not surprising findings, quite the opposite – they should hold in any reasonable formulation ofsuch an investment strategy. Moreover, they show that the NPV rule, which requires 𝑉𝑉0 = 𝐶𝐶, is correct only if the future is valueless.
How does this solution behave? The solution is plotted as a function of 𝑟𝑟, for 𝐶𝐶 = 0, 0.25 and 0.5, in Figure 11.3.1.

The horizontal axis represents interest rates, so this picture shows very high interest rates by current standards, up to 200%. Even so,
𝑉𝑉0 remains substantially above 𝐶𝐶. That is, even when the future has very little value because two-thirds of the value is destroyed bydiscounting each period, the optimal strategy deviates significantly from the NPV strategy. Figure 11.3.2 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 11.3.1: Investment Strike Price Given Interest Rate r in Percent
Figure 11.3.2 shows the cutoff values of investment for three values of C, the cost of the investment. 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 𝐶𝐶 = 0. The NPV of thisIntroduction to Economic Analysis

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project 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 the potential value of the investment is lost. However, there
is a 35% of an even higher value. The optimum value of 𝑉𝑉0 trades these considerations off against each other.
For 𝐶𝐶 = 0.25, at 10% the cutoff value for taking an investment is 0.7, nearly three times the actual cost of the investment. Indeed, thecutoff value incorporates two separate costs: the actual expenditure on the investment 𝐶𝐶, and the lost opportunity to invest in the
future. The latter cost is much larger than the expenditure on the investment in many circumstances, and in this example, can bequantitatively much larger than the actual 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 such investments, NPV analysis gets the right answer, provided that appropriate interest rates andexpectations are used. Other investments are difficult to replicate or logically impossible to replicate – having pumped and sold the oilfrom a tract, that tract is now dry. For such investments, NPV is consistently wrong because it neglects the value of the option todelay the investment. A correct analysis adds a lost value for the option to delay the cost of the investment, a value which can bequantitatively large, as we have seen.
4

2

6

8

10

0.95
0.9
0.85
0.8

C=0.5

0.75
0.7

C=0.250.65

C=0Figure 11.3.2 Investment Strike Price Given Interest Rate 𝑟𝑟 in Percent

Example: When should you refinance a mortgage? Suppose you are paying 10% on a $100,000 mortgage, and it costs $5,000 torefinance, but refinancing permits you to lock 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 in essence you borrow $105,000 at a lower
interest rate when you refinance. This is actually 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 10% of the $100,000 face value of the mortgage each year, or $10,000 per year. If one
refinances at interest rate 𝑟𝑟, one pays 𝑟𝑟 × $105,000 per year, so the NPV of refinancing is 𝑁𝑁𝑁𝑁𝑁𝑁 = $10,000 − 𝑟𝑟 ∗ $105,000. Thus10
= 9.52%.
NPV is positive whenever 𝑟𝑟 <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 the randomness governing interest rates, preferences overmoney today versus money in the future, and attitudes to risk. The model developed in this section is not a good guide to answering
this question, primarily because the interest rates are strongly correlated over time. 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 point of around8.5%.

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Key Takeaways•

The standard approach to investment under uncertainty is to compute an NPV, with the interest rate used adjusted to compensate
for the risk.

•

The most important thing to understand is that the interest rate is specific to the project, and not to the investor.

•

The option value of investment includes the value of decisions that have not yet been made. Building a factory today forecloses
the opportunity of building the factory a year later, when better information concerning market conditions has been realized, butalso creates the option of selling over the next year.

•

NPV gets the right answer when investments can be replicated.

•

An important example of the option value is refinancing a home.
Key Terms•

Corporate finance: study of funding of operations of companies•

Option: The right to buy or sell at a price determined in advance•

Strike price: the price at which an option is exercised

11.4 Resource Extraction
Learning Objectives•

How much of a limited resource should be consumed today and how much should be saved for future consumption?

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 of these 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 and that the world is in no danger of running out ofoil.
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 returnfrom this behavior is the solution to(1 + 𝑟𝑟)20 =

1000
40

This equation solves for 𝑟𝑟 = 17.46%, which represents a healthy rate of return on investment. This substitution is part of a general
conclusion known as the Ramsey51 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 value of the resource. Even if they do not, others can buy the
resource at the low present value of 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, theseproducts rise in price on average at the interest rate, where the interest rate includes storage and insurance costs, as well as the cost offunds.
−1

Example: Let time run t = 0, 1, … and suppose the demand for a resource in fixed supply has constant elasticity:𝑝𝑝(𝑄𝑄) = 𝑎𝑎𝑄𝑄 �𝜀𝜀 .
Suppose there is a total stock 𝑅𝑅 of the resource, and the interest rate is fixed at 𝑟𝑟. What is the price and consumption of the resource ateach time?
Solution: Let 𝑄𝑄𝑡𝑡 represent the quantity consumed at time 𝑡𝑡. Then the arbitrage condition requires:

𝑎𝑎𝑄𝑄0

−1�
−1�
𝜀𝜀 (1 + 𝑟𝑟)𝑡𝑡 = 𝑝𝑝(𝑄𝑄 )(1 + 𝑟𝑟)𝑡𝑡 = 𝑝𝑝(𝑄𝑄 )𝑎𝑎𝑄𝑄
𝜀𝜀
0
𝑡𝑡
𝑡𝑡

Thus, 𝑄𝑄𝑡𝑡 = 𝑄𝑄0 (1 + 𝑟𝑟)−𝑡𝑡𝑡𝑡 . Finally, the resource constraint implies

𝑅𝑅 = 𝑄𝑄0 + 𝑄𝑄1 + 𝑄𝑄2 + ⋯ = 𝑄𝑄0 (1 + (1 + 𝑟𝑟)−𝜀𝜀 + (1 + 𝑟𝑟)−2𝜀𝜀 + ⋯ ) =𝑄𝑄0
1 − (1 + 𝑟𝑟)−𝜀𝜀

This solves for the initial consumption 𝑄𝑄0 . Consumption in future periods declines geometrically, thanks to the constant elasticity
assumption.
51

The solution to this problem is known as Ramsey pricing, after the discoverer Frank Ramsey (1903-1930).

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Market arbitrage insures the availability of the resource in the future, and drives the price 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 an unlimited 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 growas a source of heat. Instead, coal was discovered. The shortage of whale oil in the mid-nineteenth century led to the development ofoil resources as a replacement. If markets expect that price increases will lead to substitutes, then we rationally should use more
today, trusting that technological developments will provide substitutes.52 Thus, while some believe we are running out of oil, mostinvestors are betting that we are not, and that energy will not be very expensive in the future, either because of continued discovery ofoil, 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.
Key Takeaways•

The Ramsey rule holds that for resources in fixed supply, prices rise at the interest rate.

•

With constant elasticity, consumption of a resource in fixed supply declines geometrically.

•

Market arbitrage insures the availability of the resource in the future, and drives the price up to ration the good. The world runsout slowly, and the price of a resource in fixed supply rises on average at the interest rate.

•

Substitutes mitigate the fixed supply aspect of natural resources; for example fiber optic cable substitutes for copper.
Key Terms•

Ramsey rule: for resources in fixed supply, prices rise at the interest rate
Exercises

11.4.1

With an elasticity of demand of 2, compute the percentage of the resource that is used each year if the interest rate is 10%. If
the interest rate falls, what happens to the proportion quantity used?

11.5 A Time to Harvest
Learning Objectives•

How are the prices of renewable resources determined?

•

When should trees be harvested?

A tree grows slowly, but is renewable, so the analysis of Section 11.4 doesn’t help us understand when it is most profitable to cut thetree down. Consider harvesting for pulp and paper use. In this use, the amount of wood chips is what matters to the profitability of
cutting down the tree, and the biomass of the tree provides a direct indication of this. Suppose the biomass sells for a net price 𝑝𝑝,
which has the costs of harvesting and replanting deducted from it , and the biomass of the tree is 𝑏𝑏(𝑡𝑡) when the tree is 𝑡𝑡 years old. It
simplifies the analysis slightly to use continuous time discounting
1 𝑡𝑡
� = 𝑒𝑒 −𝜌𝜌𝜌𝜌 , where 𝜌𝜌 = log(1 + 𝑟𝑟)
�
1 + 𝑟𝑟Consider the policy of cutting down trees when they are 𝑇𝑇 years old. This induces a cutting cycle of length 𝑇𝑇. A brand new tree willproduce a present value of profits of:𝑒𝑒 −𝜌𝜌𝜌𝜌 𝑝𝑝𝑏𝑏(𝑇𝑇) + 𝑒𝑒 −2𝜌𝜌𝜌𝜌 𝑝𝑝𝑏𝑏(𝑇𝑇) + 𝑒𝑒 −3𝜌𝜌𝜌𝜌 𝑝𝑝𝑏𝑏(𝑇𝑇) + ⋯ =𝑒𝑒 −𝜌𝜌𝜌𝜌 𝑝𝑝𝑏𝑏(𝑇𝑇)𝑝𝑝𝑏𝑏(𝑇𝑇)= 𝜌𝜌𝜌𝜌−𝜌𝜌𝜌𝜌
1 − 𝑒𝑒𝑒𝑒 − 1This profit arises because the first cut occurs at time 𝑇𝑇, with discounting 𝑒𝑒 −𝜌𝜌𝜌𝜌 , and produces a net gain of 𝑝𝑝𝑝𝑝(𝑇𝑇). The process thenstarts over, with a second tree cut down at time 2𝑇𝑇, and so on.
Profit maximization gives a first order condition on the optimal cycle length 𝑇𝑇 of

52

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 the tragedy of the commons, results in too much use and istaken up in Section 7.6. Trees have also been over-cut, most notably on Easter Island.
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𝑑𝑑 𝑝𝑝𝑝𝑝(𝑇𝑇)𝑝𝑝𝑏𝑏 ′ (𝑇𝑇)𝑝𝑝𝑝𝑝(𝑇𝑇)𝑒𝑒 𝜌𝜌𝜌𝜌� 𝜌𝜌𝜌𝜌
� = 𝜌𝜌𝜌𝜌− 𝜌𝜌𝜌𝜌
𝑒𝑒 − 1 (𝑒𝑒 − 1)2
𝑑𝑑𝑑𝑑 𝑒𝑒 − 1This can be rearranged to yield:
𝑏𝑏 ′ (𝑇𝑇)𝜌𝜌=𝑏𝑏(𝑇𝑇) 1 − 𝑒𝑒 −𝜌𝜌𝜌𝜌The left hand side of this equation is the growth rate of the tree. The right hand side is approximately the continuous-time discountfactor, at least when 𝑇𝑇 is large, as it tends to be for trees, which are usually on a 20 to 80 year cycle, depending on the species. This isthe basis for a conclusion: cut down the tree slightly before it is growing at the interest 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 into wood 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 of six to eight, more than increases the value ofthe timber by the increase in the biomass.
It turns out our theory is already capable of handling this case. The only adaptation is a change in the interpretation of the function 𝑏𝑏.
Now, rather than representing the biomass, 𝑏𝑏(𝑡𝑡) must represent the value in boards of a tree that is 𝑡𝑡 years old. (The parameter 𝑝𝑝 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 the time 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 time to harvest lobsters is governed by the same
equation, where 𝑏𝑏(𝑇𝑇) is the value of a lobster of age 𝑇𝑇. Prohibiting the harvest of lobsters under age 𝑇𝑇 is a means of ensuring the
profit-maximizing capture of lobsters, and preventing over-fishing, a topic considered in section 7.6.
The implementation of the formula is illustrated in Figure 11.5.1. The dashed line represents the growth rate𝑏𝑏 ′(𝑇𝑇)𝑏𝑏(𝑇𝑇), while the solid line

represents the discount rate, which was set at 5%. Note that the best time to cut down the trees is when they are approximately 28.7
years old, and at that time, they are growing at 6 ½ %. Figure 11.5.1 also illustrates another feature of the optimization – there may be
multiple solutions to the optimization problem, and the profit-maximizing solution involves30𝜌𝜌
1 − 𝑒𝑒 −𝜌𝜌𝜌𝜌25
20

𝑏𝑏 ′ (𝑇𝑇)𝑏𝑏(𝑇𝑇)

crossing𝜌𝜌

1−𝑒𝑒 −𝜌𝜌𝜌𝜌from above.

Growth
Rate

15
10
5
10

20

30

40

T

Figure 11.5.1: 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 time that the tree is cut down. Maximum sustainable yield maximizes the long-run𝑏𝑏(𝑇𝑇).
average value of the trees cut down, that is, it maximizes
𝑇𝑇

Maximum sustainable yield is actually a special case of the policies considered here, and arises for a discount factor of 0. It turns out(thanks to a formula known variously as L’Hôpital’s or L’Hospital’s rule) thatlim𝜌𝜌𝜌𝜌→0 1 − 𝑒𝑒 −𝜌𝜌𝜌𝜌

=

1
𝑇𝑇

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11-150Thus, the rule𝑏𝑏 ′(𝑇𝑇)𝑏𝑏(𝑇𝑇)=

𝜌𝜌1−𝑒𝑒 −𝜌𝜌𝜌𝜌1→ as ρ→0, and this is precisely the same rule that arises under maximum sustainable yield.
𝑇𝑇

Thus, the Department of the Interior acts as if the interest rate is zero, when it is not. The justification given is that the Department isvaluing future generations at the same level as current generations, that is, increasing the supply for future generations, while slightly
harming the current generation of buyers. The major consequence of the Department’s policy of maximum sustainable yield is toforce cutting of timber even when prices are low during recessions.
Key Takeaways•

Renewable resources are harvested slightly earlier than the point where they grow at the interest rate, because earlier planting of
the next generation has value.

•

Maximum sustainable yield maximizes the long-run average value of the trees cut down, which is the optimal policy only when
the interest rate is zero.
Key Terms•

Maximum sustainable yield: Maximizing the long-run average value of a renewable resource
Exercises

11.5.1

Show maximum sustainable yield results in cutting down the tree when it is T years old, where T satisfies

11.6 Collectibles𝑏𝑏 ′(𝑇𝑇)𝑏𝑏(𝑇𝑇)1= .
𝑇𝑇

Learning Objectives•

How are the prices of collectibles determined?

•

What is the investment value of collectibles?

•

How fast do the prices rise?

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, old postcards, political
campaign buttons, old clocks and even Pez dispensers. How is the value of, say, a 1961 Porsche Speedster or a $500 bill from theconfederacy, which currently sells for over $500, determined?
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, thensell the same button. Second, these items may depreciate. Cars wear out even when they aren’t driven, and the brilliant color of Pez
dispensers fades. Every time a standard 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 to store. Fourth, the population grows, and some of the potential
buyers are not yet born.

Figure 11.6.1: The Porsche Speedster
To understand the determinants of the prices of collectibles, it turns out to create a major simplification to perform the analysis incontinuous time. Let 𝑡𝑡, ranging from zero to infinity, be the continuous time variable. If the good depreciates at rate δ, and 𝑞𝑞0 is theamount available at time 0, the quantity available at time 𝑡𝑡 is 𝑞𝑞(𝑡𝑡) = 𝑞𝑞0 𝑒𝑒 −𝛿𝛿𝛿𝛿 . For simplicity, assume that there is constant elasticity ofdemand ε. If 𝑔𝑔 is the population growth rate, the quantity demanded, for any price 𝑝𝑝, is given by 𝑥𝑥𝑑𝑑 (𝑝𝑝, 𝑡𝑡) = 𝑎𝑎𝑒𝑒 𝑔𝑔𝑔𝑔 𝑝𝑝 −𝜀𝜀 ,Introduction to Economic Analysis

11-151

for a constant 𝑎𝑎 which represents the demand at time 0. This represents demand for the good for direct use, but neglects theinvestment value of the good – that the good can be resold for a higher price later. In other words, 𝑥𝑥𝑑𝑑 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 𝑡𝑡. That marginal use value 𝑣𝑣
arises from the equality of supply and demand:
𝑞𝑞0 𝑒𝑒 −𝛿𝛿𝛿𝛿 = 𝑞𝑞(𝑡𝑡) = 𝑥𝑥𝑑𝑑 (𝑝𝑝, 𝑡𝑡) = 𝑎𝑎𝑒𝑒 𝑔𝑔𝑔𝑔 𝑣𝑣 −𝜀𝜀or

𝑣𝑣 𝜀𝜀 =𝑎𝑎 (𝛿𝛿+𝑔𝑔)𝑡𝑡
𝑒𝑒
𝑞𝑞0

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

𝑎𝑎 �𝜀𝜀 (𝛿𝛿+𝑔𝑔)
𝑣𝑣 = � � 𝑒𝑒 𝜀𝜀 𝑡𝑡
𝑞𝑞0

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 the individuals with high values will own the good, and the number of goods and the values ofpeople are assumptions of the theory. Essentially, we already know that the price will ration the good to the individuals with highvalues, 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 morehigh-value people demanding them, because of population growth. Together, these factors make the marginal use value grow at therate(𝛿𝛿+𝑔𝑔)𝜀𝜀.

Assume that 𝑠𝑠 is the cost of storage per unit of time and per unit of the good, so that storing 𝑥𝑥 units for a period of length ∆ costs 𝑠𝑠𝑠𝑠∆.
This is about the simplest possible storage cost technology.

The final assumption that we make is that all potential buyers use a common discount rate 𝑟𝑟, so that the discount of money or value
received ∆ units of time in the future is 𝑒𝑒 −𝑟𝑟∆ . 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 banks. While banking is an interesting thing to study, this section is concerned with collectibles, notbanks. If we have different discount factors, then we must also introduce banks, which would complicate the model substantially.
Otherwise, we would intermingle the theory of banking and the theory of collectibles. It is probably a good idea to develop a joint
theory of banking and collectibles given the investment potential of 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 𝑣𝑣. Is it a good thing for this person to own a unit of the good at time 𝑡𝑡? Let 𝑝𝑝 be thefunction that gives the price across time, so that 𝑝𝑝(𝑡𝑡) is the price at time 𝑡𝑡. Buying the good at time 𝑡𝑡 and then selling what remains(recall that the good depreciates at rate δ) at time 𝑡𝑡 + ∆ gives a net value of∆� 𝑒𝑒 −𝑟𝑟𝑟𝑟 (𝑣𝑣 − 𝑠𝑠)𝑑𝑑𝑑𝑑 − 𝑝𝑝(𝑡𝑡) + 𝑒𝑒 −𝑟𝑟∆ 𝑒𝑒 −𝛿𝛿∆ 𝑝𝑝(𝑡𝑡 + ∆)0

For the marginal person, that is, the person who is just indifferent to buying or not buying at time 𝑡𝑡, this must be zero at every momentin time, for ∆= 0. If 𝑣𝑣 represents the value to a marginal buyer (indifferent to holding or selling) holding the good at time 𝑡𝑡, then thisexpression should come out to be zero. Thus, dividing by ∆,∆𝑝𝑝(𝑡𝑡) 𝑒𝑒 −(𝑟𝑟+𝛿𝛿)∆ 𝑝𝑝(𝑡𝑡 + ∆)1+=0lim � 𝑒𝑒 −𝑟𝑟𝑟𝑟 (𝑣𝑣 − 𝑠𝑠)𝑑𝑑𝑑𝑑 −
∆→0 ∆
∆
∆
0

= lim 𝑣𝑣 − 𝑠𝑠 +∆→0

𝑎𝑎Recall that the marginal value is 𝑣𝑣 = � �
𝑞𝑞0

1�
𝜀𝜀

𝑒𝑒

𝑝𝑝(𝑡𝑡 + ∆) − 𝑝𝑝(𝑡𝑡) 1 − 𝑒𝑒 −(𝑟𝑟+𝛿𝛿)∆−
𝑝𝑝(𝑡𝑡 + ∆) = 𝑣𝑣 − 𝑠𝑠 + 𝑝𝑝′ (𝑡𝑡) − (𝑟𝑟 + 𝛿𝛿)𝑝𝑝(𝑡𝑡)∆∆(𝛿𝛿+𝑔𝑔)𝑡𝑡
𝜀𝜀, which gives
1𝑎𝑎 �𝜀𝜀 (𝛿𝛿+𝑔𝑔)
𝑝𝑝′ (𝑡𝑡) = (𝑟𝑟 + 𝛿𝛿)𝑝𝑝(𝑡𝑡) + 𝑠𝑠 − 𝑣𝑣 = (𝑟𝑟 + 𝛿𝛿)𝑝𝑝(𝑡𝑡) + 𝑠𝑠 − � � 𝑒𝑒 𝜀𝜀 𝑡𝑡
𝑞𝑞0.

The general solution to this differential equation is
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𝑝𝑝(𝑡𝑡) = 𝑒𝑒

(𝑟𝑟+𝛿𝛿)𝑡𝑡

�𝑝𝑝(0) +1−𝑒𝑒 −(𝑟𝑟+𝛿𝛿)𝑡𝑡(𝑟𝑟+𝛿𝛿)𝑎𝑎𝑠𝑠 − � �
𝑞𝑞0

𝛿𝛿+𝑔𝑔

1�
−�𝑟𝑟+𝛿𝛿− 𝜀𝜀 �𝑡𝑡
𝜀𝜀 1−𝑒𝑒�𝑟𝑟+𝛿𝛿−

𝛿𝛿+𝑔𝑔
�
𝜀𝜀

�

𝛿𝛿+𝑔𝑔

It turns out that this equation only makes sense if �𝑟𝑟 + 𝛿𝛿 −
� > 0, for otherwise the present value of the marginal value goes to𝜀𝜀infinity, so there is no possible finite initial price. Provided demand is elastic and discounting is larger than growth rates (which is an
implication of equilibrium in the credit market), this condition will be met.
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 agood investment for everyone at time 0, using the “buy and hold for resale” strategy. That is, lim 𝑒𝑒 −𝑟𝑟𝑟𝑟 𝑝𝑝(𝑡𝑡) < ∞. This condition𝑡𝑡→∞

implies1

𝛿𝛿+𝑔𝑔−�𝑟𝑟+𝛿𝛿−�𝑡𝑡

𝜀𝜀
1 − 𝑒𝑒 −(𝑟𝑟+𝛿𝛿)𝑡𝑡𝑎𝑎 �𝜀𝜀 1 − 𝑒𝑒𝑠𝑠 − � ��<∞lim 𝑒𝑒 𝛿𝛿𝛿𝛿 �𝑝𝑝(0) +𝛿𝛿 + 𝑔𝑔𝑡𝑡→∞(𝑟𝑟 + 𝛿𝛿)𝑞𝑞0
�𝑟𝑟 + 𝛿𝛿 −�𝜀𝜀and thus1𝑎𝑎 �𝜀𝜀1
𝑠𝑠 − � �
𝑝𝑝(0) +
(𝑟𝑟 + 𝛿𝛿)𝑞𝑞01

�𝑟𝑟 + 𝛿𝛿 −𝛿𝛿 + 𝑔𝑔�𝜀𝜀=0This equation may take on two different forms. First, it may be solvable for a non-negative price, which happens if
1

𝑎𝑎 �𝜀𝜀𝑝𝑝(0) = � �
𝑞𝑞0

1

1
−
𝑠𝑠 ≥ 0𝛿𝛿 + 𝑔𝑔(𝑟𝑟 + 𝛿𝛿)��𝑟𝑟 + 𝛿𝛿 −𝜀𝜀Second, it may require destruction of some of the endowment of the good. Destruction must happen if the quantity of the good 𝑞𝑞0 attime 0 satisfies
1

𝑎𝑎 �𝜀𝜀� �
𝑞𝑞01𝛿𝛿 + 𝑔𝑔��𝑟𝑟 + 𝛿𝛿 −𝜀𝜀−1𝑠𝑠 < 0(𝑟𝑟 + 𝛿𝛿)In this case, there is too much of the good, and an amount must be destroyed to make the initial price zero. Since the initial price iszero, the good is valueless at time zero, and destruction of the good makes sense – at the current quantity, the good is too costly tostore for future profits. Enough is destroyed to insure indifference between holding the good as a collectible and destroying it.
Consider, for example, the $500 confederate bill pictured in Figure 11.6.2. 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.

Figure 11.6.2: $500 Confederate States Bill
The amount of the good that must be destroyed is such that the initial price is zero. As 𝑞𝑞0 is the initial (pre-destruction) quantity, theamount at time zero after the destruction is the quantity 𝑞𝑞(0) satisfying
𝑝𝑝(0) = �

1

�𝜀𝜀
𝑎𝑎
�
𝑞𝑞(0)

1

𝛿𝛿 + 𝑔𝑔��𝑟𝑟 + 𝛿𝛿 −𝜀𝜀−Given this construction, we have that

Introduction to Economic Analysis

1
𝑠𝑠 = 0(𝑟𝑟 + 𝛿𝛿)

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1

�𝜀𝜀
1
𝑎𝑎
𝑝𝑝(0) +
𝑠𝑠 − �
�(𝑟𝑟 + 𝛿𝛿)𝑞𝑞(0)1�𝑟𝑟 + 𝛿𝛿 −𝛿𝛿 + 𝑔𝑔�𝜀𝜀=0where either 𝑞𝑞(0) = 𝑞𝑞0 and 𝑝𝑝(0) ≥ 0, 𝑞𝑞(0) < 𝑞𝑞0 and 𝑝𝑝(0) ≥ 0.

Destruction of a portion of the stock of a collectible, followed by price increases, is actually a quite common phenomenon. In
particular, consider the “Model 500” telephone by Western Electric illustrated in Figure 11.6.3. This ubiquitous classic phone wasretired as the US switched to tone dialing and push-button phones in the 1970s, and millions 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.

Figure 11.6.3: Western Electric Model 500 Telephone
The solution for 𝑝𝑝(0) dramatically simplifies the expression for 𝑝𝑝(𝑡𝑡):𝑝𝑝(𝑡𝑡) = 𝑒𝑒

(𝑟𝑟+𝛿𝛿)𝑡𝑡

�𝑝𝑝(0) +𝑝𝑝(𝑡𝑡) = 𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 �11−𝑒𝑒 −(𝑟𝑟+𝛿𝛿)𝑡𝑡(𝑟𝑟+𝛿𝛿)−𝑒𝑒 −(𝑟𝑟+𝛿𝛿)𝑡𝑡

�𝜀𝜀
𝑎𝑎
�
𝑝𝑝(𝑡𝑡) = �𝑞𝑞(0)(𝑟𝑟+𝛿𝛿)𝑒𝑒�

𝑠𝑠 − �

𝛿𝛿+𝑔𝑔
�𝑡𝑡
𝜀𝜀

𝑎𝑎

𝑎𝑎

𝑠𝑠 − �

𝑞𝑞(0)�

�𝑟𝑟+𝛿𝛿−𝑞𝑞(0)𝛿𝛿 + 𝑔𝑔�𝑟𝑟 + 𝛿𝛿 −
�
𝜀𝜀

�

𝛿𝛿+𝑔𝑔
1�
−�𝑟𝑟+𝛿𝛿− 𝜀𝜀 �𝑡𝑡
𝜀𝜀 1−𝑒𝑒1� −�𝑟𝑟+𝛿𝛿−𝛿𝛿+𝑔𝑔
𝜀𝜀 �𝑡𝑡
𝜀𝜀 𝑒𝑒
𝛿𝛿+𝑔𝑔
�
𝜀𝜀

−

𝛿𝛿+𝑔𝑔
�
𝜀𝜀

�𝑟𝑟+𝛿𝛿−��𝑠𝑠
𝑟𝑟 + 𝛿𝛿This 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 of prices 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.
Key Takeaways•

The price of collectibles includes two distinct sources of value – use value and investment value. The relevant use value is that of
the marginal user, a value which rises as the quantity falls or the population grows.

•

The use value to the marginal owner is found without reference to the price of the good. It grows at the destruction rate plus the
population growth rate, all divided by the demand elasticity.

•

The investment value net of storage must equal the interest rate.

•

If storage costs are high, equilibrium pricing may first involve destruction of some quantity of units.

•

Storage costs enter linearly into prices, so that growth rates are approximately unaffected by storage costs. That gold is easy tostore, while stamps and art require control of humidity and temperature to preserve value and are hence more expensive to store,affects the level of prices but not the growth rate. However, depreciation and the growth of population affect the growth rate, andthey do so in combination with the demand elasticity. With more elastic demand, prices grow more slowly and start at a lower
level.

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11.7 Summer Wheat
Learning Objectives•

How are the prices of storable goods – apples, potatoes or wheat – determined?

Typically, wheat harvested in the fall has to last until the following harvest. How should prices evolve over the season? If I know that
I need wheat in January, should I buy it at harvest 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 11.6 to determine the evolution of prices for commodities like wheat,corn, orange juice, and canola oil.
Unlike collectibles, buyers need not hold for their personal use, since there is no value in admiring the wheat in your home. Let 𝑝𝑝(𝑡𝑡)be the price at time 𝑡𝑡 and suppose that the year has length 𝑇𝑇. Generally there is a substantial amount of uncertainty regarding the sizeof 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, at which
point the new harvest comes in. It is such a model that is investigated in this section.
Let δ represent the depreciation rate (which for wheat includes the quantity eaten by rodents) and 𝑠𝑠 be the storage cost. Buying at time
𝑡𝑡 and reselling at 𝑡𝑡 + ∆ should be a break-even proposition. If one purchases at time 𝑡𝑡, it costs 𝑝𝑝(𝑡𝑡) to buy the good. Reselling at 𝑡𝑡 +∆, the storage cost is about 𝑠𝑠∆. (This is not the precisely relevant cost, but rather it is the present value of the storage cost, and hence
the restriction to small values of ∆.) The good depreciates to only have 𝑒𝑒 −𝛿𝛿∆ left to sell, and discounting reduces the value of thatamount by the factor 𝑒𝑒 −𝑟𝑟∆ . For this to be a breakeven proposition, for small ∆,𝑒𝑒 −𝛿𝛿∆ 𝑒𝑒 −𝑟𝑟∆ 𝑝𝑝(𝑡𝑡 + ∆) − 𝑠𝑠∆= 𝑝𝑝(𝑡𝑡)or

𝑝𝑝(𝑡𝑡 + ∆) − 𝑝𝑝(𝑡𝑡) 1 − 𝑒𝑒 −(𝑟𝑟+𝛿𝛿)∆=
𝑝𝑝(𝑡𝑡 + ∆) + 𝑠𝑠∆∆
Taking the limit as ∆→ 0,𝑝𝑝′ (𝑡𝑡) = (𝑟𝑟 + 𝛿𝛿)𝑝𝑝(𝑡𝑡) + 𝑠𝑠

This arbitrage condition insures that it is a break-even proposition to invest in the good; the profits from the price appreciation areexactly balanced by depreciation, interest and storage costs. We can solve the differential equation to obtain:
𝑝𝑝(𝑡𝑡) = 𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 �𝑝𝑝(0) +1 − 𝑒𝑒 −(𝑟𝑟+𝛿𝛿)𝑡𝑡𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 − 1
𝑠𝑠� = 𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 𝑝𝑝(0) +𝑠𝑠
𝑟𝑟 + 𝛿𝛿
𝑟𝑟 + 𝛿𝛿

The unknown is 𝑝𝑝(0). The constraint on 𝑝𝑝(0), however, is like the resource extraction problem – 𝑝𝑝(0) is determined by the need touse up the harvest over the course of the year.

Suppose demand has constant elasticity ε. Then the quantity used comes in the form 𝑥𝑥(𝑡𝑡) = 𝑎𝑎𝑝𝑝(𝑡𝑡)−𝜀𝜀 . Let 𝑧𝑧(𝑡𝑡) represent the stock attime 𝑡𝑡. Then the equation for the evolution of the stock is 𝑧𝑧 ′ (𝑡𝑡) = −𝑥𝑥(𝑡𝑡) − 𝛿𝛿𝛿𝛿(𝑡𝑡). This equation is obtained by noting that the flowout of stock is composed of two elements: depreciation δ𝑧𝑧 and consumption 𝑥𝑥. The stock evolution equation solves for𝑧𝑧(𝑡𝑡) = 𝑒𝑒

−𝛿𝛿𝛿𝛿

𝑡𝑡

�𝑞𝑞(0) − � 𝑒𝑒 𝛿𝛿𝛿𝛿 𝑥𝑥(𝑢𝑢)𝑑𝑑𝑑𝑑�
0Thus, the quantity of wheat is consumed exactly if𝑇𝑇𝑞𝑞(0) = � 𝑒𝑒 𝛿𝛿𝛿𝛿 𝑥𝑥(𝑢𝑢)𝑑𝑑𝑑𝑑
0

But this equation determines the initial price through
𝑇𝑇

𝑇𝑇

𝑇𝑇

𝑞𝑞(0) = � 𝑒𝑒 𝑥𝑥(𝑢𝑢)𝑑𝑑𝑑𝑑 = � 𝑒𝑒 𝑎𝑎𝑝𝑝(𝑢𝑢) 𝑑𝑑𝑑𝑑 = � 𝑒𝑒 𝛿𝛿𝛿𝛿 𝑎𝑎 �𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 𝑝𝑝(0) +
0

𝛿𝛿𝛿𝛿

0

𝛿𝛿𝛿𝛿

−𝜀𝜀

0

𝑒𝑒 (𝑟𝑟+𝛿𝛿)𝑡𝑡 − 1𝑠𝑠�
𝑟𝑟 + 𝛿𝛿

−𝜀𝜀

𝑑𝑑𝑑𝑑This 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.

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Generally, the price equation produces a “saw-tooth” pattern, which is illustrated in Figure 11.7.1. The increasing portion is actuallyan exponential, but of such a small degree that it looks linear. When the new harvest comes in, prices drop abruptly as the inventory
grows dramatically, and the same pattern is repeated.
0.4

0.3

0.2

0.1

1

2

3

4

Figure 11.7.1: Prices over a Cycle for Seasonal Commodities
How well does the theory work? Figure 11.7.2 shows the log of the future price of gold over time. The relevant data comes from afutures 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 the real world, risk plays asalient role.) We can observe that prices are approximately an exponential, because the log of prices is approximately linear.
However, the estimate of 𝑟𝑟 + 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.

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 11.7.2: Log of Price of Gold over Time
Key Takeaways•

There is a seasonal pattern to goods that are produced periodically. The price equation produces a “saw-tooth” pattern. The
increasing portion is an exponential.

•

Gold prices show evidence of exponential growth predicted by the theory.
Exercises

11.7.1

Consider a market for a commodity that can be stored with zero cost from winter to summer but cannot be stored from𝑑𝑑
= 50 − 2𝑃𝑃𝑤𝑤 and 𝑄𝑄𝑤𝑤𝑠𝑠 = 3𝑃𝑃𝑤𝑤 and the summer demand and supply
summer to winter. The winter demand and supply are 𝑄𝑄𝑤𝑤
𝑑𝑑𝑠𝑠
are 𝑄𝑄𝑠𝑠 = 100 − 3𝑃𝑃𝑠𝑠 and 𝑄𝑄𝑠𝑠 = 𝑃𝑃𝑠𝑠 . Compute equilibrium prices and quantities for winter and summer, and the amount ofhoarding from winter to summer. (Set discounting to zero).

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12

Consumer Theory

Consumer theory is to demand as producer theory is to supply. The major difference is that producer theory assumes that sellers are
motivated by profit, and profit is something that one can usually directly measure. Moreover, the costs that enter into profit arise fromphysical properties of the production process – how many coffee cups come from the coffee cup manufacturing plant? In contrast,
consumer theory is based on what people like, so it begins with something that we can’t directly measure, but must 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 this toothpaste 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.

12.1 Utility Maximization
Learning Objectives•

How do economists model consumer choice?

Economists use the term utility in a peculiar and idiosyncratic way. Utility refers not to usefulness but to the flow of pleasure orhappiness that a person enjoys – some measure of 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, wewill attempt to avoid making value judgments about the preferences a consumer holds – whether they like smoking cigarettes or eating
only carrots, watching Arnold Schwarzenegger movies or spending time with a hula hoop. Consumers like whatever it is that theylike; the economic assumption is that they attempt to obtain the goods that they like. It is the consequences of the pursuit of happinessthat comprise the core of consumer theory.
In this chapter, we will focus on two goods. In many cases, the generalization to an arbitrary 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 consumptionof a bunch of other goods.53
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 capitalletters to indicate the good and a lower case letter to indicate the quantity consumed. If X is rutabagas, a consumer who ate three ofthem would have 𝑥𝑥 = 3. How can we represent preferences for this consumer? To fix ideas, suppose the consumer is both hungry
and thirsty and the goods are beer and pizza. The consumer would like more of both, reflected in greater pleasure for greater
consumption. Items one might consume are generally known as “bundles,” as in bundles of goods and services, and less frequently as“tuples,” a short-form for the “n-tuple,” meaning a list of n quantities. Since we will focus on two goods, both of these terms are
strained in the application; a bundle because a bundle of two things isn’t much of a bundle, and a tuple because what we have here is a
“two-tuple,” also known as a 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 a bundle produces
more than another, or less, or the same. Let 𝑢𝑢(𝑥𝑥, 𝑦𝑦) represent the utility a consumer gets from consuming 𝑥𝑥 units of beer and 𝑦𝑦 unitsof pizza. The function 𝑢𝑢 guides the consumer’s choice, in the sense that, if the consumer can choose either (𝑥𝑥1 , 𝑦𝑦1 ) or (𝑥𝑥2 , 𝑦𝑦2 ), we
expect him to choose (𝑥𝑥1 , 𝑦𝑦1 ) if 𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) > 𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ).
But notice that a doubling of u would lead to the same choices, because
𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) > 𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ) if and only if 2𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) > 2𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ).

53Thus, for example, savings for future consumption, or to provide for descendents, or to give to your alma mater, are all examples ofconsumption. Our consumer will, in the end, always spend all of her income, although this happens because we adopt a very broad
notion of spending. In particular, savings are “future spending.”
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Thus, doubling the utility doesn’t change the preferences of the consumer. But the situation is more extreme than this. Even
exponentiating the utility doesn’t change the consumer’s preferences, because
𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) > 𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ) if and only if 𝑒𝑒 𝑢𝑢(𝑥𝑥1,𝑦𝑦1) > 𝑒𝑒 𝑢𝑢(𝑥𝑥2,𝑦𝑦2 ) .

Another way to put this is that there are no natural units for utility, at least until such time as we are able to measure pleasure in thebrain.
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.
Key Takeaways•

Consumer theory is to demand as producer theory is to supply.

•

Consumer theory is based on the premise that we can infer what people like from the choices they make.

•Utility refers not to usefulness but to the flow of pleasure or happiness that a person enjoys – some measure of the satisfaction aperson experiences.

•

There are no natural units for utility; any increasing transformation is acceptable.
Key Terms•

Utility: Flow of pleasure or happiness from experiences

12.2 Budget or Feasible Set
Learning Objectives•

How does income limit choice?

Suppose a consumer has a fixed amount of money to spend, 𝑀𝑀. There are two goods 𝑥𝑥 and 𝑦𝑦, with associated prices 𝑝𝑝𝑥𝑥 and 𝑝𝑝𝑦𝑦 . The
feasible choices the consumer can make satisfy 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 ≤ 𝑀𝑀. In addition, we will focus on consumption and rule out negative
consumption, so 𝑥𝑥 ≥ 0 and 𝑦𝑦 ≥ 0. This gives a budget set or feasible set illustrated in Figure 12.2.1. The budget line is the boundaryof the budget set, and exhausts the budget.
yM
pY
Budget Line

Budget Set

x

M
pX
Figure 12.2.1: Budget Set

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In this diagram, the feasible set of purchases that satisfy the budget constraint are illustrated with shading. If the consumer spends all𝑀𝑀𝑀𝑀
her money on 𝑥𝑥, she can consume the quantity 𝑥𝑥 = . Similarly, if she spends all of her money on 𝑦𝑦, she consumes 𝑦𝑦 = units of 𝑦𝑦.
𝑝𝑝𝑥𝑥

𝑝𝑝𝑦𝑦

The straight line between them, known as the budget line, represents the most of the goods she can consume. The slope of the budget𝑝𝑝line is − 𝑥𝑥 .
𝑝𝑝𝑦𝑦

An increase in the price of one good pivots or rotates the budget line. Thus, if the price of 𝑥𝑥 increases, the endpoint
same, but
y

𝑀𝑀

𝑝𝑝𝑥𝑥

decreases. This is illustrated in Figure 12.2.2.

𝑀𝑀

𝑝𝑝𝑦𝑦

remains theM
pY
Budget Line
PivotsM
pX

x

Figure 12.2.2: Effect of an Increase in Price on the Budget
The effect of increasing the available money 𝑀𝑀 is to increase both

𝑀𝑀

𝑝𝑝𝑥𝑥

and

𝑀𝑀

𝑝𝑝𝑦𝑦

proportionately. This means an increase in 𝑀𝑀 shifts thebudget line out (away from the origin) in a parallel fashion, as in Figure 12.2.3.

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pY

Budget Line
shifts out as
M risesx

M
pX
Figure 12.2.3: An Increase in Income

An increase in both prices by the same proportional factor has an effect identical to a decrease in income. Thus, one of the threefinancial 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 𝑝𝑝𝑥𝑥 to be the number 1 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 to that
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 the value 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 in the 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 moneytranslate directly into one another and the existence of the time constraint won’t present significant challenges to the theory. The
conventional way to handle the time constraint is to use as a baseline working “full out,” and then view leisure as a good which ispurchased at a price equal to the wage. Thus, if you earn $20/hour, we would set your budget at $480/day, reflecting 24 hours ofwork, but then permit you to buy leisure time, during which eating, sleeping, brushing teeth and every other non-work activity isaccomplished at a price equal to $20 per hour.
Key Takeaways•

The budget set or feasible set is the set of goods the consumer can afford to purchase.

•

The budget line is the pairs of goods that exactly spend the budget. The budget line shifts out when income rises and pivots when
the price of one good changes.

•

Increasing prices and income by the same multiplicative factor leaves the feasible set unchanged.
Key Terms•

Budget set: Sets of goods a consumer can afford•

Feasible set: Same as a budget set•

Budget line: Sets of goods that just exhaust the consumer's budget•

Numeraire: A good used as a reference good, so that prices are denominated in units of that good

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Exercises
12.2.1Graph the budget line for apples and oranges, with prices of $2 and $3 respectively and $60 to spend. Now increase the priceof apples from $2 to $4 and draw the budget line.

12.2.2

Suppose that apples cost $1 each. Water can be purchased for 5 cents per gallon up to 200 gallons, and 1 cent per gallon foreach gallon beyond 200 gallons. Draw the budget constraint for a consumer who spends $200 per month on apples andwater.

12.2.3Graph 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.

12.3 Indifference Curves
Learning Objectives•

What is an indifference curve?

•

Why does it help analyze consumer choice?

With two goods, we can graphically represent utility by considering the contour map of utility. Utility contours are known as
indifference curves, since the consumer is indifferent between points on the line. 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 here is that theoutput being produced is consumer “utility” instead of a single good or service.

y
1

0.8
u=5

0.6

u=4

u=3

0.4
u=2

0.2
u=1

0
0

0.2

0.4

0.6

0.8

1

x

Figure 12.3.1: Indifference Curves
Figure 12.3.1 provides an illustration of indifference curves. Each curve represents one level of utility. Higher utilities occur to thenortheast, further away from the origin. As with production isoquants, the slope of the indifference curves has the interpretation of the
tradeoff between the two goods. The amount of 𝑦𝑦 that the consumer is willing to give up to obtain an extra bit of 𝑥𝑥 is the slope of theindifference curve. Formally, the equation 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑢𝑢0 defines an indifference curve for the reference utility 𝑢𝑢0 . Differentiating insuch a way as to preserve the equality, we obtain the slope of the indifference curve:

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑
𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑 +
𝑑𝑑𝑑𝑑 = 0 or�
= − 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

This slope is known as the marginal rate of substitution and reflects the tradeoff, from the consumer’s perspective, between the goods.
That is to say, the marginal rate of substitution (of 𝑦𝑦 for 𝑥𝑥) is the amount of 𝑦𝑦 the consumer is willing to lose to obtain an extra unit of𝑥𝑥.
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An important assumption concerning indifference curves is reflected in the diagram: “midpoints are preferred to extreme points.”
Suppose the consumer is indifferent between (𝑥𝑥1 , 𝑦𝑦1 ) and (𝑥𝑥2 , 𝑦𝑦2 ), that is, 𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) = 𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ). Then we say preferences areconvex if any point on the line segment connecting (𝑥𝑥1 , 𝑦𝑦1 ) and (𝑥𝑥2 , 𝑦𝑦2 ) is at least as good as the extremes. Formally, a point on theline segment connecting (𝑥𝑥1 , 𝑦𝑦1 ) and (𝑥𝑥2 , 𝑦𝑦2 ) comes in the form (𝛼𝛼𝑥𝑥1 + (1 − 𝛼𝛼)𝑥𝑥2 , 𝛼𝛼𝑦𝑦1 + (1 − 𝛼𝛼)𝑦𝑦2 ) for 0 ≤ 𝛼𝛼 ≤ 1. This is also
known as a “convex combination” between the two points. When 𝛼𝛼 = 0, the segment starts at (𝑥𝑥2 , 𝑦𝑦2 ) and proceeds in a linear
fashion to (𝑥𝑥1 , 𝑦𝑦1 ) at 𝛼𝛼 = 1. Preferences are convex if, for any 0 < 𝛼𝛼 < 1, 𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ) = 𝑢𝑢(𝑥𝑥2 , 𝑦𝑦2 ) implies 𝑢𝑢(𝛼𝛼𝑥𝑥1 + (1 − 𝛼𝛼)𝑥𝑥2 , 𝛼𝛼𝑦𝑦1 +(1 − 𝛼𝛼)𝑦𝑦2 ) ≥ 𝑢𝑢(𝑥𝑥1 , 𝑦𝑦1 ).

This property is illustrated in Figure 12.3.2. The line segment that connects two points on the indifference curve lies to the northeastof the indifference curve, which means the line 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 theconsumer’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

x
0.2

0.4

0.6

0.8

1

Figure 12.3.2: Convex Preferences
How does a consumer choose which bundle to select? The consumer is faced with the problem of maximizing 𝑢𝑢(𝑥𝑥, 𝑦𝑦) subject to𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 ≤ 𝑀𝑀. We can derive the solution to the consumer’s problem as follows. First, “solve” the budget constraint 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 ≤𝑀𝑀 for 𝑦𝑦, to obtain 𝑦𝑦 ≤𝑀𝑀−𝑝𝑝𝑥𝑥 𝑥𝑥
𝑝𝑝𝑦𝑦. If 𝑦𝑦 is a good (as contrasted with a ‘bad’), this constraint will be satisfied with equality and all themoney will be spent. Thus, we can write the consumer’s utility as𝑢𝑢 �𝑥𝑥,𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥
�𝑝𝑝𝑦𝑦

The first order condition for this problem, maximizing it over 𝑥𝑥, has𝑑𝑑𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥
𝜕𝜕𝜕𝜕 𝑝𝑝𝑥𝑥 𝜕𝜕𝜕𝜕𝑢𝑢 �𝑥𝑥,
�=
−
=0
𝑑𝑑𝑑𝑑
𝑝𝑝𝑦𝑦
𝜕𝜕𝜕𝜕 𝑝𝑝𝑦𝑦 𝜕𝜕𝜕𝜕This can be re-arranged to obtain the marginal rate of substitution (MRS).
𝜕𝜕𝜕𝜕
𝑝𝑝𝑥𝑥
𝑑𝑑𝑑𝑑
= 𝜕𝜕𝜕𝜕 = − �= 𝑀𝑀𝑀𝑀𝑀𝑀
𝑝𝑝𝑦𝑦 𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0
𝜕𝜕𝜕𝜕
.

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The first order condition requires that the slope of the indifference curve equals the slope of the budget line, that is, there is a tangency
between the indifference curve and the budget line. This is illustrated in Figure 12.3.3. Three indifference curves are drawn, two of
which intersect the budget line, but are not tangent. At these intersections, it is possible to increase utility by moving “toward thecenter,” 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 the highest utility for the consumer.
It will later prove useful to also state the second order condition for this to be a maximum, although we won’t use this condition now:2

𝑑𝑑 2
𝜕𝜕 2 𝑢𝑢
𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥
𝜕𝜕 2 𝑢𝑢
𝑝𝑝𝑥𝑥 𝜕𝜕 2 𝑢𝑢
𝑝𝑝𝑥𝑥
𝑢𝑢 �𝑥𝑥,
�=
−
+� �
≤0
2
2
(𝑑𝑑𝑑𝑑)(𝜕𝜕𝜕𝜕)
𝑝𝑝𝑦𝑦 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
𝑝𝑝𝑦𝑦 (𝜕𝜕𝜕𝜕)2
𝑝𝑝𝑦𝑦
Note that the vector �𝑢𝑢𝑥𝑥 , 𝑢𝑢𝑦𝑦 � = �𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕

,𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕

� is the gradient of 𝑢𝑢, and the gradient points in the direction of steepest ascent of the function

𝑢𝑢. Second, the equation which characterizes the optimum,
𝑝𝑝𝑥𝑥

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
− 𝑝𝑝𝑦𝑦= � , � ⋅ �−𝑝𝑝𝑦𝑦 , 𝑝𝑝𝑥𝑥 � = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕

y

M
pY

M
pX

x

Figure 12.3.3: Graphical Utility Maximization
where ⋅ is the “dot product” which multiplies the components of vectors and then adds them, says that the vectors �𝑢𝑢𝑥𝑥 , 𝑢𝑢𝑦𝑦 � and�−𝑝𝑝𝑦𝑦 , 𝑝𝑝𝑥𝑥 � are perpendicular, and hence that the rate 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 are three ways it can fail. First, the utility might not
be differentiable. We will set aside this kind of failure with the remark that fixing points of non-differentiability is mathematicallychallenging but doesn’t lead to significant alterations in the theory. The second failure is that a tangency didn’t maximize utility.
Figure 12.3.4 illustrates this case. Here, there is a tangency, but it doesn’t maximize utility. In Figure 12.3.4, the dotted indifference
curve maximizes utility given the budget constraint (straight line). This is exactly the kind of failure that is ruled out by convex
preferences. In Figure 12.3.4, preferences are not convex, because if we connect two points on the indifference curves and look at aconvex combination, we get something less preferred, with lower utility, not more preferred as convex preferences would require.

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Figure 12.3.4: “Concave” Preferences: Prefer Boundaries
The third failure is more fundamental: the derivative might fail to be zero because we’ve hit the boundary of 𝑥𝑥 = 0 or 𝑦𝑦 = 0. This is afundamental problem because in fact there are many 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 todeal with it: convex preferences. As we shall see, convex preferences insure that the consumer’s maximization problem is “wellbehaved.”
Key Takeaways•

Indifference curves, and represent sets of points holding utility constant. They are analogous to production isoquants.

•

Preferences are said to be convex if the any point on the line segment connecting a pair of points with equal utility is preferred tothe endpoints. This means that whenever the consumer is indifferent between two points, they prefer a mix of the two.

•

The first order conditions for the maximizing utility involve equating the marginal rate of substitution and the price ratio.

•

At the maximum, the rate of steepest ascent of the utility function is perpendicular to the budget line.

•

There are two main ways that the first order conditions fail to characterize the optimum: the consumer doesn’t have convex
preferences or the optimum involves a zero consumption of one or more goods.
Key Terms•

Indifference curves: sets of goods that produce equal utility, aka isoutility curve•

Marginal rate of substitution (MRS): The amount extra of one good needed to make up for a decrease in the another good, staying
on an indifference curve

12.4 Examples
Learning Objectives•

Are there any convenient functional forms for analyzing consumer choice?

The Cobb-Douglas utility function comes in the form 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 𝛼𝛼 𝑦𝑦1−𝛼𝛼 . Since utility is zero if either of the goods is zero, we see thata consumer with Cobb-Douglas preferences will always buy some of each good. The marginal rate of substitution for Cobb-Douglas
utility is
𝜕𝜕𝑢𝑢
𝛼𝛼𝛼𝛼
𝑑𝑑𝑑𝑑
= 𝜕𝜕𝜕𝜕 =− �
𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0 𝜕𝜕𝜕𝜕 (1 − 𝛼𝛼)𝑥𝑥
𝜕𝜕𝜕𝜕Introduction to Economic Analysis

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Thus, the consumer’s utility maximization problem yields
𝜕𝜕𝜕𝜕
𝑝𝑝𝑥𝑥
𝑑𝑑𝑑𝑑
𝛼𝛼𝛼𝛼
=− �
= 𝜕𝜕𝜕𝜕 =
𝜕𝜕𝜕𝜕
(1
𝑝𝑝𝑦𝑦
𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0− 𝛼𝛼)𝑥𝑥𝜕𝜕𝜕𝜕Thus, using the budget constraint, (1 − 𝛼𝛼)𝑝𝑝𝑥𝑥 𝑥𝑥 = 𝛼𝛼𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝛼𝛼(𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥)
This yields 𝑥𝑥 =

𝛼𝛼𝛼𝛼
𝑝𝑝𝑥𝑥

, 𝑦𝑦 =(1−𝛼𝛼)𝑀𝑀
𝑝𝑝𝑦𝑦

Cobb-Douglas utility results in constant expenditure shares. No matter what the price of x or 𝑦𝑦, the expenditure 𝑝𝑝𝑥𝑥 𝑥𝑥 on 𝑥𝑥 is α𝑀𝑀.
Similarly, the expenditure on 𝑦𝑦 is (1 − 𝛼𝛼)𝑀𝑀. This makes the Cobb-Douglas utility very useful for computing examples andhomework exercises.

When two goods are perfect complements, they are consumed proportionately. The utility that gives rise to perfect complements is in
the form 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = min{𝑥𝑥, 𝛽𝛽𝛽𝛽} for some constant 𝛽𝛽 (the Greek letter beta). First observe that with perfect complements, consumers

will buy in such a way that 𝑥𝑥 = 𝛽𝛽𝛽𝛽. The reason is that, if 𝑥𝑥 > 𝛽𝛽𝛽𝛽, some expenditure on 𝑥𝑥 is a waste since it brings in no additional
utility, and the consumer gets higher utility by decreasing 𝑥𝑥 and increasing 𝑦𝑦. This lets us define a “composite good” which involves𝑀𝑀. Inbuying 1 unit of 𝑦𝑦 and also buying β of 𝑥𝑥. The price of this composite commodity is 𝛽𝛽𝑝𝑝𝑥𝑥 + 𝑝𝑝𝑦𝑦 , and it produces utility𝑢𝑢 =this way, perfect complements boil down to a single good problem.

𝛽𝛽𝑝𝑝𝑥𝑥 +𝑝𝑝𝑦𝑦

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

0.2

u=30
u=20
u=10

0
0

0.2

0.4

0.6

0.8

1

x

Figure 12.4.1: Indifference curves 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 12.4.1. 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 a zero value of money, but even very wealthy people, whoreach satiation in goods that they personally consume, often like to do other things with the wealth and appear not to have reachedsatiation overall.

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Key Takeaways•

Cobb-Douglas utility results in constant expenditure shares.

•

When two goods are perfect complements, they are consumed proportionately. Perfect complements boil down to a single good
problem.

•A bliss point or satiation is a point at which further increases in consumption reduce utility.
Key Terms•

Satiation : A point where increased consumption does not increase utility•

Bliss point: A point that maximizes utility
Exercises

12.4.112.4.2

Consider a consumer with utility 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = �𝑥𝑥𝑥𝑥. If the consumer has $100 to spend, and the price of 𝑥𝑥 is $5 and the price of
𝑦𝑦 is $2, graph the budget line, and then find the point that maximizes the consumer’s utility given the budget. Draw theutility isoquant through this point. What are the expenditure shares?
Consider a consumer with utility 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = �𝑥𝑥𝑥𝑥. Calculate the slope of the indifference curve directly, by solving 𝑢𝑢(𝑥𝑥, 𝑦𝑦) =𝑢𝑢0 for 𝑦𝑦 as a function of 𝑥𝑥 and the utility level 𝑢𝑢0 . What is the slope −above.

12.4.312.4.5? Verify that it satisfies the formula given

𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0

The case of perfect substitutes arises when all that matters to the consumer is the sum of the products – e.g. red shirts andgreen shirts for a color-blind consumer. In this case, 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 + 𝑦𝑦. Graph the indifference curves for perfect substitutes.
Show that the consumer maximizes utility by spending her entire income on whichever product is cheaper.
Suppose 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 𝛼𝛼 + 𝑦𝑦 𝛼𝛼 for 𝛼𝛼 < 1. Show𝑥𝑥 =12.4.6

�

𝑑𝑑𝑑𝑑 𝑢𝑢=𝑢𝑢0

Consider a consumer with utility 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = (𝑥𝑥𝑥𝑥)2 . Calculate the slope of the indifference curve directly, by solving
𝑑𝑑𝑑𝑑? Verify that the result is the same𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑢𝑢0 for 𝑦𝑦 as a function of 𝑥𝑥 and the utility level 𝑢𝑢0 . What is the slope − �
as in the previous exercise. Why is it the same?

12.4.4

𝑑𝑑𝑑𝑑

𝑀𝑀

𝑀𝑀
𝑝𝑝𝑦𝑦 𝛼𝛼 𝑎𝑎𝑎𝑎𝑎𝑎 𝑦𝑦 =𝑝𝑝𝑥𝑥 𝛼𝛼𝑝𝑝𝑥𝑥 �1 + � � �
𝑝𝑝
�1
+
�
� �
𝑦𝑦
𝑝𝑝𝑥𝑥
𝑝𝑝𝑦𝑦

Suppose one consumer has the utility function 𝑢𝑢 (which is always a positive number), and a second consumer has utility 𝑤𝑤.
2
Suppose, in addition, that for any nonnegative 𝑥𝑥, 𝑦𝑦, 𝑤𝑤(𝑥𝑥, 𝑦𝑦) = �𝑢𝑢(𝑥𝑥, 𝑦𝑦)� , that is, the second person’s utility is the square of
the first. Show that these consumers make the same choices – that is 𝑤𝑤(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 ) ≥ 𝑤𝑤(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ), if and only if 𝑢𝑢(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 ) ≥𝑢𝑢(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ).

