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ned an official definition of the poverty threshold, a minimum annual income that is considered adequate to purchase the necessities of life. Families whose incomes fall below the poverty threshold are considered poor. The history of this official definition is described in the upcoming For Inquiring Minds. The official poverty threshold depends on the size and composition of a family. In 2007 the poverty threshold for an adult living alone was $10,787; for a household consisting of two adults and two children, it was $21,027. The poverty threshold is the annual income below which a family is officially considered poor. 482 Defining Poverty Who decided how much income an American family needs to escape poverty? Mollie Orshansky! Orshansky, a research analyst at the Social Security Administration, developed initial estimates of the poverty threshold in 1963–1964. Orshansky started by estimating the cost of buying an inexpensive but nutritionally adequate diet. She then observed that families with children spent about one-third of their income on food; so she argued that any family earning less than three times the cost of purchasing an adequate diet did not have adequate income. Was this the right measure of poverty? When it was created, Orshansky’s calculation made a lot of sense, and it has been the basis for U.S. poverty statistics ever since. But many experts now think that this measure of poverty is badly outdated because the composition of spending by low-income families has changed significantly since the 1960s. On average, the share of income spent on food has fallen to less than 20%, but the share spent on things such as housing, health care, transportation, and child care has risen. Many state governments have recognized this trend and now make families with incomes up to 150% or 200% of the poverty threshold eligible to receive assistance from some poverty programs. Some states offer assistance to families with incomes as high as 275% to 300% of the poverty threshold. The poverty rate is the percentage of the population with incomes below the poverty threshold. Trends in Poverty Contrary to popular misconceptions, although the official poverty threshold is adjusted each year to reflect changes in the cost of living, it has not been adjusted upward over time to reflect the long-term rise in the standard of living of the average American family. As a result, as the economy grows and becomes more prosperous, and average incomes rise, you might expect the percentage of the population living below the poverty threshold to steadily decline. Somewhat surprisingly, however, this hasn’t happened. Figure 19-1 shows the U.S. poverty rate—the percentage of the population living below the poverty threshold— from 1959 to 2006. As you can see, the poverty rate fell steeply during the 1960s and early 1970s. Since then, however, it has fluctuated up and down, with no clear trend. In fact, in 2006 the poverty rate was higher than it had been in 1973. Who Are the Poor? Many Americans probably hold a stereotyped image of poverty: an African-American or Hispanic family with no husband present and the female head of the household unemployed at least part of the time. This picture isn’t completely off-base: poverty is disproportionately high among African-Americans and FIGURE 19-1 Trends in the U.S. Poverty Rate, 1959–2006 The poverty rate fell sharply from the 1960s to the early 1970s but has not shown a clear trend since then. Source: U.S. Census Bureau. U.S. poverty rate 25% 20 15 10 1959 1970 1980 1990 2000 2006 Year FA R E S TAT E 483 POOR PEOPLE IN RICH COUNTRIES How does America’s poverty problem compare with the situation in other wealthy countries? The answer depends, in part, on the definition of poverty—although the United States performs relatively poorly regardless of the definition. The figure shows poverty rates in 2000 in five rich countries, under two definitions. One definition, which is widely used in international comparisons, defines someone as poor if they live in a household with less than half their country’s median income, which we define in an upcoming section. This is a relative definition of poverty: you’re poor if you have a low income compared with other people in your country. As the orange bars in the figure show, by this measure the United States has high poverty compared with other rich nations. One objection to this comparison is that America is even richer than other rich countries and has a somewhat higher median income than the other countries shown. Does the United States still have high poverty when this is taken into account? Poverty rate 18% 17.0% Relative Absolute 12.4% 11.4% 8.7% 8.3% 7.6% 6.9% 7.5% 6.5% 16 14 12 10 8 6 4 2 0 United States United Kingdom Canada Germany Sweden The purple bars use a measure of absolute poverty, similar to the official U.S. poverty threshold. The United States is no longer the country with the highest poverty rate by this measure—it is in second place. By either measure, the United States has a high poverty rate compared to other rich countries. Source: T. Smeeding, “Poor People in Rich Nations: The United States in Comparative Perspective,” Syracuse University working paper, 2006. Hispanics as well as among female-headed households. But a majority of the poor don’t fit the stereotype. In 2006, about 36.5 million Americans were in poverty—12.3% of the population, or about one in eight persons. About one-quarter of the poor were African-American and a roughly equal number, Hispanic. Within these two groups, poverty rates were well above the national average: 24.3% of African-Americans and 20.6% of Hispanics. But there was also widespread poverty among non-Hispanic Whites, who had a poverty rate of 8.2%. There is also a correlation between family makeup and poverty. Female-headed families with no husband present had a very high poverty rate: 30.5%. Married couples were much less likely to be poor, with a poverty rate of only 4.9%; still, about 38% of poor families were married couples. What really stands out from the data, however, is the association between poverty and lack of adequate employment. Adults who work full time are very unlikely to be poor: only 2.7% of full-time workers were poor in 2006. Adults who worked part time or not at all during the year made up 88.3% of the poor in 2006. Many industries, particularly in the retail and service sectors, now rely primarily on part-time workers. Part-time work typically lacks benefits such as health plans, paid vacation days, and retirement benefits, and it also usually pays a lower hourly wage than comparable full-time work. As a result, many of the poor are members of what analysts call the working poor: workers whose income falls at or below the poverty threshold. What Causes Poverty? Poverty is often blamed on lack of education, and educational attainment clearly has a strong positive effect on income level—those with more education earn, on average, higher incomes than those with less education. For example, in 1979 the average hourly wage of men with a college degree was 36% higher than that of 484 men with only a high school diploma; by 2006 the “college premium” had increased to 83%. Lack of proficiency in English is also a barrier to higher income. For example, Mexican-born male workers in the United States—two-thirds of whom have not graduated from high school and many of whom have poor English skills—earn less than half of what native-born men earn. And it’s important not to overlook the role of racial and gender discrimination; although less pervasive today than 50 years ago, discrimination still erects formidable barriers to advancement for many Americans. Non-Whites earn less and are less likely to be employed than Whites with comparable levels of education. Studies find that African-American males suffer persistent discrimination by employers in favor of Whites, African-American women, and Hispanic immigrants. Women earn lower incomes than men with similar qualifications. In addition, one important source of poverty that should not be overlooked is bad luck. Many families find themselves impoverished when a wage-earner loses a job or a family member falls seriously ill. Consequences of Poverty The consequences of poverty are often severe, particularly for children. Currently, more than 17.4% of children in the United States live in poverty. Poverty is often associated with lack of access to health care, which can lead to further health problems that erode the ability to attend school and work later in life. Affordable housing is also frequently a problem, leading poor families to move often, disrupting school and work schedules. Recent medical studies have shown that children raised in severe poverty tend to suffer from lifelong learning disabilities. As a result, American children growing up in or near poverty don’t have an equal chance at the starting line: they tend to be at a disadvantage throughout their lives. For example, even talented children who come from poor families are unlikely to finish college. Table 19-1 shows the results of a long-term survey conducted by the U.S. Department of Education, which tracked a group of students who were in eighth grade in 1988. That year, the students took a mathematics test that the study used as an indicator of their innate ability; the study also scored students by the socioeconomic status of their families, a measure that took into account their parents’ income and employment. As you can see, the results were disturbing: only 29% of students who were in the highest-scoring 25% on the test but whose parents were of low status finished college. By contrast, the equally talented children of high-status parents had a 74% chance of finishing college—and children of high-status parents had a 30% chance of finishing college even if they had low test scores. What this tells us is that poverty is, to an important degree, self-perpetuating: the |
children of the poor start at such a disadvantage relative to other Americans that it’s very hard for them to achieve a better life. TABLE 19-1 Percent of Eighth-Graders Finishing College, 1988 Mathematics test score in bottom quartile Mathematics test score in top quartile Parents in bottom quartile Parents in top quartile 3% 30 29% 74 Source: National Center for Education Statistics, The Condition of Education 2003, p. 47. Economic Inequality The United States is a rich country. In 2006, the average U.S. household had an income of more than $66,000, far exceeding the poverty threshold. How is it possible, then, that so many Americans still live in poverty? The answer is that income is FA R E S TAT E 485 TABLE 19-2 U.S. Income Distribution in 2006 Income group Income range Average income Percent of total income Bottom quintile Less than $20,032 Second quintile $20,032 to $37,771 Third quintile $37,771 to $60,000 Fourth quintile $60,000 to $97,030 Top quintile More than $97,030 Top 5% More than $174,000 $11,352 28,777 48,223 76,329 168,170 297,405 3.4% 8.6 14.5 22.9 50.5 22.3 Mean income = $66,570 Median income = $48,201 Source: U.S. Census Bureau. unequally distributed, with many households earning much less than the average and others earning much more. Table 19-2 shows the distribution of pre-tax income among U.S. families in 2006— income before federal income taxes are paid—as estimated by the Census Bureau. Households are grouped into quintiles, each containing 20% or one-fifth of the population. The first, or bottom, quintile contains households whose income put them below the 20th percentile in income, the second quintile contains households whose income put them between the 20th and 40th percentiles, and so on. The Census Bureau also provides data on the 5% of families with the highest incomes. For each group, Table 19-2 shows three numbers. The second column shows the range of incomes that define the group. For example, in 2006, the bottom quintile consisted of households with annual incomes of less than $20,032; the next quintile of households with incomes between $20,032 and $37,771; and so on. The third column shows the average income in each group, ranging from $11,352 for the bottom fifth to $297,405 for the top 5 percent. The fourth column shows the percentage of total U.S. income received by each group. At the bottom of Table 19-2 are two useful numbers for thinking about the incomes of American households. Mean household income, also called average household income, is the total income of all U.S. households divided by the number of households. Median household income is the income of a household in the exact middle of the income distribution—the level of income at which half of all households have lower income and half have higher income. It’s very important to realize that these two numbers do not measure the same thing. Economists often illustrate the difference by asking people first to imagine a room containing several dozen more or less ordinary wage-earners, then to think about what happens to the mean and median incomes of the people in the room if a Wall Street tycoon, some of whom earn more than a billion dollars a year, walks in. The mean income soars, because the tycoon’s income pulls up the average, but median income hardly rises at all. This example helps explain why economists generally regard median income as a better guide to the economic status of typical American families than mean income: mean income is strongly affected by the incomes of a relatively small number of veryhigh-income Americans, who are not representative of the population as a whole; median income is not. What we learn from Table 19-2 is that income in the United States is quite unequally distributed. The average income of the poorest fifth of families is less than a quarter of the average income of families in the middle, and the richest fifth have an average income more than three times that of families in the middle. The incomes Mean household income is the average income across all households. Median household income is the income of the household lying at the exact middle of the income distribution. 486 The Gini coefficient is a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles. Figure 19-2 Income Inequality Around the World The highest levels of income inequality are found in Africa and Latin America. The most equal distributions of income are in Europe, especially in Scandinavia. Compared to other wealthy countries, the United States, with a Gini coefficient of 0.470 in 2006, has unusually high inequality. Source: World Bank, Human Development Report 2007–2008. of the richest fifth of the population are, on average, about 15 times as high as those of the poorest fifth. In fact, the distribution of income in America has become more unequal since 1980, rising to a level that has made it a significant political issue. The Economics in Action at the end of this section discusses long-term trends in U.S. income inequality, which declined in the 1930s and 1940s, was stable for more than 30 years after World War II, but began rising again in the late 1970s. It’s often convenient to have a single number that summarizes a country’s level of income inequality. The Gini coefficient, the most widely used measure of inequality, is based on how disparately income is distributed across the quintiles. A country with a perfectly equal distribution of income—that is, one in which the bottom 20% of the population received 20% of the income, the bottom 40% of the population received 40% of the income, and so on—would have a Gini coefficient of 0. At the other extreme, the highest possible value for the Gini coefficient is 1—the level it would attain if all a country’s income went to just one person. One way to get a sense of what Gini coefficients mean in practice is to look at international comparisons. Figure 19-2 shows the most recent estimates of the Gini coefficient for many of the world’s countries. Aside from a few countries in Africa, the highest levels of income inequality are found in Latin America, especially Brazil; countries with a high degree of inequality, such as Brazil, have Gini coefficients close to 0.6. The most equal distributions of income are in Europe, especially in Scandinavia; countries with very equal income distributions, such as Sweden, have Gini coefficients around 0.25. Compared to other wealthy countries, the United States, with a Gini coefficient of 0.470 in 2006, has unusually high inequality, though it isn’t as unequal as in Latin America. How serious an issue is income inequality? In a direct sense, high income inequality means that some people don’t share in a nation’s overall prosperity. As we’ve seen, rising inequality explains how it’s possible that the U.S. poverty rate has failed to fall for the past 35 years even though the country as a whole has become considerably NORTH AMERICA EUROPE ASIA AFRICA SOUTH AMERICA 0–0.29 0.30–0.39 0.40–0.49 0.50–0.59 0.60–1 No Data AUSTRALIA FA R E S TAT E 487 richer. Also, extreme inequality, as found in Latin America, is often associated with political instability, because of tension between a wealthy minority and the rest of the population. It’s important to realize, however, that the data shown in Table 19-2 overstate the true degree of inequality in America, for several reasons. One is that the data represent a snapshot for a single year, whereas the incomes of many individual families fluctuate over time. That is, many of those near the bottom in any given year are having an unusually bad year and many of those at the top are having an unusually good one. Over time, their incomes will revert to a more normal level. So a table showing average incomes within quintiles over a longer period, such as a decade, would not show as much inequality. Furthermore, a family’s income tends to vary over its life cycle: most people earn considerably less in their early working years than they will later in life, then experience a considerable drop in income when they retire. Consequently, the numbers in Table 19-2, which combine young workers, mature workers, and retirees, show more inequality than would a table that compares families of similar ages. Despite these qualifications, there is a considerable amount of genuine inequality in the United States. Moreover, the fact that families’ incomes fluctuate from year to year isn’t entirely good news. Measures of inequality in a given year do overstate true inequality. But those year-to-year fluctuations are part of a problem that worries even affluent families—economic insecurity. Economic Insecurity As we stated earlier, although the rationale for the welfare state rests in part on the social benefits of reducing poverty and inequality, it also rests in part on the benefits of reducing economic insecurity, which afflicts even relatively well-off families. One form economic insecurity takes is the risk of a sudden loss of income, which usually happens when a family member loses a job and either spends an extended period without work or is forced to take a new job that pays considerably less. In a given year, according to recent estimates, about one in six American families will see their income cut in half from the previous year. Related estimates show that the percentage of people who find themselves below the poverty threshold for at least one year over the course of a decade is several times higher than the percentage of people below the poverty threshold in any given year. Even if a family doesn’t face a loss in income, it can face a surge in expenses. The most common reason for such surges is a medical problem that requires expensive treatment, such as heart disease or cancer. Many Americans have health insurance that covers a large share of their expenses in such cases, but a substantial number either do not have health insuranc |
e or rely on insurance provided by the government. ➤ECONOMICS IN ACTION Long-Term Trends in Income Inequality in the United States Does inequality tend to rise, fall, or stay the same over time? The answer is yes—all three. Over the course of the past century, the United States has gone through periods characterized by all three trends: an era of falling inequality during the 1930s and 1940s, an era of stable inequality for about 35 years after World War II, and an era of rising inequality over the past generation. Detailed U.S. data on income by quintiles, as shown in Table 19-2, are only available starting in 1947. Panel (a) of Figure 19-3 on the next page shows the annual rate of growth of income, adjusted for inflation, for each quintile over two periods: from 488 FIGURE 19-3 Trends in U.S. Income Inequality (a) Rates of Income Growth Since 1947 (b) The Richest 10% of Americans, 1917–2006 Growth in income 1947–1980 1980–2005 2.5% 2.37% 2.30% 2.36% 2.11% 2.05% 1.88% 2.0 1.5 1.0 0.5 0 0.99% 0.68% 0.48% 0.11% Share of total income going to top 10% 50% 45 40 35 30 Bottom Second Third Fourth Top 1917 1930 1960 Income group (quintile) 1990 2006 Year Panel (a) compares the rates of income growth for quintiles over two periods since World War II. In the earlier period, income grew at about the same rate for all quintiles, so the distribution of income was more or less stable. Since 1980, however, income has grown much more rapidly at the top than in the middle or at the bottom, so inequality has increased. Panel (b) shows the income share going to the richest 10% of the population since 1917. This shows a sharp fall in inequality between the 1930s and the late 1940s—the Great Compression—and a rise in inequality since 1980. Sources: U.S. Census Bureau (panel (a)). Emmanuel Saez, “Striking It Richer: The Evolution of Top Incomes in the United States,” University of California, Berkeley, discussion paper, 2008 (panel (b)). 1947 to 1980, and from 1980 to 2005. There’s a clear difference between the two periods. In the first period, income within each group grew at about the same rate—that is, there wasn’t much change in the inequality of income, just growing incomes across the board. After 1980, however, incomes grew much more quickly at the top than in the middle, and more quickly in the middle than at the bottom. So inequality has increased substantially since 1980. Overall, inflation-adjusted income for the top quintile rose 60% between 1980 and 2005, but it rose only 3% for the bottom quintile. Although detailed data on income distribution aren’t available before 1947, economists have instead used other information like income tax data to estimate the share of income going to the top 10% of the population all the way back to 1917. Panel (b) of Figure 19-3 shows this measure from 1917 to 2006. These data, like the more detailed data available since 1947, show that American inequality was more or less stable between 1947 and the late 1970s but has risen substantially since. The longer-term data also show, however, that the relatively equal distribution of 1947 was something new. In the late nineteenth century, often referred to as the Gilded Age, American income was very unequally distributed; this high level of inequality persisted into the 1930s. But inequality declined sharply between the late 1930s and the end of World War II. In a famous paper, Claudia Goldin and Robert Margo, two economic historians, dubbed this narrowing of income inequality “the Great Compression.” The Great Compression roughly coincided with World War II, a period during which the U.S. government imposed special controls on wages and prices. Evidence indicates that these controls were applied in ways that reduced inequality—for example, it was much easier for employers to get approval to increase the wages of their lowest-paid employees than to increase executive salaries. What remains puzzling is FA R E S TAT E 489 ➤➤ ➤ Welfare state programs, which include government transfers, absorb a large share of government spending in wealthy countries. ➤ The ability-to-pay principle explains one rationale for the welfare state: alleviating income inequality. Poverty programs do this by aiding the poor. Social insurance programs address the second rationale: alleviating economic insecurity. ➤ The official U.S. poverty threshold is adjusted yearly to reflect changes in the cost of living but not in the average standard of living. But even though average income in the United States has risen significantly, the U.S. poverty rate is no lower than it was 30 years ago. ➤ The causes of poverty can include lack of education, the legacy of racial and gender discrimination, and bad luck. The consequences of poverty are dire for children. ➤ Median household income is a better indicator of typical household income than mean household income. Comparison of Gini coefficients of different countries shows that the United States has less income inequality than poor countries but more than all other rich countries. ➤ The United States has seen declining and increasing income inequality. Since 1980 income inequality in the United State has increased substantially, largely due to an increase in inequality among highly educated workers. that the equality imposed by wartime controls lasted for decades after those controls were lifted in 1946. Since the 1970s, as we’ve already seen, inequality has increased substantially. In fact, pre-tax income appears to be as unequally distributed in America today as it was in the 1920s, prompting many commentators to describe the current state of the nation as a new Gilded Age—albeit one in which the effects of inequality are moderated by taxes and the existence of the welfare state. There is intense debate among economists about the causes of this widening inequality. The most popular explanation is rapid technological change, which has increased the demand for highly skilled or talented workers more rapidly than the demand for other workers, leading to a rise in the wage gap between the highly skilled and other workers. Growing international trade may also have contributed by allowing the United States to import laborintensive products from low-wage countries rather than making them domestically, reducing the demand for less skilled American workers and depressing their wages. Rising immigration may be yet another source. On average, immigrants have lower education levels than native-born workers and increase the supply of low-skilled labor while depressing low-skilled wages. All these explanations, however, fail to account for one key feature: much of the rise in inequality doesn’t reflect a rising gap between highly educated workers and those with less education but rather growing differences among highly educated workers themselves. For example, schoolteachers and top business executives have similarly high levels of education, but executive paychecks have risen dramatically and teachers’ salaries have not. For some reason, the economy now pays a few “superstars”—a group that includes literal superstars in the entertainment world but also such groups as Wall Street traders and top corporate executives—much higher incomes than it did a generation ago. It’s still unclear what caused the change. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 19-1 1. Indicate whether each of the following programs is a poverty program or a social insurance program. a. A pension guarantee program, which provides pensions for retirees if they have lost their employment-based pension due to their employer’s bankruptcy b. The SCHIP program, which provides health care for children in families that are above the poverty threshold but still have relatively low income c. The Section 8 housing program, which provides housing subsidies for low-income households d. The federal flood program, which provides financial help to communities hit by major floods 2. Recall that the poverty threshold is not adjusted to reflect changes in the standard of living. As a result, is the poverty threshold a relative or an absolute measure of poverty? That is, does it define poverty according to how poor someone is relative to others or according to some fixed measure that doesn’t change over time. Explain. 3. The accompanying table gives the distribution of income for a very small economy. a. What is the mean income? What is the median income? Which measure is more representative of the income of the average person in the economy? Why? b. What income range defines the first quintile? The third quintile? 4. Which of the following statements more accurately reflects the principal source of rising inequality in the United States today? a. The salary of the manager of the local branch of Sunrise Sephora Kelly Raul Vijay Oskar Income $39,000 17,500 900,000 15,000 28,000 Bank has risen relative to the salary of the neighborhood gas station attendant. b. The salary of the CEO of Sunrise Bank has risen relative to the salary of the local branch bank manager, who have similar education levels. Solutions appear at back of book. 490 The U.S. Welfare State The U.S. welfare state consists of three huge programs—Social Security, Medicare, and Medicaid—several other fairly big programs, including Temporary Assistance for Needy Families, food stamps, the Earned Income Tax Credit, and a number of smaller programs. Table 19-3 shows one useful way to categorize these programs, along with the amount spent on each listed program in 2005. First, the table distinguishes between programs that are means-tested and those that are not. In means-tested programs, benefits are available only to families or individuals whose income and/or wealth falls below some minimum. Basically, meanstested programs are poverty programs designed to help only those with low incomes. By contrast, non-means-tested programs to everyone, provide although, as we’ll see, they tend in practice to reduce income inequality |
. their benefits TABLE 19-3 Major U.S. Welfare State Programs, 2005 Monetary transfers In-kind Means-tested Temporary Assistance for Needy Families: $8.9 billion Supplemental Security Income: $37.2 billion Earned Income Tax Credit: $34.6 billion Food stamps: $28.5 billion Medicaid: $304.4 billion Not means-tested Social Security: $518.7 billion Medicare: $332.6 billion Unemployment insurance: $31.8 billion Second, the table distinguishes between programs that provide monetary transfers that beneficiaries can spend as they choose and those that provide in-kind benefits, which are given in the form of goods or services rather than money. As the numbers suggest, in-kind benefits are dominated by Medicare and Medicaid, which pay for health care. We’ll discuss health care in the next section of this chapter. For now, let’s examine the other major programs. Means-Tested Programs When people use the term welfare, they’re often referring to monetary aid to poor families. The main source of such monetary aid in the United States is Temporary Assistance for Needy Families, or TANF. This program does not aid everyone who is poor; it is available only to poor families with children and only for a limited period of time. TANF was introduced in the 1990s to replace a highly controversial program known as Aid to Families with Dependent Children, or AFDC. The older program was widely accused of creating perverse incentives for the poor, including encouraging family breakup. Partly as a result of the change in programs, the benefits of modern “welfare” are considerably less generous than those available a generation ago, once the data are adjusted for inflation. Also, TANF contains time limits, so welfare recipients—even single parents—must eventually seek work. As you can see from Table 19-3, TANF is a relatively small part of the modern U.S. welfare state. Other means-tested programs, though more expensive, are less controversial. The Supplemental Security Income program aids disabled Americans who are unable to work and have no other source of income. The food stamp program helps low-income families and individuals, who can use food stamps to buy food staples but not other items. Finally, economists use the term negative income tax for a program that supplements the earnings of low-income working families. The United States has a program known as the Earned Income Tax Credit (EITC), which provides additional income to millions of workers. It has become more generous as traditional welfare has become less generous. Only workers who earn income are eligible for the EITC; over a certain range of incomes, the more a worker earns, the higher the amount of EITC received. That is, the EITC acts as a negative income tax for low-wage workers. In 2007, married couples with two children earning less than $11,790 per year received EITC payments equal to 40% of their earnings. (Payments were slightly lower for single-parent families or workers without children.) At higher incomes the EITC is phased out, disappearing at an income of $37,783 in 2007. A means-tested program is a program available only to individuals or families whose incomes fall below a certain level. An in-kind benefit is a benefit given in the form of goods or services. A negative income tax is a program that supplements the income of low-income working families FA R E S TAT E 491 Social Security and Unemployment Insurance Social Security, the largest program in the U.S. welfare state, is a non-means-tested program that guarantees retirement income to qualifying older Americans. It also provides benefits to workers who become disabled and “survivor benefits” to family members of workers who die. Social Security is supported by a dedicated tax on wages: the Social Security portion of the payroll tax, which was described in Chapter 7, pays for Social Security benefits. The benefits workers receive on retirement depend on their taxable earnings during their working years: the more you earn up to the maximum amount subject to Social Security taxes ($102,000 in 2008), the more you receive in retirement. Benefits are not, however, strictly proportional to earnings. Instead, they’re determined by a formula that gives high earners more than low earners, but with a sliding scale that makes the program relatively more generous for low earners. Because most seniors don’t receive pensions from their former employers, and most don’t own enough assets to live off the income from their assets, Social Security benefits are an enormously important source of income for them. Fully 60% of Americans 65 and older rely on Social Security for more than half their income, and 20% have no income at all except for Social Security. Unemployment insurance, although a much smaller amount of government transfers than Social Security, is another key social insurance program. It provides workers who lose their jobs with about 35% of their previous salary until they find a new job or until 26 weeks have passed. Unemployment insurance is financed by a tax on employers. The Effects of the Welfare State on Poverty and Inequality Because the people who receive government transfers tend to be different from those who are taxed to pay for those transfers, the U.S. welfare state has the effect of redistributing income from some people to others. Each year the Census Bureau estimates the effect of this redistribution in a report titled “The Effects of Government Taxes and Transfers on Income and Poverty.” The report calculates only the direct effect of taxes and transfers, without taking into account changes in behavior that the taxes and transfers might cause. For example, the report doesn’t try to estimate how many older Americans who are now retired would still be working if they weren’t receiving Social Security checks. As a result, the estimates are only a partial indicator of the true effects of the welfare state. Nonetheless, the results are striking. Table 19-4 shows how taxes and government transfers affected the poverty threshold for the population as a whole and for different age groups in 2005. It shows two numbers for each group: the percentage of the group that would have had incomes below the poverty threshold if the government neither collected taxes nor TABLE 19-4 Effects of Taxes and Transfers on the Poverty Rate, 2005 Group (by age) All Under 18 18 to 64 65 and over Source: U.S. Census Bureau. Poverty rate without taxes and transfers Poverty rate with taxes and transfers 18.9% 20.1 14.6 38.6 10.3% 13.0 9.9 6.7 492 TABLE 19-5 Effects of Taxes and Transfers on the Income Distribution, 2005 Quintiles Bottom quintile Second quintile Third quintile Fourth quintile Top quintile Source: U.S. Census Bureau. Share of aggregate income without taxes and transfers Share of aggregate income with taxes and transfers 1.5% 7.3 14.0 23.4 53.8 4.4% 9.9 15.3 23.1 47.3 made transfers, and the percentage that actually fell below the poverty threshold once taxes and transfers were taken into account. (For technical reasons, the second number is somewhat lower than the standard measure of the poverty rate.) Overall, the combined effect of taxes and transfers is to cut the U.S. poverty rate nearly in half. The elderly derived the greatest benefits from redistribution, which reduced their potential poverty rate of 38.6% to an actual poverty rate of 6.7%. Table 19-5 shows the effect of taxes and transfers on the share of aggregate income going to each quintile of the income distribution in 2005. Like Table 19-4, it shows both what the distribution of income would have been if there were no taxes or government transfers, and the actual distribution of income taking into account both taxes and transfers. The effect of government programs was to increase the share of income going to the poorest 60% of the population, especially the share going to the poorest 20%, while reducing the share of income going to the richest 20%. L D VIE W R W O ➤ECONOMICS IN ACTION Britain’s War on Poverty Between 1979 and 1997, Britain, like the United States, experienced a substantial increase in inequality. Britain doesn’t have any single official definition of poverty, but the measure that most closely approximates the U.S. measurement of the poverty threshold indicates that poverty in Britain fell only slightly between 1979 and the mid-1990s even though average income rose substantially. VIEWWOR In 1997, however, control of Britain’s government switched from the Conservative Party, which generally sought to limit the size of Britain’s welfare state, to the Labour Party, which promised to reduce poverty and inequality. In its efforts to accomplish this, Britain’s Labour government has adopted policies that include child benefits paid to every family with children and a “work benefit” that is similar to the U.S. Earned Income Tax Credit but considerably more generous. As panel (a) of Figure 19-4 shows, the effects of these policies on British poverty have been impressive: the British poverty measure that corresponds most closely to the U.S. measure shows that the poverty rate was cut in half between 1997 and 2005, though it has since risen again slightly. The British government is frustrated, however, that its policies don’t seem to have helped a persistent underclass of the very poor. The effect of Labour’s policy on overall inequality is less clear. Panel (b) of Figure 19-4 shows Britain’s Gini coefficient, which rose sharply in the 1980s and has since stabilized but not fallen significantly. Closer examination of the British data reveal that income inequality has actually declined among the bottom 99% of the population; as in the United States, however, the incomes of the top 1% of the population have been rising much faster than everyone else’s (though not to the same extent as FA R E S TAT E 493 FIGURE 19-4 Effects of Policy on British Poverty (a) Britain’s Poverty Rate, 1979–2006 (b) Britain’s Gini Coefficient, 1980–2006 Percent of |
population with less than 50% of 1998–99 median income 25% 20 15 10 5 Gini coefficient 0.39 0.37 0.35 0.33 0.31 0.29 0.27 1979 1990 2000 2006 1980 1985 1990 1995 2000 2006 Year Year Panel (a) shows that British government policies achieved an impressive reduction in the poverty rate, cutting the poverty rate in half between 1997 and 2005. Panel (b) shows Britain’s Gini coefficient, which rose sharply in the 1980s and has since stabilized but not fallen significantly. As in the United States, but not to the same degree, the incomes of the top 1% of the population have been rising much faster than everyone else’s. Sources: U.K. Department for Work and Pensions (panel (a)). U.K. Office for National Statistics (panel (b)). in the United States). Defenders of the British government’s policies argue that even stabilizing inequality represents a partial success. They argue that without the government’s equalizing policies, inequality would have continued to rise, as it has on this side of the Atlantic. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 19-2 1. Explain how the negative income tax avoids the disincentive to work that characterizes poverty programs that simply give benefits based on low income. 2. According to Table 19-4, what effect does the U.S. welfare state have on the overall poverty rate? On the poverty rate for those aged 65 and over? Solutions appear at back of book. The Economics of Health Care A large part of the welfare state, in both the United States and other wealthy countries, is devoted to paying for health care. In most wealthy countries, the government pays between 70% and 80% of all medical costs. The private sector plays a larger role in the U.S. health care system. Yet even in America the government pays almost half of all health care costs; furthermore, it indirectly subsidizes private health insurance through the federal tax code. Figure 19-5 on the next page shows who paid for U.S. health care in 2006. Only 12% of medical bills were paid “out of pocket”—that is, paid directly by individuals. A much larger share, 46%, was paid by the government, mainly through Medicare and Medicaid. About 34% was paid by private insurance companies, with the remaining 7% coming mainly from charities. To understand this pattern, we need to examine the special economics of health care. ➤➤ ➤ Means-tested programs are designed to reduce poverty, but in practice non-means-tested programs do so as well. Programs are classified according to whether they provide monetary or in-kind benefits. ➤ “Welfare,” now known as TANF, aid to poor families with children, is far less generous today than a generation ago due to concerns about its effect on incentives to work and family breakup. The negative income tax addresses these concerns: it supplements the incomes of only low-income working families. ➤ Social Security, the largest program in the U.S. welfare state, is a nonmeans-tested program that provides retirement income for the elderly. It provides a significant share of the income of most elderly Americans. Unemployment insurance is also a key social insurance program. ➤ The American welfare state is redistributive. It increases the share of income going to the poorest 60% while reducing the share going to the richest 20%. 494 FIGURE 19-5 Who Paid for U.S. Health Care in 2006? In 2006, 46% of U.S. health care costs were paid for by the government, mainly through Medicare and Medicaid; 12% was directly paid by individuals; and 34% was paid by private insurance companies. The remaining 7% came mainly from charities. The United States is unique in its heavy reliance on private health care insurance. (Numbers do not add to 100% due to rounding.) Source: Department of Health and Human Services Centers for Medicare and Medicaid Services. Private insurance 34% Medicare 19% Medicaid 15% Out of pocket 12% Other public 12% Other private 7% The Need for Health Insurance In 2006, U.S. personal health care expenses were $7,026 per person—16% of gross domestic product. This did not, however, mean that the typical American spent just over $7,000 on medical treatment. In fact, in any given year half the population incurs only minor medical expenses, but a small percentage of the population faces huge medical bills. In 2002, 20% of the U.S. population accounted for 80% of the medical costs, and 5% of the population accounted for almost half the costs. Is it possible to predict who will have high medical costs? To a limited extent, yes: there are broad patterns to illness. For example, the elderly are more likely to need expensive surgery and/or drugs than the young. But the fact is that anyone can suddenly find himself or herself needing very expensive medical treatment, costing many thousands of dollars in a very short time—far beyond what most families can easily afford. Yet nobody wants to be unable to afford such treatment if it becomes necessary. Market economies have an answer to this problem: health insurance. Under private health insurance, each member of a large pool of individuals agrees to pay a fixed amount into a common fund that is managed by a private company, which then pays most of the medical expenses of the pool’s members. Although members must pay fees even in years in which they don’t have large medical expenses, they benefit from the reduction in risk: if they do turn out to have high medical costs, the pool will take care of those expenses. There are, however, inherent problems with the market for private health insurance. These problems arise from the fact that medical expenses, although unpredictable, aren’t completely unpredictable. That is, people often have some idea whether or not they are likely to face large medical bills over the next few years. This creates a serious problem for private insurance companies. Suppose that an insurance company offers a “one-size-fits-all” health care policy, under which customers pay an annual premium equal to the average American’s annual medical expenses, plus a bit more to cover the company’s operating expenses and a normal rate of profit. In return, the insurance company pays the policyholder’s medical bills, whatever they are. If all potential customers had an equal risk of incurring high medical expenses for the year, this might be a workable business proposition. In reality, however, people often have very different risks of facing high medical expenses—and, crucially, they often know this ahead of time. This reality would quickly undermine any attempt by an insurance company to offer one-size-fits-all insurance. The policy would be a bad deal for healthy Under private health insurance, each member of a large pool of individuals pays a fixed amount to a private company that agrees to pay most of the medical expenses of the pool’s members FA R E S TAT E 495 people, who don’t face a large risk of high medical bills: on average, they would pay much more in insurance premiums than the cost of their actual medical bills. But it would be a very good deal for people with chronic, costly conditions, who would on average pay less in premiums than the cost of their care. As a result, some healthy people would probably decide to take their chances and go without insurance; as a result, the insurance company’s customers would be less healthy than the average American, which would raise the company’s costs per customer. That is, the insurance company would face a problem called adverse selection, which is analyzed in greater detail in Chapter 21. Because of adverse selection, a company that tried to offer health insurance to everyone at a price reflecting average medical costs would find itself losing a lot of money. The insurance company could respond by charging more—raising its premium to reflect the higher-than-average medical bills of its customers. But this would drive off even more healthy people, leaving the company with an even sicker, higher-cost clientele, forcing it to raise the premium even more, driving off even more healthy people, and so on. This phenomenon is known as the adverse selection death spiral. This description of the problems with health insurance might lead you to believe that private health insurance can’t work. In fact, however, most Americans do have private health insurance. Insurance companies are able, to some extent, to overcome the problem of adverse selection by carefully screening people who apply for coverage, charging people who are likely to have high medical expenses higher-than-average premiums—or, in many cases, refusing to cover them at all. For the most part, however, insurance companies overcome adverse selection by selling insurance indirectly, to peoples’ employers rather than to individuals. The big advantage of employment-based health insurance— insurance that a company provides to its employees—is that these employees are likely to contain a representative mix of healthy and less healthy people, rather than a selected group of people who want insurance because they expect to pay high medical bills. This is especially true if the employer is a large company with thousands or tens of thousands of workers. As long as healthy employees are not allowed to opt out, there are typically enough healthy employees to help subsidize the cost of less-healthy employees. There’s another reason employment-based insurance is widespread in the United States: it gets special, favorable tax treatment. Workers pay taxes on their paychecks, but workers who receive health insurance from their employers don’t pay taxes on the value of the benefit. So employment-based health insurance is, in effect, subsidized by the U.S. tax system. Economists estimate the value of this subsidy at about $150 billion each year. In spite of this subsidy, however, many Americans don’t receive employment-based health insurance. Those who aren’t covered include most older Americans, because relatively few employers offer workers insurance that continues after |
they retire; the many workers whose employers don’t offer coverage; and the unemployed California Death Spiral At the beginning of 2006, 116,000 workers at more than 6,000 California small businesses received health coverage from PacAdvantage, a “purchasing pool” that offered employees at member businesses a choice of insurance plans. The idea behind PacAdvantage, which was founded in 1992, was that by banding together, small businesses could get better deals on employee health insurance. But in August 2006 PacAdvantage announced that it was closing up shop because it could no longer find insurance companies willing to offer plans to its members. What happened? It was the adverse selection death spiral. PacAdvantage offered the same policies to everyone, regardless of their prior health history. But employees didn’t have to get insurance from PacAdvantage—they were free, if they chose, to opt out and buy insurance on their own. And sure enough, healthy workers started to find that they could get lower rates by buying insurance directly for themselves, even though that meant giving up the advantages of bulk purchasing. As a result, PacAdvantage began to lose healthy clients, leaving behind an increasingly sick—and expensive—pool of customers. Premiums had to go up, driving out even more healthy workers, and eventually the whole plan had to shut down. 496 TABLE 19-6 Number of Americans Covered by Health Insurance, 2006 (thousands) Covered by private health insurance Employment-based Direct purchase Covered by government Medicaid Medicare Military health care Not covered Source: U.S. Census Bureau. 201,690 177,152 27,066 80,270 38,281 40,343 10,547 46,995 Government Health Insurance Table 19-6 shows the breakdown of health insurance coverage across the U.S. population in 2006. Most Americans, more than 177 million people, received health insurance through employers. The majority of those who didn’t have private insurance were covered by two government programs, Medicare and Medicaid. (The numbers don’t add up because some people have more than one form of coverage. For example, many recipients of Medicare also have supplemental coverage either through Medicaid or private policies.) Medicare is available to all Americans 65 and older, regardless of their income and wealth. It began in 1966 as a program to cover the cost of hospitalization but has since been expanded to cover a number of other medical expenses. You can get an idea of how much difference Medicare makes to the finances of elderly Americans by comparing the median income per person of Americans 65 and older—$15,696—with average annual Medicare payments per recipient, which were more than $8,000 (2006 data). (As with health care spending in general, however, the average can be misleading: in a given year, about 7% of Medicare recipients account for 50% of the costs.) At the beginning of 2006, there was a major expansion of Medicare, this time to cover the cost of prescription drugs. At the time Medicare was created, drugs played a relatively minor role in medicine and were rarely a major expense for patients. Today, however, many health problems, especially among the elderly, are treated with expensive drugs that must be taken for years on end, placing severe strains on some people’s finances. As a result, a new Medicare program, known as “Part D,” was created to help pay these expenses. Unlike Medicare, Medicaid is a means-tested program. There’s no simple way to summarize the criteria for eligibility because it is partly paid for by state governments and each state sets its own rules. Of the 38.3 million Americans covered by Medicaid in 2006, 20.1 million were children under 18, and many of the rest were parents of children under 18. (The SCHIP program, which we described in the opening story, is counted in these numbers as part of Medicaid.) Most of the cost of Medicaid, however, is accounted for by a small number of older Americans, especially those needing long-term care. In addition to the 79 million Americans covered by Medicare and Medicaid, nearly 11 million Americans receive health insurance as a consequence of military service. Unlike Medicare and Medicaid, which pay medical bills but don’t deliver health care directly, the Veterans Health Administration, which has 4.4 million clients, runs hospitals and clinics around the country. The U.S. health care system, then, offers a mix of private insurance, mainly from employers, and public insurance of various forms. Most Americans have health insurance either from private insurance companies or through various forms of government insurance. However, 47 million people in America, 15.8% of the population, have no health insurance at all. What accounts for the uninsured, and how much does the problem of the uninsured matter The Problem of the Uninsured The Kaiser Family Foundation, an independent nonpartisan group that studies health care issues, offers a succinct summary of who is uninsured in America: “The uninsured are largely low-income adult workers for whom coverage is unaffordable or unavailable.” The reason the uninsured are primarily adults is that Medicaid, supplemented by SCHIP, covers many, though not all, low-income children but is much less Medicare was expanded in 2006 to cover the cost of prescription drugs FA R E S TAT E 497 likely to provide coverage to adults, especially if they do not have children. Lowincome workers tend to be uninsured for two reasons: they are less likely than workers with higher income to have jobs that provide health insurance benefits, and they are less likely to be able to afford to directly purchase heath insurance themselves. Finally, insurance companies frequently refuse to cover people, regardless of their income, if they have a preexisting medical condition or something in their medical history suggesting that they are likely to need expensive medical treatment at some future date. As a result, a significant number of Americans with incomes that most would consider middle class cannot get insurance. It’s important to realize that lack of insurance is not synonymous with poverty. Most people in America without health insurance have incomes above the poverty threshold, and 35% of the uninsured have incomes more than twice the poverty threshold. We should also note that some of the uninsured are relatively healthy people who could afford insurance but prefer to save money and take their chances, although there is dispute about how large the group of voluntarily uninsured is. Like poverty, lack of health insurance has serious consequences, both medical and financial. On the medical side, the uninsured frequently have limited access to health care. Panel (a) of Figure 19-6 shows one summary of common problems associated with access to care, all of which are much worse for the uninsured than for the insured. On the financial side, those who are uninsured often face serious financial problems when illness strikes. Panel (b) shows a summary of the main financial problems associated with medical care, all of which are much worse for those without health insurance. FIGURE 19-6 The Consequences of Being Uninsured (a) Barriers to Receiving Health Care, 2003 (b) The Financial Burden of Paying Medical Bills, 2003 No regular source of care 9% 42% Had problem paying medical bill 36% 16% Postponed seeking care because of cost 15% 47% Changed way of life significantly to pay medical bills Contacted by collection agency about medical bills Needed care but did not get it 9% Did not fill a prescription because of cost 13% 35% 37% 0 10 20 30 40 50% Percent 23% 23% 9% 8% 0 10 20 30 40 50% Percent Uninsured Insured As panel (a) shows, the uninsured face significantly greater barriers to receiving health care than the insured. Compared to the insured, a much higher proportion of the uninsured needed care but either did not receive it or postponed it. Panel (b) illustrates the heavy financial consequences of being uninsured. Compared to the insured, a much higher proportion of the uninsured had problems paying a medical bill. Source: Kaiser Family Foundation, Kaiser 2003 Health Insurance Survey. 498 single-payer system is a health care system in which the government is the principal payer of medical bills funded through taxes. Health Care in Other Countries Health care is one area in which the United States is very different from other wealthy countries, including both European nations and Canada. In fact, we’re distinctive in three ways. First, we rely much more on private health insurance than any other wealthy country. Second, we spend much more on health care per person. Third, we’re the only wealthy nation in which large numbers of people lack health insurance. Table 19-7 compares the United States with three other wealthy countries: Canada, France, and Britain. The United States is the only one of the four countries that relies on private health insurance to cover most people; as a result, it’s the only one in which private spending on health care is (slightly) larger than public spending on health care. Canada has a single-payer system: a health care system in which the government acts as the principal payer of medical bills funded through taxes. For comparison, Medicare is basically a single-payer system for older Americans—and the Canadian system is, in fact, called Medicare. The British system is like the American Veterans Health Administration, extended to everyone: a government agency, the British National Health Service, employs health care workers and runs hospitals and clinics that are available free of charge to the public. France is somewhere in between the Canadian and British systems: the government acts as a single-payer, providing health insurance to everyone, and French citizens can receive treatment from private doctors and hospitals; but they also have the choice of receiving care from a sizable health care system run directly by the French government |
. All three non-U.S. systems provide health insurance to all their citizens; the United States does not. Yet all three spend much less on health care per person than we do. Many Americans assume this must mean that foreign health care is inferior in quality. But many health care experts disagree with the claim that the health care systems of other wealthy countries deliver poor-quality care. As they point out, Britain, Canada, and France generally match or exceed the United States in terms of many measures of health care provision, such as the number of doctors, nurses, and hospital beds per 100,000 people. It’s true that U.S. medical care includes more advanced technology in some areas and many more expensive surgical procedures. U.S. patients also have shorter waiting times for elective surgery than patients in Canada or Britain. France, however, also has very short waiting times. Surveys of patients seem to suggest that there are no large differences in the quality of care received by patients in Canada, Europe, and the United States. And as Table 19-7 shows, the United States does considerably worse than other advanced countries in terms of basic measures such as life expectancy and infant mortality, although our poor performance on these measures may have causes other than the quality of medical care—notably our relatively high levels of poverty and income inequality. So why does the United States spend so much more on health care than other wealthy countries? Some of the disparity is the result of higher doctors’ salaries, but TABLE 19-7 Health Care Systems in Advanced Countries (2005 data unless indicated) Government share of health care spending Health care spending per capita (US$, purchasing power parity) Life expectancy (total population at birth, years) Infant mortality (deaths per 1,000 live births) United States 45.1% $6,401 Canada France Britain 70.3 79.8 87.1 3,326 3,374 2,724 *2004 data Source: OECD health data, 2007. 77.8* 80.2* 80.3 79.0 6.8* 5.3* 3.6 5. FA R E S TAT E 499 most studies suggest that this is a secondary factor. One possibility is that Americans are getting better care than their counterparts abroad, but in ways that don’t show up in either surveys of patient experiences or statistics on health performance. Another possibility is that the U.S. system suffers from serious inefficiencies that other countries manage to avoid. Critics of the U.S. system emphasize the fact that our system’s reliance on private insurance companies, which expend resources on such activities as marketing and trying to identify and weed out high-risk patients, leads to high operating costs. On average, the operating costs of private health insurers eats up 14% of the premiums clients pay, leaving only 86% to spend on providing health care; by contrast, Medicare spends only 3% of its funds on operating costs, leaving 97% to spend on health care. A study by the McKinsey Global Institute found that the United States spends almost six times as much per person on health care administration as other wealthy countries. The United States also pays higher prices for prescription drugs, because in other countries government agencies bargain with pharmaceutical companies to get lower drug prices. The Health Care Crisis and Proposals for Reform Whatever one thinks of the past performance of the U.S. health care system, that system is clearly in trouble today. The root of the problem is the rising cost of health insurance, whether private or public. For one thing, the cost of private insurance has risen much faster than incomes. For example, between 2001 and 2007 the average premiums for employment-based health insurance rose 78%, but the wages of the average worker rose only 19%. By 2007, the average cost of insurance for a family of four was more than $12,000. As a result of these rising costs, employment-based health insurance, the centerpiece of the system for Americans under 65, is in decline. Figure 19-7 shows selected changes in the insurance status of Americans between 2000 and 2006. Over that period, the total population rose by 17 million. But the number of people with employment-based health insurance not only failed to keep up with population growth—it declined by more than 2 million. However, more people were covered by government programs, mainly due to an expansion of Medicaid. But this expansion did not keep up with population growth, and more than 8 million people joined the ranks of the uninsured. Even as private health insurance seems to be faltering and the number of Americans without health insurance is rising, public health insurance is coming under increasing financial strain. Partly this is because Medicaid and other government programs now cover more people than in the past. Mainly, however, it is FIGURE 19-7 Changes in Health Insurance Status, 2000–2006 Change (millions) Since 2000, the U.S. population has grown substantially, but the number of people with employment-based health insurance has actually declined. Growth in public health insurance, mainly Medicaid and SCHIP, made up part of the difference. There has also, however, been an increase in the number of uninsured. Source: U.S. Census Bureau. 20 15 10 5 0 –5 17.3 8.7 8.6 Population –2.3 Employment– based coverage Medicaid and SCHIP Uninsured 500 FIGURE 19-8 Rising Health Care Costs U.S. health care spending as a percentage of GDP, a measure of total income, has tripled since 1965. Similar trends can be seen in other countries. Most analysts believe that the main force behind this trend is medical progress: we spend more on health care because more medical problems are treatable. Source: Department of Health and Human Services Centers for Medicare and Medicaid Services. Health care expenditure (percent of GDP) 16% 12 8 4 1960 1970 1980 1990 2000 2006 Year because the cost per beneficiary of government health insurance, like the cost per beneficiary of private insurance, has been rising rapidly. What’s behind these rising costs? Figure 19-8 shows overall U.S. spending on health care as a percentage of GDP, a measure of the nation’s total income, since the 1960s. As you can see, health spending has tripled as a share of income since 1965; this increase in spending explains why health insurance has become more expensive. Similar trends can be observed in other countries. But why is health spending rising? The consensus of health experts is that it’s a result of medical progress. As medical science progresses, conditions that could not be treated in the past become treatable—but often only at great expense. The upcoming Economics in Action gives some examples. Both private insurers and government programs feel compelled to cover the new procedures—but this means higher costs, which either have to be passed on in the form of higher insurance premiums or require larger commitments of taxpayer funds. The combination of a rising number of uninsured and rising costs has led to many calls for health care reform in the United States. There are, however, sharp political divisions over what kind of reform is needed. Broadly speaking, the division is between those who believe that the answer is a further expansion of the welfare state and those who believe that the appropriate response is more reliance on markets and individual incentives. On one side, many liberals believe that the United States should emulate the systems of other wealthy countries by creating a system of universal health insurance, although most current proposals would offer individuals a choice of receiving that insurance either from the government or from private insurance companies. Advocates of universal coverage argue that a move in this direction would reduce the inefficiency of our current system, in particular by reducing administrative costs, as well as provide coverage to those now uninsured. They point to the striking difference in health care spending between the United States and other rich countries as evidence that a universal system would actually be cheaper than what we have now. On the other side, many conservatives argue that the problem with our system is that individuals lack FA R E S TAT E 501 much incentive to pay attention to medical costs, because the bills are covered by either public or private insurance. They call for a move to “consumer-directed” health care, in which individuals would pay a larger share of their own health care bills and therefore choose more carefully which medical procedures they want performed and bargain more over prices. They often argue that the market for health insurance is distorted by the subsidy that the tax code creates for employment-based insurance. Proposals for health care reform on the conservative side typically involve limiting the tax deduction for employment-based health insurance but offering comparable tax breaks to those who purchase insurance as individuals. Critics counter, however, that this would not solve the problem faced by individuals who are refused private insurance because of pre-existing medical conditions. One thing is sure: the debate over health care reform will be an important part of the U.S political scene for many years to come. ➤ECONOMICS IN ACTION The Trouble with Medical Progress It’s widely accepted among health care experts that medical progress leads to higher health care spending. A 2008 report from the Congressional Budget Office (CBO) tried to put numbers to this effect and also offered a number of striking examples of just how the process works. Figure 19-9 shows the growth in expensive treatments for a few major medical problems that, not too long ago, couldn’t be treated at all. ■ Coronary artery disease. “In the 1950s and much of the 1960s,” writes the CBO, “caring for patients with coronary artery disease was inexpensive because physicians could do little to help them.” But then came the development of open-heart surgery and other techniques such as angioplasty. The result is |
that many heart-disease patients who might have died receive a second lease on life—but at huge expense. ■ Kidney failure. “Until techniques and devices were developed that could perform the waste-removing functions of the kidneys (renal replacement therapy),” writes the CBO, “patients who suffered severe kidney failure tended to die quickly.” Now they can be kept alive for years thanks to dialysis—again, at great expense. ■ Joint problems. In the past, joint problems, which can often be crippling, simply had to be suffered. Now, however, it’s common to receive hip and knee replacement, a tremendous gain—but again, at great expense. FIGURE 19-9 The Cost of Medical Progress, 1970–2004 Three areas in which treatment has grown enormously over time are coronary disease, which was more or less untreatable until the late 1960s; kidney failure, which has become treatable via dialysis; and the replacement of failing joints. All these new medical procedures do a great deal of good but also cost a great deal of money. Source: Congressional Budget Office; Department of Health and Human Services; National Center for Health Statistics. Number of procedures (thousands) 1,200 1,000 Angioplasty Dialysis Hip replacement 800 600 400 200 0 1970 1980 1990 2000 2004 Year 502 ➤➤ ➤ Health insurance satisfies an important need because expensive medical treatment is unaffordable for most families. Private health insurance has an inherent problem: the adverse selection death spiral. Employment-based health insurance, the way most Americans are covered, avoids this problem. ➤ The majority of Americans not covered by private insurance are covered by Medicare, which is non-means-tested and applies only to those age 65 and older, and Medicaid, which is available based on income. ➤ The United States differs from other wealthy countries in its heavy dependence on private health insurance and its high health care spending per person. Some countries, such as Canada, have a singlepayer system. Compared to other wealthy countries, the U.S. system has much higher costs. Surprisingly, it’s hard to find clear evidence that it provides better care. Medical progress is a wonderful thing. But as we’ve seen, the growing cost of health care is causing severe strains on both private and public health insurance, both in the United States and in the rest of the world. It remains to be seen how the tension between what doctors can do and what society can afford will be resolved. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 19-3 1. If you are enrolled in a four-year degree program, it is likely that you are required to enroll in a health insurance program run by your school. a. Explain how you and your parents benefit from this health insurance program even though, given your age, it is unlikely that you will need expensive medical treatment. b. Explain how your school’s health insurance program avoids the adverse selection death spiral by requiring all students to join and pay premiums. 2. According to its critics, what partly accounts for the higher costs of the U.S. health care sys- tem compared to other wealthy countries? Solutions appear at back of book. The Debate Over the Welfare State The goals of the welfare state seem laudable: to help the poor, protect everyone from financial risk, and ensure that people can afford essential health care. But good intentions don’t always make for good policy. There is an intense debate about how large the welfare state should be, a debate that partly reflects differences in philosophy but also reflects concern about the possibly counterproductive effects of welfare state programs. Disputes about the size of the welfare state are also one of the defining issues of modern politics. Problems with the Welfare State There are two different lines of argument against the welfare state. One, which we described earlier in this chapter, is based on philosophical concerns about the proper role of government. As we learned, some political theorists believe that redistributing income is not a legitimate role of government—that government’s role should be limited to maintaining the rule of law, providing public goods, and managing externalities. The more conventional argument against the welfare state involves the trade-off between efficiency and equity, an issue that arose in Chapter 7 when we discussed the case for progressive taxation. As we explained there, the ability-to-pay-principle— the argument that an extra dollar of income matters more to a less well-off individual than to a more well-off individual—suggests that the tax system should be progressive, with high-income taxpayers paying a higher fraction of their income in taxes than those with lower incomes. But there are efficiency arguments against making marginal tax rates too high. Consider an extremely progressive tax system that imposes a marginal rate of 90% on very high incomes. The problem is that such a high marginal rate reduces the incentive to increase a family’s income by working hard or making risky investments. As a result, an extremely progressive tax system tends to make society as a whole poorer, which could hurt even those the system was intended to benefit. That’s why even economists who strongly favor progressive taxation don’t support a return to the extremely progressive system that prevailed in the 1950s, when the top U.S. marginal income tax rate was more than 90%. So, as we explained in Chapter 7, the design of the tax system involves a tradeoff between equity and efficiency. A similar trade-off between equity and efficiency is an argument against having too extensive a welfare state. A government that operates a large welfare state FA R E S TAT E 503 Marginal tax rate in 2006 33.98% 40.60 55.84 18.6% Britain United States Social expenditure in 2003 (percent of GDP) TABLE 19-8 Social Expenditure and Marginal Tax Rates requires more revenue than one that limits itself mainly to provision of public goods such as national defense. So nations that have a large welfare state must have higher tax revenue, and higher marginal tax rates, than countries with a small welfare state. Table 19-8 shows “social expenditure,” a measure that roughly corresponds to welfare state spending, as a percentage of GDP in the United States, Britain, and France; it also compares this with an estimate of the marginal tax rate faced by an average wage-earner, including payroll taxes paid by employers and state and local taxes. As you can see, France’s large welfare state goes along with a high marginal rate of taxation. As the upcoming Economics in Action explains, some but not all economists believe that this high rate of taxation is a major reason the French work substantially fewer hours per year than Americans. Sources: OECD Social Expenditure Database; OECD Taxing Wages Database. France 22.1 29.4 The trade-off between a large welfare state and high marginal tax rates seems to suggest that we should try to hold down the cost of the welfare state. One way to do this is to means-test benefits: make them available only to those who need them. But means-testing, it turns out, creates a different kind of trade-off between equity and efficiency. Consider the following example: Suppose there is some means-tested benefit, worth $2,000 per year, that is available only to families with incomes of less than $20,000 per year. Now suppose that a family currently has an income of $19,500 but that one family member is deciding whether to take a new job that will raise the family’s income to $20,500. Well, taking that job will actually make the family worse off, because it will gain $1,000 in earnings but lose the $2,000 government benefit. This situation, in which earning more actually leaves a family worse off through lost benefits, is known as a notch. It is a well-known problem with programs that aid the poor and behaves much like a high marginal tax rate on income. Most welfare state programs are designed to avoid creating a notch. This is typically done by setting a sliding scale for benefits such that they fall off gradually as the recipient’s income rises rather than come to an abrupt end. Even so, the combined effects of the major means-tested programs shown in Table 19-3, plus additional means-tested programs such as housing aid that are offered by some state and local governments, can be to create very high effective marginal tax rates. For example, one 2005 study found that a family consisting of two adults and two children that raised its income from $20,000 a year—just above the poverty threshold in 2005—to $35,000 would find almost all its increase in after-tax income offset by loss of benefits such as food stamps, the Earned Income Tax Credit, and Medicaid. The Politics of the Welfare State In 1791, in the early phase of the French Revolution, France had a sort of congress, the National Assembly, in which representatives were seated according to social class: nobles, who pretty much liked the way things were, sat on the right; commoners, who wanted big changes, sat on the left. Ever since, it has been common in political discourse to talk about politicians as being on the “right” (more conservative) or on the “left” (more liberal). But what do modern politicians on the left and right disagree about? In the modern United States, they mainly disagree about the appropriate size of the welfare state. For example, as we mentioned in the opening story, SCHIP, which provides children 504 with health insurance, was created in 1997 with bipartisan support. But in 2007 there was a fierce political debate over whether to expand the program. You might think that saying that political debate is really about just one thing— how big to make the welfare state—is a huge oversimplification. But political scientists have found that once you carefully rank members of Congress from right to left, a congressperson’s position in that ranking does a very good job of predicting his |
or her votes on proposed legislation. Modern politics isn’t completely onedimensional—but it comes pretty close. The same studies that show a strong left–right spectrum in U.S. politics also show strong polarization between the major parties on this spectrum. Thirty years ago there was a substantial overlap between the parties: some Democrats were to the right of some Republicans, or, if you prefer, some Republicans were to the left of some Democrats. Today, however, the rightmost Democrats appear to be to the left of the leftmost Republicans. There’s nothing necessarily wrong with this. Although it’s common to decry “partisanship,” it’s hard to see why members of different political parties shouldn’t have different views about policy. Can economic analysis help resolve this political conflict? Only up to a point. Some of the political controversy over the welfare state involves differences in opinion about the trade-offs we have just discussed: if you believe that the disincentive effects of generous benefits and high taxes are very large, you’re likely to look less favorably on welfare state programs than if you believe they’re fairly small. Economic analysis, by improving our knowledge of the facts, can help resolve some of these differences. To an important extent, however, differences of opinion on the welfare state reflect differences in values and philosophy. And those are differences economics can’t resolve. L D VIE W R W O W E ➤ECONOMICS IN ACTION French Family Values The United States has the smallest welfare state of any major advanced economy. France has one of the largest. As we’ve already described, France has much higher social spending than America as a percentage of total national income, and French citizens face much higher tax rates than Americans. One argument against a large welfare state is that it has negative effects on efficiency. Does French experience support this argument? VIEWWOR O R L D L W V D I On the face of it, the answer would seem to be a clear yes. French GDP per capita—the total value of the economy’s output, divided by the total population—is only 72% of the U.S. level. This reflects the fact that the French work less: French workers and U.S. workers have almost exactly the same productivity per hour, but a smaller fraction of the French population is employed, and the average French employee works substantially fewer hours over the course of a year than his or her American counterpart. Some economists have argued that high tax rates in France explain this difference: the incentives to work are less in France than in the United States, because the government takes away so much of what you earn from an additional hour of work. A closer examination, however, reveals that the story is more complicated than that. The low level of employment in France is entirely the result of low rates of employment among the young and the old; 80% of French residents of prime working age, 25–54, are employed, exactly the same percentage as in the United States. So high tax rates don’t seem to discourage the French from working in the prime of their lives. And young people in France don’t work in part because they FA R E S TAT E 505 ➤➤ ➤ Intense debate on the size of the welfare state centers on philosophy and on equity-versus-efficiency concerns. The high marginal tax rates needed to finance an extensive welfare state can reduce the incentive to work. Holding down the cost of the welfare state by means-testing can also cause inefficiency through notches that create high effective marginal tax rates for benefit recipients. ➤ Politics is often depicted as an opposition between left and right; in the modern United States, that division mainly involves disagreement over the appropriate size of the welfare state. don’t have to: college education is generally free, and students receive financial support, so French students, unlike their American counterparts, rarely work while attending school. The French will tell you that that’s a virtue of their system, not a problem. Shorter working hours also reflect factors besides tax rates. French law requires employers to offer at least a month of vacation, but most U.S. workers take less than two weeks off. Here, too, the French will tell you that their policy is better than ours, because it helps families spend time together. The aspect of French policy even the French agree is a big problem is that their retirement system allows workers to collect generous pensions even if they retire very early. As a result, only 40% of French residents between the ages of 55 and 64 are employed, compared with more than 60% in America. The cost of supporting all those early retirees is a major burden on the French welfare state—and getting worse as the French population ages. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 19-4 1. Explain how each of the following policies creates a disincentive to work or undertake a risky investment. a. A high sales tax on consumer items b. The loss of a housing subsidy when yearly income rises above $25,000 2. Over the past 30 years, has the polarization in Congress increased, decreased, or stayed the same? Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• The welfare state provides some families with additional income in the form of government transfers. For the most part, however, families receive their income in payment for the resources they supply to the economy—mostly the labor they supply, but also the capital and land they own. But what determines wage rates, land rents, and other sources of income? In the next chapter, we describe how factor markets, markets in factors of production rather than in goods and services, operate.] 506 . The welfare state absorbs a large share of government spending in all wealthy countries. Government transfers are the payments made by the government to individuals and families. Poverty programs alleviate income inequality by helping the poor; social insurance programs alleviate economic insecurity. 2. Despite the fact that the poverty threshold is adjusted according to the cost of living but not according to the standard of living, and that the average American income has risen substantially over those 30 years, the poverty rate, the percentage of the population with an income below the poverty threshold, is no lower than it was 30 years ago. There are various causes of poverty: lack of education, the legacy of discrimination, and bad luck. The consequences of poverty are particularly harmful for children. 3. Median household income, the income of a family at the center of the income distribution, is a better indicator of the income of the typical household than mean household income because it is not distorted by the inclusion of a small number of very wealthy households. The Gini coefficient, a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles, is used to compare income inequality across countries. 4. Both means-tested and non-means-tested programs reduce poverty. The major in-kind benefits programs are Medicare and Medicaid, which pay for medical care. Due to concerns about the effects on incentives to work and on family cohesion, aid to poor families has become significantly less generous even as the negative income K E Y T E R M S tax has become more generous. Social Security, the largest U.S. welfare state program, has significantly reduced poverty among the elderly. Unemployment insurance is also a key social insurance program. 5. Health insurance satisfies an important need because most families cannot afford expensive medical treatment. Private health insurance, unless it is employmentbased, has the potential to fall into an adverse selection death spiral. Most Americans are covered by employment-based private health insurance; most of the remaining are covered by Medicare (for those over 65) or Medicaid (for those with low incomes). 6. Compared to other countries, the United States relies more heavily on private health insurance and has substantially higher health care costs per person without providing better care. Some countries have a singlepayer system, a system in which the government pays most medical bills, funded through taxes. 7. Debates over the size of the welfare state are based on philosophical and equity-versus-efficiency considerations. Although high marginal tax rates to finance an extensive welfare state can reduce the incentive to work, meanstesting programs in order to reduce the cost of the welfare state also reduce the incentive to work. 8. Politicians on the left tend to favor a bigger welfare state and those on the right oppose it. This left–right distinction is central to today’s politics. America’s two major political parties have become more polarized in recent decades, with a much clearer distinction than in the past about where their members stand on the leftright spectrum. Welfare state, p. 480 Poverty rate, p. 482 In-kind benefit, p. 490 Government transfer, p. 480 Mean household income, p. 485 Negative income tax, p. 490 Poverty program, p. 480 Median household income, p. 485 Private health insurance, p. 494 Social insurance programs, p. 480 Gini coefficient, p. 486 Single-payer system, p. 498 Poverty threshold, p. 481 Means-tested, p. 490 P R O B L E M S 1. The accompanying table contains data on the U.S. economy for the years 1983 and 2006. The second column shows the poverty threshold. The third column shows the consumer price index (CPI), a measure of the overall level of prices. And the fourth column shows U.S. gross domestic product (GDP) per capita, a measure of the standard of living. Year 1983 2006 Poverty threshold $5,180 10,488 CPI (1982–1984 = 100) GDP per capita 99.6 201.6 $15,092 44,007 Source: U.S. Census Bureau; Bureau of Labor Statistics; Bureau of Economic Analysis FA R E S TAT E 507 a. By what factor has the poverty threshold increased from b. Betwe |
en 1972 and 2005, has the income distribution 1983 to 2006? That is, has it doubled, tripled, and so on? become less or more unequal? Explain. b. By what factor has the CPI (a measure of the overall price level) increased from 1983 to 2006? That is, has it doubled, tripled, and so on? c. By what factor has GDP per capita (a measure of the standard of living) increased from 1983 to 2006? That is, has it doubled, tripled, and so on? d. What do your results tell you about how those people officially classified as “poor” have done economically relative to other U.S. citizens? 2. In the city of Metropolis, there are 100 residents, each of whom lives until age 75. Residents of Metropolis have the following incomes over their lifetime: through age 14, they earn nothing. From age 15 until age 29, they earn 200 metros (the currency of Metropolis) per year. From age 30 to age 49, they earn 400 metros. From age 50 to age 64, they earn 300 metros. Finally, at age 65 they retire and are paid a pension of 100 metros per year until they die at age 75. Each year, everyone consumes whatever their income is that year (that is, there is no saving and no borrowing). Currently, 20 residents are 10 years old, 20 residents are 20 years old, 20 residents are 40 years old, 20 residents are 60 years old, and 20 residents are 70 years old. a. Study the income distribution among all residents of Metropolis. Split the population into quintiles according to their income. How much income does a resident in the lowest quintile have? In the second, third, fourth, and top quintiles? Which share of total income of all residents goes to the residents in each quintile? Construct a table showing the share of total income that goes to each quintile. Does this income distribution show inequality? b. Now look only at the 20 residents of Metropolis who are currently 40 years old, and study the income distribution among only those residents. Split those 20 residents into quintiles according to their income. How much income does a resident in the lowest quintile have? In the second, third, fourth, and top quintiles? Which share of total income of all 40-year-olds goes to the residents in each quintile? Does this income distribution show inequality? c. What is the relevance of these examples for assessing data on the distribution of income in any country? 3. The accompanying table presents data from the U.S. Census Bureau on median and mean income of male workers for the years 1972 and 2005. The income figures are adjusted to eliminate the effect of inflation. Year 1972 2005 Median income Mean income (in 2005 dollars) $42,617 42,188 $47,708 58,779 Source: U.S. Census Bureau. a. By what percentage has median income changed over this period? By what percentage has mean income changed over this period? 4. There are 100 households in the economy of Equalor. Initially, 99 of them have an income of $10,000 each, and one household has an income of $1,010,000. a. What is the median income in this economy? What is the mean income? Through its poverty programs, the government of Equalor now redistributes income: it takes $990,000 away from the richest household and distributes it equally among the remaining 99 households. b. What is the median income in this economy now? What is the mean income? Has the median income changed? Has the mean income changed? Which indicator (mean or median household income) is a better indicator of the typical Equalorian household’s income? Explain. 5. The country of Marxland has the following income tax and social insurance system. Each citizen’s income is taxed at an average tax rate of 100%. A social insurance system then provides transfers to each citizen such that each citizen’s after-tax income is exactly equal. That is, each citizen gets (through a government transfer payment) an equal share of the income tax revenue. What is the incentive for one individual citizen to work and earn income? What will the total tax revenue in Marxland be? What will be the after-tax income (including the transfer payment) for each citizen? Do you think such a tax system that creates perfect equality will work? 6. The tax system in Taxilvania includes a negative income tax. For all incomes below $10,000, individuals pay an income tax of −40% (that is, they receive a payment of 40% of their income). For any income above the $10,000 threshold, the tax rate on that additional income is 10%. For the first three scenarios below, calculate the amount of income tax to be paid and after-tax income. a. Lowani earns income of $8,000. b. Midram earns income of $40,000. c. Hi-Wan earns income of $100,000. d. Can you find a notch in this tax system? That is, can you find a situation where earning more pre-tax income actually results in less after-tax income? 7. In the city of Notchingham, each worker is paid a wage rate of $10 per hour. Notchingham administers its own unemployment benefit, which is structured as follows: if you are unemployed (that is, if you do not work at all), you get unemployment benefits (a transfer from the government) of $50 per day. As soon as you work for only one hour, the unemployment benefit is completely withdrawn. That is, there is a notch in the benefit system. a. How much income does an unemployed person have per day? How much daily income does an individual have who works four hours per day? How many hours do you need to work to earn just the same as if you were unemployed? b. Will anyone ever accept a part-time job that requires working four hours per day, rather than being unemployed? 508 . Suppose that Notchingham now changes the way in which the unemployment benefit is withdrawn. For each additional dollar an individual earns, $0.50 of the unemployment benefit is withdrawn. How much daily income does an individual who works four hours per day now have? Is there an incentive now to work four hours per day rather than being unemployed? 8. In a private insurance market, there are two different kinds of people: some who are more likely to require expensive medical treatment and some who are less likely to require medical treatment and who, if they do, require less expensive treatment. One health insurance policy is offered, tailored to the average person’s health care needs: the premium is equal to the average person’s medical expenses (plus the insurer’s expenses and normal profit). a. Explain why such an insurance policy is unlikely to be feasible. In an effort to avoid the adverse selection death spiral, a private health insurer offers two health insurance policies: one that is intended for those who are more likely to require expensive treatment (and therefore charges a higher premium) and one that is intended for those who are less likely to require treatment (and therefore charges a lower premium). b. Could this system overcome the problem created by adverse selection? c. How does the British National Health Service (NHS) avoid these problems? 9. The accompanying table shows data on the total number of people in the United States and the number of all people who were uninsured, for selected years from 1997 to 2005. It also shows data on the total number of poor children in the United States—those under 18 and below the poverty threshold—and the number of poor children who were uninsured. www.worthpublishers.com/krugmanwells Year 1997 1999 2001 2003 2005 Total people Uninsured people Total poor children Uninsured poor children 269.1 276.8 282.1 288.3 293.8 43.4 40.2 41.2 45.0 46.6 (millions) 14.1 12.3 11.7 12.9 12.9 3.4 2.8 2.5 2.5 2.4 Source: U.S. Census Bureau. For each year, calculate the percentage of all people who were uninsured and the percentage of poor children who were uninsured. How have these percentages changed over time? What is a possible explanation for the change in the percentage of uninsured poor children? 10. The American National Election Studies conducts periodic research on the opinions of U.S. voters. The accompanying table shows the percentage of people, in selected years from 1952 to 2004, who agreed with the statement “There are important differences in what the Republicans and Democrats stand for.” Year 1952 1972 1992 2004 Agree with statement 50% 46 60 76 Source: American National Election Studies. What do these data say about the degree of partisanship in U.S. politics over time? chapter: 20 the factors of production such as labor, land, and capital are traded. Factor markets, like goods markets, play a crucial role in the economy: they allocate productive resources to producers and help ensure that those >> Factor Markets and the Distribution of Income T H E VA OES HIGHER EDUCATION PAY? YES, IT DOES: IN the modern economy, employers are willing to pay a premium for workers with more educa- tion. And the size of that premium has increased a lot over the last few decades. Back in 1973 workers with resources are used efficiently. advanced degrees, such as law degrees or MBAs, earned This chapter begins by describing the major factors of only 76% more than those who had only graduated from production. Then we consider the demand for factors of high school. By 2006, the premium for an advanced production, which leads us to a crucial insight: the mar- degree had risen to over 170%. ginal productivity theory of income distribution. We then Who decided that the wages of workers with advanced consider some challenges to the marginal productivity degrees would rise so much compared with those of high theory. Next, we examine the markets for capital and for school grads? The answer, of course, is that nobody land. The chapter concludes with a discussion of the sup- decided it. Wage rates are prices, the prices of different ply of the most important factor, labor. kinds of labor; and they are decid- ed, like other prices, by supply and demand. Still, there is a qualitative differ- ence between the wage rate of high school grads and the price of used textbooks: the wage rate isn’t the price of a good, i |
t’s the price of a factor of production. And although markets for factors of production are in many ways similar to those for goods, there are also some important differences. In this chapter, we examine fac- tor markets, the markets in which If you’ve ever had doubts about attending college, consider this: factory workers with only high school degrees will make much less than college grads. The present discounted value of the difference in lifetime earnings is as much as $300,000 509 510 P A R T 9 FA WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ How factors of production—resources like land, labor, and both physical capital and human capital—are traded in factor markets, determining the factor distribution of income ➤ How the demand for factors leads to the marginal productivity theory of income distribution ➤ An understanding of the sources of wage disparities and the role of discrimination ➤ The way in which a worker’s decision about time allocation gives rise to labor supply The Economy’s Factors of Production You may recall that we defined a factor of production in Chapter 2 in the context of the circular-flow diagram; it is any resource that is used by firms to produce goods and services, items that are consumed by households. Factors of production are bought and sold in factor markets, and the prices in factor markets are known as factor prices. What are these factors of production, and why do factor prices matter? The Factors of Production As we learned in Chapter 2, economists divide factors of production into four principal classes: land, labor, physical capital, and human capital. Land is a resource provided by nature; labor is the work done by human beings. In Chapter 9 we defined capital; it is the value of the assets that are used by a firm in producing its output. There are two broad types of capital. Physical capital—often referred to simply as “capital”—consists of manufactured resources such as equipment, buildings, tools, and machines. In the modern economy, human capital, the improvement in labor created by education and knowledge, and embodied in the workforce, is at least equally significant. The importance of human capital has been greatly increased by the progress of technology, which has made a high level of technical sophistication essential to many jobs—one cause of the increased premium paid for workers with advanced degrees. Physical capital—often referred to simply as “capital”—consists of manufactured productive resources such as equipment, buildings, tools, and machines. Human capital is the improvement in labor created by education and knowledge that is embodied in the workforce. P I T F A L L S what is a factor, anyway? Imagine a business that produces shirts. The business will make use of workers and machines—that is, of labor and capital. But it will also use other inputs, such as electricity and cloth. Are all of these inputs factors of production? No: labor and capital are factors of production, but cloth and electricity are not. The key distinction is that a factor of production earns income from the selling of its services over and over again but an input cannot. For example, a worker earns income over time from repeatedly selling his or her efforts; the owner of a machine earns income over time from repeatedly selling the use of that machine. So a factor of production, such as labor and capital, represents an enduring source of income. An input like electricity or cloth, however, is used up in the production process. Once exhausted, it cannot be a source of future income for its owner. Why Factor Prices Matter: The Allocation of Resources Factor markets and factor prices play a key role in one of the most important processes that must take place in any economy: the allocation of resources among producers. Consider the example of Mississippi and Louisiana in the aftermath of Hurricane Katrina, which was the costliest hurricane to hit the U.S. mainland to date. The states had an urgent need for workers in the building trades—carpenters, plumbers, and so on—to repair or replace damaged homes and businesses. What ensured that those needed workers actually came? The factor market: the high demand for workers drove up wages. During 2005, the average U.S. weekly wage grew at a rate of around 6%. But in areas heavily affected by Katrina, the average wage during the fall of 2005 grew by 30% more than the national rate, and some areas saw a rate of increase twice as high. Over time, these higher wages led large numbers of workers with the right skills to move temporarily to these states to do the work. In other words, the market for a factor C H A P T E R 2 0 FA 511 of production—construction workers—allocated that factor of production to where it was needed. In this sense factor markets are similar to goods markets, which allocate goods among consumers. But there are two features that make factor markets special. Unlike in a goods market, demand in a factor market is what we call derived demand. That is, demand for the factor is derived from the firm’s output choice. The second feature is that factor markets are where most of us get the largest shares of our income (government transfers being the next largest source of income in the economy). Factor Incomes and the Distribution of Income Most American families get most of their income in the form of wages and salaries— that is, they get their income by selling labor. Some people, however, get most of their income from physical capital: when you own stock in a company, what you really own is a share of that company’s physical capital. And some people get much of their income from rents earned on land they own. Obviously, then, the prices of factors of production have a major impact on how the economic “pie” is sliced among different groups. For example, a higher wage rate, other things equal, means that a larger proportion of the total income in the economy goes to people who derive their income from labor, and less goes to those who derive their income from capital or land. Economists refer to how the economic pie is sliced as the “distribution of income.” Specifically, factor prices determine the factor distribution of income—how the total income of the economy is divided among labor, land, and capital. As the following Economics in Action explains, the factor distribution of income in the United States has been quite stable over the past few decades. In other times and places, however, large changes have taken place in the factor distribution. One notable example: during the Industrial Revolution, the share of total income earned by landowners fell sharply, while the share earned by capital owners rose. As explained in the following For Inquiring Minds, this shift had a profound effect on society The Factor Distribution of Income and Social Change in the Industrial Revolution The factor distribution of income is the division of total income among labor, land, and capital. L D VIE VIEWWOR W O R L D Have you read any novels by Jane Austen? How about Charles Dickens? If you’ve read both, you probably noticed that they seem to be describing quite different societies. Austen’s novels, set around 1800, describe a world in which the leaders of society are landowning aristocrats. Dickens, writing about 50 years later, describes a world in which businessmen, especially factory owners, are in control. This literary shift reflects a dramatic transformation in the factor distribution of income. The Industrial Revolution, which took place between By altering how people lived and worked, the Industrial Revolution led to huge economic and social changes. the late eighteenth century and the middle of the nineteenth century, changed England from a mainly agricultural country, in which land earned a fairly substantial share of income, to an urbanized and industrial one, in which land rents were dwarfed by capital income. Recent estimates by the economist Nancy Stokey show that between 1780 and 1850 the share of national income represented by land fell from 20% to 9%, but the share represented by capital rose from 35% to 44%. That shift changed everything—even literature 512 P A R T 9 FA ECONOMICS IN ACTION The Factor Distribution of Income in the United States When we talk about the factor distribution of income, what are we talking about in practice? In the United States, as in all advanced economies, payments to labor account for most of the economy’s total income. Figure 20-1 shows the factor distribution of income in the United States in 2007: in that year, 70.4% of total income in the economy took the form of “compensation of employees”—a number that includes both wages and benefits such as health insurance. This number has been quite stable over the long run; 35 years earlier, in 1972, compensation of employees was very similar, at 72.2% of total income. FIGURE 20-1 Factor Distribution of Income in the United States in 2007 In 2007, compensation of employees accounted for most income earned in the United States—about 70% of the total. Most of the remainder—consisting of earnings paid in the form of interest, corporate profits, and rent—went to owners of physical capital. Finally, proprietors’ income—9.3% of the total—went to individual owners of businesses as compensation for their labor and capital expended in their businesses. Source: Bureau of Economic Analysis. Compensation of employees 70.4% Interest 5.4% Corporate profits 14.3% Rent 0.6% Proprietors’ income 9.3% ➤➤ ➤ Economists usually divide the economy’s factors of production into four principal categories: labor, land, physical capital, and human capital. ➤ The demand for a factor is a derived demand. Factor prices, which are set in factor markets, determine the factor distribution of income. Labor receives the bulk—approximately 70%—of the income in the modern U.S. economy. Although the exact share is not directly measurable, much of what is called compensation of employees is a retur |
n to human capital. However, measured wages and benefits don’t capture the full income of “labor” because a significant fraction of total income in the United States (usually between 7% and 10%) is “proprietors’ income”—the earnings of people who own their own businesses. Part of that income should be considered wages these business owners pay themselves. So the true share of labor in the economy is probably a few percentage points higher than the reported “compensation of employees” share. But much of what we call compensation of employees is really a return on human capital. A surgeon isn’t just supplying the services of a pair of ordinary hands (at least the patient hopes not!): that individual is also supplying the result of many years and hundreds of thousands of dollars invested in training and experience. We can’t directly measure what fraction of wages is really a payment for education and training, but many economists believe that human capital has become the most important factor of production in modern economies. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 20-1 1. Suppose that the government places price controls on the market for college professors, imposing a wage that is lower than the market wage. Describe the effect of this policy on the production of college degrees. What sectors of the economy do you think will be adversely affected by this policy? What sectors of the economy might benefit? Solutions appear at back of book FA 513 Marginal Productivity and Factor Demand All economic decisions are about comparing costs and benefits—and usually about comparing marginal costs and marginal benefits. This goes both for a consumer, deciding whether to buy another pound of fried clams, and for a producer, deciding whether to hire an additional worker. Although there are some important exceptions, most factor markets in the modern American economy are perfectly competitive, meaning that buyers and sellers of a given factor are price-takers. And in a competitive labor market, it’s clear how to define an employer’s marginal cost of a worker: it is simply the worker’s wage rate. But what is the marginal benefit of that worker? To answer that question, we return to a concept first introduced in Chapter 12: the production function, which relates inputs to output. And as in Chapter 13, we will assume throughout this chapter that all producers are price-takers in their output markets—that is, they operate in a perfectly competitive industry. Value of the Marginal Product Figure 20-2 reproduces Figures 12-1 and 12-2, which showed the production function for wheat on George and Martha’s farm. Panel (a) uses the total product curve to show how total wheat production depends on the number of workers employed on the farm; panel (b) shows how the marginal product of labor, the increase in output from employing one more worker, depends on the number of workers employed. Table 20-1 on the next page, which reproduces the table in Figure 12-1, shows the numbers behind the figure. Assume that George and Martha want to maximize their profit, that workers must be paid $200 each, and that wheat sells for $20 per bushel. What is their optimal number of workers? That is, how many workers should they employ to maximize profit? FIGURE 20-2 The Production Function for George and Martha’s Farm (a) Total Product (b) Marginal Product of Labor Quantity of wheat (bushels) 100 80 60 40 20 0 1 2 3 TP Marginal product of labor (bushels per worker) 19 17 15 13 11 9 7 5 MPL 5 4 Quantity of labor (workers Quantity of labor (workers) 6 7 8 Panel (a) shows how the quantity of output of wheat on George and Martha’s farm depends on the number of workers employed. Panel (b) shows how the marginal product of labor depends on the number of workers employed. 514 P A R T 9 FA TABLE 20-1 Employment and Output for George and Martha’s Farm Quantity of labor L (workers) Quantity of wheat Q (bushels 19 36 51 64 75 84 91 96 The value of the marginal product of a factor is the value of the additional output generated by employing one more unit of that factor. Marginal product of labor MPL = ΔQ ΔL (bushels per worker) 19 17 15 13 11 9 7 5 In Chapters 12 and 13 we showed how to answer this question in several steps. In Chapter 12 we used information from the producer’s production function to derive the firm’s total cost and its marginal cost. And in Chapter 13 we derived the price-taking firm’s optimal output rule: a price-taking firm’s profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price. Having determined the optimal quantity of output, we can go back to the production function and find the optimal number of workers—it is simply the number of workers needed to produce the optimal quantity of output. There is, however, another way to use marginal analysis to find the number of workers that maximizes a producer’s profit. We can go directly to the question of what level of employment maximizes profit. This alternative approach is equivalent to the approach we outlined in the preceding paragraph—it’s just a different way of looking at the same thing. But it gives us more insight into the demand for factors as opposed to the supply of goods. To see how this alternative approach works, let’s suppose that George and Martha are considering whether or not to employ an additional worker. The increase in cost from employing that additional worker is the wage rate, W. The benefit to George and Martha from employing that extra worker is the value of the extra output that worker can produce. What is this value? It is the marginal product of labor, MPL, multiplied by the price per unit of output, P. This amount—the extra value of output that is generated by employing one more unit of labor—is known as the value of the marginal product of labor, or VMPL: (20-1) Value of the marginal product of labor = VMPL = P × MPL So should George and Martha hire that extra worker? The answer is yes, if the value of the extra output is more than the cost of the worker—that is, if VMPL > W. Otherwise they shouldn’t hire that worker. So the decision to hire labor is a marginal decision, in which the marginal benefit to the producer from hiring an additional worker (VMPL) should be compared with the marginal cost to the producer (W). And as with any marginal decision, the optimal choice is where marginal benefit is just equal to marginal cost. That is, to maximize profit George and Martha will employ workers up to the point at which, for the last worker employed, (20-2) VMPL = W This rule doesn’t apply only to labor; it applies to any factor of production. The value of the marginal product of any factor is its marginal product times the price of the good it produces. The general rule is that a profit-maximizing price-taking producer employs each factor of production up to the point at which the value of the marginal product of the last unit of the factor employed is equal to that factor’s price. It’s important to realize that this rule doesn’t conflict with our analysis in Chapters 12 and 13. There we saw that a profit-maximizing producer of a good chooses the level of output at which the price of that good is equal to the marginal cost of production. It’s just a different way of looking at the same rule. If the level of output is chosen so that price equals marginal cost, then it is also true that at that output level the value of the marginal product of labor will equal the wage rate. Now let’s look more closely at why choosing the level of employment at which the value of the marginal product of the last worker employed is equal to the wage rate works—and at how it helps us understand factor demand FA 515 Value of the Marginal Product and Factor Demand Table 20-2 calculates the value of the marginal product of labor on George and Martha’s farm, on the assumption that the price of wheat is $20 per bushel. In Figure 20-3 the horizontal axis shows the number of workers employed; the vertical axis measures the value of the marginal product of labor and the wage rate. The curve shown is the value of the marginal product curve of labor. This curve, like the marginal product of labor curve, slopes downward because of diminishing returns to labor in production. That is, the value of the marginal product of each worker is less than that of the preceding worker, because the marginal product of each worker is less than that of the preceding worker. TABLE 20-2 Value of the Marginal Product of Labor for George and Martha’s Farm Quantity of labor L (workers) Marginal product of labor MPL (bushels per worker) Value of the marginal product of labor VMPL = P × MPL 0 1 2 3 4 5 6 7 8 19 17 15 13 11 9 7 5 $380 340 300 260 220 180 140 100 We have just seen that to maximize profit, George and Martha must hire workers up to the point at which the wage rate is equal to the value of the marginal product of the last worker employed. Let’s use the example to see how this principle really works. Assume that George and Martha currently employ 3 workers and that workers must be paid the market wage rate of $200. Should they employ an additional worker? Looking at Table 20-2, we see that if George and Martha currently employ 3 workers, the value of the marginal product of an additional worker is $260. So if they employ an additional worker, they will increase the value of their production by $260 but increase their cost by only $200, yielding an increased profit of $60. In fact, a producer can The value of the marginal product curve of a factor shows how the value of the marginal product of that factor depends on the quantity of the factor employed. FIGURE 20-3 The Value of the Marginal Product Curve Wage rate, VMPL This curve shows how the value of the marginal product of labor depends on the number of workers employed. It slopes downward because of diminishing returns to labor in production. To maximize profit, George |
