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What you know (green) and what you still need to review (yellow), based on your answers.

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Economics PRINCIPLES, PROBLEMS, AND POLICIES

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ESSENTIALS OF ECONOMICS

Brue, McConnell, and Flynn Essentials of Economics

Third Edition

Mandel Economics: The Basics

Second Edition

Schiller Essentials of Economics

Ninth Edition

PRINCIPLES OF ECONOMICS

Colander Economics, Microeconomics,

Macroeconomics

Ninth Edition

Frank and Bernanke Principles of Economics, Principles

of Microeconomics, Principles of

Macroeconomics

Fifth Edition

Frank and Bernanke Brief Editions: Principles of Economics,

Principles of Microeconomics, Principles

of Macroeconomics

Second Edition

Karlan and Morduch Economics, Microeconomics,

Macroeconomics

First Edition

McConnell, Brue, and Flynn Economics, Microeconomics,

Macroeconomics

Twentieth Edition

McConnell, Brue, and Flynn Brief Editions: Microeconomics

and Macroeconomics

Second Edition

Miller Principles of Microeconomics

First Edition

Samuelson and Nordhaus Economics, Microeconomics,

Macroeconomics

Nineteenth Edition

Schiller The Economy Today, The Micro Economy

Today, The Macro Economy Today

Thirteenth Edition

Slavin Economics, Microeconomics,

Macroeconomics

Eleventh Edition

ECONOMICS OF SOCIAL

ISSUES

Guell Issues in Economics Today

Fifth Edition

Sharp, Register, and Grimes Economics of Social Issues

Nineteenth Edition

ECONOMETRICS

Gujarati and Porter Basic Econometrics

Fifth Edition

Gujarati and Porter Essentials of Econometrics

Fourth Edition

MANAGERIAL ECONOMICS

Baye Managerial Economics and

Business Strategy

Eighth Edition

Brickley, Smith, and Zimmerman Managerial Economics and

Organizational Architecture

Fifth Edition

Thomas and Maurice Managerial Economics

Tenth Edition

INTERMEDIATE ECONOMICS

Bernheim and Whinston Microeconomics

Second Edition

Dornbusch, Fischer, and Startz Macroeconomics

Eleventh Edition

Frank Microeconomics and Behavior

Eighth Edition

ADVANCED ECONOMICS

Romer Advanced Macroeconomics

Third Edition

MONEY AND BANKING

Cecchetti and Schoenholtz Money, Banking, and Financial Markets

Third Edition

URBAN ECONOMICS

O’Sullivan Urban Economics

Eighth Edition

LABOR ECONOMICS

Borjas Labor Economics

Fifth Edition

McConnell, Brue, and Macpherson Contemporary Labor Economics

Ninth Edition

PUBLIC FINANCE

Rosen and Gayer Public Finance

Ninth Edition

Seidman Public Finance

First Edition

ENVIRONMENTAL

ECONOMICS

Field and Field Environmental Economics:

An Introduction

Fifth Edition

INTERNATIONAL ECONOMICS

Appleyard, Field, and Cobb International Economics

Eighth Edition

King and King International Economics, Globalization,

and Policy: A Reader

Fifth Edition

Pugel International Economics

Fifteenth Edition

THE MCGRAWHILL SERIES: ECONOMICS

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THE SIX VERSIONS OF MCCONNELL, BRUE, FLYNN

Chapter*

1. Limits, Alternatives, and Choices x x x x x x

2. The Market System and the Circular Flow x x x x x x

3. Demand, Supply, and Market Equilibrium x x x x x x

4. Market Failures: Public Goods and Externalities x x x x x x

5. Government’s Role and Government Failure x x x x x x

6. Elasticity x x x x

7. Utility Maximization x x

8. Behavioral Economics x x

9. Businesses and the Costs of Production x x x x

10. Pure Competition in the Short Run x x x x

11. Pure Competition in the Long Run x x x x

12. Pure Monopoly x x x x

13. Monopolistic Competition and Oligopoly x x x x

13W. Technology, R&D, and Efficiency (Web Chapter) x x

14. The Demand for Resources x x

15. Wage Determination x x x x

16. Rent, Interest, and Profit x x

17. Natural Resource and Energy Economics x x

18. Public Finance: Expenditures and Taxes x x x

19. Antitrust Policy and Regulation x x

20. Agriculture: Economics and Policy x x

21. Income Inequality, Poverty, and Discrimination x x x x

22. Health Care x x

23. Immigration x x

24. An Introduction to Macroeconomics x x

25. Measuring Domestic Output and National Income x x x x

26. Economic Growth x x x x

27. Business Cycles, Unemployment, and Inflation x x x x

28. Basic Macroeconomic Relationships x x

29. The Aggregate Expenditures Model x x

30. Aggregate Demand and Aggregate Supply x x x x

31. Fiscal Policy, Deficits, and Debt x x x x

32. Money, Banking, and Financial Institutions x x x x

33. Money Creation x x

34. Interest Rates and Monetary Policy x x x x

35. Financial Economics x x

36. Extending the Analysis of Aggregate Supply x x x

37. Current Issues in Macro Theory and Policy x x

38. International Trade x x x x x x

39. The Balance of Payments, Exchange Rates, and Trade Deficits x x x x x x

39W. The Economics of Developing Countries (Web Chapter) x x

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*Chapter numbers refer to Economics: Principles, Problems, and Policies. A red “X” indicates chapters that combine or consolidate content from two or more Economics chapters.

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Economics PRINCIPLES, PROBLEMS, AND POLICIES

Tw en

ti et

h E

d it

io n

Campbell R. McConnell University of Nebraska

Stanley L. Brue Pacific Lutheran University

Sean M. Flynn Scripps College

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ECONOMICS: PRINCIPLES, PROBLEMS, AND POLICIES, TWENTIETH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4

ISBN 978-0-07-802175-6 (student edition) MHID 0-07-802175-8 (student edition) ISBN 978-0-07-766058-1 (instructor’s edition) MHID 0-07-766058-7 (instructor’s edition)

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Library of Congress Cataloging-in-Publication Data McConnell, Campbell R. Economics : principles, problems, and policies / Campbell R. McConnell, University of Nebraska, Stanley L. Brue, Pacific Lutheran University, Sean M. Flynn, Scripps College.—Twentieth edition. pages cm.—(The McGraw-Hill series in economics) Includes index. ISBN 978-0-07-802175-6 (student edition : alk. paper)—ISBN 0-07-802175-8 (student edition : alk. paper)—ISBN 978-0-07-766058-1 (instructor’s edition : alk. paper)—ISBN 0-07-766058-7 (instructor’s edition : alk. paper) 1. Economics. I. Brue, Stanley L., 1945- II. Flynn, Sean Masaki. III. Title. HB171.5.M47 2015 330—dc23 2013038889

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

www.mhhe.com

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To Mem and to Terri and Craig, and to past instructors

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x

ABOUT THE AUTHORS

CAMPBELL R. MCCONNELL earned his Ph.D. from the University of Iowa after receiving degrees from Cornell College and the University of Illinois. He taught at the University of Nebraska–Lincoln from 1953 until his retirement in 1990. He is also coauthor of Contemporary Labor Economics, ninth edition; Essentials of Economics, second edition; Macroeconomics: Brief Edition; and Microeconomics: Brief Edition (all The McGraw-Hill Companies), and has edited readers for the principles and labor economics courses. He is a recipient of both the University of Nebraska Distinguished Teaching Award and the James A. Lake Academic Freedom Award and is past president of the Midwest Economics Association. Professor McConnell was awarded an honorary Doctor of Laws degree from Cornell College in 1973 and received its Distinguished Achievement Award in 1994. His primary areas of interest are labor economics and economic education. He has an extensive col- lection of jazz recordings and enjoys reading jazz history.

STANLEY L. BRUE did his undergraduate work at Augustana College (South Dakota) and received its Distinguished Achievement Award in 1991. He received his Ph.D. from the University of Nebraska–Lincoln. He is retired from a long career at Pacific Lutheran University, where he was honored as a recipient of the Burlington Northern Faculty Achievement Award. Professor Brue has also received the national Leavey Award for excellence in economic education. He has served as national president and chair of the Board of Trustees of Omicron Delta Epsilon International Economics Honorary. He is coauthor of Economic Scenes, fifth edition (Prentice-Hall); Contemporary Labor Economics, ninth edition; Essentials of Economics, second edition; Macroeconomics: Brief Edition; Microeconomics: Brief Edition (all The McGraw-Hill Companies); and The Evolution of Economic Thought, seventh edition (South-Western). For relaxation, he enjoys international travel, attending sporting events, and skiing with family and friends.

SEAN M. FLYNN did his undergraduate work at the University of Southern California before completing his Ph.D. at U.C. Berkeley, where he served as the Head Graduate Student Instructor for the Department of Economics after receiving the Outstanding Graduate Student Instructor Award. He teaches at Scripps College (of the Claremont Colleges) and is the author of Economics for Dummies (Wiley) and coauthor of Essentials of Economics, second edition; Macroeconomics: Brief Edition; and Microeconomics: Brief Edition (all The McGraw-Hill Companies). His research interests include finance, behavioral econom- ics, and health economics. An accomplished martial artist, he has repre- sented the United States in international aikido tournaments and is the author of Understanding Shodokan Aikido (Shodokan Press). Other hob- bies include running, traveling, and enjoying ethnic food.

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LIST OF KEY GRAPHS

1.2 The Production Possibilities Curve 13

2.2 The Circular Flow Diagram 43

3.6 Equilibrium Price and Quantity 63

7.1 Total and Marginal Utility 154

9.2 The Law of Diminishing Returns 203

9.5 The Relationship of the Marginal-Cost Curve to the Average-Total-Cost and Average-Variable-Cost Curves 207

9.8 The Long-Run Average-Total-Cost Curve: Unlimited Number of Plant Sizes 210

10.3 Short-Run Profit Maximization for a Purely Competitive Firm 228

10.6 The P 5 MC Rule and the Competitive Firm’s Short-Run Supply Curve 231

11.6 Long-Run Equilibrium: A Competitive Firm and Market 245

12.4 Profit Maximization by a Pure Monopolist 261

13.1 A Monopolistically Competitive Firm: Short Run and Long Run 282

13.4 The Kinked-Demand Curve 292

15.3 Labor Supply and Labor Demand in (a) a Purely Competitive Labor Market and (b) a Single Competitive Firm 334

28.2 Consumption and Saving Schedules 617

28.5 The Investment Demand Curve 624

29.2 Equilibrium GDP in a Private Closed Economy 640

29.7 Recessionary and Inflationary Expenditure Gaps 651

30.7 The Equilibrium Price Level and Equilibrium Real GDP 671

34.1 The Demand for Money, the Supply of Money, and the Equilibrium Interest Rate 749

34.5 Monetary Policy and Equilibrium GDP 762

34.6 The AD-AS Theory of the Price Level, Real Output, and Stabilization Policy 770

38.2 Trading Possibilities Lines and the Gains from Trade 845

39.1 The Market for Foreign Currency (Pounds) 872

xi

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xii

PREFACE

Welcome to the 20th edition of Economics, the best-selling economics textbook in the world. An estimated 15 million students have used Economics or its companion editions, Macroeconomics and Microeconomics. Economics has been adapted into Australian and Canadian editions and trans- lated into Italian, Russian, Chinese, French, Spanish, Portuguese, and other languages. We are pleased that Economics continues to meet the market test: nearly one out of five U.S. students in principles courses used the 19th edition.

Fundamental Objectives We have three main goals for Economics: • Help the beginning student master the principles

essential for understanding the economizing problem, specific economic issues, and policy alternatives.

• Help the student understand and apply the economic perspective and reason accurately and objectively about economic matters.

• Promote a lasting student interest in economics and the economy.

Student Feedback The twentieth edition has a renewed focus on today’s stu- dents and their various approaches to learning. How do today’s students study? How are they using mobile tech- nology? When are they using the textbook, and how are they using the textbook? To help answer these questions, McGraw-Hill and author Sean Flynn formed a Student Advisory Board consisting of students from Belmont University, the University of Louisiana–Lafayette, Tarrant County College, and West Virginia University Institute of Technology. The Student Advisory Board participated in a wide variety of evaluation and testing activities over six months and provided targeted recommendations to im- prove the 20th edition and its ancillary learning materials. Their feedback was incredibly valuable, and the authors incorporated their suggestions in this revision.

What’s New and Improved? One of the benefits of writing a successful text is the op- portunity to revise—to delete the outdated and install the new, to rewrite misleading or ambiguous statements, to introduce more relevant illustrations, to improve the orga- nizational structure, and to enhance the learning aids. We trust that you will agree that we have used this op- portunity wisely and fully. Some of the more significant changes include the following.

Restructured Introductory Chapters

We have divided the five-chapter grouping of introduc- tory chapters common to Economics, Microeconomics, and Macroeconomics into two parts. Part 1 contains Chapter 1 (Limits, Alternatives, and Choices) and Chapter 2 (The Market System and the Circular Flow). The content in Part 2 has changed and now consists of the following three chapters: Chapter 3 (Demand, Supply, and Market Equilibrium), Chapter 4 (Market Failures: Public Goods and Externalities), and Chapter 5 (Government’s Role and Government Failure). As restructured, the three chapters that now form Part 2 give students a panorama of: • The efficiency and allocation benefits of competitive

markets. • How and why governments can help when there are

cases of market failure. • An appreciation of government failure so that stu-

dents do not assume that government intervention is an easy or guaranteed panacea for the misallocations and inefficiencies caused by market failure.

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Preface xiii

For example, the “Last Word” section for Chapter 1 (Limits, Alternatives, and Choices) examines pitfalls to sound economic reasoning, while the “Last Word” section for Chapter 4 (Market Failures: Public Goods and Externalities) examines cap-and-trade versus carbon taxes as policy responses to excessive carbon dioxide emissions. There are 14 new “Last Word” sections in this edition. If you are unfamiliar with Economics, we encourage you to thumb through the chapters to take a quick look at these highly visible features.

New Chapter on Government’s Role and Government Failure

We have responded to instructor suggestions by placing this new chapter on Government’s Role and Government Failure into the introductory section of the book. Its early placement gives students a taste of political economy and the practical difficulties with government regulation and intervention. Topics covered include the special-interest effect, rent seeking, regulatory capture, political corrup- tion, unfunded liabilities, and unintended consequences. The chapter begins, however, by reminding students of government’s great power to improve equity and efficiency. When read along with Chapter 4 on market failure, this new chapter on government failure should provide students with a balanced perspective. After learning why government in- tervention is needed to counter market failures, they will also learn that governments often have difficulty in fulfilling their full potential for improving economic outcomes. An optional appendix incorporates the material on public choice theory and voting paradoxes that was for- merly located in Chapter 17 of the 19th edition. Instructors wishing to give their students an even deeper appreciation of government failure may wish to assign this material. Meanwhile, the material on asymmetric information that was located in Chapter 17 of the 19th edition has

Our new approach responds to suggestions by re- viewers to:

• Move the elasticity chapter back into Microeconomics. • Boost the analysis of government failure to help

students better understand many of the problems currently besetting the U.S. economy.

Our new approach embraces these suggestions. For microeconomics instructors, the new ordering provides a clear supply-and-demand path to the subsequent chapters on consumer and producer behavior while also giving stu- dents a stronger policy background on not only market failures but government interventions in the economy and whether they are likely to improve efficiency. For macro- economics instructors, the new sequence provides a theo- retical grounding that can help students better understand issues such as excessive government deficit spending and why there may be insufficient regulation of the financial sector. And because Chapters 4 and 5 are both optional and modular, instructors can skip them if they wish to move directly from Chapter 3’s discussion of supply and demand to the core microeconomics or macroeconomics chapters.

New “Consider This” and “Last Word” Pieces

Our “Consider This” boxes are used to provide analo- gies, examples, or stories that help drive home central economic ideas in a student-oriented, real-world manner.

For instance, a “Consider This” box titled “McHits and McMisses” illustrates consumer sovereignty through a listing of suc- cessful and unsuccessful products. How businesses exploit price discrimina- tion is driven home in a “Consider This” box that explains why ballparks charge different admis- sion prices for adults and children but only one set of prices at their conces- sion stands. These brief vignettes, each accompa- nied by a photo, illustrate key points in a lively, col-

orful, and easy-to-remember way. We have added 14 new “Consider This” boxes in this edition. Our “Last Word” pieces are lengthier applications or case studies that are placed near the end of each chapter.

CONSIDER THIS . . .

Why Do Hospitals Sometimes Charge $25 for an Aspirin?

To save taxpayers money, Medicare and Medicaid set

their payment rates for medical services above marginal cost but below average total cost. Doing so gives health care pro- viders an incentive to provide services to Medicare and Medicaid patients because MR . MC. But it also means that government health insurance programs are not reimbursing the full cost of treating Medicare and Medicaid patients. In particular, the programs are not picking up their share of the fixed costs associated with providing health care. As an example, consider an elderly person who uses Medicare. If he gets into a car accident and is taken to the lo- cal emergency room, the hospital will run up a wide variety of marginal costs, including ambulance charges, X-rays, med- ications, and the time of the nurses and doctors who help him. But the hospital also has a wide variety of fixed costs in- cluding rent, utility bills, computer networks, and lots of hid- eously expensive medical equipment. These costs have to be borne by somebody. So when Medicare and Medicaid fail to pay their full share of the fixed costs, other patients must pick up the slack. The re- sult has been for hospitals to transfer as much as possible of the fixed costs onto patients with private health insur- ance. The hospitals overbill private insurance companies so as to make up for the fixed costs that the government refuses to pay. That is why you will hear stories about hospitals charging patients with private insurance $25 for a single aspirin or

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Can Economic Growth Survive Population Decline? The Demographic Transition Is Causing Greying Populations, Shrinking Labor Forces, and Overall

Population Decreases in Many Nations. Can Economic Growth Survive?

LAST WORD

As you know from this chapter, Real GDP 5 hours of work 3 labor productivity. The number of hours of work depends heavily, however, on the size of the working- age population. If it begins to shrink, the number of hours of work almost always falls. In such cases, the only way real GDP can rise is if labor pro- ductivity increases faster than hours of work decreases. The world is about to see if that can happen in coun- tries that have populations that are greying and shrinking. The historical background has to do with the fact that as nations industrialize, their economies shift from agriculture to industry. As that happens, fertility levels plummet because the shift to modern technology transforms children from being economically essential farm hands that can contrib-

h i f ili ’ i f i

investment goods that require many years of costly schooling before they can support themselves.

As people react to this change, birthrates tend to fall quite dramati- cally. The key statistic is the total fertility rate that keeps track of the average number of births that women have during their lifetimes. To keep the population stable in modern societies, the total fertility rate must be about 2.1 births per woman per lifetime (5 1 child to replace mom, 1 child to replace dad, and 0.1 child to compensate for those people who never end up reproducing as adults).

Every rich industrial nation has now seen its total fertility rate drop below the replacement level of 2.1 births per woman per lifetime. In Japan and many Eastern E t i th b h b l f l th t

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Prefacexiv

the financial crisis, the recession, and the hesitant recov- ery. We first introduce the debate over the policy response to the 2007–2009 recession in Chapter 24 (An Introduction to Macroeconomics) via a new “Last Word” that briefly lays out the major opposing viewpoints about the nature and size of the stimulus that was applied during and after the crisis. In Chapter 25 (Measuring Domestic Output and National Income), we point out that the main flows in the National Income and Product Accounts usually ex- pand over time, but not always, as demonstrated by the recession. In Chapter 26 (Economic Growth), we discuss how the recession relates to the growth/production possi- bilities dynamics of Figure 26.2. In Chapter 27 (Business Cycles, Unemployment, and Inflation), we have a new “Last Word” that discusses the very slow recovery in em- ployment after the Great Recession. In Chapter 28 (Basic Macroeconomic Relationships), we include two “Consider This” boxes, one on how the paradox of thrift applied to consumer behavior during the recession and the other on the riddle of plunging invest- ment spending at the same time the interest rate dropped to near zero during the recession. In Chapter 29 (The Aggregate Expenditures Model), we use the recession as a timely application of how a decline in aggregate expendi- tures can produce a recessionary expenditure gap and a highly negative GDP gap. Chapter 30 (Aggregate Demand and Aggregate Supply) features a new “Last Word” on the debate among economists as to why the recovery from the 2007–2009 recession was so slow despite the historically unprecedented amounts of monetary and fiscal stimulus that were applied by policymakers. Chapter 31 (Fiscal Policy, Deficits, and Debt) provided a terrific opportunity to bring each of these timely and relevant subjects up-to- date, and we took full advantage of that opportunity. In Chapter 32 (Money, Banking, and Financial Institu- tions), we updated the major section on the financial crisis and added a new “Last Word” on whether the existence of megabanks that are considered “too big to fail” has led pros- ecutors to hold off on the full enforcement of securities laws and banking regulations. Chapter 33 (Money Creation) in- cludes a new “Last Word” on the potential dangers of exces- sive leverage in the financial system and whether, consequently, regulators should increase required reserve ratios. Chapter 34 (Interest Rates and Monetary Policy) fea- tures several new discussions relating to Fed policies dur- ing the recession and recovery, including quantitative easing, the zero interest rate policy, and Operation Twist. While giving the Fed high marks for dealing with the crisis and its aftermath, we also point out that some economists think the Fed contributed to the financial crisis by keeping interest rates too low for too long during the recovery from the 2001 recession. Chapter 35 (Financial Economics)

been moved into an appendix attached to the current edi- tion’s Chapter 4 on market failure. That way, instructors wishing to give their students a deeper look at market fail- ure will have the material on asymmetric information lo- cated immediately after that chapter’s discussion of public goods and externalities.

New Chapter on Behavioral Economics

By building upon the material on prospect theory that ap- peared in Chapter 6 of the 19th edition, we have created a new full-length chapter on behavioral economics for the 20th edition. Topics covered include time inconsistency, myopia, decision-making heuristics, framing effects, men- tal accounting, loss aversion, the endowment effect, and reciprocity. The discussion is couched in terms of con- sumer decision making and includes numerous concrete examples to bring the material home for students. We have also striven to make clear to students the ways in which behavioral economics builds upon and augments the insights of traditional neoclassical economics. Thus, the chapter opens with a section comparing and contrasting be- havioral economics and neoclassical economics so that stu- dents will be able to see how both can be used in tandem to help understand and predict human choice behavior. The chapter is designed, however, to be modular. So instructors may skip it completely without any fear that its concepts are needed to understand subsequent chapters.

New Discussions of the Financial Crisis and the Recession

Our modernization of the macroeconomics in the 18th edition has met with great success, measured by reviews, instructor feedback, and market response. We recast the entire macro analysis in terms of the modern, dominant paradigm of macroeconomics, using economic growth as the central backdrop and viewing business fluctuations as significant and costly variations in the rate of growth. In this paradigm, business cycles result from demand shocks (or, less often, supply shocks) in conjunction with inflexi- ble short-run product prices and wages. The degree of price and wage stickiness decreases with time. In our mod- els, the immediate short run is a period in which both the price level and wages are not only sticky, but stuck; the short run is a period in which product prices are flexible but wages are not; and the long run is a period in which both product prices and wages are fully flexible. Each of these three periods—and thus each of the models based on them—is relevant to understanding the actual macro economy and its occasional difficulties. In this edition, we have mainly focused on incorporat- ing into our new macroeconomic schema an analysis of

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tickets at the Olympics; the myriad impacts of ethanol sub- sidies; creative destruction; applications of behavioral eco- nomics; applications of game theory; the most rapidly expanding and disappearing U.S. jobs; oil and gasoline prices; cap-and-trade systems and carbon taxes; the value- added tax; state lotteries; consumption versus income in- equality; the impact of electronic medical records on health care costs; the surprising fall in illegal immigration after the 2007–2009 recession; the massive increase in long-term un- employment; the difficulty of targeting fiscal stimulus; the rapid rise in college tuition; the slow recovery from the Great Recession; ballooning federal budget deficits and public debt; the long-run funding shortfalls in Social Security and Medicare; the effect of rising dependency ra- tios on economic growth; innovative Federal Reserve poli- cies including quantitative easing, the zero interest rate policy, and explicit inflation targets; the massive excess re- serves in the banking system; the jump in the size of the Fed’s balance sheet; the effect of the zero interest rate policy on savers; regulation of “too big to fail” banks; trade adjust- ment assistance; the European Union and the eurozone; changes in exchange rates; and many other current topics.

