discussion

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. . . . It is ideas, not vested interests, which are dangerous for good or evil.

JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY (1936)

In this state of imbecility, I had, for amusement, turned my attention to political economy.

THOMAS DEQUINCEY, CONFESSIONS OF AN ENGLISH OPIUM EATER (1821)

Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

LIONEL CHARLES ROBBINS, LORD ROBBINS, AN ESSAY ON THE NATURE AND SIGNIFICANCE OF ECONOMIC SCIENCE (1932)

THE ECONOMIC ANALYSIS of law draws upon the principles of microeconomic the-ory, which we review in this chapter. For those who have not studied this branchof economics, reading this chapter will prove challenging but useful for under- standing the remainder of the book. For those who have already mastered microeco- nomic theory, reading this chapter is unnecessary. For those readers who are somewhere in between these extremes, we suggest that you begin reading this chapter, skimming what is familiar and studying carefully what is unfamiliar. If you’re not sure where you lie on this spectrum of knowledge, turn to the questions at the end of the chapter. If you have difficulty answering them, you will benefit from studying this chapter carefully.

I. Overview: The Structure of Microeconomic Theory Microeconomics concerns decision making by individuals and small groups, such

as families, clubs, firms, and governmental agencies. As the famous quote from Lord Robbins at the beginning of the chapter says, microeconomics is the study of how

11

2 A Brief Review ofMicroeconomic Theory

12 C H A P T E R 2 A Brief Review of Microeconomic Theory

scarce resources are allocated among competing ends. Should you buy that digital au- diotape player you’d like, or should you buy a dapper suit for your job interview? Should you take a trip with some friends this weekend or study at home? Because you have limited income and time and cannot, therefore, buy or do everything that you might want to buy or do, you have to make choices. Microeconomic theory offers a general theory about how people make such decisions.

We divide our study of microeconomics into five sections. The first is the theory of consumer choice and demand. This theory describes how the typical consumer, con- strained by a limited income, chooses among the many goods and services offered for sale.

The second section deals with the choices made by business organizations or firms. We shall develop a model of the firm that helps us to see how the firm decides what goods and services to produce, how much to produce, and at what price to sell its out- put. In the third section, we shall consider how consumers and firms interact. By com- bining the theory of the consumer and the firm, we shall explain how the decisions of consumers and firms are coordinated through movements in market price. Eventually, the decisions of consumers and firms must be made consistent in the sense that some- how the two sides agree about the quantity and price of the good or service that will be produced and consumed. When these consumption and production decisions are con- sistent in this sense, we say that the market is in equilibrium. We shall see that power- ful forces propel markets toward equilibrium, so that attempts to divert the market from its path are frequently ineffectual or harmful.

The fourth section of microeconomic theory describes the supply and demand for inputs into the productive process. These inputs include labor, capital, land, and mana- gerial talent; more generally, inputs are all the things that firms must acquire in order to produce the goods and services that consumers or other firms wish to purchase.

The final section of microeconomics deals with the area known as welfare economics. There we shall discuss the organization of markets and how they achieve efficiency.

These topics constitute the core of our review of microeconomic theory. There are four additional topics that do not fit neatly into the sections noted above but that we think you should know about them in order to understand the economic analysis of legal rules and institutions. These are game theory, the economic theory of decision making under uncertainty, growth theory, and behavioral economics. We shall cover these four topics in the final sections of this chapter.

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency

Economists usually assume that each economic actor maximizes something: Consumers maximize utility (that is, happiness or satisfaction), firms maximize profits, politicians maximize votes, bureaucracies maximize revenues, charities maximize social welfare, and so forth. Economists often say that models assuming maximizing behavior work because most people are rational, and rationality requires maximization.

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency 13

One conception of rationality holds that a rational actor can rank alternatives according to the extent that they give her what she wants. In practice, the alternatives available to the actor are constrained. For example, a rational consumer can rank alternative bun- dles of consumer goods, and the consumer’s budget constrains her choice among them. A rational consumer should choose the best alternative that the constraints allow. Another common way of understanding this conception of rational behavior is to rec- ognize that consumers choose alternatives that are well suited to achieving their ends.

Choosing the best alternative that the constraints allow can be described mathe- matically as maximizing. To see why, consider that the real numbers can be ranked from small to large, just as the rational consumer ranks alternatives according to the extent that they give her what she wants. Consequently, better alternatives can be asso- ciated with larger numbers. Economists call this association a “utility function,” about which we shall say more in the following sections. Furthermore, the constraint on choice can usually be expressed mathematically as a “feasibility constraint.” Choosing the best alternative that the constraints allow corresponds to maximizing the utility function subject to the feasibility constraint. So, the consumer who goes shopping is said to maximize utility subject to her budget constraint.