12.5 Substitution Effects

Learning Objectives•

When prices change, how do consumers change their behavior?

An increase in the price of a good is really a composition of two effects: an increase in the relative 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 thechange in the relative price, with a sufficient change in income to keep the consumer on the same indifference curve.54 The income
effect changes only income.

54

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.
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ChoiceCompensatedDemandpY ↑x
Figure 12.5.1: The Substitution Effect

To graphically illustrate the substitution effect, consider Figure 12.5.1. The starting point is the tangency between the indifference
curve and the budget line, denoted with a diamond shape 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 dashedline until the original indifference curve 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 wehave compensated the consumer for the price increase by increasing income just enough to leave her unharmed, on the same isoquant.
The substitution effect is just the difference between these points – the substitution in response to the price change, holding constantthe utility of the consumer.
We can readily see that the substitution effect of a price increase in y is to decrease the consumption of y and increase theconsumption of y.55 The income effect is the change in consumption resulting from the change in income. The effect of any change
in price can 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 power arising from the price increase.
Example (Cobb-Douglas): Recall that the Cobb-Douglas utility comes in the form 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 𝛼𝛼 𝑦𝑦1−𝛼𝛼 . Solving for x, y we obtain𝑥𝑥 =(1 − 𝛼𝛼)𝑀𝑀𝑀𝑀𝛼𝛼𝛼𝛼, 𝑦𝑦 =, and 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝛼𝛼 𝛼𝛼 (1 − 𝛼𝛼)1−𝛼𝛼 𝛼𝛼 1−𝛼𝛼𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥
𝑝𝑝𝑦𝑦

Thus, consider a multiplicative increase ∆ in 𝑝𝑝𝑦𝑦 , that is, multiplying 𝑝𝑝𝑦𝑦 by ∆> 1. In order to leave utility constant, M must rise by∆1−𝛼𝛼 . Thus, x rises by the factor ∆1−𝛼𝛼 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 𝑝𝑝𝑦𝑦 for any given utility function, not necessarily Cobb-Douglas? To
address this question, it is helpful to introduce some notation. We will subscript the utility to indicate partial derivative, that is,
𝑢𝑢1 =

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
, 𝑢𝑢2 =
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕Note that, by the definition of the substitution effect, we are holding utility constant, so 𝑢𝑢(𝑥𝑥, 𝑦𝑦) is being held constant. This means,
locally, that 𝑑𝑑𝑑𝑑 = 𝑢𝑢1 𝑑𝑑𝑑𝑑 + 𝑢𝑢2 𝑑𝑑𝑑𝑑 = 0.56

In addition, we have 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀 so55

To construct a formal proof, first show that if pY rises and y rises, holding utility constant, the initial choice prior to the priceincrease 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.
56

Writing dx for an unknown infinitesimal change in x can be put on a formal basis. The easiest way to do so is to think of dx as
representing the derivative of x with respect to a parameter, which will be py.
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𝑑𝑑𝑑𝑑 = 𝑝𝑝𝑥𝑥 𝑑𝑑𝑑𝑑 + 𝑝𝑝𝑦𝑦 𝑑𝑑𝑑𝑑 + 𝑦𝑦𝑦𝑦𝑝𝑝𝑦𝑦

Finally, we have the optimality condition
𝜕𝜕𝜕𝜕
𝑝𝑝𝑥𝑥
= 𝜕𝜕𝜕𝜕
𝑝𝑝𝑦𝑦 𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕

𝜕𝜕2 𝑢𝑢which is convenient to write as 𝑝𝑝𝑥𝑥 𝑢𝑢1 = 𝑝𝑝𝑦𝑦 𝑢𝑢2. Differentiating this equation, and defining 𝑢𝑢11 = (𝜕𝜕𝜕𝜕)2, 𝑢𝑢12 =have𝑝𝑝𝑥𝑥 (𝑢𝑢12 𝑑𝑑𝑑𝑑 + 𝑢𝑢22 𝑑𝑑𝑑𝑑) = 𝑢𝑢1 𝑑𝑑𝑝𝑝𝑦𝑦 + 𝑝𝑝𝑦𝑦 (𝑢𝑢11 𝑑𝑑𝑑𝑑 + 𝑢𝑢12 𝑑𝑑𝑑𝑑)

𝜕𝜕2 𝑢𝑢𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

𝜕𝜕2 𝑢𝑢, and 𝑢𝑢22 = (𝜕𝜕𝜕𝜕)2, we

For a given 𝑑𝑑𝑝𝑝𝑦𝑦 , we now have three equations in three unknowns 𝑑𝑑𝑑𝑑, 𝑑𝑑𝑑𝑑, and 𝑑𝑑𝑑𝑑. However, 𝑑𝑑𝑑𝑑 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:𝑢𝑢1 𝑑𝑑𝑑𝑑 + 𝑢𝑢2 𝑑𝑑𝑑𝑑 = 0 and 𝑝𝑝𝑥𝑥 (𝑢𝑢12 𝑑𝑑𝑑𝑑 + 𝑢𝑢22 𝑑𝑑𝑑𝑑) = 𝑢𝑢1 𝑑𝑑𝑝𝑝𝑦𝑦 + 𝑝𝑝𝑦𝑦 (𝑢𝑢11 𝑑𝑑𝑑𝑑 + 𝑢𝑢12 𝑑𝑑𝑑𝑑) for the two unknowns 𝑑𝑑𝑑𝑑 and 𝑑𝑑𝑑𝑑. This isstraightforward and yields:
𝑝𝑝𝑦𝑦 𝑢𝑢1
𝑑𝑑𝑑𝑑=− 2
𝑝𝑝𝑥𝑥 𝑢𝑢11 + 2𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦 𝑢𝑢12 + 𝑝𝑝𝑦𝑦 2 𝑢𝑢22
𝑑𝑑𝑝𝑝𝑦𝑦and𝑝𝑝𝑦𝑦 𝑢𝑢2
𝑑𝑑𝑑𝑑=− 2
𝑝𝑝𝑥𝑥 𝑢𝑢11 + 2𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦 𝑢𝑢12 + 𝑝𝑝𝑦𝑦 2 𝑢𝑢22
𝑑𝑑𝑝𝑝𝑦𝑦These equations imply that x rises and y falls.57 We immediately see
𝑑𝑑𝑑𝑑
𝑑𝑑𝑝𝑝𝑦𝑦
𝑢𝑢1
𝑝𝑝𝑥𝑥
=− =−
𝑑𝑑𝑑𝑑
𝑢𝑢2
𝑝𝑝𝑦𝑦
𝑑𝑑𝑝𝑝𝑦𝑦Thus, the change in (𝑥𝑥, 𝑦𝑦) follows the budget line locally. (This is purely a consequence of holding utility constant.)

To complete the thought while we are embroiled in these derivatives, note that 𝑝𝑝𝑥𝑥 𝑢𝑢2 = 𝑝𝑝𝑦𝑦 𝑢𝑢1 implies that 𝑝𝑝𝑥𝑥 𝑑𝑑 + 𝑝𝑝𝑦𝑦 𝑑𝑑𝑑𝑑 = 0.

Thus, the amount of money necessary to compensate the consumer for the price increase, keeping utility constant, can be calculated
from our third equation:
𝑑𝑑𝑑𝑑 = 𝑝𝑝𝑥𝑥 𝑑𝑑𝑑𝑑 + 𝑝𝑝𝑦𝑦 𝑑𝑑𝑑𝑑 + 𝑦𝑦𝑦𝑦𝑝𝑝𝑦𝑦 = 𝑦𝑦𝑦𝑦𝑝𝑝𝑦𝑦

The amount of income necessary to ensure the consumer makes no losses from a price increase in y is the amount that lets them buy
the bundle they originally purchased, that is, 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.

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, an increase 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, the quantity of y demanded rises. Goods having this property
are called Giffen goods, after Sir Robert Giffen who proposed their existence. Empirical evidence for the existence of Giffen goods
outside the world of economics textbooks has been quite limited.

This is a consequence of the fact that 𝑝𝑝𝑥𝑥 2 𝑢𝑢11 + 2𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦 𝑢𝑢12 + 𝑝𝑝𝑦𝑦 2 𝑢𝑢22 < 0, which follows from the already stated second ordercondition for a maximum of utility.
57

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Figure 12.5.2: Substitution with an Increase in Price

Key Takeaways•

An increase in the price of a good is really a composition of two effects: an increase in the relative price of the good, and adecrease in the purchasing power of money. It is useful to examine these two effects separately. The substitution effect considers
the change in the relative price, with a sufficient change in income to keep the consumer on the same utility isoquant. The income
effect changes only income.

•The substitution effect is the change in consumption resulting from a price change keeping utility constant. The substitution
effect always involves a reduction in the good whose price increased.

•

The amount of money required to keep the consumer’s utility constant from an infinitesimal price increase is precisely the amountrequired to let them buy their old bundle at the new prices.
Key Terms•

Substitution effect : The effect on consumption of a change in the relative price, with a sufficient change in income to keep theconsumer on the same utility isoquant•

Income effect: The effect on consumption of a change in income•

Compensated demand: demand when a change in price is accompanied by just enough additional income to keep utility the same

12.6 Income Effects
Learning Objectives•

How do consumers change their purchases when their income rises or falls?

Wealthy people buy more caviar than poor people. Wealthier people buy more land, medical services, cars, telephones, andcomputers 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, and that probably isn’t because they have an assistant to wait for them. For most goods, ata 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 called a normal good for that consumer. When the
consumer buys less, the good is called an inferior good, which is an example of sensible jargon that is rare in any discipline. That is,
an inferior good is any good whose quantity demanded falls as incomes rise. At a sufficiently low income, almost all goods arenormal goods, while at a sufficiently high income, most goods become inferior. Even a Ferrari is an inferior good against somealternatives, such as Lear jets.

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The curve that shows the path of consumption as incomes rise is known as an Engel curve.58 An Engel curve graphs (𝑥𝑥(𝑀𝑀), 𝑦𝑦(𝑀𝑀))as M varies, where 𝑥𝑥(𝑀𝑀) is the amount of x chosen with income M, and similarly 𝑦𝑦(𝑀𝑀) is the amount of is the amount of y. An
example of an Engel curve is illustrated in Figure 12.6.1.
yx
Figure 12.6.1: Engel Curve
Example (Cobb-Douglas): Since the equations 𝑥𝑥 =through the origin with slope(1−𝛼𝛼)𝑝𝑝𝑥𝑥
𝛼𝛼𝑝𝑝𝑦𝑦

.

𝛼𝛼𝛼𝛼
𝑝𝑝𝑥𝑥

, 𝑦𝑦 =(1−𝛼𝛼)𝑀𝑀
𝑝𝑝𝑦𝑦

define the optimal consumption, the Engel curve is a straight line

An inferior good has the quantity fall as incomes rise. Note that, if there are only 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 Figure 12.6.2. Here, as incomes rise, the consumption of x rises, reaches a maximum, then begins 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 a price change into a substitution effect and an
income effect. This is illustrated in Figure 12.6.3.
What is the mathematical form of the income effect? This is actually more straightforward to compute than the substitution effectcomputed above. As with the substitution effect, we differentiate the conditions 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀 and 𝑝𝑝𝑥𝑥 𝑢𝑢2 = 𝑝𝑝𝑦𝑦 𝑢𝑢1, holding 𝑝𝑝𝑥𝑥 and 𝑝𝑝𝑦𝑦
constant, to obtain:
𝑑𝑑𝑑𝑑 = 𝑝𝑝𝑥𝑥 𝑑𝑑𝑑𝑑 + 𝑝𝑝𝑦𝑦 𝑑𝑑𝑑𝑑 + 𝑦𝑦𝑦𝑦𝑝𝑝𝑦𝑦 and 𝑝𝑝𝑥𝑥 (𝑢𝑢12 𝑑𝑑𝑑𝑑 + 𝑢𝑢22 𝑑𝑑𝑑𝑑) = 𝑝𝑝𝑦𝑦 (𝑢𝑢11 𝑑𝑑𝑑𝑑 + 𝑢𝑢12 𝑑𝑑𝑑𝑑)

58

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

Introduction to Economic Analysis

12-170yx
Figure 12.6.2: Backward Bending – Inferior Goody

Substitution
EffectIncomeEff tx
Figure 12.6.3: Income and Substitution Effects
The second condition can also be written as
𝑑𝑑𝑑𝑑 𝑝𝑝𝑦𝑦 𝑢𝑢11 − 𝑝𝑝𝑥𝑥 𝑢𝑢12=
𝑑𝑑𝑑𝑑 𝑝𝑝𝑥𝑥 𝑢𝑢22 − 𝑝𝑝𝑦𝑦 𝑢𝑢12This equation alone defines the slope of the Engel curve, without determining how large a change arises from a given change in M.
The two conditions together can be solved for the effects of M on x and y. The Engel curve is given by
𝑝𝑝𝑦𝑦 2 𝑢𝑢11 − 2𝑝𝑝𝑥𝑥 𝑢𝑢12 + 𝑝𝑝𝑥𝑥 2 𝑢𝑢22
𝑑𝑑𝑑𝑑 𝑝𝑝𝑦𝑦 2 𝑢𝑢11 − 2𝑝𝑝𝑥𝑥 𝑢𝑢12 + 𝑝𝑝𝑥𝑥 2 𝑢𝑢22
𝑑𝑑𝑑𝑑
=
and
=
𝑝𝑝𝑥𝑥 𝑢𝑢22 − 𝑝𝑝𝑦𝑦 𝑢𝑢12
𝑝𝑝𝑦𝑦 𝑢𝑢11 − 𝑝𝑝𝑥𝑥 𝑢𝑢12
𝑑𝑑𝑑𝑑
𝑑𝑑𝑑𝑑
Note (from the second order condition) that good y is inferior if 𝑝𝑝𝑦𝑦 𝑢𝑢11 − 𝑝𝑝𝑥𝑥 𝑢𝑢12 > 0, or if
𝑢𝑢1
𝑢𝑢2

𝑢𝑢11
𝑢𝑢1

is locally constant when M increases, equaling the price ratio, and an increase in y increases

Introduction to Economic Analysis𝑢𝑢− 12 > 0, or
𝑢𝑢2

𝑢𝑢1
𝑢𝑢2

𝑢𝑢1
𝑢𝑢2

is increasing in x. Since(thanks to the second order12-171

condition), the only way to keep

𝑢𝑢1
𝑢𝑢2

equal to the price ratio is for x to fall. This property characterizes an inferior good – an increase in

the quantity of the good increases the marginal rate of substitution of that good for another good.
Key Takeaways•

When an increase in income causes a consumer to buy more of a good, that good is called a normal good for that consumer.
When the consumer buys less, the good is called an inferior good. At a sufficiently high income, most goods become inferior.

•

The curve that shows the path of consumption as incomes rise is known as an Engel curve.

•

For Cobb-Douglas utility, Engel curves are straight lines through the origin.

•

Not all goods can be inferior.

•

The effect of a price increase decomposes into two effects – a decrease in real income and a substitution effect from the change inthe price ratio. For normal goods, a price increase decreases quantity. For inferior goods, a price increase decreases quantity only
if the substitution effect is larger than the income effect.
Key Terms•

Engel curve: Graph of consumption as income changes, holding prices constant
Exercises

12.6.1

Show that, in the case of perfect complements, the Engel curve does not depend on prices.

12.6.2Compute the substitution effect and income effect associated with a multiplicative price increase ∆ in 𝑝𝑝𝑦𝑦 , that is, multiplying
𝑝𝑝𝑦𝑦 by ∆ > 1, for the case of Cobb-Douglas utility 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 𝛼𝛼 𝑦𝑦1−𝛼𝛼 .

12.7 Mathematical Cleanup

Learning Objectives•

Are there important details that haven’t been addressed in the presentation of utility maximization?

•

What happens when consumers buy none of a good?

Let us revisit the maximization problem considered in this chapter, to provide conditions under which local maximization is global.
The consumer can spend M on either or both of two goods. This yields a payoff of ℎ(𝑥𝑥) = 𝑢𝑢 �𝑥𝑥,′′ (𝑥𝑥)𝑀𝑀−𝑝𝑝𝑥𝑥 𝑥𝑥
𝑝𝑝𝑦𝑦

�. When is this problem well

≤ 0,59 then any solution to the first order condition is in fact a
behaved? First, if h is a concave function of x, which implies ℎmaximum. To see this, note that ℎ′′ (𝑥𝑥) ≤ 0 entails ℎ′ (𝑥𝑥) decreasing. Moreover, if the point 𝑥𝑥 ∗ satisfies ℎ′ (𝑥𝑥 ∗ ) = 0, then for 𝑥𝑥 ≤ 𝑥𝑥 ∗ ,ℎ′ (𝑥𝑥) ≥ 0, and for 𝑥𝑥 ≥ 𝑥𝑥 ∗ , ℎ′ (𝑥𝑥) ≤ 0, because ℎ′ (𝑥𝑥) gets smaller as x gets larger, and ℎ′ (𝑥𝑥 ∗ ) = 0. Now consider 𝑥𝑥 ≤ 𝑥𝑥 ∗ . Sinceℎ′ (𝑥𝑥) ≥ 0, h is increasing as x gets larger. Similarly, for 𝑥𝑥 ≥ 𝑥𝑥 ∗ , ℎ′ (𝑥𝑥) ≤ 0, which means h gets smaller as x gets larger. Thus, hconcave and ℎ′ (𝑥𝑥 ∗ ) = 0 means that h is maximized at 𝑥𝑥 ∗ .

Thus, a sufficient condition for the first order condition to characterize the maximum of utility is that ℎ′′ (𝑥𝑥) ≤ 0, for all x, 𝑝𝑝𝑥𝑥 , 𝑝𝑝𝑦𝑦 , and𝑝𝑝
M. Letting 𝑧𝑧 = 𝑥𝑥 , this is equivalent to𝑝𝑝𝑦𝑦

𝑢𝑢11 − 2𝑧𝑧𝑢𝑢12 + 𝑧𝑧 2 𝑢𝑢22 ≤ 0 for all 𝑧𝑧 > 0𝑢𝑢

In turn, we can see that this requires (i) 𝑢𝑢11 ≤ 0 (𝑧𝑧 = 0) and (ii) 𝑢𝑢22 ≤ 0 (𝑧𝑧 → ∞) and (iii) √𝑢𝑢11 𝑢𝑢22 − 𝑢𝑢12 ≥ 0 �𝑧𝑧 = � 11�.
In addition, since −(𝑢𝑢11 + 2𝑧𝑧𝑢𝑢12 + 𝑧𝑧 2 𝑢𝑢22 ) = (√−𝑢𝑢11 − 𝑧𝑧√−𝑢𝑢22 )2 + 2𝑧𝑧(√𝑢𝑢11 𝑢𝑢22 − 𝑢𝑢12 ),𝑢𝑢22(i), (ii) and (iii) are sufficient for 𝑢𝑢11 + 2𝑧𝑧𝑢𝑢12 + 𝑧𝑧 2 𝑢𝑢22 ≤ 0.

Therefore, if (i) 𝑢𝑢11 ≤ 0 and (ii) 𝑢𝑢22 ≤ 0, and (iii) √𝑢𝑢11 𝑢𝑢22 − 𝑢𝑢12 ≥ 0, a solution to the first order conditions characterizes utility
maximization for the consumer.
When will a consumer specialize and consume zero of a good? A necessary condition for the choice of x to be zero is that theconsumer doesn’t benefit from consuming a very small x, that is, ℎ′ (0) ≤ 0. This means

The definition of concavity is that h is concave if 0 < 𝑎𝑎 < 1 and for all x, y, ℎ(𝑎𝑎𝑎𝑎 + (1 − 𝑎𝑎)𝑦𝑦) ≥ 𝑎𝑎ℎ(𝑥𝑥) + (1 − 𝑎𝑎)ℎ(𝑦𝑦). It isreasonably straightforward to show this implies the second derivative of h is negative, and if h is twice differentiable, the converse istrue as well.
59

Introduction to Economic Analysis

12-172ℎ′ (0) = 𝑢𝑢1 �0,or𝑀𝑀
𝑀𝑀 𝑝𝑝𝑥𝑥� − 𝑢𝑢2 �0, � ≤ 0𝑝𝑝𝑦𝑦
𝑝𝑝𝑦𝑦 𝑝𝑝𝑦𝑦

𝑀𝑀
�
𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥
≤
𝑀𝑀
𝑢𝑢2 �0, � 𝑝𝑝𝑦𝑦
𝑝𝑝𝑦𝑦
𝑢𝑢1 �0,Moreover, if the concavity of h is met, as assumed above, then this condition is sufficient to guarantee that the solution is zero. To see
that, note that concavity of h implies ℎ′ is decreasing. Combined with ℎ′ (0) ≤ 0, that entails h maximized at 0. An important class of
examples of this behavior are quasilinear utility. Quasilinear utility comes in the form 𝑢𝑢(𝑥𝑥, 𝑦𝑦) = 𝑦𝑦 + 𝑣𝑣(𝑥𝑥), where v is a concave
function (𝑣𝑣 ′′ (𝑥𝑥) ≤ 0 for all x).
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

0.8

0.6

x
1

Figure 12.7.1: Quasilinear Isoquants
The procedure for dealing with corners is generally this. First, check concavity of the h function. If h is concave, we have aprocedure to solve the problem; when h is not concave, 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 check the endpoints, and verify that ℎ′ (0) > 0 (for𝑀𝑀otherwise 𝑥𝑥 = 0 maximizes the consumer’s utility) and that ℎ′ � � < 0 (for otherwise 𝑦𝑦 = 0 maximizes the consumer’s utility).
𝑝𝑝𝑥𝑥

Finally, at this point we seek the interior solution ℎ′ (𝑥𝑥) = 0. With this procedure we can insure we find the actual maximum for the
consumer, rather than a solution to the first order conditions that doesn’t maximize the consumer’s utility.
Key Takeaways•

Conditions are available which insure the first order conditions produce a utility maximum.

•

With convex preferences zero consumption of one good arises when utility is decreasing in the consumption of one good,
spending the rest of income on the other good.
Key Terms•

Quasilinear utility: Utility that is additively separable
Exercises

12.7.1

Demonstrate that the quasilinear consumer will consume zero X if and only if 𝑣𝑣 ′ (0) ≤𝑀𝑀

consumes zero Y if 𝑣𝑣 ′ � � ≥
𝑝𝑝𝑥𝑥

𝑝𝑝𝑥𝑥

𝑝𝑝𝑦𝑦

𝑝𝑝𝑥𝑥

𝑝𝑝𝑦𝑦

, and that the consumer instead. The quasilinear indifference curves, for 𝑣𝑣(𝑥𝑥) = (𝑥𝑥 + 0.03)0.3 , are illustrated in Figure12.7.1. Note that even though the indifference curves curve, they are nonetheless parallel to each other

Introduction to Economic Analysis

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13

Applied Consumer Theory

In this chapter we apply some of the analysis of the previous chapter to specific problems like the supply of labor, real estate, searchand risk.

13.1 Labor Supply
Learning Objectives•

If we want people to work more, should we pay them more? Or will that cause them to work less?

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 𝑇𝑇 – 𝐿𝐿, where T is the amount of time available for activities of all kinds.
The variable L includes a lot of 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 this can be handled by adjusting T to represent “time available for chosen behavior” so that 𝑇𝑇 – 𝐿𝐿 is work timeand 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 andsecond as income from working. One way of expressing this is to write the consumer’s budget constraint as
𝑝𝑝𝑝𝑝 + 𝑤𝑤𝑤𝑤 = 𝑀𝑀 + 𝑤𝑤𝑤𝑤.

Here, M represents non-work income, such as gifts, government transfers, and interest income. We drop the subscript on the price ofX, 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 arepurchased at the wage rate w. Alternatively, one could express the budget constraint so as to reflect that expenditures on goods 𝑝𝑝𝑝𝑝
equals the total money, which is the sum of non-work income M and work income 𝑤𝑤(𝑇𝑇 – 𝐿𝐿), or
𝑝𝑝𝑥𝑥 = 𝑀𝑀 + 𝑤𝑤(𝑇𝑇 – 𝐿𝐿).

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 to eliminate x. That is, we write the utility 𝑢𝑢(𝑥𝑥, 𝐿𝐿) M + w(T − L ) , L .
h( L ) = upAs before, we obtain the first order condition

0 = h′( L*) = −u1  w  + u2
 p

 M + w(T − L*), L * p
 . Note that the first order condition is the same aswhere the partial derivatives u1 and u2 are evaluated at 
the standard two-good theory developed already. This is because the effect so far is merely to require two components to income: M
and wT, both of which are constant. It is only when we evaluate the effect of a wage increase that 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
+ u12
−
−  u11
0 =  u11  w  − 2u12  w  + u22 
p
p






p
p

 dw p  p 2

u11  w  − 2u12  w  + u22 < 0
 p
 p
by the standard second order condition,
Since

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13-174

u1  w 
T −L
T −L
dL
+  u11
− u12
<0
>0
p
p
p
p


dw
if, and only if,, that is, these expressions are equivalent to one another.
Simplifying the latter, we obtain

w
T −L
T −L
+ u12
−  u11
p
p
 p
>1
u1
p
, or,

w
−  u11 + u12p(T − L )  
>1
u1
, or,
∂
1
∂
Log(u1 ) >=−Log(T − L )
∂L
T −L
∂L
, or,
∂
∂
Log(T − L ) > 0
Log(u1 ) +
∂L
∂L
, or,
∂
Log(u1 (T − L )) > 0∂L.

u (T − L )being an increasing function of L. That is, L rises with an increase
Since the logarithm is increasing, this is equivalent to 1
in wages, and hours worked falls, if the marginal 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 the marginal value of an additional good, while thevalue T-L is the hours worked. Thus, in particular, if goods and leisure are substitutes, so that an increase in L decreases the marginalvalue 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 hope for 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 the utility, 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 thewage induces fewer hours worked.

α M + w(T − L )  1−α L .
h( L ) = p
Example (Cobb-Douglas):The first order condition gives

Introduction to Economic Analysis

13-175 M + w(T − L ) 
0 = h′( L ) = −α
p



α −1

α

 M + w(T − L )  −α L
+ (1 − α)pp

1 −α w

L

or

αL

w
M + w(T − L )= (1 − α)pp

M + wTw
L = (1 − α)
p
p

M

L = (1 − α)
+T 
w

or
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.

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, thegoods and leisure are complements.

Year

Figure 13.1.1: Hours per Week
As a practical matter, for most developed nations, increases in wages are associated with fewer 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 Figure13.1.1 illustrates.
A number of physicists have changed careers, to become researchers in finance or financial economics. Research in finance pays
substantially better than research in physics, 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 more difficult or challenging than physics – pays so much better. Indeed, some physicists say that otherfields – 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 ofphysicists, and a shortage of finance researchers. Finance salaries must exceed physics salaries in order to induce some of theresearchers capable of doing either one to switch to finance, which compensates those individuals for doing the less desirable task.

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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 is indifferent between the two choices – the extra pay
compensates the worker for the adverse working conditions. This is why it is known in economics jargon by the phrase of acompensating differential.
The high salaries earned by professional basketball players are not compensating differentials. These salaries are not created by aneed to induce tall people to choose basketball over alternative jobs like painting ceilings, but instead are payments that reflect therarity 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 ofthem 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.60
Housing prices also compensate for location within a city. For most people, it is more convenient – both in commuting time and forservices – to be located near the central business district than in the outlying suburbs. The main compensating differentials are school
quality, crime rates, and housing prices. We illustrate the ideas with a simple model of a city in the next section.

60

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

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Key Takeaways•

Leisure – time spent not working – is a good like other goods and the utility cost of working is less leisure.

•

Labor supply is different from other goods because the wage enters the budget constraint twice – first as the price of leisure andsecond as income from working.

•If goods and leisure are substitutes, so that an increase in L decreases the marginal value of goods, then an increase in the wage
must decrease leisure, and labor supply increases in the wage.

•

With strong complements between goods and leisure, an increase in the wage induces fewer hours worked.

•

Complementarity between goods and leisure is reasonable because it takes time to consume goods.

•

For most developed nations, increases in wages are associated with fewer hours worked.

•

A compensating differential is income or costs that equalize different choices.

•

Jobs that are dangerous or unpleasant must pay more than jobs requiring similar skills but without the bad attributes.

•

The premium – or differential pay – must be such that the marginal worker is indifferent between the two choices – the extra pay
compensates the worker for the adverse working conditions.

•

City choice is also subject to compensating differentials, and significant differentials include air quality, crime rates, tax rates, andhousing prices.
Key Terms•

Compensating differential: income or costs that equalize different choices
Exercises

16.3.1Thought Question: Does a bequest motive – the desire to give money to others – change the likelihood that goods and leisure
are complements?

13.2 Urban Real Estate Prices
Learning Objectives•

How are the prices of suburban ranch houses, downtown apartments and rural ranches determined?

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 of building 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 of land.
Usually, land is what fluctuates in value, rather than the price of the house that sits on the land. When the newspaper reports thathouse 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 do change, but historically the changes have beensmall 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 ofmost 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 the cost to the person of a commute of time t, andlet the time taken be t = λr, where r is the distance. The function c should reflect both the transportation costs and the value of time
lost. The parameter λ accounts for the inverse of the speed in commuting, with a higher λ indicating slower commuting. In addition,
we assume that people occupy a constant amount of land. This assumption is clearly wrong empirically, and we will consider 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 cost alternative. If people have identical preferences about housing and commuting, then house 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 thecity center – decreased commute time is exactly compensated by increased house prices.

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The remaining piece of the model is to figure out the constant. To do this, we need to figure out the area of the city. If the total
2
N = π rmax
, and thus
population is N, and people occupy an area of one per person, the city size rmax satisfies

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 thecity’s prices, this value is approximately constant. As the city takes more land, the change in agricultural land is a very small portionof 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 land at the edge of the city. This lets us compute the price of all housing in the city:


N 
+v
c(λr ) + p(r) = c(λrmax ) + p(rmax ) = c(λrmax ) + v = c  λ
π 

or


N 
p(r) = c  λ+ v - c(λr )π .
This equation produces housing prices like those illustrated in Figure 13.2.1, where the peak is the city center. The height of the
figure indicates the price of housing.

Figure 13.2.1: House Price Gradient
It is straightforward to verify that house prices increase in the population N and the commuting time parameter λ, as one would
expect. To quantify the predictions, we consider 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 translate these 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, sothat 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 this density requires a city of radius rmax equal to 564 purlongs, which is 5.64 miles.
The only remaining structure to identify in the model is the commuting cost c. To simplify the calculations, let c be linear. Supposethat 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.61 This translates into a cost of commuting of $100.00 per purlong. Thus, we obtain


 N

N 
p(r) = c  λ+ v - c(λr ) = $100− r  + $600
π 
= $57,000 − $100r .
 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.

61

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 11.1. 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, car depreciation, insurance) are about 35-40 cents per mile. Thus the total is around $1 per mile,
which doubles with roundtrips.

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As constructed, a quadrupling of population approximately doubles the price of land in the central city. This probably understates thechange, since a doubling of the population would likely increase road congestion, increasing λ and further increasing the price ofcentral 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 at twenty
cents per square foot. As a practical matter, the reduction of land per capita is accomplished both through smaller housing units andthrough taller buildings, which produce more housing floor space per acre of land. Second, people have distinct preferences, and thedisutility 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 the lower 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 anequilibrium 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 to be linear in distance, for simplicity. Second, the marginal value of housing decreases in thehouse size, but the value of housing doesn’t depend on distance from the center. For 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 −αu* =  α− α 1−α  p(r ) 1−α − λr




1 −α

1  α
 α
 1 −α−1−α α 
α= p(r )
 u * + λr .
Utility at every location is constant, so 
A valuable attribute of the form of the equation for p is that the general form depends on the equilibrium values only through thesingle number u*. This functional form produces the same qualitative shapes as in Figure 13.2.1. Using the form, we can solve forthe housing size H.

1
 α  1 −α
H (r ) = 
 p(r ) 1 
= α 1 −α 1αu * + λr 

1 
 α

 α 1 −α − α 1 −α 11 u * + λr  α  αα = = (u * + λr )  .
−1
1−α


α

−1 

The space in the interval [r, r+∆] is π(2r∆+∆2). In this interval, there are approximately1π(2r∆ + ∆2 )1 − α α2 H (r )= π(2r∆ + ∆ )
 α(u * +λr ) Introduction to Economic Analysis

people. Thus, the number of people within rmax of the city center is

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rmax



1− α

1
α

.

∫ 2π r  α(u * +λr )  dr = N This equation, when combined with the value of land on the periphery:
0

1 −α

1  α
 α
 1 −αα− α 1 −α v = p(rmax ) = u * +λrmax 
jointly determine rmax and u*.

When different people have different preferences, the people with the highest disutility of commuting will tend to live closer to thecity center. These tend to be people with the highest wages, since one of the costs of commuting is time that could have been spentworking.
Key Takeaways•

An important point to understand is that in cities, houses are not in limited supply, but the land on which the houses sit is.

•

The circular city model involves people who work at a single point but live dispersed around that point. Both the size of the cityand the housing prices are determined by consumers being indifferent to commuting costs – lower housing prices at a greater
distance balance the increased commuting costs.

•

Substituting plausible parameters into the circular city model produces dramatic house price differentials, explaining much of theprice differences within cities.

•

A quadrupling of population approximately doubles the price of land in the central city. This likely understates the actual change
since an increase in population slows traffic.

13.3 Dynamic Choice
Learning Objectives•

How much should you save and how do interest rate changes affect spending?

The consumption of goods doesn’t take place in a single instance, but over time. How does time enter into choice? We’re going tosimplify 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 in each period, so thatu(x1, x2) = v(x1) + δv(x2),where δ is called the rate of “pure” time preference. The consumer is expected to have income M1 in the first period and M2 in thesecond. There is a market for loaning and borrowing, 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 in period 1 equals the net expenditure in period
2. This is because whatever is saved in period 1 earns interest and can then be spent in period 2; alternatively, whatever is borrowed
in period 1 must be paid back with interest in period 2. Rewriting the constraint:(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 ispermanent income rather than “current income.” That is, a change in incomes that leaves the present value of income the same shouldhave no effect on the choice of consumption.
Once again, as with the labor supply, a change in the interest rate affects not just the price 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 a decrease in budget
for net borrowers.
As always, we rewrite the optimization problem to eliminate one of the variables, to obtain

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u = v( x1 ) + δv((1 + r )( M1 − 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,

δv′(x )

v′( x1 ) , equals the marginal value of consumption in period

2 , times the interest factor. That is, the marginal present values are equated. Note that the consumer’s private time2,
preference, δ, need not be related to the interest rate. If the consumer values period 1 consumption more than does the market, sov′( x ) < v′(x )12 , that is, the consumer consumes more in period 1 than in period 2.62 Similarly, if the consumer’sδ(1+r) < 1, thendiscount of future consumption is exactly equal to the market discount, δ(1+r) = 1, the consumer will consume the same amount inboth periods. Finally, if the consumer values period 1 consumption less than the market, δ(1+r) > 1, the consumer will consume morein period 2. In this case, the consumer is more patient than the market.
x2(M1,M2)

Repayment

Period 1
Borrowing
x1
Figure 13.3.1: Borrowing and Lending
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 Figure 13.3.1. 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 13.3.2 illustrates, the net borrower borrows less in the first period – theprice of first period consumption has risen and the borrower’s wealth has fallen. It is not clear whether the borrower consumes less inthe 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 more in the second period, but only consumes more in the first period (lends less) if the income effectoutweighs the substitution effect. This is illustrated in Figure 13.3.3.

62

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 what are called the Inada conditions:v′(0) = ∞, v′(∞ ) = 0 .
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x2(M1,M2)

x1
Figure 13.3.2: Interest Rate Changex2(M1,M2)

x1
Figure 13.3.3: Interest Rate Increase on Lenders
The government from time to time will rebate a portion of taxes to “stimulate” the economy. An important aspect of the effects ofsuch a tax rebate is the effect to which consumers will spend the rebate, versus savings the rebate, because the stimulative effects ofspending are thought to be larger than the stimulative effects of savings.63 The 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, which shouldhave 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 orwindfall gifts. From an intertemporal budget constraint perspective, these transitory effects have little significance, and thus the63This 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 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 alarger effect.
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theory suggests people shouldn’t spend much of a windfall gain in the current year, nor cut back significantly when they have amoderately-sized unexpected cost.
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 fraction of 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 13.3.4. 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. Such effects tend tofavor “neither a borrower nor a lender be,” as Shakespeare recommends, although it is still possible for the consumer to optimallyborrow in the first period (e.g. if M1=0) or in the second period (if M2 is small relative to M1).
x2

(M1,M2)

x1
Figure 13.3.4: 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 13.3.5.
x2(M1,M2)

x1
Figure 13.3.5: The Effect of a Transitory Income Increase

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Key Takeaways•

The intertemporal budget constraint takes into account that savings obtain interest, producing additional money. The price ofearly consumption is one plus the interest rate.

•

The relevant income is “permanent income” rather than “current income.” A change in incomes that leaves the present value ofincome the same should have no effect on the choice of consumption.

•

A change in the interest rate affects not just the price of consumption, but also the budget for consumption. An increase in theinterest rate represents an increase in budget for savers, but a decrease in budget for borrowers.

•

If the consumer values early consumption more than the market, the consumer consumes more early than later, and conversely.

•

Whether the consumer is a lender or borrower depends not just on the preference for earlier versus later consumption, but also on
incomes.

•

The effect of an interest rate increase is to pivot the budget constraint around the income point. The effect of an increase in theinterest rate on consumption is going to depend on whether the consumer is a borrower or a lender.

•

An increase in interest rates is a benefit to a net lender. The lender must continue to lend in the present and will consume more in
the future.

•

People should react less to a “one-time” or transitory tax rebate than to a permanent lowering of taxes.

•

Most individuals can’t borrow at the same rate at which they lend. Interest rate differentials favor spending all one’s income.

•Differences in borrowing and lending interest rates cause transitory changes in income to have larger effects than theintertemporal budget constraint would suggest.
Key Terms•

Intertemporal budget constraint: The budget constraint that allows for borrowing or lending•

Permanent income: the present value of the income stream

13.4 Risk Aversion
Learning Objectives•

How should you evaluate gambles?

•

How is risk priced?

There are many risks in life, even if one doesn’t add to these risks by intentionally buying lottery tickets. Gasoline prices go up anddown, the demand for people trained in your major fluctuates, house prices change. How do people value gambles? The starting
point for the investigation is the von Neumann-Morgenstern64 utility function. The idea of a von Neumann-Morgenstern utility
function for a given person is that for each possible outcome x, there is a value v(x) assigned by the person, and the average value of v
is the value the person assigns to the risky outcome. This is a “state of the world” approach, in the sense that each of the outcomes is
associated with a state of the world, and the person maximizes the expected value of the various possible states of the world. 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 andthe 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 theoutcome. On the other hand, in many tests, people behave in ways not consistent with the theory.65 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 of these outcomes. If the possible outcomes are x1, x2, … , xn and these occur withprobability π1, π2, … , πn respectively, the consumer’s utility is

64John von Neumann (1903 – 57) and Oskar Morgenstern (1902 – 77), authors of Theory of Games and Economic Behavior,Princeton, NJ: Princeton University Press, 1944.

65

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

Introduction to Economic Analysis

13-185nu = 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” – that utility can be written in this weighted sum form.
The first insight that flows from this definition is that a individual dislikes risk if v is concave. To see this, note that the definition of
concavity posits that v is concave if, for all 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 that is not positive. Using induction, thedefinition of concavity can be generalized to show:v( π1 x1 + π2 x2 + ... + πn x n ) ≥ π1 v( x1 ) + π2 v( x2 ) + ... + πn v( x n )vv(πx1+(1-π)x2)

πv(x1)+(1-π)v(x2)x1 CE

πx1+(1-π)x2xx2

Figure 13.4.1: Expected Utility and Certainty Equivalents
That is, a consumer with concave value function prefers the average outcome to the random outcome. This is illustrated in Figure13.4.1. 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 at the expected outcome πx1+(1-π)x2, whileπv(x1)+(1-π)v(x2) is the average of the value of the outcome. As is plainly visible in the picture, concavity makes the averageoutcome preferable to the random outcome. People with concave von Neumann-Morganstern utility functions are known as risk
averse people.
A useful concept is the certainty equivalent of a gamble. The certainty equivalent is an amount 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 the graph, this is expressed as πx1 + (1 – π)x2) andthe certainty equivalent. This is the cost of risk – it is the amount of money an individual would be willing to pay to avoid risk. Thismeans as well that the risk premium is the value of insurance. How does the risk premium of a given gamble change when the basewealth is increased? It can be shown that the risk premium falls as wealth increases for any gamble if, and only if,−v′′( x )v′( x ) is decreasing.

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13-186ρ( x ) = −v′′( x )v′( x ) is known as the Arrow-Pratt66 measure of risk aversion, and also as the measure of absolute risk

The measure
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.

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 2v ′( µ ).

That is, the risk premium, the difference between the average outcome and the certainty equivalent, is approximately equal to theArrow-Pratt measure, times half the variance, at least when the variance is small.
The translation of risk into dollars, by way of a risk premium, can be assessed even for large gambles if we are willing to make someρ=−
technical assumptions. Suppose the utility has constant absolute risk aversion or CARA, that isturns out to imply, after setting the utility of zero to zero, thatv′′( x )v′( x ) is a constant. This1v( x ) = (1 − e −ρx ).
ρ(This formulation is derived by setting v(0)=0 handling the case of ρ=0 with appropriate limits.) Now also assume that the gamble x
is normally distributed with mean µ and variance σ2. Then the expected value of v(x) is ρ −ρ µ − σ 2  1Ev( x ) =  1 − e  2  .
ρ




ρ
µ − σ22 .
It is an immediate result from this formula that the certainty equivalent, with CARA preferences and normal risks, isρ 2σHence the risk premium of a normal distribution for a CARA individual is 2
. This formulation will appear when we consider
agency theory and the challenges of motivating a risk averse employee when outcomes 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 theρµ − σ22 . Suchgamble and the variance. In fact, given a choice of gambles, the consumer selects the one with the highest value ofpreferences are often called mean variance preferences, and they comprise the foundation of modern finance theory.

66

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

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Key Takeaways•

The von Neumann-Morgenstern utility function for a given person is a value v(x) for each possible outcome x, and the averagevalue of v is the value the person assigns to the risky outcome. Under this theory, people value risk at the expected utility of the
risk.

•

The von Neumann approach is the prevailing model of behavior under risk, although there are numerous experiment-based
criticisms of the theory.

•

An individual dislikes risk if v is concave.

•

For smoothly differentiable functions, concavity is equivalent to a second derivative that is not positive.

•

People with concave von Neumann-Morgenstern utility functions are known as risk averse people.

•

The certainty equivalent of a gamble is an amount of money that provides equal utility to the random payoff of the gamble. The
certainty equivalent is less than the expected outcome if the person is risk averse.

•

The risk premium is defined to be the difference between the expected payoff and the certainty equivalent.

−•

The risk premium falls as wealth increases for any gamble if, and only ifρ( x ) = −v′′( x )v′( x ) is decreasing.

v′′( x )v′( x ) is known as the Arrow-Pratt67 measure of risk aversion, and also as the measure of absolute risk•

The measure
aversion.

•

The risk premium is approximately equal to the Arrow-Pratt measure times half the variance when the variance is small.

•

Constant absolute risk aversion provides a basis for “mean variance preferences,” the foundation of modern finance theory.
Key Terms•

von Neumann-Morgenstern utility function: The value of each outcome, constructed in such a way that a consumer values
gambles as the expected utility•

Risk averse: Prefering the expected value of a gamble to the gamble•

Certainty equivalent: an amount of money that provides equal utility to the random payoff of the gamble•

risk premium: the difference between the expected payoff and the certainty equivalent•

Arrow-Pratt measure of risk aversion: A measure of risk aversion, aka absolute risk aversion•

Absolute risk aversion: A measure of risk aversion, aka Arrow-Pratt measure of risk aversion•

Constant absolute risk aversion: the measure of risk aversion doesn’t change with wealth•

Mean variance preferences: Person who values risk linearly with the expected return
Exercises

13.4.1

Use a quadratic approximation on both sides to sharpen the estimate 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 } .

1µ − CE ≈  1 + ρ2σ2 − 1 ρ
 . This approximation is exact to the second order.
Conclude that
13.4.2

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 and compute the risk premium associated with the gamble.

13.4.3

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 the1probability 10,000,000 . Compute the certainty equivalent of the lottery ticket.
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13.4.4

The return on U.S. government treasury investments is approximately 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 and has a standard deviation that isaround 16% (the standard deviation of return on a $1 investment is $0.16). Compute the value of ρ for a CARA individual.
What is the risk premium associated equal probabilities of a $100 gain or loss given the value of ρ?

13.4.5

A consumer has utility u(x) = x7/8 and a base wealth of $100,000. She is about to take part in a gamble that will give her$10,000 (bringing her to $110,000) if a fair die rolls less than 3 (probability 1/3), but will cost her $5000 (leaving her with
$95,000) otherwise.
a.

What is the certainty equivalent of participating in this gamble?

b.

How much would she be willing to pay to not have to take this gamble?

13.5 Search
Learning Objectives•

How should a consumer go about finding the lowest price when available prices are random?

In most communities, every Wednesday grocery stores advertise sale prices in a newspaper insert, and these prices vary from week toweek. Prices can vary a lot from week 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, and you may see distinct prices at Best Buy, Circuit City, andother electronics retailers. For many goods and services, there is substantial variation in prices, which implies that there are gains forbuyers to search for the best price.
The theory of consumer search behavior is just a little bit arcane, but the basic insight will be intuitive enough. The general idea isthat, from the perspective of a buyer, the price 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, telephonically or virtually, the cost includes your time and any othercosts necessary to obtain a price quote), 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*, the consumer 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*

∫

∞

pf ( p )dp + J ( p*) f ( p )dp

0

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 price paid p, or the price will be too high, in which case the consumer is going to take another draw,
at cost c, and on average get the average price J(p*). It is useful to introduce the cumulative distribution function F, withx

F ( x ) = ∫ f ( p)dp0

. Note that something has to 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 of two terms. The first is the expected price, whichp*isf ( p)∫0 p F ( p*) dp. This has the interpretation of the average price conditional on that price being less than p*. This is becausef ( p)F ( p*) is in fact the density of the random variable which is the price given that the price is less than p*. The second term is

67

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

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F ( p*) . This is the expected search costs, and it arises because F ( p*) is the expected number of searches. This arises because
the odds of getting a price low enough to be acceptable is F(p*). There is a general statistical property underlying the number ofsearches. 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

y + 2(1 - y)y + 3(1 - y) 2 y + 4 (1 - y) 3 y + …

(

2
3= y(1 + 2(1 - y) + 3(1 - y) + 4 (1 - y) + …)

23
23
= y (1 + (1 - y) + (1 - y) + (1 - y) + …) + (1 − y)(1 + (1 - y) + (1 - y) + (1 - y) + …)
2
2
3
3
2
+ (1 − y) (1 + (1 - y) + (1 - y) + (1 - y) + …) + (1 − y) (1 + (1 - y) + (1 - y) + …) + ...

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 to finding a price less than p*.
The expected total cost of purchase, given a reservation price p* is given by∫p*

J ( p*) = 0

pf ( p)dp + c
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*)2p*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 f is positive. To see this, note that at any
solution to the equation p*=J(p*),

J ′′( p*) =J ′( p*) = 0 andd  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 the interval
between them, since J is increasing to the right of the first (lower) one, and decreasing to the left of the second (higher) one.
Consequently, the equation p*=J(p*) has a unique solution that minimizes the cost of purchase.

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13-190Consumer search to minimize cost dictates setting a reservation price equal to the expected total cost of purchasing the good, andpurchasing whenever the price offered is lower 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*

p*

dp

∫ pf ( p)dp + c = ∫a p b − a + c
J ( p*) = 0
p * −ab−a

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

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

There are a couple of interesting observations about this solution. First, not surprisingly, as c→0, p*→a, that is, as the search costs go
to zero, one holds out for the lowest possible price. This is sensible in the context of the model, but in the real search situations delay
may also have a cost that isn’t modeled here. Second, p* < b, the maximum price, if 2c<(b – a). Put another way, if the most you cansave 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, is that the expected price is a concave functionof 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*

Since

p*

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

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 ofan increase in c are passed on at a decreasing rate. Moreover, it means that a consumer should rationally be risk averse about the costof search.
Key Takeaways•

For many goods, prices vary across location and across time. In response to price variation, consumers will often search for low
prices.

•In many circumstances the best strategy is a reservation price strategy, where the consumer buys whenever offered a price below
the reservation price.

•

Consumer search to minimize cost dictates setting a reservation price equal to the expected total cost of purchasing the good, andpurchasing whenever the price offered is lower than that level.
Key Terms•

Reservation price: A maximum acceptable price; higher prices lead to further search
Exercises

13.5.1

Suppose that there are two possible prices, 1 and 2, and the probability 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 search c. 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?

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14

General Equilibrium

General equilibrium puts together consumer choice and producer theory to find sets of prices that clear many markets. It waspioneered by Kenneth Arrow, Gerard Debreu and Lionel Mackenzie in the late 1950s. Many economists consider general equilibrium
to be the pinnacle of economic analysis. General equilibrium has many practical applications. For example, a study of the impact ofcarbon taxes uses general equilibrium to assess the effects on various sectors of the economy.

14.1 Edgeworth Boxes
Learning Objectives•

How are several prices simultaneously determined?

•

What are the efficient allocations?

•

Does a price system equilibrium yield efficient prices?

The Edgeworth68 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 their exchange problem.
2

y2

y1

1
x1

x2

Figure 14.1.1: The Edgeworth Box
The Edgeworth box is represented in Figure 14.1.1. Person 1 is “located” in the lower left (southwest) corner, and person 2 in theupper 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 toperson 1, remainder to person 2. Thus, for the 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.
What points are efficient? The economic notion of efficiency is that an allocation is efficient if it is impossible to make one person
better off without harming the other, that is, 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 embedded in 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

68

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

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efficient if there is no waste or slack in the system, even if it is wildly unfair. To distinguish this economic notion, it is sometimes
called Pareto Efficiency.69
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 point, any increase in person 2’s utility must come at the expense of person 1, and vice versa,
that is, the point is Pareto-efficient. An example is illustrated in Figure 14.1.2.
2

u1

u2

1
Figure 14.1.2: An Efficient PointIn Figure 14.1.2, the isoquant of person 1 is drawn with a dark thick line. This utility level is 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 for every 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 14.1.3. 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 14.1.3 illustrates. The main properties are that it is increasing and goesfrom person 1 consuming zero of both goods to person 2 consuming zero of both goods.

69

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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2

1
Figure 14.1.3: The Contract Curve
Example: Suppose both people have Cobb-Douglas utility. Let the total endowment of each good be 1, so that x2 = 1 – x1. Thenperson 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

∂u2
∂u1
αy
∂x = β(1 − y)
∂x =
=
∂u2
(1 − β)(1 − x )(1 − α) x ∂u1∂y∂y.
Thus, 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 .

(1 − β)α
Thus, the contract curve for the Cobb-Douglas case depends on a single parameter (1 − α)β . It is graphed for a variety of examples(α and β) in Figure 14.1.4.

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1

0.8

0.6

0.4

0.2

0
0

0.2

0.4

0.8

0.6

1

Figure 14.1.4: Contract Curves with Cobb-Douglas Utility
Key Takeaways•

The Edgeworth box considers a two person, two good “exchange economy.” The Edgeworth box is a graphical representation of
the exchange problem facing these people, and also permits a straightforward solution to their exchange problem. A point in the
Edgeworth box is the consumption of one individual, with the balance of the endowment going to the other.

•

Pareto Efficiency is an allocation in which making one person better off requires making someone else worse off – there are no
gains from trade or reallocation.

•

In the Edgeworth box, the pareto efficient points arise as tangents between isoquants of the individuals. The set of such points iscalled the contract curve. The contract curve is always increasing.
Key Terms•

Edgeworth box: A graphical representation of a a two person, two good exchange economy.

•

Pareto Efficiency: An allocation where no one can be made better off without making someone worse off•

Contract curve: Set of Pareto Efficient points in the Edgeworth box.
Exercises

14.1.1

If two individuals have the same utility function concerning goods, is the contract curve the diagonal? Why or why not?

14.1.2For two individuals with Cobb-Douglas preferences, when is the contract curve the diagonal?

14.2 Equilibrium with Price System
Learning Objectives•

How are prices in the two person economy determined?

•

Are these prices efficient?

The contract curve provides the set of efficient points. What point will actually be chosen? Let’s start with an endowment of thegoods. 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 14.2.1. Note that this point gives the endowment of both person 1 and 2, because itshows the shares of each.

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2

1
Figure 14.2.1: Individually Rational Efficient Points
Figure 14.2.1 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 “no exchange” state is known as autarky. There are avariety of efficient points that give these people at least as much as they get under autarky, and those points are along the contract
curve but have a darker line.
In Figure 14.2.1, starting at the endowment, the utility of both players is increased by moving in the general direction of the southeast,that is, down and to the right, until the contract curve is reached. This involves person 1 getting more X (movement to the right) in
exchange for giving up some Y (movement down). Thus, we can view the increase in utility as a trade – 1 trades some of his Y forsome of 2’s X.
In principle, any of the darker points on the contract curve, which give both people at least 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 thecurve, depending on the bargaining skills of the players. But there is a particular point, or possibly a set of points, that result fromexchange using a price system. A price system involves a specific price for trading Y for X, and vice versa, that is available to bothparties. 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 thereciprocal).

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2

1
Figure 14.2.2: Equilibrium with a Price System
Figure 14.2.2 illustrates trade with a price system. The O in the center is the point on the contract 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 through theendowment. Start on the contract curve at the point that maximizes 1’s utility given 2’s reservation utility, and you can easily see thatthe 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, bycontinuity, somewhere in between is a price line that passes through the endowment.
The point marked with the O represents an equilibrium of the price system, in the sense that 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.

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2

1
Figure 14.2.3: Illustration of Price System Equilibrium
Figure 14.2.3 removes player 1’s isoquants, leaving only player 2’s isoquants and the price line through the endowment. The priceline 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 believe that they canbuy 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 theplayers accept the price, a balance of supply and demand emerges. In this sense, we have found an equilibrium price.
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 curve arises from as an equilibrium of the price system for some endowment. The proof of this
proposition is startlingly easy. To show that a particular point on the contract curve is an equilibrium for some endowment, just startwith an endowment equal to the point on the contract curve. No trade can occur because the starting point is Pareto-efficient – anygain by one party entails a loss by the other.
Furthermore, if a point in the Edgeworth box represents an equilibrium using a price system (that is, if the quantity supplied equals thequantity 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 equilibriumof the price system for some endowment, are known as the first and second welfare theorems of general equilibrium. They have been
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 same high levelof generality.

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Key Takeaways•

Autarky means consuming one’s endowment without trade.

•

If the endowment is not on the contract curve, there are points on the contract curve that make both people better off.

•

A price system involves a specific price for trading Y for X, and vice versa, that is available to both parties. Prices define astraight line, whose slope is the negative of the Y for X price (the X for Y price is the reciprocal).

•There is a price that (i) goes through the endowment and (ii) goes through the contract curve at a point tangent to both people’sutility. Such a price represents a supply and demand equilibrium: given the price, both parties would trade to the same point on
the contract curve.

•

In the Edgeworth box, it is possible to reach some Pareto-efficient point using a price system. Moreover, any point on thecontract curve arises as an equilibrium of the price system for some endowment.

•

If a point in the Edgeworth box represents an equilibrium using a price system, it must be Pareto-efficient.

•the first and second welfare theorems of general equilibrium are that any equilibrium of the price system is Pareto-efficient andany Pareto-efficient point is an equilibrium of the price system for some endowment .
Key Terms•

Price system: A system where the allocation is determined by exchange at common prices•

First welfare theorems of general equilibrium: any equilibrium of the price system is Pareto-efficient•

Second welfare theorems of general equilibrium: any Pareto-efficient point is an equilibrium of the price system for someendowment•

Autarky: No trade

14.3 General Equilibrium
Learning Objectives•

What happens in a general equilibrium when there are more than two people buying more than two goods?

•

Does the Cobb-Douglas case provide insight?

We will illustrate general equilibrium, for the case when all consumers have Cobb-Douglas 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 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-DouglasGα( n ,g )∏ x ( n , g)utility, which we can represent using exponents α(n,g), so that the utility of person n can be represented as g=1,
where x(n,g) is person n’s consumption of good g. Assume that 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 to maximizing 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 find prices p1, p2, …, pG for the goods, in sucha 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

Introduction to Economic Analysis.

14-199N∑ α(n, g)y(n, i ) > 0

We will assume that n =1
for every pair of goods g and i. This assumption states that for any pair of goods, there
is at least one agent that values good g 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 insures the 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 ingeneral: the share of wealth for a consumer n on good g equals the exponent α(n,g). Thus, the total demand for good g isNα(n, g)Wn
pg
n =1

Xg = ∑.

The equilibrium conditions, then, can be expressed as saying supply (sum of the endowments) equals demand, or, for each good g,NNα(n, g)Wnpg
n =1∑ y(n, g) = X g = ∑

n =1

.