and Martha choose the level of employment at which the value of the marginal product of labor is equal to the market wage rate. For example, at a wage rate of $200 the profit-maximizing level of employment is 5 workers, shown by point A. The value of the marginal product curve of a factor is the producer’s individual demand curve for that factor. Market wage rate $400 300 200 100 0 Optimal point A Value of the marginal product of labor curve, VMPL 1 2 3 4 5 6 7 8 Quantity of labor (workers) Profit-maximizing number of workers 516 P A R T 9 FA always increase profit by employing one more unit of a factor of production as long as the value of the marginal product produced by that unit exceeds its factor price. Alternatively, suppose that George and Martha employ 8 workers. By reducing the number of workers to 7, they can save $200 in wages. In addition, the value of the marginal product of the last one, the 8th worker, was only $100. So, by reducing employment by one worker, they can increase profit by $200 − $100 = $100. In other words, a producer can always increase profit by employing one less unit of a factor of production as long as the value of the marginal product produced by that unit is less than the factor price. Using this method, we can see from Table 20-2 that the profit-maximizing employment level is 5 workers given a wage rate of $200. The value of the marginal product of the 5th worker is $220, so adding the 5th worker results in $20 of additional profit. But George and Martha should not hire more than 5 workers: the value of the marginal product of the 6th worker is only $180, $20 less than the cost of that worker. So, to maximize profit, George and Martha should employ workers up to but not beyond the point at which the value of the marginal product of the last worker employed is equal to the wage rate. Now look again at the value of the marginal product curve in Figure 20-3. To determine the profit-maximizing level of employment, we set the value of the marginal product of labor equal to the price of labor—a wage rate of $200 per worker. This means that the profit-maximizing level of employment is at point A, corresponding to an employment level of 5 workers. If the wage rate were higher, we would simply move up the curve and decrease the number of workers employed: if the wage rate were lower than $200, we move down the curve and increase the number of workers employed. In this example, George and Martha have a small farm in which the potential employment level varies from 0 to 8 workers, and they hire workers up to the point at which the value of the marginal product of the last worker is no less than the wage rate. Suppose, however, that the firm in question is large and has the potential of hiring many workers. When there are many employees, the value of the marginal product of labor falls only slightly when an additional worker is employed. As a result, there will be some worker whose value of the marginal product almost exactly equals the wage rate. (In keeping with the George and Martha example, this means that some worker generates a value of the marginal product of approximately $200.) In this case, the firm maximizes profit by choosing a level of employment at which the value of the marginal product of the last worker hired equals (to a very good approximation) the wage rate. In the interest of simplicity, we will assume from now on that firms use this rule to determine the profit-maximizing level of employment. This means that the value of the marginal product of labor curve is the individual producer’s labor demand curve. And in general, a producer’s value of the marginal product curve for any factor of production is that producer’s individual demand curve for that factor of production. Shifts of the Factor Demand Curve As in the case of ordinary demand curves, it is important to distinguish between movements along the factor demand curve and shifts of the factor demand curve. What causes factor demand curves to shift? There are three main causes: ■ Changes in prices of goods ■ Changes in supply of other factors ■ Changes in technology Changes in Prices of Goods Remember that factor demand is derived demand: if the price of the good that is produced with a factor changes, so will the value of the marginal product of the factor. That is, in the case of labor demand, if P changes, VMPL = P × MPL will change at any given level of employment FA 517 FIGURE 20-4 Shifts of the Value of the Marginal Product Curve (a) An Increase in the Price of Wheat (b) A Decrease in the Price of Wheat Wage rate Wage rate Market wage rate $200 A B $200 C A VMPL2 VMPL1 VMPL1 VMPL3 0 5 8 Quantity of labor (workers) 0 2 5 Quantity of labor (workers) Panel (a) shows the effect of an increase in the price of wheat on George and Martha’s demand for labor. The value of the marginal product of labor curve shifts upward, from VMPL1 to VMPL2. If the market wage rate remains at $200, profit-maximizing employment rises from 5 workers to 8 workers, shown by the movement from point A to point B. Panel (b) shows the effect of a decrease in the price of wheat. The value of the marginal product of labor curve shifts downward, from VMPL1 to VMPL3. At the market wage rate of $200, profit-maximizing employment falls from 5 workers to 2 workers, shown by the movement from point A to point C. Figure 20-4 illustrates the effects of changes in the price of wheat, assuming that $200 is the current wage rate. Panel (a) shows the effect of an increase in the price of wheat. This shifts the value of the marginal product of labor curve upward, because VMPL rises at any given level of employment. If the wage rate remains unchanged at $200, the optimal point moves from point A to point B: the profitmaximizing level of employment rises. Panel (b) shows the effect of a decrease in the price of wheat. This shifts the value of the marginal product of labor curve downward. If the wage rate remains unchanged at $200, the optimal point moves from point A to point C: the profitmaximizing level of employment falls. Changes in Supply of Other Factors Suppose that George and Martha acquire more land to cultivate—say, by clearing a woodland on their property. Each worker now produces more wheat because each one has more land to work with. As a result, the marginal product of labor on the farm rises at any given level of employment. This has the same effect as an increase in the price of wheat, which is illustrated in panel (a) of Figure 20-4: the value of the marginal product of labor curve shifts upward, and at any given wage rate the profit-maximizing level of employment rises. Similarly, suppose George and Martha cultivate less land. This leads to a fall in the marginal product of labor at any given employment level. Each worker produces less wheat because each has less land to work with. As a result, the value of the marginal product of labor curve shifts downward—as in panel (b) of Figure 20-4—and the profit-maximizing level of employment falls. Changes in Technology In general, the effect of technological progress on the demand for any given factor can go either way: improved technology can either increase or reduce the demand for a given factor of production. 518 P A R T 9 FA How can technological progress reduce factor demand? Consider horses, which were once an important factor of production. The development of substitutes for horse power, such as automobiles and tractors, greatly reduced the demand for horses. The usual effect of technological progress, however, is to increase the demand for a given factor. In particular, although there have been persistent fears that machinery would reduce the demand for labor, over the long run the U.S. economy has seen both large wage increases and large increases in employment, suggesting that technological progress has greatly increased labor demand. The Marginal Productivity Theory of Income Distribution We’ve now seen that each perfectly competitive producer in a perfectly competitive factor market maximizes profit by hiring labor up to the point at which its value of the marginal product is equal to its price—in the case of labor, to the point where VMPL = W. What does this tell us about labor’s share in the factor distribution of income? To answer that question, we need to examine equilibrium in the labor market. From that vantage point we will go on to learn about the markets for land and capital, and how they also influence the factor distribution of income. Let’s start by assuming that the labor market is in equilibrium: at the current market wage rate, the number of workers that producers want to employ is equal to the number of workers willing to work. Thus, all employers pay the same wage rate, and each employer, whatever he or she is producing, employs labor up to the point at which the value of the marginal product of the last workers hired is equal to the market wage rate. This situation is illustrated in Figure 20-5, which shows the value of the marginal product curves of two producers—Farmer Jones, who produces wheat, and Farmer Smith, who produces corn. Despite the fact that they produce different products, they compete for the same workers and so must pay the same wage rate, $200. When both farmers maximize profit, both hire labor up to the point at which its value of the marginal product is equal to the wage rate. In the figure, this corresponds to employment of 5 workers by Jones and 7 by Smith. FIGURE 20-5 All Producers Face the Same Wage Rate (a) Farmer Jones (b) Farmer Smith Wage rate Market wage rate $200 Farmer Jones’s VMPLwheat = Pwheat x MPLwheat Wage rate $200 Farmer Smith’s VMPLcorn = Pcorn x MPLcorn VMPLcorn VMPLwheat 0 5 Quantity of labor (workers) 0 7 Quantity of labor (workers) Profit-maximizing number of workers Profit-maximizing number of workers Although Farmer Jones grows wheat and Farmer Smith grows corn, they both compete in the same market for labor and so mus |
t pay the same wage rate, $200. Each producer hires labor up to the point at which VMPL = $200: 5 workers for Jones, 7 workers for Smith FA 519 FIGURE 20-6 Equilibrium in the Labor Market The market labor demand curve is the horizontal sum of the individual labor demand curves of all producers. Here the equilibrium wage rate is W*, the equilibrium employment level is L*, and every producer hires labor up to the point at which VMPL = W*. So labor is paid its equilibrium value of the marginal product, the value of the marginal product of the last worker hired in the labor market as a whole. Wage rate Equilibrium value of the marginal product of labor W* Market labor supply curve Market labor demand curve Quantity of labor (workers) E L* Equilibrium employment Figure 20-6 illustrates the labor market as a whole. The market labor demand curve, like the market demand curve for a good (shown in Figure 3-5), is the horizontal sum of all the individual labor demand curves of all the producers who hire labor. And recall that each producer’s individual labor demand curve is the same as his or her value of the marginal product of labor curve. For now, let’s simply assume an upward-sloping labor supply curve; we’ll discuss labor supply later in this chapter. Then the equilibrium wage rate is the wage rate at which the quantity of labor supplied is equal to the quantity of labor demanded. In Figure 20-6, this leads to an equilibrium wage rate of W* and the corresponding equilibrium employment level of L*. (The equilibrium wage rate is also known as the market wage rate.) And as we showed in the examples of the farms of George and Martha and of Farmer Jones and Farmer Smith (where the equilibrium wage rate is $200), each farm hires labor up to the point at which the value of the marginal product of labor is equal to the equilibrium wage rate. Therefore, in equilibrium, the value of the marginal product of labor is the same for all employers. So the equilibrium (or market) wage rate is equal to the equilibrium value of the marginal product of labor—the additional value produced by the last unit of labor employed in the labor market as a whole. It doesn’t matter where that additional unit is employed, since equilibrium VMPL is the same for all producers. What we have just learned, then, is that the market wage rate is equal to the equilibrium value of the marginal product of labor. And the same is true of each factor of production: in a perfectly competitive market economy, the market price of each factor is equal to its equilibrium value of the marginal product. Let’s examine the markets for land and (physical) capital now. (From this point on, we’ll refer to physical capital as simply “capital.”) The Markets for Land and Capital If we maintain the assumption that the markets for goods and services are perfectly competitive, the result that we derived for the labor market also applies to other factors of production. Suppose, for example, that a farmer is considering whether to rent an The equilibrium value of the marginal product of a factor is the additional value produced by the last unit of that factor employed in the factor market as a whole. 520 P A R T 9 FA The rental rate of either land or capital is the cost, explicit or implicit, of using a unit of that asset for a given period of time. additional acre of land for the next year. He or she will compare the cost of renting that acre with the value of the additional output generated by employing an additional acre— the value of the marginal product of an acre of land. To maximize profit, the farmer must employ land up to the point at which the value of the marginal product of an acre of land is equal to the rental rate per acre. What if the farmer already owns the land? We already saw the answer in Chapter 9, which dealt with economic decisions: even if you own land, there is an implicit cost—the opportunity cost—of using it for a given activity, because it could be used for something else, such as renting it out to other farmers at the market rental rate. So a profit-maximizing producer employs additional acres of land up to the point at which the cost of the last acre employed, explicit or implicit, is equal to the value of the marginal product of that acre. The same is true for capital. The explicit or implicit cost of using a unit of land or capital for a set period of time is called its rental rate. In general, a unit of land or capital is employed up to the point at which that unit’s value of the marginal product is equal to its rental rate over that time period. How are the rental rates for land and capital determined? By the equilibria in the land market and the capital market, of course. Figure 20-7 illustrates those outcomes. Panel (a) shows the equilibrium in the market for land. Summing over the individual demand curves for land of all producers gives us the market demand curve for land. Due to diminishing returns, the demand curve slopes downward, like the demand curve for labor. As we have drawn it, the supply curve of land is relatively steep and therefore relatively inelastic. This reflects the fact that finding new supplies of land for production is typically difficult and expensive—for example, creating new farmland through expensive irrigation. The equilibrium rental rate for land, R*Land, and the equilibrium quantity of land employed in production, Q*Land, are given by the intersection of the two curves. Rental rate R*Land FIGURE 20-7 Equilibria in the Land and Capital Markets (a) The Market for Land (b) The Market for Capital SLand Rental rate R*Capital DLand SCapital DCapital Q*Land Quantity Q*Capital Quantity Panel (a) illustrates equilibrium in the market for land; panel (b) illustrates equilibrium in the market for capital. The supply curve for land is relatively steep, reflecting the high cost of increasing the quantity of productive land. The supply curve for capital, in contrast, is relatively flat, due to the relatively high responsiveness of savings to changes in the rental rate for capital. The equilibrium rental rates for land and capital, as well as the equilibrium quantities transacted, are given by the intersections of the demand and supply curves. In a competitive land market, each unit of land will be paid the equilibrium value of the marginal product of land, R*Land. Likewise, in a competitive capital market, each unit of capital will be paid the equilibrium value of the marginal product of capital, R*Capital FA 521 According to the marginal productivity theory of income distribution, every factor of production is paid its equilibrium value of the marginal product. Panel (b) shows the equilibrium in the market for capital. In contrast to the supply curve for land, the supply curve for capital is relatively elastic. That’s because the supply of capital is relatively responsive to price: capital comes from the savings of investors, and the amount of savings that investors make available is relatively responsive to the rental rate for capital. The equilibrium rental rate for capital, R*Capital, and the equilibrium quantity of capital employed in production, Q*Capital, are given by the intersection of the two curves. One small aside—you may have noted that producers frequently purchase land or capital rather than rent it over time. Does this fact mean that our model no longer works? No—it just means that we have to make an adjustment. We have to take into account that a parcel of land or a piece of machinery that has been purchased by a producer generates future revenue as well as current revenue. Using the present value method, which we learned in Chapter 9, we can convert the value of the marginal product stream that the parcel of land or machine generates today and in the future into its present value. Thus, a producer will purchase parcels of land or pieces of machinery up to the point at which the present value of its current and future stream of the value of the marginal product is equal to its factor price. If you examine our analysis of present value in Chapter 9, you’ll see that, other things equal, present value increases when the interest rate falls. This leads to an important observation about how markets interact: other things equal, a fall in the interest rate (the real interest rate, which is the interest rate adjusted for changes in the purchasing power of money) leads to a rightward shift of the demand curves for land and for capital, with higher equilibrium prices and quantities transacted. The Marginal Productivity Theory of Income Distribution So we have learned that when the markets for goods and services and the factor markets are perfectly competitive, a factor of production will be employed up to the point at which its value of the marginal product is equal to its market equilibrium price. That is, it will be paid its equilibrium value of the marginal product. What does this say about the factor distribution of income? It leads us to the marginal productivity theory of income distribution, which says that each factor is paid the value of the output generated by the last unit of that factor employed in the factor market as a whole—its equilibrium value of the marginal product. To understand why the marginal productivity theory of income distribution is important, look back at Figure 20-1, which shows the factor distribution of income in the United States, and ask yourself this question: who or what decided that labor would get 70.4% of total U.S. income? Why not 90% or 50%? The answer, according to the marginal productivity theory of income distribution, is that the division of income among the economy’s factors of production isn’t arbitrary: it is determined by each factor’s marginal productivity at the economy’s equilibrium. The wage rate earned by all workers in the economy is equal to the increase in the value of output generated by the last worker employed in the economy-wide labor market. Here we have assu |
med that all workers are of the same ability. (Similarly, we’ve assumed that all units of land and capital are equally productive.) But in reality workers differ considerably in ability. Rather than thinking of one labor market for all workers in the economy, we can instead think of different markets for different types of workers, where workers are of equivalent ability within each market. For example, the market for computer programmers is different from the market for pastry chefs. And in the market for computer programmers, all participants are assumed to have equal ability; likewise for the market for pastry chefs. In this scenario, the marginal productivity theory of income distribution still holds. That is, when the labor market for computer programmers is in equilibrium, the wage rate earned by all computer programmers is equal to the market’s equilibrium value of the marginal product—the value of the marginal product of the last computer programmer hired in that market. P I T F A L L S getting marginal productivity theory right It’s important to be careful about what the marginal productivity theory of income distribution says: it says that all units of a factor get paid the factor’s equilibrium value of the marginal product—the additional value produced by the last unit of the factor employed. The most common source of error is to forget that the relevant value of the marginal product is the equilibrium value, not the value of the marginal products you calculate on the way to equilibrium. In looking at Table 20-2, you might be tempted to think that because the first worker has a value of the marginal product of $380, that worker is paid $380 in equilibrium. Not so: if the equilibrium value of the marginal product in the labor market is equal to $200, then all workers receive $200. 522 P A R T 9 FA ECONOMICS IN ACTION Help Wanted! Hamill Manufacturing of Pennsylvania makes precision components for military helicopters and nuclear submarines. Their highly skilled senior machinists are well paid compared to other workers in manufacturing, earning nearly $70,000 in 2006, excluding benefits. Like most skilled machinists in the United States, Hamill’s machinists are very productive: according to the National Mechanists Association, in 2006 each skilled American machinist generated approximately $120,000 in yearly revenue. But there is a $50,000 difference between the salary paid to Hamill machinists and the revenue they generate. Does this mean that the marginal productivity theory of income distribution doesn’t hold? Doesn’t the theory imply that machinists should be paid $120,000, the average revenue that each one generates? The answer is no, for two reasons. First, the $120,000 figure is averaged over all machinists currently employed. The theory says that machinists will be paid the value of the marginal product of the last machinist hired, and due to diminishing returns to labor, that value will be lower than the average over all machinists currently employed. Second, a worker’s equilibrium wage rate includes other costs, such as employee benefits, that have to be added to the $70,000 salary. The marginal productivity theory of income distribution says that workers are paid a wage rate, including all benefits, equal to the value of the marginal product. You can see all these costs are present at Hamill. There the machinists have good benefits and job security, which add to their salary. Including these benefits, machinists’ total compensation will be equal to the value of the marginal product of the last machinist employed In Hamill’s case, there is yet another factor that explains the $50,000 gap: there are not enough machinists at the current wage rate. Although the company increased the number of employees from 85 in 2004 to 110 in 2006, they would like to hire more. Why doesn’t Hamill raise its wages in order to attract more skilled machinists? The problem is that the work they do is so specialized that it is hard to hire from the outside, even when the company raises wages as an inducement. To address this problem, Hamill is now spending a significant amount of money training each new hire. In the end, it does appear that the marginal productivity theory of income distribution holds. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 20-2 1. In the following cases, state the direction of the shift of the demand curve for labor and what will happen, other things equal, to the market equilibrium wage rate and quantity of labor employed as a result. a. Service industries, such as retailing and banking, experience an increase in demand. These industries use relatively more labor than nonservice industries. b. Due to overfishing, there is a fall in the amount of fish caught per day by commercial fishers; this decrease affects their demand for workers. 2. Explain the following statement: “When firms in different industries all compete for the same workers, then the value of the marginal product of the last worker hired will be equal across all firms regardless of whether they are in different industries.” Solutions appear at back of book. Is the Marginal Productivity Theory of Income Distribution Really True? Although the marginal productivity theory of income distribution is a well-established part of economic theory, closely linked to the analysis of markets in general, it is a source of some controversy. There are two main objections to it. The marginal productivity theory of income distribution holds for skilled machinists at Hamill Manufacturing. ➤➤ ➤ In a perfectly competitive market economy, the price of the good multiplied by the marginal product of labor is equal to the value of the marginal product of labor: VMPL = P × MPL. A profit-maximizing producer hires labor up to the point at which the value of the marginal product of labor is equal to the wage rate: VMPL = W. The value of the marginal product of labor curve slopes downward due to diminishing returns to labor in production. ➤ The market demand curve for labor is the horizontal sum of all the individual demand curves of producers in that market. It shifts for three reasons: changes in output price, changes in the supply of other factors, and technological progress. ➤ As in the case of labor, producers will employ land or capital until the point at which its value of the marginal product is equal to its rental rate. According to the marginal productivity theory of income distribution, in a perfectly competitive economy each factor of production is paid its equilibrium value of the marginal product FA 523 First, in the real world we see large disparities in income between factors of production that, in the eyes of some observers, should receive the same payment. Perhaps the most conspicuous examples in the United States are the large differences in the average wages between women and men and among various racial and ethnic groups. Do these wage differences really reflect differences in marginal productivity, or is something else going on? Second, many people wrongly believe that the marginal productivity theory of income distribution gives a moral justification for the distribution of income, implying that the existing distribution is fair and appropriate. This misconception sometimes leads other people, who believe that the current distribution of income is unfair, to reject marginal productivity theory. To address these controversies, we’ll start by looking at income disparities across gender and ethnic groups. Then we’ll ask what factors might account for these disparities and whether these explanations are consistent with the marginal productivity theory of income distribution. Wage Disparities in Practice Wage rates in the United States cover a very wide range. In 2007, hundreds of thousands of workers received the legal federal minimum of $5.85 per hour. At the other extreme, the chief executives of several companies were paid more than $100 million, which works out to $20,000 per hour even if they worked 100-hour weeks. Even leaving out these extremes, there is a huge range of wage rates. Are people really that different in their marginal productivities? A particular source of concern is the existence of systematic wage differences across gender and ethnicity. Figure 20-8 compares annual median earnings in 2006 of workers 25 years or older classified by gender and ethnicity. As a group, White males had the highest earnings. Other data show that women (averaging across all ethnicities) earned only about 60% as much; African-American workers (male and female combined) only 64% as much; Hispanic workers only 54% as much. We are a nation founded on the belief that all men are created equal—and if the Constitution were rewritten today, we would say that all people are created equal. So why do they receive such unequal pay? Let’s start with the marginal productivity explanations, then look at other influences. FIGURE 20-8 Median Earnings by Gender and Ethnicity, 2006 The U.S. labor market continues to show large differences across workers according to gender and ethnicity. Women are paid substantially less than men; African-American and Hispanic workers are paid substantially less than White male workers. Source: Bureau of Labor Statistics. Annual median earnings, 2006 $50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 $45,722 $27,337 $29,166 $24,893 White male Female (al l ethnicities) AfricanAmerican (male a nd female) Hispanic (male a nd female) 524 P A R T 9 FA Compensating differentials are wage differences across jobs that reflect the fact that some jobs are less pleasant than others. Marginal Productivity and Wage Inequality A large part of the observed inequality in wages can be explained by considerations that are consistent with the marginal productivity theory of income distribution. In particular, there are three well-understood sources of wage differences across occupations and individuals. First is t |
he existence of compensating differentials: across different types of jobs, wages are often higher or lower depending on how attractive or unattractive the job is. Workers with unpleasant or dangerous jobs demand a higher wage in comparison to workers with jobs that require the same skill and effort but lack the unpleasant or dangerous qualities. For example, truckers who haul hazardous loads are paid more than truckers who haul normal loads. But for any given job, the marginal productivity theory of income distribution generally holds true. For example, hazardousload truckers are paid a wage equal to the equilibrium value of the marginal product of the last person employed in the market for hazardous-load truckers. A second reason for wage inequality that is clearly consistent with marginal productivity theory is differences in talent. People differ in their abilities: a high-ability person, by producing a better product that commands a higher price compared to a lower-ability person, generates a higher value of the marginal product. And these differences in the value of the marginal product translate into differences in earning potential. We all know that this is true in sports: practice is important, but 99.99% (at least) of the population just doesn’t have what it takes to hit golf balls like Tiger Woods or hit tennis balls like Maria Sharapova. The same is true, though less obvious, in other fields of endeavor. A third, very important reason for wage differences is differences in the quantity of human capital. Recall that human capital—education and training—is at least as important in the modern economy as physical capital in the form of buildings and machines. Different people “embody” quite different quantities of human capital, and a person with a higher quantity of human capital typically generates a higher value of the marginal product by producing a product that commands a higher price. So differences in human capital account for substantial differences in wages. People with high levels of human capital, such as skilled surgeons or engineers, generally receive high wages. The most direct way to see the effect of human capital on wages is to look at the relationship between educational levels and earnings. Figure 20-9 shows earnings differentials by gender, ethnicity, and three educational levels for people 25 years or older in 2006. As you can see, regardless of gender or ethnicity, higher education is associated with higher median earnings. For example, in 2006 White females with 9 to 12 years of schooling but without a high school diploma had median earnings 31% less than those with a high school diploma and 64% less than those with a college degree—and similar patterns exist for the other five groups. Additional data show that surgeons—an occupation that requires steady hands and many years of formal training—earned an average of $184,150 in 2006. Because even now men typically have had more years of education than women and Whites more years than non-Whites, differences in level of education are part of the explanation for the earnings differences shown in Figure 20-8. It’s also important to realize that formal education is not the only source of human capital; on-the-job training and experience are also very important. This point was highlighted by a 2003 National Science Foundation report on earnings differences between male and female scientists and engineers. The study was motivated by concerns over the male–female earnings gap: the median salary for women in science and engineering is about 24% less than the median salary for men. The study found that women in these occupations are, on average, younger than men and have considerably less experience than their male counterparts. This difference in age and experience, according to the study, explained most of the earnings differential. Differences in job tenure and experience can partly explain one notable aspect of C H A P T E R 2 0 FA 525 FIGURE 20-9 Earnings Differentials by Education, Gender, and Ethnicity, 2006 It is clear that, regardless of gender or ethnicity, education pays: those with a high school diploma earn more than those without one, and those with a college degree earn substantially more than those with only a high school diploma. Other patterns are evident as well: for any given education level, White males earn more than every other group, and males earn more than females for any given ethnic group. Source: Bureau of Labor Statistics. Annual median earnings, 2006 $70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 No HS degree HS degree College degree White male White female AfricanAmerican male AfricanAmerican female Hispanic male Hispanic female Figure 20-9: that, across all ethnicities, women’s median earnings are less than men’s median earnings for any given education level. But it’s also important to emphasize that earnings differences arising from differences in human capital are not necessarily “fair.” A society in which non-White children typically receive a poor education because they live in underfunded school districts, then go on to earn low wages because they are poorly educated, may have labor markets that are well described by marginal productivity theory (and would be consistent with the earnings differentials across ethnic groups shown in Figure 208). Yet many people would still consider the resulting distribution of income unfair. Still, many observers think that actual wage differentials cannot be entirely explained by compensating differentials, differences in talent, and differences in human capital. They believe that market power, efficiency wages, and discrimination also play an important role. We will examine these forces next. Market Power The marginal productivity theory of income distribution is based on the assumption that factor markets are perfectly competitive. In such markets we can expect workers to be paid the equilibrium value of their marginal product, regardless of who they are. But how valid is this assumption? We studied markets that are not perfectly competitive in Chapters 14, 15, and 16; now let’s touch briefly on the ways in which labor markets may deviate from the competitive assumption. One undoubted source of differences in wages between otherwise similar workers is the role of unions—organizations that try to raise wages and improve working conditions for their members. Labor unions, when they are successful, replace one-onone wage deals between workers and employers with “collective bargaining,” in which the employer must negotiate wages with union representatives. Without question, this leads to higher wages for those workers who are represented by unions. In 2007 the median weekly earnings of union members in the United States were $863, compared with $663 for workers not represented by unions—about a 23% difference. Unions are organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively. 526 P A R T 9 FA According to the efficiency-wage model, some employers pay an aboveequilibrium wage as an incentive for better performance. Just as workers can sometimes organize to extract higher wages than they would otherwise receive, employers can sometimes organize to pay lower wages than would result from competition. For example, health care workers—doctors, nurses, and so on—sometimes argue that health maintenance organizations (HMOs) are engaged in a collective effort to hold down their wages. How much does collective action, either by workers or by employers, affect wages in the modern United States? Several decades ago, when around 30% of American workers were union members, unions probably had a significant upward effect on wages. Today, however, most economists think unions exert a fairly minor influence. Union membership in the United States is relatively limited: less than 9% of the employees of private businesses are represented by unions. And although there are fields like health care in which a few large firms account for a sizable share of employment in certain geographical areas, the sheer size of the U.S. labor market is enormous and the ease with which most workers can move in search of higher-paying jobs probably means that concerted efforts to hold wages below the unrestrained market equilibrium level rarely occur and even more rarely succeed. Efficiency Wages A second source of wage inequality is the phenomenon of efficiency wages—a type of incentive scheme used by employers to motivate workers to work hard and to reduce worker turnover. Suppose a worker performs a job that is extremely important but that the employer can observe how well the job is being performed only at infrequent intervals—say, serving as a caregiver for the employer’s child. Then it often makes sense for the employer to pay more than the worker could earn in an alternative job—that is, more than the equilibrium wage. Why? Because earning a premium makes losing this job and having to take the alternative job quite costly for the worker. So a worker who happens to be observed performing poorly and is therefore fired is now worse off for having to accept a lower-paying job. The threat of losing a job that pays a premium motivates the worker to perform well and avoid being fired. Likewise, paying a premium also reduces worker turnover—the frequency with which an employee leaves a job voluntarily. Despite the fact that it may take no more effort and skill to be a child’s caregiver than to be an office worker, efficiency wages show why it often makes economic sense for a parent to pay a caregiver more than the equilibrium wage of an office worker. The efficiency-wage model explains why we may observe wages offered above their equilibrium level. Like the price floors we studied in Chapter 5—and, in particular, much like the minimum wage—this phenomenon leads to a surplus of labor in labor markets that are characterized by the efficienc |
y-wage model. This surplus of labor translates into unemployment—some workers are actively searching for a highpaying efficiency-wage job but are unable to get one, and other more fortunate but no more deserving workers are able to acquire one. As a result, two workers with exactly the same profile—the same skills and same job history—may earn unequal wages: the worker who is lucky enough to get an efficiency-wage job earns more than the worker who gets a standard job (or who remains unemployed while searching for a higher-paying job). Efficiency wages are a response to a type of market failure that arises from the fact that some employees don’t always perform as well as they should and are able to hide that fact. As a result, employers use nonequilibrium wages in order to motivate their employees, leading to an inefficient outcome. Discrimination It is a real and ugly fact that throughout history there has been discrimination against workers who are considered to be of the wrong race, ethnicity, gender, or other characteristics. How does this fit into our economic models? The main insight economic analysis offers is that discrimination is not a natural consequence of market competition. On the contrary, market forces tend to work C H A P T E R 2 0 FA 527 against discrimination. To see why, consider the incentives that would exist if social convention dictated that women be paid, say, 30% less than men with equivalent qualifications and experience. A company whose management was itself unbiased would then be able to reduce its costs by hiring women rather than men—and such companies would have an advantage over other companies that hired men despite their higher cost. The result would be to create an excess demand for female workers, which would tend to drive up their wages. But if market competition works against discrimination, how is it that so much discrimination has taken place? The answer is twofold. First, when labor markets don’t work well, employers may have the ability to discriminate without hurting their profits. For example, market interferences (such as unions or minimum-wage laws) or market failures (such as efficiency wages) can lead to wages that are above their equilibrium levels. In these cases, there are more job applicants than there are jobs, leaving employers free to discriminate among applicants. In research published in the American Economic Review, two economists, Marianne Bertrand and Sendhil Mullainathan, documented discrimination in hiring by sending fictitious résumés to prospective employers on a random basis. Applicants with “White-sounding” names such as Emily Walsh were 50% more likely to be contacted than applicants with “African-American-sounding” names such as Lakisha Washington. Also, applicants with White-sounding names and good credentials were much more likely to be contacted than those without such credentials. By contrast, potential employers seemed to ignore the credentials of applicants with African-American-sounding names. Second, discrimination has sometimes been institutionalized in government policy. This institutionalization of discrimination has made it easier to maintain it against market pressure, and historically it is the form that discrimination has typically taken. For example, at one time in the United States, African-Americans were barred from attending “Whites-only” public schools and universities in many parts of the country and forced to attend inferior schools. Although market competition tends to work against current discrimination, it is not a remedy for past discrimination, which typically has had an impact on the education and experience of its victims and thereby reduces their income. The following Economics in Action illustrates the way in which government policy enforced discrimination in the world’s most famous racist regime, that of the former government of South Africa. So Does Marginal Productivity Theory Work? The main conclusion you should draw from this discussion is that the marginal productivity theory of income distribution is not a perfect description of how factor incomes are determined but that it works pretty well. The deviations are important. But, by and large, in a modern economy with well-functioning labor markets, factors of production are paid the equilibrium value of the marginal product—the value of the marginal product of the last unit employed in the market as a whole. It’s important to emphasize, once again, that this does not mean that the factor distribution of income is morally justified. L D VIE W R W O ➤ECONOMICS IN ACTION The Economics of Apartheid The Republic of South Africa is the richest nation in Africa, but it also has a harsh political history. Until the peaceful transition to majority rule in 1994, the country was controlled by its White minority, Afrikaners, the descendants of European (mainly Dutch) immigrants. This minority imposed an economic system known as VIEWWOR 528 P A R T 9 FA ➤➤ ➤ Existing large disparities in wages both among individuals and across groups lead some to question the marginal productivity theory of income distribution. ➤ Compensating differentials, as well as differences in the values of the marginal products of workers that arise from differences in talent, job experience, and human capital, account for some wage disparities. ➤ Market power, in the form of unions or collective action by employers, as well as the efficiency-wage model, also explain how some wage disparities arise. ➤ Discrimination has historically been a major factor in wage disparities. Market competition tends to work against discrimination. apartheid, which overwhelmingly favored White interests over those of native Africans and other groups considered “non-White,” such as Asians. The origins of apartheid go back to the early years of the twentieth century, when large numbers of White farmers began moving into South Africa’s growing cities. There they discovered, to their horror, that they did not automatically earn higher wages than other races. But they had the right to vote—and non-Whites did not. And so the South African government instituted “job-reservation” laws designed to ensure that only Whites got jobs that paid well. The government also set about creating jobs for Whites in government-owned industries. As Allister Sparks notes in The Mind of South Africa (1990), in its efforts to provide high-paying jobs for Whites, the country “eventually acquired the largest amount of nationalized industry of any country outside the Communist bloc.” In other words, racial discrimination was possible because it was backed by the power of the government, which prevented markets from following their natural course. A postscript: in 1994, in one of the political miracles of modern times, the White regime ceded power and South Africa became a full-fledged democracy. Apartheid was abolished. Unfortunately, large racial differences in earnings remain. The main reason is that apartheid created huge disparities in human capital, which will persist for many years to come. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 20-3 1. Assess each of the following statements. Do you think they are true, false, or ambiguous? Explain. a. The marginal productivity theory of income distribution is inconsistent with the presence of income disparities associated with gender, race, or ethnicity. b. Companies that engage in workplace discrimination but whose competitors do not are likely to have lower profits as a result of their actions. c. Workers who are paid less because they have less experience are not the victims of discrimination. Solutions appear at back of book. The Supply of Labor Up to this point we have focused on the demand for factors, which determines the quantities demanded of labor, capital, or land by producers as a function of their factor prices. What about the supply of factors? In this section we focus exclusively on the supply of labor. We do this for two reasons. First, in the modern U.S. economy, labor is the most important factor of production, accounting for most of factor income. Second, as we’ll see, labor supply is the area in which factor markets look most different from markets for goods and services. Work versus Leisure In the labor market, the roles of firms and households are the reverse of what they are in markets for goods and services. A good such as wheat is supplied by firms and demanded by households; labor, though, is demanded by firms and supplied by households. How do people decide how much labor to supply? As a practical matter, most people have limited control over their work hours: either you take a job that involves working a set number of hours per week, or you don’t get the job at all. To understand the logic of labor supply, however, it helps to put realism to one side for a bit and imagine an individual who can choose to work as many or as few hours as he or she likes FA 529 Decisions about labor supply result from decisions about time allocation: how many hours to spend on different activities. Leisure is time available for purposes other than earning money to buy marketed goods. Why wouldn’t such an individual work as many hours as possible? Because workers are human beings, too, and have other uses for their time. An hour spent on the job is an hour not spent on other, presumably more pleasant, activities. So the decision about how much labor to supply involves making a decision about time allocation—how many hours to spend on different activities. By working, people earn income that they can use to buy goods. The more hours an individual works, the more goods he or she can afford to buy. But this increased purchasing power comes at the expense of a reduction in leisure, the time spent not working. (Leisure doesn’t necessarily mean time goofing off. It could mean time spent with one’s family, pursuing hobbies, exercising, and so on.) And though purchased goods yield utility, s |
o does leisure. Indeed, we can think of leisure itself as a normal good, which most people would like to consume more of as their incomes increase. How does a rational individual decide how much leisure to consume? By making a marginal comparison, of course. In analyzing consumer choice, we asked how a utility-maximizing consumer uses a marginal dollar. In analyzing labor supply, we ask how an individual uses a marginal hour. Consider Clive, an individual who likes both leisure and the goods money can buy. Suppose that his wage rate is $10 per hour. In deciding how many hours he wants to work, he must compare the marginal utility of an additional hour of leisure with the additional utility he gets from $10 worth of goods. If $10 worth of goods adds more to his total utility than an additional hour of leisure, he can increase his total utility by giving up an hour of leisure in order to work an additional hour. If an extra hour of leisure adds more to his total utility than $10 worth of goods, he can increase his total utility by working one fewer hour in order to gain an hour of leisure. At Clive’s optimal labor supply choice, then, his marginal utility of one hour of leisure is equal to the marginal utility he gets from the goods that his hourly wage can purchase. This is very similar to the optimal consumption rule we encountered in Chapter 10, except that it is a rule about time rather than money. Our next step is to ask how Clive’s decision about time allocation is affected when his wage rate changes. Wages and Labor Supply Suppose that Clive’s wage rate doubles, from $10 to $20 per hour. How will he change his time allocation? You could argue that Clive will work longer hours, because his incentive to work has increased: by giving up an hour of leisure, he can now gain twice as much money as before. But you could equally well argue that he will work less, because he doesn’t need to work as many hours to generate the income to pay for the goods he wants. As these opposing arguments suggest, the quantity of labor Clive supplies can either rise or fall when his wage rate rises. To understand why, let’s recall the distinction between substitution effects and income effects that we learned in Chapters 10 and 11. We saw there that a price change affects consumer choice in two ways: by changing the opportunity cost of a good in terms of other goods (the substitution effect) and by making the consumer richer or poorer (the income effect). Now think about how a rise in Clive’s wage rate affects his demand for leisure. The opportunity cost of leisure—the amount of money he gives up by taking an hour off instead of working—rises. That substitution effect gives him an incentive, other things equal, to consume less leisure and work longer hours. Conversely, a higher wage rate makes Clive richer—and this income effect leads him, other things equal, to want to consume more leisure and supply less labor, because leisure is a normal good. So in the case of labor supply, the substitution effect and the income effect work in opposite directions. If the substitution effect is so powerful that it dominates the 530 P A R T 9 FA The individual labor supply curve shows how the quantity of labor supplied by an individual depends on that individual’s wage rate. income effect, an increase in Clive’s wage rate leads him to supply more hours of labor. If the income effect is so powerful that it dominates the substitution effect, an increase in the wage rate leads him to supply fewer hours of labor. We see, then, that the individual labor supply curve—the relationship between the wage rate and the number of hours of labor supplied by an individual worker— does not necessarily slope upward. If the income effect dominates, a higher wage rate will reduce the quantity of labor supplied. Figure 20-10 illustrates the two possibilities for labor supply. If the substitution effect dominates the income effect, the individual labor supply curve slopes upward; panel (a) shows an increase in the wage rate from $10 to $20 per hour leading to a rise in the number of hours worked from 40 to 50. However, if the income effect dominates, the quantity of labor supplied goes down when the wage rate increases. Panel (b) shows the same rise in the wage rate leading to a fall in the number of hours worked from 40 to 30. (Economists refer to an individual labor supply curve that contains both upward-sloping and downward-sloping segments as a “backwardbending labor supply curve”—a concept that we analyze in detail in this chapter’s appendix.) Is a negative response of the quantity of labor supplied to the wage rate a real possibility? Yes: many labor economists believe that income effects on the supply of labor may be somewhat stronger than substitution effects. The most compelling piece of evidence for this belief comes from Americans’ increasing consumption of leisure over the past century. At the end of the nineteenth century, wages adjusted for inflation were only about one-eighth what they are today; the typical work week was 70 hours, and very few workers retired at age 65. Today the typical work week is less than 40 hours, and most people retire at age 65 or earlier. So it seems that Americans have chosen to take advantage of higher wages in part by consuming more leisure. Wage rate $20 10 0 FIGURE 20-10 The Individual Labor Supply Curve (a) The Substitution Effect Dominates (b) The Income Effect Dominates Individual labor supply curve Wage rate $20 10 0 40 50 Quantity of labor (hours) Individual labor supply curve 30 40 Quantity of labor (hours) When the substitution effect of a wage increase dominates the income effect, the individual labor supply curve slopes upward, as in panel (a). Here a rise in the wage rate from $10 to $20 per hour increases the number of hours worked from 40 to 50. But when the income effect of a wage increase dominates the substitution effect, the individual labor supply curve slopes downward, as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30 FA 531 Why You Can’t Find a Cab When It’s Raining Everyone says that you can’t find a taxi in New York when you really need one—say, when it’s raining. That could be because everyone else is trying to get a taxi at the same time. But according to a study published in the Quarterly Journal of Economics, it’s more than that: cab drivers actually go home early when it’s raining. The reason is that the hourly wage rate of a taxi driver depends on the weather: when it’s raining, drivers get more fares and therefore earn more per hour. And it seems that the income effect of this higher wage rate outweighs the substitution effect. This behavior leads the authors of the study to question drivers’ rationality. They point out that if taxi drivers thought in terms of the long run, they would realize that rainy days and nice days tend to average out and that their high earnings on a rainy day don’t really affect their long-run income very much. Indeed, experienced drivers (who have probably figured this out) are less likely than inexperienced drivers to go home early on a rainy day. But leaving such issues to one side, the study does seem to show clear evidence of a labor supply curve that slopes downward instead of upward, thanks to income effects. (See source note on copyright page.) Shifts of the Labor Supply Curve Now that we have examined how income and substitution effects shape the individual labor supply curve, we can turn to the market labor supply curve. In any labor market, the market supply curve is the horizontal sum of the individual labor supply curves of all workers in that market. A change in any factor other than the wage that alters workers’ willingness to supply labor causes a shift of the labor supply curve. A variety of factors can lead to such shifts, including changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth. Changes in Preferences and Social Norms Changes in preferences and social norms can lead workers to increase or decrease their willingness to work at any given wage. A striking example of this phenomenon is the large increase in the number of employed women—particularly married employed women—that has occurred in the United States since the 1960s. Until that time, women who could afford to largely avoided working outside the home. Changes in preferences and norms in post–World War II America (helped along by the invention of labor-saving home appliances such as washing machines, increasing urbanization of the population, and higher female education levels) have induced large numbers of American women to join the workforce—a phenomenon often repeated in other countries that experience similar social and technological forces. Changes in Population Changes in the population size generally lead to shifts of the labor supply curve. A larger population tends to shift the labor supply curve rightward as more workers are available at any given wage; a smaller population tends to shift the labor supply curve leftward. Currently the size of the U.S. labor force grows by approximately 1% per year, a result of immigration from other countries and, in comparison to other developed countries, a relatively high birth rate. As a result, many labor markets in the United States are experiencing rightward shifts of their labor supply curves. Changes in Opportunities At one time, teaching was the only occupation considered suitable for well-educated women. However, as opportunities in other professions opened up to women starting in the 1960s, many women left teaching and potential female teachers chose other careers. This generated a leftward shift of the supply curve for teachers, reflecting a fall in the willingness to work at any given wage and forcing school districts to pay more to maintain an adequate teaching staff. These events illustrate a general result: when superi |
or alternatives arise for workers in 532 P A R T 9 FA THE OVERWORKED AMERICAN? Americans today may work less than they did 100 years ago, but they still work more than workers in other developed countries. This figure compares average annual hours worked in the United States with average annual hours worked elsewhere. The differences result from a combination of shorter work weeks and longer vacation times. For example, the great majority of full-time American workers work at least 40 hours per week; until recently, however, a government mandate limited most French workers to a 35-hour work week. Americans also take less vacation time than their peers in other countries, and their vacation time is shrinking. About 25% of American workers in the private sector do not get any paid vacation time, and another 33% take only a one-week vacation. A 2006 U.S. survey found that only 40% of respondents planned to take a vacation over the next six months, the lowest percentage recorded in 28 years. In contrast, in many European countries, workers get four to six weeks of annual leave each year. Why do Europeans work less than Americans? Recent economic research suggests that the main reasons for these differences are government regulations that limit the number of hours worked per week as well as a guaranteed minimum amount of vacation time. Germany France Sweden United Kingdom Australia Canada Japan 2% United States 0 1,450 1,500 1,550 1,600 1,650 1,700 1,750 1,800 1,850 Hours worked Source: OECD. another labor market, the supply curve in the original labor market shifts leftward as workers move to the new opportunities. Similarly, when opportunities diminish in one labor market—say, layoffs in the manufacturing industry due to increased foreign competition—the supply in alternative labor markets increases as workers move to these other markets. Changes in Wealth A person whose wealth increases will buy more normal goods, including leisure. So when a class of workers experiences a general rise in their wealth levels—say, due to a stock market boom—the income effect from the wealth increase will shift the labor supply curve associated with those workers leftward as workers consume more leisure and work less. Note that the income effect caused by a change in wealth shifts the labor supply curve, but the income effect from a wage rate increase—as we discussed in the case of the individual labor supply curve—is a movement along the labor supply curve. The following Economics in Action illustrates how such a change in the wealth levels of many families during the late 1990s led to a shift of the market labor supply curve associated with their employable children. ➤ECONOMICS IN ACTION The Decline of the Summer Job Come summertime, resort towns along the New Jersey shore find themselves facing a recurring annual problem: a serious shortage of lifeguards. Traditionally, lifeguard positions, together with many other seasonal jobs, have been filled mainly by high C H A P T E R 2 0 FA 533 ➤➤ ➤ The choice of how much labor to supply is a problem of time allocation: a choice between work and leisure. ➤ A rise in the wage rate causes both an income and a substitution effect on an individual’s labor supply. The substitution effect of a higher wage rate induces longer work hours, other things equal. This is countered by the income effect: higher income leads to a higher demand for leisure, a normal good. If the income effect dominates, a rise in the wage rate can actually cause the individual labor supply curve to slope the “wrong” way: downward. ➤ The market labor supply curve is the horizontal sum of the individual labor supply curves of all workers in that market. It shifts for four main reasons: changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth. school and college students. But in recent years a growing number of young Americans have chosen not to take summer jobs. In 1979, 71% of Americans between the ages of 16 and 19 were in the summer workforce. Twenty years later that number had fallen to 63%; and by 2007, it was 42%. Data show that young men in particular have become much less willing to take summer jobs. One explanation for the decline in the summer labor supply is that more students feel they should devote their summers to additional study. But an important factor in the decline is increasing household affluence. As a result, many teenagers no longer feel pressured to contribute to household finances by taking a summer job; that is, the income effect leads to a reduced labor supply. Another factor points to the substitution effect: increased competition from immigrants, who are now doing the jobs typically done by teenagers (mowing lawns, delivering pizzas), has led to a decline in wages. So many teenagers forgo summer work and consume leisure instead. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 20-4 1. Formerly, Clive was free to work as many or as few hours per week as he wanted. But a new law limits the maximum number of hours he can work per week to 35. Explain under what circumstances, if at all, he is made: a. Worse off b. Equally as well off c. Better off 2. Explain in terms of the income and substitution effects how a fall in Clive’s wage rate can induce him to work more hours than before. Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• The next chapter, the final one in this book, addresses a topic that is everywhere in today’s economy: risk. Up until this point, we’ve limited ourselves to studying an economy in which there are no surprises and the future is perfectly predictable. But in the real world, uncertainty abounds: prices fluctuate, wages change, industries are created and destroyed, and so on. Risk is uncertainty about future outcomes; but more to the point, it is the potential for future economic loss. A substantial and growing part of today’s global economy is devoted to managing risk. In this final chapter we’ll learn about the markets for managing risk—insurance, including health insurance, as well as the stock market. We’ll come to understand why these markets are so important and how the ability of individuals and institutions to trade risk improves society’s welfare.] 534 P A R T 9 FA . Just as there are markets for goods and services, there are markets for factors of production, including labor, land, and both physical capital and human capital. These markets determine the factor distribution of income. 2. Profit-maximizing price-taking producers will employ a factor up to the point at which its price is equal to its value of the marginal product—the marginal product of the factor multiplied by the price of the output it produces. The value of the marginal product curve is therefore the individual price-taking producer’s demand curve for a factor. 3. The market demand curve for labor is the horizontal sum of the individual demand curves of producers in that market. It shifts for three main reasons: changes in output price, changes in the supply of other factors, and technological changes. 4. When a competitive labor market is in equilibrium, the market wage is equal to the equilibrium value of the marginal product of labor, the additional value produced by the last worker hired in the labor market as a whole. The same principle applies to other factors of production: the rental rate of land or capital is equal to the equilibrium value of the marginal products. This insight leads to the marginal productivity theory of income distribution, according to which each factor is paid the value of the marginal product of the last unit of that factor employed in the factor market as a whole. 5. Large disparities in wages raise questions about the validity of the marginal productivity theory of income K E Y T E R M S distribution. Many disparities can be explained by compensating differentials and by differences in talent, job experience, and human capital across workers. Market interference in the forms of unions and collective action by employers also creates wage disparities. The efficiency-wage model, which arises from a type of market failure, shows how wage disparities can result from employers’ attempts to increase worker performance. Free markets tend to diminish discrimination, but discrimination remains a real source of wage disparity. Discrimination is typically maintained either through problems in labor markets or (historically) through institutionalization in government policies. 6. Labor supply is the result of decisions about time allocation, where each worker faces a trade-off between leisure and work. An increase in the hourly wage rate tends to increase work hours via the substitution effect but to reduce work hours via the income effect. If the net result is that a worker increases the quantity of labor supplied in response to a higher wage, the individual labor supply curve slopes upward. If the net result is that a worker reduces work hours, the individual labor supply curve—unlike supply curves for goods and services—slopes downward. 7. The market labor supply curve is the horizontal sum of the individual labor supply curves of all workers in that market. It shifts for four main reasons: changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth. Physical capital, p. 510 Human capital, p. 510 Factor distribution of income, p. 511 Value of the marginal product, p. 514 Value of the marginal product curve, p. 515 Equilibrium value of the marginal product, Unions, p. 525 p. 519 Rental rate, p. 520 Efficiency-wage model, p. 526 Time allocation, p. 529 Marginal productivity theory of income dis- Leisure, p. 529 tribution, p. 521 Compensating differentials, p. 524 Individual labor supply curve, p. 530 C H A P T E R 2 0 FA 535 P R O B L E M S 1. In 2007, national income in the United States was $11,186.9 billion. In the same year, 137 million workers were employe |
d, at an average wage of $57,526 per worker per year. a. How much compensation of employees was paid in the United States in 2007? b. Analyze the factor distribution of income. What percentage of national income was received in the form of compensation to employees in 2007? c. Suppose that a huge wave of corporate downsizing leads many terminated employees to open their own businesses. What is the effect on the factor distribution of income? d. Suppose the supply of labor rises due to an increase in the retirement age. What happens to the percentage of national income received in the form of compensation of employees? 2. Marty’s Frozen Yogurt has the production function per day shown in the accompanying table. The equilibrium wage rate for a worker is $80 per day. Each cup of frozen yogurt sells for $2. Quantity of labor (workers) Quantity of frozen yogurt (cups) 0 1 2 3 4 5 6 0 110 200 270 300 320 330 a. Calculate the marginal product of labor for each worker and the value of the marginal product of labor per worker. b. How many workers should Marty employ? 3. Patty’s Pizza Parlor has the production function per hour shown in the accompanying table. The hourly wage rate for each worker is $10. Each pizza sells for $2. Quantity of labor (workers) Quantity of pizza 0 1 2 3 4 5 0 9 15 19 22 24 a. Calculate the marginal product of labor for each worker and the value of the marginal product of labor per worker. b. Draw the value of the marginal product of labor curve. Use your diagram to determine how many workers Patty should employ. c. Now the price of pizza increases to $4. Calculate the value of the marginal product of labor per worker, and draw the new value of the marginal product of labor curve in your diagram. Use your diagram to determine how many workers Patty should employ now. 4. The production function for Patty’s Pizza Parlor is given in the table in Problem 3. The price of pizza is $2, but the hourly wage rate rises from $10 to $15. Use a diagram to determine how Patty’s demand for workers responds as a result of this wage rate increase. 5. Patty’s Pizza Parlor initially had the production function given in the table in Problem 3. A worker’s hourly wage rate was $10, and pizza sold for $2. Now Patty buys a new high-tech pizza oven that allows her workers to become twice as productive as before. That is, the first worker now produces 18 pizzas per hour instead of 9, and so on. a. Calculate the new marginal product of labor and the new value of the marginal product of labor. b. Use a diagram to determine how Patty’s hiring decision responds to this increase in the productivity of her workforce. 6. Jameel runs a driver education school. The more driving instructors he hires, the more driving lessons he can sell. But because he owns a limited number of training automobiles, each additional driving instructor adds less to Jameel’s output of driving lessons. The accompanying table shows Jameel’s production function per day. Each driving lesson can be sold at $35 per hour. Quantity of labor (driving instructors) Quantity of driving lessons (hours 15 21 26 30 33 Determine Jameel’s labor demand schedule (his demand schedule for driving instructors) for each of the following daily wage rates for driving instructors: $160, $180, $200, $220, $240, and $260. 7. Dale and Dana work at a self-service gas station and convenience store. Dale opens up everyday, and Dana arrives later to help stock the store. They are both paid the current market wage of $9.50 per hour. But Dale feels he should be paid much more because the revenue generated from the gas pumps he turns on every morning is much higher than the revenue generated by the items that Dana stocks. Assess this argument. 536 P A R T 9 FA . A New York Times article published in September 2007 observed that the wage of farmworkers in Mexico is $11 an hour but the wage of immigrant Mexican farmworkers in California is $9 an hour. a. Assume that the output sells for the same price in the two countries. Does this imply that the marginal product of labor of farmworkers is higher in Mexico or in California? Explain your answer, and illustrate with a diagram that shows the demand and supply curves for labor in the respective markets. In your diagram, assume that the quantity supplied of labor for any given wage rate is the same for Mexican farmworkers as it is for immigrant Mexican farmworkers in California. b. Now suppose that farmwork in Mexico is more arduous and more dangerous than farmwork in California. As a result, the quantity supplied of labor for any given wage rate is not the same for Mexican farmworkers as it is for immigrant Mexican farmworkers in California. How does this change your answer to part a? What concept best accounts for the difference between wage rates between Mexican farmworkers and immigrant Mexican farmworkers in California? c. Illustrate your answer to part b with a diagram. In this diagram, assume that the quantity of labor demanded for any given wage rate is the same for Mexican employers as it is for Californian employers. 9. Kendra is the owner of Wholesome Farms, a commercial dairy. Kendra employs labor, land, and capital. In her operations, Kendra can substitute between the amount of labor she employs and the amount of capital she employs. That is, to produce the same quantity of output she can use more labor and less land; similarly, to produce the same quantity of output she can use less labor and more land. However, if she uses more land, she must use more of both labor and capital; if she uses less land, she can use less of both labor and capital. Let w* represent the annual cost of labor in the market, let rL* represent the annual cost of a unit of land in the market, and let rK* represent the annual cost of a unit of capital in the market. a. Suppose that Kendra can maximize her profits by employing less labor and more capital than she is currently using but the same amount of land. What three conditions must now hold for Kendra’s operations (involving her value of the marginal product of labor, land and capital) for this to be true? b. Kendra believes that she can increase her profits by renting and using more land. What three conditions must hold (involving her value of the marginal product of labor, land, and capital) for this to be true? 10. For each of the following situations in which similar workers are paid different wages, give the most likely explanation for these wage differences. a. Test pilots for new jet aircraft earn higher wages than air- line pilots. www.worthpublishers.com/krugmanwells b. College graduates usually have higher earnings in their first year on the job than workers without college degrees have in their first year on the job. c. Full professors command higher salaries than assistant professors for teaching the same class. d. Unionized workers are generally better paid than non- unionized workers. 11. Research consistently finds that despite nondiscrimination policies, African-American workers on average receive lower wages than White workers do. What are the possible reasons for this? Are these reasons consistent with marginal productivity theory? 12. Greta is an enthusiastic amateur gardener and spends a lot of her free time working in her yard. She also has a demanding and well-paid job as a freelance advertising consultant. Because the advertising business is going through a difficult time, the hourly consulting fee Greta can charge falls. Greta decides to spend more time gardening and less time consulting. Explain her decision in terms of income and substitution effects. 13. Wendy works at a fast-food restaurant. When her wage rate was $5 per hour, she worked 30 hours per week. When her wage rate rose to $6 per hour, she decided to work 40 hours. But when her wage rate rose further to $7, she decided to work only 35 hours. a. Draw Wendy’s individual labor supply curve. b. Is Wendy’s behavior irrational, or can you find a rational explanation? Explain your answer. 14. You are the governor’s economic policy adviser. The governor wants to put in place policies that encourage employed people to work more hours at their jobs and that encourage unemployed people to find and take jobs. Assess each of the following policies in terms of reaching that goal. Explain your reasoning in terms of income and substitution effects, and indicate when the impact of the policy may be ambiguous. a. The state income tax rate is lowered, which has the effect of increasing workers’ after-tax wage rate. b. The state income tax rate is increased, which has the effect of decreasing workers’ after-tax wage rate. c. The state property tax rate is increased, which reduces workers’ after-tax income. 15. A study by economists at the Federal Reserve Bank of Boston found that between 1965 and 2003 the average American’s leisure time increased by between 4 and 8 hours a week. The study claims that this increase is primarily driven by a rise in wage rates. a. Use the income and substitution effects to describe the labor supply for the average American. Which effect dominates? b. The study also finds an increase in female labor force participation—more women are choosing to hold jobs rather than exclusively perform household tasks. For the average woman who has newly entered the labor force, which effect dominates? c. Draw typical individual labor supply curves that illustrate your answers to part a and part b above. >> Chapter 20 Appendix: Indifference Curve Analysis of Labor Supply In the body of this chapter, we explained why the labor supply curve can slope downward instead of upward: the substitution effect of a higher wage rate, which provides an incentive to work longer hours, can be outweighed by the income effect of a higher wage rate, which may lead individuals to consume more leisure. In this appendix we show how this analysis can be carried out using the indifference curves introduced in Chapter 11. A time allocation |
budget line shows an individual’s trade-off between consumption of leisure and the income that allows consumption of marketed goods. The Time Allocation Budget Line Let’s return to the example of Clive, who likes leisure but also likes having money to spend. We now assume that Clive has a total of 80 hours per week that he could spend either working or enjoying as leisure time. (The remaining hours in his week, we assume, are taken up with necessary activities, mainly sleeping.) Let’s also assume, initially, that his hourly wage rate is $10. His consumption possibilities are defined by the time allocation budget line in Figure 20A-1, a budget line that shows Clive’s trade-offs between consumption of leisure and income. Hours of leisure per week are measured on the horizontal axis, and the money he earns from working is measured on the vertical axis. The horizontal intercept, point X, is at 80 hours: if Clive didn’t work at all, he would have 80 hours of leisure per week but would not earn any money. The vertical intercept, point Y, is at $800: if Clive worked all the time, he would earn $800 per week. Why can we use a budget line to describe Clive’s time allocation choice? The budget lines found in Chapters 10 and 11 represented the trade-offs facing consumers deciding how to allocate their income among different goods. Here, instead of asking how FIGURE 20A-1 The Time Allocation Budget Line Income Clive’s time allocation budget line shows his trade-off between work, which pays a wage rate of $10 per hour, and leisure. At point X he allocates all his time, 80 hours, to leisure but has no income. At point Y he allocates all his time to work, earning $800, but consumes no leisure. His hourly wage rate of $10, the opportunity cost of an hour of leisure, is equal to minus the slope of the time allocation budget line. We have assumed that point A, at 40 hours of leisure and $400 in income, is Clive’s optimal time allocation. It obeys the optimal time allocation rule: the additional utility Clive gets from one more hour of leisure must equal the additional utility he gets from the goods he can purchase with one hour’s wages. Y $800 400 0 Optimal time allocation choice A Time allocation budget line, BL X 40 80 Quantity of leisure (hours per week) 537 538 P A R T 9 FA The optimal time allocation rule says that an individual should allocate time so that the marginal utility gained from the income earned from an additional hour worked is equal to the marginal utility of an additional hour of leisure. Clive allocates his income, we ask how he allocates his time. But the principles underlying the allocation of income and the allocation of time are the same: each involves allocating a fixed amount of a resource (80 hours of time in this case) with a constant trade-off (Clive must forgo $10 for each additional hour of leisure). So using a budget line is just as appropriate for time allocation as it is for income allocation. As in the case of ordinary budget lines, opportunity cost plays a key role. The opportunity cost of an hour of leisure is what Clive must forgo by working one less hour—$10 in income. This opportunity cost is, of course, Clive’s hourly wage rate and is equal to minus the slope of his time allocation budget line. You can verify this by noting that the slope is equal to minus the vertical intercept, point Y, divided by the horizontal intercept, point X—that is, −$800/(80 hours) = −$10 per hour. To maximize his utility, Clive must choose the optimal point on the time allocation budget line in Figure 20A-1. In Chapter 10 we saw that a consumer who allocates spending to maximize utility finds the point on the budget line that satisfies the optimal consumption rule: the marginal utility per dollar spent on two goods must be equal. Although Clive’s choice involves allocating time rather than money, the same principles apply. Since Clive “spends” time rather than money, the counterpart of the optimal consumption rule is the optimal time allocation rule: the marginal utility Clive gets from the extra money earned from an additional hour spent working must equal the marginal utility of an additional hour of leisure. The Effect of a Higher Wage Rate Depending on his tastes, Clive’s utility-maximizing choice of hours of leisure and income could lie anywhere on the time allocation budget line in Figure 20A-1. Let’s assume that his optimal choice is point A, at which he consumes 40 hours of leisure and earns $400. Now we are ready to link the analysis of time allocation to labor supply. When Clive chooses a point like A on his time allocation budget line, he is also choosing the quantity of labor he supplies to the labor market. By choosing to consume 40 of his 80 available hours as leisure, he has also chosen to supply the other 40 hours as labor. Now suppose that Clive’s wage rate doubles, from $10 to $20 per hour. The effect of this increase in his wage rate is shown in Figure 20A-2. His time allocation budget line rotates outward: the vertical intercept, which represents the amount he could earn if he devoted all 80 hours to work, shifts upward from point Y to point Z. As a result of the doubling of his wage, Clive would earn $1,600 instead of $800 if he devoted all 80 hours to working. But how will Clive’s time allocation actually change? As we saw in the chapter, this depends on the income effect and substitution effect that we learned about in Chapters 10 and 11. The substitution effect of an increase in the wage rate works as follows. When the wage rate increases, the opportunity cost of an hour of leisure increases; this induces Clive to consume less leisure and work more hours—that is, to substitute hours of work in place of hours of leisure as the wage rate rises. If the substitution effect were the whole story, the individual labor supply curve would look like any ordinary supply curve and would always slope upward—a higher wage rate leads to a greater quantity of labor supplied. What we learned in our analysis of demand was that for most consumer goods, the income effect isn’t very important because most goods account for only a very small share of a consumer’s spending. In addition, in the few cases of goods where the income effect is significant—for example, major purchases like housing—it usually reinforces the substitution effect: most goods are normal goods, so when a price increase makes a consumer poorer, he or she buys less of that good LY LY 539 FIGURE 20A-2 An Increase in the Wage Rate (a) The Substitution Effect Dominates The two panels show Clive’s initial optimal choice, point A, on BL1, the time allocation budget line corresponding to a wage rate of $10. After his wage rate rises to $20, his budget line rotates out to the new budget line, BL2: if he spends all his time working, the amount of money he earns rises from $800 to $1,600, reflected in the movement from point Y to point Z. This generates two opposing effects: the substitution effect pushes him to consume less leisure and to work more hours; the income effect pushes him to consume more leisure and to work fewer hours. Panel (a) shows the change in time allocation when the substitution effect is stronger: Clive’s new optimal choice is point B, representing a decrease in hours of leisure to 30 hours and an increase in hours of labor to 50 hours. In this case the individual labor supply curve slopes upward. Panel (b) shows the change in time allocation when the income effect is stronger: point C is the new optimal choice, representing an increase in hours of leisure to 50 hours and a decrease in hours of labor to 30 hours. Now the individual labor supply curve slopes downward. Income Z $1,600 Y 800 B A 0 30 40 New optimal choice Initial optimal choice BL1 BL2 X 80 Income Z $1,600 Y 800 Quantity of leisure (hours per week) (b) The Income Effect Dominates Initial optimal choice C A New optimal choice BL1 BL2 X 80 0 40 50 Quantity of leisure (hours per week) In the labor/leisure choice, however, the income effect takes on a new significance, for two reasons. First, most people get the great majority of their income from wages. This means that the income effect of a change in the wage rate is not small: an increase in the wage rate will generate a significant increase in income. Second, leisure is a normal good: when income rises, other things equal, people tend to consume more leisure and work fewer hours. So the income effect of a higher wage rate tends to reduce the quantity of labor supplied, working in opposition to the substitution effect, which tends to increase the quantity of labor supplied. So the net effect of a higher wage rate on the quantity of labor Clive supplies could go either way—depending on his preferences, he might choose to supply more labor, or he might choose to supply less labor. The two panels of Figure 20A-2 illustrate these two outcomes. In each panel, point A represents Clive’s initial consumption choice. Panel (a) shows the case in which Clive works more hours in response to a higher wage rate. An increase in the wage rate induces him to move from point A to point B, where he consumes less leisure than at A and therefore works more hours. Here the substitution effect prevails over the 540 P A R T 9 FA FIGURE 20A-3 A Backward-Bending Individual Labor Supply Curve Wage rate Individual labor supply curve At lower wage rates, the substitution effect dominates the income effect for this individual. This is illustrated by the movement along the individual labor supply curve from point A to point B: a rise in the wage rate from W1 to W2 leads the quantity of labor supplied to increase from L1 to L2. But at higher wage rates, the income effect dominates the substitution effect, shown by the movement from point B to point C: here, a rise in the wage rate from W2 to W3 leads the quantity of labor supplied to decrease from L2 to L3. W3 W2 W1 C B A L1 L3 L2 Quantity of labor (hours per week) income effect. Panel (b) sho |
ws the case in which Clive works fewer hours in response to a higher wage rate. Here, he moves from point A to point C, where he consumes more leisure and works fewer hours than at A. Here the income effect prevails over the substitution effect. When the income effect of a higher wage rate is stronger than the substitution effect, the individual labor supply curve, which shows how much labor an individual will supply at any given wage rate, slopes the “wrong” way—downward: a higher wage rate leads to a smaller quantity of labor supplied. Economists believe that the substitution effect usually dominates the income effect in the labor supply decision when an individual’s wage rate is low. An individual labor supply curve typically slopes upward for lower wage rates as people work more in response to rising wage rates. But they also believe that many individuals have stronger preferences for leisure and will choose to cut back the number of hours worked as their wage rate continues to rise. For these individuals, the income effect eventually dominates the substitution effect as the wage rate rises, leading their individual labor supply curves to change slope and to “bend backward” at high wage rates. An individual labor supply curve with this feature, called a backwardbending individual labor supply curve, is shown in Figure 20A-3. Although an individual labor supply curve may bend backward, market labor supply curves almost always slope upward over their entire range as higher wage rates draw more new workers into the labor market. A backward-bending individual labor supply curve is an individual labor supply curve that slopes upward at low to moderate wage rates and slopes downward at higher wage rates. Indifference Curve Analysis In Chapter 11, we showed that consumer choice can be represented using the concept of indifference curves, which provide a “map” of consumer preferences. If you have covered Chapter 11, you may find it interesting to learn that indifference curves are also useful for addressing the issue of labor supply. In fact, this is one place where they are particularly helpful. Using indifference curves, Figure 20A-4 shows how an increase in the wage rate can lead to a fall in the quantity of labor supplied. Point A is Clive’s initial optimal LY LY 541 FIGURE 20A-4 Labor Supply Choice: The Indifference Curve Approach Income Point A, on BL1, is Clive’s initial optimal choice. After a wage rate increase his income and utility level increase: his new time allocation budget line is BL2 and his new optimal choice is point C. This change can be decomposed into the substitution effect—the fall in the hours of leisure from point A to point S, and the income effect— the increase in the number of hours of leisure from point S to point C. As shown here, the income effect dominates the substitution effect: the net result of an increase in the wage rate is an increase in the hours of leisure consumed and a decrease in the hours of labor supplied. Z $1,600 Y 800 Initial optimal choice S C A I1 BLS BL1 New optimal choice I2 BL2 0 Income effect Substitution effect X 80 Quantity of leisure (hours per week) choice, given an hourly wage rate of $10. It is the same as point A in Figure 20A-2; this time, however, we include an indifference curve to show that it is a point at which the budget line is tangent to the highest possible indifference curve. Now consider the effect of a rise in the wage rate to $20. Imagine, for a moment, that at the same time Clive was offered a higher wage, he was told that he had to start repaying his student loan and that the good-news/bad-news combination left his utility unchanged. Then he would find himself at point S: on the same indifference curve as at A, but tangent to a steeper budget line, the dashed line BLS in Figure 20A-4, which is parallel to BL2. The move from point A to point S is the substitution effect of his wage increase: it leads him to consume less leisure and therefore supply more labor. But now cancel the repayment on the student loan, and Clive is able to move to a higher indifference curve. His new optimum is at point C, which corresponds to C in panel (b) of Figure 20A-2. The move from point S to point C is the income effect of his wage increase. And we see that this income effect can outweigh the substitution effect: at C he consumes more leisure, and therefore supplies less labor, than he did at A. Leandro has 16 hours per day that he can allocate to work or leisure. His job pays a wage rate of $20. Leandro decides to consume 8 hours of leisure. His indifference curves have the usual shape: they slope downward, they do not cross, and they have the characteristic convex shape. d. Leandro’s decision to work less as the wage rate falls is the result of a substitution effect and an income effect. In your diagram, show the income effect and the substitution effect from this reduced wage rate. Which effect is stronger? a. Draw Leandro’s time allocation budget line for a typical day. Then illustrate the indifference curve at his optimal choice. 2. Florence is a highly paid fashion consultant who earns $100 per hour. She has 16 hours per day that she can allocate to work or leisure, and she decides to work for 12 hours. Now Leandro’s wage rate falls to $10. b. Draw Leandro’s new budget line. c. Suppose that Leandro now works only 4 hours as a result of his reduced wage rate. Illustrate the indifference curve at his new optimal choice. a. Draw Florence’s time allocation budget line for a typical day, and illustrate the indifference curve at her optimal choice. One of Florence’s clients is featured on the front page of Vague, an influential fashion magazine. As a result, Florence’s 542 P A R T 9 FA consulting fee now rises to $500 per hour. Florence decides to work only 10 hours per day. b. Draw Florence’s new time allocation budget line, and illustrate the indifference curve at her optimal choice. c. In your diagram, show the income effect and the substitution effect from this increase in the wage rate. Which effect is stronger? 3. Tamara has 80 hours per week that she can allocate to work or leisure. Her job pays a wage rate of $20 per hour, but Tamara is being taxed on her income in the following way. On the first $400 that Tamara makes, she pays no tax. That is, for the first 20 hours she works, her net wage—what she takes home after taxes—is $20 per hour. On all income above $400, Tamara pays a 75% tax. That is, for all hours above the first 20 hours, her net wage rate is only $5 per hour. Tamara decides to work 30 hours. Her indifference curves have the usual shape. a. Draw Tamara’s time allocation budget line for a typical week. Also illustrate the indifference curve at her optimal choice. The government changes the tax scheme. Now only the first $100 of income is tax-exempt. That is, for the first 5 hours she works, Tamara’s net wage rate is $20 per hour. But the government reduces the tax rate on all other income to 50%. That is, for all hours above the first 5 hours, Tamara’s net wage rate is now $10. After these changes, Tamara finds herself exactly equally as well off as before. That is, her new optimal choice is on the same indifference curve as her initial optimal choice. b. Draw Tamara’s new time allocation budget line on the same diagram. Also illustrate her optimal choice. Bear in mind that she is equally as well off (on the same indifference curve) as before the tax changes occurred. c. Will Tamara work more or less than before the changes to the tax scheme? Why? www.worthpublishers.com/krugmanwells chapter: 21 >> Uncertainty, Risk, and Private Information HE NATIONAL WEATHER SERVICE RANKS THE intensity of hurricanes on a scale from 1 to 5, with a category-5 hurricane being the most pow- erful, producing wind speeds in excess of 155 miles per Texas, and for their insurers, it was consistent with a pat- tern newly recognized by atmospheric scientists: the inci- dence of the most destructive hurricanes had doubled over the past 35 years. Not surprisingly, in response to the hour. The destructive capacity of a category-5 hurricane losses they suffered in 2005 and the potential for future was made clear in August 2005, when Hurricane Katrina catastrophic losses, in 2006 private insurers began to sig- slammed into Mississippi and southeastern Louisiana. nificantly reduce the number of policies they wrote in The widespread devastation was worse than that created coastal areas. For the lucky few homeowners who were by any natural disaster the United States had seen before: able to get insurance, premiums skyrocketed. In Louisiana over 1,400 dead and entire communities wiped out. The and Mississippi, the lack of insurance has severely ham- monetary losses were also huge: up to $50 billion in losses pered the ability of some communities to rebuild. to private insurers and $23 billion in losses to the Mortgage companies typically won’t lend money for National Flood Insurance Program. And these figures sig- rebuilding without proof that a homeowner has insur- nificantly understate the true level of loss because many ance, and businesses are usually unwilling to invest with- people were uninsured while others were underinsured, out insurance for their facilities. To address the pullback and as a consequence their insurance payments fell far of insurers that threatened the state economy, Florida short of their actual losses. Unbelievably, disaster struck three times that year. One month after Katrina, Hurricane Rita, another category-5 hurricane, blew into Texas and southwestern Louisiana, causing over $11 billion in damage. In October 2005, another category-5 hurricane, Wilma, caused over $29 billion in damage to Florida. (Fortu- nately, both Rita and Wilma had diminished to category-3 hurricanes by the time of landfall). Although 2005 was a terribly unlucky year for residents of Louisiana, Mississippi, Florida, and 2005 was a year of catastrophic losses for vic |
tims of hurricanes and their insurers. 543 544 P A R T 9 FA created a state-run insurance program, the Citizens created by uncertainty. Markets for insurance do very well Property Insurance Corporation. In 2008, it had written at coping with situations in which two conditions hold: more than 1.3 million policies. when risk can be reasonably well diversified and when the Anyone who lives in an area threatened by hurricanes probability of loss is equally well known to everyone. or floods knows that uncertainty is an important feature Private insurers cut back their policy-writing in coastal of the real-world. Up to this point, we have largely areas due to the failure of the first condition: with deteri- assumed that people make decisions with knowledge of orating weather patterns over a huge area of the country, exactly how the future will unfold. (The exception is they no longer believed that profits from areas with good health insurance discussed in Chapter 19.) In reality, weather would be sufficient to offset losses from however, people often make economic decisions—such as hurricane-hit areas. (In contrast, state-run insurance pro- whether to build a house in a coastal area—without full grams like the one in Florida can tap tax revenues to cover knowledge of future events. As the residents of Louisiana, losses.) But in practice, the second condition is the more Mississippi, Florida, and Texas know, making decisions limiting one. Markets run into trouble when some people when the future is uncertain carries with it the risk of loss. know things that others do not—a situation that involves Yet it is often possible for individuals to use markets private information. We’ll see that private information to reduce the risk they face. For example, hurricane vic- can cause inefficiency by preventing mutually beneficial tims who had insurance were able to receive some, if not transactions. complete, compensation for their losses. In fact, In this chapter we’ll examine the economics of risk through insurance and other devices, the modern econ- and private information. We’ll start by looking at why omy offers many ways for individuals to reduce their people dislike risk. Then we’ll explore how a market exposure to risk. economy allows people to reduce risk, at a price. Finally, However, as the retrenchment of the insurers illus- we’ll turn to the special problems created when some trates, a market economy cannot always solve the problems people have information that others don’t. WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ That risk is an important feature of the economy and that most people are risk-averse—they would like to avoid risk ➤ Why diminishing marginal utility makes people risk-averse and determines the premium they are willing to pay to reduce risk ➤ How exposure to risk can be reduced through diversification and pooling ➤ How risk can be traded, with riskaverse people paying others to assume part of their risk ➤ The special problems posed by private information—situations in which some people know things that other people do not The Economics of Risk Aversion In general, people don’t like risk and are willing to pay a price to avoid it. Just ask the U.S. insurance industry, which collects more than $1 trillion in premiums every year. But what exactly is risk? And why don’t people like it? To answer these questions, we need to look briefly at the concept of expected value and the meaning of uncertainty. Then we can turn to why people dislike risk. Expectations and Uncertainty The Lee family doesn’t know how big its medical bills will be next year. If all goes well, it won’t have any medical expenses at all. Let’s assume that there’s a 50% chance of that happening. But if family members require hospitalization or expensive drugs TA I N T Y VAT E I N F O R M AT I O N 545 A random variable is a variable with an uncertain future value. The expected value of a random variable is the weighted average of all possible values, where the weights on each possible value correspond to the probability of that value occurring. A state of the world is a possible future event. Risk is uncertainty about future outcomes. When the uncertainty is about monetary outcomes, it becomes financial risk. they will face medical expenses of $10,000. Let’s assume that there’s also a 50% chance that these high medical expenses will materialize. In this example—which is designed to illustrate a point, rather than to be realistic—the Lees’ medical expenses for the coming year are a random variable, a variable that has an uncertain future value. No one can predict which of its possible values, or outcomes, a random variable will take. But that doesn’t mean we can say nothing about the Lees’ future medical expenses. On the contrary, an actuary (a person trained in evaluating uncertain future events) could calculate the expected value of expenses next year—the weighted average of all possible values, where the weights on each possible value correspond to the probability of that value occurring. In this example, the expected value of the Lees’ medical expenses is (0.5 × $0) + (0.5 × $10,000) = $5,000. To derive the general formula for the expected value of a random variable, we imagine that there are a number of different states of the world, possible future events. Each state is associated with a different realized value—the value that actually occurs—of the random variable. You don’t know which state of the world will actually occur, but you can assign probabilities, one for each state of the world. Let’s assume that P1 is the probability of state 1, P2 the probability of state 2, and so on. And you know the realized value of the random value in each state of the world: S1 in state 1, S2 in state 2, and so on. Let’s also assume that there are N possible states. Then the expected value of a random variable is: (21-1) Expected value of a random variable EV = (P1 × S1) + (P2 × S2) + . . . + (PN × SN) In the case of the Lee family, there are only two possible states of the world, each with a probability of 0.5. Notice, however, that the Lee family doesn’t actually expect to pay $5,000 in medical bills next year. That’s because in this example there is no state of the world in which the family pays exactly $5,000. Either the family pays nothing, or it pays $10,000. So the Lees face considerable uncertainty about their future medical expenses. But what if the Lee family can buy health insurance that will cover its medical expenses, whatever they turn out to be? Suppose, in particular, that the family can pay $5,000 up front in return for full coverage of whatever medical expenses actually arise during the coming year. Then the Lees’ future medical expenses are no longer uncertain for them: in return for $5,000—an amount equal to the expected value of the medical expenses—the insurance company assumes all responsibility for paying those medical expenses. Would this be a good deal from the Lees’ point of view? Yes, it would—or at least most families would think so. Most people prefer, other things equal, to reduce risk—uncertainty about future outcomes. (We’ll focus here on financial risk, in which the uncertainty is about monetary outcomes, as opposed to uncertainty about outcomes that can’t be assigned a monetary value.) In fact, most people are willing to pay a substantial price to reduce their risk; that’s why we have an insurance industry. But before we study the market for insurance, we need to understand why people feel that risk is a bad thing, an attitude that economists call risk aversion. The source of risk aversion lies in a concept we first encountered in our analysis of consumer demand, back in Chapter 10: diminishing marginal utility. The Logic of Risk Aversion To understand how diminishing marginal utility gives rise to risk aversion, we need to look not only at the Lees’ medical costs but also at how those costs affect the income the family has left after medical expenses. Let’s assume the family knows that 546 P A R T 9 FA Expected utility is the expected value of an individual’s total utility given uncertainty about future outcomes. it will have an income of $30,000 next year. If the family has no medical expenses, it will be left with all of that income. If its medical expenses are $10,000, its income after medical expenses will be only $20,000. Since we have assumed that there is an equal chance of these two outcomes, the expected value of the Lees’ income after medical expenses is (0.5 × $30,000) + (0.5 × $20,000) = $25,000. At times we will simply refer to this as expected income. But as we’ll now see, if the family’s utility function has the shape typical of most families’, its expected utility—the expected value of its total utility given uncertainty about future outcomes—is less than it would be if the family didn’t face any risk and knew with certainty that its income after medical expenses would be $25,000. To see why, we need to look at how total utility depends on income. Panel (a) of Figure 21-1 shows a hypothetical utility function for the Lee family, where total utility depends on income—the amount of money the Lees have available for consumption of goods and services (after they have paid any medical bills). The table within the figure shows how the family’s total utility varies over the income range of FIGURE 21-1 The Utility Function and Marginal Utility Curve of a Risk-Averse Family (a) Total Utility H Utility function S Total utility (utils) 1,080 920 800 560 400 Utility in state H, UH Utility in state S, US 0 $10,000 20,000 30,000 Income (b) Marginal Utility Marginal utility (utils) 70 60 50 40 30 20 10 0 Marginal utility in state S Marginal utility in state H S $10,000 20,000 30,000 Income H Marginal utility curve Income $20,000 21,000 22,000 23,000 24,000 25,000 26,000 27,000 28,000 29,000 30,000 Total utility (utils) 920 945 968 989 1,008 1,025 1,040 1,053 1,064 1,073 1,080 Panel (a) shows how the total utility o |
f the Lee family depends on its income available for consumption (that is, its income after medical expenses). The curve slopes upward: more income leads to higher total utility. But it gets flatter as we move up it and to the right, reflecting diminishing marginal utility. Panel (b) reflects the negative relationship between income and marginal utility when there is risk aversion: the marginal utility from each additional $1,000 of income is lower the higher your income. So the marginal utility of income is higher when the family has high medical expenses (point S) than when it has low medical expenses (point H). TA I N T Y VAT E I N F O R M AT I O N 547 A premium is a payment to an insurance company in return for the insurance company’s promise to pay a claim in certain states of the world. A fair insurance policy is an insurance policy for which the premium is equal to the expected value of the claim. Risk-averse individuals will choose to reduce the risk they face when that reduction leaves the expected value of their income or wealth unchanged. $20,000 to $30,000. As usual, the utility function slopes upward, because more income leads to higher total utility. Notice as well that the curve gets flatter as we move up and to the right, which reflects diminishing marginal utility. In Chapter 10 we applied the principle of diminishing marginal utility to individual goods and services: each successive unit of a good or service that a consumer purchases adds less to his or her total utility. The same principle applies to income used for consumption: each successive dollar of income adds less to total utility than the previous dollar. Panel (b) shows how marginal utility varies with income, confirming that marginal utility of income falls as income rises. As we’ll see in a moment, diminishing marginal utility is the key to understanding the desire of individuals to reduce risk. To analyze how a person’s utility is affected by risk, economists start from the assumption that individuals facing uncertainty maximize their expected utility. We can use the data in Figure 21-1 to calculate the Lee family’s expected utility. We’ll first do the calculation assuming that the Lees have no insurance, and then we’ll recalculate it assuming that they have purchased insurance. Without insurance, if the Lees are lucky and don’t incur any medical expenses, they will have an income of $30,000, generating total utility of 1,080 utils. But if they have no insurance and are unlucky, incurring $10,000 in medical expenses, they will have just $20,000 of their income to spend on consumption and total utility of only 920 utils. So without insurance, the family’s expected utility is (0.5 × 1,080) + (0.5 × 920) = 1,000 utils. Now let’s suppose that an insurance company offers to pay whatever medical expenses the family incurs during the next year in return for a premium—a payment to the insurance company—of $5,000. Note that the amount of the premium in this case is equal to the expected value of the Lees’ medical expenses—the expected value of their future claim against the policy. An insurance policy with this feature, for which the premium is equal to the expected value of the claim, has a special name— a fair insurance policy. If the family purchases this fair insurance policy, the expected value of its income available for consumption is the same as it would be without insurance: $25,000— that is, $30,000 minus the $5,000 premium. But the family’s risk has been eliminated: the family has an income available for consumption of $25,000 for sure, which means that it receives the utility level associated with an income of $25,000. Reading from the table in Figure 21-1, we see that this utility level is 1,025 utils. Or to put it a slightly different way, their expected utility with insurance is 1 × 1,025 = 1,025 utils, because with insurance they will receive a utility of 1,025 utils with a probability of 1. And this is higher than the level of expected utility without insurance—only 1,000 utils. So by eliminating risk through the purchase of a fair insurance policy, the family increases its expected utility even though its expected income hasn’t changed. The calculations for this example are summarized in Table 21-1. This example shows that the Lees, like most people in real life, are risk-averse: they will choose to TABLE 21-1 The Effect of Fair Insurance on the Lee Family’s Income Available for Consumption and Expected Utility Income in different states of the world $0 in medical expenses (0.5 probability) $10,000 in medical expenses (0.5 probability) $30,000 $20,000 Expected value of income available for consumption (0.5 × $30,000) + (0.5 × $20,000) = $25,000 Expected utility (0.5 × 1,080 utils) + (0.5 × 920 utils) = 1,000 utils $25,000 $25,000 (0.5 × $25,000) + (0.5 × $25,000) = $25,000 (0.5 × 1,025 utils) + (0.5 × 1,025 utils) = 1,025 utils Without insurance With fair insurance 548 P A R T 9 FA reduce the risk they face when the cost of that reduction leaves the expected value of their income or wealth unchanged. So the Lees, like most people, will be willing to buy fair insurance. You might think that this result depends on the specific numbers we have chosen. In fact, however, the proposition that purchase of a fair insurance policy increases expected utility depends on only one assumption: diminishing marginal utility. The reason is that with diminishing marginal utility, a dollar gained when income is low adds more to utility than a dollar gained when income is high. That is, having an additional dollar matters more when you are facing hard times than when you are facing good times. And as we will shortly see, a fair insurance policy is desirable because it transfers a dollar from highincome states (where it is valued less) to low-income states (where it is valued more). But first, let’s see how diminishing marginal utility leads to risk aversion by examining expected utility more closely. In the case of the Lee family, there are two states of the world; let’s call them H and S, for healthy and sick. In state H the family has no medical expenses; in state S it has $10,000 in medical expenses. Let’s use the symbols UH and US to represent the Lee family’s total utility in each state. Then the family’s expected utility is: (21-2) Expected utility = (Probability of state H × Total utility in state H) + (Probability of state S × Total utility in state S) = (0.5 × UH) + (0.5 × US) The fair insurance policy reduces the family’s income available for consumption in state H by $5,000, but it increases it in state S by the same amount. As we’ve just seen, we can use the utility function to directly calculate the effects of these changes on expected utility. But as we have also seen in many other contexts, we gain more insight into individual choice by focusing on marginal utility. To use marginal utility to analyze the effects of fair insurance, let’s imagine introducing the insurance a bit at a time, say in 5,000 small steps. At each of these steps, we reduce income in state H by $1 and simultaneously increase income in state S by $1. At each of these steps, total utility in state H falls by the marginal utility of income in that state but total utility in state S rises by the marginal utility of income in that state. Now look again at panel (b) of Figure 21-1, which shows how marginal utility varies with income. Point S shows marginal utility when the Lee family’s income is $20,000; point H shows marginal utility when income is $30,000. Clearly, marginal utility is higher when income after medical expenses is low. Because of diminishing marginal utility, an additional dollar of income adds more to total utility when the family has low income (point S) than when it has high income (point H). This tells us that the gain in expected utility from increasing income in state S is larger than the loss in expected utility from reducing income in state H by the same amount. So at each step of the process of reducing risk, by transferring $1 of income from state H to state S, expected utility increases. This is the same as saying that the family is risk-averse; that is, risk aversion is a result of diminishing marginal utility. Almost everyone is risk-averse, because almost everyone has diminishing marginal utility. But the degree of risk aversion varies among individuals—some people are more risk-averse than others. To illustrate this point, Figure 21-2 compares two individuals, Danny and Mel. We suppose that each of them earns the same income now but is confronted with the possibility of earning either $1,000 more or $1,000 less. Panel (a) shows how each individual’s total utility would be affected by the change in income. Danny would gain very few utils from a rise in income, which moves him from N to HD, but lose a large number of utils from a fall in income, which moves him from N to LD. That is, he is highly risk-averse. This is reflected in panel (b) by his steeply declining marginal utility curve. Mel, though, as shown in panel (a), would gain almost as many utils from higher income, which moves him from N to HM, as he TA I N T Y VAT E I N F O R M AT I O N 549 Total utility FIGURE 21-2 Differences in Risk Aversion Danny and Mel have different utility functions. Danny is highly risk-averse: a gain of $1,000 in income, which moves him from N to HD, adds only a few utils to his total utility, but a $1,000 fall in income, which moves him from N to LD, reduces his total utility by a large number of utils. By contrast, Mel gains almost as many utils from a $1,000 rise in income (the movement from N to HM) as he loses from a $1,000 fall in income (the movement from N to LM). This difference—reflected in the differing slopes of the two men’s marginal utility curves—means that Danny would be willing to pay much more than Mel for insurance. (a) Total Utility HM HD N Mel’s utility function Danny’s utility function LM LD Income falls by $1,000 Current |
income Income rises by $1,000 Income (b) Marginal Utility Marginal utility Mel’s marginal utility curve Danny’s marginal utility curve Income Current income would lose from lower income, which moves him from N to LM. He is barely riskaverse at all. This is reflected in his marginal utility curve in panel (b), which is almost horizontal. So other things equal, Danny will gain a lot more utility from insurance than Mel will. Someone who is completely insensitive to risk is called risk-neutral. Individuals differ in risk aversion for two main reasons: differences in preferences and differences in initial income or wealth. ■ Differences in preferences. Other things equal, people simply differ in how much their marginal utility is affected by their level of income. Someone whose marginal utility is relatively unresponsive to changes in income will be much less sensitive to risk. In contrast, someone whose marginal utility depends greatly on changes in income will be much more risk-averse. A risk-neutral person is completely insensitive to risk. 550 P A R T 9 FA The Paradox of Gambling If most people are risk-averse and riskaverse individuals won’t take a fair gamble, how come Las Vegas, Atlantic City, and other places where gambling is legal do so much business? After all, a casino doesn’t even offer gamblers a fair gamble: all the games in any gambling facility are designed so that, on average, the casino makes money. So why would anyone play their games? You might argue that the gambling industry caters to the minority of people who are actually the opposite of riskaverse: risk-loving. But a glance at the customers of Las Vegas hotels quickly refutes that hypothesis: most of them Gambling: enjoyment or addiction? aren’t daredevils who also sky-dive and hang-glide. Instead, most of them are ordinary people who have health and life insurance and who wear seat belts. In other words, they are risk-averse like the rest of us. So why do people gamble? Presumably because they enjoy the experience. Also, gambling may be one of those areas where the assumption of rational behavior goes awry. Psychologists have concluded that gambling can be addictive in ways that are not that different from the addictive effects of drugs. Taking dangerous drugs is irrational; so is excessive gambling. Alas, both happen all the same before the fact versus after the fact Why is an insurance policy different from a doughnut? No, it’s not a riddle. Although the supply and demand for insurance behave like the supply and demand for any good or service, the payoff is very different. When you buy a doughnut, you know what you’re going to get; when you buy insurance, by definition you don’t know what you’re going to get. If you bought car insurance and then didn’t have an accident, you got nothing from the policy, except peace of mind, and might wish that you hadn’t bothered. But if you did have an accident, you probably would be glad that you bought insurance that covered the cost. This means we have to be careful in assessing the rationality of insurance purchases (or, for that matter, any decision made in the face of uncertainty). After the fact—after the uncertainty has been resolved— such decisions are almost always subject to secondguessing. But that doesn’t mean that the decision was wrong before the fact, given the information available at the time. One highly successful Wall Street investor told us that he never looks back—that as long as he believes he made the right decision given what he knew when he made it, he never reproaches himself if things turn out badly. That’s the right attitude, and it almost surely contributes to his success. ■ Differences in initial income or wealth. The possible loss of $1,000 makes a big difference to a family living below the poverty threshold; it makes very little difference to someone who earns $1 million a year. In general, people with high incomes or high wealth will be less risk-averse. Differences in risk aversion have an important consequence: they affect how much an individual is willing to pay to avoid risk. Paying to Avoid Risk The risk-averse Lee family is clearly better off taking out a fair insurance policy—a policy that leaves their expected income unchanged but eliminates their risk. Unfortunately, real insurance policies are rarely fair: because insurance companies have to cover other costs, such as salaries for salespeople and actuaries, they charge more than they expect to pay in claims. Will the Lee family still want to purchase an “unfair” insurance policy—one for which the premium is larger than the expected claim? It depends on the size of the premium. Look again at Table 211. We know that without insurance expected utility is 1,000 utils and that insurance costing $5,000 raises expected utility to 1,025 utils. If the premium were $6,000, the Lees would be left with an income of $24,000, which, as you can see from Figure 21-1, would give them a total utility of 1,008 utils—which is still higher than their expected utility if they had no insurance at all. So the Lees would be willing to buy insurance with a $6,000 premium. But they wouldn’t be willing to pay $7,000, which would reduce their income to $23,000 and their total utility to 989 utils. This example shows that risk-averse individuals are willing to make deals that reduce their expected income but also reduce their risk: they are willing to pay a premium that exceeds their expected claim. The more risk-averse they are, the higher the premium they are willing to pay. That willingness to pay is what makes the insurance industry possible. In contrast, a risk-neutral person is unwilling to pay at all to reduce his or her risk TA I N T Y VAT E I N F O R M AT I O N 551 ➤➤ ➤ The expected value of a random variable is the weighted average of all possible values, where the weight corresponds to the probability of a given value occurring. ➤ Uncertainty about states of the world entails risk, or financial risk when there is an uncertain monetary outcome. When faced with uncertainty, a consumer chooses the option that yields the highest level of expected utility. ➤ Most people are risk-averse: they would be willing to purchase a fair insurance policy—a policy in which the premium is equal to the expected value of the claim. ➤ Risk aversion arises from diminishing marginal utility. Differences in preferences and in income or wealth lead to differences in risk aversion. ➤ Depending on the size of the premium, a risk-averse person may be willing to purchase an “unfair” insurance policy—a policy with a premium larger than the expected claim. The greater your risk aversion, the greater the premium you are willing to pay. A risk-neutral person is unwilling to pay any premium to avoid risk. ➤ECONOMICS IN ACTION Warranties Many expensive consumer goods—stereos, major appliances, cars—come with some form of warranty. Typically, the manufacturer guarantees to repair or replace the item if something goes wrong with it during some specified period after purchase—usually six months or one year. Why do manufacturers offer warranties? Part of the answer is that warranties signal to consumers that the goods are of high quality (see the discussion of private information later in this chapter). But mainly warranties are a form of consumer insurance. For many people, the cost of repairing or replacing an expensive item like a refrigerator—or, worse yet, a car—would be a serious burden. If they were obliged to come up with the cash, their consumption of other goods would be restricted; as a result, their marginal utility of income would be higher than if they didn’t have to pay for repairs. So a warranty that covers the cost of repair or replacement increases the consumer’s expected utility, even if the cost of the warranty is greater than the expected future claim paid by the manufacturer. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 21-1 1. Compare two families who own homes near the coast in Florida. Which family is likely to be more risk-averse—(i) a family with income of $2 million per year or (ii) a family with income of $60,000 per year? Would either family be willing to buy an “unfair” insurance policy to cover losses to their Florida home? 2. Karma’s income next year is uncertain: there is a 60% probability she will make $22,000 and a 40% probability she will make $35,000. The accompanying table shows some income and utility levels for Karma. a. What is Karma’s expected income? Her expected utility? Income $22,000 25,000 26,000 35,000 Total utility (utils) 850 1,014 1,056 1,260 b. What certain income level leaves her as well off as her uncertain income? What does this imply about Karma’s attitudes toward risk? Explain. c. Would Karma be willing to pay some amount of money greater than zero for an insurance policy that guarantees her an income of $26,000? Explain. Solutions appear at back of book. Buying, Selling, and Reducing Risk Lloyd’s of London is the oldest existing commercial insurance company, and it is an institution with an illustrious past. Originally formed in the eighteenth century to help merchants cope with the risks of commerce, it grew in the heyday of the British Empire into a mainstay of imperial trade. The basic idea of Lloyd’s was simple. In the eighteenth century, shipping goods via sailing vessels was risky: the chance that a ship would sink in a storm or be captured by pirates was fairly high. The merchant who owned the ship and its cargo could easily be ruined financially by such an event. Lloyd’s matched shipowners seeking insurance with wealthy investors who promised to compensate a merchant if his ship was lost. In return, the merchant paid the investor a fee in advance; if his ship didn’t sink, the investor still kept the fee. In effect, the merchant paid a price to relieve himself of risk. By matching people who wanted to purchase insurance with people who wanted to provide it, Lloyd’s performed the functions |