Chapter-by-Chapter Changes

Each chapter of Economics, 20th edition, contains updated data reflecting the current economy, revised Learning Objectives, and reorganized and expanded end-of-chapter content. Several chapters also contain one or more addi- tional Quick Review boxes to help students review and solidify content as they are reading along. Chapter-specific updates include:

Chapter 1: Limits Alternatives, and Choices features three refreshed “Consider This” pieces, a more concise definition of macroeconomics, and wording improve- ments that clarify the main concepts.

Chapter 2: The Market System and the Circular Flow contains a heavily revised introductory section on the dif- ferent types of economic systems found in the world today as well as a new section on how the market system deals with risk and uncertainty. Reviewers asked for more mate- rial on risk and its effects on economic behavior. This short section provides a brief, nontechnical framework for students to understand how the market economy deals with risk and uncertainty. There is also a new “Consider This” box on how insurance encourages investment by transferring risk from those who do not wish to bear it to those who are willing to bear it as a business proposition.

Chapter 3: Demand, Supply, and Market Equilibrium contains a short new section in the appendix that intro- duces students to markets with vertical supply curves so

presented a new opportunity for us to demonstrate how a sharp decline of the “appetite for risk” alters the slope of the Security Market Line (SML) and changes investment patterns between stocks and bonds. Other mentions of the recession and subsequent recov- ery are spread throughout the remainder of the macro chapters, including in the discussions of macro debates, trade protectionism, and trade deficits. Although we found these various ways to work the recession and recovery into our macro chapters, we are confident that our basic macro- economic models will serve equally well in explaining ex- pansion back to the economy’s historical growth path. The new inclusions simply help students see the relevance of the models to what they are seeing in the news and perhaps ex- periencing in their own lives. The overall tone of the book, including the macro, continues to be optimistic with respect to the long-term growth prospects of market economies.

Reorganized and Extended End-of-Chapter Questions and Problems

The 19th edition featured separate sections for end-of- chapter Questions and Problems. Due to strong demand on the part of instructors for an increase in the number of problems that are both autogradable and algorithmic, we have for the 20th edition added about 10 new problems per chapter and have, in addition, revised our organiza- tional scheme for questions and problems. The questions and problems are now divided into three categories: Discussion Questions, Review Questions, and Problems. • The Discussion Questions are analytic and often

allow for free responses. • The Review Questions focus on the apprehension of

key concepts but are worded so as to always require specific answers, thereby allowing for autograding and algorithmic variation.

• The Problems are quantitative and require specific answers so that they, too, are both autogradable and algorithmic.

All of the questions and problems are assignable through McGraw-Hill’s Connect Economics and we have ad- ditionally aligned all of the questions and problems with the learning objectives presented at the beginning of chapters. The new structure as well as the newly added problems were well received by reviewers, many of them long-time users of the book.

Current Discussions and Examples

The 20th edition of Economics refers to and discusses many current topics. Examples include surpluses and shortages of

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in Chapter 6 of the 19th edition. New concepts include a discussion of the human brain’s cognitive limitations and dependence on heuristics, how time inconsistency and myopia cause people to make suboptimal long-run deci- sions, and how people’s sense of fairness and reciprocity affects decision making. The discussion of prospect theory includes anchoring, mental accounting, loss aversion, and the endowment effect.

Chapter 9: Businesses and the Costs of Production has a new “Consider This” vignette on sunk costs as well as a new “Last Word” on how additive manufacturing and 3-D print- ing may replace mass production with mass customization.

Chapter 10: Pure Competition in the Short Run is mostly unchanged from the 19th edition (where it appeared as Chapter 8). It contains several wording changes to im- prove clarity as well as a new Quick Review to increase retention.

Chapter 11: Pure Competition in the Long Run features a new “Last Word” that discusses the possibility that in cer- tain industries patent protections may hinder rather than help innovation and the process of creative destruction.

Chapter 12: Pure Monopoly has a new “Last Word” on how network effects and economies of scale have driven the monopolistic growth of Internet giants such as Facebook, Google, and Amazon. We have also revised our explanation of barriers to entry in monopoly industries with high fixed costs. The revised presentation builds upon the new material in Chapter 2 that covers risk and its effects on economic decision making.

Chapter 13: Monopolistic Competition and Oligopoly contains several updated examples as well as a new “Last Word” on the intense oligopolistic competition that has ensued between major Internet companies like Google, Apple, and Microsoft as they have attempted to compete in each other’s core lines of business.

Chapter 13 Web: Technology, R&D, and Efficiency con- tains a new “Last Word” discussing the drastic decline in federal research and development (R&D) spending over the past 50 years.

Chapter 14: The Demand for Resources features extensive data updates and a new Quick Review summarizing the material toward the end of the chapter.

Chapter 15: Wage Determination contains a new “Consider This” box on fringe benefits. It makes the point that if workers in a competitive labor market want higher fringe benefits, they must accept lower take-home pay (because total compensation is fixed by the equilibrium wage).

that the concept of perfectly inelastic supply will come more easily to microeconomics students and the concept of vertical long-run aggregate supply will come more eas- ily to macroeconomics students.

Chapter 4: Market Failures: Public Goods and

Externalities includes a new “Consider This” piece on how musicians have reacted to the reality that Internet file shar- ing has transformed recorded music from a private good into a public good. There is also a new appendix that ex- plains market failures caused by asymmetric information. The appendix gives instructors the option of extending and deepening this chapter’s study of market failure. Its content previously appeared in Chapter 17 of the 19th edition.

Chapter 5: Government’s Role and Government Failure is a new chapter that offers a balanced treatment of both the great benefits as well as the possible drawbacks of govern- ment economic intervention and regulation. The chapter in- cludes topics of interest for both microeconomics and macroeconomics students, such as: regulatory capture, un- funded liabilities, the collective-action problem, bureaucratic inertia, the tendency for politicians to run budget deficits to please voters, and the special-interest effect. So while Chapter 4 makes the case for government regulation to com- pensate for market failures, this new chapter introduces stu- dents to the fact that government interventions are themselves susceptible to both allocative and productive inefficiency. As noted previously, the chapter also includes an appendix that incorporates the voting and public choice material that ap- peared in Chapter 17 of the 19th edition for instructors who wish to present their students with the most prominent theo- retical models dealing with government failure.

Chapter 6: Elasticity contains a new “Consider This” vi- gnette that relates elasticity to the high cost of college tu- ition as well as a number of wording improvements to increase clarity. This chapter was previously located in the 19th edition directly after Chapter 3 on supply and de- mand. It has been move to this new location to serve as the first chapter of the new three-chapter Part 3 that deals with consumer behavior. Along those lines, this chapter on elasticity explains in greater depth than Chapter 3 how consumers and producers react to changes in prices.

Chapter 7: Utility Maximization contains the utility- maximization material that previously appeared as the first half of the 19th edition’s Chapter 6 (Consumer Behavior). This core content has been refreshed with a new example using iPads to explain consumer equilibrium.

Chapter 8: Behavioral Economics is a new, chapter-length overview of behavioral economics. The chapter incorpo- rates the short section on prospect theory that was located

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Chapter 25: Measuring Domestic Output and National

Income features two clarifications driven directly by stu- dent input. First, the table giving U.S. GDP by both the expenditure method and the income method is more clearly referenced in all instances so as to reduce any pos- sible confusion as to which part of the table is being re- ferred to. Second, there is now a more detailed explanation of the statistical discrepancy that appears when the income method is used to calculate GDP.

Chapter 26: Economic Growth benefits from extensive data updates, a new Quick Review to help solidify compre- hension, and a new “Last Word” that discusses the chal- lenges to economic growth posed by falling birth rates and a greying population.

Chapter 27: Business Cycles, Unemployment, and Inflation features a new “Last Word” on the slow recovery of em- ployment after the Great Recession. There are also two new “Consider This” vignettes that discuss, respectively, the relationship between downwardly sticky wages and unemployment and the idea that moderate inflation rates may help to lower unemployment by allowing firms to cut real wages without cutting nominal wages.

Chapter 28: Basic Macroeconomic Relationships features a revised header structure to better guide students through the material, a new Quick Review to help solidify reten- tion, and substantial revisions to several graphs and their captions to further refine and clarify the fundamental con- cepts introduced in this chapter.

Chapter 29: The Aggregate Expenditures Model has sub- stantial changes to a key figure in order to improve clarity as well as a heavily revised list of Learning Objectives.

Chapter 30: Aggregate Demand and Aggregate Supply features a new “Last Word” on the discussion economists have been having as to why the recovery from the Great Recession has been so slow despite record amounts of monetary and fiscal stimulus.

Chapter 31: Fiscal Policy, Deficits, and Debt features exten- sive data updates to help students understand the historically unprecedented size of recent federal budget deficits.

Chapter 32: Money, Banking, and Financial Institutions features a new “Last Word” on how some banks are now considered “too big to fail” and how that has affected the prosecution of financial crimes. The chapter also contains four new Quick Reviews to help students better retain the chapter’s material.

Chapter 33: Money Creation features a new “Last Word” on the dangers of leverage in the banking system and whether required reserve ratios should consequently be increased.

Chapter 16: Rent, Interest, and Profit features extensive data updating and several new examples in addition to ad- ditional Quick Reviews and nearly a dozen new Review Questions.

Chapter 17: Natural Resource and Energy Economics contains numerous data updates, an additional Quick Review, and two new “Consider This” vignettes. The first reports on alternative energy subsidies and the surge in oil and gas production resulting from hydraulic fracking. The second introduces students to Garret Hardin’s “The Tragedy of the Commons” story as a way of understanding most resource-depletion crises.

Chapter 18: Public Finance: Expenditures and Taxes fea- tures numerous data updates, a new Quick Review, and a reference to the recent study that found that the United States has the most progressive tax system among all 30 OECD nations.

Chapter 19: Antitrust Policy and Regulation has many new examples of real-world collusive behavior and an ex- panded explanation of cartel behavior in the section on legal cartel theory.

Chapter 20: Agriculture: Economics and Policy features numerous data updates as well as a new discussion of the recent run-up in agricultural commodity prices.

Chapter 21: Income Inequality, Poverty, and Discrimination contains major data updates, enhanced figure captions, and several short additions that add clarity regarding the specific arguments made in the debate over income in- equality.

Chapter 22: Health Care features three new “Consider This” pieces. The first explains how Medicare’s decision to reimburse medical services at rates above marginal cost but below total cost forces hospitals to transfer the difference onto those with private health insurance. The second relates how electronic medical records have unexpectedly lowered care and increased costs. The third describes some of the problems being encountered with the implementation of the Patient Protection and Affordable Care Act (Obamacare).

Chapter 23: Immigration contains extensive data updates as well as a new “Last Word” piece covering the startling decline in illegal immigration that happened during and after the Great Recession of 2007–2009.

Chapter 24: An Introduction to Macroeconomics benefits from extensive revisions to the chapter’s header structure, several new Quick Reviews, and a new “Last Word” that cov- ers in a brief and accessible form the major opposing policy viewpoints about the effectiveness and ideal size of govern- ment stimulus during and after the 2007–2009 recession.

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from planning to markets while a handful of other coun- tries such as Venezuela seem to be trying to reestablish government-controlled, centrally planned economies. Our detailed description of the institutions and operation of the market system in Chapter 2 (The Market System and the Circular Flow) is therefore even more relevant than before. We pay particular attention to property rights, en- trepreneurship, freedom of enterprise and choice, compe- tition, and the role of profits because these concepts are often misunderstood by beginning students worldwide.

Extensive Treatment of International Economics We give the principles and institutions of the global economy extensive treatment. The appendix to Chapter 3 (Demand, Supply, and Market Equilibrium) has an application on ex- change rates. Chapter 38 (International Trade) examines key facts of international trade, specialization and compar- ative advantage, arguments for protectionism, impacts of tariffs and subsidies, and various trade agreements. Chap- ter  39 (The Balance of Payments, Exchange Rates, and Trade Deficits) discusses the balance of payments, fixed and floating exchange rates, and U.S. trade deficits. Web Chap- ter 39 (The Economics of Developing Countries) takes a look at the special problems faced by developing countries and how the advanced industrial countries try to help them. As noted previously in this preface, Chapter 38 (International Trade) is constructed such that instructors who want to cover international trade early in the course can assign it immediately after Chapter 3. Chapter 38 re- quires only a good understanding of production possibili- ties analysis and supply and demand analysis to comprehend. International competition, trade flows, and financial flows are integrated throughout the micro and macro sections. “Global Perspective” boxes add to the in- ternational flavor of the book.

Early and Extensive Treatment of Government The public sector is an integral component of modern capital- ism. This book introduces the role of government early. Chapter 4 (Market Failures: Public Goods and Externali- ties) systematically discusses public goods and government policies toward externalities. Chapter 5 (Government’s Role and Government Failure) details the factors that cause government failure. And Chapter 18 (Public Finance: Ex- penditures and Taxes) examines taxation and government expenditures in detail. Both the micro and the macro sec- tions of the text include issue- and policy-oriented chapters.

Stress on the Theory of the Firm We have given much attention to microeconomics in general and to the theory of the firm in particular, for two reasons. First, the con- cepts of microeconomics are difficult for most beginning students; abbreviated expositions usually compound these

Chapter 34: Interest Rates and Monetary Policy features a new section on the Fed’s monetary policy initiatives after the Great Recession, including quantitative easing (QE), for- ward guidance, the zero interest rate policy (ZIRP), and Operation Twist. There is also a new “Last Word” discussing the potential unintended consequences of QE and ZIRP.

Chapter 35: Financial Economics features extensive data updates, five new Quick Reviews, and revised section headers to increase clarity.

Chapter 36: Extending the Analysis of Aggregate Supply features data updates, an extended discussion of the Laffer Curve, and a new Quick Review.

Chapter 37: Current Issues in Macro Theory and Policy has a new Quick Review plus a brief discussion of the Fed’s recent decisions to (1) have an explicit inflation target and (2) preannounce the likely duration of open-market oper- ations and quantitative easing.

Chapter 38: International Trade features extensive data updates, several revised figure captions, and three new Quick Reviews.

Chapter 39: The Balance of Payments, Exchange Rates,

and Trade Deficits features revised problems, extensive data updates, four new Quick Reviews, and a new set of Learning Objectives.

Chapter 39 Web: The Economics of Developing Countries features extensive data revisions and an all-new set of Discussion Questions.

COI1: The United States in the Global Economy features a heavily revised map of the international distribution of income levels, a totally new set of Discussion Questions, and extensive data updates.

COI2: Previous International Exchange Rate Systems re- mains unchanged for the 20th edition.

Distinguishing Features Comprehensive Explanations at an Appropriate

Level Economics is comprehensive, analytical, and chal- lenging yet fully accessible to a wide range of students. The thoroughness and accessibility enable instructors to select topics for special classroom emphasis with confi- dence that students can read and comprehend other inde- pendently assigned material in the book. Where needed, an extra sentence of explanation is provided. Brevity at the expense of clarity is false economy.

Fundamentals of the Market System Many economies throughout the world are still making difficult transitions

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math notes, and other features. Our Web site is part and parcel of our student learning package, customized to the book. The in-text Web buttons (or indicators) merit special mention. Two differently colored rectangular indicators appear throughout the book, informing readers that com- plementary content on a subject can be found at our Web site, www.mcconnell20e.com. The indicator types are:

Worked Problems Written by Norris Peterson of Pacific Lutheran University (WA), these pieces consist of side-by-side computa- tional questions and com- putational procedures used to derive the answers. In es- sence, they extend the textbook’s explanations of various computations—for example, of real GDP, real GDP per capita, the unemployment rate, the inflation rate, per-unit production costs, economic profit, and more. From a stu- dent’s perspective, they provide “cookbook” help for solving numerical problems.

Origin of the Ideas These pieces, written by Randy Grant of Linfield College (OR), are brief histories of 70 major ideas discussed in the book. They identify the particular economists who developed ideas such as op- portunity cost, equilibrium price, the multiplier, compara- tive advantage, and elasticity.

Organizational Alternatives Although instructors generally agree on the content of principles of economics courses, they sometimes differ on how to arrange the material. Economics includes 11 parts, and thus provides considerable organizational flexibility. We place microeconomics before macroeconomics be- cause this ordering is consistent with how contemporary economists view the direction of linkage between the two components. The introductory material of Parts 1 and 2, however, can be followed immediately by the macroanaly- sis of Parts 7 and 8. Similarly, the two-path macro enables covering the full aggregate expenditures model or advanc- ing directly from the basic macro relationships chapter to the AD-AS model. Some instructors will prefer to intersperse the micro- economics of Parts 4 and 5 with the problems chapters of

difficulties by raising more questions than they answer. Second, we wanted to couple analysis of the various mar- ket structures with a discussion of the impact of each mar- ket arrangement on price, output levels, resource allocation, and the rate of technological advance.

Step-by-Step, Two-Path Macro As in the previous edi- tion, our macro continues to be distinguished by a system- atic step-by-step approach to developing ideas and building models. Explicit assumptions about price and wage stickiness are posited and then systematically peeled away, yielding new models and extensions, all in the broader context of growth, expectations, shocks, and de- grees of price and wage stickiness over time. In crafting this step-by-step macro approach, we took care to preserve the “two-path macro” that many instructors appreciated. Instructors who want to bypass the immediate short-run model (Chapter 29: The Aggregate Expenditures Model) can proceed without loss of continuity directly to the short-run AD-AS model (Chapter 30: Aggregate Demand and Aggregate Supply), fiscal policy, money and banking, monetary policy, and the long-run AD-AS analysis.

Emphasis on Technological Change and Economic

Growth This edition continues to emphasize economic growth. Chapter 1 (Limits, Alternatives, and Choices) uses the production possibilities curve to show the basic ingre- dients of growth. Chapter 26 (Economic Growth) explains how growth is measured and presents the facts of growth. It also discusses the causes of growth, looks at productivity growth, and addresses some controversies surrounding economic growth. Chapter 26’s “Last Word” examines whether economic growth can survive demographic de- cline. Web Chapter 39 focuses on developing countries and the growth obstacles they confront. Web Chapter 13 (Technology, R&D, and Efficiency) provides an explicit and cohesive discussion of the microeconomics of techno- logical advance, including topics such as invention, innova- tion, and diffusion; start-up firms; R&D decision making; market structure and R&D effort; and creative destruction.

Focus on Economic Policy and Issues For many stu- dents, the micro chapters on antitrust, agriculture, income inequality, health care, and immigration, along with the macro chapters on fiscal policy and monetary policy, are where the action is centered. We guide that action along logical lines through the application of appropriate analyti- cal tools. In the micro, we favor inclusiveness; instructors can effectively choose two or three chapters from Part 6.

Integrated Text and Web Site Economics and its Web site are highly integrated through in-text Web buttons, bonus Web chapters, multiple-choice self-tests at the Web site,

W1.1

Budget lines

WORKED PROBLEMS

O1.1

Origin of the term “economics”

ORIGIN OF THE IDEA

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• Answers to the end-of-chapter questions and prob- lems, plus correlation guides mapping content to the learning objectives.

The Instructor’s Manual is available on the instructor’s side of the Online Learning Center.

Three Test Banks Test Bank I contains about 6,500 multiple- choice and true-false questions, most of which were written by the text authors. Randy Grant revised Test Bank I for the 20th edition. Test Bank II contains around 6,000 multiple- choice and true-false questions, updated by Felix Kwan of Maryville University. All Test Bank I and II questions are organized by learning objective, topic, AACSB Assurance of Learning, and Bloom’s Taxonomy guidelines. Test Bank III, written by William Walstad, contains more than 600 pages of short-answer questions and problems created in the style of the book’s end-of-chapter questions. Test Bank III can be used to construct student assignments or design essay and problem exams. Suggested answers to the essay and problem questions are included. In all, more than 14,000 questions give instructors maximum testing flexibility while ensuring the fullest possible text correlation. Test Banks I and II are available in Connect Economics, through EZ Test Online, and in MS Word. EZ Test allows professors to create customized tests that contain both ques- tions that they select from the test banks as well as questions that they craft themselves. Test Bank III is available in MS Word on the password-protected instructor’s side of the Online Learning Center, and on the Instructor Resource CD.

PowerPoint Presentations The PowerPoint Presenta- tions for the 20th edition were updated by a dedicated team of instructors: Stephanie Campbell of Mineral Area College, Amy Chataginer of Mississippi Gulf Coast Community College, and Shannon Aucoin of the Univer- sity of Louisiana at Lafayette. Each chapter is accompa- nied by a concise yet thorough tour of the key concepts. Instructors can use these Web site presentations in the classroom, and students can use them on their computers.

Digital Image Library Every graph and table in the text is available on the instructor’s side of the Web site and on the Instructor’s Resource CD-ROM.

Scanning Barcodes For students using smartphones and tablets, scanning barcodes (or QR codes) located within the chapter guide students to additional chapter resources, including: • Web buttons • Student PowerPoints • Worked problems

Part 6. Chapter 20 on agriculture may follow Chapters 10 and 11 on pure competition; Chapter 19 on antitrust and regulation may follow Chapters 12, 13, and 13Web on im- perfect competition models and technological advance. Chapter 23 on immigration may follow Chapter 15 on wages; and Chapter 21 on income inequality may follow Chapters 15 and 16 on distributive shares of national income. Instructors who teach the typical two-semester course and feel comfortable with the book’s organization will find that, by putting Parts 1 to 6 in the first semester and Parts 7 to 11 in the second, the material is divided logically be- tween the two semesters. Finally, Chapter 38 on international trade can easily be moved up to immediately after Chapter 3 on supply and demand for instructors who want an early discussion of international trade.

Pedagogical Aids Economics is highly student-oriented. The “To the Student” statement at the beginning of Part 1 details the book’s many pedagogical aids. The 20th edition is also accompanied by a variety of high-quality supplements that help students master the subject and help instructors implement cus- tomized courses.

Supplements for Students and Instructors

Study Guide One of the world’s leading experts on eco- nomic education, William Walstad of the University of Nebraska–Lincoln, prepared the Study Guide. Many stu- dents find either the printed or digital version indispens- able. Each chapter contains an introductory statement, a checklist of behavioral objectives, an outline, a list of im- portant terms, fill-in questions, problems and projects, objective questions, and discussion questions. The Guide comprises a superb “portable tutor” for the principles student. Separate Study Guides are available for the macro and micro paperback editions of the text.

Instructor’s Manual Shawn Knabb of Western Washington University revised and updated the Instructor’s Manuals to accompany the 20th edition of the text. The revised Instructor’s Manual includes: • Chapter summaries. • Listings of “what’s new” in each chapter. • Teaching tips and suggestions. • Learning objectives. • Chapter outlines. • Extra questions and problems.

Try It Now!

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Preface xxi

objective. Each test bank question for Economics also maps to a specific learning objective. You can use our test bank software, EZ Test Online, or Connect Economics to easily query for learning outcomes and objectives that directly relate to the learning objec- tives for your course. You can then use the reporting fea- tures to aggregate student results in a similar fashion, making the collection and presentation of assurance-of- learning data simple and easy.