We can rewrite this expression, provided pg>0 (and it must be for otherwise demand is infinite), to beNGpg − ∑i =1∑ y(n, i )α(n, g)

pi n =1N=0∑ 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 must have an eigenvalue equal to 1, and acorresponding eigenvector p that is positive in each component. 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 price vector, 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 other goods are indexed in terms of that good, and thenumeraire’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.70 It states that if B is a positive matrix (each component positive), then there
is an eigenvalue λ>0 and an associated positive eigenvector p, and moreover λ is the largest (in absolute value) eigenvector of B.71

70 Oskar Perron, 1880 - 1975 and Georg Frobenius, 1849 – 1917.
71

The Perron-Frobenius theorem, as usually stated, only assumes that B is non-negative and that B is irreducible. It turns out that astrictly positive matrix is irreducible, so this condition is sufficient to invoke 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 endowed with anything thepeople 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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14-200This conclusion does most of the work of demonstrating the existence of an equilibrium. The only remaining condition to check isthat the eigenvalue is in fact 1, so that (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 not necessarily occur for other utility functions. Moreover, the equilibrium is readily approximated.
tlim B v = p. While approximations are very
Denote by Bt the product of B with itself t times. Then for any positive vector v, t →∞useful for large systems (large numbers of goods), the system can readily be computed exactly with small numbers of goods, evenwith a large number of individuals. Moreover, the approximation can be interpreted in a potentially useful manner. Let v be a
candidate for an equilibrium price vector. Use v to permit people to calculate their wealth, which for person n isG

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

G

N

n =1

i =1

n =1

x g ( v) = ∑ α(n, g)Wn = ∑ vi ∑ α(n, g)y(n, i )GN= i =1n =1
N∑ vi ∑ α(n, g)y(n, i )pg∑ y(n, g)n =1, which is equivalent to p = Bv. This defines anand the market clears, given the wealth levels, if
iterative process. Start with an arbitrary price vector, 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 compute a 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 can let an = α(n, 1), and then conclude α(n, 2) =1 – an. Then let

Introduction to Economic Analysis

14-201N

Y g = ∑ y(n, g)
n =1

be the endowment of good g. Then the matrix B is

1 N

 1 N
(
,
1
)
y
n
a
y (n,2)an ∑∑n
Y1 n =1Y1 n =1

B=
N

1 N
1
y (n,2)(1 − an ) ∑ ∑ y (n,1)(1 − an )Y2 n =1
 Y2 n =1
1 N
1 N


y (n,1)any (n,2)an ∑∑
Y1 n =1Y1 n =1

=
N

1
1 N

  Y1 − ∑ y (n,1)an  1 − ∑ y (n,2)an 
Y2 n =1n =1
 Y2 
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 equilibrium price – so the relevant term is the priceratio, which is the price of good 1 in terms of good 2, orN∑ y(n,2)an
p1
=1
n
=
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 the price of good 1. When people who value good 1 relatively highly are endowedwith a lot of good 2, the correlation between preference for good 1 an and endowment of good 2 is higher. 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 behigher. 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, thecorrelation between endowments and preferences also matters to the price ratio.
In our second special case, we consider people with the same preferences, but who start with different endowments. Hypothesizing
identical preferences sets aside the correlation between endowments and preferences found in the two good case. Since people are thesame, 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 iYgn =1

Introduction to Economic Analysis,

14-202

N

Y g = ∑ y(n, g)
where as before

pg =

n =1

is the total endowment of good g. The matrix B has a special structure, and in this case,Ag
Yg

is the equilibrium price vector. Prices are proportional to the preference for the good divided by the total endowment forthat good.
Now consider a third special case, where no common structure is imposed on preferences, but endowments are proportional to eachother, 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, anN∑ wn = 1

equation assumed to hold for all people n and goods g. Note that by construction, n =1
share of the total endowment. In this case, we have, since the value wn represents n’sN∑ y(n, i )α(n, g)bgi= n =1

Yi N=∑ wn α(n, g)
Y g n =1N∑ y(n, g)n =1.

These matrices also have a special structure, and it is readily verified that the equilibrium price vector satisfies

1 N
pg =
∑ wn α(n, g)
Y g n =1.

This formula receives a similar interpretation – the price of good g is the strength of preference for good g, where strength ofpreference is a wealth-weighted average of the individual 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 theirwealth on each good. It also generalizes the conclusion found in the two good case to more goods, but with the restriction that thecorrelation is now between wealth and preferences. The special case has the virtue that individual wealth, which is endogenous
because it depends on prices, can be readily determined.

Introduction to Economic Analysis

14-203

Key Takeaways•

General equilibrium puts together consumer choice and producer theory to find sets of prices that clear many markets.

•

For the case of an arbitrary number of goods and an arbitrary number of consumers each with Cobb-Douglas utility, there is a
closed form for the demand curves and the price vector can be found by finding an eigenvector of a particular matrix. The
equilibrium is unique (true for Cobb-Douglas but not more generally.)•

The actual price vector is not completely identified, because if p is an equilibrium price vector, 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.

•

The intuition arising from one good models may fail because of interactions with other markets – increasing preferences for agood (shifting out demand) changes the values of endowments in ways that then reverberate through the system.
Key Terms•

Exchange economy: an economy where the supply of each good is just the total endowment of that good and there is no
production•

Perron-Frobenius theorem: A theorem of linear algebra, stating that a positive matrix has a positive eigenvalue and it is the largest
eigenvalue in absolute value is positive
Exercises

14.3.1

Consider a consumer with Cobb-Douglas utility,G

14.3.2

i =1

G

G

a

U = ∏ xi i

∑ ai = 1, where i =1

W = ∑ pi x i, and facing the budget constraint

i =1. Show that the consumer maximizes
G −1



1 
aW
xG =
W − ∑ pi x i 
xi = ippi for each good i. Hint: Express the budget constraint as
G
i =1
 , andutility by choosingaG −1
 G −1 a  1 
 G

i



U = ∏ xiW − ∑ pi x i   pG i =1
  . This function can now be maximized in an unconstrained
 i =1thus utility as

pi x i =fashion. Verify that the result of the maximization can be expressed as
G
G
ai
p x
W=
pi x i =pG xG = G GaaG
p x = aiW .
i =1
i =1 G, which yields i i

∑

ai
pG xG
aG
, and thus∑

Introduction to Economic Analysis

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15

Monopoly

We have spent a great deal of time on the competitive model, and we now turn to the polar opposite case, that of monopoly.

15.1 Sources of Monopoly
Learning Objectives•

How do monopoles come about?

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-class mail, but faces competition by FedEx andother express mail companies, as well as by faxes and email, in the broader “send documents to others” market. Microsoft has a great
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, which means that they can increase their price above
marginal cost and sustain sales for a long period of time.72 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 of rivals. 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 a firm lacks monopoly power. U.S. Air
dominated air traffic to Philadelphia and Pittsburgh, but still lost money. Porsche has a small share of the automobile market, or eventhe high-end automobile market, but still has monopoly power in that market.
There are three basic sources of monopoly. The most common source is to be granted a monopoly by the government, either throughpatents, in which case the monopoly is temporary, or through a government franchise. Intelsat was a government franchise that was
granted a monopoly on satellite communications, a monopoly that ultimately proved lucrative indeed. Many cities and towns license asingle cable TV company or taxi 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 of time. (Patents generally last twenty years, but pharmaceutical drugs
have their own patent laws.) Copyright also confers a monopoly for a supposedly limited period of time. Thus, the DisneyCorporation owns copyrights on Mickey Mouse, copyrights which by law should have expired, but have been granted an extension by
Congress each time they were due to expire. Copyrights create monopoly power over music as well as cartoon characters, and TimeWarner owns the rights to the song “Happy Birthday to You,” and receives royalties every time it is played on the radio or othercommercial venue.73 Many of the Beatles songs which McCartney co-authored were purchased by Michael Jackson.
A second source of monopoly is a large economy of scale. The scale economy needs to be large relative to the size of demand. If theaverage cost when a single firm serves the entire market is lower than when two or more firms serve the market, a monopoly can be
the result. For example, long distance telephone lines were expensive to install, and the first company to do so, A.T. & T., wound up
being the only provider of long distance service in the United States. Similarly, scale economies in electricity generation meant thatmost communities had a single electricity provider prior to the 1980s, when new technology 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 each consumer. Standards are a common source of network externality. That AA batteries are
standardized makes them more readily accessible, helps drive down their price through competition and economies of scale, and thus
makes the AA battery more valuable. AA batteries are available everywhere, unlike proprietary batteries. Fax machines are valuable
only if others have similar machines. In addition to standards, a source of network externality is third-party products. Choosing
Microsoft Windows as a computer operating system means that there is more software available than for Macintosh or Linux, as thewidespread adoption of Windows has led a large variety of software to be written for it. The JVC Video Home System of VCRs cameto dominate the Sony Beta system, primarily because there were more movies to rent in the VHS format than in the Beta format at thevideo 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 to reach 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 of72

These terms are used somewhat differently by different authors. Both require downward sloping demand, and usually some notionof sustainability of sales. Some distinguish the terms by whether they are “large” or not, others by how long the price increase can besustained. We won’t need such distinctions here.

73

Fair use provisions protect individuals with non-commercial uses of copyrighted materials.

Introduction to Economic Analysis

15-205

DVD players. As DVD players became more prevalent, and the number of discs for rent increased, the market tipped and DVDs cameto 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 cost advantage. For example, software is run by a computer operating system, and needs to be designed
to work well with the operating system. There have been a series of allegations that Microsoft kept secret some of the “application
program interfaces” used by Word as a means of hobbling rivals. If so, access to the design of the operating system itself is an
important input.
Key Takeaways•

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. There are many firms that have market power or monopoly power, which means that they
can increase their price above marginal cost and sustain sales for a long period of time.

•

A large market share is not a proof of monopoly, nor is a small market share proof that a firm lacks monopoly power. There arethree basic sources of monopoly: created by government like patents, a large economy of scale or a network externality, andcontrol of an essential, or a sufficiently valuable, input to the production process.
Key Terms•

Monopoly: Firm with monopoly power•

Monopoly power: The ability to increase their price above marginal cost and sustain sales for a long period of time•

Market Power: Same as monopoly power•

Network externality: Demand with the property that others’ use of a product makes it more valuable to each consumer

15.2 Basic Analysis
Learning Objectives•

What are the basic effects of monopoly, compared to a competitive industry?

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 a monopoly choose its price and quantity?
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 of quantity rather than price, because costs are a function of quantity. Thus, we let p(q) be thedemand 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 order condition, for the profit-maximizing quantity qm:

0=∂π= p(qm ) + qm p′(qm ) − c ′(qm )∂q.

p(q) + qp′(q)The term
is known as marginal revenue. It is the derivative of revenue pq with respect to quantity. Thus, amonopoly 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 is downward sloping. That is,p(q) + qp′(q) < p(q) .

Introduction to Economic Analysis

15-206p
MC
Dead
Weightpm

L

Monopoly
Profits

D
q
qm

qc
MR

Figure 15.2.1: Basic Monopoly Diagram
The choice of monopoly quantity is illustrated in Figure 15.2.1. The key points of this diagram 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, the monopoly
quantity equates marginal revenue and marginal cost, but the monopoly price is higher than the marginal cost. Third, there is a deadweight loss, for the same reason that taxes create a dead weight loss: the higher price of the monopoly prevents some units from being
traded that are valued more highly than they cost. Fourth, the monopoly profits from the increase in price, and the monopoly profit isshaded. Fifth, since under competitive conditions supply equals marginal cost, the intersection of marginal cost and demandcorresponds to the competitive outcome. We see that the monopoly restricts output and charges a higher price than would prevail
under competition.
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== .
εp(qm )p(qm )The left hand side of this equation is known as the price-cost margin or Lerner Index.74 The right hand side is one over the elasticity
of demand. This formula relates the markup 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 inparticular says that the deviation from competition 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, the least expensive way to produce a given
quantity is to produce more and throw some away. 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 ofthe product.
In addition, the effects of monopoly are related to the elasticity of demand. If demand is very elastic, the effect of monopoly on prices
is quite limited. In contrast, if the demand is relatively inelastic, monopolies will increase prices by a large margin.

74

Abba Lerner, 1903-1982. Note that

Introduction to Economic Analysis

dq1
which is used in the derivation.
qm
1
q
=−
= ε,
=−
− qm p′(qm )dpp′(qm )pp(qm )p(qm )

15-207

We can rewrite the formula to obtainp(qm ) =εc ′(qm ).
ε −1εThus, a monopolist marks up marginal cost by the factor ε − 1 , at least when ε>1. This formula is sometimes used to justify a “fixedmarkup policy,” which means a company adds a constant percentage markup to its products. This is an ill-advised policy not justified
by the formula, because the formula suggests a markup which depends on the demand for the product in question and thus not a fixedmarkup for all products a company produces.

Introduction to Economic Analysis

15-208

Key Takeaways•

Even a monopoly is constrained by demand.

•

A monopoly can choose price, or a monopoly can choose quantity and let the demand dictate the price.

•

A monopoly chooses a quantity qm where marginal revenue equals marginal cost, and charges the maximum price p(qm) themarket will bear at that quantity.

•

Marginal revenue is below demand p(q) because demand is downward sloping.

•

The monopoly price is higher than the marginal cost.

•

There is a dead weight loss of monopoly for the same reason that taxes create a dead weight loss: the higher price of themonopoly prevents some units from being traded that are valued more highly than they cost.

•

A monopoly restricts output and charges a higher price than would prevail under competition.

•

The price-cost margin is the ratio price minus marginal cost over price and measures the deviation from marginal cost pricing.

•

A monopoly chooses a price or quantity which equates the price cost margin to inverse of the demand elasticity.

•

A monopolist produces in the elastic portion of demand.

•εA monopolist marks up marginal cost by the factor ε − 1 , when the elasticity of demand ε exceeds one.
Key Terms•

Marginal revenue: the derivative of revenue pq with respect to quantity•

Price-cost margin: price minus marginal cost over price•Lerner Index: Same as price-cost margin
Exercises

15.2.1

If demand is linear, p(q)=a – bq, what is marginal revenue? Plot demand and marginal revenue, and total revenue qp(q) as afunction of q.

15.2.2For the case of constant elasticity of demand, what is marginal revenue?

15.2.3

Consider a monopolist with cost c = 3q

15.2.4a.

If demand is given by q = 50 – 2p, what is the monopoly price and quantity? What are the profits?

b.

Repeat part a for demand given by q = 10 / p

The government wishes to impose a tax, of fraction t, on the profits of a monopolist. How does this affect the monopolist’s
optimal output quantity?

15.3 Effect of Taxes
Learning Objectives•

How does a monopoly respond to taxes?

A tax imposed on a seller with monopoly power performs differently than a tax imposed on a competitive industry. Ultimately aperfectly competitive industry must pass on all of 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 long-run.
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∂q.

Introduction to Economic Analysis

15-209Viewing the monopoly quantity as a function of t, we obtain:

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

dqm
p′(qm )=> 0.
dt
2 p′(qm ) + qm p′′(qm ) − c′′(qm )Thus, a tax causes a monopoly to increase its price. In addition, the monopoly price rises by less than the tax iforp′(qm )

dqm
<1
dt
,

p′(qm ) + qm p′′(qm ) − c′′(qm ) < 0.
This condition need not be true, but is a standard regularity condition imposed by assumption. It is true for linear demand andincreasing marginal cost. It is false for constant elasticity of demand, ε>1 (which is the relevant case, for otherwise the second orderconditions 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 the tax.
Key Takeaways•

A perfectly competitive industry must pass on all of a tax to consumers, because in the long-run the competitive industry earns
zero profits. A monopolist might absorb some portion of a tax even in the long-run.

•

A tax causes a monopoly to increase its price and reduce its quantity.

•

A tax may or may not increase the monopoly markup.
Exercises

15.3.1

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 – the before tax monopoly preferred qb
to qa and the taxed monopoly made higher profits from qb together imply 𝑞𝑞𝑏𝑏 ≥ 𝑞𝑞𝑎𝑎

15.4 Price Discrimination

Learning Objectives•

Do monopolies charge different consumers different prices?

•

Why and how much?

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. andEuropean prices. (The comparison is between identical drugs produced by the same manufacturer.)
Pharmaceutical drugs differ in price across countries primarily because demand conditions 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 toεcustomers with more elastic demand, because ε − 1 is a decreasing function of ε, for ε>1. Charging different prices for the same

product to different customers is known as price discrimination. In business settings, 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 proofof being a student to qualify for the lower price. Such student discounts are examples of price discrimination, and students have moreelastic 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 – for different prices, and thus qualify as price discrimination.
Introduction to Economic Analysis

15-210In order for a seller to price-discriminate, the seller must be able toidentify (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 price than another, there is potentially an opportunity for arbitrage, arising from members of thelow 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 the low price.
Why offer student discounts at the movies? You already know the answer to this – students have lower incomes on average thanothers, and lower incomes translate into a lower 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 United States, atleast). However, seniors have more free time, and thus are able to substitute to matinee showings75 or drive to more distant locations
should those offer discounts. Thus seniors have relatively elastic demand more because of their ability to substitute than because of
their income.
Airlines commonly price discriminate, using “Saturday night stay-overs” and other devices. To see that such charges represent pricediscrimination, consider a passenger who lives in Dallas but needs to spend Monday through Thursday in Los Angeles two weeks in arow. 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 two round-trips, one of which originates in Dallas, while the other originates in Los Angeles:
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 less than $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 for most
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. Businesstravelers 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 a weekend stay-over is an indicator of a leisure traveler. It
doesn’t work perfectly as an indicator – some business travelers must be away for the weekend – but it is sufficiently correlated withleisure 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, andqualifying for the discount requires showing an identity card. In contrast, airline price discrimination is not based on the identity of

75

Matinee showings are those early in the day, which are usually discounted. These discounts are not price discrimination because ashow at noon isn’t the same product as a show in the evening.

Introduction to Economic Analysis

15-211the buyer but on the choices by the buyer. The former is known as direct price discrimination, while the latter is known as indirect
price discrimination.76
Two common examples of indirect price discrimination are coupons and quantity discounts. Coupons offer discounts for products andare especially common in grocery stores, where they are usually provided in a newspaper section available free at the front of thestore. Coupons discriminate on the basis of the cost of time. It takes time to find the coupons for the products one is interested inbuying, and thus those with a high value of time won’t find it worthwhile spending twenty minutes to save $5 (effectively a $15 perhour return), while those with a low value of time will find that return worthwhile. Since those with a low value of time tend to be
more price sensitive (more elastic demand), coupons offer a discount available to all but used primarily by customers with a moreelastic 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 perunit than smaller sizes, and the difference is 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 thendiscounted. Thus, the “twenty-four pack” 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.
Key Takeaways•

A monopoly seller would like to charge a higher markup over marginal cost to customers with less elastic demand than tocustomers with more elastic demand.

•

In order for a seller to price-discriminate, the seller must be able to identify (approximately) the demand of groups of customers
and prevent arbitrage•

Since price discrimination requires charging one group a higher price than another, there is potentially an opportunity forarbitrage•

Airlines commonly price discriminate, using “Saturday night stay-overs” and other devices.

•

Direct price discrimination conditions on the identity of the buyer, while indirect price discrimination involves several offers andachieves price discrimination through customer choices.

•

Two common examples of indirect price discrimination are coupons and quantity discounts.
Key Terms•

Price discrimination: Charging distinct customers different prices for the same good•

Value-based pricing: Same as price discrimination•

Direct price discrimination: Charging customers based on their identity•

Indirect price discrimination: Offering a menu or set of prices and permitting customers to choose distinct prices•

Exercises•

Determine whether the following are direct price discrimination, indirect price discrimination, or not price discrimination, andwhy•Student discounts at local restaurants•

Financial aid at colleges•

Matinee discount at the movies•

Home and professional versions of Microsoft’s operating system•

Lower airline fares for weekend flights•

Buy one, get one free specials

76

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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15.5 Welfare Effects
Learning Objectives•

Is price discrimination efficient, or inefficient?

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.
This exercise illustrates a much more general proposition: if a price-discriminating monopolist produces less than a non-discriminating
monopolist, then price discrimination 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 fromtrade. Arbitrage, however, leads to a common price like that charged by a non-discriminating monopolist. Thus, the only way pricediscrimination can increase welfare is if it leads a seller to sell more output than she would otherwise. This is possible, as the next
exercise shows.
In exercise 16.3.2, 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 pricediscrimination. (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 thatpeople with lower incomes tend to have more elastic demand, and thus get lower prices under price discrimination than absent pricediscrimination. Consequently, a ban on price discrimination tends to hurt the poor and benefit the rich no matter what the overall
effect.
A common form of price discrimination is known as two-part pricing. Two-part pricing usually involves a fixed charge and amarginal charge, and thus offers an ability for a seller to capture a portion of the consumer surplus. For example, electricity often
comes with a fixed price per month and then a price per kilowatt-hour, which is two-part pricing. Similarly, long distance and cellular
telephone companies charge a fixed fee per month, with a fixed number of “included” minutes, and a price per minute for additional
minutes. Such contracts really involve three parts rather than two-parts, but are similar in 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 from trade. This is illustrated in Figure 15.5.1.
pMCConsumer
Surplus =Fi d F
Price=pcDqqc
Figure 15.5.1: Two-Part Pricing

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Key Takeaways•

If a price-discriminating monopolist produces less than a non-discriminating monopolist, then price discrimination reduces
welfare.

•Price discrimination which opens a new, previously unserved market increases welfare.

•

A ban on price discrimination tends to hurt the poor and benefit the rich no matter what the overall effect.

•

Two-part pricing involves a fixed charge and a marginal charge.

•

The ideal two-part price is to charge marginal cost plus a fixed charge equal to the customer’s consumer surplus, in which casethe seller captures the entire gains from trade.
Key Terms•

Two-part pricing: A fixed charge plus a price per unit
Exercises

16.3.1

Let marginal cost be zero for all quantities. Suppose there are two equal-sized groups of customers, group 1 with demandq(p)=12-p, group 2 with demand q(p)=8-p. Show that a non-discriminating monopolist charges a price of 5 and thediscriminating monopolist charges group 1 the price 6 and group 2 the price 4. Then calculate the gains from trade, withdiscrimination and without, and show that price discrimination reduces the gains from trade.

16.3.2

Let marginal cost be zero for all quantities. Suppose there are two equal-sized groups of customers, group 1 with demandq(p)=12-p, group 2 with demand q(p)=4-p. Show that a non-discriminating monopolist charges a price of 6 and thediscriminating monopolist charges group 1 the price 6 and group 2 the price 2. Then calculate the gains from trade, withdiscrimination and without, and show that price discrimination increases the gains from trade.

15.6 Natural Monopoly
Learning Objectives•

When there is a scale economy, what market prices will arise?

•

How is the monopoly price constrained by the threat of entry?

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 is illustrated in Figure 15.6.1. 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 like to price at pm, which maximizes profits.77
Historically, the United States and other nations have regulated natural monopolies like those found in electricity, telephony and water
service. An immediate problem with regulation is that the efficient price, that is, the price that maximizes the gains from trade,
requires a subsidy from outside the industry. We see the need for a subsidy in Figure 15.6.1 because the price that maximizes thegains from trade is p1, which sets the demand (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 besubsidized, and subsidies are used with postal service and passenger rail in the United States, and historically for many more productsin Canada and Europe including airlines and airplane manufacture. Alternatively, regulation could be imposed that aims to limit theprice to p2, the lowest break-even price. This is the more common strategy in the United States.

77

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 price is 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 15.6.1: Natural Monopoly
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 of firms. Both of these approaches induce some inefficiency of production. In both cases, anincrease in average cost may translate into additional profits for the firm, causing regulated firms to engage in unnecessary activities.
Key Takeaways•

A natural monopoly arises when a single firm can efficiently serve the entire market•

Historically, the United States and other nations have regulated natural monopolies like those found in electricity, telephony andwater service.

•

The efficient price tends not to be sustainable because of decreasing average cost.

•

Efficient prices can be achieved with subsidies, as used with postal service and passenger rail in the United States, and historicallyfor more products in Canada and Europe including airlines and airplane manufacture. Alternatively, regulation could be imposedthat aims to limit the price to average cost, the lowest break-even price. This is the more common strategy in the United States.

•

Two common strategies for limiting the price are price-cap regulation, which directly imposes a maximum price, and rate of
return regulation, that limits the profitability of firms. Both of these approaches induce some inefficiency of production.
Key Terms•

Natural monopoly: A monopoly arising because of a scale economy•

Price-cap regulation: Direct regulation of prices•

Rate of return regulation: Regulation of profits

15.7 Peak Load Pricing
Learning Objectives•

How do monopolies respond to predictable cost fluctuation as arises in electricity and hotel markets?

Fluctuations in demand often require holding capacity which is used only a fraction of the time. Hotels have off-seasons when mostrooms are empty. Electric power plants are designed to handle peak demand, usually hot summer days, with some of the capacity
standing idle on other days. Demand for trans-Atlantic airline flights is much higher in the summer than the rest of the year. All ofthese examples have the similarity that an amount of capacity – hotel space, airplane seats, electric generation capacity – will be usedover and over, which means it is used in both high demand and low demand states. How should pricing be accomplished when
demand fluctuates? This can be thought of as a question of how to allocate the cost of capacity across several time periods when
demand systematically fluctuates.

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Consider a firm that experiences two kinds of costs – a capacity cost and a marginal cost. How should capacity be priced? This issue
is applicable to a wide variety of industries, including pipelines, airlines, telephone networks, construction, electricity, highways, andthe internet.
The basic peak-load pricing problem, pioneered by Marcel Boiteux (1922 – ), considers two periods. The firm’s profits are given by

π = p1q1 + p2q2 − β max {q1 , q2 } − mc(q1 + q2 ).
Setting price equal to marginal costs is not sustainable, because a firm selling with price equal to marginal cost would not earn a returnon the capacity, and thus would lose money and go out of business. Consequently, a capacity charge is necessary. The question ofpeak load pricing is how the capacity charge should be allocated. This question is not trivial because some of the capacity is used inboth 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 in computing
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 toinstead 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 λincreases. Thus, the correct solution to the constrained 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. This is a function which is 1 when A is true, andzero otherwise. Using this notation, the first order 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

)

or,

p1 (q1 ) − β 1q1 ≥q2 − mc
p1

=

λ 1
λ + 1 ε11
where 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
p2 (q2 ) − mc
λ 1
=
=
p2
λ + 1 ε2 .
p1
λ + 1 ε1 andIn 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 the peak –assigning all of the capacity charge to good 1 would make period 2 the peak.
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15-216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 is allocated 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 thequantity 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.
Key Takeaways•

Fluctuations in demand often require holding capacity which is used only a fraction of the time. Peak load pricing allocates thecost of capacity across several time periods when demand systematically fluctuates.

•

Important industries with peak load problems include pipelines, airlines, telephone networks, construction, electricity, highways,
and the internet.

•

Under efficient peak load pricing, either the prices equalize the quantity demanded, or the prices impose the entire cost of
capacity only on one peak period. Moreover, the markup over marginal cost is proportional to the inverse of the elasticity.
Key Terms•

Peak-load pricing: Pricing based on demand variation
Exercises

15.7.1For each of the following, state whether you would expect peak load pricing to equalize the quantity demanded acrossperiods or impose the entire cost of capacity on the peak period. Explain why.
a.

Hotels in Miamib.

Electricity

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16

Games & 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 take prices as given is justified only when there are many competing participants. We have also
examined monopoly, precisely because a monopoly by definition doesn’t have to worry about competitors. Strategic behavior
involves the examination of the intermediate case, where there are few enough participants that they take each other into account andtheir 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 made by others.
The right tool for the job of examining strategic behavior in economic circumstances is game theory, the study of how people playgames. Game theory was pioneered by the mathematical 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. wasguided by game theoretic analyses.78
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, and a set of actions they can take. Both information andactions may depend on the history of the game prior to that moment. Finally, players have payoffs, and are assumed to play in such a
way as to maximize their expected payoff, taking into account their expectations for the play of others. When the players, theirinformation and available actions, and payoffs have been specified, we have a game.

16.1 Matrix Games
Learning Objectives•

How are games modeled?

•

What is optimal play?

The 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 amatrix; the column player simultaneously chooses a column. The outcome of the game is a pair of payoffs where the first entry is thepayoff of the row player and the second is the payoff of the column player. Table 16.1.1 provides an example of a “2 × 2” matrix
payoff game, the most famous game of all, which is known as the prisoner’s dilemma.
Table 16.1.1: The Prisoner’s Dilemma

Row

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 guilty of the crime. Each player can choose either to confess or not. If Row confesses, we are in 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. (The entries
correspond to the number of years lost to prison. The first entry is always Row’s payoff, the second Column’s payoff.) Thus, forexample, if Column confesses and Row does not, the relevant payoff is the first column and the second row, in reverse color in Table
16.1.2.
Table 16.1.2: Solving the Prisoner's Dilemma
Column78

An important reference for game theory is John von Neumann (1903-1957) and Oskar Morgenstern (1902-1977), Theory of Gamesand 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, applicationsin the military arena were pioneered by Nobel Laureate Thomas Schelling (1921 – ), The Strategy of Conflict, Cambridge: Cambridge
University Press, 1960.
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16-218Row

Confess

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 no years, that is, goes free. This is the payoff (20,0) in reverse color in Table 16.1.2. If both confess, 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 convicted anyway (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 a strict 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 from not confessing, and is better off confessing. Either way, nomatter what Column does, Row should choose to confess.79 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 should choose to confess. That is, Column also has adominant 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. Either way, Column gets a higher payoff (lower
number of years lost to prison) by confessing.
The presence of a dominant strategy makes the prisoner’s dilemma particularly easy to solve. 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 doabout it in the context of the game, because for each, the alternative to serving ten years is to serve twenty years. This outcome isreferred 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. BothMicrosoft and Piuny are considering entering a new market for an online service. The payoff structure is
Table 16.1.3: An Entry Game

MS

Piuny
Enter

Don’t

Enter

(2,-2)

(5,0)

Don’t

(0,5)

(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 themarket to itself, they get 5 and the other firm gets 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 than when 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 of Microsoft.80 Thus, Piuny can conclude that Microsoft
is going to enter, and this means that Piuny should not enter. Thus, the equilibrium of the game is for MS to enter and Piuny not toenter. 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 toenter, which means the strategy of not entering is dominated by the strategy of entering, so we eliminated the dominated strategy.
That leaves a simplified game in which Microsoft enters:
Table 16.1.4; Eliminating a Dominated Strategy
Piuny

79

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 orfriendship among thieves, and Row and Column only care about what they themselves will get.
80

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 aregoing to play a certain way, that is, to demonstrate commitment to a particular advantageous strategy. Such topics are taken up in
business strategy and managerial economics.
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MS

Enter

Enter

Don’t

(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 dominated strategies 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.81
Here is another game, with three strategies for each player.
Table 16.1.5: A 3 X 3 Game

Row

Column
Left

CenterRight

Top(-5,-1)

(2,2)

(3,3)

Middle(1,-3)

(1,2)

(1,1)

Bottom(0,10)(0,0)(0,-10)The process of iterated elimination of dominated strategies is illustrated by actually eliminating the rows and columns, as follows. A
reverse color (white writing on black background) indicates a dominated strategy.
Middle dominates bottom for Row, yielding:
Table 16.1.6: Eliminating a Dominated Strategy

Row

Column
Left

CenterRight

Top(-5,-1)

(2,2)

(3,3)

Middle(1,-3)

(1,2)

(1,1)

Bottom(0,10)(0,0)(0,-10)With bottom eliminated, Left is now dominated for Column by either Center or Right, which eliminates the left column.
Table 16.1.7: Eliminating Another Dominated Strategy

Row

Column
Left

CenterRight

Top(-5,-1)

(2,2)

(3,3)

Middle(1,-3)

(1,2)

(1,1)

Bottom(0,10)(0,0)(0,-10)With Left and Bottom eliminated, Top now dominates Middle for Row.
Table 16.1.8: Eliminating a Third Dominated Strategy

Row

ColumnTop

Left

CenterRight(-5,-1)

(2,2)

(3,3)

81

A strategy may be dominated not by any particular alternate strategy but by a randomization over other strategies, which is anadvanced topic not considered here.

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16-220Middle(1,-3)

(1,2)

(1,1)

Bottom(0,10)(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).
Table 16.1.9: Game Solved

Row

Column
Left

CenterRight

Top(-5,-1)

(2,2)

(3,3)

Middle(1,-3)

(1,2)

(1,1)

Bottom(0,10)(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 no player 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 a Nash equilibrium, named for Nobel
laureate John Nash (1928 – ).
Key Takeaways•

Strategic behavior arises when there are few enough market participants that their actions individually matter, and where thebehavior of any one participant influences choices of the other participants.

•

Game theory is the study of how people play games. A game is the players, their information and available actions, and payoffs.

•

In a matrix payoff game, all actions are chosen simultaneously. 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 the second is the payoff of the column player.

•

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 guilty of the crime. Each player can choose either to confess or not. Each player individually
benefits from confessing, but together they are harmed.

•

A dominant strategy is a strategy that is best for a player no matter what others choose.

•

Iterated elimination of dominated strategies, first removes strategies dominated by others, then checks if any new strategies are
dominated and removes them, and so on. In many cases iterated elimination of dominated strategies solves a game.
Key Terms•

Matrix payoff game: A game in which all actions are chosen simultaneously; the two person version has a matrix representation•

Prisoner’s dilemma: A game in which the strategies are to confess or not confess; first to confess avoids jail•

Iterated elimination of dominated strategies,: Eliminating strategies by sequentially removing strategies that are dominated for aplayer•Dominant strategy: a strategy that is optimal no matter what the other players do

16.2 Nash Equilibrium
Learning Objectives•

What is an equilibrium to a game?

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 therow player. Let us consider first the prisoner’s dilemma, which we have already seen.
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Table 16.2.1: Prisoner's Dilemma Again

Row

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 player chooses confession, the row player chooses confession, because -10 is better than -20. Thus, for bothplayers to confess is a Nash equilibrium. Now let us consider whether any other outcome is a Nash equilibrium. In any outcome, atleast one player is not confessing. But that player could get a higher payoff by confessing, so no other outcome could be a Nashequilibrium.
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 the other hand, if it involves a tied value, a strategy may be dominated but still part of a Nashequilibrium.
The Nash equilibrium is justified as a solution concept for games as follows. First, if the players are playing a Nash equilibrium, no
one has an incentive to change their play or re-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 at least 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 eachother’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 playerfrom winning, so the outcome is a tie. Young children play Tic-Tac-Toe and eventually learn how to play equilibrium strategies, atwhich point the game ceases to be very interesting since it just repeats the same outcome. In contrast, it is known that Chess has anequilibrium, but no one knows what it is. Thus, at this point we don’t know if the first mover (White) always wins, or the second
mover (Black) always wins, or if the outcome is a draw (neither is able to win). 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 the game thirty or forty
moves after the start. So we can be quite confident that people are not (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 of the sexes involves a married couple who aregoing to meet each other after work, but haven’t decided where they are meeting. Their options are a baseball game or the ballet.
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:Table 16.2.2: The Battle of the Sexes

Man

Woman
BaseballBalletBaseball

(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 they both 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 eliminationof dominated strategies eliminates nothing. You can readily verify that there are two Nash equilibria: one in which they both go to thebaseball game, and one in which they both go to ballet. The logic is: if the man is going to the baseball game, the woman prefers the 2points she gets at the baseball game to the single point she would get at the ballet. Similarly, if the woman is going to the baseballgame, the man gets three points going there, versus zero at the ballet. Thus, for both to go to the baseball game is a Nash equilibrium.
It is straightforward to show that for both to go to the ballet 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 the column player choose heads or tails, and ifthey match, the row player gets the coins, while if they don’t match, the column player gets the coins. The payoffs are provided in thenext table.
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Table 16.2.3: Matching Pennies

Row

Column
Heads

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 the players
mix across various actions.
Key Takeaways•

In a Nash equilibrium, each player chooses the strategy that maximizes their expected payoff, given the strategies employed byothers. Outcomes that aren’t Nash equilibria involve mistakes for at least one player.

•

The game called the” battle of the sexes” has two Nash equilibria.

•

In the game of matching pennies, none of the four possibilities represents a Nash equilibrium. Consequently players need torandomize. Random strategies are known as mixed strategies, because the players mix across various actions.
Key Terms•

Nash equilibrium: A set of strategies which are individually optimal given the strategies of the other players•

The battle of the sexes: A coordination game•

Matching pennies: A child's game in which the sum of the payoffs is zero•

Mixed strategies: Strategies that involve randomization

16.3 Mixed Strategies
Learning Objectives•

What games require or admit randomization as part of their solution?

Let us consider the matching pennies game again.
Table 16.3.1: Matching Pennies Again

Row

Column
Heads

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 value of 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 is summarized in the next table.
Table 16.3.2: Mixed Strategy in Matching Pennies

Row

Column
Heads

Tails

Heads

(1,-1)(-1,1)

1p + -1(1-p)=2p-1

Tails(-1,1)(1,-1)-1p + 1(1-p)=1-2p

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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 an alternate strategy. A Nash equilibrium without randomization is called a pure strategy Nashequilibrium.
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, and wouldn’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 withwhich 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 of playing Tails was 1 – 2p. Row is willing to randomize if these are equal, which solves for p =½.
Now let’s try a somewhat more challenging example, and revisit the battle of the sexes.
Table 16.3.3: Mixed Strategy in Battle of the Sexes

Man

Woman
BaseballBalletBaseball

(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 amixed strategy, let the Woman go to the baseball game with probability p, and the Man go to the baseball game with probability q.
Table 16.3.4 contains the computation of the mixed strategy payoffs for each player.
Table 16.3.4: Full Computation of the Mixed Strategy

Man

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, whichyields p = ¼ . That is, the Man will be willing to randomize which event he attends if the Woman is going to the ballet ¾ of the time,and otherwise to the baseball game. This makes the Man indifferent between the two events, because he prefers to be with the
Woman, but he also likes to be at the baseball game; to make up for the advantage 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 of thetime. These are independent probabilities, so to get the probability that both go to the game, we multiply the probabilities, which

3
yields16 . The next table fills in the probabilities for all four possible outcomes.

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Table 16.3.5: Mixed Strategy Probabilities
Woman

Man

BaseballBalletBaseballBallet

3

9

1

16
16

3

16
16

Note 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 aswell. 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 that neither party can improve their payoff, given the behavior of theother party.
In the Battle of the sexes, the mixed strategy Nash equilibrium may seem unlikely, and we might expect the couple to coordinate more
effectively. Indeed, a simple call on the telephone should rule out the mixed strategy. So let’s consider another game related to theBattle of the Sexes, where a failure of coordination makes more sense. This is the game of “Chicken.” Chicken is played by two
drivers driving toward each other, trying to convince 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 other doesn’t, the swerver loses and the other wins, andwe’ll give the winner one point.82 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 can change the game and see what happens.
Table 16.3.6: Chicken

Row

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 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 is¾. You can verify that the Row player has the same probability by setting the probability that Row swerves equal to q and computing

1
Column’s expected payoffs. Thus, the probability of a collision is

16 in 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, theywouldn’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 more reasonable 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
Table 16.3.7: Paper, Scissors, RockRow

ColumnPaper

Scissors

Rock

Paper

(0,0)

(-1,1)(1,-1)

Scissors(1,-1)(0,0)(-1,1)

82

Note that adding a constant to a player’s payoffs, or multiplying that player’s payoffs by a positive constant, doesn’t affect the Nashequilibria, pure or mixed. Therefore, we can always let one outcome for each player be zero, and another outcome be one.
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16-225Rock(-1,1)(1,-1)(0,0)

Key Takeaways•

A mixed strategy Nash equilibrium involves at least one player playing a randomized strategy, and no player being able toincrease their expected payoff by playing an alternate strategy. A Nash equilibrium without randomization is called a purestrategy Nash equilibrium.

•

If a player is supposed to randomize over two strategies, then both must produce the same expected payoff.

•

The matching pennies game has a mixed strategy and no pure strategy.

•

The battle of the sexes game has a mixed strategy and two pure strategies.

•

The game of chicken is similar to the battle of the sexes, and like it, has two pure and one mixed strategy.
Key Terms•

A mixed strategy Nash equilibrium: A Nash equilibrium in which at least one player randomizes•

A pure strategy Nash equilibrium: A Nash equilibrium in which no player randomizes
Exercises

16.3.1

Let q be the probability that Row plays Heads. Show that Column is willing 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.)

16.3.2

Show that, in the Paper, Scissors, Rock game, there are no pure strategy equilibria. Show that playing all three actions withequal likelihood is a mixed strategy equilibrium.

16.3.316.3.4

Find all equilibria of the following games:
If you multiply a positive constant to a player’s payoff, the equilibria of the game do not change. True or false, and why?
Column
Right

Up

(3,2)

(11,1)

Down

(4,5)

(8,0)

How
to

Right

(3,3)

(0,0)

Down (4,5)(8,0)

Column

Row

•

Left

c

Left

Right

Up

(7,2)

(0,9)

Down

(8,7)

(8,8)

e

Clean

Don’t

Clean

(10,10)(0,15)

Don’t(15,0)(2,2)

ColumnRow

Row

ColumnUp

Column

Row

Left

b

Learning

d

Left

Right

Up

(1,1)

(2,4)

Down

(4,1)

(3,2)

16.4

ExamplesObjectivesfColumncan game
economic

Up

Left

Right

(4,2)

(2,3)

theory be applied
settings?

Row

Row

a

Our first
exampleconcerns public
Down (3,8)(1,5)
goods. In
this game,each player caneither contribute, or not. For example, two roommates can either clean their apartment, or not. If they both clean, the apartment is
nice. If one cleans, that roommate does all the work and the other gets half of the benefits. Finally, if neither clean, neither is very
happy. This suggests payoffs like:
Table 16.4.1: Cleaning the Apartment

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You can verify that this game is similar to the prisoner’s dilemma, in that the only Nash equilibrium 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 this problem, using strategies that we will investigate
when we consider dynamic games.
Table 16.4.2: Driving on the Right

Row

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 right side but that it is the same side. This iscaptured in the Driving on the Right game above. If both players drive on the same side, then they both get one point, otherwise theyget 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 past each 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.83
Table 16.4.3: Bank Location GameLANYC
No Concession

Tax Rebate

No Concession(30,10)(10,20)

Tax Rebate(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 withthe bank. LA could also offer the concession, which would bring the bank back to LA.
Table 16.4.4: Political Mudslinging

Dem

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, and83

Continental Europe drove on the left until about the time of the French revolution. At that time, some individuals 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 theright 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, another coordination 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 canlead 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 and stopping on green (because ‘red is the color of progress’) but wiser heads prevailed and the plan
was scrapped.
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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.
You have probably had the experience of trying to avoid encountering someone, who we will call Rocky. In this instance, Rocky is
actually trying to find you. The situation is that 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(these different 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 he attends is worth 10. These values are reflected in the following table.
Table 16.4.5: Avoiding Rocky

You

Rocky
Party 1

Party 2

Party 1

(5,15)(20,10)Party 2

(15,5)(0,20)

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:
Table 16.4.6: Price Cutting Game

Firm 1

Firm 2
High

Low

High

(15,15)(0,25)

Low(25,0)(5,5)

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Key Takeaways•

The free-rider problem of public goods with two players can be formulated as a game.

•

Whether to drive on the right or left is a game similar to battle of the sexes.

•

Many everyday situations are reasonably formulated as games.
Exercises

16.4.1

Verify that the bank location game has no pure strategy equilibria, and that there is a mixed strategy equilibrium where eachcity offers a rebate with probability ½.

16.4.2

Show that the only Nash equilibrium of the Political Mudslinging game is a mixed strategy with equal probabilities ofthrowing mud and not throwing mud.

16.4.3

Suppose that voters partially forgive a candidate for throwing mud in the Political Mudslinging game when the rival throws
mud, so that the (Mud, Mud) outcome has payoff (2.5,.5). How does the equilibrium change?

16.4.4a.

Show there are no pure strategy Nash equilibria in the Avoiding Rocky game.

b.

Find the mixed strategy Nash equilibria.

7c.
15.7.2

Show that the probability you encounter Rocky is

12 .

Show that the firms in the Price Cutting game have a dominant strategy to price low, so that the only Nash equilibrium is(Low, Low).

16.5 Subgame Perfection
Learning Objectives•

How do dynamic games play out?

So far, we have considered only games that are played simultaneously. Several of these games, notably the price cutting andapartment 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:
Table 16.5.1; Bank Location RevisitedLA

NYC
No Concession

Tax Rebate

No Concession(30,10)(10,20)

Tax Rebate(20,10)(20,0)

If neither city offered a rebate, then LA won the bidding. So suppose instead of the simultaneous move game, that first New York
decided whether to offer a rebate, and then LA could decide to offer a rebate. This sequential structure leads to a game that looks like
Figure 16.5.1:
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 canthen choose Rebate or None. Similarly, if NYC chooses No Rebate, LA can choose Rebate or None. The payoffs (using the standardof (LA, NYC) ordering) are written below the choices.

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16-229NYC
RebateNo Rebate

LA

LA
RebateRebateNone

None(20,0)(10,20)(20,10)(30,10)Figure 16.5.1 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 thatrhetorical 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.
Subgame perfection requires each player to act in its best interest, independent of the history of the game.84 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 threetimes 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 in some 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 notwhen NYC doesn’t. This is illustrated in the game 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 16.5.2.
Once LA’s subgame perfect choices are taken into account, NYC is presented with the choice of offering a rebate, in which case itgets 0, or not offering a rebate, in which case it 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 basedon the last player’s expected behavior, what the penultimate player does, and so on.

NYC
RebateNo Rebate

LA

LA
RebateRebateNone(20,0)(10,20)None(20,10)(30,10)Figure 16.5.2: Subgame Perfection

84

Subgame perfection was introduced by Nobel laureate Reinhart Selten (1930 – ).

Introduction to Economic Analysis

16-230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 your choice. Then you might as well go to the party you like best, because Rocky is going to follow
you wherever you go. This is represented in Figure 16.5.3.

You
Party 1

Party 2

R

R
Party 1

Party 1

Party 2

(5,15)(20,10)Party 2

(15,5)(0,20)

Figure 16.5.3: Can’t Avoid Rocky
Since Rocky’s optimal choice eliminates your best outcomes, you make the best of a bad situation 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 a simultaneousgame. In contrast, a first mover advantage is a situation where choosing first is better than choosing simultaneously. First moveradvantages arise when going first influences the second mover advantageously.
Key Takeaways•

To decide what one should do in a sequential game, one figures out what will happen in the future, and then work backwards todecide what to do in the present.

•

Subgame perfection requires each player to act in its best interest, independent of the history of the game.

•

A first mover advantage is a situation where choosing first is better than choosing simultaneously. First mover advantages arise
when going first influences the second mover advantageously.

•

A second mover advantage is a situation where choosing second is better than choosing simultaneously. Second moveradvantages arise when going second permits exploiting choices made by others.
Key Terms•

Subgame perfection: A requirement on Nash equilibria that every stage of a dynamic game is played in an optimal way•

Second mover advantage: a game where choosing second is better than choosing simultaneously•First mover advantage: a game where choosing first is better than choosing simultaneously
Exercises

16.5.1

Formulate the battle of the sexes as a sequential game, letting the woman choose first. (This situation could arise if thewoman can leave a message for the man about where she has gone.) Show that there is only one subgame perfectequilibrium, and that the woman enjoys a first-mover advantage over the man, and she gets her most preferred outcome.

16.5.2

What payoffs would players receive if they played this two-player sequential game below? Payoffs are listed in parentheses,with player 1’s payoffs always listed first. (Note that choosing “in” allows the other player to make a decision, whilechoosing “out” ends the game.)

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1

in

2

in

out

out

(1, 1)
16.5.3

1(2, 3)

in

2

out

in

(15, 15)out(8, 20)(3, 5)

Consider the following game:

Column

Row

L

R

U

1, 3

3, 2

D

4, 1

2, 4

a.

Find all equilibria of the above game.

b.

What is the subgame perfect equilibrium if you turn this into a sequential game, with Column going first? With Row
going first?

c.

In which game does Column get the highest payoff—the simultaneous game, the sequential game when Column goesfirst, or the sequential game when Column goes second?

16.6 Supergames
Learning Objectives•

What can happen in games that are repeated several times?

•

What role does the threat of retaliation play?

Some situations, like the pricing game or the apartment-cleaning game, are played over and over. Such situations are best modeled asa supergame.85 A supergame is a game played over and over again without end, where the players discount the future. The gameplayed each time is known as a stage game. Generally supergames are played in times 1, 2, 3, …
Cooperation may be possible in supergames, if the future is important enough. Consider the pricing game introduced above.
Table 16.6.1: Price Cutting, Revisited

Firm 1

Firm 2
High

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, and then your best choice is to also price low from then on. Thus, your strategy is to price high up
until some point t – 1, and then price low from time t on. Your rival will price high through t, and price low from t + 1 on. This gives

85

The supergame was invented by Robert Aumann (1930 – ) in 1959.

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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
δt
15
δt
15
δt
+ 25δ t + 5=−(15 − 25(1 − δ) − 5δ) =−(−10 + 20δ)1− δ
1− δ 1− δ 1− δ
1− δ 1− δ.

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 to price low, that is, t = ∞. Thus, in particular, the grim trigger strategy is an optimal strategy fora player when the rival is playing the grim trigger strategy if δ≥½. In other words, cooperation in pricing is a subgame perfectequilibrium if the future is important enough, 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 price cutting 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:
Table 16.6.2: A Variation of the Price Cutting Game

Firm 1

Firm 2
High

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 isthat the total profits of firms 1 and 2 are higher in either (High, Low) or (Low, High) than in (High, High). One solution is to alternate
between (High, Low) and (Low, High). Such alternation can also be supported as an equilibrium, using the grim trigger strategy – thatis, if a firm does anything other than what is it supposed to in the alternating solution, the firms instead play (Low, Low) forever.
The folk theorem says that if the value of the future is high enough, any outcome that is individually rational can be supported as anequilibrium 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 from that player’s perspective. Thus, in the pricing
game, the worst equilibrium of the stage game offered each player 5, so an outcome can be supported if it offers each player at least arunning 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 play their role inthe stage game equilibrium every period. Second, any other plan of action can be turned into a subgame perfect equilibrium merely bythreatening any agent who deviates from that plan with an infinite repetition of the worst stage game equilibrium from 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 type threat, 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 kindsof coordination failures we saw in the battle of 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 descriptions of these games, assumptions that matter andare unlikely to be true in practice. First, the players know their own payoffs. Second, they know their rival’s payoffs. They possess acomplete description of the available strategies and can calculate the consequences 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 the same, 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 are common 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 of equilibria to supergames, and provides noguidance on which one will be played. These assumptions 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.

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Key Takeaways•

A supergame is a game played over and over again without end, where the players discount the future. The game played eachtime is known as a stage game.

•

Playing a (“one-shot”) Nash equilibrium to the stage game forever is a subgame perfect equilibrium to the supergame.

•

A grim trigger strategy involves starting play by using one behavior and if another player ever does something else, switching to
one-shot Nash behavior forever.

•

The folk theorem says that if the value of the future is high enough, any outcome that is individually rational can be supported as
an equilibrium to the supergame. Individual rationality for a player means that the outcome offers a present value of profits atleast as high as that offered in the worst equilibrium in the stage game from that player’s perspective.

•

If players are patient, full cooperation is obtainable as one of many subgame perfect equilibria to supergames.
Key Terms•

Supergame: A game repeated an infinite number of times•

Stage game: The game that is repeated in a supergame•

Grim trigger strategy: The strategy which involves being nice initially but not nice forever when someone else isn't cooperative•

Individual rationality: The constraint that a player can't get less from an equilibrium than they can individually insist on, e.g. their
payoff in the worst equilibrium from their perspective•

Folk theorem: A theorem stating that if the value of the future is high enough, any outcome that is individually rational can besupported as an equilibrium to the supergame•

Common knowledge: Common awareness of a fact
Exercises

16.6.1

Consider the game in Table 16.6.2, and consider a strategy in which firm 1 prices high in odd numbered periods, and low ineven numbered periods, while 2 prices high in even numbered periods, low in odd numbered periods. If either deviate from25
these strategies, both price low from then on. Let δ be the discount factor. Show that these firms have a payoff of 1 − δ

225δ

or 1 − δ

2

25𝛿𝛿

5

, depending on which period it is. Then show that the alternating strategy is sustainable if (1−𝛿𝛿2) ≥ (1−𝛿𝛿) This, in
1

turn, is equivalent to 𝛿𝛿 ≥ .
4Introduction to Economic Analysis

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17

Imperfect Competition

When there are only a handful of firms – as in most industries from which final consumers purchase – the assumptions of perfectcompetition are unreasonable. But with two or more firms, monopoly isn’t a good model either. Imperfect competition refers to thecase of firms that individually have some price-setting ability or “market power,” but are constrained by rivals. Our analysis starts
with one model of imperfect competition formulated over 170 years ago.

17.1 Cournot Oligopoly
Learning Objectives•

How do industries with only a few firms behave?

•

How is their performance measured?

The Cournot86 oligopoly model is the most popular model of imperfect competition. It is a 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 typical firm 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 the same price for each firm. It is probably best to thinkof the quantity as really 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 ) .
Each firm chooses qi to maximize profit. The first order conditions87 give:0=∂πi= p(Q ) + p′(Q )qi − ci′ (qi )∂qi.

This equation holds with equality provided qi > 0. A simple thing that can be done with the first order conditions is to rewrite them toobtain 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 εqsi = i
Q is firm i’s market share. Multiplying this equation by the market share and summing over all firms i = 1, … , n yields
Herenp(Q ) − ci′ (qi )1 n 2 HHI=s
∑ p(Q)∑ si = ε
i
ε
i =1
i =1

86

,

Augustus Cournot, 1801-1877.

87

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 sameamount.
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HHI = ∑ si2

i =1
where
is the Hirschman-Herfindahl Index.88 The HHI has the property that if the firms are identical, so that si = 1/n
for all i, then the HHI is also 1/n. For this reason, antitrust economists will sometimes use 1/HHI as a proxy for the number of firms,
and describe an industry with “2 ½ firms,” meaning an HHI of 0.4.89

We can draw several inferences from these equations. First, larger firms, those with larger market shares, have a larger deviation fromcompetitive behavior (price equal to marginal cost). Small firms are approximately competitive (price nearly equals marginal cost)
while large firms reduce output to keep the price higher, and the amount of 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 proportion by which
price equal to marginal cost is violated. Third, the equation generalizes the “inverse elasticity result” proved for monopoly, whichshowed that the price – cost margin was the inverse of the elasticity of demand. The generalization states that the weighted average ofthe 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 fromcompetition 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 ordercondition 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 more elastic, and indeed is a substitute for elasticity as adeterminant of price.

88

Named for Albert Hirschman(1915 – ), who invented it in 1945, and Orris Herfindahl (1918 – 1972), who invented it independently
in 1950.
89

To make matters more confusing, antitrust economists tend to state the HHI using shares in percent, so that the HHI is on a 0 to
10,000 scale.
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Key Takeaways•

Imperfect competition refers to the case of firms that individually have some price-setting ability or “market power,” but are
constrained by rivals.

•

The Cournot oligopoly model is the most popular model of imperfect competition.

•

In the Cournot model, firms choose quantities simultaneously and independently, and industry output determines price throughdemand. A Cournot equilibrium is a Nash equilibrium to the Cournot model.

•

In a Cournot equilibrium, the price-cost margin of each firm is that firm’s market share divided by the elasticity of demand.
Hence the share-weighted average price-cost margin is the sum of market squared market shares divided by the elasticity ofdemand.

•The sum of squared market shares is known as the Hirschman-Herfindahl Index, or HHI.

•In the Cournot model, larger firms deviate more from competitive behavior than small firms.

•

The HHI measures the industry deviation from perfect competition.

•

The Cournot model generalizes the “inverse elasticity result” proved for monopoly.

•

A large HHI means the industry “looks like monopoly.” In contrast, a small HHI looks like perfect competition, holding constantthe elasticity of demand.

•

With n identical firms, a Cournot industry behaves like a monopoly facing a demand that is n times more elastic.

The HHI is one with monopoly.

Key Terms•

Cournot model: A model of imperfect competition where firms simultaneously set quantities•

Hirschman-Herfindahl Index: The sum of the market shares squared

17.2 Cournot Industry Performance
Learning Objectives•

What happens to quantity-setting firms when there are fixed costs of entry?

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 wehave an estimate of the demand elasticity, we know how much the price deviates from the perfect competition benchmark.
The general Cournot industry actually has two sources of inefficiency. First, price is above marginal cost, so there is the dead weightloss associated with unexploited gains from trade. Second, there is the inefficiency associated with different marginal costs. This isinefficient because a re-arrangement of production, keeping total output the same, from the firm with high marginal cost to the firmwith low marginal cost, would reduce the cost of production. That is, not only is too little output produced, but what output isproduced is inefficiently produced, unless the firms are identical.

c′
To assess the productive inefficiency, we let 1 be the lowest marginal cost. The average deviation from the lowest marginal cost,then, is
n

n

n

i =1

i =1

i =1

χ = ∑ si (ci′ − c1′ ) = ∑ si ( p − c1′ − ( p − ci′ )) = p − c1′ − ∑ si ( p − ci′ )n= p − c1′ − p ∑ si
i =1

( p − ci′ )p np= p − c1′ − ∑ si2 = p − c1′ − HHIpεε i =1.

Thus, while a large HHI means a large deviation from price equal to marginal cost and hence 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 thanother industry structures.
There are a number of caveats worth mentioning in the assessment of industry performance. First, the analysis has held constant theelasticity of demand, which could easily fail to be correct in an application. Second, fixed costs have not been considered. An
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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 thenumber of firms, and that the firms have no long-run market power, just short-run market power. Thus, entry and fixed costs could
lead the firms to have approximately zero profits, in spite of price above marginal cost.
Using exercise 17.2.1, suppose there is a fixed cost F to become a firm. The number of firms n should be such that firms are able tocover 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 .
222

(2n + 3)(1 − c )2
 1−c  1−c   1−c  −F ≤ −
 = n +1 n +1  n +2
(n + 1)2 (n + 2)2 .
Thus, each firm’s net profits are(2n + 3)42
2
Note that the monopoly profits πm are ¼ (1-c)2. Thus, with free entry, net profits are less than (n + 1) (n + 2)n(2n + 3)4
π
2
2 m
(
n
+
1
)
(
n
+
2
)
industry net profits are less than
.