of a market. The fact that British merchants could use Lloyd’s to reduce their risk made many more people in Britain willing to undertake merchant trade. 552 P A R T 9 FA The funds that an insurer places at risk when providing insurance is called the insurer’s capital at risk. Insurance companies have changed quite a lot from the early days of Lloyd’s. They no longer consist of wealthy individuals deciding on insurance deals over port and boiled mutton. But asking why Lloyd’s worked to the mutual benefit of merchants and investors is a good way to understand how the market economy as a whole “trades” and thereby transforms risk. The insurance industry rests on two principles. The first is that trade in risk, like trade in any good or service, can produce mutual gains. In this case, the gains come when people who are less willing to bear risk transfer it to people who are more willing to bear it. The second is that some risk can be made to disappear through diversification. Let’s consider each principle in turn. Trading Risk It may seem a bit strange to talk about “trading” risk. After all, risk is a bad thing— and aren’t we supposed to be trading goods and services? But people often trade away things they don’t like to other people who dislike them less. Suppose you have just bought a house for $100,000, the average price for a house in your community. But you have now learned, to your horror, that the building next door is being turned into an all-night disco. You want to sell the house immediately and are willing to accept $95,000 for it. But who will now be willing to buy it? The answer: a person who doesn’t really mind late-night noise. Such a person might be willing to pay up to $100,000. So there is an opportunity here for a mutually beneficial deal—you are willing to sell for as little as $95,000, and the other person is willing to pay as much as $100,000, so any price in between will benefit both of you. The key point is that the two parties have different sensitivities to noise, which enables those who most dislike noise, in effect, to pay other people to make their lives quieter. Trading risk works exactly the same way: people who want to reduce the risk they face can pay other people who are less sensitive to risk to take some of their risk away. As we saw in the previous section, individual preferences account for some of the variations in people’s attitudes toward risk, but differences in income and wealth are probably the principal reason behind different risk sensitivities. Lloyd’s made money by matching wealthy investors who were more risk-tolerant with less wealthy and therefore more risk-averse shipowners. Suppose, staying with our Lloyd’s of London story, that a merchant whose ship went down would lose £1,000 and that there was a 10% chance of such a disaster. The expected loss in this case would be 0.10 × £1,000 = £100. But the merchant, whose whole livelihood was at stake, might have been willing to pay £150 to be compensated in the amount of £1,000 if the ship sank. Meanwhile, a wealthy investor for whom the loss of £1,000 was no big deal would have been willing to take this risk for a return only slightly better than the expected loss—say, £110. Clearly, there is room for a mutually beneficial deal here: the merchant pays something less than £150 and more than £110—say, £130—in return for compensation if the ship goes down. In effect, he has paid a less risk-averse individual to bear the burden of his risk. Everyone has been made better off by this transaction. The funds that an insurer places at risk when providing insurance are called the insurer’s capital at risk. In our example, the wealthy Lloyd’s investor places capital of £1,000 at risk in return for a premium of £130. In general, the amount of capital that potential insurers are willing to place at risk depends, other things equal, on the premium offered. If every ship is worth £1,000 and has a 10% chance of going down, nobody would offer insurance for less than a £100 premium, equal to the expected claim. In fact, only an investor who isn’t risk-averse at all—that is, who is riskneutral—would be willing to offer a policy at that price, because accepting a £100 premium would leave the insurer’s expected income unchanged while increasing his or her risk. Suppose there is one investor who is risk-neutral; but the next most willing TA I N T Y VAT E I N F O R M AT I O N 553 FIGURE 21-3 The Supply of Insurance This is the supply of insurance policies to provide £1,000 in coverage to a merchant ship that has a 10% chance of being lost. Each investor has £1,000 of capital at risk. The lowest possible premium at which a policy is offered is £100, equal to the expected claim, and only a risk-neutral investor is willing to supply this policy. As the premium increases, investors who are more riskaverse are induced to supply policies to the market, increasing the quantity of policies supplied. Premium of policy £115 110 105 100 S More risk-averse investor Slightly risk-averse investor Risk-neutral investor 0 1 2 3 4 Quantity of policies investor is slightly risk-averse and insists on a £105 premium. The next investor, being somewhat more risk-averse, demands a premium of £110, and so on. By varying the premium and asking how many insurers would be willing to provide insurance at that premium, we can trace out a supply curve for insurance, as shown in Figure 21-3. As the premium increases as we move up the supply curve, more riskaverse investors are induced to provide coverage. Meanwhile, potential buyers will consider their willingness to pay a given premium, defining the demand curve for insurance. In Figure 21-4, the highest premium that any shipowner is willing to pay is £200. Who’s willing to pay this? The most risk-averse shipowner, of course. A slightly less risk-averse shipowner might be willing to pay £190, an even slightly less risk-averse shipowner is willing to pay £180, and so on. FIGURE 21-4 The Demand for Insurance This is the demand for insurance policies for £1,000 in coverage of a merchant ship that has a 10% chance of being lost. In this example, the highest premium at which anyone demands a policy is £200, which only the most risk-averse shipowner will desire. As the premium falls, shipowners who are less risk-averse are induced to demand policies, increasing the quantity of policies demanded. Premium of policy £200 190 180 170 Most risk-averse shipowner Slightly less risk-averse shipowner Still less risk-averse shipowner D 0 1 2 3 Quantity of policies 554 P A R T 9 FA FIGURE 21-5 The Insurance Market Here we represent the hypothetical market for insuring a merchant ship, where each ship requires £1,000 in coverage. The demand curve is made up of shipowners who wish to buy insurance, and the supply curve is made up of wealthy investors who wish to supply insurance. In this example, at a premium of £200, only the most risk-averse shipowners will purchase insurance; at a premium of £100, only risk-neutral investors are willing to supply insurance. The equilibrium is at a premium of £130 with 5,000 policies bought and sold. In the absence of private information, the insurance market leads to an efficient allocation of risk. Premium of policy £200 130 100 0 E S D 5,000 Quantity of policies Now imagine a market in which there are thousands of shipowners and potential insurers, so that the supply and demand curves for insurance are smooth lines. In this market, as in markets for ordinary goods and services, there will be an equilibrium price and quantity. Figure 21-5 illustrates such a market equilibrium at a premium of £130, with a total quantity of 5,000 policies bought and sold, representing a total capital at risk of £5,000,000. Notice that in this market risk is transferred from the people who most want to get rid of it (the most risk-averse shipowners) to the people least bothered by risk (the least risk-averse investors). So just as markets for goods and services typically produce an efficient allocation of resources, markets for risk also typically lead to an efficient allocation of risk—an allocation of risk in which those who are most willing to bear risk are those who end up bearing it. But as in the case of the markets for goods and services, there is an important qualification to this result: there are well-defined cases in which the market for risk fails to achieve efficiency. These arise from the presence of private information, an important topic that we will cover in the next section. The trading of risk between individuals who differ in their degree of risk aversion plays an extremely important role in the economy, but it is not the only way that markets can help people cope with risk. Under some circumstances, markets can perform a sort of magic trick: they can make some (though rarely all) of the risk that individuals face simply disappear. Making Risk Disappear: The Power of Diversification In the early days of Lloyd’s, British merchant ships traversed the world, trading spices and silk from Asia, tobacco and rum from the New World, and textiles and wool from Britain, among many other goods. Each of the many routes that British ships took had its own unique risks—pirates in the Caribbean, gales in the North Atlantic, typhoons in the Indian Ocean. In the face of all these risks, how were merchants able to survive? One important way was by reducing their risks by not putting all their eggs in one basket: by sending different ships to different destinations, they could reduce the probability that all their ships would be lost. A strategy of investing in such a way as to reduce the probability of severe losses is known as diversification. As we’ll now see, diversification can often make some of the economy’s risk disappear. An efficient allocation of risk is an allocation of risk in which those who are most willing to bear risk are those who end up bearing it TA I N T Y VAT E I N F O R M AT I O N 555 Two possib |
le events are independent events if each of them is neither more nor less likely to happen if the other one happens. An individual can engage in diversification by investing in several different things, so that the possible losses are independent events. Let’s stay with our shipping example. It was all too likely that a pirate might seize a merchant ship in the Caribbean or that a typhoon might sink another ship in the Indian Ocean. But the key point here is that the various threats to shipping didn’t have much to do with each other. So it was considerably less likely that a merchant who had one ship in the Caribbean and another ship in the Indian Ocean in a given year would lose them both, one to a pirate and the other to a typhoon. After all, there was no connection: the actions of cutthroats in the Caribbean had no influence on weather in the Indian Ocean, or vice versa. Statisticians refer to such events—events that have no connection, so that one is no more likely to happen if the other does than if it does not—as independent events. Many unpredictable events are independent of each other. If you toss a coin twice, the probability that it will come up heads on the second toss is the same whether it came up heads or tails on the first toss. If your house burns down today, it does not affect the probability that my house will burn down the same day (unless we live next door to each other or employ the services of the same incompetent electrician). There is a simple rule for calculating the probability that two independent events will both happen: multiply the probability that one event would happen on its own by the probability that the other event would happen on its own. If you toss a coin once, the probability that it will come up heads is 0.5; if you toss the coin twice, the probability that it will come up heads both times is 0.5 × 0.5 = 0.25. But what did it matter to shipowners or Lloyd’s investors that ship losses in the Caribbean and ship losses in the Indian Ocean were independent events? The answer is that by spreading their investments across different parts of the world, shipowners or Lloyd’s investors could make some of the riskiness of the shipping business simply disappear. Let’s suppose that Joseph Moneypenny, Esq., is wealthy enough to outfit two ships—and let’s ignore for a moment the possibility of insuring his ships. Should Mr. Moneypenny equip two ships for the Caribbean trade and send them off together? Or should he send one ship to Barbados and one to Calcutta? Assume that both voyages will be equally profitable if successful, yielding £1,000 if the voyage is completed. Also assume that there is a 10% chance both that a ship sent to Barbados will run into a pirate and that a ship sent to Calcutta will be sunk by a typhoon. And if two ships travel to the same destination, we will assume that they share the same fate. So if Mr. Moneypenny were to send both his ships to either destination, he would face a probability of 10% of losing all his investment. But if Mr. Moneypenny were instead to send one ship to Barbados and one to Calcutta, the probability that he would lose both of them would be only 0.1 × 0.1 = 0.01, or just 1%. As we will see shortly, his expected payoff would be the same—but the chance of losing it all would be much less. So by engaging in diversification— investing in several different things, where the possible losses are independent events—he could make some of his risk disappear. Table 21-2 on the next page summarizes Mr. Moneypenny’s options and their possible consequences. If he sends both ships to the same destination, he runs a 10% chance of losing them both. If he sends them to different destinations, there are three possible outcomes. Both ships could arrive safely: because there is a 0.9 probability of either one making it, the probability that both will make it is 0.9 × 0.9 = 81%. Both could be lost—but the probability of that happening is only 0.1 × 0.1 = 1%. Finally, there are two ways that only one ship can arrive. The probability that the first ship arrives and the second ship is lost is 0.9 × 0.1 = 9%. The probability that the first ship is lost but the second ship arrives is 0.1 × 0.9 = 9%. So the probability that only one ship makes it is 9% + 9% = 18%. You might think that diversification is a strategy available only to those with a lot of money to begin with. Can Mr. Moneypenny diversify if he is able to afford only one ship? There are ways for even small investors to diversify. Even if Mr. Moneypenny is only wealthy enough to equip one ship, he can enter a partnership 556 P A R T 9 FA TABLE 21-2 How Diversification Reduces Risk (a) If both ships sent to the same destination State Both ships arrive Both ships lost Probability 0.9 = 90% 0.1 = 10% (b) If one ship sent east, one west State Probability Both ships arrive Both ships lost 0.9 × 0.9 = 81% 0.1 × 0.1 = 1% One ship arrives (0.9 × 0.1) + (0.1 × 0.9) = 18% Payoff £2,000 0 Payoff £2,000 0 1,000 Expected payoff (0.9 × £2,000) + (0.1 × £0) = £1,800 Expected payoff (0.81 × £2,000) + (0.01 × £0) + (0.18 × £1,000) = £1,800 with another merchant. They can jointly outfit two ships, agreeing to share the profits equally, and then send those ships to different destinations. That way each faces less risk than if he equips one ship alone. In the modern economy, diversification is made much easier for investors by the fact that they can easily buy shares in many companies by using the stock market. The owner of a share in a company is the owner of part of that company—typically a very small part, one-millionth or less. An individual who put all of his or her wealth in shares of a single company would lose all of that wealth if the company went bankrupt. But most investors hold shares in many companies, which makes the chance of losing all their investment very small. In fact, Lloyd’s of London wasn’t just a way to trade risks; it was also a way for investors to diversify. To see how this worked, let’s introduce Lady Penelope SmedleySmythe, a wealthy aristocrat, who decides to increase her income by placing £1,000 of her capital at risk via Lloyd’s. She could use that capital to insure just one ship. But more typically she would enter a “syndicate,” a group of investors, who would jointly insure a number of ships going to different destinations, agreeing to share the cost if any one of those ships went down. Because it would be much less likely for all the ships insured by the syndicate to sink than for any one of them to go down, Lady Smedley-Smythe would be at much less risk of losing her entire capital. In some cases, an investor can make risk almost entirely disappear by taking a small share of the risk in many independent events. This strategy is known as pooling. Consider the case of a health insurance company, which has millions of policyholders, with thousands of them requiring expensive treatment each year. The insurance company can’t know whether any given individual will, say, require a heart bypass operation. But heart problems for two different individuals are pretty much independent events. And when there are many possible independent events, it is possible, using statistical analysis, to predict with great accuracy how many events of a given type will happen. For example, if you toss a coin 1,000 times, it will come up heads about 500 times—and it is very unlikely to be more than a percent or two off that figure. So a company offering fire insurance can predict very accurately how many of its clients’ homes will burn down in a given year; a company offering health insurance can predict very accurately how many of its clients will need heart surgery in a given year; a life insurance company can predict how many of its clients will . . . Well, you get the idea. When an insurance company is able to take advantage of the predictability that comes from aggregating a large number of independent events, it is said to engage in pooling of risks. And this pooling often means that even though insurance companies protect people from risk, the owners of the insurance companies may not themselves face much risk. A share in a company is a partial ownership of that company. Pooling is a strong form of diversification in which an investor takes a small share of the risk in many independent events. This produces a payoff with very little total overall risk TA I N T Y VAT E I N F O R M AT I O N 557 Those Pesky Emotions For a small investor (someone investing less than several hundred thousand dollars), financial economists agree that the best strategy for investing in stocks is to buy an index fund. Why index funds? Because they contain a wide range of stocks that reflect the overall market, they achieve diversification; and they have very low management fees. In addition, financial economists agree that it’s a losing strategy to try to “time” the market: to buy when the stock market is low and sell when it’s high. Instead, small investors should buy a fixed dollar amount of stocks and other financial assets every year, regardless of the state of the market. Yet many, if not most, small investors don’t follow this advice. Instead, they buy individual stocks or funds that charge high fees. They spend endless hours in Internet chat rooms chasing the latest hot tip or sifting through data trying to discern patterns in stocks’ behavior. They try to time explains it, the problem is that the human brain evolved to detect and interpret simple patterns. (Is there a lion lurking in that bush?) As a consequence, “when it comes to investing, our incorrigible search for patterns leads us to assume that order exists where it often doesn’t.” In other words, investors fool themselves into believing that they’ve discovered a lucrative stock market pattern when, in fact, stock market behavior is largely ranYour mother called to remind you to diversify.” the market but invariably buy when stocks are high and refuse to sell loser |
s before they lose even more. And they fail to diversify, instead concentrating too much money in a few stocks they think are “winners.” So why are human beings so dense when it comes to investing? According to many experts, the culprit is emotion. In his recent book Your Money and Your Brain, Jason Zweig states, “the brain is not an optimal tool for making financial decisions.” As he dom. Not surprisingly, how people make financial decisions is a major topic of study in the area of behavioral economics, a new branch of economics that studies why human beings often fail to behave rationally. So, what’s the typical twenty-first-century investor to do? According to Mr. Zweig, there’s hope: if you recognize the influence of your emotions, then you can tame them. One test of how well you’ve evolved from a CroMagnon state of mind: are you diversified? (See source note on copyright page.) Lloyd’s of London wasn’t just a way for wealthy individuals to get paid for taking on some of the risks of less wealthy merchants. It was also a vehicle for pooling some of those risks. The effect of that pooling was to shift the supply curve in Figure 21-5 rightward: to make investors willing to accept more risk, at a lower price, than would otherwise have been possible. The Limits of Diversification Diversification can reduce risk. In some cases it can eliminate it. But these cases are not typical, because there are important limits to diversification. We can see the most important reason for these limits by returning to Lloyd’s one more time. During the period when Lloyd’s was creating its legend, there was one important hazard facing British shipping other than pirates or storms: war. Between 1690 and 1815, Britain fought a series of wars, mainly with France (which, among other things, went to war with Britain in support of the American Revolution). Each time, France would sponsor “privateers”—basically pirates with official backing—to raid British shipping and thus indirectly damage Britain’s war effort. Whenever war broke out between Britain and France, losses of British merchant ships would suddenly increase. Unfortunately, merchants could not protect themselves against this eventuality by sending ships to different ports: the privateers would prey on British ships anywhere in the world. So the loss of a ship to French privateers in the Caribbean and the loss of another ship to French privateers in the Indian Ocean would not be independent events. It would be quite likely that they would happen in the same year. 558 P A R T 9 FA Two events are positively correlated if each event is more likely to occur if the other event also occurs. When an event is more likely to occur if some other event occurs, these two events are said to be positively correlated. And like the risk of having a ship seized by French privateers, many financial risks are, alas, positively correlated. Here are some of the positively correlated financial risks that investors in the mod- ern world face: ■ Severe weather. Within any given region of the United States, losses due to weather are definitely not independent events. When a hurricane hits Florida, a lot of Florida homes will suffer hurricane damage. To some extent, insurance companies can diversify away this risk by insuring homes in many states. But events like El Niño (a recurrent temperature anomaly in the Pacific Ocean that disrupts weather around the world) can cause simultaneous flooding across the United States. And as we mentioned in our opening story, the positive correlation between the incidence of highly destructive hurricanes in the United States has gone up. ■ Political events. Modern governments do not, thankfully, license privateers— although submarines served much the same function during World War II. Even today, however, some kinds of political events—say, a war or revolution in a key raw-material-producing area—can damage business around the globe. ■ Business cycles. The causes of business cycles, fluctuations in the output of the economy as a whole, are a subject for macroeconomics. What we can say here is that if one company suffers a decline in business because of a nationwide economic slump, many other companies will also suffer such declines. So these events will be positively correlated. When events are positively correlated, the risks they pose cannot be diversified away. An investor can protect herself from the risk that any one company will do badly by investing in many companies; she cannot use the same technique to protect against an economic slump in which all companies do badly. An insurance company can protect itself against the risk of losses from local flooding by insuring houses in many different places; but a global weather pattern that produces floods in many places will defeat this strategy. Not surprisingly, then, insurers pulled back from writing policies in U.S. coastal areas when it became clear that global weather patterns for hurricanes had become worse. They could no longer be confident that profits from policies written in good weather areas would be sufficient to compensate for losses incurred on policies in hurricane-prone areas. So institutions like insurance companies and stock markets cannot make risk go away completely. There is always an irreducible core of risk that cannot be diversified. Markets for risk, however, do accomplish two things: First, they enable the economy to eliminate the risk that can be diversified. Second, they allocate the risk that remains to the people most willing to bear it. L D VIE W R W O ➤ECONOMICS IN ACTION When Lloyd’s Almost Llost It At the end of the 1980s, the venerable institution of Lloyd’s found itself in severe trouble. Investors who had placed their capital at risk, believing that the risks were small and the return on their investments more or less assured, found themselves required to make large payments to satisfy enormous claims. A number of investors, including members of some very old aristocratic families, found themselves pushed into bankruptcy. VIEWWOR What happened? Part of the answer is that ambitious managers at Lloyd’s had persuaded investors to take on risks that were much larger than the investors realized. (Or to put it a different way, the premiums the investors accepted were too small for the true level of risk contained in the policies.) But the biggest single problem was that many of the events against which Lloyd’s had become a major insurer were not independent. In the 1970s and 1980s, Lloyd’s had become a major provider of corporate liability insurance in the United States TA I N T Y VAT E I N F O R M AT I O N 559 it protected American corporations against the possibility that they might be sued for selling defective or harmful products. Everyone expected such suits to be more or less independent events. Why should one company’s legal problems have much to do with another’s? The answer turned out to lie in one word: asbestos. For decades, this fireproofing material had been used in many products, which meant that many companies were responsible for its use. Then it turned out that asbestos can cause severe damage to the lungs, especially in children. The result was a torrent of lawsuits by people who believed they were injured by asbestos and billions of dollars in damage awards—many of them ultimately paid by Lloyd’s investors. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 21-2 1. Explain how each of the following events would change the equilibrium premium and quantity of insurance in the market, indicating any shifts in the supply and demand curves. a. An increase in the number of ships traveling the same trade routes and so facing the same kinds of risks b. An increase in the number of trading routes, with the same number of ships traveling a greater variety of routes and so facing different kinds of risk c. An increase in the degree of risk aversion among the shipowners in the market d. An increase in the degree of risk aversion among the investors in the market e. An increase in the risk affecting the economy as a whole f. A fall in the wealth levels of investors in the market Solutions appear at back of book. Private Information: What You Don’t Know Can Hurt You Markets do very well at dealing with diversifiable risk and with risk due to uncertainty: situations in which nobody knows what is going to happen, whose house will be flooded, or who will get sick. However, markets have much more trouble with situations in which some people know things that other people don’t know—situations of private information. As we will see, private information can distort economic decisions and sometimes prevent mutually beneficial economic transactions from taking place. (Sometimes economists use the term asymmetric information rather than private information, but they are equivalent.) Why is some information private? The most important reason is that people generally know more about themselves than other people do. For example, you know whether or not you are a careful driver; but unless you have already been in several accidents, your auto insurance company does not. You are more likely to have a better estimate than your insurance company of whether or not you will need an expensive medical procedure. And if you are selling me your used car, you are more likely to be aware of any problems with it than I am. But why should such differences in who knows what be a problem? It turns out that there are two distinct sources of trouble: adverse selection, which arises from having private information about the way things are, and moral hazard, which arises from having private information about what people do. Adverse Selection: The Economics of Lemons Suppose that someone offers to sell you an almost brand-new car—purchased just three months ago, with only 2,000 miles on the odometer and no dents or scratches. Will you be willing to pay almost the same for it as for a car direct from the deale |
r? Probably not, for one main reason: you cannot help but wonder why this car is being sold. Is it because the owner has discovered that something is wrong with it— that it is a “lemon”? Having driven the car for a while, the owner knows more about it than you do—and people are more likely to sell cars that give them trouble. ➤➤ ➤ Insurance markets exist because there are gains from trade in risk. Except in the case of private information, they lead to an efficient allocation of risk: those who are most willing to bear risk place their capital at risk to cover the financial losses of those least willing to bear risk. ➤ When independent events are involved, a strategy of diversification can substantially reduce risk. Diversification is made easier by the existence of institutions like the stock market, in which people trade shares of companies. A form of diversification, relevant especially to insurance companies, is pooling. ➤ When events are positively corre- lated, there is a core of risk that will not go away no matter how much individuals diversify. Private information is information that some people have that others do not. 560 P A R T 9 FA Adverse selection occurs when an individual knows more about the way things are than other people do. Private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market. Adverse selection can be reduced through screening: using observable information about people to make inferences about their private information. You might think that the fact that sellers of used cars know more about them than the buyers do represents an advantage to the sellers. But potential buyers know that potential sellers are likely to offer them lemons—they just don’t know exactly which car is a lemon. Because potential buyers of a used car know that potential sellers are more likely to sell lemons than good cars, buyers will offer a lower price than they would if they had a guarantee of the car’s quality. Worse yet, this poor opinion of used cars tends to be self-reinforcing, precisely because it depresses the prices that buyers offer. Used cars sell at a discount because buyers expect a disproportionate share of those cars to be lemons. Even a used car that is not a lemon would sell only at a large discount, because buyers don’t know whether it’s a lemon or not. But potential sellers who have good cars are unwilling to sell them at a deep discount, except under exceptional circumstances. So good used cars are rarely offered for sale, and used cars that are offered for sale have a strong tendency to be lemons. (This is why people who have a compelling reason to sell a car, such as moving overseas, make a point of revealing that information to potential buyers—as if to say “This car is not a lemon!”) The end result, then, is not only that used cars sell for low prices and that there are a large number of used cars with hidden problems. Equally important, many potentially beneficial transactions—sales of good cars by people who would like to get rid of them to people who would like to buy them—end up being frustrated by the inability of potential sellers to convince potential buyers that their cars are actually worth the higher price demanded. So some mutually beneficial trades between those who want to sell used cars and those who want to buy them go unexploited. Although economists sometimes refer to situations like this as the “lemons problem” (the issue was introduced in a famous 1970 paper by economist and Nobel laureate George Akerlof entitled “The Market for Lemons”), the more formal name of the problem is adverse selection. The reason for the name is obvious: because the potential sellers know more about the quality of what they are selling than the potential buyers, they have an incentive to select the worst things to sell. Adverse selection does not apply only to used cars. It is a problem for many parts of the economy—notably for insurance companies, and most notably for health insurance companies. Suppose that a health insurance company were to offer a standard policy to everyone with the same premium. The premium would reflect the average risk of incurring a medical expense. But that would make the policy look very expensive to healthy people, who know that they are less likely than the average person to incur medical expenses. So healthy people would be less likely than less healthy people to buy the policy, leaving the health insurance company with exactly the customers it doesn’t want: people with a higher-than-average risk of needing medical care, who would find the premium to be a good deal. In order to cover its expected losses from this sicker customer pool, the health insurance company is compelled to raise premiums, driving away more of the remaining healthier customers, and so on. Because the insurance company can’t determine who is healthy and who is not, it must charge everyone the same premium, thereby discouraging healthy people from purchasing policies and encouraging unhealthy people to buy policies. As we discussed in Chapter 19, adverse selection can lead to a phenomenon called an adverse selection death spiral as the market for health insurance collapses: insurance companies refuse to offer policies because there is no premium at which the company can cover its losses. Because of the severe adverse selection problems, governments in many advanced countries assume the role of providing health insurance to their citizens. As we saw in Chapter 19, the U.S. government, through its various health insurance programs like Medicare, Medicaid, and SCHIP, now disburses more than half the total payments for medical care in the United States. In general, people or firms faced with the problem of adverse selection follow one of several well-established strategies for dealing with it. One strategy is screening: using observable information to make inferences about private information. If you apply to purchase health insurance, you’ll find that the insurance company will TA I N T Y VAT E I N F O R M AT I O N 561 Adverse selection can be diminished by people signaling their private information through actions that credibly reveal what they know. A long-term reputation allows an individual to reassure others that he or she isn’t concealing adverse private information. demand documentation of your health status in an attempt to “screen out” sicker applicants—customers they will refuse to insure or will insure only at very high premiums. Auto insurance also provides a very good example. An insurance company may not know whether you are a careful driver, but it has statistical data on the accident rates of people who resemble your profile—and it uses those data in setting premiums. A 19-year-old male who drives a sports car and has already had a fender-bender is likely to pay a very high premium. A 40-year-old female who drives a minivan and has never had an accident is likely to pay much less. In some cases, this may be quite unfair: some adolescent males are very careful drivers, and some mature women drive their minivans as if they were F-16’s. But nobody can deny that the insurance companies are right on average. Another strategy is for people who are good prospects to do something signaling their private information—taking some action that wouldn’t be worth taking unless they were indeed good prospects. Reputable used-car dealers often offer warranties— promises to repair any problems with the cars they sell that arise within a given amount of time. This isn’t just a way of insuring their customers against possible expenses; it’s a way of credibly showing that they are not selling lemons. As a result, more sales occur and dealers can command higher prices for their used cars. Finally, in the face of adverse selection, it can be very valuable to establish a good reputation: a used-car dealership will often advertise how long it has been in business to show that it has continued to satisfy its customers. As a result, new customers will be willing to purchase cars and to pay more for that dealer’s cars. Moral Hazard In the late 1970s, New York and other major cities experienced an epidemic of suspicious fires—fires that appeared to be deliberately set. Some of the fires were probably started by teenagers on a lark, others by gang members struggling over turf. But investigators eventually became aware of patterns in a number of the fires. Particular landlords who owned several buildings seemed to have an unusually large number of their buildings burn down. Although it was difficult to prove, police had few doubts that most of these fire-prone landlords were hiring professional arsonists to torch their own properties. Why burn your own building? These buildings were typically in declining neighborhoods, where rising crime and middle-class flight had led to a decline in property values. But the insurance policies on the buildings were written to compensate owners based on historical property values, and so would pay the owner of a destroyed building more than the building was worth in the current market. For an unscrupulous landlord who knew the right people, this presented a profitable opportunity. The arson epidemic became less severe during the 1980s, partly because insurance companies began making it difficult to overinsure properties, and partly because a boom in real estate values made many previously arson-threatened buildings worth more unburned. The arson episodes make it clear that it is a bad idea for insurance companies to let customers insure buildings for more than their value—it gives the customers some destructive incentives. You might think, however, that the incentive problem would go away as long as the insurance is no more than 100% of the value of what is being insured. But, unfortunately, anything close to 100% insurance still distorts incentives—it induces policyholders to beh |
ave differently than they would in the absence of insurance. The reason is that preventing fires requires effort and cost on the part of a building’s owner. Fire alarms and sprinkler systems have to be kept in good repair, fire safety rules have to be strictly enforced, and so on. All of this takes time and money— time and money that the owner may not find worth spending if the insurance policy will provide close to full compensation for any losses. 562 P A R T 9 FA Moral hazard occurs when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort. A deductible in an insurance policy is a sum that the insured individual must pay before being compensated for a claim. Of course, the insurance company could specify in the policy that it won’t pay if basic safety precautions have not been taken. But it isn’t always easy to tell how careful a building’s owner has been—the owner knows, but the insurance company does not. The point is that the building’s owner has private information about his or her own actions, about whether he or she has really taken all appropriate precautions. As a result, the insurance company is likely to face greater claims than if it were able to determine exactly how much effort a building owner exerts to prevent a loss. The problem of distorted incentives arises when an individual has private information about his or her own actions but someone else bears the costs of a lack of care or effort. This is known as moral hazard. To deal with moral hazard, it is necessary to give individuals with private information some personal stake in what happens, a stake that gives them a reason to exert effort even if others cannot verify that they have done so. Moral hazard is the reason salespeople in many stores receive a commission on sales: it’s hard for managers to be sure how hard the salespeople are really working, and if they were paid only straight salary, they would not have an incentive to exert effort to make those sales. As described in the following Economics in Action, similar logic explains why many stores and restaurants, even if they are part of national chains, are actually franchises, licensed outlets owned by the people who run them. Insurance companies deal with moral hazard by requiring a deductible: they compensate for losses only above a certain amount, so that coverage is always less than 100%. The insurance on your car, for example, may pay for repairs only after the first $500 in loss. This means that a careless driver who gets into a fender-bender will end up paying $500 for repairs even if he is insured, which provides at least some incentive to be careful and reduces moral hazard. In addition to reducing moral hazard, deductibles provide a partial solution to the problem of adverse selection. Your insurance premium often drops substantially if you are willing to accept a large deductible. This is an attractive option to people who know they are low-risk customers; it is less attractive to people who know they are high-risk—and so are likely to have an accident and end up paying the deductible. By offering a menu of policies with different premiums and deductibles, insurance companies can screen their customers, inducing them to sort themselves out on the basis of their private information. As the example of deductibles suggests, moral hazard limits the ability of the economy to allocate risks efficiently. You generally can’t get full (100%) insurance on your home or car, even though you would like to buy it, and you bear the risk of large deductibles, even though you would prefer not to. The following Economics in Action illustrates how in some cases moral hazard limits the ability of investors to diversify their investments. ➤ECONOMICS IN ACTION Franchise Owners Try Harder When Americans go out for a quick meal, they often end up at one of the fast-food chains—McDonald’s, Burger King, and so on. Because these are large corporations, most customers probably imagine that the people who serve them are themselves employees of large corporations. But usually they aren’t. Most fast-food restaurants— for example, 85% of McDonald’s outlets—are franchises. That is, some individual has paid the parent company for the right to operate a restaurant selling its product; he or she may look like an arm of a giant company but is in fact a small-business owner. Becoming a franchisee is not a guarantee of success. You must put up a large amount of money, both to buy the license and to set up the restaurant itself (to open a Taco Bell, for example, cost approximately $1.7 million in 2008). And although McDonald’s takes care that its franchises are not too close to each other, they often face stiff competition from rival chains and even from a few truly independent restaurants. Becoming a franchise owner, in other words, involves taking on quite a lot of risk TA I N T Y VAT E I N F O R M AT I O N 563 But why should people be willing to take these risks? Didn’t we just learn that it is better to diversify, to spread your wealth among many investments? The logic of diversification would seem to say that it’s better for someone with $1.7 million to invest in a wide range of stocks rather than put it all into one Taco Bell. This implies that Taco Bell would find it hard to attract franchisees: nobody would be willing to be a franchisee unless they expected to earn considerably more than they would as a simple hired manager with their wealth invested in a diversified portfolio of stocks. So wouldn’t it be more profitable for McDonald’s or Taco Bell simply to hire managers to run their restaurants? It turns out that it isn’t, because the success of a restaurant depends a lot on how hard the manager works, on the effort he or she puts into choosing the right employees, on keeping the place clean and attractive to customers, and so on. Could McDonald’s get the right level of effort from a salaried manager? Probably not. The problem is moral hazard: the manager knows whether he or she is really putting 100% into the job; but company headquarters, which bears the costs of a poorly run restaurant, does not. So a salaried manager, who gets a salary even without doing everything possible to make the restaurant a success, does not have the incentive to do that extra bit—an incentive the owner does have because he or she has a substantial personal stake in the success of the restaurant. In other words, there is a moral hazard problem when a salaried manager runs a McDonald’s, where the private information is how hard the manager works. Franchising resolves this problem. A franchisee, whose wealth is tied up in the business and who stands to profit personally from its success, has every incentive to work extremely hard. The result is that fast-food chains rely mainly on franchisees to operate their restaurants, even though the contracts with these owner-managers allow the franchisees on average to make much more than it would have cost the companies to employ store managers. The higher earnings of franchisees compensate them for the risk they accept, and the companies are compensated by higher sales that lead to higher license fees. In addition, franchisees are forbidden by the licensing agreement with the company from reducing their risk by taking actions such as selling shares of the franchise to outside investors and using the proceeds to diversify. It’s an illustration of the fact that moral hazard prevents the elimination of risk through diversification. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 21-3 1. Your car insurance premiums are lower if you have had no moving violations for several years. Explain how this feature tends to decrease the potential inefficiency caused by adverse selection. 2. A common feature of home construction contracts is that when it costs more to construct a building than was originally estimated, the contractor must absorb the additional cost. Explain how this feature reduces the problem of moral hazard but also forces the contractor to bear more risk than she would like. 3. True or false? Explain your answer, stating what concept analyzed in this chapter accounts for the feature. People with higher deductibles on their auto insurance: a. Generally drive more carefully b. Pay lower premiums c. Generally are wealthier Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• With this chapter we’ve completed our study of microeconomics. We hope that it has illuminated the world around you, helping you to understand the common linkages between events and human behavior. And we hope that it has sparked in you a continuing interest in economics because, in the end, there is always more to learn. Perhaps, soon, you will turn to the study of macroeconomics.] ➤➤ ➤ Private information can distort incentives and prevent mutually beneficial transactions from occurring. One source is adverse selection: sellers have private information about their goods and buyers offer low prices, leading the sellers of quality goods to drop out and leaving the market dominated by “lemons.” ➤ Adverse selection can be reduced by revealing private information through screening or signaling, or by cultivating a long-term reputation. ➤ Another source of problems is moral hazard. In the case of insurance, it leads individuals to exert too little effort to prevent losses. This gives rise to features like deductibles, which limit the efficient allocation of risk. 564 P A R T 9 FA . The expected value of a random variable is the weighted average of all possible values, where the weight corresponds to the probability of a given value occurring. 2. Risk is uncertainty about future events or states of the world. It is financial risk when the uncertainty is about monetary outcomes. 3. Under uncertainty, people maximize expected utility. A risk-averse per |
son will choose to reduce risk when that reduction leaves the expected value of his or her income or wealth unchanged. A fair insurance policy has that feature: the premium is equal to the expected value of the claim. A risk-neutral person is completely insensitive to risk and therefore unwilling to pay any premium to avoid it. 4. Risk aversion arises from diminishing marginal utility: an additional dollar of income generates higher marginal utility in low-income states than in high-income states. A fair insurance policy increases a risk-averse person’s utility because it transfers a dollar from a high-income state (a state when no loss occurs) to a low-income state (a state when a loss occurs). 5. Differences in preferences and income or wealth lead to differences in risk aversion. Depending on the size of the premium, a risk-averse person is willing to purchase “unfair” insurance, a policy for which the premium exceeds the expected value of the claim. The greater your risk aversion, the higher the premium you are willing to pay. 6. There are gains from trade in risk, leading to an efficient allocation of risk: those who are most willing to bear risk put their capital at risk to cover the losses of those least willing to bear risk. 7. Risk can also be reduced through diversification, investing in several different things that correspond to independent events. The stock market, where shares in companies are traded, offers one way to diversify. Insurance companies can engage in pooling, insuring many independent events so as to eliminate almost all risk. But when the underlying events are positively correlated, all risk cannot be diversified away. 8. Private information can cause inefficiency in the allocation of risk. One problem is adverse selection, private information about the way things are. It creates the “lemons problem” in used-car markets, where sellers of high-quality cars drop out of the market. Adverse selection can be limited in several ways—through screening of individuals, through signaling that people use to reveal their private information, and through the building of a reputation. 9. A related problem is moral hazard: individuals have private information about their actions, which distorts their incentives to exert effort or care when someone else bears the costs of that lack of effort or care. It limits the ability of markets to allocate risk efficiently. Insurance companies try to limit moral hazard by imposing deductibles, placing more risk on the insured. K E Y T E R M S Random variable, p. 545 Expected value, p. 545 State of the world, p. 545 Risk, p. 545 Financial risk, p. 545 Expected utility, p. 546 Premium, p. 547 Fair insurance policy, p. 547 P R O B L E M S Risk-averse, p. 547 Risk-neutral, p. 549 Capital at risk, p. 552 Efficient allocation of risk, p. 554 Independent events, p. 555 Diversification, p. 555 Share, p. 556 Pooling, p. 556 Positively correlated, p. 558 Private information, p. 559 Adverse selection, p. 560 Screening, p. 560 Signaling, p. 561 Reputation, p. 561 Moral hazard, p. 562 Deductible, p. 562 1. For each of the following situations, calculate the expected value. a. Tanisha owns one share of IBM stock, which is currently trading at $80. There is a 50% chance that the share price will rise to $100 and a 50% chance that it will fall to $70. What is the expected value of the future share price? b. Sharon buys a ticket in a small lottery. There is a probability of 0.7 that she will win nothing, of 0.2 that she will win $10, and of 0.1 that she will win $50. What is the expected value of Sharon’s winnings? c. Aaron is a farmer whose rice crop depends on the weather. If the weather is favorable, he will make a profit of $100. If the weather is unfavorable, he will make a profit TA I N T Y VAT E I N F O R M AT I O N 565 of −$20 (that is, he will lose money). The weather forecast reports that the probability of weather being favorable is 0.9 and the probability of weather being unfavorable is 0.1. What is the expected value of Aaron’s profit? 2. Vicky N. Vestor is considering investing some of her money in a startup company. She currently has income of $4,000, and she is considering investing $2,000 of that in the company. There is a 0.5 probability that the company will succeed and will pay out $8,000 to Vicky (her original investment of $2,000 plus $6,000 of the company’s profits). And there is a 0.5 probability that the company will fail and Vicky will get nothing (and lose her investment). The accompanying table illustrates Vicky’s utility function. Income Total utility (utils) $0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 0 50 85 115 140 163 183 200 215 229 241 a. Calculate Vicky’s marginal utility of income for each income level. Is Vicky risk-averse? b. Calculate the expected value of Vicky’s income if she makes this investment. c. Calculate Vicky’s expected utility from making the investment. a. What is the expected value of your earnings from invest- ing in Ford stock? b. Suppose you are risk-averse. Can we say for sure whether you will invest in Ford stock or put your money into the bank? 5. You have $1,000 that you can invest. If you buy General Motors stock, then, in one year’s time: with a probability of 0.4 you will get $1,600; with a probability of 0.4 you will get $1,100; and with a probability of 0.2 you will get $800. If you put the money into the bank, in one year’s time you will get $1,100 for certain. a. What is the expected value of your earnings from invest- ing in General Motors stock? b. Suppose you prefer putting your money into the bank to investing it in General Motors stock. What does that tell us about your attitude to risk? 6. Wilbur is an airline pilot who currently has income of $60,000. If he gets sick and loses his flight medical certificate, he loses his job and has only $10,000 income. His probability of staying healthy is 0.6, and his probability of getting sick is 0.4. Wilbur’s utility function is given in the accompanying table. Income $0 10,000 20,000 30,000 40,000 50,000 60,000 Total utility (utils) 0 60 110 150 180 200 210 a. What is the expected value of Wilbur’s income? d. What is Vicky’s utility from not making the investment? b. What is Wilbur’s expected utility? Will Vicky therefore invest in the company? 3. Vicky N. Vestor’s utility function was given in Problem 2. As in Problem 2, Vicky currently has income of $4,000. She is considering investing in a startup company, but the investment now costs $4,000 to make. If the company fails, Vicky will get nothing from the company. But if the company succeeds, she will get $10,000 from the company (her original investment of $4,000 plus $6,000 of the company’s profits). Each event has a 0.5 probability of occurring. Will Vicky invest in the company? 4. You have $1,000 that you can invest. If you buy Ford stock, you face the following returns and probabilities from holding the stock for one year: with a probability of 0.2 you will get $1,500; with a probability of 0.4 you will get $1,100; and with a probability of 0.4 you will get $900. If you put the money into the bank, in one year’s time you will get $1,100 for certain. Wilbur thinks about buying “loss-of-license” insurance that will compensate him if he loses his flight medical certificate. c. One insurance company offers Wilbur full compensation for his income loss (that is, the insurance company pays Wilbur $50,000 if he loses his flight medical certificate), and it charges a premium of $40,000. That is, regardless of whether he loses his flight medical certificate, Wilbur’s income after insurance will be $20,000. What is Wilbur’s utility? Will he buy the insurance? d. What is the highest premium Wilbur would just be willing to pay for full insurance (insurance that completely compensates him for the income loss)? 7. In 2003, 1 in approximately every 200 cars in the United States was stolen. Beth owns a car worth $20,000 and is considering purchasing an insurance policy to protect herself from car theft. For the following questions, assume that the chance of car theft is the same in all regions and across all car models. 566 P A R T 9 FA . What should the premium for a fair insurance policy have been in 2003 for a policy that replaces Beth’s car if it is stolen? b. Suppose an insurance company charges 0.6% of the car’s value for a policy that pays for replacing a stolen car. How much will the policy cost Beth? c. Will Beth purchase the insurance in part b if she is risk- neutral? d. Discuss a possible moral hazard problem facing Beth’s insurance company if she purchases the insurance. 8. Hugh’s income is currently $5,000. His utility function is shown in the accompanying table. price of a share of stock in either company is $100. The fortunes of each company are closely linked to the weather. When it is warm, the value of Ted and Larry’s stock rises to $150 but the value of Ethel’s stock falls to $60. When it is cold, the value of Ethel’s stock rises to $150 but the value of Ted and Larry’s stock falls to $60. There is an equal chance of the weather being warm or cold. a. If you invest all your money in Ted and Larry’s, what is your expected stock value? What if you invest all your money in Ethel’s? b. Suppose you diversify and invest half of your $1,000 in each company. How much will your total stock be worth if the weather is warm? What if it is cold? Income Total utility (utils) c. Suppose you are risk-averse. Would you prefer to put all $0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 0 100 140 166 185 200 212 222 230 236 240 a. Calculate Hugh’s marginal utility of income. What is his attitude toward risk? b. Hugh is thinking about gambling in a casino. With a probability of 0.5 he will lose $3,000, and with a probability of 0.5 he will win $5,000. What is the expected value of Hugh’s income? What is Hugh’s expected utility? Will he decide to gamble? (Suppose that he gets no extra utilit |
y from going to the casino.) c. Suppose that the “spread” (how much he can win versus how much he can lose) of the gamble narrows, so that with a probability of 0.5 Hugh will lose $1,000, and with a probability of 0.5 he will win $3,000. What is the expected value of Hugh’s income? What is his expected utility? Is this gamble better for him than the gamble in part b? Will he decide to gamble? 9. Eva is risk-averse. Currently she has $50,000 to invest. She faces the following choice: she can invest in the stock of a dotcom company, or she can invest in IBM stock. If she invests in the dot-com company, then with probability 0.5 she will lose $30,000, but with probability 0.5 she will gain $50,000. If she invests in IBM stock, then with probability 0.5 she will lose only $10,000, but with probability 0.5 she will gain only $30,000. Can you tell which investment she will prefer to make? 10. Suppose you have $1,000 that you can invest in Ted and Larry’s Ice Cream Parlor and/or Ethel’s House of Cocoa. The your money in Ted and Larry’s, as in part a? Or would you prefer to diversify, as in part b? Explain your reasoning. 11. U.S. Mid Cap Companies and International Aggregate are two portfolios constructed from U.S. and international stocks, respectively. The accompanying table shows historical data from the period 1975–2006, which suggest the expected value of the annual percentage returns associated with these portfolios. Portfolio Expected value of return (percent) U.S. Mid Cap Companies International Aggregate 17.0% 14.5 a. Which portfolio would a risk-neutral investor prefer? b. Juan, a risk-averse investor, chooses to invest in the International Aggregate portfolio. What can be inferred about the risk of the two portfolios from Juan’s choice of investment? Based on historical performance, would a risk-neutral investor ever choose International Aggregate? c. Juan is aware that diversification can reduce risk. He considers a portfolio in which half his investment is in U.S. companies and the other half in international companies. What is the expected value of the return for this combined portfolio? Would you expect this combined portfolio to be more risky or less risky than the International Aggregate portfolio? Why or why not? 12. You are considering buying a second-hand Volkswagen. From reading car magazines, you know that half of all Volkswagens have problems of some kind (they are “lemons”) and the other half run just fine (they are “plums”). If you knew that you were getting a plum, you would be willing to pay $10,000 for it: this is how much a plum is worth to you. You would also be willing to buy a lemon, but only if its price was no more than $4,000: this is how much a lemon is worth to you. And someone who owns a plum would be willing to sell it at any price above $8,000. Someone who owns a lemon would be willing to sell it for any price above $2,000. a. For now, suppose that you can immediately tell whether the car that you are being offered is a lemon or a plum. Suppose someone offers you a plum. Will there be trade TA I N T Y VAT E I N F O R M AT I O N 567 b. Some people are prone to see doctors unnecessarily for minor complaints like headaches, and health maintenance organizations do not know how urgently you need a doctor. A solution is for insurees to have to make a copayment of a certain dollar amount (for example, $10) each time they visit a health care provider. All insurees are risk-averse. c. When airlines sell tickets, they do not know whether a buyer is a business traveler (who is willing to pay a lot for a seat) or a leisure traveler (who has a low willingness to pay). A solution for a profit-maximizing airline is to offer an expensive ticket that is very flexible (it allows date and route changes) and a cheap ticket that is very inflexible (it has to be booked in advance and cannot be changed). d. A company does not know whether workers on an assembly line work hard or whether they slack off. A solution is to pay the workers “piece rates,” that is, pay them according to how much they have produced each day. All workers are risk-averse, but the company is not risk-neutral. e. When making a decision about hiring you, prospective employers do not know whether you are a productive or unproductive worker. A solution is for productive workers to provide potential employers with references from previous employers. 15. Kory owns a house that is worth $300,000. If the house burns down, she loses all $300,000. If the house does not burn down, she loses nothing. Her house burns down with a probability of 0.02. Kory is risk-averse. a. What would a fair insurance policy cost? b. Suppose an insurance company offers to insure her fully against the loss from the house burning down, at a premium of $1,500. Can you say for sure whether Kory will or will not take the insurance? c. Suppose an insurance company offers to insure her fully against the loss from the house burning down, at a premium of $6,000. Can you say for sure whether Kory will or will not take the insurance? d. Suppose that an insurance company offers to insure her fully against the loss from the house burning down, at a premium of $9,000. Can you say for sure whether Kory will or will not take the insurance? Now suppose that the seller has private information about the car she is selling: the seller knows whether she has a lemon or a plum. But when the seller offers you a Volkswagen, you do not know whether it is a lemon or a plum. So this is a situation of adverse selection. b. Since you do not know whether you are being offered a plum or a lemon, you base your decision on the expected value to you of a Volkswagen, assuming you are just as likely to buy a lemon as a plum. Calculate this expected value. c. Suppose, from driving the car, the seller knows she has a plum. However, you don’t know whether this particular car is a lemon or a plum, so the most you are willing to pay is your expected value. Will there be trade? 13. You own a company that produces chairs, and you are thinking about hiring one more employee. Each chair produced gives you revenue of $10. There are two potential employees, Fred Ast and Sylvia Low. Fred is a fast worker who produces ten chairs per day, creating revenue for you of $100. Fred knows that he is fast and so will work for you only if you pay him more than $80 per day. Sylvia is a slow worker who produces only five chairs per day, creating revenue for you of $50. Sylvia knows that she is slow and so will work for you if you pay her more than $40 per day. Although Sylvia knows she is slow and Fred knows he is fast, you do not know who is fast and who is slow. So this is a situation of adverse selection. a. Since you do not know which type of worker you will get, you think about what the expected value of your revenue will be if you hire one of the two. What is that expected value? b. Suppose you offered to pay a daily wage equal to the expected revenue you calculated in part a. Whom would you be able to hire: Fred, or Sylvia, or both, or neither? c. If you knew whether a worker is fast or slow, which one would you prefer to hire and why? Can you devise a compensation scheme to guarantee that you employ only the type of worker you prefer? 14. For each of the following situations, do the following: first describe whether it is a situation of moral hazard or of adverse selection. Then explain what inefficiency can arise from this situation and explain how the proposed solution reduces the inefficiency. a. When you buy a second-hand car, you do not know whether it is a lemon (low quality) or a plum (high quality), but the seller knows. A solution is for sellers to offer a warranty with the car that pays for repair costs. www.worthpublishers.com/krugmanwells This page intentionally left blank >> Solutions to “Check Your Understanding” Questions This section offers suggested answers to the “Check Your Understanding” questions found within chapters. Chapter One Check Your Understanding 1-1 1. a. This illustrates the concept of opportunity cost. Given that a person can only eat so much at one sitting, having a slice of chocolate cake requires that you forgo eating something else, such as a slice of coconut cream pie. b. This illustrates the concept that resources are scarce. Even if there were more resources in the world, the total amount of those resources would be limited. As a result, scarcity would still arise. For there to be no scarcity, there would have to be unlimited amounts of everything (including unlimited time in a human life), which is clearly impossible. c. This illustrates the concept that people usually exploit opportunities to make themselves better off. Students will seek to make themselves better off by signing up for the tutorials of teaching assistants with good reputations and avoiding those teaching assistants with poor reputations. It also illustrates the concept that resources are scarce. If there were unlimited spaces in tutorials with good teaching assistants, they would not fill up. d. This illustrates the concept of marginal analysis. Your decision about allocating your time is a “how much” decision: how much time spent exercising versus how much time spent studying. You make your decision by comparing the benefit of an additional hour of exercising to its cost, the effect on your grades of one fewer hour spent studying. 2. a. Yes. The increased time spent commuting is a cost you will incur if you accept the new job. That additional time spent commuting—or equivalently, the benefit you would get from spending that time doing something else—is an opportunity cost of the new job. b. Yes. One of the benefits of the new job is that you will be making $50,000. But if you take the new job, you will have to give up your current job; that is, you have to give up your current salary of $45,000. So $45,000 is one of the opportunity costs of taking the new job. c. No. A more spacious office is an addi |
tional benefit of your new job and does not involve forgoing something else. So it is not an opportunity cost. Check Your Understanding 1-2 1. a. This illustrates the concept that markets usually lead to efficiency. Any seller who wants to sell a book for at least $30 does indeed sell to someone who is willing to buy a book for $30. As a result, there is no way to change how used textbooks are distributed among buyers and sellers in a way that would make one person better off without making someone else worse off. b. This illustrates the concept that there are gains from trade. Students trade tutoring services based on their different abilities in academic subjects. c. This illustrates the concept that when markets don’t achieve efficiency, government intervention can improve society’s welfare. In this case the market, left alone, will permit bars and nightclubs to impose costs on their neighbors in the form of loud music, costs that the bars and nightclubs have no incentive to take into account. This is an inefficient outcome because society as a whole can be made better off if bars and nightclubs are induced to reduce their noise. d. This illustrates the concept that resources should be used as efficiently as possible to achieve society’s goals. By closing neighborhood clinics and shifting funds to the main hospital, better health care can be provided at a lower cost. e. This illustrates the concept that markets move toward equilibrium. Here, because books with the same amount of wear and tear sell for about the same price, no buyer or seller can be made better off by engaging in a different trade than he or she undertook. This means that the market for used textbooks has moved to an equilibrium. 2. a. This does not describe an equilibrium situation. Many students should want to change their behavior and switch to eating at the restaurants. Therefore, the situation described is not an equilibrium. An equilibrium will be established when students are equally as well off eating at the restaurants as eating at the dining hall—which would happen if, say, prices at the restaurants were higher than at the dining hall. b. This does describe an equilibrium situation. By changing your behavior and riding the bus, you would not be made better off. Therefore, you have no incentive to change your behavior. Check Your Understanding 1-3 1. a. This illustrates the principle that government policies can change spending. The tax cut would increase people’s after-tax incomes, leading to higher consumer spending. b. This illustrates the principle that one person’s spending is another person’s income. As oil companies increase their spending on labor by hiring more workers, or pay existing workers higher wages, those workers’ incomes rise. In turn, these workers increase their consumer spending, which becomes income to restaurants and other consumer businesses. c. This illustrates the principle that overall spending sometimes gets out of line with the economy’s productive capacity. In this case, spending on housing was too high relative to the economy’s capacity to create new housing. This first led to a rise in house prices, and then—as a result—to a rise in overall prices, or inflation. S-1 S- Chapter Two Check Your Understanding 2-1 1. a. False. An increase in the resources available to Tom for use in producing coconuts and fish changes his production possibility frontier by shifting it outward. This is because he can now produce more fish and coconuts than before. In the accompanying figure, the line labeled “Tom’s original PPF” represents Tom’s original production possibility frontier, and the line labeled “Tom’s new PPF” represents the new production possibility frontier that results from an increase in resources available to Tom. Quantity of coconuts Tom's original PPF Tom's new PPF Quantity of fish b. True. A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibility frontier. This is illustrated in the accompanying figure: the new production possibility frontier is represented by the line labeled “Tom’s new PPF,” and the original production frontier is represented by the line labeled “Tom’s original PPF.” Since the maximum quantity of coconuts that Tom can gather is the same as before, the new production possibility frontier intersects the vertical axis at the same point as the old frontier. But since the maximum possible quantity of fish is now greater than before, the new frontier intersects the horizontal axis to the right of the old frontier. Quantity of coconuts Tom's original PPF Tom's new PPF Quantity of fish c. False. The production possibility frontier illustrates how much of one good an economy must give up to get more of another good only when resources are used efficiently in production. If an economy is producing inefficiently— that is, inside the frontier—then it does not have to give up a unit of one good in order to get another unit of the other good. Instead, by becoming more efficient in production, this economy can have more of both goods. 2. a. The United States has an absolute advantage in automobile production because it takes fewer Americans (6) to produce a car in one day than Italians (8). The United States also has an absolute advantage in washing machine production because it takes fewer Americans (2) to produce a washing machine in one day than Italians (3). b. In Italy the opportunity cost of a washing machine in terms of an automobile is 3⁄8: 3⁄8 of a car can be produced with the same number of workers and in the same time it takes to produce 1 washing machine. In the United States the opportunity cost of a washing machine in terms of an automobile is 2⁄6 = 1⁄3: 1⁄3 of a car can be produced with the same number of workers and in the same time it takes to produce 1 washing machine. Since 1⁄3 < 3⁄8, the United States has a comparative advantage in the production of washing machines: to produce a washing machine, only 1⁄3 of a car must be given up in the United States but 3⁄8 of a car must be given up in Italy. This means that Italy has a comparative advantage in automobiles. This can be checked as follows. The opportunity cost of an automobile in terms of a washing machine in Italy is 8⁄3, equal to 22⁄3: 22⁄3 washing machines can be produced with the same number of workers and in the time it takes to produce 1 car in Italy. And the opportunity cost of an automobile in terms of a washing machine in the United States is 6⁄2, equal to 3: 3 washing machines can be produced with the same number of workers and in the time it takes to produce 1 car in the United States. c. The greatest gains are realized when each country specializes in producing the good for which it has a comparative advantage. Therefore, the United States should specialize in washing machines and Italy should specialize in automobiles. At a trade of 1 fish for 1.5 coconuts, Hank gives up less for a fish than he would if he were producing fish himself—that is, he gives up less than 2 coconuts for 1 fish. Likewise, Tom gives up less for a coconut than he would if he were producing coconuts himself—with trade, a coconut costs 1⁄1.5 = 2⁄3 of a fish, less than the 4⁄3 of a fish he must give up if he does not trade. An increase in the amount of money spent by households results in an increase in the flow of goods to households. This, in turn, generates an increase in demand for factors of production by firms. Therefore, there is an increase in the number of jobs in the economy. 3. 4. Check Your Understanding 2-2 1. a. This is a normative statement because it stipulates what should be done. In addition, it may have no “right” answer. That is, should people be prevented from all dangerous personal behavior if they enjoy that behavior—like skydiving? Your answer will depend on your point of view. b. This is a positive statement because it is a description of fact-3 2. a. True. Economists often have different value judgments about the desirability of a particular social goal. But despite those differences in value judgments, they will tend to agree that society, once it has decided to pursue a given social goal, should adopt the most efficient policy to achieve that goal. Therefore economists are likely to agree on adopting policy choice B. b. False. Disagreements between economists are more likely to arise because they base their conclusions on different models or because they have different value judgments about the desirability of the policy. c. False. Deciding which goals a society should try to achieve is a matter of value judgments, not a question of economic analysis. Chapter Three Check Your Understanding 3-1 1. a. The quantity of umbrellas demanded is higher at any given price on a rainy day than on a dry day. This is a rightward shift of the demand curve, since at any given price the quantity demanded rises. This implies that any specific quantity can now be sold at a higher price. b. The quantity of weekend calls demanded rises in response to a price reduction. This is a movement along the demand curve for weekend calls. c. The demand for roses increases the week of Valentine’s Day. This is a rightward shift of the demand curve. d. The quantity of gasoline demanded falls in response to a rise in price. This is a movement along the demand curve. Check Your Understanding 3-2 1. a. The quantity of houses supplied rises as a result of an increase in prices. This is a movement along the supply curve. b. The quantity of strawberries supplied is higher at any given price. This is a rightward shift of the supply curve. c. The quantity of labor supplied is lower at any given wage. This is a leftward shift of the supply curve compared to the supply curve during school vacation. So, in order to attract workers, fast-food chains have to offer higher wages. d. The quantity of labor supplied rises in response to a rise in wages. This is a movement along the s |
upply curve. e. The quantity of cabins supplied is higher at any given price. This is a rightward shift of the supply curve. Check Your Understanding 3-3 1. a. The supply curve shifts rightward. At the original equilibrium price of the year before, the quantity of grapes supplied exceeds the quantity demanded. This is a case of surplus. The price of grapes will fall. b. The demand curve shifts leftward. At the original equilibrium price, the quantity of hotel rooms supplied exceeds the quantity demanded. This is a case of surplus. The rates for hotel rooms will fall. c. The demand curve for secondhand snowblowers shifts rightward. At the original equilibrium price, the quantity of secondhand snowblowers demanded exceeds the quantity supplied. This is a case of shortage. The equilibrium price of secondhand snowblowers will rise. Check Your Understanding 3-4 1. a. The market for large cars: this is a rightward shift in demand caused by a decrease in the price of a complement, gasoline. As a result of the shift, the equilibrium price of large cars will rise and the equilibrium quantity of large cars bought and sold will also rise. b. The market for fresh paper made from recycled stock: this is a rightward shift in supply due to a technological innovation. As a result of this shift, the equilibrium price of fresh paper made from recycled stock will fall and the equilibrium quantity bought and sold will rise. c. The market for movies at a local movie theater: this is a leftward shift in demand caused by a fall in the price of a substitute, pay-per-view movies. As a result of this shift, the equilibrium price of movie tickets will fall and the equilibrium number of people who go to the movies will also fall. Upon the announcement of the new chip, the demand curve for computers using the earlier chip shifts leftward, as demand decreases, and the supply curve for these computers shifts rightward, as supply increases. a. If demand decreases relatively more than supply increases, then the equilibrium quantity falls, as shown here: 2. Price of computer P1 P2 S1 S2 D1 E2 E1 D2 Q2 Q1 Quantity of computers b. If supply increases relatively more than demand decreases, then the equilibrium quantity rises, as shown here: Price of computer S1 E1 S2 P1 P2 E2 D1 D2 Q1 Q2 Quantity of computers In both cases, the equilibrium price falls. S- Chapter Four Check Your Understanding 4-1 1. A consumer buys each pepper if the price is less than (or just equal to) the consumer’s willingness to pay for that pepper. The demand schedule is constructed by asking how many peppers will be demanded at any given price. The accompanying table illustrates the demand schedule. Price of pepper Quantity of peppers demanded Quantity of peppers demanded by Casey Quantity of peppers demanded by Josey $0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 When the price is $0.40, Casey’s consumer surplus from the first pepper is $0.50, from his second pepper $0.30, from his third pepper $0.10, and he does not buy any more peppers. Casey’s individual consumer surplus is therefore $0.90. Josey’s consumer surplus from her first pepper is $0.40, from her second pepper $0.20, from her third pepper $0.00 (since the price is exactly equal to her willingness to pay, she buys the third pepper but receives no consumer surplus from it), and she does not buy any more peppers. Josey’s individual consumer surplus is therefore $0.60. Total consumer surplus at a price of $0.40 is therefore $0.90 + $0.60 = $1.50. Check Your Understanding 4-2 1. A producer supplies each pepper if the price is greater than (or just equal to) the producer’s cost of producing that pepper. The supply schedule is constructed by asking how many peppers will be supplied at any price. The accompanying table illustrates the supply schedule. Price of pepper Quantity of peppers supplied Quantity of peppers supplied by Cara Quantity of peppers supplied by Jamie $0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 When the price is $0.70, Cara’s producer surplus from the first pepper is $0.60, from her second pepper $0.60, from her third pepper $0.30, from her fourth pepper $0.10, and she does not supply any more peppers. Cara’s individual producer surplus is therefore $1.60. Jamie’s producer surplus from his first pepper is $0.40, from his second pepper $0.20, from his third pepper $0.00 (since the price is exactly equal to his cost, he sells the third pepper but receives no producer surplus from it), and he does not supply any more peppers. Jamie’s individual producer surplus is therefore $0.60. Total producer surplus at a price of $0.70 is therefore $1.60 + $0.60 = $2.20. Check Your Understanding 4-3 1. The quantity demanded equals the quantity supplied at a price of $0.50, the equilibrium price. At that price, a total quantity of five peppers will be bought and sold. Casey will buy three peppers and receive consumer surplus of $0.40 on his first, $0.20 on his second, and $0.00 on his third pepper. Josey will buy two peppers and receive consumer surplus of $0.30 on her first and $0.10 on her second pepper. Total consumer surplus is therefore $1.00. Cara will supply three peppers and receive producer surplus of $0.40 on her first, $0.40 on her second, and $0.10 on her third pepper. Jamie will supply two peppers and receive producer surplus of $0.20 on his first and $0.00 on his second pepper. Total producer surplus is therefore $1.10. Total surplus in this market is therefore $1.00 + $1.10 = $2.10. 2. a. If Josey consumes one less pepper, she loses $0.60 (her willingness to pay for her second pepper); if Casey consumes one more pepper, he gains $0.30 (his willingness to pay for his fourth pepper). This results in an overall loss of consumer surplus of $0.60 − $0.30 = $0.30. b. Cara’s cost of the last pepper she supplied (the third pepper) is $0.40, and Jamie’s cost of producing one more (his third pepper) is $0.70. Total producer surplus therefore falls by $0.70 − $0.40 = $0.30. c. Josey’s willingness to pay for her second pepper is $0.60; this is what she would lose if she were to consume one less pepper. Cara’s cost of producing her third pepper is $0.40; this is what she would save if she were to produce one less pepper. If we therefore reduced quantity by one pepper, we would lose $0.60 − $0.40 = $0.20 of total surplus. The new guideline is likely to reduce the total life span of kidney recipients because older recipients (those with small children) are more likely to get a kidney compared to the original guideline. As a result, total surplus is likely to fall. However, this new policy can be justified as an acceptable sacrifice of efficiency for fairness because it’s a desirable goal to reduce the chance of a small child losing a parent. 3. Check Your Understanding 4-4 1. When these rights are separated, someone who owns both the above-ground and the mineral rights can sell each of these separately in the market for above-ground rights and the market for mineral rights. And each of these markets will achieve efficiency: if the market price for above-ground rights is higher than the seller’s cost-5 the seller will sell that right and total surplus increases. If the market price for mineral rights is higher than the seller’s cost, the seller will sell that right and total surplus increases. If the two rights, however, cannot be sold separately, a seller can only sell both rights or none at all. Imagine a situation in which the seller values the mineral right highly (that is, has a high cost of selling it) but values the above-ground right much less. If the two rights are separate, the owner may sell the above-ground right (increasing total surplus) but not the mineral right. If, however, the two rights cannot be sold separately, and the owner values the mineral right sufficiently highly, she may not sell either of the two rights. In this case, surplus could have been created through the sale of the aboveground right but goes unrealized because the two rights could not be sold separately. 2. There will be many sellers willing to sell their books but only a few buyers who want to buy books at that price. As a result, only a few transactions will actually occur, and many transactions that would have been mutually beneficial will not take place. This, of course, is inefficient. 3. Markets, alas, do not always lead to efficiency. When there is market failure, the market outcome may be inefficient. This can occur for three main reasons. Markets can fail when, in an attempt to capture more surplus, one party—a monopolist, for instance—prevents mutually beneficial trades from occurring. Markets can also fail when one individual’s actions have side effects—externalities—on the welfare of others. Finally, markets can fail when the goods themselves—such as goods about which some relevant information is private—are unsuited for efficient management by markets. And when markets don’t achieve efficiency, government intervention can improve society’s welfare. Chapter Five Check Your Understanding 5-1 1. a. Fewer homeowners are willing to rent out their driveways because the price ceiling has reduced the payment they receive. This is an example of a fall in price leading to a fall in the quantity supplied. It is shown in the accompanying diagram by the movement from point E to point A along the supply curve, a reduction in quantity of 400 parking spaces. Parking fee Decrease in quantity supplied + Increase in quantity demanded = Shortage of parking spaces $15 11 7 3 0 E A S B Price ceiling D 3,200 3,600 4,400 4,000 Quantity of parking spaces 4,800 b. The quantity demanded increases by 400 spaces as the price decreases. At a lower price, more fans are willing to drive and rent a parking space. It is shown in the diagram by the movement from point E to point B along the demand curve. c. Under a price ceiling, the quantity demanded exceeds the quantity supplied; as a result, shortages arise. In this case, there will be a |
shortage of 800 parking spaces. It is shown by the horizontal distance between points A and B. d. Price ceilings result in wasted resources. The additional time fans spend to guarantee a parking space is wasted time. e. Price ceilings lead to inefficient allocation of a good— here, the parking spaces—to consumers. f. Price ceilings lead to black markets. 2. a. False. By lowering the price that producers receive, a price ceiling leads to a decrease in the quantity supplied. b. True. A price ceiling leads to a lower quantity supplied than in an efficient, unregulated market. As a result, some people who would have been willing to pay the market price, and so would have gotten the good in an unregulated market, are unable to obtain it when a price ceiling is imposed. c. True. Those producers who still sell the product now receive less for it and are therefore worse off. Other producers will no longer find it worthwhile to sell the product at all and so will also be made worse off. 3. a. Since the apartment is rented quickly at the same price, there is no change (either gain or loss) in producer surplus. So any change in total surplus comes from changes in consumer surplus. When you are evicted, the amount of consumer surplus you lose is equal to the difference between your willingness to pay for the apartment and the rent-controlled price. When the apartment is rented to someone else at the same price, the amount of consumer surplus the new renter gains is equal to the difference between his or her willingness to pay and the rentcontrolled price. So this will be a pure transfer of surplus from one person to another only if both your willingness to pay and the new renter’s willingness to pay are the same. Since under rent control apartments are not always allocated to those who have the highest willingness to pay, the new renter’s willingness to pay may be either equal to, lower, or higher than your willingness to pay. If the new renter’s willingness to pay is lower than yours, this will create additional deadweight loss: there is some additional consumer surplus that is lost. However, if the new renter’s willingness to pay is higher than yours, this will create an increase in total surplus, as the new renter gains more consumer surplus than you lost. b. This creates deadweight loss: if you were able to give the ticket away, someone else would be able to obtain consumer surplus, equal to their willingness to pay for the ticket. You neither gain nor lose any surplus, since you cannot go to the concert whether or not you give the ticket away. If you were able to sell the ticket, the buyer would obtain consumer surplus equal to the difference between their willingness to pay for the ticket and the price at which you sell the ticket. In addition, you would obtain producer surplus equal to the difference between the price at which you sell the ticket and your cost of selling the ticket (which, since you won the ticket, is presumably zero). Since the restriction to neither sell nor give away the ticket means that this surplus cannot be obtained by anybody, it creates deadweight loss. If you could give the ticket away, as described above, there would be consumer surplus that accrues to the recipient S- of the ticket; and if you give the ticket to the person with the highest willingness to pay, there would be no deadweight loss. c. This creates deadweight loss. If students buy ice cream on campus, they obtain consumer surplus: their willingness to pay must have been higher than the price of the ice cream. Your college obtains producer surplus: the price is higher than your college’s cost of selling the ice cream. Prohibiting the sale of ice cream on campus means that these two sources of total surplus are lost: there is deadweight loss. d. Given that your dog values ice cream equally as much as you do, this is a pure transfer of surplus. As you lose consumer surplus, your dog gains equally as much consumer surplus. Check Your Understanding 5-2 1. a. Some gas station owners will benefit from getting a higher price. QF indicates the sales made by these owners. But some will lose; there are those who make sales at the market equilibrium price of PE but do not make sales at the regulated price of PF. These missed sales are indicated on the graph by the fall in the quantity demanded along the demand curve, from point E to point A. b. Those who buy gas at the higher price of PF will probably receive better service; this is an example of inefficiently high quality caused by a price floor as gas station owners compete on quality rather than price. But opponents are correct to claim that consumers are generally worse off— those who buy at PF would have been happy to buy at PE, and many who were willing to buy at a price between PE and PF are now unwilling to buy. This is indicated on the graph by the fall in the quantity demanded along the demand curve, from point E to point A. c. Proponents are wrong because consumers and some gas station owners are hurt by the price floor, which creates “missed opportunities”—desirable transactions between consumers and station owners that never take place. The deadweight loss, the amount of total surplus lost because of missed opportunities, is indicated by the shaded area in the accompanying figure. Moreover, the inefficiency of wasted resources arises as consumers spend time and money driving to other states. The price floor also tempts people to engage in black market activity. With the price floor, only QF units are sold. But at prices between PE and PF , there are drivers who cumulatively want to buy more than QF and owners who are willing to sell to them, a situation likely to lead to illegal activity. Deadweight loss A Price of gas PF PE S B Price floor E QF QE D Quantity of gas Check Your Understanding 5-3 1. a. The price of a ride is $7 since the quantity demanded at this price is 6 million: $7 is the demand price of 6 million rides. This is represented by point A in the accompanying figure. Fare (per ride) $7.00 5.00 3.00 A B Deadweight loss E S D 0 6 8 10 12 14 Quantity of rides (millions per year) b. At 6 million rides, the supply price is $3 per ride, represented by point B in the figure. The wedge between the demand price of $7 per ride and the supply price of $3 per ride is the quota rent per ride, $4. This is represented in the figure above by the vertical distance between points A and B. c. The quota discourages 4 million mutually beneficial transactions. The shaded triangle in the figure represents the deadweight loss. d. At 9 million rides, the demand price is $5.50 per ride, indicated by point C in the accompanying figure, and the supply price is $4.50 per ride, indicated by point D. The quota rent is the difference between the demand price and the supply price: $1. The deadweight loss is represented by the shaded triangle in the figure. As you can see, the deadweight loss is smaller when the quota is set at 9 million rides than when it is set at 6 million rides. Fare (per ride) $7.00 5.50 5.00 4.50 3.00 Deadweight loss C D E S D 0 6 8 9 10 12 14 Quantity of rides (millions per year) 2. The accompanying figure shows a decrease in demand by 4 million rides, represented by a leftward shift of the demand curve from D1 to D2: at any given price, the quantity demanded falls by 4 million rides. (For example, at a price of $5, the quantity demanded falls from 10 million to 6 million rides per year.) This eliminates the effect of -7 quota limit of 8 million rides. At point E2, the new market equilibrium, the equilibrium quantity is equal to the quota limit; as a result, the quota has no effect on the market. Fare (per ride) $7.00 6.00 5.00 4.00 3.00 Quota E1 E2 S D1 0 6 8 10 12 14 Quantity of rides (millions per year) D2 Chapter Six Check Your Understanding 6-1 1. By the midpoint method, the percent change in the price of strawberries is $1.00 − $1.50 ($1.50 + $1.00)/2 × 100 = −$0.50 $1.25 × 100 = −40% Similarly, the percent change in the quantity of strawberries demanded is 200,000 − 100,000 (100,000 + 200,000)/2 × 100 = 100,000 150,000 × 100 = 67% Dropping the minus sign, the price elasticity of demand using the midpoint method is 67%/40% = 1.7. By the midpoint method, the percent change in the quantity of movie tickets demanded in going from 4,000 tickets to 5,000 tickets is 5,000 − 4,000 (4,000 + 5,000)/2 × 100 = 1,000 4,500 × 100 = 22% Since the price elasticity of demand is 1 at the current consumption level, it will take a 22% reduction in the price of movie tickets to generate a 22% increase in quantity demanded. Since price rises, we know that quantity demanded must fall. Given the current price of $0.50, a $0.05 increase in price represents a 10% change, using the method in Equation 6-2. So the price elasticity of demand is % change in quantity demanded 10% = 1.2 so that the percent change in quantity demanded is 12%. A 12% decrease in quantity demanded represents 100,000 × 0.12, or 12,000 sandwiches. 2. 3. Check Your Understanding 6-2 1. a. Elastic demand. Consumers are highly responsive to changes in price. For a rise in price, the quantity effect (which tends to reduce total revenue) outweighs the price effect (which tends to increase total revenue). Overall, this leads to a fall in total revenue. b. Unit-elastic demand. Here the revenue lost to the fall in price is exactly equal to the revenue gained from higher sales. The quantity effect exactly offsets the price effect. c. Inelastic demand. Consumers are relatively unresponsive to changes in price. For consumers to purchase a given percent increase in output, the price must fall by an even greater percent. The price effect of a fall in price (which tends to reduce total revenue) outweighs the quantity effect (which tends to increase total revenue). As a result, total revenue decreases. d. Inelastic demand. Consumers are relatively unresponsive to price, so a given percent fall in output is accompanied by an even gre |
ater percent rise in price. The price effect of a rise in price (which tends to increase total revenue) outweighs the quantity effect (which tends to reduce total revenue). As a result, total revenue increases. 2. a. Once bitten by a venomous snake, the victim’s demand for an antidote is very likely to be perfectly inelastic because there is no substitute and it is necessary for survival. The demand curve will be vertical, at a quantity equal to the needed dose. b. Students’ demand for green erasers is likely to be perfectly elastic because there are easily available substitutes: nongreen erasers. The demand curve will be horizontal, at a price equal to that of non-green erasers. Check Your Understanding 6-3 1. By the midpoint method, the percent increase in Chelsea’s income is $18,000 − $12,000 ($12,000 + $18,000)/2 × 100 = $6,000 $15,000 × 100 = 40% Similarly, the percent increase in her consumption of CDs is 40 − 10 (10 + 40)/2 × 100 = 30 25 × 100 = 120% 2. 3. Chelsea’s income elasticity of demand for CDs is therefore 120%/40% = 3. Sanjay’s consumption of expensive restaurant meals will fall more than 10% because a given percent change in income (a fall of 10% here) induces a larger percent change in consumption of an income-elastic good. The cross-price elasticity of demand is 5%/20% = 0.25. Since the cross-price elasticity of demand is positive, the two goods are substitutes. Check Your Understanding 6-4 1. By the midpoint method, the percent change in the number of hours of web-design services contracted is 500,000 − 300,000 (300,000 + 500,000)/2 × 100 = 200,000 400,000 × 100 = 50% Similarly, the percent change in the price of web-design services is: $150 − $100 ($100 + $150)/2 × 100 = $50 $125 × 100 = 40% S-. 3. 4. The price elasticity of supply is 50%/40% = 1.25. Hence supply is elastic. True. An increase in demand raises price. If the price elasticity of supply of milk is low, then relatively little additional supply will be forthcoming as the price rises. As a result, the price of milk will rise substantially to satisfy the increased demand for milk. If the price elasticity of supply is high, then a relatively large amount of additional supply will be produced as the price rises. As a result, the price of milk will rise only by a little to satisfy the higher demand for milk. False. It is true that long-run price elasticities of supply are generally larger than short-run elasticities of supply. But this means that the short-run supply curves are generally steeper, not flatter, than the long-run supply curves. True. When supply is perfectly elastic, the supply curve is a horizontal line. So a change in demand has no effect on price; it affects only the quantity bought and sold. Chapter Seven Check Your Understanding 7-1 1. The following figure shows that, after introduction of the excise tax, the price paid by consumers rises to $1.20; the price received by producers falls to $0.90. Consumers bear $0.20 of the $0.30 tax per pound of butter; producers bear $0.10 of the $0.30 tax per pound of butter. The tax drives a wedge of $0.30 between the price paid by consumers and the price received by producers. As a result, the quantity of butter bought and sold is now 9 million pounds. Price of butter (per pound) Price paid by consumers post-tax Price pre-tax Price received by producers post-tax $1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 $0.20 of tax falls on consumers $0.10 of tax falls on producers S E D 0 6 7 8 9 10 11 12 13 14 Quantity of butter (millions of pounds) textbooks and very little on publishers, as shown in the accompanying figure. Price of textbook Excise tax Price paid by consumers post-tax Price pre-tax Price received by producers post-tax S D Quantity of textbooks 3. 4. True. When a substitute is readily available, demand is elastic. This implies that producers cannot easily pass on the cost of the tax to consumers because consumers will respond to an increased price by switching to the substitute. Furthermore, when producers have difficulty adjusting the amount of the good produced, supply is inelastic. That is, producers cannot easily reduce output in response to a lower price net of tax. So the tax burden will fall more heavily on producers than consumers. The fact that supply is very inelastic means that producers will reduce their supply of bottled water very little in response to the fall in price caused by the tax. Demand, on the other hand, will fall in response to an increase in price because demand is somewhat elastic. As a result, the incidence of the tax will fall heavily on producers of bottled spring water and very little on consumers, as shown in the accompanying figure. Price of spring water (per bottle) S Price paid by consumers post-tax Price pre-tax Excise tax Price received by producers post-tax D Quantity of spring water (bottles) 5. True. The lower the elasticity of supply, the more the burden of a tax will fall on producers rather than consumers, other things equal. 2. The fact that demand is very inelastic means that consumers will reduce their demand for textbooks very little in response to an increase in the price caused by the tax. The fact that supply is somewhat elastic means that suppliers will respond to the fall in the price by reducing supply. As a result, the incidence of the tax will fall heavily on consumers of economics Check Your Understanding 7-2 1. a. Without the excise tax, Zhang, Yves, Xavier, and Walter sell, and Ana, Bernice, Chizuko, and Dagmar buy one can of soda each, at $0.40 per can. So the quantity bought and sold is 4-9 b. With the excise tax, Zhang and Yves sell, and Ana and Bernice buy one can of soda each. So the quantity bought and sold is 2. c. Without the excise tax, Ana’s individual consumer surplus is $0.70 − $0.40 = $0.30, Bernice’s is $0.60 − $0.40 = $0.20, Chizuko’s is $0.50 − $0.40 = $0.10, and Dagmar’s is $0.40 − $0.40 = $0.00. Total consumer surplus is $0.30 + $0.20 + $0.10 + $0.00 = $0.60. With the tax, Ana’s individual consumer surplus is $0.70 − $0.60 = $0.10 and Bernice’s is $0.60 − $0.60 = $0.00. Total consumer surplus post-tax is $0.10 + $0.00 = $0.10. So the total consumer surplus lost because of the tax is $0.60 − $0.10 = $0.50. d. Without the excise tax, Zhang’s individual producer surplus is $0.40 − $0.10 = $0.30, Yves’s is $0.40 − $0.20 = $0.20, Xavier’s is $0.40 − $0.30 = $0.10, and Walter’s is $0.40 − $0.40 = $0.00. Total producer surplus is $0.30 + $0.20 + $0.10 + $0.00 = $0.60. With the tax, Zhang’s individual producer surplus is $0.20 − $0.10 = $0.10 and Yves’s is $0.20 − $0.20 = $0.00. Total producer surplus post-tax is $0.10 + $0.00 = $0.10. So the total producer surplus lost because of the tax is $0.60 − $0.10 = $0.50. e. With the tax, two cans of soda are sold, so the government tax revenue from this excise tax is 2 × $0.40 = $0.80. f. Total surplus without the tax is $0.60 + $0.60 = $1.20. With the tax, total surplus is $0.10 + $0.10 = $0.20, and government tax revenue is $0.80. So deadweight loss from this excise tax is $1.20 − ($0.20 + $0.80) = $0.20. 2. a. The demand for gasoline is inelastic because there is no close substitute for gasoline itself and it is difficult for drivers to arrange substitutes for driving, such as taking public transportation. As a result, the deadweight loss from a tax on gasoline would be relatively small, as shown in the accompanying diagram. Price of gasoline Excise tax Deadweight loss S E D Quantity of gasoline b. The demand for milk chocolate bars is elastic because there are close substitutes: dark chocolate bars, milk chocolate kisses, and so on. As a result, the deadweight loss from a tax on milk chocolate bars would be relatively large, as shown in the accompanying diagram. Price of milk chocolate bar Deadweight loss S Excise tax E D Quantity of milk chocolate bars Check Your Understanding 7-3 1. a. Since drivers are the beneficiaries of highway safety programs, this tax performs well according to the benefits principle. But since the level of the tax does not depend on ability to pay the tax, it does not perform well according to the ability-to-pay principle. Since higher-income car purchasers are likely to spend more on a new car, a tax assessed as a percentage of the purchase price of the car would perform better on the ability-to-pay principle. A $500-per-car tax will cause people to buy fewer new cars, while a percentage-based tax will cause people to buy fewer cars and less expensive cars. b. This tax does not perform well according to the benefits principle because the payers are nonresidents of the local area, but the beneficiaries are local residents who will enjoy greater government services. But to the extent that people who stay in hotels have higher income compared to those who don’t, the tax performs well according to the ability-to-pay principle. It will distort the action of staying in a hotel room in this area, resulting in fewer nights of hotel room stays. c. This tax performs well according to the benefits principle because local homeowners are the users of local schools. It also performs well according to the abilityto-pay principle because it is assessed as a percentage of home value: higher-income residents, who own more expensive homes, will pay higher taxes. It will distort the action of buying a house in this area versus another area with a lower property tax rate or the action of making changes to a house that increase its assessed value. d. This tax performs well according to the benefits principle because food consumers are the beneficiaries of government food safety programs. It does not perform well according to the ability-to-pay principle because food is a necessity, and lower-income people will pay approximately as much as higher-income people. This tax will distort the action of buying food, leading people to purchase cheaper varieties of food. S-10 Check Your Understanding 7-4 1. a. The marginal tax rate for someone with income of |
$5,000 is 1%: for each additional $1 in income, $0.01 or 1%, is taxed away. This person pays total tax of $5,000 × 1% = $50, which is ($50/$5,000) × 100 = 1% of his or her income. b. The marginal tax rate for someone with income of $20,000 is 2%: for each additional $1 in income, $0.02 or 2%, is taxed away. This person pays total tax of $10,000 × 1% + $10,000 × 2% = $300, which is ($300/$20,000) × 100 = 1.5% of his or her income. c. Since the high-income taxpayer pays a larger percentage of his or her income than the low-income taxpayer, this tax is progressive. 2. A 1% tax on consumption spending means that a family earning $15,000 and spending $10,000 will pay a tax of 1% × $10,000 = $100, equivalent to 0.67% of its income; ($100/$15,000) × 100 = 0.67%. But a family earning $10,000 and spending $8,000 will pay a tax of 1% × $8,000 = $80, equivalent to 0.80% of its income; ($80/$10,000) × 100 = 0.80%. So the tax is regressive, since the lower-income family pays a higher percentage of its income in tax than the higher-income family. 3. a. False. Recall that a seller always bears some burden of a tax as long as his or her supply of the good is not perfectly elastic. Since the supply of labor a worker offers is not perfectly elastic, some of the payroll tax will be borne by the worker, and therefore the tax will affect the person’s incentive to take a job. b. False. Under a proportional tax, the percentage of the tax base is the same for everyone. Under a lump-sum tax, the total tax paid is the same for everyone, regardless of their income. A lump-sum tax is regressive. Chapter Eight Check Your Understanding 8-1 1. a. To determine comparative advantage, we must compare the two countries’ opportunity costs for a given good. Take the opportunity cost of 1 ton of corn in terms of bicycles. In China, the opportunity cost of 1 bicycle is 0.01 ton of corn; so the opportunity cost of 1 ton of corn is 1/0.01 bicycles = 100 bicycles. The United States has the comparative advantage in corn since its opportunity cost in terms of bicycles is 50, a smaller number. Similarly, the opportunity cost in the United States of 1 bicycle in terms of corn is 1/50 ton of corn = 0.02 ton of corn. This is greater than 0.01, the Chinese opportunity cost of 1 bicycle in terms of corn, implying that China has a comparative advantage in bicycles. b. Given that the United States can produce 200,000 bicycles if no corn is produced, it can produce 200,000 bicycles × 0.02 ton of corn/bicycle = 4,000 tons of corn when no bicycles are produced. Likewise, if China can produce 3,000 tons of corn if no bicycles are produced, it can produce 3,000 tons of corn × 100 bicycles/ton of corn = 300,000 bicycles if no corn is produced. These points determine the vertical and horizontal intercepts of the U.S. and Chinese production possibility frontiers, as shown in the accompanying diagram. Quantity of corn (tons) 4,000 1,000 0 Quantity of corn (tons) 3,000 (a) U.S. Production Possibility Frontier U.S. production with trade Slope = –0.02 U.S. consumption with trade PPFUS 200,000 Quantity of bicycles (b) Chinese Production Possibility Frontier Chinese consumption with trade Slope = –0.01 0 100,000 Chinese production with trade PPFChina 300,000 Quantity of bicycles c. The diagram shows the production and consumption points of the two countries. Each country is clearly better off with international trade because each now consumes a bundle of the two goods that lies outside its own production possibility frontier, indicating that these bundles were unattainable in autarky. 2. a. According to the Heckscher–Ohlin model, this pattern of trade occurs because the United States has a relatively larger endowment of factors of production, such as human capital and physical capital, that are suited to the production of movies, but France has a relatively larger endowment of factors of production suited to wine-making, such as vineyards and the human capital of vintners. b. According to the Heckscher–Ohlin model, this pattern of trade occurs because the United States has a relatively larger endowment of factors of production, such as human and physical capital, that are suited to making machinery, but Brazil has a relatively larger endowment of factors of production suited to shoe-making, such as unskilled labor and leather. Check Your Understanding 8-2 1. In the accompanying diagram, PA is the U.S. price of grapes in autarky and PW is the world price of grapes under international trade. With trade, U.S. consumers -11 pay a price of PW for grapes and consume quantity QD, U.S. grape producers produce quantity QS, and the differ− QS, represents imports of Mexican grapes. As ence, QD a consequence of the strike by truckers, imports are halted, the price paid by American consumers rises to the autarky price, PA, and U.S. consumption falls to the autarky quantity QA. Price of grapes PA PW W X Y Domestic supply Z QS QA QD Imports Domestic demand Quantity of grapes a. Before the strike, U.S. consumers enjoyed consumer surplus equal to areas W + X + Z. After the strike, their consumer surplus shrinks to W. So consumers are worse off, losing consumer surplus represented by X + Z. b. Before the strike, U.S. producers had producer surplus equal to the area Y. After the strike, their producer surplus increases to Y + X. So U.S. producers are better off, gaining producer surplus represented by X. c. U.S. total surplus falls as a result of the strike by an amount represented by area Z, the loss in consumer surplus that does not accrue to producers. 2. Mexican grape producers are worse off because they − QS, and Mexican lose sales in the amount of QD grape pickers are worse off because they lose the wages that were associated with the lost sales. The lower demand for Mexican grapes caused by the strike implies that the price Mexican consumers pay for grapes falls, making them better off. American grape pickers are better off because their wages increase as a result of the increase of QA − QS in U.S. sales. Check Your Understanding 8-3 1. a. If the tariff is $0.50, the price paid by domestic consumers for a pound of imported butter is $0.50 + $0.50 = $1.00, the same price as a pound of domestic butter. Imported butter will no longer have a price advantage over domestic butter, imports will cease, and domestic producers will capture all the feasible sales to domestic consumers, selling amount QA in the accompanying figure. But if the tariff is less than $0.50—say, only $0.25—the price paid by domestic consumers for a pound of imported butter is $0.50 + $0.25 = $0.75, $0.25 cheaper than a pound of domestic butter. American butter producers will gain − Q1 as a result of the sales in the amount of Q2 $0.25 tariff. But this is smaller than the amount they would have gained under the $0.50 tariff, the amount QA − Q1. Price of butter (per pound) Tariff = $0.50 Tariff = $0.25 $1.00 0.75 0.50 Domestic supply Domestic demand 0 Q1 Q2 C2 QA C1 Quantity of butter (pounds) b. As long as the tariff is at least $0.50, increasing it more has no effect. At a tariff of $0.50, all imports are effectively blocked. 2. All imports are effectively blocked at a tariff of $0.50. So such a tariff corresponds to an import quota of 0. Check Your Understanding 8-4 1. There are many fewer businesses that use steel as an input than there are consumers who buy sugar or clothing. So it will be easier for such businesses to communicate and coordinate among themselves to lobby against tariffs than it will be for consumers. In addition, each business will perceive that the cost of a steel tariff is quite costly to its profits, but an individual consumer is either unaware of or perceives little loss from tariffs on sugar or clothing. The tariffs were indeed lifted at the end of 2003. 2. Countries are often tempted to protect domestic industries by claiming that an import poses a quality, health, or environmental danger to domestic consumers. A WTO official should examine whether domestic producers are subject to the same stringency in the application of quality, health, or environmental regulations as foreign producers. If they are, then it is more likely that the regulations are for legitimate, non–trade protection purposes; if they are not, then it is more likely that the regulations are intended as trade protection measures. Chapter Nine Check Your Understanding 9-1 1. a. Supplies are an explicit cost because they require an out- lay of money. b. If the basement could be used in some other way that generates money, such as renting it to a student, then the implicit cost is that money forgone. Otherwise, the implicit cost is zero. c. Wages are an explicit cost. d. By using the van for their business, Karma and Don forgo the money they could have gained by selling it. So use of the van is an implicit cost. e. Karma’s forgone wages from her job are an implicit cost. S-12 Check Your Understanding 9-2 1. a. The marginal cost of doing your laundry is the opportunity cost of your time spent doing laundry today—that is, the value you would place on spending time today on your next best alternative activity, like seeing a movie. The marginal benefit is having more clean clothes today to choose from. b. The marginal cost of changing your oil is the opportunity cost of time spent changing your oil now as well as the explicit cost of the oil change. The marginal benefit is the improvement in your car’s performance. c. The marginal benefit of another jalapeno on your nachos is the pleasant taste that you receive from it. The marginal cost is the unpleasant feeling of a burning mouth that you receive from it plus any explicit cost of the jalapeno. d. The marginal benefit of hiring another worker in your company is the value of the output that worker produces. The marginal cost is the wage you must pay that worker. e. The marginal benefit of another dose of the drug is the value of the reduction in the patient’s disease. The marginal co |