AACSB Statement The McGraw-Hill Companies is a proud corporate member of AACSB International. Under- standing the importance and value of AACSB accredita- tion, Economics, 20th edition, has sought to recognize the curricula guidelines detailed in the AACSB standards for business accreditation by connecting end-of-chapter questions in Economics, 20th edition, and the accompany- ing test banks to the general knowledge and skill guide- lines found in the AACSB standards. This AACSB Statement for Economics, 20th edition, is provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual schools, their respective missions, and their respective faculty. While Economics, 20th edition, and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within Economics, 20th edition, labeled selected questions accord- ing to the six general knowledge and skills areas.

Digital Solutions McGraw-Hill Connect® Economics

Less Managing. More Teaching.

Greater Learning. Connect Economics is an online assignment and assessment solution that offers a number of powerful tools and features that make manag- ing assignments easier so faculty can spend more time teaching. With Connect Economics, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient.

Simple Assignment Management With Connect Eco- nomics, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to: • Create and deliver assignments easily with selectable

end-of-chapter questions and test bank items. • Streamline lesson planning, student progress

reporting, and assignment grading to make classroom management more efficient than ever.

Students not using smartphones or tablets can access the same resources by clicking the barcodes when viewing the eBook or by going to www.mcconnell20e.com.

Online Learning Center (www.mcconnell20e.com) The Web site accompanying this book is a central resource for students and instructors alike. The optional Web Chapters (Chapter 13W: Technology, R&D, and Efficiency and Chapter 39W: The Economics of Developing Countries) plus the two Content Options for Instructors (The United States in the Global Economy and Previous International Exchange-Rate Systems), are posted as full-color PDF files. The in-text Web buttons alert the students to points in the book where they can springboard to the Web site to get more information. Students can also review PowerPoint presentations and test their knowledge of a chapter’s con- cepts with a self-graded multiple-choice quiz. The password- protected Instructor Center houses the Instructor’s Manual, all three Test Banks, and links to EZ Test Online, Power- Point presentations, and the Digital Image Library.

Computerized Test Bank Online A comprehensive bank of test questions is provided within McGraw-Hill’s flexi- ble electronic testing program EZ Test Online (www. eztestonline.com). EZ Test Online allows instructors to simply and quickly create tests or quizzes for their students. Instructors can select questions from multiple McGraw-Hill test banks or author their own, and then ei- ther print the finalized test or quiz for paper distribution or publish it online for access via the Internet. This user-friendly program allows instructors to sort questions by format; select questions by learning objec- tives or Bloom’s taxonomy tags; edit existing questions or add new ones; and scramble questions for multiple ver- sions of the same test. Instructors can export their tests for use in WebCT, Blackboard, and PageOut, making it easy to share assessment materials with colleagues, adjuncts, and TAs. Instant scoring and feedback are provided, and EZ Test Online’s record book is designed to easily export to instructor gradebooks.

Assurance-of-Learning Ready Many educational insti- tutions are focused on the notion of assurance of learning, an important element of some accreditation standards. Economics is designed to support your assurance-of-learning initiatives with a simple yet powerful solution. Each chap- ter in the book begins with a list of numbered learning objectives to which each end-of-chapter question and problem is then mapped. In this way, student responses to  those questions and problems can be used to assess how well students are mastering each particular learning

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Prefacexxii

• A powerful search function to pinpoint and connect key concepts in a snap.

In short, Connect Plus Economics offers you and your stu- dents powerful tools and features that optimize your time and energies, enabling you to focus on course content, teaching, and student learning. Connect Plus Economics also offers a wealth of content resources for both instructors and students. This state-of-the-art, thoroughly tested system supports you in preparing students for the world that awaits. For more information about Connect, go to www. mcgrawhillconnect.com, or contact your local McGraw- Hill sales representative.

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New from McGraw- H i l l E d u c a t i o n ,

LearnSmart Advantage is a series of adaptive learning prod- ucts fueled by LearnSmart, the most widely used and intel- ligent adaptive learning resource on the market. Developed to deliver demonstrable results in boosting grades, increas- ing course retention, and strengthening memory recall, LearnSmart Advantage spans the entire learning process, from course preparation to the first adaptive reading experi- ence. A smarter learning experience for students coupled with valuable reporting tools for instructors, LearnSmart Advantage is advancing learning like no other product in higher education today. Products in McConnell’s LearnSmart Advantage Suite include:

LearnSmart LearnSmart is one of the most effective and successful adaptive learning resources in the market today, proven to strengthen memory recall, keep students in class, and boost grades. Distinguishing what students know from what they don’t, and honing in on the concepts they are most likely to forget, LearnSmart continuously adapts to each student’s needs to build an individual learning path so students study smarter and retain more knowledge. Reports provide valuable insight to instructors, so precious class time can be spent on higher-level concepts and discussion.

LearnSmart Achieve LearnSmart Achieve is a revolution- ary new learning system that combines a continually adaptive learning experience with necessary course resources to focus students on mastering concepts they don’t already know. The program adjusts to each student individually as he or she pro- gresses, creating just-in-time learning experiences by pre- senting interactive content that is tailored to each student’s needs. A convenient time-management feature and reports for instructors also ensure students stay on track.

SmartBook SmartBook is the first and only adaptive read- ing experience available today. SmartBook changes reading

• Go paperless with online submission and grading of student assignments.

Smart Grading Connect Economics helps students learn more efficiently by providing feedback and practice mate- rial when they need it, where they need it. The grading function enables instructors to: • Score assignments automatically, giving students

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• Reinforce classroom concepts with practice tests and instant quizzes.

Instructor Library The Connect Economics Instructor Li- brary is your repository for additional resources to im- prove student engagement in and out of class. You can select and use any asset that enhances your lecture.

Student Study Center The Connect Economics Student Study Center is the place for students to access additional resources. The Student Study Center offers students quick access to lectures, practice materials, eBooks, study ques- tions, and more.

Student Progress Tracking Connect Economics keeps in- structors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables instructors to: • View scored work immediately and track individual or

group performance with assignment and grade reports. • Access a real-time view of student or class

performance relative to learning objectives. • Collect data and generate reports required by many

accreditation organizations like AACSB.

McGraw-Hill Connect® Plus Economics McGraw-Hill rein- vents the textbook learning experience for the modern student

with Connect Plus Economics. A seamless integration of an eBook and Connect Economics, Connect Plus Economics provides all of the Connect Economics features plus the following: • An integrated eBook, allowing for anytime, anywhere

access to the textbook. • Dynamic links between the problems or questions

you assign to your students and the location in the eBook where that problem or question is covered.

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Preface xxiii

McGraw-Hill Customer Care Contact Information

Getting the most from new technology can be challeng- ing. So McGraw-Hill offers a large suite of complemen- tary support services for faculty using Economics. You can contact our Product Specialists 24 hours a day to set up online technology instruction. Or you can contact cus- tomer support at any time by either calling 800-331-5094 or by visiting the Customer Experience Group (CXG) Support Center at www.mhhe.com/support. They will put you in touch with a Technical Support Analyst familiar with Economics and its technology offerings. And, of course, our online knowledge bank of Frequently Asked Questions is always available at the just-mentioned Web site for in- stant answers to the most common technology questions.

Acknowledgments We give special thanks to Norris Peterson and Randy Grant, who created the “button” content on our Web site. We again thank James Reese of the University of South Carolina at Spartanburg, who wrote the original Internet exercises. Although many of those questions were replaced or modified in the typical course of revision, several remain virtually unchanged. Ryan Umbeck, Peter Staples, and Heather Schumacker deserve considerable credit for their hard work on the questions and problems in Connect. Thanks to the many dedicated instructors who accuracy- checked the end-of-chapter content, test banks, and Instructor’s Manuals: Jennifer Pate, Charles Harrington, Rick Hirschi, Melissa Rueterbusch, Gregory McGiffney, and Mike Winterhalter. Finally, we thank William Walstad and Tom Barbiero (the coauthor of our Canadian edition) for their helpful ideas and insights. We are greatly indebted to an all-star group of profes- sionals at McGraw-Hill—in particular Douglas Reiner, Lori Koetters, Casey Rasch, Scott Smith, Bruce Gin, and Katie Hoenicke—for their publishing and marketing ex- pertise. We thank Keri Johnson for her selection of the “Consider This” and “Last Word” photos and Debra Kubiak for the design. The 20th edition has benefited from a number of per- ceptive formal reviews. The reviewers, listed at the end of the preface, were a rich source of suggestions for this revi- sion. To each of you, and others we may have inadvertently overlooked, thank you for your considerable help in im- proving Economics.

Sean M. Flynn Stanley L. Brue

Campbell R. McConnell

from a passive and linear experience to an engaging and dynamic one in which students are more likely to master and retain important concepts, coming to class better pre- pared. Valuable reports provide instructors insight as to how students are progressing through textbook content, and are useful for shaping in-class time or assessment. This revolutionary technology suite is available only from McGraw-Hill Education. To learn more, go to http://learnsmartadvantage.com or contact your repre- sentative for a demo.

Tegrity Campus: Lectures 24/7

Tegrity Campus is a ser- vice that makes class time available 24/7 by automat-

ically capturing every lecture in a searchable format for students to review when they study and complete assign- ments. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. This search function helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students’ study time into learning moments immediately supported by your lecture. To learn more about Tegrity, you can watch a two- minute Flash demo at tegritycampus.mhhe.com.

CourseSmart

CourseSmart is a new way for faculty to find and review eText- books. It’s also a great option for students who are interested in

accessing their course materials digitally. CourseSmart of- fers thousands of the most commonly adopted textbooks across hundreds of courses from a wide variety of higher education publishers. It is the only place for faculty to re- view and compare the full text of a textbook online. At CourseSmart, students can save up to 50% off the cost of a print book, reduce their impact on the environment, and gain access to powerful Web tools for learning, including full text search, notes and highlighting, and e-mail tools for sharing notes between classmates. Complete tech support is also included with each title. Finding your eBook is easy. Visit www.CourseSmart.com and search by title, author, or ISBN.

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Richard Agesa, Marshall University Yamin Ahmad, University of Wisconsin–Whitewater Eun Ahn, University of Hawaii, West Oahu Thomas Andrews, West Chester University of Pennsylvania Fatma Antar, Manchester Community College Len Anyanwu, Union County College Emmanuel Asigbee, Kirkwood Community College John Atkins, Pensacola State College Moses Ayiku, Essex County College Wendy Bailey, Troy University Dean Baim, Pepperdine University Herman Baine, Broward College Tyra Barrett, Pellissippi State Community College Jill Beccaris-Pescatore, Montgomery County Community College Kevin Beckwith, Salem State University Christian Beer, Cape Fear Community College Robert Belsterling, Pennsylvania State University, Altoona Laura Jean Bhadra, Northern Virginia Community College, Manassas Priscilla Block, Broward College Augustine Boakye, Essex County College Stephanie Campbell, Mineral Area College Bruce Carpenter, Mansfield University Tom Cate, Northern Kentucky University Semih Emre Çekin, Texas Tech University Suparna Chakraborty, University of San Francisco Claude Chang, Johnson & Wales University Amy Chataginer, Mississippi Gulf Coast Community College–Gautier Shuo Chen, State University of New York–Geneseo Jon Chesbro, Montana Tech of the University of Montana Amod Choudhary, Lehman College Constantinos Christofides, East Stroudsburg University Jane Clary, College of Charleston Jane Cline, Forsyth Technical Community College Anthony Daniele, St. Petersburg College–Gibbs Rosa Lee Danielson, College of DuPage Ribhi Daoud, Sinclair Community College William L. Davis, University of Tennessee–Martin Richard Dixon, Thomas Nelson Community College Tanya Downing, Cuesta College Scott Dressler, Villanova University Brad Duerson, Des Moines Area Community College Mark J. Eschenfelder, Robert Morris University Maxwell Eseonu, Virginia State University Michael Fenick, Broward College Tyrone Ferdnance, Hampton University Jeffrey Forrest, St. Louis Community College–Florissant Valley Mark Frascatore, Clarkson University Shelby Frost, Georgia State University Sudip Ghosh, Penn State University–Berks Daniel Giedeman, Grand Valley State University Scott Gilbert, Southern Illinois University James Giordano, Villanova University Susan Glanz, St. John’s University

REVIEWERS

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Reviewers xxv

Shahriar Mostashari, Campbell University Ted Muzio, St. John’s University Cliff Nowell, Weber State University Albert Okunade, University of Memphis Mary Ellen Overbay, Seton Hall University Tammy Parker, University of Louisiana at Monroe Alberto Alexander Perez, Harford Community College David Petersen, American River College Mary Anne Pettit, Southern Illinois University–Edwardsville Jeff Phillips, Morrisville State College Robert Poulton, Graceland University Dezzie Prewitt, Rio Hondo College Joe Prinzinger, Lynchburg College Jaishankar Raman, Valparaiso University Natalie Reaves, Rowan University Virginia Reilly, Ocean County College Tim Reynolds, Alvin Community College John Romps, Saint Anselm College Tom Scheiding, Elizabethtown College Amy Schmidt, Saint Anselm College Ron Schuelke, Santa Rosa Junior College Alexandra Shiu, McLennan Community College Dorothy Siden, Salem State University Timothy Simpson, Central New Mexico Community College Jonathan Sleeper, Indian River State College Jose Rodriguez Solis, Northern Virginia Community College Camille Soltau-Nelson, Oregon State University Robert Sonora, Fort Lewis College Nick Spangenberg, Ozarks Technical Community College Dennis Spector, Naugatuck Valley Community College Thomas Stevens, University of Massachusetts, Amherst Tamika Steward, Tarrant County College, Southeast Robin Sturik, Cuyahoga Community College Western–Parma Travis Taylor, Christopher Newport University Ross Thomas, Central New Mexico Community College Mark Thompson, Augusta State University Deborah Thorsen, Palm Beach State College Michael Toma, Armstrong Atlantic State University Dosse Toulaboe, Fort Hays State University Jeff Vance, Sinclair Community College Cheryl Wachenheim, North Dakota State University–Fargo Christine Wathen, Middlesex County College Wendy Wysocki, Monroe County Community College Edward Zajicek, Winston-Salem State University

Lowell Glenn, Utah Valley University Terri Gonzales, Delgado Community College Moonsu Han, North Shore Community College Virden Harrison, Modesto Junior College Richard R. Hawkins, University of West Florida Kim Hawtrey, Hope College Glenn Haynes, Western Illinois University Michael Heslop, Northern Virginia Community College, Annandale Jesse Hoyt Hill, Tarrant County College Calvin Hoy, County College of Morris Jim Hubert, Seattle Central Community College Greg W. Hunter, California State Polytechnic University, Pomona Christos Ioannou, University of Minnesota–Minneapolis Faridul Islam, Utah Valley University Mahshid Jalilvand, University of Wisconsin–Stout Ricot Jean, Valencia Community College–Osceola Jonatan Jelen, City College of New York Brad Kamp, University of South Florida, Sarasota-Manatee Kevin Kelley, Northwest Vista College Chris Klein, Middle Tennessee State University Barry Kotlove, Edmonds Community College Richard Kramer, New England College Felix Kwan, Maryville University Ted Labay, Bishop State Community College Tina Lance, Germanna Community College–Fredericksburg Yu-Feng Lee, New Mexico State University–Las Cruces Adam Y.C. Lei, Midwestern State University Phillip Letting, Harrisburg Area Community College Brian Lynch, Lake Land College Zagros Madjd-Sadjadi, Winston-Salem State University Laura Maghoney, Solano Community College Vincent Mangum, Grambling State University Benjamin Matta, New Mexico State University–Las Cruces Pete Mavrokordatos, Tarrant County College–Northeast Campus Frederick May, Trident Technical College Katherine McClain, University of Georgia Michael McIntyre, Copiah-Lincoln Community College Robert McKizzie, Tarrant County College–Southeast Campus Kevin McWoodson, Moraine Valley Community College Edwin Mensah, University of North Carolina at Pembroke Randy Methenitis, Richland College Ida Mirzaie, The Ohio State University David Mitch, University of Maryland–Baltimore County Ramesh Mohan, Bryant University Daniel Morvey, Piedmont Technical College

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Preface xii

PART ONE

Introduction to Economics and the Economy

1 Limits, Alternatives, and Choices 4 2 The Market System and the Circular Flow 31

PART TWO

Price, Quantity, and Efficiency

3 Demand, Supply, and Market Equilibrium 53 4 Market Failures: Public Goods and Externalities 83 5 Government’s Role and Government Failure 112

PART THREE

Consumer Behavior

6 Elasticity 134 7 Utility Maximization 152 8 Behavioral Economics 173

PART FOUR

Microeconomics of Product Markets

9 Businesses and the Costs of Production 196 10 Pure Competition in the Short Run 220 11 Pure Competition in the Long Run 239 12 Pure Monopoly 254 13 Monopolistic Competition and Oligopoly 278 13w Technology, R&D, and Efficiency

(WEB CHAPTER, www.mcconnell20e.com) 13W-1

PART FIVE

Microeconomics of Resource Markets and Government

14 The Demand for Resources 312 15 Wage Determination 330 16 Rent, Interest, and Profit 360 17 Natural Resource and Energy Economics 380 18 Public Finance: Expenditures and Taxes 405

PART SIX

Microeconomic Issues and Policies

19 Antitrust Policy and Regulation 428 20 Agriculture: Economics and Policy 446

21 Income Inequality, Poverty, and Discrimination 465 22 Health Care 490 23 Immigration 513

PART SEVEN

GDP, Growth, and Instability

24 An Introduction to Macroeconomics 531 25 Measuring Domestic Output and National Income 546 26 Economic Growth 568 27 Business Cycles, Unemployment, and Inflation 591

PART EIGHT

Macroeconomic Models and Fiscal Policy

28 Basic Macroeconomic Relationships 614 29 The Aggregate Expenditures Model 635 30 Aggregate Demand and Aggregate Supply 659 31 Fiscal Policy, Deficits, and Debt 684

PART NINE

Money, Banking, and Monetary Policy

32 Money, Banking, and Financial Institutions 709 33 Money Creation 731 34 Interest Rates and Monetary Policy 747 35 Financial Economics 777

PART TEN

Extensions and Issues

36 Extending the Analysis of Aggregate Supply 799 37 Current Issues in Macro Theory and Policy 820

PART ELEVEN

International Economics

38 International Trade 838 39 The Balance of Payments, Exchange Rates,

and Trade Deficits 866 39w The Economics of Developing Countries

(WEB CHAPTER, www.mcconnell20e.com) 39W-1 COI1 The United States in the Global Economy

(Content Option for Instructors, www.mcconnell20e.com) COI2 Previous International Exchange-Rate Systems

(Content Option for Instructors, www.mcconnell20e.com)

Glossary G0

BRIEF CONTENTS

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CONTENTS

List of Key Graphs xi Preface xii Reviewers xxiv

PART ONE

Introduction to Economics and the Economy 1

To the Student 2

Chapter 1

Limits, Alternatives, and Choices 4 The Economic Perspective 5

Scarcity and Choice / Purposeful Behavior / Marginal Analysis: Comparing Benefits and Costs Consider This: Free for All? 5 Consider This: Fast-Food Lines 6

Theories, Principles, and Models 7 Microeconomics and Macroeconomics 7

Microeconomics / Macroeconomics / Positive and Normative Economics

Individual’s Economizing Problem 9 Limited Income / Unlimited Wants / A Budget Line Consider This: Did Zuckerberg, Winfrey, and James Make Bad Choices? 11

Society’s Economizing Problem 11 Scarce Resources / Resource Categories

Production Possibilities Model 12 Production Possibilities Table / Production Possibilities Curve / Law of Increasing Opportunity Costs / Optimal Allocation Consider This: The Economics of War 15

Unemployment, Growth, and the Future 15 A Growing Economy / Present Choices and Future Possibilities / A Qualification: International Trade Last Word: Pitfalls to Sound Economic Reasoning 18

Chapter 1 Appendix: Graphs and Their Meaning 24

Chapter 2

The Market System and the Circular Flow 31 Economic Systems 32

Laissez-Faire Capitalism / The Command System / The Market System

Characteristics of the Market System 33 Private Property / Freedom of Enterprise and Choice / Self-Interest / Competition / Markets and Prices / Technology and Capital Goods / Specialization / Use of Money / Active, but Limited, Government

Five Fundamental Questions 37 What Will Be Produced? / How Will the Goods and Services Be Produced? / Who Will Get the Output? / How Will the System Accommodate Change? / How Will the System Promote Progress? Consider This: McHits and McMisses 38

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Contentsxxviii

Externalities 96 Negative Externalities / Positive Externalities / Government Intervention / Consider This: The Fable of the Bees 98

Society’s Optimal Amount of Externality Reduction 100 MC, MB, and Equilibrium Quantity / Shifts in Locations of the Curves / Government’s Role in the Economy Last Word: Carbon Dioxide Emissions, Cap and Trade, and Carbon Taxes 102

Chapter 4 Appendix: Information Failures 108

Chapter 5

Government’s Role and Government Failure 112 Government’s Economic Role 113

Government’s Right to Coerce / The Problem of Directing and Managing Government Consider This: Does Big Government Equal Bad Government? 114

Government Failure 115 Representative Democracy and the Principal-Agent Problem / Clear Benefits, Hidden Costs / Unfunded Liabilities / Chronic Budget Deficits / Misdirection of Stabilization Policy / Limited and Bundled Choice / Bureaucracy and Inefficiency / Inefficient Regulation and Intervention / Corruption / Imperfect Institutions Consider This: Mohair and the Collective Action Problem 116 Consider This: Unintended Consequences 119 Last Word: “Government Failure” in the News 123

Chapter 5 Appendix: Public Choice Theory and

Voting Paradoxes 127

PART THREE

Consumer Behavior 133

Chapter 6

Elasticity 134 Price Elasticity of Demand 135

The Price-Elasticity Coefficient and Formula / Interpretations of Ed The Total-Revenue Test 137

Elastic Demand / Inelastic Demand / Unit Elasticity / Price Elasticity along a Linear Demand Curve / Price Elasticity and the Total-Revenue Curve Consider This: A Bit of a Stretch 137

Determinants of Price Elasticity of Demand 141 Applications of Price Elasticity of Demand

Price Elasticity of Supply 143 Price Elasticity of Supply: The Immediate Market Period / Price Elasticity of Supply: The Short Run / Price Elasticity of Supply: The Long Run / Applications of Price Elasticity of Supply Consider This: Elasticity and College Costs 144 Last Word: Elasticity and Pricing Power: Why Different Consumers Pay Different Prices 146

Cross Elasticity and Income Elasticity of Demand 146 Cross Elasticity of Demand / Income Elasticity of Demand

The “Invisible Hand” 41 The Demise of the Command Systems / The Incentive Problem Consider This: The Two Koreas 42

The Circular Flow Model 43 Households / Businesses / Product Market / Resource Market

How the Market System Deals with Risk 45 The Profit System / Shielding Employees and Suppliers from Business Risk / Benefits of Restricting Business Risk to Owners Consider This: Insurance 46 Last Word: Shuffling the Deck 47

PART TWO

Price, Quantity, and Efficiency 52

Chapter 3

Demand, Supply, and Market Equilibrium 53 Markets 54 Demand 54

Law of Demand / The Demand Curve / Market Demand / Changes in Demand / Changes in Quantity Demanded

Supply 59 Law of Supply / The Supply Curve / Market Supply / Determinants of Supply / Changes in Supply / Changes in Quantity Supplied

Market Equilibrium 62 Equilibrium Price and Quantity / Rationing Function of Prices / Efficient Allocation / Changes in Supply, Demand, and Equilibrium Consider This: Ticket Scalping: A Bum Rap! 64 Consider This: Salsa and Coffee Beans 65

Application: Government-Set Prices 67 Price Ceilings on Gasoline / Rent Controls / Price Floors on Wheat Last Word: A Legal Market for Human Organs? 68

Chapter 3 Appendix: Additional Examples of Supply

and Demand 75

Chapter 4

Market Failures: Public Goods and Externalities 83 Market Failures in Competitive Markets 84