πm
, and

Table 17.2.1 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 frommonopoly. But when fixed costs sufficient to insure that only two firms enter are 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 is justdeterred from entering. That still leaves the two firms with significant profits, even though 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 17.2.1: Industry Profits as a Fraction of Monopoly Profits
NumberGross

Netof Firms

Industry

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 perfectcompetition. 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.

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Key Takeaways•

The Cournot industry has two sources of inefficiency: too little output is produced, and what output is produced is inefficiently
produced (unless the firms are identical).

•The HHI analysis has held constant the elasticity of demand, which could easily fail to be correct and fixed costs have not been
considered.

•

Consideration of fixed costs reduce the apparent inefficiency of Cournot industry.
Exercises

17.2.1

Suppose the inverse demand curve is p(Q) = 1 – Q, and that there are n Cournot firms, each with constant marginal cost c,Q=selling in the market. (i) Show that the Cournot equilibrium quantity and price are2n(1 − c )1 + ncp(Q ) =
n +1 .
n + 1 and 1−c (ii) Show each firm’s gross profits are  n + 1  .
17.2.2

What formula from the Cournot model is used in antitrust analysis? How is it used?

17.2.3

Consider n identical Cournot firms in equilibrium.

17.2.4a.

Show that the elasticity of market demand satisfies ε > 1 / n .

b.

Is this consistent in the case when n = 1 (monopoly)?

The market for Satellite Radio consists of only two firms. Suppose the market demand is given by P = 250– Q where P is theprice and Q is the total quantity, so Q = Q1 + Q2. Each firm has total costs given by: C(Qi) = Qi2 + 5 Qi + 200a.

What is the market price predicted by the Cournot duopoly model?

b.

If the industry produces a total quantity X, what allocation of quantity (with X=Q1+Q2) between the two companies
minimizes total cost? (Your answer should express total cost as a function of X.)

c.

If the firms merge with the cost found in b), what is the market price?

17.3 Hotelling Differentiation
Learning Objectives•

What are the types of differentiated products and how do firms selling differentiated products behave?

Breakfast cereals range from indigestible, unprocessed whole grains to cereals that are almost 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 Hotelling model.90 Hotelling was the first to use a line
segment to represent both the product that is sold and the preferences of the consumers who are buying the products. In the Hotellingmodel, there is a line, and preferences of each consumer is represented by a point 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, aredesigned to be enjoyed by particular ages. Thus a “pre-teen” movie is unlikely 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 a target age, andcustomers have ages, and these are graphed on the same line.
High Fiber

Adult Cereals

Kid Cereals

Sugar Content
Figure 17.3.1: Hotelling Model for Breakfast Cereals
Breakfast cereal is a classic application of the Hotelling line, and this application is illustrated in Figure 17.3.1. Breakfast cereals areprimarily distinguished by their sugar content, which ranges on the Hotelling line from low on the left to high on the right. Similarly,

90

Hotelling Theory is named for Harold Hotelling, 1895-1973.

Introduction to Economic Analysis

17-239the preferences of consumers also fall on the same line. Each consumer has a “most desired point,” and prefers cereals closer to thatpoint than those at more distant points.
There are two main types of differentiation, each of which can be modeled using the Hotelling line. These types are quality andvariety. 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, better braking, 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 than quality
differentiators. Some people like almond colored appliances, others choose white, with blue a distant third. Food flavors are varieties,
and while the quality of ingredients 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.
The standard Hotelling model fits two ice cream vendors on a beach. The vendors sell the identical product, and moreover they canchoose 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 the closest vendor, since the price is the same.
Thus, if one vendor locates at x and the other at 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 17.3.2.
Buy at x

0x

Buy at y½ (x + y)y

1

Figure 17.3.2: 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 the description of an equilibrium, we need to let the two “share” apoint and still have one on 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 a scale 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 share the same
“middle of the road” platform.
The model with constant prices is unrealistic for the study of the behavior of firms. Moreover, the two-firm model on the beach iscomplicated to solve and has the undesirable property that it matters significantly whether the number of firms is odd or even. As aresult, we will consider a Hotelling model on a circle, and let the firms choose their prices.

Introduction to Economic Analysis

17-240Key Takeaways•

In the Hotelling model, there is a line, and preferences of each consumer is represented by a point on this line. The same line isused to represent products.

•

There are two main types of differentiation, quality and variety. Quality refers to a situation where consumers agree on what
product is better. Varieties are the differentiators about which there is not widespread agreement.

•

Quality is often called vertical differentiation, while variety is horizontal differentiation.

•

The standard Hotelling model involves two vendors selling identical product, and choosing to locate on a line. Both charge thesame price. People along the line buy from the closest vendor.

•

The Nash equilibrium for the standard model involves both sellers locating in the middle. This is inefficient since it doesn’t
minimize transport costs.

•

The standard model is commonly used as a model of political candidate positions.
Key Terms•

Hotelling model: A model of imperfect competition where customers' preferences and products are located on the same line
segment•

Vertical differentiation: Quality•

Horizontal differentiation: Differences about which customers disagree
Exercises

17.3.1

Suppose there are four ice cream vendors on the beach, and customers are distributed uniformly. Show that it is a Nashequilibrium for two to locate at ¼, and two at ¾.

17.4 The Circle Model
Learning Objectives•

Is there a simple, convenient model of differentiated product competition and how does it perform?

In the circle model, there are n firms evenly spaced around the circle whose circumference is one. Thus, the distance between any
firm and each of its closest neighbors is 1/n. 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. Each consumer’s preference is uniformly distributed around the circle. The locations of firms are illustrated
in Figure 17.4.1.
length 1/n

Firm

length 1/n

Firm

Firm

Figure 17.4.1: 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 the others all charge p. So suppose the firm in the middle of Figure 17.4.1 charges an alternate
price r, but every other firm charges p. A consumer who is x units away from the firm pays the price r + tx from buying at the firm, or
p + t(1/n – x) from buying from the rival. The consumer is just indifferent between the nearby firms if these are equal, that is,
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 .

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Thus, consumers who are closer than x* to the firm charging r buy from that firm, and consumers who are further away than x* buyfrom the alternative firm. Demand for the firm charging r is twice x* (because the firm sells to both sides), so profits are price minus
marginal cost times two x*, that is, 1 p−r (r − c )2 x * = (r − c ) +

t .
n
The first order condition91 for profit maximization is∂ 1 p−r   1 p−r  r −c
(r − c ) +
.
= +
−
∂r
t  n
t 
t
n

0=

We could solve the first order condition for r. But remember that the concern is when is p represents a Nash equilibrium price? The
price p is an equilibrium price if the firm wants to choose 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 the value of the average distance between the firms, since the average distance is 1/n and thettvalue to a consumer of traveling that distance is t. The profit level of each firm is n , so industry profits are n .
2

How many firms will enter the market? Suppose the fixed cost is F. We are going to take a slightly unusual approach and assume thatthe number of firms can adjust in a continuous fashion, in which case the number of firms is determined by the zero profit conditionF=tn 2 , or

n=

t

F

.

What 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

2n

1

2n

2

1
 1 
n ∫| x | dx = 2n ∫ xdx = n =4n
 2n 
1
0
−

2n

.

t
+ nF
4
n
Thus, the socially efficient number of firms minimizes the transport costs plus the entry costs. This occurs at
n=

1 t
F . The socially efficient number of firms is half the level that enter with free entry!
2

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 of themarginal consumer. That is, competing firms’ prices are determined by the most distant customer, and that leads to prices that are toohigh 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 ameans of differentiating themselves and creating profits.

91

Since profit is quadratic in r, we will find a global maximum.

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Key Takeaways•

A symmetric Nash equilibrium to the circle model involves a price that is marginal cost plus the transport cost t divided by thettnumber of firms n. The profit level of each firm is n , so industry profits are n .
2•

The socially efficient number of firms is half the number that enter with free entry.

•

The circle model is sometimes used to justify an assertion that firms will advertise too much, or engage in too much R&D,
relative to the socially efficient amount.
Key Terms•

Circle model: A Hotelling model on a circle

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18

Information

An important advantage of the price system is that it economizes on information. A typical consumer needs to know only the prices ofgoods 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 to direct production and consumption decisions using something other than prices, and centrally-planned
economies typically experience chronic shortages and occasional surpluses. Shortages of important inputs to production may havedramatic effects and the 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 makegood decisions. In such circumstances, information itself can lead to market failures.

18.1 Market for LemonsLearning Objectives•

Can information held by sellers but relevant to buyers be an impediment to trade?

Nobel laureate George Akerlof (1940 – ) examined the market for used cars and considered a situation where the sellers are better
informed than the buyers. This is quite reasonable, as sellers have owned the car for a while and are likely to know its quirks andpotential problems. Akerlof showed that this differential information, in a model known as the market for lemons, may cause the used
car market to collapse; that is, the information possessed by sellers of used 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, and suppose
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 theseller. 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, thismeans the distribution of qualities of cars offered for trade at price p will be uniform on the interval 0 to p. Consequently, the average
quality of these cars will be ½ p, and the buyer values these cars 50% more which yields ¾ p. Thus, the buyer is not willing to pay theprice p for the average car offered 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 the buyer – not knowing the quality of the car – isn’t willing to pay as much as the actual valueof 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.
In the real world, of course, the market has found partial or imperfect solutions to the lemons 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 thelemons problem. The existence of both of these 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 is difficult or impossible to patent. Consider aninnovation 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 price negotiations, because then the computer company could justcopy the innovation. Similarly, the computer company can’t possibly offer a price for the innovation in advance of knowing what theinnovation is. As a result, such innovations usually require the inventor to enter the computer manufacturing business, rather thanselling to an existing manufacturer, entailing many otherwise unnecessary costs.

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Key Takeaways•

Information itself can lead to market failures.

•

The market for lemons refers to a situation where sellers are better informed than buyers about the quality of the good for sale,like used cars.

•

The informational asymmetry – sellers know more than buyers – causes the market to collapse.

•

Inspections, warranties and certification mitigate the lemons problem. The existence of these costly solutions is itself evidence
that the lemons problem (informational asymmetry is an impediment to trade) is a real and significant problem.

•

An example of the lemons problem is the inventor who creates an idea that is difficult or impossible to patent, which cannot be
verified without being revealed.
Key Terms•

Market for lemons: A model where sellers are better informed about quality than buyers•

Informational asymmetry: Games where some players know things others don't
Exercises

18.1.1

In Akerlof’s market for lemons model, suppose it is possible to certify cars, verifying that they are better than a particularquality q. Thus, a market 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.] What quality maximizes the expected gains from trade?

18.2 Myerson-Satterthwaite Theorem
Learning Objectives•

Can information about values and costs, not relevant to the other party, be an impediment to trade?

The lemons problem is a situation where the buyers are relatively uninformed and care about the information held by sellers. Lemonsproblems are limited to situations where the buyer isn’t well-informed and can be mitigated by making information public. In manytransactions, 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 a limited 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’s value as uniformly distributed on [0,1].92 Can
efficient trade take place? Efficient trade requires 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 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

1

∫ ∫ v − c dc dv = ∫ 2 dv = 6.

A means of arranging trade, known as a mechanism,93 asks the buyer and seller for their value and cost, respectively, and then orders
trade if the value exceeds the cost, and dictates a payment p by the buyer to the seller. Buyers need not make honest reports to the92

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 (Correlated Information 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 MyersonSatterthwaite theorem.
93

A mechanism is a game for achieving an objective, in this case to arrange trades.

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mechanism, however, and the mechanisms must be designed to induce the buyer and seller to report honestly to the mechanism, sothat efficient trades can be arranged.94
Consider a buyer who actually has value v but reports a value r. The buyer trades with the 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 the seller’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 to choose 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 conclude95du( 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; the second equality because u is maximized overthe first argument r at r=v, and the first order condition insures u1 = 0. Finally, u2 is just r, and we are evaluating the derivative at the
point r = v. A buyer who has a value v + ∆, but who reports v, trades with probability v and makes the payment Ecp(v, c). Such abuyer gets ∆v more in utility than the buyer with value v. Thus a ∆ increase in value produces an increase in utility of at least ∆v,

du( v + ∆, v + ∆) ≥ u(v, v) + ∆v and hence that dv
showing thatu( v, v) ≥ v. A similar argument considering a buyer withvalue v who reports v + ∆ shows that equality occurs.
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, thetotal gain accruing to the average buyer can be 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 thebuyer’s value, the buyer must obtain the entire gains from trade! This is actually a quite general proposition. If you offer the entire
gains from trade to a party, they are induced to maximize the gains from trade. Otherwise, they will want to distort away frommaximizing 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 report her cost honestly is to offer her the entire gains
from trade.
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 than they do, and sellers act like their costs arehigher 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 tozero, and markets become efficient. Thus, informational problems of this kind are a “small numbers” issue. However, many markets
do in fact have small numbers of buyers or sellers. In such markets, it seems likely that informational problems will be an impedimentto efficient trade.

94

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 tothe mechanism, where the buyer reports a type, which is converted via the function z to a report, and then that report given to theoriginal mechanism. In the new mechanism, reporting v is tantamount to reporting z(v) to the original mechanism.
95

We maintain an earlier notation that the subscript refers to a partial derivative, so that if we have a function f, f1 is the partial
derivative of f with respect to the first argument of f.

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Key Takeaways•

The Myerson-Satterthwaite theorem shows that the gains from trade are insufficient to induce honesty about values and costs by abuyer and seller. Any mechanism for arranging trades between the buyer and the seller must suffer some inefficiency.

•

Generally this inefficiency occurs because buyers act like they value the good less than they do, and sellers act like their costs arehigher than they truly are, resulting in an inefficiently low level of trade.

•

As markets get “thick,” the per capita losses converge to zero, and markets become efficient. Informational problems of this kind
are a “small numbers” issue.
Key Terms•

Mechanism: a game which accomplishes an objective•

Myerson-Satterthwaite theorem: A theorem that shows that private information about value is enough to prevent efficient trade
Exercises

18.2.1

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 seller1(c=1) never sells and thus obtains zero profits, show that honesty by the seller implies the expected value of h is 6 .

18.3 Signaling
Learning Objectives•

Why do people spend so much money on things that aren’t much better than the cheap versions?

Why do people who study ancient Greek get good jobs that don’t involve reading ancient Greek?
An interesting approach to solving informational problems involves signaling.96 Signaling, in economic jargon, means expendituresof 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 tossing out 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 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 areable to adapt to changing circumstances, and who 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 isdifficult to determine from an interview whether someone is type A or not. Type A is worth more to businesses, 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 signals that the student is type A. Thus, a level of
education x in this case signals a trait (ease of learning) 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; thestudent could be studying astronomy or ancient Greek, neither of which are very useful in most businesses, but are nevertheless strong
signals of the ability to learn. Second, the best subject matter for signaling is that in which the difference in cost between the typedesired by employers and the less desirable type is greatest, that is, where cB – cA is greatest. Practical knowledge is somewhat
unlikely to make this difference great; instead, challenging abstract problem-solving 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 isuseful, but because the less desirable type is so much worse at it.

96

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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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 their clients.
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 aresuccessful.”
The law firm example is similar to the education example. Here, the cost of the expenditures 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 no pleasure 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 take standardized 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. Win-loss 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.
Key Takeaways•

Signaling means expenditures of time or money whose purpose is to convince others of something.

•A university education signals the ability to learn. The education need not be useful in itself to be helpful in signaling. The best
subject matter for signaling is something that easy for fast learners and difficult for slower learners.

•

Signals are interpreted by asking “what kinds of people would make this choice?” while understanding that the person makes the
choice hoping to send the signal.
Key Terms•

Signaling: expenditures of time or money whose purpose is to convince others of something

18.4 Search and Price Dispersion
Learning Objectives•

Why do we see such random prices at the grocery store?

•

Why are prices unpredictable?

Decades ago, economists used to make a big deal about the Law of One Price, which states 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 the lowest priceseller. Consequently, the only seller to make any sales is the low-price seller. This kind of consumer behavior forces all sellers to sellat 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 that pureprice 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 of airline tickets is notorious for unpredictability.
The price of milk, soft drinks, paper towels and canned tuna varies 50% or more depending on whether the store has an advertised saleof the item or not. Prices of goods sold on the internet varies substantially from day to day.97 Such variation is known as pricedispersion by economists. It is different from price discrimination, in that price dispersion entails a given store quoting the same priceto all customers; the variation is across stores, while price discrimination is across customers.
Why are prices so unpredictable? We now develop a model that shows they have to be.
To understand price dispersion, we divide consumers into two types: shoppers and loyal customers. Loyal customers won’t pay morethan 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

97

It is often very challenging to assess internet prices because of variation in shipping charges.

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18-248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 other stores
equally, so that, if there are n stores, each store gets a fraction (1 – s)/n of the customers. Let the marginal cost of the good be c, andassume c < pm. Both kinds of customers buy only one unit.
For the purposes of this analysis, we will assume that prices can be chosen from the continuum. This makes the analysis morestraightforward, but there is an alternate version of the analysis (not developed here) that makes the more reasonable assumption ofprices 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, thefirm 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 a cent less than p, and thereby capturing all the
shoppers rather than sharing them with the 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 canincrease price somewhat and not suffer any loss of sales. This contradicts profit maximization for that firm. The conclusion is thatfirms 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 the firm 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 be charged 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 haven −1
. Thus, the firm’s profits arehigher prices, which occurs with probability (1 − F ( p))1−s+ s(1 − F ( p))n −1 π( p) = ( p − c ) 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 the interval [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. (An increase 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 the probability 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 the minimum price. Since all firms charge a price exceeding p with probability (1 – F(p))n, atleast 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, thedistribution of prices charged to shoppers is

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18-249n ( p − p)(1 − s )  n −1
1 − (1 − F ( p))n = 1 −  m
 s( p − c )n .
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 same that 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 not work for a monopoly. In order to capture monopoly, one must set s=0, because shoppers
have no alternative under monopoly.
As the number of firms gets large, the price charged by any one firm converges to the monopoly price pm. However, the lowest priceoffered by any firm actually converges to c, marginal cost. Thus, in the limit as the number of firms get large, shoppers obtain priceequal to marginal cost and loyal firms pay the monopoly price.

Price
1

Expected price for loyal
customers

0.8

0.6

0.4

0.2

Expected price for shoppers

20

40

60

80

100

n

Figure 18.4.1: Expected Prices in Search Equilibrium
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 18.4.1, letting the number of firms
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.
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 the set of loyal customers is reduced. Figure
18.4.2 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.
People who are price-sensitive and shop around convey a positive externality on other buyers by encouraging price competition.
Similarly, people who are less price sensitive and 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 and some are not, randomized prices are a natural
outcome. That is, randomization of prices, and the failure of the law of one price, is just a reflection of the different willingness orability to search on the part of consumers.

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18-250Price1
Expected price for
l
l
t

0.8

0.6

0.4

Expected pricefor shoppers

0.2

0.2

0.4

0.6

0.8

1

s

Figure 18.4.2: Expected Prices (s=Proportion of Shoppers)
This difference in the willingness to search could arise simply because search is itself costly. That is, the shoppers could bedetermined by their choice to shop, in such a way that the cost of shopping just balances the expected gains from searching. The
proportion of shoppers may adjust endogenously to insure that the gains from searching exactly equal the costs of searching. In thisway, a cost of shopping is translated into a randomized price equilibrium in which there is a benefit from shopping and all consumers
get the same total cost of purchase on average.
Key Takeaways•

The “Law of One Price,” which states that identical goods sell at the same price, is empirically false.

•

There are many markets where prices appear unpredictable to consumers. Price variation over time or across stores is known as
price dispersion.

•

The basic price dispersion model involves firms setting prices simultaneously and selling to two types of customers, one loyal to aparticular store, the other (“shoppers”) buying from the cheapest store.

•

There is no pure strategy equilibrium because firms either want to be just barely cheapest or at the monopoly price. The only
candidate for an equilibrium is a mixed strategy.

•

There is a mixed strategy involving randomizing over an interval of prices.

•

Industry profits in price dispersion arise from the number of loyal customers and are independent of the number firms.

•

An increase in the number of firms is good for shoppers and bad for loyal customers. In the limit as the number of firms goes toinfinity the shoppers pay marginal cost and loyal customers pay the monopoly price.

•

Shoppers convey a positive externality on other buyers by encouraging price competition.
Key Terms•

Law of One Price: identical goods sell at the same price•Price dispersion: Price fluctuation across stores

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19

Agency Theory

Agency theory is one of the most important developments in microeconomics in the past twenty years. It has influence in accounting,industrial organization and labor economics and has become the basis of the economic model of compensation. Agency studies
incentives, risk and selection of employees.

19.1 Principals and Agents
Learning Objectives•

What is an agency?

•

How should a principal compensate an agent?

An agent is a person who works for, or on behalf of, another. Thus, an employee is an agent 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 the company. 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 interestsand 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 touse cheap or used replacement parts and bill for new, high quality parts. These are all examples of a conflict in the incentives of theagent and the goals of the principal.
Agency theory focuses on the cost of providing incentives. When you rent a car, an agency 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-enginedcar. I say a rented car. Nothing handles better than a rented car. You can go faster, turn corners 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." 98
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 andunpleasant 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 imperfect solution, 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 with GPS tracking.
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 is a choice the agent makes. However, x will come withrisk to the agent, which we model using 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 isfixed independently of sales. This scheme – a combination of salary and commission – covers many different situations. Real estateagents receive a mix of salary and commission. Authors receive an advance and a royalty, which works like a salary and commission.

x2
The monetary compensation of the agent is sx + y. In addition, the agent has a cost of effort, which we take to be 2a . Here arepresents the ability of the agent: more able agents, 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 the monetary risk, λ defines the agent’s attitude or cost ofrisk, and s is the share of the risk imposed on the agent. This results in a payoff to the agent of98

P. J. O'Rourke, Republican Party Reptile, Atlantic Monthly Press, 1987.

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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 Marshalland 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 productmarketing, mediated by myself. Individual salesmen came in to make their cases for how
they just had to have a huge discount, else they would lose a particular sale. 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 theirsubstantial creative powers to dream up good justifications for their next plea for a huge
discount. They knew that if we were willing to bleed enough we could usually win thesale. I wanted to solve both the resultant profitability problem and the problem of theunpleasant meeting.
“Commissions were traditionally a percentage of bookings (net of discount), with part heldback until cash was received. The percentage increased after a salesman met his individual
quota for the quarter (the performances at quota-setting time to sandbag the quota wereeven more impressive). The fact that a discount reduced commission did not affect asalesman's behavior, because the difference in commission was small. Better to buy theorder 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 totalcommission. Most salesmen I have met are quite good at math. Further, they have learned
to “watch the hips, not the lips” – in other words, they judge management intentions byactions rather than words. They reason – and I agree with them – that if management reallywanted them to maximize margins rather than revenues, then they would pay them more if
they maximize margins.

u = sx + y −x2− sλσ22a.

The first two terms, sx + y, are thepayments made to the agent. The nextterm is the cost of generating that levelof 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 asalary y. The agent can either accept or
reject the contract and accepts if heobtains at least u0 units of utility, thevalue of his next best offer. Then theagent decides how much effort toexpend, 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 a straightforward exercise, and we
conclude x=sa. This can be embedded
into u, and we obtain the agent’s
optimized utility, u*, is“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 thelist 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 price near list,
then his commission was somewhat higher than before. If he started discounting, hiscommission dropped sharply. We gave broad discretion to sales management to approvediscounts.
“We still had sales guys claiming that a sale was massively strategic and had to be sold ator below cost, and that they needed their commission anyway to justify the effort. In somecases we approved this, but mostly we said that if it's strategic then you'll get yourcommission 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 ofother variables, but I like to think that it was a factor. Now our salesmen spent more of
their creative energies devising ways to sell our customers on the value of our products andcompany, instead of conspiring with sales management as to the 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 each sale. There certainly were steep discounts given in some cases, but theyreflected the competitive situation and future sales potential at each account much moreaccurately.”(Source: private correspondence, quotation permission received)

u* = s 2 a + y −( sa)2− sλσ2 = y + ½s 2a − sλσ22a.

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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 + sλσ2 .
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.
Key Takeaways•

An agent is a person who works for, or on behalf of, another.

•An employee is an agent of a company. Independent contractors are also agents. 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. In the basic agency model, a principal sets a salary and commission
and the agent chooses the effort to expend. The principal keeps the random output minus the salary and commission. Higher
commissions increase the agent’s incentive but impose risk on the agent.
Key Terms•

Agent : a person who works for, or on behalf of, another•Principal: The entity – person or corporation – on whose behalf an agent works

19.2 Cost of Providing Incentives
Learning Objectives•

How much does it cost to motivate agents?

The principal obtains profits which are the remainder of the value after paying the agent, 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. That is, the principal obtains the full gains from trade – the value of production minus the total
cost of production. However, the fact that the principal obtains the full gains from trade 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 riskon the agent, and this risk is costly to the principal. Agents are induced to work hard by tying their pay to their performance, and sucha link necessarily imposes risk on the agent, and risk is costly.99
We take the principal to be risk neutral. This is reasonable when the principal is “economically large” relative to the agent, so that therisks 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 to effort, 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 to farm 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 unlikely to be
optimal. The contract with s=1 is known as “selling the agency” since the principal 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 more common contract,
however, had the landowner and the tenant farmer share the proceeds of farming, which gives rise to the name sharecropper.

There is a technical requirement that the principal’s return π must be positive, for otherwise the principal 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.

99

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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 is high, 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 – in the 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 agentsshould obtain higher commissions. But in addition, RE/MAX’s formula also tends to attract more able agents, since able agents earn ahigher wage under the high commission formula. (There is a potential downside to the RE/MAX formula, that it discourages agencywide cooperation.)
Consider what contracts attract what kinds of agents. For a fixed salary y and commission 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 get higher utility, and less risk averse agents gethigher utility.
How do the terms of the contract affect the pool of applicants? Let us suppose two contracts are offered, one with a salary y1 andcommission 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 − s1 λσ2 ,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 high commission, low salary contract. A company that puts
more of the compensation in the form of commission tends to attract more able agents, and agents less averse to risk. The former is a
desirable feature of the incentive scheme, since more able agents produce more. The latter, the attraction of less risk averse agents,
may or may not be desirable but is probably neutral overall.
One important consideration is that agents who overestimate their ability will react the same as people who have higher ability. Thus,
the contract equally attracts those with high 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 and performance; when performance is subject to random fluctuations, linking pay and performance 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 is costly.
In addition, the extent to which pay is linked to performance will tend to affect the type of 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, but also
the type of agent who would choose to accept such a contract.

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Key Takeaways•

The principal chooses the salary to minimize the cost of the agent, thus the principal nets the total output, minus the cost of theagent.

•

The agent’s cost must be at least as large as what the agent would get in an alternative occupation and thus includes a risk
adjustment.

•

The optimal commission offered by the principal is decreasing in the risk aversion of the agent and the level of risk and increasingin the agent’s ability.

•

If the agent is neutral to risk, the principal gets a lump sum, and “sells the agency.”•

Total output falls as the risk costs rise.

•

A company that puts more of the compensation in the form of commission tends to attract more able agents, and agents lessaverse to risk. 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.
Exercise

19.2.1

Describe how a principal would go about hiring agents who are willing to take risks.

19.3 Multi-tasking
Learning Objectives•

How does an employer compensate an agent who performs several tasks of varying importance?

•

What happens when the tasks conflict?

Multi-tasking refers to performing several activities simultaneously. All of us multi-task. We study while drinking a caffeinatedbeverage; we think about things in the shower; we talk all too much on cell phones and eat French fries while driving. In the context
of employees, an individual employee will be assigned a variety of tasks and responsibilities, and the employee must divide their timeand efforts among the tasks. Incentives provided to the employee must direct not only the total efforts of the employee, but also theallocation of time and effort across activities. An important aspect of multi-tasking is the interaction of incentives provided to
employees, and the effects of changes in one incentive on the behavior of the employee over many different dimensions. In thissection, we will establish conditions under which the problem of an employer disaggregates, that is to say, the incentives on eachindividual 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 the presentation, 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 we will 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 byof actions x. We make four assumptions on c:

x = ( x1 , … , x n ) . We suppose the agent bears a cost c(x) of undertaking the vector

c is increasing in each xi,
c has a continuous second derivative
c is strictly convex, andc is homogeneous100 of degree r.
For example, if there are two tasks (n=2), then all four of these assumptions are met by the cost functionc( x1 , x2 ) = x12 + x22 + ½x 1 x2 . This function is increasing in x1 and x2, has continuous derivatives, is strictly convex (moreabout this below) and is homogeneous of degree 2.
It is assumed that c is increasing to identify the activities as costly. Continuity of derivatives is used for convenience. Convexity of cwill insure that a solution to the first order conditions is actually an optimum for the employee. Formally, a function is a convex
function that for any vectors x ≠ y and scalar α between zero and one (0 ≤ α ≤ 1),

100

Homogeneous functions were defined in 10.2.3.

Introduction to Economic Analysis

19-256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 two things than the average of the costs of thethings. Intuitively, convexity requires that doing 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 less than a fixed amount, {x | c(x) ≤ b}, is a convex
set. Thus, if two points cost less than a given budget, the line segment connecting them does, too. Convexity of the cost function
insures that the agent’s optimization problem is concave, and thus that the first order-conditions describe a maximum. When theinequality 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 very strong implications that are probably unreasonable in many settings. Nevertheless, homogeneity
leads to an elegant and useful theory, as we shall see. Recall the definition of a homogeneous function: c is homogeneous of degree rmeans 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 )rrwhich implies (α + (1 − α)λ ) > (α + (1 − α)λ ) .
Define a function k which is the left hand side minus the right hand side: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 is greater 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, showing that r≤1 is not compatible with the strict convexity ofc.
How should our person behave? Consider linear incentives, which are also known as piece rates. With piece rates, the employee getsa 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 =1.

Here • 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 )
∂x i
∂x i
,
where ci is the partial derivative of c with respect to the ith argument xi. This first order condition can be expressed more compactlyas

0 = p − c′( x )Introduction to Economic Analysis

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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, and strict convexity insures that there is at most one solution to the first orderconditions.101
One very useful implication of homogeneity is that incentives scale. Homogeneity has the effect of turning a very complicatedoptimization problem into a problem that is readily solved, thanks to this very scaling.

1
r
α −1

Claim: If all incentives rise by a scalar factor α, then x rises by.

r
λci (λx ) = λr ci ( x ) , and thus
Proof of Claim: Note that differentiating c(λx ) = λ c( x ) with respect to xi yieldsc ′(λx ) = λr −1c ′( x ) . That is, if c is homogeneous of degree r, c ′ is homogeneous of degree r – 1. Consequently, if
1
1
r
−
1
0 = p − c′( x ) , 0 = αp − c′(α x ) . Thus, if the incentives are scaled up by α, the efforts rise by the scalar factor α r −1 .

Now consider an employer with an agent engaging in n activities. The employer values the ith activity at vi, and thus wishes tomaximize
n

n

i =1

i =1

π = ∑ ( vi − pi ) x i = ∑ ( vi − ci ( x )) x i.

This equation embodies a standard trick in agency theory. Think of the principal (employer) not as choosing the incentives p, butinstead as choosing the effort levels x, with the incentives as a constraint. That is, the principal can be thought of choosing x and thenchoosing the p that implements this x. The principal’s expected profit is readily 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

0 = v j − c j ( x ) − ∑ cij ( x )) x i = v j − rc j ( x )and thus

i =1.

This expression proves the main result of this section. Under the maintained hypotheses (convexity and homogeneity), an employer ofa 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, the principal uses a sharing rule, sharing a fixedproportion of value with the agent.
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 (just the degree of homogeneity). Moreover, the incentive scheme works through a somewhat
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 by increasing x1, but the other activities may rise or fall depending on how complementary they are toactivity 1. Overall, the agent’s substitution across activities given the new incentive level on activity 1 implements the desired effort

This description is slightly inadequate, because we haven’t considered boundary conditions. Often a requirement like xi≥0 is alsoneeded. In this case, the first order conditions may not hold with equality for those choices where xi=0 is optimal.
101

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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!
Key Takeaways•

Multi-tasking refers to performing several activities simultaneously.

•

In the agency context, multi-tasking refers to the incentives of a principal to compensate different tasks.

•

A simple model of multi-tasking provides a convex cost of a set of tasks which is homogeneous of degree r in the tasks. Thismeans scaling up activities increases costs at a fixed rate r.

•

With piece rates, the employee gets a fixed payment for each unit produced.

•

One very useful implication of homogeneity is that incentives scale. If all incentives rise by a scalar factor α, then x rises by1r
α −1 , where r is the degree of homogeneity.

•

Given convexity and homogeneity, an employer of a multi-tasking agent uses incentives which are a constant proportion of value,that is,

pj =

vj
r .
Key Terms•

Multi-tasking: performing several activities simultaneously•

Convex function: the function lies below the straight line segment connecting two points, for any two points in the interval•

Homogeneous function: Applying a scalar to the inputs applies the scalar raised to a power to the output; the power is called thedegree of homogeneity•

Sharing rule: In agency theory, sharing a fixed proportion of the output with the agent

19.4 Multi-tasking without Homogeneity
Learning Objectives•

When will the incentives on tasks be related to each other, and how are they related?

In the previous section we saw, for example, that if the agent has quadratic costs, the principal pays the agent half the value of eachactivity. 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 is itself an important limitation, although thisassumption is reasonable in some settings. More serious is the assumption that all of the incentives are set optimally for the employer.
Suppose, instead, that one of the incentives is set “too high,” at least from the employer’s perspective. This might arise if, forexample, the agent acquired all the benefits of one of the activities. An increase in the power of one incentive will then tend to “spillover” 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 of that type.102
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:nc( x ) = g ∑ x i2  = g( x • x ) i =1 .
This is a situation where vector notation (dot-products) dramatically simplifies the expressions. You may find it useful to workthrough the notation on a separate sheet, or in the margin, using summation notation to verify each step. At the moment, we won’t beconcerned with the exact specification of g, but instead use the first order conditions to characterize the solution.
The agent maximizes

102

Multi-tasking, and agency theory more generally, is a rich theory with many implications not discussed here. For a challenging andimportant 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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19-259u = p • x − g( x • x ) .
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 andconvex (increasing second derivative).
This is a particularly simple expression, because the vector of efforts, x, points in the same direction as the incentive payments p. The
scalar that gives the overall effort levels, however, is not necessarily a constant, as occurs with homogeneous cost functions. Indeed,
we can readily see that x•x is the solution top • p = (2 g′( x • x ))2 ( x • x ) .
Because x•x is a number, it is worth introducing notation for it: S = x•x. Then S is the solution top • p = 4 S ( g′( S ))2 .
The principal or employer chooses p to maximize

π = v • x − p • x = v • x − 2g′( 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 of proportionality
Using the same trick (dotting each side of the first order conditiong ′( x • x ) + x • xg ′′( x • x ) .

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





1
1
v
v
=
p = 2 g′( x • x )x = 2 g′( 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 this case, g(S) must be in the form Sr/2, and theformula gives

p=

1
1
v


v =
21 +r −1ras we already established.
2′′′
The natural assumption to impose on the function g is that (g ( S ) + Sg ( S )) S is an increasing function of S. This assumption
implies that as the value of effort rises, the total effort also rises.

Sg′′( S )′Suppose g ( S ) is increasing in S. Then an increase in vi increases S, decreasing pj for j≠i. That is, when one item becomes more
2′valuable, the incentives on the others are reduced. Moreover, since p • p = 4 S ( g ( S )) , an increase in S only occurs if p•pincreases.

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These equations together imply that an increase in any one vi increases the total effort (as measured by S* = x•x), increases the total

Sg′′( S )′incentives as measured by p•p, and decreases the incentives on all activities other than activity i. In contrast, if g ( S ) is adecreasing 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 activity

Sg′′( S )′to fall (since g ( S ) decreases), which induces a desire to increase the other activity levels, which is accomplished by increase in
the incentives on the other activities.
This conclusion generalizes readily and powerfully. Suppose that c(x) = g(h(x)), where h is homogeneous of degree r and g isincreasing. In the case just considered, h(x)=x•x. Then the same conclusion, that the sign ofSg′′( S )g′( S ) , holds. In the generalization, S now stands for h(x).

dpi
dv j

is determined by the derivative of

Key Takeaways•

In general, incentives can be substitutes or complements, that is, an increase in the importance of one activity may increase or
decrease the incentives provided on other activities. Homogeneity is the condition that causes such interactions to be zero.

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20

Auctions

When we think of auctions, we tend to think of movies where people scratch their ear and accidentally purchase a Faberge egg, likethe one pictured at left.103 However, stock exchanges, bond markets and commodities markets are organized as auctions, too, andbecause of such exchanges, auctions are the most common means of establishing prices. Auctions are one of the oldest transactions
means recorded in human history, and were used by the Babylonians. The word auction comes from the Latin auctio, meaning toincrease.
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 byauction. The U.S. purchases everything from fighter aircraft to French fries by auction, and the U.S. government is the world’s largest
purchaser of French 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.

20.1 English Auction
Learning Objectives•

What is the most common auction form?

•

How should I bid in it if I know my own value?

•

When we share a value that none of us know, should I bid my estimate of value?

An English auction is the common auction form used for selling antiques, art, used cars and cattle. The auctioneer starts low, and calls
out prices until no bidder is willing to bid higher than the current high price. The most common procedure is for a low price to becalled 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 that point theauction ends, and the highest bidder wins.
Information plays a significant role in bidding in auctions. The two major extremes in information, which lead to distinct theories, areprivate values, which means bidders know their own value, and common values, in which bidders don’t know their own value, buthave some indication or signal about the value. In the private values situation, a bidder may be outbid by another bidder, but doesn’tlearn anything from another bidder’s willingness to pay. The case of private values arises when the good being sold has a quality
apparent to all bidders, no hidden attributes, and no possibility of resale. In contrast, the case of common values arises when bidders
don’t know the value 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 off-shore lease, and companies have estimates of the amount of oil. The
estimates are closely guarded because rivals could learn from them. Similarly, when antiques dealers bid on an antique, the value theyplace 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.
In a private values setting, a very simple bidding strategy is optimal for bidders: a bidder should 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 the priceexceeds their value, because at that point, winning entails a loss. Every bidder should be willing to continue to bid and not let the item

103

Photo courtesy of Paris Jewelers, 107 East Ridgewood Ave. Ridgewood, New Jersey 07450.

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sell to someone else if the price is 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 a purchase at this price would provide profits. This strategy is adominant strategy for each private values bidder, because no matter what strategy other bidders adopt, bidding up to value is thestrategy 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 ananalysis of the outcome of the English auction relatively simple.
Most auctioneers use a somewhat flexible system of bid increments. A bid increment is the difference between successive pricerequests. 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, the bidder with the second-highest value would submit another bid. If we denote the secondhighest 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, when bid increments are small and bidders haveprivate 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).
Key Takeaways•

An auction is a trading mechanism where the highest bidder wins an object. Auctions are typically used when values are
uncertain, and thus information is an important aspect of analyzing auctions.

•

Private values means bidders know their own value.

•

Common values means bidders share a common but unknown value, and have some indication or signal about the value. With
common values, willingness to pay by one bidder is informative for other bidders.

•

In an English auction, the auctioneer starts low, and calls out prices until no bidder is willing to bid higher than the current highprice. At that point the auction ends, and the highest bidder wins.

•

In a private values setting, the English auction has a dominant strategy: remain bidding until one’s value is reached.

•

When bid 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.
Key Terms•

Private values: Bidders in an auction know their own value•

Common values: Bidders in an auction have the same value, which is generally not known with certainty•

English Auction: The auction form where bids increase until no one is willing to top the current bid•

Bid increments: the difference between successive price requests

20.2 Sealed-bid Auction
Learning Objectives•

How should I bid if I don’t get to see the bids of others?

In a sealed-bid auction, each bidder submits a bid in an envelope. These are opened simultaneously, and the highest bidder wins theitem and pays his or her bid. Sealed-bid auctions are used to sell off-shore oil leases, and used by governments to purchase a wide
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.
To pursue an analysis of the sealed-bid auction, we are going to make a variety of simplifying 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
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assumed independence – the value one bidder places on the object for sale is statistically independent from the value placed by others.
In addition, each bidder knows their own value, but doesn’t know the other bidders’ 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 bidder bids 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, the remaining bidder will, too.
So fix a bidder and suppose that bidder’s value is vi. What bid should the bidder choose? A bid of b wins the bidding if all otherbidders bid less than b. Since the other bidders, by hypothesis, bid λv when their value is v, our bidder wins whenb ≥ λv jfor eachb ≥vbjfor each other bidder j, and this in turn occurs with probability λ .104 Thus, our bidder
other bidder j. This occurs when λb )n −1(, since the bidder must beat all n-1 other bidders. That creates expectedwith value vi who bids b wins with probability λprofits 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 .
λ=

But this is a linear rule! Thus, if

n −1
n , we have a Nash equilibrium.
λ=The nature of this equilibrium is that each bidder bids a fraction
equal to that fraction of their value.

n −1n of their value, and the highest value bidder wins at a priceIn some cases, the sealed-bid auction produces regret. Regret means that a bidder wishes she had bid differently. Recall our notation

n −1
v(1)
, the
for values: v(1) is the highest value and v(2) is the second-highest value. Since the price in a sealed-bid auction is nn −1v(2) >v(1)n. In this case, the bidder with the second-highest value could havesecond-highest bidder will regret her bid when
bid higher and won, if the bidder had known the winning bidder’s bid. In contrast, the English auction is regret-free, in that the pricerises 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 independence of 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) 



v



distribution  (1) value of v(2) of104, since this is the probability that all n-1 other bidders have values less than v(2). But this gives an expected

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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v(1 )

Ev(2) = ∫ v(2) (n − 1)0v(n2−)2v(n1−) 1

dv(2) =

n −1
v(1)
n
.

Thus, the average price paid in the sealed-bid auction is the same as the average price in the English auction.
Key Takeaways•

In a sealed-bid auction, bids are opened simultaneously, and the highest bidder wins the item and pays his or her bid.

•

The analysis of the sealed-bid auction is more challenging because the bidders don’t have a dominant strategy.

•

When bidders have uniformly and independently distributed values, there is an equilibrium where they bid a constant fraction of•

Statistical independence of private values implies revenue equivalence, which means English and sealed-bid auctions produce thesame prices on average.

n −1value, n , where n is the number of bidders.

Key Terms•

Sealed-bid auction: The auction form where bidders bid simultaneously, and the highest bidder wins and pays the highest bid•

Revenue equivalence: Two auctions produce the same price on average

20.3 Dutch Auction
Learning Objectives•

Don’t the Dutch use a different kind of auction to sell tulips?

•

How does it work?

The Dutch auction is like an English auction, except that prices start high and are successively dropped until a bidder accepts thegoing price, at which point the auction ends. The Dutch auction is so named because it is used to sell cut flowers in Holland, in theenormous 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 the auction ends. Note that a bidder could revise their bid in the course of the auction, but there
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 theprice gets to $450, the bidder could decide to revise and wait until $350. However, no new information has become available andthere is no reason to revise. In order for the price to reach the original 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 price reaching $450 means that a bidof $350 is optimal, than the original bid of $400 wasn’t optimal.105
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 the winningbidder 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 to the 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 natureof the values of the bidders (private versus common) or the distribution of information (independent versus correlated). Indeed, theprediction that the two games should produce the same outcome doesn’t even depend on risk aversion, although that is morechallenging to demonstrate.

105

Of course, a bidder who thinks losing is likely may wait for a lower price to formulate the bid, a consideration 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 away of speeding it along, another small effect that is ignored for simplicity.
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Key Takeaways•

The Dutch auction is like an English auction, except that prices start high and are successively dropped until a bidder accepts thegoing price, at which point the auction ends.

•

The Dutch auction is so named because it is used to sell cut flowers in Holland.

•

The Dutch auction has exactly the same possible strategies and outcomes as the sealed-bid auction. This is called strategic
equivalence. As a result the Dutch and Sealed Bid auctions have the same equilibria.
Key Terms•

Dutch Auction: The auction form where prices start high and decrease until a bidder signals willingness to pay, at which point theauction stops•

Strategic equivalence: Two games are strategically equivalent if they have the same strategies (after a renaming) and the strategies
lead to the same outcomes

20.4 Vickrey Auction
Learning Objectives•

How should I bid in the auction used by eBay, assuming I don’t want to “buy it now.”

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 most familiar because it is the foundation of eBay’s
auction design. The Vickrey auction is a sealed-bid auction, but with a twist: the high bidder wins, but pays the second-highest bid.
This is why the Vickrey auction is called a second-price auction: the price is not the highest 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-highest bid, 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 a dominant strategy. Fix a bidder, with value v, andlet p be the highest bid of the other bidders. If the bidder bids b, the bidder earns profits ofif b < p 0v − p if b > p
.

It is profitable for the bidder to win if v > p, and lose if v < p. To win when v > p, and lose if v < p, can be assured by bidding v.
Essentially, there is no gain to bidding less than 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 acircumstance 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 made is 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 price reaches 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 theoretical niceties, the Vickrey auction can be politically disastrous. Indeed, New Zealand sold radio spectrumwith the Vickrey auction on the basis of advice by a naïve economist, and the Vickrey auction created a political nightmare when anationwide cellular license received a high bid of $110 million, and a second-highest bid of $11 million. The political problem was

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that the demand revelation showed that the government received only about 10% of the value of the license, making the public quite
irate and dominating news coverage at the time.106 Some smaller licenses sold for tenths of a percent of the highest bid.
In a private values setting, the Vickrey auction, or the English auction, are much easier on 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 the risks ofeither bidding more than necessary, or losing the bidding. Thus, the regular sealed-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, because that 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 two that 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 kinds of bidding errors. In the U.S. PCS auctions, inwhich rights to use the radio spectrum 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. Sucherrors have little consequence in a Vickrey auction, since getting the price wrong by an order of magnitude requires two bidders tomake such errors.
Key Takeaways•

There can be more than one way of implementing a given kind of auction.

•

The Vickrey auction is a sealed-bid auction where the high bidder wins, but pays the second-highest bid. The Vickrey auction is
also called a second-price auction: the price is not the highest bid, but the second-highest bid.

•

The Vickrey auction underlies eBay because when a bidder submits a bid in the eBay auction, the current “going” price is not thehighest bid, but the second-highest bid, plus a bid increment. Thus, up to the granularity of the bid increment, the basic eBay
auction is a Vickrey auction run over time.

•

In the private values setting, bidders in a Vickrey auction have a dominant strategy to bid their value. The Vickrey auction isrevenue equivalent to the other three auctions.

•Because the Vickrey auction induces bidders to bid their value, it is said to be demand revealing.
Key Terms•

Vickrey auction: The auction form where bidders bid simultaneously, and the highest bidder wins and pays the second-highest bid

20.5 The Winner’s Curse and Linkage
Learning Objectives•

How do I interpret the bids of others when other bidders may have relevant information about the value of the good?

"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 theactual value of the item being sold, and information held by others is relevant to the valuation of the item. If I estimate an antique tobe worth $5,000, but no one else is willing to bid more than $1,000, I might revise my estimate of the value down. This revision leads
bidders to learn from the auction 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 morethan the rights were worth. This phenomenon came to be known as the winner’s curse. The winner's curse is the fact that 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.

106

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 telephonecompany 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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Auctions, by their nature, select optimistic bidders.
Consider the case of an oil lease (right to drill for and pumpoil) that has an unknown value v. Different bidders willobtain different estimates of the value, and we may view
0.3
these estimates as draws from a normal distribution
illustrated in Figure 20.5.1. The estimates are correct on
average, which is represented by the fact that the
distribution is centered on the true value v. Thus a
0.2
randomly chosen bidder will have an estimate that is toohigh as often as it is too low, and the average estimate of arandomly selected bidder will be correct. However, the0.1
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
2
4
-4
-2
bidders, the highest estimate is larger than the true value
with probability 99.9%, because the odds that all the
Figure 20.5.1: The Standard Normal Distribution
estimates are less than the true value is (½)10 = 0.1%. Thisphenomenon – that auctions tend to select the bidder with the highest estimate, and the highest estimate is larger than the true value
most of the time – is characteristic of the winner’s curse.

0.4

A savvy bidder corrects for the winner’s curse. Such a correction is actually quite straightforward when a few facts are available, andhere 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.107 Finally, suppose that no priorinformation 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 of value, 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 20.5.1. This shows, as a function of the number of bidders, how much each bidder should reduce their estimate of value tocorrect for the fact that auctions select optimistic bidders. The units are standard deviations.
Table 20.5.1: Winner's Curse Correction
n

1

2

3

4

5

10

15

WCC (σ)

0

.56

.85

1.03

1.16

1.54

1.74

n

20

25

50

100

500

1000

10,000WCC (σ)

1.87

1.97

2.25

2.51

3.04

3.24

3.85

For example, with one bidder, there is no correction, since it was supposed that the estimates are right on average. With two bidders,
the winner’s curse correction is the amount that the higher of two will be above the mean, which turns out to be 0.56σ, a little morethan 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 is on average correct. With four bidders, the highest is a bit over a whole standard deviation. As is apparent fromthe table, the winner’s curse correction increases relatively slowly after ten or fifteen bidders. With a million bidders, it is 4.86σ.
The standard deviation σ measures how much randomness or noise there is in the estimates. It is a measure of the average difference
between the true value and the estimated 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 can correct their estimates to account for the winner’s curseusing their historical inaccuracies.
Bidders who are imperfectly informed about the value of an item for sale are subject to losses arising from the way auctions select thewinning bidder. The winning bidder is usually 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 the winner’s curse correction. The size of the winner’s
curse correction is larger the more bidders there are but tends to grow slowly beyond a dozen or so bidders.

107

The standard deviation is a measure of the dispersion of the distribution, and is the square root of the average of the square of thedifference 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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If the bidders have the same information on a common value item, they will generally not earn profits on it. Indeed, there is a generalprinciple that it is the privacy of information, rather than the accuracy of information, that leads to profits. Bidders earn profits on theinformation that they hold that is not available to others. Information held by others will be built into the bid price and therefore notlead to profits.
The U.S. Department of the Interior, when selling off-shore oil leases, not only takes an upfront 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, sharesrisk, since the payment is higher when there is more oil. Similarly, a book contract provides an author with an upfront payment and aroyalty. Many U.S. Department of Defense purchases of major weapons systems involve cost-sharing, where the payments made pickup a portion of the cost. Purchases of ships, for example, generally involve 50% to 70% cost sharing, which means the DOD pays aportion of cost overruns. The contract for U.S. television broadcast rights for the summer Olympics in Seoul, 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 to the actual value, which is unknown at the time of
the auction. Linkage shares risk, which is a topic already considered in Section 19. But linkage does something else, too. Linkage
reduces the importance of estimates in the auction, replacing the estimates with actual 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 the auction bytaking the price out of the bidder’s hands, at least partially.
The linkage principle108 states that, in auctions where bidders are buyers, the expected price rises the more the price is linked to theactual value. (In a parallel fashion, the expected 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 tounderstand. Suppose the government is purchasing by auction a contract for delivery of 10,000 gallons of gasoline each week for 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 acushion to compensate for the risk, and for 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 andthen pays for the cost of the gasoline, 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 the overall 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 effectmust be balanced against the reduction in bidder profits from the auction to select a supplier.

108

The linkage principle, and much of modern auction theory, was developed by Paul Milgrom (1948 – ).

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Key Takeaways•

Auctions, by their nature, select optimistic bidders. This phenomenon – that auctions tend to select the bidder with the highest
estimate, and the highest estimate is larger than the true value most of the time – is known as the winner’s curse.

•

A savvy bidder corrects for the winner’s curse.

•

The size of the winner’s curse correction is larger the more bidders there are but tends to grow slowly beyond a dozen or sobidders.

•

There is a general principle that it is the privacy of information, rather than the accuracy of information, that leads to profits.
Information held by others will be built into the bid price and therefore not lead to profits.

•

The linkage principle states that, in auctions where bidders are buyers, the expected price rises the more the price is linked to theactual value. Examples of linkage include English or Vickrey auctions, which link the price to the second bidder’s information,and use of royalties or cost-shares.
Key Terms•

Winner’s curse: the bidder who most overestimates the value of the object wins the bidding.

•

Linkage principle: the expected price in an auction to sell rises the more the price is linked to the actual value

20.6 Auction Design
Learning Objectives•

What kind of auction should I hold to sell something?

•

Should I impose a minimum bid?

•

Use an open or sealed bid auction?

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 the auction to the circumstances of the bidders and the goal of
the seller. Some of the principles 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 is easier for bidders to collude in a sealed-bid
auction than in an English auction; and reserve 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 allbidders, 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 is an additional negative consideration for a high reserve price.
Ascending price auctions like the English auction have several advantages. Such auctions 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 notplan for every contingency in advance. In addition, because bidders in an English auction can see the behavior of others, there is alinkage created – the price paid by 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 the seller.
One caveat to the selection of the English auction is that risk aversion doesn’t affect the outcome in the private values case. In
contrast, in a sealed-bid auction, risk aversion 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 sealedbid auction than in the English auction.
When considering the revelation of information, there is always an issue of lying and misleading. In the long-run, lying andmisleading 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,
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information about the value of the good for sale dominates the policy of concealing information, because the revelation of information
links the payment to the actual outcome.
In contrast, revealing information about the extent of competition may not increase the prices. 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 the extent
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 are risk averse, the concealment of information tends to increase the bid prices, because the risk created by theuncertainty about the extent of competition works to the advantage of the seller. Of course, it may be difficult to conceal the extent ofcompetition 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 arewilling to pay more for spectrum in their areas than outsiders are. Advantaged bidders discourage participation of others, since theothers are likely to lose. This can result in a bidder with an advantage facing no competition and picking up the good cheaply.
Second, rivals don’t present much competition to the advantaged bidder, even if the rivals do participate. Consequently, when abidder has a large advantage over rivals, it is advantageous to handicap the advantaged bidder, favoring the rivals. This handicapping
encourages participation and levels 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 auctions of spectrum, were the first major instance ofauction design in an important practical setting, and the auction design was credited with increasing the revenue raised by thegovernment substantially.
Key Takeaways•

Some of the principles of auction design include:oImpose an appropriate reserve price or minimum bidoUse ascending price (English) auctions rather than sealed-bidoReveal information about the value of the itemoConceal information about the extent of competitionoHandicap bidders with a known advantage•

The optimal reserve trades off this failure to sell against the higher prices when sales arise.

•

Ascending price auctions create linkage and reduce the complexity of the bidder’s problem.

•

Consistent revelation of accurate information about the value of a good increases average prices through linkage, relative to thepolicy of concealing information.

•

Revealing information about the extent of competition may not increase the prices.

•

When a bidder has a large advantage over rivals, it is advantageous to handicap the advantaged bidder, favoring the rivals. Thishandicapping encourages participation and levels the playing field, forcing the advantaged bidder to bid more competitively towin.

•

A common means of favoring disadvantaged bidders is by the use of bidder credits.

•

Auction design is used to improve the performance of markets and is becoming a field in its own right.
Key Terms•

Reserve prices: Minimum bid in an auction•

Bidder credits: Favoritism in an auction for certain bidders in the form of a discount on payment

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21

Antitrust21.1 Sherman Act
Learning Objectives•

What is the first US antitrust law?

•

What is antitrust, anyway?

In somewhat archaic language, a trust was a group of firms acting in concert, which is now known as a cartel. The antitrust laws madesuch trusts illegal, and were intended to protect competition. In the United States, these laws are enforced by the US 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 hassince copied the U.S. antitrust laws in one version or another.
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 trade or 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 orconspiracy hereby declared to be illegal shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine notexceeding $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 the discretion of the court.
Section 2. Monopolizing trade a felony; penalty
Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, tomonopolize 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, shall be punished by fine not exceeding $10,000,000 if a corporation, or, if any other person, $350,000, orby imprisonment not exceeding three years, or by both said punishments, in the discretion of the court.109
The phrase “in restraint of trade” is challenging to interpret. Early enforcement of the Sherman 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 oilfrom 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 make unreasonable
contracts illegal, and therefore concluded that judicial discretion is necessary in applying the antitrust laws. In addition, Chief JusticeWhite noted that the 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 the 1945 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 have monopoly
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 maintain that monopoly power? In the language of a later decision, did the firm engage in “the willful acquisitionor maintenance of that power as distinguished from growth or development 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 notmake having a monopoly illegal. Indeed, three legal ways of obtaining a monopoly – a better product, running a better business, orluck – are spelled out in one decision. It is illegal to leverage that existing monopoly into new products or services, or to engage inanticompetitive tactics to maintain the monopoly. Moreover, you must have monopoly power currently to be found guilty of illegal
tactics.

109

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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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 an illegalmonopoly. 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 anegligible share at the time.) Second, it alleged a browser was not a separate market but an integrated product necessary for thefunctioning 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 aregood substitutes in the minds of consumers – will they substitute to an alternate product in the event of some bad behavior by theseller? By this test, Microsoft had an operating system monopoly in spite of the fact that there was a rival, because for mostconsumers, Microsoft could increase the price, tie the browser and MP3 player to the operating system, or even disable 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 price-fixing 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 theprices 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 price of thiscommon additive to animal feed. When highway contractors are convicted of bid-rigging, generally the conviction is under the
Sherman Act, for monopolizing their market.
Key Takeaways•

A trust is a group of firms acting in concert, now known as a cartel. The antitrust laws made such trusts illegal, and were intended
to protect competition. In the United States, these laws are enforced by the Department of Justice’s Antitrust Division, and by theFederal Trade Commission.

•

The Sherman Act, passed in 1890, is the first significant piece of antitrust legislation. It prevents mergers and cartels that would
increase prices.

•

Having a monopoly is legal, provided it is obtained through legal means. Legal means include “superior product, businessacumen or historic accident.”•

Modern antitrust investigations involve two-part test. First, does the firm have monopoly power in a market? If not, nomonopolization has occurred and there is no issue for the court. Second, if so, did the firm use illegal tactics to extend or
maintain that monopoly power?