st is the value lost due to the increased side effects from this additional dose. f. The marginal benefit of assigning one more soldier to your invasion force is the increased probability of a successful invasion generated by that extra soldier. The marginal cost is the decreased probability of success in the alternative project for which you could use that soldier, such as defending your borders. 2. The accompanying table shows Babette’s new marginal cost and her new net gain. It also reproduces Babette’s marginal benefit from Table 9-5. Quantity of chicken wings 0 1 2 3 4 5 6 7 Total cost $4.00 4.25 4.40 4.50 4.65 4.90 5.35 6.20 Marginal cost (per wing) Marginal benefit (per wing) Net gain (per wing) $0.25 $4.30 $4.05 0.15 0.10 0.15 0.25 0.45 0.85 2.50 1.50 1.20 0.90 0.70 0.60 2.35 1.40 1.05 0.65 0.25 −0.25 Babette’s marginal cost is now decreasing at first, until the portion size is 3 wings. When Babette increases the portion size beyond 3 wings, marginal cost increases. The optimal quantity is 6 wings. For any quantities fewer than 6 wings, marginal benefit exceeds marginal cost; for any quantities greater than 6 wings, marginal cost exceeds marginal benefit. Check Your Understanding 9-3 1. a. Your sunk cost is $8,000 because none of the $8,000 spent on the truck is recoverable. b. Your sunk cost is $4,000 because 50% of the $8,000 spent on the truck is recoverable. 2. a. This is an invalid argument because the time and money already spent are a sunk cost at this point. b. This is also an invalid argument because what you should have done two years ago is irrelevant to what you should do now. c. This is a valid argument because it recognizes that sunk costs are irrelevant to what you should do now. d. This is a valid argument given that you are concerned about disappointing your parents. But your parents’ views are irrational because they do not recognize that the time already spent is a sunk cost. Check Your Understanding 9-4 1. a. The net present value of project A is unaffected by the interest rate since it is money received today; its present value is still $100. The net present value of project B is now −$10 + $115/1.02 = $102.75. The net present value of project C is now $119 − $20/1.02 = $99.39. Project B is now preferred. b. When the interest rate is lower, the cost of waiting for money that arrives in the future is lower. For example, at a 10% interest rate, $1 arriving 1 year from today is worth only 1/$1.10 = $0.91. But when the interest rate is 2%, $1 arriving 1 year from today is worth 1/$1.02 = $0.98, a sizable increase. As a result, project B, which has a benefit one year from today, becomes more attractive. And project C, which has a cost 1 year from today, becomes less attractive. Chapter Ten Check Your Understanding 10-1 1. Consuming a unit that generates negative marginal utility leaves the consumer with lower total utility than not consuming that unit at all. A rational consumer, a consumer who maximizes utility, would not do that. For example, from Figure 10-1 you can see that Cassie receives 64 utils if she consumes 8 clams; but if she consumes the 9th clam, she loses a util, netting her a total utility of only 63 utils. So whenever consuming a unit generates negative marginal utility, the consumer is made better off by not consuming that unit, even when that unit is free. 2. Since Marta has diminishing marginal utility of coffee, her first cup of coffee of the day generates the greatest increase in total utility. Her third and last cup of the day generates the least. 3. a. Mabel has increasing marginal utility of exercising since each additional unit consumed brings more additional enjoyment than the previous unit. b. Mei has constant marginal utility of CDs because each additional unit generates the same additional enjoyment as the previous unit. c. Dexter has diminishing marginal utility of restaurant meals since the additional utility generated by a good restaurant meal is less when he consumes lots of them than when he consumed few of them-13 Check Your Understanding 10-2 1. a. The accompanying table shows the consumer’s consumption possibilities, A through C. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line. Consumption bundle Quantity of Quantity of popcorn (buckets) movie tickets A B C Quantity of movie tickets BL C 4 Quantity of popcorn (buckets) b. The accompanying table shows the consumer’s consumption possibilities, A through D. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line. Consumption bundle Quantity of underwear (pairs) Quantity of socks (pairs) A B C D Quantity of socks (pairs BL D 1 2 3 Quantity of underwear (pairs) Check Your Understanding 10-3 1. From Table 10-3 you can see that Sammy’s marginal utility per dollar from increasing his consumption of clams from 3 pounds to 4 pounds and his marginal utility per dollar from increasing his consumption of potatoes from 9 to 10 pounds are the same, 0.75 utils. But a consumption bundle consisting of 4 pounds of clams and 10 pounds of potatoes is not Sammy’s optimal consumption bundle because it is not affordable given his income of $20; 4 pounds of clams and 10 pounds of potatoes costs $4 × 4 + $2 × 10 = $36, $16 more than Sammy’s income. This can be illustrated with Sammy’s budget line from Figure 10-3: a bundle of 4 pounds of clams and 10 pounds of potatoes is represented by point X in the accompanying diagram, a point that lies outside Sammy’s budget line. If you look at the horizontal axis of Figure 10-4, it is quite clear that there is no such thing in Sammy’s consumption possibilities as a bundle consisting of 4 pounds of clams and 10 pounds of potatoes. Quantity of potatoes (pounds) 10 8 6 4 2 0 Bundle X is not affordable X BL 1 2 3 5 Quantity of clams (pounds) 4 2. Sammy’s maximum utility per dollar is generated when he goes from consuming 0 to 1 pound of clams (3.75 utils) and as he goes from 0 to 1 pound of potatoes (5.75 utils). But this bundle consisting of 1 pound of clams and 1 pound of potatoes generates only 26.5 utils for him. Instead, Sammy should choose the consumption bundle that satisfies his budget constraint and for which the marginal utility per dollar for both goods is equal. Check Your Understanding 10-4 1. a. Since spending on orange juice is a small share of Clare’s spending, the income effect from a rise in the price of orange juice is insignificant. Only the substitution effect, represented by the substitution of lemonade in place of orange juice, is significant. b. Since rent is a large share of Delia’s expenditures, the increase in rent generates an income effect, making Delia feel poorer. Since housing is a normal good for Delia, the income and substitution effects move in the same direction, leading her to reduce her consumption of housing by moving to a smaller apartment. c. Since a meal ticket is a significant share of the students’ living costs, an increase in its price will generate an income effect. Students respond to the price increase by eating more often in the cafeteria. So the substitution effect (which would induce them to eat in the cafeteria less often as they substitute restaurant meals in place of meals at the cafeteria) and the income effect (which would induce them to eat in the cafeteria more often because they are poorer) move in opposite directions. This happens because cafeteria meals are an inferior good. In fact, since the income effect outweighs the S-14 substitution effect (students eat in the cafeteria more as the price of meal tickets increases), cafeteria meals are a Giffen good. Chapter Eleven Check Your Understanding 11-1 1. a. As you can see from the accompanying diagram, the four bundles are associated with three indifference curves: B on the 10-util indifference curve, A and C on the 6-util indifference curve, and D on the 4-util indifference curve. Quantity of licorice drops 7 6 5 4 3 2 1 0 6 utils I3 I2 I1 10 utils A B 4 utils C D 1 3 2 5 Quantity of chocolate kisses 4 b. From comparing the quantities of chocolate kisses and licorice drops, you can predict that Samantha will prefer B to A because B gives her one more chocolate kiss and the same amount of licorice drops as A. Next, you can predict that she will prefer C to D because C gives her one more chocolate kiss and the same amount of licorice drops as D. You can also predict that she prefers B to D because B gives her two more licorice drops and the same amount of chocolate kisses as D. But without data about utils, you cannot predict how Samantha would rank A versus C or D because C and D have more chocolate kisses but fewer licorice drops than A. Neither can you rank B versus C, for the same reason. Bundles A and B each generate 200 utils since they both lie on the 200-util indifference curve. Likewise, bundles A and C each generate 100 utils since they both lie on the 100-util indifference curve. But this implies that A generates 100 utils and also that A generates 200 utils. This is a contradiction and so cannot be true. It shows that indifference curves cannot cross. 2. Check Your Understanding 11-2 1. a. The marginal rate of substitution of books in place of games, MUB/MUG, is 2 for Lucinda and 5 for Kyle. This implies that Lucinda is willing to trade 1 more book for 2 fewer games and Kyle is willing to trade 1 more book for 5 fewer games. So starting from a bundle of 3 books and 6 games, Lucinda would be equally content with a bundle of 4 books and 4 games and Kyle would be equally content with a bundle of 4 books and 1 game. Lucinda finds it more difficult to trade games for books: she is willing to give up only 2 games for a book but Kyle is willing to give up 5 games for a book. If books are measured on the horizontal axis and games on the vertical axis, Kyle’s indifference curve will be steeper than Lucinda’s at the current consumption bundle. b. Lucinda’s curren |
t consumption bundle is optimal if PB/PG, the relative price of books in terms of games, is 2. Kyle’s current consumption bundle is not optimal at this relative price; his bundle would be optimal only if the relative price of books in terms of games is 5. Since, for Kyle, MUB/MUG fewer games and more books to lower his MUB/MUG until it is equal to 2. = 2, he should consume = 5 but PB/PG Check Your Understanding 11-3 1. a. Since Sanjay cares only about the number of jelly beans, not about whether they are banana- or pineappleflavored, he is always willing to exchange one for the other at the same rate. This implies that his marginal rate of substitution of one flavor of jelly bean in place of another is constant. So they are perfect substitutes. b. Cherry pie and vanilla ice cream are complements for Hillary since her marginal utility of cherry pie goes up as she has another scoop of vanilla ice cream. But they are ordinary goods, not perfect complements, because she gains some utility from having cherry pie without any vanilla ice cream. c. Omnisoft’s software programs and its operating system are perfect complements for its customers: they gain no utility from the software programs without the operating system. So their marginal rate of substitution of one good in place of the other is undefined, and their indifference curves have a right-angle shape. d. Income and leisure are ordinary goods for Darnell: the more income he has made by working more hours, the less willing he is to earn yet more by giving up additional leisure time. Check Your Understanding 11-4 1. a. Sammy’s original budget line is illustrated in the accompanying diagram by BL1. His original consumption is at point A. When the price of clams falls, his budget line rotates outward to BL2, allowing him to achieve a higher level of total utility. The pure substitution effect would involve the same change in the slope of his budget line, but without any increase in total utility. So the pure substitution effect is illustrated by the movement from A to B. In fact, his total utility does rise, so his total consumption moves from A to C. The movement from B to C is the income effect. Quantity of potatoes (pounds) 60 50 40 30 20 10 0 A C B BL1 BLS 6 12 I1 18 I2 BL2 24 Quantity of clams (pounds) b. Again, in the accompanying diagram Sammy’s original budget line is BL1, and his original consumption is at point A. The increase in the price of clams causes his budget line to rotate inward to BL2. This reduces his total utility. The pure substitution effect is what would happen if the slope of the budget line changed but his total utility -15 did not; it is shown as the movement from A to B. The full effect of the price change is the movement from A to C. The movement from B to C is the income effect. Quantity of potatoes (pounds) 60 50 40 30 20 10 0 B A C I2 I1 BL2 BLS 6 BL1 12 18 24 Quantity of clams (pounds) Chapter Twelve Check Your Understanding 12-1 1. a. The fixed input is the 10-ton machine, and the variable input is electricity. b. As you can see from the declining numbers in the third column of the accompanying table, electricity does indeed exhibit diminishing returns: the marginal product of each additional kilowatt of electricity is less than that of the previous kilowatt. Quantity of electricity (kilowatts) Quantity of ice (pounds) Marginal product of electricity (pounds per kilowatt) 0 1 2 3 4 0 1,000 1,800 2,400 2,800 1,000 800 600 400 c. A 50% increase in the size of the fixed input means that Bernie now has a 15-ton machine. So the fixed input is now the 15-ton machine. Since it generates a 100% increase in output for any given amount of electricity, the quantity of output and marginal product are now as shown in the accompanying table. Quantity of electricity (kilowatts) Quantity of ice (pounds) Marginal product of electricity (pounds per kilowatt) Check Your Understanding 12-2 1. a. As shown in the accompanying table, the marginal cost for each pie is found by multiplying the marginal cost of the previous pie by 1.5. Variable cost for each output level is found by summing the marginal cost for all the pies produced to reach that output level. So, for example, the variable cost of three pies is $1.00 + $1.50 + $2.25 = $4.75. Average fixed cost for Q pies is calculated as $9.00/Q since fixed cost is $9.00. Average variable cost for Q pies is equal to variable cost for the Q pies divided by Q; for example, the average variable cost of five pies is $13.19/5, or approximately $2.64. Finally, average total cost can be calculated in two equivalent ways: as TC/Q or as AVC + AFC. Quantity of pies Marginal cost of pie Variable cost Average fixed cost of pie Average variable cost of pie Average total cost of pie 0 1 2 3 4 5 6 $1.00 1.50 2.25 3.38 5.06 7.59 $0.00 — — — 1.00 2.50 4.75 8.13 13.19 20.78 $9.00 $1.00 $10.00 4.50 3.00 2.25 1.80 1.50 1.25 1.58 2.03 2.64 3.46 5.75 4.58 4.28 4.44 4.96 b. The spreading effect dominates the diminishing returns effect when average total cost is falling: the fall in AFC dominates the rise in AVC for pies 1 to 4. The diminishing returns effect dominates when average total cost is rising: the rise in AVC dominates the fall in AFC for pies 5 and 6. c. Alicia’s minimum-cost output is 4 pies; this generates the lowest average total cost, $4.28. When output is less than 4, the marginal cost of a pie is less than the average total cost of the pies already produced. So making an additional pie lowers average total cost. For example, the marginal cost of pie 3 is $2.25, whereas the average total cost of pies 1 and 2 is $5.75. So making pie 3 lowers average total cost to $4.58, equal to (2 × $5.75 + $2.25)/3. When output is more than 4, the marginal cost of a pie is greater than the average total cost of the pies already produced. Consequently, making an additional pie raises average total cost. So, although the marginal cost of pie 6 is $7.59, the average total cost of pies 1 through 5 is $4.44. Making pie 6 raises average total cost to $4.96, equal to (5 × $4.44 + $7.59)/6. 0 1 2 3 4 0 2,000 3,600 4,800 5,600 2,000 1,600 1,200 800 Check Your Understanding 12-3 1. a. The accompanying table shows the average total cost of producing 12,000, 22,000, and 30,000 units for each of the three choices of fixed cost. For example, if the firm makes choice 1, the total cost of producing 12,000 units of output is $8,000 + 12,000 × $1.00 = $20,000. The S-16 average total cost of producing 12,000 units of output is therefore $20,000/12,000 = $1.67. The other average total costs are calculated similarly. 12,000 units 22,000 units 30,000 units $1.67 $1.36 $1.27 1.75 1.30 1.15 2.25 1.34 1.05 Average total cost from choice 1 Average total cost from choice 2 Average total cost from choice 3 So if the firm wanted to produce 12,000 units, it would make choice 1 because this gives it the lowest average total cost. If it wanted to produce 22,000 units, it would make choice 2. If it wanted to produce 30,000 units, it would make choice 3. b. Having historically produced 12,000 units, the firm would have adopted choice 1. When producing 12,000 units, the firm would have had an average total cost of $1.67. When output jumps to 22,000 units, the firm cannot alter its choice of fixed cost in the short run, so its average total cost in the short run will be $1.36. In the long run, however, it will adopt choice 2, making its average total cost fall to $1.30. c. If the firm believes that the increase in demand is tempo- rary, it should not alter its fixed cost from choice 1 because choice 2 generates higher average total cost as soon as output falls back to its original quantity of 12,000 units: $1.75 versus $1.67. 2. a. This firm is likely to experience constant returns to scale. To increase output, the firm must hire more workers, purchase more computers, and pay additional telephone charges. Because these inputs are easily available, their long-run average total cost is unlikely to change as output increases. b. This firm is likely to experience decreasing returns to scale. As the firm takes on more projects, the costs of communication and coordination required to implement the expertise of the firm’s owner are likely to increase. c. This firm is likely to experience increasing returns to scale. Because diamond mining requires a large initial setup cost for excavation equipment, long-run average total cost will fall as output increases. 3. The accompanying diagram shows the long-run average total cost curve (LRATC) and the short-run average total cost curve corresponding to a long-run output choice of 5 cases of salsa (ATC5). The curve ATC5 shows the short-run average total cost for which the level of fixed cost minimizes average total cost at an output of 5 cases of salsa. This is confirmed by the fact that at 5 cases per day, ATC5 touches LRATC, the longrun average total cost curve. If Selena expects to produce only 4 cases of salsa for a long time, she should change her fixed cost. If she does not change her fixed cost and produces 4 cases of salsa, her average total cost in the short run is indicated by point B on ATC5; it is no longer on the LRATC. If she changes her fixed cost, though, her average total cost could be lower, at point A. Cost of case 0 ATC5 LRATC B C A 4 5 Quantity of salsa (cases) Chapter Thirteen Check Your Understanding 13-1 1. a. With only two producers in the world, each producer will represent a sizable share of the market. So the industry will not be perfectly competitive. b. Because each producer of natural gas from the North Sea has only a small market share of total world supply of natural gas, and since natural gas is a standardized product, the natural gas industry will be perfectly competitive. c. Because each designer has a distinctive style, high-fashion clothes are not a standardized product. So the industry will not be perfectly competitive. d. The market described here is the market in each city for tickets to |
baseball games. Since there are only one or two teams in each major city, each team will represent a sizable share of the market. So the industry will not be perfectly competitive. Check Your Understanding 13-2 1. a. The firm should shut down immediately when price is less than minimum average variable cost, the shut-down price. In the accompanying diagram, this is optimal for prices in the range 0 to P1. Price, cost of unit P2 P1 0 MC ATC AVC Q1 Q2 Quantity -17 2. b. When price is greater than minimum average variable cost (the shut-down price) but less than minimum average total cost (the break-even price), the firm should continue to operate in the short run even though it is making a loss. This is optimal for prices in the range P1 to P2 and for quantities Q1 to Q2. c. When price exceeds minimum average total cost (the break-even price), the firm makes a profit. This happens for prices in excess of P2 and results in quantities greater than Q2. This is an example of a temporary shut-down by a firm when the market price lies below the shut-down price, the minimum average variable cost. In this case, the market price is the price of a lobster meal and variable cost is the variable cost of serving such a meal, such as the cost of the lobster, employee wages, and so on. In this example, however, it is the average variable cost curve rather than the market price that shifts over time, due to seasonal changes in the cost of lobsters. Maine lobster shacks have relatively low average variable cost during the summer, when cheap Maine lobsters are available; during the rest of the year, their average variable cost is relatively high due to the high cost of imported lobsters. So the lobster shacks are open for business during the summer, when their minimum average variable cost lies below price; but they close during the rest of the year, when price lies below their minimum average variable cost. Check Your Understanding 13-3 1. a. A fall in the fixed cost of production generates a fall in the average total cost of production and, in the short run, an increase in each firm’s profit at the current output level. So in the long run new firms will enter the industry. The increase in supply drives down price and profits. Once profits are driven back to zero, entry will cease. b. An increase in wages generates an increase in the average variable and the average total cost of production at every output level. In the short run, firms incur losses at the current output level, and so in the long run some firms 2. will exit the industry. (If the average variable cost rises sufficiently, some firms may even shut down in the short run.) As firms exit, supply decreases, price rises, and losses are reduced. Exit will cease once losses return to zero. c. Price will rise as a result of the increased demand, leading to a short-run increase in profits at the current output level. In the long run, firms will enter the industry, generating an increase in supply, a fall in price, and a fall in profits. Once profits are driven back to zero, entry will cease. d. The shortage of a key input causes that input’s price to increase, resulting in an increase in average variable and average total costs for producers. Firms incur losses in the short run, and some firms will exit the industry in the long run. The fall in supply generates an increase in price and decreased losses. Exit will cease when losses have returned to zero. In the accompanying diagram, point XMKT in panel (b), the intersection of S1 and D1, represents the long-run industry equilibrium before the change in consumer tastes. When tastes change, demand falls and the industry moves in the short run to point YMKT in panel (b), at the intersection of the new demand curve D2 and S1, the short-run supply curve representing the same number of egg producers as in the original equilibrium at point XMKT. As the market price falls, an individual firm reacts by producing less—as shown in panel (a)—as long as the market price remains above the minimum average variable cost. If market price falls below minimum average variable cost, the firm would shut down immediately. At point YMKT the price of eggs is below minimum average total cost, creating losses for producers. This leads some firms to exit, which shifts the short-run industry supply curve leftward to S2. A new long-run equilibrium is established at point ZMKT. As this occurs, the market price rises again, and, as shown in panel (c), each remaining producer reacts by increasing output (here, from point Y to point Z). All remaining producers again make zero profits. The decrease in the quantity of eggs supplied in the industry comes entirely from the exit of some producers from the industry. The long-run industry supply curve is the curve labeled LRS in panel (b). Panel (a) Panel (b) Panel (c) Price, cost Price MC ATC X Y S2 ZMKT XMKT S1 LRS D1 YMKT D2 Price, cost MC ATC Z Y Quantity of eggs QZ QY QX Quantity of eggs Quantity of eggs Decrease in output from exit S-18 Chapter Fourteen Check Your Understanding 14-1 1. a. This does not support the conclusion. Texas Tea has a limited amount of oil, and the price has risen in order to equalize supply and demand. b. This supports the conclusion because the market for home heating oil has become monopolized, and a monopolist will reduce the quantity supplied and raise price to generate profit. c. This does not support the conclusion. Texas Tea has raised its price to consumers because the price of its input, home heating oil, has increased. d. This supports the conclusion. The fact that other firms have begun to supply heating oil at a lower price implies that Texas Tea must have earned profits—profits that attracted the other firms to Frigid. e. This supports the conclusion. It indicates that Texas Tea enjoys a barrier to entry because it controls access to the only Alaskan heating oil pipeline. 2. a. Extending the length of a patent increases the length of time during which the inventor can reduce the quantity supplied and increase the market price. Since this increases the period of time during which the inventor can earn economic profits from the invention, it increases the incentive to invent new products. b. Extending the length of a patent also increases the period of time during which consumers have to pay higher prices. So determining the appropriate length of a patent involves making a trade-off between the desirable incentive for invention and the undesirable high price to consumers. Check Your Understanding 14-2 1. a. The price at each output level is found by dividing the total revenue by the number of emeralds produced; for example, the price when 3 emeralds are produced is $252/3 = $84. The price at the various output levels is then used to construct the demand schedule in the accompanying table. b. The marginal revenue schedule is found by calculating the change in total revenue as output increases by one unit. For example, the marginal revenue generated by increasing output from 2 to 3 emeralds is ($252 − $186) = $66. c. The quantity effect component of marginal revenue is the additional revenue generated by selling one more unit of the good at the market price. For example, as shown in the accompanying table, at 3 emeralds, the market price is $84; so, when going from 2 to 3 emeralds the quantity effect is equal to $84. d. The price effect component of marginal revenue is the decline in total revenue caused by the fall in price when one more unit is sold. For example, as shown in the table, when only 2 emeralds are sold, each emerald sells at a price of $93. However, when Emerald, Inc. sells an additional emerald, the price must fall by $9 to $84. So the price effect component in going from 2 to 3 emeralds is (−$9) × 2 = −$18. That’s because 2 emeralds can only be sold at a price of $84 when 3 emeralds in total are sold, although they could have been sold at a price of $93 when only 2 in total were sold. Quantity of emeralds demanded 1 2 3 4 5 Price of emerald $100 93 84 70 50 Marginal revenue Quantity effect component Price effect component $86 66 28 −30 $93 84 70 50 −$7 −18 −42 −80 2. e. In order to determine Emerald, Inc.’s profit-maximizing output level, you must know its marginal cost at each output level. Its profit-maximizing output level is the one at which marginal revenue is equal to marginal cost. As the accompanying diagram shows, the marginal cost curve shifts upward to $400. The profit-maximizing price rises and quantity falls. Profit falls from $3,200 to $300 × 6 = $1,800. Competitive industry profits, though, are unchanged at zero. Price, cost, marginal revenue of diamond $1,000 Profit falls. MC shifts upward. 700 600 400 200 0 –200 –400 MC2 MC1 D 20 Quantity of diamonds 6 8 10 12 16 Profit-maximizing quantity falls. MR QC Check Your Understanding 14-3 1. a. Cable Internet service is a natural monopoly. So the gov- ernment should intervene only if it believes that price exceeds average total cost, where average total cost is based on the cost of laying the cable. In this case it should impose a price ceiling equal to average total cost. Otherwise, it should do nothing. b. The government should approve the merger only if it fosters competition by transferring some of the company’s landing slots to another, competing airline. 2. a. False. As can be seen from Figure 14-8, panel (b), the inefficiency arises from the fact that some of the consumer surplus is transformed into deadweight loss (the yellow area), not that it is transformed into profit (the green area). b. True. If a monopolist sold to all customers who have a valuation greater than or equal to marginal cost, all mutually beneficial transactions would occur and there would be no deadweight loss-19 3. As shown in the accompanying diagram, a profit– maximizing monopolist produces QM , the output level at which MR = MC. A monopolist who mistakenly believes that P = MR produces the output level at which P = |
MC (when, in fact, P > MR, and at the true profitmaximizing level of output, P > MR = MC). This misguided monopolist will produce the output level QC , where the demand curve crosses the marginal cost curve—the same output level produced if the industry were perfectly competitive. It will charge the price PC, which is equal to marginal cost, and make zero profit. The entire shaded area is equal to the consumer surplus, which is also equal to total surplus in this case (since the monopolist receives zero producer surplus). There is no deadweight loss since every consumer who is willing to pay as much as or more than marginal cost gets the good. A smart monopolist, however, will produce the output level QM and charge the price PM. Profit equals the green area, consumer surplus corresponds to the blue area, and total surplus is equal to the sum of the green and blue areas. The yellow area is the deadweight loss generated by the monopolist. Price, cost, marginal revenue PM PC MC D MR QM QC Quantity Check Your Understanding 14-4 1. a. False. A price-discriminating monopolist will sell to some customers that a single-price monopolist will refuse to— namely, customers with a high price elasticity of demand who are willing to pay only a relatively low price for the good. b. False. Although a price-discriminating monopolist does indeed capture more of the consumer surplus, inefficiency is lower: more mutually beneficial transactions occur because the monopolist makes more sales to customers with a low willingness to pay for the good. c. True. Under price discrimination consumers are charged prices that depend on their price elasticity of demand. A consumer with highly elastic demand will pay a lower price than a consumer with inelastic demand. 2. a. This is not a case of price discrimination because all con- sumers, regardless of their price elasticities of demand, value the damaged merchandise less than undamaged merchandise. So the price must be lowered to sell the merchandise. b. This is a case of price discrimination. Senior citizens have a higher price elasticity of demand for restaurant meals (their demand for restaurant meals is more responsive to price changes) than other patrons. Restaurants lower the price to high-elasticity consumers (senior citizens). Consumers with low price elasticity of demand will pay the full price. c. This is a case of price discrimination. Consumers with a high price elasticity of demand will pay a lower price by collecting and using discount coupons. Consumers with a low price elasticity of demand will not use coupons. d. This is not a case of price discrimination; it is simply a case of supply and demand. Chapter Fifteen Check Your Understanding 15-1 1. a. The world oil industry is an oligopoly because a few countries control a necessary resource for production, oil reserves. b. The microprocessor industry is an oligopoly because two firms possess superior technology and so dominate industry production. c. The wide-bodied passenger jet industry is an oligopoly because there are increasing returns to scale in production. 2. a. The HHI in this industry is 442 + 292 + 132 + 62 + 52 + 32 = 3,016. b. If Yahoo! and MSN were to merge, making their com- bined market 29% + 13% = 42%, the HHI in this industry would be 442 + 422 + 62 + 52 + 32 = 3,770. Check Your Understanding 15-2 1. a. The firm is likely to act noncooperatively and raise output, which will generate a negative price effect. But because the firm’s current market share is small, the negative price effect will fall much more heavily on its rivals’ revenues than on its own. At the same time, the firm will benefit from a positive quantity effect. b. The firm is likely to act noncooperatively and raise output, which will generate a fall in price. Because its rivals have higher costs, they will lose money at the lower price while the firm continues to make profits. So the firm may be able to drive its rivals out of business by increasing its output. c. The firm is likely to collude. Because it is costly for consumers to switch products, the firm would have to lower its price quite substantially (by increasing quantity a lot) to induce consumers to switch to its product. So increasing output is likely to be unprofitable given the large negative price effect. d. The firm is likely to collude. It cannot increase sales because it is currently at maximum production capacity. Check Your Understanding 15-3 1. When Margaret builds a missile, Nikita’s payoff from building a missile as well is −10; it is −20 if he does not. The same set of payoffs holds for Margaret when Nikita builds a missile: her payoff is −10 if she builds one as well, −20 if she does not. So it is a Nash (or noncooperative) equilibrium for both Margaret and Nikita to build missiles, and their total payoff is (−10) + (−10) = −20. But their total payoff is greatest when neither builds a missile: their total payoff is 0 + 0 = 0. S-20 But this outcome—the cooperative outcome—is unlikely. If Margaret builds a missile but Nikita does not, Margaret gets a payoff of +8, rather than the 0 she gets if she doesn’t build a missile. So Margaret is better off if she builds a missile but Nikita doesn’t. Similarly, Nikita is better off if he builds a missile but Margaret doesn’t: he gets a payoff of +8, rather than the 0 he gets if he doesn’t build a missile. So both players have an incentive to build a missile. Both will build a missile, and each gets a payoff of −10. So unless Nikita and Margaret are able to communicate in some way to enforce cooperation, they will act in their own individual interests and each will build a missile. 2. a. Future entry by several new firms will increase competition and drive down industry profits. As a result, there is less future profit to protect by behaving cooperatively today. So each oligopolist is more likely to behave noncooperatively today. b. When it is very difficult for a firm to detect if another firm has raised output, then it is very difficult to enforce cooperation by playing “tit for tat.” So it is more likely that a firm will behave noncooperatively. c. When firms have coexisted while maintaining high prices for a long time, each expects cooperation to continue. So the value of behaving cooperatively today is high, and it is likely that firms will engage in tacit collusion. Check Your Understanding 15-4 1. a. This is likely to be interpreted as evidence of tacit collusion. Firms in the industry are able to tacitly collude by setting their prices according to the published “suggested” price of the largest firm in the industry. This is a form of price leadership. b. This is not likely to be interpreted as evidence of tacit collusion. Considerable variation in market shares indicates that firms have been competing to capture each others’ business. c. This is not likely to be interpreted as evidence of tacit collusion. These features make it more unlikely that consumers will switch products in response to lower prices. So this is a way for firms to avoid any temptation to gain market share by lowering price. This is a form of product differentiation used to avoid direct competition. d. This is likely to be interpreted as evidence of tacit collusion. In the guise of discussing sales targets, firms can create a cartel by designating quantities to be produced by each firm. e. This is likely to be interpreted as evidence of tacit collusion. By raising prices together, each firm in the industry is refusing to undercut its rivals by leaving its price unchanged or lowering it. Because it could gain market share by doing so, refusing to do it is evidence of tacit collusion. Chapter Sixteen Check Your Understanding 16-1 1. a. Ladders are not differentiated as a result of monopolistic competition. A ladder producer makes different ladders (tall ladders versus short ladders) to satisfy different consumer needs, not to avoid competition with rivals. So two tall ladders made by two different producers will be indistinguishable by consumers. b. Soft drinks are an example of product differentiation as a result of monopolistic competition. For example, several producers make colas; each is differentiated in terms of taste, which fast-food chains sell it, and so on. c. Department stores are an example of product differentiation as a result of monopolistic competition. They serve different clienteles that have different price sensitivities and different tastes. They also offer different levels of customer service and are situated in different locations. d. Steel is not differentiated as a result of monopolistic competition. Different types of steel (beams versus sheets) are made for different purposes, not to distinguish one steel manufacturer’s products from another’s. 2. a. Perfectly competitive industries and monopolistically competitive industries both have many sellers. So it may be hard to distinguish between them solely in terms of number of firms. And in both market structures, there is free entry into and exit from the industry in the long run. But in a perfectly competitive industry, one standardized product is sold; in a monopolistically competitive industry, products are differentiated. So you should ask whether products are differentiated in the industry. b. In a monopoly there is only one firm, but a monopolistically competitive industry contains many firms. So you should ask whether or not there is a single firm in the industry. Check Your Understanding 16-2 1. a. An increase in fixed cost raises average total cost and shifts the average total cost curve upward. In the short run, firms incur losses. In the long run, some will exit the industry, resulting in a rightward shift of the demand curves for those firms that remain in the industry, since each one now serves a larger share of the market. Longrun equilibrium is reestablished when the demand curve for each remaining firm has shifted rightward to the point where it is tangent to the fi |
rm’s new, higher average total cost curve. At this point each firm’s price just equals its average total cost, and each firm makes zero profit. b. A decrease in marginal cost lowers average total cost and shifts the average total cost curve and the marginal cost curve downward. Because existing firms now make profits, in the long run new entrants are attracted into the industry. In the long run, this results in a leftward shift of each existing firm’s demand curve since each firm now has a smaller share of the market. Long-run equilibrium is reestablished when each firm’s demand curve has shifted leftward to the point where it is tangent to the new, lower average total cost curve. At this point each firm’s price just equals average total cost, and each firm makes zero profit. 2. If all the existing firms in the industry joined together to create a monopoly, they would achieve monopoly profits. But this would induce new firms to create new, differentiated products and then enter the industry and capture some of the monopoly profits. So in the long run it would be impossible to maintain a monopoly. The problem arises from the fact that because new firms can create new products, there is no barrier to entry that can maintain a monopoly-21 Check Your Understanding 16-3 1. a. False. As can be seen from panel (b) of Figure 16-4, a monopolistically competitive firm produces at a point where price exceeds marginal cost—unlike a perfectly competitive firm, which produces where price equals marginal cost (at the point of minimum average total cost). A monopolistically competitive firm will refuse to sell at marginal cost. This would be below average total cost and the firm would incur a loss. b. True. Firms in a monopolistically competitive industry could achieve higher profits (monopoly profits) if they all joined together and produced a single product. In addition, since the industry possesses excess capacity, producing a larger quantity of output would lower the firm’s average total cost. The effect on consumers, however, is ambiguous. They would experience less choice. But if consolidation substantially reduces industry-wide average total cost and therefore substantially increases industrywide output, consumers may experience lower prices under monopoly. c. True. Fads and fashions are created and promulgated by advertising, which is found in oligopolies and monopolistically competitive industries but not in monopolies or perfectly competitive industries. Check Your Understanding 16-4 1. a. This is economically useful because such advertisements are likely to focus on the medical benefits of aspirin. b. This is economically wasteful because such advertise- ments are likely to focus on promoting Bayer aspirin versus a rival’s aspirin product. The two products are medically indistinguishable. c. This is economically useful because such advertisements are likely to focus on the health and enjoyment benefits of orange juice. d. This is economically wasteful because such advertise- ments are likely to focus on promoting Tropicana orange juice versus a rival’s product. The two are likely to be indistinguishable by consumers. e. This is economically useful because the longevity of a business gives a potential customer information about its quality. A successful brand name indicates a desirable attribute, such as quality, to a potential buyer. So, other things equal—such as price—a firm with a successful brand name will achieve higher sales than a rival with a comparable product but without a successful brand name. This is likely to deter new firms from entering an industry in which an existing firm has a successful brand name. 2. Chapter Seventeen Check Your Understanding 17-1 1. a. The external cost is the pollution caused by the wastewater runoff, an uncompensated cost imposed by the poultry farms on their neighbors. b. Since poultry farmers do not take the external cost of their actions into account when making decisions about 2. how much wastewater to generate, they will create more runoff than is socially optimal in the absence of government intervention or a private deal. They will produce runoff up to the point at which the marginal social benefit of an additional unit of runoff is zero; however, their neighbors experience a high, positive level of marginal social cost of runoff from this output level. So the quantity of wastewater runoff is inefficient: reducing runoff by one unit would reduce total social benefit by less than it would reduce total social cost. c. At the socially optimal quantity of wastewater runoff, the marginal social benefit is equal to the marginal social cost. This quantity is lower than the quantity of wastewater runoff that would be created in the absence of government intervention or a private deal. Yasmin’s reasoning is not correct: allowing some late returns of books is likely to be socially optimal. Although you impose a marginal social cost on others every day that you are late in returning a book, there is some positive marginal social benefit to you of returning a book late—for example, you get a longer period to use it in working on a term paper. The socially optimal number of days that a book is returned late is the number at which the marginal social benefit equals the marginal social cost. A fine so stiff that it prevents any late returns is likely to result in a situation in which people return books although the marginal social benefit of keeping them another day is greater than the marginal social cost—an inefficient outcome. In that case, allowing an overdue patron another day would increase total social benefit more than it would increase total social cost. So charging a moderate fine that reduces the number of days that books are returned late to the socially optimal number of days is appropriate. Check Your Understanding 17-2 1. This is a misguided argument. Allowing polluters to sell emissions permits makes polluters face a cost of polluting: the opportunity cost of the permit. If a polluter chooses not to reduce its emissions, it cannot sell its emissions permits. As a result, it forgoes the opportunity of making money from the sale of the permits. So despite the fact that the polluter receives a monetary benefit from selling the permits, the scheme has the desired effect: to make polluters internalize the externality of their actions. 2. a. If the emissions tax is smaller than the marginal social cost at QOPT, a polluter will face a marginal cost of polluting (equal to the amount of the tax) that is less than the marginal social cost at the socially optimal quantity of pollution. Since a polluter will produce emissions up to the point where the marginal social benefit is equal to its marginal cost, the resulting amount of pollution will be larger than the socially optimal quantity. As a result, there is inefficiency: if the amount of pollution is larger than the socially optimal quantity, the marginal social cost exceeds the marginal social benefit, and society could gain from a reduction in emissions levels. If the emissions tax is greater than the marginal social cost at QOPT, a polluter will face a marginal cost of polluting (equal to the amount of the tax) that is greater S-22 than the marginal social cost at the socially optimal quantity of pollution. This will lead the polluter to reduce emissions below the socially optimal quantity. This also is inefficient: whenever the marginal social benefit is greater than the marginal social cost, society could benefit from an increase in emissions levels. b. If the total amount of allowable pollution is set too high, the supply of emissions permits will be high and so the equilibrium price at which permits trade will be low. That is, polluters will face a marginal cost of polluting (the price of a permit) that is “too low”—lower than the marginal social cost at the socially optimal quantity of pollution. As a result, pollution will be greater than the socially optimal quantity. This is inefficient. If the total level of allowable pollution is set too low, the supply of emissions permits will be low and so the equilibrium price at which permits trade will be high. That is, polluters will face a marginal cost of polluting (the price of a permit) that is “too high”—higher than the marginal social cost at the socially optimal quantity of pollution. As a result, pollution will be lower than the socially optimal quantity. This also is inefficient. Check Your Understanding 17-3 1. The London congestion charge acts like a Pigouvian tax on driving in central London. If the marginal external cost in terms of pollution and congestion of an additional car driven in central London is indeed £8, then the scheme is an optimal policy. 2. a. Planting trees imposes an external benefit: the marginal social benefit of planting trees is higher than the marginal benefit to individual tree planters, since many people (not just those who plant the trees) can benefit from the increased air quality and lower summer temperatures. The difference between the marginal social benefit and the marginal benefit to individual tree planters is the marginal external benefit. A Pigouvian subsidy could be placed on each tree planted in urban areas in order to increase the marginal benefit to individual tree planters to the same level as the marginal social benefit. b. Water-saving toilets impose an external benefit: the marginal benefit to individual homeowners from replacing a traditional toilet with a water-saving toilet is zero, since water is virtually costless. But the marginal social benefit is large, since fewer rivers and aquifers need to be pumped. The difference between the marginal social benefit and the marginal benefit to individual homeowners is the marginal external benefit. A Pigouvian subsidy on installing water-saving toilets could bring the marginal benefit to individual homeowners in line with the marginal social benefit. c. Disposing of old |
computer monitors imposes an external cost: the marginal cost to those disposing of old computer monitors is lower than the marginal social cost, since environmental pollution is borne by people other than the person disposing of the monitor. The difference between the marginal social cost and the marginal cost to those disposing of old computer monitors is the marginal external cost. A Pigouvian tax on disposing of computer monitors, or a system of tradable permits for their disposal, could raise the marginal cost to those disposing of old computer monitors sufficiently to make it equal to the marginal social cost. Check Your Understanding 17-4 1. a. The voltage of an appliance must be consistent with the voltage of the electrical outlet it is plugged into. Consumers will want to have 110-volt appliances when houses are wired for 110-volt outlets, and builders will want to install 110-volt outlets when most prospective homeowners use 110-volt appliances. So a network externality arises because a consumer will want to use appliances that operate with the same voltage as the appliances used by most other consumers. b. Printers, copy machines, fax machines, and so on are 2. designed for specific paper sizes. Consumers will want to purchase paper of a size that can be used in these machines, and machine manufacturers will want to manufacture their machines for the size of paper that most consumers use. So a network externality arises because a consumer will want to use the size of paper used by most other consumers—namely, 81⁄2-by-11-inch paper rather than 8-by-121⁄2-inch paper. Of the two competing companies, the company able to achieve the higher number of sales is likely to dominate the market. In a market with a network externality, new consumers will base their buying decisions on the number of existing consumers of a specific product. In other words, the more consumers a company can attract initially, the more consumers will choose to buy that company’s product; therefore, the good exhibits positive feedback. So it is important for a company to make a large number of sales early on. It can do this by pricing its good cheaply and taking a loss on each unit sold. The company that can best afford to subsidize a large number of sales early on is likely to be the winner of this competition. Chapter Eighteen Check Your Understanding 18-1 1. a. Use of a public park is nonexcludable, but it may or may not be rival in consumption, depending on the circumstances. For example, if both you and I use the park for jogging, then your use will not prevent my use—use of the park is nonrival in consumption. In this case the public park is a public good. But use of the park is rival in consumption if there are many people trying to use the jogging path at the same time or when my use of the public tennis court prevents your use of the same court. In this case the public park is a common resource. b. A cheese burrito is both excludable and rival in consump- tion. Hence it is a private good. c. Information from a password-protected website is excludable but nonrival in consumption. So it is an artificially scarce good. d. Publicly announced information on the path of an incoming hurricane is nonexcludable and nonrival in consumption. So it is a public good-23 2. A private producer will supply only a good that is excludable; otherwise, the producer won’t be able to charge a price for it that covers the costs of production. So a private producer would be willing to supply a cheese burrito and information from a password-protected website but unwilling to supply a public park or publicly announced information about an incoming hurricane. Check Your Understanding 18-2 1. a. With 10 Homebodies and 6 Revelers, the marginal social benefit schedule of money spent on the party is as shown in the accompanying table. Money spent on party $0 1 2 3 4 Marginal social benefit (10 × $0.05) + (6 × $0.13) = $1.28 (10 × $0.04) + (6 × $0.11) = $1.06 (10 × $0.03) + (6 × $0.09) = $0.84 (10 × $0.02) + (6 × $0.07) = $0.62 The efficient spending level is $2, the highest level for which the marginal social benefit is greater than the marginal cost ($1). b. With 6 Homebodies and 10 Revelers, the marginal social benefit schedule of money spent on the party is as shown in the accompanying table. Money spent on party $0 1 2 3 4 Marginal social benefit (6 × $0.05) + (10 × $0.13) = $1.60 (6 × $0.04) + (10 × $0.11) = $1.34 (6 × $0.03) + (10 × $0.09) = $1.08 (6 × $0.02) + (10 × $0.07) = $0.82 The efficient spending level is now $3, the highest level for which the marginal social benefit is greater than the marginal cost ($1). The efficient level of spending has increased from that in part a because with relatively more Revelers than Homebodies, an additional dollar spent on the party generates a higher level of social benefit compared to when there are relatively more Homebodies than Revelers. c. When the numbers of Homebodies and Revelers are unknown but residents are asked their preferences, Homebodies will pretend to be Revelers to induce a higher level of spending on the public party. That’s because a Homebody still receives a positive individual marginal benefit from an additional $1 spent, despite the fact that his or her individual marginal benefit is lower than that of a Reveler for every additional $1. In this case the “reported” marginal social benefit schedule of money spent on the party will be as shown in the accompanying table. Money spent on party Marginal social benefit $0 1 2 3 4 16 × $0.13 = $2.08 16 × $0.11 = $1.76 16 × $0.09 = $1.44 16 × $0.07 = $1.12 As a result, $4 will be spent on the party, the highest level for which the “reported” marginal social benefit is greater than the marginal cost ($1). Regardless of whether there are 10 Homebodies and 6 Revelers (part a) or 6 Homebodies and 10 Revelers (part b), spending $4 in total on the party is clearly inefficient because marginal cost exceeds marginal social benefit at this spending level. As a further exercise, consider how much Homebodies gain by this misrepresentation. In part a, the efficient level of spending is $2. So by misrepresenting their preferences, the 10 Homebodies gain, in total, 10 × ($0.03 + $0.02) = $0.50—that is, they gain the marginal individual benefit in going from a spending level of $2 to $4. The 6 Revelers also gain from the misrepresentations of the Homebodies; they gain 6 × ($0.09 + $0.07) = $0.96 in total. This outcome is clearly inefficient—when $4 in total is spent, the marginal cost is $1 but the marginal social benefit is only $0.62, indicating that too much money is being spent on the party. In part b, the efficient level of spending is actually $3. The misrepresentation by the 6 Homebodies gains them, in total, 6 × $0.02 = $0.12, but the 10 Revelers gain 10 × $0.07 = $0.70 in total. This outcome is also clearly inefficient—when $4 is spent, marginal social benefit is only $0.12 + $0.70 = $0.82 but marginal cost is $1. Check Your Understanding 18-3 1. When individuals are allowed to harvest freely, the 2. government-owned forest becomes a common resource, and individuals will overuse it—they will harvest an inefficiently excessive number of trees. In economic terms, the marginal social cost of harvesting a tree is greater than a private logger’s individual marginal cost. The three methods consistent with economic theory are (i) Pigouvian taxes, (ii) a system of tradable licenses, and (iii) allocation of property rights. i. Pigouvian taxes. You would enforce a tax on loggers that equals the difference between the marginal social cost and the individual marginal cost of logging a tree at the socially efficient harvest amount. In order to do this, you must know the marginal social cost schedule and the individual marginal cost schedule. ii. System of tradable licenses. You would issue tradable licenses, setting the total number of trees harvested equal to the socially efficient harvest number. The market that arises S-24 in these licenses will allocate the right to log efficiently when loggers differ in their costs of logging: licenses will be purchased by those who have a relatively lower cost of logging. The market price of a license will be equal to the difference between the marginal social cost and the individual marginal cost of logging a tree at the socially efficient harvest amount. In order to implement this level, you need to know the socially efficient harvest amount. iii. Allocation of property rights. Here you would sell or give the forest to a private party. This party will have the right to exclude others from harvesting trees. Harvesting is now a private good—it is excludable and rival in consumption. As a result, there is no longer any divergence between social and private costs, and the private party will harvest the efficient level of trees. You need no additional information to use this method. Check Your Understanding 18-4 1. a. The efficient price to a consumer is $0, since the marginal cost of allowing a consumer to download it is $0. b. Xenoid will not produce the software unless it can charge a price that allows it at least to make back the $300,000 cost of producing it. So the lowest price at which Xenoid is willing to produce it is $150. At this price, it makes a total revenue of $150 × 2,000 = $300,000; at any lower price, Xenoid will not cover its cost. The shaded area in the accompanying diagram shows the deadweight loss when Xenoid charges a price of $150. Price of upgrade $150 Deadweight loss 0 2,000 D 3,500 Quantity of upgrades Chapter Nineteen Check Your Understanding 19-1 1. a. A pension guarantee program is a social insurance pro- gram. The possibility of an employer declaring bankruptcy and defaulting on its obligation to pay employee pensions creates insecurity. By providing pension income to those employees, such a program alleviates this source of economic insecurity. b. The SCHIP program is a poverty program. By provid |
ing health care to children in low-income households, it targets its spending specifically to the poor. c. The Section 8 housing program is a poverty program. By targeting its support to low-income households, it specifically helps the poor. d. The federal flood program is a social insurance program. For many people, the majority of their wealth is tied up 2. in the home they own. The potential for a loss of that wealth creates economic insecurity. By providing assistance to those hit by a major flood, the program alleviates this source of insecurity. The poverty threshold is an absolute measure of poverty. It defines individuals as poor if their incomes fall below a level that is considered adequate to purchase the necessities of life, irrespective of how well other people are doing. And that measure is fixed: in 2007, for instance, it took $10,787 for an individual living alone to purchase the necessities of life, regardless of how well-off other Americans were. In particular, the poverty threshold is not adjusted for an increase in living standards: even if other Americans are becoming increasingly well-off over time, in real terms (that is, how many goods an individual at the poverty threshold can buy) the poverty threshold remains the same. 3. a. To determine mean (or average) income, we take the total income of all individuals in this economy and divide it by the number of individuals. Mean income is ($39,000 + $17,500 + $900,000 + $15,000 + $28,000)/5 = $999,500/5 = $199,900. To determine median income, look at the accompanying table, which lines up the five individuals in order of their income. Vijay Kelly Oskar Sephora Raul Income $15,000 17,500 28,000 39,000 900,000 The median income is the income of the individual in the exact middle of the income distribution: Oskar with an income of $28,000. So the median income is $28,000. Median income is more representative of the income of individuals in this economy: almost everyone earns income between $15,000 and $39,000, close to the median income of $28,000. Only Raul is the exception: it is his income that raises the mean income to $199,900, which is not representative of most incomes in this economy. b. The first quintile is made up of the 20% (or one-fifth) of individuals with the lowest incomes in the economy. Vijay makes up the 20% of individuals with the lowest incomes. His income is $15,000, so that is the average income of the first quintile. Oskar makes up the 20% of individuals with the third-lowest incomes. His income is $28,000, so that is the average income of the third quintile. As the Economics in Action pointed out, much of the rise in inequality reflects growing differences among highly educated workers. That is, workers with similar levels of education earn very dissimilar incomes. As a result, the principal source of rising inequality in the United States today is reflected by statement b: the rise in the bank CEO’s salary relative to that of the branch manager. 4. Check Your Understanding 19-2 1. The Earned Income Tax Credit (EITC), a negative income tax, applies only to those workers who earn income; over a certain range of incomes, the more a worker earns, the -25 higher the amount of EITC received. A person who earns no income receives no income tax credit. By contrast, poverty programs that pay individuals based solely on low income still make those payments even if the individual does not work at all; once the individual earns a certain amount of income, these programs discontinue payments. As a result, such programs contain an incentive not to work and earn income, since earning more than a certain amount makes individuals ineligible for their benefits. The negative income tax, however, provides an incentive to work and earn income because its payments increase the more an individual works. According to the data in Table 19-4, the U.S. welfare state reduces the poverty rate for every age group. It does so particularly dramatically for those aged 65 and over, where it cuts the poverty rate by more than 80%. 2. Check Your Understanding 19-3 1. a. The program benefits you and your parents because the pool of all college students contains a representative mix of healthy and less healthy people, rather than a selected group of people who want insurance because they expect to pay high medical bills. In that respect, this insurance is like employment-based health insurance. Because no student can opt out, the school can offer health insurance based on the health care costs of its average student. If each student had to buy his or her own health insurance, some students would not be able to obtain any insurance and many would pay more than they do to the school’s insurance program. b. Since all students are required to enroll in its health insurance program, even the healthiest students cannot leave the program in an effort to obtain cheaper insurance tailored specifically to healthy people. If this were to happen, the school’s insurance program would be left with an adverse selection of less healthy students and so would have to raise premiums, beginning the adverse selection death spiral. But since no student can leave the insurance program, the school’s program can continue to base its premiums on the average student’s probability to require health care, avoiding the adverse selection death spiral. 2. According to critics, part of the reason the U.S. health care system is so much more expensive than that of other countries is its fragmented nature. Since each of the many insurance companies has significant administrative (overhead) costs—in part because each insurance company incurs marketing costs and exerts significant effort in weeding out high-risk insureds—the system tends to be more expensive than one in which there is only a single medical insurer. Another part of the explanation is that U.S. medical care includes many more expensive treatments than found in other wealthy countries, pays higher physician salaries, and has higher drug prices. Check Your Understanding 19-4 1. a. Recall one of the principles from Chapter 1: one person’s spending is another person’s income. A high sales tax on consumer items is the same as a high marginal tax rate on income. As a result, the incentive to earn income by working or by investing in risky projects is reduced, since the payoff, after taxes, is lower. b. If you lose a housing subsidy as soon as your income rises above $25,000, your incentive to earn more than $25,000 is reduced. If you earn exactly $25,000, you obtain the housing subsidy; however, as soon as you earn $25,001, you lose the entire subsidy, making you worse off than if you had not earned the additional dollar. The complete withdrawal of the housing subsidy as income rises above $25,000 is what economists refer to as a notch. Over the past 30 years, polarization in Congress has increased. Thirty years ago, some Republicans were to the left of some Democrats. Today, the rightmost Democrats appear to be to the left of the leftmost Republicans. 2. Chapter Twenty Check Your Understanding 20-1 1. Many college professors will depart for other lines of work if the government imposes a wage that is lower than the market wage. Fewer professors will result in fewer courses taught and therefore fewer college degrees produced. It will adversely affect sectors of the economy that depend directly on colleges, such as the local shopkeepers who sell goods and services to students and faculty, college textbook publishers, and so on. It will also adversely affect firms that use the “output” produced by colleges: new college graduates. Firms that need to hire new employees with college degrees will be hurt as a smaller supply results in a higher market wage for college graduates. Ultimately, the reduced supply of collegeeducated workers will result in a lower level of human capital in the entire economy relative to what it would have been without the policy. And this will hurt all sectors of the economy that depend on human capital. The sectors of the economy that might benefit are firms that compete with colleges in the hiring of would-be college professors. For example, accounting firms will find it easier to hire people who would otherwise have been professors of accounting, and publishers will find it easier to hire people who would otherwise have been professors of English (easier in the sense that the firms can recruit would-be professors with a lower wage than before). In addition, workers who already have college degrees will benefit; they will command higher wages as the supply of college-educated workers falls. Check Your Understanding 20-2 1. a. As the demand for services increases, the price of services will rise. And as the price of the output produced by the industries increases, this shifts the VMPL curve upward— that is, the demand for labor rises. This results in an increase in both the equilibrium wage rate and the quantity of labor employed. b. The fall in the catch per day means that the marginal product of labor in the industry declines. The VMPL curve shifts downward, generating a fall in the equilibrium wage rate and the equilibrium quantity of labor employed. S-26 . When firms from different industries compete for the same workers, then each worker in the various industries will be paid the same equilibrium wage rate, W. And since, by the marginal productivity theory of income distribution, VMPL = P × MPL = W for the last worker hired in equilibrium, the last worker hired in each of these different industries will have the same value of the marginal product of labor. Check Your Understanding 20-3 1. a. False. Income disparities associated with gender, race, or ethnicity can be explained by the marginal productivity theory of income distribution provided that differences in marginal productivity across people are correlated with gender, race, or ethnicity. One possible source for such correlation is past discrimination. |
Such discrimination can lower individuals’ marginal productivity by, for example, preventing them from acquiring the human capital that would raise their productivity. Another possible source of the correlation is differences in work experience that are associated with gender, race, or ethnicity. For example, in jobs where work experience or length of tenure is important, women may earn lower wages because on average more women than men take childcare-related absences from work. b. True. Companies that discriminate when their competitors do not are likely to hire less able workers because they discriminate against more able workers who are considered to be of the wrong gender, race, ethnicity, or other characteristic. And with less able workers, such companies are likely to earn lower profits than their competitors who don’t discriminate. c. Ambiguous. In general, workers who are paid less because they have less experience may or may not be the victims of discrimination. The answer depends on the reason for the lack of experience. If workers have less experience because they are young or have chosen to do something else rather than gain experience, then they are not victims of discrimination if they are paid less. But if workers lack experience because previous job discrimination prevented them from gaining experience, then they are indeed victims of discrimination when they are paid less. Check Your Understanding 20-4 1. a. Clive is made worse off if, before the new law, he had preferred to work more than 35 hours per week. As a result of the law, he can no longer choose his preferred time allocation; he now consumes fewer goods and more leisure than he would like. b. Clive’s utility is unaffected by the law if, before the law, he had preferred to work 35 or fewer hours per week. The law has not changed his preferred time allocation. c. Clive can never be made better off by a law that restricts the number of hours he can work. He can only be made worse off (case a) or equally as well off (case b). 2. The substitution effect would induce Clive to work fewer hours and consume more leisure after his wage rate falls—the fall in the wage rate means the price of an hour of leisure falls, leading Clive to consume more leisure. But a fall in his wage rate also generates a fall in Clive’s income. The income effect of this is to induce Clive to consume less leisure and therefore work more hours, since he is now poorer and leisure is a normal good. If the income effect dominates the substitution effect, Clive will in the end work more hours than before. Chapter Twenty-0ne Check Your Understanding 21-1 1. The family with the lower income is likely to be more risk-averse. In general, higher income or wealth results in lower degrees of risk aversion, due to diminishing marginal utility. Both families may be willing to buy an “unfair” insurance policy. Most insurance policies are “unfair” in that the expected claim is less than the premium. The degree to which a family is willing to pay more than an expected claim for insurance depends on the family’s degree of risk aversion. 2. a. Karma’s expected income is the weighted average of all possible values of her income, weighted by the probabilities with which she earns each possible value of her income. Since she makes $22,000 with a probability of 0.6 and $35,000 with a probability of 0.4, her expected income is (0.6 × $22,000) + (0.4 × $35,000) = $13,200 + $14,000 = $27,200. Her expected utility is simply the expected value of the total utilities she will experience. Since with a probability of 0.6 she will experience a total utility of 850 utils (the utility to her from making $22,000), and with a probability of 0.4 she will experience a total utility of 1,260 utils (the utility to her from making $35,000), her expected utility is (0.6 × 850 utils) + (0.4 × 1,260 utils) = 510 utils + 504 utils = 1,014 utils. b. If Karma makes $25,000 for certain, she experiences a utility level of 1,014 utils. From the answer to part a, we know that this leaves her equally as well off as when she has a risky expected income of $27,200. Since Karma is indifferent between a risky expected income of $27,200 and a certain income of $25,000, you can conclude that she would prefer a certain income of $27,200 to a risky expected income of $27,200. That is, she would definitely be willing to reduce the risk she faces when this reduction in risk leaves her expected income unchanged. In other words, Karma is risk-averse. c. Yes. Karma experiences a utility level of 1,056 utils when she has a certain income of $26,000. This is higher than the expected utility level of 1,014 utils generated by a risky expected income of $27,200. So Karma is willing to pay a premium to guarantee a certain income of $26,000. Check Your Understanding 21-2 1. a. An increase in the number of ships implies an increase in the quantity of insurance demanded at any given premium. This is a rightward shift of the demand curve, resulting in a rise in both the equilibrium premium and the equilibrium quantity of insurance bought and sold. b. An increase in the number of trading routes means that investors can diversify more. In other words, they can reduce risk further. At any given premium, there are now more investors willing to supply insurance. This is -27 rightward shift of the supply curve for insurance, leading to a fall in the equilibrium premium and a rise in the equilibrium quantity of insurance bought and sold. c. If shipowners in the market become even more risk- averse, they will be willing to pay even higher premiums for insurance. That is, at any given premium, there are now more people willing to buy insurance. This is a rightward shift of the demand curve for insurance, leading to a rise in both the equilibrium premium and the equilibrium quantity of insurance bought and sold. d. If investors in the market become more risk-averse, they will be less willing to accept risk at any given premium. This is a leftward shift of the supply curve for insurance, leading to a rise in the equilibrium premium and a fall in the equilibrium quantity of insurance bought and sold. e. As the overall level of risk increases, those willing to buy insurance will be more willing to buy insurance at any given premium; the demand curve for insurance shifts to the right. But since overall risk cannot be diversified away, those ordinarily willing to take on risk will be less willing to do so, leading to a leftward shift in the supply curve for insurance. As a result, the equilibrium premium will rise; the effect on the equilibrium quantity of insurance is uncertain. f. If the wealth levels of investors fall, investors will become more risk-averse and so less willing to supply insurance at any given premium. This is a leftward shift of the supply curve for insurance, leading to a rise in the equilibrium premium and a fall in the equilibrium quantity of insurance bought and sold. Check Your Understanding 21-3 1. The inefficiency caused by adverse selection is that an insurance policy with a premium based on the average risk of all drivers will attract only an adverse selection of bad drivers. Good (that is, safe) drivers will find this insurance premium too expensive and so will remain uninsured. This is inefficient. However, safe drivers are also those drivers who have had fewer moving violations for several years. Lowering premiums for only those drivers allows the insurance company to screen its customers 2. and sell insurance to safe drivers, too. This means that at least some of the good drivers now are also insured, which decreases the inefficiency that arises from adverse selection. In a way, having no moving violations for several years is building a reputation for being a safe driver. The moral hazard problem in home construction arises from private information about what the contractor does: whether she takes care to reduce the cost of construction or allows costs to increase. The homeowner cannot, or can only imperfectly, observe the cost-reduction effort of the contractor. If the contractor were fully reimbursed for all costs incurred during construction, she would have no incentive to reduce costs. Making the contractor responsible for any additional costs above the original estimate means that she now has an incentive to keep costs low. However, this imposes risk on the contractor. For instance, if the weather is bad, home construction will take longer, and will be more costly, than if the weather had been good. Since the contractor pays for any additional costs (such as weather-induced delays) above the original estimate, she now faces risk that she cannot control. 3. a. True. Drivers with higher deductibles have more incentive to take care in their driving, to avoid paying the deductible. This is a moral hazard phenomenon. b. True. Suppose you know that you are a safe driver. You have a choice of a policy with a high premium but a low deductible or one with a lower premium but a higher deductible. In this case, you would be more likely to choose the cheap policy with the high deductible because you know that you will be unlikely to have to pay the deductible. When there is adverse selection, insurance companies use screening devices such as this to make inferences about people’s private information about how skillful they are as drivers. c. True. The wealthier you are, the less risk-averse you are. If you are less risk-averse, you are more willing to bear risk yourself. Having an insurance policy with a high deductible means that you are exposed to more risk: you have to pay more of any insurance claim yourself. This is an implication of how risk aversion changes with a person’s income or wealth. This page intentionally left blank Glossary ability-to-pay principle the principle of tax fairness by which those with greater ability to pay a tax should pay more tax. absolute advantage the advantage conferred on an individual in a |
n activity if he or she can do it better than other people. absolute value the value of a number without regard to a plus or minus sign. accounting profit a business’s revenue minus the explicit cost and depreciation. administrative costs (of a tax) the resources used (which is a cost) by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it. adverse selection occurs when an individual knows more about the way things are than other people do. Adverse selection problems can lead to market problems: private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market. antitrust policy legislative and regulatory efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. artificially scarce good a good that is excludable but nonrival in consumption. autarky a situation in which a country does not trade with other countries. average cost an alternative term for average total cost; the total cost divided by the quantity of output produced. average fixed cost the fixed cost per unit of output. average total cost total cost divided by quantity of output produced. Also referred to as average cost. average variable cost the variable cost per unit of output. backward-bending individual labor supply curve an individual labor supply curve that slopes upward at low to moderate wage rates and slopes downward at higher wage rates. bar graph a graph that uses bars of varying height or length to show the comparative sizes of different observations of a variable. Italicized terms within definitions are key terms that are defined elsewhere in this glossary. barrier to entry something that prevents other firms from entering an industry. Crucial in protecting the profits of a monopolist. There are four types of barriers to entry: control over scarce resources or inputs, increasing returns to scale, technological superiority, and government-created barriers such as licenses. barter people directly exchange goods or services that they have for goods or services that they want. benefits principle the principle of tax fairness by which those who benefit from public spending should bear the burden of the tax that pays for that spending. black market a market in which goods or services are bought and sold illegally, either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling. brand name a name owned by a particular firm that distinguishes its products from those of other firms. break-even price the market price at which a firm earns zero profits. budget constraint the cost of a consumer’s consumption bundle cannot exceed the consumer’s income. budget line all the consumption bundles available to a consumer who spends all of his or her income. capital the combined value of a business’s assets; includes equipment, buildings, tools, inventory, and financial assets. capital at risk funds that an insurer places at risk when providing insurance. cartel an agreement among several producers to obey output restrictions in order to increase their joint profits. causal relationship the relationship between two variables in which the value taken by one variable directly influences or determines the value taken by the other variable. circular-flow diagram represents the transactions in an economy by two kinds of flows around a circle: flows of physical things such as goods or labor in one direction and flows of money to pay for these physical things in the opposite direction. Coase theorem the proposition that even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs are sufficiently low. collusion cooperation among producers to limit production and raise prices so as to raise one another’s profits. commodity output of different producers regarded by consumers as the same good; also referred to as a standardized product. common resource a resource that is nonexcludable and rival in consumption. comparative advantage the advantage conferred on an individual or nation in producing a good or service if the opportunity cost of producing the good or service is lower for that individual or nation than for other producers. compensating differentials wage differences across jobs that reflect the fact that some jobs are less pleasant or more dangerous than others. competitive market a market in which there are many buyers and sellers of the same good or service, none of whom can influence the price at which the good or service is sold. complements pairs of goods for which a rise in the price of one good leads to a decrease in the demand for the other good. constant marginal cost each additional unit costs the same to produce as the previous one. constant returns to scale long-run average total cost is constant as output increases. consumer surplus a term often used to refer both to individual consumer surplus and to total consumer surplus. consumption bundle (of an individual) the collection of all the goods and services consumed by a given individual. consumption possibilities the set of all consumption bundles that can be consumed, given a consumer’s income and prevailing prices. copyright the exclusive legal right of the creator of a literary or artistic work to profit from that work; like a patent, it is a temporary monopoly. cost (of seller) the lowest price at which a seller is willing to sell a good. G-1 G-2 G L O S S A R Y cost-benefit analysis an estimate of the costs and benefits of providing a good. When governments use costbenefit analysis, they estimate the social costs and social benefits of providing a public good. cross-price elasticity of demand a measure of the effect of the change in the price of one good on the quantity demanded of the other; it is equal to the percent change in the quantity demanded of one good divided by the percent change in the price of another good. curve a line on a graph, which may be curved or straight, that depicts a relationship between two variables. deadweight loss the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity. decreasing marginal benefit the case in which each additional unit of an activity produces less benefit than the previous unit. decreasing returns to scale long-run average total cost increases as output increases (also known as diseconomies of scale). deductible a sum specified in an insurance policy that the insured individual must pay before being compensated for a claim; deductibles reduce moral hazard. demand curve a graphical representation of the demand schedule, showing the relationship between quantity demanded and price. demand price the price of a given quantity at which consumers will demand that quantity. demand schedule a list or table showing how much of a good or service consumers will want to buy at different prices. dependent variable the determined variable in a causal relationship. diminishing marginal rate of substitution the principle that the more of one good that is consumed in proportion to another, the less of the second good the consumer is willing to substitute for another unit of the first good. diminishing returns to an input the effect observed when an increase in the quantity of an input, while holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. diversification reducing risk by investing in several different things, so that the possible losses are independent events. domestic demand curve a demand curve that shows how the quantity of a good demanded by domestic consumers depends on the price of that good. domestic supply curve a supply curve that shows how the quantity of a good supplied by domestic producers depends on the price of that good. dominant strategy in game theory, an action that is a player’s best action regardless of the action taken by the other player. duopolist one of the two firms in a duopoly. duopoly an oligopoly consisting of only two firms. economic growth the growing ability of the economy to produce goods and services. economic profit a business’s revenue minus the opportunity cost of resources; usually less than the accounting profit. economic signal any piece of information that helps people make better economic decisions. economics the social science that studies the production, distribution, and consumption of goods and services. economy a system for coordinating society’s productive activities. efficiency-wage model a model in which some employers pay an aboveequilibrium wage as an incentive for better performance. efficient description of a market or economy that takes all opportunities to make some people better off without making other people worse off. efficient allocation of risk the case in which those most willing to bear risk are those who end up bearing it. elastic demand when the price elasticity of demand is greater than 1. emissions tax a tax that depends on the amount of pollution a firm produces. environmental standards rules established by a government to protect the environment by specifying actions by producers and consumers. equilibrium an economic situation in which no individual would be better off doing something different. equilibrium price the price at which the market is in equilibrium, that is, the quantity of a good or service demanded equals the quantity of that good or service supplied; also referred to as the market-clearing price. equilibrium quantity the quantity of a good or service bought and sold at the equilibrium (or market-clearing) price. equilibrium value of the marginal product the additional value produced by the last unit of a factor employed in the factor market as a whole. equity fairness; everyone gets his or her fair share. S |
ince people can disagree about what is “fair,” equity is not as well defined a concept as efficiency. European Union (EU) a customs union among 27 European nations. excess capacity when firms produce less than the output at which average total cost is minimized; characteristic of monopolistically competitive firms. excise tax a tax on sales of a good or service. excludable referring to a good, describes the case in which the supplier can prevent those who do not pay from consuming the good. expected utility the expected value of an individual’s total utility given uncertainty about future outcomes. expected value in reference to a random variable, the weighted average of all possible values, where the weights on each possible value correspond to the probability of that value occurring. explicit cost a cost that involves actually laying out money. exporting industries industries that produce goods and services that are sold abroad. exports goods and services sold to other countries. external benefit an uncompensated benefit that an individual or firm confers on others; also known as positive externalities. external cost an uncompensated cost that an individual or firm imposes on others; also known as negative externalities. externalities external benefits and external costs. factor distribution of income the division of total income among labor, land, and capital. factor intensity the difference in the ratio of factors used to produce a good in various industries. For example, oil refining is capital-intensive compared to clothing manufacture because oil refiners use a higher ratio of capital to labor than do clothing producers. factor markets markets in which firms buy the resources they need to produce goods and services. factors of production the resources used to produce goods and services. Labor and capital are examples of factors. fair insurance policy an insurance policy for which the premium is equal to the expected value of the claim. financial risk uncertainty about monetary outcomes. firm an organization that produces goods and services for sale. fixed cost a cost that does not depend on the quantity of output produced; the cost of a fixed input. fixed input an input whose quantity is fixed for a period of time and cannot be varied (for example, land). forecast a simple prediction of the future. free entry and exit describes an industry that potential producers can easily enter or current producers can leave. free trade trade that is unregulated by government tariffs or other artificial barriers; the levels of exports and imports occur naturally, as a result of supply and demand. free-rider problem when individuals have no incentive to pay for their own consumption of a good, they will take a “free ride” on anyone who does pay; a problem with goods that are nonexcludable. gains from trade by dividing tasks and trading, people can get more of what they want through trade than they could if they tried to be self-sufficient. game theory the study of behavior in situations of interdependence. Used to explain the behavior of an oligopoly. Gini coefficient a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles. globalization the phenomenon of growing economic linkages among countries. government transfer a government payment to an individual or a family. Hecksher–Olin model a model of international trade in which a country has a comparative advantage in a good whose production is intensive in the factors that are abundantly available in that country. horizontal axis the horizontal number line of a graph along which values of the x-variable are measured; also referred to as the x-axis. horizontal intercept the point at which a curve hits the horizontal axis; it indicates the value of the x-variable when the value of the y-variable is zero. household a person or a group of people that share their income. human capital the improvement in labor created by education and knowledge that is embodied in the workforce. imperfect competition a market structure in which no firm is a monopolist, but producers nonetheless have market power they can use to affect market prices. implicit cost a cost that does not require the outlay of money; it is measured by the value, in dollar terms, of forgone benefits. implicit cost of capital the opportunity cost of the capital used by a business; that is, the income that could have been realized had the capital been used in the next best alternative way. import quota a legal limit on the quantity of a good that can be imported. import-competing industries industries that produce goods and services that are also imported. imports goods and services purchased from other countries. incentive anything that offers rewards to people who change their behavior. incidence (of a tax) a measure of who really pays a tax. income distribution the way in which total income is divided among the owners of the various factors of production. income effect the change in the quantity of a good consumed that results from the change in a consumer’s purchasing power due to the change in the price of the good-3 income elasticity of demand the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in the consumer’s income. income tax a tax on the income of an individual or family. income-elastic demand when the income elasticity of demand for a good is greater than 1. income-inelastic demand when the income elasticity of demand for a good is positive but less than 1. increasing marginal cost the case in which each additional unit costs more to produce than the previous one. increasing returns to scale long-run average total cost declines as output increases (also referred to as economies of scale). independent events events for which the occurrence of one does not affect the likelihood of occurrence of any of the others. independent variable the determining variable in a causal relationship. indifference curve a contour line showing all consumption bundles that yield the same amount of total utility for an individual. indifference curve map a collection of indifference curves for a given individual that represents the individual’s entire utility function; each curve corresponds to a different total utility level. individual choice the decision by an individual of what to do, which necessarily involves a decision of what not to do. individual consumer surplus the net gain to an individual buyer from the purchase of a good; equal to the difference between the buyer’s willingness to pay and the price paid. individual demand curve a graphical representation of the relationship between quantity demanded and price for an individual consumer. individual labor supply curve a graphical representation showing how the quantity of labor supplied by an individual depends on that individual’s wage rate. individual producer surplus the net gain to an individual seller from selling a good; equal to the difference between the price received and the seller’s cost. G-4 G L O S S A R Y individual supply curve a graphical representation of the relationship between quantity supplied and price for an individual producer. industrial policy a policy that supports industries believed to yield positive externalities. industry supply curve a graphical representation that shows the relationship between the price of a good and the total output of the industry for that good. inefficient describes a market or economy in which there are missed opportunities: some people could be made better off without making other people worse off. inefficient allocation to consumers a form of inefficiency in which people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it; often a result of a price ceiling. inefficient allocation of sales among sellers a form of inefficiency in which sellers who would be willing to sell a good at the lowest price are not always those who actually manage to sell it; often the result of a price floor. inefficiently high quality a form of inefficiency in which sellers offer high-quality goods at a high price even though buyers would prefer a lower quality at a lower price; often the result of a price floor. inefficiently low quality a form of inefficiency in which sellers offer lowquality goods at a low price even though buyers would prefer a higher quality at a higher price; often a result of a price ceiling. inelastic demand when the price elasticity of demand is less than 1. inferior good a good for which a rise in income decreases the demand for the good. in-kind benefit a benefit given in the form of goods or services. input a good or service used to produce another good or service. interaction (of choices) my choices affect your choices, and vice versa; a feature of most economic situations. The results of this interaction are often quite different from what the individuals intend. interdependence the relationship among firms when their decisions significantly affect one another’s profits; characteristic of oligopolies. interest rate the price, calculated as a percentage of the amount borrowed, charged by the lender. internalize the externality when individuals take into account external costs and external benefits. international trade agreements treaties by which countries agree to lower trade protections against one another. invisible hand a phrase used by Adam Smith to refer to the way in which an individual’s pursuit of self-interest can lead, without the individual intending it, to good results for society as a whole. kinked demand curve a model used to explain the stability of oligopoly pricing; a demand curve that kinks (bends) because the oligopolist will lose sales if output is reduced and price is increased but gain only a few additional sales if output is in |
creased and price is lowered (because the lower price will be matched at once by other oligopolists), the curve will be very flat above the kink and very steep below the kink. law of demand a higher price for a good or service, other things equal, leads people to demand a smaller quantity of that good or service. leisure the time available for purposes other than earning money to buy marketed goods. license the right, conferred by the government, to supply a good. linear relationship the relationship between two variables in which the slope is constant and therefore is depicted on a graph by a curve that is a straight line. long run the time period in which all inputs can be varied. long-run average total cost curve a graphical representation showing the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. long-run industry supply curve a graphical representation that shows how quantity supplied responds to price once producers have had time to enter or exit the industry. long-run market equilibrium an economic balance in which, given sufficient time for producers to enter or exit an industry, the quantity supplied equals the quantity demanded. lump-sum tax a tax that is the same for everyone, regardless of any actions people take. macroeconomics the branch of economics that is concerned with the overall ups and downs in the economy. marginal analysis the study of marginal decisions. marginal benefit the additional benefit derived from producing one more unit of a good or service. marginal benefit curve a graphical representation showing how the benefit from producing one more unit depends on the quantity that has already been produced. marginal cost the additional cost incurred by producing one more unit of a good or service. marginal cost curve a graphical representation showing how the cost of producing one more unit depends on the quantity that has already been produced. marginal decision a decision made at the “margin” of an activity to do a bit more or a bit less of an activity. marginal product the additional quantity of output produced by using one more unit of a given input. marginal productivity theory of income distribution the proposition that every factor of production is paid its equilibrium value of the marginal product. marginal rate of substitution (MRS) the ratio of the marginal utility of one good to the marginal utility of another. marginal revenue the change in total revenue generated by an additional unit of output. marginal revenue curve a graphical representation showing how marginal revenue varies as output varies. marginal social benefit of a good or activity the marginal benefit that accrues to consumers plus the marginal external benefit. marginal social benefit of pollution the additional gain to society as a whole from an additional unit of pollution. marginal social cost of a good or activity the marginal cost of production plus the marginal external cost. marginal social cost of pollution the additional cost imposed on society as a whole by an additional unit of pollution. marginal tax rate the percentage of an increase in income that is taxed anyway. marginal utility the change in total utility generated by consuming one additional unit of a good or service. marginal utility curve a graphical representation showing how marginal utility depends on the quantity of the good or service consumed. marginal utility per dollar the additional utility gained from spending one more dollar on a good or service. market-clearing price the price at which the market is in equilibrium, that is, the quantity of a good or service demanded equals the quantity of that good or service supplied; also referred to as the equilibrium price. market economy an economy in which decisions about production and consumption are made by individual producers and consumers. market failure occurs when a market fails to be efficient. market power the ability of a producer to raise prices. market share the fraction of the total industry output accounted for by a given producer’s output. markets for goods and services markets in which firms sell goods and services that they produce to households. maximum the highest point on a nonlinear curve, where the slope changes from positive to negative. mean household income the average income across all households. means-tested a program in which benefits are available only to individuals or families whose incomes fall below a certain level. median household income the income of the household lying at the exact middle of the income distribution. microeconomics the branch of economics that studies how people make decisions and how those decisions interact. midpoint method a technique for calculating the percent change in which changes in a variable are compared with the average, or midpoint, of the starting and final values. minimum the lowest point on a nonlinear curve, where the slope changes from negative to positive. minimum-cost output the quantity of output at which the average total cost is lowest—the bottom of the U-shaped average total cost curve. minimum wage a legal floor on the wage rate. The wage rate is the market price of labor. model a simplified representation of a real situation that is used to better understand real-life situations. monopolist a firm that is the only producer of a good that has no close substitutes. monopolistic competition a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry and exit into and from the industry in the long run. monopoly an industry controlled by a monopolist. moral hazard the situation that can exist when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to expend effort when someone else bears the costs of the lack of care or effort. movement along the demand curve a change in the quantity demanded of a good that results from a change in the price of that good. movement along the supply curve a change in the quantity supplied of a good that results from a change in the price of that good. Nash equilibrium in game theory, the equilibrium that results when all players choose the action that maximizes their payoffs given the actions of other players, ignoring the effect of that action on the payoffs of other players; also known as noncooperative equilibrium. natural monopoly a monopoly that exists when increasing returns to scale provide a large cost advantage to having all output produced by a single firm. negative externalities external costs. negative income tax a government program that supplements the income of low-income working families. negative relationship a relationship between two variables in which an G L O S S A R Y G-5 increase in the value of one variable is associated with a decrease in the value of the other variable. It is illustrated by a curve that slopes downward from left to right. net present value the present value of current and future benefits minus the present value of current and future costs. network externality the increase in the value of a good to an individual is greater when a large number of others own or use the same good. noncooperative behavior actions by firms that ignore the effects of those actions on the profits of other firms. noncooperative equilibrium in game theory, the equilibrium that results when all players choose the action that maximizes their payoffs given the actions of other players, ignoring the effect of that action on the payoffs of other players; also known as Nash equilibrium. nonexcludable referring to a good, describes the case in which the supplier cannot prevent those who do not pay from consuming the good. nonlinear curve a curve in which the slope is not the same between every pair of points. nonlinear relationship the relationship between two variables in which the slope is not constant and therefore is depicted on a graph by a curve that is not a straight line. nonprice competition competition in areas other than price to increase sales, such as new product features and advertising; especially engaged in by firms that have a tacit understanding not to compete on price. nonrival in consumption referring to a good, describes the case in which the same unit can be consumed by more than one person at the same time. normal good a good for which a rise in income increases the demand for that good—the “normal” case. normative economics the branch of economic analysis that makes prescriptions about the way the economy should work. North American Free Trade Agreement (NAFTA) a trade agreement among the United States, Canada, and Mexico. offshore outsourcing businesses hiring people in another country to perform various tasks. G-6 G L O S S A R Y oligopolist a firm in an industry with only a small number of producers. oligopoly an industry with only a small number of producers. omitted variable an unobserved variable that, through its influence on other variables, creates the erroneous appearance of a direct causal relationship among those variables. opportunity cost the real cost of an item: what you must give up in order to get it. optimal consumption bundle the consumption bundle that maximizes a consumer’s total utility, given that consumer’s budget constraint. optimal consumption rule when a consumer maximizes utility, the marginal utility per dollar spent must be the same for all goods and services in the consumption bundle. optimal output rule profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. optimal quantity the quantity that generates the maximum possible total net gain. optimal time allocation rule an individual should allocate time so that the marginal utility gained from the income earned from an additio |
nal hour worked is equal to the marginal utility of an additional hour of leisure. ordinary goods in a consumer’s utility function, those for which additional units of one good are required to compensate for fewer units of another, and vice versa; and for which the consumer experiences a diminishing marginal rate of substitution when substituting one good in place of another. origin the point where the axes of a two-variable graph meet. other things equal assumption in the development of a model, the assumption that all relevant factors except the one under study remain unchanged. overuse the depletion of a common resource that occurs when individuals ignore the fact that their use depletes the amount of the resource remaining for others. patent a temporary monopoly given by the government to an inventor for the use or sale of an invention. payoff in game theory, the reward received by a player (for example, the profit earned by an oligopolist). payoff matrix in game theory, a diagram that shows how the payoffs to each of the participants in a two-player game depend on the actions of both; a tool in analyzing interdependence. payroll tax a tax on the earnings an employer pays to an employee. perfect complements goods a consumer wants to consume in the same ratio, regardless of their relative price. perfect price discrimination when a monopolist charges each consumer the maximum that the consumer is willing to pay. perfect substitutes goods for which the indifference curves are straight lines; the marginal rate of substitution of one good in place of another good is constant, regardless of how much of each an individual consumes. perfectly competitive industry an industry in which all producers are price-takers. perfectly competitive market a market in which all participants are pricetakers. perfectly elastic demand the case in which any price increase will cause the quantity demanded to drop to zero; the demand curve is a horizontal line. perfectly elastic supply the case in which even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite; the perfectly elastic supply curve is a horizontal line. perfectly inelastic demand the case in which the quantity demanded does not respond at all to changes in the price; the demand curve is a vertical line. perfectly inelastic supply the case in which the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied; the perfectly inelastic supply curve is a vertical line. physical capital manufactured productive resources, such as buildings and machines; often referred to simply as “capital.” pie chart a circular graph that shows how some total is divided among its components, usually expressed in percentages. Pigouvian subsidy a payment designed to encourage activities that yield external benefits. Pigouvian taxes taxes designed to reduce external costs. pooling a strong form of diversification in which an investor takes a small share of the risk in many independent events, so the payoff has very little total overall risk. positive economics the branch of economic analysis that describes the way the economy actually works. positive externalities external benefits. positive feedback put simply, success breeds success, failure breeds failure; the effect is seen with goods that are subject to network externalities. positive relationship a relationship between two variables in which an increase in the value of one variable is associated with an increase in the value of the other variable. It is illustrated by a curve that slopes upward from left to right. positively correlated a relationship between events such that each event is more likely to occur if the other event also occurs. poverty program a government program designed to aid the poor. poverty rate the percentage of the population with incomes below the poverty threshold. poverty threshold the annual income below which a family is officially considered poor. premium a payment to an insurance company in return for the promise to pay a claim in certain states of the world. present value the amount of money needed at the present time to produce, at the prevailing interest rate, a given amount of money at a specified future time. price ceiling a maximum price sellers are allowed to charge for a good or service; a form of price control. price controls legal restrictions on how high or low a market price may go. price discrimination charging different prices to different consumers for the same good. price elasticity of demand the ratio of the percent change in the quantity demanded to the percent change in the G L O S S A R Y G-7 price as we move along the demand curve (dropping the minus sign). price elasticity of supply a measure of the responsiveness of the quantity of a good supplied to the price of that good; the ratio of the percent change in the quantity supplied to the percent change in the price as we move along the supply curve. price floor a minimum price buyers are required to pay for a good or service; a form of price control. price leadership a pattern of behavior in which one firm sets its price and other firms in the industry follow. price regulation a limitation on the price a monopolist is allowed to charge. price war a collapse of prices when tacit collusion breaks down. price-taking consumer a consumer whose actions have no effect on the market price of the good or service he or she buys. price-taking firm’s optimal output rule the profit of a price-taking firm is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced. price-taking producer a producer whose actions have no effect on the market price of the good or service it sells. principle of diminishing marginal utility the proposition that each successive unit of a good or service consumed adds less to total utility than did the previous unit. principle of marginal analysis the proposition that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost. prisoner’s dilemma a game based on two premises in which (1) each player has an incentive to choose an action that benefits itself at the other player’s expense; and (2) both players are then worse off than if they had acted cooperatively. private good a good that is both excludable and rival in consumption. private health insurance program in which each member of a large pool of individuals pays a fixed amount to a private company that agrees to pay most of the medical expenses of the pool’s members. private information information that some people have that others do not. producer surplus a term often used to refer both to individual producer surplus and to total producer surplus. product differentiation the attempt by firms to convince buyers that their products are different from those of other firms in the industry. If firms can so convince buyers, they can charge a higher price. production function the relationship between the quantity of inputs a firm uses and the quantity of output it produces. production possibility frontier illustrates the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for any given quantity produced of the other. profits tax a tax on the profits of a firm. progressive tax a tax that takes a larger share of the income of high-income taxpayers than of low-income taxpayers. property rights the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose. property tax a tax on the value of property, such as the value of a home. proportional tax a tax that is the same percentage of the tax base regardless of the taxpayer’s income or wealth. protection an alternative term for trade protection; policies that limit imports. public good a good that is both nonexcludable and nonrival in consumption. public ownership when goods are supplied by the government or by a firm owned by the government to protect the interests of the consumer in response to natural monopoly. quantity control an upper limit, set by the government, on the quantity of some good that can be bought or sold; also referred to as a quota. quantity demanded the actual amount of a good or service consumers are willing to buy at some specific price. quantity supplied the actual amount of a good or service producers are willing to sell at some specific price. quota an upper limit, set by the government, on the quantity of some good that can be bought or sold; also referred to as a quantity control. quota limit the total amount of a good under a quota or quantity control that can be legally transacted. quota rent the difference between the demand price and the supply price at the quota limit; this difference, the earnings that accrue to the licenseholder, is equal to the market price of the license when the license is traded. random variable a variable with an uncertain future value. recession a downturn in the economy. regressive tax a tax that takes a smaller share of the income of high-income taxpayers than of low-income taxpayers. relative price the ratio of the price of one good to the price of another. relative price rule at the optimal consumption bundle, the marginal rate of substitution of one good in place of another is equal to the relative price. rental rate the cost, implicit or explicit, of using a unit of land or capital for a given period of time. reputation a long-term standing in the public regard that serves to reassure others that private information is not being concealed; a valuable asset in the face of adverse selection. resource anything, such as land, labor, and capital, that can be used to produce something else; includes natural resources (from the physical environment) and human resources (labor, skill, intelligence). revers |
e causality the error committed when the true direction of causality between two variables is reversed, and the independent variable and the dependent variable are incorrectly identified. Ricardian model of international trade a model that analyzes international trade under the assumption that opportunity costs are constant. risk uncertainty about future outcomes. risk-averse describes individuals who choose to reduce risk when that reduction leaves the expected value of their income or wealth unchanged. risk-neutral describes individuals who are completely insensitive to risk. rival in consumption referring to a good, describes the case in which one unit cannot be consumed by more than one person at the same time. G-8 G L O S S A R Y sales tax a tax on the value of goods sold. scarce in short supply; a resource is scarce when there is not enough of the resources available to satisfy all the various ways a society wants to use them. scatter diagram a graph that shows points that correspond to actual observations of the x- and y-variables; a curve is usually fitted to the scatter of points to indicate the trend in the data. screening using observable information about people to make inferences about their private information; a way to reduce adverse selection. share a partial ownership of a company. shift of the demand curve a change in the quantity demanded at any given price, represented graphically by the change of the original demand curve to a new position, denoted by a new demand curve. shift of the supply curve a change in the quantity supplied of a good or service at any given price, represented graphically by the change of the original supply curve to a new position, denoted by a new supply curve. short run the time period in which at least one input is fixed. short-run individual supply curve a graphical representation that shows how an individual producer’s profitmaximizing output quantity depends on the market price, taking fixed cost as given. short-run industry supply curve a graphical representation that shows how the quantity supplied by an industry depends on the market price, given a fixed number of producers. short-run market equilibrium an economic balance that results when the quantity supplied equals the quantity demanded, taking the number of producers as given. shortage the insufficiency of a good or service that occurs when the quantity demanded exceeds the quantity supplied; shortages occur when the price is below the equilibrium price. shut-down price the price at which a firm ceases production in the short run because the market price has fallen below the minimum average variable cost. signaling taking some action to establish credibility despite possessing private information; a way to reduce adverse selection. single-payer system a health care system in which the government is the principal payer of medical bills funded through taxes. single-price monopolist a monopolist that offers its product to all consumers at the same price. slope a measure of how steep a line or curve is. The slope of a line is measured by “rise over run”—the change in the yvariable between two points on the line divided by the change in the x-variable between those same two points. social insurance program a government program designed to provide protection against unpredictable financial distress. socially optimal quantity of pollution the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for. specialization each person specializes in the task that he or she is good at performing. standardized product output of different producers regarded by consumers as the same good; also referred to as a commodity. state of the world a possible future event. strategic behavior actions taken by a firm that attempt to influence the future behavior of other firms. substitutes pairs of goods for which a rise in the price of one of the goods leads to an increase in the demand for the other good. substitution effect the change in the quantity of a good consumed as the consumer substitutes a good that has become relatively cheaper in place of one that has become relatively more expensive. sunk cost a cost that has already been incurred and is not recoverable. supply and demand model a model of how a competitive market works. supply curve a graphical representation of the supply schedule, showing the relationship between quantity supplied and price. supply price the price of a given quantity at which producers will supply that quantity. supply schedule a list or table showing how much of a good or service producers will supply at different prices. surplus the excess of a good or service that occurs when the quantity supplied exceeds the quantity demanded; surpluses occur when the price is above the equilibrium price. tacit collusion cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise one anothers’ profits. tangency condition on a graph of a consumer’s budget line and available indifference curves of available consumption bundles, the point at which an indifference curve and the budget line just touch. When the indifference curves have the typical convex shape, this point determines the optimal consumption bundle. tangent line a straight line that just touches a nonlinear curve at a particular point; the slope of the tangent line is equal to the slope of the nonlinear curve at that point. tariff a tax levied on imports. tax base the measure or value, such as income or property value, that determines how much tax an individual pays. tax rate the amount of tax people are required to pay per unit of whatever is being taxed. tax structure specifies how a tax depends on the tax base; usually expressed in percentage terms. technology the technical means for producing goods and services. technology spillover an external benefit that results when knowledge spreads among individuals and firms. time allocation the decision about how many hours to spend on different activities, which leads to a decision about how much labor to supply. time allocation budget line an individual’s possible trade-off between consumption of leisure and the income that allows consumption of marketed goods. time-series graph a two-variable graph that has dates on the horizontal axis and values of a variable that occurred on those dates on the vertical axis. tit for tat in game theory, a strategy that involves playing cooperatively at first, then doing whatever the other player did in the previous period-9 willingness to pay the maximum price a consumer is prepared to pay for a good. world price the price at which a good can be bought or sold abroad. World Trade Organization (WTO) an international organization of member countries that oversees international trade agreements and rules on disputes between countries over those agreements. x-axis the horizontal number line of a graph along which values of the xvariable are measured; also referred to as the horizontal axis. y-axis the vertical number line of a graph along which values of the yvariable are measured; also referred to as the vertical axis. zero-profit equilibrium an economic balance in which each firm makes zero profit at its profit-maximizing quantity. total consumer surplus the sum of the individual consumer surpluses of all the buyers of a good in a market. total cost the sum of the fixed cost and the variable cost of producing a given quantity of output. total cost curve a graphical representation of the total cost, showing how total cost depends on the quantity of output. total producer surplus the sum of the individual producer surpluses of all the sellers of a good in a market. total product curve a graphical representation of the production function, showing how the quantity of output depends on the quantity of the variable input for a given quantity of the fixed input. total revenue the total value of sales of a good or service (the price of the good or service multiplied by the quantity sold). total surplus the total net gain to consumers and producers from trading in a market; the sum of the producer surplus and the consumer surplus. tradable emissions permits licenses to emit limited quantities of pollutants that can be bought and sold by polluters. trade in a market economy, individuals provide goods and services to others and receive goods and services in return. trade protection policies that limit imports. trade-off a comparison of costs and benefits of doing something. trade-off between equity and efficiency the dynamic whereby a well-designed tax system can be made more efficient only by making it less fair, and vice versa. transaction costs the costs to individuals of making a deal. truncated cut; in a truncated axis, some of the range of values are omitted, usually to save space. U-shaped average total cost curve a distinctive graphical representation of the relationship between output and average total cost; the average total cost curve at first falls when output is low and then rises as output increases. unions organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively. unit-elastic demand the case in which the price elasticity of demand is exactly 1. util a unit of utility. utility (of a consumer) a measure of the satisfaction derived from consumption of goods and services. utility function (of an individual) the total utility generated by an individual’s consumption bundle. value of the marginal product the value of the additional output generated by employing one more unit of a given factor, such as labor. value of the marginal product curve a graphical representation showing how the value of the marginal product of a factor depends on the quantity of the factor employed. variable a quantity that can take on more than one value. variable cost a cost that depends on the quantity of output produced; |