Demand-Side Market Failures / Supply-Side Market Failures

Efficiently Functioning Markets 85 Consumer Surplus / Producer Surplus / Efficiency Revisited / Efficiency Losses (or Deadweight Losses)

Public Goods 90 Private Goods Characteristics / Public Goods Characteristics / Optimal Quantity of a Public Good / Demand for Public Goods / Comparing MB and MC / Cost-Benefit Analysis / Quasi-Public Goods / The Reallocation Process Consider This: Street Entertainers 92 Consider This: Responding to Digital Free Riding 93

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Contents xxix

Short-Run Production Relationships 200 Law of Diminishing Returns Consider This: Diminishing Returns from Study 201

Short-Run Production Costs 202 Fixed, Variable, and Total Costs / Per-Unit, or Average, Costs / Marginal Cost / Shifts of the Cost Curves Consider This: Ignoring Sunk Costs 206

Long-Run Production Costs 209 Firm Size and Costs / The Long-Run Cost Curve / Economies and Diseconomies of Scale / Minimum Efficient Scale and Industry Structure

Applications and Illustrations 213 Rising Gasoline Prices / Successful Start-Up Firms / The Verson Stamping Machine / The Daily Newspaper / Aircraft and Concrete Plants Last Word: 3-D Printers 214

Chapter 10

Pure Competition in the Short Run 220 Four Market Models 221 Pure Competition: Characteristics and Occurrence 222 Demand as Seen by a Purely Competitive Seller 222

Perfectly Elastic Demand / Average, Total, and Marginal Revenue

Profit Maximization in the Short Run:

Total-Revenue–Total-Cost Approach 224 Profit Maximization in the Short Run:

Marginal-Revenue–Marginal-Cost Approach 226 Profit-Maximizing Case / Loss-Minimizing Case / Shutdown Case

Marginal Cost and Short-Run Supply 230 Generalized Depiction / Diminishing Returns, Production Costs, and Product Supply / Changes in Supply / Firm and Industry: Equilibrium Price Consider This: The “Still There” Motel 232 Last Word: Fixed Costs: Digging Yourself Out of a Hole 234

Chapter 11

Pure Competition in the Long Run 239 The Long Run in Pure Competition 240

Profit Maximization in the Long Run

The Long-Run Adjustment Process in Pure Competition 240 Long-Run Equilibrium

Long-Run Supply Curves 242 Long-Run Supply for a Constant-Cost Industry / Long-Run Supply for an Increasing-Cost Industry / Long-Run Supply for a Decreasing-Cost Industry

Pure Competition and Efficiency 244 Productive Efficiency: P 5 Minimum ATC / Allocative Efficiency: P 5 MC / Maximum Consumer and Producer Surplus / Dynamic Adjustments / “Invisible Hand” Revisited

Chapter 7

Utility Maximization 152 Law of Diminishing Marginal Utility 153

Terminology / Total Utility and Marginal Utility / Marginal Utility and Demand Consider This: Vending Machines and Marginal Utility 155

Theory of Consumer Behavior 155 Consumer Choice and the Budget Constraint / Utility-Maximizing Rule / Numerical Example / Algebraic Generalization

Utility Maximization and the Demand Curve 158 Deriving the Demand Schedule and Curve

Income and Substitution Effects 159 Applications and Extensions 159

iPads / The Diamond-Water Paradox / Opportunity Cost and the Value of Time / Medical Care Purchases / Cash and Noncash Gifts Last Word: Criminal Behavior 161

Chapter 7 Appendix: Indifference Curve Analysis 166

Chapter 8

Behavioral Economics 173 Systematic Errors and the Origin of Behavioral

Economics 174 Comparing Behavioral Economics with Neoclassical Economics Consider This: Wannamaker’s Lament 176

Our Efficient, Error-Prone Brains 177 Heuristics Are Energy Savers / Brain Modularity

Prospect Theory 180 Losses and Shrinking Packages / Framing Effects and Advertising / Anchoring and Credit Card Bills / Mental Accounting and Overpriced Warranties / The Endowment Effect and Market Transactions / Status Quo Bias Consider This: Rising Consumption and the Hedonic Treadmill 181

Myopia and Time Inconsistency 184 Myopia / Time Inconsistency Consider This: Betting Against Yourself 186

Fairness and Self-Interest 187 Field Evidence for Fairness / Experimental Evidence for Fairness Last Word: Nudging People Toward Better Decisions 188

PART FOUR

Microeconomics of Product Markets 195

Chapter 9

Businesses and the Costs of Production 196 Economic Costs 197

Explicit and Implicit Costs / Accounting Profit and Normal Profit / Economic Profit / Short Run and Long Run

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Oligopoly Behavior: A Game Theory Overview 289 Mutual Interdependence Revisited / Collusion / Incentive to Cheat Consider This: The Prisoner’s Dilemma 289

Three Oligopoly Models 290 Kinked-Demand Theory: Noncollusive Oligopoly / Cartels and Other Collusion / Price Leadership Model

Oligopoly and Advertising 296 Positive Effects of Advertising / Potential Negative Effects of Advertising

Oligopoly and Efficiency 298 Productive and Allocative Efficiency / Qualifications Last Word: Internet Oligopolies 299

Chapter 13 Appendix: Additional Game

Theory Applications 304

WEB Chapter 13 www.mcconnell20e.com

Technology, R&D, and Efficiency 13W-1 Invention, Innovation, and Diffusion 13W-2

Invention / Innovation / Diffusion / R&D Expenditures / Modern View of Technological Advance

Role of Entrepreneurs and Other Innovators 13W-4 Forming Start-Ups / Innovating within Existing Firms / Anticipating the Future / Exploiting University and Government Scientific Research

A Firm’s Optimal Amount of R&D 13W-6 Interest-Rate Cost of Funds / Expected Rate of Return / Optimal R&D Expenditures

Increased Profit via Innovation 13W-9 Increased Revenue via Product Innovation / Reduced Cost via Process Innovation

Imitation and R&D Incentives 13W-11 Benefits of Being First / Profitable Buyouts Consider This: Trade Secrets 13W-12

Role of Market Structure 13W-13 Market Structure and Technological Advance / Inverted-U Theory of R&D / Market Structure and Technological Advance: The Evidence

Technological Advance and Efficiency 13W-15 Productive Efficiency / Allocative Efficiency / Creative Destruction Last Word: The Relative Decline of Federal R&D Spending 13W-16

PART FIVE

Microeconomics of Resource Markets and Government 311

Chapter 14

The Demand for Resources 312 Significance of Resource Pricing 313 Marginal Productivity Theory of Resource Demand 313

Resource Demand as a Derived Demand / Marginal Revenue Product / Rule for Employing Resources: MRP 5 MRC /

Technological Advance and Competition 248 Creative Destruction Consider This: Running a Company Is Hard Business 250 Last Word: A Patent Failure? 248

Chapter 12

Pure Monopoly 254 An Introduction to Pure Monopoly 255

Examples of Monopoly / Dual Objectives of the Study of Monopoly

Barriers to Entry 255 Economies of Scale / Legal Barriers to Entry: Patents and Licenses / Ownership or Control of Essential Resources / Pricing and Other Strategic Barriers to Entry

Monopoly Demand 257 Marginal Revenue Is Less Than Price / The Monopolist Is a Price Maker / The Monopolist Sets Prices in the Elastic Region of Demand

Output and Price Determination 260 Cost Data / MR 5 MC Rule / No Monopoly Supply Curve / Misconceptions Concerning Monopoly Pricing / Possibility of Losses by Monopolist

Economic Effects of Monopoly 263 Price, Output, and Efficiency / Income Transfer / Cost Complications / Assessment and Policy Options

Price Discrimination 268 Conditions / Examples of Price Discrimination / Graphical Analysis Consider This: Price Discrimination at the Ballpark 269

Regulated Monopoly 270 Socially Optimal Price: P 5 MC / Fair-Return Price: P 5 ATC / Dilemma of Regulation Last Word: Monopoly Power in the Internet Age 272

Chapter 13

Monopolistic Competition and Oligopoly 278 Monopolistic Competition 279

Relatively Large Number of Sellers / Differentiated Products / Easy Entry and Exit / Advertising / Monopolistically Competitive Industries

Price and Output in Monopolistic Competition 281 The Firm’s Demand Curve / The Short Run: Profit or Loss / The Long Run: Only a Normal Profit

Monopolistic Competition and Efficiency 284 Neither Productive nor Allocative Efficiency / Excess Capacity

Product Variety 285 Benefits of Product Variety / Further Complexity

Oligopoly 286 A Few Large Producers / Homogeneous or Differentiated Products / Control over Price, but Mutual Interdependence / Entry Barriers / Mergers / Oligopolistic Industries Consider This: Creative Strategic Behavior 287

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Land Rent: A Surplus Payment / Land Ownership: Fairness versus Allocative Efficiency / Application: A Single Tax on Land

Interest 364 Money Is Not a Resource / Interest Rates and Interest Income / Range of Interest Rates / Pure Rate of Interest

Loanable Funds Theory of Interest Rates 366 Supply of Loanable Funds / Demand for Loanable Funds / Extending the Model

Time-Value of Money 368 Compound Interest / Future Value and Present Value Consider This: That Is Interest 369

Role of Interest Rates 369 Interest and Total Output / Interest and the Allocation of Capital / Interest and R&D Spending / Nominal and Real Interest Rates / Application: Usury Laws

Economic Profit 371 Entrepreneurship and Profit / Insurable and Uninsurable Risks / Sources of Uninsurable Risks / Profit as Compensation for Bearing Uninsurable Risks / Sources of Economic Profit / Profit Rations Entrepreneurship / Entrepreneurs, Profits, and Corporate Stockholders Consider This: Apple CEO Steve Jobs 373 Last Word: Determining the Price of Credit 374

Income Shares 376

Chapter 17

Natural Resource and Energy Economics 380 Resource Supplies: Doom or Boom? 381

Population Growth / Resource Consumption per Person Consider This: Can Governments Raise Birthrates? 382

Energy Economics 386 Energy Efficiency Is Increasing / Efficient Electricity Use

Running Out of Energy? 388 Consider This: Alternative Energy Subsidies and the Fracking Boom 388

Natural Resource Economics 389 Renewables vs. Nonrenewables / Optimal Resource Management / Using Present Values to Evaluate Future Possibilities / Nonrenewable Resources / Incomplete Property Rights Lead to Excessive Present Use / Application: Conflict Diamonds

Renewable Resources 394 Elephant Preservation / Forest Management / Optimal Fisheries Management / Policies to Limit Catch Sizes Consider This: The Tragedy of the Commons 400 Last Word: Is Economic Growth Bad for the Environment? 398

Chapter 18

Public Finance: Expenditures and Taxes 405 Government and the Circular Flow 406 Government Finance 406

Government Purchases and Transfers / Government Revenues

MRP as Resource Demand Schedule / Resource Demand under Imperfect Product Market Competition / Market Demand for a Resource Consider This: Superstars 317

Determinants of Resource Demand 317 Changes in Product Demand / Changes in Productivity / Changes in the Prices of Other Resources / Occupational Employment Trends

Elasticity of Resource Demand 320 Optimal Combination of Resources 322

The Least-Cost Rule / The Profit-Maximizing Rule / Numerical Illustration

Marginal Productivity Theory of Income Distribution 324 Last Word: Input Substitution: The Case of ATMs 325

Chapter 15

Wage Determination 330 Labor, Wages, and Earnings 331

General Level of Wages / Role of Productivity / Real Wages and Productivity / Long-Run Trend of Real Wages

A Purely Competitive Labor Market 333 Market Demand for Labor / Market Supply of Labor / Labor Market Equilibrium Consider This: Fringe Benefits vs. Take-Home Pay 335

Monopsony Model 335 Upsloping Labor Supply to Firm / MRC Higher Than the Wage Rate / Equilibrium Wage and Employment / Examples of Monopsony Power

Three Union Models 338 Demand-Enhancement Model / Exclusive or Craft Union Model / Inclusive or Industrial Union Model / Wage Increases and Job Loss

Bilateral Monopoly Model 340 Indeterminate Outcome of Bilateral Monopoly / Desirability of Bilateral Monopoly

The Minimum-Wage Controversy 341 Case against the Minimum Wage / Case for the Minimum Wage / Evidence and Conclusions

Wage Differentials 342 Marginal Revenue Productivity / Noncompeting Groups / Compensating Differences / Market Imperfections Consider This: My Entire Life 345

Pay for Performance 346 The Principal-Agent Problem / Addenda: Negative Side Effects of Pay for Performance Last Word: Are Chief Executive Officers (CEOs) Overpaid? 348

Chapter 15 Appendix: Labor Unions and Their Impacts 353

Chapter 16

Rent, Interest, and Profit 360 Economic Rent 361

Perfectly Inelastic Supply / Equilibrium Rent and Changes in Demand / Productivity Differences and Rent Differences /

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Consider This: Putting Corn in Your Gas Tank 456

Criticisms and Politics 457 Criticisms of the Parity Concept / Criticisms of the Price- Support System / The Politics of Farm Policy

Recent Farm Policies 459 Freedom to Farm Act of 1996 / The Food, Conservation, and Energy Act of 2008 Last Word: The Sugar Program: A Sweet Deal 460

Chapter 21

Income Inequality, Poverty, and Discrimination 465 Facts about Income Inequality 466

Distribution by Income Category / Distribution by Quintiles (Fifths) / The Lorenz Curve and Gini Ratio / Income Mobility: The Time Dimension / Effect of Government Redistribution

Causes of Income Inequality 469 Ability / Education and Training / Discrimination / Preferences and Risks / Unequal Distribution of Wealth / Market Power / Luck, Connections, and Misfortune

Income Inequality over Time 471 Rising Income Inequality since 1975 / Causes of Growing Inequality Consider This: Laughing at Shrek 472

Equality versus Efficiency 473 The Case for Equality: Maximizing Total Utility / The Case for Inequality: Incentives and Efficiency / The Equality-Efficiency Trade-off Consider This: Slicing the Pizza 474

The Economics of Poverty 475 Definition of Poverty / Incidence of Poverty / Poverty Trends / Measurement Issues

The U.S. Income-Maintenance System 477 Social Insurance Programs / Public Assistance Programs

Economic Analysis of Discrimination 480 Taste-for-Discrimination Model / Statistical Discrimination / Occupational Segregation: The Crowding Model / Cost to Society as Well as to Individuals Last Word: U.S. Family Wealth and Its Distribution 484

Chapter 22

Health Care 490 The Health Care Industry 491

The U.S. Emphasis on Private Health Insurance / Twin Problems: Costs and Access / High and Rising Health Care Costs / Quality of Care: Are We Healthier?

Economic Implications of Rising Costs? 494 Reduced Access to Care / Labor Market Effects / Personal Bankruptcies / Impact on Government Budgets / Too Much Spending?

Limited Access 495 Why the Rapid Rise in Costs? 496

Peculiarities of the Health Care Market / The Increasing Demand for Health Care / Role of Health Insurance /

Federal Finance 409 Federal Expenditures / Federal Tax Revenues

State and Local Finance 410 State Finances / Local Finances Consider This: State Lotteries: A Good Bet? 412

Local, State, and Federal Employment 412 Apportioning the Tax Burden 413

Benefits Received versus Ability to Pay / Progressive, Proportional, and Regressive Taxes Consider This: The VAT: A Very Alluring Tax? 415

Tax Incidence and Efficiency Loss 416 Elasticity and Tax Incidence / Efficiency Loss of a Tax

Probable Incidence of U.S. Taxes 419 Personal Income Tax / Payroll Taxes / Corporate Income Tax / Sales and Excise Taxes / Property Taxes / The U.S. Tax Structure Last Word: Taxation and Spending: Redistribution versus Recycling 422

PART SIX

Microeconomic Issues and Policies 427

Chapter 19

Antitrust Policy and Regulation 428 The Antitrust Laws 429

Historical Background / Sherman Act of 1890 / Clayton Act of 1914 / Federal Trade Commission Act of 1914 / Celler-Kefauver Act of 1950

Antitrust Policy: Issues and Impacts 430 Issues of Interpretation / Issues of Enforcement / Effectiveness of Antitrust Laws Consider This: Of Catfish and Art (and Other Things in Common) 435

Industrial Regulation 435 Natural Monopoly / Problems with Industrial Regulation / Legal Cartel Theory / Deregulation

Social Regulation 438 Distinguishing Features / The Optimal Level of Social Regulation / Two Reminders Last Word: United States v. Microsoft 440

Chapter 20

Agriculture: Economics and Policy 446 Economics of Agriculture 447

The Short Run: Price and Income Instability

The Long Run: A Declining Industry 450 Technology and Supply Increases / Lagging Demand / Graphical Portrayal / Consequences / Farm-Household Income Consider This: Risky Business 451

Economics of Farm Policy 453 Rationale for Farm Subsidies / Background: The Parity Concept / Economics of Price Supports / Reduction of Surpluses

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Chapter 25

Measuring Domestic Output and National Income 546 Assessing the Economy’s Performance 547

Gross Domestic Product / A Monetary Measure / Avoiding Multiple Counting / GDP Excludes Nonproduction Transactions / Two Ways of Looking at GDP: Spending and Income

The Expenditures Approach 550 Personal Consumption Expenditures (C ) / Gross Private Domestic Investment (Ig) / Government Purchases (G) / Net Exports (Xn) / Putting It All Together: GDP 5 C 1 Ig 1 G 1 Xn Consider This: Stocks versus Flows 553

The Income Approach 553 Compensation of Employees / Rents / Interest / Proprietors’ Income / Corporate Profits / Taxes on Production and Imports / From National Income to GDP

Other National Accounts 555 Net Domestic Product / National Income / Personal Income / Disposable Income / The Circular Flow Revisited

Nominal GDP versus Real GDP 557 Adjustment Process in a One-Product Economy / An Alternative Method / Real-World Considerations and Data

Shortcomings of GDP 561 Nonmarket Activities / Leisure / Improved Product Quality / The Underground Economy / GDP and the Environment / Composition and Distribution of Output / Noneconomic Sources of Well-Being Last Word: Magical Mystery Tour 562

Chapter 26

Economic Growth 568 Economic Growth 569

Growth as a Goal / Arithmetic of Growth / Growth in the United States

Modern Economic Growth 571 The Uneven Distribution of Growth / Catching Up Is Possible / Institutional Structures That Promote Modern Economic Growth Consider This: Economic Growth Rates Matter! 573 Consider This: Patents and Innovation 575

Determinants of Growth 575 Supply Factors / Demand Factor / Efficiency Factor / Production Possibilities Analysis

Accounting for Growth 578 Labor Inputs versus Labor Productivity / Technological Advance / Quantity of Capital / Education and Training / Economies of Scale and Resource Allocation Consider This: Women, the Labor Force, and Economic Growth 579

The Rise in the Average Rate of Productivity Growth 581 Reasons for the Rise in the Average Rate of Productivity Growth / Implications for Economic Growth / Skepticism about Longevity / What Can We Conclude?

Supply Factors in Rising Health Care Prices / Relative Importance Consider This: Why Do Hospitals Sometimes Charge $25 for an Aspirin? 498 Consider This: Electronic Medical Records 502

Cost Containment: Altering Incentives 503 Deductibles and Copayments / Health Savings Accounts / Managed Care / Medicare and DRG / Limits on Malpractice Awards

The Patient Protection and Affordable Care Act 505 Major Provisions / Objections and Alternatives Consider This: PPACA Implementation Problems 506 Last Word: Singapore’s Efficient and Effective Health Care System 508

Chapter 23

Immigration 513 Number of Immigrants 514

Legal Immigrants / Illegal Immigrants

The Decision to Migrate 515 Earnings Opportunities / Moving Costs / Factors Affecting Costs and Benefits

Economic Effects of Immigration 517 Personal Gains / Impacts on Wage Rates, Efficiency, and Output / Income Shares / Complications and Modifications / Fiscal Impacts / Research Findings Consider This: Stars and Stripes 518

The Illegal Immigration Debate 523 Employment Effects / Wage Effects / Price Effects / Fiscal Impacts on Local and State Governments / Other Concerns Last Word: The Startling Slowdown in Illegal Immigration 525

Optimal Immigration 526

PART SEVEN

GDP, Growth, and Instability 530

Chapter 24

An Introduction to Macroeconomics 531 Performance and Policy 532 The Miracle of Modern Economic Growth 533 Saving, Investment, and Choosing between Present

and Future Consumption 535 Banks and Other Financial Institutions Consider This: Economic versus Financial Investment 535

Uncertainty, Expectations, and Shocks 536 The Importance of Expectations and Shocks / Demand Shocks and Sticky Prices / Example: A Single Firm Dealing with Demand Shocks and Sticky Prices / Generalizing from a Single Firm to the Entire Economy Consider This: The Great Recession 539

How Sticky Are Prices? 540 Last Word: Debating the Great Recession 540

Categorizing Macroeconomic Models Using

Price Stickiness 542

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The Multiplier Effect 628 Rationale / The Multiplier and the Marginal Propensities / How Large Is the Actual Multiplier Effect? Last Word: Squaring the Economic Circle 631

Chapter 29

The Aggregate Expenditures Model 635 Assumptions and Simplifications 636 Consumption and Investment Schedules 637 Equilibrium GDP: C 1 Ig 5 GDP 638

Tabular Analysis / Graphical Analysis

Other Features of Equilibrium GDP 641 Saving Equals Planned Investment / No Unplanned Changes in Inventories

Changes in Equilibrium GDP and the Multiplier 642 Adding International Trade 643

Net Exports and Aggregate Expenditures / The Net Export Schedule / Net Exports and Equilibrium GDP / International Economic Linkages

Adding the Public Sector 646 Government Purchases and Equilibrium GDP / Taxation and Equilibrium GDP

Equilibrium versus Full-Employment GDP 650 Recessionary Expenditure Gap / Inflationary Expenditure Gap / Application: The Recession of 2007–2009 Last Word: Say’s Law, the Great Depression, and Keynes 653

Chapter 30

Aggregate Demand and Aggregate Supply 659 Aggregate Demand 660

Aggregate Demand Curve

Changes in Aggregate Demand 661 Consumer Spending / Investment Spending / Government Spending / Net Export Spending

Aggregate Supply 664 Aggregate Supply in the Immediate Short Run / Aggregate Supply in the Short Run / Aggregate Supply in the Long Run / Focusing on the Short Run

Changes in Aggregate Supply 667 Input Prices / Productivity / Legal-Institutional Environment

Equilibrium in the AD-AS Model 670 Changes in Equilibrium 670

Increases in AD: Demand-Pull Inflation / Decreases in AD: Recession and Cyclical Unemployment / Decreases in AS: Cost-Push Inflation / Increases in AS: Full Employment with Price-Level Stability Consider This: Ratchet Effect 673 Last Word: Stimulus and the Great Recession 676

Chapter 30 Appendix: The Relationship of the

Aggregate Demand Curve to the Aggregate

Expenditures Model 681

Is Growth Desirable and Sustainable? 585 The Antigrowth View / In Defense of Economic Growth Last Word: Can Economic Growth Survive Population Decline? 586

Chapter 27

Business Cycles, Unemployment, and Inflation 591 The Business Cycle 592

Phases of the Business Cycle / Causation: A First Glance / Cyclical Impact: Durables and Nondurables

Unemployment 594 Measurement of Unemployment / Types of Unemployment / Definition of Full Employment / Economic Cost of Unemployment / Noneconomic Costs / International Comparisons Consider This: Downwardly Sticky Wages and Unemployment 596

Inflation 600 Meaning of Inflation / Measurement of Inflation / Facts of Inflation / Types of Inflation / Complexities / Core Inflation Consider This: Clipping Coins 603

Redistribution Effects of Inflation 603 Who Is Hurt by Inflation? / Who Is Unaffected or Helped by Inflation? / Anticipated Inflation / Other Redistribution Issues Consider This: Could a Little Inflation Help Reduce Unemployment? 604

Does Inflation Affect Output? 607 Cost-Push Inflation and Real Output / Demand-Pull Inflation and Real Output / Hyperinflation Last Word: Unemployment after the Great Recession 608

PART EIGHT

Macroeconomic Models and Fiscal Policy 613

Chapter 28

Basic Macroeconomic Relationships 614 The Income-Consumption and Income-Saving

Relationships 615 The Consumption Schedule / The Saving Schedule / Average and Marginal Propensities

Nonincome Determinants of Consumption and Saving 619 Other Important Considerations Consider This: The Great Recession and the Paradox of Thrift 621

The Interest-Rate–Investment Relationship 622 Expected Rate of Return / The Real Interest Rate / Investment Demand Curve

Shifts of the Investment Demand Curve 623 Instability of Investment Consider This: The Great Recession and the Investment Riddle 626

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The Postcrisis U.S. Financial Services Industry 723 Last Word: Too Big to Fail. Too Big to Jail? 724

Chapter 33

Money Creation 731 The Fractional Reserve System 732

Illustrating the Idea: The Goldsmiths / Significant Characteristics of Fractional Reserve Banking

A Single Commercial Bank 733 Transaction 1: Creating a Bank / Transaction 2: Acquiring Property and Equipment / Transaction 3: Accepting Deposits / Transaction 4: Depositing Reserves in a Federal Reserve Bank / Transaction 5: Clearing a Check Drawn against the Bank

Money-Creating Transactions of a Commercial Bank 736 Transaction 6: Granting a Loan / Transaction 7: Buying Government Securities / Profits, Liquidity, and the Federal Funds Market

The Banking System: Multiple-Deposit Expansion 739 The Banking System’s Lending Potential

The Monetary Multiplier 741 Reversibility: The Multiple Destruction of Money Last Word: Banking, Leverage, and Financial Instability 742

Chapter 34

Interest Rates and Monetary Policy 747 Interest Rates 748

The Demand for Money / The Equilibrium Interest Rate / Interest Rates and Bond Prices

The Consolidated Balance Sheet of the Federal

Reserve Banks 751 Assets / Liabilities

Tools of Monetary Policy 752 Open-Market Operations / The Reserve Ratio / The Discount Rate / Interest on Reserves / Relative Importance

Targeting the Federal Funds Rate 757 Expansionary Monetary Policy / Restrictive Monetary Policy / The Taylor Rule Consider This: The Fed as a Sponge 760

Monetary Policy, Real GDP, and the Price Level 761 Cause-Effect Chain / Effects of an Expansionary Monetary Policy / Effects of a Restrictive Monetary Policy

Monetary Policy: Evaluation and Issues 765 Recent U.S. Monetary Policy / Problems and Complications Consider This: Up, Up, and Away 768

The “Big Picture” 769 Last Word: Worries about ZIRP, QE, and Twist 772

Chapter 35

Financial Economics 777 Financial Investment 778 Present Value 778

Compound Interest / The Present Value Model / Applications

Chapter 31

Fiscal Policy, Deficits, and Debt 684 Fiscal Policy and the AD-AS Model 685

Expansionary Fiscal Policy / Contractionary Fiscal Policy / Policy Options: G or T ?