•

The Sherman Act provides criminal penalties, which are commonly applied in price-fixing cases.
Key Terms•

Trust : a group of firms acting in concert•

Sherman Act: The first US antitrust law, makes restraint of trade, monopolization illegal•

Two-part test: In antitrust, the requirement for an antitrust violation that first a firm had monopoly power, then it abused that
power

•

US Department of Justice: Federal government agency that enforces the antitrust laws, along with the Federal Trade Commission,
among other responsibilities

21.2 Clayton Act
Learning Objectives•

What other major antitrust legislation exists in the US?

•

What is predatory pricing and why is it illegal?

•

Is price discrimination illegal?

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.

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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 driven out 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 that name. It prohibits price discrimination thatlessens competition. Thus, price discrimination to final consumers is legal under the Clayton Act; the only way price discrimination
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, which concluded 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 cost-based, 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 prohibitedfrom favoring its own service organization. Generally manufacturers may not require the use of the manufacturer’s 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 Boschparts directly from Bosch, even though Mercedes itself was selling Bosch parts to the dealers. This practice was ruled illegal because
the quality of the 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 inpredation, 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: a reputation 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 the real world (e.g. Tourette’s syndrome), predatory pricing
probably happens more often in textbooks than in the real world.110
The Federal Trade Commission also has authority to regulate mergers that would lessen competition. As a practical matter, theDepartment 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, usinga threat of “we’re your only customer.” The Federal Communications Commission has statutory authority over telephone andtelevision companies. The Federal Reserve Bank has authority over national and most other banks.
Most states have antitrust laws as well, and can challenge mergers that would affect commerce 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 in other
antitrust actions, or sue independently. For example, many states joined the Department of Justice in its lawsuit against Microsoft.
Forty-two states jointly sued the major record companies over their “minimum advertised prices” policies, which the states 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.

110

Economists have argued that American Tobacco, Standard Oil and A.T. & T. each engaged in predation in their respective
industries.
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Key Takeaways•

The Clayton Act was passed in 1914 and adds detail to the Sherman Act. The Federal Trade Commission, which has authority to
enforce the Clayton Act, as well as engage in other consumer protection activities, was created the same year.

•

The Clayton Act does not have criminal penalties, but does allow for monetary penalties that are three times as large as thedamage created by the illegal behavior.

•Highlights of the Clayton Act include:oSection 2, which prohibits price discrimination that would lessen competition,oSection 3, which prohibits exclusionary practices that lessen competition, such as tying, exclusive dealing andpredatory pricing,oSection 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.

•

Predatory pricing involves pricing below cost in order to drive a rival out of business.

•

The Department of Justice and the Federal Trade Commission divide responsibility for evaluating mergers.

•

Most states have antitrust laws as well, and can challenge mergers that would affect commerce in the state.
Key Terms•

Clayton Act: Second major US antitrust law; prohibits various behavior leading to a lessening of competition•

Robinson-Patman: The section of the Clayton act prohibiting price discrimination that lessens competition•

Predatory pricing: pricing below cost in order to drive a rival out of business•

Federal Trade Commission: Federal government agency that enforces the antitrust laws, along with the US Department of Justice,and consumer protection

21.3 Price-Fixing
Learning Objectives•

What is price fixing and how does it work?

Price-fixing, which is called bid-rigging in a bidding context, involves a group of firms agreeing to increase the prices they charge andrestrict competition against each other. The most famous example of price-fixing is probably the “Great Electrical Conspiracy” inwhich GE and Westinghouse (and a smaller firm, Allis-Chalmers) 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 allcompanies. An amusing element of the price-fixing scheme was the means by which the companies identified the winner 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 basedon the phase of the moon. Executives from the companies met often to discuss terms of the price-fixing arrangement, and theDepartment of Justice acquired a great deal of physical evidence in the process of preparing its 1960 case. Seven executives went tojail and hundreds of millions 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 numberof competitors in a given region.
As a theoretical matter, it should be difficult for a large firm to motivate a manager to engage in price-fixing. The problem is that thefirm can’t write a contract promising the manager 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 price-fixing tomanagers, in exchange for the personal risks the managers would face from engaging 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 the same person, and thus the personal risk more likely to be justified by
the personal return.
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We developed earlier a simple theory of cooperation, in which the grim trigger strategy was used to induce cooperation. Let us applythat 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 fromcheating. Once the others react, the collusion breaks down and the firms earn zero profits (the competitive level) from then on. The
cartel is feasible if 1/n of the monopoly profits forever is better than the whole monopoly profits for a short period of time. Thus,
cooperation is sustainable if:πmπ= m (1 + δ + δ2 + ...) ≥ πmn(1 − δ) n.
The left hand side gives the profits from cooperating – the present value of the 1/n share of the monopoly profits. In contrast, if a firmchooses to cheat, it can take at most the monopoly profits, but only temporarily. How many firms will this sustain? The inequalityn≤11 − δ . Suppose the annual interest rate is 5% and the reaction time is 1 week – that is, a firm that cheats on thesimplifies tocooperative agreement sustains profits for a week, after which time prices fall to the competitive level. In this case, 1-δ is a week’s1
δ = 0.95 52 = .999014 . According to standard
worth of interest (δ is the value of money received in a week) and therefore
theory, the industry with a week-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 to persist. The problem is the prisoner’s dilemma
itself: generally the first participant to turn in the conspiracy can avoid jail. Thus, if one member of a cartel is uncertain whether theother members of a price-fixing conspiracy are contacting the Department of 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 – amember who feels guilty, a disgruntled ex-spouse of a member, or perhaps a member who thinks another member is suffering pangsof 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 annuallyof a breakdown of a conspiracy, at least among those that are eventually caught.
Key Takeaways•

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 fixed theprices of turbines. The companies used the phase of the moon to determine the winner of government procurement auctions.

•

Theoretically, collusions should be easy to sustain; it practice it does not seem to be.
Key Terms•

Price-fixing: a group of firms agreeing to increase the prices they charge and restrict competition against each other•

Bid-rigging: Price-fixing in an auction context

21.4 Mergers
Learning Objectives•

How does the government decide which mergers to block and which to permit?

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 under the 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 the second request, the government again has a limited amount of time before it either approves the merger orsues to block it. The agencies themselves don’t stop the merger, but instead sue to block the merger, asking a federal judge to preventthe 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.
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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, andthousands of gas stations were sold to other companies. The 1996 merger of Kimberley-Clark and Scott Paper would have resulted ina single company with over 50% of the facial tissue and baby wipes markets, and in both cases divestitures of production capacity andthe “Scotties” brand name preserved 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 topreserve 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 verticalmerger is a merger between an input supplier and input buyer. The attempt by book retailer Barnes and Noble to purchase theintermediary Ingram, a company that buys books from publishers and sells to retailers but didn’t directly sell to the public, would haveresulted in a vertical merger. Similarly, Disney is a company that sells programs to television stations (among other activities), 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 a large 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 Warner merger threatened rivals to AOL internet service (like EarthLink) with an inability to offer
broadband services to consumers with Time Warner cable. This potentially injures competition 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 be forced
to purchase AOL internet service in order to have access to Time Warner content. Both of these threaten foreclosure of rivals, andboth 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 to content, AOL--Time Warner could instead make thecontent available under disadvantageous terms. For example, American Airlines developed the Sabre computerized reservation
system, which was used by about 40% of travel agents. This system 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 just increased 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 the customers of other banks. Suchcharges 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 a three step procedure for each product that the merging companies have in common.
The procedure starts by identifying product markets. To identify a product market, start with a product or products produced by bothcompanies. 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 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 the merging parties will increase price unilaterally after themerger 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 of these 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 enoughsubstitutes have been identified which, if controlled by a hypothetical monopoly, would have their prices significantly increased.
The logic of product market definition is that, if a monopoly wouldn’t increase price in a meaningful way, that there is no threat toconsumers – 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 in which both companies sell, and asks if themerged company has an incentive to increase price by a SSNIP. If so, that geographic area is a geographic market. If not, it isbecause of 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 price profitably 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 more distant 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 the smallest area in which competitive concerns would beraised by a hypothetical monopoly. In any smaller area, attempts to increase price are defeated by substitution to sellers outside thearea.
The product and geographic markets together are known as a relevant antitrust market, relevant for the purposes of analyzing themerger.
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The third and last step of the procedure is to identify the level of concentration in each relevant antitrust market. The HirschmanHerfindahl index, or HHI, is used for this purpose. 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 inpercent are used, which makes the scale range from 0 to 10,000. For example, if one firm has 40%, one 30%, one 20% and theremaining firm 10%, the HHI is402 + 302 + 202 + 102 = 3,000.
Usually, anything over 1800 is considered “very concentrated,” and anything over 1000 is “concentrated.”
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 (𝑥𝑥 + 𝑦𝑦)2 − 𝑥𝑥 2 − 𝑦𝑦 2 = 2𝑥𝑥𝑥𝑥. This is 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 more accurate 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 isunlikely 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, thegovernment may define quite small geographic markets, and possibly as small as a single customer. Second, if one firm is very 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 firm is 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 to monopoly of the only intercity bus companies in the UnitedStates.
Antitrust originated in the United States and the United States remains the most vigorous enforcer of antitrust laws. However, theEuropean Union has recently taken a more 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 of law andeconomics in this text. For example, intellectual property, patents and standards all have their own distinct antitrust issues.

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Key Takeaways•

Firms with large assets are required to notify the government prior to merging.

•

Many proposed mergers result in settlements.

•

A horizontal merger is a merger of competitors. In contrast, a vertical merger is a merger between an input supplier and input
buyer.

•

Vertical mergers raise two problems: foreclosure and raising rivals’ costs. Foreclosure refers to denying access to necessary
inputs. Raising rivals’ costs is a softer version of foreclosure, charging more for inputs.

•

Mergers are evaluated by a three step procedure: product market, geographic market and effects.

•

A product market is a set of products sufficiently extensive that a monopolist can profitably raise price by a small but significant
and non-transitory increase in price, also known as a “SSNIP,” pronounced ‘snip.’•

The logic of product market definition is that, if a monopoly wouldn’t increase price in a meaningful way, that there is no threat toconsumers – 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, which exactly parallels the product market, looking for an area large enoughthat a hypothetical monopolist over the product market in that geographic market would profitably raise price by a SSNIP.

•

The product and geographic markets together are known as a relevant antitrust market, relevant for the purposes of analyzing themerger.

•

The third and last step of the procedure is to identify the level of concentration in each relevant antitrust market. The HirschmanHerfindahl index, or HHI, is used for this purpose.

•

Several additional factors affect the government’s decision to sue to block mergers, including price discrimination and failingfirms.

•

Antitrust is, in some sense, the applied arm of oligopoly theory.
Key Terms•

Horizontal merger: a merger of competitors•

Vertical merger: a merger between an input supplier and input buyer•

Foreclosure : denying access to necessary inputs•

Raising rival’s costs: increasing input prices as a means of harming a rival•

SSNIP: a small but significant and non-transitory increase in price•

Unilateral effect: In antitrust, the merging parties will increase price unilaterally after the merger is consummated•Relevant antitrust market: A set of products sold in a geographic area in which a hypothetical monopoly can profitably raise theprice.

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22

Solutions to Exercises

Chapter 2

Supply and Demand

2.1

Demand and Consumer Surplus

2.1.1.

If a consumer has a reservation price of $30 for 1 unit of a good, her demand curve looks like this:
60
50

P

40
30
20
10
0
0

0.2

0.4

0.6

0.8

1

1.2

Q
2.1.2.

The expenditure function 𝑥𝑥(𝑝𝑝) = 𝑝𝑝(1 − 𝑝𝑝):

Expenditure

0.3
0.25

x(p)

0.2
0.15
0.1
0.05
0
0

0.5

1

p

2.1.3.

Expenditure is maximized at 𝑝𝑝 = 0.5.

Demand looks like this:Introduction to Economic Analysis

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1.5

1
p

CS

0.5

p

0
0

0.5

1

1.5

x
1

𝐶𝐶𝐶𝐶(𝑝𝑝) = � 1 − 𝑦𝑦 𝑑𝑑𝑑𝑑𝑝𝑝

𝐶𝐶𝐶𝐶(𝑝𝑝) = �𝑦𝑦 −

2.1.4.

2.1.5.

𝐶𝐶𝐶𝐶(𝑝𝑝) = 1 −
∞

1

𝑦𝑦 2
��
2 𝑝𝑝

1
𝑝𝑝2
1
− �𝑝𝑝 − � = (1 − 𝑝𝑝)222
2

𝐶𝐶𝐶𝐶(𝑝𝑝) = ∫𝑝𝑝 𝑦𝑦 −𝜀𝜀 𝑑𝑑𝑑𝑑
𝐶𝐶𝐶𝐶(𝑝𝑝) =𝑞𝑞𝑑𝑑 = 𝑞𝑞𝑠𝑠∞

𝑦𝑦1−𝜀𝜀𝑝𝑝1−𝜀𝜀� =1 − 𝜀𝜀 𝑝𝑝
𝜀𝜀 − 13 − 𝑝𝑝 = 2𝑝𝑝
3𝑝𝑝 = 3

𝑝𝑝 = 1, 𝑞𝑞 = 2
4

3

p 2

qs
qd

1

0
0

1

2

3

4

q
1
𝐶𝐶𝐶𝐶 = (3 − 1)(2) = 2
2

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1
𝑃𝑃𝑃𝑃 = (1)(2) = 1
2

Now suppose 𝑞𝑞𝑠𝑠 = 2𝑝𝑝 + 1. Now,

𝑞𝑞𝑑𝑑 = 𝑞𝑞𝑠𝑠

3 − 𝑝𝑝 = 2𝑝𝑝 + 1

3𝑝𝑝 = 2𝑝𝑝 =7
2
, 𝑞𝑞 =
3
3
4

3

qs

p 2

qd
qs, shifted

1

0
0

1

2

3

4

q
2.1.6.

2.1.7.

a.

a. Droughts in Colombia and Costa Rica will shift the supply of coffee to the left, increasing the price and decreasing
the quantity.

b.

A shift toward longer work days will shift the demand for coffee to the right as people seek to self-medicate.
Equilibrium price and quantity will both increase.

c.

Milk and coffee are complements. A decrease in the price of milk will cause the demand for coffee to shift to the right;
equilibrium price of coffee and quantity consumed will both rise.

d.

A study showing many health benefits of tea will (probably) cause the demand for coffee to fall as people choose asubstitute good instead. The demand curve for coffee shifts to the left; equilibrium price of coffee and quantity
consumed both decline.

The demand curve for T-shirts looks like this:Introduction to Economic Analysis

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12
10
8
p

6
4
2
0
0

2

4

6

8

10

12

14

q
2.1.8.

If there are nine T-shirts available, imagine a vertical supply curve at a quantity of 9. Equilibrium price will be $10. If there
are 11 T-shirts available, the price is not uniquely determined; any price from $0 to $5 will clear the market. Likewise, if
there are 10 shirts available, any price from $5 through $10 will clear the market.

2.1.9.

The individual’s demand for pizza looks like this. The negative p means that he’d have to be paid $1 to take the 5th slice of
pizza.
5
4
3
2
p

1
0
-1

0

1

-2

2.2
2.2.1.

2

3

4

5

6

q

Supply and Profit
$30

1 ℎ𝑟𝑟

∗

1 ℎ𝑟𝑟

15 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝=$2

𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝. Supply is horizontal at a price of $2 per page.

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2.5
2
1.5
p
1
0.5
0
0

10

20

30

40

50

60

q
2.2.2.

Technology A costs $5000 and yields 1000 barrels. Therefore, 𝜋𝜋𝐴𝐴 = 1000𝑝𝑝 − 5000, where p is the price of oil. Likewise,
the profit function for Technology B is 𝜋𝜋𝐵𝐵 = 2000𝑝𝑝 − 10,000 − (5 ∗ 2000) = 2000𝑝𝑝 − 20,000. Technology B will be
used iff
𝜋𝜋𝐵𝐵 ≥ 𝜋𝜋𝐴𝐴

2000𝑝𝑝 − 20,000 ≥ 1000𝑝𝑝 − 5000
1000𝑝𝑝 ≥ 15,000
𝑝𝑝 ≥ 15

At this price, profit is $10,000. At some lower price, the producer will choose to shut down as neither technology is
profitable. This price is where 𝜋𝜋𝐴𝐴 = 0.

𝜋𝜋𝐴𝐴 = 1000𝑝𝑝 − 5000
0 = 1000𝑝𝑝 − 5000
𝑝𝑝 = 50
So, the supply function (number of barrels produced) is 𝑞𝑞𝑠𝑠 = �1000
2000
20

𝑝𝑝 < 55 ≤ 𝑝𝑝 < 15. The supply curve looks like this:15 ≤ 𝑝𝑝

15

p 10

5

0
0

500

1000

1500

2000

2500

q
2.2.3.

𝜋𝜋 = 𝑝𝑝𝑞𝑞𝑠𝑠 − 𝑤𝑤𝑤𝑤

Introduction to Economic Analysis

22-284𝜋𝜋 = 𝑝𝑝𝐿𝐿𝑎𝑎 − 𝑤𝑤𝑤𝑤

𝑑𝑑𝑑𝑑
= 𝑎𝑎𝑎𝑎𝐿𝐿𝑎𝑎−1 − 𝑤𝑤 = 0
𝑑𝑑𝑑𝑑
𝑎𝑎𝑎𝑎𝐿𝐿𝑎𝑎−1 = 𝑤𝑤𝑎𝑎𝑎𝑎
𝐿𝐿1−𝑎𝑎 =𝑤𝑤
𝐿𝐿 = �

𝑎𝑎𝑎𝑎 1�1−𝑎𝑎�𝑤𝑤𝑞𝑞𝑠𝑠 = 𝐿𝐿𝑎𝑎 = �

2.2.4.

1

𝑎𝑎𝑎𝑎 𝑎𝑎�1−𝑎𝑎
�
𝑤𝑤

𝑎𝑎𝑎𝑎

If 𝑎𝑎 = , then 𝐿𝐿 = � �
2

𝑤𝑤

1�
1−𝑎𝑎

1
𝑝𝑝
2

=� �
𝑤𝑤

1
�1−1
2

=

𝑝𝑝2

4𝑤𝑤2

1

and 𝑞𝑞𝑠𝑠 = 𝐿𝐿 �2 =

𝑝𝑝

2𝑤𝑤

.

20 𝐿𝐿 ≤ 40
. But if 𝑤𝑤 = �, then at what price (of the good) does it make sense
30 𝐿𝐿 > 40
𝑑𝑑𝑑𝑑
to pay for overtime? Intuitively, the firm hires labor until the marginal revenue from another hour’s work, 𝑝𝑝 = 𝑎𝑎𝑎𝑎𝐿𝐿𝑎𝑎−1 , is𝑑𝑑𝑑𝑑
less than the wage the firm must pay for that hour. Observe that this marginal revenue product is monotonically decreasingin L; this means that if the 27th hour isn’t worth a $20 wage, then a 41st hour certainly isn’t worth $30. So if 𝐿𝐿(20, 𝑝𝑝) =So if 𝑤𝑤 = 20, then labor demand is 𝐿𝐿 =
𝑝𝑝2

1600

2.2.5.

𝑝𝑝2

1600≤ 40, then labor demand is 𝐿𝐿(20, 𝑝𝑝). The entrepreneur won’t pay for overtime until it is profitable to do so, which iswhere 𝐿𝐿(30, 𝑝𝑝) =

𝑝𝑝2

3600

> 40.

At low prices, the entrepreneur hires less than 40 hours labor and pays a wage of $20.
𝑝𝑝2

1600

≤ 40

𝑝𝑝2 ≤ 64,000

𝑝𝑝 ≤ 80√10

At very high prices, the firm hires more than 40 hours of labor.
𝑝𝑝2
> 40
3600

𝑝𝑝2 > 144,000
𝑝𝑝 > 120√10

If 80√10 < 𝑝𝑝 ≤ 120√10 then the entrepreneur hires 40 hours of labor.

Labor Demand as a function of price

450
400
350
300
250
p
200
150
100
50
0
0

10

20

30

40

50

60

L

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2.2.6.

Marginal cost is the derivative of the cost function. So if 𝑚𝑚𝑚𝑚(𝑞𝑞) = 𝑚𝑚𝑚𝑚, then
𝑚𝑚𝑞𝑞 2

𝑐𝑐(𝑞𝑞) = ∫ 𝑚𝑚𝑚𝑚 𝑑𝑑𝑑𝑑 =+ 𝐹𝐹. Here, the constant of integration is the fixed cost (the part that doesn’t vary with quantity
2
produced). Therefore, the firm’s profit is
𝜋𝜋 = 𝑝𝑝𝑝𝑝 −𝑚𝑚𝑞𝑞 2− 𝐹𝐹
2The firm chooses the quantity that maximizes profit, so
𝑑𝑑𝑑𝑑= 𝑝𝑝 − 𝑚𝑚𝑚𝑚 = 0
𝑑𝑑𝑑𝑑

𝑝𝑝 = 𝑚𝑚𝑚𝑚
𝑝𝑝𝑞𝑞 ∗ = . This is the profit maximizing quantity. Substitute this back into the profit function to obtain𝑚𝑚

𝑝𝑝 2𝑚𝑚 � �
𝑝𝑝𝑚𝑚
𝜋𝜋 = 𝑝𝑝 � � −
− 𝐹𝐹
𝑚𝑚
2
𝜋𝜋 =

2.3

𝜋𝜋 =

𝑝𝑝2 𝑝𝑝2−− 𝐹𝐹
𝑚𝑚 2𝑚𝑚

𝑝𝑝2
− 𝐹𝐹
2𝑚𝑚

Market Demand and Supply

B
AC

2.3.1.
Triangle A is consumer 1’s surplus, while area A+ B is consumer 2’s surplus. The area under the market demand curve is A+
B+C. But C is a triangle with the same dimensions as A, so the area under the market demand curve is the sum of theindividuals’ consumer surplus.
2.4

Equilibrium

2.4.1.

Equilibrium is where quantity demanded equals quantity supplied.
𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎 − 𝑏𝑏𝑏𝑏 = 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑐𝑐𝑐𝑐
𝑎𝑎 = (𝑏𝑏 + 𝑐𝑐)𝑝𝑝
𝑎𝑎
𝑎𝑎𝑎𝑎
𝑝𝑝∗ =
, 𝑞𝑞 ∗ = 𝑐𝑐𝑝𝑝∗ =𝑏𝑏 + 𝑐𝑐𝑏𝑏 + 𝑐𝑐

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2.4.2.

Again, equilibrium is where quantity demanded equals quantity supplied.
𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 = 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑏𝑏𝑝𝑝𝜂𝜂

𝑎𝑎𝑝𝑝 −𝜀𝜀 = 𝑏𝑏𝑝𝑝𝜂𝜂
𝑎𝑎𝑝𝑝𝜂𝜂+𝜀𝜀 =𝑏𝑏𝑎𝑎 1�𝜂𝜂+𝜀𝜀𝑝𝑝∗ = � �𝑏𝑏𝜂𝜂𝑎𝑎 �𝜂𝜂+𝜀𝜀
𝑞𝑞 = 𝑏𝑏𝑝𝑝 = 𝑏𝑏 � �
𝑏𝑏
∗

𝜂𝜂

2.5

Changes in Demand and Supply

2.5.1.

A rightward shift in the supply of video games will cause a decrease in the equilibrium price of video games. This will cause
demand for music CD’s to decline; the demand curve for music CD’s shifts to the left. This will cause equilibrium price andquantity of music CD’s to fall.

2.5.2.

An increase in the price of electricity will cause the supply curve of aluminum to shift to the left. This will result in an
increase in the equilibrium price of aluminum. This increase in the price of aluminum will cause the demand for steel to shift
to the right; the equilibrium price and quantity of steel will both increase.

2.5.3.

Concerns about terrorism reduced demand for air travel. Air travel and Hawaiian hotel rooms are strong complements indemand; we would expect the demand for Hawaiian hotel rooms to shift leftward, resulting in a decline in the equilibrium
price.

Chapter 3

Quantification

3.1

Elasticity

3.1.1.

The consumer’s demand is 𝑞𝑞𝑑𝑑 = 𝑎𝑎𝑝𝑝 −𝜀𝜀 . So expenditure is 𝑥𝑥 = 𝑝𝑝 ∗ 𝑞𝑞𝑑𝑑 = 𝑎𝑎𝑝𝑝1−𝜀𝜀𝑑𝑑𝑑𝑑

3.1.2.

𝑑𝑑𝑑𝑑= (1 − 𝜀𝜀)𝑎𝑎𝑝𝑝−𝜀𝜀 . If 𝜀𝜀 > 1, this is negative. Therefore, as price rises, total expenditure declines and vice versa.

From above,

𝑑𝑑𝑑𝑑

𝑑𝑑𝑑𝑑

infinite price.
3.1.3.

3.1.4.

∞= (1 − 𝜀𝜀)𝑎𝑎𝑝𝑝−𝜀𝜀 . If 𝜀𝜀 < 1, then a higher price results in greater expenditure. Expenditure is maximized at an

𝐶𝐶𝐶𝐶(𝑝𝑝) = ∫𝑝𝑝 𝑎𝑎𝑎𝑎 −𝜀𝜀 𝑑𝑑𝑑𝑑
𝐶𝐶𝐶𝐶(𝑝𝑝) =∞𝑎𝑎𝑎𝑎1−𝜀𝜀𝑎𝑎𝑎𝑎1−𝜀𝜀� =1 − 𝜀𝜀 𝑝𝑝
𝜀𝜀 − 1

If supply has constant elasticity, then the supply function has the form 𝑞𝑞𝑠𝑠 = 𝑏𝑏𝑝𝑝𝜂𝜂 . Therefore,𝑝𝑝

𝑃𝑃𝑃𝑃(𝑝𝑝) = � 𝑏𝑏𝑦𝑦 𝜂𝜂 𝑑𝑑𝑑𝑑
0𝑝𝑝𝑏𝑏𝑝𝑝𝜂𝜂+1
𝑏𝑏𝑦𝑦 𝜂𝜂+1� =𝑃𝑃𝑃𝑃(𝑝𝑝) =𝜂𝜂 + 1 0𝜂𝜂 + 1

3.2

Supply and Demand Changes

3.2.1.

From our solution to Problem 2.4.2, we have𝑞𝑞𝑑𝑑 (𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 = 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑏𝑏𝑝𝑝𝜂𝜂

𝑎𝑎𝑝𝑝 −𝜀𝜀 = 𝑏𝑏𝑝𝑝𝜂𝜂
𝑎𝑎𝑝𝑝𝜂𝜂+𝜀𝜀 =𝑏𝑏𝑎𝑎 1�𝜂𝜂+𝜀𝜀1−1𝑝𝑝∗ = � �
= 𝑎𝑎 �𝜂𝜂+𝜀𝜀 𝑏𝑏 �𝜂𝜂+𝜀𝜀𝑏𝑏𝑎𝑎𝑞𝑞 ∗ = 𝑏𝑏𝑝𝑝𝜂𝜂 = 𝑏𝑏 � �𝑏𝑏𝜂𝜂�𝜂𝜂+𝜀𝜀Introduction to Economic Analysis

𝜂𝜂

𝜂𝜂

𝜂𝜂

𝜀𝜀

= 𝑎𝑎 �𝜂𝜂+𝜀𝜀 𝑏𝑏1− �𝜂𝜂+𝜀𝜀 = 𝑎𝑎 �𝜂𝜂+𝜀𝜀 𝑏𝑏 �𝜂𝜂+𝜀𝜀
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3.2.2.
3.2.3.

3.2.4.

We can think of a small percentage increase in supply as replacing b by 𝑏𝑏(1 + ∆). Using the approximation that (1 + ∆)𝑟𝑟 ≈1 + 𝑟𝑟∆, we can see from the equations above that the price declines by approximately ∆�𝜂𝜂 + 𝜀𝜀 percent and quantity increasesby ∆𝜀𝜀�𝜂𝜂 + 𝜀𝜀 percent.

If demand is perfectly inelastic (𝜀𝜀 = 0), then a small decrease in supply will cause the price to increase by ∆�𝜂𝜂 and thequantity won’t change at all.

From the text, an increase in demand of 3% results in a price increase of ∆�𝜂𝜂 + 𝜀𝜀 , which in our case is 3%�(3 + 3) = 0.5%.

Likewise, a decrease in supply of 3% will also increase price by 0.5%. The total increase in price will therefore be about 1%.
∆𝜂𝜂
The demand shift will increase equilibrium quantity by �𝜂𝜂 + 𝜀𝜀, which is in this case 3% ∗ 3�(3 + 3) = 1.5%. But the
supply decrease will decrease the equilibrium quantity by the same amount, so there is no net quantity change.

If 𝑥𝑥(𝑝𝑝) = 𝑎𝑎𝑝𝑝−𝜀𝜀 , thenln 𝑥𝑥(𝑝𝑝) = ln 𝑎𝑎𝑝𝑝−𝜀𝜀 = ln 𝑎𝑎 − 𝜀𝜀 ln 𝑝𝑝

𝑑𝑑 ln 𝑥𝑥(𝑝𝑝)= −𝜀𝜀. Therefore, the constant A in the question equals -1.

𝑑𝑑 ln 𝑝𝑝3.2.5.

𝑆𝑆

The PPF:
6,000,000
5,000,000

trucks4,000,000
3,000,000
2,000,000
1,000,000
0
0

2000

4000

6000

8000

10000

12000

sedans
3.2.6.

Assigning all 100 workers to make trucks maximizes revenue, at $125 billion. When the PPF has a shape like above, themaximum will be a ‘corner solution’ where all resources are allocated to producing one of the goods. The other corner yields
revenue of only $200 million.

Chapter 4

The US Economy

4.3

Households and Consumption

4.3.1.

This question doesn’t have a solution as such; it’s intended to encourage you to think about the difficulties of measuringchanges in prices, incomes and living standards across time in the face of changes in technology.

4.3.2.

Likewise for this question. The differences in technology between 1980 and today are not as dramatic as those between 1913
and today, but they’re substantial indeed.

Chapter 5

Government Interventions

5.1

Effects of Taxes

5.1.1.

𝑞𝑞𝑑𝑑 (𝑝𝑝) = 1 − 𝑝𝑝, 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑝𝑝. First, we’ll solve for equilibrium without any tax:
1 − 𝑝𝑝 = 𝑝𝑝

2𝑝𝑝 = 1Introduction to Economic Analysis

22-288𝑝𝑝 = $0.50, 𝑞𝑞 = 0.5

Since after the tax is introduced, the price the consumer pays will be different from the price the producer receives, let’s
introduce some notation that recognizes that difference:
𝑞𝑞𝑑𝑑 (𝑝𝑝𝑑𝑑 ) = 1 − 𝑝𝑝𝑑𝑑 , 𝑞𝑞𝑠𝑠 (𝑝𝑝𝑠𝑠 ) = 𝑝𝑝𝑠𝑠

The tax is levied on suppliers, so they receive the price consumers pay, minus the tax: 𝑝𝑝𝑠𝑠 = 𝑝𝑝𝑑𝑑 − $0.10
𝑞𝑞𝑠𝑠 (𝑝𝑝𝑑𝑑 ) = 𝑝𝑝𝑑𝑑 − $0.10

Now solve for equilibrium:
1 − 𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑑𝑑 − $0.10

2𝑝𝑝𝑑𝑑 = 1 + $0.10
𝑝𝑝𝑑𝑑 = $0.55

𝑝𝑝𝑠𝑠 = $0.55 − $0.10 = $0.45

𝑞𝑞 = 𝑝𝑝𝑠𝑠 = 0.45

5.1.2.

The quantity is equal to the producer’s price, as we can see from the supply curve. Before the tax, the price and quantity areboth $0.50 a result we can obtain by plugging in a tax of zero into our expressions. The tax raises the price consumers pay
by $0.05, decreases the price producers receive by $0.05, and reduces the equilibrium quantity by 0.05 units.

Now, the tax is levied on consumers. In this case,
𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑠𝑠 + $0.10

𝑞𝑞𝑑𝑑 (𝑝𝑝𝑠𝑠 ) = 1 − (𝑝𝑝𝑠𝑠 + $0.10) = $0.90 − 𝑝𝑝𝑠𝑠

Now solve for equilibrium:$0.90 − 𝑝𝑝𝑠𝑠 = 𝑝𝑝𝑠𝑠

2𝑝𝑝𝑠𝑠 = $0.90

𝑝𝑝𝑠𝑠 = $0.45

𝑝𝑝𝑑𝑑 = $0.45 + $0.10 = $0.55

𝑞𝑞 = 𝑝𝑝𝑠𝑠 = 0.45

Results are identical to Problem 1 above. Imposing a tax on the buyer or the seller has the same effect on prices and quantity.
5.1.3.

𝑝𝑝𝑠𝑠 = 𝑝𝑝𝑑𝑑 − 𝑡𝑡

𝑞𝑞𝑠𝑠 (𝑝𝑝𝑑𝑑 ) = 𝑝𝑝𝑑𝑑 − 𝑡𝑡

Now solve for equilibrium:
1 − 𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑑𝑑 − 𝑡𝑡
2𝑝𝑝𝑑𝑑 = 1 + 𝑡𝑡
𝑝𝑝𝑑𝑑 =

1 + 𝑡𝑡2

𝑝𝑝𝑠𝑠 = 𝑝𝑝𝑑𝑑 − 𝑡𝑡 =𝑞𝑞 = 𝑝𝑝𝑠𝑠 =

1−𝑡𝑡

.

2

1 + 𝑡𝑡
1 − 𝑡𝑡− 𝑡𝑡 =
2
2

Government revenue collected is the tax multiplied by the quantity transacted:
1 − 𝑡𝑡𝑡𝑡 − 𝑡𝑡 2�=2
2

𝑅𝑅 = 𝑡𝑡𝑡𝑡 = 𝑡𝑡 �

Maximum revenue is collected at the tax rate where the derivative of revenue is zero:
𝑑𝑑𝑑𝑑 1 − 2𝑡𝑡
=
=0
2
𝑑𝑑𝑑𝑑

1 − 2𝑡𝑡 = 0

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2𝑡𝑡 = 1

𝑡𝑡 ∗ = $0.50. At this tax rate, 0.25 units of the good will be transacted in equilibrium, yielding revenue of $0.125.

5.2

Incidence of Taxes

5.2.1.

From the text, equilibrium quantity in the presence of the tax is
𝜂𝜂

−𝜂𝜂𝜂𝜂
𝑎𝑎 �𝜂𝜂+𝜀𝜀(1 + 𝑡𝑡) �𝜂𝜂+𝜀𝜀
𝑞𝑞 = 𝑏𝑏 � �
𝑏𝑏∗

Revenue is the tax multiplied by this quantity.
𝜂𝜂

−𝜂𝜂𝜂𝜂
𝑎𝑎 �𝜂𝜂+𝜀𝜀(1 + 𝑡𝑡) �𝜂𝜂+𝜀𝜀
𝑅𝑅 = 𝑡𝑡𝑡𝑡 � �𝑏𝑏𝑎𝑎

For simplicity of notation, introduce 𝐾𝐾 = 𝑏𝑏 � �
𝑏𝑏is zero:𝜂𝜂�𝜂𝜂+𝜀𝜀−𝜂𝜂𝜂𝜂�𝜂𝜂+𝜀𝜀.

. So 𝑅𝑅 = 𝑡𝑡𝑡𝑡(1 + 𝑡𝑡)

Revenue is maximized where its derivative

−𝜂𝜂𝜂𝜂
−𝜂𝜂𝜂𝜂
𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝑑𝑑𝑑𝑑(1 + 𝑡𝑡) �𝜂𝜂+𝜀𝜀−1 = 0= 𝐾𝐾(1 + 𝑡𝑡) �𝜂𝜂+𝜀𝜀 −𝜂𝜂 + 𝜀𝜀𝑑𝑑𝑑𝑑−𝜂𝜂𝜂𝜂�𝜂𝜂+𝜀𝜀�1 −𝐾𝐾(1 + 𝑡𝑡)

𝑡𝑡𝑡𝑡𝑡𝑡�=0(𝜂𝜂 + 𝜀𝜀)(1 + 𝑡𝑡)

This can only be equal to zero if the term in the square brackets is zero, as the other terms are certainly nonzero.
𝑡𝑡𝑡𝑡𝑡𝑡=1(𝜂𝜂 + 𝜀𝜀)(1 + 𝑡𝑡)

𝑡𝑡𝑡𝑡𝑡𝑡 = (𝜂𝜂 + 𝜀𝜀)(1 + 𝑡𝑡)

𝑡𝑡𝑡𝑡𝑡𝑡 − 𝑡𝑡𝑡𝑡 − 𝑡𝑡𝑡𝑡 = 𝜂𝜂 + 𝜀𝜀𝑡𝑡(𝜂𝜂𝜂𝜂 − 𝜂𝜂 − 𝜀𝜀) = 𝜂𝜂 + 𝜀𝜀𝑡𝑡 =𝜂𝜂 + 𝜀𝜀𝜂𝜂𝜂𝜂 − 𝜂𝜂 − 𝜀𝜀

Since the parameters are positive constants, the numerator is positive. However, the denominator may be negative if either
supply or demand elasticity is low. In this case, revenue is everywhere increasing in the tax rate, and there is no maximum.
The revenue-maximizing tax rate, if it exists, increases as demand (or supply) becomes less elastic.
5.3

Excess Burden of Taxation

5.3.1.

𝑞𝑞𝑑𝑑 = 𝑎𝑎 − 𝑏𝑏𝑝𝑝𝑑𝑑 , 𝑞𝑞𝑠𝑠 = 𝑐𝑐 + 𝑑𝑑𝑝𝑝𝑠𝑠

For a quantity tax, 𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑠𝑠 + 𝑡𝑡

Solving for equilibrium:𝑎𝑎 − 𝑏𝑏(𝑝𝑝𝑠𝑠 + 𝑡𝑡) = 𝑐𝑐 + 𝑑𝑑𝑝𝑝𝑠𝑠(𝑏𝑏 + 𝑑𝑑)𝑝𝑝𝑠𝑠 = 𝑎𝑎 − 𝑐𝑐 − 𝑏𝑏𝑏𝑏

𝑎𝑎 − 𝑐𝑐 − 𝑏𝑏𝑏𝑏
𝑏𝑏 + 𝑑𝑑𝑎𝑎 − 𝑐𝑐 − 𝑏𝑏𝑏𝑏
𝑎𝑎 − 𝑐𝑐 + 𝑑𝑑𝑑𝑑
+ 𝑡𝑡 =
𝑝𝑝𝑑𝑑 =
𝑏𝑏 + 𝑑𝑑
𝑏𝑏 + 𝑑𝑑
𝑝𝑝𝑠𝑠 =

5.3.2.

For an ad valorem tax, 𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑠𝑠 (1 + 𝑡𝑡)
Solving for equilibrium:𝑎𝑎 − 𝑏𝑏�𝑝𝑝𝑠𝑠 (1 + 𝑡𝑡)� = 𝑐𝑐 + 𝑑𝑑𝑝𝑝𝑠𝑠(𝑏𝑏(1 + 𝑡𝑡) + 𝑑𝑑)𝑝𝑝𝑠𝑠 = 𝑎𝑎 − 𝑐𝑐𝑎𝑎 − 𝑐𝑐
𝑝𝑝𝑠𝑠 =𝑏𝑏(1 + 𝑡𝑡) + 𝑑𝑑
Introduction to Economic Analysis

22-2905.3.3.

𝑝𝑝𝑑𝑑 = 𝑝𝑝𝑠𝑠 (1 + 𝑡𝑡) =(𝑎𝑎 − 𝑐𝑐)(1 + 𝑡𝑡)
𝑏𝑏(1 + 𝑡𝑡) + 𝑑𝑑

From exercise 5.1.1, we know that the new quantity traded is 0.45 units, so the quantity has declined by 0.05 units. Tax
1revenue is 𝑅𝑅 = 𝑡𝑡𝑡𝑡 = ($0.10)(0.45) = $0.045. Deadweight loss is a triangle with area 𝐷𝐷𝐷𝐷𝐷𝐷 = 𝑡𝑡∆𝑞𝑞.
1
𝐷𝐷𝐷𝐷𝐷𝐷 = ($0.10)(0.05)
2

2

𝐷𝐷𝐷𝐷𝐷𝐷 = $0.0025

5.4

Effects of Price Floors

5.4.1.

First, let’s work through the logic and math of the example. The supply function is given by 𝑞𝑞𝑠𝑠 (𝑝𝑝) = 𝑝𝑝 and the demand by
𝑞𝑞𝑑𝑑 (𝑝𝑝) = 1 − 𝑝𝑝. Equilibrium quantity and price are both 1�2, as we worked out in Problem 5.1.1. Now we consider the
impact of a price floor 𝑝𝑝 > 1�2. (A price floor lower than this would have no impact on equilibrium). Now we must makemore specific assumptions about the market we’re analyzing. We’ll assume that the good must be produced before a buyer isfound. (We’ll also assume that the good cannot be stored for later sale if a buyer is not found). Now the potential supplier’s
decision is whether to produce the good, given the less-than-certain probability that a buyer will be found; if the quantity
supplied is greater than the quantity demanded, then some mechanism must allocate buyers among the potential sellers.
We’ll model this mechanism as if it were random chance. So the probability that a seller will be lucky enough to sell his
𝑞𝑞
good is 𝑑𝑑�𝑞𝑞𝑠𝑠 . The revenue, if a seller is found, is 𝑝𝑝. A potential supplier will only produce the good if the expected revenue
is at least as great as the cost of production (which we obtain from the supply function). So potential suppliers will produce
𝑞𝑞
until 𝑝𝑝 𝑑𝑑�𝑞𝑞𝑠𝑠 = 𝑝𝑝 = 𝑞𝑞𝑠𝑠
𝑞𝑞𝑠𝑠2 = 𝑝𝑝𝑞𝑞𝑑𝑑 = 𝑝𝑝(1 − 𝑝𝑝); we obtain the quantity demanded from the demand function.
𝑞𝑞𝑠𝑠 = �𝑝𝑝(1 − 𝑝𝑝)

One thing to note about the quantity supplied is that it’s greater than the quantity demanded; if the first term under the squareroot were (1 − 𝑝𝑝) rather than 𝑝𝑝, then the quantity supplied would be just (1 − 𝑝𝑝), which is the quantity demanded. But since
𝑝𝑝 > 1�2, supply is greater. Now, let’s calculate the gains from trade.
2
1
1
𝐶𝐶𝐶𝐶 = �1 − 𝑝𝑝� 𝑞𝑞𝑑𝑑 = �1 − 𝑝𝑝�
22

Producer’s surplus is the price floor times the quantity sold, minus the total cost of producing all units produced (including
the unsold units).
1
1
1
𝑃𝑃𝑃𝑃 = 𝑝𝑝𝑞𝑞𝑑𝑑 − 𝑞𝑞𝑠𝑠 2 = 𝑝𝑝 �1 − 𝑝𝑝� − 𝑝𝑝 �1 − 𝑝𝑝� = 𝑝𝑝 �1 − 𝑝𝑝�
222

Add consumer surplus to producer surplus to obtain gains from trade.
𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 =

2
1
1
1
1
�1 − 𝑝𝑝� + 𝑝𝑝 �1 − 𝑝𝑝� = �1 − 𝑝𝑝� �1 − 𝑝𝑝 + 𝑝𝑝� = �1 − 𝑝𝑝�2222

Contrast this with gains from trade in the market equilibrium without a price floor.
1 1
1
1
𝐶𝐶𝐶𝐶 = �1 − � � � =
2 2
8
2
1
1 1 1
𝑃𝑃𝑃𝑃 = � � � � =
8
2 2 2
1
𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 =4

5.4.2.

Since 𝑝𝑝 > 1�2, �1 − 𝑝𝑝� < 1�2 and hence total gains from trade are smaller in the presence of the price floor. Deadweightloss is equal to gains from trade in equilibrium minus gains from trade in the presence of the price ceiling:
1 1
1
1
𝐷𝐷𝐷𝐷𝐷𝐷 = − �1 − 𝑝𝑝� = �𝑝𝑝 − �
4 2
22

The key difference between this problem and the previous price floor problem is that goods are not produced until a buyer isfound. Since sellers need not worry about being stuck with unsold output, more sellers will wish to supply the good – up to

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𝑞𝑞𝑠𝑠 = 𝑝𝑝. As above, we’ll assume that buyers are allocated randomly among the interested sellers. As before, quantity
purchased is obtained from the demand function: 𝑞𝑞𝑑𝑑 = 1 − 𝑝𝑝. Consumer surplus is identical to above:
2
1
1
𝐶𝐶𝐶𝐶 = �1 − 𝑝𝑝� 𝑞𝑞𝑑𝑑 = �1 − 𝑝𝑝�
2
2

1

𝑞𝑞

The total cost of producing the 𝑝𝑝 units offered by the interested suppliers is 𝑞𝑞𝑠𝑠 𝑝𝑝. However, only a fraction 𝑑𝑑 of offered2

𝑞𝑞𝑠𝑠

goods will find buyers and be produced. Thus, producer surplus is the revenue collected from sales, minus the cost of
production.
𝑃𝑃𝑃𝑃 = 𝑝𝑝𝑞𝑞𝑑𝑑 −𝑞𝑞𝑑𝑑 1∗ 𝑞𝑞 𝑝𝑝
𝑞𝑞𝑠𝑠 2 𝑠𝑠

𝑃𝑃𝑃𝑃 = 𝑝𝑝 �1 − 𝑝𝑝� −�1 − 𝑝𝑝� 1∗ 𝑝𝑝 2
2
𝑝𝑝

1
1
𝑃𝑃𝑃𝑃 = 𝑝𝑝 �1 − 𝑝𝑝� − �1 − 𝑝𝑝� 𝑝𝑝 = �1 − 𝑝𝑝� 𝑝𝑝
2
2

Producer surplus, consumer surplus, gains from trade and deadweight loss are all identical to Problem 5.4.1 above.

5.4.3.

Now we consider the welfare effect of a price ceiling, 𝑝𝑝 < 1�2. Producers will wish to sell a total of 𝑞𝑞𝑠𝑠 = 𝑝𝑝 units of thegood, but consumers want to buy 𝑞𝑞𝑑𝑑 = 1 − 𝑝𝑝, which is greater than the quantity supplied. The quantity supplied must be
allocated among the willing consumers by some mechanism, which we’ll model as random chance. The producer surplus is
the revenue from sales minus the cost of production:
1
1
1 2
𝑃𝑃𝑃𝑃 = 𝑝𝑝𝑞𝑞𝑠𝑠 − 𝑝𝑝𝑞𝑞𝑠𝑠 = 𝑝𝑝𝑞𝑞𝑠𝑠 = 𝑝𝑝222

Consumer surplus for all the interested buyers is
1
1
𝐶𝐶𝐶𝐶 = (1 − 𝑝𝑝)𝑞𝑞𝑑𝑑 = (1 − 𝑝𝑝)22
2
However, only a fraction
𝐶𝐶𝐶𝐶 =

𝐶𝐶𝐶𝐶 =

𝑞𝑞𝑠𝑠 1∗ (1 − 𝑝𝑝)2
𝑞𝑞𝑑𝑑 2

𝑞𝑞𝑠𝑠

𝑞𝑞𝑑𝑑

of buyers will get lucky and obtain the good. Thus, consumer surplus is1
1 𝑝𝑝(1 − 𝑝𝑝)2 = 𝑝𝑝(1 − 𝑝𝑝)2
2 (1 − 𝑝𝑝)

Total gains from trade:11
𝑝𝑝(1 − 𝑝𝑝) + (1 − 𝑝𝑝)22
2
1
𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 = (1 − 𝑝𝑝)[𝑝𝑝 + (1 − 𝑝𝑝)]2
1
𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 = (1 − 𝑝𝑝)
2

𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 =As in Problem 1 above, we can calculate deadweight loss by subtracting the gains from trade in the presence of the priceceiling from the gains from trade in equilibrium.
𝐷𝐷𝐷𝐷𝐷𝐷 =11
1 1− (1 − 𝑝𝑝) = �𝑝𝑝 − �
2
2
4 2

5.7

Quantity Restrictions and Quotas

5.7.1.

The demand for the quota is the difference between the amount consumers are willing to pay for that marginal unit of thegood and the cost of production.
𝑣𝑣 = 1 − 𝑄𝑄 − 𝑐𝑐

The total value of the quota is this value multiplied by the quantity permitted under the quota:
𝑉𝑉 = 𝑣𝑣𝑣𝑣 = 𝑄𝑄 − 𝑄𝑄2 − 𝑐𝑐𝑐𝑐

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If a government wishes to maximize revenue from the quota:
𝑑𝑑𝑑𝑑= 1 − 2𝑄𝑄 − 𝑐𝑐𝑑𝑑𝑑𝑑
𝑄𝑄 ∗ =

Chapter 6

1 − 𝑐𝑐
2

Trade

6.1

Production Possibilities Frontier

6.1.1.

𝑇𝑇 = √𝑚𝑚

𝐶𝐶 = 5√𝑛𝑛

𝑚𝑚 + 𝑛𝑛 = 400

𝑚𝑚 = 𝑇𝑇 2

𝐶𝐶 2 = 25𝑛𝑛

𝑛𝑛 =

𝐶𝐶 2
25

𝑇𝑇 2 +

𝐶𝐶 2
= 400
25

𝑇𝑇 2 = 400 −

𝐶𝐶 2
25

𝑇𝑇 = �400 −
120

𝐶𝐶 2
25

100
80
C

60
40
20
0
0

5

10

15

20

25

T
6.1.2.

𝑇𝑇 = 2𝐿𝐿 𝑇𝑇

𝐴𝐴 = �𝐿𝐿𝐴𝐴

𝐿𝐿𝐴𝐴 + 𝐿𝐿 𝑇𝑇 = 400
𝑇𝑇
= 400
2
𝑇𝑇
𝐴𝐴2 = 400 −
2

𝐴𝐴2 +

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6.1.3.

𝐴𝐴 = �400 −𝑇𝑇
2Let’s determine the combination of inputs that minimizes cost to produce any given quantity. Cost is
𝐶𝐶 = 𝑥𝑥 + 10𝑦𝑦

The production function is
𝑇𝑇 = 20𝑥𝑥 0.25 𝑦𝑦 0.5

Minimize cost, subject to the constraint of producing at least T.
𝐿𝐿 = 𝑥𝑥 + 10𝑦𝑦 + 𝜆𝜆[𝑇𝑇 − 20𝑥𝑥 0.25 𝑦𝑦 0.5 ]𝜕𝜕𝜕𝜕= 1 − 5𝜆𝜆𝑥𝑥 −0.75 𝑦𝑦 0.5 = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
= 10 − 10𝜆𝜆𝑥𝑥 0.25 𝑦𝑦 −0.5 = 0𝜕𝜕𝜕𝜕
5𝜆𝜆𝑥𝑥 −0.75 𝑦𝑦 0.5 = 1

𝜆𝜆𝜆𝜆
=1
4𝑥𝑥
4𝑥𝑥
𝜆𝜆 =
𝑇𝑇

10𝜆𝜆𝑥𝑥 0.25 𝑦𝑦 −0.5 = 10
4𝑥𝑥 𝑇𝑇� � � = 10𝑇𝑇 2𝑦𝑦�

4𝑥𝑥 𝑇𝑇� � � = 10𝑇𝑇 2𝑦𝑦�

𝑥𝑥 = 5𝑦𝑦This is the proportion of x and y that minimizes cost.

6.1.4.

The firm’s profit function is
𝜋𝜋 = 𝑝𝑝(20𝑥𝑥 0.25 𝑦𝑦 0.5 ) − 𝑥𝑥 − 10𝑦𝑦𝜋𝜋 = 20𝑝𝑝((5𝑦𝑦)0.25 𝑦𝑦 0.5 ) − 15𝑦𝑦
Now maximize.

𝑑𝑑𝑑𝑑= 15𝑝𝑝(5)0.25 𝑦𝑦 −0.25 − 15 = 0
𝑑𝑑𝑑𝑑

15𝑝𝑝(5)0.25 𝑦𝑦 −0.25 = 15

𝑦𝑦 0.25 = 𝑝𝑝(5)0.25
𝑦𝑦 = 5𝑝𝑝4

𝑥𝑥 = 5𝑦𝑦 = 25𝑝𝑝4

𝑇𝑇 = 20𝑥𝑥 0.25 𝑦𝑦 0.5 = 100𝑝𝑝3

𝜋𝜋 = 𝑝𝑝𝑝𝑝 − 𝑥𝑥 − 10𝑦𝑦

6.1.5.

𝜋𝜋 = 𝑝𝑝(100𝑝𝑝3 ) − 25𝑝𝑝4 − 25𝑝𝑝4 = 50𝑝𝑝4(Exercise 6.1.4 is the general case and is above).
𝑦𝑦 = 5𝑥𝑥 = 25

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6.1.6.

𝜋𝜋 = 50

The supply function is
𝑇𝑇 = 100𝑝𝑝3

So, the elasticity of supply is 3.

6.2

Comparative and Absolute Advantage

6.2.1.

Ann can produce 120 ounces of vegetables or 60 hors d’oeuvres in an hour; Charlie can produce 60 of either. Ann’s
opportunity cost of vegetables is ½ of one hors d’oeuvre, while Charlie’s is 1 hors d’oeuvre. So Ann should be the firstindividual allocated toward producing vegetables.
200
180
160
Vegetables

140
120
100
80
60
40
20
0
0

20

40

60

80

100

120

140

Hors D'Oeuvres
If 80 of each is required, then Charlie should produce 60 hors d’oeuvres and Ann should spend 20 minutes producing horsd’oeuvres (making 20) and 40 minutes making vegetables (producing 80).
6.2.2.

From Exercise 6.1.1,
𝑇𝑇 = �400 −

𝐶𝐶 2
25

𝐶𝐶 2
𝑑𝑑𝑑𝑑 1= �400 − �
25𝑑𝑑𝑑𝑑 2−1�
2

𝑑𝑑𝑑𝑑 −𝐶𝐶
𝐶𝐶 2=
�400 − �
25
𝑑𝑑𝑑𝑑
25

−2𝐶𝐶
�
25

�

−1�
2

From Exercise 6.1.2,

𝐴𝐴 = �400 −

𝑇𝑇
2

−1�
2

𝑑𝑑𝑑𝑑 1𝑇𝑇= �400 − �
𝑑𝑑𝑑𝑑 22−1�
2

𝑑𝑑𝑑𝑑 −1𝑇𝑇=�400 − �
𝑑𝑑𝑑𝑑
42

Chapter 7

−1
�
2

�

Externalities

7.1

External Effects

7.1.1.

Suppose the probability of contracting polio through contagion is a linear function of the fraction of the population
unvaccinated. (It probably isn’t, but assuming otherwise complicates our analysis unnecessarily). Also assume that the

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probability of contracting polio through the vaccine is some constant 𝛽𝛽. An individual will get vaccinated if doing so
provides him with an expected net benefit; in this case, if it reduces his probability of contracting the disease.
𝜋𝜋𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝛼𝛼(1 − 𝑣𝑣) − 𝛽𝛽Here, v is the fraction of the population that’s vaccinated and 𝛼𝛼 is the coefficient of the linear function relating the probabilityof contracting the disease through contagion to the fraction unvaccinated. Notice that this is a decreasing function of v,
which becomes negative as v approaches 1. If allowed to choose for themselves, individuals will vaccinate until this is nolonger positive.
𝛼𝛼(1 − 𝑣𝑣) − 𝛽𝛽 = 0
1 − 𝑣𝑣 =𝛽𝛽𝛼𝛼𝑣𝑣𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 1 −𝛽𝛽𝛼𝛼This leaves out the external effect of vaccination. If an individual vaccinates, he increases (infinitesimally) the fraction of the
population that’s vaccinated; by doing so, he confers an external benefit on those individuals not yet vaccinated. The size of
this benefit is𝐵𝐵𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 𝛼𝛼(1 − 𝑣𝑣)

This is true because 𝛼𝛼 is the rate at which a change in v affects the probability of contracting the disease, and (1 − 𝑣𝑣) is thefraction of the population that benefits from others’ vaccinations. Thus, the external benefit of vaccination is also decreasing
in v, and is (in this case) exactly equal to the private benefit. The social benefit of an individual’s vaccination is the sum of
the net private benefit and the external benefit:
𝜋𝜋𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 + 𝐵𝐵𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 2𝛼𝛼(1 − 𝑣𝑣) − 𝛽𝛽Social benefit is maximized if individuals vaccinate until this is no longer positive.
2𝛼𝛼(1 − 𝑣𝑣) = 𝛽𝛽
1 − 𝑣𝑣 =𝛽𝛽
2𝛼𝛼𝑣𝑣𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 1 −𝛽𝛽2𝛼𝛼This is greater than the fraction that will vaccinate if allowed to choose. Graphically:
5
4
3
2

Private benefit

1

Social benefit

0
-1

0

v

1

-2

As you can see, there is a region where the private benefit to vaccination is negative but the social benefit is positive. If the
population is within that region, then there is a possible justification for forcing vaccination of schoolchildren; it’s not in thechild’s individual best interest to get vaccinated, but the external benefits make the net benefit positive.

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7.1.2.

Each barrel pumped by one of the producers sharing the field confers a negative externality on the other producers, since it
reduces the total produced.
p

marginal social cost

marginal private cost

Marginal benefitqIndividual producers won’t account for the external cost of their production when deciding how much oil to pump; this leads
to extraction being faster than is socially optimal. Texas’s process of unitization internalizes this externality quite elegantly.
Since the producers share their revenues, an individual producer will account for the adverse impact of his own fasterpumping on other producers when making his decisions.
7.1.3.

The music is a negative externality. Theory suggest several ways to resolve the problem, including rules about how muchnoise is allowed, fines or taxes on the partiers, and subsidies to the residents who are bothered.
Residents of neighboring communities may use the expressway without paying the taxes to help build it. A toll booth might
resolve this problem.

7.2

Pigouvian Taxes
marginal social costp

mpc+taxBmarginal
private
cost

A
E
D

C

marginal
benefitq7.2.1.