the cost of a variable input. variable input an input whose quantity the firm can vary at any time (for example, labor). vertical axis the vertical number line of a graph along which values of the y-variable are measured; also referred to as the y-axis. vertical intercept the point at which a curve hits the vertical axis; it shows the value of the y-variable when the value of the x-variable is zero. wasted resources a form of inefficiency in which people expend money, effort, and time to cope with the shortages caused by a price ceiling. wealth tax a tax on the wealth of an individual. wedge the difference between the demand price of the quantity transacted and the supply price of the quantity transacted for a good when the supply of the good is legally restricted. Often created by a quantity control, or quota. welfare state the collection of government programs designed to alleviate economic hardship. This page intentionally left blank Index Note: Key terms appear in boldface type. A Ability-to-pay principle, 502 of tax fairness, 184, 185 Ability-to-pay programs, 480–481 Absolute advantage, 33 comparative advantage ver- sus, 200–201 Absolute value, 51 Absolut vodka, 429–430 Accounting profit, 227, 228–229 economic profit compared, 336–340 ACSI (American Consumer Satisfaction Index), 418 Activities marginal social benefit of, 448 marginal social cost of, 449 Adelman, David, 262 ADM (Archer Daniels Midland), 387, 391–392, 396, 399–400, 406 Administrative costs, 180 Advanced Micro Devices (AMD), 360 Advance purchase restrictions, 380 Adverse selection, 495, 559–561 Adverse selection death spiral, 495 Advertising, product differentia- tion and, 427–428, 429–430 AFC (Average fixed cost), 314, 315–316, 323 AFDC (Aid to Families with Dependent Children), 490 African-Americans employment discrimination against, 527 poverty among, 482–483 wages of, 523 AgCert, 450 Agricultural prices international trade and, 211 price floors and, 128 price supports and, 129 Agricultural surpluses, in Europe, 161 Agriculture corn production and, 344 decline in United States, 157 global comparisons of wheat yields and, 306 grape production and, 350 implicit cost of capital due to Asbestos, lawsuits related to, monopoly and, 359 development pressure and, 229 marginal decisions in, 303 organic products and, 329 Ahold, 389 Aid to Families with Dependent Children (AFDC), 490 Airbus, 389 Aircraft industry, as oligopoly, 389, 394 Airline industry network externalities and, 451 as oligopoly, 388, 389 price discrimination and, 378–379, 381 price floors and, 131 Airplane design, 23 Ajinomoto, 387, 391–392, 396, 399–400, 406 Akerlof, George, 560 Albertsons, 389 Alcoa, 88 All Creatures Great and Small (Herriot), 77 Allocation efficiency in, 27 inefficient, rent control and, 123 559 Asymmetric information. See Private information ATC. See Average total cost (ATC) AT&T, 427 Auction houses, price-fixing by, 407 Audio files, as substitutes versus complements, 290 Austen, Jane, 511 Australia drug prices in, 361 greenhouse gas emissions of, 441 hours worked in, 532 lobster stock in, 472–473 minimum wage in, 131 voter turnout in, 467 Autarky, 198–199 Automobile(s), international trade in, 203 Automobile industry as oligopoly, 389 product differentiation and, 408, 419 AVC (Average variable cost), 315–316, 323 inefficient, price floors and, Average cost. See Average total 130 Alrosa, 389 Aluminum market, 88 Amazon.com, 418 AMD (Advanced Micro Devices), 360 American Airlines, 389 American Consumer Satisfaction Index (ACSI), 418 American Economic Association, 5 Amtrak, 368, 373 Anarchy, State, and Utopia (Nozick), 481 cost (ATC) Average fixed cost (AFC), 314, 315–316, 323 Average total cost (ATC), 314–316, 323 long-run, 321–322 minimum, 316–317, 339–340 under monopolistic competition versus perfect competition, 425–426 Average total cost curves, U- shaped, 314–316 Average variable cost (AVC), 315–316, 323 Antipoverty programs, 481 Antitrust policy, 372, 389, Axes, 46 truncated, 57 405 AOL, 389 Apartheid, 527–528 Apple, 451, 453 Applebee’s, 68 Archer Daniels Midland (ADM), 387, 391–392, 396, 399–400, 406 Arc method of calculating slope, 51 Area below or above a curve, calculating, 53, 54 Arms races, 400 Army Corps of Engineers, 468–469 Artificially scarce goods, 461, 473–475 B Babysitting co-ops, 18–19 Backward-bending individual labor supply curve, 540 Banana industry, as oligopoly, 388 Bangladesh clothing production in, 34, 36–37, 201 U.S. imports from, 204–205 Bar graphs, 56 Barriers to entry government-created, 360–361 Barter, 35 BASF, 395 Bazalgette, Joseph, 459–460 Bear Stearns, 262 Belgium, exclusive dealing in, 393 Bell Telephone, 405 Benefit(s) external, of pollution, 437 in-kind, 490 marginal, 232–233 private. See Private benefits social. See Social benefits Benefits principle, of tax fair- ness, 183, 185 Bertrand, Marianne, 527 Bertrand behavior, 394–395 Best Western, 428 Biotech industry, sunk costs and, 238–239 Black markets, 125 Boeing, 389 Bounded rationality, 262 Bow Street Runners, 463 Brand names, product differentiation and, 428–429 Brazil, coffee beans from, 61 Break-even price, 340 Britain. See also United Kingdom amount paid in taxes in, 189 antipoverty policies of, 492–493 congestion charge in London, 71 health care in, 498 London sewage system and, 459–460 minimum wage in, 131 poll tax in, 167, 184 public ownership in, 373 shipping of, war as hazard facing, 557–558 spending on traffic safety in, 237 British Airways, 373 British Telecom, 373 Brooks, Diana D., 407 Brooks, Frederick P., Jr., 310 Budget constraints, 249, 254–257 rat experiments on, 285–286 Budget line, 254–255 slope of, 281–283 time allocation, 537–538 Buena Vista, 389 Bureau of Labor Statistics, 40 Burger King, moral hazard and, 562 Business cycles, 4, 17–18 diversification of risk and, 558 I-1 I-2 I N D E X C Cable television industry, price regulation in, 375 Churchill, Winston, 468 Cigarettes, excise tax on, 182 Circular-flow diagram, 25, 35–36 California Citizens Property Insurance adverse selection death spiral Corporation, 544 in, 495 Clams Competition Consumption imperfect, 388. See also Monopolistic competition; Oligopoly monopolistic. See Mon- opolistic competition nonprice, 408 perfect. See Perfect competi- tion budget constraints and, 253–257 optimal. See Optimal consumption entries reallocation among con- sumers, 106–107 taxing, income taxes versus, 189 in prices versus quantities, utility and, 250–251 393–395 Competitive markets, 62, 88 Complements, 67 audio files as, 290 cross-price elasticity of demand and, 162 perfect, 288–289 price of, shifts of demand curve and, 67–68 price of, shifts of supply curve and, 75 in production, 75 Computer chip industry, technological superiority in, 360 Computer industry, as oligop- oly, 389 Computer operating systems, network externalities and, 451–452 Concert ticket market, 82 Constant marginal cost, 231 Constant returns to scale, 323 Consumption bundle, 250 Consumption possibilities, 254 for American workers, 1895- 2000, 257–258 Copyrights, 360–361 Corn demand for, 104–105 price of, rise in, 87 production of, 344 Costa Rica, clothing production in, 34 Cost(s) administrative, of taxes, 180 average fixed, 314, 315–316, 323 average total (average). See Average total cost (ATC); Average total cost curves average variable, 315–316, 323 of capital, implicit, 228 constant across industry, 348 decreasing across industry, license system and, 473 quota on, 13, 137–138 Clean Air Act of 1970, 440 Climate, comparative advantage and, 202 Clothing Chinese exports of, 217 comparative advantage in, 34, 36–37, 201 CNN, 375 Coase, Ronald, 438 Coase theorem, 438 Coca-Cola Company, 388 exclusive dealing by, 393 Coffee beans demand for, 68 supply of, 61, 72–73, 83–87 Cola industry, as oligopoly, 388 Cold War, 400, 408 College education opportunity cost of, 227 price sensitivity of demand and, 154–155 Collusion, 391–393 tacit, 401 Comcast, 389 Command economies, 2 inefficiency in allocation in, Consumer(s) 27 changes in number of, shifts 349 Commodities, 331 Common resources, 112, 460, 461, 469–473 efficient use and mainte- nance of, 471–472 lobstering industry and, 472–473 overuse of, 470–471 “Community Charge,” in Britain, 167, 184 Comparative advantage, 25, 30–34, 196–205 absolute advantage versus, of demand curve and, 69–70 excise taxes paid mainly by, 171–172 inefficient allocation to, rent controls causing, 123 price-taking, 330 Consumer choice(s) income changes and, 292–295 preferences and, 284, 285 price increases and, 291–292 explicit, 226–227 external, of pollution, 436–437 fixed. See Fixed cost implicit, 226–227 increasing across industry, 348–349 marginal. See Marginal cost; Marginal cost curve of medical progress, 501–502 minimum average total, 316–317 Consumer choice theory. See opportunity. See Opportunity 200–201 also Rational consumer cost autarky and, 198–199 gains from trade and, 30–33, 199–200 international trade and, 33–34, 196–205 production possibility frontier and, 196–199 Ricardian model of international trade and, 197–199 rich and poor nations and, 36–37 skill and, 204–205 sources of, 200–204 Compensating differentials, 524 indifference curves and, private, social costs versus, 277–284 rationality and, 285–286 Consumer satisfaction, measurement of, 418 Consumer surplus, 93 demand curve and, 94–100 gains from trade and, 105, 106 individual, 96 market efficiency and, 106–110 price changes and, 97–99 total, 96 willingness to pay and, 95–97 449–450 producer surplus and, 100–103 of quantity controls, 136–137 short- versus long-run, 319–324 social. See Social costs summary of, 323 sunk, 238–239 of taxation, 178–180 total, 309–310, 323 transaction, 438 variable, 309–310, 323 Cost-benefit analysis, 467 natural gas costs in, 369–370 California Dental Association, 429 Canada aircraft exports to United States, 33–34 amount paid in taxes in, 189 drug prices in, 361 greenhouse gas emissions of, 441 health care in, 498 hours worked |
in, 532 minimum wage in, 131 poverty rate in, 483 U.S. pork exports to, 33–34 voter turnout in, 467 Capacity, excess, 426 Cap and trade systems, 445, 450 Capital, 228 human, 510, 524–525 implicit cost of, 228 market for, 519–521 physical, 510 Capital at risk, 552 Capitol Hill babysitting co-op, 18–19 Caracas, Venezuela, price con- trols in, 126 Carlyle, Thomas, 308 Cartels, 391. See also Organization of Petroleum Exporting Countries (OPEC) antitrust policy and, 405 Cash rewards for grades, 10 Causal relationships, 46 Charter, 389 Chavez, Hugo, 126 Cheney, Dick, 177 Children living in poverty, 484 SCHIP program for, 479, 496–497, 503–504 China greenhouse gas emissions of, 441 planned economy of, 112–113 wages in, 218 Chiquita, 388 Chiron Corporation, 143, 161 Choice. See Consumer choice(s); Consumer choice theory; Individual choice Christie’s, 407 Christmas, price wars of, 408–409 Chrysler, 389, 408 I N D E X I-3 Costco, 389 Cost curves, 309–310 Council of Economic Advisers, 40 Cournot behavior, 394 Cross-price elasticity of demand, 155–156, 162 Curves, 47–48. See also specific quantity demanded versus, 66 substitution effect and, 264 unit-elastic, 149, 151, 162 for wine, 350 Demand curve, 62–71 consumer surplus and, 94–100 curves calculating area below or above, 53, 54 horizontal, 49 linear, slope of, 48–49 minimum and maximum points on, 52–53 nonlinear, 50–52 vertical, 49 Customs unions, 216 D Data Resources, Inc., 24 Deadweight loss monopoly and, 371–372 price ceilings and, 121–123 of taxes, elasticity and, 180–182 Deadweight loss triangle, 121 De Beers, 355, 357, 362, 363, 365–367, 372, 389 Decision making, 225–245 marginal analysis in, 230–237 opportunity cost and, 226–229 present value and, 239–244 sunk costs and, 238–239 Decreasing marginal benefit, 233 Decreasing marginal cost, 232 Decreasing returns to scale, 323 Deductibles, 562 Del Monte, 388 DeLong, J. Bradford, 257–258 Delta, 388 Demand. See also Supply and demand model for coffee beans, 68 for corn, 104–105 derived, 511 elastic, 149, 151, 162 excess, 82 income effect and, 264–265 income-elastic, 157 income elasticity of, 162 income-inelastic, 157 inelastic, 149, 151 for inferior goods, 265 for Irish potatoes, 265 law of, 64 mortgage rates and, 265–266 for normal goods, 265 perfectly elastic, 148–149, 162 perfectly inelastic, 148, 162 demand schedule and, 63–64 domestic, 206–209 for factors, shifts of, 516–518 individual, 69 kinked, 401–402 market, 69–70 of monopolist, 363–366 price elasticity along, 152–153 shifts of, 64–70 willingness to pay and, 94, 95 Demand elasticity cross-price, 155–156, 162 income, 156–157 price. See Price elasticity of demand Demand price, 134, 137 Demand schedule, 63–64 Department store sales, 381 Dependent variable, 46 Depressions, 17–18 Derived demand, 511 Diamond industry monopoly in, 355, 359, 362, 363, 365–367, 372 as oligopoly, 389 Dickens, Charles, 253, 511 Differentiated product(s), 332 Diminishing marginal rate of substitution, 280 Diminishing marginal utility, principle of, 252 Diminishing returns effect, average total cost and, 315 Diminishing returns to an input, 306–307, 308, 310–311 Discount(s), volume, 380 Discount clubs, 380 Discrimination, wage differ- ences due to, 526–527 Diseconomies of scale, 323 “Dismal science,” 308 Diversification limits of, 557–558 for risk avoidance, 554–557 Doha Round, 219–220 Dole, 388 Dollar marginal, spending, 258–263 marginal utility per, 259–260 Domestic demand curve, 206–209 Domestic supply curve, 206–209 Dominant strategy, 398 Duopolists, 390 Duopoly, 390–391 Duracell, 428–429 E Early childhood intervention programs, social benefit of, 450 Earned Income Tax Credit (EITC), 185–186, 490 Earthlink, 389 Eastern Europe, planned economies of, 112 eBay, efficiency and, 110 Economic fluctuations, 3–4 Economic growth, 4 greenhouse gases and, 441 production possibility frontier and, 28–30 Economic inequality, 484–487 Economic insecurity, 487 welfare state to alleviate, 480 Economic profit, 227–229 under perfect competition, 336–340 Economic questions, 1–2 Economic Report of the President, 40 Economics, 2 as “dismal science,” 308 Economic signals, 111–112 The Economics of Welfare (Pigou), 443–444 Economies of scale. See Increasing returns to scale Economists disagreements among, 38–40 in government, 40 Economy, 2, 27 market. See Market economies planned, 112–113 Efficiency, 14–15. See also Inefficiency in allocation, 27 consumer surplus and, 106–110 eBay and, 110 equity and, 109, 184–185 in long run in perfect com- petition, 350 of market supply of private goods, 461–462 of monopolistic competition, 426–427 producer surplus and, 106–110 in production, 26–27 production possibility frontier and, 26–27 taxes and, 184–185 trade-off between equity and, 185 Efficiency-wage model, 526 Efficient allocation of risk, 554 Eisenhower, Dwight David, 68 EITC (Earned Income Tax Credit), 185–186, 490 “Either-or” decisions, opportunity cost and, 226–229 Elastic demand, 149, 151, 162 Elasticity, 143–163 calculating, 144–147 deadweight loss of taxes and, 180–182 demand. See Demand elasticity; Price elasticity of demand estimating, 147 summary of, 161, 162 supply. See Price elasticity of supply Electrical equipment conspiracy, 406–407 Electricity, in California, price controls on, 119 El Paso Corporation, 369–370 El Salvador, clothing production in, 34, 36 Emissions taxes, 442–444 Employment. See also Labor entries; Wage(s); Wage inequalities poverty and, 483 Employment-based health insurance, 495 Energizer, 428–429 Energy Policy Act of 2005, 87, 344 Enron, 262 Environmental standards, 440–441 Equilibrium, 12–14, 16 market, long-run, 347, 349–350 market, short-run, 345 Nash, 398 noncooperative, 398 zero-profit, 422–424 Equilibrium price, 78, 79–90 market price above, fall in, 80, 81 market price below, rise of, 81–82 Equilibrium quantity, 78, 79–90 Equilibrium value of the marginal product of labor, 519 Equity, 14–15 efficiency and, 109, 184–185 of taxes, 183–185 trade-off between efficiency and, 185 welfare state and, 484–485 An Essay on the Principle of Population (Malthus), 308 I-4 I N D E X Ethanol, corn production and, Factor endowments, compara- social benefits of, 434, Germany 344 Ethanol fuel, 104–105 Ethiopia, wheat yield in, 306 Europe. See also specific countries farm surpluses in, 161 minimum wage in, 131, 132 tive advantage and, 202–203 Factor intensity, 203 Factor markets, 35–36, 509, 510 Hurricane Katrina and, European Commission, 128 European Union (EU), 216, 510–511 Factor prices, 510 217 agricultural exports of, 128 anti-price-fixing laws in, 387 antitrust policy and, 405 cap and trade system of, 445 international trade and, 210–211 resource allocation and, 510–511 wages as, 210 446–448 Food. See also Fast-food industry amount spent on, global comparison of, 157 global comparisons of portion sizes and, 236 prices of, in Caracas, 126 Food stamps, 490 Ford, 389, 408, 419 Ford, Henry, 419 Forecasts, 38 401(k) plans, marginal utility and, 262 Excess capacity, 426 Excess demand, 82 Excess supply, 80, 81 Excise taxes, 168 on cigarettes, 182 effect on quantities and prices, 168–171 paid mainly by consumers, 171–172 paid mainly by producers, 172–173 revenue from, 174–175 Excludable goods, 461 Exclusive dealing, 393 Expectations, changes in Factors of production, 29, France 509, 510–512. See also Capital; Labor; Land factor distribution of income and, 511–512 prices of, 210–211, 510–511 resource allocation and, 510–511 Fair insurance policies, 547 Family makeup, poverty and, amount paid in taxes in, 189 drug prices in, 361 exclusive dealing in, 393 health care in, 498 hours worked in, 532 minimum wage in, 131 portion sizes in, 236 welfare state in, 504–505 wheat yield in, 306 482–483 Franchise owners, moral hazard FAO Schwartz, 408 Farming. See Agricultural and, 562–563 Free entry and exit entries; Agriculture under monopolistic competi- Fashion models, global market tion, 417 shifts of demand curve and, for, 86 under perfect competition, 69 Fast-food industry shifts of supply curve and, income elasticity of demand 75–76 Expected utility, 546–547 Expected value, 545 Explicit costs, 226–227 Explorer vodka, 429 Export(s), 196 effect on international trade, 208–209 Exporting industries, 210 External benefits, of pollution, 437 External costs, of pollution, 436–437 Externalities, 433–455. See also Pollution internalizing, 438–439 negative, 437 network, 360, 451–454 positive, 437, 465 private solutions to, 438–439 private versus social benefits and, 446–448 private versus social costs and, 449–450 Exxon, 372, 405 ExxonMobil, 372 F Factor demand curve, shifts of, 516–518 Factor distribution of income, 511–512 in United States, 512 and, 158 product differentiation in, 415 Fast Food Nation, 415 Federal Energy Regulatory Commission, 370 Federal Insurance Contribution Act (FICA) tax incidence of, 173–174 principle underlying, 185 Federal Trade Commission, Herfindahl-Hirschman index and, 389 FICA tax. See Federal Insurance Contribution Act (FICA) tax Financial risk, 545 Firms, 35. See also Producers duopolistic, 390 interdependent, 396 monopolistic. See Monopolists oligopolistic, 388 price-taking, firm’s optimal output rule of, 335 Fishing, as common resource, 470–471, 472–473 Fixed cost, 309–310, 323 changing, 342–343 of snow removal, 324 Fixed inputs, 304 Flat taxes, 186 Flu vaccine shortage of, 143, 159, 161 331–332 Free-rider problem, 462 Free trade, 211–212 G Gains from trade, 12 comparative advantage and, 30–33 consumer surplus and, 105, 106 international trade and, 199–200 producer surplus and, 105, 106 Gambling, reasons for, 550 Game theory, 396–404 kinked demand curve and, 401–402 prisoners’ dilemma and, 396–398 repeated interaction and tacit collusion and, 398–401 Gasoline, prices and consump- tion of, 64 Gates, Bill, 227, 453 Gender, wage differences based on, 524–525 Genentech, 238 General Electric, 406–407 General Mills, 331 General Motors, 389, 408, 419 Generic drugs, 333, 407–408 “Gentle |
men’s agreements,” 393 Gerik, Ronnie, 344 exclusive dealing in, 393 hours worked in, 532 poverty rate in, 483 U.S. imports from, 204–205 Giffen goods, 265 Gilded Age, 488 Gini coefficient, 486 for Britain, 492–493 Global comparisons of amount paid in taxes, 189 of amount spent on food, 157 of clothing production, 34 of drug prices, 361 of exclusive dealing, 393 of gasoline prices and con- sumption, 64 of greenhouse gas emissions, 441 of hours worked, 532 of income inequality, 486 of minimum wages, 131 of portion sizes, 236 of poverty rates, 483 of productivity and wages, 202 of voter turnout, 467 of wheat yields, 306 Global Insight, 24 Globalization, 196 Goldin, Claudia, 488 Gomez, Bianca, 86 Goods. See also Product(s) artificially scarce, 112, 461, 473–475 complements. See Complements excludable, 461 inferior. See Inferior goods marginal social benefit of, 448 marginal social cost of, 449 nonexcludable, 461, 462 nonrival in consumption, 461, 462 normal. See Normal goods ordinary, 276, 280 private. See Private goods public. See Public goods rival in consumption, 461 substitutes. See Substitutes Government antitrust policy and, 372, 389, 405 barriers to entry created by, 360–361 economists in, 40 health insurance provided by, 479, 490, 493, 496–497, 503–504, 560 macroeconomic policy and, 18 taxes and. See Excise taxes; Income taxes; Tax(es) Government intervention, 15–16 Government transfers, 480 Grades, pay for, 10 Grape production, 350 Graphs, 45–58 bar, 56 calculating area below or above curve and, 54 curves on, 47–48 numerical, 54–58 pie charts, 56 scatter diagrams, 54–55 slope and, 48–53 time-series, 54, 55 two-variable, 45–47 Great Compression, 488–489 Great Depression, 17–18 Great Stink, 459–460 Greenhouse gases capture of, 450 economic growth and, 441 Grocery industry, as oligopoly, 389 H Hamill Manufacturing, 522 Hatch, Orrin, 479 HBO, 375 Health care, 493–502 in Canada, France, and Britain compared with United States, 498–499 for children, 479, 496–497, 503–504 cost of medical progress and, 501–502 crisis in, 499–500 government health insurance and, 496 need for health insurance and, 494–495 reform proposals for, 500–501 uninsured people and, 496–497 Health insurance adverse selection and, 560–561 employment-based, 495 government, 479, 490, 493, 496–497, 503–504, 560 Medicaid, 490, 493, 496–497 Medicare, 490, 493, 496, 560. See also Federal Insurance Contribution Act (FICA) tax need for, 494–495 private, 494–495 SCHIP, 479, 496–497, 503–504, 560 single-payer system for, 498 Heckscher-Ohlin model, 202–203, 210 Herfindahl-Hirschman index I N D E X I-5 Herriot, James, 77 HHI (Herfindahl-Hirschman changes in, consumption and, 292–295 slope of budget line and, 281–283 index), 389–390 changes in, shifts of demand substitutes and, 287–288, Higher education, wages and, 509 Hispanic Americans poverty among, 482–483 wages of, 523 Holiday Inn, 429 Honda, 389 Hong Kong, television viewing in, 375 Horizontal axis, 46 Horizontal curves, slope of, 49 Horizontal intercept, 48 Households, 35 Housing. See also Rent control income elasticity of demand and, 158 indifference curves and, 271–272 mortgage rates and consumer demand for, 265–266 new developments of, taxes and, 318–319 Houthakker, Hendrik, 147 “How much” decisions, mar- ginal analysis and, 230–237 Human capital, 510 curve and, 68 household, mean, 485 household, median, 485 share spent on a good, price elasticity of demand and, 154 spending and, 17 Income distribution, 36 factor, 511–512 marginal productivity theory of. See Marginal productivity theory of income distribution Income effect 289, 290 tangency condition and, 280–281 Indifference curve maps, 274 Individual choice, 5, 6–11 incentives and, 9 opportunity cost and, 7–8 resource scarcity and, 6–7 trade-offs and, 8–9 Individual consumer surplus, 96 Individual demand curve, 69 Individual labor supply curve, 530–531, 540 consumer choice and, Individual producer surplus, 295–297 101 demand and, 264–265 labor supply and, 529–530 mortgage rates and, 266 Income-elastic demand, 157 Income elasticity of demand, 156–157, 162 Income-inelastic demand, 157 Income inequality long-term trends in, 487–489 Individual supply curve, 76 short-run, 342 Industrial policy, 448 Industrial Revolution, factor distribution of income and, 511 Industries. See also specific industries exporting, 210 Herfindahl-Hirschman index and, 389–390 quantity of, wage inequality welfare state and, 480, market entry and exit and. and, 524–525 491–492 Human life, marginal benefit of Income taxes, 186 See Barriers to entry; Free entry and exit saving, 237 Hurricane(s), diversification of risk and, 558 Hurricane Katrina, 543 factor market and, 510–511 New Orleans and, 468–469 Hurricane Rita, 543 Hurricane Wilma, 543 I Ibuprofen, 333 Illegal activity, price floors and, 131 Imperfect competition, 388. See also Monopolistic competition; Oligopoly Imperfect substitutes, 417 Implicit cost(s), 226–227 Implicit cost of capital, 228 Import(s), 196 effect on international trade, 206–208 Import-competing indus- tries, 210 Import quotas, 214 “tariff quotas” and, 214 Incentives, 9 Incidence of taxes, 171–173 of FICA, 173–174 price elasticities and, 171–173 Income. See also Poverty; marginal tax rate and, 187, 190 negative, 490 taxing consumption versus, 189 in United States, 185, 188 Increasing marginal cost, 232 Increasing returns to scale, 322 international trade and, 204 monopoly and, 359, 360 oligopoly and, 388 Independent events, 555 Independent variable, 46 India arms race with Pakistan, 400 greenhouse gas emissions of, 441 voter turnout in, 467 Indifference curve(s), 272–290 Industry supply curve, 344–349 long-run, 346–349 short-run, 345 Inefficiency, 112 of excess pollution, 437– 438 price ceilings and, 120–125 Inefficient allocation of sales among sellers, price floors and, 130 Inefficient allocation to con- sumers, 123 Inefficiently high quality, price floors and, 130–131 Inefficiently low quality price ceilings and, 124–125 price floors and, 129, 130 Inelastic demand, 149, 151 Infant industry argument for labor supply and, 537–541 marginal rate of substitution trade protection, 215–216 and, 277–280 Inferior goods, 68 movement along, marginal utility and, 279–280 perfect complements and, 288–289 preferences and choices and, 284, 285 properties of, 275–276 relative price rule and, 283–284 consumption of, income changes and, 293–294 demand for, 265 income elasticity of demand and, 156–157, 162 Inflation, 18 In-kind benefits, 490 Input, production function and, 304–307, 308 (HHI), 389–390 Wage(s); Wage inequality I-6 I N D E X Inputs, 75 availability of, price elasticity of supply and, 160 changes in prices of, shifts of supply curve and, 75 diminishing returns to, 306–307, 308, 310–311 fixed, 304 variable, 304 Insurance, 550 diversification and, 554–557 fair insurance policies and, 547 health. See Health insurance hurricanes and, 543–544 Lloyd’s of London and, 551–552, 554–555, 556–557, 558–559 premiums for, 547 social, 480 trading risk and, 552–554 warranties as form of, 551 Intel, 360 Interaction, 5, 11–19 economy-wide, 17–19 efficiency and, 14–15 equilibrium and, 12–14, 16 gains from trade and, 12 government intervention and, 15–16 Interdependence, 396 Interest rate, 240 Internalizing externalities, 438–439 International Monetary Fund, 40 International trade, 195–221 comparative advantage and. See Comparative advantage export effects and, 208–209 import effects and, 206–208 increasing returns to scale and, 204 Ricardian model of, 198–199 trade protection and. See Trade protection wages and, 209–211 International trade agree- ments, 216–218 Internet browser software market, 452 Internet Explorer, 452 Internet service provider indus- try, as oligopoly, 389 Invisible hand, 3 Ireland. See also United Kingdom demand for potatoes from, 265 minimum wage in, 131 Israel, amount spent on food in, 157 Italy minimum wage in, 132 voter turnout in, 467 J James, LeBron, 8 Japan amount paid in taxes in, 189 automobile exports of, 203 hours worked in, 532 wheat yield in, 306 Jiffy Lube, 9 Job creation argument for trade protection, 215 Johnson, Lyndon, 481 Jolie, Angelina, 86 Justice Department antitrust policy and, 405 oligopolistic industries and, 389 price-fixing and, 393 suit against National Association of Realtors, 424 K Kahneman, Daniel, 262 KB Toys, 408 Kellogg’s, 331 Kennedy, Ted, 479 KFC, 68 Kidney transplants, organs for, 99, 106, 109 Kinked demand curve, 401–402 Kroger, 389 Kwan, Michelle, 524 L Labor, marginal product of, 305, 513–514, 519 Labor force. See also Wage(s); Wage inequalities unions and, 525–526 women in, 10–11 Labor market, 36 Labor supply, 528–533 indifference curve analysis of, 537–541 shifts of the labor supply curve and, 531–532 wages and, 529–531 work versus leisure and, 528–529 Labor supply curve individual, 530–531, 540 market, shifts of, 531–532 Laffer, Arthur, 177 Land, market for, 519–521 Law of demand, 64 marginal utility and, 263–264 Learning effects, 232 Leisure, work versus, 528–529 Leontief, Wassily, 204 Levinson, Arthur, 238 Licenses, 133 Linear relationships, 47 Linux, 389, 451, 453 Lionsgate, 389 Lloyd’s of London, 551–552, 554–555, 556 Lobstering industry, stock of lobsters and, 472–473 Location, product differentia- tion by, 418 The Logic of Collective Action (Olson), 468 London congestion charge in, 71 sewage system in, 459–460 Long run, 304 monopolistic competition in, 422–424 Long-run average total cost curve (LRATC), 321–322, 323 Long-run industry supply curve, 346–349 Long-run market equilibri- um, 347 cost of production and efficiency in, 349–350 Long-Term Capital Marginal cost curve, 232 direction of slope of, 317–318 Marginal decisions, 8–9 Marginal dollar, spending, 258–263 Marginal product curve, value of, 515–516 Marginal productivity theory of income distribution, 509, 518–528 apartheid and, 527–528 discrimination and, 526–527 efficiency wages and, 526 market power and, 525–526 markets for land and capital an |
d, 519–521 wage disparities in practice and, 523 wage inequality and, 524–525 Marginal product of labor (MPL), 305 equilibrium value of, 519 value of, 513–514 Management (LTCM), 24 Marginal rate of substitution (MRS), 277–280 Lottery jackpots, 243–244 LRATC (Long-run average diminishing, 280 prices and, 281–283 total cost curve), 321–322, 323 LTCM (Long-Term Capital Management), 24 Lump-sum taxes, 184 Luxuries, price elasticity of demand and, 154 Lysine, price-fixing and, 387 M Macroeconomic policy, 18 Macroeconomics, 4, 17–18 Madonna, 227 Maine, groundwater debate in, 471 Malthus, Thomas, 308, 310 Marginal analysis, 9, 225, 233–236 applications of, 236–237 principle of, 234–235 value of a life and, 237 Marginal benefit, 232–233 decreasing, 233 Marginal benefit curve, 233 Marginal cost, 230–232, 312–314, 323 constant, 231 decreasing, 232 imposed by new housing developments, 318–319 increasing, 232 under monopolistic competition versus perfect competition, 425–426 social, 435, 449 Marginal revenue, 334–336 of monopolist, 363–366 Marginal revenue curve, 335 Marginal social benefit of a good or activity, 448 Marginal social benefit of pollution, 435 Marginal social cost of a good or activity, 449 Marginal social cost of pollu- tion, 435 Marginal tax rate, 187 top, in United States, 190 Marginal utility, 251–253 diminishing, principle of, 252 law of demand and, 263–264 movement along indifference curve and, 279–280 substitution effect and, 264 Marginal utility curve, 251 Marginal utility per dollar, 259–260 Margo, Robert, 488 Market(s). See also specific com- modities black, 125 competitive, 62, 88 efficient. See Efficiency efficient supply of private goods by, 461–462 equilibrium and. See Equilibrium factor, 35, 36, 509, 510–511 for goods and services, 35 inefficient, 112 I N D E X I-7 antitrust case against, 452, 453–454 Motel 6, 428 Movements along the Midpoint method, for computing elasticities, 146–147 The Mind of South Africa demand curve, 66 shifts of curve versus, 65–66 Movements along the supply Noncooperative behavior, 392 Noncooperative equilibrium, 398 Nonexcludable goods, 461, curve, 73 462 shifts of curve versus, 73 Nonlinear curves, slope of, of, 468–469 424 MLS (Multiple Listing Service), Mumbai, India, rent control in, (Sparks), 528 Minimum, of curve, 53 Minimum average total cost, 339–340 Minimum-cost output, 316–317 under monopolistic competition versus perfect competition, 426 Minimum wage, 127, 128 in Europe, 131, 132 global comparisons of, 131 Mississippi River, shift in course 424 Mobil, 372, 405 Models, 19, 23–42. See also specific models business applications of, 24 circular flow, 25, 35–37 comparative advantage as, 25, 30–34 economists’ disagreements and, 38–40 positive versus normative economics and, 37–38 production possibility fron- tier as, 25–30 Monopolistic competition, 356–357, 388, 415–431 characteristics of, 416–417 efficiency of, 426–427 in long run, 422–424 perfect competition compared with, 425–427 product differentiation and, 416–420, 427–430 in short run, 420–421 Monopolists, 112, 357 actions of, 358–359 demand curve and marginal revenue of, 363–366 single-price, 376 Monopoly, 355, 356–383 antitrust policy and, 372 effects of, 358–359 natural, 359, 360, 372–375 perfect competition versus, 367–368 preventing, 372 price discrimination and. See Price discrimination profit maximization under, 363–370 reasons for, 359–361 welfare effects of, 371–372 Monsanto, 393 Moral hazard, 561–563 Mortgage rates, consumer demand and, 265–266 Movie industry as oligopoly, 389 zero-profit equilibrium in, 423 MPL. See Marginal product of labor (MPL) MRS. See Marginal rate of substitution (MRS) Mullainathan, Sendhil, 527 Multifiber Agreement, 217 Multiple Listing Service (MLS), 124 The Mythical Man-Month (Brooks), 3310–311 N NAFTA (North American Free Trade Agreement), 216 Napster, 290 Nash, John, 398 Nash equilibrium, 398 National Association of Realtors, Justice Department suit against, 424 National security argument for 50–51 Nonlinear relationships, 47 Nonprice competition, 408 Nonrival in consumption goods, 461, 462 Normal goods, 68 consumption of, income changes and, 293, 294 demand for, 265 income elasticity of demand and, 156–157, 162 Normandy invasion, 225 Normative economics, 37–38 North American Free Trade Agreement (NAFTA), 216 Nozick, Robert, 481 Numerical graphs, 54–58 interpreting, 57–58 types of, 54–56 O Offshore outsourcing, 218–219 Oil international trade in, 203 OPEC and, 391, 402–404 price controls on, 119 Old River Control Structure, trade protection, 215 468–469 Natural gas, price of, in California, 369–370 Natural monopolies, 359, Oligopolists, 388 Oligopoly, 356–357, 359, 387–410 360 allowing to exist, 374–375 public policy and, 372–375 Necessities, price elasticity of demand and, 154 Negative externalities, 437 Negative income tax, 490 Negative relationships, 48 Net present value, 243 Netscape Navigator, 452 Network externalities, 360, 451–454 types of, 451–453 New Mexico Airlines, 389 New Orleans, Hurricane Katrina and, 468–469 New York City parking in, 9 rent control in, 117, 119–123 taxi cabs and weather in, 531 taxi licenses in, 117, 133, 134–137 Christmas price wars and, 408–409 collusion and competition under, 391–393 competition in prices versus quantities and, 393–395 duopoly example of, 390–391 Herfindahl-Hirschman index and, 389–390 importance of, 409 kinked demand curve and, 401–402 legal constraints on, 404–405 OPEC and, 402–404 prevalence of, 388–390 Prisoners’ dilemma and, 396–398 product differentiation and price leadership and, 407–408 strategic behavior and, New Zealand, drug prices in, 398–401 361 Nissan, 389 tacit collusion and price wars and, 405–407 for land and capital, 519–521 perfectly competitive, 330 Market-clearing price, 78 Market demand curve, 69–70 Market economies, 2–3, 110–112 effectiveness of, 111–112 inefficiency and, 112 Market entry and exit. See Barriers to entry; Free entry and exit Market equilibrium long-run, 347, 349–350 short-run, 345 Market failure, 3, 15, 112 government intervention and, 15–16 Market power of monopolists, 358–359 of oligopolists, 388 wage differences and, 525–526 Market price, 80–82 above equilibrium price, fall in, 80, 81 below equilibrium price, rise in, 81–82 Markets for goods and services, 35 Market share, 331 Market structure. See also Monopolistic competition; Monopoly; Oligopoly; Perfect competition types of, 356–357 Market supply curve, 76–77 Marriott, 428–429 Marshall, Alfred, 1, 4, 252 Maximum, of curve, 52–53 McDonald’s, 68, 429 global locations of, 158 moral hazard and, 562–563 MCI, 428–429 Mean household income, 485 Means-tested programs, 490 Median household income, 485 Medicaid, 490, 493, 496–497 Medical care. See Health care; Health insurance Medicare, 490, 493, 496, 560 FICA tax and. See Federal Insurance Contribution Act (FICA) tax Med-Stat, 143, 159 Mega Millions, 243–244 Mercal, 126 Merck, 360 Mexico, amount spent on food in, 157 Mexico City, tortilla prices in, 87 Microeconomics, 3 Microsoft, 360, 389, 452 I-8 I N D E X Olive Garden, 68 Olson, Mancur, 468 Omidyar, Pierre, 110 Omitted variables, 58 OPEC (Organization of Petroleum Exporting Countries), 391, 402–404 Opportunities, changes in, shifts of labor supply curve and, 531–532 Opportunity cost, 7–8 of college education, 227 decision making and, 226–229 production possibility frontier and, 27–28 of selling used textbooks, 101–103 of working outside the home, 10–11 Optimal consumption, 260–261 budgets and, 253–258 Optimal consumption bundle, 255–257, 277–284 income effect and, 295–297 marginal rate of substitution and, 277–280 prices and marginal rate of substitution and, 283–284 slope of budget line and indifference curves and, 281–283 substitution effect and, 295–297 P PacAdvantage, 495 Pakistan arms race with India, 400 voter turnout in, 467 Paramount, 389 Parrott Middle School (Florida), 10 Patents, 360–361 Pauper labor fallacy, 201, 202 Payoff, 396–398 Payoff matrices, 396–397 Payroll tax, 173–174, 186 principle underlying, 185 in United States, 188 Peel, Robert, 463 Penny, purchasing power of, 8 Pepsi, 388 exclusive dealing by, 393 Perfect competition, 329–351, 356–357 changing fixed cost and, 342–343 monopoly in, 360 perfect competition in, 332–333 product differentiation and, 407–408 Physical capital, 510 The Pickwick Papers (Dickens), 253 Pie charts, 56 Pigou, A. C., 443–444 Pigouvian subsidies, 448 Pigouvian taxes, 443–444 Pioneer Hi-Bred International, 393 Planned economies, 112–113 Point method of calculating slope, 51–52 Poland Spring Water, 471 Police departments, 463 Political factors diversification of risk and, 558 trade protection and, 216 welfare state and, 503–504 definition of, 330–331 determining profitability and, Poll tax, in Britain, 167, 184 Pollution, 433–446 336–340 free entry and exit in, 331–332 industry supply curve under, 344–350 monopolistic competition compared with, 425–427 monopoly versus, 367–368 necessary conditions for, 331 in pharmaceutical industry, 332–333 cap and trade systems and, 445 costs and benefits of, 435–436 emissions taxes and, 442–444 environmental standards and, 440–441 excess, inefficiency of, 437–438 as external cost, 436–437 private solutions to, 438–439 tangency condition and, production condition under, 280–281 343 Optimal consumption rule, profitability condition under, tradable emissions permits 261, 277 Optimal output rule, 334 of price-taking firm, 335 Optimal quantity, 234 Optimal time allocation rule, 538 Ordinary goods, 276, 280 Organization of Petroleum Exporting Countries (OPEC), 391, 402–404 Origin, 46 Orshansky, Mollie, 482 Other things equal assump- tion, 24 Outlet stores, 381 Output 343 profit-maximizing quantity of output under, 333–336 short-run production decision and, 340–342 Perfect complements, 288–289 Perfectly competitive indus- tries, 331 Perfectly competitive markets, 330 Perfectly elastic demand, 148–149, 162 Perfectly elastic supply, 160, 162 minimum-cost, |
316–317, 426 production function and, 304–307, 308 profit-maximizing, of Perfectly inelastic demand, 148, 162 Perfectly inelastic supply, 160, 162 and, 444–445 Pooling, 556 Population, changes in, shifts of labor supply curve and, 531 Positive economics, 37–38 Positive externalities, 437, 465 Positive feedback, 452 Positively correlated events, 558 Positive relationships, 48 Post, 331 Poverty, 481–484 causes of, 483–484 consequences of, 484 definition of, 482 incidence of, 482–483 trends in, 482 welfare state effects on, monopolist, 366–367 Perfect price discrimination, 491–492 profit-maximizing, under perfect competition, 333–336 378–381 Perfect substitutes, 287–288 Pharmaceutical industry Outsourcing, offshore, 218–219 Overuse, 470–471 global comparison of drug prices and, 361 Poverty programs, 480, 490 Poverty rate, 482 Poverty threshold, 481 Preferences. See Tastes Premiums, for insurance, 547 Present value, 239–244 definition of, 240–242 loans and, 239–240 lottery jackpots and, 243–244 net, 243 using, 242–243 Price(s) agricultural. See Agricultural prices break-even, 340 of complements, shifts of demand curve and, 67–68 of complements, shifts of supply curve and, 75 demand, 134, 137 as economic signals, 111–112 equilibrium. See Equilibrium price excise taxes and, 168–171 of factors, 210–211, 510–511 increase in, consumption choices and, 291–292 of inputs, changes in, shifts of supply curve and, 75 marginal rate of substitution and, 281–283 market. See Market price market-clearing, 78 under monopolistic competition versus perfect competition, 425–426 relative, 282–283 relative price rule and, 281–283 shut-down, 341 of substitutes, shifts of demand curve and, 67 of substitutes, shifts of supply curve and, 75 supply, 135, 137 of tortillas, rise in, 87 world, 206, 207 Price ceilings, 118–127 inefficiency caused by, 120–125 model of, 119–120 reasons for, 125 in Venezuela, 126 during World War II, 119 Price changes consumer surplus and, 97–98, 99 producer surplus and, 103–104 of related goods or services, shifts of demand curve and, 67–68 of related goods or services, shifts of supply curve and, 75 shifts of factor demand curve and, 516–517 I N D E X I-9 Price competition, 394–395 Price controls. See also Price adverse selection and, 559–561 ceilings; Price floors moral hazard and, 561–563 on oil, 119 reasons for, 118 Price discrimination, 361, 376–382 elasticity and, 378 logic of, 376–377 perfect, 378–381 in practice, 381 techniques for, 380 Price effect on marginal revenue of monopolist, 366, 392 price elasticity of demand and, 151 Price elasticity of demand, 162 along demand curve, 152–153 calculating, 144–146 classifying, 148–152 estimating, 147 factors determining, 153–154 monopoly and, 368 total revenue and, 150–152 Price elasticity of supply, 158–161, 162 factors determining, 160–161 measuring, 159–160 Price-fixing, 387, 393 by auction houses, 407 in vitamin industry, 395, 405 Price floors, 118, 127–133 inefficiency caused by, 129–131 minimum wages as, 127, 132 reasons for, 131–132 school lunches and, 128, 129 Price leadership, 408 Price regulation, 370, 373–374, 375 Price-taking consumers, 330 Price-taking firm’s optimal output rule, 335 Price-taking producers, 330 Price wars, 405–407 of Christmas, 408–409 Principle of diminishing marginal utility, 252 Principle of marginal analy- Producers. See also Firms changes in number of, shifts of supply curve and, 76–77 excise taxes paid mainly by, 172–173 monopolist. See Monopolists; Monopoly price-taking, 330 Producer surplus, 93 cost and, 100–103 gains from trade and, 105, 106 individual, 101 market efficiency and, 106–110 price changes and, 103–104 supply curve and, 100–105 total, 102 Product(s). See also Goods differentiated, 332 standardized, 331, 332 Product differentiation, 407–408, 415, 416–420, 427–430 advertising and, 427–428, 429–430 in automobile industry, 419 brand names and, 428–429 by location, 418 by quality, 418–419 by style or type, 417–418 Production complements in, 75 cost of, in long run in perfect competition, 349–350 determining profitability of, 336–340 efficiency in, 26–27 factors of. See Factor entries Production decision, short-run, 340–342 Production function, 304–311 cost curves and, 309, 310f inputs and outputs and, 304–307, 308 Production possibility fron- tier, 25–30 sis, 234–235 comparative advantage and, Prisoners’ dilemma, 396–398 Private benefits, social benefits versus, 446–448 Private costs, social costs versus, 449–450 Private goods, 460–463 characteristics, 460–461 efficient supply by markets, 461–462 Private health insurance, 494–495 Private information, 112, 196–199 economic growth and, 28–30 efficiency and, 26–27 opportunity cost and, 27–28 Profit accounting, 227, 228–229 economic, 227–229 Profit-maximizing output of monopolist, 366–367 under perfect competition, 333–336 Profits tax, 186 Progressive taxes, 187, 189–190 Propecia, 360 Property rights, 111 assigning to common resources, 472 Property taxes, 186 in United States, 188 Proportional taxes, 186 Protection. See Trade protection Public goods, 112, 460, 461, 463–469 amount to provide, 464–466 provision of, 463–464 voting as, 468 Public ownership, 372–373 Public policy, monopoly and, 370–376 Purchasing power, of a penny, 8 Q Quaker Foods, 331 Quality inefficiently high, price floors and, 130–131 inefficiently low, price ceilings and, 124–125 inefficiently low, price floors and, 129, 130 product differentiation by, 418–419 Quantity equilibrium, 78, 79–90 excise taxes and, 168–171 optimal, 234 Quantity competition, 394 Quantity controls, 133–138 anatomy of, 134–136 on clams, 133, 137–138 costs of, 136–137 Quantity demanded, 64 demand versus, 66 Quantity effect on marginal revenue of monopolist, 366, 392 price elasticity of demand and, 151 Quantity supplied, 71 Quantity traded, change in, 107–109 Quintiles, 485 Quota(s), 133. See also Import quotas; Quantity controls Quota limits, 133 Quota rent, 136 Qwest, 389 R Racial discrimination in South Africa, 527–528 wage differences due to, 526–527 Railroads, network externalities 559–563 in United States, 188 and, 451 Ramada, 428–429 Random variables, 545 Rational consumer, 249–267. See also Optimal consumption consumer choice theory and, 285–286 controversy over rationality and, 262 marginal utility per dollar and, 258–263 paying more to get less and, 262–263 utility and, 250–253 Rationing, during wartime, 100 Rawls, John, 481 Real estate business, as monopolistic competition, 424 Recessions, 4, 18 Regressive taxes, 187, 189–190 Relative price, 282–283 Relative price rule, 281–283 Renat Brannwinn vodka, 429 Rental rate, 520 Rent control misallocation of apartments caused by, 123 in Mumbai, 124 in New York City, 117, 119–123 in San Francisco, 117 winners and losers created by, 122 Reputation, 561 Resources, 6 common. See Common resources scarcity of, 6–7 Retirement investments, mar- ginal utility and, 262 Returns to scale, 322–323 increasing. See Increasing returns to scale Revenue from excise taxes, 174–175 marginal, 334–336 tax rates and, 175–177 total, 150–152 Reverse causality, 58 Rhode Island, lobster stock in, 472 Rhodes, Cecil, 357, 359, 362, 363 Rhone-Poulenc, 395, 405 Ricardian model of international trade, 198–199 Ricardo, David, 198, 211 Richard II, King of England, 184 Rio Tinto, 389 Risk, 545 avoiding through diversifica- tion, 554–557 efficient allocation of, 554 financial, 545 I-10 I N D E X Risk (continued) pooling of, 556 trading, 552–554 Risk aversion, 544–551 Shifts of the supply curve, pollution, 435–436 with simultaneous shift in Social insurance programs, Substitutes, 67 supply curve, 85–87 480 tastes and, 68 Socially optimal quantity of expectations and uncertainty and, 544–545 gambling and, 550 insurance premiums and, 550 logic of, 545–550 72–77 effects of, 84–85 expectations and, 75–76 input prices and, 75 movements along curve versus, 73 Rival in consumption goods, number of producers and, Social norms, changes in, shifts of labor supply curve and, 531 Social Security program, 490, 491 FICA tax and. See Federal Insurance Contribution Act (FICA) tax Sony Pictures, 389 Sotheby’s, 407 South Africa apartheid in, 527–528 diamond industry in, 355, 357, 362, 363, 365–367, 372, 389 76–77 prices of related goods or services and, 75 with simultaneous shift in demand curve, 85–87 technological change and, 75 Shortage, 82 Short run, 304 audio files as, 290 cross-price elasticity of demand and, 162 imperfect, 417 less than perfect, 289 perfect, 287–288 price elasticity of demand and, 154 price of, shifts of demand curve and, 67 price of, shifts of supply curve and, 75 in production, 75 Substitution diminishing marginal rate of, 280 marginal rate of, 277–280, 281–283 Substitution effect consumer choice and, 295–297 demand and, 264 labor supply and, 529–530, 531 Summer jobs, decline of, 532–533 Sunk costs, 238–239 Supplemental Security Income program, 490 Supply. See also Supply and demand model changes in, shifts of factor demand curve and, 517 83–87 excess, 80, 81 of labor. See Labor supply perfectly elastic, 160, 162 perfectly inelastic, 160, 162 price elasticity of, 162 of veterinarians, 77–78 Supply and demand model, 61–89 changes in supply and demand and, 83–88 competitive markets and, 62, 88 demand curve and, 62–71 key elements in, 62 Supply curve, 71–78 domestic, 206–209 individual, 76, 342 industry, 344–349 market, 76–77 producer surplus and, monopolistic competition in, 420–421 Short-run individual supply curve, 342 Short-run industry supply curve, 345 voter turnout in, 467 Southeast Asia, planned economies of, 112 South Korea, clothing produc- tion in, 34 Soviet Union, former, 2 um, 345 400 Short-run production decision, 340–342 Cold War and, 408 inefficiency in allocation in, Shrimp, U.S. imports of, 195, 27 Short-run market equilibri- arms race with United States, mortgage rates and, 266 comparative advantage and, of coffee beans, 61, 72–73, 317–318 amount spent on food in, Spain drug prices in, 361 |
voter turnout in, 467 Sparks, Allister, 528 Specialization, 12 203 Spending income and, 17 overall, macroeconomic poli- cy and, 18 overall, unmatched with overall production, 17–18 Spreading effect, average total cost and, 315 Sri Lanka 157 clothing production in, 36 Standardized products, 332 perfect competition and, 331 Standard Oil Company, 372, 405 Standard Oil of New Jersey, 405 Standard Oil of New York, 405 Standard Oil Trust, 405 Starbucks, 61, 68, 69, 418 State Children’s Health 217 Shut-down price, 341 Signaling, 561 Simon, Herbert, 262 Single-payer system, 498 Single-price monopolists, 376 Skane vodka, 429 Skill, comparative advantage and, 204–205 Sloan, Alfred P., 419 Slope, 48–53 arc method of calculating, 51 of budget line, 281–283 of linear curve, 47–48, 49 of marginal cost curve, of nonlinear curve, 50–52 point method of calculating, 51–52 Smith, Adam, 2–3, 12 Snow removal, fixed costs and, 324 Social benefits of early childhood intervention programs, 450 marginal, 435, 448 of pollution, 435 private benefits versus, 446–448 Social costs marginal, 435, 449 of pollution, 435 private costs versus, 449–450 of second-hand smoke, Insurance Program (SCHIP), 479, 496–497, 503–504, 560 100–105 shifts of, 72–77 supply schedule and, 71–72 States of the world, 545 Stock market, 556 Stokey, Nancy, 511 Strategic behavior, 398–401 Style, product differentiation by, Supply price, 135, 137 Supply schedule, 71–72 Surplus, 80, 81 consumer. See Consumer surplus 439–440 417–418 producer. See Producer surplus 461 Road Runner, 389 Rockefeller, John D., 372, 405 Rules of the road, 13 Russia planned economy of, 112 wheat yield in, 306 S “Safeguard mechanisms,” 217 Sales (department store), 381 Sales, reallocation among sellers, 107, 108 Sales taxes, 186 in United States, 188 Sam’s Club, 380 San Francisco, rent control in, 117 Saudi Arabia, oil exports of, 203 Saving, marginal utility and, 262 SBC, 389 “Scandinavian Sandwich,” 131 Scarce goods, artificially scarce, 112 Scarce resources, 6–7 control of, by monopolists, 359 Scatter diagrams, 54–55 SCHIP (State Children’s Health Insurance Program), 479, 496–497, 503–504, 560 Schlieffen, Alfred von, 225 School lunches, 128, 129 Screening, 560–561 Sears, 389 Second-hand smoke, 439–440 Sewage system, in London, England, 459–460 Shares (of stock), 556 Sherman Antitrust Act of 1890, 405 Shifts of the demand curve, 64–70 effects of, 83, 84 expectations and, 69 income and, 68 movements along curve versus, 65–66 number of consumers and, 69–70 prices of related goods or services and, 67–68 I N D E X I-11 Surpluses, agricultural, in Europe, 161 Sweatshop labor fallacy, 201, 202 Sweden amount paid in taxes in, 189 drug prices in, 361 hours worked in, 532 poverty rate in, 483 Switzerland, watch production in, 203 T Tacit collusion, 401 price wars and, 405–407 Taco Bell, moral hazard and, 563 TANF (Temporary Assistance for Needy Families) Act, 490 Tangency condition, 281 Tangent lines, 51–52 Target, 6, 389, 408 Tariff(s), 212–214 “Tariff quotas,” 214–215 Tastes changes in, shifts of demand curve and, 68 changes in, shifts of labor supply curve and, 531 consumer choices and, 284, 285 Tax(es), 167–191 costs of taxation and, 178–180 deadweight loss from, 180–182 efficiency of, 168, 184–185, 187 emissions, 442–444 equity of, 168, 183–184, 187 excise. See Excise taxes federal, principle underlying, 185–186 FICA, 173–174, 185 flat, 186 housing developments and, 318–319 incidence of, 171–174 income. See Income taxes on income versus consump- tion, 189 lump-sum, 184 payroll, 173–174, 185, 186, 188 Pigouvian, 443–444 poll, in Britain, 167, 184 profits, 186, 188 progressive, 187, 189–190 property, 186, 188 proportional, 186 regressive, 187, 189–190 sales, 186, 188 Social Security, principle underlying, 185 in United States, 188–190 value-added, 39, 189 Tax base, 186 Tax competition, 189 Taxi licenses, in New York City, 117, 133, 134–137 Tax rates, 175 in France, 504–505 marginal, 187, 190 revenue and, 175–177 Tax structure, 186 Taylor, Lester D., 147 Technology, 29 changes in, shifts in supply curve and, 75–76 changes in, shifts of factor demand curve and, 517–518 comparative advantage and, 203–204 monopoly and, 360 Technology spillovers, 448 Teenagers, summer jobs for, 532–533 Television viewing blacked-out games and, 474 in United Kingdom, 464 Trade, 12 gains from. See Gains from trade Trade-off(s), 8–9 Trade-off between equity and efficiency, 185 Trade protection, 211–220 arguments for, 215–216 global trade negotiations and, 219–220 import quotas as, 214 inequality and, 218 international trade agreements and, 216–218 outsourcing and, 218–219 politics of, 216 tariffs as, 212–214 in United States, 214–215 World Trade Organization and, 217–218 Traffic congestion, 3 anti-traffic policies, 70–71 in Los Angeles, 16 Traffic safety, spending on, 237 Transaction costs, 438 Truncated axis, 57 Tuition, price sensitivity of Temporary Assistance for Needy demand and, 154–155 Families (TANF) Act, 490 Textbooks, used, market for, 93–99, 101–103 Thailand, U.S. shrimp imports from, 217 Thames River, 459 Thames River Police, 463 Thatcher, Margaret, 167 A Theory of Justice (Rawls), 481 Time price elasticity of demand and, 154 price elasticity of supply and, 160–161 Time allocation, 528–529 Time allocation budget line, 537–538 Time horizon. See also Long run; Short run fixed versus variable inputs and, 304 Time-series graphs, 54, 55 Tit for tat, 399, 400 Tortilla prices, rise in, 87 Total consumer surplus, 96 Total cost, 309–310, 323 Total cost curve, 309–310 Total producer surplus, 102 Total product curve, 305 Total revenue, 150–152 price elasticity of demand and, 150–152 Total surplus, 105 Toyota, 389 Toys “R” Us, 408 Tradable emissions permits, 444–445 Tversky, Daniel, 262 20th Century Fox, 389 Twenty Ads That Shook the World (Twitchell), 429 Twitchell, James B., 429 Two-part tariffs, 380 Tyler, Wat, 184 U Uganda, wheat yield in, 306 Uncertainty, 544–545 Undercutting, by oligopolists, 394 Unemployment insurance, 491 Unions, 525–526 United Airlines, 389 United Kingdom. See also Britain; Ireland drug prices in, 361 hours worked in, 532 poverty rate in, 483 television viewing in, 464 voter turnout in, 467 United Network for Organ Sharing (UNOS), 99, 109 United States. See also Federal entries agricultural surplus in, 128, 129 amount spent on food in, 157 anti-price-fixing laws in, 387 arms race with Soviet Union, 400 Canadian aircraft exports to, 33–34 cap and trade system of, 445 clothing imports of, 201 clothing production in, 34 Cold War and, 408 consumption possibilities for American workers, 1895-2000, 257–258 decline of farming in, 157 drug prices in, 361 economists in government of, 40 exclusive dealing in, 393 factor distribution of income in, 512 federal tax philosophy in, 185–186 greenhouse gas emissions of, 441 health care in, 494, 498–499 hours worked in, 532 imports from Germany and Bangladesh compared, 204–205 Justice Department of, 389, 393, 405, 424 long-term trends in income inequality in, 487–489 minimum wage in, 131, 132 oil imports of, 203 oil production in, 203 pork exports to Canada, 33–34 portion sizes in, 236 poverty rate in, 483 shrimp imports of, 195, 217 taxes in, 173–174, 185, 188–190 television viewing in, 375 trade protection in, 214–215 voter turnout in, 467 wheat yield in, 306 U.S. Postal Service, 373 Unit-elastic demand, 149, 151, 162 Universal, 389 UNOS (United Network for Organ Sharing), 99, 109 Upjohn, 333 US Airways, 388 U-shaped average total cost curves, 314–316 Util(s), 250 usefulness of, 275 Utilities as natural monopolies, 359 power shortages in California and, 369–370 Utility, 250–253 consumption and, 250–251 expected, 546–547 indifference curves and. See Indifference curve(s) marginal. See Marginal utility entries Utility function, 250 I-12 I N D E X V Value, absolute, 51 Value-added tax (VAT), 39, 189 Value of the marginal prod- uct curve, 515–516 Value of the marginal product of labor, 513–514 Variable(s), 45 dependent, 46 independent, 46 omitted, 58 random, 545 Variable cost, 309–310, 323 Variable inputs, 304 VAT (value-added tax), 39, 189 Verizon, 389 Vertical axis, 46 Vertical curves, slope of, 49 Vertical intercept, 48 Veterans Health Administration, 496 Veterinarians, supply of, 77–78 Vietnam coffee beans from, 61 U.S. shrimp imports from, 217 Vitamin industry, price-fixing in, 395, 405 Volume discounts, 380 Volunteer fire departments, 464 von Mooltke, Helmuth, 225 Voter turnout, global compari- son of, 467 Voting Wealth, changes in, shifts of Willingness to pay British poll tax and, 167, 184 as public good, 468 labor supply curve and, 532 consumer surplus and, 95–97 demand curve and, 94, 95 VW, 389 W Wage(s) Chinese, 218 efficiency, 526 as factor price, 210 higher education and, 509 international trade and, 209–211 labor supply and, 529–531 optimal time allocation and, 538–541 Wage inequalities globalization and, 218 marginal productivity and, 524–525 in practice, 523 Walgreens, 389 Wal-Mart, 6, 389, 406, 408, 409 Wanniski, Jude, 177 Warner Bros., 389 “War on poverty,” 481 Warranties, 551 Wartime rationing, 100 Washington, George, 2 Wasted resources price ceilings and, 123–124 price floors and, 130 Watches, Swiss production of, 203 Water, as common resource, 471 The Wealth of Nations (Smith), 2–3, 12 Wealth tax, 186 Wedges, 136 Welfare state, 479–506. See also Health care in Britain, 492–493 economic inequality and, 484–487 economic insecurity and, 487–489 effects on poverty and Windows operating system, 451–452, 453–454 Wind tunnels, 23 Wine, demand for, 350 Women, in labor force, 10–11 Woods, Tiger, 227, 524 Working poor, 483 World Bank, 40 World price, 206, 207 World Trade Organization (WTO), 217–218 protests against, 219 inequality, 491–492 World War II, Normandy inva- in France, 504–505 justice and, 481 logic of, 480–481 means-tested programs for, 490 politics of, 503–504 poverty and. See Poverty problems with, 502–503 Social Security and, 491 unemploymen |
t insurance and, 491 in United States, 490–493 Wharton Economic Forecasting Associates, 24 White Americans poverty among, 483 wages of, 523 Whole Foods, 390 Wild Oats, 390 sion and, 225 Wright, Orville, 23 Wright, Wilbur, 23 WTO. See World Trade Organization (WTO) X x-axis, 46 Xoma, 238–239 x-variable, 45–46 Y y-axis, 46 y-variable, 45–46 Z Zany Brainy, 408 Zero-profit equilibrium, 422–424 Key Graphs and Equations The following lists indicate the key equations and graphs in Microeconomics. You can use them as a short-cut for finding topics that have been explained in text using a graph or an equation. KEY GRAPHS 2 Economic Models: Trade-offs and Trade 2-1 2-2 2-6 The production possibility frontier, 26 Increasing opportunity cost, 28 Comparative advantage and international trade, 34 2 Appendix: Graphs in Economics 2A-3 2A-5 2A-7 Calculating the slope, 49 Calculating the slope using the point method, 52 Calculating the area below and above a linear curve, 54 3 Supply and Demand 3-1 3-5 The demand schedule and the demand curve, 63 Individual demand curves and the market demand curve, 69 The supply schedule and the supply curve, 72 3-6 3-10 The individual supply curve and the market supply curve, 76 3-11 Market equilibrium, 79 3-13 Price below its equilibrium level creates a short- age, 81 4 Consumer and Producer Surplus Consumer surplus, 97 Producer surplus, 103 4-3 4-8 4-10 Total surplus, 106 5 The Market Strikes Back 5-2 5-6 5-9 The effects of a price ceiling, 120 The effects of a price floor, 128 Effect of a quota on the market for taxi rides, 135 6 Elasticity 6-3 6-4 6-5 Unit-elastic demand, inelastic demand, and elastic demand, 149 Total revenue, 150 The price elasticity of demand changes along the demand curve, 153 7 Taxes 7-7 7-9 Tax rates and revenue, 176 The deadweight loss of a tax, 179 8 International Trade 8-3 The gains from international trade, 200 The effects of imports on surplus, 208 8-7 8-11 A tariff reduces total surplus, 213 9 Making Decisions 9-1 Marginal cost, 231 9-2 Marginal benefit, 233 9-3 Babette’s optimal portion size, 235 10 The Rational Consumer 10-1 10-2 10-3 Cassie’s total utility and marginal utility, 251 The budget line, 254 Optimal consumption bundle, 257 11 Consumer Preferences and Consumer Choice An indifference curve map, 274 11-3 The optimal consumption bundle, 281 11-6 11-18 Income and substitution effects, 295 12 Behind the Supply Curve: Inputs and Costs 12-1 Production function and total product curve for George and Martha’s farm, 305 12-2 Marginal product of labor curve for George and 12-6 Martha’s farm, 307 Total cost and marginal cost curves for Selena’s Gourmet Salsas, 313 12-8 Marginal cost and average cost curves for Selena’s Gourmet Salsas, 316 13 Perfect Competition and the Supply Curve 13-3 13-5 13-6 Profitability and the market price, 339 The short-run market equilibrium, 345 The long-run market equilibrium, 346 14 Monopoly The monopolist’s profit, 369 14-7 14-8 Monopoly causes inefficiency, 371 15 Oligopoly 15-4 The kinked demand curve, 401 16 Monopolistic Competition and Product Differentiation 16-1 16-3 The monopolistically competitive firm in the short run, 421 The long-run zero-profit equilibrium, 423 Key Graphs, continued 17 Externalities 17-4 17-5 Positive externalities and production, 447 Negative externalities and production, 449 18 Public Goods and Common Resources 18-2 18-3 18-4 A public good, 466 A common resource, 470 An artificially scarce good, 474 KEY EQUATIONS (2A) The slope of a linear curve, 48 The arc method of calculating the slope, 51 The point method of calculating the slope, 52 Calculating the area below or above a curve, 53 (6-3) Price elasticity of demand, 145 (6-5) Price elasticity of demand—the midpoint method, 147 (6-7) Cross-price elasticity of demand, 156 (6-8) (6-9) Price elasticity of supply, 159 Income elasticity of demand, 156 Also see Table 6-3, An elasticity menagerie, 162 (7) The revenue from an excise tax, 175 (9-8) Present value of $1 realized two years from now, 242 (10-1) The budget constraint, 253 (10-2) Marginal utility per dollar spent, 260 (10-3) The optimal consumption rule, 261 (11-6) The marginal rate of substitution, 279 The budget line, 282 (11-7) (11-10) The slope of the budget line, 282 (11-11) The slope of the indifference curve equals the marginal rate of substitution, 283 (11-12) The relative price rule, 283 20 Factor Markets and the Distribution of Income The value of the marginal product curve, 515 20-3 Equilibrium in the labor market, 519 20-6 20-10 The individual labor supply curve, 530 21 Uncertainty, Risk, and Private Information 21-1 The utility function and marginal utility curve of a risk-averse family, 546 Differences in risk-aversion, 549 21-2 (12-1) Marginal product of labor, 305 (12-2) Total cost, 309 (12-3) Marginal cost, 312 (12-4) Average total cost, 314 (12-5) Average fixed cost and average variable cost, 315 Also see Table 12-3, Concepts and measures of cost, 323 (13-1) Total revenue, 334 (13-2) Profit, 334 (13-3) Marginal revenue, 334 Price-taking firm’s optimal output rule, 335 (13-4) Profit per unit of output, 338 Also see Table 13-4, Summary of the perfectly competitive firm’s profitability and production conditions, 343 (14-1) Monopolist’s optimal output rule, 367 (15) Hirfindahl-Hirschman index, 389 (20-1) Value of the marginal product of labor, 514 (20-2) Firm’s optimal employment rule, 514 (21-1) Expected value of a random variable, 545 (21-2) Expected utility, 548 |
Knott, and Dawn Elliott Linahan provided secretarial assistance with the first edition. We especially want to thank Lynn Steele and Jay Tharp, who provided considerable editorial support for the second edition. Mark Glickman and Steve Wiggins assisted with the examples in the third edition, while Andrew Guest, Jeanette Sayre, and Lynn Steele provided valuable editorial support for the third, fourth, and fifth editions, as did Brandi Henson and Jeanette Sayre for the sixth edition, and as did Ida Ng for the seventh edition and Ida Ng and Dagmar Trantinova for the eighth. In addition, Carola Conces and Catherine Martin provided superb research assistance on this eighth edition. Writing this book has been both a painstaking and enjoyable process. At each stage we received exceptionally fine guidance from teachers of microeconomics throughout the country. After the first draft of the first edition of the book had been edited and reviewed, it was discussed at a two-day focus group meeting in New York. This provided an opportunity to get ideas from instructors with a variety of backgrounds and perspectives. We would like to thank the following focus group members for advice and criticism: Carl Davidson of Michigan State University; Richard Eastin of the University of Southern California; Judith Roberts of California State University, Long Beach; and Charles Strein of the University of Northern Iowa. We would like to thank the reviewers who provided comments and ideas that have contributed significantly to the eighth edition of Microeconomics: Anita Alves Pena, Colorado State University Donald L. Bumpass, Sam Houston State University Joni Charles, Texas State University–San Marcos Ben Collier, Northwest Missouri State University Lee Endress, University of Hawaii Tammy R. Feldman, University of Michigan Todd Matthew Fitch, University of San Francisco Thomas J. Grennes, North Carolina State University Philip Grossman, Saint Cloud State University Nader Habibi, Brandeis University Robert G. Hansen, Dartmouth College Donald Holley, Boise State University Folke Kafka, University of Pittsburgh Anthony M. Marino, University of Southern California Laudo M. Ogura, Grand Valley State University June Ellenoff O’Neill, Baruch College Lourenço Paz, Syracuse University Philip Young, University of Maryland We would also like to thank all those who reviewed the first seven editions at various stages of their evolution: Nii Adote Abrahams, Missouri Southern State College Jack Adams, University of Arkansas, Little Rock Sheri Aggarwal, Dartmouth College Anca Alecsandru, Louisiana State University Ted Amato, University of North Carolina, Charlotte John J. Antel, University of Houston Albert Assibey-Mensah, Kentucky State University Kerry Back, Northwestern University Dale Ballou, University of Massachusetts, Amherst William Baxter, Stanford University Charles A. Bennett, Gannon University Gregory Besharov, Duke University Maharukh Bhiladwalla, Rutgers University Victor Brajer, California State University, Fullerton xxii • PREFACE James A. Brander, University of British Columbia David S. Bullock, University of Illinois Jeremy Bulow, Stanford University Raymonda Burgman, DePauw University H. Stuart Burness, University of New Mexico Peter Calcagno, College of Charleston Winston Chang, State University of New York, Buffalo Henry Chappel, University of South Carolina Larry A. Chenault, Miami University Harrison Cheng, University of Southern California Eric Chiang, Florida Atlantic University Kwan Choi, Iowa State University Charles Clotfelter, Duke University Kathryn Combs, California State University, Los Angeles Tom Cooper, Georgetown College Richard Corwall, Middlebury College John Coupe, University of Maine at Orono Robert Crawford, Marriott School, Brigham Young Stella Hofrenning, Augsburg College Duncan M. Holthausen, North Carolina State University Robert Inman, The Wharton School, University of Pennsylvania Brian Jacobsen, Wisconsin Lutheran College Joyce Jacobsen, Rhodes College Jonatan Jelen, New York University Changik Jo, Anderson University B. Patrick Joyce, Michigan Technological University Mahbubul Kabir, Lyon College David Kaserman, Auburn University Brian Kench, University of Tampa Michael Kende, INSEAD, France Philip G. King, San Francisco State University Paul Koch, Olivet Nazarene University Tetteh A. Kofi, University of San Francisco Dennis Kovach, Community College of Allegheny University County Jacques Cremer, Virginia Polytechnic Institute and State University Julie Cullen, University of California, San Diego Carl Davidson, Michigan State University Gilbert Davis, University of Michigan Arthur T. Denzau, Washington University Tran Dung, Wright State University Richard V. Eastin, University of Southern California Maxim Engers, University of Virginia Carl E. Enomoto, New Mexico State University Michael Enz, Western New England College Ray Farrow, Seattle University Gary Ferrier, Southern Methodist University John Francis, Auburn University, Montgomery Roger Frantz, San Diego State University Delia Furtado, University of Connecticut Craig Gallet, California State University, Sacramento Patricia Gladden, University of Missouri Michele Glower, Lehigh University Otis Gilley, Louisiana Tech University Tiffani Gottschall, Washington & Jefferson College William H. Greene, New York University Thomas A. Gresik, Notre Dame University John Gross, University of Wisconsin at Milwaukee Adam Grossberg, Trinity College Jonathan Hamilton, University of Florida Claire Hammond, Wake Forest University Bruce Hartman, California State University, The California Maritime Academy James Hartigan, University of Oklahoma Daniel Henderson, Binghamton University George Heitman, Pennsylvania State University Wayne Hickenbottom, University of Texas at Austin George E. Hoffer, Virginia Commonwealth University Anthony Krautman, DePaul University Leonard Lardaro, University of Rhode Island Sang Lee, Southeastern Louisiana University Robert Lemke, Florida International University Peter Linneman, University of Pennsylvania Leonard Loyd, University of Houston R. Ashley Lyman, University of Idaho James MacDonald, Rensselaer Polytechnical Institute Wesley A. Magat, Duke University Peter Marks, Rhode Island College Anthony M. Marino, University of Southern Florida Lawrence Martin, Michigan State University John Makum Mbaku, Weber State University Richard D. McGrath, College of William and Mary Douglas J. Miller, University of Missouri–Columbia David Mills, University of Virginia, Charlottesville Richard Mills, University of New Hampshire Jennifer Moll, Fairfield University Michael J. Moore, Duke University W. D. Morgan, University of California at Santa Barbara Julianne Nelson, Stern School of Business, New York University George Norman, Tufts University Laudo Ogura, Grand Valley State University Daniel Orr, Virginia Polytechnic Institute and State University Ozge Ozay, University of Utah Christos Paphristodoulou, Mälardalen University Sharon J. Pearson, University of Alberta, Edmonton Ivan P’ng, University of California, Los Angeles Michael Podgursky, University of Massachusetts, Amherst Jonathan Powers, Knox College Lucia Quesada, Universidad Torcuato Di Telia Benjamin Rashford, Oregon State University Charles Ratliff, Davidson College Judith Roberts, California State University, Long Beach Fred Rodgers, Medaille College William Rogers, University of Missouri–Saint Louis Geoffrey Rothwell, Stanford University Nestor Ruiz, University of California, Davis Edward L. Sattler, Bradley University Roger Sherman, University of Virginia Nachum Sicherman, Columbia University Sigbjørn Sødal, Agder University College Menahem Spiegel, Rutgers University Houston H. Stokes, University of Illinois, Chicago Richard W. Stratton, University of Akron Houston Stokes, University of Illinois at Chicago Charles T. Strein, University of Northern Iowa Charles Stuart, University of California, Santa Barbara Valerie Suslow, University of Michigan PREFACE • xxiii Theofanis Tsoulouhas, North Carolina State Mira Tsymuk, Hunter College, CUNY Abdul Turay, Radford University Sevin Ugural, Eastern Mediterranean University Nora A. Underwood, University of California, Davis Nikolaos Vettas, Duke University David Vrooman, St. Lawrence University Michael Wasylenko, Syracuse University Thomas Watkins, Eastern Kentucky University Robert Whaples, Wake Forest University David Wharton, Washington College Lawrence J. White, New York University Michael F. Williams, University of St. Thomas Beth Wilson, Humboldt State University Arthur Woolf, University of Vermont Chiou-nan Yeh, Alabama State University Peter Zaleski, Villanova University Joseph Ziegler, University of Arkansas, Fayetteville Apart from the formal review process, we are especially grateful to Jean Andrews, Paul Anglin, J. C. K. Ash, Ernst Berndt, George Bittlingmayer, Severin Borenstein, Paul Carlin, Whewon Cho, Setio Angarro Dewo, Avinash Dixit, Frank Fabozzi, Joseph Farrell, Frank Fisher, Jonathan Hamilton, Robert Inman, Joyce Jacobsen, Paul Joskow, Stacey Kole, Preston McAfee, Jeannette Mortensen, John Mullahy, Krishna Pendakur, Jeffrey Perloff, Ivan P’ng, A. Mitchell Polinsky, Judith Roberts, Geoffrey Rothwell, Garth Saloner, Joel Schrag, Daniel Siegel, Thomas Stoker, David Storey, James Walker, and Michael Williams, who were kind enough to provide comments, criticisms, and suggestions as the various editions of this book developed. There were a number of people who offered helpful comments, corrections, and suggestions for the eighth edition. We wish to thank the following people for their comments, suggestions, and corrections: Ernst Berndt, David Colander, Kurt von dem Hagen, Chris Knittel, Thomas Stoker, and Lawrence White. Chapter 5 of this eighth edition contains new and updated material on behavioral economics, whose genesis owes much to the thoughtful comments of George Akerlof. We also want to thank Ida Ng for her outstandi |
ng editorial assistance, and for carefully reviewing the page proofs of this edition. We also wish to express our sincere thanks for the extraordinary effort those at Macmillan, Prentice Hall, and Pearson made in the development of the various editions of our book. Throughout the writing of the first edition, Bonnie Lieberman provided invaluable guidance and encouragement; Ken MacLeod kept the progress of the book on an even keel; Gerald Lombardi provided masterful editorial assistance and advice; and John Molyneux ably oversaw the book’s production. In the development of the second edition, we were fortunate to have the encouragement and support of David Boelio, and the organizational and editorial help of two Macmillan editors, Caroline Carney and Jill Lectka. The second edition also benefited greatly from the superb development editing of Gerald Lombardi, and from John Travis, who managed the book’s production. Jill Lectka and Denise Abbott were our editors for the third edition, and we benefited greatly from their input. Leah Jewell was our editor for the fourth edition; her patience, thoughtfulness, and perseverance were greatly xxiv • PREFACE appreciated. Chris Rogers provided continual and loyal guidance through editions five through seven. With respect to this eighth edition, we are grateful to our economics editor Adrienne D’Ambrosio who has worked diligently through this major revision. We also appreciate the efforts of our Development Editor, Deepa Chungi; Senior Production Project Manager Kathryn Dinovo; Art Director Jonathan Boylan; Project Manager with Integra, Angela Norris; Editor in Chief, Donna Battista; Editorial Project Manager, Sarah Dumouchelle; Executive Marketing Manager, Lori DeShazo; MyEconLab Content Lead, Noel Lotz; Executive Media Producer, Melissa Honig; and Supplements Editor, Alison Eusden. We owe a special debt of thanks to Catherine Lynn Steele, whose superb editorial work carried us through five editions of this book. Lynn passed away on December 10, 2002. We miss her very much. R.S.P. D.L.R. Part One Introduction: Markets and Prices Part 1 surveys the scope of microeconomics and introduces some basic concepts and tools. Chapter 1 discusses the range of problems that microeconomics addresses, and the kinds of answers it can provide. It also explains what a market is, how we determine the boundaries of a market, and how we measure market price. Chapter 2 covers one of the most important tools of microeconomics: supply-demand analysis. We explain how a competitive market works and how supply and demand determine the prices and quantities of goods and services. We also show how supplydemand analysis can be used to determine the effects of changing market conditions, including government intervention Preliminaries 3 2 The Basics of Supply and Demand 21 11 This page intentionally left blank C H A P T E R 1 Preliminaries Economics is divided into two main branches: microeconomics and macroeconomics. Microeconomics deals with the behavior of individual economic units. These units include consumers, workers, investors, owners of land, business firms—in fact, any individual or entity that plays a role in the functioning of our economy.1 Microeconomics explains how and why these units make economic decisions. For example, it explains how consumers make purchasing decisions and how their choices are affected by changing prices and incomes. It also explains how firms decide how many workers to hire and how workers decide where to work and how much work to do. Another important concern of microeconomics is how economic units interact to form larger units—markets and industries. Microeconomics helps us to understand, for example, why the American automobile industry developed the way it did and how producers and consumers interact in the market for automobiles. It explains how automobile prices are determined, how much automobile companies invest in new factories, and how many cars are produced each year. By studying the behavior and interaction of individual firms and consumers, microeconomics reveals how industries and markets operate and evolve, why they differ from one another, and how they are affected by government policies and global economic conditions. By contrast, macroeconomics deals with aggregate economic quantities, such as the level and growth rate of national output, interest rates, unemployment, and inflation. But the boundary between macroeconomics and microeconomics has become less and less distinct in recent years. The reason is that macroeconomics also involves the analysis of markets—for example, the aggregate markets for goods and services, labor, and corporate bonds. To understand how these aggregate markets operate, we must first understand the behavior of the firms, consumers, workers, and investors who constitute them. Thus macroeconomists have become increasingly concerned with the microeconomic foundations of aggregate economic phenomena, and much of macroeconomics is actually an extension of microeconomic analysis. 1The prefix micro- is derived from the Greek word meaning “small.” However, many of the individual economic units that we will study are small only in relation to the U.S. economy as a whole. For example, the annual sales of General Motors, IBM, or Microsoft are larger than the gross national products of many countries.1 The Themes of Microeconomics 4 1.2 What Is a Market? 7 1.3 Real versus Nominal Prices 12 1.4 Why Study Microeconomics? 16 .1 The Market for Sweeteners 10 1.2 A Bicycle Is a Bicycle. Or Is It? 11 1.3 The Price of Eggs and the Price of a College Education 13 1.4 The Minimum Wage 15 3 4 PART 1 • Introduction: Markets and Prices • microeconomics Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise. • macroeconomics Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation. 1.1 The Themes of Microeconomics The Rolling Stones once said: “You can’t always get what you want.” This is true. For most people (even Mick Jagger), that there are limits to what you can have or do is a simple fact of life learned in early childhood. For economists, however, it can be an obsession. Much of microeconomics is about limits—the limited incomes that consumers can spend on goods and services, the limited budgets and technical know-how that firms can use to produce things, and the limited number of hours in a week that workers can allocate to labor or leisure. But microeconomics is also about ways to make the most of these limits. More precisely, it is about the allocation of scarce resources. For example, microeconomics explains how consumers can best allocate their limited incomes to the various goods and services available for purchase. It explains how workers can best allocate their time to labor instead of leisure, or to one job instead of another. And it explains how firms can best allocate limited financial resources to hiring additional workers versus buying new machinery, and to producing one set of products versus another. In a planned economy such as that of Cuba, North Korea, or the former Soviet Union, these allocation decisions are made mostly by the government. Firms are told what and how much to produce, and how to produce it; workers have little flexibility in choice of jobs, hours worked, or even where they live; and consumers typically have a very limited set of goods to choose from. As a result, many of the tools and concepts of microeconomics are of limited relevance in those countries. Trade-Offs In modern market economies, consumers, workers, and firms have much more flexibility and choice when it comes to allocating scarce resources. Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these trade-offs are best made. The idea of making optimal trade-offs is an important theme in microeconomics—one that you will encounter throughout this book. Let’s look at it in more detail. CONSUMERS Consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future. Consumer theory, the subject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based on their preferences, maximize their well-being by trading off the purchase of more of some goods for the purchase of less of others. We will also see how consumers decide how much of their incomes to save, thereby trading off current consumption for future consumption. WORKERS Workers also face constraints and make trade-offs. First, people must decide whether and when to enter the workforce. Because the kinds of jobs—and corresponding pay scales—available to a worker depend in part on educational attainment and accumulated skills, one must trade off working now (and earning an immediate income) for continued education (and the hope of earning a higher future income). Second, workers face trade-offs in their choice of employment. For example, while some people choose to work for large corporations that offer job security but limited potential for advancement, others prefer to work for small companies where there is more opportunity for CHAPTER 1 • Preliminaries 5 advancement but less security. Finally, workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure. FIRMS Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them. General Motors, for example, is very good at producing cars and trucks, but it does not have the ability to produce airplanes, computers, or pharmaceuticals. It is also constrained in terms of financial resources and the current production capacity of its factories. Given these constraints, GM must decide how many of each type of vehicle |
to produce. If it wants to produce a larger total number of cars and trucks next year or the year after, it must decide whether to hire more workers, build new factories, or do both. The theory of the firm, the subject matter of Chapters 6 and 7, describes how these trade-offs can best be made. Prices and Markets A second important theme of microeconomics is the role of prices. All of the trade-offs described above are based on the prices faced by consumers, workers, or firms. For example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but also on their prices. Likewise, workers trade off labor for leisure based in part on the “price” that they can get for their labor—i.e., the wage. And firms decide whether to hire more workers or purchase more machines based in part on wage rates and machine prices. Microeconomics also describes how prices are determined. In a centrally planned economy, prices are set by the government. In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets—collections of buyers and sellers that together determine the price of a good. In the automobile market, for example, car prices are affected by competition among Ford, General Motors, Toyota, and other manufacturers, and also by the demands of consumers. The central role of markets is the third important theme of microeconomics. We will say more about the nature and operation of markets shortly. Theories and Models Like any science, economics is concerned with the explanations of observed phenomena. Why, for example, do firms tend to hire or lay off workers when the prices of their raw materials change? How many workers are likely to be hired or laid off by a firm or an industry if the price of raw materials increases by, say, 10 percent? In economics, as in other sciences, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. The theory of the firm, for example, begins with a simple assumption—firms try to maximize their profits. The theory uses this assumption to explain how firms choose the amounts of labor, capital, and raw materials that they use for production and the amount of output they produce. It also explains how these choices depend on the prices of inputs, such as labor, capital, and raw materials, and the prices that firms can receive for their outputs. Economic theories are also the basis for making predictions. Thus the theory of the firm tells us whether a firm’s output level will increase or decrease in response to an increase in wage rates or a decrease in the price of raw materials. With the application of statistical and econometric techniques, theories can be used to construct models from which quantitative predictions can be made. 6 PART 1 • Introduction: Markets and Prices A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity. For example, we might develop a model of a particular firm and use it to predict by how much the firm’s output level will change as a result of, say, a 10-percent drop in the price of raw materials. Statistics and econometrics also let us measure the accuracy of our predictions. For example, suppose we predict that a 10-percent drop in the price of raw materials will lead to a 5-percent increase in output. Are we sure that the increase in output will be exactly 5 percent, or might it be somewhere between 3 and 7 percent? Quantifying the accuracy of a prediction can be as important as the prediction itself. No theory, whether in economics, physics, or any other science, is perfectly correct. The usefulness and validity of a theory depend on whether it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observation. As a result of this testing, they are often modified or refined and occasionally even discarded. The process of testing and refining theories is central to the development of economics as a science. When evaluating a theory, it is important to keep in mind that it is invariably imperfect. This is the case in every branch of science. In physics, for example, Boyle’s law relates the volume, temperature, and pressure of a gas.2 The law is based on the assumption that individual molecules of a gas behave as though they were tiny, elastic billiard balls. Physicists today know that gas molecules do not, in fact, always behave like billiard balls, which is why Boyle’s law breaks down under extremes of pressure and temperature. Under most conditions, however, it does an excellent job of predicting how the temperature of a gas will change when the pressure and volume change, and it is therefore an essential tool for engineers and scientists. The situation is much the same in economics. For example, because firms do not maximize their profits all the time, the theory of the firm has had only limited success in explaining certain aspects of firms’ behavior, such as the timing of capital investment decisions. Nonetheless, the theory does explain a broad range of phenomena regarding the behavior, growth, and evolution of firms and industries, and has thus become an important tool for managers and policymakers. Positive versus Normative Analysis Microeconomics is concerned with both positive and normative questions. Positive questions deal with explanation and prediction, normative questions with what ought to be. Suppose the U.S. government imposes a quota on the import of foreign cars. What will happen to the price, production, and sales of cars? What impact will this policy change have on American consumers? On workers in the automobile industry? These questions belong to the realm of positive analysis: statements that describe relationships of cause and effect. Positive analysis is central to microeconomics. As we explained above, theories are developed to explain phenomena, tested against observations, and used to construct models from which predictions are made. The use of economic theory for prediction is important both for the managers of firms and for public policy. Suppose the federal government is considering raising the tax on gasoline. The change would affect the price of gasoline, consumers’ purchasing 2Robert Boyle (1627–1691) was a British chemist and physicist who discovered experimentally that pressure (P), volume (V), and temperature (T) were related in the following way: PV = RT, where R is a constant. Later, physicists derived this relationship as a consequence of the kinetic theory of gases, which describes the movement of gas molecules in statistical terms. • positive analysis Analysis describing relationships of cause and effect. CHAPTER 1 • Preliminaries 7 choices for small or large cars, the amount of driving that people do, and so on. To plan sensibly, oil companies, automobile companies, producers of automobile parts, and firms in the tourist industry would all need to estimate the impact of the change. Government policymakers would also need quantitative estimates of the effects. They would want to determine the costs imposed on consumers (perhaps broken down by income categories); the effects on profits and employment in the oil, automobile, and tourist industries; and the amount of tax revenue likely to be collected each year. Sometimes we want to go beyond explanation and prediction to ask such questions as “What is best?” This involves normative analysis, which is also important for both managers of firms and those making public policy. Again, consider a new tax on gasoline. Automobile companies would want to determine the best (profit-maximizing) mix of large and small cars to produce once the tax is in place. Specifically, how much money should be invested to make cars more fuel-efficient? For policymakers, the primary issue is likely to be whether the tax is in the public interest. The same policy objectives (say, an increase in tax revenues and a decrease in dependence on imported oil) might be met more cheaply with a different kind of tax, such as a tariff on imported oil. Normative analysis is not only concerned with alternative policy options; it also involves the design of particular policy choices. For example, suppose it has been decided that a gasoline tax is desirable. Balancing costs and benefits, we then ask what is the optimal size of the tax. Normative analysis is often supplemented by value judgments. For example, a comparison between a gasoline tax and an oil import tariff might conclude that the gasoline tax will be easier to administer but will have a greater impact on lower-income consumers. At that point, society must make a value judgment, weighing equity against economic efficiency. When value judgments are involved, microeconomics cannot tell us what the best policy is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the debate. 1.2 What Is a Market? Business people, journalists, politicians, and ordinary consumers talk about markets all the time—for example, oil markets, housing markets, bond markets, labor markets, and markets for all kinds of goods and services. But often what they mean by the word “market” is vague or misleading. In economics, markets are a central focus of analysis, so economists try to be as clear as possible about what they mean when they refer to a market. It is easiest to understand what a market is and how it works by dividing individual economic units into two broad groups according to function— buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services; workers, who sell their labor services; and resource owners, w |
ho rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers, but we will find it helpful to think of them as simply buyers when they are buying something and sellers when they are selling something. Together, buyers and sellers interact to form markets. A market is the collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. In the market for personal computers, for example, the buyers are business firms, households, and students; the sellers are • normative analysis Analysis examining questions of what ought to be. • market Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. 8 PART 1 • Introduction: Markets and Prices • market definition Determination of the buyers, sellers, and range of products that should be included in a particular market. • arbitrage Practice of buying at a low price at one location and selling at a higher price in another. • perfectly competitive market Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price. Hewlett-Packard, Lenovo, Dell, Apple, and a number of other firms. Note that a market includes more than an industry. An industry is a collection of firms that sell the same or closely related products. In effect, an industry is the supply side of the market. Economists are often concerned with market definition—with determining which buyers and sellers should be included in a particular market. When defining a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold in New York will interact only with sellers in New York. But because the cost of transporting gold is small relative to its value, buyers of gold in New York could purchase their gold in Zurich if the prices there were significantly lower. Significant differences in the price of a commodity create a potential for arbitrage: buying at a low price in one location and selling at a higher price somewhere else. The possibility of arbitrage prevents the prices of gold in New York and Zurich from differing significantly and creates a world market for gold. Markets are at the center of economic activity, and many of the most interesting issues in economics concern the functioning of markets. For example, why do only a few firms compete with one another in some markets, while in others a great many firms compete? Are consumers necessarily better off if there are many firms? If so, should the government intervene in markets with only a few firms? Why have prices in some markets risen or fallen rapidly, while in other markets prices have hardly changed at all? And which markets offer the best opportunities for an entrepreneur thinking of going into business? Competitive versus Noncompetitive Markets In this book, we study the behavior of both competitive and noncompetitive markets. A perfectly competitive market has many buyers and sellers, so that no single buyer or seller has any impact on price. Most agricultural markets are close to being perfectly competitive. For example, thousands of farmers produce wheat, which thousands of buyers purchase to produce flour and other products. As a result, no single farmer and no single buyer can significantly affect the price of wheat. Many other markets are competitive enough to be treated as if they were perfectly competitive. The world market for copper, for example, contains a few dozen major producers. That number is enough for the impact on price to be small if any one producer goes out of business. The same is true for many other natural resource markets, such as those for coal, iron, tin, or lumber. Other markets containing a small number of producers may still be treated as competitive for purposes of analysis. For example, the U.S. airline industry contains several dozen firms, but most routes are served by only a few firms. Nonetheless, because competition among those firms is often fierce, for some purposes airline markets can be treated as competitive. Finally, some markets contain many producers but are noncompetitive; that is, individual firms can jointly affect the price. The world oil market is one example. Since the early 1970s, that market has been dominated by the OPEC cartel. (A cartel is a group of producers that acts collectively.) • market price Price prevailing in a competitive market. Market Price Markets make possible transactions between buyers and sellers. Quantities of a good are sold at specific prices. In a perfectly competitive market, a single price—the market price—will usually prevail. The price of wheat in Kansas CHAPTER 1 • Preliminaries 9 City and the price of gold in New York are two examples. These prices are usually easy to measure. For example, you can find the price of corn, wheat, or gold each day in the business section of a newspaper. In markets that are not perfectly competitive, different firms might charge different prices for the same product. This might happen because one firm is trying to win customers from its competitors, or because customers have brand loyalties that allow some firms to charge higher prices than others. For example, two brands of laundry detergent might be sold in the same supermarket at different prices. Or two supermarkets in the same town might sell the same brand of laundry detergent at different prices. In cases such as this, when we refer to the market price, we will mean the price averaged across brands or supermarkets. The market prices of most goods will fluctuate over time, and for many goods the fluctuations can be rapid. This is particularly true for goods sold in competitive markets. The stock market, for example, is highly competitive because there are typically many buyers and sellers for any one stock. As anyone who has invested in the stock market knows, the price of any particular stock fluctuates from minute to minute and can rise or fall substantially during a single day. Likewise, the prices of commodities such as wheat, soybeans, coffee, oil, gold, silver, and lumber can rise or fall dramatically in a day or a week. Market Definition—The Extent of a Market As we saw, market definition identifies which buyers and sellers should be included in a given market. However, to determine which buyers and sellers to include, we must first determine the extent of a market—its boundaries, both geographically and in terms of the range of products to be included in it. When we refer to the market for gasoline, for example, we must be clear about its geographic boundaries. Are we referring to downtown Los Angeles, southern California, or the entire United States? We must also be clear about the range of products to which we are referring. Should regular-octane and high-octane premium gasoline be included in the same market? Gasoline and diesel fuel? For some goods, it makes sense to talk about a market only in terms of very restrictive geographic boundaries. Housing is a good example. Most people who work in downtown Chicago will look for housing within commuting distance. They will not look at homes 200 or 300 miles away, even though those homes might be much cheaper. And homes (together with the land they are sitting on) 200 miles away cannot be easily moved closer to Chicago. Thus the housing market in Chicago is separate and distinct from, say, that in Cleveland, Houston, Atlanta, or Philadelphia. Likewise, retail gasoline markets, though less limited geographically, are still regional because of the expense of shipping gasoline over long distances. Thus the market for gasoline in southern California is distinct from that in northern Illinois. On the other hand, as we mentioned earlier, gold is bought and sold in a world market; the possibility of arbitrage prevents the price from differing significantly from one location to another. We must also think carefully about the range of products to include in a market. For example, there is a market for single-lens reflex (SLR) digital cameras, and many brands compete in that market. But what about compact “point-and-shoot” digital cameras? Should they be considered part of the same market? Probably not, because they are typically used for different purposes and so do not compete with SLR cameras. Gasoline is another example. Regular- and premium-octane gasolines might be considered part of the same market because • extent of a market Boundaries of a market, both geographical and in terms of range of products produced and sold within it. 10 PART 1 • Introduction: Markets and Prices most consumers can use either. Diesel fuel, however, is not part of this market because cars that use regular gasoline cannot use diesel fuel, and vice versa.3 Market definition is important for two reasons: • A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future. It must also know the product boundaries and geographical boundaries of its market in order to set price, determine advertising budgets, and make capital investment decisions. • Market definition can be important for public policy decisions. Should the government allow a merger or acquisition involving companies that produce similar products, or should it challenge it? The answer depends on the impact of that merger or acquisition on future competition and prices; often this can be evaluated only by defining a market. E XAM PLE 1.1 THE MARKET FOR SWEETENERS In 1990, the Archer-Daniels-Midland Company (ADM) acquired the Clinton Corn Processing Company (CCP).4 ADM was a large company that produced many agricultural products, one of which was high-fructose corn syrup (HFCS). CCP was another major U.S |
. corn syrup producer. The U.S. Department of Justice (DOJ) challenged the acquisition on the grounds that it would lead to a dominant producer of corn syrup with the power to push prices above competitive levels. Indeed, ADM and CCP together accounted for over 70 percent of U.S. corn syrup production. ADM fought the DOJ decision, and the case went to court. The basic issue was whether corn syrup represented a distinct market. If it did, the combined market share of ADM and CCP would have been about 40 percent, and the DOJ’s concern might have been warranted. ADM, however, argued that the correct market definition was much broader—a market for sweeteners which included sugar as well as corn syrup. Because the ADM–CCP combined share of a sweetener market would have been quite small, there would be no concern about the company’s power to raise prices. ADM argued that sugar and corn syrup should be considered part of the same market because they are used interchangeably to sweeten a vast array of food products, such as soft drinks, spaghetti sauce, and pancake syrup. ADM also showed that as the level of prices for corn syrup and sugar fluctuated, industrial food producers would change the proportions of each sweetener that they used in their products. In October 1990, a federal judge agreed with ADM’s argument that sugar and corn syrup were both part of a broad market for sweeteners. The acquisition was allowed to go through. Sugar and corn syrup continue to be used almost interchangeably to satisfy Americans’ strong taste for sweetened foods. The use of all sweeteners rose steadily through the 1990s, reaching 150 pounds per person in 1999. But starting in 2000, sweetener use began to decline as health concerns led people to find substitute snacks with less added sugar. By 2010, American per-capita consumption of sweeteners had dropped to 130 pounds per person. In addition, for the first time since 1985, people consumed more sugar (66 pounds per person) than corn syrup (64.5 pounds per person). Part of the shift from corn syrup to sugar was due to a growing belief that sugar is somehow more “natural”—and therefore healthier—than corn syrup. 3How can we determine the extent of a market? Since the market is where the price of a good is established, one approach focuses on market prices. We ask whether product prices in different geographic regions (or for different product types) are approximately the same, or whether they tend to move together. If either is the case, we place them in the same market. For a more detailed discussion, see George J. Stigler and Robert A. Sherwin, “The Extent of the Market,” Journal of Law and Economics 27 (October 1985): 555–85. 4This example is based on F. M. Scherer, “Archer-Daniels-Midland Corn Processing,” Case C16-92-1126, John F. Kennedy School of Government, Harvard University, 1992. CHAPTER 1 • Preliminaries 11 EXAM PLE 1.2 A BICYCLE IS A BICYCLE. OR IS IT? Where did you buy your last bicycle? You might have bought a used bike from a friend or from a posting on Craigslist. But if it was new, you probably bought it from either of two types of stores. If you were looking for something inexpensive, just a functional bicycle to get you from A to B, you would have done well by going to a mass merchandiser such as Target, WalMart, or Sears. There you could easily find a decent bike costing around $100 to $200. On the other hand, if you are a serious cyclist (or at least like to think of yourself as one), you would probably go to a bicycle dealer—a store that specializes in bicycles and bicycle equipment. There it would be difficult to find a bike costing less than $400, and you could easily spend far more. But of course you would have been happy to spend more, because you are serious cyclist. What does a $1000 Trek bike give you that a $120 Huffy bike doesn’t? Both might have 21-speed gear shifts (3 in front and 7 in back), but the shifting mechanisms on the Trek will be higher quality and probably shift more smoothly and evenly. Both bikes will have front and rear hand brakes, but the brakes on the Trek will likely be stronger and more durable. And the Trek is likely to have a lighter frame than the Huffy, which could be important if you are a competitive cyclist. So there are actually two different markets for bicycles, markets that can be identified by the type of store in which the bicycle is sold. This is illustrated in Table 1.1. “Mass market” bicycles, the ones that are sold in Target and Wal-Mart, are made by companies such as Huffy, Schwinn, and Mantis, are priced as low as $90 and rarely cost more than $250. These companies are focused on producing functional bicycles as cheaply as possible, and typically do their manufacturing in China. “Dealer” bicycles, the ones sold in your local bicycle store, include such brands as Trek, Cannondale, Giant, Gary Fisher, and Ridley, and are priced from $400 and up—way up. For these companies the emphasis is on performance, as measured by weight and the quality of the brakes, gears, tires, and other hardware. Companies like Huffy and Schwinn would never try to produce a $1000 bicycle, because that is simply not their forte (or competitive advantage, as economists like to say). Likewise, Trek and Ridley have developed a reputation for quality, and they have neither the skills nor the factories TABLE 1.1 MARKETS FOR BICYCLES TYPE OF BICYCLE COMPANIES AND PRICES (2011) Mass Market Bicycles: Sold by mass merchandisers such as Target, Wal-Mart, Kmart, and Sears. Dealer Bicycles: Sold by bicycle dealers – stores that sell only (or mostly) bicycles and bicycle equipment. Huffy: $90—$140 Schwinn: $140—$240 Mantis: $129—$140 Mongoose: $120—$280 Trek: $400—$2500 Cannondale: $500—$2000 Giant: $500—$2500 Gary Fisher: $600—$2000 Mongoose: $700—$2000 Ridley: $1300—$2500 Scott: $1000—$3000 Ibis: $2000 and up 12 PART 1 • Introduction: Markets and Prices to produce $100 bicycles. Mongoose, on the other hand, straddles both markets. They produce mass market bicycles costing as little as $120, but also high-quality dealer bicycles costing $700 to $2000. After you buy your bike, you will need to lock it up carefully due to the unfortunate reality of yet another market—the black market for used bikes and their parts. We hope that you—and your bike— stay out of that market! • nominal price Absolute price of a good, unadjusted for inflation. • real price Price of a good relative to an aggregate measure of prices; price adjusted for inflation. • Consumer Price Index Measure of the aggregate price level. • Producer Price Index Measure of the aggregate price level for intermediate products and wholesale goods. 1.3 Real versus Nominal Prices We often want to compare the price of a good today with what it was in the past or is likely to be in the future. To make such a comparison meaningful, we need to measure prices relative to an overall price level. In absolute terms, the price of a dozen eggs is many times higher today than it was 50 years ago. Relative to prices overall, however, it is actually lower. Therefore, we must be careful to correct for inflation when comparing prices across time. This means measuring prices in real rather than nominal terms. The nominal price of a good (sometimes called its “current-dollar” price) is its absolute price. For example, the nominal price of a pound of butter was about $0.87 in 1970, $1.88 in 1980, about $1.99 in 1990, and about $3.42 in 2010. These are the prices you would have seen in supermarkets in those years. The real price of a good (sometimes called its “constant-dollar” price) is the price relative to an aggregate measure of prices. In other words, it is the price adjusted for inflation. For consumer goods, the aggregate measure of prices most often used is the Consumer Price Index (CPI). The CPI is calculated by the U.S. Bureau of Labor Statistics by surveying retail prices, and is published monthly. It records how the cost of a large market basket of goods purchased by a “typical” consumer changes over time. Percentage changes in the CPI measure the rate of inflation in the economy. Sometimes we are interested in the prices of raw materials and other intermediate products bought by firms, as well as in finished products sold at wholesale to retail stores. In this case, the aggregate measure of prices often used is the Producer Price Index (PPI). The PPI is also calculated by the U.S. Bureau of Labor Statistics and published monthly, and records how, on average, prices at the wholesale level change over time. Percentage changes in the PPI measure cost inflation and predict future changes in the CPI. So which price index should you use to convert nominal prices to real prices? It depends on the type of product you are examining. If it is a product or service normally purchased by consumers, use the CPI. If instead it is a product normally purchased by businesses, use the PPI. Because we are examining the price of butter in supermarkets, the relevant price index is the CPI. After correcting for inflation, do we find that the price of butter was more expensive in 2010 than in 1970? To find out, let’s calculate the 2010 price of butter in terms of 1970 dollars. The CPI was 38.8 in 1970 and rose to about 218.1 in 2010. (There was considerable inflation in the United States during the 1970s and early 1980s.) In 1970 dollars, the price of butter was 38.8 218.1 * $3.42 = $0.61 CHAPTER 1 • Preliminaries 13 In real terms, therefore, the price of butter was lower in 2010 than it was in 1970.5 Put another way, the nominal price of butter went up by about 293 percent, while the CPI went up 462 percent. Relative to the aggregate price level, butter prices fell. In this book, we will usually be concerned with real rather than nominal prices because consumer choices involve analyses of price comparisons. These relative prices can most easily be evaluated if there is a common basis of comparison. Stating all prices in real ter |