Built-In Stability 689 Automatic or Built-In Stabilizers

Evaluating How Expansionary or Contractionary

Fiscal Policy Is Determined 690 Cyclically Adjusted Budget

Recent and Projected U.S. Fiscal Policy 692 Fiscal Policy from 2000 to 2007 / Fiscal Policy during and after the Great Recession / Past and Projected Budget Deficits and Surpluses

Problems, Criticisms, and Complications of

Implementing Fiscal Policy 694 Problems of Timing / Political Considerations / Future Policy Reversals / Offsetting State and Local Finance / Crowding-Out Effect / Current Thinking on Fiscal Policy

The U.S. Public Debt 697 Ownership / Debt and GDP / International Comparisons / Interest Charges / False Concerns Bankruptcy / Burdening Future Generations / Substantive Issues / Income Distribution / Incentives / Foreign-Owned Public Debt / Crowding-Out Effect Revisited Last Word: The Social Security and Medicare Shortfalls 702

PART NINE

Money, Banking, and Monetary Policy 708

Chapter 32

Money, Banking, and Financial Institutions 709 The Functions of Money 710 The Components of the Money Supply 711

Money Definition M1 / Money Definition M2 Consider This: Are Credit Cards Money? 713

What “Backs” the Money Supply? 714 Money as Debt / Value of Money / Money and Prices / Stabilizing Money’s Purchasing Power

The Federal Reserve and the Banking System 716 Historical Background / Board of Governors / The 12 Federal Reserve Banks / FOMC / Commercial Banks and Thrifts

Fed Functions, Responsibilities, and Independence 719 Federal Reserve Independence

The Financial Crisis of 2007 and 2008 720 The Mortgage Default Crisis / Securitization / Failures and Near-Failures of Financial Firms

The Policy Response to the Financial Crisis 722 The Treasury Bailout: TARP / The Fed’s Lender-of- Last-Resort Activities

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Rules or Discretion? 828 In Support of Policy Rules / In Defense of Discretionary Stabilization Policy / Policy Successes Consider This: On the Road Again 829

Summary of Alternative Views 833 Last Word: The Taylor Rule: Could a Robot Replace Ben Bernanke? 832

PART ELEVEN

International Economics 837

Chapter 38

International Trade 838 Some Key Trade Facts 839 The Economic Basis for Trade 840

Comparative Advantage / Two Isolated Nations / Specializing Based on Comparative Advantage / Terms of Trade / Gains from Trade / Trade with Increasing Costs / The Case for Free Trade Consider This: A CPA and a House Painter 841 Consider This: Misunderstanding the Gains from Trade 847

Supply and Demand Analysis of Exports

and Imports 848 Supply and Demand in the United States / Supply and Demand in Canada / Equilibrium World Price, Exports, and Imports

Trade Barriers and Export Subsidies 851 Economic Impact of Tariffs / Economic Impact of Quotas / Net Costs of Tariffs and Quotas Consider This: Buy American? 852

The Case for Protection: A Critical Review 854 Military Self-Sufficiency Argument / Diversification-for- Stability Argument / Infant Industry Argument / Protection-against-Dumping Argument / Increased Domestic Employment Argument / Cheap Foreign Labor Argument

Multilateral Trade Agreements and Free-Trade Zones 857 General Agreement on Tariffs and Trade / World Trade Organization / The European Union / North American Free Trade Agreement / Recognizing Those Hurt by Free Trade / Trade Adjustment Assistance / Offshoring of Jobs Last Word: Petition of the Candlemakers, 1845 860

Chapter 39

The Balance of Payments, Exchange Rates, and Trade Deficits 866 International Financial Transactions 867 The Balance of Payments 867

Current Account / Capital and Financial Account / Why the Balance? / Official Reserves, Payments Deficits, and Payments Surpluses

Some Popular Investments 781 Stocks / Bonds / Mutual Funds

Calculating Investment Returns 783 Percentage Rates of Return / The Inverse Relationship between Asset Prices and Rates of Return

Arbitrage 784 Risk 785

Diversification

Comparing Risky Investments 787 Average Expected Rate of Return / Beta / Relationship of Risk and Average Expected Rates of Return / The Risk-Free Rate of Return

The Security Market Line 789 Security Market Line: Applications Consider This: Ponzi Schemes 791 Last Word: Index Funds versus Actively Managed Funds 793

PART TEN

Extensions and Issues 798

Chapter 36

Extending the Analysis of Aggregate Supply 799 From Short Run to Long Run 800

Short-Run Aggregate Supply / Long-Run Aggregate Supply / Long-Run Equilibrium in the AD-AS Model

Applying the Extended AD-AS Model 802 Demand-Pull Inflation in the Extended AD-AS Model / Cost- Push Inflation in the Extended AD-AS Model / Recession and the Extended AD-AS Model / Economic Growth with Ongoing Inflation

The Inflation-Unemployment Relationship 807 The Phillips Curve / Aggregate Supply Shocks and the Phillips Curve

The Long-Run Phillips Curve 810 Short-Run Phillips Curve / Long-Run Vertical Phillips Curve / Disinflation

Taxation and Aggregate Supply 812 Taxes and Incentives to Work / Incentives to Save and Invest / The Laffer Curve / Criticisms of the Laffer Curve / Rebuttal and Evaluation Consider This: Sherwood Forest 814 Last Word: Do Tax Increases Reduce Real GDP? 816

Chapter 37

Current Issues in Macro Theory and Policy 820 What Causes Macro Instability? 821

Mainstream View / Monetarist View / Real-Business- Cycle View / Coordination Failures Consider This: Too Much Money? 824

Does the Economy “Self-Correct”? 825 New Classical View of Self-Correction / Mainstream View of Self-Correction

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Contents xxxvii

The Vicious Circle 39W-11 The Role of Government 39W-12

A Positive Role / Public Sector Problems

The Role of Advanced Nations 39W-14 Expanding Trade / Admitting Temporary Workers / Discouraging Arms Sales / Foreign Aid: Public Loans and Grants / Flows of Private Capital Last Word: Famine in Africa 39W-16

COI1 The United States in the Global Economy

(Content Option for Instructors, www.mcconnell20e.com)

COI2 Previous International Exchange-Rate Systems

(Content Option for Instructors, www.mcconnell20e.com)

Glossary G0 Credits CR0 Index IND1

Flexible Exchange Rates 871 Depreciation and Appreciation / Determinants of Exchange Rates / Flexible Rates and the Balance of Payments / Disadvantages of Flexible Exchange Rates

Fixed Exchange Rates 877 Use of Official Reserves / Trade Policies / Exchange Controls and Rationing / Domestic Macroeconomic Adjustments

The Current Exchange Rate System: The Managed Float 879 Recent U.S. Trade Deficits 880

Causes of the Trade Deficits / Implications of U.S. Trade Deficits Last Word: Speculation in Currency Markets 882

WEB Chapter 39 www.mcconnell20e.com

The Economics of Developing Countries 39W-1 The Rich and the Poor 39W-2

Classifications / Comparisons / Growth, Decline, and Income Gaps / The Human Realities of Poverty

Obstacles to Economic Development 39W-4 Natural Resources / Human Resources / Capital Accumulation / Technological Advance / Sociocultural and Institutional Factors

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PART ONE

CHAPTER 1 Limits, Alternatives, and Choices

CHAPTER 2 The Market System and The Circular Flow

INTRODUCTION TO ECONOMICS AND THE ECONOMY

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TO THE STUDENT

This book and its ancillaries contain several fea-

tures designed to help you learn economics:

• Web buttons (indicators) A glance through

the book reveals

many pages with

rectangular icons set

into the text. These

“buttons” alert you

to helpful learning

aids available

with the book.

The orange button

symbolizes “Worked

Problems.” Numeric

problems are presented and then solved, side-

by-side, step-by-step. Seeing how the problems

are worked will help you solve similar problems

on quizzes and exams. The green button stands

for “Origin of the Idea.” Each of these pieces

traces a particular economic idea to the people

who first developed it.

After reading a chapter, look back at the

chapter’s Web buttons and their associated

numbers. On the home page of our Internet site, www.mcconnell20e.com,

select Student Edition

and use the pull-down

list under “Choose one”

to find the Web button

content for each chapter.

You can also scan the

accompanying QR code

with your smartphone

or tablet. Need a bar-

code reader? Try

ScanLife, available

in your app store.

Economics students learn

more, understand more, and

make better choices for

themselves and others. This

book and its interactive

learning materials like

LearnSmart will speed you on

your way to mastering the

principles of economics and

making a better

life for yourself

and those

around you.

O1.4

Ceteris paribus

ORIGIN OF THE IDEA

W2.1

Least-cost production

WORKED PROBLEMS

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• Other Internet aids Our Web site contains many other aids. In the Student Edition

you will find self-testing multiple-choice

quizzes, PowerPoint presentations, and much

more. For those of you with a very strong

mathematics background, be sure to note the

“See the Math” section on the Web site. There

you will find nearly 50 notes that develop the

algebra and, in a few cases, the calculus that

underlie the economic concepts.

• Appendix on graphs Be assured, however, that you will need only basic math skills to do well

in your introductory economics course. In

particular, you will need to be comfortable with

basic graphical analysis and a few quantitative

concepts. The appendix at the end of Chapter 1

reviews graphs and slopes of curves. You may

want to read it before starting Chapter 1.

• Reviews Each chapter contains several Quick Reviews as well as an end-of-chapter

summary. These review sections will help you

focus on essential ideas and study for exams.

• Key terms and Key Graphs Key terms are set in boldface type within the chapters, listed at the

end of each chapter, and again defined in the

glossary at the end of the book. Graphs with

special importance are labeled Key Graphs,

and each includes a multiple-choice Quick

Quiz. Your instructor may or may not

emphasize all of these figures, but you

should pay special attention to those that

are discussed in class; you can be certain

there will be exam questions on them.

• Consider This and Last Word boxes Many chapters include a “Consider This” box. These

brief pieces provide commonplace analogies,

examples, and stories that help you understand

and remember central economic ideas. Each

chapter concludes with a “Last Word” box. Some

of them are revealing applications of economic

ideas; others are short case studies. While it is

tempting to ignore in-text boxes, don’t. Most

are fun to read, and all will improve your grasp

of economics.

• Questions and Problems The end of each chapter features separate sections of

Discussion Questions, Review Questions,

and Problems. The Discussion Questions are

analytic and often ask for free responses, and

the Review Questions require either specific

answers to short computations or brief

definitions about important concepts. The

Problems involve longer computations for

which a series of specific answers must be

given. Each is keyed to a particular learning

objective (LO) in the list of LOs at the

beginning of the chapter. At the Web site

is a multiple-choice quiz for each chapter.

• Study Guide We enthusiastically recommend the Study Guide accompanying this text. This “portable tutor” contains not only a broad

sampling of various kinds of questions but a host

of useful learning aids. Software-driven tutorials,

including the Self Quiz and Study in Connect Economics, are also available with the text. Our two main goals are to help you understand

and apply economics and help you improve your

analytical skills. An understanding of economics

will enable you to comprehend a whole range of

economic, social, and political problems that oth-

erwise would seem puzzling and perplexing. Also,

your study will enhance reasoning skills that are

highly prized in the workplace.

Good luck with your study. We think it will be

well worth your time and effort.

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4

LO1.7 Explain how economic growth and international trade increase

consumption possibilities.

LO1.8 (Appendix) Understand graphs, curves, and slopes as they relate to

economics.

Learning Objectives

LO1.1 Define economics and the features of the economic perspective.

LO1.2 Describe the role of economic theory in economics.

LO1.3 Distinguish microeconomics from macroeconomics and positive

economics from normative

economics.

LO1.4 Explain the individual’s economizing problem and how

trade-offs, opportunity costs, and

attainable combinations can be

illustrated with budget lines.

LO1.5 List the categories of scarce resources and delineate the

nature of society’s economizing

problem.

LO1.6 Apply production possibilities analysis, increasing opportunity

costs, and economic growth.

Limits, Alternatives, and Choices

CHAPTER 1

(An appendix on understanding graphs follows this chapter. If you need a quick review of this mathe- matical tool, you might benefit by reading the ap- pendix first.) People’s wants are numerous and varied. Biologically, people need only air, water,

food, clothing, and shelter. But in modern societies

people also desire goods and services that provide

a more comfortable or affluent standard of living.

We want bottled water, soft drinks, and fruit juices,

not just water from the creek. We want salads, burg-

ers, and pizzas, not just berries and nuts. We want

jeans, suits, and coats, not just woven reeds. We

want apartments, condominiums, or houses, not

just mud huts. And, as the saying goes, “That is not

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CHAPTER 1 Limits, Alternatives, and Choices 5

economic wants far ex-

ceed the productive

capacity of our scarce

(limited) resources. We

are forced to make

choices. This unyield-

ing truth underlies the definition of economics,

which is the social science concerned with how

individuals, institutions, and society make optimal

(best) choices under conditions of scarcity.

the half of it.” We also want flat-panel TVs, Internet

service, education, national defense, cell phones,

health care, and much more.

Fortunately, society possesses productive re-

sources, such as labor and managerial talent, tools

and machinery, and land and mineral deposits.

These resources, employed in the economic sys-

tem (or simply the economy), help us produce

goods and services that satisfy many of our

economic wants. But the blunt reality is that our

The Economic Perspective LO1.1 Define economics and the features of the economic perspective. Economists view things from a unique perspective. This economic perspective, or economic way of thinking, has several critical and closely interrelated features.

Scarcity and Choice

The economic resources needed to make goods and ser- vices are in limited supply. This scarcity restricts options and demands choices. Because we “can’t have it all,” we must decide what we will have and what we must forgo. At the core of economics is the idea that “there is no free lunch.” You may be treated to lunch, making it “free” from your perspective, but someone bears a cost. Because all resources are either privately or collectively owned by members of society, ultimately society bears the cost. Scarce inputs of land, equipment, farm labor, the labor of cooks and waiters, and managerial talent are required. Because society could have used these resources to produce something else, it sacrifices those other goods and services in making the lunch available. Economists call such sacri- fices opportunity costs: To obtain more of one thing, so- ciety forgoes the opportunity of getting the next best thing. That sacrifice is the opportunity cost of the choice.

Purposeful Behavior

Economics assumes that human behavior reflects “rational self-interest.” Individuals look for and pursue opportunities to increase their utility—the pleasure, happiness, or satisfac- tion obtained from consuming a good or service. They allo- cate their time, energy, and money to maximize their

CONSIDER THIS . . .

Free for All?

Free products are seemingly every- where. Sellers of- fer free apps, free cell phones, and free checking ac- counts. Dentists give out free tooth-

brushes. At state visitor centers, there are free brochures and maps. Does the presence of so many free products contradict the economist’s assertion that “There is no free lunch”? No! Resources are used to produce each of these products, and because those resources have alternative uses, society gives up something else to get the “free” good. Because alternatives must be forsaken, there is no such thing as a free lunch. So why are these goods offered for free? In a word: marketing! Firms sometimes offer free products to entice people to try them, hoping they will then purchase those goods later. Getting to try out the free version of an app may eventually entice you to buy the pay version that has more features. In other cases, a product is free only in conjunction with a larger purchase. To get the free bottle of soda, you must buy the large pizza. To get the free cell  phone, you need to sign up for a year’s worth of cell phone service. But while “free” products may come at no cost to the indi- viduals receiving them, they are never free to society be- cause their manufacture requires the use of resources that could have been put to alternative uses.

O1.1

Origin of the term “Economics”

ORIGIN OF THE IDEA

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PART ONE Introduction to Economics and the Economy6

satisfaction. Because they weigh costs and benefits, their economic decisions are “purposeful” or “rational,” not “random” or “chaotic.”

Consumers are pur- poseful in deciding what goods and services to buy.

Business firms are purposeful in deciding what products to produce and how to produce them. Government entities are purposeful in deciding what public services to provide and how to finance them. “Purposeful behavior” does not assume that people and institutions are immune from faulty logic and therefore are perfect decision makers. They sometimes make mistakes. Nor does it mean that people’s decisions are unaffected by emotion or the decisions of those around them. Indeed, economists acknowledge that people are sometimes impul- sive or emulative. “Purposeful behavior” simply means that people make decisions with some desired outcome in mind. Rational self-interest is not the same as selfishness. In the economy, increasing one’s own wage, rent, interest, or profit normally requires identifying and satisfying somebody else’s wants! Also, people make personal sacrifices for oth- ers. They contribute time and money to charities because they derive pleasure from doing so. Parents help pay for their children’s education for the same reason. These self- interested, but unselfish, acts help maximize the givers’ satis- faction as much as any personal purchase of goods or services. Self-interested behavior is simply behavior designed to in- crease personal satisfaction, however it may be derived.

Marginal Analysis: Comparing Benefits and Costs

The economic perspective focuses largely on marginal analysis—comparisons of marginal benefits and marginal costs, usually for decision making. To economists, “mar- ginal” means “extra,” “additional,” or “a change in.” Most choices or decisions involve changes in the status quo, meaning the existing state of affairs. Should you attend school for another year? Should you study an extra hour for an exam? Should you supersize your fries? Similarly, should a business expand or reduce its out-

put? Should government in- crease or decrease its funding for a missile defense system?

Each option involves marginal benefits and, be- cause of scarce resources, marginal costs. In making choices rationally, the deci-

O1.2

Utility

ORIGIN OF THE IDEA CONSIDER THIS . . .

Fast-Food Lines

The economic perspec tive is useful in analyz- i n g a l l s o r t s o f b e h a v i o r s . Consider an ev- eryday example: the behavior of

fast-food customers. When customers enter the restaurant, they go to the shortest line, believing that line will minimize their time cost of obtaining food. They are acting purpose- fully; time is limited, and people prefer using it in some way other than standing in line. If one fast-food line is temporarily shorter than other lines, some people will move to that line. These movers apparently view the time saving from the shorter line (marginal benefit) as exceeding the cost of moving from their present line (mar- ginal cost). The line switching tends to equalize line lengths. No further movement of customers between lines occurs once all lines are about equal. Fast-food customers face another cost-benefit decision when a clerk opens a new station at the counter. Should they move to the new station or stay put? Those who shift to the new line decide that the time saving from the move exceeds the extra cost of physically moving. In so deciding, customers must also consider just how quickly they can get to the new station compared with others who may be contemplating the same move. (Those who hesitate in this situation are lost!) Customers at the fast-food establishment do not have perfect information when they select lines. Thus, not all deci- sions turn out as expected. For example, you might enter a short line only to find that someone in front of you is order- ing hamburgers and fries for 40 people in the Greyhound bus parked out back (and also that the guy taking orders in your new line is a trainee)! Nevertheless, at the time you made your decision, you thought it was optimal. Finally, customers must decide what food to order when they arrive at the counter. In making their choices, they again compare marginal costs and marginal benefits in attempting to obtain the greatest personal satisfaction for their expenditure. Economists believe that what is true for the behavior of customers at fast-food restaurants is true for economic be- havior in general. Faced with an array of choices, consumers, workers, and businesses rationally compare marginal costs and marginal benefits when making decisions.

O1.3

Marginal analysis

ORIGIN OF THE IDEA

sion maker must compare those two amounts. Example: You and your fiancée are shopping for an engagement ring. Should you buy a 12-carat diamond, a

3 4-carat diamond,

a 1-carat diamond, or something even larger? The marginal cost of a larger-size diamond is the added expense beyond

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CHAPTER 1 Limits, Alternatives, and Choices 7

cause and effect (or action and outcome) within the eco- nomic system. Good theories do a good job of explaining and predicting. They are supported by facts concerning how individuals and institutions actually behave in pro- ducing, exchanging, and consuming goods and services. There are some other things you should know about economic principles.

• Generalizations Economic principles are generalizations relating to economic behavior or to the economy itself. Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms. For example, economists say that consumers buy more of a particular product when its price falls. Economists recognize that some consumers may increase their purchases by a large amount, others by a small amount, and a few not at all. This “price-quantity” principle, however, holds for the typical consumer and for consumers as a group.

• Other-things-equal assumption In constructing their theories, economists use the ceteris paribus or other- things-equal assumption—the assumption that factors other than those being considered do not change. They assume that all vari- ables except those under immediate con- sideration are held constant for a parti- cular analysis. For example, consider the relationship between the price of Pepsi and the amount of it purchased. Assume that of all the factors that might influence the amount of Pepsi purchased (for example, the price of Pepsi, the price of Coca-Cola, and consumer incomes and preferences), only the price of Pepsi varies. This is helpful because the economist can then focus on the relationship between the price of Pepsi and purchases of Pepsi in isolation without being confused by changes in other variables.