In this case, the tax revenue collected is ABCD, while the damage produced by the negative externality is EBCD. Since themarginal damage is increasing in q while the tax is constant, the tax revenue is greater than the marginal damage.

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p

marginalsocialbenefitmarginal
cost
subsidymarginal
privatebenefitq

7.2.2.

The optimal Pigouvian subsidy is just enough to make the marginal private benefit, plus the subsidy, equal to the marginal
social benefit at the socially efficient quantity. If the marginal external benefit is increasing in q, then the total amount of thesubsidy will be greater than the total external benefit.
7.2.3.

The optimal Pigouvian tax is exactly big enough to cause the buyer and seller to internalize the cost of the externality. If themarginal external cost is twice the marginal private cost, then the marginal external cost is exactly equal to the marginal
private cost, since the marginal social cost is the sum of the marginal private cost and the marginal external cost. Therefore,
the efficient Pigouvian tax rate is 100%.

7.3

Quotas

7.3.1.

If the quota is set to the socially efficient level, then the value of the quota right will be equal to the size of the optimal
Pigouvian tax.

7.3.2.

The advantage of speeding permits is primarily allocational – those drivers who value speeding the most highly will be theones who purchase permits. This would be more difficult and expensive to enforce, as some fraction of speeders will bepulled over, whereupon the police would discover the permit and release the driver. A potentially bigger problem is that
accidents may be caused not only by high speeds but by large differences in speeds between drivers on the same road; if thisis the case, then a system of speeding permits may cause more accidents.

7.6

Fishing and Extinction

7.6.1.

Let’s examine the differential equation modeling the dynamics of the fish population:𝑎𝑎𝑎𝑎 𝜀𝜀�𝑏𝑏𝑆𝑆̇ = 𝑟𝑟𝑟𝑟(1 − 𝑆𝑆) − �

If 𝜀𝜀 = 1, this reduces to𝑆𝑆̇ = 𝑟𝑟𝑟𝑟(1 − 𝑆𝑆) −

𝑎𝑎𝑎𝑎
𝑏𝑏

𝑎𝑎
𝑆𝑆̇ = �𝑟𝑟 − � 𝑆𝑆 − 𝑟𝑟𝑆𝑆 2
𝑏𝑏

If this expression is negative for all values of S, then extinction is inevitable. Since the second term is quadratic andnegative, the expression is certainly negative for large values of S. What about small values? If S is very small, then thequadratic term is ignorable and hence𝑎𝑎𝑆𝑆̇ = �𝑟𝑟 − � 𝑆𝑆
𝑏𝑏
Therefore, the expression is negative iff
𝑎𝑎
𝑟𝑟 <
𝑏𝑏

𝑎𝑎

Since r is a supply side parameter modeling the rate at which the fish reproduce and models the fish caught for𝑏𝑏
consumption, we can think of this expression as saying that extinction is inevitable if the demand for fish caught exceeds the
production via reproduction.
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Chapter 8

Public Goods

8.1

Free Riders

8.1.1.

The value of the park to the individual is 𝑉𝑉 = 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 . We can decompose the size of the park into others’ contributions andthe individual’s own contributions, as in the text: 𝑉𝑉𝑖𝑖 = (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏 𝑛𝑛−𝑎𝑎 , where 𝑆𝑆−𝑖𝑖 = ∑𝑗𝑗≠𝑖𝑖 𝑠𝑠𝑗𝑗 . The individual’s net benefit
from contributing is the value of the park, minus the cost of contributing:
𝑈𝑈𝑖𝑖 = (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑠𝑠𝑖𝑖

The individual will choose 𝑠𝑠𝑖𝑖 so as to maximize this expression:

𝑑𝑑𝑑𝑑𝑖𝑖= 𝑏𝑏(𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏−1 𝑛𝑛−𝑎𝑎 − 1 = 0
𝑑𝑑𝑠𝑠𝑖𝑖𝑏𝑏(𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏−1 𝑛𝑛−𝑎𝑎 = 1(𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏−1 =1𝑏𝑏𝑛𝑛−𝑎𝑎(𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )1−𝑏𝑏 = 𝑏𝑏𝑛𝑛−𝑎𝑎
1

𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 = (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏

The term on the left is S, the size of the park. If the park is smaller than this, the individual will increase her contribution andmake the park bigger; the converse is also true.

8.1.2.

From the text, the optimal park size is1

𝑆𝑆 ∗ = (𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏
1𝑆𝑆 ∗ = 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛

1
1 − 𝑎𝑎ln 𝑏𝑏 +ln 𝑛𝑛
1 − 𝑏𝑏
1 − 𝑏𝑏𝑑𝑑 ln 𝑆𝑆 ∗ 1 − 𝑎𝑎=
𝑑𝑑𝑑𝑑
1 − 𝑏𝑏ln 𝑆𝑆 ∗ =8.1.3.

1−𝑎𝑎�
1−𝑏𝑏

From our solution to exercise 8.1.1 above, an individual’s utility is
𝑈𝑈𝑖𝑖 = (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑠𝑠𝑖𝑖

If the park is optimally sized and the expenses are shared equally, then
𝑆𝑆 ∗𝑈𝑈𝑖𝑖 = (𝑆𝑆 ∗ )𝑏𝑏 𝑛𝑛−𝑎𝑎 − � �𝑛𝑛Substituting our expression for the optimal park size into the utility function,
1

𝑈𝑈𝑖𝑖 = �𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
Simplifying:

1�
1−𝑎𝑎�
1−𝑏𝑏 𝑛𝑛
1−𝑏𝑏

𝑛𝑛

𝑏𝑏

𝑏𝑏−𝑎𝑎𝑎𝑎�
11−𝑎𝑎�
1−𝑏𝑏 −𝑎𝑎 − 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
1−𝑏𝑏 −1𝑏𝑏

𝑏𝑏−𝑎𝑎�
1𝑏𝑏−𝑎𝑎�
1−𝑏𝑏 − 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
1−𝑏𝑏

𝑈𝑈𝑖𝑖 = 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
𝑏𝑏

𝑈𝑈𝑖𝑖 = 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
𝑈𝑈𝑖𝑖 = 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛

𝑈𝑈𝑖𝑖 = 𝑛𝑛

𝑏𝑏
𝑏𝑏
1−𝑎𝑎�
1−𝑏𝑏 � 𝑛𝑛−𝑎𝑎 − ��

𝑏𝑏−𝑎𝑎𝑎𝑎−𝑎𝑎+𝑎𝑎𝑎𝑎�
11−𝑎𝑎−1+𝑏𝑏�
1−𝑏𝑏 − 𝑏𝑏 �1−𝑏𝑏 𝑛𝑛
1−𝑏𝑏

𝑏𝑏−𝑎𝑎�
𝑏𝑏
1
1−𝑏𝑏 �𝑏𝑏 �1−𝑏𝑏 − 𝑏𝑏 �1−𝑏𝑏 �

Since 𝑏𝑏 < 1, the term in the parentheses is positive. Since 𝑏𝑏 ≥ 𝑎𝑎, utility is increasing in n (or at least non-decreasing). So,
the model predicts an increase in utility from larger communities.
8.1.4.

1

If the value of the park is √𝑆𝑆, then our parameters are 𝑎𝑎 = 0 and 𝑏𝑏 = . Substituting these values into our expression of the2equilibrium park size under voluntary contributions from our solution to Exercise 8.1.1 above,1

𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 = (𝑏𝑏𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏

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1 �1−11 2 1
2
𝑠𝑠1 + 𝑠𝑠2 = � �=� � =
2
2
4

The efficient size (with 𝑛𝑛 = 2) is
1

𝑆𝑆 ∗ = (𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏
1

� 1
1
1−
2 =1
𝑆𝑆 = �� � (2)�2∗

8.1.5.

Without loss of generality, suppose Person Two offers matching funds. Now consider the utility of Person One:1

𝑈𝑈1 = (𝑠𝑠1 + 𝑠𝑠2 ) �2 − 𝑠𝑠1

Person One chooses 𝑠𝑠1 so as to maximize his own utility.

𝑑𝑑𝑠𝑠2
𝑑𝑑𝑈𝑈1 1−1
= (𝑠𝑠 + 𝑠𝑠2 ) �2 �1 +
�−1= 0𝑑𝑑𝑠𝑠1 2 1
𝑑𝑑𝑠𝑠1

Since Person Two is matching Person One’s contribution,

1−1(𝑠𝑠 + 𝑠𝑠2 ) �2 (2) = 1
2 1(𝑠𝑠1 + 𝑠𝑠2 )

𝑑𝑑𝑠𝑠2
𝑑𝑑𝑠𝑠1

= 1.

−1�
2 = 1

𝑠𝑠1 + 𝑠𝑠2 = 1

This mechanism achieves efficient provision in this case.

8.2

Provision with Taxation

8.2.1.

With heterogeneous preferences (different values for the public good), the individual’s value for the public good is now
𝑉𝑉𝑖𝑖 = 𝑣𝑣𝑖𝑖 (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏 𝑛𝑛−𝑎𝑎

So his utility function is
𝑈𝑈𝑖𝑖 = 𝑣𝑣𝑖𝑖 (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑠𝑠𝑖𝑖

An individual will choose his contribution so as to maximize his utility, taking the contributions of others as given:
𝑑𝑑𝑑𝑑𝑖𝑖= 𝑏𝑏𝑣𝑣𝑖𝑖 (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏−1 𝑛𝑛−𝑎𝑎 − 1 = 0
𝑑𝑑𝑠𝑠𝑖𝑖𝑏𝑏𝑣𝑣𝑖𝑖 (𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )𝑏𝑏−1 𝑛𝑛−𝑎𝑎 = 1(𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 )1−𝑏𝑏 = 𝑏𝑏𝑣𝑣𝑖𝑖 𝑛𝑛−𝑎𝑎
1

𝑆𝑆−𝑖𝑖 + 𝑠𝑠𝑖𝑖 = (𝑏𝑏𝑣𝑣𝑖𝑖 𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏
1𝑠𝑠𝑖𝑖 = (𝑏𝑏𝑣𝑣𝑖𝑖 𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 − 𝑆𝑆−𝑖𝑖

8.2.2.

This equation has a simple interpretation: Whatever the contributions of others are (𝑆𝑆−𝑖𝑖 ), the individual will contribute to1
bring the park size up to (𝑏𝑏𝑣𝑣𝑖𝑖 𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 . Now, let’s consider the problem faced by the individual with the largest 𝑣𝑣𝑖𝑖 . If this1
individual assumes that no others will contribute ((𝑆𝑆−𝑖𝑖 = 0), she will contribute (𝑏𝑏𝑣𝑣𝑖𝑖 𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 . Given this contribution,others will see that the total contributed is already greater than their own optimal size (because their own 𝑣𝑣𝑖𝑖 is smaller thanthat of the individual with the largest 𝑣𝑣𝑖𝑖 ) and will therefore contribute nothing. The size of the park is therefore
1(𝑏𝑏𝑣𝑣𝑚𝑚𝑚𝑚𝑚𝑚 𝑛𝑛−𝑎𝑎 ) �1−𝑏𝑏 , where 𝑣𝑣𝑚𝑚𝑚𝑚𝑚𝑚 satisfies 𝑣𝑣𝑖𝑖 ≥ 𝑣𝑣𝑗𝑗 ∀𝑗𝑗 ≠ 𝑖𝑖

First, let’s derive the result in the text. The median voter’s utility function is
𝑈𝑈𝑘𝑘 = 𝑣𝑣𝑘𝑘 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑠𝑠𝑘𝑘

If the tax to fund the park is imposed equally on all voters, then𝑠𝑠𝑘𝑘 =

𝑆𝑆
𝑛𝑛

Substituting,Introduction to Economic Analysis

22-300𝑈𝑈𝑘𝑘 = 𝑣𝑣𝑘𝑘 𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 − 𝑆𝑆𝑛𝑛−1

The median voter’s optimal park size satisfies
𝑑𝑑𝑈𝑈𝑘𝑘= 𝑏𝑏𝑣𝑣𝑘𝑘 𝑆𝑆 𝑏𝑏−1 𝑛𝑛−𝑎𝑎 − 𝑛𝑛−1 = 0
𝑑𝑑𝑑𝑑

𝑏𝑏𝑣𝑣𝑘𝑘 𝑆𝑆 𝑏𝑏−1 𝑛𝑛−𝑎𝑎 = 𝑛𝑛−1
𝑏𝑏𝑣𝑣𝑘𝑘 𝑛𝑛1−𝑎𝑎 = 𝑆𝑆 1−𝑏𝑏

1

𝑆𝑆 = (𝑏𝑏𝑣𝑣𝑘𝑘 𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏

If all individuals value the good equally, then 𝑣𝑣𝑖𝑖 = 𝑣𝑣 ∀𝑖𝑖, and1

𝑆𝑆 = (𝑏𝑏𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏

What is the efficient park size? Since the value of the park to each individual is 𝑣𝑣𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 , the total value to all individuals is
𝑉𝑉 = 𝑛𝑛𝑛𝑛𝑆𝑆 𝑏𝑏 𝑛𝑛−𝑎𝑎 = 𝑣𝑣𝑆𝑆 𝑏𝑏 𝑛𝑛1−𝑎𝑎 . Further, 𝑈𝑈 = 𝑉𝑉 − 𝑆𝑆, since the park must be paid for.

The optimal park size satisfies
𝑑𝑑𝑑𝑑= 𝑏𝑏𝑏𝑏𝑆𝑆 𝑏𝑏−1 𝑛𝑛1−𝑎𝑎 − 1 = 0
𝑑𝑑𝑑𝑑

𝑏𝑏𝑏𝑏𝑆𝑆 𝑏𝑏−1 𝑛𝑛1−𝑎𝑎 = 1

𝑏𝑏𝑏𝑏𝑛𝑛1−𝑎𝑎 = 𝑆𝑆 1−𝑏𝑏
1

𝑆𝑆 = (𝑏𝑏𝑏𝑏𝑛𝑛1−𝑎𝑎 ) �1−𝑏𝑏

The median voter’s preferred park size is the efficient size.
8.3

Local Public Goods

8.3.1.

The utility of family j is
1
𝑈𝑈𝑗𝑗 = 𝑣𝑣𝑗𝑗 𝑌𝑌 − 𝑛𝑛𝑦𝑦𝑗𝑗 2
2

1
𝑈𝑈𝑗𝑗 = 𝑣𝑣𝑗𝑗 �𝑦𝑦𝑗𝑗 + � 𝑦𝑦𝑖𝑖 � − 𝑛𝑛𝑦𝑦𝑗𝑗 22𝑖𝑖≠𝑗𝑗The family chooses its own contribution so as to maximize its own utility, taking the contributions of others as given.
𝑑𝑑𝑑𝑑𝑗𝑗= 𝑣𝑣𝑗𝑗 − 𝑛𝑛𝑦𝑦𝑗𝑗 = 0
𝑑𝑑𝑑𝑑𝑗𝑗𝑣𝑣𝑗𝑗 = 𝑛𝑛𝑦𝑦𝑗𝑗
𝑦𝑦𝑗𝑗 =

𝑣𝑣𝑗𝑗
𝑛𝑛

Total contributions from all families are
𝑌𝑌 = � 𝑦𝑦𝑗𝑗
𝑗𝑗

𝑌𝑌 = �
𝑌𝑌 =

𝑗𝑗

𝑣𝑣𝑗𝑗
𝑛𝑛

1
� 𝑣𝑣𝑗𝑗 = 𝜇𝜇𝑛𝑛𝑗𝑗

The total utility of all families is
1
𝑈𝑈 = � 𝑈𝑈𝑗𝑗 = � �𝑣𝑣𝑗𝑗 𝑌𝑌 − 𝑛𝑛𝑦𝑦𝑗𝑗 2 �
2
𝑗𝑗

𝑗𝑗

We now choose each family’s contribution so as to maximize this expression.
Introduction to Economic Analysis

22-301𝜕𝜕𝜕𝜕= � 𝑣𝑣𝑗𝑗 − 𝑛𝑛𝑦𝑦𝑘𝑘 = 0
𝜕𝜕𝑦𝑦𝑘𝑘𝑗𝑗

Note that this differs from the voluntary contributions expression above, since the efficient level accounts for the positiveeffect of each family’s contribution on others’ welfare.
� 𝑣𝑣𝑗𝑗 = 𝑛𝑛𝑦𝑦𝑘𝑘
𝑗𝑗

𝑦𝑦𝑘𝑘 =

1
� 𝑣𝑣𝑗𝑗 = 𝜇𝜇 ∀𝑘𝑘𝑛𝑛𝑗𝑗

Note that all families’ contributions are identical here. Total contributions by all families are
𝑌𝑌 = � 𝑦𝑦𝑘𝑘
𝑘𝑘

𝑌𝑌 = � 𝜇𝜇 = 𝑛𝑛𝑛𝑛
𝑘𝑘

What is the welfare impact of voluntary contributions? Recall from above that𝑛𝑛
𝑈𝑈 = � 𝑈𝑈𝑗𝑗 = � �𝑣𝑣𝑗𝑗 𝑌𝑌 − 𝑦𝑦𝑗𝑗 2 �2𝑗𝑗Also recall that𝑣𝑣𝑗𝑗
𝑦𝑦𝑗𝑗 =
𝑛𝑛

𝑗𝑗

and

𝑌𝑌 =

1
� 𝑣𝑣𝑗𝑗 = 𝜇𝜇𝑛𝑛𝑗𝑗

Substitute our expressions for individual and group contributions into the group utility expression:
1 𝑣𝑣𝑗𝑗 2
𝑈𝑈 = � �𝑣𝑣𝑗𝑗 𝜇𝜇 − 𝑛𝑛 � � �𝑛𝑛
2𝑗𝑗

𝑈𝑈 = 𝜇𝜇 � 𝑣𝑣𝑗𝑗 −𝑗𝑗𝑈𝑈 = 𝑛𝑛𝜇𝜇 2 −1� 𝑣𝑣𝑗𝑗 2
2𝑛𝑛
𝑗𝑗

1
� 𝑣𝑣𝑗𝑗 2
2𝑛𝑛
𝑗𝑗1
𝑈𝑈 = 𝑛𝑛𝜇𝜇 2 − (𝜇𝜇2 + 𝜎𝜎 2 )2Chapter 9

Producer Theory: Costs

9.2

Production Functions

9.2.1.

If the production function is Cobb-Douglas,
𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽

If the sum of the exponents is 1, then𝑓𝑓(𝐾𝐾, 𝐿𝐿) = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿1−𝛼𝛼Now, the marginal product of capital is𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿)= 𝛼𝛼𝛼𝛼𝛼𝛼 𝛼𝛼−1 𝐿𝐿1−𝛼𝛼𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿) 𝛼𝛼𝛼𝛼𝛼𝛼 𝛼𝛼 𝐿𝐿1−𝛼𝛼
=
𝐾𝐾
𝜕𝜕𝜕𝜕

Introduction to Economic Analysis

22-302𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿) 𝛼𝛼𝛼𝛼
=
𝜕𝜕𝜕𝜕
𝐾𝐾

By a similar process, we can obtain an expression for the marginal product of labor:𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿)= (1 − 𝛼𝛼)𝐴𝐴𝐴𝐴 𝛼𝛼 𝐿𝐿−𝛼𝛼𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿) (1 − 𝛼𝛼)𝐴𝐴𝐴𝐴 𝛼𝛼 𝐿𝐿1−𝛼𝛼
=
𝐿𝐿
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿) (1 − 𝛼𝛼)𝑓𝑓
=
𝐿𝐿
𝜕𝜕𝜕𝜕

If capital is paid its marginal product, then the total payments to capital will be 𝐾𝐾
payments to labor. Total payments to all factors of production are

9.3
9.3.1.

𝐾𝐾(1 − 𝛼𝛼)𝑓𝑓𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿)
𝛼𝛼𝛼𝛼𝜕𝜕𝜕𝜕(𝐾𝐾, 𝐿𝐿)
+ 𝐿𝐿
= 𝐾𝐾
+ 𝐿𝐿
= 𝛼𝛼𝛼𝛼 + (1 − 𝛼𝛼)𝑓𝑓 = 𝑓𝑓
𝜕𝜕𝜕𝜕
𝐾𝐾
𝐿𝐿
𝜕𝜕𝜕𝜕

𝜕𝜕𝜕𝜕(𝐾𝐾,𝐿𝐿)𝜕𝜕𝜕𝜕, and likewise 𝐿𝐿

𝜕𝜕𝜕𝜕(𝐾𝐾,𝐿𝐿)𝜕𝜕𝜕𝜕

will beProfit Maximization

𝑄𝑄 = 𝑚𝑚𝑚𝑚𝑚𝑚{𝐾𝐾, 𝐿𝐿}

𝜋𝜋 = 𝑝𝑝𝑝𝑝 − 𝑟𝑟𝑟𝑟 − 𝑤𝑤𝑤𝑤

𝜋𝜋 = 𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚{𝐾𝐾, 𝐿𝐿} − 𝑟𝑟𝑟𝑟 − 𝑤𝑤𝑤𝑤

Since K is fixed, the only variable here is L. The firm maximizes profit:
𝑑𝑑𝑑𝑑
1= 𝑝𝑝 �
0
𝑑𝑑𝑑𝑑

9.3.2.

𝐿𝐿 < 𝐾𝐾− 𝑤𝑤
𝐿𝐿 ≥ 𝐾𝐾

This is positive if 𝐿𝐿 < 𝐾𝐾 and 𝑤𝑤 < 𝑝𝑝. So if 𝑤𝑤 < 𝑝𝑝, the firm will hire labor until 𝐿𝐿 = 𝐾𝐾. If 𝑤𝑤 > 𝑝𝑝, the firm will not find it
profitable to produce at all, and will therefore hire zero labor. If 𝑤𝑤 = 𝑝𝑝, the firm is indifferent between hiring K units oflabor and hiring zero, as both result in zero profit.

The production function is 𝑏𝑏 = √𝑥𝑥 where b is the quantity of burgers and x is the quantity of meat, so 𝑥𝑥 = 𝑏𝑏 2. If the firm’s
fixed cost is $2000 and the price of meat is $2, then the firm’s cost function is
𝐶𝐶 = 2000 + 2𝑏𝑏 2Long run equilibrium occurs where the firm’s average cost is minimized; if it’s not, profits are nonzero and entry or exit will
occur.
𝐶𝐶 2000
=
+ 2𝑏𝑏
𝑏𝑏
𝑏𝑏
𝑑𝑑𝑑𝑑𝐶𝐶 −2000
=
+2=0
𝑑𝑑𝑑𝑑
𝑏𝑏 2
𝐴𝐴𝐴𝐴 =

𝑏𝑏 2 = 1000

𝑏𝑏 = 10√10

𝑥𝑥 = 1000

𝐶𝐶 = 2000 + 2𝑏𝑏 2 = 4000

𝐴𝐴𝐴𝐴 =𝐶𝐶= 40√10 = 𝑝𝑝𝑏𝑏

The long run supply for the industry is horizontal at a price of 𝑝𝑝 = 40√10. Each firm produces 𝑏𝑏 = 10√10 burgers. Market
demand is
𝐵𝐵 = 8000𝑝𝑝−1 = 20√10Since each firm produces 10√10 burgers, there must be 𝑛𝑛 = 2 firms. With a cost function of 𝐶𝐶 = 2000 + 2𝑏𝑏 2 , the firm’s
marginal cost is
𝑀𝑀𝑀𝑀 =

𝑑𝑑𝑑𝑑= 4𝑏𝑏 = 𝑝𝑝
𝑑𝑑𝑑𝑑

Introduction to Economic Analysis

22-303

So the firm’s short run supply is
𝑝𝑝
𝑏𝑏 =
4

With 𝑛𝑛 = 2 firms, the industry supply is𝑝𝑝
𝐵𝐵 = 𝑛𝑛𝑛𝑛 =2

The short run industry supply has a constant elasticity of 1.
9.3.3.

The firm’s production function is1

1

𝑇𝑇 = 4𝑥𝑥 �3 𝑦𝑦 �3

𝑇𝑇 3 = 64𝑥𝑥𝑥𝑥

𝑦𝑦 =

𝑇𝑇 3
64𝑥𝑥

The firm’s cost function is
𝐶𝐶 = 𝑝𝑝𝑝𝑝 + 𝑟𝑟𝑟𝑟

What combination of inputs minimizes the cost to make any particular quantity? Minimize the cost function:
𝐶𝐶 = 𝑝𝑝𝑝𝑝 + 𝑟𝑟 �

𝑇𝑇 3
�
64𝑥𝑥

𝑑𝑑𝑑𝑑
𝑇𝑇 3
= 𝑝𝑝 − 𝑟𝑟 ��=064𝑥𝑥 2𝑑𝑑𝑑𝑑
𝑝𝑝 = 𝑟𝑟 �
𝑥𝑥 2 =𝑇𝑇 3
�
64𝑥𝑥 2𝑟𝑟𝑟𝑟 364𝑝𝑝

1�

𝑟𝑟𝑟𝑟 3 2
�
𝑥𝑥 = �
64𝑝𝑝

𝑇𝑇 3 𝑟𝑟𝑟𝑟 3
𝑇𝑇 3
=
�
�
𝑦𝑦 =
64𝑥𝑥 64 64𝑝𝑝

𝐶𝐶 = 𝑝𝑝𝑝𝑝 + 𝑟𝑟𝑟𝑟

−1�
2

1�

𝑝𝑝𝑝𝑝 3 2
=�
�
64𝑟𝑟

1�

1�

1�

1�

𝑟𝑟𝑟𝑟 3 2𝑝𝑝𝑝𝑝 3 2
𝐶𝐶 = 𝑝𝑝 �� + 𝑟𝑟 �
�
64𝑝𝑝
64𝑟𝑟
𝐶𝐶 = �
𝑀𝑀𝑀𝑀 =

1�

1�

𝑝𝑝𝑟𝑟𝑟𝑟 3 2
𝑝𝑝𝑝𝑝𝑝𝑝 3 2
𝑝𝑝𝑝𝑝𝑝𝑝 3 2
𝑝𝑝𝑝𝑝𝑝𝑝 3 2 1
1
� +�� = 2�
� =�
� = (𝑝𝑝𝑝𝑝𝑝𝑝 3 ) �2
64
64
64
16
4
3 1
3
𝑑𝑑𝑑𝑑
1
1
= � � (𝑝𝑝𝑝𝑝𝑝𝑝) �2 = (𝑝𝑝𝑝𝑝𝑝𝑝) �2
2 4
8
𝑑𝑑𝑑𝑑

What ratio of inputs is optimal, for any combination of input prices?
1�𝑦𝑦𝑝𝑝𝑝𝑝 3 2 𝑟𝑟𝑟𝑟 3
=�
� �
�
64𝑟𝑟
64𝑝𝑝
𝑥𝑥
9.3.4.

−1�
2

=

𝑝𝑝
𝑟𝑟

𝑝𝑝

So if each programmer needs 2 computers to do his job, then the ratio of p and r that makes this optimal is = 2.

If the marginal cost is 𝑀𝑀𝐶𝐶 = max �10,

Introduction to Economic Analysis

𝑞𝑞 2

1000

�, we can also think of this as𝑟𝑟

22-304

10
𝑀𝑀𝑀𝑀 = � 𝑞𝑞 2
1000

𝑞𝑞 ≤ 100𝑞𝑞 > 100since 𝑞𝑞 = 100 is the point at which 𝑀𝑀𝑀𝑀 = 10. Total cost is the integral of marginal cost:𝑞𝑞

𝐶𝐶(𝑞𝑞) = $2,000,000 + � 𝑀𝑀𝑀𝑀(𝑟𝑟)𝑑𝑑𝑑𝑑
0

So for 𝑞𝑞 ≤ 100,𝑞𝑞

𝐶𝐶(𝑞𝑞) = $2,000,000 + � 10 𝑑𝑑𝑑𝑑 = $2,000,000 + 10𝑞𝑞
0

For 𝑞𝑞 > 100,

100

𝑞𝑞

0

100

𝐶𝐶(𝑞𝑞) = $2,000,000 + � 10 𝑑𝑑𝑑𝑑 + �𝐶𝐶(𝑞𝑞) = $2,000,000 + $1000 +𝐶𝐶(𝑞𝑞) = $2,001,000 +To sum up,

𝑞𝑞

𝑟𝑟 3
�
3000 100

1003 6,002,000,000 + 𝑞𝑞 3
𝑞𝑞 3−=
3000 3000
3000$2,000,000 + 10𝑞𝑞
𝐶𝐶(𝑞𝑞) = �6,002,000,000 + 𝑞𝑞 3
3000
𝐶𝐶
𝐴𝐴𝐴𝐴 =𝑞𝑞
𝐴𝐴𝐴𝐴(𝑞𝑞) =

𝑟𝑟 2
𝑑𝑑𝑑𝑑
1000

⎧ $2,000,000 + 10⎪
𝑞𝑞

⎨6,002,000,000 + 𝑞𝑞⎪
3000𝑞𝑞⎩𝑞𝑞 ≤ 100𝑞𝑞 > 1003𝑞𝑞 ≤ 100𝑞𝑞 > 100

The short run supply curve is the marginal cost.
10
𝑀𝑀𝑀𝑀 = � 𝑞𝑞 2
1000

𝑞𝑞 ≤ 100𝑞𝑞 > 100

So at 𝑝𝑝 = 10, the firm is willing to supply 100 toys. For 𝑝𝑝 > 10,
𝑞𝑞 2= 𝑀𝑀𝑀𝑀 = 𝑝𝑝1000

𝑞𝑞 2 = 1000𝑝𝑝

𝑞𝑞 = �1000𝑝𝑝

So the short run supply is0𝑞𝑞(𝑝𝑝) = � 100
�1000𝑝𝑝𝑝𝑝 < 10
𝑝𝑝 = 10

𝑝𝑝 > 10In the long run, the competitive supply of toys is determined by the point at which the average cost is a minimum. Average
cost isIntroduction to Economic Analysis

22-305

𝐴𝐴𝐴𝐴(𝑞𝑞) =⎧ $2,000,000 + 10⎪
𝑞𝑞

⎨6,002,000,000 + 𝑞𝑞⎪
3000𝑞𝑞⎩𝑞𝑞 ≤ 1003𝑞𝑞 > 100

For 𝑞𝑞 ≤ 100, average cost is clearly decreasing in q. What about the region 𝑞𝑞 > 100? In this region,
𝑑𝑑𝑑𝑑𝑑𝑑(𝑞𝑞) 3000𝑞𝑞(3𝑞𝑞 2 ) − (6,002,000,000 + 𝑞𝑞 3 )(3000)=(3000𝑞𝑞)2
𝑑𝑑𝑑𝑑

𝑑𝑑𝑑𝑑𝑑𝑑(𝑞𝑞) 3𝑞𝑞 3 − 6,002,000,000 − 𝑞𝑞 3 2𝑞𝑞 3 − 6,002,000,000==
3000𝑞𝑞 2
3000𝑞𝑞 2
𝑑𝑑𝑑𝑑

At 𝑞𝑞 = 100, this is negative, so average cost is still decreasing in q at this point. Where is AC minimized?
2𝑞𝑞 3 − 6,002,000,000=03000𝑞𝑞 2

2𝑞𝑞 3 = 6,002,000,000
𝑞𝑞 3 = 3,001,000,000
33𝑞𝑞 ∗ = �3,001,000,000 = 100 √3001 ≈ 1442

𝐴𝐴𝐴𝐴 =

6,002,000,000 + (1442)3= 20813000(1442)

Long run supply is horizontal at a price of about $2081 per toy.
9.5

Input Demand

9.5.1.

From the text:
1�

𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽
𝐿𝐿 = � 𝛼𝛼 1−𝛼𝛼 �
𝑟𝑟 𝑤𝑤
∗∗

1�

−𝛼𝛼
𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽 1
𝜕𝜕𝐿𝐿∗∗=
� 𝛼𝛼 1−𝛼𝛼 �� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟 𝑤𝑤
𝑟𝑟

−𝛼𝛼
𝐿𝐿∗∗
𝜕𝜕𝐿𝐿∗∗=� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟
𝑟𝑟 𝜕𝜕𝐿𝐿∗∗−𝛼𝛼=
𝐿𝐿∗∗ 𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽1�𝜕𝜕𝐿𝐿∗∗ −(1 − 𝛼𝛼) 𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽 1
=
�
�
� �
𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟 𝛼𝛼 𝑤𝑤 1−𝛼𝛼𝑤𝑤

𝜕𝜕𝐿𝐿∗∗ −(1 − 𝛼𝛼) 𝐿𝐿∗∗
=
� �
𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑤𝑤
𝑤𝑤 𝜕𝜕𝐿𝐿∗∗ −(1 − 𝛼𝛼)=
𝐿𝐿∗∗ 𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽
𝐾𝐾

∗∗

1�

𝐴𝐴𝐴𝐴𝛼𝛼 1−𝛽𝛽 𝛽𝛽 𝛽𝛽 1−𝛼𝛼−𝛽𝛽= � 1−𝛽𝛽 𝛽𝛽 �
𝑟𝑟 𝑤𝑤

1�

𝜕𝜕𝐾𝐾 ∗∗ −(1 − 𝛽𝛽) 𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽 1
=
�
�
� �
𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟 𝛼𝛼 𝑤𝑤 1−𝛼𝛼𝑟𝑟𝜕𝜕𝐾𝐾 ∗∗ −(1 − 𝛽𝛽) 𝐾𝐾 ∗∗
=
� �
𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟
𝑟𝑟 𝜕𝜕𝐾𝐾 ∗∗ −(1 − 𝛽𝛽)=𝐾𝐾 ∗∗ 𝜕𝜕𝜕𝜕1 − 𝛼𝛼 − 𝛽𝛽Introduction to Economic Analysis

22-306

1�

𝜕𝜕𝐾𝐾 ∗∗−𝛽𝛽
𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽 1=
� 𝛼𝛼 1−𝛼𝛼 �� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟 𝑤𝑤
𝑤𝑤

−𝛽𝛽
𝐾𝐾 ∗∗
𝜕𝜕𝐾𝐾 ∗∗=� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑤𝑤
𝑤𝑤 𝜕𝜕𝐾𝐾 ∗∗−𝛽𝛽=
𝐾𝐾 ∗∗ 𝜕𝜕𝜕𝜕1 − 𝛼𝛼 − 𝛽𝛽1�1𝐴𝐴𝐴𝐴𝛼𝛼 𝛼𝛼 𝛽𝛽1−𝛼𝛼 1−𝛼𝛼−𝛽𝛽 1
𝜕𝜕𝐾𝐾 ∗∗=
� 𝛼𝛼 1−𝛼𝛼 �� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑟𝑟 𝑤𝑤
𝑝𝑝
1
𝐾𝐾 ∗∗
𝜕𝜕𝐾𝐾 ∗∗=� �𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽 𝑝𝑝

𝑝𝑝 𝜕𝜕𝐾𝐾 ∗∗1=∗∗
𝐾𝐾 𝜕𝜕𝜕𝜕
1 − 𝛼𝛼 − 𝛽𝛽9.6Myriad Costs

9.6.1.

Assuming a Cobb-Douglas production function
𝑞𝑞 = 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽

In the short run, K is fixed. Therefore, q is a function only of L, and we can invert it:𝑞𝑞
𝐿𝐿𝛽𝛽 =𝐴𝐴𝐾𝐾 𝛼𝛼
𝐿𝐿 = �

𝑞𝑞 1�𝛽𝛽�
𝐴𝐴𝐾𝐾 𝛼𝛼

Since 𝑇𝑇𝑇𝑇 = 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤, we can substitute the above expression into the cost function to obtain
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑟𝑟𝑟𝑟 + 𝑤𝑤 �𝑞𝑞

𝑞𝑞

𝐴𝐴𝐾𝐾 𝛼𝛼

1�
𝛽𝛽

�

1�
𝛽𝛽

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑤𝑤 � 𝛼𝛼� since the cost of capital is fixed in the short run here. Average variable cost is just variable cost divided
𝐴𝐴𝐾𝐾
by quantity produced:
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑤𝑤 �

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑤𝑤𝑞𝑞

𝑞𝑞 1�𝛽𝛽 1� � �𝑞𝑞
𝐴𝐴𝐾𝐾 𝛼𝛼

1−𝛽𝛽
−1
�𝛽𝛽
(𝐴𝐴𝐾𝐾 𝛼𝛼 ) �𝛽𝛽

Marginal cost is the derivative of total cost with respect to quantity.
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 =−1
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑤𝑤 1−𝛽𝛽�𝛽𝛽 (𝐴𝐴𝐾𝐾 𝛼𝛼 ) �𝛽𝛽
= 𝑞𝑞
𝑑𝑑𝑑𝑑
𝛽𝛽

In the long run, the amount of capital can be adjusted and is therefore chosen optimally by the firm. Consequently, we mustmodel the firm as choosing the combination of capital and labor that costs the least to produce a given quantity. As above,
the Lagrange method provides an elegant way to solve such constrained optimization problems. The firm’s problem is
min 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤 𝑠𝑠. 𝑡𝑡. 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 ≥ 𝑞𝑞
𝐾𝐾,𝐿𝐿

𝐶𝐶 = 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤 − 𝜆𝜆�𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 − 𝑞𝑞�𝜕𝜕𝜕𝜕= 𝑟𝑟 − 𝜆𝜆𝜆𝜆𝜆𝜆𝐾𝐾 𝛼𝛼−1 𝐿𝐿𝛽𝛽 = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
= 𝑤𝑤 − 𝜆𝜆𝜆𝜆𝜆𝜆𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽−1 = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
= 𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 − 𝑞𝑞 = 0𝜕𝜕𝜕𝜕Solve the first of these equations for 𝜆𝜆:Introduction to Economic Analysis

22-307

𝑟𝑟 = 𝜆𝜆𝜆𝜆𝜆𝜆𝐾𝐾 𝛼𝛼−1 𝐿𝐿𝛽𝛽𝑟𝑟𝜆𝜆 =𝛼𝛼𝛼𝛼𝐾𝐾 𝛼𝛼−1 𝐿𝐿𝛽𝛽
𝑟𝑟𝑟𝑟
𝜆𝜆 =
𝛼𝛼𝛼𝛼

By a similar process, we can solve the second equation for 𝜆𝜆 as well:

𝜆𝜆 =

𝑤𝑤𝑤𝑤
𝛽𝛽𝛽𝛽

Now we can set the first equal to the second:
𝑟𝑟𝑟𝑟 𝑤𝑤𝑤𝑤=
𝛼𝛼𝛼𝛼 𝛽𝛽𝛽𝛽
𝐾𝐾 =𝛼𝛼𝛼𝛼𝛼𝛼𝛽𝛽𝛽𝛽

Substitute this into the third equation (which is the constraint):
𝐴𝐴𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽 = 𝑞𝑞

𝑞𝑞 = 𝐴𝐴 �
𝑞𝑞 = 𝐴𝐴 �𝛼𝛼𝛼𝛼𝛼𝛼 𝛼𝛼 𝛽𝛽
� 𝐿𝐿
𝛽𝛽𝛽𝛽

𝛼𝛼𝛼𝛼 𝛼𝛼 𝛼𝛼+𝛽𝛽
� 𝐿𝐿
𝛽𝛽𝛽𝛽

𝑞𝑞 𝛼𝛼𝛼𝛼 −𝛼𝛼
𝐿𝐿𝛼𝛼+𝛽𝛽 = � � � �
𝐴𝐴 𝛽𝛽𝛽𝛽1𝛼𝛼

𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛽𝛽𝛽𝛽 �𝛼𝛼+𝛽𝛽
𝐿𝐿 = � �
� �
𝐴𝐴
𝛼𝛼𝛼𝛼
∗

Note that this is different from the 𝐿𝐿∗∗ we solved earlier in the chapter, since this is a function of quantity, rather than price.
Substitute this expression into the above to solve for 𝐾𝐾 ∗ :𝐾𝐾 ∗ =𝐾𝐾 ∗ =

𝛼𝛼𝛼𝛼𝐿𝐿∗
𝛽𝛽𝛽𝛽

1

𝛼𝛼

𝛼𝛼𝛼𝛼 𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛽𝛽𝛽𝛽 �𝛼𝛼+𝛽𝛽� �� �𝛽𝛽𝛽𝛽 𝐴𝐴𝛼𝛼𝛼𝛼
1𝛽𝛽

𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛼𝛼𝛼𝛼 �𝛼𝛼+𝛽𝛽� �
𝐾𝐾 = � �𝐴𝐴𝛽𝛽𝛽𝛽∗

Now that we have our cost-minimizing input levels, we can substitute these back into the cost function:
𝐶𝐶 = 𝑟𝑟𝑟𝑟 + 𝑤𝑤𝑤𝑤
1

𝛽𝛽

1

𝛼𝛼

𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛼𝛼𝛼𝛼 �𝛼𝛼+𝛽𝛽
𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛽𝛽𝛽𝛽 �𝛼𝛼+𝛽𝛽𝐶𝐶 = 𝑟𝑟 � �� �+ 𝑤𝑤 � �
� �
𝐴𝐴
𝐴𝐴
𝛽𝛽𝛽𝛽
𝛼𝛼𝛼𝛼
1

𝛽𝛽

1

𝛼𝛼

𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛽𝛽𝛽𝛽 �𝛼𝛼+𝛽𝛽 𝛽𝛽�𝑞𝑞 �𝛼𝛼+𝛽𝛽 𝛼𝛼𝛼𝛼 �𝛼𝛼+𝛽𝛽 𝛼𝛼�� �
𝑟𝑟 𝛼𝛼+𝛽𝛽 + � �� �𝑤𝑤 𝛼𝛼+𝛽𝛽𝐶𝐶 = � �
𝐴𝐴
𝐴𝐴
𝛽𝛽
𝛼𝛼
𝛽𝛽

9.6.2.

𝛼𝛼𝛽𝛽
𝛼𝛼 �𝛼𝛼+𝛽𝛽
𝛽𝛽 �𝛼𝛼+𝛽𝛽
𝑞𝑞 1�𝛼𝛼+𝛽𝛽 𝛼𝛼��
𝑟𝑟 𝛼𝛼+𝛽𝛽 𝑤𝑤 𝛼𝛼+𝛽𝛽 �� �+� �
�
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿(𝑞𝑞) = � �
𝛽𝛽
𝛼𝛼
𝐴𝐴

Our cost function is

𝑐𝑐(𝑞𝑞) = 𝑞𝑞 2 + 2𝑞𝑞 + 16
Introduction to Economic Analysis

22-308

𝑚𝑚𝑚𝑚(𝑞𝑞) =𝑎𝑎𝑎𝑎(𝑞𝑞) =𝑑𝑑𝑑𝑑(𝑞𝑞)= 2𝑞𝑞 + 2
𝑑𝑑𝑑𝑑

16𝑐𝑐(𝑞𝑞)= 𝑞𝑞 + 2 +𝑞𝑞
𝑞𝑞

𝑣𝑣𝑣𝑣(𝑞𝑞) = 𝑞𝑞 2 + 2𝑞𝑞
𝑎𝑎𝑎𝑎𝑎𝑎(𝑞𝑞) =𝑣𝑣𝑣𝑣(𝑞𝑞)= 𝑞𝑞 + 2
𝑞𝑞

The firm maximizes profit; this leads to a first order condition 𝑝𝑝 = 𝑚𝑚𝑚𝑚. So,

𝑝𝑝 = 𝑚𝑚𝑚𝑚(𝑞𝑞) = 2𝑞𝑞 + 2

𝑝𝑝 − 2 = 2𝑞𝑞
𝑝𝑝𝑞𝑞 = − 12This is the firm’s supply curve. Our long run equilibrium condition, though, is that profits are competed away; thus, profits
must be zero and 𝑝𝑝 = 𝑎𝑎𝑎𝑎(𝑞𝑞) in the long run. Therefore,

𝑚𝑚𝑚𝑚(𝑞𝑞) = 𝑎𝑎𝑎𝑎(𝑞𝑞)2𝑞𝑞 + 2 = 𝑞𝑞 + 2 +𝑞𝑞 2 = 16

16𝑞𝑞𝑞𝑞 = 4, 𝑝𝑝 = 10. The long run supply for the industry is horizontal at a price of 10.

Chapter 10
10.1

Producer Theory: Dynamics

Reactions of Competitive Firms

10.1.1. The firm’s cost function is
𝑞𝑞 2
2𝐾𝐾
𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟
𝑞𝑞
𝐴𝐴𝐴𝐴𝐴𝐴 =
=
+
𝑞𝑞
𝑞𝑞
2𝐾𝐾
𝑇𝑇𝑇𝑇 = 𝑟𝑟𝑟𝑟 +𝑀𝑀𝑀𝑀 =

𝑑𝑑𝑑𝑑𝑑𝑑 𝑞𝑞
=
𝑑𝑑𝑑𝑑
𝐾𝐾

ATC

C

MC

q
To find the level of capital that minimizes the total cost for a given quantity, we differentiate the cost function:

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𝑇𝑇𝑇𝑇 = 𝑟𝑟𝑟𝑟 +

𝑞𝑞0 2
2𝐾𝐾

𝑞𝑞0 2
𝑑𝑑𝑑𝑑𝑑𝑑= 𝑟𝑟 −
=0
2𝐾𝐾 2
𝑑𝑑𝑑𝑑

𝑟𝑟 =

𝑞𝑞0 2
2𝐾𝐾 2

𝐾𝐾 2 =𝐾𝐾 ∗ =

𝑞𝑞0 2
2𝑟𝑟
𝑞𝑞0

√2𝑟𝑟

Substitute this expression into the expression for average total cost from above.

𝑞𝑞
𝑇𝑇𝑇𝑇 𝑟𝑟𝑟𝑟
=
+
𝑞𝑞
2𝐾𝐾
𝑞𝑞
𝑞𝑞
𝑟𝑟 0
𝑞𝑞0
𝐴𝐴𝐴𝐴𝐴𝐴 ∗ = √2𝑟𝑟 + 𝑞𝑞
𝑞𝑞0
2 0
√2𝑟𝑟
𝐴𝐴𝐴𝐴𝐴𝐴 =𝑟𝑟
𝑟𝑟
𝐴𝐴𝐴𝐴𝐴𝐴 ∗ = � + �
2
2

𝐴𝐴𝐴𝐴𝐴𝐴 ∗ = 2�
10.2

𝑟𝑟
2

𝐴𝐴𝐴𝐴𝐴𝐴 ∗ = √2𝑟𝑟

Economies of Scale and Scope

10.2.1. The Cobb-Douglas production function:𝑛𝑛

𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 ) = � 𝑥𝑥𝑖𝑖 𝑎𝑎𝑖𝑖
𝑖𝑖=1

If we scale each of the inputs by a factor 𝜆𝜆 > 1, then𝑛𝑛

𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = �(𝜆𝜆𝑥𝑥𝑖𝑖 )𝑎𝑎𝑖𝑖
𝑖𝑖=1𝑛𝑛

𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = � 𝜆𝜆𝑎𝑎𝑖𝑖 𝑥𝑥𝑖𝑖 𝑎𝑎𝑖𝑖
𝑖𝑖=1

𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = 𝜆𝜆𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = 𝜆𝜆∑ 𝑎𝑎𝑖𝑖∑ 𝑎𝑎𝑖𝑖𝑛𝑛

� 𝑥𝑥𝑖𝑖 𝑎𝑎𝑖𝑖
𝑖𝑖=1

𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )If ∑ 𝑎𝑎𝑖𝑖 > 1, then 𝜆𝜆∑ 𝑎𝑎𝑖𝑖 > 𝜆𝜆 and there are increasing returns to scale. If ∑ 𝑎𝑎𝑖𝑖 = 1, then 𝜆𝜆∑ 𝑎𝑎𝑖𝑖 = 𝜆𝜆 and returns to scale areconstant. Finally, if ∑ 𝑎𝑎𝑖𝑖 < 1, , then 𝜆𝜆∑ 𝑎𝑎𝑖𝑖 < 𝜆𝜆 and there are decreasing returns to scale.

10.2.2. From our solution to Exercise 10.1.1 above,
𝐴𝐴𝐴𝐴𝐴𝐴 ∗ = √2𝑟𝑟

This is not a function of q; ATC is constant. This implies constant returns to scale in the long run. If ATC were an
increasing function of q, we’d have decreasing returns to scale, and if ATC were a decreasing function of q, we’d haveincreasing returns to scale.
10.2.3. The proof here is an application of Euler’s homogeneous function theorem. The firm’s production function is homogeneousof degree r:𝑓𝑓(𝜆𝜆𝜆𝜆1 , 𝜆𝜆𝜆𝜆2 , … , 𝜆𝜆𝜆𝜆𝑛𝑛 ) = 𝜆𝜆𝑟𝑟 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )Introduction to Economic Analysis

22-310Differentiate this expression with respect to 𝜆𝜆:

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝑥𝑥1 +
𝑥𝑥2 + ⋯ +𝑥𝑥 = 𝑟𝑟𝜆𝜆𝑟𝑟−1 𝑓𝑓(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )𝜕𝜕𝑥𝑥2
𝜕𝜕𝑥𝑥𝑛𝑛 𝑛𝑛
𝜕𝜕𝑥𝑥1
If 𝜆𝜆 = 1, then

𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
𝑥𝑥1 +
𝑥𝑥2 + ⋯ +𝑥𝑥 = 𝑟𝑟𝑟𝑟(𝑥𝑥1 , 𝑥𝑥2 , … , 𝑥𝑥𝑛𝑛 )𝜕𝜕𝑥𝑥2
𝜕𝜕𝑥𝑥𝑛𝑛 𝑛𝑛
𝜕𝜕𝑥𝑥1

10.4

The left side of this expression is the sum of the quantities of all factors multiplied by their marginal products. The right sideis the homogeneity factor, 𝑟𝑟, times total output. Thus, total factor payments are a fraction 𝑟𝑟 of total output, leaving 1 − 𝑟𝑟 left
over.

General Long-run Dynamics

SSR
SLR

p
A
B

D1
D0
q
10.4.1.
Since land is in fixed supply, the short run supply curve is completely inelastic (vertical). So as demand shifts out from D0 to
D1, the price increases to A. But in the long run, the supply of usable land is upward sloping, rather than completely
inelastic; taller buildings can be built, though they are more expensive. So in the long run, the effect of an increase indemand for housing close to the center of a city is more like B, where the equilibrium price and quantity both increase.

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SSR
p
A

B

SLR

D1
D0
q
10.4.2.
In the short run, the quantity of emus is fixed and a shift in demand from D0 to D1 will result in an increase in price, to A.
But in the long run, the supply of emus is essentially horizontal, and price will come down as quantity supplied increases, toB.
Laptops

Desktops
SSR

SSR

p

p

SLR

D1

D0

D1
q

10.4.3.

D0
q

Long
run economies of scale are frequently (but not always) associated with declining long run average cost, and therefore
downward sloping long run supply curves. So what happens in 2001, when demand for laptops shifts to the right anddemand for desktops shifts to the left? In the short run, an upward sloping supply curve in both markets means that in themarket for laptops, the price increases and the quantity increases. Meanwhile, in the market for desktops, the price declines
and the quantity falls in response to the drop in demand. In the long run, though, the story gets interesting. A downward
sloping long run supply curve means that laptop prices eventually decline, while the price of desktop PC’s rises as economies
of scale affect average cost. This change in relative prices is likely to have feedback effects – since laptops are now cheaper
relative to desktops, even more people will substitute from the latter to the former, which will shift the demand for laptops
even further to the right and the demand for desktops even further to the left.

Chapter 11
11.1

SLR

Investment

Present Value

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Familiarizing yourself with certain functions built into Microsoft Excel will make these problems much easier. Pay particularattention to the PV(), RATE(), PMT(), NPER() and NPV() functions. Goal Seek, and other similar numerical methods, arealso very helpful here.
$100

$200

11.1.1. 𝑃𝑃𝑃𝑃 = (1+7%)1 + (1+7%)2
𝑃𝑃𝑃𝑃 = $268.15

11.1.2. Semi-annual payments happen twice per year. Assuming the 4% interest rate is an APR, the interest rate per payment period
is 2%. The PV of the stream of payments promised by the bond is
6

𝑃𝑃𝑃𝑃 = �𝑡𝑡=1$250$10,000+(1 + 2%)𝑡𝑡 (1 + 2%)6

𝑃𝑃𝑃𝑃 = $10,280.07

11.1.3. Let’s first calculate the payment on the 5% loan. Assuming the 5% interest rate is an APR, the payment satisfies the equation
60

𝑃𝑃𝑃𝑃𝑃𝑃$20,000 = �

𝑡𝑡=1 �1 +

5% 𝑡𝑡
�
12

The simplest way to solve this is numerically in Excel, which yields a solution
𝑃𝑃𝑃𝑃𝑃𝑃 = $377.42

Now let’s consider the loan with one year interest free followed by 4 years at 7%. This payment satisfies the equation
1260

𝑃𝑃𝑃𝑃𝑃𝑃

𝑃𝑃𝑃𝑃𝑃𝑃

+�
7% 𝑡𝑡
0% 𝑡𝑡
𝑡𝑡=13 �1 +
𝑡𝑡=1 �1 +��

$20,000 = �

1260

𝑃𝑃𝑃𝑃𝑃𝑃$20,000 = 12 ∗ 𝑃𝑃𝑃𝑃𝑃𝑃 + �$20,000 = 12 ∗ 𝑃𝑃𝑃𝑃𝑃𝑃 +𝑡𝑡=13 �1 +𝑃𝑃𝑃𝑃𝑃𝑃

7% 𝑡𝑡
�
12

12

48

1

�
7% 𝑡𝑡
7% 12
�
� 𝑡𝑡=1 �1 +
�1 +
12

12

Again using Excel’s numerical methods, we obtain
𝑃𝑃𝑃𝑃𝑃𝑃 = $373.05

11.1.4. At what interest rate does $7 million today equal the present value of 20 annual payments of $500,000? The critical interest
rate satisfies the equation20$7,000,000 = �

𝑟𝑟 = 3.67%

𝑡𝑡=1$500,000(1 + 𝑟𝑟)𝑡𝑡

At interest rates greater than 3.67%, you’re better off taking the $7 million now; at interest rates lower than this, the PV of theannual payments is larger.

11.1.5. This is an application of the constant-growth dividend discount model. The PV of the stock’s stream of dividends is∞

𝑃𝑃𝑃𝑃 = �
𝑡𝑡=1($𝐷𝐷𝐷𝐷𝐷𝐷)(1 + 𝑔𝑔)𝑡𝑡−1(1 + 𝑟𝑟)𝑡𝑡

Multiplying this expression by
∞

1+𝑟𝑟

1+𝑔𝑔

yields($𝐷𝐷𝐷𝐷𝐷𝐷)(1 + 𝑔𝑔)𝑡𝑡−1(1 + 𝑟𝑟)𝑃𝑃𝑃𝑃=�(1 + 𝑟𝑟)𝑡𝑡(1 + 𝑔𝑔)
𝑡𝑡=0

Subtract our original expression for the present value of the dividend stream, obtaining
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∞

∞

𝑡𝑡=0

𝑡𝑡=1

(1 + 𝑟𝑟)𝑃𝑃𝑃𝑃($𝐷𝐷𝐷𝐷𝐷𝐷)(1 + 𝑔𝑔)𝑡𝑡−1($𝐷𝐷𝐷𝐷𝐷𝐷)(1 + 𝑔𝑔)𝑡𝑡−1− 𝑃𝑃𝑃𝑃 = �−�𝑡𝑡(1 + 𝑟𝑟)(1 + 𝑟𝑟)𝑡𝑡(1 + 𝑔𝑔)(1 + 𝑟𝑟)𝑃𝑃𝑃𝑃($𝐷𝐷𝐷𝐷𝐷𝐷)− 𝑃𝑃𝑃𝑃 =(1 + 𝑔𝑔)(1 + 𝑔𝑔)(1 + 𝑟𝑟)𝑃𝑃𝑃𝑃 (1 + 𝑔𝑔)𝑃𝑃𝑃𝑃 ($𝐷𝐷𝐷𝐷𝐷𝐷)−=(1 + 𝑔𝑔)(1 + 𝑔𝑔)(1 + 𝑔𝑔)(𝑟𝑟 − 𝑔𝑔)𝑃𝑃𝑃𝑃 = $𝐷𝐷𝐷𝐷𝐷𝐷
𝑃𝑃𝑃𝑃 =$𝐷𝐷𝐷𝐷𝐷𝐷(𝑟𝑟 − 𝑔𝑔)

𝑃𝑃𝑃𝑃 =$1= $25(5% − 1%)

Plugging our values from the exercise into this formula:11.1.6. The number of payments satisfies the equation
𝑇𝑇$20,000 = �
𝑡𝑡=1

11.2

$1000
(1 + 1%)𝑡𝑡

Numerical methods yield 𝑇𝑇 = 22.4. If the interest rate falls to 0.5%, then 𝑇𝑇 = 21.1
Investment

11.2.1. The cost of the college education is the $25,000 in foregone income as well as the $20,000 tuition for 4 years. The benefit of
the education is the $25,000 in additional wages obtained in years 5 through 44. The NPV of the education is
4

44

𝑡𝑡=1

𝑡𝑡=5

−$45000$25000𝑁𝑁𝑁𝑁𝑁𝑁 = �+�(1 + 7%)𝑡𝑡(1 + 7%)𝑡𝑡
𝑁𝑁𝑁𝑁𝑁𝑁 = $101,842.91

11.2.2. The NPV calculation for East State U is
4

𝑁𝑁𝑁𝑁𝑁𝑁 = �
𝑡𝑡=1

44

−$28000$15000+�𝑡𝑡(1 + 7%)(1 + 7%)𝑡𝑡
𝑡𝑡=5

𝑁𝑁𝑁𝑁𝑁𝑁(𝐸𝐸𝐸𝐸𝐸𝐸) = $57,718.54

The NPV of North Private U is
4

44

𝑡𝑡=1

𝑡𝑡=5

$25000−$47000+�
𝑁𝑁𝑁𝑁𝑁𝑁 = �𝑡𝑡(1 + 7%)𝑡𝑡(1 + 7%)
𝑁𝑁𝑁𝑁𝑁𝑁(𝑁𝑁𝑁𝑁𝑁𝑁) = $95,068.49

At a 7% interest rate, North Private is the better deal.
11.2.3. The PV of the stream of cash flows promised by the bond is
10

𝑃𝑃𝑃𝑃 = �
𝑡𝑡=1

𝐶𝐶
$1000
+
𝑡𝑡
(1 + 10%)(1 + 10%)10

In equilibrium, this will equal the price of the bond. So the coupon rate of the bond satisfies the equation
10$900 = �
𝑡𝑡=1

𝐶𝐶 = $83.73

$1000
𝐶𝐶
+
(1 + 10%)𝑡𝑡 (1 + 10%)10

The bond’s coupon rate is
Introduction to Economic Analysis$83.73$1000, or 8.373%.
22-314

11.2.4. In 40 years, at 4% growth, an initial value of $1000 will become
𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃(1 + 𝑟𝑟)𝑡𝑡

𝐹𝐹𝐹𝐹 = $1000(1 + 4%)40

𝐹𝐹𝐹𝐹 = $4801.02

11.2.5. If you sell the invention, your income is $1 million now plus$75,000 per year for 10 years (start of year). The PV of sellingis
9

𝑃𝑃𝑃𝑃(𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠) = $1,075,000 + �
𝑡𝑡=1$75,000(1 + 𝑟𝑟)𝑡𝑡

The PV of developing it yourself is
𝑃𝑃𝑃𝑃(𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑) =$5,000,000(1 + 𝑟𝑟)10

The critical interest rate satisfies the equation
9$1,075,000 + �
𝑡𝑡=1$75,000 $5,000,000=(1 + 𝑟𝑟)10(1 + 𝑟𝑟)𝑡𝑡

The interest rate that satisfies this equation is 𝑟𝑟 = 13.11% per year. If the interest rate is higher than this critical value,
you’re better off selling now.