ms achieves this objective. Thus, even though we will often measure prices in dollars, we will be thinking in terms of the real purchasing power of those dollars. EXAMPLE 1.3 THE PRICE OF EGGS AND THE PRICE OF A COLLEGE EDUCATION In 1970, Grade A large eggs cost about 61 cents a dozen. In the same year, the average annual cost of a college education at a private four-year college, including room and board, was about $2112. By 2010, the price of eggs had risen to $1.54 a dozen, and the average cost of a college education was $21,550. In real terms, were eggs more expensive in 2010 than in 1970? Had a college education become more expensive? Table 1.2 shows the nominal price of eggs, the nominal cost of a college education, and the CPI for 1970–2010. (The CPI is based on 1983 = 100.) TABLE 1.2 THE REAL PRICES OF EGGS AND OF A COLLEGE EDUCATION6 1970 1980 1990 2000 2010 Consumer Price Index 38.8 82.4 130.7 172.2 218.1 Nominal Prices Grade A Large Eggs $0.61 $0.84 $1.01 $0.91 $1.54 College Education $2,112 $3,502 $7,619 $12,976 $21,550 Real Prices ($1970) Grade A Large Eggs $0.61 $0.40 $0.30 $0.21 $0.27 College Education $2,112 $1,649 $2,262 $2,924 $3,835 5Two good sources of data on the national economy are the Economic Report of the President and the Statistical Abstract of the United States. Both are published annually and are available from the U.S. Government Printing Office. 6You can get data on the cost of a college education by visiting the National Center for Education Statistics and download the Digest of Education Statistics at http://nces.ed.gov. Historical and current data on the average retail price of eggs can be obtained from the Bureau of Labor Statistics (BLS) at http://www.bls.gov, by selecting CPI—Average Price Data. 14 PART 1 • Introduction: Markets and Prices Also shown are the real prices of eggs and college education in 1970 dollars, calculated as follows: Real price of eggs in 1980 = Real price of eggs in 1990 = CPI1970 CPI1980 CPI1970 CPI1990 * nominal price in 1980 * nominal price in 1990 and so forth. The table shows clearly that the real cost of a college education rose (by 82 percent) during this period, while the real cost of eggs fell (by 55 percent). It is these relative changes in prices that are important for the choices that consumers make, not the fact that both eggs and college cost more in nominal dollars today than they did in 1970. In the table, we calculated real prices in terms of 1970 dollars, but we could just as easily have calculated them in terms of dollars of some other base year. For example, suppose we want to calculate the real price of eggs in 1990 dollars. Then: Real price of eggs in 1970 = CPI1990 CPI1970 * nominal price in 1970 = 130.7 38.8 * 0.61 = 2.05 Real price of eggs in 2010 = CPI1990 CPI2010 * nominal price in 2010 = 130.7 218.1 * 1.54 = 0.92 Percentage change in real price = real price in 2010 - real price in 1970 real price in 1970 = 0.92 - 2.05 2.05 = -0.55 Notice that the percentage decline in real price is the same whether we use 1970 dollars or 1990 dollars as the base year. CHAPTER 1 • Preliminaries 15 EXAM PLE 1.4 THE MINIMUM WAGE The federal minimum wage—first instituted in 1938 at a level of 25 cents per hour—has been increased periodically over the years. From 1991 through 1995, for example, it was $4.25 an hour. Congress voted to raise it to $4.75 in 1996 and then to $5.15 in 1997. Legislation in 2007 to increase the minimum wage yet again would raise it to $6.55 an hour in 2008 and $7.25 in 2009.7 Figure 1.1 shows the minimum wage from 1938 through 2015, both in nominal terms and in 2000 constant dollars. Note that although the legislated minimum wage has steadily increased, in real terms the minimum wage today is not much different from what is was in the 1950s. Nonetheless, the 2007 decision to increase the minimum wage was a difficult one. Although the higher minimum wage would provide a better standard of living for those workers who had been paid below the minimum, some analysts feared that it would also lead to increased unemployment among young and unskilled workers. The decision to increase the minimum wage, therefore, raises both normative and positive issues. The normative issue is whether any loss of teenage and low-skilled jobs is outweighed by two factors: (1) the direct benefits to those workers who now earn more as a result; and (2) any indirect benefits to other workers whose wages might be increased along Real Wage (2000$) Nominal Wage 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year FIGURE 1.1 THE MINIMUM WAGE In nominal terms, the minimum wage has increased steadily over the past 70 years. However, in real terms its 2010 level is below that of the 1970s. 7Some states also have minimum wages that are higher than the federal minimum wage. For example, in 2011 the minimum wage in Massachusetts was $8.00 per hour, in New York it was $7.25, and in California it was $8.00 and scheduled to increase to $8.00 in 2008. You can learn more about the minimum wage at http://www.dol.gov. 16 PART 1 • Introduction: Markets and Prices with the wages of those at the bottom of the pay scale. An important positive issue is how many fewer workers (if any) would be able to get jobs with a higher minimum wage. As we will see in Chapter 14, this issue is still hotly debated. Statistical studies have suggested that an increase in the minimum wage of about 10 percent would increase teenage unemployment by 1 to 2 percent. (The actual increase from $5.15 to $7.25 represents a 41- percent increase.) However, one review of the evidence questions whether there are any significant unemployment effects.8 1.4 Why Study Microeconomics? We think that after reading this book you will have no doubt about the importance and broad applicability of microeconomics. In fact, one of our major goals is to show you how to apply microeconomic principles to actual decision-making problems. Nonetheless, some extra motivation early on never hurts. Here are two examples that not only show the use of microeconomics in practice, but also provide a preview of this book. Corporate Decision Making: The Toyota Prius In 1997, Toyota Motor Corporation introduced the Prius in Japan, and started selling it worldwide in 2001. The Prius, the first hybrid car to be sold in the United States, can run off both a gasoline engine and a battery, and the momentum of the car charges the battery. Hybrid cars are more energy efficient than cars with just a gasoline engine; the Prius, for example, can get 45 to 55 miles per gallon. The Prius was a big success, and within a few years other manufacturers began introducing hybrid versions of some of their cars. The design and efficient production of the Prius involved not only some impressive engineering, but a lot of economics as well. First, Toyota had to think carefully about how the public would react to the design and performance of this new product. How strong would demand be initially, and how fast would it grow? How would demand depend on the prices that Toyota charged? Understanding consumer preferences and trade-offs and predicting demand and its responsiveness to price are essential to Toyota and every other automobile manufacturer. (We discuss consumer preferences and demand in Chapters 3, 4, and 5.) Next, Toyota had to be concerned with the cost of manufacturing these cars — whether produced in Japan or, starting in 2010, in the United States. How high would production costs be? How would the cost of each car depend on the total number of cars produced each year? How would the cost of labor and the prices of steel and other raw materials affect costs? How much and how fast would costs decline as managers and workers gained experience with the production 8The first study is David Neumark and William Wascher, “Employment Effects of Minimum and Subminimum Wages: Panel Data on State Minimum Wage Laws,” Industrial and Labor Relations Review 46 (October 1992): 55–81. A review of the literature appears in David Card and Alan Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton: Princeton University Press, 1995). CHAPTER 1 • Preliminaries 17 process? And to maximize profits, how many of these cars should Toyota plan to produce each year? (We discuss production and cost in Chapters 6 and 7, and the profit-maximizing choice of output in Chapters 8 and 10.) Toyota also had to design a pricing strategy and consider how competitors would react to it. Although the Prius was the first hybrid car, Toyota knew that it would compete with other small fuel-efficient cars, and that soon other manufacturers would introduce their own hybrid cars. Should Toyota charge a relatively low price for a basic stripped-down version of the Prius and high prices for individual options like leather seats? Or would it be more profitable to make these options “standard” items and charge a higher price for the whole package? Whatever pricing strategy Toyota chose, how were competitors likely to react? Would Ford or Nissan try to undercut by lowering the prices of its smaller cars, or rush to bring out their own hybrid cars at lower prices? Might Toyota be able to deter Ford and Nissan from lowering prices by threatening to respond with its own price cuts? (We discuss pricing in Chapters 10 and 11, and competitive strategy in Chapters 12 and 13.) Manufacturing the Prius required large investments in new capital equipment, so Toyota had to consider both the risks and possible outcomes of its decisions. Some of this risk was due to uncertainty over the future price of oil and thus the price of gasoline (lower gasoline prices would reduce the demand for small fuelefficient cars). Some of the risk was due to uncertainty over the wages that Toyota would have to pay its workers at its plants in Japan and in the United States. (Oil and other commodity markets are discussed in Chapters 2 and 9. Labor markets and the impact |
of unions are discussed in Chapter 14. Investment decisions and the implications of uncertainty are discussed in Chapters 5 and 15.) Toyota also had to worry about organizational problems. Toyota is an integrated firm in which separate divisions produce engines and parts and then assemble finished cars. How should the managers of different divisions be rewarded? What price should the assembly division be charged for the engines it receives from another division? (We discuss internal pricing and organizational incentives for the integrated firm in Chapters 11 and 17.) Finally, Toyota had to think about its relationship to the government and the effects of regulatory policies. For example, all of its cars sold in the United States must meet federal emissions standards, and U.S. production-line operations must comply with health and safety regulations. How might those regulations and standards change over time? How would they affect costs and profits? (We discuss the role of government in limiting pollution and promoting health and safety in Chapter 18.) Public Policy Design: Fuel Efficiency Standards for the Twenty-First Century In 1975, the U.S. government imposed regulations designed to improve the average fuel economy of domestically-sold cars and light trucks (including vans and sport utility vehicles). The CAFE (Corporate Average Fuel Economy) standards have become increasingly stringent over the years. In 2007, President George W. Bush signed into law the Energy Independence and Security Act, which required automakers to boost fleet wide gas mileage to 35 miles per gallon (mpg) by 2020. In 2011, the Obama administration pushed the 35 mpg target forward to 2016, and (with the agreement of 13 auto companies) set a standard of 55 mpg for 2020. While the program’s primary goal is to increase 18 PART 1 • Introduction: Markets and Prices energy security by reducing the U.S. dependence on imported oil, it would also generate substantial environmental benefits, such as a reduction in greenhouse gas emissions. A number of important decisions have to be made when designing a fuel efficiency program, and most of those decisions involve economics. First, the government must evaluate the monetary impact of the program on consumers. Higher fuel economy standards will increase the cost of purchasing a car (the cost of achieving higher fuel economy will be borne in part by consumers), but will lower the cost of operating it (gas mileage will be higher). Analyzing the ultimate impact on consumers means analyzing consumer preferences and demand. For example, would consumers drive less and spend more of their income on other goods? If so, would they be nearly as well off? (Consumer preferences and demand are discussed in Chapters 3 and 4). Before imposing CAFE standards, it is important to estimate the likely impact those standards will have on the cost of producing cars and light trucks. Might automobile companies minimize cost increases by using new lightweight materials or by changing the footprint of new model cars? (Production and cost are discussed in Chapters 6 and 7.) Then the government needs to know how changes in production costs will affect the production levels and prices of new automobiles and light trucks. Are the additional costs likely to be absorbed by manufacturers or passed on to consumers in the form of higher prices? (Output determination is discussed in Chapter 8 and pricing in Chapters 10 through 13.) The government must also ask why problems related to oil consumption are not solved by our market-oriented economy. One answer is that oil prices are determined in part by a cartel (OPEC) that is able to push the price of oil above competitive levels. (Pricing in markets in which firms have the power to control prices are discussed in Chapters 10 through 12.) Finally, the high U.S. demand for oil has led to a substantial outflow of dollars to the oil-producing countries, which in turn has created political and security issues that go beyond the confines of economics. What economics can do, however, is help us evaluate how best to reduce our dependence on foreign oil. Are standards like those of the CAFE program preferred to fees on oil consumption? What are the environmental implications of increasingly stringent standards? (These problems are discussed in Chapter 18.) These are just two examples of how microeconomics can be applied in the arenas of private and public-policy decision making. You will discover many more applications as you read this book. SUMMARY 1. Microeconomics is concerned with the decisions made by individual economic units—consumers, workers, investors, owners of resources, and business firms. It is also concerned with the interaction of consumers and firms to form markets and industries. 2. Microeconomics relies heavily on the use of theory, which can (by simplification) help to explain how economic units behave and to predict what behavior will occur in the future. Models are mathematical representations of theories that can help in this explanation and prediction process. 3. Microeconomics is concerned with positive questions that have to do with the explanation and prediction of phenomena. But microeconomics is also important for normative analysis, in which we ask what choices are best—for a firm or for society as a whole. Normative analyses must often be combined with individual value judgments because issues of equity and fairness as well as of economic efficiency may be involved. 4. A market refers to a collection of buyers and sellers who interact, and to the possibility for sales and purchases that result from that interaction. CHAPTER 1 • Preliminaries 19 Microeconomics involves the study of both perfectly competitive markets, in which no single buyer or seller has an impact on price, and noncompetitive markets, in which individual entities can affect price. 5. The market price is established by the interaction of buyers and sellers. In a perfectly competitive market, a single price will usually prevail. In markets that are not perfectly competitive, different sellers might charge different prices. In this case, the market price refers to the average prevailing price. 6. When discussing a market, we must be clear about its extent in terms of both its geographic boundaries and the range of products to be included in it. Some markets (e.g., housing) are highly localized, whereas others (e.g., gold) are global in nature. 7. To account for the effects of inflation, we measure real (or constant-dollar) prices, rather than nominal (or current-dollar) prices. Real prices use an aggregate price index, such as the CPI, to correct for inflation. QUESTIONS FOR REVIEW 1. It is often said that a good theory is one that can be refuted by an empirical, data-oriented study. Explain why a theory that cannot be evaluated empirically is not a good theory. 2. Which of the following two statements involves positive economic analysis and which normative? How do the two kinds of analysis differ? a. Gasoline rationing (allocating to each individual a maximum amount of gasoline that can be purchased each year) is poor social policy because it interferes with the workings of the competitive market system. b. Gasoline rationing is a policy under which more people are made worse off than are made better off. 3. Suppose the price of regular-octane gasoline were 20 cents per gallon higher in New Jersey than in Oklahoma. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy gas in Oklahoma and then sell it at a profit in New Jersey)? Why or why not? 4. In Example 1.3, what economic forces explain why the real price of eggs has fallen while the real price of a college education has increased? How have these changes affected consumer choices? 5. Suppose that the Japanese yen rises against the U.S. dollar—that is, it will take more dollars to buy a given amount of Japanese yen. Explain why this increase simultaneously increases the real price of Japanese cars for U.S. consumers and lowers the real price of U.S. automobiles for Japanese consumers. 6. The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45-percent (18 cents/40 cents) decrease. The Consumer Price Index increased by 10 percent over this period. What happened to the real price of telephone service? EXERCISES 1. Decide whether each of the following statements is true or false and explain why: a. Fast-food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore, the market for fast food is a national market. b. People generally buy clothing in the city in which they live. Therefore, there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles. c. Some consumers strongly prefer Pepsi and some strongly prefer Coke. Therefore, there is no single market for colas. 2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2010, scaled so that the CPI = 100 in 1980. 1980 1990 2000 2010 CPI 100 158.56 208.98 218.06 Retail price of butter (salted, grade AA, per lb.) $1.88 $1.99 $2.52 $2.88 a. Calculate the real price of butter in 1980 dollars. Has the real price increased/decreased/stayed the same from 1980 to 2000? From 1980 to 2010? b. What is the percentage change in the real price (1980 dollars) from 1980 to 2000? From 1980 to 2010? c. Convert the CPI into 1990 = 100 and determine the real price of butter in 1990 dollars. 20 PART 1 • Introduction: Markets and Prices d. What is the percentage change in real price (1990 dollars) from 1980 to 2000? Compare this with your answer in (b). What do you notice? Explain. 3. At the time this book went to print, the minimum wage was $7.25. To find the current value of the CPI, go to http://www.bls.gov/cpi/home.htm. Click on “CPI Tables,” which is found on the left side of the web page. Then, |
click on “Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes from 1913 to Present.” This will give you the CPI from 1913 to the present. a. With these values, calculate the current real mini- mum wage in 1990 dollars. b. Stated in real 1990 dollars, what is the percentage change in the real minimum wage from 1985 to the present? C H A P T E R 2 The Basics of Supply and Demand One of the best ways to appreciate the relevance of economics is to begin with the basics of supply and demand. Supplydemand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems. To name a few: • Understanding and predicting how changing world economic con- ditions affect market price and production • Evaluating the impact of government price controls, minimum wages, price supports, and production incentives • Determining how taxes, subsidies, tariffs, and import quotas affect consumers and producers We begin with a review of how supply and demand curves are used to describe the market mechanism. Without government intervention (e.g., through the imposition of price controls or some other regulatory policy), supply and demand will come into equilibrium to determine both the market price of a good and the total quantity produced. What that price and quantity will be depends on the particular characteristics of supply and demand. Variations of price and quantity over time depend on the ways in which supply and demand respond to other economic variables, such as aggregate economic activity and labor costs, which are themselves changing. We will, therefore, discuss the characteristics of supply and demand and show how those characteristics may differ from one market to another. Then we can begin to use supply and demand curves to understand a variety of phenomena—for example, why the prices of some basic commodities have fallen steadily over a long period while the prices of others have experienced sharp fluctuations; why shortages occur in certain markets; and why announcements about plans for future government policies or predictions about future economic conditions can affect markets well before those policies or conditions become reality. Besides understanding qualitatively how market price and quantity are determined and how they can vary over time, it is also important to learn how they can be analyzed quantitatively. We will see how simple “back of the envelope” calculations can be used to analyze and predict evolving market conditions. We will also show how markets respond .1 Supply and Demand 2.2 The Market Mechanism 2.3 Changes in Market Equilibrium 2.4 Elasticities of Supply and Demand 2.5 Short-Run versus 22 25 26 33 39 Long-Run Elasticities *2.6 Understanding and Predicting the Effects of Changing Market Conditions 2.7 Effects of Government 48 Intervention—Price Controls 58 .1 The Price of Eggs and the Price of a College Education 28 Revisited 2.2 Wage Inequality in the United States 29 2.3 The Long-Run Behavior of Natural Resource Prices 29 2.4 The Effects of 9/11 on the Supply and Demand for New 31 York City Office Space 2.5 The Market for Wheat 2.6 The Demand for Gasoline and Automobiles 2.7 The Weather in Brazil and 43 37 the Price of Coffee in New York 2.8 The Behavior of Copper Prices 2.9 Upheaval in the World Oil Market 2.10 Price Controls and Natural Gas Shortages 46 52 54 59 21 22 PART 1 • Introduction: Markets and Prices • supply curve Relationship between the quantity of a good that producers are willing to sell and the price of the good. both to domestic and international macroeconomic fluctuations and to the effects of government interventions. We will try to convey this understanding through simple examples and by urging you to work through some exercises at the end of the chapter. 2.1 Supply and Demand The basic model of supply and demand is the workhorse of microeconomics. It helps us understand why and how prices change, and what happens when the government intervenes in a market. The supply-demand model combines two important concepts: a supply curve and a demand curve. It is important to understand precisely what these curves represent. The Supply Curve The supply curve shows the quantity of a good that producers are willing to sell at a given price, holding constant any other factors that might affect the quantity supplied. The curve labeled S in Figure 2.1 illustrates this. The vertical axis of the graph shows the price of a good, P, measured in dollars per unit. This is the price that sellers receive for a given quantity supplied. The horizontal axis shows the total quantity supplied, Q, measured in the number of units per period. The supply curve is thus a relationship between the quantity supplied and the price. We can write this relationship as an equation: QS = QS(P) Or we can draw it graphically, as we have done in Figure 2.1. Note that the supply curve in Figure 2.1 slopes upward. In other words, the higher the price, the more that firms are able and willing to produce and sell. For example, a higher price may enable current firms to expand production by hiring extra workers or by having existing workers work overtime (at greater cost to the firm). Likewise, they may expand production over a longer period of time by increasing the size of their plants. A higher price may also attract new FIGURE 2.1 THE SUPPLY CURVE The supply curve, labeled S in the figure, shows how the quantity of a good offered for sale changes as the price of the good changes. The supply curve is upward sloping: The higher the price, the more firms are able and willing to produce and sell. If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right (from S to S’). Price P1 P2 S S′ Q1 Q 2 Quantity CHAPTER 2 • The Basics of Supply and Demand 23 firms to the market. These newcomers face higher costs because of their inexperience in the market and would therefore have found entry uneconomical at a lower price. OTHER VARIABLES THAT AFFECT SUPPLY The quantity supplied can depend on other variables besides price. For example, the quantity that producers are willing to sell depends not only on the price they receive but also on their production costs, including wages, interest charges, and the costs of raw materials. The supply curve labeled S in Figure 2.1 was drawn for particular values of these other variables. A change in the values of one or more of these variables translates into a shift in the supply curve. Let’s see how this might happen. The supply curve S in Figure 2.1 says that at a price P1, the quantity produced and sold would be Q1. Now suppose that the cost of raw materials falls. How does this affect the supply curve? Lower raw material costs—indeed, lower costs of any kind—make production more profitable, encouraging existing firms to expand production and enabling new firms to enter the market. If at the same time the market price stayed constant at P1, we would expect to observe a greater quantity supplied. Figure 2.1 shows this as an increase from Q1 to Q2. When production costs decrease, output increases no matter what the market price happens to be. The entire supply curve thus shifts to the right, which is shown in the figure as a shift from S to S’. Another way of looking at the effect of lower raw material costs is to imagine that the quantity produced stays fixed at Q1 and then ask what price firms would require to produce this quantity. Because their costs are lower, they would accept a lower price—P2. This would be the case no matter what quantity was produced. Again, we see in Figure 2.1 that the supply curve must shift to the right. We have seen that the response of quantity supplied to changes in price can be represented by movements along the supply curve. However, the response of supply to changes in other supply-determining variables is shown graphically as a shift of the supply curve itself. To distinguish between these two graphical depictions of supply changes, economists often use the phrase change in supply to refer to shifts in the supply curve, while reserving the phrase change in the quantity supplied to apply to movements along the supply curve. The Demand Curve The demand curve shows how much of a good consumers are willing to buy as the price per unit changes. We can write this relationship between quantity demanded and price as an equation: • demand curve Relationship between the quantity of a good that consumers are willing to buy and the price of the good. QD = QD(P) or we can draw it graphically, as in Figure 2.2. Note that the demand curve in that figure, labeled D, slopes downward: Consumers are usually ready to buy more if the price is lower. For example, a lower price may encourage consumers who have already been buying the good to consume larger quantities. Likewise, it may allow other consumers who were previously unable to afford the good to begin buying it. Of course the quantity of a good that consumers are willing to buy can depend on other things besides its price. Income is especially important. With greater incomes, consumers can spend more money on any good, and some consumers will do so for most goods. 24 PART 1 • Introduction: Markets and Prices FIGURE 2.2 THE DEMAND CURVE The demand curve, labeled D, shows how the quantity of a good demanded by consumers depends on its price. The demand curve is downward sloping; holding other things equal, consumers will want to purchase more of a good as its price goes down. The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods. For most products, the quantity demanded increases when income rises. A higher income level shifts the demand curve to the right (from D to D’). Price P2 P1 D′ D Q1 Q 2 Quantity • substitutes Two goods for which an increase in the price of one leads to a |
n increase in the quantity demanded of the other. • complements Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other. SHIFTING THE DEMAND CURVE Let’s see what happens to the demand curve if income levels increase. As you can see in Figure 2.2, if the market price were held constant at P1, we would expect to see an increase in the quantity demanded—say, from Q1 to Q2, as a result of consumers’ higher incomes. Because this increase would occur no matter what the market price, the result would be a shift to the right of the entire demand curve. In the figure, this is shown as a shift from D to D’. Alternatively, we can ask what price consumers would pay to purchase a given quantity Q1. With greater income, they should be willing to pay a higher price—say, P2 instead of P1 in Figure 2.2. Again, the demand curve will shift to the right. As we did with supply, we will use the phrase change in demand to refer to shifts in the demand curve, and reserve the phrase change in the quantity demanded to apply to movements along the demand curve.1 SUBSTITUTE AND COMPLEMENTARY GOODS Changes in the prices of related goods also affect demand. Goods are substitutes when an increase in the price of one leads to an increase in the quantity demanded of the other. For example, copper and aluminum are substitute goods. Because one can often be substituted for the other in industrial use, the quantity of copper demanded will increase if the price of aluminum increases. Likewise, beef and chicken are substitute goods because most consumers are willing to shift their purchases from one to the other when prices change. Goods are complements when an increase in the price of one leads to a decrease in the quantity demanded of the other. For example, automobiles and gasoline are complementary goods. Because they tend to be used together, a decrease in the price of gasoline increases the quantity demanded for automobiles. Likewise, computers and computer software are complementary goods. The price of computers has dropped dramatically over the past decade, fueling an increase not only in purchases of computers, but also purchases of software packages. We attributed the shift to the right of the demand curve in Figure 2.2 to an increase in income. However, this shift could also have resulted from either an increase in the price of a substitute good or a decrease in the price of a 1Mathematically, we can write the demand curve as QD = D(P, I) where I is disposable income. When we draw a demand curve, we are keeping I fixed. CHAPTER 2 • The Basics of Supply and Demand 25 complementary good. Or it might have resulted from a change in some other variable, such as the weather. For example, demand curves for skis and snowboards will shift to the right when there are heavy snowfalls. 2.2 The Market Mechanism The next step is to put the supply curve and the demand curve together. We have done this in Figure 2.3. The vertical axis shows the price of a good, P, again measured in dollars per unit. This is now the price that sellers receive for a given quantity supplied, and the price that buyers will pay for a given quantity demanded. The horizontal axis shows the total quantity demanded and supplied, Q, measured in number of units per period. EQUILIBRIUM The two curves intersect at the equilibrium, or market-clearing, price and quantity. At this price (P0 in Figure 2.3), the quantity supplied and the quantity demanded are just equal (to Q0). The market mechanism is the tendency in a free market for the price to change until the market clears— i.e., until the quantity supplied and the quantity demanded are equal. At this point, because there is neither excess demand nor excess supply, there is no pressure for the price to change further. Supply and demand might not always be in equilibrium, and some markets might not clear quickly when conditions change suddenly. The tendency, however, is for markets to clear. To understand why markets tend to clear, suppose the price were initially above the market-clearing level—say, P1 in Figure 2.3. Producers will try to produce and sell more than consumers are willing to buy. A surplus—a situation in which the quantity supplied exceeds the quantity demanded—will result. To sell this surplus—or at least to prevent it from growing—producers would begin to lower prices. Eventually, as price fell, quantity demanded would increase, and quantity supplied would decrease until the equilibrium price P0 was reached. The opposite would happen if the price were initially below P0—say, at P2. A shortage—a situation in which the quantity demanded exceeds the quantity • equilibrium (or marketclearing) price Price that equates the quantity supplied to the quantity demanded. • market mechanism Tendency in a free market for price to change until the market clears. • surplus Situation in which the quantity supplied exceeds the quantity demanded. • shortage Situation in which the quantity demanded exceeds the quantity supplied. Price (dollars per unit) P1 P0 P2 Surplus Shortage S D Q0 Quantity FIGURE 2.3 SUPPLY AND DEMAND The market clears at price P0 and quantity Q0. At the higher price P1, a surplus develops, so price falls. At the lower price P2, there is a shortage, so price is bid up. 26 PART 1 • Introduction: Markets and Prices supplied—would develop, and consumers would be unable to purchase all they would like. This would put upward pressure on price as consumers tried to outbid one another for existing supplies and producers reacted by increasing price and expanding output. Again, the price would eventually reach P0. WHEN CAN WE USE THE SUPPLY-DEMAND MODEL? When we draw and use supply and demand curves, we are assuming that at any given price, a given quantity will be produced and sold. This assumption makes sense only if a market is at least roughly competitive. By this we mean that both sellers and buyers should have little market power—i.e., little ability individually to affect the market price. Suppose instead that supply were controlled by a single producer—a monopolist. In this case, there will no longer be a simple one-to-one relationship between price and the quantity supplied. Why? Because a monopolist’s behavior depends on the shape and position of the demand curve. If the demand curve shifts in a particular way, it may be in the monopolist’s interest to keep the quantity fixed but change the price, or to keep the price fixed and change the quantity. (How this could occur is explained in Chapter 10.) Thus when we work with supply and demand curves, we implicitly assume that we are referring to a competitive market. 2.3 Changes in Market Equilibrium We have seen how supply and demand curves shift in response to changes in such variables as wage rates, capital costs, and income. We have also seen how the market mechanism results in an equilibrium in which the quantity supplied equals the quantity demanded. Now we will see how that equilibrium changes in response to shifts in the supply and demand curves. Let’s begin with a shift in the supply curve. In Figure 2.4, the supply curve has shifted from S to S’ (as it did in Figure 2.1), perhaps as a result of a decrease in the price of raw materials. As a result, the market price drops (from P1 to P3), and the total quantity produced increases (from Q1 to Q3). This is what we FIGURE 2.4 NEW EQUILIBRIUM FOLLOWING SHIFT IN SUPPLY When the supply curve shifts to the right, the market clears at a lower price P3 and a larger quantity Q3. Price P1 P3 S S′ D Q1 Q 3 Quantity CHAPTER 2 • The Basics of Supply and Demand 27 would expect: Lower costs result in lower prices and increased sales. (Indeed, gradual decreases in costs resulting from technological progress and better management are an important driving force behind economic growth.) Figure 2.5 shows what happens following a rightward shift in the demand curve resulting from, say, an increase in income. A new price and quantity result after demand comes into equilibrium with supply. As shown in Figure 2.5, we would expect to see consumers pay a higher price, P3, and firms produce a greater quantity, Q3, as a result of an increase in income. In most markets, both the demand and supply curves shift from time to time. Consumers’ disposable incomes change as the economy grows (or contracts, during economic recessions). The demands for some goods shift with the seasons (e.g., fuels, bathing suits, umbrellas), with changes in the prices of related goods (an increase in oil prices increases the demand for natural gas), or simply with changing tastes. Similarly, wage rates, capital costs, and the prices of raw materials also change from time to time, and these changes shift the supply curve. Supply and demand curves can be used to trace the effects of these changes. In Figure 2.6, for example, shifts to the right of both supply and demand result in a slightly higher price (from P1 to P2) and a much larger quantity (from Q1 to Q2). In general, price and quantity will change depending both on how much the supply and demand curves shift and on the shapes of those curves. To predict the sizes and directions of such changes, we must be able to characterize quantitatively the dependence of supply and demand on price and other variables. We will turn to this task in the next section. Price P3 P1 S Price S S′ P2 P1 D′ D Q1 Q 3 Quantity D′ D Q1 Q2 Quantity FIGURE 2.5 NEW EQUILIBRIUM FOLLOWING SHIFT IN DEMAND When the demand curve shifts to the right, the market clears at a higher price P3 and a larger quantity Q3. FIGURE 2.6 NEW EQUILIBRIUM FOLLOWING SHIFTS IN SUPPLY AND DEMAND Supply and demand curves shift over time as market conditions change. In this example, rightward shifts of the supply and demand curves lead to a slightly higher price and a much larger quantity. In general, changes in price and quantity depend on the amount by which each curve shifts and the shape of each curv |
e. 28 PART 1 • Introduction: Markets and Prices E XAM PLE 2.1 THE PRICE OF EGGS AND THE PRICE OF A COLLEGE EDUCATION REVISITED In Example 1.3 (page 13), we saw that from 1970 to 2010, the real (constant-dollar) price of eggs fell by 55 percent, while the real price of a college education rose by 82 percent. What caused this large decline in egg prices and large increase in the price of college? We can understand these price changes by examining the behavior of supply and demand for each good, as shown in Figure 2.7. For eggs, the mechanization of poultry farms sharply reduced the cost of producing eggs, shifting the supply curve downward. At the same time, the demand curve for eggs shifted to the left as a more healthconscious population changed its eating habits and tended to avoid eggs. As a result, the real price of eggs declined sharply while total annual consumption increased (from 5300 million dozen to 6392 million dozen). As for college, supply and demand shifted in the opposite directions. Increases in the costs of equipping and maintaining modern classrooms, laboratories, and libraries, along with increases in faculty salaries, pushed the supply curve up. At the same time, the demand curve shifted to the right as a larger percentage of a growing number of high school graduates decided that a college education was essential. Thus, despite the increase in price, 2010 found 12.5 million students enrolled in four-year undergraduate college degree programs, compared with 6.9 million in 1970. P (1970 dollars per dozen) $0.61 $0.27 S1970 P (annual cost in 1970 dollars) S2010 $3835 $2112 S2010 S1970 D1970 D2010 5300 6392 Q (million dozens) (a) D2010 D1970 6.9 12.5 Q (millions of students enrolled) (b) FIGURE 2.7 (a) MARKET FOR EGGS (b) MARKET FOR COLLEGE EDUCATION (a) The supply curve for eggs shifted downward as production costs fell; the demand curve shifted to the left as consumer preferences changed. As a result, the real price of eggs fell sharply and egg consumption rose. (b) The supply curve for a college education shifted up as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. As a result, both price and enrollments rose sharply. CHAPTER 2 • The Basics of Supply and Demand 29 EXAM PLE 2.2 WAGE INEQUALITY IN THE UNITED STATES Although the U.S. economy has grown vigorously over the past two decades, the gains from this growth have not been shared equally by all. The wages of skilled high-income workers have grown substantially, while the wages of unskilled lowincome workers have, in real terms, actually fallen slightly. Overall, there has been growing inequality in the distribution of earnings, a phenomenon which began around 1980 and has accelerated in recent years. For example, from 1978 to 2009, people in the top 20 percent of the income distribution experienced an increase in their average real (inflationadjusted) pretax household income of 45 percent, while those in the bottom 20 percent saw their average real pretax income increase by only 4 percent.2 Why has income distribution become so much more unequal during the past two decades? The answer is in the supply and demand for workers. While the supply of unskilled workers—people with limited educations—has grown substantially, the demand for them has risen only slightly. This shift of the supply curve to the right, combined with little movement of the demand curve, has caused wages of unskilled workers to fall. On the other hand, while the supply of skilled workers—e.g., engineers, scientists, managers, and economists—has grown slowly, the demand has risen dramatically, pushing wages up. (We leave it to you as an exercise to draw supply and demand curves and show how they have shifted, as was done in Example 2.1.) These trends are evident in the behavior of wages for different categories of employment. From 1980 to 2009, for example, the real (inflationadjusted) weekly earnings of skilled workers (such as finance, insurance, and real estate workers) rose by more than 20 percent. Over the same period, the weekly real incomes of relatively unskilled workers (such as retail trade workers) rose by only 5 percent.3 Most projections point to a continuation of this phenomenon during the coming decade. As the high-tech sectors of the American economy grow, the demand for highly skilled workers is likely to increase further. At the same time, the computerization of offices and factories will further reduce the demand for unskilled workers. (This trend is discussed further in Example 14.7.) These changes can only exacerbate wage inequality. EXAM PLE 2.3 THE LONG-RUN BEHAVIOR OF NATURAL RESOURCE PRICES Many people are concerned about the earth’s natural resources. At issue is whether our energy and mineral resources are likely to be depleted in the near future, leading to sharp price increases that could bring an end to economic growth. An analysis of supply and demand can give us some perspective. The earth does indeed have only a finite amount of mineral resources, such as copper, iron, coal, and oil. During the past century, however, the prices of these and most other natural resources have declined or remained roughly constant relative to overall prices. Figure 2.8, for example, 2In after-tax terms, the growth of inequality has been even greater; the average real after-tax income of the bottom 20 percent of the distribution fell over this period. For historical data on income inequality in the United States, see the Historical Income Inequality Tables at the U.S. Census Bureau Web site: http://www.census.gov/. 3For detailed earnings data, visit the Detailed Statistics section of the web site of the Bureau of Labor Statistics (BLS): http://www.bls.gov/. Select Employment, Hours, and Earnings from the Current Employment Statistics survey (National). 30 PART 1 • Introduction: Markets and Prices ) 105 90 75 60 45 30 15 0 Consumption Price 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year FIGURE 2.8 CONSUMPTION AND PRICE OF COPPER Although annual consumption of copper has increased about a hundredfold, the real (inflationadjusted) price has not changed much. shows the price of copper in real terms (adjusted for inflation), together with the quantity consumed from 1880 to 2010. (Both are shown as an index, with 1880 = 1.) Despite short-term variations in price, no significant long-term increase has occurred, even though annual consumption is now about 100 times greater than in 1880. Similar patterns hold for other mineral resources, such as iron, oil, and coal.4 How can we explain this huge increase in copper consumption but very little change in price? The answer is shown graphically in Figure 2.9. As you can see from that figure, the demands for these resources grew along with the world economy. But as demand grew, production costs fell. The decline in costs was due, first, to the discovery of new and bigger deposits that were cheaper to mine, and then to technical progress and the economic advantage of mining and refining on a large scale. As a result, the supply curve shifted over time to the right. Over the long term, because increases in supply were 4The index of U.S. copper consumption was around 102 in 1999 and 2000 but then dropped off significantly due to falling demand from 2001 to 2006. Consumption data (1880–1899) and price data (1880–1969) in Figure 2.8 are from Robert S. Manthy, Natural Resource Commodities—A Century of Statistics (Baltimore: Johns Hopkins University Press, 1978). More recent price (1970–2010) and consumption data (1970–2010) are from the U.S. Geological Survey—Minerals Information, Copper Statistics and Information (http://minerals.usgs.gov/). FIGURE 2.9 LONG-RUN MOVEMENTS OF SUPPLY AND DEMAND FOR MINERAL RESOURCES Although demand for most resources has increased dramatically over the past century, prices have fallen or risen only slightly in real (inflation-adjusted) terms because cost reductions have shifted the supply curve to the right just as dramatically. CHAPTER 2 • The Basics of Supply and Demand 31 Price S1900 S1950 S2000 Long-Run Path of Price and Consumption D1900 D1950 D2000 Quantity greater than increases in demand, price often fell, as shown in Figure 2.9. This is not to say that the prices of copper, iron, and coal will decline or remain constant forever. After all, these resources are finite. But as prices begin to rise, consumption will likely shift, at least in part, to substitute materials. Copper, for example, has already been replaced in many applications by aluminum and, more recently, in electronic applications by fiber optics. (See Example 2.8 for a more detailed discussion of copper prices.) EXAM PLE 2.4 THE EFFECTS OF 9/11 ON THE SUPPLY AND DEMAND FOR NEW YORK CITY OFFICE SPACE The September 11, 2001, terrorist attack on the World Trade Center (WTC) complex damaged or destroyed 21 buildings, accounting for 31.2 million square feet (msf) of Manhattan office space—nearly 10 percent of the city’s entire inventory. Just prior to the attack, the Manhattan office vacancy rate was 8.0 percent, and the average asking rent was $52.50 per square foot (psf). Given the huge unexpected reduction in the quantity of office space supplied, we might expect the equilibrium rental price of office space to increase and, as a result, the equilibrium quantity of rented office space to decrease. And because it takes time to construct new office buildings and restore damaged ones, we might also expect the vacancy rate to decline sharply. Surprisingly, however, the vacancy rate in Manhattan increased from 8.0 percent in August 2001 to 9.3 percent in November 2001. Moreover, the average rental price fell from $52.50 to $50.75 per square foot. In downtown Manhattan, the location of the Trade Center, the changes were even more dramatic: The vacancy rate rose from 7.5 percent to 10.6 perc |
ent, and the average rental price fell nearly 8 percent, to $41.81. What happened? Rental prices fell because the demand for office space fell. Figure 2.10 describes the market for office space in downtown Manhattan. The supply and demand curves before 9/11 appear as SAug and DAug. The equilibrium price and quantity of downtown Manhattan office space were $45.34 psf and 76.4 msf, respectively. The reduction in supply from August until November is indicated by a leftward shift in the supply curve (from SAug to S’Nov); the result is a higher equilibrium price P’ and a lower 32 PART 1 • Introduction: Markets and Prices Price ($/psf) P′ 45.34 41.81 FIGURE 2.10 SUPPLY AND DEMAND FOR NEW YORK CITY OFFICE SPACE Following 9/11 the supply curve shifted to the left, but the demand curve also shifted to the left, so that the average rental price fell. S′ Nov SAug DAug D′ Nov 0 57.2 Q′ 76.4 Quantity (msf) equilibrium quantity, Q’. This is the outcome that most forecasters predicted for the months following September 11. Many forecasters, however, failed to predict the significant decrease in demand for office space complementing the loss in supply. First, many firms, both displaced and non-displaced, chose not to relocate downtown because of quality-of-life concerns (i.e., the WTC ruins, pollution, disabled transportation, and aging inventory). Firms displaced by the attack were also forced to reevaluate their office-space needs, and they ultimately repurchased a little more than 50 percent of their original office space in Manhattan. Others left Manhattan but stayed in New York City; still others moved to New Jersey.5 Furthermore, in late 2001, the U.S. economy was experiencing an economic slowdown (exacerbated by the events of September 11) that further reduced the demand for office space. Therefore, the cumulative decrease in demand (a shift from DAug to D’Nov ) actually caused the average rental price of downtown Manhattan office space to decrease rather than increase in the months following September 11. By November, even though the price had fallen to $41.81, there were 57.2 msf on the market. There is evidence that office real estate markets in other major U.S. cities experienced similar surges in vacancy rates following 9/11. For instance, in Chicago, not only did vacancy rates increase in downtown office buildings, this increase was significantly more pronounced in properties in or near landmark buildings that are considered preferred targets for terrorist attacks.6 The Manhattan commercial real estate market bounced back strongly after 2001. In 2007, the office vacancy rate in Manhattan was 5.8 percent, its lowest figure since 9/11 and the average asking rent was over $74 psf. By May 2009, the vacancy rate had risen above 13 percent. Financial services firms occupy more than a quarter of Manhattan office space, and with the financial crisis came a slump in commercial real estate. Goldman Sachs, for example, vacated more than 1 million square feet of office space. On the supply side, the new skyscraper at the northwest corner of the World Trade Center site will add 2.6 million square feet of office space upon completion. 5See Jason Bram, James Orr, and Carol Rapaport, “Measuring the Effects of the September 11 Attack on New York City,” Federal Reserve Bank of New York, Economic Policy Review, November, 2002. 6See Alberto Abadie and Sofia Dermisi, “Is Terrorism Eroding Agglomeration Economies in Central Business Districts? Lessons from the Office Real Estate Market in Downtown Chicago,” National Bureau of Economic Research, Working Paper 12678, November, 2006. CHAPTER 2 • The Basics of Supply and Demand 33 • elasticity Percentage change in one variable resulting from a 1-percent increase in another. • price elasticity of demand Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price. 2.4 Elasticities of Supply and Demand We have seen that the demand for a good depends not only on its price, but also on consumer income and on the prices of other goods. Likewise, supply depends both on price and on variables that affect production cost. For example, if the price of coffee increases, the quantity demanded will fall and the quantity supplied will rise. Often, however, we want to know how much the quantity supplied or demanded will rise or fall. How sensitive is the demand for coffee to its price? If price increases by 10 percent, how much will the quantity demanded change? How much will it change if income rises by 5 percent? We use elasticities to answer questions like these. An elasticity measures the sensitivity of one variable to another. Specifically, it is a number that tells us the percentage change that will occur in one variable in response to a 1-percent increase in another variable. For example, the price elasticity of demand measures the sensitivity of quantity demanded to price changes. It tells us what the percentage change in the quantity demanded for a good will be following a 1-percent increase in the price of that good. PRICE ELASTICITY OF DEMAND Let’s look at this in more detail. We write the price elasticity of demand, Ep, as Ep = (,Q)/(,P) where % Q means “percentage change in quantity demanded” and %P means “percentage change in price.” (The symbol is the Greek capital letter delta; it means “the change in.” So X means “the change in the variable X,” say, from one year to the next.) The percentage change in a variable is just the absolute change in the variable divided by the original level of the variable. (If the Consumer Price Index were 200 at the beginning of the year and increased to 204 by the end of the year, the percentage change—or annual rate of inflation—would be 4/200 = .02, or 2 percent.) Thus we can also write the price elasticity of demand as follows:7 = Ep Q/Q P/P = P Q Q P (2.1) The price elasticity of demand is usually a negative number. When the price of a good increases, the quantity demanded usually falls. Thus Q/P (the change in quantity for a change in price) is negative, as is Ep. Sometimes we refer to the magnitude of the price elasticity—i.e., its absolute size. For example, if Ep = -2, we say that the elasticity is 2 in magnitude. When the price elasticity is greater than 1 in magnitude, we say that demand is price elastic because the percentage decline in quantity demanded is greater than the percentage increase in price. If the price elasticity is less than 1 in magnitude, demand is said to be price inelastic. In general, the price elasticity of demand for a good depends on the availability of other goods that can be substituted for it. When there are close substitutes, a price increase will cause the consumer to buy less of the good and more of the substitute. Demand will then be highly price elastic. When there are no close substitutes, demand will tend to be price inelastic. 7In terms of infinitesimal changes (letting the P become very small), Ep = (P/Q)(dQ/dP). 34 PART 1 • Introduction: Markets and Prices FIGURE 2.11 LINEAR DEMAND CURVE The price elasticity of demand depends not only on the slope of the demand curve but also on the price and quantity. The elasticity, therefore, varies along the curve as price and quantity change. Slope is constant for this linear demand curve. Near the top, because price is high and quantity is small, the elasticity is large in magnitude. The elasticity becomes smaller as we move down the curve. Price 4 Ep = – Q = 8 – 2P 2 Ep = –1 Ep = 0 4 8 Quantity • linear demand curve Demand curve that is a straight line. • infinitely elastic demand Principle that consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit. • completely inelastic demand Principle that consumers will buy a fixed quantity of a good regardless of its price. LINEAR DEMAND CURVE Equation (2.1) says that the price elasticity of demand is the change in quantity associated with a change in price (Q/P) times the ratio of price to quantity (P/Q). But as we move down the demand curve, Q/Pmay change, and the price and quantity will always change. Therefore, the price elasticity of demand must be measured at a particular point on the demand curve and will generally change as we move along the curve. This principle is easiest to see for a linear demand curve—that is, a demand curve of the form Q = a - bP As an example, consider the demand curve Q = 8 - 2P For this curve, Q/P is constant and equal to -2 (a P of 1 results in a Q of -2). However, the curve does not have a constant elasticity. Observe from Figure 2.11 that as we move down the curve, the ratio P/Q falls; the elasticity therefore decreases in magnitude. Near the intersection of the curve with = -2(P/Q) is large in magnitude. When the price axis, Q is very small, so Ep P = 2 and Q = 4 , Ep = -1. At the intersection with the quantity axis, P = 0 so EP = 0. Because we draw demand (and supply) curves with price on the vertical axis and quantity on the horizontal axis, Q/P = (1/slope of curve). As a result, for any price and quantity combination, the steeper the slope of the curve, the less elastic is demand. Figure 2.12 shows two special cases. Figure 2.12(a) shows a demand curve reflecting infinitely elastic demand: Consumers will buy as much as they can at a single price P*. For even the smallest increase in price above this level, quantity demanded drops to zero, and for any decrease in price, quantity demanded increases without limit. The demand curve in Figure 2.12(b), on the other hand, reflects completely inelastic demand: Consumers will buy a fixed quantity Q*, no matter what the price. OTHER DEMAND ELASTICITIES We will also be interested in elasticities of demand with respect to other variables besides price. For example, demand for most goods usually rises when aggregate income rises. The income elasticity of CHAPTER 2 • |
The Basics of Supply and Demand 35 Price D Price P* D Quantity (a) Q* Quantity (b) FIGURE 2.12 (a) INFINITELY ELASTIC DEMAND (b) COMPLETELY INELASTIC DEMAND (a) For a horizontal demand curve, Q/P is infinite. Because a tiny change in price leads to an enormous change in demand, the elasticity of demand is infinite. (b) For a vertical demand curve, Q/P is zero. Because the quantity demanded is the same no matter what the price, the elasticity of demand is zero. demand is the percentage change in the quantity demanded, Q, resulting from a 1-percent increase in income I: • income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income. EI = Q/Q I/I = I Q Q I (2.2) The demand for some goods is also affected by the prices of other goods. For example, because butter and margarine can easily be substituted for each other, the demand for each depends on the price of the other. A cross-price elasticity of demand refers to the percentage change in the quantity demanded for a good that results from a 1-percent increase in the price of another good. So the elasticity of demand for butter with respect to the price of margarine would be written as • cross-price elasticity of demand Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another. EQbPm = Qb/Qb Pm/Pm = Pm Qb Qb Pm (2.3) where Qb is the quantity of butter and Pm is the price of margarine. In this example, the cross-price elasticities will be positive because the goods are substitutes: Because they compete in the market, a rise in the price of margarine, which makes butter cheaper relative to margarine, leads to an increase in the quantity of butter demanded. (Because the demand curve for butter will shift to the right, the price of butter will rise.) But this is not always the case. Some goods are complements: Because they tend to be used together, an increase in the price of one tends to push down the consumption of the other. Take gasoline and motor oil. If the price of gasoline goes up, the quantity of 36 PART 1 • Introduction: Markets and Prices • price elasticity of supply Percentage change in quantity supplied resulting from a 1-percent increase in price. • point elasticity of demand Price elasticity at a particular point on the demand curve. gasoline demanded falls—motorists will drive less. And because people are driving less, the demand for motor oil also falls. (The entire demand curve for motor oil shifts to the left.) Thus, the cross-price elasticity of motor oil with respect to gasoline is negative. ELASTICITIES OF SUPPLY Elasticities of supply are defined in a similar manner. The price elasticity of supply is the percentage change in the quantity supplied resulting from a 1-percent increase in price. This elasticity is usually positive because a higher price gives producers an incentive to increase output. We can also refer to elasticities of supply with respect to such variables as interest rates, wage rates, and the prices of raw materials and other intermediate goods used to manufacture the product in question. For example, for most manufactured goods, the elasticities of supply with respect to the prices of raw materials are negative. An increase in the price of a raw material input means higher costs for the firm; other things being equal, therefore, the quantity supplied will fall. Point versus Arc Elasticities So far, we have considered elasticities at a particular point on the demand curve or the supply curve. These are called point elasticities. The point elasticity of demand, for example, is the price elasticity of demand at a particular point on the demand curve and is defined by Equation (2.1). As we demonstrated in Figure 2.11 using a linear demand curve, the point elasticity of demand can vary depending on where it is measured along the demand curve. There are times, however, when we want to calculate a price elasticity over some portion of the demand curve (or supply curve) rather than at a single point. Suppose, for example, that we are contemplating an increase in the price of a product from $8.00 to $10.00 and expect the quantity demanded to fall from 6 units to 4. How should we calculate the price elasticity of demand? Is the price increase 25 percent (a $2 increase divided by the original price of $8), or is it 20 percent (a $2 increase divided by the new price of $10)? Is the percentage decrease in quantity demanded 33 1/3 percent (2/6) or 50 percent (2/4)? There is no correct answer to such questions. We could calculate the price elasticity using the original price and quantity. If so, we would find that = (-33 1/3 percent/25 percent) = -1.33. Or we could use the new price Ep = (-50 percent/20 percent) and quantity, in which case we would find that Ep = -2.5. The difference between these two calculated elastici ties is large, and neither seems preferable to the other. • arc elasticity of demand Price elasticity calculated over a range of prices. ARC ELASTICITY OF DEMAND We can resolve this problem by using the arc elasticity of demand: the elasticity calculated over a range of prices. Rather than choose either the initial or the final price, we use an average of the two, P; for the quantity demanded, we use Q. Thus the arc elasticity of demand is given by Arc elasticity: Ep = (Q/P)(P/Q) (2.4) In our example, the average price is $9 and the average quantity 5 units. Thus the arc elasticity is Ep = (-2/$2)($9/5) = -1.8 CHAPTER 2 • The Basics of Supply and Demand 37 The arc elasticity will always lie somewhere (but not necessarily halfway) between the point elasticities calculated at the lower and the higher prices. Although the arc elasticity of demand is sometimes useful, economists generally use the word “elasticity” to refer to a point elasticity. Throughout the rest of this book, we will do the same, unless noted otherwise. EXAM PLE 2.5 THE MARKET FOR WHEAT Wheat is an important agricultural commodity, and the wheat market has been studied extensively by agricultural economists. During recent decades, changes in the wheat market had major implications for both American farmers and U.S. agricultural policy. To understand what happened, let’s examine the behavior of supply and demand beginning in 1981. From statistical studies, we know that for 1981 the supply curve for wheat was approximately as follows:8 Supply: QS = 1800 + 240P where price is measured in nominal dollars per bushel and quantities in millions of bushels per year. These studies also indicate that in 1981, the demand curve for wheat was Demand: QD = 3550 - 266P By setting the quantity supplied equal to the quantity demanded, we can determine the market-clearing price of wheat for 1981: QS = QD 1800 + 240P = 3550 - 266P 506P = 1750 P = $3.46 per bushel To find the market-clearing quantity, substitute this price of $3.46 into either the supply curve equation or the demand curve equation. Substituting into the supply curve equation, we get Q = 1800 + (240)(3.46) = 2630 million bushels 8For a survey of statistical studies of the demand and supply of wheat and an analysis of evolving market conditions, see Larry Salathe and Sudchada Langley, “An Empirical Analysis of Alternative Export Subsidy Programs for U.S. Wheat,” Agricultural Economics Research 38:1 (Winter 1986). The supply and demand curves in this example are based on the studies they surveyed. 38 PART 1 • Introduction: Markets and Prices What are the price elasticities of demand and supply at this price and quantity? We use the demand curve to find the price elasticity of demand: D = EP P Q QD P = 3.46 2630 ( -266) = -0.35 Thus demand is inelastic. We can likewise calculate the price elasticity of supply: S = E P P Q QS P = 3.46 2630 (240) = 0.32 Because these supply and demand curves are linear, the price elasticities will vary as we move along the curves. For example, suppose that a drought caused the supply curve to shift far enough to the left to push the price up to $4.00 per bushel. In this case, the quantity demanded would fall to 3550 - (266)(4.00) = 2486 million bushels. At this price and quantity, the elasticity of demand would be D = EP 4.00 2486 ( -266) = - 0.43 The wheat market has evolved over the years, in part because of changes in demand. The demand for wheat has two components: domestic (demand by U.S. consumers) and export (demand by foreign consumers). During the 1980s and 1990s, domestic demand for wheat rose only slightly (due to modest increases in population and income). Export demand, however, fell sharply. There were several reasons. First and foremost was the success of the Green Revolution in agriculture: Developing countries like India, which had been large importers of wheat, became increasingly self-sufficient. In addition, European countries adopted protectionist policies that subsidized their own production and imposed tariff barriers against imported wheat. In 2007, demand and supply were Demand: QD Supply: QS = 2900 - 125P = 1460 + 115P Once again, equating quantity supplied and quantity demanded yields the market-clearing (nominal) price and quantity: 1460 + 115P = 2900 - 125P P = $6.00 per bushel Q = 1460 + (115)(6) = 2150 million bushels CHAPTER 2 • The Basics of Supply and Demand 39 Thus the price of wheat (in nominal terms) rose considerably since 1981. In fact, nearly all of this increase occurred during 2005 to 2007. (In 2002, for example, the price of wheat was only $2.78 per bushel.) The causes? Dry weather in 2005, even dryer weather in 2006, and heavy rains in 2007 combined with increased export demand. You can check to see that, at the 2007 price and quantity, the price elasticity of demand was - 0.35 and the price elasticity of supply 0.32. Given these low elasticities, it is not surprising that the price of wheat rose so sharply.9 International demand for U. S. wheat fluctuates with the weather and political conditions in other major wheat producing c |
ountries, such as China, India and Russia. Between 2008 and 2010, U.S. wheat exports fell by 30% in the face of robust international production, so the price of wheat reached a low of $4.87 in 2010, down from $6.48 two years earlier. Inclement weather led to shortfalls in 2011, however, and U.S. exports shot up by 33%, driving the price up to $5.70 in 2011. We found that the market-clearing price of wheat was $3.46 in 1981, but in fact the price was greater than this. Why? Because the U.S. government bought wheat through its price support program. In addition, farmers have been receiving direct subsidies for the wheat they produce. This aid to farmers (at the expense of taxpayers) has increased in magnitude. In 2002—and again in 2008—Congress passed legislation continuing (and in some cases expanding) subsidies to farmers. The Food, Conservation, and Energy Act of 2008 authorized farm aid through 2012, at a projected cost of $284 billion over five years. Recent U.S. budget crises, however, have given support to those in Congress who feel these subsidies should end.10 Agricultural policies that support farmers exist in the United States, Europe, Japan, and many other countries. We discuss how these policies work, and evaluate the costs and benefits for consumers, farmers, and the government budget in Chapter 9. 2.5 Short-Run versus Long-Run Elasticities When analyzing demand and supply, we must distinguish between the short run and the long run. In other words, if we ask how much demand or supply changes in response to a change in price, we must be clear about how much time is allowed to pass before we measure the changes in the quantity demanded or supplied. If we allow only a short time to pass—say, one year or less—then we are dealing with the short run. When we refer to the long run we mean that enough time is allowed for consumers or producers to adjust fully to the price change. In general, short-run demand and supply curves look very different from their long-run counterparts. 9These are short-run elasticity estimates from Economics Research Service (ERS) of the U.S. Department of Agriculture (USDA). For more information, consult the following publications: William Lin, Paul C. Westcott, Robert Skinner, Scott Sanford, and Daniel G. De La Torre Ugarte, Supply Response Under the 1996 Farm Act and Implications for the U.S. Field Crops Sector (Technical Bulletin No. 1888, ERS, USDA, July 2000, http://www.ers.usda.gov/); and James Barnes and Dennis Shields, The Growth in U.S. Wheat Food Demand (Wheat Situation and Outlook Yearbook, WHS-1998, http://www.ers.usda.gov/). 10For more information on past farm bills: http://www.ers.usda.gov/farmbill/2008/. 40 PART 1 • Introduction: Markets and Prices Demand For many goods, demand is much more price elastic in the long run than in the short run. For one thing, it takes time for people to change their consumption habits. For example, even if the price of coffee rises sharply, the quantity demanded will fall only gradually as consumers begin to drink less. In addition, the demand for a good might be linked to the stock of another good that changes only slowly. For example, the demand for gasoline is much more elastic in the long run than in the short run. A sharply higher price of gasoline reduces the quantity demanded in the short run by causing motorists to drive less, but it has its greatest impact on demand by inducing consumers to buy smaller and more fuel-efficient cars. But because the stock of cars changes only slowly, the quantity of gasoline demanded falls only slowly. Figure 2.13(a) shows short-run and long-run demand curves for goods such as these. DEMAND AND DURABILITY On the other hand, for some goods just the opposite is true—demand is more elastic in the short run than in the long run. Because these goods (automobiles, refrigerators, televisions, or the capital equipment purchased by industry) are durable, the total stock of each good owned by Price DSR Price DLR DLR Quantity (a) (b) DSR Quantity FIGURE 2.13 (a) GASOLINE: SHORT-RUN AND LONG-RUN DEMAND CURVES (b) AUTOMOBILES: SHORT-RUN AND LONG-RUN DEMAND CURVES (a) In the short run, an increase in price has only a small effect on the quantity of gasoline demanded. Motorists may drive less, but they will not change the kinds of cars they are driving overnight. In the longer run, however, because they will shift to smaller and more fuel-efficient cars, the effect of the price increase will be larger. Demand, therefore, is more elastic in the long run than in the short run. (b) The opposite is true for automobile demand. If price increases, consumers initially defer buying new cars; thus annual quantity demanded falls sharply. In the longer run, however, old cars wear out and must be replaced; thus annual quantity demanded picks up. Demand, therefore, is less elastic in the long run than in the short run. CHAPTER 2 • The Basics of Supply and Demand 41 consumers is large relative to annual production. As a result, a small change in the total stock that consumers want to hold can result in a large percentage change in the level of purchases. Suppose, for example, that the price of refrigerators goes up 10 percent, causing the total stock of refrigerators that consumers want to hold to drop 5 percent. Initially, this will cause purchases of new refrigerators to drop much more than 5 percent. But eventually, as consumers’ refrigerators depreciate (and units must be replaced), the quantity demanded will increase again. In the long run, the total stock of refrigerators owned by consumers will be about 5 percent less than before the price increase. In this case, while the long-run price elasticity of demand for refrigerators would be -.05/.10 = -0.5, the short-run elasticity would be much larger in magnitude. Or consider automobiles. Although annual U.S. demand—new car purchases—is about 10 to 12 million, the stock of cars that people own is around 130 million. If automobile prices rise, many people will delay buying new cars. The quantity demanded will fall sharply, even though the total stock of cars that consumers might want to own at these higher prices falls only a small amount. Eventually, however, because old cars wear out and must be replaced, the quantity of new cars demanded picks up again. As a result, the long-run change in the quantity demanded is much smaller than the shortrun change. Figure 2.13(b) shows demand curves for a durable good like automobiles. INCOME ELASTICITIES Income elasticities also differ from the short run to the long run. For most goods and services—foods, beverages, fuel, entertainment, etc.—the income elasticity of demand is larger in the long run than in the short run. Consider the behavior of gasoline consumption during a period of strong economic growth during which aggregate income rises by 10 percent. Eventually people will increase gasoline consumption because they can afford to take more trips and perhaps own larger cars. But this change in consumption takes time, and demand initially increases only by a small amount. Thus, the long-run elasticity will be larger than the short-run elasticity. For a durable good, the opposite is true. Again, consider automobiles. If aggregate income rises by 10 percent, the total stock of cars that consumers will want to own will also rise—say, by 5 percent. But this change means a much larger increase in current purchases of cars. (If the stock is 130 million, a 5-percent increase is 6.5 million, which might be about 60 to 70 percent of normal demand in a single year.) Eventually consumers succeed in increasing the total number of cars owned; after the stock has been rebuilt, new purchases are made largely to replace old cars. (These new purchases will still be greater than before because a larger stock of cars outstanding means that more cars need to be replaced each year.) Clearly, the short-run income elasticity of demand will be much larger than the long-run elasticity. CYCLICAL INDUSTRIES Because the demands for durable goods fluctuate so sharply in response to short-run changes in income, the industries that produce these goods are quite vulnerable to changing macroeconomic conditions, and in particular to the business cycle—recessions and booms. Thus, these industries are often called cyclical industries—their sales patterns tend Industries • cyclical industries in which sales tend to magnify cyclical changes in gross domestic product and national income. 42 PART 1 • Introduction: Markets and Prices ) 20 15 10 5 0 5 10 15 20 GDP Equipment Investment 1950 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 FIGURE 2.14 GDP AND INVESTMENT IN DURABLE EQUIPMENT Annual growth rates are compared for GDP and investment in durable equipment. Because the short-run GDP elasticity of demand is larger than the long-run elasticity for long-lived capital equipment, changes in investment in equipment magnify changes in GDP. Thus capital goods industries are considered “cyclical.” to magnify cyclical changes in gross domestic product (GDP) and national income. Figures 2.14 and 2.15 illustrate this principle. Figure 2.14 plots two variables over time: the annual real (inflation-adjusted) rate of growth of GDP and the annual real rate of growth of investment in producers’ durable equipment (i.e., machinery and other equipment purchased by firms). Note that although the durable equipment series follows the same pattern as the GDP series, the changes in GDP are magnified. For example, in 1961–1966 GDP grew by at least 4 percent each year. Purchases of durable equipment also grew, but by much more (over 10 percent in 1963–1966). Equipment investment likewise grew much more quickly than GDP during 1993–1998. On the other hand, during the recessions of 1974–1975, 1982, 1991, 2001, and 2008, equipment purchases fell by much more than GDP. Figure 2.15 also shows the real rate of growth of GDP, along with the annual real rates of growth of spe |
nding by consumers on durable goods (automobiles, appliances, etc.) and nondurable goods (food, fuel, clothing, etc.). Note that while both consumption series follow GDP, only the durable goods series tends to magnify changes in GDP. Changes in consumption of nondurables are roughly the same as changes in GDP, but changes in consumption of durables are usually several times larger. This is why companies CHAPTER 2 • The Basics of Supply and Demand 43 GDP 20 15 10 10 Durables Nondurables 1950 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 FIGURE 2.15 CONSUMPTION OF DURABLES VERSUS NONDURABLES Annual growth rates are compared for GDP, consumer expenditures on durable goods (automobiles, appliances, furniture, etc.), and consumer expenditures on nondurable goods (food, clothing, services, etc.). Because the stock of durables is large compared with annual demand, short-run demand elasticities are larger than long-run elasticities. Like capital equipment, industries that produce consumer durables are “cyclical” (i.e., changes in GDP are magnified). This is not true for producers of nondurables. such as General Motors and General Electric are considered “cyclical”: Sales of cars and electrical appliances are strongly affected by changing macroeconomic conditions. EXAM PLE 2.6 THE DEMAND FOR GASOLINE AND AUTOMOBILES Gasoline and automobiles exemplify some of the different characteristics of demand discussed above. They are complementary goods—an increase in the price of one tends to reduce the demand for the other. In addition, their respective dynamic behaviors (long-run versus short-run elasticities) are just the opposite from each other. For gasoline, the long-run price and income elasticities are larger than the short-run elasticities; for automobiles, the reverse is true. 44 PART 1 • Introduction: Markets and Prices TABLE 2.1 DEMAND FOR GASOLINE NUMBER OF YEARS ALLOWED TO PASS FOLLOWING A PRICE OR INCOME CHANGE ELASTICITY Price Income 1 –0.2 0.2 2 –0.3 0.4 3 –0.4 0.5 5 –0.5 0.6 10 –0.8 1.0 There have been a number of statistical studies of the demands for gasoline and automobiles. Here we report elasticity estimates based on several that emphasize the dynamic response of demand.11 Table 2.1 shows price and income elasticities of demand for gasoline in the United States for the short run, the long run, and just about everything in between. Note the large differences between the long-run and the short-run elasticities. Following the sharp increases that occurred in the price of gasoline with the rise of the OPEC oil cartel in 1974, many people (including executives in the automobile and oil industries) claimed that the quantity of gasoline demanded would not change much—that demand was not very elastic. Indeed, for the first year after the price rise, they were right. But demand did eventually change. It just took time for people to alter their driving habits and to replace large cars with smaller and more fuel-efficient ones. This response continued after the second sharp increase in oil prices that occurred in 1979–1980. It was partly because of this response that OPEC could not maintain oil prices above $30 per barrel, and prices fell. The oil and gasoline price increases that occurred in 2005–2011 likewise led to a gradual demand response. Table 2.2 shows price and income elasticities of demand for automobiles. Note that the short-run elasticities are much larger than the long-run TABLE 2.2 DEMAND FOR AUTOMOBILES NUMBER OF YEARS ALLOWED TO PASS FOLLOWING A PRICE OR INCOME CHANGE ELASTICITY Price Income 1 –1.2 3.0 2 –0.9 2.3 3 –0.8 1.9 5 –0.6 1.4 10 –0.4 1.0 11For gasoline and automobile demand studies and elasticity estimates, see R. S. Pindyck, The Structure of World Energy Demand (Cambridge, MA: MIT Press, 1979); Carol Dahl and Thomas Sterner, “Analyzing Gasoline Demand Elasticities: A Survey,” Energy Economics (July 1991); Molly Espey, “Gasoline Demand Revised: An International Meta-Analysis of Elasticities,” Energy Economics (July 1998); David L. Greene, James R. Kahn, and Robert C. Gibson, “Fuel Economy Rebound Effects for U.S. Household Vehicles,” The Energy Journal 20 (1999); Daniel Graham and Stephen Glaister, “The Demand for Automobile Fuel: A Survey of Elasticities,” Journal of Transport Economics and Policy 36 (January 2002); and Ian Parry and Kenneth Small, “Does Britain or the United States Have the Right Gasoline Tax?” American Economic Review 95 (2005). CHAPTER 2 • The Basics of Supply and Demand 45 elasticities. It should be clear from the income elasticities why the automobile industry is so highly cyclical. For example, GDP fell 2 percent in real (inflationadjusted) terms during the 1991 recession, but automobile sales fell by about 8 percent. Auto sales began to recover in 1993, and rose sharply between 1995 and 1999. During the 2008 recession, GDP fell by nearly 3 percent, and car and truck sales decreased by 21%. Sales began to recover in 2010, when they increased by nearly 10%. Supply Elasticities of supply also differ from the long run to the short run. For most products, long-run supply is much more price elastic than short-run supply: Firms face capacity constraints in the short run and need time to expand capacity by building new production facilities and hiring workers to staff them. This is not to say that the quantity supplied will not increase in the short run if price goes up sharply. Even in the short run, firms can increase output by using their existing facilities for more hours per week, paying workers to work overtime, and hiring some new workers immediately. But firms will be able to expand output much more when they have the time to expand their facilities and hire larger permanent workforces. For some goods and services, short-run supply is completely inelastic. Rental housing in most cities is an example. In the very short run, there is only a fixed number of rental units. Thus an increase in demand only pushes rents up. In the longer run, and without rent controls, higher rents provide an incentive to renovate existing buildings and construct new ones. As a result, the quantity supplied increases. For most goods, however, firms can find ways to increase output even in the short run—if the price incentive is strong enough. However, because various constraints make it costly to increase output rapidly, it may require large price increases to elicit small short-run increases in the quantity supplied. We discuss these characteristics of supply in more detail in Chapter 8. SUPPLY AND DURABILITY For some goods, supply is more elastic in the short run than in the long run. Such goods are durable and can be recycled as part of supply if price goes up. An example is the secondary supply of metals: the supply from scrap metal, which is often melted down and refabricated. When the price of copper goes up, it increases the incentive to convert scrap copper into new supply, so that, initially, secondary supply increases sharply. Eventually, however, the stock of good-quality scrap falls, making the melting, purifying, and refabricating more costly. Secondary supply then contracts. Thus the long-run price elasticity of secondary supply is smaller than the short-run elasticity. Figures 2.16(a) and 2.16(b) show short-run and long-run supply curves for primary (production from the mining and smelting of ore) and secondary copper production. Table 2.3 shows estimates of the elasticities for each component of supply and for total supply, based on a weighted average of the component elasticities.12 Because secondary supply is only about 20 percent of total supply, the price elasticity of total supply is larger in the long run than in the short run. 12These estimates were obtained by aggregating the regional estimates reported in Franklin M. Fisher, Paul H. Cootner, and Martin N. Baily, “An Econometric Model of the World Copper Industry,” Bell Journal of Economics 3 (Autumn 1972): 568–609. 46 PART 1 • Introduction: Markets and Prices Price SSR Price SLR SSR SLR Quantity Quantity (a) (b) FIGURE 2.16 COPPER: SHORT-RUN AND LONG-RUN SUPPLY CURVES Like that of most goods, the supply of primary copper, shown in part (a), is more elastic in the long run. If price increases, firms would like to produce more but are limited by capacity constraints in the short run. In the longer run, they can add to capacity and produce more. Part (b) shows supply curves for secondary copper. If the price increases, there is a greater incentive to convert scrap copper into new supply. Initially, therefore, secondary supply (i.e., supply from scrap) increases sharply. But later, as the stock of scrap falls, secondary supply contracts. Secondary supply is therefore less elastic in the long run than in the short run. TABLE 2.3 SUPPLY OF COPPER PRICE ELASTICITY OF: SHORT-RUN LONG-RUN Primary supply Secondary supply Total supply 0.20 0.43 0.25 1.60 0.31 1.50 E XAM PLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK Droughts or subfreezing weather occasionally destroy or damage many of Brazil’s coffee trees. Because Brazil is by far the world’s largest coffee producer the result is a decrease in the supply of coffee and a sharp run-up in its price. In July 1975, for example, a frost destroyed most of Brazil’s 1976–1977 coffee crop. (Remember that it is winter in Brazil when it is summer in the northern hemisphere.) As Figure 2.17 shows, the price of a pound of coffee in New York went from 68 cents in 1975 to $1.23 in 1976 and $2.70 in 1977. Prices fell but then jumped again in 1986, after a seven-month drought in 1985 ruined much of Brazil’s crop. Finally, starting in June 1994, freezing CHAPTER 2 • The Basics of Supply and Demand 47 ) 3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year FIGURE 2.17 PRICE OF BRAZILIAN COFFEE When droughts or freezes damage Brazil’s coffee trees, the price of coffee can soar. The price usually falls again afte |
r a few years, as demand and supply adjust. weather followed by a drought destroyed nearly half of Brazil’s crop. As a result, the price of coffee in 1994–1995 was about double its 1993 level. By 2002, however, the price had dropped to its lowest level in 30 years. (Researchers predict that over the next 50 years, global warming may eliminate as much as 60 percent of Brazil’s coffee-growing areas, resulting in a major decline in coffee production and an increase in prices. Should that happen, we will discuss it in the twentieth edition of this book.) The important point in Figure 2.17 is that any run-up in price following a freeze or drought is usually short-lived. Within a year, price begins to fall; within three or four years, it returns to its earlier levels. In 1978, for example, the price of coffee in New York fell to $1.48 per pound, and by 1983, it had fallen in real (inflation-adjusted) terms to within a few cents of its prefreeze 1975 price.13 Likewise, in 1987 the price of coffee fell to below its predrought 1984 level, and then continued declining until the 1994 freeze. After hitting a low of 45 cents per pound in 2002, coffee prices increased at an average rate of 17% per year, reaching $1.46—equal to the 1995 peak—in 2010. Brazilian coffee growers have worked to increase their production in the past decade, but bad weather has led to inconsistent crop yields. Coffee prices behave this way because both demand and supply (especially supply) are much more elastic in the long run than in the short run. Figure 2.18 illustrates this fact. Note from part (a) of the figure that in the very short run (within one or two months after a freeze), supply is completely inelastic: There are simply a fixed number of coffee beans, some of which have been damaged by the frost. Demand is also relatively inelastic. As a result of the frost, the supply curve shifts to the left, and price increases sharply, from P0 to P1. 13During 1980, however, prices temporarily went just above $2.00 per pound as a result of export quotas imposed under the International Coffee Agreement (ICA). The ICA is essentially a cartel agreement implemented by the coffee-producing countries in 1968. It has been largely ineffective and has seldom had an effect on the price. We discuss cartel pricing in detail in Chapter 12. 48 PART 1 • Introduction: Markets and Prices S′ S Price Price S′ S P2 P0 P0 Price P1 P0 S D D Q0 Quantity Q1 (a) D Q 2 Q0 Quantity (b) Q0 Quantity (c) FIGURE 2.18 SUPPLY AND DEMAND FOR COFFEE (a) A freeze or drought in Brazil causes the supply curve to shift to the left. In the short run, supply is completely inelastic; only a fixed number of coffee beans can be harvested. Demand is also relatively inelastic; consumers change their habits only slowly. As a result, the initial effect of the freeze is a sharp increase in price, from P0 to P1. (b) In the intermediate run, supply and demand are both more elastic; thus price falls part of the way back, to P2. (c) In the long run, supply is extremely elastic; because new coffee trees will have had time to mature, the effect of the freeze will have disappeared. Price returns to P0. In the intermediate run—say, one year after the freeze—both supply and demand are more elastic, supply because existing trees can be harvested more intensively (with some decrease in quality), and demand because consumers have had time to change their buying habits. As part (b) shows, although the intermediate-run supply curve also shifts to the left, price has come down from P1 to P2. The quantity supplied has also increased somewhat from the short run, from Q1 to Q2. In the long run shown in part (c), price returns to its normal level because growers have had time to replace trees damaged by the freeze. The long-run supply curve, then, simply reflects the cost of producing coffee, including the costs of land, of planting and caring for the trees, and of a competitive rate of profit.14 * 2.6 Understanding and Predicting the Effects of Changing Market Conditions So far, our discussion of supply and demand has been largely qualitative. To use supply and demand curves to analyze and predict the effects of changing market conditions, we must begin attaching numbers to them. For example, to see how a 50-percent reduction in the supply of Brazilian coffee may affect the world price of coffee, we must determine actual supply and demand 14You can learn more about the world coffee market from the Foreign Agriculture Service of the U.S. Department of Agriculture by visiting their Web site at http://www.fas.usda.gov/htp/coffee.asp. Another good source of information is http://www.nationalgeographic.com/coffee. CHAPTER 2 • The Basics of Supply and Demand 49 curves and then calculate the shifts in those curves and the resulting changes in price. In this section, we will see how to do simple “back of the envelope” calculations with linear supply and demand curves. Although they are often approximations of more complex curves, we use linear curves because they are easier to work with. It may come as a surprise, but one can do some informative economic analyses on the back of a small envelope with a pencil and a pocket calculator. First, we must learn how to “fit” linear demand and supply curves to market data. (By this we do not mean statistical fitting in the sense of linear regression or other statistical techniques, which we will discuss later in the book.) Suppose we have two sets of numbers for a particular market: The first set consists of the price and quantity that generally prevail in the market (i.e., the price and quantity that prevail “on average,” when the market is in equilibrium or when market conditions are “normal”). We call these numbers the equilibrium price and quantity and denote them by P* and Q*. The second set consists of the price elasticities of supply and demand for the market (at or near the equilibrium), which we denote by ES and ED, as before. These numbers may come from a statistical study done by someone else; they may be numbers that we simply think are reasonable; or they may be numbers that we want to try out on a “what if” basis. Our goal is to write down the supply and demand curves that fit (i.e., are consistent with) these numbers. We can then determine numerically how a change in a variable such as GDP, the price of another good, or some cost of production will cause supply or demand to shift and thereby affect market price and quantity. Let’s begin with the linear curves shown in Figure 2.19. We can write these curves algebraically as follows: Demand: Q = a - bP Q = c + dP Supply: (2.5a) (2.5b) Price a/b P* – c/d Supply: Q = c + dP ED = –b(P*/Q*) ES = d(P*/Q*) Demand: Q = a – bP Q* a Quantity FIGURE 2.19 FITTING LINEAR SUPPLY AND DEMAND CURVES TO DATA Linear supply and demand curves provide a convenient tool for analysis. Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the elasticities of demand and supply ED and ES, we can calculate the parameters c and d for the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The curves can then be used to analyze the behavior of the market quantitatively. 50 PART 1 • Introduction: Markets and Prices Our problem is to choose numbers for the constants a, b, c, and d. This is done, for supply and for demand, in a two-step procedure: Step 1: Recall that each price elasticity, whether of supply or demand, can be written as E = (P/Q)(Q/P) where Q/P is the change in quantity demanded or supplied resulting from a small change in price. For linear curves, Q/P is constant. From equations (2.5a) and (2.5b), we see that Q/P = d for supply and Q/P = -b for demand. Now, let’s substitute these values for Q/P into the elasticity formula: Demand: ED ES Supply: = -b(P*/Q*) = d(P*/Q*) (2.6a) (2.6b) where P* and Q* are the equilibrium price and quantity for which we have data and to which we want to fit the curves. Because we have numbers for ES, ED, P*, and Q*, we can substitute these numbers in equations (2.6a) and (2.6b) and solve for b and d. Step 2: Since we now know b and d, we can substitute these numbers, as well as P* and Q*, into equations (2.5a) and (2.5b) and solve for the remaining constants a and c. For example, we can rewrite equation (2.5a) as a = Q* + bP* and then use our data for Q* and P*, together with the number we calculated in Step 1 for b, to obtain a. Let’s apply this procedure to a specific example: long–run supply and demand for the world copper market. The relevant numbers for this market are as follows: Quantity Q* = 18 million metric tons per year (mmt/yr) Price P* = $3.00 per pound = 1.5 Elasticity of suppy ES Elasticity of demand ED = - 0.5. (The price of copper has fluctuated during the past few decades between $0.60 and more than $4.00, but $3.00 is a reasonable average price for 2008–2011). We begin with the supply curve equation (2.5b) and use our two-step procedure to calculate numbers for c and d. The long-run price elasticity of supply is 1.5, P* = $3.00, and Q* = 18. Step 1: Substitute these numbers in equation (2.6b) to determine d: 1.5 = d(3/18) = d/6 so that d = (1.5)(6) = 9. Step 2: Substitute this number for d, together with the numbers for P* and Q*, into equation (2.5b) to determine c: 18 = c + (9)(3.00) = c + 27 CHAPTER 2 • The Basics of Supply and Demand 51 so that c = 18 - 27 = -9. We now know c and d, so we can write our supply curve: Supply: Q = -9 + 9P We can now follow the same steps for the demand curve equation (2.5a). An estimate for the long-run elasticity of demand is −0.5.15 First, substitute this number, as well as the values for P* and Q*, into equation (2.6a) to determine b: -0.5 = -b(3/18) = -b/6 so that b = (0.5)(6) = 3. Second, substitute this value for b and the values for P* and Q* in equation (2.5a) to determine a: 18 = a = (3)(3) = a - 9 so that a = 18 + 9 = 27. Thus, our demand curve is: Demand: Q = 27 - 3P To check that we |
have not made a mistake, let’s set the quantity supplied equal to the quantity demanded and calculate the resulting equilibrium price: Supply = -9 + 9P = 27 - 3P = Demand 9P + 3P = 27 + 9 or P = 36/12 = 3.00, which is indeed the equilibrium price with which we began. Although we have written supply and demand so that they depend only on price, they could easily depend on other variables as well. Demand, for example, might depend on income as well as price. We would then write demand as Q = a - bP + fI (2.7) where I is an index of the aggregate income or GDP. For example, I might equal 1.0 in a base year and then rise or fall to reflect percentage increases or decreases in aggregate income. For our copper market example, a reasonable estimate for the long-run income elasticity of demand is 1.3. For the linear demand curve (2.7), we can then calculate f by using the formula for the income elasticity of demand: E = (I/Q)(Q/I). Taking the base value of I as 1.0, we have 1.3 = (1.0/18)( f ). Thus f = (1.3)(18)/(1.0) = 23.4. Finally, substituting the values b = 3, f = 23.4, P* = 3.00, and Q* = 18 into equation (2.7), we can calculate that a must equal 3.6. 15See Claudio Agostini, “Estimating Market Power in the U.S. Copper Industry,” Review of Industrial Organization 28 (2006), 1739. 52 PART 1 • Introduction: Markets and Prices We have seen how to fit linear supply and demand curves to data. Now, to see how these curves can be used to analyze markets, let’s look at Example 2.8, which deals with the behavior of copper prices, and Example 2.9, which concerns the world oil market. E XAM PLE 2.8 THE BEHAVIOR OF COPPER PRICES After reaching a level of about $1.00 per pound in 1980, the price of copper fell sharply to about 60 cents per pound in 1986. In real (inflation-adjusted) terms, this price was even lower than during the Great Depression 50 years earlier. Prices increased in 1988–1989 and in 1995, largely as a result of strikes by miners in Peru and Canada that disrupted supplies, but then fell again from 1996 through 2003. Prices increased sharply, however, between 2003 and 2007, and while copper fell along with many other commodities during the 2008–2009 recession, the price of copper had recovered by early 2010. Figure 2.20 shows the behavior of copper prices from 1965 to 2011 in both real and nominal terms. Worldwide recessions in 1980 and 1982 contributed to the decline of copper prices; as mentioned above, the income elasticity of copper demand is about 1.3. But copper demand did not pick up as the industrial economies recovered during the mid-1980s. Instead, the 1980s saw a steep decline in demand. The price decline through 2003 occurred for two reasons. First, a large part of copper consumption is Nominal Price Real Price (2000$) ) 440 420 400 380 360 340 320 300 280 260 240 220 200 180 160 140 120 100 80 60 40 20 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year FIGURE 2.20 COPPER PRICES, 1965–2011 Copper prices are shown in both nominal (no adjustment for inflation) and real (inflation-adjusted) terms. In real terms, copper prices declined steeply from the early 1970s through the mid-1980s as demand fell. In 1988–1990, copper prices rose in response to supply disruptions caused by strikes in Peru and Canada but later fell after the strikes ended. Prices declined during the 1996–2002 period but then increased sharply starting in 2005. CHAPTER 2 • The Basics of Supply and Demand 53 for the construction of equipment for electric power generation and transmission. But by the late 1970s, the growth rate of electric power generation had fallen dramatically in most industrialized countries. In the United States, for example, the growth rate fell from over 6 percent per annum in the 1960s and early 1970s to less than 2 percent in the late 1970s and 1980s. This decline meant a big drop in what had been a major source of copper demand. Second, in the 1980s, other materials, such as aluminum and fiber optics, were increasingly substituted for copper. Why did the price increase so sharply after 2003? First, the demand for copper from China and other Asian countries began increasing dramatically, replacing the demand from Europe and the U.S. Chinese copper consumption, for example, has nearly tripled since 2001. Second, because prices had dropped so much from 1996 through 2003, producers in the U.S., Canada, and Chile closed unprofitable mines and cut production. Between 2000 and 2003, for example, U.S. mine production of copper declined by 23 percent.16 One might expect increasing prices to stimulate investments in new mines and increases in production, and that is indeed what has happened. Arizona, for example, experienced a copper boom as Phelps Dodge opened a major new mine in 2007.17 By 2007, producers began to worry that prices would decline again, either as a result of these new investments or because demand from Asia would level off or even drop. P* = 3.00 P′ = 2.68 ) ′ D S Q′ = 15.1 Q* = 18 0 5 10 15 20 25 30 Quantity (million metric tons/yr) FIGURE 2.21 COPPER SUPPLY AND DEMAND The shift in the demand curve corresponding to a 20-percent decline in demand leads to a 10.7-percent decline in price. 16Our thanks to Patricia Foley, Executive Director of the American Bureau of Metal Statistics, for supplying the data on China. Other data are from the Monthly Reports of the U.S. Geological Survey Mineral Resources Program—http://minerals.usgs.gov/minerals/pubs/copper. 17The boom created hundreds of new jobs, which in turn led to increases in housing prices: “Copper Boom Creates Housing Crunch,” The Arizona Republic, July 12, 2007. 54 PART 1 • Introduction: Markets and Prices What would a decline in demand do to the price of copper? To find out, we can use the linear supply and demand curves that we just derived. Let’s calculate the effect on price of a 20-percent decline in demand. Because we are not concerned here with the effects of GDP growth, we can leave the income term, fI, out of the demand equation. We want to shift the demand curve to the left by 20 percent. In other words, we want the quantity demanded to be 80 percent of what it would be otherwise for every value of price. For our linear demand curve, we simply multiply the right–hand side by 0.8: Q = (0.8)(27 - 3P ) = 21.6 - 2.4P Supply is again Q = -9 + 9P. Now we can equate the quantity supplied and the quantity demanded and solve for price: -9 + 9P = 21.6 - 2.4P or P = 30.6/11.4 = $2.68 per pound. A decline in demand of 20 percent, therefore, entails a drop in price of roughly 32 cents per pound, or 10.7 percent.18 EXAMPLE 2.9 UPHEAVAL IN THE WORLD OIL MARKET Since the early 1970s, the world oil market has been buffeted by the OPEC cartel and by political turmoil in the Persian Gulf. In 1974, by collectively restraining output, OPEC (the Organization of Petroleum Exporting Countries) pushed world oil prices well above what they would have been in a competitive market. OPEC could do this because it accounted for much of world oil production. During 1979–1980, oil prices shot up again, as the Iranian revolution and the outbreak of the Iran-Iraq war sharply reduced Iranian and Iraqi production. During the 1980s, the price gradually declined, as demand fell and competitive (i.e., non-OPEC) supply rose in response to price. Prices remained relatively stable during 1988–2001, except for a temporary spike in 1990 following the Iraqi invasion of Kuwait. Prices increased again in 2002–2003 as a result of a strike in Venezuela and then the war with Iraq that began in the spring of 2003. Oil prices continued to increase through the summer of 2008 as a result of rising demand in Asia and reductions in OPEC output. By the end of 2008, the recession had reduced demand around the world, leading prices to plummet 127% in six months. Between 2009 and 2011, oil prices have gradually recovered, partially buoyed by China’s continuing growth. Figure 2.22 shows the world price of oil from 1970 to 2011, in both nominal and real terms.19 The Persian Gulf is one of the less stable regions of the world—a fact that has led to concern over the possibility of new oil supply disruptions and sharp increases in oil prices. What would happen to oil prices—in both the 18Note that because we have multiplied the demand function by 0.8—i.e., reduced the quantity demanded at every price by 20 percent—the new demand curve is not parallel to the old one. Instead, the curve rotates downward at its intersection with the price axis. 19For a nice overview of the factors that have affected world oil prices, see James D. Hamilton, “Understanding Crude Oil Prices,” The Energy Journal, 2009, Vol. 30, pp. 179–206. CHAPTER 2 • The Basics of Supply and Demand 55 ) 140 120 100 80 60 40 20 0 Real Price (2000$) Nominal Price 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year FIGURE 2.22 PRICE OF CRUDE OIL The OPEC cartel and political events caused the price of oil to rise sharply at times. It later fell as supply and demand adjusted. short run and longer run—if a war or revolution in the Persian Gulf caused a sharp cutback in oil production? Let’s see how simple supply and demand curves can be used to predict the outcome of such an event. Because this example is set in 2009–2011, all prices are measured in 2011 dollars. Here are some rough figures: • 2009–2011 world price = $80 per barrel • World demand and total supply = 32 billion barrels per year (bb/yr) • OPEC supply = 13 bb/yr • Competitive (non-OPEC) supply = 19 bb/yr The following table gives price elasticity estimates for oil supply and demand:20 SHORT RUN LONG RUN World demand: Competitive supply: –0.05 0.05 –0.30 0.30 20For the sources of these numbers and a more detailed discussion of OPEC oil pricing, see Robert S. Pindyck, “Gains to Producers from the Cartelization of Exhaustible Resources,” Review of Economics and Statistics 60 (May 1978): 238–51; James M. Griffin and David J. Teece, OPEC Behavior and World Oil Prices (London: Alle |
n and Unwin, 1982); and John C. B. Cooper, “Price Elasticity of Demand for Crude Oil: Estimates for 23 Countries,” Organization of the Petroleum Exporting Countries Review (March 2003). 56 PART 1 • Introduction: Markets and Prices You should verify that these numbers imply the following for demand and competitive supply in the short run: Short-run demand: D = 33.6 - .020P Short-run competitive demand: SC = 18.05 + 0.012P Of course, total supply is competitive supply plus OPEC supply, which we take as constant at 13 bb/yr. Adding this 13 bb/yr to the competitive supply curve above, we obtain the following for the total short-run supply: Short@run total supply: ST = 31.05 + 0.012P You should verify that the quantity demanded and the total quantity supplied are equal at an equilibrium price of $80 per barrel. You should also verify that the corresponding demand and supply curves for the long run are as follows: Long@run demand: D = 41.6 - 0.120P = 13.3 + 0.071P = 26.3 + 0.071P Long-run competitive supply: SC Long@run total supply: ST Again, you can check that the quantities supplied and demanded equate at a price of $80. Saudi Arabia is one of the world’s largest oil producers, accounting for roughly 3 bb/yr, which is nearly 10 percent of total world production. What would happen to the price of oil if, because of war or political upheaval, Saudi Arabia stopped producing oil? We can use our supply and demand curves to find out. For the short run, simply subtract 3 from short-run total supply: Short@run demand: D = 33.6 - .020P Short@run total demand: ST = 28.05 + 0.012P By equating this total quantity supplied with the quantity demanded, we can see that in the short run, the price will more than double to $173.44 per barrel. Figure 2.23 shows this supply shift and the resulting short-run increase in price. The initial equilibrium is at the intersection of ST and D. After the drop in Saudi production, the equilibrium occurs where S'T and D cross. In the long run, however, things will be different. Because both demand and competitive supply are more elastic in the long run, the 3 bb/yr cut in oil production will no longer support such a high price. Subtracting 3 from long-run total supply and equating with long-run demand, we can see that the price will fall to $95.81, only $15.81 above the initial $80 price. Thus, if Saudi Arabia suddenly stops producing oil, we should expect to see about a doubling in price. However, we should also expect to see the price gradually decline afterward, as demand falls and competitive supply rises. CHAPTER 2 • The Basics of Supply and Demand 57 SC S T ST D P = 173.44 P* = 80.00 0 5 10 15 20 25 30 35 40 Quantity (billion barrels/yr) Q* = 32 D SC S T ST P′= 95.81 P*= 80.00 0 5 10 15 20 25 30 35 40 45 Quantity (billion barrels/yr) Q* = 32 200 190 180 170 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 ab) FIGURE 2.23 IMPACT OF SAUDI PRODUCTION CUT The total supply is the sum of competitive (non-OPEC) supply and the 13 bb/yr of OPEC supply. Part (a) shows the short-run supply and demand curves. If Saudi Arabia stops producing, the supply curve will shift to the left by 3 bb/yr. In the short-run, price will increase sharply. Part (b) shows long-run curves. In the long run, because demand and competitive supply are much more elastic, the impact on price will be much smaller. 58 PART 1 • Introduction: Markets and Prices This is indeed what happened following the sharp decline in Iranian and Iraqi production in 1979–1980. History may or may not repeat itself, but if it does, we can at least predict the impact on oil prices.21 2.7 Effects of Government Intervention—Price Controls In the United States and most other industrial countries, markets are rarely free of government intervention. Besides imposing taxes and granting subsidies, governments often regulate markets (even competitive markets) in a variety of ways. In this section, we will see how to use supply and demand curves to analyze the effects of one common form of government intervention: price controls. Later, in Chapter 9, we will examine the effects of price controls and other forms of government intervention and regulation in more detail. Figure 2.24 illustrates the effects of price controls. Here, P0 and Q0 are the equilibrium price and quantity that would prevail without government regulation. The government, however, has decided that P0 is too high and mandated that the price can be no higher than a maximum allowable ceiling price, denoted by Pmax. What is the result? At this lower price, producers (particularly those with higher costs) will produce less, and the quantity supplied will drop to Q1. Consumers, on the other hand, will demand more at this low price; they would like to purchase the quantity Q2. Demand therefore exceeds supply, and a shortage develops—i.e., there is excess demand. - Q1. The amount of excess demand is Q2 Price S FIGURE 2.24 EFFECTS OF PRICE CONTROLS Without price controls, the market clears at the equilibrium price and quantity P0 and Q0. If price is regulated to be no higher than Pmax, the quantity supplied falls to Q1, the quantity demanded increases to Q2, and a shortage develops. P0 Pmax D Excess Demand Q1 Q0 Q2 Quantity 21You can obtain recent data and learn more about the world oil market by accessing the Web sites of the American Petroleum Institute at www.api.org or the U.S. Energy Information Administration at www.eia.doe.gov. CHAPTER 2 • The Basics of Supply and Demand 59 This excess demand sometimes takes the form of queues, as when drivers lined up to buy gasoline during the winter of 1974 and the summer of 1979. In both instances, the lines were the result of price controls; the government prevented domestic oil and gasoline prices from rising along with world oil prices. Sometimes excess demand results in curtailments and supply rationing, as with natural gas price controls and the resulting gas shortages of the mid-1970s, when industrial consumers closed factories because gas supplies were cut off. Sometimes it spills over into other markets, where it artificially increases demand. For example, natural gas price controls caused potential buyers of gas to use oil instead. Some people gain and some lose from price controls. As Figure 2.24 suggests, producers lose: They receive lower prices, and some leave the industry. Some but not all consumers gain. While those who can purchase the good at a lower price are better off, those who have been “rationed out” and cannot buy the good at all are worse off. How large are the gains to the winners and how large are the losses to the losers? Do total gains exceed total losses? To answer these questions, we need a method to measure the gains and losses from price controls and other forms of government intervention. We discuss such a method in Chapter 9. EXAM PLE 2.10 PRICE CONTROLS AND NATURAL GAS SHORTAGES In 1954, the federal government began regulating the wellhead price of natural gas. Initially the controls were not binding; the ceiling prices were above those that cleared the market. But in about 1962, when these ceiling prices did become binding, excess demand for natural gas developed and slowly began to grow. In the 1970s, this excess demand, spurred by higher oil prices, became severe and led to widespread curtailments. Soon ceiling prices were far below prices that would have prevailed in a free market.22 Today, producers and industrial consumers of natural gas, oil, and other commodities are concerned that the government might respond, once again, with price controls if prices rise sharply. Let’s calculate the likely impact of price controls on natural gas, based on market conditions in 2007. Figure 2.25 shows the wholesale price of natural gas, in both nominal and real (2000 dollars) terms, from 1950 through 2007. The following numbers describe the U.S. market in 2007: • The (free-market) wholesale price of natural gas was $6.40 per mcf (thousand cubic feet); • Production and consumption of gas were 23 Tcf (trillion cubic feet); • The average price of crude oil (which affects the supply and demand for natural gas) was about $50 per barrel. A reasonable estimate for the price elasticity of supply is 0.2. Higher oil prices also lead to more natural gas production because oil and gas are often discovered and produced together; an estimate of the cross-price elasticity of supply is 0.1. As for demand, the price elasticity is about - 0.5, and the cross-price elasticity with respect to oil price is about 1.5. You can verify that the following linear supply and demand curves fit these numbers: Q = 15.90 + 0.72PG Supply: Demand: Q = 0.02 - 1.8PG + 0.69PO + 0.05PO 22This regulation began with the Supreme Court’s 1954 decision requiring the then Federal Power Commission to regulate wellhead prices on natural gas sold to interstate pipeline companies. These price controls were largely removed during the 1980s, under the mandate of the Natural Gas Policy Act of 1978. For a detailed discussion of natural gas regulation and its effects, see Paul W. MacAvoy and Robert S. Pindyck, The Economics of the Natural Gas Shortage (Amsterdam: North-Holland, 1975); R. S. Pindyck, “Higher Energy Prices and the Supply of Natural Gas,” Energy Systems and Policy 2(1978): 177–209; and Arlon R. Tussing and Connie C. Barlow, The Natural Gas Industry (Cambridge, MA: Ballinger, 1984). 60 PART 1 • Introduction: Markets and Prices Nominal Price Real Price (2000$) .00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1950 1960 1970 1980 Year 1990 2000 2010 FIGURE 2.25 PRICE OF NATURAL GAS Natural gas prices rose sharply after 2000, as did the prices of oil and other fuels. where Q is the quantity of natural gas (in Tcf), PG is the price of natural gas (in dollars per mcf), and PO is the price of oil (in dollars per barrel). You can also verify, by equating the quantities supplied and demanded and substituting $5 |
0 for PO, that these supply and demand curves imply an equilibrium free-market price of $6.40 for natural gas. Suppose the government determines that the free-market price of $6.40 per mcf is too high, decides to impose price controls, and sets a maximum price of $3.00 per mcf. What impact would this have on the quantity of gas supplied and the quantity demanded? Substitute $3.00 for PG in both the supply and demand equations (keeping the price of oil, PO, fixed at $50). You should find that the supply equation gives a quantity supplied of 20.6 Tcf and the demand equation a quantity demanded of 29.1 Tcf. Therefore, these price controls would create an excess demand (i.e., shortage) of 29.1 - 20.6 = 8.5 Tcf. In Example 9.1 we’ll show how to measure the resulting gains and loses to producers and consumers. SUMMARY 1. Supply-demand analysis is a basic tool of microeconomics. In competitive markets, supply and demand curves tell us how much will be produced by firms and how much will be demanded by consumers as a function of price. 2. The market mechanism is the tendency for supply and demand to equilibrate (i.e., for price to move to the market-clearing level), so that there is neither excess demand nor excess supply. The equilibrium price is the price that equates the quantity demanded with the quantity supplied. 3. Elasticities describe the responsiveness of supply and demand to changes in price, income, or other variables. For example, the price elasticity of demand measures CHAPTER 2 • The Basics of Supply and Demand 61 the percentage change in the quantity demanded resulting from a 1-percent increase in price. 4. Elasticities pertain to a time frame, and for most goods it is important to distinguish between short-run and long-run elasticities. 5. We can use supply-demand diagrams to see how shifts in the supply curve and/or demand curve can explain changes in the market price and quantity. 6. If we can estimate, at least roughly, the supply and demand curves for a particular market, we can calculate the market-clearing price by equating the quantity supplied with the quantity demanded. Also, if we know how supply and demand depend on other economic variables, such as income or the prices of other goods, we can calculate how the market-clearing price and quantity will change as these other variables change. This is a means of explaining or predicting market behavior. 7. Simple numerical analyses can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities. For many markets, such data and estimates are available, and simple “back of the envelope” calculations can help us understand the characteristics and behavior of the market. 8. When a government imposes price controls, it keeps the price below the level that equates supply and demand. A shortage develops; the quantity demanded exceeds the quantity supplied. QUESTIONS FOR REVIEW 1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market- clearing level? 2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold: (a) an increase in the price of margarine; (b) an increase in the price of milk; (c) a decrease in average income levels. 3. If a 3-percent increase in the price of corn flakes causes a 6-percent decline in the quantity demanded, what is the elasticity of demand? 4. Explain the difference between a shift in the supply curve and a movement along the supply curve. 5. Explain why for many goods, the long-run price elas- ticity of supply is larger than the short-run elasticity. 6. Why do long-run elasticities of demand differ from short-run elasticities? Consider two goods: paper towels and televisions. Which is a durable good? Would you expect the price elasticity of demand for paper towels to be larger in the short run or in the long run? Why? What about the price elasticity of demand for televisions? 7. Are the following statements true or false? Explain your answers. a. The elasticity of demand is the same as the slope of the demand curve. b. The cross-price elasticity will always be positive. c. The supply of apartments is more inelastic in the short run than the long run. 8. Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels. Explain why shortages of these goods will develop and what factors will determine the sizes of the shortages. What will happen to the price of pork? Explain briefly. 9. The city council of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two-bedroom apartment had been $700 per month and that rents were expected to increase to $900 within a year. The city council limits rents to their current $700-per-month level. a. Draw a supply and demand graph to illustrate what will happen to the rental price of an apartment after the imposition of rent controls. b. Do you think this policy will benefit all students? Why or why not? 10. In a discussion of tuition rates, a university official argues that the demand for admission is completely price inelastic. As evidence, she notes that while the university has doubled its tuition (in real terms) over the past 15 years, neither the number nor quality of students applying has decreased. Would you accept this argument? Explain briefly. (Hint: The official makes an assertion about the demand for admission, but does she actually observe a demand curve? What else could be going on?) 11. Suppose the demand curve for a product is given by Q = 10 - 2P + PS where P is the price of the product and PS is the price of a substitute good. The price of the substitute good is $2.00. a. Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand? b. Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand? What is the cross-price elasticity of demand? 12. Suppose that rather than the declining demand assumed in Example 2.8, a decrease in the cost of copper production causes the supply curve to shift to the right by 40 percent. How will the price of copper change? 13. Suppose the demand for natural gas is perfectly inelastic. What would be the effect, if any, of natural gas price controls? 62 PART 1 • Introduction: Markets and Prices EXERCISES 1. Suppose the demand curve for a product is given by Q = 300 - 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P - 50. a. If I = 25, find the market-clearing price and quantity for the product. b. If I = 50, find the market-clearing price and quantity for the product. c. Draw a graph to illustrate your answers. 2. Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows: PRICE (DOLLARS) DEMAND (MILLIONS) SUPPLY (MILLIONS) 60 80 100 120 22 20 18 16 14 16 18 20 a. Calculate the price elasticity of demand when the price is $80 and when the price is $100. b. Calculate the price elasticity of supply when the price is $80 and when the price is $100. c. What are the equilibrium price and quantity? d. Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how large will it be? 3. Refer to Example 2.5 (page 37) on the market for wheat. In 1998, the total demand for U.S. wheat was Q = 3244 - 283P and the domestic supply was = 1944 + 207P. At the end of 1998, both Brazil QS and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new markets add 200 million bushels to U.S. wheat demand. What will be the free-market price of wheat and what quantity will be produced and sold by U.S. farmers? 4. A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound. Unlimited quantities are available for import into the United States at this price. The U.S. domestic supply and demand for various price levels are shown as follows: PRICE U.S. SUPPLY (MILLION LBS) U.S. DEMAND (MILLION LBS) 3 6 9 12 15 18 2 4 6 8 10 12 34 28 22 16 10 4 a. What is the equation for demand? What is the equa- tion for supply? b. At a price of $9, what is the price elasticity of demand? What is it at a price of $12? c. What is the price elasticity of supply at $9? At $12? d. In a free market, what will be the U.S. price and level of fiber imports? *5. Much of the demand for U.S. agricultural output has come from other countries. In 1998, the total demand for wheat was Q = 3244 - 283P. Of this, total domes= 1700 - 107P, and domestic tic demand was QD = 1944 + 207P. Suppose the export supply was QS demand for wheat falls by 40 percent. a. U.S. farmers are concerned about this drop in export demand. What happens to the free-market price of wheat in the United States? Do farmers have much reason to worry? b. Now suppose the U.S. government wants to buy enough wheat to raise the price to $3.50 per bushel. With the drop in export demand, how much wheat would the government have to buy? How much would this cost the government? 6. The rent control agency of New York City has found = 160 - 8P. Quantity is that aggregate demand is QD measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city from Long Island and demanding apartments. The city’s board of realtors acknowledges that this is a good demand estimate and has shown that supply is QS a. If both the agency and the board are right about demand and supply, what is the free-market price? What is the change in city population if the agency sets a maximum average monthly rent of $300 and all those who cannot find an a |