• Graphical expression Many economic models are ex- pressed graphically. Be sure to read the special appendix at the end of this chapter as a review of graphs.

Microeconomics and Macroeconomics LO1.3 Distinguish microeconomics from macroeconomics and positive economics from normative economics. Economists develop economic principles and models at two levels.

the cost of the smaller-size diamond. The marginal benefit is the perceived lifetime pleasure (utility) from the larger- size stone. If the marginal benefit of the larger diamond exceeds its marginal cost (and you can afford it), buy the larger stone. But if the marginal cost is more than the marginal benefit, you should buy the smaller diamond instead—even if you can afford the larger stone! In a world of scarcity, the decision to obtain the mar- ginal benefit associated with some specific option always includes the marginal cost of forgoing something else. The money spent on the larger-size diamond means for- going some other product. An opportunity cost—the value of the next best thing forgone—is always present when- ever a choice is made.

Theories, Principles, and Models LO1.2 Describe the role of economic theory in economics. Like the physical and life sciences, as well as other social sciences, economics relies on the scientific method. That procedure consists of several elements:

• Observing real-world behavior and outcomes. • Based on those observations, formulating a possible

explanation of cause and effect (hypothesis). • Testing this explanation by comparing the outcomes

of specific events to the outcome predicted by the hypothesis.

• Accepting, rejecting, and modifying the hypothesis, based on these comparisons.

• Continuing to test the hypothesis against the facts. If favorable results accumulate, the hypothesis evolves into a theory. A very well-tested and widely accepted theory is referred to as an economic law or an economic principle—a statement about economic behavior or the economy that enables prediction of the probable effects of certain actions. Combinations of such laws or principles are incorporated into models, which are simplified representations of how something works, such as a market or segment of the economy.

Economists develop theories of the behavior of individu- als (consumers, workers) and institutions (businesses, gov- ernments) engaged in the production, exchange, and consumption of goods and services. Theories, principles, and models are “purposeful simplifications.” The full scope of economic reality itself is too complex and bewildering to be understood as a whole. In developing theories, principles, and models economists remove the clutter and simplify. Economic principles and models are highly useful in analyzing economic behavior and understanding how the economy operates. They are the tools for ascertaining

O1.4

Ceteris paribus

ORIGIN OF THE IDEA

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PART ONE Introduction to Economics and the Economy8

Positive economics focuses on facts and cause-and-effect relationships. It includes description, theory development, and theory testing. Positive economics avoids value judg- ments. It tries to establish scientific statements about eco- nomic behavior and deals with what the economy is actually like. Such scientific-based analysis is critical to good policy analysis. Economic policy, on the other hand, involves norma- tive economics, which incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desir- able goal. Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for particular economic policies. Positive economics concerns what is, whereas norma- tive economics embodies subjective feelings about what ought to be. Examples: Positive statement: “The unemploy- ment rate in France is higher than that in the United States.” Normative statement: “France ought to undertake policies to make its labor market more flexible to reduce unemployment rates.” Whenever words such as “ought” or “should” appear in a sentence, you are very likely encoun- tering a normative statement. Most of the disagreement among economists involves normative, value-based policy questions. Of course, econ- omists sometime disagree about which theories or models best represent the economy and its parts, but they agree on a full range of economic principles. Most economic controversy thus reflects differing opinions or value judg- ments about what society should be like.

Microeconomics

Microeconomics is the part of economics concerned with decision making by individual customers, workers, house- holds, and business firms. At this level of analysis, we ob- serve the details of their behavior under a figurative microscope. We measure the price of a specific product, the number of workers employed by a single firm, the rev- enue or income of a particular firm or household, or the expenditures of a specific firm, government entity, or fam- ily. In microeconomics, we examine the sand, rocks, and shells, not the beach.

Macroeconomics

Macroeconomics examines the performance and behav- ior of the economy as a whole. It focuses its attention on economic growth, the business cycle, interest rates, infla- tion, and the behavior of major economic aggregates such as the government, household, and business sectors. An aggregate is a collection of specific economic units treated as if they were one unit. Therefore, we might lump together the millions of consumers in the U.S. economy and treat them as if they were one huge unit called “consumers.” In using aggregates, macroeconomics seeks to ob- tain an overview, or general outline, of the structure of the economy and the relationships of its major aggre- gates. Macroeconomics speaks of such economic mea- sures as total output, total employment, total income, aggregate expenditures, and the general level of prices in  analyzing various economic problems. Very little attention is given to the specific units making up the various aggregates. Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells. The micro–macro distinction does not mean that eco- nomics is so highly compartmentalized that every topic can be readily labeled as either micro or macro; many top- ics and subdivisions of economics are rooted in both. Example: While the problem of unemployment is usually treated as a macroeconomic topic (because unemployment relates to aggregate production), economists recognize that the decisions made by individual workers on how long to search for jobs and the way specific labor markets en- courage or impede hiring are also critical in determining the unemployment rate.

Positive and Normative Economics

Both microeconomics and macroeconomics contain ele- ments of positive economics and normative economics.

QUICK REVIEW 1.1

• Economics examines how individuals, institutions, and society make choices under conditions of scarcity.

• The economic perspective stresses (a) resource scarcity and the necessity of making choices, (b) the assumption of purposeful (or rational) behavior, and (c) comparisons of marginal benefit and marginal cost.

• In choosing the best option, people incur an opportu- nity cost—the value of the next-best option.

• Economists use the scientific method to establish eco- nomic theories—cause-effect generalizations about the economic behavior of individuals and institutions.

• Microeconomics focuses on specific decision-making units within the economy. Macroeconomics examines the economy as a whole.

• Positive economics deals with factual statements (“what is”); normative economics involves value judg- ments (“what ought to be”).

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CHAPTER 1 Limits, Alternatives, and Choices 9

wants for himself, but his massive charitable giving sug- gests that he keenly wants better health care for the world’s poor. Our desires for a particular good or service can be satisfied; over a short period of time we can surely get enough toothpaste or pasta. And one appendectomy is plenty. But our broader desire for more goods and ser- vices and higher-quality goods and services seems to be another story. Because we have only limited income (usually through our work) but seemingly insatiable wants, it is in our self- interest to economize: to pick and choose goods and services that maximize our satisfaction given the limitations we face.

A Budget Line

We can clarify the economizing problem facing consum- ers by visualizing a budget line (or, more technically, a budget constraint). It is a schedule or curve that shows vari- ous combinations of two products a consumer can pur- chase with a specific money income. Although we assume two products, the analysis generalizes to the full range of products available to consumers.

Individual’s Economizing Problem LO1.4 Explain the individual’s economizing problem and how trade-offs, opportunity costs, and attainable combinations can be illustrated with budget lines. A close examination of the economizing problem—the need to make choices because economic wants exceed economic means—will enhance your understanding of economic models and the difference between micro- economic and macroeconomic analysis. Let’s first build a microeconomic model of the economizing problem faced by an individual.

Limited Income

We all have a finite amount of income, even the wealthiest among us. Even Donald Trump must decide how to spend his money! And the majority of us have much more lim- ited means. Our income comes to us in the form of wages, interest, rent, and profit, although we may also receive money from government programs or family members. As Global Perspective 1.1 shows, the average income of Americans in 2011 was $48,450. In the poorest nations, it was less than $500.

Unlimited Wants

For better or worse, most people have virtually unlimited wants. We desire various goods and services that provide utility. Our wants extend over a wide range of products, from necessities (for example, food, shelter, and clothing) to luxuries (for example, perfumes, yachts, and sports cars). Some wants such as basic food, clothing, and shelter have biological roots. Other wants, for example, specific kinds of food, clothing, and shelter, arise from the conventions and customs of society. Over time, as new and improved products are intro- duced, economic wants tend to change and multiply. Only recently have people wanted iPods, Internet service, or cam- era phones because those products did not exist a few de- cades ago. Also, the satisfaction of certain wants may trigger others: the acquisition of a Ford Focus or a Honda Civic has been known to whet the appetite for a Lexus or a Mercedes. Services, as well as goods, satisfy our wants. Car repair work, the removal of an inflamed appendix, legal and ac- counting advice, and haircuts all satisfy human wants. Actually, we buy many goods, such as automobiles and washing machines, for the services they render. The differ- ences between goods and services are often smaller than they appear to be. For most people, the desires for goods and services cannot be fully satisfied. Bill Gates may have all that he

GLOBAL PERSPECTIVE 1.1

Average Income, Selected Nations

Average income (total income/population) and therefore typical individual budget constraints vary greatly among nations.

Source: World Bank, www.worldbank.org.

Country Per Capita Income, 2011

(U.S. dollars, based on exchange rates)

Norway $88,890

Switzerland

Singapore

United States

France

South Korea

Mexico

China

India

Iraq

Madagascar

Congo

76,380

42,930

48,450

42,420

20,870

9240

4940

1410

2640

430

190

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PART ONE Introduction to Economics and the Economy10

utility you will want to spend the full $120. The budget line shows all combinations that cost exactly the full $120. In contrast, all combinations beyond the budget line are unattainable. The $120 limit simply does not allow you to purchase, for example, 5 DVDs at $20 each and 5 books at $10 each. That $150 expenditure would clearly exceed the $120 limit. In Figure 1.1 the attainable combinations are on and within the budget line; the unattainable combinations are beyond the budget line.

Trade-Offs and Opportunity Costs The budget line in Figure 1.1 illustrates the idea of trade-offs arising from limited income. To obtain more DVDs, you have to give up some books. For example, to obtain the first DVD, you trade off 2 books. So the opportunity cost of the first DVD is 2 books. To obtain the second DVD the opportunity cost is also 2 books. The straight-line budget constraint, with its constant slope, indicates constant opportunity cost. That is, the opportunity cost of 1 extra DVD remains the same (5 2 books) as more DVDs are pur- chased. And, in reverse, the opportunity cost of 1 extra book does not change 15 12 DVD2 as more books are bought.

Choice Limited income forces people to choose what to buy and what to forgo to fulfill wants. You will select the combination of DVDs and paperback books that you think is “best.” That is, you will evaluate your marginal benefits and marginal costs (here, product price) to make choices that maximize your satisfaction. Other people, with the same $120 gift card, would undoubtedly make different choices.

To understand the idea of a budget line, suppose that you received a Barnes & Noble gift card as a birthday present. The $120 card is soon to expire. You take the card to the store and confine your purchase decisions to two alternatives: DVDs and paperback books. DVDs are $20 each and paperback books are $10 each. Your purchase op- tions are shown in the table in Figure 1.1. At one extreme, you might spend all of your $120 “income” on 6 DVDs at $20 each and have nothing left to spend on books. Or, by giving up 2 DVDs and thereby gaining $40, you can have 4 DVDs at $20 each and 4 books at $10 each. And so on to the other extreme, at which you could buy 12 books at $10 each, spending your entire gift card on books with nothing left to spend on DVDs. The graph in Figure 1.1 shows the budget line. Note that the graph is not restricted to whole units of DVDs and books as is the table. Every point on the graph represents a possible combination of DVDs and books, including fractional quantities. The slope of the graphed budget line  measures the ratio of the price of books (P

b ) to the

price of DVDs (P dvd

); more precisely, the slope is P

b yP

dvd 5 $210y$120 5 212. So you must forgo 1 DVD

(measured on the vertical axis) to buy 2 books (measured on the horizontal axis). This yields a slope of 212 or 2.5. The budget line illustrates several ideas.

Attainable and Unattainable Combinations All the combinations of DVDs and books on or inside the budget line are attainable from the $120 of money income. You can afford to buy, for example, 3 DVDs at $20 each and 6 books at $10 each. You also can obviously afford to buy 2 DVDs and 5 books, thereby using up only $90 of the $120 available on your gift card. But to achieve maximum

Income = $120 Pdvd = $20

12

10

8

6

4

2

2 4 6 8 10 12 14

Quantity of paperback books

Q u an

ti ty

o f

D V

D s

Unattainable

Attainable

Income = $120 Pb = $10

0

= 6

= 12

FIGURE 1.1 A consumer’s budget line. The budget line (or budget constraint) shows all the combinations of any two products that can be purchased, given the prices of the products and the consumer’s money income.

The Budget Line: Whole-Unit Combinations of DVDs

and Paperback Books Attainable with an Income of $120

Units of DVDs Units of Books

(Price 5 $20) (Price 5 $10) Total Expenditure

6 0 $120 (5 $120 1 $0)

5 2 $120 (5 $100 1 $20)

4 4 $120 (5 $80 1 $40)

3 6 $120 (5 $60 1 $60)

2 8 $120 (5 $40 1 $80)

1 10 $120 (5 $20 1 $100)

0 12 $120 (5 $0 1 $120)

O1.5

Opportunity costs

ORIGIN OF THE IDEA

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CHAPTER 1 Limits, Alternatives, and Choices 11

Income Changes The location of the budget line varies with money income. An increase in money income shifts the budget line to the right; a decrease in money income

shifts it to the left. To ver- ify this, recalculate the ta- ble in Figure 1.1, assuming the card value (income) is (a)  $240 and (b) $60, and plot the new budget lines in the graph. No wonder people like to have more income: That shifts their

budget lines outward and enables them to buy more goods and services. But even with more income, people will still face spending trade-offs, choices, and opportunity costs.

CONSIDER THIS . . .

Did Zuckerberg, Winfrey, and James Make Bad Choices?

Opportunity costs come into play in decisions well beyond simple buying decisions. Consider the different choices people make with respect to college. The average salaries earned by college graduates are nearly twice as high as those earned by persons

with just high school diplomas. For most capable students, “Go to college, stay in college, and earn a degree” is very sound advice. Yet Facebook founder Mark Zuckerberg and talk show host Oprah Winfrey* both dropped out of college, and basketball star LeBron James never even bothered to start classes. What were they thinking? Unlike most students, Zukerberg faced enormous opportunity costs for staying in college. He had a vi- sion for his company, and dropping out helped to ensure Facebook’s success. Similarly, Winfrey landed a spot in local television news when she was a teenager, eventually produc- ing and starring in the Oprah Winfrey Show when she was 32 years old. Getting a degree in her twenties might have inter- rupted the string of successes that made her famous talk show possible. And James knew that professional athletes have short careers. Therefore, going to college directly after high school would have taken away four years of his peak earning potential. So Zuckerberg, Winfrey, and James understood opportu- nity costs and made their choices accordingly. The size of op- portunity costs matters greatly in making individual decisions.

*Winfrey eventually went back to school and earned a degree from Tennessee State University when she was in her thirties.

Society’s Economizing Problem LO1.5 List the categories of scarce resources and delineate the nature of society’s economizing problem. Society must also make choices under conditions of scar- city. It, too, faces an economizing problem. Should it de- vote more of its limited resources to the criminal justice system (police, courts, and prisons) or to education (teach- ers, books, and schools)? If it decides to devote more re- sources to both, what other goods and services does it forgo? Health care? Energy development?

Scarce Resources

Society has limited or scarce economic resources, mean- ing all natural, human, and manufactured resources that go into the production of goods and services. This in- cludes the entire set of factory and farm buildings and all the equipment, tools, and machinery used to produce manufactured goods and agricultural products; all trans- portation and communication facilities; all types of labor; and land and mineral resources.

Resource Categories

Economists classify economic resources into four general categories.

Land Land means much more to the economist than it does to most people. To the economist land includes all natural resources (“gifts of nature”) used in the production process. These include forests, mineral and oil deposits, water resources, wind power, sunlight, and arable land.

Labor The resource labor consists of the physical ac- tions and mental activities that people contribute to the production of goods and services. The work-related activi- ties of a logger, retail clerk, machinist, teacher, profes- sional football player, and nuclear physicist all fall under the general heading “labor.”

Capital For economists, capital (or capital goods) in- cludes all manufactured aids used in producing consumer

W1.1

Budget lines

WORKED PROBLEMS

• Because wants exceed incomes, individuals face an economizing problem; they must decide what to buy and what to forgo.

• A budget line (budget constraint) shows the various combinations of two goods that a consumer can pur- chase with a specific money income.

• Straight-line budget constraints imply constant oppor- tunity costs for both goods.

QUICK REVIEW 1.2

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PART ONE Introduction to Economics and the Economy12

understood through a macroeconomic model of production possibilities. To keep things simple, let’s initially assume

• Full employment The economy is employing all of its available resources.

• Fixed resources The quantity and quality of the factors of production are fixed.

• Fixed technology The state of technology (the methods used to produce output) is constant.

• Two goods The economy is producing only two goods: pizzas and industrial robots. Pizzas symbolize consumer goods, products that satisfy our wants directly; industrial robots (for example, the kind used to weld automobile frames) symbolize capital goods, products that satisfy our wants indirectly by making possible more efficient production of consumer goods.

Production Possibilities Table

A production possibilities table lists the different combina- tions of two products that can be produced with a specific set of resources, assuming full employment. Table 1.1 presents a simple, hypothetical economy that is producing pizzas and industrial robots; the data are, of course, hypothetical. At al- ternative A, this economy would be devoting all its available resources to the production of industrial robots (capital goods); at alternative E, all resources would go to pizza pro- duction (consumer goods). Those alternatives are unrealistic extremes; an economy typically produces both capital goods and consumer goods, as in B, C, and D. As we move from alternative A to E, we increase the production of pizzas at the expense of the production of industrial robots. Because consumer goods satisfy our wants directly, any movement toward E looks tempting. In producing more pizzas, society increases the satisfaction of its current wants. But there is a cost: More pizzas mean fewer industrial ro- bots. This shift of resources to consumer goods catches up with society over time because the stock of capital goods expands more slowly, thereby reducing potential future production. By moving toward alternative E, society chooses “more now” at the expense of “much more later.” By moving toward A, society chooses to forgo current consumption, thereby freeing up resources that can be used to increase the production of capital goods. By building up

goods and services. Included are all factory, storage, trans- portation, and distribution facilities, as well as tools and machinery. Economists use the term investment to de- scribe spending that pays for the production and accumu- lation of capital goods. Capital goods differ from consumer goods because con- sumer goods satisfy wants directly, whereas capital goods do so indirectly by aiding the production of consumer goods. For example, large commercial baking ovens (capital goods) help make loaves of bread (consumer goods). Note that the term “capital” as used by economists refers not to money but to tools, machinery, and other productive equipment. Because money produces nothing, economists do not in- clude it as an economic resource. Money (or money capital or financial capital) is simply a means for purchasing goods and services, including capital goods.

Entrepreneurial Ability Finally, there is the special human resource, distinct from labor, called entrepre- neurial ability. It is supplied by entrepreneurs, who perform several critically important economic functions:

• The entrepreneur takes the initiative in combining the resources of land, labor, and capital to produce a good or a service. Both a sparkplug and a catalyst, the entrepreneur is the driving force behind production and the agent who combines the other resources in what is hoped will be a successful business venture.

• The entrepreneur makes the strategic business decisions that set the course of an enterprise.

• The entrepreneur innovates. He or she commercializes new products, new production techniques, or even new forms of business organization.

• The entrepreneur bears risk. Innovation is risky, as nearly all new products and ideas are subject to the possibility of failure as well as success. Progress would cease without entrepreneurs who are willing to take on risk by devoting their time, effort, and ability—as well as their own money and the money of others—to commercializing new products and ideas that may enhance society’s standard of living.

Because land, labor, capital, and entrepreneurial ability are combined to produce goods and services, they are called the factors of production, or simply “inputs.”

Production Possibilities Model LO1.6 Apply production possibilities analysis, increasing opportunity costs, and economic growth. Society uses its scarce resources to produce goods and services. The alternatives and choices it faces can best be

TABLE 1.1 Production Possibilities of Pizzas and Industrial Robots

Production Alternatives

Type of Product A B C D E

Pizzas (in hundred thousands) 0 1 2 3 4

Robots (in thousands) 10 9 7 4 0

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CHAPTER 1 Limits, Alternatives, and Choices 13

13

and services that society can produce in a fully employed economy, assuming a fixed availability of supplies of re- sources and fixed technology. We arbitrarily represent the economy’s output of capital goods (here, industrial ro- bots) on the vertical axis and the output of consumer goods (here, pizzas) on the horizontal axis, as shown in Figure 1.2 (Key Graph). Each point on the production possibilities curve repre- sents some maximum output of the two products. The curve is a “constraint” because it shows the limit of attain- able outputs. Points on the curve are attainable as long as the economy uses all its available resources. Points lying inside the curve are also attainable, but they reflect less total output and therefore are not as desirable as points on the curve. Points inside the curve imply that the economy could have more of both industrial robots and pizzas if it achieved full employment of its resources. Points lying

its stock of capital this way, society will have greater future production and, therefore, greater future consumption. By moving toward A, society is choosing “more later” at the cost of “less now.” Generalization: At any point in time, a fully employed economy must sacrifice some of one good to obtain more of another good. Scarce resources prohibit a fully em- ployed economy from having more of both goods. Society must choose among alternatives. There is no such thing as a free pizza, or a free industrial robot. Having more of one thing means having less of something else.

Production Possibilities Curve

The data presented in a production possibilities table are shown graphically as a production possibilities curve. Such a curve displays the different combinations of goods

KEY GRAPH

QUICK QUIZ FOR FIGURE 1.2

1. Production possibilities curve ABCDE is bowed out from the origin because:

a. the marginal benefit of pizzas declines as more pizzas are consumed.

b. the curve gets steeper as we move from E to A. c. it reflects the law of increasing opportunity costs. d. resources are scarce.

2. The marginal opportunity cost of the second unit of pizza is: a. 2 units of robots. b. 3 units of robots. c. 7 units of robots. d. 9 units of robots.

3. The total opportunity cost of 7 units of robots is: a. 1 unit of pizza. b. 2 units of pizza. c. 3 units of pizza. d. 4 units of pizza.

4. All points on this production possibilities curve necessarily represent: a. society’s optimal choice. b. less than full use of resources. c. unattainable levels of output. d. full employment.

FIGURE 1.2 The production possibilities curve. Each point on the production possibilities curve represents some maximum combination of two products that can be produced if resources are fully employed. When an economy is operating on the curve, more industrial robots means fewer pizzas, and vice versa. Limited resources and a fixed technology make any combination of industrial robots and pizzas lying outside the curve (such as at W ) unattainable. Points inside the curve are attainable, but they indicate that full employment is not being realized.

Answers: 1. c; 2. a; 3. b; 4. d

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Q

Q 0 1 2 3 4 5 6 7 8 9

In d u st

ri al

r o

b o

ts (

th o

u sa

n d s)

Pizzas (hundred thousands)

B

A

C

D

E

W

Unattainable

Attainable

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production of robots, it must use land that is less and less suited to making their components. If we start at A and move to B in Figure 1.2, we can shift resources whose productivity is relatively high in pizza pro- duction and low in industrial robots. But as we move from B to C, C to D, and so on, re- sources highly productive in pizzas become increas- ingly scarce. To get more pizzas, resources whose productivity in industrial robots is relatively great will be needed. Increasingly more of such resources, and hence greater sacrifices of industrial robots, will be needed to achieve each 1-unit increase in pizzas. This lack of perfect flexibility, or interchangeability, on the part of resources is the cause of increasing opportunity costs for society.