Turning to the second fundamental concept, there is no habit of thought so deeply ingrained among economists as the urge to characterize each social phenomenon as an equilibrium in the interaction of maximizing actors. An equilibrium is a pattern of in- teraction that persists unless disturbed by outside forces. Economists usually assume that interactions tend toward an equilibrium, regardless of whether they occur in mar- kets, elections, clubs, games, teams, corporations, or marriages.

There is a vital connection between maximization and equilibrium in microeco- nomic theory. We characterize the behavior of every individual or group as maximizing something. Maximizing behavior tends to push these individuals and groups toward a point of rest, an equilibrium. They certainly do not intend for an equilibrium to result; instead, they simply try to maximize whatever it is that interests them. Nonetheless, the interaction of maximizing agents usually results in an equilibrium.

A stable equilibrium is one that will not change unless outside forces intervene. To illustrate, the snowpack in a mountain valley is in stable equilibrium, whereas the snowpack on the mountain’s peak may be in unstable equilibrium. An interaction headed toward a stable equilibrium actually reaches this destination unless outside forces divert it. In social life, outside forces often intervene before an interaction reaches equilibrium. Nevertheless, equilibrium analysis makes sense. Advanced micro- economic theories of growth, cycles, and disequilibria exist, but we shall not need them in this book. The comparison of equilibria, called comparative statics, will be our basic approach.

Turning to the third fundamental concept, economists have several distinct defini- tions of efficiency. A production process is said to be productively efficient if either of two conditions holds:

1. It is not possible to produce the same amount of output using a lower-cost combination of inputs, or

2. It is not possible to produce more output using the same combination of inputs.

14 C H A P T E R 2 A Brief Review of Microeconomic Theory

Consider a firm that uses labor and machinery to produce a consumer good called a “widget.” Suppose that the firm currently produces 100 widgets per week using 10 workers and 15 machines. The firm is productively efficient if

1. it is not possible to produce 100 widgets per week by using 10 workers and fewer than 15 machines, or by using 15 machines and fewer than 10 work- ers, or

2. it is not possible to produce more than 100 widgets per week from the com- bination of 10 workers and 15 machines.

The other kind of efficiency, called Pareto efficiency after its inventor1 or sometimes referred to as allocative efficiency, concerns the satisfaction of individual preferences. A particular situation is said to be Pareto or allocatively efficient if it is impossible to change it so as to make at least one person better off (in his own estimation) without making another person worse off (again, in his own estimation). For simplicity’s sake, assume that there are only two consumers, Smith and Jones, and two goods, umbrellas and bread. Initially, the goods are distributed between them. Is the allocation Pareto effi- cient? Yes, if it is impossible to reallocate the bread and umbrellas so as to make either Smith or Jones better off without making the other person worse off.2

These three basic concepts—maximization, equilibrium, and efficiency—are fun- damental to explaining economic behavior, especially in decentralized institutions like markets that involve the coordinated interaction of many different people.

III. Mathematical Tools You may have been anxious about the amount of mathematics that you will find in

this book. There is not much. We use simple algebra and graphs.

A. Functions Economics is rife with functions: production functions, utility functions, cost func-

tions, social welfare functions, and others. A function is a relationship between two sets of numbers such that for each number in one set, there corresponds exactly one number in the other set. To illustrate, the columns below correspond to a functional relationship between the numbers in the left-hand column and those in the right-hand column. Thus, the number 4 in the x-column below corresponds to the number 10 in the y-column.

In fact, notice that each number in the x-column corresponds to exactly one number in the y-column. Thus, we can say that the variable y is a function of the variable x, or in the most common form of notation.

y = f(x).

1 Vilfredo Pareto was an Italian-Swiss political scientist, lawyer, and economist who wrote around 1900. 2 There is another efficiency concept—a potential Pareto improvement or Kaldor-Hicks efficiency—that we

describe in section IX.C that follows.

III. Mathematical Tools 15

Note that the number 4 is not the only number in the x-column that corresponds to the number 10 in the y-column; the number 6 also corresponds to the number 10. In this table, for a given value of x, there corresponds one value of y, but for some values of y, there corresponds more than one value of x. A value of x determines an exact value of y, whereas a value of y does not determine an exact value of x. Thus, in is called the dependent variable, because it depends on the value of x, and x is called the independent variable. Because y depends upon x in this table, y is a function of x, but because x does not (to our knowledge) depend for its values on y, x is not a function of y.