partment leave the city? b. Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on all apartments to allow landlords a “fair” rate of return. If 50 percent of any long-run increases in apartment offerings comes from new construction, how many apartments are constructed? = 70 + 7P. 7. In 2010, Americans smoked 315 billion cigarettes, or 15.75 billion packs of cigarettes. The average retail price (including taxes) was about $5.00 per pack. Statistical studies have shown that the price elasticity of demand is −0.4, and the price elasticity of supply is 0.5. a. Using this information, derive linear demand and supply curves for the cigarette market. b. In 1998, Americans smoked 23.5 billion packs of cigarettes, and the retail price was about $2.00 per pack. The decline in cigarette consumption from 1998 to 2010 was due in part to greater public awareness of the health hazards from smoking, but was also due in part to the increase in price. Suppose that the entire decline was due to the CHAPTER 2 • The Basics of Supply and Demand 63 increase in price. What could you deduce from that about the price elasticity of demand? 8. In Example 2.8 we examined the effect of a 20-percent decline in copper demand on the price of copper, using the linear supply and demand curves developed in Section 2.6. Suppose the long-run price elasticity of copper demand were −0.75 instead of −0.5. a. Assuming, as before, that the equilibrium price and quantity are P* = $3 per pound and Q* = 18 million metric tons per year, derive the linear demand curve consistent with the smaller elasticity. b. Using this demand curve, recalculate the effect of a 20-percent decline in copper demand on the price of copper. 9. In Example 2.8 (page 52), we discussed the recent increase in world demand for copper, due in part to China’s rising consumption. a. Using the original elasticities of demand and sup= -0.5), calculate the ply (i.e., ES effect of a 20-percent increase in copper demand on the price of copper. = 1.5 and ED b. Now calculate the effect of this increase in demand on the equilibrium quantity, Q*. c. As we discussed in Example 2.8, the U.S. production of copper declined between 2000 and 2003. Calculate the effect on the equilibrium price and quantity of both a 20-percent increase in copper demand (as you just did in part a) and of a 20-percent decline in copper supply. 10. Example 2.9 (page 54) analyzes the world oil market. Using the data given in that example: a. Show that the short-run demand and competitive supply curves are indeed given by D = 33.6 - .020P SC = 18.05 + 0.012P that instead of a decline in supply, OPEC production increases by 2 billion barrels per year (bb/yr) because the Saudis open large new oil fields. Calculate the effect of this increase in production on the price of oil in both the short run and the long run. 11. Refer to Example 2.10 (page 59), which analyzes the effects of price controls on natural gas. a. Using the data in the example, show that the following supply and demand curves describe the market for natural gas in 2005–2007: Q = 15.90 + 0.72PG Supply: Demand: Q = 0.02 - 1.8PG + 0.05PO + 0.69PO Also, verify that if the price of oil is $50, these curves imply a free-market price of $6.40 for natural gas. b. Suppose the regulated price of gas were $4.50 per thousand cubic feet instead of $3.00. How much excess demand would there have been? c. Suppose that the market for natural gas remained unregulated. If the price of oil had increased from $50 to $100, what would have happened to the freemarket price of natural gas? *12. The table below shows the retail price and sales for instant coffee and roasted coffee for two years. a. Using these data alone, estimate the short-run price elasticity of demand for roasted coffee. Derive a linear demand curve for roasted coffee. b. Now estimate the short-run price elasticity of demand for instant coffee. Derive a linear demand curve for instant coffee. c. Which coffee has the higher short-run price elasticity of demand? Why do you think this is the case? b. Show that the long-run demand and competitive supply curves are indeed given by YEAR D = 41.6 - 0.120P = 13.3 + 0.071P SC RETAIL PRICE OF INSTANT COFFEE ($/LB) SALES OF INSTANT COFFEE (MILLION LBS) RETAIL PRICE OF ROASTED COFFEE ($/LB) SALES OF ROASTED COFFEE (MILLION LBS) c. In Example 2.9 we examined the impact on price of a disruption of oil from Saudi Arabia. Suppose Year 1 Year 2 10.35 10.48 75 70 4.11 3.76 820 850 This page intentionally left blank Part Two Producers, Consumers, and Competitive Markets Part 2 presents the theoretical core of microeconomics. Chapters 3 and 4 explain the principles underlying consumer demand. We see how consumers make consumption decisions, how their preferences and budget constraints determine their demands for various goods, and why different goods have different demand characteristics. Chapter 5 contains more advanced material that shows how to analyze consumer choice under uncertainty. We explain why people usually dislike risky situations and show how they can reduce risk and choose among risky alternatives. We also discuss aspects of consumer behavior that can only be explained by delving into the psychological aspects of how people make decisions. Chapters 6 and 7 develop the theory of the firm. We see how firms combine inputs, such as capital, labor, and raw materials, to produce goods and services in a way that minimizes the costs of production. We also see how a firm’s costs depend on its rate of production and production experience. Chapter 8 then shows how firms choose profit-maximizing rates of production. We also see how the production decisions of individual firms combine to determine the competitive market supply curve and its characteristics. Chapter 9 applies supply and demand curves to the analysis of competitive markets. We show how government policies, such as price controls, quotas, taxes, and subsidies, can have wide-ranging effects on consumers and producers, and we explain how supplydemand analysis can be used to evaluate these effects Consumer Behavior 67 4 Individual and Market Demand 111 5 Uncertainty and Consumer Behavior 159 6 Production 201 7 The Cost of Production 229 8 Profit Maximization and Competitive Supply 279 9 The Analysis of Competitive Markets 317 65 65 This page intentionally left blank C H A P T E R 3 Consumer Behavior Some time ago, General Mills introduced a new breakfast cereal. The new brand, Apple-Cinnamon Cheerios, was a sweetened and more flavorful variant on General Mills’ classic Cheerios product. But before Apple-Cinnamon Cheerios could be extensively marketed, the company had to resolve an important problem: How high a price should it charge? No matter how good the cereal was, its profitability would depend on the company’s pricing decision. Knowing that consumers would pay more for a new product was not enough. The question was how much more. General Mills, therefore, had to conduct a careful analysis of consumer preferences to determine the demand for Apple-Cinnamon Cheerios. General Mills’ problem in determining consumer preferences mirrors the more complex problem faced by the U.S. Congress in evaluating the federal Food Stamps program. The goal of the program is to give low-income households coupons that can be exchanged for food. But there has always been a problem in the program’s design that complicates its assessment: To what extent do food stamps provide people with more food, as opposed to simply subsidizing the purchase of food that they would have bought anyway? In other words, has the program turned out to be little more than an income supplement that people spend largely on nonfood items instead of a solution to the nutritional problems of the poor? As in the cereal example, we need an analysis of consumer behavior. In this case, the federal government must determine how spending on food, as opposed to spending on other goods, is affected by changing income levels and prices. Solving these two problems—one involving corporate policy and the other public policy—requires an understanding of the theory of consumer behavior: the explanation of how consumers allocate incomes to the purchase of different goods and services. Consumer Behavior How can a consumer with a limited income decide which goods and services to buy? This is a fundamental issue in microeconomics—one that we address in this chapter and the next. We will see how consumers allocate their incomes across goods and explain how these allocation decisions determine the demands for various goods and .1 Consumer Preferences 69 3.2 Budget Constraints 82 3.3 Consumer Choice 86 3.4 Revealed Preference 92 3.5 Marginal Utility and Consumer Choice 95 *3.6 Cost-of-Living Indexes 100 .1 Designing New Automobiles (I) 77 3.2 Can Money Buy Happiness? 81 3.3 Designing New Automobiles (II) 88 3.4 Consumer Choice of Health Care 90 3.5 A College Trust Fund 92 3.6 Revealed Preference for Recreation 94 3.7 Marginal Utility and Happiness 97 3.8 The Bias in the CPI 105 67 68 PART 2 • Producers, Consumers, and Competitive Markets • theory of consumer behavior Description of how consumers allocate incomes among different goods and services to maximize their well-being. services. In turn, understanding consumer purchasing decisions will help us to understand how changes in income and prices affect the demand for goods and services and why the demand for some products is more sensitive than others to changes in prices and income. Consumer behavior is best understood in three distinct steps: 1. Consumer Preferences: The first step is to find a practical way to describe the reasons people might prefer one good to another. We will see how a consumer’s preferences for various goods can be described graphically and algebraically. 2. Budget Constraints: Of course, consumers also consider prices. In Step 2, therefore, we take into account the fact that c |
onsumers have limited incomes which restrict the quantities of goods they can buy. What does a consumer do in this situation? We find the answer to this question by putting consumer preferences and budget constraints together in the third step. 3. Consumer Choices: Given their preferences and limited incomes, consumers choose to buy combinations of goods that maximize their satisfaction. These combinations will depend on the prices of various goods. Thus, understanding consumer choice will help us understand demand—i.e., how the quantity of a good that consumers choose to purchase depends on its price. These three steps are the basics of consumer theory, and we will go through them in detail in the first three sections of this chapter. Afterward, we will explore a number of other interesting aspects of consumer behavior. For example, we will see how one can determine the nature of consumer preferences from actual observations of consumer behavior. Thus, if a consumer chooses one good over a similarly priced alternative, we can infer that he or she prefers the first good. Similar kinds of conclusions can be drawn from the actual decisions that consumers make in response to changes in the prices of the various goods and services that are available for purchase. At the end of this chapter, we will return to the discussion of real and nominal prices that we began in Chapter 1. We saw that the Consumer Price Index can provide one measure of how the well-being of consumers changes over time. In this chapter, we delve more deeply into the subject of purchasing power by describing a range of indexes that measure changes in purchasing power over time. Because they affect the benefits and costs of numerous social-welfare programs, these indexes are significant tools in setting government policy in the United States. WHAT DO CONSUMERS DO? Before proceeding, we need to be clear about our assumptions regarding consumer behavior, and whether those assumptions are realistic. It is hard to argue with the proposition that consumers have preferences among the various goods and services available to them, and that they face budget constraints which put limits on what they can buy. But we might take issue with the proposition that consumers decide which combinations of goods and services to buy so as to maximize their satisfaction. Are consumers as rational and informed as economists often make them out to be? We know that consumers do not always make purchasing decisions rationally. Sometimes, for example, they buy on impulse, ignoring or not CHAPTER 3 • Consumer Behavior 69 fully accounting for their budget constraints (and going into debt as a result). Sometimes consumers are unsure about their preferences or are swayed by the consumption decisions of friends and neighbors, or even by changes in mood. And even if consumers do behave rationally, it may not always be feasible for them to account fully for the multitude of prices and choices that they face daily. Economists have recently been developing models of consumer behavior that incorporate more realistic assumptions about rationality and decision making. This area of research, called behavioral economics, has drawn heavily from findings in psychology and related fields. We will discuss some key results from behavioral economics in Chapter 5. At this point we simply want to make it clear that our basic model of consumer behavior necessarily makes some simplifying assumptions. But we also want to emphasize that this model has been extremely successful in explaining much of what we actually observe regarding consumer choice and the characteristics of consumer demand. As a result, this model is a basic “workhorse” of economics. It is used widely, not only in economics, but also in related fields such as finance and marketing. 3.1 Consumer Preferences Given both the vast number of goods and services that our industrial economy provides for purchase and the diversity of personal tastes, how can we describe consumer preferences in a coherent way? Let’s begin by thinking about how a consumer might compare different groups of items available for purchase. Will one group of items be preferred to another group, or will the consumer be indifferent between the two groups? Market Baskets We use the term market basket to refer to such a group of items. Specifically, a market basket is a list with specific quantities of one or more goods. A market basket might contain the various food items in a grocery cart. It might also refer to the quantities of food, clothing, and housing that a consumer buys each month. Many economists also use the word bundle to mean the same thing as market basket. How do consumers select market baskets? How do they decide, for example, how much food versus clothing to buy each month? Although selections may occasionally be arbitrary, as we will soon see, consumers usually select market baskets that make them as well off as possible. Table 3.1 shows several market baskets consisting of various amounts of food and clothing purchased on a monthly basis. The number of food items can be measured in any number of ways: by total number of containers, by number of packages of each item (e.g., milk, meat, etc.), or by number of pounds or grams. Likewise, clothing can be counted as total number of pieces, as number of pieces of each type of clothing, or as total weight or volume. Because the method of measurement is largely arbitrary, we will simply describe the items in a market basket in terms of the total number of units of each commodity. Market basket A, for example, consists of 20 units of food and 30 units of clothing, basket B consists of 10 units of food and 50 units of clothing, and so on. • market basket (or bundle) List with specific quantities of one or more goods. 70 PART 2 • Producers, Consumers, and Competitive Markets TABLE 3.1 ALTERNATIVE MARKET BASKETS MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING A B D E G H 20 10 40 30 10 10 30 50 20 40 20 40 Note: We will avoid the use of the letters C and F to represent market baskets, whenever market baskets might be confused with the number of units of food and clothing. To explain the theory of consumer behavior, we will ask whether consumers prefer one market basket to another. Note that the theory assumes that consumers’ preferences are consistent and make sense. We explain what we mean by these assumptions in the next subsection. Some Basic Assumptions about Preferences The theory of consumer behavior begins with three basic assumptions about people’s preferences for one market basket versus another. We believe that these assumptions hold for most people in most situations. 1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible baskets. Thus, for any two market baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either basket. Note that these preferences ignore costs. A consumer might prefer steak to hamburger but buy hamburger because it is cheaper. 2. Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the consumer also prefers A to C. For example, if a Porsche is preferred to a Cadillac and a Cadillac to a Chevrolet, then a Porsche is also preferred to a Chevrolet. Transitivity is normally regarded as necessary for consumer consistency. 3. More is better than less: Goods are assumed to be desirable—i.e., to be good. Consequently, consumers always prefer more of any good to less. In addition, consumers are never satisfied or satiated; more is always better, even if just a little better.1 This assumption is made for pedagogic reasons; namely, it simplifies the graphical analysis. Of course, some goods, such as air pollution, may be undesirable, and consumers will always prefer less. We ignore these “bads” in the context of our immediate discussion of consumer choice because most consumers would not choose to purchase them. We will, however, discuss them later in the chapter. These three assumptions form the basis of consumer theory. They do not explain consumer preferences, but they do impose a degree of rationality and reasonableness on them. Building on these assumptions, we will now explore consumer behavior in greater detail. 1Thus some economists use the term nonsatiation to refer to this third assumption. CHAPTER 3 • Consumer Behavior 71 • indifference curve Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction. Indifference Curves We can show a consumer’s preferences graphically with the use of indifference curves. An indifference curve represents all combinations of market baskets that provide a consumer with the same level of satisfaction. That person is therefore indifferent among the market baskets represented by the points graphed on the curve. Given our three assumptions about preferences, we know that a consumer can always indicate either a preference for one market basket over another or indifference between the two. We can then use this information to rank all possible consumption choices. In order to appreciate this principle in graphic form, let’s assume that there are only two goods available for consumption: food F and clothing C. In this case, all market baskets describe combinations of food and clothing that a person might wish to consume. As we have already seen, Table 3.1 provides some examples of baskets containing various amounts of food and clothing. In order to graph a consumer’s indifference curve, it helps first to graph his or her individual preferences. Figure 3.1 shows the same baskets listed in Table 3.1. The horizontal axis measures the number of units of food purchased each week; the vertical axis measures the number of units of clothing. Market |
basket A, with 20 units of food and 30 units of clothing, is preferred to basket G because A contains more food and more clothing (recall our third assumption that more is better than less). Similarly, market basket E, which contains even more food and even more clothing, is preferred to A. In fact, we can easily compare all market baskets in the two shaded areas (such as E and G) to A because they contain either more or less of both food and clothing. Note, however, that B contains more clothing but less food than A. Similarly, D contains more food but less clothing than A. Therefore, comparisons of market basket A with baskets B, D, and H are not possible without more information about the consumer’s ranking. This additional information is provided in Figure 3.2, which shows an indifference curve, labeled U1, that passes through points A, B, and D. This curve indicates that the consumer is indifferent among these three market baskets. It tells us that in moving from market basket A to market basket B, the consumer feels neither better nor worse off in giving up 10 units of food to obtain 20 additional Clothing (units per week) B • H• G• 50 40 30 20 10 E• A • D• 10 20 30 40 Food (units per week) FIGURE 3.1 DESCRIBING INDIVIDUAL PREFERENCES Because more of each good is preferred to less, we can compare market baskets in the shaded areas. Basket A is clearly preferred to basket G, while E is clearly preferred to A. However, A cannot be compared with B, D, or H without additional information. 72 PART 2 • Producers, Consumers, and Competitive Markets Clothing (units per week) FIGURE 3.2 AN INDIFFERENCE CURVE The indifference curve U1 that passes through market basket A shows all baskets that give the consumer the same level of satisfaction as does market basket A; these include baskets B and D. Our consumer prefers basket E, which lies above U1, to A, but prefers A to H or G, which lie below U1. H B G 50 40 30 20 10 E A D U1 10 20 30 Food 40 (units per week) units of clothing. Likewise, the consumer is indifferent between points A and D: He or she will give up 10 units of clothing to obtain 20 more units of food. On the other hand, the consumer prefers A to H, which lies below U1. Note that the indifference curve in Figure 3.2 slopes downward from left to right. To understand why this must be the case, suppose instead that it sloped upward from A to E. This would violate the assumption that more of any commodity is preferred to less. Because market basket E has more of both food and clothing than market basket A, it must be preferred to A and therefore cannot be on the same indifference curve as A. In fact, any market basket lying above and to the right of indifference curve U1 in Figure 3.2 is preferred to any market basket on U1. Indifference Maps To describe a person’s preferences for all combinations of food and clothing, we can graph a set of indifference curves called an indifference map. Each indifference curve in the map shows the market baskets among which the person is indifferent. Figure 3.3 shows three indifference curves that form part of an indifference map (the entire map includes an infinite number of such curves). Indifference curve U3 generates the highest level of satisfaction, followed by indifference curves U2 and U1. Indifference curves cannot intersect. To see why, we will assume the contrary and see how the resulting graph violates our assumptions about consumer behavior. Figure 3.4 shows two indifference curves, U1 and U2, that intersect at A. Because A and B are both on indifference curve U1, the consumer must be indifferent between these two market baskets. Because both A and D lie on indifference curve U2, the consumer is also indifferent between these market baskets. Consequently, using the assumption of transitivity, the consumer is also • indifference map Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent. Clothing (units per week) D B CHAPTER 3 • Consumer Behavior 73 Clothing (units per week) U2 U1 A U3 U2 U1 Food (units per week) A B D Food (units per week) FIGURE 3.3 AN INDIFFERENCE MAP An indifference map is a set of indifference curves that describes a person’s preferences. Any market basket on indifference curve U3, such as basket A, is preferred to any basket on curve U2 (e.g., basket B), which in turn is preferred to any basket on U1, such as D. FIGURE 3.4 INDIFFERENCE CURVES CANNOT INTERSECT If indifference curves U1 and U2 intersect, one of the assumptions of consumer theory is violated. According to this diagram, the consumer should be indifferent among market baskets A, B, and D. Yet B should be preferred to D because B has more of both goods. indifferent between B and D. But this conclusion can’t be true: Market basket B must be preferred to D because it contains more of both food and clothing. Thus, intersecting indifference curves contradicts our assumption that more is preferred to less. Of course, there are an infinite number of nonintersecting indifference curves, one for every possible level of satisfaction. In fact, every possible market basket (each corresponding to a point on the graph) has an indifference curve passing through it. The Shape of Indifference Curves Recall that indifference curves are all downward sloping. In our example of food and clothing, when the amount of food increases along an indifference curve, the amount of clothing decreases. The fact that indifference curves slope downward follows directly from our assumption that more of a good is better than less. If an indifference curve sloped upward, a consumer would be indifferent between two market baskets even though one of them had more of both food and clothing. As we saw in Chapter 1, people face trade-offs. The shape of an indifference curve describes how a consumer is willing to substitute one good for another. Look, for example, at the indifference curve in Figure 3.5. Starting at market basket A and moving to basket B, we see that the consumer is willing to give up 6 units of clothing to obtain 1 extra unit of food. However, in moving from B to D, he is willing to give up only 4 units of clothing to obtain an additional unit of 74 PART 2 • Producers, Consumers, and Competitive Markets A –6 B 1 – 4 Clothing (units per week) 16 14 12 10 8 6 4 2 D 1 –2 1 –1 E 1 G 1 2 3 4 5 Food (units per week) FIGURE 3.5 THE MARGINAL RATE OF SUBSTITUTION The magnitude of the slope of an indifference curve measures the consumer’s marginal rate of substitution (MRS) between two goods. In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E ) to 1 (between E and G). When the MRS diminishes along an indifference curve, the curve is convex. • marginal rate of substitution (MRS) Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. food; in moving from D to E, he will give up only 2 units of clothing for 1 unit of food. The more clothing and the less food a person consumes, the more clothing he will give up in order to obtain more food. Similarly, the more food that a person possesses, the less clothing he will give up for more food. The Marginal Rate of Substitution To quantify the amount of one good that a consumer will give up to obtain more of another, we use a measure called the marginal rate of substitution (MRS). The MRS of food F for clothing C is the maximum amount of clothing that a person is willing to give up to obtain one additional unit of food. Suppose, for example, the MRS is 3. This means that the consumer will give up 3 units of clothing to obtain 1 additional unit of food. If the MRS is 1/2, the consumer is willing to give up only 1/2 unit of clothing. Thus, the MRS measures the value that the individual places on 1 extra unit of a good in terms of another. Look again at Figure 3.5. Note that clothing appears on the vertical axis and food on the horizontal axis. When we describe the MRS, we must be clear about which good we are giving up and which we are getting more of. To be consistent throughout the book, we will define the MRS in terms of the amount of the good on the vertical axis that the consumer is willing to give up in order to obtain 1 extra unit of the good on the horizontal axis. Thus, in Figure 3.5 the MRS refers to the amount of clothing that the consumer is willing to give up to obtain an additional unit of food. If we denote the change in clothing by C and the change in food by F, the MRS can be written as - C/F. We add the negative sign to make the marginal rate of substitution a positive number. (Remember that C is always negative; the consumer gives up clothing to obtain additional food.) CHAPTER 3 • Consumer Behavior 75 Thus the MRS at any point is equal in magnitude to the slope of the indifference curve. In Figure 3.5, for example, the MRS between points A and B is 6: The consumer is willing to give up 6 units of clothing to obtain 1 additional unit of food. Between points B and D, however, the MRS is 4: With these quantities of food and clothing, the consumer is willing to give up only 4 units of clothing to obtain 1 additional unit of food. CONVEXITY Also observe in Figure 3.5 that the MRS falls as we move down the indifference curve. This is not a coincidence. This decline in the MRS reflects an important characteristic of consumer preferences. To understand this, we will add an additional assumption regarding consumer preferences to the three that we discussed earlier in this chapter (see page 70): 4. Diminishing marginal rate of substitution: Indifference curves are usually convex, or bowed inward. The term convex means that the slope of the indifference curve increases (i.e., becomes less negative) as we move down along the curve. In other words, an indifference curve is convex if the MRS diminishes along the curve. The indifference curve in Figure 3.5 is convex. |
As we have seen, starting with market basket A in Figure 3.5 and moving to basket B, the MRS of food F for clothing C is - C/F = -(-6)/1 = 6. However, when we start at basket B and move from B to D, the MRS falls to 4. If we start at basket D and move to E, the MRS is 2. Starting at E and moving to G, we get an MRS of 1. As food consumption increases, the slope of the indifference curve falls in magnitude. Thus the MRS also falls.2 Is it reasonable to expect indifference curves to be convex? Yes. As more and more of one good is consumed, we can expect that a consumer will prefer to give up fewer and fewer units of a second good to get additional units of the first one. As we move down the indifference curve in Figure 3.5 and consumption of food increases, the additional satisfaction that a consumer gets from still more food will diminish. Thus, he will give up less and less clothing to obtain additional food. Another way of describing this principle is to say that consumers generally prefer balanced market baskets to market baskets that contain all of one good and none of another. Note from Figure 3.5 that a relatively balanced market basket containing 3 units of food and 6 units of clothing (basket D) generates as much satisfaction as another market basket containing 1 unit of food and 16 units of clothing (basket A). It follows that a balanced market basket containing, for example, 6 units of food and 8 units of clothing will generate a higher level of satisfaction. Perfect Substitutes and Perfect Complements The shape of an indifference curve describes the willingness of a consumer to substitute one good for another. An indifference curve with a different shape implies a different willingness to substitute. To see this principle, look at the two somewhat extreme cases illustrated in Figure 3.6. In §2.1, we explain that two goods are substitutes when an increase in the price of one leads to an increase in the quantity demanded of the other. 2With nonconvex preferences, the MRS increases as the amount of the good measured on the horizontal axis increases along any indifference curve. This unlikely possibility might arise if one or both goods are addictive. For example, the willingness to substitute an addictive drug for other goods might increase as the use of the addictive drug increased. 76 PART 2 • Producers, Consumers, and Competitive Markets (a) Perfect Substitutes (b) Perfect Complements Apple juice (glasses) 4 3 2 1 0 Left shoes 4 3 2 1 0 1 2 3 4 Orange juice (glasses) 1 2 3 4 Right shoes FIGURE 3.6 PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS In (a), Bob views orange juice and apple juice as perfect substitutes: He is always indifferent between a glass of one and a glass of the other. In (b), Jane views left shoes and right shoes as perfect complements: An additional left shoe gives her no extra satisfaction unless she also obtains the matching right shoe. Figure 3.6 (a) shows Bob’s preferences for apple juice and orange juice. These two goods are perfect substitutes for Bob because he is entirely indifferent between having a glass of one or the other. In this case, the MRS of apple juice for orange juice is 1: Bob is always willing to trade 1 glass of one for 1 glass of the other. In general, we say that two goods are perfect substitutes when the marginal rate of substitution of one for the other is a constant. Indifference curves describing the trade-off between the consumption of the goods are straight lines. The slope of the indifference curves need not be 1 in the case of perfect substitutes. Suppose, for example, that Dan believes that one 16-megabyte memory chip is equivalent to two 8-megabyte chips because both combinations have the same memory capacity. In that case, the slope of Dan’s indifference curve will be 2 (with the number of 8-megabyte chips on the vertical axis). Figure 3.6 (b) illustrates Jane’s preferences for left shoes and right shoes. For Jane, the two goods are perfect complements because a left shoe will not increase her satisfaction unless she can obtain the matching right shoe. In this case, the MRS of left shoes for right shoes is zero whenever there are more right shoes than left shoes; Jane will not give up any left shoes to get additional right shoes. Correspondingly, the MRS is infinite whenever there are more left shoes than right because Jane will give up all but one of her excess left shoes in order to obtain an additional right shoe. Two goods are perfect complements when the indifference curves for both are shaped as right angles. BADS So far, all of our examples have involved products that are “goods”—i.e., cases in which more of a product is preferred to less. However, some things are bads: Less of them is preferred to more. Air pollution is a bad; asbestos in housing • perfect substitutes Two goods for which the marginal rate of substitution of one for the other is a constant. In §2.1 we explain that goods are complements when an increase in the price of one leads to a decrease in the quantity demanded of the other. • perfect complements Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles. • bad Good for which less is preferred rather than more. CHAPTER 3 • Consumer Behavior 77 insulation is another. How do we account for bads in the analysis of consumer preferences? The answer is simple: We redefine the product under study so that consumer tastes are represented as a preference for less of the bad. This reversal turns the bad into a good. Thus, for example, instead of a preference for air pollution, we will discuss the preference for clean air, which we can measure as the degree of reduction in air pollution. Likewise, instead of referring to asbestos as a bad, we will refer to the corresponding good, the removal of asbestos. With this simple adaptation, all four of the basic assumptions of consumer theory continue to hold, and we are ready to move on to an analysis of consumer budget constraints. EXAMPLE 3.1 DESIGNING NEW AUTOMOBILES (I) Suppose you worked for the Ford Motor Company and had to help plan new models to introduce. Should the new models emphasize interior space or handling? Horsepower or gas mileage? To decide, you would want to know how people value the various attributes of a car, such as power, size, handling, gas mileage, interior features, and so on. The more desirable the attributes, the more people would be willing to pay for a car. However, the better the attributes, the more the car will cost to manufacture. A car with a more powerful engine and more interior space, for example, will cost more to produce than a car with a smaller engine and less space. How should Ford trade off these different attributes and decide which ones to emphasize? The answer depends in part on the cost of production, but it also depends on consumer preferences. To find out how much people are willing to pay for various attributes, economists and marketing experts look at the prices that people actually do pay for a wide range of models with a range of attributes. For example, if the only difference between two cars is interior space, and if the car with 2 additional cubic feet sells for $1000 more than its smaller counterpart, then interior space will be valued at $500 per cubic foot. By evaluating car purchases over a range of buyers and a range of models, one can estimate the values associated with various attributes, while accounting for the fact that these valuations may diminish as more and more of each attribute is included in a car. One way to obtain such information is by conducting surveys in which individuals are asked about their preferences for various automobiles with different combinations of attributes. Another way is to statistically analyze past consumer purchases of cars whose attributes varied. One recent statistical study looked at a wide range of Ford models with varying attributes.3 Figure 3.7 describes two sets of indifference curves, derived from an analysis that varies two attributes: interior size (measured in cubic feet) and acceleration (measured in horsepower) for typical consumers of Ford automobiles. Figure 3.7 (a) describes the preferences of typical owners of Ford Mustang coupes. Because they tend to place greater value on acceleration than size, Mustang owners have a high marginal rate of substitution for size versus acceleration; in other words, they are willing to give up quite a bit of size to get better acceleration. Compare these preferences to those of Ford Explorer owners, shown in Figure 3.7 (b). They have a lower MRS and will consequently give up a considerable amount of acceleration to get a car with a roomier interior. 3Amil Petrin, “Quantifying the Benefits of New Products: The Case of the Minivan,” Journal of Political Economy 110 (2002): 705–729. We wish to thank Amil Petrin for providing some of the empirical information in this example. 78 PART 2 • Producers, Consumers, and Competitive Markets Space (cubic feet) Space (cubic feet) 120 100 80 60 40 20 120 100 80 60 40 20 50 100 150 200 250 (a) Acceleration (horsepower) 50 100 150 200 250 (b) Acceleration (horsepower) FIGURE 3.7 PREFERENCES FOR AUTOMOBILE ATTRIBUTES Preferences for automobile attributes can be described by indifference curves. Each curve shows the combination of acceleration and interior space that give the same satisfaction. Owners of Ford Mustang coupes (a) are willing to give up considerable interior space for additional acceleration. The opposite is true for owners of Ford Explorers (b). UTILITY You may have noticed a convenient feature of the theory of consumer behavior as we have described it so far: It has not been necessary to associate a numerical level of satisfaction with each market basket consumed. For example, with respect to the three indifference curves in Figure 3.3 (page 73), we know that market basket A (or any other basket on indifference curve U3) gives more satisfaction than any |
market basket on U2, such as B. Likewise, we know that the market baskets on U2 are preferred to those on U1. The indifference curves simply allow us to describe consumer preferences graphically, building on the assumption that consumers can rank alternatives. We will see that consumer theory relies only on the assumption that consumers can provide relative rankings of market baskets. Nonetheless, it is often useful to assign numerical values to individual baskets. Using this numerical approach, we can describe consumer preferences by assigning scores to the levels of satisfaction associated with each indifference curve. The concept is known as utility. In everyday language, the word utility has rather broad connotations, meaning, roughly, “benefit” or “well-being.” Indeed, people obtain “utility” by getting things that give them pleasure and by avoiding things that give them pain. In the language of economics, the concept of utility refers to the numerical score representing the satisfaction that a consumer gets from a market basket. In other words, utility is a device used to simplify the ranking of market baskets. If buying three copies of this textbook makes you happier than buying one shirt, then we say that the three books give you more utility than the shirt. • utility Numerical score representing the satisfaction that a consumer gets from a given market basket. CHAPTER 3 • Consumer Behavior 79 • utility function Formula that assigns a level of utility to individual market baskets. UTILITY FUNCTIONS A utility function is a formula that assigns a level of utility to each market basket. Suppose, for example, that Phil’s utility function for food (F) and clothing (C) is u(F,C) F 2C. In that case, a market basket consisting of 8 units of food and 3 units of clothing generates a utility of 8 (2)(3) 14. Phil is therefore indifferent between this market basket and a market basket containing 6 units of food and 4 units of clothing [6 (2)(4) 14]. On the other hand, either market basket is preferred to a third containing 4 units of food and 4 units of clothing. Why? Because this last market basket has a utility level of only 4 (4)(2) 12. We assign utility levels to market baskets so that if market basket A is preferred to basket B, the number will be higher for A than for B. For example, market basket A on the highest of three indifference curves U3 might have a utility level of 3, while market basket B on the second-highest indifference curve U2 might have a utility level of 2; on the lowest indifference curve U1, basket D has a utility level of 1. Thus the utility function provides the same information about preferences that an indifference map does: Both order consumer choices in terms of levels of satisfaction. Let’s examine one particular utility function in some detail. The utility function u(F,C) FC tells us that the level of satisfaction obtained from consuming F units of food and C units of clothing is the product of F and C. Figure 3.8 shows indifference curves associated with this function. The graph was drawn by initially choosing one particular market basket—say, F 5 and C 5 at point A. This market basket generates a utility level U1 of 25. Then the indifference curve (also called an isoutility curve) was drawn by finding all market baskets for which FC 25 (e.g., F 10, C 2.5 at point B; F 2.5, C 10 at point D). The second indifference curve, U2, contains all market baskets for which FC 50 and the third, U3, all market baskets for which FC 100. It is important to note that the numbers attached to the indifference curves are for convenience only. Suppose the utility function were changed to u(F,C) 4FC. Consider any market basket that previously generated a utility level of 25—say, F 5 and C 5. Now the level of utility has increased, by a factor of 4, to 100. Thus the indifference curve labeled 25 looks the same, although it should now be labeled 100 rather than 25. In fact, the only difference between the indifference curves associated with the utility function 4FC and the utility Clothing (units per week) 15 10 5 D FIGURE 3.8 UTILITY FUNCTIONS AND INDIFFERENCE CURVES A utility function can be represented by a set of indifference curves, each with a numerical indicator. This figure shows three indifference curves (with utility levels of 25, 50, and 100, respectively) associated with the utility function FC. A B U3 100 U2 50 U1 25 5 10 15 Food (units per week) 80 PART 2 • Producers, Consumers, and Competitive Markets function FC is that the curves are numbered 100, 200, and 400, rather than 25, 50, and 100. It is important to stress that the utility function is simply a way of ranking different market baskets; the magnitude of the utility difference between any two market baskets does not really tell us anything. The fact that U3 has a level of utility of 100 and U2 has a level of 50 does not mean that market baskets on U3 generate twice as much satisfaction as those on U2. This is so because we have no means of objectively measuring a person’s satisfaction or level of wellbeing from the consumption of a market basket. Thus whether we use indifference curves or a measure of utility, we know only that U3 is better than U2 and that U2 is better than U1. We do not, however, know by how much one is preferred to the other. ORDINAL VERSUS CARDINAL UTILITY The three indifference curves in Figure 3.3 (page 73) provide a ranking of market baskets that is ordered, or ordinal. For this reason, a utility function that generates a ranking of market baskets is called an ordinal utility function. The ranking associated with the ordinal utility function places market baskets in the order of most to least preferred. However, as explained above, it does not indicate by how much one is preferred to another. We know, for example, that any market basket on U3, such as A, is preferred to any on U2, such as B. However, the amount by which A is preferred to B (and B to D) is not revealed by the indifference map or by the ordinal utility function that generates it. When working with ordinal utility functions, we must be careful to avoid a trap. Suppose that Juan’s ordinal utility function attaches a utility level of 5 to a copy of this textbook; meanwhile Maria’s utility function attaches a level of 10. Will Maria be happier than Juan if each of them gets a copy of this book? We don’t know. Because these numerical values are arbitrary, interpersonal comparisons of utility are impossible. When economists first studied utility and utility functions, they hoped that individual preferences could be quantified or measured in terms of basic units and could therefore provide a ranking that allowed for interpersonal comparisons. Using this approach, we could say that Maria gets twice as much satisfaction as Juan from a copy of this book. Or if we found that having a second copy increased Juan’s utility level to 10, we could say that his happiness has doubled. If the numerical values assigned to market baskets did have meaning in this way, we would say that the numbers provided a cardinal ranking of alternatives. A utility function that describes by how much one market basket is preferred to another is called a cardinal utility function. Unlike ordinal utility functions, a cardinal utility function attaches to market baskets numerical values that cannot arbitrarily be doubled or tripled without altering the differences between the values of various market baskets. Unfortunately, we have no way of telling whether a person gets twice as much satisfaction from one market basket as from another. Nor do we know whether one person gets twice as much satisfaction as another from consuming the same basket. (Could you tell whether you get twice as much satisfaction from consuming one thing versus another?) Fortunately, this constraint is unimportant. Because our objective is to understand consumer behavior, all that matters is knowing how consumers rank different baskets. Therefore, we will work only with ordinal utility functions. This approach is sufficient for understanding both how individual consumer decisions are made and what this knowledge implies about the characteristics of consumer demand. • ordinal utility function Utility function that generates a ranking of market baskets in order of most to least preferred. • cardinal utility function Utility function describing by how much one market basket is preferred to another. CHAPTER 3 • Consumer Behavior 81 EXAM PLE 3.2 CAN MONEY BUY HAPPINESS? Economists use the term utility to represent a measure of the satisfaction or happiness that individuals get from the consumption of goods and services. Because a higher income allows one to consume more goods and services, we say that utility increases with income. But does greater income and consumption really translate into greater happiness? Research comparing various measures of happiness suggests that the answer is a qualified yes.4 In one study, an ordinal scale for happiness was derived from the answer to the following question. “How satisfied are you at present with your life, all things considered?”5 Possible responses ran on a scale from 0 (completely dissatisfied) to 10 (completely satisfied). Income was found to be a very strong predictor of happiness (another strong predictor was whether a person was employed or not). On average, as income increased by one percent, the satisfaction score increased one half a point. Knowing that there is a positive relationship between utility or satisfaction and income, it is reasonable to assign utility values to the baskets of goods and services that consumers buy. Whether that relationship is cardinal or ordinal remains an ongoing debate. Let’s take this inquiry one step further. Can one compare levels of happiness across as well as within countries? Once again, the evidence says yes. In a separate survey of individuals in 67 countries, a team of researchers asked: “All things considered, how sati |
sfied are you with your life as a whole these days?” Responses were given on a ten-point scale, with 1 representing the most dissatisfied and 10 the most satisfied.6 Income was measured by each country’s per-capita gross domestic product in U.S. dollars. Figure 3.9 shows the results, with each data point representing a different country. You can see that as we move from poor countries with incomes below $5000 per capita to those with incomes closer to $10,000 per capita, satisfaction increases substantially. Once we move past the $10,000 level, the index scale of satisfaction increases at a lower rate. Comparisons across countries are difficult because there are likely to be many other factors that explain satisfaction besides income (e.g., health, climate, political environment, human rights, etc.). Interestingly, a recent survey of 136,000 individuals over 132 countries shows that the United States, which had the highest GDP per capita, was ranked 16th overall in happiness. The number 1 rated country was Denmark. Generally, countries in Northern Europe and English-speaking countries did well overall, as did a number of Latin American countries. However, South Korea and Russia were not rated as high as their incomes would predict. Does location affect feelings of well-being within the United States? The answer is apparently yes, with the top-ranked states (in order) being Utah, Hawaii, Wyoming, and Colorado, all west of the Mississippi River. (The lowest four, in reverse order, were West Virginia, Kentucky, Mississippi, and Ohio, all east of the Mississippi.) Moreover, it is possible that the relationship between income and satisfaction goes two ways: Although higher incomes generate more satisfaction, greater satisfaction offers greater motivation for individuals to work hard and generate higher incomes. Interestingly, even when studies account for other factors, the positive relationship between income and satisfaction remains. 4For a review of the relevant literature which underlies this example, see Raphael DiTella and Robert MacCulloch, “Some Uses of Happiness Data in Economics,” Journal of Economic Perspectives 20 (Winter 2006): 25–46. 5Paul Frijters, John P. Haisken-Denew, and Michael A. Shields, “Money Does Matter! Evidence from Increasing Real Income and Life Satisfaction in East Germany Following Reunification,” American Economic Review 94 (June 2004): 730–40. 6Ronald Inglehart et al., European and World Values Surveys Four-Wave Integrated Data File, 1981–2004 (2006). Available online: http://www.worldvaluessurvey.org. 82 PART 2 • Producers, Consumers, and Competitive Markets 5000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 GDP per capita in 1996 U.S. $ FIGURE 3.9 INCOME AND HAPPINESS A cross-country comparison shows that individuals living in countries with higher GDP per capita are on average happier than those living in countries with lower per-capita GDP. • budget constraints Constraints that consumers face as a result of limited incomes. • budget line All combinations of goods for which the total amount of money spent is equal to income. 3.2 Budget Constraints So far, we have focused only on the first element of consumer theory—consumer preferences. We have seen how indifference curves (or, alternatively, utility functions) can be used to describe how consumers value various baskets of goods. Now we turn to the second element of consumer theory: the budget constraints that consumers face as a result of their limited incomes. The Budget Line To see how a budget constraint limits a consumer’s choices, let’s consider a situation in which a woman has a fixed amount of income, I, that can be spent on food and clothing. Let F be the amount of food purchased and C be the amount of clothing. We will denote the prices of the two goods PF and PC. In that case, PFF (i.e., price of food times the quantity) is the amount of money spent on food and PCC the amount of money spent on clothing. The budget line indicates all combinations of F and C for which the total amount of money spent is equal to income. Because we are considering only two goods (and ignoring the possibility of saving), our hypothetical consumer will spend her entire income on food and clothing. As a result, the combinations of food and clothing that she can buy will all lie on this line: PF F + PC C = I (3.1) CHAPTER 3 • Consumer Behavior 83 TABLE 3.2 MARKET BASKETS AND THE BUDGET LINE MARKET BASKET FOOD (F) CLOTHING (C) TOTAL SPENDING A B D E G 0 20 40 60 80 40 30 20 10 0 $80 $80 $80 $80 $80 Suppose, for example, that our consumer has a weekly income of $80, the price of food is $1 per unit, and the price of clothing is $2 per unit. Table 3.2 shows various combinations of food and clothing that she can purchase each week with her $80. If her entire budget were allocated to clothing, the most that she could buy would be 40 units (at a price of $2 per unit), as represented by market basket A. If she spent her entire budget on food, she could buy 80 units (at $1 per unit), as given by market basket G. Market baskets B, D, and E show three additional ways in which her $80 could be spent on food and clothing. Figure 3.10 shows the budget line associated with the market baskets given in Table 3.2. Because giving up a unit of clothing saves $2 and buying a unit of food costs $1, the amount of clothing given up for food along the budget line must be the same everywhere. As a result, the budget line is a straight line from point A to point G. In this particular case, the budget line is given by the equation F 2C $80. The intercept of the budget line is represented by basket A. As our consumer moves along the line from basket A to basket G, she spends less on clothing and more on food. It is easy to see that the extra clothing which must be given up to consume an additional unit of food is given by the ratio of the price of food to the price of clothing ($1/$2 1/2). Because clothing costs $2 per unit and food only $1 per unit, 1/2 unit of clothing must be given up to get 1 unit of food. In Figure 3.10, the slope of the line, C/F −1/2, measures the relative cost of food and clothing. Clothing (units per week) (I/PC) = 40 A B 10 20 30 20 10 Budget Line F + 2C = $80 D Slope ΔC/ΔF = – 1 = –PF/PC 2 E G 0 20 40 60 80 = (I/PF) Food (units per week) FIGURE 3.10 A BUDGET LINE A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods. Line AG (which passes through points B, D, and E ) shows the budget associated with an income of $80, a price of food of PF = $1 per unit, and a price of clothing of PC = $2 per unit. The slope of the budget line (measured between points B and D) is −PF/PC = −10/20 = −1/2. 84 PART 2 • Producers, Consumers, and Competitive Markets Using equation (3.1), we can see how much of C must be given up to consume more of F. We divide both sides of the equation by PC and then solve for C: C = (I/PC) - (PF/PC)F (3.2) Equation (3.2) is the equation for a straight line; it has a vertical intercept of I/PC and a slope of −(PF/PC). The slope of the budget line, −(PF/PC), is the negative of the ratio of the prices of the two goods. The magnitude of the slope tells us the rate at which the two goods can be substituted for each other without changing the total amount of money spent. The vertical intercept (I/PC) represents the maximum amount of C that can be purchased with income I. Finally, the horizontal intercept (I/PF) tells us how many units of F can be purchased if all income were spent on F. The Effects of Changes in Income and Prices We have seen that the budget line depends both on income and on the prices of the goods, PF and PC. But of course prices and income often change. Let’s see how such changes affect the budget line. INCOME CHANGES What happens to the budget line when income changes? From the equation for the straight line (3.2), we can see that a change in income alters the vertical intercept of the budget line but does not change the slope (because the price of neither good changed). Figure 3.11 shows that if income is doubled (from $80 to $160), the budget line shifts outward, from budget line L1 to budget line L2. Note, however, that L2 remains parallel to L1. If she desires, our consumer can now double her purchases of both food and clothing. Likewise, if her income is cut in half (from $80 to $40), the budget line shifts inward, from L1 to L3. FIGURE 3.11 EFFECTS OF A CHANGE IN INCOME ON THE BUDGET LINE A change in income (with prices unchanged) causes the budget line to shift parallel to the original line (L1). When the income of $80 (on L1) is increased to $160, the budget line shifts outward to L2. If the income falls to $40, the line shifts inward to L3. Clothing (units per week) 80 60 40 20 L 3 L 1 L 2 (I = $40) (I = $80) (I = $160) 40 80 120 160 Food (units per week) CHAPTER 3 • Consumer Behavior 85 PRICE CHANGES What happens to the budget line if the price of one good changes but the price of the other does not? We can use the equation C (I/PC) − (PF/PC)F to describe the effects of a change in the price of food on the budget line. Suppose the price of food falls by half, from $1 to $0.50. In that case, the vertical intercept of the budget line remains unchanged, although the slope changes from −PF/PC $1/$2 $1/2 to $0.50/$2 $1/4. In Figure 3.12, we obtain the new budget line L2 by rotating the original budget line L1 outward, pivoting from the C-intercept. This rotation makes sense because a person who consumes only clothing and no food is unaffected by the price change. However, someone who consumes a large amount of food will experience an increase in his purchasing power. Because of the decline in the price of food, the maximum amount of food that can be purchased has doubled. On the other hand, when the price of food doubles from $1 to $2, the budget line rotates inward to line L3 because the person’s purchasing power has diminished. Again |
, a person who consumed only clothing would be unaffected by the food price increase. What happens if the prices of both food and clothing change, but in a way that leaves the ratio of the two prices unchanged? Because the slope of the budget line is equal to the ratio of the two prices, the slope will remain the same. The intercept of the budget line must shift so that the new line is parallel to the old one. For example, if the prices of both goods fall by half, then the slope of the budget line does not change. However, both intercepts double, and the budget line is shifted outward. This exercise tells us something about the determinants of a consumer’s purchasing power—her ability to generate utility through the purchase of goods and services. Purchasing power is determined not only by income, but also by prices. For example, our consumer’s purchasing power can double either because her income doubles or because the prices of all the goods that she buys fall by half. Finally, consider what happens if everything doubles—the prices of both food and clothing and the consumer’s income. (This can happen in an inflationary economy.) Because both prices have doubled, the ratio of the prices has not changed; neither, therefore, has the slope of the budget line. Because the price of clothing has doubled along with income, the maximum amount of clothing that can be purchased (represented by the vertical intercept of the budget Clothing (units per week) 40 FIGURE 3.12 EFFECTS OF A CHANGE IN PRICE ON THE BUDGET LINE A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. When the price of food falls from $1.00 to $0.50, the budget line rotates outward from L1 to L2. However, when the price increases from $1.00 to $2.00, the line rotates inward from L1 to L3. L 3 L 1 L 2 (PF = 2) (PF = 1) (PF = )1 2 40 80 120 160 Food (units per week) 86 PART 2 • Producers, Consumers, and Competitive Markets line) is unchanged. The same is true for food. Therefore, inflationary conditions in which all prices and income levels rise proportionately will not affect the consumer’s budget line or purchasing power. 3.3 Consumer Choice Given preferences and budget constraints, we can now determine how individual consumers choose how much of each good to buy. We assume that consumers make this choice in a rational way—that they choose goods to maximize the satisfaction they can achieve, given the limited budget available to them. The maximizing market basket must satisfy two conditions: 1. It must be located on the budget line.To see why, note that any market basket to the left of and below the budget line leaves some income unallocated—income which, if spent, could increase the consumer’s satisfaction. Of course, consumers can—and often do—save some of their incomes for future consumption. In that case, the choice is not just between food and clothing, but between consuming food or clothing now and consuming food or clothing in the future. At this point, however, we will keep things simple by assuming that all income is spent now. Note also that any market basket to the right of and above the budget line cannot be purchased with available income. Thus, the only rational and feasible choice is a basket on the budget line. 2. It must give the consumer the most preferred combination of goods and services. These two conditions reduce the problem of maximizing consumer satisfaction to one of picking an appropriate point on the budget line. In our food and clothing example, as with any two goods, we can graphically illustrate the solution to the consumer’s choice problem. Figure 3.13 shows how Clothing (units per week) 40 30 20 FIGURE 3.13 MAXIMIZING CONSUMER SATISFACTION A consumer maximizes satisfaction by choosing market basket A. At this point, the budget line and indifference curve U2 are tangent, and no higher level of satisfaction (e.g., market basket D) can be attained. At A, the point of maximization, the MRS between the two goods equals the price ratio. At B, however, because the MRS [−(−10/10) = 1] is greater than the price ratio (1/2), satisfaction is not maximized. –10C B +10F D A 20 40 80 U3 U2 U1 Budget Line Food (units per week) CHAPTER 3 • Consumer Behavior 87 the problem is solved. Here, three indifference curves describe a consumer’s preferences for food and clothing. Remember that of the three curves, the outermost curve, U3, yields the greatest amount of satisfaction, curve U2 the next greatest amount, and curve U1 the least. Note that point B on indifference curve U1 is not the most preferred choice, because a reallocation of income in which more is spent on food and less on clothing can increase the consumer’s satisfaction. In particular, by moving to point A, the consumer spends the same amount of money and achieves the increased level of satisfaction associated with indifference curve U2. In addition, note that baskets located to the right and above indifference curve U2, like the basket associated with D on indifference curve U3, achieve a higher level of satisfaction but cannot be purchased with the available income. Therefore, A maximizes the consumer’s satisfaction. We see from this analysis that the basket which maximizes satisfaction must lie on the highest indifference curve that touches the budget line. Point A is the point of tangency between indifference curve U2 and the budget line. At A, the slope of the budget line is exactly equal to the slope of the indifference curve. Because the MRS (−C/F) is the negative of the slope of the indifference curve, we can say that satisfaction is maximized (given the budget constraint) at the point where MRS = PF/PC (3.3) This is an important result: Satisfaction is maximized when the marginal rate of substitution (of F for C) is equal to the ratio of the prices (of F to C). Thus the consumer can obtain maximum satisfaction by adjusting his consumption of goods F and C so that the MRS equals the price ratio. The condition given in equation (3.3) illustrates the kinds of optimization conditions that arise in economics. In this instance, satisfaction is maximized when the marginal benefit—the benefit associated with the consumption of one additional unit of food—is equal to the marginal cost—the cost of the additional unit of food. The marginal benefit is measured by the MRS. At point A, it equals 1/2 (the magnitude of the slope of the indifference curve), which implies that the consumer is willing to give up 1/2 unit of clothing to obtain 1 unit of food. At the same point, the marginal cost is measured by the magnitude of the slope of the budget line; it too equals 1/2 because the cost of getting one unit of food is giving up 1/2 unit of clothing (PF 1 and PC 2 on the budget line). If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not been maximized. For example, compare point B in Figure 3.13 to point A. At point B, the consumer is purchasing 20 units of food and 30 units of clothing. The price ratio (or marginal cost) is equal to 1/2 because food costs $1 and clothing $2. However, the MRS (or marginal benefit) is greater than 1/2; it is approximately 1. As a result, the consumer is able to substitute 1 unit of food for 1 unit of clothing without loss of satisfaction. Because food is cheaper than clothing, it is in her interest to buy more food and less clothing. If our consumer purchases 1 less unit of clothing, for example, the $2 saved can be allocated to two units of food, even though only one unit is needed to maintain her level of satisfaction. The reallocation of the budget continues in this manner (moving along the budget line), until we reach point A, where the price ratio of 1/2 just equals the MRS of 1/2. This point implies that our consumer is willing to trade one unit of clothing for two units of food. Only when the condition MRS 1/2 PF/PC holds is she maximizing her satisfaction. The result that the MRS equals the price ratio is deceptively powerful. Imagine two consumers who have just purchased various quantities of food and • marginal benefit Benefit from the consumption of one additional unit of a good. • marginal cost Cost of one additional unit of a good. 88 PART 2 • Producers, Consumers, and Competitive Markets clothing. If both are maximizing, you can tell the value of each person’s MRS by looking at the prices of the two goods. What you cannot tell, however, is the quantity of each good purchased, because that decision is determined by their individual preferences. If the two consumers have different tastes, they will consume different quantities of food and clothing, even though each MRS is the same. E XAM PLE 3.3 DESIGNING NEW AUTOMOBILES (II) Our analysis of consumer choice allows us to see how different preferences of consumer groups for automobiles can affect their purchasing decisions. Following up on Example 3.1 (page 77), we consider two groups of consumers planning to buy new cars. Suppose that each consumer has an overall car budget of $20,000, but has decided to allocate $10,000 to interior size and acceleration and $10,000 to all the other attributes of a new car. Each group, however, has different preferences for size and acceleration. Figure 3.14 shows the car-buying budget constraint faced by individuals in each group. Those in the first group, who are typical of Ford Mustang coupe owners with preferences similar to those in Figure 3.7 (page 78), prefer acceleration to size. By finding the point of tangency between a typical individual’s indifference curve and the budget constraint, we see that consumers in this group would prefer to buy a car whose acceleration was worth $7000 and whose size was worth $3000. Individuals in the second group, who are typical of Ford Size (cubic feet) $10,000 $3000 Size (cubic feet) $10,000 $7500 $7000 $10,000 Acceleration (horsepower) $2500 $10,000 Acceleration (horsepower) (a) (b) FIGURE 3.14 CONSUMER CHOICE OF AUTOMOB |
ILE ATTRIBUTES The consumers in (a) are willing to trade off a considerable amount of interior space for some additional acceleration. Given a budget constraint, they will choose a car that emphasizes acceleration. The opposite is true for consumers in (b). CHAPTER 3 • Consumer Behavior 89 Explorer users, would prefer cars with $2500 worth of acceleration and $7500 worth of size.7 We have simplified matters for this example by considering only two attributes. In practice, an automobile company will use marketing and statistical studies to learn how different groups of consumers value a broad set of attributes. Combined with information about how these attributes will affect manufacturing costs, the company can design a production and marketing plan. In the context of our example, one potentially profitable option is to appeal to both groups of consumers by manufacturing a model emphasizing acceleration to a slightly lesser degree than preferred by those in Figure 3.14 (a). A second option is to produce a relatively large number of cars that emphasize size and a smaller number emphasizing acceleration. Knowledge about the preferences of each group (i.e., the actual indifference curves), along with information about the number of consumers in each, would help the firm make a sensible business decision. In fact, an exercise similar to the one we’ve described here was carried out by General Motors in a survey of a large number of automobile buyers.8 Some of the results were expected. For example, households with children tended to prefer functionality over style and so tended to buy minivans rather than sedans and sporty cars. Rural households, on the other hand, tended to purchase pickups and allwheel drives. More interesting was the strong correlation between age and attribute preferences. Older consumers tended to prefer larger and heavier cars with more safety features and accessories (e.g., power windows and steering). Further, younger consumers preferred greater horsepower and more stylish cars. • corner solution Situation in which the marginal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line. Corner Solutions Sometimes consumers buy in extremes, at least within categories of goods. Some people, for example, spend no money on travel and entertainment. Indifference curve analysis can be used to show conditions under which consumers choose not to consume a particular good. In Figure 3.15, a man faced with budget line AB for snacks chooses to purchase only ice cream (IC) and no frozen yogurt (Y). This decision reflects what is called a corner solution. When one of the goods is not consumed, the consumption bundle appears at the corner of the graph. At B, which is the point of maximum satisfaction, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This inequality suggests that if the consumer had more frozen yogurt to give up, he would gladly trade it for additional ice cream. At this point, however, our consumer is already consuming all ice cream and no frozen yogurt, and it is impossible to consume negative amounts of frozen yogurt. When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio. Unlike the condition expressed in equation (3.3), the necessary condition for satisfaction to be maximized when choosing between ice cream and frozen yogurt in a corner solution is given by the following inequality.9 MRS Ú PIC/PY (3.4) 7The first set of indifference curves for the Ford Mustang coupe will be of the following form: U (level of utility) b0 (constant) b1 *S (space in cubic feet) * b2*S2 b3*H (horsepower) b4*H2 b5*O (a list of other attributes). Each indifference curve represents the combinations of S and H that generate the same level of utility. The comparable relationship for the Ford Explorer will have the same form, but different b’s. 8The survey design and the results are described in Steven Berry, James Levinsohn, and Ariel Pakes, “Differentiated Products Demand Systems from a Combination of Micro and Macro Data: The New Car Market,” Journal of Political Economy, 112 (February 2004): 68–105. 9Strict equality could hold if the slope of the budget constraint happened to equal the slope of the indifference curve—a condition that is unlikely. 90 PART 2 • Producers, Consumers, and Competitive Markets Frozen yogurt (cups per month) A U 1 U 2 U 3 FIGURE 3.15 A CORNER SOLUTION When the consumer’s marginal rate of substitution is not equal to the price ratio for all levels of consumption, a corner solution arises. The consumer maximizes satisfaction by consuming only one of the two goods. Given budget line AB, the highest level of satisfaction is achieved at B on indifference curve U1, where the MRS (of ice cream for frozen yogurt) is greater than the ratio of the price of ice cream to the price of frozen yogurt. B Ice cream (cups per month) This inequality would, of course, be reversed if the corner solution were at point A rather than B. In either case, we can see that the marginal benefit–marginal cost equality that we described in the previous section holds only when positive quantities of all goods are consumed. An important lesson here is that predictions about how much of a product consumers will purchase when faced with changing economic conditions depend on the nature of consumer preferences for that product and related products and on the slope of the consumer’s budget line. If the MRS of ice cream for frozen yogurt is substantially greater than the price ratio, as in Figure 3.15, then a small decrease in the price of frozen yogurt will not alter the consumer’s choice; he will still choose to consume only ice cream. But if the price of frozen yogurt falls far enough, the consumer could quickly choose to consume a lot of frozen yogurt. E XAM PLE 3.4 CONSUMER CHOICE OF HEALTH CARE Expenditures on health care in the United States have risen dramatically over the past few decades, a phenomenon that some people find alarming. Some economists have argued that these expenditures have increased so much because our health care system is inefficient. That may well be, but there could also be another reason: As consumers become better off economically, their preferences shift toward health care and away from other goods. After all, if you already own a nice home and two cars, what would give you more satisfaction—a third CHAPTER 3 • Consumer Behavior 91 car, or additional medical care that might extend your life by a year? Many would choose the extra health care. The preferences for health care are illustrated in Figure 3.16, which shows a series of indifference curves and budget lines that characterize the tradeoff between consumption of health care (H) versus other goods (O). Indifference curve U1 applies to a consumer with low income; the consumer’s budget line is tangent at point A, so that the consumption of health care and consumption of other goods that maximize the consumer’s satisfaction are H1 and O1. Indifference curve U2 yields a greater amount of satisfaction, but is only feasible for a consumer with higher income. In this case utility is maximized at point B. Curve U3 applies to a high-income consumer, and implies less willingness to give up health care for other goods. Moving from point B to point C, the consumer’s consumption of health care increases considerably (from H2 to H3), while her consumption of other goods increases only modestly (from O2 to O3). Does Figure 3.16 correctly characterize the preferences of consumers? At least one recent statistical study indicates that it does.10 So does common sense. If your income were high enough so that you could have most of the things you wanted, would you prefer to spend additional income on life-extending health care or on another car? Health Care H3 H2 H1 C B A O1 O2 O3 FIGURE 3.16 CONSUMER PREFERENCES FOR HEALTH CARE VERSUS OTHER GOODS These indifference curves show the trade-off between consumption of health care (H) versus other goods (O). Curve U1 applies to a consumer with low income; given the consumer’s budget constraint, satisfaction is maximized at point A. As income increases the budget line shifts to the right, and curve U2 becomes feasible. The consumer moves to point B, with greater consumption of both health care and other goods. Curve U3 applies to a high-income consumer, and implies less willingness to give up health care for other goods. Moving from point B to point C, the consumer’s consumption of health care increases considerably (from H2 to H3), while her consumption of other goods increases only modestly (from O2 to O3). U3 U2 Other Goods U1 10See the interesting article by Robert E. Hall and Charles I. Jones, “The Value of Life and the Rise in Health Spending,” Quarterly Journal of Economics, February 2007, pp. 39–72. The authors explain that the optimal composition of total spending shifts toward health as income increases. They predict that the optimal heath share of spending is likely to exceed 30 percent by 2050. 92 PART 2 • Producers, Consumers, and Competitive Markets E XAM PLE 3.5 A COLLEGE TRUST FUND Jane Doe’s parents have provided a trust fund for her college education. Jane, who is 18, can receive the entire trust fund on the condition that she spend it only on education. The fund is a welcome gift but perhaps not as welcome as an unrestricted trust. To see why Jane feels this way, consider Figure 3.17, in which dollars per year spent on education are shown on the horizontal axis and dollars spent on other forms of consumption on the vertical. The budget line that Jane faces before being awarded the trust is given by line PQ. The trust fund expands the budget line outward as long as the full amount of the fund, shown by distance PB, is spent on education. By accepting the trust fund and going to college, Jane increases her satisfaction, moving from A on indifference curve U1 to B |
on indifference curve U2. Note that B represents a corner solution because Jane’s marginal rate of substitution of education for other consumption is lower than the relative price of other consumption. Jane would prefer to spend a portion of the trust fund on other goods in addition to education. Without restriction on the trust fund, she would move to C on indifference curve U3, decreasing her spending on education (perhaps going to a junior college rather than a four-year college) but increasing her spending on items that she enjoys more than education. Recipients usually prefer unrestricted to restricted trusts. Restricted trusts are popular, however, because they allow parents to control children’s expenditures in ways that they believe are in the children’s long-run best interests. Other consumption ($) FIGURE 3.17 A COLLEGE TRUST FUND When given a college trust fund that must be spent on education, the student moves from A to B, a corner solution. If, however, the trust fund could be spent on other consumption as well as education, the student would be better off at C. Q Education ($) 3.4 Revealed Preference In Section 3.1, we saw how an individual’s preferences could be represented by a series of indifference curves. Then in Section 3.3, we saw how preferences, given budget constraints, determine choices. Can this process be reversed? If we know the choices that a consumer has made, can we determine his or her preferences? CHAPTER 3 • Consumer Behavior 93 We can if we have information about a sufficient number of choices that have been made when prices and income levels varied. The basic idea is simple. If a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the alternative, then the consumer must prefer the chosen market basket. Suppose that an individual, facing the budget constraint given by line l1 in Figure 3.18, chooses market basket A. Let’s compare A to baskets B and D. Because the individual could have purchased basket B (and all baskets below line l1) and did not, we say that A is preferred to B. It might seem at first glance that we cannot make a direct comparison between baskets A and D because D is not on l1. But suppose the relative prices of food and clothing change, so that the new budget line is l2 and the individual then chooses market basket B. Because D lies on budget line l2 and was not chosen, B is preferred to D (and to all baskets below line l2). Because A is preferred to B and B is preferred to D, we conclude that A is preferred to D. Furthermore, note in Figure 3.18 that basket A is preferred to all of the baskets that appear in the green-shaded areas. However, because food and clothing are “goods” rather than “bads,” all baskets that lie in the pink-shaded area in the rectangle above and to the right of A are preferred to A. Thus, the indifference curve passing through A must lie in the unshaded area. Given more information about choices when prices and income levels vary, we can get a better fix on the shape of the indifference curve. Consider Figure 3.18. Suppose that facing line l3 (which was chosen to pass through A), the individual chooses market basket E. Because E was chosen even though A was equally expensive (it lies on the same budget line), E is preferred to A, as are all points in the rectangle above and to the right of E. Now suppose that facing line l4 (which passes through A), the individual chooses market basket G. Because G was chosen and A was not, G is preferred to A, as are all market baskets above and to the right of G. We can go further by making use of the assumption that indifference curves are convex. In that case, because E is preferred to A, all market baskets above and to the right of line AE in Figure 3.19 must be preferred to A. Otherwise, the indifference curve passing through A would have to pass through a point above Clothing (units per month) l1 l2 FIGURE 3.18 REVEALED PREFERENCE: TWO BUDGET LINES If an individual facing budget line l1 chose market basket A rather than market basket B, A is revealed to be preferred to B. Likewise, the individual facing budget line l2 chooses market basket B, which is then revealed to be preferred to market basket D. Whereas A is preferred to all market baskets in the green-shaded area, all baskets in the pinkshaded area are preferred to A. A B D Food (units per month) 94 PART 2 • Producers, Consumers, and Competitive Markets Clothing (units per month) l3 FIGURE 3.19 REVEALED PREFERENCE: FOUR BUDGET LINES Facing budget line l3 the individual chooses E, which is revealed to be preferred to A (because A could have been chosen). Likewise, facing line l4, the individual chooses G which is also revealed to be preferred to A. Whereas A is preferred to all market baskets in the green-shaded area, all market baskets in the pink-shaded area are preferred to A. E l1 l4 l2 A B G Food and to the right of AE and then fall below the line at E—in which case the indifference curve would not be convex. By a similar argument, all points on AG or above are also preferred to A. Therefore, the indifference curve must lie within the unshaded area. The revealed preference approach is valuable as a means of checking whether individual choices are consistent with the assumptions of consumer theory. As Example 3.6 shows, revealed preference analysis can help us understand the implications of choices that consumers must make in particular circumstances. E XAM PLE 3.6 REVEALED PREFERENCE FOR RECREATION A health club has been offering the use of its facilities to anyone who is willing to pay an hourly fee. Now the club decides to alter its pricing policy by charging both an annual membership fee and a lower hourly fee. Does this new financial arrangement make individuals better off or worse off than they were under the old arrangement? The answer depends on people’s preferences. Suppose that Roberta has $100 of income available each week for recreational activities, including exercise, movies, restaurant meals, and so on. When the health club charged a fee of $4 per hour, Roberta used the facility 10 hours per week. Under the new arrangement, she is required to pay $30 per week but can use the club for only $1 per hour. Is this change beneficial for Roberta? Revealed preference analysis provides the answer. In Figure 3.20, line l1 represents the budget constraint that Roberta faced under the original pricing arrangement. In this case, she maximized her satisfaction by choosing market basket A, with 10 hours of exercise and $60 of other recreational activities. Under the new arrangement, which shifts the budget line to l2, she could still choose market basket A. But because U1 is clearly not tangent to l2, Roberta will be better off choosing another basket, such as B, with 25 hours of exercise and $45 worth of other recreational activities. Because she would choose B when she could still choose A, she prefers B to A. The new pricing arrangement CHAPTER 3 • Consumer Behavior 95 therefore makes Roberta better off. (Note that B is also preferred to C, which represents the option of not using the health club at all.) We could also ask whether this new pricing system—called a two-part tariff—will increase the club’s profits. If all members are like Roberta and more use generates more profit, then the answer is yes. In general, however, the answer depends on two factors: the preferences of all members and the costs of operating the facility. We discuss the twopart tariff in detail in Chapter 11, where we study ways in which firms with market power set prices. Other recreational activities ($) C 100 A 80 60 40 20 0 FIGURE 3.20 REVEALED PREFERENCE FOR RECREATION When facing budget line l1, an individual chooses to use a health club for 10 hours per week at point A. When the fees are altered, she faces budget line l2. She is then made better off because market basket A can still be purchased, as can market basket B, which lies on a higher indifference curve. B U1 l1 25 U2 l 2 50 75 Amount of exercise (hours) 3.5 Marginal Utility and Consumer Choice In Section 3.3, we showed graphically how a consumer can maximize his or her satisfaction, given a budget constraint. We do this by finding the highest indifference curve that can be reached, given that budget constraint. Because the highest indifference curve also has the highest attainable level of utility, it is natural to recast the consumer’s problem as one of maximizing utility subject to a budget constraint. The concept of utility can also be used to recast our analysis in a way that provides additional insight. To begin, let’s distinguish between the total utility obtained by consumption and the satisfaction obtained from the last item consumed. Marginal utility (MU) measures the additional satisfaction obtained from consuming one additional unit of a good. For example, the marginal utility associated with a consumption increase from 0 to 1 unit of food might be 9; from 1 to 2, it might be 7; from 2 to 3, it might be 5. These numbers imply that the consumer has diminishing marginal utility: As more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility. Imagine, for example, the consumption of television: Marginal utility might fall after the second or third hour and could become very small after the fourth or fifth hour of viewing. We can relate the concept of marginal utility to the consumer ’s utility-maximization problem in the following way. Consider a small movement • marginal utility (MU) Additional satisfaction obtained from consuming one additional unit of a good. • diminishing marginal utility Principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility. 96 PART 2 • Producers, Consumers, and Competitive Markets down an indifference curve in Figure 3.8 (page 79). The additional consumption of food, F, will generate m |
arginal utility MUF. This shift results in a total F. At the same time, the reduced consumption of increase in utility of MUF clothing, C, will lower utility per unit by MUC, resulting in a total loss of MUC C. Because all points on an indifference curve generate the same level of utility, the total gain in utility associated with the increase in F must balance the loss due to the lower consumption of C. Formally, 0 = MUF(F) + MUC(C) Now we can rearrange this equation so that -(C/F) = MUF/MUC But because −(C/F) is the MRS of F for C, it follows that MRS = MUF/MUC (3.5) Equation (3.5) tells us that the MRS is the ratio of the marginal utility of F to the marginal utility of C. As the consumer gives up more and more of C to obtain more of F, the marginal utility of F falls and that of C increases, so MRS decreases. We saw earlier in this chapter that when consumers maximize their satisfac- tion, the MRS of F for C is equal to the ratio of the prices of the two goods: MRS = PF/PC (3.6) Because the MRS is also equal to the ratio of the marginal utilities of consuming F and C (from equation 3.5), it follows that MUF/MUC = PF/PC or MUF/PF = MUC/PC (3.7) Equation (3.7) is an important result. It tells us that utility maximization is achieved when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. To see why this principle must hold, suppose that a person gets more utility from spending an additional dollar on food than on clothing. In this case, her utility will be increased by spending more on food. As long as the marginal utility of spending an extra dollar on food exceeds the marginal utility of spending an extra dollar on clothing, she can increase her utility by shifting her budget toward food and away from clothing. Eventually, the marginal utility of food will decrease (because there is diminishing marginal utility in its consumption) and the marginal utility of clothing will increase (for the same reason). Only when the consumer has satisfied the equal marginal principle—i.e., has equalized the marginal utility per dollar of expenditure across all goods—will she have maximized utility. The equal marginal principle is an important concept in microeconomics. It will reappear in different forms throughout our analysis of consumer and producer behavior. • equal marginal principle Principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods. CHAPTER 3 • Consumer Behavior 97 EXAM PLE 3.7 MARGINAL UTILITY AND HAPPINESS In Example 3.2 (page 81), we saw that money (i.e., a higher income) can buy happiness, at least to a degree. But what, if anything, does research on consumer satisfaction tell us about the relationship between happiness and the concepts of utility and marginal utility? Interestingly, that research is consistent with a pattern of diminishing marginal utility of income, both in the U.S. and across countries. To see why, let’s re-examine Figure 3.9 (page 82) in Example 3.2. The data suggest that as incomes increase from one country to the next, satisfaction, happiness, or utility (we are using the three words interchangeably) all increase as per-capita income increases. The incremental increase in satisfaction, however, declines as income increases. If one is willing to accept that the satisfaction index resulting from the survey is a cardinal index, then the results are consistent with a diminishing marginal utility of income. The results for the U.S. are qualitatively very similar to those for the 67 countries that make up the data for Figure 3.9. Figure 3.21 calculates the mean level of life satisfaction for nine separate income groups in the population; the lowest has a mean income of $6,250, the next a mean income of $16,250, and so on until the highest group, whose mean income is $87,500. The solid curve is the one that best fits the data. Once again, we can see that reported happiness increases with income, but at a diminishing rate. For those students concerned about future income prospects, a recent survey by psychologist Daniel Kahneman and economist Angus Deaton shows that 8.2 8 7.8 7.6 7.4 7..8 0 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000 Income in 1999 U.S. $ FIGURE 3.21 MARGINAL UTILITY AND HAPPINESS A comparison of mean levels of satisfaction with life across income classes in the United States shows that happiness increases with income, but at a diminishing rate. 98 PART 2 • Producers, Consumers, and Competitive Markets for this relatively high income group, making additional money does not improve a person’s ability to enjoy leisure time and good health—all of which factor into one’s overall well-being.11 These results offer strong support for the modern theory of economic decision making that underlies this text, but they are still being carefully scrutinized. For example, they do not account for the fact that satisfaction tends to vary with age, with younger people often expressing less satisfaction than older folks. Or we can look at this a different way. Students have something positive to look forward to as they get older and wiser. A second issue arises when we compare the results of happiness studies over time. Per-capita incomes in the U.S., U.K., Belgium, and Japan have all risen substantially over the past 20 years. Average happiness, however, has remained relatively unchanged. (Denmark, Germany, and Italy did show some increased satisfaction.) One plausible interpretation is that happiness is a relative, not absolute, measure of well-being. As a country’s income increases over time, its citizens increase their expectations; in other words, they aspire to having higher incomes. To the extent that satisfaction is tied to whether those aspirations are met, satisfaction may not increase as income grows over time. Rationing In times of war and other crises, governments sometimes ration food, gasoline, and other products, rather than allow prices to increase to competitive levels. During World War II, for example, individual households in the United States were limited to twelve ounces of sugar per week, one pound of coffee every five weeks, and three gallons of gasoline per week. Rationing has often been used with respect to water in periods of drought. Within the United States, California has often faced water rationing for both household consumption and agricultural production. Outside the United States, countries such as Rwanda, India, Pakistan, and Egypt have imposed water rationing as recently as 2010. Nonprice rationing is an alternative that some consider more equitable than relying on uncontested market forces. Under a market system, those with higher incomes can outbid those with lower incomes to obtain goods that are in scarce supply. However, if products are rationed through a mechanism such as the allocation of coupons to households or businesses, everyone will have an equal chance to purchase a rationed good. To understand how we can analyze rationing using the basic consumer model, let’s use the gasoline rationing that occurred during 1979 as an example. Following the 1979 Iranian Revolution, oil prices jumped, but the United States imposed price controls that prevented increases in the price of gasoline, resulting in shortages. Gasoline was allocated by long lines at the gas pump: While those who were willing to give up their time waiting got the gas they wanted, others did not. By guaranteeing every eligible person a minimum amount of gasoline, rationing can provide some people with access to a product that they could not otherwise afford. But rationing hurts others by limiting the amount of gasoline that they can buy.12 We can see this principle clearly in Figure 3.22, which applies to a woman with an annual income of $20,000. The horizontal axis shows her annual consumption of gasoline, the vertical axis her remaining income after purchasing 11Daniel Kahneman and Angus Deaton, “High Income Improves Evaluation of Life But not Emotional Well-Being,” PNAS, Vol. 107 (September 21, 2010): 16489–16493. 12For a more extensive discussion of gasoline rationing, see H. E. Frech III and William C. Lee, “The Welfare Cost of Rationing-by-Queuing Across Markets: Theory and Estimates from the U.S. Gasoline Crises,” Quarterly Journal of Economics (1987): 97–108. CHAPTER 3 • Consumer Behavior 99 FIGURE 3.22 INEFFICIENCY OF GASOLINE RATIONING When a good is rationed, less is available than consumers would like to buy. Consumers may be worse off. Without gasoline rationing, up to 20,000 gallons of gasoline are available for consumption (at point B). The consumer chooses point C on indifference curve U2, consuming 5000 gallons of gasoline. However, with a limit of 2000 gallons of gasoline under rationing (at point E), the consumer moves to D on the lower indifference curve U1. Spending on other goods ($) 20,000 18,000 15,000 D A C E U2 U1 B 0 2000 5000 20,000 Gasoline (gallons per year) gasoline. Suppose the controlled gasoline price is $1 per gallon. Because her income is $20,000, she is limited to the points on budget line AB, which has a slope of −1. Point A represents her total income of $20,000. (If no gasoline were purchased, she would have $20,000 to spend on other goods.) At point B she would be spending her entire income on gasoline. At $1 per gallon, she might wish to buy 5000 gallons of gasoline per year and spend $15,000 on other goods, represented by C. At this point, she would have maximized her utility (by being on the highest possible indifference curve U2), given her budget constraint of $20,000. Let’s assume that with rationing, our consumer can purchase up to a maximum of 2000 gallons of gasoline. Thus, she now faces budget line ADE, which is not a straight line because purchases above 2000 gallons are not possible. Point D represents the point of consumption of 2000 gallons per year. At that point, the budget line become |
vertical, declining to point E, since rationing has limited gasoline consumption. The figure shows that her choice to consume at D involves a lower level of utility, U1, than would be achieved without rationing, U2, because she is consuming less gasoline and more of other goods than she would otherwise prefer. It is clear that at the rationed price the woman would be better off if her consumption were not constrained. But is she better off under a rationing system than she would be if there were no rationing at all? The answer, not surprisingly, depends on what the competitive market price of gasoline would have been without rationing. Figure 3.23 illustrates this point. Recall that had the price of gasoline been determined by the market to be $1 per gallon, our consumer would have been able to buy up to 20,000 gallons of gasoline per year—hence the original budget line. With rationing, she chooses to buy the maximum allowable 2000 gallons per year, putting her on indifference curve U1. Now suppose that the competitive market price had been $2.00 per gallon rather than $1.00. Now the relevant budget line would be the line that was associated with a maximum gasoline consumption of only 10,000 gallons per year, and with no rationing she 100 PART 2 • Producers, Consumers, and Competitive Markets FIGURE 3.23 COMPARING GASOLINE RATIONING TO THE FREE MARKET Some consumers will be worse off, but others may be better off with rationing. With rationing and a gasoline price of $1.00 she buys the maximum allowable 2000 gallons per year, putting her on indifference curve U1. Had the competitive market price been $2.00 per gallon with no rationing, she would have chosen point F, which lies below indifference curve U1. However, had the price of gasoline been only $1.33 per gallon, she would have chosen point G, which lies above indifference curve U1. Spending on other goods ($) 20,000 D F G 14,000 U1 0 3000 10,000 15,000 20,000 Gasoline (gallons per year) would choose point F, which lies below indifference curve U1. (At point F, she purchases 3,000 gallons of gasoline and has $14,000 to spend on other goods.) But, consider what would happen if the price of gasoline were only $1.33 per gallon. Then the relevant budget line would be the line associated with a maximum gasoline consumption of about 15,000 gallons per year ($20,000/$1.33). She would choose a point such as G, where she purchases more than 3,000 galls of gasoline and has more than $14,000 to spend on other goods. In this case, she would be better off without rationing, since point G lies above indifference curve U1. We can conclude, therefore, that while rationing is a less efficient means of allocating goods and serves, under any particular rationing scheme some individuals may well be better off, even though others will necessarily be worse off. *3.6 Cost-of-Living Indexes The Social Security system has been the subject of heated debate for some time now. Under the present system, a retired person receives an annual benefit that is initially determined at the time of retirement and is based on his or her work history. The benefit then increases from year to year at a rate equal to the rate of increase of the Consumer Price Index (CPI). Does the CPI accurately reflect the cost of living for retirees? Is it appropriate to use the CPI as we now do—as a cost-of-living index for other government programs, for private union pensions, and for private wage agreements? On a similar note, we might ask whether the Producer Price Index (PPI) accurately measures the change over time in the cost of production. The answers to these questions lie in the economic theory of consumer behavior. In this section, we describe the theoretical underpinnings of cost indexes such as the CPI, using an example that describes the hypothetical price changes that students and their parents might face. In §1.3, we introduced the Consumer Price Index as a measure of the cost of a “typical” consumer’s entire market basket. As such, changes in the CPI also measure the rate of inflation. • cost-of-living index Ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period. In §1.3, we explained that the Producer Price Index provides a measure of the aggregate price level for intermediate products and wholesale goods. CHAPTER 3 • Consumer Behavior 101 TABLE 3.3 IDEAL COST-OF-LIVING INDEX 2000 (SARAH ) 2010 (RACHEL) Price of books Number of books Price of food Pounds of food Expenditure $20/book 15 $2.00/lb. 100 $500 $100/book 6 $2.20/lb. 300 $1260 Ideal Cost-of-Living Index Let’s look at two sisters, Rachel and Sarah, whose preferences are identical. When Sarah began her college education in 2000, her parents gave her a “discretionary” budget of $500 per quarter. Sarah could spend the money on food, which was available at a price of $2.00 per pound, and on books, which were available at a price of $20 each. Sarah bought 100 pounds of food (at a cost of $200) and 15 books (at a cost of $300). Ten years later, in 2010, when Rachel (who had worked during the interim) is about to start college, her parents promise her a budget that is equivalent in buying power to the budget given to her older sister. Unfortunately, prices in the college town have increased, with food now $2.20 per pound and books $100 each. By how much should the discretionary budget be increased to make Rachel as well off in 2010 as her sister Sarah was in 2000? Table 3.3 summarizes the relevant data and Figure 3.24 provides the answer. The initial budget constraint facing Sarah in 2000 is given by line l1 in Figure 3.24; her utility-maximizing combination of food and books is at point A on indifference curve U1. We can check that the cost of achieving this level of utility is $500, as stated in the table: $500 = 100 lbs. of food * $2.00/lb. + 15 books * $20/book As Figure 3.24 shows, to achieve the same level of utility as Sarah while facing the new higher prices, Rachel requires a budget sufficient to purchase the food-book Books (per quarter) U1 A 25 20 15 10 5 0 FIGURE 3.24 COST-OF-LIVING INDEXES A price index, which represents the cost of buying bundle A at current prices relative to the cost of bundle A at base-year prices, overstates the ideal cost-of-living index. B l1 l3 l2 50 100 150 200 250 300 350 400 450 500 550 600 Food (lb. per quarter) 102 PART 2 • Producers, Consumers, and Competitive Markets • ideal cost-of-living index Cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices. • Laspeyres price index Amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices. consumption bundle given by point B on line l2 (and tangent to indifference curve U1), where she chooses 300 lbs. of food and 6 books. Note that in doing so, Rachel has taken into account the fact that the price of books has increased relative to food. Therefore, she has substituted toward food and away from books. The cost to Rachel of attaining the same level of utility as Sarah is given by $1260 = 300 lbs. of food * $2.20/lb. + 6 books * $100/book The ideal cost-of-living adjustment for Rachel is therefore $760 (which is $1260 minus the $500 that was given to Sarah). The ideal cost-of-living index is $1260/$500 = 2.52 Our index needs a base year, which we will set at 2000 100, so that the value of the index in 2010 is 252. A value of 252 implies a 152 percent increase in the cost of living, whereas a value of 100 would imply that the cost of living has not changed. This ideal cost-of-living index represents the cost of attaining a given level of utility at current (2010) prices relative to the cost of attaining the same utility at base (2010) prices. Laspeyres Index Unfortunately, such an ideal cost-of-living index would entail large amounts of information. We would need to know individual preferences (which vary across the population) as well as prices and expenditures. Actual price indexes are therefore based on consumer purchases, not preferences. A price index that uses a fixed consumption bundle in the base period is called a Laspeyres price index. The Laspeyres price index answers the question: What is the amount of money at current-year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base-year prices? The Laspeyres price index was illustrated in Figure 3.24. Calculating a Laspeyres cost-of-living index for Rachel is a straightforward process. Buying 100 pounds of food and 15 books in 2010 would require an expenditure of $1720 (100 * $2.20 + 15 * $100). This expenditure allows Rachel to choose bundle A on budget line l3 (or any other bundle on that line). Line l3 was constructed by shifting line l2 outward until it intersected point A. Note that l3 is the budget line that allows Rachel to purchase, at current 2010 prices, the same consumption bundle that her sister purchased in 2000. To compensate Rachel for the increased cost of living, we must increase her discretionary budget by $1220. Using 100 as the base in 2000, the Laspeyres index is therefore 100 * $1720/$500 = 344 COMPARING IDEAL COST-OF-LIVING AND LASPEYRES INDEXES In our example, the Laspeyres price index is clearly much higher than the ideal price index. Does a Laspeyres index always overstate the true cost-of-living index? The answer is yes, as you can see from Figure 3.24. Suppose that Rachel was given the budget associated with line l3 during the base year of 2000. She could choose bundle A, but clearly she could achieve a higher level of utility if she purchased more food and fewer books (by moving to the right on line l3). Because A and B generate equal utility, it follows that Rachel is better off |
receiving a Laspeyres cost-of-living adjustment rather than an ideal adjustment. The Laspeyres index overcompensates Rachel for the higher cost of living, and the Laspeyres cost-ofliving index is, therefore, greater than the ideal cost-of-living index. CHAPTER 3 • Consumer Behavior 103 This result holds generally. Why? Because the Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change. By changing consumption, however—increasing purchases of items that have become relatively cheaper and decreasing purchases of relatively more expensive items—consumers can achieve the same level of utility without having to consume the same bundle of goods that they did before the price change. Paasche Index Another commonly used cost-of-living index is the Paasche index. Unlike the Laspeyres index, which focuses on the cost of buying a base-year bundle, the Paasche index focuses on the cost of buying the current year’s bundle. In particular, the Paasche index answers another question: What is the amount of money at current-year prices that an individual requires to purchase the current bundle of goods and services divided by the cost of purchasing the same bundle in the base year? • Paasche index Amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year. COMPARING THE LASPEYRES AND PAASCHE INDEXES It is helpful to compare the Laspeyres and the Paasche cost-of-living indexes. • Laspeyres index: The amount of money at current-year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base-year prices. • Paasche index: The amount of money at current-year prices that an individual requires to purchase the bundle of goods and services chosen in the current year divided by the cost of purchasing the same bundle in the base year. Both the Laspeyres (LI) and Paasche (PI) indexes are fixed-weight indexes: The quantities of the various goods and services in each index remain unchanged. For the Laspeyres index, however, the quantities remain unchanged at base-year levels; for the Paasche they remain unchanged at current-year levels. Suppose generally that there are two goods, food (F) and clothing (C). Let: • fixed-weight index Cost-of-living index in which the quantities of goods and services remain unchanged. PFt and PCt be current-year prices PFb and PCb be base-year prices Ft and Ct be current-year quantities Fb and Cb be base-year quantities We can write the two indexes as: LI = PFtFb PFbFb PI = PFtFt PFbFt + PCtCb + PCbCb + PCtCt + PCbCt Just as the Laspeyres index will overstate the ideal cost of living, the Paasche will understate it because it assumes that the individual will buy the current-year bundle in the base period. In actuality, facing base-year prices, consumers would have been able to achieve the same level of utility at a lower cost by changing their consumption bundles. Because the Paasche index is a ratio of the cost of 104 PART 2 • Producers, Consumers, and Competitive Markets buying the current bundle divided by the cost of buying the current bundle at base-year prices, overstating the cost of the base-year bundle (the denominator in the ratio) will cause the Paasche index itself to be understated. To illustrate the Laspeyres-Paasche comparison, let’s return to our earlier example and focus on Sarah’s choices of books and food. For Sarah (who went to college in 2000), the cost of buying the base-year bundle of books and food at current-year prices is $1720 (100 lbs. * $2.20/lb. + 15 books * $100/book). The cost of buying the same bundle at base-year prices is $500 (100 lbs * $2/lb. + 15 books * $20/book). The Laspeyres price index, LI, is therefore 100 * $1720/$500 = 344, as reported previously. In contrast, the cost of buying the current-year bundle at current-year prices is $1260 (300 lbs. * $2.20/lb. + 6 books * $100/book). The cost of buying the same bundle at base-year prices is $720 (300 lbs * $2/lb. + 6 books * $20/book). Consequently, the Paasche price index, PI, is 100 * $1260/$720 = 175. As expected, the Paasche index is lower than the Laspeyres index and lower than the ideal index of 252. Price Indexes in the United States: Chain Weighting Historically, both the CPI and the PPI were measured as Laspeyres price indexes. The overall CPI was calculated each month by the U.S. Bureau of Labor Statistics as the ratio of the cost of a typical bundle of consumer goods and services to the cost during a base period. A CPI for a particular category of goods and services (e.g., housing) would utilize a bundle of goods and services from that category. Similar calculations were done for the PPI using bundles of intermediate and wholesale goods. We have seen that the Laspeyres index overstates the amount needed to compensate individuals for price increases. With respect to Social Security and other government programs, this means that using the CPI with base weights to adjust retirement benefits would tend to overcompensate most recipients and would thus require greater government expenditure. While economists have known of this problem for years, it was not until the energy-price shocks of the 1970s, more recent fluctuations in food prices, and concerns surrounding federal deficits that dissatisfaction with the Laspeyres index grew. It was estimated, for example, that a failure to account for changes in computer-buying patterns in response to a sharp decrease in computer prices had caused the CPI to overstate the cost of living substantially. For this reason, the U.S. government changed the construction of the CPI and the PPI, switching from a simple Laspeyres index to an index in which the base weights are updated every few years. A chain-weighted price index is a costof-living index that accounts for changes in quantities of goods and services over time. Chain weighting was not new to the U.S. It had been adopted in 1995 as an improvement to the GDP deflator, a Paasche price index used to deflate measures of gross domestic product (GDP) in order to obtain an estimate of real GDP (GDP adjusted for inflation).13 Using chain-weighted versions of the CPI, PPI, and GDP deflator has reduced the biases associated with the use of simple Laspeyres and Paasche indexes, but because the weights are changed only infrequently, the biases have not been eliminated.14 13For the latest changes in the CPI and PPI, see http://www.bls.gov/cpi and http://www.bls.gov/ppi. For information about the calculation of real GDP, see http://www.bea.gov. 14Failures to account adequately for the appearance of new goods and improvements in the quality of exisiting goods are additional sources of bias with respect to the CPI and PPI. • chain-weighted price index Cost-of-living index that accounts for changes in quantities of goods and services. CHAPTER 3 • Consumer Behavior 105 EXAM PLE 3.8 THE BIAS IN THE CPI In the past decade, there has been growing public concern about the solvency of the Social Security system. At issue is the fact that retirement benefits are linked to the Consumer Price Index. Because the CPI was a Laspeyres index that could overstate the cost of living substantially, Congress has asked several economists to look into the matter. A commission chaired by Stanford University professor Michael Boskin concluded that the CPI overstated inflation by approximately 1.1 percentage points—a significant amount given the relatively low rate of inflation in the United States in recent years.15 According to the commission, approximately 0.4 percentage points of the 1.1-percentage-point bias was due to the failure of the Laspeyres price index to account for changes in the current year mix of consumption of the products in the base-year bundle. The remainder of the bias was due to the failure of the index to account for the growth of discount stores (approximately 0.1 percentage points), for improvements in the quality of existing products, and, most significantly, for the introduction of new products (0.6 percentage points). The bias in the CPI was particularly acute when evaluating the costs of medical care. From 1986 to 1996, the average increase in the CPI was 3.6 percent, but the medical component of the CPI increased at an average annual rate of 6.5 percent per year. Thus, one estimate placed the total bias of the medical insurance part of the CPI at approximately 3.1 percentage points annually. This bias has enormous policy implications as the nation struggles to contain medical-care costs and provide health care to an aging population.16 If any remaining bias in the CPI were to be eliminated, in whole or in part, the cost of a number of federal programs would decrease substantially (as would, of course, the corresponding benefits to eligible recipients in the programs). In addition to Social Security, affected programs would include federal retirement programs (for railroad employees and military veterans), Supplemental Security Income (income support for the poor), food stamps, and child nutrition. According to one study, a 1-percentage-point reduction in the CPI would increase national savings and thereby reduce the national debt by approximately $95 billion per year in year 2000 dollars.17 In addition, the effect of any CPI adjustments would not be restricted to the expenditure side of the federal budget. Because personal income tax brackets are inflation-adjusted, a CPI adjustment decreasing the rate of measured price increase would necessitate a smaller upper adjustment in tax brackets and, consequently, increase federal tax revenues. SUMMARY 1. The theory of consumer choice rests on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and servic |
es. 2. Consumer choice has two related parts: the study of the consumer’s preferences and the analysis of the budget line that constrains consumer choices. 3. Consumers make choices by comparing market baskets or bundles of commodities. Preferences are assumed to be complete (consumers can compare all possible market baskets) and transitive (if they prefer basket A to B, and B to C, then they prefer A to C). In addition, economists assume that more of each good is always preferred to less. 15Michael J. Boskin, Ellen R. Dulberger, Robert J. Gordon, Zvi Griliches, and Dale W. Jorgenson, “The CPI Commission: Findings and Recommendations,” American Economic Review 87 (May 1997): 78–93. The Bureau of Labor Statistics adopted changes in the measurement of the CPI, but these changes reduced the bias to only 0.8 or 0.9 percentage points. See, Michael J. Boskin, “Causes and Consequences of Bias in the Consumer Price Index as a Measure of the Cost of Living,” Atlantic Economic Journal 33 (March 2005): 1–13. 16For more information, see Chapters 1 and 2 of Measuring the Prices of Medical Treatments, Jack E. Triplett, Editor; Washington, D.C.: Brookings Institution Press, 1999 (http://brookings.nap.edu/). 17Michael F. Bryan and Jagadeesh Gokhale, “The Consumer Price Index and National Savings,” Economic Commentary (October 15, 1995) at http://www.clev.frb.org/. The data have been adjusted upward using the GDP deflator. 106 PART 2 • Producers, Consumers, and Competitive Markets 4. Indifference curves, which represent all combinations of goods and services that give the same level of satisfaction, are downward-sloping and cannot intersect one another. 5. Consumer preferences can be completely described by a set of indifference curves known as an indifference map. An indifference map provides an ordinal ranking of all choices that the consumer might make. 6. The marginal rate of substitution (MRS) of F for C is the maximum amount of C that a person is willing to give up to obtain 1 additional unit of F. The MRS diminishes as we move down along an indifference curve. When there is a diminishing MRS, indifference curves are convex. 7. Budget lines represent all combinations of goods for which consumers expend all their income. Budget lines shift outward in response to an increase in consumer income. When the price of one good (on the horizontal axis) changes while income and the price of the other good do not, budget lines pivot and rotate about a fixed point (on the vertical axis). 8. Consumers maximize satisfaction subject to budget constraints. When a consumer maximizes satisfaction by consuming some of each of two goods, the marginal rate of substitution is equal to the ratio of the prices of the two goods being purchased. 9. Maximization is sometimes achieved at a corner solution in which one good is not consumed. In such cases, the marginal rate of substitution need not equal the ratio of the prices. 10. The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. When an individual chooses basket A even though he or she could afford B, we know that A is preferred to B. 11. The theory of the consumer can be presented by two different approaches. The indifference curve approach uses the ordinal properties of utility (that is, it allows for the ranking of alternatives). The utility function approach obtains a utility function by attaching a number to each market basket; if basket A is preferred to basket B, A generates more utility than B. 12. When risky choices are analyzed or when comparisons must be made among individuals, the cardinal properties of the utility function can be important. Usually the utility function will show diminishing marginal utility: As more and more of a good is consumed, the consumer obtains smaller and smaller increments of utility. 13. When the utility function approach is used and both goods are consumed, utility maximization occurs when the ratio of the marginal utilities of the two goods (which is the marginal rate of substitution) is equal to the ratio of the prices. 14. In times of war and other crises, governments sometimes ration food, gasoline, and other products, rather than allow prices to increase to competitive levels. Some consider nonprice rationing to be more equitable than relying on uncontested market forces. 15. An ideal cost-of-living index measures the cost of buying, at current prices, a bundle of goods that generates the same level of utility as was provided by the bundle of goods consumed at base-year prices. The Laspeyres price index, however, represents the cost of buying the bundle of goods chosen in the base year at current prices relative to the cost of buying the same bundle at base-year prices. The CPI, even with chain weighting, overstates the ideal cost-of-living index. By contrast, the Paasche index measures the cost at current-year prices of buying a bundle of goods chosen in the current year divided by the cost of buying the same bundle at base-year prices. It thus understates the ideal cost-of-living index. QUESTIONS FOR REVIEW 1. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each. 2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods? 3. Explain why two indifference curves cannot intersect. 4. Jon is always willing to trade one can of Coke for one can of Sprite, or one can of Sprite for one can of Coke. a. What can you say about Jon’s marginal rate of sub- stitution? b. Draw a set of indifference curves for Jon. c. Draw two budget lines with different slopes and illustrate the satisfaction-maximizing choice. What conclusion can you draw? 5. What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve? 6. Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction. 7. Describe the indifference curves associated with two goods that are perfect substitutes. What if they are perfect complements? 8. What is the difference between ordinal utility and cardinal utility? Explain why the assumption of cardinal utility is not needed in order to rank consumer choices. 9. Upon merging with the West German economy, East German consumers indicated a preference for CHAPTER 3 • Consumer Behavior 107 Mercedes-Benz automobiles over Volkswagens. However, when they converted their savings into deutsche marks, they flocked to Volkswagen dealerships. How can you explain this apparent paradox? 10. Draw a budget line and then draw an indifference curve to illustrate the satisfaction-maximizing choice associated with two products. Use your graph to answer the following questions. a. Suppose that one of the products is rationed. Explain why the consumer is likely to be worse off. b. Suppose that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like. Can you tell if the consumer is better off or worse off? 11. Describe the equal marginal principle. Explain why this principle may not hold if increasing marginal utility is associated with the consumption of one or both goods. 12. The price of computers has fallen substantially over the past two decades. Use this drop in price to explain why the Consumer Price Index is likely to overstate substantially the cost-of-living index for individuals who use computers intensively. 13. Explain why the Paasche index will generally under- state the ideal cost-of-living index. EXERCISES 1. In this chapter, consumer preferences for various commodities did not change during the analysis. In some situations, however, preferences do change as consumption occurs. Discuss why and how preferences might change over time with consumption of these two commodities: a. cigarettes. b. dinner for the first time at a restaurant with a special cuisine. 2. Draw indifference curves that represent the following individuals’ preferences for hamburgers and soft drinks. Indicate the direction in which the individuals’ satisfaction (or utility) is increasing. a. Joe has convex indifference curves and dislikes both hamburgers and soft drinks. b. Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it down the drain rather than drink it. c. Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he will drink it to be polite. d. Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats. e. Bill likes hamburgers, but neither likes nor dislikes soft drinks. f. Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra soft drink. 3. If Jane is currently willing to trade 4 movie tickets for 1 basketball ticket, then she must like basketball better than movies. True or false? Explain. 4. Janelle and Brian each plan to spend $20,000 on the styling and gas mileage features of a new car. They can each choose all styling, all gas mileage, or some combination of the two. Janelle does not care at all about styling and wants the best gas mileage possible. Brian likes both equally and wants to spend an equal amount on each. Using indifference curves and budget lines, illustrate the choice that each person will make. 5. Suppose that Bridget and Erin spend their incomes on two goods, food (F) and clothing (C). Bridget’s preferences are represented by the utility function U(F,C) 10FC, while Erin’s preferences are represented by the utility function U(F,C) .20F2C2. a. With food on the horizontal axis and clothing on the vertical axis, identify on a graph the set of points that give Bridget the same level of utility as the bundle (10, 5). Do the same for Erin on a separate graph. b. On the same two g |