Optimal Allocation

Of all the attainable combinations of pizzas and industrial robots on the curve in Figure 1.2, which is optimal (best)? That is, what specific quantities of resources should be al- located to pizzas and what specific quantities should be al- located to industrial robots in order to maximize satisfaction? Recall that economic decisions center on comparisons of marginal benefit (MB) and marginal cost (MC). Any eco- nomic activity should be expanded as long as marginal ben- efit exceeds marginal cost and should be reduced if marginal cost exceeds marginal benefit. The optimal amount of the activity occurs where MB 5 MC. Society needs to make a similar assessment about its production decision. Consider pizzas. We already know from the law of in- creasing opportunity costs that the marginal cost of addi- tional units of pizza will rise as more units are produced. At the same time, we need to recognize that the extra or mar- ginal benefits that come from producing and consuming pizza decline with each successive unit of pizza. Consequently, each successive unit of pizza brings with it both increasing marginal costs and decreasing marginal benefits. The optimal quantity of pizza production is indicated by point e at the intersection of the MB and MC curves: 200,000 units in Figure 1.3. Why is this amount the opti- mal quantity? If only 100,000 units of pizzas were pro- duced, the marginal benefit of an extra unit of pizza (point a) would exceed its marginal cost (point b). In money terms, MB is $15, while MC is only $5. When society gains some- thing worth $15 at a marginal cost of only $5, it is better off. In Figure 1.3, net gains can continue to be realized un- til pizza-product production has been increased to 200,000.

beyond the production possibilities curve, like W, would represent a greater output than the output at any point on the curve. Such points, however, are unattainable with the current availability of resources and technology.

Law of Increasing Opportunity Costs

Figure 1.2 clearly shows that more pizzas mean fewer in- dustrial robots. The number of units of industrial robots that must be given up to obtain another unit of pizzas, of course, is the opportunity cost of that unit of pizzas. In moving from alternative A to alternative B in Table 1.1, the cost of 1 additional unit of pizzas is 1 fewer unit of industrial robots. But when additional units are considered—B to C, C to D, and D to E—an important economic principle is revealed: For society, the opportu- nity cost of each additional unit of pizzas is greater than the opportunity cost of the preceding one. When we move from A to B, just 1 unit of industrial robots is sacrificed for 1 more unit of pizzas; but in going from B to C we sacri- fice 2 additional units of industrial robots for 1 more unit of pizzas; then 3 more of industrial robots for 1 more of pizzas; and finally 4 for 1. Conversely, confirm that as we move from E to A, the cost of an additional unit of indus- trial robots (on average) is 14,

1 3,

1 2, and 1 unit of pizzas,

respectively, for the four successive moves. Our example illustrates the law of increasing opportu- nity costs. As the production of a particular good increases, the opportunity cost of producing an additional unit rises.

Shape of the Curve The law of increasing opportu- nity costs is reflected in the shape of the production pos- sibilities curve: The curve is bowed out from the origin of the graph. Figure 1.2 shows that when the economy moves from A to E, it must give up successively larger amounts of industrial robots (1, 2, 3, and 4) to acquire equal increments of pizzas (1, 1, 1, and 1). This is shown in the slope of the production possibilities curve, which becomes steeper as we move from A to E.

Economic Rationale The law of increasing opportu- nity costs is driven by the fact that economic resources are not completely adaptable to alternative uses. Many re- sources are better at producing one type of good than at producing others. Consider land. Some land is highly suited to growing the ingredients necessary for pizza pro- duction. But as pizza production expands, society has to start using land that is less bountiful for farming. Other land is rich in mineral deposits and therefore well-suited to producing the materials needed to make industrial robots. That land will be the first land devoted to the production of industrial robots. But as society steps up the

PART ONE Introduction to Economics and the Economy14

W1.2

Production possibilities

WORKED PROBLEMS

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CHAPTER 1 Limits, Alternatives, and Choices 15

In contrast, the production of 300,000 units of pizzas is excessive. There the MC of an added unit is $15 (point c) and its MB is only $5 (point d ). This means that 1 unit of pizza is worth only $5 to society but costs it $15 to obtain. This is a losing proposition for society! So resources are being efficiently allocated to any product when the marginal benefit and marginal cost of its output are equal (MB 5 MC). Suppose that by applying the same analysis to industrial robots, we find that the op- timal (MB 5 MC) quantity of robots is 7,000. This would mean that alternative C (200,000 units of pizzas and 7,000 units of industrial robots) on the production possibilities curve in Figure 1.2 would be optimal for this economy.

$15

10

5

0 100,000 200,000 300,000

M ar

gi n al

b en

efi t

an d

m ar

gi n al

c o

st

Quantity of pizza

MB

MC

MB = MC

a

db

c

e

FIGURE 1.3 Optimal output: MB 5 MC. Achieving the optimal output requires the expansion of a good’s output until its marginal benefit (MB) and marginal cost (MC) are equal. No resources beyond that point should be allocated to the product. Here, optimal output occurs at point e, where 200,000 units of pizzas are produced.

CONSIDER THIS . . .

The Economics of War

Production possibili- ties analysis is helpful in assessing the costs and benefits of wag- ing the broad war on terrorism, includ- ing the wars in

Afghanistan and Iraq. At the end of 2011, the estimated cost of these efforts exceeded $1.4 trillion. If we categorize all U.S. production as either “defense goods” or “civilian goods,” we can measure them on the axes of a production possibilities diagram such as that shown in Figure 1.2. The opportunity cost of using more resources for defense goods is the civilian goods sacrificed. In a fully em- ployed economy, more defense goods are achieved at the opportunity cost of fewer civilian goods—health care, edu- cation, pollution control, personal computers, houses, and so on. The cost of war and defense is the other goods for- gone. The benefits of these activities are numerous and di- verse but clearly include the gains from protecting against future loss of American lives, assets, income, and well-being. Society must assess the marginal benefit (MB) and mar- ginal cost (MC) of additional defense goods to determine their optimal amounts—where to locate on the defense goods–civilian goods production possibilities curve. Although estimating marginal benefits and marginal costs is an impre- cise art, the MB-MC framework is a useful way of approaching choices. An optimal allocation of resources requires that soci- ety expand production of defense goods until MB 5 MC. The events of September 11, 2001, and the future threats they foreshadowed increased the marginal benefits of de- fense goods, as perceived by Americans. If we label the hori- zontal axis in Figure 1.3 “defense goods” and draw in a rightward shift of the MB curve, you will see that the optimal quantity of defense goods rises. In view of the concerns relat- ing to September 11, the United States allocated more of its resources to defense. But the MB-MC analysis also reminds us we can spend too much on defense, as well as too little. The United States should not expand defense goods beyond the point where MB 5 MC. If it does, it will be sacrificing civilian goods of greater value than the defense goods obtained.

Unemployment, Growth, and the Future LO1.7 Explain how economic growth and international trade increase consumption possibilities. In the depths of the Great Depression of the 1930s, one- quarter of U.S. workers were unemployed and one-third of

QUICK REVIEW 1.3

• Economists categorize economic resources as land, labor, capital, and entrepreneurial ability.

• The production possibilities curve illustrates several ideas: (a) scarcity of resources is implied by the area of unattainable combinations of output lying outside the production possibilities curve; (b) choice among out- puts is reflected in the variety of attainable combina- tions of goods lying along the curve; (c) opportunity cost is illustrated by the downward slope of the curve; (d) the law of increasing opportunity costs is reflected in the bowed-outward shape of the curve.

• A comparison of marginal benefits and marginal costs is needed to determine the best or optimal output mix on a production possibilities curve.

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PART ONE Introduction to Economics and the Economy16

A Growing Economy

When we drop the assumptions that the quantity and quality of resources and technology are fixed, the produc- tion possibilities curve shifts positions and the potential maximum output of the economy changes.

Increases in Resource Supplies Although resource supplies are fixed at any specific moment, they change over time. For example, a nation’s growing population brings about increases in the supplies of labor and entre- preneurial ability. Also, labor quality usually improves over time via more education and training. Historically, the economy’s stock of capital has increased at a signifi- cant, though unsteady, rate. And although some of our energy and mineral resources are being depleted, new sources are also being discovered. The development of irrigation systems, for example, adds to the supply of arable land. The net result of these increased supplies of the factors of production is the ability to produce more of both con- sumer goods and capital goods. Thus, 20 years from now, the production possibilities may supersede those shown in Table 1.1. The new production possibilities might look like those in the table in Figure 1.5. The greater abun- dance of resources will result in a greater potential output of one or both products at each alternative. The economy will have achieved economic growth in the form of ex- panded potential output. Thus, when an increase in the quantity or quality of resources occurs, the production possibilities curve shifts outward and to the right, as illus- trated by the move from the inner curve to curve A9B9C9D9E9 in Figure 1.5. This sort of shift represents growth of economic capacity, which, when used, means economic growth: a larger total output.

Advances in Technology An advancing technology brings both new and better goods and improved ways of producing them. For now, let’s think of technological advance as being only improvements in the methods of production, for example, the introduction of computer- ized systems to manage inventories and schedule pro- duction. These advances alter our previous discussion of the economizing problem by allowing society to pro- duce more goods with available resources. As with in- creases in resource supplies, technological advances make possible the production of more industrial robots and more pizzas. A real-world example of improved technology is the recent surge of new technologies relating to computers, communications, and biotechnology. Technological ad- vances have dropped the prices of computers and greatly

U.S. production capacity was idle. Subsequent downturns have been much less severe. During the deep 2007–2009 recession, for instance, production fell by a comparably smaller 3.7 percent and 1-in-10 workers was without a job. Almost all nations have experienced widespread unem- ployment and unused production capacity from business downturns at one time or another. Since 2000, for exam- ple, many nations—including Argentina, Japan, Mexico, Germany, and South Korea—have had economic down- turns and unemployment. How do these realities relate to the production possi- bilities model? Our analysis and conclusions change if we relax the assumption that all available resources are fully employed. The five alternatives in Table 1.1 represent maximum outputs; they illustrate the combinations of piz- zas and industrial robots that can be produced when the economy is operating at full employment. With unem- ployment, this economy would produce less than each alternative shown in the table. Graphically, we represent situations of unemployment by points inside the original production possibilities curve (reproduced here in Figure 1.4). Point U is one such point. Here the economy is falling short of the various maximum combinations of pizzas and industrial robots represented by the points on the production possibilities curve. The arrows in Figure 1.4 indicate three possible paths back to full employment. A move toward full employment would yield a greater output of one or both products.

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Q 0 1 2 3 4 5 6 7 8 9

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U

FIGURE 1.4 Unemployment and the production possibilities curve. Any point inside the production possibilities curve, such as U, represents unemployment or a failure to achieve full employment. The arrows indicate that by realizing full employment, the economy could operate on the curve. This means it could produce more of one or both products than it is producing at point U.

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CHAPTER 1 Limits, Alternatives, and Choices 17

increased their speed. Improved software has greatly in- creased the everyday usefulness of computers. Cellular phones and the Internet have increased communications capacity, enhancing production and improving the effi- ciency of markets. Advances in biotechnology have re- sulted in important agricultural and medical discoveries. These and other new and improved technologies have contributed to U.S. economic growth (outward shifts of the nation’s production possibilities curve). Conclusion: Economic growth is the result of (1) in- creases in supplies of resources, (2) improvements in re- source quality, and (3) technological advances. The consequence of growth is that a full-employment econ- omy can enjoy a greater output of both consumption goods and capital goods. Whereas static, no-growth econ- omies must sacrifice some of one good to obtain more of another, dynamic, growing economies can have larger quantities of both goods.

FIGURE 1.5 Economic growth and the production possibilities curve. The increase in supplies of resources, improvements in resource quality, and technological advances that occur in a dynamic economy move the production possibilities curve outward and to the right, allowing the economy to have larger quantities of both types of goods.

0

R o

b o

ts (

th o

u sa

n d s)

Pizzas (hundred thousands)

1 2 3 4 5 6 7 8 9

1

2

3

4

5

6

7

8

9

10

11

12

13

14

Q

Q

A9

B9

C9

D9

E9

Production Alternatives

Type of Product A9 B9 C9 D9 E9

Pizzas (in hundred thousands) 0 2 4 6 8

Robots (in thousands) 14 12 9 5 0

Present Choices and Future Possibilities

An economy’s current choice of positions on its production possibilities curve helps determine the future location of that curve. Let’s designate the two axes of the production possibilities curve as “goods for the future” and “goods for the present,” as in Figure 1.6. Goods for the future are such

(a) Presentville

G o

o d s

fo r

th e

fu tu

re

Goods for the present0

Current curve

Future curve

P

(b) Futureville

G o

o d s

fo r

th e

fu tu

re

Goods for the present0

Future curve

Current curve

F

FIGURE 1.6 Present choices and future locations of production possibilities curves. (a) Presentville’s current choice to produce more “present goods” and fewer “future goods,” as represented by point P, will result in a modest outward shift of the production possibilities curve in the future. (b) Futureville’s current choice of producing fewer “present goods” and more “future goods,” as depicted by point F, will lead to a greater outward shift of the production possibilities curve in the future.

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Pitfalls to Sound Economic Reasoning

Here are some common pitfalls to avoid in successfully applying the economic perspective.

Biases Most people bring a bundle of biases and preconcep- tions to the field of economics. For example, some might think that corporate profits are excessive or that lending money is al- ways superior to borrowing money. Others might believe that government is necessarily less efficient than businesses or that more government regulation is always better than less. Biases cloud thinking and interfere with objective analysis. All of us must be willing to shed biases and preconceptions that are not supported by facts.

Loaded Terminology The economic terminology used in newspapers and broadcast media is sometimes emotionally bi- ased, or loaded. The writer or spokesperson may have a cause to promote or an ax to grind and may slant comments accord- ingly. High profits may be labeled “obscene,” low wages may be called “exploitative,” or self-interested behavior may be “greed.” Government workers may be referred to as “mindless bureaucrats” and those favoring stronger government regula- tions may be called “socialists.” To objectively analyze eco- nomic issues, you must be prepared to reject or discount such terminology.

Fallacy of Composition Another pitfall in economic think- ing is the assumption that what is true for one individual or part of a whole is necessarily true for a group of individuals or the whole. This is a logical fallacy called the fallacy of composition; the assumption is not correct. A statement that is valid for an indi- vidual or part is not necessarily valid for the larger group or whole. Noneconomic example: You may see the action better if

Because They Affect Us So Personally, We Often Have Difficulty Thinking Accurately

and Objectively About Economic Issues.

LAST WORD

18

for goods for the present, at the expense of less goods for the future. Futureville, in contrast, makes a current choice that stresses larger amounts of future goods and smaller amounts of present goods, as shown by point F in Figure 1.6b. Now, other things equal, we can expect Futureville’s future production possibilities curve to be farther to the right than Presentville’s future production possibilities curve. By currently choosing an output more favorable to technological advances and to increases in the quantity and quality of resources, Futureville will achieve greater economic growth than Presentville. In terms of capital goods, Futureville is choosing to make larger current additions to its “national factory” by devoting more of its  current output to capital than does Presentville. The

things as capital goods, research and education, and pre- ventive medicine. They increase the quantity and quality of property resources, enlarge the stock of technological in- formation, and improve the quality of human resources. As we have already seen, goods for the future such as capital goods are the ingredients of economic growth. Goods for the present are consumer goods such as food, clothing, and entertainment. Now suppose there are two hypothetical economies, Presentville and Futureville, that are initially identical in every respect except one: Presentville’s current choice of positions on its production possibilities curve strongly favors present goods over future goods. Point P in Figure 1.6a indicates that choice. It is located quite far down the curve to the right, indicating a high priority

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CHAPTER 1 Limits, Alternatives, and Choices 19

19

you leap to your feet to see an outstanding play at a football game. But if all the spectators leap to their feet at the same time, nobody—including you—will have a better view than when all remained seated. Here are two economic examples: An individual stock- holder can sell shares of, say, Google stock without affecting the price of the stock. The individual’s sale will not noticeably reduce the share price because the sale is a negligible fraction of the total shares of Google being bought and sold. But if all the Google shareholders decide to sell their shares the same day, the market will be flooded with shares and the stock price will fall precipitously. Similarly, a single cattle ranch can in- crease its revenue by expanding the size of its livestock herd. The extra cattle will not affect the price of cattle when they are brought to market. But if all ranchers as a group expand their herds, the total output of cattle will increase so much that the price of cattle will decline when the cattle are sold. If the price reduction is relatively large, ranchers as a group might find that their income has fallen despite their having sold a greater number of cattle because the fall in price overwhelms the in- crease in quantity.

Post Hoc Fallacy You must think very carefully before con- cluding that because event A precedes event B, A is the cause of B. This kind of faulty reasoning is known as the post hoc, ergo propter hoc, or “after this, therefore because of this,” fallacy. Noneconomic example: A professional football team hires a new coach and the team’s record improves. Is the new coach the cause? Maybe. Perhaps the presence of more experienced and talented players or an easier schedule is the true cause. The rooster crows before dawn but does not cause the sunrise.

Economic example: Many people blamed the Great Depression of the 1930s on the stock market crash of 1929. But the crash did not cause the Great Depression. The same severe weaknesses in the economy that caused the crash caused the Great Depression. The depression would have occurred even without the preceding stock market crash.

Correlation but Not Causation Do not confuse correla- tion, or connection, with causation. Correlation between two events or two sets of data indicates only that they are associated in some systematic and dependable way. For example, we may find that when variable X increases, Y also increases. But this cor- relation does not necessarily mean that there is causation—that increases in X cause increases in Y. The relationship could be purely coincidental or dependent on some other factor, Z, not included in the analysis. Here is an example: Economists have found a positive cor- relation between education and income. In general, people with more education earn higher incomes than those with less educa- tion. Common sense suggests education is the cause and higher incomes are the effect; more education implies a more knowl- edgeable and productive worker, and such workers receive larger salaries. But might the relationship be explainable in other ways? Are education and income correlated because the characteris- tics required for succeeding in education—ability and moti- vation—are the same ones required to be a productive and highly paid worker? If so, then people with those traits will probably both obtain more education and earn higher in- comes. But greater education will not be the sole cause of the higher income.

payoff from this choice for Futureville is greater future production capacity and economic growth. The opportu- nity cost is fewer consumer goods in the present for Futureville to enjoy. Is Futureville’s choice thus necessarily “better” than Presentville’s? That, we cannot say. The different out- comes simply reflect different preferences and priorities in the two countries. But each country will have to live with the economic consequences of its choice.

A Qualification: International Trade

Production possibilities analysis implies that an individual nation is limited to the combinations of output indicated by its production possibilities curve. But we must modify this principle when international specialization and trade exist.

You will see in later chapters that an economy can circumvent, through international specialization and trade, the output limits imposed by its domestic produc- tion possibilities curve. Under international specializa- tion and trade, each nation first specializes in the production of those items for which it has the lowest opportunity costs (due to an abundance of the neces- sary resources). Countries then engage in international trade, with each country exchanging the items that it can  produce at the lowest opportunity costs for the items that other countries can produce at the lowest opportunity costs. International specialization and trade allow a nation to get more of a desired good at less sacrifice of some other good. Rather than sacrifice three units of domestically

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PART ONE Introduction to Economics and the Economy20

produced robots to get a third unit of domestically pro- duced pizza, as in Table 1.1, a nation that engages in in- ternational specialization and trade might be able to do much better. If it specializes in robots while another country specializes in pizza, then it may be able to obtain the third unit of pizza by trading only two units of domestically produced robots for one unit of foreign- produced pizza. Specialization and trade have the same effect as having more and better resources or discovering improved production techniques; both increase the quantities of capital and consumer goods available to so- ciety. Expansion of domestic production possibilities and international trade are two separate routes for obtaining greater output.

SUMMARY wants exceed the available resources necessary to fulfill them. Society therefore must decide what to produce and what to forgo.

Graphically, a budget line (or budget constraint) illustrates the economizing problem for individuals. The line shows the various combinations of two products that a consumer can purchase with a specific money income, given the prices of the two products.

LO1.5 List the categories of scarce resources and delineate the nature of society’s economizing

problem.

Economic resources are inputs into the production process and can be classified as land, labor, capital, or entrepreneurial ability. Economic resources are also known as factors of production or inputs.

Economists illustrate society’s economizing problem through production possibilities analysis. Production possibilities tables and curves show the different combinations of goods and services that can be produced in a fully employed economy, assuming that resource quantity, resource quality, and technology are fixed.

LO1.6 Apply production possibilities analysis, increasing opportunity costs, and economic growth.

An economy that is fully employed and thus operating on its production possibilities curve must sacrifice the output of some types of goods and services to increase the production of others. The gain of one type of good or service is always accompanied by an opportunity cost in the form of the loss of some of the other type of good or service.

Because resources are not equally productive in all possible uses, shifting resources from one use to another creates increasing opportunity costs. The production of additional units of one product requires the sacrifice of increasing amounts of the other product.

LO1.1 Define economics and the features of the economic perspective.

Economics is the social science that examines how individuals, in- stitutions, and society make optimal choices under conditions of scarcity. Central to economics is the idea of opportunity cost: the value of the next-best good or service forgone to obtain something.

The economic perspective includes three elements: scarcity and choice, purposeful behavior, and marginal analysis. It sees individuals and institutions making rational decisions based on comparisons of marginal costs and marginal benefits.

LO1.2 Describe the role of economic theory in economics.

Economists employ the scientific method, in which they form and test hypotheses of cause-and-effect relationships to generate theories, laws, and principles. Economists often combine theo- ries into representations called models.

LO1.3 Distinguish microeconomics from macroeconomics and positive economics from

normative economics.

Microeconomics examines the decision making of specific eco- nomic units or institutions. Macroeconomics looks at the econ- omy as a whole or its major aggregates.

Positive economic analysis deals with facts; normative eco- nomics reflects value judgments.

LO1.4 Explain the individual’s economizing problem and how trade-offs, opportunity costs, and attainable

combinations can be illustrated with budget lines.

Individuals face an economizing problem. Because their wants ex- ceed their incomes, they must decide what to purchase and what to forgo. Society also faces an economizing problem. Societal

QUICK REVIEW 1.4

• Unemployment causes an economy to operate at a point inside its production possibilities curve.

• Increases in resource supplies, improvements in re- source quality, and technological advance cause eco- nomic growth, which is depicted as an outward shift of the production possibilities curve.

• An economy’s present choice of capital and consumer goods helps determine the future location of its pro- duction possibilities curve.

• International specialization and trade enable a nation to obtain more goods than its production possibilities curve indicates.

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CHAPTER 1 Limits, Alternatives, and Choices 21

all goods and services, that is, to experience economic growth. Society’s choice as to the mix of consumer goods and capital goods in current output is a major determinant of the future lo- cation of the production possibilities curve and thus of the extent of economic growth.

International trade enables a nation to obtain more goods from its limited resources than its production possibilities curve indicates.

The optimal (best) point on the production possibilities curve represents the most desirable mix of goods and is determined by expanding the production of each good until its marginal benefit (MB) equals its marginal cost (MC).

LO1.7 Explain how economic growth and international trade increase consumption possibilities.

Over time, technological advances and increases in the quantity and quality of resources enable the economy to produce more of

TERMS AND CONCEPTS economics economic perspective scarcity opportunity cost utility marginal analysis scientific method economic principle other-things-equal assumption microeconomics

macroeconomics aggregate positive economics normative economics economizing problem budget line economic resources land labor capital

investment entrepreneurial ability entrepreneurs factors of production consumer goods capital goods production possibilities curve law of increasing

opportunity costs economic growth

D I S C U S S I O N Q U E S T I O N S

1. What is an opportunity cost? How does the idea relate to the definition of economics? Which of the following deci- sions would entail the greater opportunity cost: Allocating a square block in the heart of New York City for a surface parking lot or allocating a square block at the edge of a typ- ical suburb for such a lot? Explain. LO1.1

2. Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal cost and marginal benefit. LO1.1

3. What is meant by the term “utility” and how does the idea relate to purposeful behavior? LO1.1

4. What are the key elements of the scientific method and how  does this method relate to economic principles and laws? LO1.2

5. State (a) a positive economic statement of your choice, and then (b) a normative economic statement relating to your first statement. LO1.3

6. How does the slope of a budget line illustrate opportunity costs and trade-offs? How does a budget line illustrate scar- city and the effect of limited incomes? LO1.4

7. What are economic resources? What categories do eco- nomists use to classify them? Why are resources also called factors of production? Why are they called inputs? LO1.5

8. Why is money not considered to be a capital resource in economics? Why is entrepreneurial ability considered a category of economic resource, distinct from labor? What are the major functions of the entrepreneur? LO1.5

9. Specify and explain the typical shapes of marginal-benefit and marginal-cost curves. How are these curves used to de- termine the optimal allocation of resources to a particular product? If current output is such that marginal cost ex- ceeds marginal benefit, should more or fewer resources be allocated to this product? Explain. LO1.6

10. Suppose that, on the basis of a nation’s production possibili- ties curve, an economy must sacrifice 10,000 pizzas domesti- cally to get the 1 additional industrial robot it desires but that it can get the robot from another country in exchange for 9,000 pizzas. Relate this information to the following state- ment: “Through international specialization and trade, a na- tion can reduce its opportunity cost of obtaining goods and thus ‘move outside its production possibilities curve.’” LO1.7

11. LAST WORD Studies indicate that married men on aver- age earn more income than unmarried men of the same age and education level. Why must we be cautious in con- cluding that marriage is the cause and higher income is the effect?