Now suppose that there is another dependent variable, named z, that also depends upon x. The function relating z to x might be named g:

When there are two functions, g(x) and f(x), with different dependent variables, z and y, remembering which function goes with which variable can be hard. To avoid this difficulty, the same name is often given to a function and the variable determined by it. Following this strategy, the preceding functions would be renamed as follows:

Sometimes an abstract function will be discussed without ever specifying the exact numbers that belong to it. For example, the reader might be told that y is a function of x, and never be told exactly which values of y correspond to which values of x. The point then is simply to make the general statement that y depends upon x but in an as yet unspecified way. If exact numbers are given, they may be listed in a table, as we have seen. Another way of showing the relationship between a dependent and an inde- pendent variable is to give an exact equation. For example, a function might be given the exact form

which states that the function z matches values of x with values of z equal to five plus one-half of whatever value x takes. The table below gives the values of z associated with several different values of x:

z = z(x) = 5 + x>2, z = z(x)

z = g(x) Q z = z(x). y = f(x) Q y = y(x),

z = g(x).

y = f(x), y

y-column x-column

2 3 3 0

10 4 10 6 12 9 7 12

This is read as “y is a function of x” or “y equals some f of x.”

16 C H A P T E R 2 A Brief Review of Microeconomic Theory

A function can relate a dependent variable (there is always just one of them to a function) to more than one independent variable. If we write we are saying that the function h matches one value of the dependent variable y to every pair of values of the independent variables x and z. This function might have the specific form

according to which y decreases by 3 units when x increases by 1 unit, and y increases by 1 unit when z increases by 1 unit.

B. Graphs We can improve the intuitive understanding of a functional relationship by visual-

izing it in a graph. In a graph, values of the independent variable are usually read off the horizontal axis, and values of the dependent variable are usually read off the verti- cal axis. Each point in the grid of lines corresponds to a pair of values for the variables. For an example, see Figure 2.1. The upward-sloping line on the graph represents all of the pairs of values that satisfy the function You can check this by find- ing a couple of points that ought to be on the line that corresponds to that function. For example, what if What value should x have? If then a little arithmetic will reveal that x should equal Thus, the pair is a point on the line de- fined by the function. What if What value will y have? In that case, the secondx = 0?

(0, - 10)- 10. y = 0,y = 0?

y = 5 + x>2.

y = h(x, z) = - 3x + z,

y = h(x, z),

y

x

–y

–x

15

10

0

5

5 10 15– 5

– 5

– 10

– 10– 15

y = 5 – x!2

y = 5 + x!2

FIGURE 2.1 Graphs of the linear relationships

(with a positive slope) and (with a negative slope).y = 5 - x>2y = 5 + x>2

z-column x-column

6.5 3 12.5 15 8.0 6 6.0 2 9.5 9

III. Mathematical Tools 17

term in the right-hand side of the equation disappears, so that Thus, the pair of values (5, 0) is a point on the line defined by the function.

The graph of reveals some things about the relationship between y and x that we otherwise might not so easily discover. For example, notice that the line representing the equation slopes upward, or from southwest to northeast. The positive slope, as it is called, reveals that the relationship between x and y is a direct one. Thus, as x increases, so does y. And as x decreases, y decreases. Put more generally, when the independent and dependent variables move in the same direction, the slope of the graph of their relationship will be positive.

The graph also reveals the strength of this direct relationship by showing whether small changes in x lead to small or large changes in y. Notice that if x increases by 2 units, y increases by 1 unit. Another way of putting this is to say that in order to get a 10-unit increase in y, there must be a 20-unit increase in x.3

The opposite of a direct relationship is an inverse relationship. In that sort of rela- tionship, the dependent and independent variables move in opposite directions. Thus, if x and y are inversely related, an increase in x (the independent variable) will lead to a decrease in y. Also, a decrease in x will lead to an increase in y. An example of an in- verse relationship between an independent and a dependent variable is The graph of this line is also shown in Figure 2.1. Note that the line is downward- sloping; that is, the line runs from northwest to southeast.

or shallower than that of the one in

The graph of in Figure 2.1 also reveals that the relationship between the variables is linear. This means that when we graph the values of the independent and dependent variables, the resulting relationship is a straight line. One of the impli- cations of linearity is that changes in the independent variable cause a constant rate of change in the dependent variable. In terms of Figure 2.1, if we would like to know the effect on y of doubling the amount of x, it doesn’t matter whether we investigate that effect when x equals 2 or 3147. The effect on y of doubling the value of x is proportion- ally the same, regardless of the value of x.

The alternative to a linear relationship is, of course, a nonlinear relationship. In general, nonlinear relationships are trickier to deal with than are linear relationships.

y = 5 + x>2 y = 5 - x?