11.2.6. The project is yielding a rate of return of
𝑟𝑟 =

$2000

$50,000= 4% per period. However, a period is 2 years here; the APR of the project is 2%. (The effective annual interest

rate is slightly lower than this, due to compounding).

11.3

Investment Under Uncertainty

11.3.1. Suppose you’ve been offered a job paying a wage 𝑤𝑤 per week, where 𝑤𝑤~𝑈𝑈[0,1]. If you accept this job, you’ll receive 𝑤𝑤 per
𝑤𝑤week in perpetuity, which has a PV of . You’ll take this job if the PV of the job is greater than the PV of continuing the𝑟𝑟search. Your expected NPV of lifetime earnings is therefore
𝑤𝑤 𝐸𝐸[𝐽𝐽(𝑤𝑤)]
𝐽𝐽(𝑤𝑤) = max � ,�
𝑟𝑟 1 + 𝑟𝑟

The first argument here is the PV of wages under the current offer. The second term is the PV of passing on that offer andcontinuing the search. What is the PV of continuing the search? There is a probability (1 − 𝑤𝑤0 ) that you’ll find a better job
𝑤𝑤 +1
at a higher wage next week. If you do, that job has an expected wage of the average of the distribution from 𝑤𝑤0 to 1, or 0 .
2
Or, there’s a probability 𝑤𝑤0 that the next offer will be lower than the current offer; if it is, you’ll reject it and continue thesearch.
1 + 𝑤𝑤
� + 𝑤𝑤
2𝑟𝑟

𝐽𝐽(𝑤𝑤) = (1 − 𝑤𝑤) �
11.4

The goal here is to find the critical 𝑤𝑤0 where you are exactly indifferent between taking the job and continuing the search.

Resource Extraction

11.4.1. From the text,
𝑅𝑅 =

𝑄𝑄0
(1
1 − + 𝑟𝑟)−𝜀𝜀

Inverting this,1 − (1 + 𝑟𝑟)−𝜀𝜀 =𝑄𝑄0𝑅𝑅Plugging in our numbers of 𝑟𝑟 = 10% and 𝜀𝜀 = 2 we obtain
𝑄𝑄0= 17.4%𝑅𝑅

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If r decreases, this proportion falls.
11.5

A Time to Harvest

11.5.1. Maximum sustainable yield maximizes
𝑝𝑝𝑝𝑝(𝑇𝑇)𝑇𝑇
𝑇𝑇𝑏𝑏 ′ (𝑇𝑇) − 𝑏𝑏(𝑇𝑇)𝑑𝑑𝑑𝑑(𝑇𝑇)
= 𝑝𝑝
=0
𝑇𝑇 2
𝑑𝑑𝑑𝑑
𝑀𝑀(𝑇𝑇) =𝑇𝑇𝑏𝑏 ′ (𝑇𝑇) = 𝑏𝑏(𝑇𝑇)𝑏𝑏 ′ (𝑇𝑇) 1=𝑏𝑏(𝑇𝑇) 𝑇𝑇

11.5.2. From the text, the optimal time to harvest satisfies the equation

11.7

𝑏𝑏 ′ (𝑇𝑇)𝜌𝜌== 𝑇𝑇𝑒𝑒 −𝑇𝑇
𝑏𝑏(𝑇𝑇) 1 − 𝑒𝑒 −𝜌𝜌𝜌𝜌Summer Wheat

11.7.1. Define the amount hoarded as H. Then, equilibrium price in winter is
50 − 2𝑃𝑃𝑤𝑤 = 3𝑃𝑃𝑤𝑤 − 𝐻𝐻
5𝑃𝑃𝑤𝑤 = 50 + 𝐻𝐻

𝑃𝑃𝑤𝑤 = 10 +𝐻𝐻
5Equilibrium price in summer satisfies
100 − 3𝑃𝑃𝑠𝑠 = 𝑃𝑃𝑠𝑠 + 𝐻𝐻
4𝑃𝑃𝑠𝑠 = 100 − 𝐻𝐻
𝑃𝑃𝑠𝑠 = 25 −𝐻𝐻
4

Costless storage and no discounting implies 𝑃𝑃𝑤𝑤 ≥ 𝑃𝑃𝑠𝑠 , or else it would be profitable to increase hoarding. Thus in equilibrium

𝐻𝐻
𝐻𝐻= 10 +
5
4
𝐻𝐻 𝐻𝐻+ = 15
4 5
9𝐻𝐻
= 15
20
100
𝐻𝐻 =
3
𝐻𝐻 50
𝑃𝑃𝑤𝑤 = 10 + =
5
3
𝐻𝐻 50
𝑃𝑃𝑠𝑠 = 25 − =4350
𝑄𝑄𝑤𝑤 = 50 − 2𝑃𝑃𝑤𝑤 =3
25 −𝑄𝑄𝑠𝑠 = 100 − 3𝑃𝑃𝑠𝑠 = 50

Chapter 1212.2

Consumer Theory

Budget or Feasible Set

Introduction to Economic Analysis

22-316

35
30

Apples25
20
Apples ($2)

15Apples ($4)

10
5
0
0

5

10

15

20

25

Oranges12.2.1.
12.2.2. Need to do this one.
50
45
40

Apples

35
30
25

Y=$60

20

Y=$90

15
10
5
0
0

10

20

30

40

Oranges12.2.3.
12.4

Examples12.4.1. Let’s solve the consumer’s problem analytically.
max �𝑥𝑥𝑥𝑥 𝑠𝑠. 𝑡𝑡. 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀𝑥𝑥,𝑦𝑦

𝐿𝐿 = �𝑥𝑥𝑥𝑥 + 𝜆𝜆�𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦�𝜕𝜕𝜕𝜕 1 −1� 1�
= 𝑥𝑥 2 𝑦𝑦 2 − 𝜆𝜆𝑝𝑝𝑥𝑥 = 0𝜕𝜕𝜕𝜕 2𝜕𝜕𝜕𝜕 1 1� −1�
= 𝑥𝑥 2 𝑦𝑦 2 − 𝜆𝜆𝑝𝑝𝑦𝑦 = 0𝜕𝜕𝜕𝜕 2
𝜕𝜕𝜕𝜕= 𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦 = 0𝜕𝜕𝜕𝜕From the first equation:
1 −1� 1�𝑥𝑥 2 𝑦𝑦 2 = 𝜆𝜆𝑝𝑝𝑥𝑥
2

Introduction to Economic Analysis

22-317

𝜆𝜆 =�𝑦𝑦

2𝑝𝑝𝑥𝑥 √𝑥𝑥

From the second equation,
1 1� −1�
𝑥𝑥 2 𝑦𝑦 2 = 𝜆𝜆𝑝𝑝𝑦𝑦
2
𝜆𝜆 =

So,

√𝑥𝑥

2𝑝𝑝𝑦𝑦 �𝑦𝑦�𝑦𝑦

2𝑝𝑝𝑥𝑥 √𝑥𝑥=

√𝑥𝑥

2𝑝𝑝𝑦𝑦 �𝑦𝑦

𝑝𝑝𝑥𝑥 𝑥𝑥 = 𝑝𝑝𝑦𝑦 𝑦𝑦

𝑦𝑦 =𝑝𝑝𝑥𝑥 𝑥𝑥𝑝𝑝𝑦𝑦

Now we use our third equation:
𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀

𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 �
2𝑝𝑝𝑥𝑥 𝑥𝑥 = 𝑀𝑀𝑥𝑥 =𝑝𝑝𝑥𝑥 𝑥𝑥
� = 𝑀𝑀
𝑝𝑝𝑦𝑦

𝑀𝑀
2𝑝𝑝𝑥𝑥

𝑀𝑀
𝑝𝑝𝑥𝑥 𝑥𝑥 𝑝𝑝𝑥𝑥 �2𝑝𝑝𝑥𝑥 �
𝑀𝑀
𝑦𝑦 =
=
=
𝑝𝑝𝑦𝑦
𝑝𝑝𝑦𝑦
2𝑝𝑝𝑦𝑦

With the parameters 𝑀𝑀 = $100, 𝑝𝑝𝑥𝑥 = $5, and 𝑝𝑝𝑦𝑦 = $2, we obtain 𝑥𝑥 = 10 and 𝑦𝑦 = 25.
100
90
80
70
60
y

50

Budget40

Indifference Curve

30
20
10
0
0

5

10

15

20

25

x
12.4.2. If 𝑈𝑈 = �𝑥𝑥𝑥𝑥, then𝑈𝑈 2 = 𝑥𝑥𝑥𝑥

𝑦𝑦 =

𝑈𝑈 2
𝑥𝑥

The slope of the indifference curve (holding utility constant) is

Introduction to Economic Analysis

22-318

𝑑𝑑𝑑𝑑 −𝑈𝑈 2
= 2
𝑥𝑥
𝑑𝑑𝑑𝑑

12.4.3. Now 𝑈𝑈 = (𝑥𝑥𝑥𝑥)2√𝑈𝑈 = 𝑥𝑥𝑥𝑥

𝑦𝑦 =

√𝑈𝑈
𝑥𝑥

𝑑𝑑𝑑𝑑 −√𝑈𝑈
= 2
𝑑𝑑𝑑𝑑
𝑥𝑥

Utility is only an ordinal function, assigning larger values to more preferred bundles.
12.4.4. Perfect substitutes (𝑈𝑈 = 𝑥𝑥 + 𝑦𝑦):
6
5
4
y 3
2
1
0
0

1

2

3

4

5

6

x
If 𝑝𝑝𝑥𝑥 < 𝑝𝑝𝑦𝑦 , then the budget constraint is flatter than the isoquants (which have a slope of -1). Consequently, the consumer
will maximize utility at the corner where only x is consumed and zero y. Obviously the converse is also true.

12.4.5. 𝑈𝑈 = 𝑥𝑥 𝛼𝛼 + 𝑦𝑦 𝛼𝛼 𝑠𝑠. 𝑡𝑡. 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀

𝐿𝐿 = 𝑥𝑥 𝛼𝛼 + 𝑦𝑦 𝛼𝛼 + 𝜆𝜆�𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦�𝜕𝜕𝜕𝜕= 𝛼𝛼𝑥𝑥 𝛼𝛼−1 − 𝜆𝜆𝑝𝑝𝑥𝑥 = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
= 𝛼𝛼𝑦𝑦 𝛼𝛼−1 − 𝜆𝜆𝑝𝑝𝑦𝑦 = 0
𝜕𝜕𝜕𝜕
𝜕𝜕𝜕𝜕
= 𝑀𝑀 − 𝑝𝑝𝑥𝑥 𝑥𝑥 − 𝑝𝑝𝑦𝑦 𝑦𝑦 = 0𝜕𝜕𝜕𝜕𝛼𝛼𝑥𝑥 𝛼𝛼−1 = 𝜆𝜆𝑝𝑝𝑥𝑥
𝜆𝜆 =𝛼𝛼𝑥𝑥 𝛼𝛼−1 𝛼𝛼𝑦𝑦 𝛼𝛼−1
=
𝑝𝑝𝑥𝑥
𝑝𝑝𝑦𝑦

𝑦𝑦 𝛼𝛼−1 =𝑦𝑦1−𝛼𝛼 =𝑝𝑝𝑦𝑦 𝑥𝑥 𝛼𝛼−1
𝑝𝑝𝑥𝑥

𝑝𝑝𝑥𝑥 𝑥𝑥 1−𝛼𝛼𝑝𝑝𝑦𝑦
1𝑝𝑝𝑥𝑥 1−𝛼𝛼𝑥𝑥𝑦𝑦 = � �
𝑝𝑝𝑦𝑦

Introduction to Economic Analysis

22-319𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀

1𝑝𝑝𝑥𝑥 1−𝛼𝛼𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 �� �𝑥𝑥� = 𝑀𝑀𝑝𝑝𝑦𝑦
1𝑝𝑝𝑥𝑥 1−𝛼𝛼𝑥𝑥 �𝑝𝑝𝑥𝑥 + 𝑝𝑝𝑦𝑦 � � � = 𝑀𝑀𝑝𝑝𝑦𝑦
1𝑝𝑝𝑦𝑦 𝑝𝑝𝑥𝑥 1−𝛼𝛼𝑝𝑝𝑥𝑥 𝑥𝑥 �1 + � � � = 𝑀𝑀
𝑝𝑝𝑥𝑥 𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥 𝑥𝑥 �1 + �

𝑥𝑥 =

𝛼𝛼

𝑝𝑝𝑥𝑥
� � = 𝑀𝑀
𝑝𝑝𝑦𝑦
𝑀𝑀

𝑝𝑝 𝛼𝛼
𝑝𝑝𝑥𝑥 �1 + � 𝑥𝑥 � �𝑝𝑝𝑦𝑦

By symmetry,
𝑦𝑦 =

𝑀𝑀

𝑝𝑝𝑦𝑦 �1 + �

𝑝𝑝𝑦𝑦 𝛼𝛼� �
𝑝𝑝𝑥𝑥

12.4.6. If 𝑈𝑈(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 ) > 𝑈𝑈(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ), then Consumer U prefers bundle a to bundle b. But if this is true, then2

�𝑈𝑈(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 )� > (𝑈𝑈(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ))22

�𝑈𝑈(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 )� > (𝑈𝑈(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ))2

12.6

𝑊𝑊(𝑥𝑥𝑎𝑎 , 𝑦𝑦𝑎𝑎 ) > 𝑊𝑊(𝑥𝑥𝑏𝑏 , 𝑦𝑦𝑏𝑏 ) and consumer W also prefers bundle a.
Engel Curves

12.6.1. If the goods are perfect complements, the consumer will always optimize at the right angle of the isoquant; this solution
occurs no matter the slope of the budget constraint – that is, the relative prices of the two goods don’t affect the consumer’s
preferred bundle. Changes in income will shift the consumer to a higher isoquant, but this will not depend on prices.
12.6.2. If the utility function is Cobb-Douglas, then from the text𝑥𝑥 =(1 − 𝛼𝛼)𝑀𝑀
𝛼𝛼𝛼𝛼, 𝑦𝑦 =
𝑝𝑝𝑥𝑥
𝑝𝑝𝑦𝑦

𝑈𝑈 = 𝑥𝑥 𝛼𝛼 𝑦𝑦1−𝛼𝛼 = �1−𝛼𝛼𝛼𝛼𝛼𝛼 𝛼𝛼 (1 − 𝛼𝛼)𝑀𝑀
� �
�
𝑝𝑝𝑥𝑥
𝑝𝑝𝑦𝑦

𝑈𝑈 = 𝛼𝛼 𝛼𝛼 (1 − 𝛼𝛼)1−𝛼𝛼 �𝑀𝑀�𝑝𝑝𝑥𝑥 𝛼𝛼 𝑝𝑝𝑦𝑦 1−𝛼𝛼If 𝑝𝑝𝑦𝑦 increases by the factor ∆, then M must increase by a factor ∆1−𝛼𝛼 to keep U constant. So the substitution effect of anincrease in 𝑝𝑝𝑦𝑦 on 𝑦𝑦 is
𝑦𝑦𝑠𝑠 =(1 − 𝛼𝛼)∆1−𝛼𝛼 𝑀𝑀= ∆−𝛼𝛼 𝑦𝑦∆𝑝𝑝𝑦𝑦

𝑥𝑥𝑠𝑠 =

𝛼𝛼∆1−𝛼𝛼 𝑀𝑀= ∆1−𝛼𝛼 𝑥𝑥
𝑝𝑝𝑥𝑥

The substitution effect of an increase in 𝑝𝑝𝑦𝑦 on 𝑥𝑥 is
One way to obtain the income effect is through the insight that the total effect of the price change is the sum of thesubstitution and income effects. Since 𝑝𝑝𝑦𝑦 doesn’t appear in the demand function for 𝑥𝑥 (this is an artifact of the Cobb-

Introduction to Economic Analysis

22-320Douglas functional form), an increase in 𝑝𝑝𝑦𝑦 doesn’t change the demand for 𝑥𝑥 at all. Hence, the income effect must exactly
counteract the substitution effect. Since the substitution effect is𝑥𝑥𝑠𝑠 = ∆1−𝛼𝛼 𝑥𝑥, the income effect must be
𝑥𝑥𝐼𝐼 = ∆𝛼𝛼−1 𝑥𝑥.

The effect of a change in 𝑝𝑝𝑦𝑦 on 𝑦𝑦 is
𝑦𝑦𝑆𝑆+𝐼𝐼 =(1 − 𝛼𝛼)𝑀𝑀= ∆−1 𝑦𝑦∆𝑝𝑝𝑦𝑦

Since the substitution effect is 𝑦𝑦𝑠𝑠 = ∆−𝛼𝛼 𝑦𝑦, the income effect must be the remaining portion of the decrease.

12.7

𝑦𝑦𝐼𝐼 = ∆𝛼𝛼−1 𝑦𝑦

Mathematical Cleanup

12.7.1. Quasilinear utility takes the form
𝑈𝑈(𝑥𝑥, 𝑦𝑦) = 𝑦𝑦 + 𝑣𝑣(𝑥𝑥) where 𝑣𝑣 ′ (𝑥𝑥) > 0, 𝑣𝑣 ′′ (𝑥𝑥) < 0. Substituting the budget constraint 𝑝𝑝𝑥𝑥 𝑥𝑥 + 𝑝𝑝𝑦𝑦 𝑦𝑦 = 𝑀𝑀 into the utility
function, we obtain
𝑈𝑈(𝑥𝑥) =𝑀𝑀 𝑝𝑝𝑥𝑥 𝑥𝑥−+ 𝑣𝑣(𝑥𝑥)
𝑝𝑝𝑦𝑦
𝑝𝑝𝑦𝑦

The individual will consume zero x if a small increase in x would decrease her welfare. Formally,
𝑈𝑈 ′ (0) ≤ 0−𝑝𝑝𝑥𝑥
𝑈𝑈 ′ (0) =+ 𝑣𝑣 ′ (0) ≤ 0
𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥
≥ 𝑣𝑣 ′ (0)𝑝𝑝𝑦𝑦

The individual will consume zero y if an increase in x would increase her welfare even if she is already consuming zero y.
Formally,
𝑀𝑀
𝑈𝑈 ′ � � ≥ 0
𝑝𝑝𝑥𝑥

𝑀𝑀
−𝑝𝑝𝑥𝑥
𝑀𝑀
𝑈𝑈 ′ � � =+ 𝑣𝑣 ′ � � ≥ 0
𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥
𝑝𝑝𝑥𝑥
𝑣𝑣 ′ �

Chapter 13
13.1

𝑀𝑀
𝑝𝑝𝑥𝑥
�≥
𝑝𝑝𝑦𝑦
𝑝𝑝𝑥𝑥

Applied Consumer Theory

Labor Supply

13.1.1. This is a thought question and doesn’t have a definitive solution.
13.1.2. If the individual has the utility function 𝑈𝑈(𝑥𝑥, 𝐿𝐿) and the budget constraint 𝑝𝑝𝑝𝑝 = 𝑀𝑀 + 𝑤𝑤(𝑇𝑇 − 𝐿𝐿), then we can solve theindividual’s utility maximization problem by solving the budget constraint for x and substituting this into the utility function,then maximizing.
𝑀𝑀 𝑤𝑤+ (𝑇𝑇 − 𝐿𝐿), 𝐿𝐿� = ℎ(𝐿𝐿)
𝑝𝑝 𝑝𝑝

𝑈𝑈(𝑥𝑥, 𝐿𝐿) = 𝑈𝑈 �
𝑑𝑑ℎ
𝑑𝑑𝑑𝑑

= 𝑢𝑢1 �obtain−𝑤𝑤𝑝𝑝

� + 𝑢𝑢2 = 0 where both partial derivatives are evaluated at the optimum. From the budget constraint, we can

𝑤𝑤 𝑑𝑑𝐿𝐿∗
𝑑𝑑𝑥𝑥 ∗ 1= (𝑇𝑇 − 𝐿𝐿∗ ) −𝑑𝑑𝑑𝑑 𝑝𝑝𝑝𝑝 𝑑𝑑𝑑𝑑
This is positive iff

𝑤𝑤 𝑑𝑑𝐿𝐿∗
1(𝑇𝑇 − 𝐿𝐿∗ ) >𝑝𝑝 𝑑𝑑𝑑𝑑𝑝𝑝

Introduction to Economic Analysis

22-321

(𝑇𝑇 − 𝐿𝐿∗ ) 𝑑𝑑𝐿𝐿∗
>
𝑑𝑑𝑑𝑑
𝑤𝑤

13.2

We can follow the text’s method of differentiating the first order condition with respect to w:−𝑤𝑤
𝑢𝑢11 �
� + 𝑢𝑢2 = 0
𝑝𝑝

Urban Real Estate Prices

13.2.1. From the text,
𝛼𝛼

1

−𝛼𝛼

𝑢𝑢∗ = �𝛼𝛼 1−𝛼𝛼 − 𝛼𝛼 1−𝛼𝛼 � 𝑝𝑝(𝑟𝑟)1−𝛼𝛼 − 𝜆𝜆𝜆𝜆1

Substituting 𝛼𝛼 = we obtain1− 𝜆𝜆𝜆𝜆4𝑝𝑝(𝑟𝑟)𝑢𝑢∗ =𝑝𝑝(𝑟𝑟) =2

1

4(𝑢𝑢∗ + 𝜆𝜆𝜆𝜆)

At the edge of the city,
𝑣𝑣 = 𝑝𝑝(𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚 ) =1

4(𝑢𝑢∗ + 𝜆𝜆𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚 )City population is given by𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚1

�𝛼𝛼
1 − 𝛼𝛼𝑁𝑁 = � 2𝜋𝜋𝜋𝜋 ��𝑑𝑑𝑑𝑑𝛼𝛼(𝑢𝑢∗ + 𝜆𝜆𝜆𝜆)01

Substituting 𝛼𝛼 = we obtain
𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚

2

𝑁𝑁 = � 2𝜋𝜋𝜋𝜋(𝑢𝑢∗ + 𝜆𝜆𝜆𝜆)−2 𝑑𝑑𝑑𝑑
0

We make the substitution 𝑡𝑡 = 𝑢𝑢∗ + 𝜆𝜆𝜆𝜆𝑡𝑡 − 𝑢𝑢∗
𝜆𝜆𝑑𝑑𝑑𝑑 1=
𝑑𝑑𝑑𝑑 𝜆𝜆𝑟𝑟 =Now,𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚

𝑡𝑡 − 𝑢𝑢∗ −2 𝑑𝑑𝑑𝑑
� 𝑡𝑡 � �𝜆𝜆𝜆𝜆𝑁𝑁 = � 2𝜋𝜋𝜋𝜋(𝑢𝑢∗ + 𝜆𝜆𝜆𝜆)−2 𝑑𝑑𝑑𝑑 = 2𝜋𝜋 � �
0𝑡𝑡 − 𝑢𝑢∗
2𝜋𝜋
𝑁𝑁 = 2 � � 2 � 𝑑𝑑𝑑𝑑
𝑡𝑡
𝜆𝜆
𝑁𝑁 =

𝑁𝑁 =

2𝜋𝜋
𝑡𝑡
2𝜋𝜋
𝑢𝑢∗
�
�
�
𝑑𝑑𝑑𝑑
−
�
�
� 𝑑𝑑𝑑𝑑
𝑡𝑡 2
𝜆𝜆2
𝑡𝑡 2
𝜆𝜆2
2𝜋𝜋𝑢𝑢∗ 1
2𝜋𝜋
ln
𝑡𝑡
+
� �
𝜆𝜆2 𝑡𝑡𝜆𝜆2

𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚
2𝜋𝜋
2𝜋𝜋𝑢𝑢∗
𝑁𝑁 = � 2 ln(𝑢𝑢∗ + 𝜆𝜆𝜆𝜆) + 2 ∗��𝜆𝜆 (𝑢𝑢 + 𝜆𝜆𝜆𝜆) 0
𝜆𝜆

13.4

𝑁𝑁 =

2𝜋𝜋𝑢𝑢∗
2𝜋𝜋𝑢𝑢∗
2𝜋𝜋
2𝜋𝜋
∗
∗)
)
+
−
ln(𝑢𝑢
+
𝜆𝜆𝑟𝑟
−
ln(𝑢𝑢
𝑚𝑚𝑚𝑚𝑚𝑚𝜆𝜆2 (𝑢𝑢∗ + 𝜆𝜆𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚 ) 𝜆𝜆2
𝜆𝜆2 (𝑢𝑢∗ )𝜆𝜆2

Risk Aversion

Introduction to Economic Analysis

22-322

13.4.1. Consider the utility function 𝑣𝑣(𝑥𝑥), where x is a random variable with mean 𝜇𝜇. Using a second order expansion of 𝑣𝑣(𝑥𝑥)around 𝜇𝜇,
1𝑣𝑣(𝑥𝑥) ≈ 𝑣𝑣(𝜇𝜇) + 𝑣𝑣 ′ (𝜇𝜇)(𝑥𝑥 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝑥𝑥 − 𝜇𝜇)221𝑣𝑣(𝐶𝐶𝐶𝐶) ≈ 𝑣𝑣(𝜇𝜇) + 𝑣𝑣 ′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2213.4.2. From above,1
1
𝑣𝑣(𝐶𝐶𝐶𝐶) ≈ 𝑣𝑣(𝜇𝜇) + 𝑣𝑣 ′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 = 𝐸𝐸 �𝑣𝑣(𝜇𝜇) + 𝑣𝑣 ′ (𝜇𝜇)(𝑥𝑥 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝑥𝑥 − 𝜇𝜇)2 �
2
2
1
1
𝑣𝑣 ′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 = 𝐸𝐸 � 𝑣𝑣 ′′ (𝜇𝜇)(𝑥𝑥 − 𝜇𝜇)2 �
2
2
1
1
𝑣𝑣 ′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇) + 𝑣𝑣 ′′ (𝜇𝜇)(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 = 𝑣𝑣 ′′ (𝜇𝜇)𝜎𝜎 222′ (𝜇𝜇)
𝑣𝑣(𝐶𝐶𝐶𝐶 − 𝜇𝜇) = 𝜎𝜎 2
(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 + 2 ′′𝑣𝑣 (𝜇𝜇)2(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 − (𝐶𝐶𝐶𝐶 − 𝜇𝜇) = 𝜎𝜎 2𝜌𝜌Completing the square,1
2
1(𝐶𝐶𝐶𝐶 − 𝜇𝜇)2 − (𝐶𝐶𝐶𝐶 − 𝜇𝜇) + 2 = 𝜎𝜎 2 + 2
𝜌𝜌
𝜌𝜌
𝜌𝜌
1 2
1
�𝐶𝐶𝐶𝐶 − 𝜇𝜇 − � = 𝜎𝜎 2 + 2
𝜌𝜌
𝜌𝜌

1
1
= −�𝜎𝜎 2 + 2𝜌𝜌𝜌𝜌

𝐶𝐶𝐶𝐶 − 𝜇𝜇 −𝐶𝐶𝐶𝐶 − 𝜇𝜇 = −�𝜎𝜎 2 +𝜇𝜇 − 𝐶𝐶𝐶𝐶 = �𝜎𝜎 2 +𝜇𝜇 − 𝐶𝐶𝐶𝐶 =1 1+
𝜌𝜌2 𝜌𝜌

1 1−
𝜌𝜌2 𝜌𝜌

1
��𝜌𝜌2 𝜎𝜎 2 + 1 − 1�𝜌𝜌

13.4.3. From the utility function, the certainty equivalent satisfies
1
1
𝑢𝑢($50,000 + $100) + 𝑢𝑢($50,000 − $100)
221
1
𝐶𝐶𝐶𝐶 0.95 = ($50,100)0.95 + ($49,900)0.95
22𝑢𝑢(𝐶𝐶𝐶𝐶) =𝐶𝐶𝐶𝐶 = $49999.995

𝑅𝑅𝑅𝑅 = 𝜇𝜇 − 𝐶𝐶𝐶𝐶 = $50,000 − 𝐶𝐶𝐶𝐶

The risk premium is about half a cent.
13.4.4. 𝑢𝑢(𝐶𝐶𝐶𝐶) =1

10,000,000(𝐶𝐶𝐶𝐶)0.99 =𝑢𝑢($100,000 − $1 + $5,000,000) +9,999,999

10,000,000

𝑢𝑢($100,000 − $1)

19,999,999($100,000 − $1 + $5,000,000)0.99 +($100,000 − $1)0.99
10,000,000
10,000,000

𝐶𝐶𝐶𝐶 = $99,999.49

13.4.5. The certainty equivalent for an individual with CARA preferences is
Introduction to Economic Analysis

22-323𝜌𝜌
𝐶𝐶𝐶𝐶 = 𝜇𝜇 − 𝜎𝜎 22Equilibrium requires𝜌𝜌
3% = 7% − (16%)
2
1
𝜌𝜌 =
2

Now that we’ve solved for this parameter, we know the utility function is𝑣𝑣(𝑥𝑥) =1−𝑥𝑥(1 − 𝑒𝑒 −𝜌𝜌𝜌𝜌 ) = 2�1 − 𝑒𝑒 �2 �𝜌𝜌The certainty equivalent is the value that satisfies
𝑣𝑣(𝐶𝐶𝐶𝐶) =1
1𝑣𝑣(𝑤𝑤 + 100) + 𝑣𝑣(𝑤𝑤 − 100)22Where w is initial wealth. Substituting our utility function into this expression,
2 �1 − 𝑒𝑒11−(𝑤𝑤+100)�
−(𝑤𝑤−100)�
−𝐶𝐶𝐶𝐶�
2 � + 2 �1 − 𝑒𝑒2�2 � = 2 �1 − 𝑒𝑒2
2
1
1−(𝑤𝑤+100)−(𝑤𝑤−100)
−𝐶𝐶𝐶𝐶
�2
�2
𝑒𝑒 �2 = 𝑒𝑒
+ 𝑒𝑒
22
1 −(𝑤𝑤)� 50
−𝐶𝐶𝐶𝐶
2 [𝑒𝑒
𝑒𝑒 �2 = 𝑒𝑒
+ 𝑒𝑒 −50 ]2−𝐶𝐶𝐶𝐶� = −𝑤𝑤� + ln[𝑒𝑒 50 + 𝑒𝑒 −50 ] − ln 222
𝐶𝐶𝐶𝐶� = 𝑤𝑤� − ln[𝑒𝑒 50 + 𝑒𝑒 −50 ] + ln 222
𝐶𝐶𝐶𝐶 = 𝑤𝑤 − 2 ln[𝑒𝑒 50 + 𝑒𝑒 −50 ] + 2 ln 2
𝐶𝐶𝐶𝐶 ≈ 𝑤𝑤 − 100

Thus, the equity premium puzzle – the premium to stock returns is far greater than can be explained by risk aversion.

13.4.6. The certainty equivalent satisfies
1
2
𝑣𝑣($110,000) + 𝑣𝑣($95,000)3312𝐶𝐶𝐶𝐶 0.875 = ($110,000)0.875 + ($95,000)0.87533𝑣𝑣(𝐶𝐶𝐶𝐶) =𝐶𝐶𝐶𝐶 = $99,969.29

She would pay $30.71 to avoid taking this gamble.
13.6

Search

13.6.1. The average price the consumer will discover if he performs a search is𝐸𝐸(𝑝𝑝) = 𝑥𝑥(1) + (1 − 𝑥𝑥)(2) = 2 − 𝑥𝑥

His expected gain from searching is therefore
2 − (2 − 𝑥𝑥) = 𝑥𝑥

The cost of searching is c. Therefore, if 𝑐𝑐 < 𝑥𝑥, the consumer should search for the lower price; if 𝑐𝑐 > 𝑥𝑥, he should accept theprice of 2.

Chapter 14
14.1

General Equilibrium

Edgeworth Boxes

14.1.1. No. If, for example, 𝑈𝑈(𝑥𝑥, 𝑦𝑦) = 𝑥𝑥 for both individuals (they’re indifferent to y), then the contract curve is undefined in x-y
space.

14.1.2. From the text, the contract curve for two individuals with Cobb-Douglas preferences is
Introduction to Economic Analysis

22-324𝑥𝑥(1 − 𝛽𝛽)𝛼𝛼� (1 − 𝑥𝑥)
𝑥𝑥 + �
(1 − 𝛼𝛼)𝛽𝛽

𝑦𝑦 =(1−𝛽𝛽)𝛼𝛼For notational ease, introduce 𝑘𝑘 = (1−𝛼𝛼)𝛽𝛽, so𝑥𝑥𝑥𝑥 + 𝑘𝑘(1 − 𝑥𝑥)𝑦𝑦 =𝑑𝑑𝑑𝑑 𝑥𝑥 + 𝑘𝑘(1 − 𝑥𝑥) − 𝑥𝑥(1 − 𝑘𝑘)=2𝑑𝑑𝑑𝑑�𝑥𝑥 + 𝑘𝑘(1 − 𝑥𝑥)�
𝑑𝑑𝑑𝑑
𝑘𝑘
=
𝑑𝑑𝑑𝑑 �𝑥𝑥 + 𝑘𝑘(1 − 𝑥𝑥)�2

14.3

This is constant iff 𝑘𝑘 = 1.

General Equilibrium

14.3.1. The consumer’s problem is to maximize utility, subject to the budget constraint. Let’s use the Lagrange formulation:
𝐺𝐺

𝑈𝑈 = � 𝑥𝑥𝑖𝑖
𝑖𝑖=1

𝛼𝛼𝑖𝑖

𝐺𝐺

+ 𝜆𝜆 �𝑊𝑊 − � 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 �
𝑖𝑖=1

𝜕𝜕𝜕𝜕
= 𝛼𝛼𝑖𝑖 𝑥𝑥𝑖𝑖 𝛼𝛼𝑖𝑖−1 � 𝑥𝑥𝑗𝑗 𝛼𝛼𝑗𝑗 − 𝜆𝜆𝑝𝑝𝑖𝑖 = 0
𝜕𝜕𝑥𝑥𝑖𝑖𝑗𝑗≠𝑖𝑖

𝜆𝜆 =

𝛼𝛼𝑖𝑖 𝛼𝛼 −1𝑥𝑥 𝑖𝑖 � 𝑥𝑥𝑗𝑗 𝛼𝛼𝑗𝑗
𝑝𝑝𝑖𝑖 𝑖𝑖
𝑗𝑗≠𝑖𝑖

This is true for all i. Therefore,
𝛼𝛼𝑖𝑖 𝛼𝛼 −1
𝛼𝛼𝑘𝑘 𝛼𝛼 −1𝑥𝑥𝑖𝑖 𝑖𝑖 � 𝑥𝑥𝑗𝑗 𝛼𝛼𝑗𝑗 =𝑥𝑥 𝑘𝑘 � 𝑥𝑥𝑗𝑗 𝛼𝛼𝑗𝑗
𝑝𝑝𝑖𝑖𝑝𝑝𝑘𝑘 𝑘𝑘
𝑗𝑗≠𝑖𝑖

𝑗𝑗≠𝑘𝑘

𝛼𝛼𝑘𝑘
𝛼𝛼𝑖𝑖
=
𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 𝑝𝑝𝑘𝑘 𝑥𝑥𝑘𝑘
𝛼𝛼𝑘𝑘 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
𝑥𝑥𝑘𝑘 =
𝛼𝛼𝑖𝑖 𝑝𝑝𝑘𝑘

So, we can express quantities of all goods as a function of the quantity of good i. Substituting this back into the budget
constraint:
𝐺𝐺

𝐺𝐺

𝐺𝐺

𝐺𝐺

𝑗𝑗=1

𝑗𝑗=1

𝑗𝑗=1

𝑗𝑗=1

𝛼𝛼𝑗𝑗 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
𝛼𝛼𝑗𝑗 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖 𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖
𝑝𝑝𝑖𝑖 𝑥𝑥𝑖𝑖=�=� 𝛼𝛼𝑗𝑗 =𝑊𝑊 = � 𝑝𝑝𝑗𝑗 𝑥𝑥𝑗𝑗 = � 𝑝𝑝𝑗𝑗
𝛼𝛼𝑖𝑖 𝑝𝑝𝑗𝑗
𝛼𝛼𝑖𝑖
𝛼𝛼𝑖𝑖
𝛼𝛼𝑖𝑖

𝑥𝑥𝑖𝑖 =

Chapter 1515.2𝛼𝛼𝑖𝑖 𝑊𝑊
𝑝𝑝𝑖𝑖

Monopoly

Basic Analysis

15.2.1. If demand is linear:𝑝𝑝(𝑞𝑞) = 𝑎𝑎 − 𝑏𝑏𝑏𝑏

Revenue is 𝑅𝑅 = 𝑞𝑞𝑞𝑞(𝑞𝑞)
𝑅𝑅 = 𝑎𝑎𝑎𝑎 − 𝑏𝑏𝑞𝑞 2

𝑀𝑀𝑀𝑀 =

𝑑𝑑𝑑𝑑= 𝑎𝑎 − 2𝑏𝑏𝑏𝑏
𝑑𝑑𝑑𝑑

Introduction to Economic Analysis

22-325

If demand is linear, then marginal revenue is linear as well, with the same intercept and twice the slope.
15.2.2. Now, demand has constant elasticity:
𝑞𝑞 = 𝐴𝐴𝑝𝑝−𝜀𝜀

𝑝𝑝𝜀𝜀 = 𝐴𝐴𝑞𝑞 −1
11

𝑝𝑝 = 𝐴𝐴 �𝜀𝜀 𝑞𝑞 − �𝜀𝜀
1

1

1

1

𝑅𝑅 = 𝑞𝑞𝐴𝐴 �𝜀𝜀 𝑞𝑞 − �𝜀𝜀 = 𝐴𝐴 �𝜀𝜀 𝑞𝑞 �𝜀𝜀+1
𝑀𝑀𝑀𝑀 =

𝜀𝜀 − 1
𝑑𝑑𝑑𝑑 𝜀𝜀 − 1 1� −1�
=𝐴𝐴 𝜀𝜀 𝑞𝑞 𝜀𝜀 =
𝑝𝑝
𝜀𝜀
𝜀𝜀
𝑑𝑑𝑑𝑑

15.2.3. The monopolist’s original profit function, before the imposition of the tax, is
𝜋𝜋 = 𝑞𝑞 ∗ 𝑝𝑝(𝑞𝑞) − 𝑐𝑐(𝑞𝑞)𝑑𝑑𝑑𝑑= 𝑝𝑝(𝑞𝑞) + 𝑞𝑞𝑝𝑝′ (𝑞𝑞) − 𝑐𝑐 ′ (𝑞𝑞) = 0
𝑑𝑑𝑑𝑑

After the tax is imposed, the profit function is
𝜋𝜋 = (1 − 𝑡𝑡)[𝑞𝑞 ∗ 𝑝𝑝(𝑞𝑞) − 𝑐𝑐(𝑞𝑞)]𝑑𝑑𝑑𝑑= (1 − 𝑡𝑡)[𝑝𝑝(𝑞𝑞) + 𝑞𝑞𝑝𝑝′ (𝑞𝑞) − 𝑐𝑐 ′ (𝑞𝑞)] = 0
𝑑𝑑𝑑𝑑

Thus, a tax on the monopolist’s profits does not affect his profit maximizing quantity.
15.3

Effect of Taxes

15.3.1. Profit maximization before the tax implies that𝑞𝑞𝑏𝑏 𝑝𝑝(𝑞𝑞𝑏𝑏 ) − 𝑐𝑐(𝑞𝑞𝑏𝑏 ) ≥ 𝑞𝑞𝑎𝑎 𝑝𝑝(𝑞𝑞𝑎𝑎 ) − 𝑐𝑐(𝑞𝑞𝑎𝑎 )But the monopolist maximizes profit after the tax is imposed, too:
𝑞𝑞𝑏𝑏 𝑝𝑝(𝑞𝑞𝑏𝑏 ) − 𝑐𝑐(𝑞𝑞𝑏𝑏 ) − 𝑡𝑡𝑞𝑞𝑏𝑏 ≤ 𝑞𝑞𝑎𝑎 𝑝𝑝(𝑞𝑞𝑎𝑎 ) − 𝑐𝑐(𝑞𝑞𝑎𝑎 ) − 𝑡𝑡𝑞𝑞𝑎𝑎

Subtract the second expression from the first:

𝑞𝑞𝑏𝑏 𝑝𝑝(𝑞𝑞𝑏𝑏 ) − 𝑐𝑐(𝑞𝑞𝑏𝑏 ) − [𝑞𝑞𝑏𝑏 𝑝𝑝(𝑞𝑞𝑏𝑏 ) − 𝑐𝑐(𝑞𝑞𝑏𝑏 ) − 𝑡𝑡𝑞𝑞𝑏𝑏 ] ≥ 𝑞𝑞𝑎𝑎 𝑝𝑝(𝑞𝑞𝑎𝑎 ) − 𝑐𝑐(𝑞𝑞𝑎𝑎 ) − [𝑞𝑞𝑎𝑎 𝑝𝑝(𝑞𝑞𝑎𝑎 ) − 𝑐𝑐(𝑞𝑞𝑎𝑎 ) − 𝑡𝑡𝑞𝑞𝑎𝑎 ]𝑡𝑡𝑞𝑞𝑏𝑏 ≥ 𝑡𝑡𝑞𝑞𝑎𝑎
15.4

𝑞𝑞𝑏𝑏 ≥ 𝑞𝑞𝑎𝑎

Price Discrimination

15.4.1.

15.5

a.

Student discounts at local restaurants are direct price discrimination, based on identity.

b.

Financial aid at colleges is direct price discrimination. You reveal all of your financial information, and the college doesits best to determine how much you’re willing to pay it.

c.

Matinee discounts at the movies are indirect price discrimination (arguably). Anyone can go, but those not otherwise
employed are both more likely to have a high demand elasticity and be available during the day. It can also be argued
that the matinee is a different product from an evening show, and thus there is no price discrimination. Indeed, thesethree categories do not have absolutely clear distinctions.

d.

Home and professional versions of Microsoft’s operating system are indirect price discrimination. Anyone can buy
either version. (One might argue that the features are sufficiently different that the goods are different).

e.

Lower airline fares for weekend flights are indirect price discrimination. Anyone can buy any flight, they’re simply
designed so that different types of consumers self-select into different flights.

f.

BOGO deals are indirect price discrimination; anyone can take advantage of them but they’re better for folks who havethe space to store a second item or the consumption rate to justify getting two.

Welfare Effects

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15.5.1. The monopolist’s problem is to maximize profit. Group 1 has a demand curve of 𝑞𝑞(𝑝𝑝) = 12 − 𝑝𝑝, and Group 2 has a demand
curve of 𝑞𝑞(𝑝𝑝) = 8 − 𝑝𝑝. Without loss of generality, suppose there is 1 consumer in each group. Then the nondiscriminating
monopolist has a profit of
𝜋𝜋 = 𝑝𝑝 ∗ (12 − 𝑝𝑝) + 𝑝𝑝 ∗ (8 − 𝑝𝑝)
𝑑𝑑𝑑𝑑= 12 − 2𝑝𝑝 + 8 − 2𝑝𝑝 = 0
𝑑𝑑𝑑𝑑

4𝑝𝑝 = 20
𝑝𝑝 = 5The monopolist’s profit is
𝜋𝜋 = 5 ∗ (12 − 5) + 5 ∗ (8 − 5) = 50

The consumer surplus of Consumer 1 is1
49
𝐶𝐶𝐶𝐶1 = (12 − 𝑝𝑝1 )2 =2
2

The consumer surplus of Consumer 2 is1
9
𝐶𝐶𝐶𝐶2 = (8 − 𝑝𝑝2 )2 =2
2

Total gains from trade are 50 +

49
2

9

+ = 792

The discriminating monopolist can charge different prices.
𝜋𝜋 = 𝑝𝑝1 ∗ (12 − 𝑝𝑝1 ) + 𝑝𝑝2 ∗ (8 − 𝑝𝑝2 )𝜕𝜕𝜕𝜕= 12 − 2𝑝𝑝1 = 0
𝜕𝜕𝑝𝑝1
𝑝𝑝1 = 6𝜕𝜕𝜕𝜕
= 8 − 2𝑝𝑝2 = 0
𝜕𝜕𝑝𝑝2

𝑝𝑝2 = 4The monopolist’s profits are
𝜋𝜋 = 𝑝𝑝1 ∗ (12 − 𝑝𝑝1 ) + 𝑝𝑝2 ∗ (8 − 𝑝𝑝2 )𝜋𝜋 = 6 ∗ (12 − 6) + 4 ∗ (8 − 4) = 52

The consumer surplus of Consumer 1 is1
𝐶𝐶𝐶𝐶1 = (12 − 𝑝𝑝1 )2 = 18
2

The consumer surplus of Consumer 2 is1
𝐶𝐶𝐶𝐶2 = (8 − 𝑝𝑝2 )2 = 8
2Total gains from trade are 52 + 18 + 8 = 78

In this case, price discrimination reduces gains from trade.
15.5.2. Now, the two consumers’ demand curves are 𝑞𝑞(𝑝𝑝) = 12 − 𝑝𝑝 and 𝑞𝑞(𝑝𝑝) = 4 − 𝑝𝑝. This exercise is just a bit tricky because wemust think of the second demand curve as having two segments:0𝑞𝑞(𝑝𝑝) = �
4 − 𝑝𝑝𝑝𝑝 > 4𝑝𝑝 ≤ 4

If we don’t do this, we’ll be adding negative values when we sum the demand curves – and this time (unlike above) it’llmatter. The nondiscriminating monopolist faces a demand of
12 − 𝑝𝑝
𝑞𝑞(𝑝𝑝) = �
16 − 2𝑝𝑝

𝑝𝑝 > 4𝑝𝑝 ≤ 4Introduction to Economic Analysis

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Suppose the optimum is found on the latter segment of the demand curve. If this is the case, then
𝜋𝜋 = 𝑝𝑝 ∗ (16 − 2𝑝𝑝)

𝑑𝑑𝑑𝑑
= 16 − 4𝑝𝑝 = 0
𝑑𝑑𝑑𝑑
𝑝𝑝 = 4, 𝜋𝜋 = 32

Now suppose the optimum is found on the first segment of the demand curve. Here𝜋𝜋 = 𝑝𝑝 ∗ (12 − 𝑝𝑝)

𝑑𝑑𝑑𝑑= 12 − 2𝑝𝑝 = 0
𝑑𝑑𝑑𝑑

𝑝𝑝 = 6, 𝜋𝜋 = 36

Since this is greater than 32, it’s the nondiscriminating monopolist’s optimal price and profit. Consumer surplus is1
𝐶𝐶𝐶𝐶1 = (12 − 𝑝𝑝1 )2 = 18
2

Gains from trade are 36 + 18 = 54.

The discriminating monopolist will also maximize profit:
𝜋𝜋 = 𝑝𝑝1 ∗ (12 − 𝑝𝑝1 ) + 𝑝𝑝2 ∗ (4 − 𝑝𝑝2 )𝜕𝜕𝜕𝜕= 12 − 2𝑝𝑝1 = 0
𝜕𝜕𝑝𝑝1
𝑝𝑝1 = 6𝜕𝜕𝜕𝜕
= 4 − 2𝑝𝑝2 = 0
𝜕𝜕𝑝𝑝2

𝑝𝑝2 = 2The monopolist’s profits are

𝜋𝜋 = 𝑝𝑝1 ∗ (12 − 𝑝𝑝1 ) + 𝑝𝑝2 ∗ (4 − 𝑝𝑝2 )𝜋𝜋 = 6 ∗ (12 − 6) + 2 ∗ (4 − 2) = 40

The consumer surplus of Consumer 1 is1
𝐶𝐶𝐶𝐶1 = (12 − 𝑝𝑝1 )2 = 18
2

The consumer surplus of Consumer 2 is1
𝐶𝐶𝐶𝐶2 = (4 − 𝑝𝑝2 )2 = 4
2Total gains from trade are 40 + 18 + 4 = 62

In this case, price discrimination increases gains from trade.
15.7

Peak-Load Pricing

15.7.1. a.

Hotels in Miami: Most people likely want to visit Miami in the winter, so that’s the peak. But cheap hotel prices might
entice them to visit during other times of the year, so some load balancing may occur.

b.

Electricity: Most people are awake during the day and this is difficult to change for coordination reasons. It’s quitedifficult and costly to shift load to the low-demand nighttime. Therefore, the cost of capacity will likely be imposed on
daytime users.

Chapter 16
16.3

Games & Strategic Behavior

Mixed Strategies

16.3.1. The game:

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Row

Column

Heads
(q)
Tails
(1-q)

Heads

Tails

1,-1

-1,1

-1,1

1,-1

If Row plays Heads with probability q, then Column’s payoff from playing Heads is
𝜋𝜋𝐻𝐻 = −𝑞𝑞 + 1(1 − 𝑞𝑞) = 1 − 2𝑞𝑞

Column’s payoff from playing Tails is
𝜋𝜋 𝑇𝑇 = 𝑞𝑞 − 1(1 − 𝑞𝑞) = 2𝑞𝑞 − 1

Column is better off playing Heads if
𝜋𝜋𝐻𝐻 > 𝜋𝜋𝐿𝐿

1 − 2𝑞𝑞 > 2𝑞𝑞 − 1
2 > 4𝑞𝑞

𝑞𝑞 <

1
2

1

1

Likewise, Column is better off playing Tails if 𝑞𝑞 > . Only if 𝑞𝑞 = is Column indifferent between playing Heads and Tails,
22and therefore willing to randomize.

16.3.2. The game:

Row

ColumnPaper

Scissors

Rock

Paper

0,0

-1,1

1,-1

Scissors

1,-1

0,0

-1,1

Rock

-1,1

1,-1

0,0

Consider the strategy combination (Paper, Paper). In this case, both Column and Row wish to deviate and play Scissors,
given the other’s strategy. If the strategy combination is (Scissors, Paper), then Column wishes to deviate and play Rock. If
the strategy combination is (Rock, Paper), then Row wishes to deviate and play Scissors. Confirming that the other six purestrategy sets also permit profitable deviations is straightforward. Since a Nash equilibrium permits no profitable deviations,
there are no pure strategy Nash equilibria in this game.
Now for mixed strategies: Suppose Row plays Paper with probability 𝑞𝑞𝑃𝑃 and Scissors with probability 𝑞𝑞𝑆𝑆 . Then Column’s
payoff from playing Paper is
𝜋𝜋𝑃𝑃 = 𝑞𝑞𝑃𝑃 (0) + 𝑞𝑞𝑆𝑆 (−1) + (1 − 𝑞𝑞𝑃𝑃 −𝑞𝑞𝑆𝑆 )(1) = 1 − 𝑞𝑞𝑃𝑃 − 2𝑞𝑞𝑆𝑆
Column’s payoff from playing Scissors is

𝜋𝜋𝑆𝑆 = 𝑞𝑞𝑃𝑃 (1) + 𝑞𝑞𝑆𝑆 (0) + (1 − 𝑞𝑞𝑃𝑃 −𝑞𝑞𝑆𝑆 )(−1) = 2𝑞𝑞𝑃𝑃 + 𝑞𝑞𝑆𝑆 − 1

Column’s payoff from playing Rock is

𝜋𝜋𝑅𝑅 = 𝑞𝑞𝑃𝑃 (−1) + 𝑞𝑞𝑆𝑆 (1) + (1 − 𝑞𝑞𝑃𝑃 −𝑞𝑞𝑆𝑆 )(0) = 𝑞𝑞𝑆𝑆 −𝑞𝑞𝑃𝑃

If Row is mixing strategies optimally, Column will be indifferent among her own strategies. Therefore, 𝜋𝜋𝑃𝑃 = 𝜋𝜋𝑆𝑆 = 𝜋𝜋𝑅𝑅
2𝑞𝑞𝑃𝑃 + 𝑞𝑞𝑆𝑆 − 1 = 𝑞𝑞𝑆𝑆 −𝑞𝑞𝑃𝑃

3𝑞𝑞𝑃𝑃 = 1

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1
3

𝑞𝑞𝑃𝑃 =

1 − 𝑞𝑞𝑃𝑃 − 2𝑞𝑞𝑆𝑆 = 𝑞𝑞𝑆𝑆 −𝑞𝑞𝑃𝑃
1 = 3𝑞𝑞𝑆𝑆

𝑞𝑞𝑆𝑆 =

1
3

a.

(Down, Left) is the unique Nash equilibrium.

b.

(Down, Left) is the unique Nash equilibriumc.

There are no pure strategy Nash equilibria. There is a mixed strategy Nash equilibrium. Row’s optimal mix is the onethat makes Column indifferent between Left and Right. If Row plays Up with probability q, then Column’s payoff fromplaying Left is 𝜋𝜋𝐿𝐿 = 3𝑞𝑞, and Column’s payoff from playing Right is 𝜋𝜋𝑅𝑅 = 4(1 − 𝑞𝑞). Column is willing to randomize if

So if Row plays all three actions with equal likelihood, then Column is indifferent among her own actions and willing torandomize. Since the game is symmetric, this also applies to Column’s optimal mix so as to make Row indifferent among his
actions. Therefore, this is a mixed strategy Nash equilibrium.

16.3.3.

𝜋𝜋𝐿𝐿 = 𝜋𝜋𝑅𝑅

3𝑞𝑞 = 4(1 − 𝑞𝑞)
7𝑞𝑞 = 4𝑞𝑞 =4
7Column’s optimal mix is the one that makes Row indifferent between Up and Down. If Column plays Left withprobability p, then Row’s payoff from playing Up is 𝜋𝜋𝑈𝑈 = 3(1 − 𝑝𝑝), and Row’s payoff from playing Down is 𝜋𝜋𝐷𝐷 = 4𝑝𝑝.
Row is willing to randomize if
𝜋𝜋𝑈𝑈 = 𝜋𝜋𝐷𝐷3(1 − 𝑝𝑝) = 4𝑝𝑝

7𝑝𝑝 = 3𝑝𝑝 =3
7

Therefore, the (unique) mixed strategy Nash equilibrium has Row playing Up with probability 4/7 and Down withprobability 3/7, and Column plays Left with probability 3/7 and Right with probability 4/7.

d.

(Down, Right) is the unique Nash equilibriume.

(Down, Right) is the unique Nash equilibriumf.

(Up, Right) is the unique Nash equilibrium

16.3.4. True, multiplying a player’s payoff by a positive constant does not change the game, since it preserves both the rank order ofthe different outcomes for that player and the relative differences among the outcomes.
16.4

Examples16.4.1. The game:

LA

NYC
No
Concession

Tax
RebateNo
Concession

30,10

10,20

Tax Rebate

20,10

20,0

Introduction to Economic Analysis

22-330First, consider the strategy combination (No Concession, No Concession). Here, NYC wishes to deviate. If the strategy
combination is (No Concession, Tax Rebate), then LA wishes to deviate. If the strategy combination is (Tax Rebate, No
Concession), then LA wishes to deviate. Finally, if the strategy combination is (Tax Rebate, Tax Rebate), then NYC wishes
to deviate. Therefore, there are no pure strategy Nash equilibria to this game. To find the mixed strategy Nash equilibrium,
suppose LA plays No Concession with probability p. Then NYC’s payoff from playing No Concession is
𝜋𝜋𝑁𝑁𝑁𝑁 = 10𝑝𝑝 + 10(1 − 𝑝𝑝) = 10

NYC’s payoff from playing Tax Rebate is
𝜋𝜋 𝑇𝑇𝑇𝑇 = 20𝑝𝑝 + 0(1 − 𝑝𝑝) = 20𝑝𝑝

1

NYC is willing to randomize only if these two payoffs are equal, which occurs at 𝑝𝑝 = . This is LA’s optimal mix. Now to2find NYC’s optimal mix, suppose NYC plays No Concession with probability q. Then LA’s payoff from playing No
Concession is
𝜋𝜋𝑁𝑁𝑁𝑁 = 30𝑞𝑞 + 10(1 − 𝑞𝑞) = 10 + 20𝑞𝑞

LA’s payoff from playing Tax Rebate is

𝜋𝜋 𝑇𝑇𝑇𝑇 = 20𝑞𝑞 + 20(1 − 𝑞𝑞) = 20

1

LA is willing to randomize only if these two payoffs are equal, which occurs at 𝑞𝑞 = . This is our mixed strategy Nash2equilibrium.