raphs, identify the set of bundles that give Bridget and Erin the same level of utility as the bundle (15, 8). c. Do you think Bridget and Erin have the same pref- erences or different preferences? Explain. 6. Suppose that Jones and Smith have each decided to allocate $1000 per year to an entertainment budget in the form of hockey games or rock concerts. They both like hockey games and rock concerts and will choose to consume positive quantities of both goods. However, they differ substantially in their preferences for these two forms of entertainment. Jones prefers hockey games to rock concerts, while Smith prefers rock concerts to hockey games. a. Draw a set of indifference curves for Jones and a second set for Smith. b. Using the concept of marginal rate of substitution, explain why the two sets of curves are different from each other. 7. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a budget of $100 to spend on the two goods. Suppose that he has already bought one DVD and one CD. In addition, there are 3 more DVDs and 5 more CDs that he would really like to buy. a. Given the above prices and income, draw his budget line on a graph with CDs on the horizontal axis. b. Considering what he has already purchased and what he still wants to purchase, identify the three 108 PART 2 • Producers, Consumers, and Competitive Markets different bundles of CDs and DVDs that he could choose. For this part of the question, assume that he cannot purchase fractional units. 8. Anne has a job that requires her to travel three out of every four weeks. She has an annual travel budget and can travel either by train or by plane. The airline on which she typically flies has a frequent-traveler program that reduces the cost of her tickets according to the number of miles she has flown in a given year. When she reaches 25,000 miles, the airline will reduce the price of her tickets by 25 percent for the remainder of the year. When she reaches 50,000 miles, the airline will reduce the price by 50 percent for the remainder of the year. Graph Anne’s budget line, with train miles on the vertical axis and plane miles on the horizontal axis. 9. Debra usually buys a soft drink when she goes to a movie theater, where she has a choice of three sizes: the 8-ounce drink costs $1.50, the 12-ounce drink $2.00, and the 16-ounce drink $2.25. Describe the budget constraint that Debra faces when deciding how many ounces of the drink to purchase. (Assume that Debra can costlessly dispose of any of the soft drink that she does not want.) 10. Antonio buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost only $50 each. When the bookstore announces that there will be a 10 percent increase in the price of new books and a 5 percent increase in the price of used books, Antonio’s father offers him $40 extra. a. What happens to Antonio’s budget line? Illustrate the change with new books on the vertical axis. b. Is Antonio worse or better off after the price change? Explain. 11. Consumers in Georgia pay twice as much for avocados as they do for peaches. However, avocados and peaches are the same price in California. If consumers in both states maximize utility, will the marginal rate of substitution of peaches for avocados be the same for consumers in both states? If not, which will be higher? 12. Ben allocates his lunch budget between two goods, pizza and burritos. a. Illustrate Ben’s optimal bundle on a graph with pizza on the horizontal axis. b. Suppose now that pizza is taxed, causing the price to increase by 20 percent. Illustrate Ben’s new optimal bundle. c. Suppose instead that pizza is rationed at a quantity less than Ben’s desired quantity. Illustrate Ben’s new optimal bundle. 13. Brenda wants to buy a new car and has a budget of $25,000. She has just found a magazine that assigns each car an index for styling and an index for gas mileage. Each index runs from 1 to 10, with 10 representing either the most styling or the best gas mileage. While looking at the list of cars, Brenda observes that on average, as the style index increases by one unit, the price of the car increases by $5000. She also observes that as the gas-mileage index rises by one unit, the price of the car increases by $2500. a. Illustrate the various combinations of style (S) and gas mileage (G) that Brenda could select with her $25,000 budget. Place gas mileage on the horizontal axis. b. Suppose Brenda’s preferences are such that she always receives three times as much satisfaction from an extra unit of styling as she does from gas mileage. What type of car will Brenda choose? c. Suppose that Brenda’s marginal rate of substitution (of gas mileage for styling) is equal to S/(4G). What value of each index would she like to have in her car? d. Suppose that Brenda’s marginal rate of substitution (of gas mileage for styling) is equal to (3S)/G. What value of each index would she like to have in her car? 14. Connie has a monthly income of $200 that she allocates between two goods: meat and potatoes. a. Suppose meat costs $4 per pound and potatoes $2 per pound. Draw her budget constraint. b. Suppose also that her utility function is given by the equation U(M, P) 2M P. What combination of meat and potatoes should she buy to maximize her utility? (Hint: Meat and potatoes are perfect substitutes.) c. Connie’s supermarket has a special promotion. If she buys 20 pounds of potatoes (at $2 per pound), she gets the next 10 pounds for free. This offer applies only to the first 20 pounds she buys. All potatoes in excess of the first 20 pounds (excluding bonus potatoes) are still $2 per pound. Draw her budget constraint. d. An outbreak of potato rot raises the price of potatoes to $4 per pound. The supermarket ends its promotion. What does her budget constraint look like now? What combination of meat and potatoes maximizes her utility? 15. Jane receives utility from days spent traveling on vacation domestically (D) and days spent traveling on vacation in a foreign country (F), as given by the utility function U(D,F) 10DF. In addition, the price of a day spent traveling domestically is $100, the price of a day spent traveling in a foreign country is $400, and Jane’s annual travel budget is $4000. a. Illustrate the indifference curve associated with a utility of 800 and the indifference curve associated with a utility of 1200. b. Graph Jane’s budget line on the same graph. c. Can Jane afford any of the bundles that give her a utility of 800? What about a utility of 1200? *d. Find Jane’s utility-maximizing choice of days spent traveling domestically and days spent in a foreign country. 16. Julio receives utility from consuming food (F) and clothing (C) as given by the utility function U(F,C) FC. CHAPTER 3 • Consumer Behavior 109 In addition, the price of food is $2 per unit, the price of clothing is $10 per unit, and Julio’s weekly income is $50. a. What is Julio’s marginal rate of substitution of food for clothing when utility is maximized? Explain. b. Suppose instead that Julio is consuming a bundle with more food and less clothing than his utility maximizing bundle. Would his marginal rate of substitution of food for clothing be greater than or less than your answer in part a? Explain. 17. The utility that Meredith receives by consuming food F and clothing C is given by U(F,C) FC. Suppose that Meredith’s income in 1990 is $1200 and that the prices of food and clothing are $1 per unit for each. By 2000, however, the price of food has increased to $2 and the price of clothing to $3. Let 100 represent the cost of living index for 1990. Calculate the ideal and the Laspeyres cost-of-living index for Meredith for 2000. (Hint: Meredith will spend equal amounts on food and clothing with these preferences.) This page intentionally left blank C H A P T E R 4 Individual and Market Demand Chapter 3 laid the foundation for the theory of consumer demand. We discussed the nature of consumer preferences and saw how, given budget constraints, consumers choose market baskets that maximize utility. From here it’s a short step to analyzing demand and showing how the demand for a good depends on its price, the prices of other goods, and income. Our analysis of demand proceeds in six steps: 1. We begin by deriving the demand curve for an individual consumer. Because we know how changes in price and income affect a person’s budget line, we can determine how they affect consumption choice. We will use this information to see how the quantity of a good demanded varies in response to price changes as we move along an individual’s demand curve. We will also see how this demand curve shifts in response to changes in the individual’s income. 2. With this foundation, we will examine the effect of a price change in more detail. When the price of a good goes up, individual demand for it can change in two ways. First, because it has now become more expensive relative to other goods, consumers will buy less of it and more of other goods. Second, the higher price reduces the consumer’s purchasing power. This reduction is just like a reduction in income and will lead to a reduction in consumer demand. By analyzing these two distinct effects, we will better understand the characteristics of demand. 3. Next, we will see how individual demand curves can be aggregated to determine the market demand curve. We will also study the characteristics of market demand and see why the demands for some kinds of goods differ considerably from the demands for others. 4. We will go on to show how market demand curves can be used to measure the benefits that people receive when they consume products, above and beyond the expenditures they make. This information will be especially important later, when we study the effects of government intervention in a market. 5. We then describe the effects of network externalities—i.e., what happens when a person’s demand for a good also depends |
on the .1 Individual Demand 112 4.2 Income and Substitution Effects 119 4.3 Market Demand 124 4.4 Consumer Surplus 132 4.5 Network Externalities 135 *4.6 Empirical Estimation of Demand 139 Appendix: Demand Theory— A Mathematical Treatment 149 .1 Consumer Expenditures in the United States 117 4.2 The Effects of a Gasoline Tax 122 4.3 The Aggregate Demand for Wheat 128 4.4 The Demand for Housing 129 4.5 The Long-Run Demand for Gasoline 131 4.6 The Value of Clean Air 134 4.7 Facebook 138 4.8 The Demand for Ready-to-Eat Cereals 142 111 112 PART 2 • Producers, Consumers, and Competitive Markets demands of other people. These effects play a crucial role in the demands for many high-tech products, such as computer hardware and software, and telecommunications systems. 6. Finally, we will briefly describe some of the methods that economists use to obtain empirical information about demand. 4.1 Individual Demand This section shows how the demand curve of an individual consumer follows from the consumption choices that a person makes when faced with a budget constraint. To illustrate these concepts graphically, we will limit the available goods to food and clothing, and we will rely on the utility-maximization approach described in Section 3.3 (page 86). Price Changes We begin by examining ways in which the consumption of food and clothing changes when the price of food changes. Figure 4.1 shows the consumption choices that a person will make when allocating a fixed amount of income between the two goods. Initially, the price of food is $1, the price of clothing $2, and the consumer’s income $20. The utility-maximizing consumption choice is at point B in Figure 4.1 (a). Here, the consumer buys 12 units of food and 4 units of clothing, thus achieving the level of utility associated with indifference curve U2. Now look at Figure 4.1 (b), which shows the relationship between the price of food and the quantity demanded. The horizontal axis measures the quantity of food consumed, as in Figure 4.1 (a), but the vertical axis now measures the price of food. Point G in Figure 4.1 (b) corresponds to point B in Figure 4.1 (a). At G, the price of food is $1, and the consumer purchases 12 units of food. Suppose the price of food increases to $2. As we saw in Chapter 3, the budget line in Figure 4.1 (a) rotates inward about the vertical intercept, becoming twice as steep as before. The higher relative price of food has increased the magnitude of the slope of the budget line. The consumer now achieves maximum utility at A, which is found on a lower indifference curve, U1. Because the price of food has risen, the consumer’s purchasing power—and thus attainable utility—has fallen. At A, the consumer chooses 4 units of food and 6 units of clothing. In Figure 4.1 (b), this modified consumption choice is at E, which shows that at a price of $2, 4 units of food are demanded. Finally, what will happen if the price of food decreases to 50 cents? Because the budget line now rotates outward, the consumer can achieve the higher level of utility associated with indifference curve U3 in Figure 4.1 (a) by selecting D, with 20 units of food and 5 units of clothing. Point H in Figure 4.1 (b) shows the price of 50 cents and the quantity demanded of 20 units of food. The Individual Demand Curve We can go on to include all possible changes in the price of food. In Figure 4.1 (a), the price-consumption curve traces the utility-maximizing combinations of food and clothing associated with every possible price of food. Note that as the price of food falls, attainable utility increases and the consumer buys more food. This pattern of increasing consumption of a good in response to a decrease in In §3.3, we explain how a consumer chooses the market basket on the highest indifference curve that touches the consumer’s budget line. In §3.2, we explain how the budget line shifts in response to a price change. • price-consumption curve Curve tracing the utilitymaximizing combinations of two goods as the price of one changes. CHAPTER 4 • Individual and Market Demand 113 price almost always holds. But what happens to the consumption of clothing as the price of food falls? As Figure 4.1 (a) shows, the consumption of clothing may either increase or decrease. The consumption of both food and clothing can increase because the decrease in the price of food has increased the consumer’s ability to purchase both goods. An individual demand curve relates the quantity of a good that a single consumer will buy to the price of that good. In Figure 4.1 (b), the individual demand curve relates the quantity of food that the consumer will buy to the price of food. This demand curve has two important properties: 1. The level of utility that can be attained changes as we move along the curve. The lower the price of the product, the higher the level of utility. Note from Figure 4.1 (a) that a higher indifference curve is reached as the price falls. Again, this result simply reflects the fact that as the price of a product falls, the consumer’s purchasing power increases. Clothing (units per month) • individual demand curve Curve relating the quantity of a good that a single consumer will buy to its price. U1 A 6 5 4 Price-Consumption Curve D B U3 U2 4 12 20 Food (units per month) (a) Price of food $2.00 E 1.50 1.00 0.50 Demand Curve G H 4 12 20 (b) Food (units per month) FIGURE 4.1 EFFECT OF PRICE CHANGES A reduction in the price of food, with income and the price of clothing fixed, causes this consumer to choose a different market basket. In (a), the baskets that maximize utility for various prices of food (point A, $2; B, $1; D, $0.50) trace out the price-consumption curve. Part (b) gives the demand curve, which relates the price of food to the quantity demanded. (Points E, G, and H correspond to points A, B, and D, respectively). 114 PART 2 • Producers, Consumers, and Competitive Markets In §3.1, we introduce the marginal rate of substitution (MRS) as a measure of the maximum amount of one good that the consumer is willing to give up in order to obtain one unit of another good. • income-consumption curve Curve tracing the utilitymaximizing combinations of two goods as a consumer’s income changes. 2. At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of substitution (MRS) of food for clothing equals the ratio of the prices of food and clothing. As the price of food falls, the price ratio and the MRS also fall. In Figure 4.1 (b), the price ratio falls from 1 ($2/$2) at E (because the curve U1 is tangent to a budget line with a slope of -1 at A) to 1/2 ($1/$2) at G, to 1/4 ($0.50/$2) at H. Because the consumer is maximizing utility, the MRS of food for clothing decreases as we move down the demand curve. This phenomenon makes intuitive sense because it tells us that the relative value of food falls as the consumer buys more of it. The fact that the MRS varies along the individual’s demand curve tells us something about how consumers value the consumption of a good or service. Suppose we were to ask a consumer how much she would be willing to pay for an additional unit of food when she is currently consuming 4 units. Point E on the demand curve in Figure 4.1 (b) provides the answer: $2. Why? As we pointed out above, because the MRS of food for clothing is 1 at E, one additional unit of food is worth one additional unit of clothing. But a unit of clothing costs $2, which is, therefore, the value (or marginal benefit) obtained by consuming an additional unit of food. Thus, as we move down the demand curve in Figure 4.1 (b), the MRS falls. Likewise, the value that the consumer places on an additional unit of food falls from $2 to $1 to $0.50. Income Changes We have seen what happens to the consumption of food and clothing when the price of food changes. Now let’s see what happens when income changes. The effects of a change in income can be analyzed in much the same way as a price change. Figure 4.2 (a) shows the consumption choices that a consumer will make when allocating a fixed income to food and clothing when the price of food is $1 and the price of clothing $2. As in Figure 4.1 (a), the quantity of clothing is measured on the vertical axis and the quantity of food on the horizontal axis. Income changes appear as changes in the budget line in Figure 4.2 (a). Initially, the consumer’s income is $10. The utility-maximizing consumption choice is then at A, at which point she buys 4 units of food and 3 units of clothing. This choice of 4 units of food is also shown in Figure 4.2 (b) as E on demand curve D1. Demand curve D1 is the curve that would be traced out if we held income fixed at $10 but varied the price of food. Because we are holding the price of food constant, we will observe only a single point E on this demand curve. What happens if the consumer’s income is increased to $20? Her budget line then shifts outward parallel to the original budget line, allowing her to attain the utility level associated with indifference curve U2. Her optimal consumption choice is now at B, where she buys 10 units of food and 5 units of clothing. In Figure 4.2 (b) her consumption of food is shown as G on demand curve D2. D2 is the demand curve that would be traced out if we held income fixed at $20 but varied the price of food. Finally, note that if her income increases to $30, she chooses D, with a market basket containing 16 units of food (and 7 units of clothing), represented by H in Figure 4.2 (b). We could go on to include all possible changes in income. In Figure 4.2 (a), the income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level. The incomeconsumption curve in Figure 4.2 slopes upward because the consumption of both food and clothing increases as income increases. Previously, we saw that a change in the price of a good corresponds to a movement al |
ong a demand curve. Here, the situation is different. Because each demand curve is CHAPTER 4 • Individual and Market Demand 115 FIGURE 4.2 EFFECT OF INCOME CHANGES An increase in income, with the prices of all goods fixed, causes consumers to alter their choice of market baskets. In part (a), the baskets that maximize consumer satisfaction for various incomes (point A, $10; B, $20; D, $30) trace out the income-consumption curve. The shift to the right of the demand curve in response to the increases in income is shown in part (b). (Points E, G, and H correspond to points A, B, and D, respectively.) Clothing (units per month) 7 5 3 Price of food $1.00 Income-Consumption Curve D U3 U2 B U1 A 4 10 16 (a) Food (units per month) E G H D3 D2 D1 4 10 16 (b) Food (units per month) measured for a particular level of income, any change in income must lead to a shift in the demand curve itself. Thus A on the income-consumption curve in Figure 4.2 (a) corresponds to E on demand curve D1 in Figure 4.2 (b); B corresponds to G on a different demand curve D2. The upward-sloping income-consumption curve implies that an increase in income causes a shift to the right in the demand curve—in this case from D1 to D2 to D3. Normal versus Inferior Goods When the income-consumption curve has a positive slope, the quantity demanded increases with income. As a result, the income elasticity of demand is positive. The greater the shifts to the right of the demand curve, the larger the income elasticity. In this case, the goods are described as normal: Consumers want to buy more of them as their incomes increase. In some cases, the quantity demanded falls as income increases; the income elasticity of demand is negative. We then describe the good as inferior. The term inferior simply means that consumption falls when income rises. Hamburger, for example, is inferior for some people: As their income increases, they buy less hamburger and more steak. In §2.4, we explain that the income elasticity of demand is the percentage change in the quantity demanded resulting from a 1-percent increase in income. 116 PART 2 • Producers, Consumers, and Competitive Markets FIGURE 4.3 AN INFERIOR GOOD An increase in a person’s income can lead to less consumption of one of the two goods being purchased. Here, hamburger, though a normal good between A and B, becomes an inferior good when the income-consumption curve bends backward between B and C. 15 Steak (units per month) 10 5 Income-Consumption Curve C B A U1 5 10 U3 U2 20 30 Hamburger (units per month) Figure 4.3 shows the income-consumption curve for an inferior good. For relatively low levels of income, both hamburger and steak are normal goods. As income rises, however, the income-consumption curve bends backward (from point B to C). This shift occurs because hamburger has become an inferior good—its consumption has fallen as income has increased. • Engel curve Curve relating the quantity of a good consumed to income. Engel Curves Income-consumption curves can be used to construct Engel curves, which relate the quantity of a good consumed to an individual’s income. Figure 4.4 shows how such curves are constructed for two different goods. Figure 4.4 (a), which shows Income (dollars per month) 30 20 10 0 Income (dollars per month) Engel Curve 4 8 12 16 Food (units per month) (a) FIGURE 4.4 ENGEL CURVES 30 20 10 0 Inferior Normal 5 10 Hamburger (units per month) (b) Engel curves relate the quantity of a good consumed to income. In (a), food is a normal good and the Engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month. CHAPTER 4 • Individual and Market Demand 117 an upward-sloping Engel curve, is derived directly from Figure 4.2 (a). In both figures, as the individual’s income increases from $10 to $20 to $30, her consumption of food increases from 4 to 10 to 16 units. Recall that in Figure 4.2 (a) the vertical axis measured units of clothing consumed per month and the horizontal axis units of food per month; changes in income were reflected as shifts in the budget line. In Figures 4.4 (a) and (b), we have replotted the data to put income on the vertical axis, while keeping food and hamburger on the horizontal. The upward-sloping Engel curve in Figure 4.4 (a)—like the upward-sloping income-consumption curve in Figure 4.2 (a)—applies to all normal goods. Note that an Engel curve for clothing would have a similar shape (clothing consumption increases from 3 to 5 to 7 units as income increases). Figure 4.4 (b), derived from Figure 4.3, shows the Engel curve for hamburger. We see that hamburger consumption increases from 5 to 10 units as income increases from $10 to $20. As income increases further, from $20 to $30, consumption falls to 8 units. The portion of the Engel curve that slopes downward is the income range within which hamburger is an inferior good. E XAMP LE 4.1 CONSUMER EXPENDITURES IN THE UNITED STATES The Engel curves we just examined apply to individual consumers. However, we can also derive Engel curves for groups of consumers. This information is particularly useful if we want to see how consumer spending varies among different income groups. Table 4.1 illustrates spending patterns for several items taken from a survey by the U.S. Bureau of Labor Statistics. Although the data are averaged over many households, they can be interpreted as describing the expenditures of a typical family. Note that the data relate expenditures on a particular item rather than the quantity of the item to income. The first two items, entertainment and owned dwellings, are consumption goods for which the income elasticity of demand is high. Average family expenditures on entertainment increase almost fivefold when we move from the lowest to highest income group. The same pattern TABLE 4.1 ANNUAL U.S. HOUSEHOLD CONSUMER EXPENDITURES INCOME GROUP (2009 $) EXPENDITURES ($) ON: LESS THAN $10,000 10,000– 19,999 20,000– 29,999 30,000– 39,999 40,000– 49,999 50,000– 69,999 70,000 AND ABOVE Entertainment Owned Dwelling Rented Dwelling Health Care Food Clothing 1,041 1,880 3,172 1,222 3,429 799 1,025 2,083 3,359 1,917 3,529 927 1,504 3,117 3,228 2,536 4,415 1,080 1,970 4,038 3,296 2,684 4,737 1,225 2,008 4,847 3,295 2,937 5,384 1,336 2,611 6,473 2,977 3,454 6,420 1,608 4,733 12,306 2,098 4,393 9,761 2,850 Source: U. S. Department of Labor, Bureau of Labor Statistics, “Consumer Expenditure Survey, Annual Report 2010.” 118 PART 2 • Producers, Consumers, and Competitive Markets applies to the purchase of homes: There is a more than a sixfold increase in expenditures from the lowest to the highest category. In contrast, expenditures on rental housing actually fall as income rises. This pattern reflects the fact that most higher-income individuals own rather than rent homes. Thus rental housing is an inferior good, at least for incomes above $30,000 per year. Finally, note that health care, food, and clothing are consumption items for which the income elasticities are positive, but not as high as for entertainment or owner-occupied housing. The data in Table 4.1 for rented dwellings, health care, and entertainment have been plotted in Figure 4.5. Observe in the three Engel curves that as income rises, expenditures on entertainment and health care increase rapidly, while expenditures on rental housing increase when income is low, but decrease once income exceeds $30,00080,000 $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 FIGURE 4.5 ENGEL CURVES FOR U.S. CONSUMERS Average per-household expenditures on rented dwellings, health care, and entertainment are plotted as functions of annual income. Health care and entertainment are normal goods, as expenditures increase with income. Rental housing, however, is an inferior good for incomes above $30,000. $500 $1000 $1500 $2000 $2500 $3000 $3500 $4000 $4500 $5000 Annual Expenditure Entertainment Rented Dwelling Health Care Substitutes and Complements The demand curves that we graphed in Chapter 2 showed the relationship between the price of a good and the quantity demanded, with preferences, income, and the prices of all other goods held constant. For many goods, demand is related to the consumption and prices of other goods. Baseball bats and baseballs, hot dogs and mustard, and computer hardware and software are all examples of goods that tend to be used together. Other goods, such as cola and diet cola, owner-occupied houses and rental apartments, movie tickets and videocassette rentals, tend to substitute for one another. Recall from Section 2.1 (page 22) that two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other. CHAPTER 4 • Individual and Market Demand 119 If the price of a movie ticket rises, we would expect individuals to rent more videos, because movie tickets and videos are substitutes. Similarly, two goods are complements if an increase in the price of one good leads to a decrease in the quantity demanded of the other. If the price of gasoline goes up, causing gasoline consumption to fall, we would expect the consumption of motor oil to fall as well, because gasoline and motor oil are used together. Two goods are independent if a change in the price of one good has no effect on the quantity demanded of the other. One way to see whether two goods are complements or substitutes is to examine the price-consumption curve. Look again at Figure 4.1 (page 113). Note that in the downward-sloping portion of the price-consumption curve, food and clothing are substitutes: The lower price of food leads to a lower consumption of clothing (perhaps because as food expenditures increase, less income is available to spend on clothing). Similarly, food and clothing are complements in the upward-sloping portion of the curve: The lower price of food leads to higher clothing consumption (perhaps because the co |
nsumer eats more meals at restaurants and must be suitably dressed). The fact that goods can be complements or substitutes suggests that when studying the effects of price changes in one market, it may be important to look at the consequences in related markets. (Interrelationships among markets are discussed in more detail in Chapter 16.) Determining whether two goods are complements, substitutes, or independent goods is ultimately an empirical question. To answer the question, we need to look at the ways in which the demand for the first good shifts (if at all) in response to a change in the price of the second. This question is more difficult than it sounds because lots of things are likely to be changing at the same time that the price of the first good changes. In fact, Section 4.6 of this chapter is devoted to examining ways to distinguish empirically among the many possible explanations for a change in the demand for the second good. First, however, it will be useful to undertake a basic theoretical exercise. In the next section, we delve into the ways in which a change in the price of a good can affect consumer demand. 4.2 Income and Substitution Effects A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. This response to a change in the relative prices of goods is called the substitution effect. 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. They are better off because they can buy the same amount of the good for less money, and thus have money left over for additional purchases. The change in demand resulting from this change in real purchasing power is called the income effect. Normally, these two effects occur simultaneously, but it will be useful to distinguish between them for purposes of analysis. The specifics are illustrated in Figure 4.6, where the initial budget line is RS and there are two goods, food and clothing. Here, the consumer maximizes utility by choosing the market basket at A, thereby obtaining the level of utility associated with the indifference curve U1. 120 PART 2 • Producers, Consumers, and Competitive Markets FIGURE 4.6 INCOME AND SUBSTITUTION EFFECTS: NORMAL GOOD A decrease in the price of food has both an income effect and a substitution effect. The consumer is initially at A, on budget line RS. When the price of food falls, consumption increases by F1F2 as the consumer moves to B. The substitution effect F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect EF2 is positive. Clothing (units per month) R C1 C2 A B D U2 U1 O F1 E S F2 Substitution Effect Income Effect T Food (units per month) Total Effect In §3.4, we show how information about consumer preferences is revealed by consumption choices made. • substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant. Now let’s see what happens if the price of food falls, causing the budget line to rotate outward to line RT. The consumer now chooses the market basket at B on indifference curve U2. Because market basket B was chosen even though market basket A was feasible, we know (from our discussion of revealed preference in Section 3.4) that B is preferred to A. Thus, the reduction in the price of food allows the consumer to increase her level of satisfaction—her purchasing power has increased. The total change in the consumption of food caused by the lower price is given by F1F2. Initially, the consumer purchased OF1 units of food, but after the price change, food consumption has increased to OF2. Line segment F1F2, therefore, represents the increase in desired food purchases. Substitution Effect The drop in price has both a substitution effect and an income effect. The substitution effect is the change in food consumption associated with a change in the price of food, with the level of utility held constant. The substitution effect captures the change in food consumption that occurs as a result of the price change that makes food relatively cheaper than clothing. This substitution is marked by a movement along an indifference curve. In Figure 4.6, the substitution effect can be obtained by drawing a budget line which is parallel to the new budget line RT (reflecting the lower relative price of food), but which is just tangent to the original indifference curve U1 (holding the level of satisfaction constant). The new, lower imaginary budget line reflects the fact that nominal income was reduced in order to accomplish our conceptual goal of isolating the substitution effect. Given that budget line, the consumer chooses market basket D and consumes OE units of food. The line segment F1E thus represents the substitution effect. Figure 4.6 makes it clear that when the price of food declines, the substitution effect always leads to an increase in the quantity of food demanded. The explanation lies in the fourth assumption about consumer preferences discussed in CHAPTER 4 • Individual and Market Demand 121 Section 3.1—namely, that indifference curves are convex. Thus, with the convex indifference curves shown in the figure, the point that maximizes satisfaction on the new imaginary budget line parallel to RT must lie below and to the right of the original point of tangency. Income Effect Now let’s consider the income effect: the change in food consumption brought about by the increase in purchasing power, with relative prices held constant. In Figure 4.6, we can see the income effect by moving from the imaginary budget line that passes through point D to the parallel budget line, RT, which passes through B. The consumer chooses market basket B on indifference curve U2 (because the lower price of food has increased her level of utility). The increase in food consumption from OE to OF2 is the measure of the income effect, which is positive, because food is a normal good (consumers will buy more of it as their incomes increase). Because it reflects a movement from one indifference curve to another, the income effect measures the change in the consumer’s purchasing power. We have seen in Figure 4.6 that the total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect: Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2) Recall that the direction of the substitution effect is always the same: A decline in price leads to an increase in consumption of the good. However, the income effect can move demand in either direction, depending on whether the good is normal or inferior. A good is inferior when the income effect is negative: As income rises, consumption falls. Figure 4.7 shows income and substitution effects for an inferior good. The negative income effect is measured by line segment EF2. Even with • income effect Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. • inferior good A good that has a negative income effect. Clothing (units per month) R B A D U2 O F1 F2 E S Substitution Effect Total Effect Income Effect U1 T Food (units per month) FIGURE 4.7 INCOME AND SUBSTITUTION EFFECTS: INFERIOR GOOD The consumer is initially at A on budget line RS. With a decrease in the price of food, the consumer moves to B. The resulting change in food purchased can be broken down into a substitution effect, F1E (associated with a move from A to D), and an income effect, EF2 (associated with a move from D to B). In this case, food is an inferior good because the income effect is negative. However, because the substitution effect exceeds the income effect, the decrease in the price of food leads to an increase in the quantity of food demanded. 122 PART 2 • Producers, Consumers, and Competitive Markets Clothing (units per month) FIGURE 4.8 UPWARD-SLOPING DEMAND CURVE: THE GIFFEN GOOD When food is an inferior good, and when the income effect is large enough to dominate the substitution effect, the demand curve will be upward-sloping. The consumer is initially at point A, but, after the price of food falls, moves to B and consumes less food. Because the income effect EF2 is larger than the substitution effect F1E, the decrease in the price of food leads to a lower quantity of food demanded. B A D U2 U1 O F2 F1 E Substitution Effect Income Effect Total Effect Food (units per month) • Giffen good Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect. inferior goods, the income effect is rarely large enough to outweigh the substitution effect. As a result, when the price of an inferior good falls, its consumption almost always increases. A Special Case: The Giffen Good Theoretically, the income effect may be large enough to cause the demand curve for a good to slope upward. We call such a good a Giffen good, and Figure 4.8 shows its income and substitution effects. Initially, the consumer is at A, consuming relatively little clothing and much food. Now the price of food declines. The decline in the price of food frees enough income so that the consumer desires to buy more clothing and fewer units of food, as illustrated by B. Revealed preference tells us that the consumer is better off at B rather than A even though less food is consumed. Though intriguing, the Giffen good is rarely of practical interest because it requires a large negative income effect. But the income effect is usually small: Individually, most goods account for only a small part of a consumer’s budget. Large income effects are often associated with normal rather than inferior goods (e.g., t |
otal spending on food or housing). E XAM PLE 4 .2 THE EFFECTS OF A GASOLINE TAX In part to conserve energy and in part to raise revenues, the U.S. government has often considered increasing the federal gasoline tax. In 1993, for example, a modest 4.3 cent increase was enacted as part of a larger budget-reform package. This increase was much less than the increase that would have been necessary to put U.S. gasoline prices on a par with those in Europe. Because an important goal of higher gasoline taxes is to discourage gasoline consumption, the government has also considered ways of passing the resulting income back to consumers. One popular suggestion is a rebate program in which tax revenues would be returned to households on an equal percapita basis. What would be the effect of such a program? CHAPTER 4 • Individual and Market Demand 123 Let’s begin by focusing on the effect of the program over a period of five years. The relevant price elasticity of demand is about -0.5.1 Suppose that a low-income consumer uses about 1200 gallons of gasoline per year, that gasoline costs $1 per gallon, and that our consumer’s annual income is $9000. Figure 4.9 shows the effect of the gasoline tax. (The graph has intentionally been drawn not to scale so that the effects we are discussing can be seen more clearly.) The original budget line is AB, and the consumer maximizes utility (on indifference curve U2) by consuming the market basket at C, buying 1200 gallons of gasoline and spending $7800 on other goods. If the tax is 50 cents per gallon, price will increase by 50 percent, shifting the new budget line to AD.2 (Recall that when price changes and income stays fixed, the budget line rotates around a pivot point on the unchanged axis.) With a price elasticity of -0.5, consumption will decline 25 percent, from 1200 to 900 gallons, as shown by the utility-maximizing point E on indifference curve U1 (for every 1-percent increase in the price of gasoline, quantity demanded drops by 1/2 percent). The rebate program, however, partially counters this effect. Suppose that because the tax revenue After Gasoline Tax Plus Rebate F A Expenditures on other goods ($) H E C After Gasoline Tax U2 U1 Original Budget Line 900 913.5 1200 D J B Gasoline consumption (gallons per year) FIGURE 4.9 EFFECT OF A GASOLINE TAX WITH A REBATE A gasoline tax is imposed when the consumer is initially buying 1200 gallons of gasoline at point C. After the tax takes effect, the budget line shifts from AB to AD and the consumer maximizes his preferences by choosing E, with a gasoline consumption of 900 gallons. However, when the proceeds of the tax are rebated to the consumer, his consumption increases somewhat, to 913.5 gallons at H. Despite the rebate program, the consumer’s gasoline consumption has fallen, as has his level of satisfaction. 1We saw in Chapter 2 that the price elasticity of demand for gasoline varies substantially from the short run to the long run. 2To simplify the example, we have assumed that the entire tax is paid by consumers in the form of a higher price. A broader analysis of tax shifting is presented in Chapter 9. 124 PART 2 • Producers, Consumers, and Competitive Markets per person is about $450 (900 gallons times 50 cents per gallon), each consumer receives a $450 rebate. How does this increased income affect gasoline consumption? The effect can be shown graphically by shifting the budget line upward by $450, to line FJ, which is parallel to AD. How much gasoline does our consumer buy now? In Chapter 2, we saw that the income elasticity of demand for gasoline is approximately 0.3. Because $450 represents a 5-percent increase in income ($450/$9000 = 0.05), we would expect the rebate to increase consumption by 1.5 percent (0.3 times 5 percent) of 900 gallons, or 13.5 gallons. The new utility-maximizing consumption choice at H reflects this expectation. (We omitted the indifference curve that is tangent at H to simplify the diagram.) With the rebate program, the tax would reduce gasoline consumption by 286.5 gallons, from 1200 to 913.5. Because the income elasticity of demand for gasoline is relatively low, the income effect of the rebate program is dominated by the substitution effect, and the program with a rebate does indeed reduce consumption. In order to put a real tax-rebate program into effect, Congress would have to solve a variety of practical problems. First, incoming tax receipts and rebate expenditures would vary from year to year, making it difficult to plan the budgeting process. For example, the tax rebate of $450 in the first year of the program is an increase in income. During the second year, it would lead to some increase in gasoline consumption among the low-income consumers that we are studying. With increased consumption, however, the tax paid and the rebate received by an individual will increase in the second year. As a result, it may be difficult to predict the size of the program budget. Figure 4.9 reveals that the gasoline tax program makes this particular low-income consumer slightly worse off because H lies just below indifference curve U2. Of course, some low-income consumers might actually benefit from the program (if, for example, they consume less gasoline on average than the group of consumers whose consumption determines the selected rebate). Nevertheless, the substitution effect caused by the tax will make consumers, on average, worse off. Why, then, introduce such a program? Those who support gasoline taxes argue that they promote national security (by reducing dependence on foreign oil) and encourage conservation, thus helping to slow global warming by reducing the buildup of carbon dioxide in the atmosphere. We will further examine the impact of a gasoline tax in Chapter 9. • market demand curve Curve relating the quantity of a good that all consumers in a market will buy to its price. 4.3 Market Demand So far, we have discussed the demand curve for an individual consumer. Now we turn to the market demand curve. Recall from Chapter 2 that a market demand curve shows how much of a good consumers overall are willing to buy as its price changes. In this section, we show how market demand curves can be derived as the sum of the individual demand curves of all consumers in a particular market. From Individual to Market Demand To keep things simple, let’s assume that only three consumers (A, B, and C) are in the market for coffee. Table 4.2 tabulates several points on each consumer’s demand curve. The market demand, column (5), is found by adding columns (2), (3), and (4), representing our three consumers, to determine the total quantity demanded at every price. When the price is $3, for example, the total quantity demanded is 2 + 6 + 10, or 18. Figure 4.10 shows these same three consumers’ demand curves for coffee (labeled DA, DB, and DC). In the graph, the market demand curve is the horizontal summation of the demands of each consumer. We sum horizontally to find the total amount that the three consumers will demand at any given price. For CHAPTER 4 • Individual and Market Demand 125 TABLE 4.2 DETERMINING THE MARKET DEMAND CURVE (1) PRICE ($) (2) INDIVIDUAL A (UNITS) (3) INDIVIDUAL B (UNITS) (4) INDIVIDUAL C (UNITS) (5) MARKET (UNITS 10 8 6 4 2 16 13 10 7 4 32 25 18 11 6 example, when the price is $4, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), by B (4 units), and by C (7 units). Because all of the individual demand curves slope downward, the market demand curve will also slope downward. However, even though each of the individual demand curves is a straight line, the market demand curve need not be. In Figure 4.10, for example, the market demand curve is kinked because one consumer makes no purchases at prices that the other consumers find acceptable (those above $4). Price (dollars per unit) 5 4 3 2 1 0 Market Demand DA DB DC 5 10 15 20 25 30 Quantity FIGURE 4.10 SUMMING TO OBTAIN A MARKET DEMAND CURVE The market demand curve is obtained by summing our three consumers’ demand curves DA, DB, and DC. At each price, the quantity of coffee demanded by the market is the sum of the quantities demanded by each consumer. At a price of $4, for example, the quantity demanded by the market (11 units) is the sum of the quantity demanded by A (no units), B (4 units), and C (7 units). 126 PART 2 • Producers, Consumers, and Competitive Markets Two points should be noted as a result of this analysis: 1. The market demand curve will shift to the right as more consumers enter the market. 2. Factors that influence the demands of many consumers will also affect market demand. Suppose, for example, that most consumers in a particular market earn more income and, as a result, increase their demands for coffee. Because each consumer’s demand curve shifts to the right, so will the market demand curve. The aggregation of individual demands into market demands is not just a theoretical exercise. It becomes important in practice when market demands are built up from the demands of different demographic groups or from consumers located in different areas. For example, we might obtain information about the demand for home computers by adding independently obtained information about the demands of the following groups: • Households with children • Households without children • Single individuals Or, we might determine U.S. wheat demand by aggregating domestic demand (i.e., by U.S. consumers) and export demand (i.e., by foreign consumers), as we will see in Example 4.3. In §2.4, we show how the price elasticity of demand describes the responsiveness of consumer demands to changes in price. Elasticity of Demand Recall from Section 2.4 (page 33) that the price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent increase in price. Denoting the quantity of a good by Q and its price by P, the price elasticity of demand is = EP |
Q/Q P/4.1) (Here, because means “a change in,” Q/Q is the percentage change in Q.) INELASTIC DEMAND When demand is inelastic (i.e., EP is less than 1 in absolute value), the quantity demanded is relatively unresponsive to changes in price. As a result, total expenditure on the product increases when the price increases. Suppose, for example, that a family currently uses 1000 gallons of gasoline a year when the price is $1 per gallon; suppose also that our family’s price elasticity of demand for gasoline is -0.5. If the price of gasoline increases to $1.10 (a 10-percent increase), the consumption of gasoline falls to 950 gallons (a 5-percent decrease). Total expenditure on gasoline, however, will increase from $1000 (1000 gallons * $1 per gallon) to $1045 (950 gallons * $1.10 per gallon). ELASTIC DEMAND In contrast, when demand is elastic (EP is greater than 1 in absolute value), total expenditure on the product decreases as the price goes up. Suppose that a family buys 100 pounds of chicken per year at a price of $2 per pound; the price elasticity of demand for chicken is -1.5. If the price of chicken increases to $2.20 (a 10-percent increase), our family’s consumption of chicken falls to 85 pounds Recall from §2.4 that because the magnitude of an elasticity refers to its absolute value, an elasticity of −0.5 is less in magnitude than a −1.0 elasticity. Price of movie tickets ($) 9 6 3 CHAPTER 4 • Individual and Market Demand 127 FIGURE 4.11 UNIT-ELASTIC DEMAND CURVE When the price elasticity of demand is −1.0 at every price, the total expenditure is constant along the demand curve D. D 600 900 1800 Thousands of movie tickets a year (a 15-percent decrease). Total expenditure on chicken will also fall, from $200 (100 pounds * $2 per pound) to $187 (85 pounds * $2.20 per pound). ISOELASTIC DEMAND When the price elasticity of demand is constant all along the demand curve, we say that the curve is isoelastic. Figure 4.11 shows an isoelastic demand curve. Note how this demand curve is bowed inward. In contrast, recall from Section 2.4 what happens to the price elasticity of demand as we move along a linear demand curve. Although the slope of the linear curve is constant, the price elasticity of demand is not. It is zero when the price is zero, and it increases in magnitude until it becomes infinite when the price is sufficiently high for the quantity demanded to become zero. A special case of the isoelastic curve is the unit-elastic demand curve: a demand curve with price elasticity always equal to - 1, as is the case for the curve in Figure 4.11. In this case, total expenditure remains the same after a price change. A price increase, for instance, leads to a decrease in the quantity demanded that leaves the total expenditure on the good unchanged. Suppose, for example, that the total expenditure on first-run movies in Berkeley, California, is $5.4 million per year, regardless of the price of a movie ticket. For all points along the demand curve, the price times the quantity will be $5.4 million. If the price is $6, the quantity will be 900,000 tickets; if the price increases to $9, the quantity will drop to 600,000 tickets, as shown in Figure 4.11. Table 4.3 summarizes the relationship between elasticity and expenditure. It is useful to review this table from the perspective of the seller of the good rather TABLE 4.3 PRICE ELASTICITY AND CONSUMER EXPENDITURES DEMAND Inelastic Unit elastic Elastic IF PRICE INCREASES, EXPENDITURES IF PRICE DECREASES, EXPENDITURES Increase Decrease Are unchanged Are unchanged Decrease Increase • isoelastic demand curve Demand curve with a constant price elasticity. In §2.4, we show that when the demand curve is linear, demand becomes more elastic as the price of the product increases. 128 PART 2 • Producers, Consumers, and Competitive Markets than the buyer. (What the seller perceives as total revenue, the consumer views as total expenditures.) When demand is inelastic, a price increase leads only to a small decrease in quantity demanded; thus, the seller’s total revenue increases. But when demand is elastic, a price increase leads to a large decline in quantity demanded and total revenue falls. EXAMPLE 4.3 THE AGGREGATE DEMAND FOR WHEAT In Chapter 2 (Example 2.5—page 37), we explained that the demand for U.S. wheat has two components: domestic demand (by U.S. consumers) and export demand (by foreign consumers). Let’s see how the total demand for wheat can be obtained by aggregating the domestic and foreign demands. Domestic demand for wheat is given by the equation QDD = 1430 - 55P where QDD is the number of bushels (in millions) demanded domestically, and P is the price in dollars per bushel. Export demand is given by QDE = 1470 - 70P where QDE is the number of bushels (in millions) demanded from abroad. As shown in Figure 4.12, domestic demand, given by AB, is relatively price inelastic. (Statistical studies have shown that price elasticity of domestic demand is about −0.2 to −0.3.) However, export demand, given by CD, is more price elastic, with an elasticity of about −0.4. Why? Export demand is more elastic than ) 30 25 20 15 10 5 0 A C E Total Demand Export Demand Domestic Demand B D F 0 500 1000 1500 2000 2500 3000 Quantity (million bushels per year) FIGURE 4.12 THE AGGREGATE DEMAND FOR WHEAT The total world demand for wheat is the horizontal sum of the domestic demand AB and the export demand CD. Even though each individual demand curve is linear, the market demand curve is kinked, fact that reflecting the there is no export demand when the price of wheat is greater than about $21 per bushel. CHAPTER 4 • Individual and Market Demand 129 domestic demand because poorer countries that import U.S. wheat turn to other grains and foodstuffs if wheat prices rise.3 To obtain the world demand for wheat, we set the left side of each demand equation equal to the quantity of wheat (the variable on the horizontal axis). We then add the right side of the equations, obtaining QDD + QDE = (1430 - 55P ) + (1470 - 70P ) = 2900 - 125P This generates the line segment EF in Figure 4.12. At all prices above point C, however, there is no export demand, so that world demand and domestic demand are identical. As a result, for all prices above C, world demand is given by line segment AE. (If we were to add QDE for prices above C, we would be incorrectly adding a negative export demand to a positive domestic demand.) As the figure shows, the resulting total demand for wheat, given by AEF, is kinked. The kink occurs at point E, the price level above which there is no export demand. Speculative Demand So far in our treatment of demand, we have assumed that consumers are “rational,” in that they allocate their income among various goods and services to maximize their overall satisfaction. At times, however, the demands for some goods are based not on the satisfaction one obtains from actually consuming the good, but instead on the belief that the price of the good will rise. In that case, it might be possible to profit by buying the good and then reselling it later at a higher price. This speculative demand is partly to blame for the sharp increases in housing prices that occurred in the U.S., Europe, and China during the past decade. Speculative demand is often (but as we will explain in Chapter 5, not always) irrational. People see that the price of a good has been rising, and somehow conclude that the price will therefore keep rising. But there is usually no rational E XAMP LE 4.4 THE DEMAND FOR HOUSING • speculative demand Demand driven not by the direct benefits one obtains from owning or consuming a good but instead by an expectation that the price of the good will increase. Housing is typically the most important single expenditure in a household’s budget—on average, households spend 25 percent of their income on housing. A family’s demand for housing depends on the age and status of the household making the purchasing decision. One approach to the housing demand is to relate the number of rooms per house for each household (the quantity demanded) both to an estimate of the price of an additional room in a house and to the household’s family income. (Prices of rooms vary because of differences in construction costs, including the price of 3For a survey of statistical studies of demand and supply elasticities and an analysis of the U.S. wheat market, see Larry Salathe and Sudchada Langley, “An Empirical Analysis of Alternative Export Subsidy Programs for U.S. Wheat,” Agricultural Economics Research 38, No. 1 (Winter 1986). 130 PART 2 • Producers, Consumers, and Competitive Markets TABLE 4.4 PRICE AND INCOME ELASTICITIES OF THE DEMAND FOR ROOMS GROUP Single individuals Married, head of household age less than 30, 1 child Married, head age 30–39, 2 or more children Married, head age 50 or older, 1 child PRICE ELASTICITY INCOME ELASTICITY −0.10 −0.25 −0.15 −0.08 0.21 0.06 0.12 0.19 land.) Table 4.4 lists price and income elasticities for different demographic groups. There are significant differences among subgroups of the population. For example, families with young household heads have a price elasticity of −0.25, which is more price elastic than the demands of families with older household heads. Presumably, families buying houses are more price sensitive when parents and their children are younger and there may be plans for more children. Among married households, the income elasticity of demand for rooms also increases with age, which tells us that older households buy larger houses than younger households. For poor families, the fraction of income spent on housing is large. For instance, renters with an income in the bottom 20 percent of the income distribution spend roughly 55 percent of their income on housing, as compared to 2.8 percent of income for households overall.4 Many government programs, such as subsidies, rent controls, and land-use regulations, have been proposed to shape the housi |
ng market in ways that might ease the housing burden on the poor. How effective are income subsidies? If the subsidy increases the demand for housing substantially, then we can presume that the subsidy will lead to improved housing for the poor.5 On the other hand, if the extra money were spent on items other than housing, the subsidy will have failed to address policy concerns related to housing. The evidence indicates that for poor households (with incomes in the bottom tenth percentile of all households), the income elasticity of housing is only about 0.09, which implies that income subsidies would be spent primarily on items other than housing. By comparison, the income elasticity for housing among the wealthiest households (the top 10 percent) is about 0.54. This discussion assumes that consumers choose their expenditures on housing and other goods to maximize their overall satisfaction, where the benefits of housing (and thus the demand for housing) arise from the amount of living space, the safety of the neighborhood, the quality of schools, etc. In recent years, however, the demand for housing has been partly driven by speculative demand: People bought homes under the assumption that they can re-sell the homes in the future at a much higher price. Speculative demand—demand driven not by the direct benefits one obtains from owning a home but instead by an expectation that the price will increase—has caused housing prices in many parts of the United States to increase sharply, far more than could be justified by demographics. Speculative demand can lead to a bubble—an increase in price based not on the fundamentals of demand, but instead on a belief that the price will keep going up. Eventually, bubbles burst—the price stops rising as new buyers stop coming into the market, owners of the good become alarmed and start to sell, the price drops, more people sell, and the price drops further. As we will see in Chapter 5, bubbles are problematic because they can distort the functioning of a market and lead to financial dislocations when they burst. That is what happened to the U.S. housing market, which experienced a housing price bubble that finally burst in 2008, leading to mortgage defaults and contributing to the financial crisis that hit the U.S. and the global economy in late 2008. 4This is the starting point of the “affordable” housing debate. For an overview, see John Quigley and Steven Raphael, “Is Housing Unaffordable? Why Isn’t It More Affordable,” Journal of Economic Perspectives 18 (2004): 191–214. 5Julia L. Hansen, John P. Formby, and W. James Smith, “Estimating the Income Elasticity of Demand for Housing: A Comparison of Traditional and Lorenz-Concentration Curve Methodologies,” Journal of Housing Economics 7 (1998): 328–42. CHAPTER 4 • Individual and Market Demand 131 E XAMP LE 4.5 THE LONG-RUN DEMAND FOR GASOLINE Among industrialized countries, the United States is unique in that the price of gasoline is relatively low. The reason is simple: Europe, Japan, and other countries have stiff taxes on gasoline, so that gas prices are typically double or triple that in the United States, which imposes very low taxes on gasoline. Many economists have argued that the United States should substantially increase its tax on gasoline, because doing so would lower gasoline consumption and thereby reduce dependence on imported oil and reduce the greenhouse gas emissions that contribute to global warming (in addition to providing much-needed revenue to the government). Politicians have resisted, however, because they fear that a tax increase would anger voters. Putting the politics of a gas tax aside, would higher gasoline prices indeed reduce gasoline consumption, or are drivers so wedded to big gas-guzzling cars that higher prices would make little difference? What matters here is the long-run demand for gasoline, because we can’t expect drivers to immediately scrap their old cars and buy new ones following a price increase. One way to get at the long-run demand curve is by looking at per-capital consumption of gasoline in different countries which historically have had very different prices (because they imposed different gasoline taxes). Figure 4.13 does just that. It plots the per-capita consumption of gasoline on the vertical axis and the price in dollars per gallon for 10 countries on the horizontal axis.6 (Each circle represents the population of the corresponding country.) Note that the United States has had by far the lowest gasoline prices and also the highest per-capita gasoline consumption. Australia is roughly in the middle in terms of prices, and likewise in terms of consumption. Most of the European countries, on the other hand, have much higher prices and correspondingly lower per capita consumption levels. The long-run elasticity of demand for gasoline turns out to be about −1.4. Now we come back to our question: Would higher gasoline prices reduce gasoline consumption? Figure 4.13 provides a clear answer: Most definitely 500 400 300 200 100 2 United States New Zealand Australia Sweden United Kingdom Germany Austria France Norway 4 6 8 Gasoline Price FIGURE 4.13 GASOLINE PRICES AND PER CAPITA CONSUMPTION IN 10 COUNTRIES The graph plots per capita consumption of gasoline versus the price per gallon (converted to U.S. dollars) for 10 countries over the period 2008 to 2010. Each circle represents the population of the corresponding country. 6Our thanks to Chris Knittel for providing us with the data for this figure. The figure controls for income differences and is based on Figure 1 in Christopher Knittel, "Reducing Petroleum Consumption from Transportation," Journal of Economic Perspectives, 2012. All underlying data are available from www.worldbank.org. 132 PART 2 • Producers, Consumers, and Competitive Markets • consumer surplus Difference between what a consumer is willing to pay for a good and the amount actually paid. basis for the “therefore,” so that a consumer who buys something because he believes the price will keep rising is often doing little more than gambling. 4.4 Consumer Surplus Consumers buy goods because the purchase makes them better off. Consumer surplus measures how much better off individuals are, in the aggregate, because they can buy goods in the market. Because different consumers place different values on the consumption of particular goods, the maximum amount they are willing to pay for those goods also differs. Individual consumer surplus is the difference between the maximum amount that a consumer is willing to pay for a good and the amount that the consumer actually pays. Suppose, for example, that a student would have been willing to pay $13 for a rock concert ticket even though she only had to pay $12. The $1 difference is her consumer surplus.7 When we add the consumer surpluses of all consumers who buy a good, we obtain a measure of the aggregate consumer surplus. Consumer Surplus and Demand Consumer surplus can be calculated easily if we know the demand curve. To see the relationship between demand and consumer surplus, let’s examine the individual demand curve for concert tickets shown in Figure 4.14. (Although the following discussion applies to this particular individual demand curve, a similar argument also applies to a market demand curve.) Drawing the demand curve as a staircase rather than a straight line shows us how to measure the value that our consumer obtains from buying different numbers of tickets. FIGURE 4.14 CONSUMER SURPLUS Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it. Here, the consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the yellow-shaded area. Price (dollars per ticket) 20 19 18 17 16 15 14 13 0 Consumer Surplus 1 2 3 4 5 6 Rock concert tickets 7Measuring consumer surplus in dollars involves an implicit assumption about the shape of consumers’ indifference curves: namely, that the marginal utility associated with increases in a consumer’s income remains constant within the range of income in question. In many cases, this is a reasonable assumption. It may be suspect, however, when large changes in income are involved. CHAPTER 4 • Individual and Market Demand 133 When deciding how many tickets to buy, our student might reason as follows: The first ticket costs $14 but is worth $20. This $20 valuation is obtained by using the demand curve to find the maximum amount that she will pay for each additional ticket ($20 being the maximum that she will pay for the first ticket). The first ticket is worth purchasing because it generates $6 of surplus value above and beyond its cost. The second ticket is also worth buying because it generates a surplus of $5 ($19 - $14). The third ticket generates a surplus of $4. The fourth, however, generates a surplus of only $3, the fifth a surplus of $2, and the sixth a surplus of just $1. Our student is indifferent about purchasing the seventh ticket (which generates zero surplus) and prefers not to buy any more than that because the value of each additional ticket is less than its cost. In Figure 4.14, consumer surplus is found by adding the excess values or surpluses for all units purchased. In this case, then, consumer surplus equals $6 + $5 + $4 + $3 + $2 + $1 = $21 To calculate the aggregate consumer surplus in a market, we simply find the area below the market demand curve and above the price line. For our rock concert example, this principle is illustrated in Figure 4.15. Now, because the number of tickets sold is measured in thousands and individuals’ demand curves differ, the market demand curve appears as a straight line. Note that the actual expenditure on tickets is 6500 $14 $91,000. Consumer surplus, shown as the yellow-shaded triangle, is 1/2 * ($20 - $14) * 6500 = $19,500 This amount is the total benefit to consumers, less what they paid for the tickets. Of course, market demand cu |
rves are not always straight lines. Nonetheless, we can always measure consumer surplus by finding the area below the demand curve and above the price line. Price (dollars per ticket) 20 19 18 17 16 15 14 13 0 1 FIGURE 4.15 CONSUMER SURPLUS GENERALIZED For the market as a whole, consumer surplus is measured by the area under the demand curve and above the line representing the purchase price of the good. Here, the consumer surplus is given by the yellow-shaded triangle and is equal to 1/2 ($20 $14) 6500 $19,500. Consumer Surplus Market Price Actual Expenditure Demand Curve 3 2 7 Rock concert tickets (thousands) 4 6 5 134 PART 2 • Producers, Consumers, and Competitive Markets APPLYING CONSUMER SURPLUS Consumer surplus has important applications in economics. When added over many individuals, it measures the aggregate benefit that consumers obtain from buying goods in a market. When we combine consumer surplus with the aggregate profits that producers obtain, we can evaluate both the costs and benefits not only of alternative market structures, but of public policies that alter the behavior of consumers and firms in those markets. EXAMP LE 4 .6 THE VALUE OF CLEAN AIR Air is free in the sense that we don’t pay to breathe it. But the absence of a market for air may help explain why the air quality in some cities has been deteriorating for decades. To encourage cleaner air, Congress passed the Clean Air Act in 1977 and has since amended it a number of times. In 1990, for example, automobile emissions controls were tightened. Were these controls worth it? Were the benefits of cleaning up the air sufficient to outweigh the costs imposed directly on car producers and indirectly on car buyers? To answer these questions,Congress asked the National Academy of Sciences to evaluate emissions controls in a cost-benefit study. Using empirically determined estimates of the demand for clean air, the benefits portion of the study determined how much people value clean air. Although there is no actual market for clean air, people do pay more for houses where the air is clean than for comparable houses in areas with dirtier air. This information was used to estimate the demand for clean air.8 Detailed data on house prices in neighborhoods of Boston and Los Angeles were compared with the levels of various air pollutants. The effects of other variables that might affect house values were taken into account statistically. The study determined a demand curve for clean air that looked approximately like the one shown in Figure 4.16. Value (dollars per pphm of reduction) 2000 1000 A FIGURE 4.16 VALUING CLEANER AIR The yellow-shaded triangle gives the consumer surplus generated when air pollution is reduced by 5 parts per 100 million of nitrogen oxide at a cost of $1000 per part reduced. The surplus is created because most consumers are willing to pay more than $1000 for each unit reduction of nitrogen oxide. 0 5 10 NOX (pphm) pollution reduction 8The results are summarized in Daniel L. Rubinfeld, “Market Approaches to the Measurement of the Benefits of Air Pollution Abatement,” in Ann Friedlaender, ed., The Benefits and Costs of Cleaning the Air (Cambridge: MIT Press, 1976), 240–73. CHAPTER 4 • Individual and Market Demand 135 The horizontal axis measures the amount of air pollution reduction, as exemplified by a level of nitrogen oxides (NOX) of 10 parts per 100 million (pphm); the vertical axis measures the increased value of a home associated with those reductions. Consider, for example, the demand for cleaner air of a homeowner in a city in which the air is rather dirty. If the family were required to pay $1000 for each 1 pphm reduction in air pollution, it would choose A on the demand curve in order to obtain a pollution reduction of 5 pphm. How much is a 50-percent, or 5-pphm, reduction in pollution worth to this same family? We can measure this value by calculating the consumer surplus associated with reducing air pollution. Because the price for this reduction is $1000 per unit, the family would pay $5000. However, the family values all but the last unit of reduction by more than $1000. As a result, the yellow-shaded triangle in Figure 4.16 gives the value of the cleanup (above and beyond the payment). Because the demand curve is a straight line, the surplus can be calculated from the area of the triangle whose height is $1000 ($2000 - $1000) and whose base is 5 pphm. Therefore, the value to the household of the nitrogen oxide pollution reduction is $2500. A more recent study that focused on suspended participates also found that households place substantial value on air pollution reduction.9 A one-milligram per cubic meter reduction in total suspended particulates (from a mean of about 60 milligrams per cubic meter) was valued at $2,400 per household. A complete cost-benefit analysis would use a measure of the total benefit of the cleanup—the benefit per household times the number of households. This figure could be compared with the total cost of the cleanup to determine whether such a project was worthwhile. We will discuss clean air further in Chapter 18, when we describe the tradeable emissions permits that were introduced by the Clean Air Act Amendments of 1990. 4.5 Network Externalities So far, we have assumed that people’s demands for a good are independent of one another. In other words, Tom’s demand for coffee depends on Tom’s tastes and income, the price of coffee, and perhaps the price of tea. But it does not depend on Dick’s or Harry’s demand for coffee. This assumption has enabled us to obtain the market demand curve simply by summing individuals’ demands. For some goods, however, one person’s demand also depends on the demands of other people. In particular, a person’s demand may be affected by the number of other people who have purchased the good. If this is the case, there exists a network externality. Network externalities can be positive or negative. A positive network externality exists if the quantity of a good demanded by a typical consumer increases in response to the growth in purchases of other consumers. If the quantity demanded decreases, there is a negative network externality. Positive Network Externalities One example of a positive network externality is word processing. Many students use Microsoft Word in part because their friends and many of their professors do as well. That allows us to send and receive drafts without the need to convert from one program to another. The more people use a particular product or participate in a particular activity, the greater the intrinsic value of that activity or product to each individual. Social network websites provide another good example. If I am the only member of that site, it will have no value to me. But the greater number of 9Kenneth Y. Chay and Michael Greenstone, “Does Air Quality Matter? Evidence from the Housing Market,” Journal of Political Economy 113 (2005): 376–424. • network externality Situation in which each individual’s demand depends on the purchases of other individuals. 136 PART 2 • Producers, Consumers, and Competitive Markets • bandwagon effect Positive network externality in which a consumer wishes to possess a good in part because others do. people who join the site, the more valuable it will become. If one social networking site has a small advantage in terms of market share early on, the advantage will grow, because new members will prefer to join the larger site. Hence the huge success of personal website Facebook and professional website LinkedIn. A similar story holds for virtual worlds and for multiplayer online games. Another example of a positive network externality is the bandwagon effect— the desire to be in style, to possess a good because almost everyone else has it, or to indulge a fad. The bandwagon effect often arises with children’s toys (video games, for example). In fact, exploiting this effect is a major objective in marketing and advertising toys. Often it is the key to success in selling clothing. Positive network externalities are illustrated in Figure 4.17, in which the horizontal axis measures the sales of a product in thousands per month. Suppose consumers think that only 20,000 people have purchased a certain product. Because this is a small number relative to the total population, consumers will have little incentive to buy the product. Some consumers may still buy it (depending on price), but only for its intrinsic value. In this case demand is given by the curve D20. (This hypothetical demand curve assumes that there are no externalities.) Suppose instead that consumers think 40,000 people have bought the product. Now they find it more attractive and want to buy more. The demand curve is D40, which is to the right of D20. Similarly, if consumers think that 60,000 people have bought the product, the demand curve will be D60, and so on. The more people consumers believe to have purchased the product, the farther to the right the demand curve shifts. Ultimately, consumers will get a good sense of how many people have in fact purchased a product. This number will depend, of course, on its price. In Figure 4.17, for example, we see that if the price were $30, then 40,000 people would buy the product. Thus the relevant demand curve would be D40. If the price were $20, 80,000 people would buy the product and the relevant demand curve would be D80. The market demand curve is therefore found by joining the Price (dollars per unit) D20 D40 D60 D80 D100 FIGURE 4.17 POSITIVE NETWORK EXTERNALITY With a positive network externality, the quantity of a good that an individual demands grows in response to the growth of purchases by other individuals. Here, as the price of the product falls from $30 to $20, the positive externality causes the demand for the good to shift to the right, from D40 to D80. 30 20 20 40 48 60 80 100 Pure price effect Externality effect Demand Quantity (thousands per month) CHAPTER 4 • Individ |
ual and Market Demand 137 points on the curves D20, D40, D60, D80, and D100 that correspond to the quantities 20,000, 40,000, 60,000, 80,000 and 100,000. Compared with the curves D20, etc., the market demand curve is relatively elastic. To see why the positive externality leads to a more elastic demand curve, consider the effect of a drop in price from $30 to $20, with a demand curve of D40. If there were no externality, the quantity demanded would increase from 40,000 to only 48,000. But as more people buy the product, the positive network externality increases the quantity demanded further, to 80,000. Thus, the positive network externality increases the response of demand to price changes—i.e., it makes demand more elastic. As we’ll see later, this result has important implications for producers’ pricing strategies. Negative Network Externalities Network externalities are sometimes negative. Congestion offers one example. When skiing, I prefer short lines at ski lifts and fewer skiers on the slopes. As a result, the value of a lift ticket at a ski resort is lower the more people who bought the tickets. Likewise for entry to an amusement park, skating rink, or beach. Another example of a negative network externality is the snob effect— the desire to own an exclusive or unique good. The quantity demanded of a “snob good” is higher the fewer people who own it. Rare works of art, specially designed sports cars, and made-to-order clothing are snob goods. The value one gets from a painting or a sports car is partly the prestige, status, and exclusivity resulting from the fact that few other people own one like it. Figure 4.18 illustrates how a negative network externality works. We will assume that the product in question is a snob good, so people value exclusivity. • snob effect Negative network externality in which a consumer wishes to own an exclusive or unique good. Price (dollars per unit) 30,000 Demand 15,000 FIGURE 4.18 NEGATIVE NETWORK EXTERNALITY: SNOB EFFECT The snob effect is a negative network externality in which the quantity of a good that an individual demands falls in response to the growth of purchases by other individuals. Here, as the price falls from $30,000 to $15,000 and more people buy the good, the snob effect causes the demand for the good to shift to the left, from D2 to D6. D2 D4 D6 D8 2 4 6 8 Pure Price Effect Snob Effect Net Effect 14 Quantity (thousands per month) 138 PART 2 • Producers, Consumers, and Competitive Markets In the figure, D2 is the demand curve that would apply if consumer believed that only 2000 people used the good. If they believe that 4000 people use the good, it would be less exclusive, and so its value decreases. The quantity demanded will therefore be lower; curve D4 applies. Similarly, if consumers believe that 6000 people use the good, demand is even smaller and D6 applies. Eventually, consumers learn how widely owned the good actually is. Thus, the market demand curve is found by joining the points on curves D2, D4, D6, etc., that actually correspond to the quantities 2000, 4000, 6000, etc. Note that the negative network externality makes market demand less elastic. To see why, suppose the price was initially $30,000 with 2000 people using the good. What happens when the price is lowered to $15,000? If there were no externality, the quantity purchased would increase to 14,000 (along curve D2). But the value of the good is greatly reduced if more people own it. The negative network externality dampens the increase in the quantity demanded, cutting it by 8000 units; the net increase in sales is only to 6000 units. For a variety of goods, marketing and advertising are geared to creating a snob effect. (Think of Rolex watches.) The goal is a very inelastic demand— which makes it possible for firms to charge very high prices. Negative network externalities can arise for other reasons. Consider the effect of congestion in queues. Because I prefer short lines and fewer skiers on the slopes, the value I obtain from a lift ticket at a ski resort is lower the more people there are who have bought tickets. Likewise for entry to an amusement park, skating rink, or beach.10 EXAMP LE 4 .7 FACEBOOK The social networking website, Facebook, began operation in 2004 and had a million users by the end of the year. By early 2011, with over 600 million users, Facebook became the world’s second most visited website (after Google). A strong positive network externality was central to Facebook’s success. To understand this, just ask yourself why you would join Facebook rather than some other social networking site. You would join because so many other people have joined. The more friends that also joined, the more useful the site becomes for you as a way to share news and other information with friends. Conversely, if you are the only one of your social circle who does not use Facebook, you may find yourself out of the loop with respect to news and upcoming events. With more members, there are more people to meet or reconnect with, a bigger audience for your photos and opinions, and generally, a larger variety of content for you to enjoy. In Table 4.5, you can see that as the number of Facebook users has grown, the time the average user spent on the site grew as well. Network externalities have been crucial drivers for many modern technologies over many years. Telephones, fax machines, email, Craigslist, Second Life, and Twitter are just a few examples. 10Tastes, of course, differ. Some people associate a positive network externality with skiing or a day on the beach; they enjoy crowds and may even find the slope or beach lonely without them. CHAPTER 4 • Individual and Market Demand 139 TABLE 4.5 FACEBOOK USERS YEAR 2004 2005 2006 2007 2008 2009 2010 FACEBOOK USERS (MILLIONS) HOURS PER USER PER MONTH 1 5.5 12 50 100 350 500 <1 2 3 5.5 7 Source: www.facebook.com/press/info.php?timeline *4.6 Empirical Estimation of Demand Later in this book, we will explain how demand information is used as input into a firm’s economic decision-making process. General Motors, for example, must understand automobile demand to decide whether to offer rebates or below-market-rate loans for new cars. Knowledge about demand is also important for public policy decisions. Understanding the demand for oil, for instance, can help Congress decide whether to pass an oil import tax. You may wonder how it is that economists determine the shape of demand curves and how price and income elasticities of demand are actually calculated. In this starred section, we will briefly examine some methods for evaluating and forecasting demand. The section is starred not only because the material is more advanced, but also because it is not essential for much of the later analysis in the book. Nonetheless, this material is instructive and will help you appreciate the empirical foundation of the theory of consumer behavior. The basic statistical tools for estimating demand curves and demand elasticities are described in the appendix to this book, entitled “The Basics of Regression.” The Statistical Approach to Demand Estimation Firms often rely on market information based on actual studies of demand. Properly applied, the statistical approach to demand estimation can help researchers sort out the effects of variables, such as income and the prices of other products, on the quantity of a product demanded. Here we outline some of the conceptual issues involved in the statistical approach. Table 4.6 shows the quantity of raspberries sold in a market each year. Information about the market demand for raspberries would be valuable to an organization representing growers because it would allow them to predict sales on the basis of their own estimates of price and other demand-determining variables. Let’s suppose that, focusing on demand, researchers find that the quantity of raspberries produced is sensitive to weather conditions but not to the current market price (because farmers make their planting decisions based on last year’s price). 140 PART 2 • Producers, Consumers, and Competitive Markets TABLE 4.6 DEMAND DATA YEAR 2004 2005 2006 2007 2008 2009 2010 2011 2012 QUANTITY (Q) PRICE (P) INCOME (I ) 4 7 8 13 16 15 19 20 22 24 20 17 17 10 15 12 9 5 10 10 10 17 27 27 20 20 20 The price and quantity data from Table 4.6 are graphed in Figure 4.19. If we believe that price alone determines demand, it would be plausible to describe the demand for the product by drawing a straight line (or other appropriate curve), Q a bP, which “fit” the points as shown by demand curve D. (The “leastsquares” method of curve-fitting is described in the appendix to the book.) Does curve D (given by the equation Q = 28.2 - 1.00P) really represent the demand for the product? The answer is yes—but only if no important factors other than price affect demand. In Table 4.6, however, we have included data for one other variable: the average income of purchasers of the product. Note that income (I) has increased twice during the study, suggesting that the demand curve has shifted twice. Thus demand curves d1, d2, and d3 in Figure 4.19 give a more likely description of demand. This linear demand curve would be described algebraically as Q = a - bP + cI (4.2) The income term in the demand equation allows the demand curve to shift in a parallel fashion as income changes. The demand relationship, calculated using the least-squares method, is given by Q = 8.08 - .49P + .81I. The Form of the Demand Relationship Because the demand relationships discussed above are straight lines, the effect of a change in price on quantity demanded is constant. However, the price elasticity of demand varies with the price level. For the demand equation Q = a - bP, for example, the price elasticity EP is EP = (Q/P)(P/Q) = -b(P/Q) (4.3) Thus elasticity increases in magnitude as the price increases (and the quantity demanded falls). Consider, for example, the linear demand for raspberries, w |
hich was estimated to be Q = 8.08 - .49P + .81I. The elasticity of demand in 1999 (when Q = 16 and P = 10) is equal to -.49 (10/16) = -.31, whereas the elasticity in 2003 (when Q = 22 and P = 5) is substantially lower: -.11. CHAPTER 4 • Individual and Market Demand 141 Price 25 20 15 10 5 0 FIGURE 4.19 ESTIMATING DEMAND Price and quantity data can be used to determine the form of a demand relationship. But the same data could describe a single demand curve D or three demand curves d1, d2, and d3 that shift over time. d1 d2 D d3 5 10 15 20 25 Quantity There is no reason to expect elasticities of demand to be constant. Nevertheless, we often find it useful to work with the isoelastic demand curve, in which the price elasticity and the income elasticity are constant. When written in its log-linear form, the isoelastic demand curve appears as follows: log(Q) = a - b log(P) + c log(I) (4.4) where log ( ) is the logarithmic function and a, b, and c are the constants in the demand equation. The appeal of the log-linear demand relationship is that the slope of the line -b is the price elasticity of demand and the constant c is the income elasticity.11 Using the data in Table 4.5, for example, we obtained the regression line log(Q) = -0.23 - 0.34 log(P) + 1.33 log(I) This relationship tells us that the price elasticity of demand for raspberries is - 0.34 (that is, demand is inelastic), and that the income elasticity is 1.33. We have seen that it can be useful to distinguish between goods that are complements and goods that are substitutes. Suppose that P2 represents the price of a second good—one which is believed to be related to the product we are studying. We can then write the demand function in the following form: log(Q) = a - b log(P) + b2 log(P2) + c log(I) When b2, the cross-price elasticity, is positive, the two goods are substitutes; when b2 is negative, the two goods are complements. 11The natural logarithmic function with base e has the property that (log(Q)) = Q/Q for any change in log(Q). Similarly, (log(P)) = P/P for any change in log(P). It follows that (log(Q)) = Q/Q = - b[(log(P))] = -b(P/P). Therefore, (Q/Q)/(P/P) = - b, which is the price elasticity of demand. By a similar argument, the income elasticity of demand c is given by (Q/Q)/(I/I). 142 PART 2 • Producers, Consumers, and Competitive Markets The specification and estimation of demand curves has been a rapidly growing endeavor, not only in marketing, but also in antitrust analyses. It is now commonplace to use estimated demand relationships to evaluate the likely effects of mergers.12 What were once prohibitively costly analyses involving mainframe computers can now be carried out in a few seconds on a personal computer. Accordingly, governmental competition authorities and economic and marketing experts in the private sector make frequent use of supermarket scanner data as inputs for estimating demand relationships. Once the price elasticity of demand for a particular product is known, a firm can decide whether it is profitable to raise or lower price. Other things being equal, the lower in magnitude the elasticity, the more likely the profitability of a price increase. EXAMP LE 4 .8 THE DEMAND FOR READY-TO-EAT CEREAL The Post Cereals division of Kraft General Foods acquired the Shredded Wheat cereals of Nabisco in 1995. The acquisition raised the legal and economic question of whether Post would raise the price of its best-selling brand, Grape Nuts, or the price of Nabisco’s most successful brand, Shredded Wheat Spoon Size.13 One important issue in a lawsuit brought by the state of New York was whether the two brands were close substitutes for one another. If so, it would be more profitable for Post to increase the price of Grape Nuts (or Shredded Wheat) after rather than before the acquisition. Why? Because after the acquisition the lost sales from consumers who switched away from Grape Nuts (or Shredded Wheat) would be recovered to the extent that they switched to the substitute product. The extent to which a price increase will cause consumers to switch is given (in part) by the price elasticity of demand for Grape Nuts. Other things being equal, the higher the demand elasticity, the greater the loss of sales associated with a price increase. The more likely, too, that the price increase will be unprofitable. The substitutability of Grape Nuts and Shredded Wheat can be measured by the cross-price elasticity of demand for Grape Nuts with respect to the price of Shredded Wheat. The relevant elasticities were calculated using weekly data obtained from supermarket scanning of household purchases for 10 cities over a three-year period. One of the estimated isoelastic demand equations appeared in the following log-linear form: log(QGN) = 1.998 - 2.085 log(PGN) + 0.62 log(I) + 0.14 log(PSW) where QGN is the amount (in pounds) of Grape Nuts sold weekly, PGN the price per pound of Grape Nuts, I real personal income, and PSW the price per pound of Shredded Wheat Spoon Size. The demand for Grape Nuts is elastic (at current prices), with a price elasticity of about -2. The income elasticity is 0.62: In other words, increases in income lead to increases in cereal purchases, but at less than a 1-for-1 rate. Finally, the cross-price elasticity is 0.14. This figure is consistent with the fact that although the two cereals are substitutes (the quantity demanded of Grape Nuts increases in response to an increase in the price of Shredded Wheat), they are not very close substitutes. 12See Jonathan B. Baker and Daniel L. Rubinfeld, “Empirical Methods in Antitrust Litigation: Review and Critique,” American Law and Economics Review, 1(1999): 386–435. 13State of New York v. Kraft General Foods, Inc., 926 F. Supp. 321, 356 (S.D.N.Y. 1995). CHAPTER 4 • Individual and Market Demand 143 Interview and Experimental Approaches to Demand Determination Another way to obtain information about demand is through interviews in which consumers are asked how much of a product they might be willing to buy at a given price. This approach, however, may not succeed when people lack information or interest or even want to mislead the interviewer. Therefore, market researchers have designed various indirect survey techniques. Consumers might be asked, for example, what their current consumption behavior is and how they would respond if a certain product were available at, say, a 10-percent discount. They might be asked how they would expect others to behave. Although indirect approaches to demand estimation can be fruitful, the difficulties of the interview approach have forced economists and marketing specialists to look to alternative methods. In direct marketing experiments, actual sales offers are posed to potential customers. An airline, for example, might offer a reduced price on certain flights for six months, partly to learn how the price change affects demand for flights and partly to learn how competitors will respond. Alternatively, a cereal company might test market a new brand in Buffalo, New York, and Omaha, Nebraska, with some potential customers being given coupons ranging in value from 25 cents to $1 per box. The response to the coupon offer tells the company the shape of the underlying demand curve, helping the marketers decide whether to market the product nationally and internationally, and at what price. Direct experiments are real, not hypothetical, but even so, problems remain. The wrong experiment can be costly, and even if profits and sales rise, the firm cannot be entirely sure that these increases resulted from the experimental change; other factors probably changed at the same time. Moreover, the response to experiments—which consumers often recognize as short-lived—may differ from the response to permanent changes. Finally, a firm can afford to try only a limited number of experiments. SUMMARY 1. Individual consumers’ demand curves for a commodity can be derived from information about their tastes for all goods and services and from their budget constraints. 2. Engel curves, which describe the relationship between the quantity of a good consumed and income, can be useful in showing how consumer expenditures vary with income. 3. Two goods are substitutes if an increase in the price of one leads to an increase in the quantity demanded of the other. In contrast, two goods are complements if an increase in the price of one leads to a decrease in the quantity demanded of the other. 4. The effect of a price change on the quantity demanded of a good can be broken into two parts: a substitution effect, in which the level of utility remains constant while price changes, and an income effect, in which the price remains constant while the level of utility changes. Because the income effect can be positive or negative, a price change can have a small or a large effect on quantity demanded. In the unusual case of a so-called Giffen good, the quantity demanded may move in the same direction as the price change, thereby generating an upward-sloping individual demand curve. 5. The market demand curve is the horizontal summation of the individual demand curves of all consumers in the market for a good. It can be used to calculate how much people value the consumption of particular goods and services. 6. Demand is price inelastic when a 1-percent increase in price leads to a less than 1-percent decrease in quantity demanded, thereby increasing the consumer’s expenditure. Demand is price elastic when a 1-percent increase in price leads to a more than 1-percent decrease in quantity demanded, thereby decreasing the consumer’s expenditure. Demand is unit elastic when a 1-percent increase in price leads to a 1-percent decrease in quantity demanded. 144 PART 2 • Producers, Consumers, and Competitive Markets 7. The concept of consumer surplus can be useful in determining the benefits that people receive from the consumption of a product. Consumer surplus is the difference betwe |
en the maximum amount a consumer is willing to pay for a good and what he actually pays for it. 8. In some instances demand will be speculative, driven not by the direct benefits one obtains from owning or consuming a good but instead by an expectation that the price of the good will increase. 9. A network externality occurs when one person’s demand is affected directly by the purchasing or usage decisions of other consumers. There is a positive network externality when a typical consumer’s quantity demanded increases because others have purchased or are using the product or service. Conversely, there is a negative network externality when quantity demanded increases because fewer people own or use the product or service. 10. A number of methods can be used to obtain information about consumer demand. These include interview and experimental approaches, direct marketing experiments, and the more indirect statistical approach. The statistical approach can be very powerful in its application, but it is necessary to determine the appropriate variables that affect demand before the statistical work is done. QUESTIONS FOR REVIEW 1. Explain the difference between each of the following terms: a. a price consumption curve and a demand curve b. an individual demand curve and a market demand curve c. an Engel curve and a demand curve d. an income effect and a substitution effect 2. Suppose that an individual allocates his or her entire budget between two goods, food and clothing. Can both goods be inferior? Explain. 3. Explain whether the following statements are true or false: a. The marginal rate of substitution diminishes as an individual moves downward along the demand curve. b. The level of utility increases as an individual moves downward along the demand curve. c. Engel curves always slope upward. 4. Tickets to a rock concert sell for $10. But at that price, the demand is substantially greater than the available number of tickets. Is the value or marginal benefit of an additional ticket greater than, less than, or equal to $10? How might you determine that value? 5. Which of the following combinations of goods are complements and which are substitutes? Can they be either in different circumstances? Discuss. a. a mathematics class and an economics class b. tennis balls and a tennis racket c. steak and lobster d. a plane trip and a train trip to the same destination e. bacon and eggs 6. Suppose that a consumer spends a fixed amount of income per month on the following pairs of goods: a. tortilla chips and salsa b. tortilla chips and potato chips c. movie tickets and gourmet coffee d. travel by bus and travel by subway If the price of one of the goods increases, explain the effect on the quantity demanded of each of the goods. In each pair, which are likely to be complements and which are likely to be substitutes? 7. Which of the following events would cause a movement along the demand curve for U.S. produced clothing, and which would cause a shift in the demand curve? a. the removal of quotas on the importation of foreign clothes b. an increase in the income of U.S. citizens c. a cut in the industry’s costs of producing domestic clothes that is passed on to the market in the form of lower prices 8. For which of the following goods is a price increase likely to lead to a substantial income (as well as substitution) effect? a. salt b. housing c. theater tickets d. food 9. Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20-cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program? 10. Which of the following three groups is likely to have the most, and which the least, price-elastic demand for membership in the Association of Business Economists? a. students b. junior executives c. senior executives 11. Explain which of the following items in each pair is more price elastic. a. The demand for a specific brand of toothpaste and the demand for toothpaste in general b. The demand for gasoline in the short run and the demand for gasoline in the long run 12. Explain the difference between a positive and a negative network externality and give an example of each. CHAPTER 4 • Individual and Market Demand 145 EXERCISES 1. An individual sets aside a certain amount of his income per month to spend on his two hobbies, collecting wine and collecting books. Given the information below, illustrate both the price-consumption curve associated with changes in the price of wine and the demand curve for wine. PRICE WINE PRICE BOOK QUANTITY WINE QUANTITY BOOK BUDGET $10 $12 $15 $20 $10 $10 $10 $10 7 5 4 2 8 9 9 11 $150 $150 $150 $150 2. An individual consumes two goods, clothing and food. Given the information below, illustrate both the income-consumption curve and the Engel curve for clothing and food. PRICE CLOTHING PRICE FOOD QUANTITY CLOTHING QUANTITY FOOD INCOME $10 $10 $10 $10 $2 $2 $2 $2 6 8 11 15 20 35 45 50 $100 $150 $200 $250 3. Jane always gets twice as much utility from an extra ballet ticket as she does from an extra basketball ticket, regardless of how many tickets of either type she has. Draw Jane’s income-consumption curve and her Engel curve for ballet tickets. 4. a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate price- consumption curve (for a variable price of orange juice) and income-consumption curve. b. Left shoes and right shoes are perfect complements. Draw the appropriate price-consumption and income-consumption curves. 5. Each week, Bill, Mary, and Jane select the quantity of two goods, x1 and x2, that they will consume in order to maximize their respective utilities. They each spend their entire weekly income on these two goods. a. Suppose you are given the following information about the choices that Bill makes over a three-week period: X1 10 7 8 X2 20 19 31 P1 2 3 3 P2 1 1 1 I 40 40 55 Week 1 Week 2 Week 3 Did Bill’s utility increase or decrease between week 1 and week 2? Between week 1 and week 3? Explain using a graph to support your answer. b. Now consider the following information about the choices that Mary makes: X1 10 6 20 X2 20 14 10 P1 2 2 2 P2 1 2 2 I 40 40 60 Week 1 Week 2 Week 3 Did Mary’s utility increase or decrease between week 1 and week 3? Does Mary consider both goods to be normal goods? Explain. *c. Finally, examine the following information about Jane’s choices: X1 12 16 12 X2 24 32 24 P1 2 1 1 P2 1 1 1 I 48 48 36 Week 1 Week 2 Week 3 Draw a budget line-indifference curve graph that illustrates Jane’s three chosen bundles. What can you say about Jane’s preferences in this case? Identify the income and substitution effects that result from a change in the price of good x1. 6. Two individuals, Sam and Barb, derive utility from the hours of leisure (L) they consume and from the amount of goods (G) they consume. In order to maximize utility, they need to allocate the 24 hours in the day between leisure hours and work hours. Assume that all hours not spent working are leisure hours. The price of a good is equal to $1 and the price of leisure is equal to the hourly wage. We observe the following information about the choices that the two individuals make: SAM BARB SAM BARB PRICE OF G PRICE OF L L (HOURS) L (HOURS) G ($) G ($) 1 1 1 1 8 9 10 11 16 15 14 14 14 14 15 16 64 81 100 110 80 90 90 88 Graphically illustrate Sam’s leisure demand curve and Barb’s leisure demand curve. Place price on the vertical axis and leisure on the horizontal axis. Given that they both maximize utility, how can you explain the difference in their leisure demand curves? 146 PART 2 • Producers, Consumers, and Competitive Markets 7. The director of a theater company in a small college town is considering changing the way he prices tickets. He has hired an economic consulting firm to estimate the demand for tickets. The firm has classified people who go to the theater into two groups and has come up with two demand functions. The demand curves for the general public (Qgp) and students (Qs) are given below: Qgp Qs = 500 - 5P = 200 - 4P a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the horizontal axis. If the current price of tickets is $35, identify the quantity demanded by each group. b. Find the price elasticity of demand for each group at the current price and quantity. c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for each ticket? Explain. d. What price should he charge each group if he wants to maximize revenue collected from ticket sales? 8. Judy has decided to allocate exactly $500 to college textbooks every year, even though she knows that the prices are likely to increase by 5 to 10 percent per year and that she will be getting a substantial monetary gift from her grandparents next year. What is Judy’s price elasticity of demand for textbooks? Income elasticity? 9. The ACME Corporation determines that at current prices, the demand for its computer chips has a price elasticity of -2 in the short run, while the price elasticity for its disk drives is -1. a. If the corporation decides to raise the price of both products by 10 percent, what will happen to its sales? To its sales revenue? b. Can you tell from the available information which product will generate the most revenue? If yes, why? If not, what additional information do you need? 10. By observing an individual’s behavior in the situations outlined below, determine the relevant income elasticities of demand for each good (i.e., whether it is normal or inferior). If you cannot determine the income elasticity, what additional information do you need? a. Bill spends all his income on books and coffee. He finds $20 while rummaging through a used paperback bin at the bookstore. He immediately buys a new hardcover book of poetry. b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell his ne |
w book at a discount to a friend and use the money to buy coffee. c. Being bohemian becomes the latest teen fad. As a result, coffee and book prices rise by 25 percent. Bill lowers his consumption of both goods by the same percentage. d. Bill drops out of art school and gets an M.B.A. instead. He stops reading books and drinking coffee. Now he reads the Wall Street Journal and drinks bottled mineral water. 11. Suppose the income elasticity of demand for food is 0.5 and the price elasticity of demand is -1.0. Suppose also that Felicia spends $10,000 a year on food, the price of food is $2, and that her income is $25,000. a. If a sales tax on food caused the price of food to increase to $2.50, what would happen to her consumption of food? (Hint: Because a large price change is involved, you should assume that the price elasticity measures an arc elasticity, rather than a point elasticity.) b. Suppose that Felicia gets a tax rebate of $2500 to ease the effect of the sales tax. What would her consumption of food be now? c. Is she better or worse off when given a rebate equal to the sales tax payments? Draw a graph and explain. 12. You run a small business and would like to predict what will happen to the quantity demanded for your product if you raise your price. While you do not know the exact demand curve for your product, you do know that in the first year you charged $45 and sold 1200 units and that in the second year you charged $30 and sold 1800 units. a. If you plan to raise your price by 10 percent, what would be a reasonable estimate of what will happen to quantity demanded in percentage terms? b. If you raise your price by 10 percent, will revenue increase or decrease? 13. Suppose you are in charge of a toll bridge that costs essentially nothing to operate. The demand for bridge crossings Q is given by P = 15 - (1/2)Q. a. Draw the demand curve for bridge crossings. b. How many people would cross the bridge if there were no toll? c. What is the loss of consumer surplus associated with a bridge toll of $5? d. The toll-bridge operator is considering an increase in the toll to $7. At this higher price, how many people would cross the bridge? Would the tollbridge revenue increase or decrease? What does your answer tell you about the elasticity of demand? e. Find the lost consumer surplus associated with the increase in the price of the toll from $5 to $7. 14. Vera has decided to upgrade the operating system on her new PC. She hears that the new Linux operating system is technologically superior to Windows and substantially lower in price. However, when she asks her friends, it turns out they all use PCs with Windows. They agree that Linux is more appealing but add that they see CHAPTER 4 • Individual and Market Demand 147 relatively few copies of Linux on sale at local stores. Vera chooses Windows. Can you explain her decision? 15. Suppose that you are the consultant to an agricultural cooperative that is deciding whether members should cut their production of cotton in half next year. The cooperative wants your advice as to whether this action will increase members’ revenues. Knowing that cotton (C) and soybeans (S) both compete for agricultural land in the South, you estimate the demand for cotton to be C = 3.5 - 1.0PC + 0.25PS + 0.50I, where PC is the price of cotton, PS the price of soybeans, and I income. Should you support or oppose the plan? Is there any additional information that would help you to provide a definitive answer? This page intentionally left blank Appendix to Chapter 4 Demand Theory—A Mathematical Treatment This appendix presents a mathematical treatment of the basics of demand theory. Our goal is to provide a short overview of the theory of demand for students who have some familiarity with the use of calculus. To do this, we will explain and then apply the concept of constrained optimization. Utility Maximization The theory of consumer behavior is based on the assumption that consumers maximize utility subject to the constraint of a limited budget. We saw in Chapter 3 that for each consumer, we can define a utility function that attaches a level of utility to each market basket. We also saw that the marginal utility of a good is defined as the change in utility associated with a one-unit increase in the consumption of the good. Using calculus, as we do in this appendix, we measure marginal utility as the utility change that results from a very small increase in consumption. Suppose, for example, that Bob’s utility function is given by U(X, Y) = log X + log Y, where, for the sake of generality, X is now used to represent food and Y represents clothing. In that case, the marginal utility associated with the additional consumption of X is given by the partial derivative of the utility function with respect to good X. Here, MUX, representing the marginal utility of good X, is given by In §3.1, we explain that a utility function is a formula that assigns a level of utility to each market basket. In §3.5, marginal utility is described as the additional satisfaction obtained by consuming an additional amount of a good. 0U(X, Y) 0X = 0(log X + log Y) 0X = 1 X In the following analysis, we will assume, as in Chapter 3, that while the level of utility is an increasing function of the quantities of goods consumed, marginal utility decreases with consumption. When there are two goods, X and Y, the consumer’s optimization problem may thus be written as Maximize U(X, Y) (A4.1) subject to the constraint that all income is spent on the two goods: PXX + PYY = 1 (A4.2) Here, U( ) is the utility function, X and Y the quantities of the two goods pur- chased, PX and PY the prices of the goods, and I income.1 To determine the individual consumer’s demand for the two goods, we choose those values of X and Y that maximize (A4.1) subject to (A4.2). When we know the particular form of the utility function, we can solve to find the 1To simplify the mathematics, we assume that the utility function is continuous (with continuous derivatives) and that goods are infinitely divisible. The logarithmic function log (.) measures the natural logarithm of a number. 149 150 PART 2 • Producers, Consumers, and Competitive Markets consumer’s demand for X and Y directly. However, even if we write the utility function in its general form U(X, Y), the technique of constrained optimization can be used to describe the conditions that must hold if the consumer is maximizing utility. The Method of Lagrange Multipliers • method of Lagrange multipliers Technique to maximize or minimize a function subject to one or more constraints. The method of Lagrange multipliers is a technique that can be used to maximize or minimize a function subject to one or more constraints. Because we will use this technique to analyze production and cost issues later in the book, we will provide a step-by-step application of the method to the problem of finding the consumer’s optimization given by equations (A4.1) and (A4.2). • Lagrangian Function to be maximized or minimized, plus a variable (the Lagrange multiplier) multiplied by the constraint. 1. Stating the Problem First, we write the Lagrangian for the problem. The Lagrangian is the function to be maximized or minimized (here, utility is being maximized), plus a variable which we call times the constraint (here, the consumer’s budget constraint). We will interpret the meaning of in a moment. The Lagrangian is then = U(X, Y) - l(PXX + PYY - I) (A4.3) Note that we have written the budget constraint as PXX + PYY - I = 0 i.e., as a sum of terms that is equal to zero. We then insert this sum into the Lagrangian. 2. Differentiating the Lagrangian If we choose values of X and Y that satisfy the budget constraint, then the second term in equation (A4.3) will be zero. Maximizing will therefore be equivalent to maximizing U(X, Y). By differentiating with respect to X, Y, and and then equating the derivatives to zero, we can obtain the necessary conditions for a maximum.2 The resulting equations are 0 0X 0 0Y 0 0l = MUX(X, Y) - lPX = 0 = MUY(X, Y) - lPY = 0 (A4.4) = I - PXX - PYY = 0 Here as before, MU is short for marginal utility: In other words, MUX(X, Y) = U(X, Y)/X, the change in utility from a very small increase in the consumption of good X. 2These conditions are necessary for an “interior” solution in which the consumer consumes positive amounts of both goods. The solution, however, could be a “corner” solution in which all of one good and none of the other is consumed. 3. Solving the Resulting Equations The three equations in (A4.4) can be rewritten as CHAPTER 4 • Individual and Market Demand 151 MUX = lPX = lPY MUY PXX + PYY = I Now we can solve these three equations for the three unknowns. The resulting values of X and Y are the solution to the consumer’s optimization problem: They are the utility-maximizing quantities. The Equal Marginal Principle The third equation above is the consumer’s budget constraint with which we started. The first two equations tell us that each good will be consumed up to the point at which the marginal utility from consumption is a multiple () of the price of the good. To see the implication of this, we combine the first two conditions to obtain the equal marginal principle: l = MUX(X, Y) PX = MUY(X, Y) PY (A4.5) In other words, the marginal utility of each good divided by its price is the same. To optimize, the consumer must get the same utility from the last dollar spent by consuming either X or Y. If this were not the case, consuming more of one good and less of the other would increase utility. To characterize the individual’s optimum in more detail, we can rewrite the information in (A4.5) to obtain MUX(X, Y) MUY(X, Y) = PX PY (A4.6) In other words, the ratio of the marginal utilities is equal to the ratio of the prices. Marginal Rate of Substitution We can use equation (A4.6) to see the link between utility functions and indifference curves that was spelled out in C |
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