Suppose that the equation were y = 5 + x. Show in a graph like the one in Figure 2.1 what the graph of that equation would look like. Is the relationship between x and y direct or inverse? Is the slope of the new equation greater or less than the slope shown in Figure 2.1?

Now suppose that the equation were y = 5 - x. Show in a graph like the one in Figure 2.1 what the graph of that equation would look like. Is the rela- tionship between x and y direct or inverse? Is the slope of the new equation positive or negative? Would the slope of the equation y = 5 - x>2 be steeper

y = 5 - x>2.

y = 5 + x>2 y = 5.

3 The slope of the equation we have been dealing with in Figure 2.1 is which is the coefficient of x in the equation. In fact, in any linear relationship the coefficient of the independent variable gives the slope of the equation.

1 2,

18 C H A P T E R 2 A Brief Review of Microeconomic Theory

They frequently, although not always, are characterized by the independent variable be- ing raised to a power by an exponent. Examples are and Figure 2.2 shows a graph of Another common nonlinear relationship in economics is given by the example where A is a constant. A graph of that function is given in Figure 2.3.

IV. The Theory of Consumer Choice and Demand The economist’s general theory of how people make choices is referred to as the

theory of rational choice. In this section we show how that theory explains the con- sumer’s choice of what goods and services to purchase and in what amounts.

A. Consumer Preference Orderings The construction of the economic model of consumer choice begins with an ac-

count of the preferences of consumers. Consumers are assumed to know the things they like and dislike and to be able to rank the available alternative combinations of goods and services according to their ability to satisfy the consumer’s preferences. This in- volves no more than ranking the alternatives as better than, worse than, or equally as good as one another. Indeed, some economists believe that the conditions they impose on the ordering or ranking of consumer preferences constitute what an economist means by the term rational. What are those conditions? They are that a consumer’s preference ordering or ranking be complete, transitive, and reflexive. For an ordering to be complete simply means that the consumer be able to tell us how she ranks all the

A = xy, y = x2.

y = 5>x12.y = x2

y

x– x 0

y = x2

FIGURE 2.2 The graph of a nonlinear relationship, given by the equation y = x 2.

y

x0

A = xy

FIGURE 2.3 The graph of a nonlinear relationship, A = xy.

IV. The Theory of Consumer Choice and Demand 19

possible combinations of goods and services. Suppose that A represents a bundle of certain goods and services and B represents another bundle of the same goods and serv- ices but in different amounts. Completeness requires that the consumer be able to tell us that she prefers A to B, or that she prefers B to A, or that A and B are equally good (that is, that the consumer is indifferent between having A and having B). The consumer is not allowed to say, “I can’t compare them.”

Reflexivity is an arcane condition on consumer preferences. It means that any bun- dle of goods, A, is at least as good as itself. That condition is so trivially true that it is difficult to give a justification for its inclusion.

Transitivity means that the preference ordering obeys the following condition: If bundle A is preferred to bundle B and bundle B is preferred to bundle C, then it must be the case that A is preferred to C. This also applies to indifference: If the consumer is indifferent between A and B and between B and C, then she is also in- different between A and C. Transitivity precludes the circularity of individual pref- erences. That is, transitivity means that it is impossible for A to be preferred to B, B to be preferred to C, and C to be preferred to A. Most of us would probably feel that someone who had circular preferences was extremely young or childish or crazy.

It is important to remember that the preferences of the consumer are subjective. Different people have different tastes, and these will be reflected in the fact that they may have very different preference orderings over the same goods and services. Economists leave to other disciplines, such as psychology and sociology, the study of the source of these preferences. We take consumer tastes or preferences as given, or, as economists say, as exogenous, which means that they are determined outside the eco- nomic system.4

An important consequence of the subjectivity of individual preferences is that economists have no accepted method for comparing the strength of people’s prefer- ences. Suppose that Stan tells us that he prefers bundle A to bundle B, and Jill tells us that she feels the same way: She also prefers A to B. Is there any way to tell who would prefer having A more? In the abstract, the answer is, “No, there is not.” All we have from each consumer is the order of preference, not the strength of those preferences. Indeed, there is no metric by which to measure the strength of preferences, although economists sometimes jokingly refer to the “utils” of satisfaction that a consumer is enjoying. The inability to make interpersonal comparisons of well-being has some

4 Many people new to the study of microeconomics will find this assumption of the exogeneity of preferences to be highly unrealistic. And there is some controversy about this assumption even within economics, some economists contending that preferences are endogenous—that is, determined within the economic system by such things as advertising. We cannot elaborate on this controversy here but are well aware of it.

20 C H A P T E R 2 A Brief Review of Microeconomic Theory

important implications for the design and implementation of public policy, as we shall see in the section on welfare economics.