16.4.2. The game:

Democrat

Republican
Clean

Mud

Clean

3,1

1,2

Mud

2,1

2,0

First, consider the strategy combination (Clean, Clean). Here, Republican wishes to deviate. If the strategy combination is(Clean, Mud), then Democrat wishes to deviate. If the strategy combination is (Mud, Mud), then Republican wishes todeviate. Finally, if the strategy combination is (Mud, Clean), then Democrat wishes to deviate. Therefore, there are no purestrategy Nash equilibria to this game. To find the mixed strategy Nash equilibrium, suppose Democrat plays Clean withprobability p. Then Republican’s payoff from playing Clean is
𝜋𝜋𝐶𝐶 = 𝑝𝑝 + (1 − 𝑝𝑝) = 1

Republican’s payoff from playing Mud is
𝜋𝜋𝑀𝑀 = 2𝑝𝑝 + 0(1 − 𝑝𝑝) = 2𝑝𝑝

1

Republican is only willing to randomize if these two payoffs are the same; this occurs at 𝑝𝑝 = . This is Democrat’s optimal
2
mix. To find Republican’s optimal mix, suppose Republican plays Clean with probability q. Then Democrat’s payoff fromplaying Clean is
𝜋𝜋𝐶𝐶 = 3𝑞𝑞 + 1(1 − 𝑞𝑞) = 2𝑞𝑞 + 1

Democrat’s payoff from playing Mud is
𝜋𝜋𝑀𝑀 = 2𝑞𝑞 + 2(1 − 𝑞𝑞) = 2

1

Democrat is only willing to randomize if these two payoffs are equal, which occurs at 𝑞𝑞 = . This is the mixed strategy Nash2equilibrium.
16.4.3. The new game:

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Democrat

Republican
Clean

Mud

Clean

3,1

1,2

Mud

2,1

2.5,0.5

First, consider the strategy combination (Clean, Clean). Here, Republican wishes to deviate. If the strategy combination is(Clean, Mud), then Democrat wishes to deviate. If the strategy combination is (Mud, Mud), then Republican wishes todeviate. Finally, if the strategy combination is (Mud, Clean), then Democrat wishes to deviate. Therefore, there are no purestrategy Nash equilibria to this game. To find the mixed strategy Nash equilibrium, suppose Democrat plays Clean withprobability p. Then Republican’s payoff from playing Clean is
𝜋𝜋𝐶𝐶 = 𝑝𝑝 + (1 − 𝑝𝑝) = 1

Republican’s payoff from playing Mud is
1 3𝑝𝑝
1𝜋𝜋𝑀𝑀 = 2𝑝𝑝 + (1 − 𝑝𝑝) = −
2 2
2

1

Republican is only willing to randomize if these two payoffs are the same; this occurs at 𝑝𝑝 = . This is Democrat’s optimal
3
mix. To find Republican’s optimal mix, suppose Republican plays Clean with probability q. Then Democrat’s payoff fromplaying Clean is
𝜋𝜋𝐶𝐶 = 3𝑞𝑞 + 1(1 − 𝑞𝑞) = 2𝑞𝑞 + 1

Democrat’s payoff from playing Mud is
𝜋𝜋𝑀𝑀 = 2𝑞𝑞 + 2.5(1 − 𝑞𝑞) =

5 𝑞𝑞
−
2 2

Democrat is only willing to randomize if these two payoffs are equal, which occurs at
2𝑞𝑞 + 1 =
5𝑞𝑞 3
=
2
2

5 𝑞𝑞
−
2 2

3

𝑞𝑞 = . This (with p above) is the mixed strategy Nash equilibrium.
5

16.4.4. The game:

You

Rocky
Party 1

Party 2

Party 1

5,15

20,10

Party 2

15,5

0,20

a.

If you choose Party 1 and Rocky chooses Party 1, then you wish to deviate. If you choose Party 2 and Rocky chooses
Party 1, Rocky wants to deviate. If both choose Party 2, then you want to deviate. Finally, if you choose Party 1 andRocky chooses Party 2, then Rocky wants to deviate. Therefore, there are no pure strategy Nash equilibriab.

To find your optimal mix, suppose you play Party 1 with probability p. Then, Rocky’s payoff from choosing Party 1 is
𝜋𝜋1 = 15𝑝𝑝 + 5(1 − 𝑝𝑝) = 5 + 10𝑝𝑝

Rocky’s payoff from choosing Party 2 is
𝜋𝜋2 = 10𝑝𝑝 + 20(1 − 𝑝𝑝) = 20 − 10𝑝𝑝
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Rocky is willing to randomize if these are equal.
5 + 10𝑝𝑝 = 20 − 10𝑝𝑝

20𝑝𝑝 = 15

𝑝𝑝 =

3
4

Meanwhile, we find Rocky’s optimal mix by supposing he plays Party 1 with probability q. Then, your payoff fromchoosing Party 1 is
𝜋𝜋1 = 5𝑞𝑞 + 20(1 − 𝑞𝑞) = 20 − 15𝑞𝑞

Your payoff from choosing Party 2 is
𝜋𝜋2 = 15𝑞𝑞 + 0(1 − 𝑞𝑞) = 15𝑞𝑞c.

2

You are willing to randomize if these are equal, which occurs at 𝑞𝑞 = .
3

3

2

You choose Party 1 with probability and Rocky chooses Party 1 with probability , so the probability that you meet at32Party 1 is � � � � =
4

3

6

12

4

3

1

1

. You choose Party 2 with probability and Rocky chooses Party 2 with probability , so the11

probability that you meet at Party 2 is � � � � =4

16.4.5. The game:

3

1

12

4

. The probability that you meet Rocky at either party is

3
6

12

+

1

12

=

7

12

.

Fir
m1

Firm 2
High

Low

High

15,15

0,25

Low

25,0

5,5

Suppose Firm 2 chooses High. Then Firm 1 obtains a payoff of 15 from choosing High or 25 from choosing Low, so Firm 1
prefers Low. If Firm 2 chooses Low, then Firm 1 obtains 0 from choosing High or 5 from choosing Low. Once again, Low
is preferred. Since Firm 1 obtains a higher payoff from choosing Low than it does from choosing High no matter which
strategy Firm 2 chooses, Low dominates High. Since the game is symmetric, Low also dominates High for Firm 2.
Therefore, the only pure strategy Nash equilibrium is (Low, Low).
16.5

Subgame Perfection
Woman
BaseballBalletMan
Baseball

2,3

Man
Ballet0,0Baseball

1,1

Ballet3,2

16.5.1.
Here the order of the payoffs is reversed compared to the simultaneous move game, because now the woman is Player 1. If
the woman has chosen Baseball, then the man will choose Baseball, as 3 is greater than 0. If the woman has chosen Ballet,
then the man will choose Ballet, as 2 is greater than 1. We can therefore eliminate the branches of the tree that end with (0,0)
and (1,1). The choice for the woman, then, is to choose Baseball, knowing that the man will then choose Baseball, andIntroduction to Economic Analysis

22-333choosing Ballet, knowing that the man will do so also. Since the woman’s payoff from this latter strategy is higher, she’ll
choose Ballet.
16.5.2. Consider Player 2’s last move first. If presented with this decision, he’ll choose In. Working backward to Player 1’s second
move, we can see that he’ll choose In, since he understands that Player 2 will choose In at the node we just analyzed.
Continuing to work backward to Player 2’s first node, we see that he’ll choose In here, rationally foreseeing the courses ofaction we’ve already solved. Finally, we can analyze Player 1’s first node, and we can see that he’ll choose In here. Thus,
the subgame perfect Nash equilibrium is where all players choose In at all nodes.
16.5.3. The game in strategic form:

Row

Column

a.

Left

Right

Up

1,3

3,2

Down

4,1

2,4

The usual inspection method reveals that there are no pure strategy Nash equilibria here. So we must be seeking a mixed
strategy Nash equilibrium. Assume Row plays Up with probability p. Column’s payoff from playing Left is
𝜋𝜋𝐿𝐿 = 3𝑝𝑝 + 1(1 − 𝑝𝑝) = 1 + 2𝑝𝑝

Column’s payoff from playing Right is
𝜋𝜋𝑅𝑅 = 2𝑝𝑝 + 4(1 − 𝑝𝑝) = 4 − 2𝑝𝑝

Column is willing to randomize if these are equal.
1 + 2𝑝𝑝 = 4 − 2𝑝𝑝
4𝑝𝑝 = 33

𝑝𝑝 = . This is Row’s optimal mix.
4

To find Column’s optimal mix, assume that Column plays Left with probability q. Row’s payoff from playing Up is
𝜋𝜋𝑈𝑈 = 1𝑞𝑞 + 3(1 − 𝑞𝑞) = 3 − 2𝑞𝑞

Row’s payoff from playing Down is
𝜋𝜋𝐷𝐷 = 4𝑞𝑞 + 2(1 − 𝑞𝑞) = 2 + 2𝑞𝑞

Row is willing to randomize if these are equal.
3 − 2𝑞𝑞 = 2 + 2𝑞𝑞
4𝑞𝑞 = 11b.

𝑞𝑞 = . This is Column’s optimal mix.
4

If the game becomes a sequential-move game with Column going first, the extensive form looks like this:Introduction to Economic Analysis

22-334

Column
Left

Right

Row

Up

Row

Down

Down
Down

3,1

1,4

2,3

4,2

If Column has played Left, Row must choose between Up (1) and Down (4); she’ll choose Down if presented with thissituation. Likewise, if Column has played Right, Row must choose between Up (3) and Down (2), so she’ll choose Up
here. With two branches eliminated, we can now examine Column’s decision. Column must choose between Leftknowing that Row will play Down (1) and Right followed by Row playing Up (2). He’ll choose Right. So (Right, Up)is the unique subgame perfect Nash equilibrium. If Row moves first, we have a different game:
Row
Up

Up

ColumnLeft

1,3

Column
Right

3,2

Left

4,1

Right

2,4

As before, we analyze
the last moves first. If Row has chosen Up, Column prefers Left (3) over Right (2). If Row has chosen Down, Column
prefers Right (4) over Left (1). Now, Row’s decision is between Up followed by Left (1) and Down followed by Right(2). Row prefers Down here. So the unique subgame perfect Nash equilibrium in this game is (Down, Right).
c.

When Column moves first, he receives a payoff of 2. When Column moves second, he receives a payoff of 4. In the
Nash equilibrium to the simultaneous move game, Column receives a payoff of

31
5𝜋𝜋𝐿𝐿 = 3 � � + 1 � � =4
42(The payoff to playing Right is the same, or Row isn’t mixing optimally). This game has a second mover advantage.
16.6

Supergames

16.6.1. Since Firm 1 starts the sequence by pricing Low, its stream of payoffs is (25, 0, 25, 0,…). At a discount rate of 𝛿𝛿 per period,
the present value of this stream of payoffs isΠ1 = 25(1 + 𝛿𝛿 2 + 𝛿𝛿 4 + ⋯ )To solve this infinite sum, multiply by 𝛿𝛿 2 :𝛿𝛿 2 Π1 = 25(𝛿𝛿 2 + 𝛿𝛿 4 + 𝛿𝛿 6 + ⋯ )Now subtract this second expression from the first:
Π1 − 𝛿𝛿 2 Π1 = 25(1 + 𝛿𝛿 2 + 𝛿𝛿 4 + ⋯ ) − 25(𝛿𝛿 2 + 𝛿𝛿 4 + 𝛿𝛿 6 + ⋯ ) = 25

Π1 (1 − 𝛿𝛿 2 ) = 25

Introduction to Economic Analysis

22-335Π1 =

25(1 − 𝛿𝛿 2 )Firm 2 starts by pricing High, so its stream of payoffs is (0,25,0,25,…). The present value of this stream of payoffs isΠ2 = 25(𝛿𝛿 + 𝛿𝛿 3 + 𝛿𝛿 5 + ⋯ )To solve this infinite sum, multiply by 𝛿𝛿 2 :𝛿𝛿 2 Π2 = 25(𝛿𝛿 3 + 𝛿𝛿 5 + 𝛿𝛿 7 + ⋯ )Now subtract this second expression from the first:
Π2 − 𝛿𝛿 2 Π2 = 25(𝛿𝛿 + 𝛿𝛿 3 + 𝛿𝛿 5 + ⋯ ) − 25(𝛿𝛿 3 + 𝛿𝛿 5 + 𝛿𝛿 7 + ⋯ ) = 25𝛿𝛿

Π2 (1 − 𝛿𝛿 2 ) = 25𝛿𝛿
Π2 =

25𝛿𝛿
(1 − 𝛿𝛿 2 )In any period, the firm whose turn is to price High will have the greater incentive to deviate from the alternating strategy.
This is the dilemma faced by Firm 2 in Round 1. If Firm 2 deviates from its assigned role to price High in Round 1, it
receives a payoff of 5 in the current round and then 5 in every round thereafter as Firm 1 will then begin to price Low. The
present value of this stream of payoffs from defection isΠ2D = 5(1 + 𝛿𝛿 + 𝛿𝛿 2 + ⋯ )To solve this infinite sum, multiply by 𝛿𝛿:𝛿𝛿Π2D = 5(𝛿𝛿 + 𝛿𝛿 2 + 𝛿𝛿 3 + ⋯ )Now subtract this second expression from the first:
Π2D − 𝛿𝛿Π2D = 5(1 + 𝛿𝛿 + 𝛿𝛿 2 + ⋯ ) − 5(𝛿𝛿 + 𝛿𝛿 2 + 𝛿𝛿 3 + ⋯ ) = 5

Π2D (1 − 𝛿𝛿) = 5
Π2D =5(1 − 𝛿𝛿)The alternating strategy is sustainable if Firm 2’s payoff from following the alternating strategy is at least as great as its
payoff from deviating.
Π2 ≥ Π2D525𝛿𝛿
≥(1 − 𝛿𝛿 2 ) (1 − 𝛿𝛿)25𝛿𝛿
≥5
1 + 𝛿𝛿

25𝛿𝛿 ≥ 5 + 5𝛿𝛿20𝛿𝛿 ≥ 5𝛿𝛿 ≥Chapter 17
17.2

1
4

Imperfect Competition

Cournot Industry Performance

17.2.1. The demand function is𝑝𝑝(𝑄𝑄) = 1 − 𝑄𝑄

𝑝𝑝 = 1 − � 𝑞𝑞𝑖𝑖
𝑖𝑖

The profit of firm j is𝜋𝜋𝑗𝑗 = 𝑝𝑝𝑞𝑞𝑗𝑗 − 𝑐𝑐𝑞𝑞𝑗𝑗

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𝜋𝜋𝑗𝑗 = �1 − � 𝑞𝑞𝑖𝑖 � 𝑞𝑞𝑗𝑗 − 𝑐𝑐𝑞𝑞𝑗𝑗
𝑖𝑖

Firm j maximizes its own profits, taking the output of the other firms as given.
𝑑𝑑𝜋𝜋𝑗𝑗= �1 − � 𝑞𝑞𝑖𝑖 � − 𝑞𝑞𝑗𝑗 − 𝑐𝑐 = 0
𝑑𝑑𝑞𝑞𝑗𝑗𝑖𝑖

2𝑞𝑞𝑗𝑗 = 1 − 𝑐𝑐 − � 𝑞𝑞𝑖𝑖
𝑞𝑞𝑗𝑗 =𝑖𝑖≠𝑗𝑗

1 − 𝑐𝑐 − ∑𝑖𝑖≠𝑗𝑗 𝑞𝑞𝑖𝑖
2This is firm j’s best response function. In equilibrium, all firms will have the same output, so� 𝑞𝑞𝑖𝑖 = (𝑛𝑛 − 1)𝑞𝑞𝑗𝑗
𝑖𝑖≠𝑗𝑗

Now,
𝑞𝑞𝑗𝑗 =

1 − 𝑐𝑐 − (𝑛𝑛 − 1)𝑞𝑞𝑗𝑗
2

2𝑞𝑞𝑗𝑗 = 1 − 𝑐𝑐 − (𝑛𝑛 − 1)𝑞𝑞𝑗𝑗(𝑛𝑛 + 1)𝑞𝑞𝑗𝑗 = 1 − 𝑐𝑐

𝑞𝑞𝑗𝑗 =

1 − 𝑐𝑐𝑛𝑛 + 1Since there are n firms, 𝑄𝑄 = 𝑛𝑛𝑞𝑞𝑗𝑗 =𝑃𝑃 = 1 − 𝑄𝑄 = 1 −𝑛𝑛(1−𝑐𝑐)𝑛𝑛+1

𝑛𝑛(1 − 𝑐𝑐) 𝑛𝑛 + 1 𝑛𝑛(1 − 𝑐𝑐) 1 + 𝑛𝑛𝑛𝑛=−=
𝑛𝑛 + 1
𝑛𝑛 + 1
𝑛𝑛 + 1
𝑛𝑛 + 1The profit of firm j is𝜋𝜋𝑗𝑗 = 𝑝𝑝𝑞𝑞𝑗𝑗 − 𝑐𝑐𝑞𝑞𝑗𝑗
𝜋𝜋𝑗𝑗 = (𝑝𝑝 − 𝑐𝑐)𝑞𝑞𝑗𝑗

1 + 𝑛𝑛𝑛𝑛
1 − 𝑐𝑐𝜋𝜋𝑗𝑗 = �− 𝑐𝑐� ��𝑛𝑛 + 1
𝑛𝑛 + 1
1 + 𝑛𝑛𝑛𝑛 𝑛𝑛𝑛𝑛 + 𝑐𝑐 1 − 𝑐𝑐−���
𝜋𝜋𝑗𝑗 = �𝑛𝑛 + 1
𝑛𝑛 + 1 𝑛𝑛 + 1
1 − 𝑐𝑐 2𝜋𝜋𝑗𝑗 = ��𝑛𝑛 + 117.2.2. The Herschman-Herfindahl index (HHI) measures the weighted average of price-cost deviations. If the industry is accurately
modeled by Cournot competition, then the HHI measures the extent of the deviation from perfect competition. A large HHI
means the industry has high price-cost margins and looks like a monopoly, while a low HHI means the industry is close toperfectly competitive.
17.2.3. From the text’s derivation of the HHI, we know𝑝𝑝(𝑄𝑄) − 𝑐𝑐 ′ (𝑞𝑞𝑖𝑖 ) 𝑠𝑠𝑖𝑖=𝜀𝜀𝑝𝑝(𝑄𝑄)

1

If the firms are identical, then 𝑠𝑠𝑖𝑖 = .

𝑝𝑝(𝑄𝑄) − 𝑐𝑐 ′ (𝑞𝑞𝑖𝑖 )1=
𝑝𝑝(𝑄𝑄)
𝑛𝑛𝑛𝑛

Introduction to Economic Analysis𝑛𝑛22-337

1

If 𝜀𝜀 ≤ , then the fraction on the right of this expression is greater than 1. But the left side of this expression must be less𝑛𝑛

1than 1, so this is impossible. Therefore, 𝜀𝜀 > . This is consistent with the monopoly case, since we already know that a𝑛𝑛monopolist whose demand is inelastic isn’t maximizing profit.
17.2.4. a.

Consider Firm 1’s profit maximization problem.
𝜋𝜋1 = 𝑝𝑝(𝑄𝑄)𝑞𝑞1 − 𝑐𝑐(𝑞𝑞1 )

𝜋𝜋1 = (250 − 𝑞𝑞1 − 𝑞𝑞2 )𝑞𝑞1 − 200 − 5𝑞𝑞1 − 𝑞𝑞1 2

Firm 1 chooses its quantity to maximize its profit, taking the quantity of Firm 2 as given.
𝑑𝑑𝜋𝜋1= 250 − 2𝑞𝑞1 − 𝑞𝑞2 − 5 − 2𝑞𝑞1 = 0
𝑑𝑑𝑞𝑞1

4𝑞𝑞1 = 245 − 𝑞𝑞2

𝑞𝑞1 =245 − 𝑞𝑞2
4This is Firm 1’s best response function. The firms are identical, so Firm 2’s best response function is symmetric.
𝑞𝑞2 =245 − 𝑞𝑞1
4

Cournot-Nash equilibrium occurs when each is best responding to the other:245 − 𝑞𝑞14
𝑞𝑞1 =
4245 − 𝑞𝑞1
4𝑞𝑞1 = 245 −4
245 −16𝑞𝑞1 = 980 − 245 + 𝑞𝑞1
15𝑞𝑞1 = 735

𝑞𝑞1 = 49, 𝑞𝑞2 = 49b.

𝑝𝑝 = 250 − 𝑞𝑞1 − 𝑞𝑞2 = 152
The industry’s cost is

𝐶𝐶 = 200 + 5𝑞𝑞1 + 𝑞𝑞1 2 + 200 + 5𝑞𝑞2 + 𝑞𝑞2 2

𝐶𝐶 = 200 + 5𝑞𝑞1 + 𝑞𝑞1 2 + 200 + 5(𝑋𝑋 − 𝑞𝑞1 ) + (𝑋𝑋 − 𝑞𝑞1 )2

Minimize C as a function of 𝑞𝑞1 .

𝑑𝑑𝑑𝑑= 5 + 2𝑞𝑞1 − 5 − 2(𝑋𝑋 − 𝑞𝑞1 ) = 0
𝑑𝑑𝑞𝑞1
2𝑞𝑞1 − 2(𝑋𝑋 − 𝑞𝑞1 ) = 0

4𝑞𝑞1 = 2𝑋𝑋
𝑞𝑞1 =

𝑋𝑋
2

To minimize cost, output should be split evenly across the firms.
c.

If the firms merge, then there is only one profit to maximize.
𝜋𝜋 = 𝜋𝜋1 + 𝜋𝜋2

𝜋𝜋 = 𝑝𝑝(𝑄𝑄)𝑞𝑞1 − 𝑐𝑐(𝑞𝑞1 ) + 𝑝𝑝(𝑄𝑄)𝑞𝑞2 − 𝑐𝑐(𝑞𝑞2 )𝜋𝜋 = (250 − 𝑞𝑞1 − 𝑞𝑞2 )(𝑞𝑞1 + 𝑞𝑞2 ) − 200 − 5𝑞𝑞1 − 𝑞𝑞1 2 − 200 − 5𝑞𝑞2 − 𝑞𝑞2 2

The merged firm maximizes profit as a function of both quantities.
𝜕𝜕𝜕𝜕= (250 − 𝑞𝑞1 − 𝑞𝑞2 ) − (𝑞𝑞1 + 𝑞𝑞2 ) − 5 − 2𝑞𝑞1 = 0
𝜕𝜕𝑞𝑞1

Introduction to Economic Analysis

22-338𝜕𝜕𝜕𝜕= (250 − 𝑞𝑞1 − 𝑞𝑞2 ) − (𝑞𝑞1 + 𝑞𝑞2 ) − 5 − 2𝑞𝑞2 = 0𝜕𝜕𝑞𝑞2(250 − 2𝑞𝑞1 − 2𝑞𝑞2 ) − 5 − 2𝑞𝑞1 = 0
245 − 4𝑞𝑞1 − 2𝑞𝑞2 = 0

245 − 2𝑞𝑞1 − 4𝑞𝑞2 = 0

From the previous exercise, we know 𝑞𝑞1 = 𝑞𝑞2 .
6𝑞𝑞1 = 245

𝑞𝑞1 = 𝑞𝑞2 =

17.3

245
6

𝑝𝑝 = 250 − 𝑞𝑞1 − 𝑞𝑞2 =Hotelling Differentiation

505
3

1

3

17.3.1. Suppose that vendors a and b locate at 𝑥𝑥 = , and vendors c and d locate at 𝑥𝑥 = . With these locations, the market share of
1

4

4

1

each is -- vendors a and b split the span from 0 to . Can vendor a deviate profitably from this? Consider a deviation to the
4

1

1

2

left, to 𝑥𝑥 < . Since vendor b is still at 𝑥𝑥 = , vendor a’s market share is now
4

4

1
𝑥𝑥 +
4−0<1
2
4

1

3

So this deviation is not profitable. What about a deviation into the middle, to < 𝑥𝑥 < ? Now a’s market share is
1
3
𝑥𝑥 +
4=1
4−
2
2
4

4

𝑥𝑥 +

3

4

1

This deviation is not profitable, either. The deviation to 𝑥𝑥 > is symmetric to the deviation to 𝑥𝑥 < , so that is clearly not
3

4

1

4

profitable. Finally, the deviation to 𝑥𝑥 = reduces a’s market share to , since she now enjoys a one-third share of the right4
6
half of the market. Since there are no profitable deviations, this is a Nash equilibrium.

Chapter 18
18.1

Information

Market for Lemons

18.1.1. Suppose a certified car is verified to have quality of at least 𝑞𝑞. Sellers will only offer a car for sale if 𝑞𝑞 ≤ 𝑞𝑞 ≤ 𝑝𝑝. In this case,the average quality of a car offered for sale is𝑞𝑞 𝑝𝑝
𝐸𝐸(𝑞𝑞) = +2 2
Buyers, meanwhile, will only purchase if𝑝𝑝 ≤3𝐸𝐸(𝑞𝑞)2

Substituting,𝑞𝑞 𝑝𝑝
3� + �
2 2
𝑝𝑝 ≤2
3𝑞𝑞 3𝑝𝑝𝑝𝑝 ≤+4
4
3𝑞𝑞 3𝑝𝑝𝑝𝑝 ≤+44
𝑝𝑝 3𝑞𝑞≤44
𝑝𝑝 = 3𝑞𝑞

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1

3

1

3

So if, for example, 𝑞𝑞 = , then 𝑝𝑝 = . All of the cars with quality levels ≤ 𝑞𝑞 ≤ will be offered for sale; these cars will
4

1

4

3

4

4

have an average quality level of . Buyers’ value of such a car is , so those trades will happen.
2

4

Gains from trade are the buyer’s value minus the seller’s value for all the trades that occur.
3𝑞𝑞

3𝑞𝑞

𝑞𝑞=𝑞𝑞

𝑞𝑞=𝑞𝑞

𝑞𝑞
3𝑞𝑞
𝐺𝐺1 = � � − 𝑞𝑞� 𝑑𝑑𝑑𝑑 = � 𝑑𝑑𝑑𝑑2
2
1

This is only the case until 𝑞𝑞 = , since quality level is limited above at 1. After this point,
1

𝐺𝐺2 = �

𝑞𝑞=𝑞𝑞

3

𝑞𝑞
𝑑𝑑𝑑𝑑
2

We want to know where these gains are maximized.
𝑑𝑑𝑑𝑑1 3𝑞𝑞 𝑞𝑞=− = 𝑞𝑞𝑑𝑑𝑞𝑞
2 2

1This is positive, so gains are increasing in 𝑞𝑞 for 0 ≤ 𝑞𝑞 ≤ . Above this point,
3

𝑞𝑞
𝑑𝑑𝑑𝑑2
=−
2
𝑑𝑑𝑞𝑞

1

This is negative, so gains are decreasing in 𝑞𝑞 for ≤ 𝑞𝑞 ≤ 1. Therefore, the quality certification that maximizes gains from3

1

trade is 𝑞𝑞 = . At this certification level, all cars above this quality will be offered for sale, the average quality of these cars
2

18.2

3

is 𝑞𝑞 = , so buyers are willing to pay 𝑝𝑝 = 1 and we’re consistent.
3

Myerson-Satterthwaite Theorem

18.2.1. Let ℎ(𝑟𝑟, 𝑐𝑐)be the profits of a seller who has cost 𝑐𝑐 and reports 𝑟𝑟.
ℎ(𝑟𝑟, 𝑐𝑐) = 𝑝𝑝(𝑣𝑣, 𝑟𝑟) − (1 − 𝑟𝑟)𝑐𝑐

Consider the seller’s strategy 𝑟𝑟 = 𝑟𝑟(𝑐𝑐). Now
𝑑𝑑ℎ(𝑟𝑟, 𝑐𝑐) 𝜕𝜕ℎ(𝑟𝑟, 𝑐𝑐) 𝑑𝑑𝑑𝑑 𝜕𝜕ℎ(𝑟𝑟, 𝑐𝑐)=+𝜕𝜕𝜕𝜕 𝑑𝑑𝑑𝑑
𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑

The first term here is zero, since the seller must be optimizing his gain as a function of r. Thus
𝑑𝑑ℎ(𝑟𝑟, 𝑐𝑐) 𝜕𝜕ℎ(𝑟𝑟, 𝑐𝑐)== −(1 − 𝑟𝑟) = −(1 − 𝑐𝑐)
𝜕𝜕𝜕𝜕
𝑑𝑑𝑑𝑑
What are the profits of the average seller?
1

1

0

0

� ℎ(𝑐𝑐, 𝑐𝑐) 𝑑𝑑𝑑𝑑 = ℎ(𝑐𝑐, 𝑐𝑐)𝑐𝑐|10 − �
1

1

𝑑𝑑ℎ
𝑐𝑐 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑

� ℎ(𝑐𝑐, 𝑐𝑐) 𝑑𝑑𝑑𝑑 = ℎ(𝑐𝑐, 𝑐𝑐)𝑐𝑐|10 − � −(1 − 𝑐𝑐) 𝑐𝑐 𝑑𝑑𝑑𝑑
0

1

1

0

0

0

� ℎ(𝑐𝑐, 𝑐𝑐) 𝑑𝑑𝑑𝑑 = �(1 − 𝑐𝑐) 𝑐𝑐 𝑑𝑑𝑑𝑑1

� ℎ(𝑐𝑐, 𝑐𝑐) 𝑑𝑑𝑑𝑑 =01

𝑐𝑐 2 𝑐𝑐 31− �=
2
3 𝑐𝑐=0 6

Thus, the only way to induce honesty is to offer the seller the entire gains from trade.

Chapter 19

Agency Theory

Introduction to Economic Analysis

22-34019.2

Cost of Providing Incentives

19.2.1. The principal needs to offer the agent an incentive to take the risks. One contract that achieves this is a contract with low (orzero, or negative) salary and high commission.

Introduction to Economic Analysis

22-341

Index
ABC, 21-274

Bargaining, 7-97, 7-98, 8-103, 13-188, 14-193, 18-242

ADM, 9-107, 21-270, 21-271, 21-272

Basketball, 9-107, 13-174, 13-187

Agency, 4-60, 7-95, 13-184, 19-249, 19-250, 19-251, 19-252, 19255, 19-256, 19-257, 20-266

Beer, 2-13, 2-15, 12-154, 12-162

Akerlof, George, 18-241, 18-242
Alcoa, 21-269
Allocation, 1-7, 6-84, 6-86, 7-96, 7-97, 14-189, 19-253
Ambiguity, 5-80, 6-86, 21-270
American Airlines, 15-208, 21-274
Analysis

Benefit Concentrated, 5-79
Bliss Point, 12-162, 12-163
Boeing, 10-125
Bosch, 21-271
Brands, 11-146, 21-274
British Petroleum, 1-7

Normative, 1-7, 1-8

Budget Line, 12-156, 12-157, 12-158, 12-160, 12-161, 12-163, 12164, 12-165, 14-195

Positive, 1-7, 1-8

Budget Set, 12-155, 12-160

Antitrust, 1-7, 17-232, 17-232, 21-269, 21-270, 21-271, 21-272, 21273, 21-274, 21-275, 21-276
Clayton Act, 21-270, 21-271, 21-272
FTC Act, 21-270
Market Power, 15-202, 15-203, 17-234
Monopoly Power, 15-202, 15-203, 15-206, 17-234, 17-235, 21269, 21-270, 21-274
Peckham Rule, 21-269
Predatory Pricing, 21-271, 21-272
Robinson Patman, 21-271
Sherman Act, 21-269, 21-270
SSNIP, 21-274, 21-276
Tying, 19-251, 20-266, 21-271, 21-272
Vertical Merger, 21-274, 21-276
AOL, 21-274
Arbitrage, 11-137, 11-139, 11-145, 11-146, 11-152, 15-208, 15-209,
15-210Certainty Equivalent, 1-9, 13-183, 13-184, 13-185, 13-186
Ceteris Paribus, 1-10, 1-11
Coase, Ronald, 7-97, 7-98
Cobb-Douglas Production Function, 9-109, 9-110, 9-112, 9-115, 9116, 9-117, 9-118, 9-119, 9-121, 10-127, 12-161, 12-162, 12-163,
12-164, 12-167, 12-169, 13-172, 14-191, 14-192, 14-196, 14-197,
14-198, 14-200, 14-201
Compact Disc, 12-157, 21-271
Comparative Advantage, 6-85, 6-86, 6-87, 6-88
Comparative Statics, 1-11, 3-29, 9-114, 9-117
Compensating Differential, 13-173, 13-174
Competition
Imperfect, 17-232, 17-233, 17-234, 17-235, 17-236, 21-275
Competitive Equilibrium, 7-94
Complement, 2-15, 2-16, 2-19, 2-20, 2-24, 2-25, 3-29, 9-110, 9-112,
9-115, 9-116, 12-162, 12-163, 12-169, 13-172, 13-173, 13-175,
19-255, 19-256

Arbitrage Condition, 11-145, 11-152

Concave, 6-82, 12-169, 12-170, 13-179, 13-183, 13-185, 13-188, 14193, 19-254, 19-255

Attitude, 19-249

Consols, 11-138

Auction, 1-7, 20-259, 20-261, 20-262, 20-263, 20-264, 20-265, 20266, 20-267

Consumer Surplus, 2-13, 2-14, 2-16, 2-17, 2-18, 2-22, 2-23, 3-29, 15210, 15-211

Bid-Increment, 20-259, 20-260, 20-263, 20-264
Common Values, 20-259, 20-260, 20-265
English, 20-259, 20-260, 20-261, 20-262, 20-263, 20-264, 20-266,
20-267
Linkage Principle, 20-266, 20-267

Consumption, 2-13, 2-14, 2-15, 2-16, 4-46, 4-48, 4-66, 4-67, 11-145,
11-152, 12-154, 12-155, 12-157, 12-159, 12-162, 12-164, 12-165,
12-167, 12-169, 13-171, 13-172, 13-173, 13-178, 13-179, 13-181,
13-182, 14-189, 14-196, 18-241
Contract Curve, 14-190, 14-191, 14-192, 14-193, 14-194, 14-195, 14196
Contracts, 2-18, 6-87, 15-210, 19-251, 19-252, 21-269, 21-270

Sealed-Bid, 20-260, 20-261, 20-262, 20-263, 20-264, 20-266, 20267

Convexity, 19-254, 19-255, 19-256

Vickrey, 20-263, 20-264

Cooperation, 16-230, 19-252, 21-273

Autarky, 14-193

Cartel, 2-25, 20-267, 21-269, 21-270, 21-273

Availability, 11-146

Tacit Collusion, 21-273

Coordination, 9-108, 16-222, 16-224, 16-230
Corporate Finance, 11-142
Cost, 1-8, 1-9, 1-10, 1-11, 2-13, 2-14, 2-18, 2-19, 2-20, 2-23, 2-24, 225, 4-43, 4-44, 4-45, 4-46, 4-50, 4-52, 4-54, 4-59, 5-70, 5-72, 573, 5-75, 5-76, 5-77, 5-78, 5-79, 5-80, 6-83, 6-84, 6-85, 6-86, 687, 7-90, 7-91, 7-92, 7-94, 7-95, 7-96, 7-97, 7-101, 8-102, 9-107,
9-111, 9-112, 9-113, 9-116, 9-118, 9-119, 9-120, 9-121, 10-122,
10-123, 10-124, 10-125, 10-126, 10-127, 10-128, 10-130, 10-132,
10-134, 11-137, 11-140, 11-141, 11-142, 11-144, 11-145, 11-148,
11-149, 11-152, 12-158, 13-175, 13-176, 13-177, 13-181, 13-183,
13-186, 13-187, 13-188, 15-202, 15-203, 15-204, 15-206, 15-207,
15-208, 15-209, 15-210, 15-211, 15-212, 15-213, 15-214, 17-233,
17-234, 17-237, 17-238, 17-239, 18-241, 18-242, 18-243, 18-244,
18-245, 18-247, 18-248, 19-249, 19-250, 19-251, 19-252, 19-253,
19-254, 19-255, 19-256, 19-257, 19-258, 20-265, 20-266, 21-271,
21-272
Fixed, 9-120, 9-121, 10-134, 17-234, 17-235, 17-236, 17-239
Long-Run, 5-78, 9-120
Marginal, 1-11, 2-18, 2-19, 2-20, 2-24, 5-69, 5-72, 5-75, 5-81, 685, 6-86, 6-87, 7-90, 8-102, 9-120, 9-121, 10-122, 10-123, 10124, 10-127, 15-202, 15-203, 15-204, 15-205, 15-206, 15-207,
15-209, 15-210, 15-211, 15-213, 15-214, 17-233, 17-234, 17236, 17-239, 18-246, 18-247
Opportunity, 1-8, 1-9, 5-69, 6-82, 6-83, 6-84, 6-85, 6-86
Short-Run, 9-120
Variable, 9-120, 9-121, 10-122, 10-123, 10-127, 10-130
Cost-Benefit Analysis, 1-8
Cournot, 17-232, 17-233, 17-234, 17-235, 17-236, 21-275

Dominant strategy, 16-216, 16-217, 16-226, 16-229, 20-259, 20-260,
20-262, 20-263, 20-264
DRAM, 2-13, 2-24, 10-134, 10-135
DuPont, 9-108
Durable Good, 4-66, 4-67, 11-148
Dynamic Optimization, 13-178, 13-180, 13-181, 13-182
eBay, 1-7, 2-21, 5-68, 20-259, 20-263, 20-264
Economy of Scale, 10-124, 10-125, 10-126, 10-127, 10-132, 10-134,
10-136, 15-202, 15-203, 17-234
Economy of Scope, 10-125
Edgeworth Box, 14-189, 14-192, 14-195, 14-196
Education, 1-8, 3-28, 4-39, 7-90, 7-94, 7-95, 11-141, 18-244, 18-245
Efficiency, 2-23, 2-25, 5-68, 5-74, 5-81, 6-86, 7-90, 7-92, 7-93, 7-94,
7-95, 7-96, 7-97, 7-99, 7-101, 8-102, 8-104, 8-105, 9-118, 10-132,
14-189, 14-190, 14-192, 14-193, 14-195, 14-196, 15-202, 15-211,
17-234, 17-239, 18-242, 18-243, 18-244
Elasticity, 3-28, 3-29, 5-71, 5-74, 5-77, 5-78, 5-79, 7-99, 7-100, 10132, 10-133, 11-150, 11-151, 15-204, 15-206, 15-207, 15-208, 15209, 15-210, 17-233
Demand, 3-27, 3-28, 3-29, 7-100, 11-146, 15-204, 17-233, 17234, 17-236
Supply, 3-28, 3-29
Unitary, 3-28, 3-29
Engel Curve, 12-167, 12-168, 12-169

Damages, 21-273

Entrepreneur, 2-20, 9-112, 9-113, 9-114, 9-115, 9-116, 9-117, 9-118,
10-122

Dead Weight Loss, 5-69, 5-70, 5-73, 5-74, 5-75, 5-76, 5-77, 5-80, 791, 15-204, 15-206, 17-234

Entry, 4-52, 5-80, 10-125, 15-211, 16-215, 16-216, 16-218, 17-234,
17-235, 17-239, 21-271

DemandElasticity, 3-27, 3-28, 3-29, 5-71, 5-72, 5-78, 7-94, 7-99, 7-100,
11-146, 11-151, 15-204, 15-207, 15-208, 15-209, 15-210, 17233, 17-234, 17-236

Equilibrium, 2-13, 2-22, 2-23, 3-29, 3-30, 5-69, 5-70, 5-71, 5-74, 575, 5-76, 5-77, 5-79, 5-80, 7-93, 7-99, 7-100, 8-102, 8-104, 9-118,
10-127, 10-128, 10-130, 10-131, 10-132, 10-133, 10-134, 10-135,
10-136, 11-150, 13-177, 14-194, 14-195, 14-196, 14-197, 14-198,
14-199, 14-200, 14-201, 16-216, 16-218, 16-219, 16-220, 16-221,
16-222, 16-223, 16-224, 16-226, 16-228, 16-229, 16-230, 16-231,
17-236, 17-237, 17-238, 17-239, 18-245, 18-246, 18-248, 20-260,
20-261, 21-273

Market, 2-21, 2-22

Exclusive Dealing, 21-271, 21-272

Perfect Substitute, 9-110, 9-112, 12-163

Expenditure Shares, 12-162, 12-163

Compensated, 12-164
Constant Elasticity, 3-29, 11-148, 15-206, 15-207

Depreciation, 11-149, 11-151, 11-152, 11-153, 13-176
Differentiation, 17-237, 17-238

Externality, 7-90, 7-92, 7-93, 7-94, 7-95, 7-96, 7-97, 7-98, 7-99, 7100, 7-101, 10-134, 15-202, 18-247, 18-248

Horizontal, 17-237, 17-238

Common Resource, 7-92

Vertical, 17-237, 17-238

Commons, 7-92, 7-93, 7-101, 11-146, 16-224

Diminishing Marginal Returns, 6-82, 6-84, 6-85, 6-86

Network, 10-134, 15-202, 15-203

Diminishing Marginal Value, 2-13, 2-16

Extinction, 7-92, 7-99, 7-100, 7-101

Discounting, 11-143, 11-146, 11-147, 11-149, 11-150, 11-152, 11153, 16-230, 16-231

Exxon-Mobil, 9-108, 21-274

Disney, 15-202, 17-236, 21-274

Factor Price Equalization, 6-88

Distribution, 4-41, 8-105, 11-143, 13-186, 13-188, 18-241, 18-242,
18-246, 20-260, 20-261, 20-262, 20-264, 20-265

Factors of Production, 6-87, 6-88, 6-89

Factor of Production, 6-88

FedEx, 15-202
Firm, 9-107, 9-108, 16-225, 16-229, 16-230, 17-232, 19-256

Competitive, 10-122, 10-127

Hotelling Model, 17-236, 17-237, 17-238, 17-239, 17-240

Corporation, 1-10, 9-107, 9-108, 19-249, 19-251, 21-269

Hotelling, Harold, 17-236

Non-Profit, 9-107, 9-108

Hypothesis, 7-97, 12-164, 16-220, 20-261

Partnership, 9-107, 9-108

Hysteresis, 2-25, 2-26

Proprietorship, 9-107, 9-108

IBM, 10-125

Fixed-Proportions, 9-110, 9-112

Identification, 15-208

Fluctuations, 4-65, 4-66, 4-67, 19-252

Income, 1-8, 2-15, 4-41, 4-42, 4-43, 4-44, 4-45, 4-46, 4-48, 4-52, 459, 4-61, 4-62, 5-68, 5-74, 10-128, 12-154, 12-157, 12-163, 12164, 12-165, 12-166, 12-167, 12-169, 13-171, 13-173, 13-175, 13178, 13-179, 13-180, 13-181, 13-182, 15-208

Ford, 1-7
Foreclosure, 1-7, 21-274, 21-276
Free Market, 5-68, 5-76
Free-Rider, 8-103
Gains from Trade, 2-14, 2-23, 5-69, 5-72, 5-73, 5-74, 5-75, 5-76, 577, 6-85, 6-86, 6-87, 7-97, 11-149, 15-210, 15-211, 17-234, 18242, 18-243, 18-244, 19-251
Game Theory, 16-215, 16-218, 16-219
Battle of the Sexes, 16-219, 16-221, 16-228, 16-230
Common Knowledge, 16-230

Income Effect, 12-163, 12-164, 12-166, 12-167, 12-169, 13-173, 13179
Indifference Curve, 12-158, 12-159, 12-160, 12-161
Inferior Good, 2-15, 2-16, 12-166, 12-167, 12-169
Information, 2-24, 4-46, 4-47, 10-125, 11-141, 16-215, 18-241, 18242, 18-247, 20-259, 20-262, 20-264, 20-265, 20-266, 20-267, 20268, 21-273
Intertemporal Budget Constraint, 13-178, 13-180, 13-181, 13-182
Inventory, 2-22, 11-152, 11-153

Elimination of Dominated Strategies, 16-216, 16-217, 16-218, 16219

Isocost, 9-119

Folk Theorem, 16-230, 16-231

Isoquant, 9-109, 9-119, 12-163, 12-166, 14-190, 14-193, 14-195

Grim Trigger Strategy, 16-229, 16-230, 16-231, 21-273

Managers, 9-107, 9-108, 10-125, 21-272

Mixed Strategy, 16-221, 16-222, 16-223, 16-224, 16-226, 18-246

Marginal Product, 9-110, 9-111, 9-112, 9-115, 10-126, 10-127

Pure Strategy, 16-221, 16-222, 16-223, 16-224, 16-226, 18-246,
18-248

Value of, 9-111, 9-112, 9-113, 9-116, 9-117, 10-126
Marginal Rate of Substitution, 12-158, 12-159, 12-161, 12-169

Second-Mover Advantage, 16-228

Marginal Rate of Technical Substitution, 9-119

Strategic Behavior, 16-215

Marginal Returns, Diminishing, 6-82, 6-84, 6-85, 6-86

Subgame Perfection, 16-227, 16-228, 16-229, 16-230, 19-250

Marginal Revenue, 15-203, 15-204, 15-206

Gasoline, 1-7, 2-13, 2-15, 2-19, 2-24, 2-25, 5-68, 7-95, 9-108, 10130, 10-132, 13-186, 20-266

Marginal Value, Diminishing, 2-13, 2-16

General Electric, 21-272, 21-273, 21-274
General Equilibrium, 14-195, 14-196
Welfare Theorems, 14-195, 14-196
General Motors, 9-108
Chevrolet, 3-28

Market for Lemons, 18-242
Marketing, 9-108
Markets, 1-7, 1-8, 1-10, 2-22, 2-24, 2-26, 5-68, 7-90, 7-93, 10-136,
11-146, 18-241, 18-243, 18-244, 18-245, 18-247, 18-248, 20-259,
20-267, 20-268, 21-274, 21-275, 21-276
Maximum Sustainable Yield, 11-147, 11-148

Goldwyn, Samuel, 20-264

McAfee, R. Preston, 9-108, 18-242

Government, 1-7, 1-8, 1-10, 4-39, 4-46, 4-48, 4-53, 4-54, 4-55, 4-56,
4-57, 4-58, 4-59, 4-60, 4-61, 4-62, 5-68, 5-69, 5-70, 5-71, 5-72, 573, 5-76, 5-79, 5-80, 5-81, 7-94, 7-95, 7-97, 7-98, 9-107, 11-137,
11-138, 13-171, 13-180, 13-186, 15-202, 20-259, 20-260, 20-264,
20-266, 20-267, 21-273, 21-274, 21-275, 21-276

Mercedes, 21-271

Greyhound, 21-275
Gross Domestic Product, 4-46, 4-47, 4-48, 4-50, 4-53, 4-54, 4-55, 456, 4-59, 4-60, 4-61, 4-62, 4-63, 4-64
Holmstrom, Bengt, 19-256
Homo Economicus, 1-10, 1-11
Homogeneity, 8-105, 19-254, 19-255, 19-256
Homogeneous Function, 10-127, 19-253, 19-254, 19-255, 19-258

Merger, 21-271, 21-272, 21-273, 21-274, 21-275, 21-276
Horizontal, 21-274, 21-276
Microsoft, 1-7, 2-24, 15-202, 15-203, 16-216, 16-217, 21-270, 21271
Milgrom, Paul, 19-256, 20-266
Monopoly, 5-68, 5-72, 5-73, 15-202, 15-203, 15-204, 15-206, 15207, 15-209, 15-211, 15-212, 15-213, 16-215, 17-232, 17-233, 17234, 17-235, 18-247, 21-269, 21-270, 21-271, 21-272, 21-273, 21274, 21-275, 21-276
Monopoly Power, 15-202, 15-203, 15-206, 17-234, 17-235, 21-269,
21-270, 21-274

Morgenstern, Oskar, 16-215

Reservation, 2-17, 13-186, 13-187, 13-188

Mortgage, 11-138, 11-144

Price – Cost Margin, 17-233, 17-234, 21-275

Multi-Tasking, 19-253, 19-255, 19-256

Price Discrimination, 15-207, 15-208, 15-209, 15-210, 15-211, 18245, 21-271, 21-272, 21-275

Myerson, Roger, 18-242, 18-243, 18-244
Myerson-Satterthwaite Theorem, 18-242, 18-243, 18-244
Nash, John, 16-215, 16-218
Netscape, 1-7, 21-270
Network, 10-134, 15-202, 15-203, 21-274
Newton, Sir Isaac, 7-98
Nonexcludability, 8-102, 8-103
Nonrivalry, 8-102, 8-103
Normal Good, 12-166, 12-167, 12-169, 15-208
Northwest, 6-87, 6-88
NPV, 11-138, 11-139, 11-140, 11-141, 11-142, 11-143, 11-144, 11145
Numeraire, 12-157, 14-197
Ohlin, Bertil, 6-88
Oil, 1-7, 2-13, 2-19, 2-20, 2-25, 4-49, 4-61, 7-93, 7-95, 9-108, 10130, 11-140, 11-141, 11-142, 11-144, 11-145, 11-146, 11-152, 13174, 20-259, 20-260, 20-264, 20-265, 20-266, 21-269, 21-274
Oligopoly, 17-232, 17-233, 21-275, 21-276
OPEC, 2-25
Opportunity Cost, 1-8, 1-9, 5-69, 6-82, 6-83, 6-84, 6-85, 6-86
Option Value of Investment, 11-142, 11-145
Options, 1-9, 11-142, 11-144, 11-145
O'Rourke, P. J., 19-249
Pareto Efficiency, 14-190, 14-191, 14-195, 14-196
Partnership, 9-107, 9-108
Patent, 9-111, 15-202, 18-241, 18-242
Perron-Frobenius Theorem, 14-197, 14-198
Peter Principle, 10-125
Pigou, Arthur Cecil, 7-94

Coupons, 15-209
Direct, 15-209
Indirect, 15-209
Quantity Discount, 15-209
Price Dispersion, 18-245, 18-248
Price Floor, 5-73, 5-74, 5-75, 5-76, 5-77, 5-79, 5-80
Price Support, 5-79, 5-80
Price System, 6-86, 14-193, 14-194, 14-195, 14-196, 15-208, 18-241
Price-Cost Margin, 15-204, 17-232
Pricing
Ramsey, 11-145, 15-214
Private Values, 20-259, 20-260, 20-261, 20-262, 20-263, 20-264, 20267
Production Possibilities Frontier, 6-82, 6-83, 6-84, 6-85, 6-87
Property Rights, 7-97, 7-98
Proprietorship, 9-107, 9-108
Public Good, 8-102, 8-103, 8-104, 8-105, 16-224
Quintiles, 4-41, 4-42, 4-45
Raising Rivals’ Cost, 21-274, 21-276
Ramsey Pricing, 11-145, 15-214
Ramsey, Frank, 11-145
RE/MAX, 19-251
Reagan, Ronald, 4-53, 4-54
Regulation
Price-Cap, 15-212
Rent Control, 5-77, 5-78, 5-79
Rents, 5-78, 9-112

Porsche, 2-15, 11-148, 11-149, 15-202

Research and Development, 4-60, 4-61, 10-125, 10-126, 17-239, 17240

Post Office, US, 15-202

Reservation Price, 2-17, 13-186, 13-187, 13-188

Preferences, 1-8, 2-16, 7-90, 8-104, 8-105, 11-144, 12-154, 12-155,
12-159, 12-160, 12-161, 13-175, 13-177, 13-178, 13-184, 14-190,
14-192, 14-199, 14-200, 16-225, 16-230, 17-236, 17-237, 18-241

Revealed Preference, 9-114, 9-115, 15-207

Present Value, 11-137, 11-138, 11-139, 11-140, 11-141, 11-142, 11145, 11-146, 11-150, 11-152, 13-176, 13-178, 13-179, 13-180, 13182, 16-230, 16-231, 18-244, 21-273
Price
Ceiling, 5-74, 5-75, 5-76, 5-77
Hedonic, 1-9
Law of One, 18-245, 18-247
Peak Load, 15-213, 15-214

Revenue equivalence, 20-261, 20-262
Risk, 1-9, 2-13, 5-80, 9-113, 10-125, 11-137, 11-140, 11-141, 11142, 11-144, 11-153, 13-182, 13-183, 13-184, 13-185, 13-186, 13188, 19-249, 19-250, 19-251, 19-252, 20-262, 20-265, 20-266, 20267, 21-272
Certainty Equivalent, 1-9, 13-183, 13-184, 13-185, 13-186
Risk Management, 1-9, 10-125
Risk Aversion, 13-184, 13-185, 19-251, 19-252, 20-262, 20-267
Risk Premium, 1-9, 13-183, 13-184, 13-185, 13-186
Rivalry, 9-108

Roosevelt, Teddy, 21-270

Market, 2-21, 10-127

S&P 500, 13-186

Substitute, 2-19, 2-20, 2-25, 2-26

Samuelson, Paul, 6-88
Satiation, 12-162
Satterthwaite, Mark, 18-242
Saving, 2-25, 11-137, 11-146
Scale Economy, 10-125, 15-202
Schelling, Thomas, 16-215
Schwarzenegger, Arnold, 12-154
Sears, 9-108
Second-Price Auction, 20-263, 20-264
Self-Interest, 1-10, 1-11
Selten, Reinhart, 16-227
Service, 2-22, 2-23, 4-52, 4-57, 5-73, 5-74, 5-76, 6-86, 9-112, 12158, 15-202, 15-211, 15-212, 16-216, 21-271, 21-274
Shadow Value, 9-116, 9-117
Sharecropper, 19-251

Surplus, 2-13, 2-14, 2-16, 2-17, 2-22, 2-23, 4-62, 5-69, 5-70, 5-74, 576, 5-79, 5-80, 13-173, 15-210
Tax
Ad Valorem, 5-68, 5-72
Excess Burden of, 5-72, 5-73
Excise, 4-61, 4-62, 5-68
Income, 4-61, 4-62, 5-68
Sales, 1-8, 4-61, 5-68, 9-108
Time preference, 13-178, 13-179
Trailways, 21-275
Transaction Costs, 5-68, 11-137
Truman, Harry, 1-10
Tyranny of the Majority, 5-79
U. S. Federal Trade Commission, 21-269, 21-270, 21-271, 21-273,
21-274

Shortage, 2-13, 2-22, 2-23, 5-75, 5-76, 5-78, 11-146, 13-173

U.S. Department of Justice, 1-7, 21-269, 21-270, 21-271, 21-272, 21273, 21-274

Signaling, 18-244, 18-245

Uncertainty, 2-25, 11-141, 11-142, 11-145, 11-152, 20-267

Smith, Adam, 6-84

Unitization, 7-93

Sony, 1-7, 13-186, 15-202

Utility, 8-103, 8-104, 12-154, 12-155, 12-158, 12-159, 12-160, 12161, 12-162, 12-163, 12-164, 12-165, 12-166, 12-169, 12-170, 13171, 13-172, 13-177, 13-179, 13-182, 13-183, 13-184, 13-185, 14189, 14-190, 14-191, 14-192, 14-193, 14-194, 14-195, 14-196, 14197, 14-198, 14-201, 18-243, 19-250, 19-251, 19-252, 19-255, 19257

Spence, Michael, 18-244
Standard Oil, 9-108, 21-269, 21-271
Standardization, 9-107, 15-202, 18-245
Statistics, 4-32, 4-47, 4-65, 4-67, 18-245
Correlation, 14-199, 14-200
Normal Distribution, 13-184, 20-265
Steady State, 2-22, 7-98, 7-99, 7-100, 7-101, 16-219
Strategy, 5-76, 7-95, 7-96, 8-102, 10-122, 11-142, 11-143, 11-150,
12-170, 13-171, 15-211, 15-212, 16-215, 16-216, 16-217, 16-218,
16-219, 16-220, 16-221, 16-222, 16-223, 16-224, 16-229, 16-230,
16-231, 20-259, 20-262, 21-273
Substitute, 2-15, 2-16, 2-19, 2-20, 2-24, 2-25, 2-26, 5-74, 5-77, 9115, 10-133, 15-208, 17-233, 19-258, 21-270, 21-274
Supergames, 16-229, 16-230, 16-231
Supply, 1-11, 2-13, 2-18, 2-19, 2-20, 2-21, 2-22, 2-23, 2-24, 2-25, 226, 3-28, 3-29, 3-30, 3-31, 4-50, 5-68, 5-69, 5-70, 5-71, 5-72, 573, 5-74, 5-75, 5-77, 5-78, 5-79, 5-80, 6-85, 6-86, 7-92, 7-94, 796, 10-126, 10-127, 10-128, 10-129, 10-130, 10-131, 10-132, 10133, 10-134, 10-135, 10-136, 11-137, 11-145, 11-146, 11-148, 11149, 11-152, 12-154, 12-155, 12-157, 13-171, 13-172, 13-173, 13175, 13-178, 14-194, 14-195, 14-196, 14-197, 14-199, 15-204, 19256, 20-266

Compensated Demand, 12-164
Convex Preferences, 12-159, 12-160, 12-161
Indifference Curve, 12-158, 12-159, 12-160, 12-161
Quasilinear, 12-170
Satiation, 12-162
von Neumann-Morgenstern, 13-182, 13-183
Value
Marginal, 1-11, 2-13, 2-14, 2-15, 2-16, 2-18, 5-68, 5-72, 7-91, 795, 9-115, 11-149, 11-150, 13-172, 13-177, 13-179, 15-211
Vickrey, William, 20-263
Video Home System, 2-23, 15-202
von Neumann, John, 16-215
VotingMedian Voter, 8-104
Warranties, 18-241, 18-242

Complement, 2-19, 2-20, 2-25

Welfare Analysis, 1-8

Constant Elasticity, 3-29

Western Electric, 11-151

Elasticity, 3-28, 3-29, 5-71, 5-72

Willingness To Pay, 1-8, 2-13, 2-15, 2-17, 5-69, 15-208, 20-259

Increase in, 2-19, 2-20, 2-24, 2-25, 2-26