The following and additional problems can be found in

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PART ONE Introduction to Economics and the Economy22

R E V I E W Q U E S T I O N S

1. Match each term with the correct definition. LO1.1 economics opportunity cost marginal analysis utility a. The next-best thing that must be forgone in order to

produce one more unit of a given product. b. The pleasure, happiness, or satisfaction obtained from

consuming a good or service. c. The social science concerned with how individuals, insti-

tutions, and society make optimal (best) choices under conditions of scarcity.

d. Making choices based on comparing marginal benefits with marginal costs.

2. Indicate whether each of the following statements applies to microeconomics or macroeconomics: LO1.3

a. The unemployment rate in the United States was 8.1 percent in August 2012.

b. A U.S. software firm discharged 15 workers last month and transferred the work to India.

c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise.

d. U.S. output, adjusted for inflation, decreased by 2.4 percent in 2009.

e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1 percentage point.

f. The consumer price index rose by 3.8 percent from August 2011 to August 2012.

3. Suppose that you initially have $100 to spend on books or  movie tickets. The books start off costing $25 each and the movie tickets start off costing $10 each. For each of the following situations, would the attainable set of  combinations that you can afford increase or decrease? LO1.4

a. Your budget increases from $100 to $150 while the prices stay the same.

b. Your budget remains $100, the price of books remains $25, but the price of movie tickets rises to $20.

c. Your budget remains $100, the price of movie tickets re- mains $10, but the price of a book falls to $15.

4. Suppose that you are given a $100 budget at work that can be spent only on two items: staplers and pens. If staplers cost $10 each and pens cost $2.50 each, then the opportu- nity cost of purchasing one stapler is: LO1.4

a. 10 pens. b. 5 pens. c. zero pens. d. 4 pens. 5. For each of the following situations involving marginal cost

(MC) and marginal benefit (MB), indicate whether it would be best to produce more, fewer, or the current number of units. LO1.4

a. 3,000 units at which MC 5 $10 and MB 5 $13. b. 11 units at which MC 5 $4 and MB 5 $3. c. 43,277 units at which MC 5 $99 and MB 5 $99. d. 82 units at which MC , MB. e. 5 units at which MB , MC. 6. Explain how (if at all) each of the following events affects the

location of a country’s production possibilities curve: LO1.6 a. The quality of education increases. b. The number of unemployed workers increases. c. A new technique improves the efficiency of extracting

copper from ore. d. A devastating earthquake destroys numerous production

facilities. 7. What are the two major ways in which an economy can grow

and push out its production possibilities curve? LO1.7 a. Better weather and nicer cars. b. Higher taxes and lower spending. c. Increases in resource supplies and advances in technology. d. Decreases in scarcity and advances in auditing.

P R O B L E M S

1. Potatoes cost Janice $1 per pound, and she has $5.00 that she could possibly spend on potatoes or other items. If she feels that the first pound of potatoes is worth $1.50, the sec- ond pound is worth $1.14, the third pound is worth $1.05, and all subsequent pounds are worth $0.30, how many pounds of potatoes will she purchase? What if she only had $2 to spend? LO1.1

2. Pham can work as many or as few hours as she wants at the college bookstore for $9 per hour. But due to her hectic schedule, she has just 15 hours per week that she can spend working at either the bookstore or other potential jobs. One potential job, at a café, will pay her $12 per hour for up to 6 hours per week. She has another job offer at a ga- rage that will pay her $10 an hour for up to 5 hours per

week. And she has a potential job at a daycare center that will pay her $8.50 per hour for as many hours as she can work. If her goal is to maximize the amount of money she can make each week, how many hours will she work at the bookstore? LO1.1

3. Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts. Candy bars cost $0.75 each while bags of peanuts cost $1.50 each. LO1.5

a. Construct a table showing the alternative combinations of the two products that are available.

b. Plot the data in your table as a budget line in a graph. What is the slope of the budget line? What is the oppor- tunity cost of one more candy bar? Of one more bag of

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CHAPTER 1 Limits, Alternatives, and Choices 23

peanuts? Do these opportunity costs rise, fall, or remain constant as additional units are purchased?

c. Does the budget line tell you which of the available com- binations of candy bars and bags of peanuts to buy?

d. Suppose that you had won $30 on your ticket, not $15.  Show the $30 budget line in your diagram. Has the number of available combinations increased or decreased?

4. Suppose that you are on a desert island and possess exactly 20 coconuts. Your neighbor, Friday, is a fisherman, and he is willing to trade 2 fish for every 1 coconut that you are willing to give him. Another neighbor, Kwame, is also a fisherman, and he is willing to trade 3 fish for every 1 coconut. LO1.5

a. On a single figure, draw budget lines for trading with Friday and for trading with Kwame. (Put coconuts on the vertical axis.)

b. What is the slope of the budget line from trading with Friday?

c. What is the slope of the budget line from trading with Kwame?

d. Which budget line features a larger set of attainable combinations of coconuts and fish?

e. If you are going to trade coconuts for fish, would you rather trade with Friday or Kwame?

5. To the right is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts): LO1.6

a. Show these data graphically. Upon what specific assump- tions is this production possibilities curve based?

b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift? Which charac- teristic of the production possibilities curve reflects the law of increasing opportunity costs: its shape or its length?

c. If the economy characterized by this production possi- bilities table and curve were producing 3 automobiles and 20 forklifts, what could you conclude about its use of its available resources?

d. Is production at a point outside the production possibili- ties curve currently possible? Could a future advance in technology allow production beyond the current pro- duction possibilities curve? Could international trade al- low a country to consume beyond its current production possibilities curve?

Production Alternatives

Type of Production A B C D E

Automobiles 0 2 4 6 8

Forklifts 30 27 21 12 0

6. Look at Figure 1.3. Suppose that the cost of cheese falls, so that the marginal cost of producing pizza decreases. Will the MC curve shift up or down? Will the optimal amount of pizza increase or decrease? LO1.6

7. Referring to the table in problem 5, suppose improvement occurs in the technology of producing forklifts but not in the technology of producing automobiles. Draw the new produc- tion possibilities curve. Now assume that a technological ad- vance occurs in producing automobiles but not in producing forklifts. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technologi- cal improvement in the production of both goods. LO1.7

8. Because investment and capital goods are paid for with sav- ings, higher savings rates reflect a decision to consume fewer goods for the present in order to be able to invest in more goods for the future. Households in China save 40 percent of their annual incomes each year, whereas U.S. households save less than 5 percent. At the same time, production possi- bilities are growing at roughly 9 percent per year in China but only about 3.5 percent per year in the United States. Use graphical analysis of “present goods” versus “future goods” to explain the difference between China’s growth rate and the U.S. growth rate. LO1.7

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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CHAPTER ONE APPENDIX24

LO1.8 Understand graphs, curves, and slopes as they relate to economics. If you glance quickly through this text, you will find many graphs. Some seem simple, while others seem more formi- dable. All are included to help you visualize and understand economic relationships. Physicists and chemists sometimes illustrate their theories by building arrangements of multi- colored wooden balls, representing protons, neutrons, and electrons, that are held in proper relation to one another by wires or sticks. Economists most often use graphs to il- lustrate their models. By understanding these “pictures,” you can more readily comprehend economic relationships.

Construction of a Graph

A graph is a visual representation of the relationship between two economic quantities, or variables. The table in Figure 1 is a hypothetical illustration showing the rela- tionship between income and consumption for the econ- omy as a whole. Without even studying economics, we would logically expect that people would buy more goods and services when their incomes go up. Thus, it is not sur- prising to find in the table that total consumption in the economy increases as total income increases. The information in the table is expressed graphically in Figure 1. Here is how it is done: We want to show visu- ally how consumption changes as income changes. We therefore represent income on the horizontal axis of the graph and consumption on the vertical axis. Now we arrange the vertical and horizontal scales of the graph to reflect the ranges of values of consumption and

income and mark the scales in convenient increments. As you can see, the values marked on the scales cover all the values in the table. The increments on both scales are $100. Because the graph has two dimensions, each point within it represents an income value and its associated consumption value. To find a point that represents one of the five income-consumption combinations in the table in Figure 1, we draw straight lines from the appropriate val- ues on the vertical and horizontal axes. For example, to plot point c (the $200 income–$150 consumption point), we draw straight lines up from the horizontal (income) axis at $200 and across from the vertical (consumption) axis at $150. These lines intersect at point c, which repre- sents this particular income- consumption combination. You should verify that the other income-consumption combinations shown in the table are properly located in the graph in Figure 1. Finally, by assuming that the same general relationship between income and consumption prevails for all other incomes, we draw a line or smooth curve to connect these points. That line or curve repre- sents the income-consumption relationship. If the curve is a straight line, as in Figure 1, we say the relationship is linear. (It is permissible, and even custom- ary, to refer to straight lines in graphs as “curves.”)

Direct and Inverse Relationships

The line in Figure 1 slopes upward to the right, so it de- picts a direct relationship between income and consump- tion. By a direct relationship (or positive relationship) we mean that two variables—in this case, consumption and

Graphs and Their Meaning

Income Consumption

per Week per Week Point

$ 0 $ 50 a

100 100 b

200 150 c

300 200 d

400 250 e

0

C o

n su

m p ti

o n (

C )

100

$100 200 300 400

200

300

$400

Income (Y )

Consumption

a

b

c

d

eC = 50 + .5Y

FIGURE 1 Graphing the direct relationship between consumption and income. Two sets of data that are positively or directly related, such as consumption and income, graph as an upsloping line.

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25CHAPTER ONE APPENDIX

Ticket Attendance,

Price Thousands Point

$50 0 a

40 4 b

30 8 c

20 12 d

10 16 e

0 20 f

0

T ic

ke t

p ri

ce (

P)

10

4 8 12 16

20

30

40

Attendance in thousands (Q)

Ticket demand

a

b

c

d

e

f

P = 50 – 2.5Q

20

$50

FIGURE 2 Graphing the inverse relationship between ticket prices and game attendance. Two sets of data that are negatively or inversely related, such as ticket price and the attendance at basketball games, graph as a downsloping line.

income—change in the same direction. An increase in con- sumption is associated with an increase in income; a de- crease in consumption accompanies a decrease in income. When two sets of data are positively or directly related, they always graph as an upsloping line, as in Figure 1. In contrast, two sets of data may be inversely related. Consider the table in Figure 2, which shows the relation- ship between the price of basketball tickets and game at- tendance at Gigantic State University (GSU). Here we have an inverse relationship (or negative relationship) because the two variables change in opposite directions. When ticket prices decrease, attendance increases. When ticket prices increase, attendance decreases. The six data points in the table in Figure 2 are plotted in the graph. Observe that an inverse relationship always graphs as a downsloping line.

Dependent and Independent Variables

Although it is not always easy, economists seek to deter- mine which variable is the “cause” and which is the “ef- fect.” Or, more formally, they seek the independent variable and the dependent variable. The independent variable is the cause or source; it is the variable that changes first. The dependent variable is the effect or outcome; it is the variable that changes because of the change in the independent variable. As in our income- consumption example, income generally is the indepen- dent variable and consumption the dependent variable. Income causes consumption to be what it is rather than the other way around. Similarly, ticket prices (set in ad- vance of the season and printed on the ticket) determine attendance at GSU basketball games; attendance at games

does not determine the printed ticket prices for those games. Ticket price is the independent variable and the quantity of tickets purchased is the dependent variable. You may recall from your high school courses that mathematicians put the independent variable (cause) on the horizontal axis and the dependent variable (effect) on the vertical axis. Economists are less tidy; their graphing of independent and dependent variables is more arbitrary. Their conventional graphing of the income-consumption relationship is consistent with mathematical convention, but economists put price and cost data on the vertical axis. Hence, economists’ graphing of GSU’s ticket price– attendance data differs from normal mathematical proce- dure. This does not present a problem, but we want you to be aware of this fact to avoid any possible confusion.

Other Things Equal

Our simple two-variable graphs purposely ignore many other factors that might affect the amount of consumption occurring at each income level or the number of people who attend GSU basketball games at each possible ticket price. When economists plot the relationship between any two variables, they employ the ceteris paribus (other-things- equal) assumption. Thus, in Figure 1 all factors other than income that might affect the amount of consumption are presumed to be constant or unchanged. Similarly, in Figure 2 all factors other than ticket price that might influence at- tendance at GSU basketball games are assumed constant. In reality, “other things” are not equal; they often change, and when they do, the relationship represented in our two tables and graphs will change. Specifically, the lines we have plotted would shift to new locations.

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CHAPTER ONE APPENDIX26

4,000 people. That ratio also implies that a $2.50 price re- duction will increase attendance by 1,000 persons.

Slopes and Measurement Units The slope of a line will be affected by the choice of units for either variable. If, in our ticket price illustration, we had chosen to measure at- tendance in individual people, our horizontal change would have been 4,000 and the slope would have been

Slope 5 210

14,000 5

21 1400

5 2.0025

The slope depends on the way the relevant variables are measured.

Slopes and Marginal Analysis Recall that economics is largely concerned with changes from the status quo. The concept of slope is important in economics because it reflects marginal changes—those involving 1 more (or 1 fewer) unit. For example, in Figure 1 the .5 slope shows that $0.50 of extra or marginal consumption is associated with each $1 change in income. In this example, people collectively will consume $0.50 of any $1 increase in their incomes and reduce their consumption by $0.50 for each $1 decline in income.

Infinite and Zero Slopes Many variables are unrelated or independent of one another. For example, the quantity of wristwatches purchased is not related to the price of bananas. In Figure 3a we represent the price of bananas on the verti- cal axis and the quantity of watches demanded on the hori- zontal axis. The graph of their relationship is the line parallel to the vertical axis. The line’s vertical slope indicates that the same quantity of watches is purchased no matter what the price of bananas. The slope of vertical lines is infinite. Similarly, aggregate consumption is completely unre- lated to the nation’s divorce rate. In Figure 3b we put con- sumption on the vertical axis and the divorce rate on the horizontal axis. The line parallel to the horizontal axis rep- resents this lack of relatedness because the amount of con- sumption remains the same no matter what happens to the divorce rate. The slope of horizontal lines is zero.

Vertical Intercept

A line can be positioned on a graph (without plotting points) if we know just two things: its slope and its vertical intercept. We have already discussed slope. The vertical intercept of a line is the point where the line meets the vertical axis. In Figure 1 the intercept is $50. This intercept means that if current income were zero, consumers would still spend $50. They might do this through borrowing or by selling some of their assets. Similarly, the $50 vertical intercept in Figure 2 shows that at a $50 ticket price, GSU’s basketball team would be playing in an empty arena.

Consider a stock market “crash.” The dramatic drop in the value of stocks might cause people to feel less wealthy and therefore less willing to consume at each level of in- come. The result might be a downward shift of the con- sumption line. To see this, you should plot a new consumption line in Figure 1, assuming that consumption is, say, $20 less at each income level. Note that the rela- tionship remains direct; the line merely shifts downward to reflect less consumption spending at each income level. Similarly, factors other than ticket prices might affect GSU game attendance. If GSU loses most of its games, attendance at GSU games might be less at each ticket price. To see this, redraw Figure 2 assuming that 2,000 fewer fans attend GSU games at each ticket price.

Slope of a Line

Lines can be described in terms of their slopes. The slope of a straight line is the ratio of the vertical change (the rise or drop) to the horizontal change (the run) between any two points of the line.

Positive Slope Between point b and point c in Figure 1, the rise or vertical change (the change in consumption) is 1$50 and the run or horizontal change (the change in in- come) is 1$100. Therefore:

Slope 5 vertical change

horizontal change 5

150 1100

5 1 2

5 .5

Note that our slope of 12 or .5 is positive because consump- tion and income change in the same direction; that is, con- sumption and income are directly or positively related. The slope of .5 tells us there will be a $0.50 increase in consumption for every $1 increase in income. Similarly, there will be a $0.50 decrease in consumption for every $1 decrease in income.

Negative Slope Between any two of the identified points in Figure 2, say, point c and point d, the vertical change is 210 (the drop) and the horizontal change is 14 (the run). Therefore:

Slope 5 vertical change

horizontal change 5

210 14

5 22 1 2

5 22.5

This slope is negative because ticket price and attendance have an inverse relationship. Note that on the horizontal axis attendance is stated in thousands of people. So the slope of 210/14 or 22.5 means that lowering the price by $10 will increase attendance by

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CHAPTER ONE APPENDIX 27

relationships (curvy lines). The slope of a straight line is the same at all its points. The slope of a line representing a non- linear relationship changes from one point to another. Such lines are always referred to as curves. Consider the downsloping curve in Figure 4. Its slope is negative throughout, but the curve flattens as we move down along it. Thus, its slope constantly changes; the curve has a different slope at each point. To measure the slope at a specific point, we draw a straight line tangent to the curve at that point. A straight line is tangent at a point if it touches, but does not inter- sect, the curve at that point. Thus line aa is tangent to the curve in Figure 4 at point A. The slope of the curve at that point is equal to the slope of the tangent line. Specifically, the total vertical change (drop) in the tangent line aa is 220 and the total horizontal change (run) is 15. Because the slope of the tangent line aa is 220y15, or 24, the slope of the curve at point A is also 24. Line bb in Figure 4 is tangent to the curve at point B. Following the same procedure, we find the slope at B to be 25y115, or 213. Thus, in this flatter part of the curve, the slope is less negative.

Equation of a Linear Relationship

If we know the vertical intercept and slope, we can de- scribe a line succinctly in equation form. In its general form, the equation of a straight line is

y 5 a 1 bx

where y 5 dependent variable a 5 vertical intercept b 5 slope of line x 5 independent variable

For our income-consumption example, if C represents consumption (the dependent variable) and Y represents in- come (the independent variable), we can write C 5 a 1 bY. By substituting the known values of the intercept and the slope, we get

C 5 50 1 .5Y

This equation also allows us to determine the amount of consumption C at any specific level of income. You should use it to confirm that at the $250 income level, consump- tion is $175. When economists reverse mathematical convention by putting the independent variable on the vertical axis and the dependent variable on the horizontal axis, then y stands for the independent variable, rather than the dependent variable in the general form. We noted previously that this case is relevant for our GSU ticket price–attendance data. If P represents the ticket price (independent variable) and Q represents attendance (dependent variable), their rela- tionship is given by

P 5 50 2 2.5Q

where the vertical intercept is 50 and the negative slope is 2212, or 22.5. Knowing the value of P lets us solve for Q, our dependent variable. You should use this equation to predict GSU ticket sales when the ticket price is $15.

Slope of a Nonlinear Curve

We now move from the simple world of linear relationships (straight lines) to the more complex world of nonlinear

(a)

P ri

ce o

f b an

an as

Purchases of watches

Slope = infinite

0

(b)

Divorce rate

C o

n su

m p ti

o n

Slope = zero

0

FIGURE 3 Infinite and zero slopes. (a) A line parallel to the vertical axis has an infinite slope. Here, purchases of watches remain the same no matter what happens to the price of bananas. (b) A line parallel to the horizontal axis has a slope of zero. In this case, consumption remains the same no matter what happens to the divorce rate. In both (a) and (b), the two variables are totally unrelated to one another.

FIGURE 4 Determining the slopes of curves. The slope of a nonlinear curve changes from point to point on the curve. The slope at any point (say, B) can be determined by drawing a straight line that is tangent to that point (line bb) and calculating the slope of that line.

20

15

10

5

0 1510

A

B

5 20

a

b

ba

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CHAPTER ONE APPENDIX28

APPENDIX SUMMARY The slope of a straight line is the ratio of the vertical

change to the horizontal change between any two points. The slope of an upsloping line is positive; the slope of a downslop- ing line is negative.

The slope of a line or curve depends on the units used in measuring the variables. The slope is especially relevant for eco- nomics because it measures marginal changes.

The slope of a horizontal line is zero; the slope of a vertical line is infinite.

Together, the vertical intercept and slope of a line determine its location; they are used in expressing the line—and the rela- tionship between the two variables—as an equation.

The slope of a curve at any point is determined by calculating the slope of a straight line tangent to the curve at that point.

LO1.8 Understand graphs, curves, and slopes as they relate to economics.

Graphs are a convenient and revealing way to represent eco- nomic relationships.

Two variables are positively or directly related when their val- ues change in the same direction. The line (curve) representing two directly related variables slopes upward.

Two variables are negatively or inversely related when their values change in opposite directions. The line (curve) represent- ing two inversely related variables slopes downward.

The value of the dependent variable (the “effect”) is deter- mined by the value of the independent variable (the “cause”).

When the “other factors” that might affect a two-variable re- lationship are allowed to change, the graph of the relationship will likely shift to a new location.

APPENDIX TERMS AND CONCEPTS horizontal axis vertical axis direct relationship

inverse relationship independent variable dependent variable

slope of a straight line vertical intercept

A P P E N D I X R E V I E W Q U E S T I O N S

1. Indicate whether each of the following relationships is  usually a direct relationship or an inverse relation- ship. LO1.8

a. A sports team’s winning percentage and attendance at its home games.

b. Higher temperatures and sweater sales. c. A person’s income and how often he or she shops at dis-

count stores. d. Higher gasoline prices and miles driven in automobiles.

A P P E N D I X D I S C U S S I O N Q U E S T I O N S

1. Briefly explain the use of graphs as a way to represent eco- nomic relationships. What is an inverse relationship? How does it graph? What is a direct relationship? How does it graph? LO1.8

2. Describe the graphical relationship between ticket prices and the number of people choosing to visit amusement parks. Is that relationship consistent with the fact that, his- torically, park attendance and ticket prices have both risen? Explain. LO1.8

3. Look back at Figure 2, which shows the inverse relationship between ticket prices and game attendance at Gigantic State University. (a) Interpret the meaning of both the slope and the intercept. (b) If the slope of the line were steeper, what would that say about the amount by which ticket sales re- spond to increases in ticket prices? (c) If the slope of the line stayed the same but the intercept increased, what can you say about the amount by which ticket sales respond to in- creases in ticket prices? LO1.8

The following and additional problems can be found in

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CHAPTER ONE APPENDIX 29

2. Erin grows pecans. The number of bushels (B) that she can produce depends on the number of inches of rainfall (R) that her orchards get. The relationship is given algebraically as follows: B 5 3,000 1 800R. Match each part of this equa- tion with the correct term. LO1.8

B slope 3,000 dependent variable 800 vertical intercept R independent variable

A P P E N D I X P R O B L E M S

1. Graph and label as either direct or indirect the relationships you would expect to find between (a) the number of inches of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a university, and (c) the popularity of an entertainer and the price of her concert tickets. LO1.8

2. Indicate how each of the following might affect the data shown in the table and graph in Figure 2 of this appendix: LO1.8

a. GSU’s athletic director schedules higher-quality opponents.

b. An NBA team locates in the city where GSU plays. c. GSU contracts to have all its home games televised. 3. The following table contains data on the relationship be-

tween saving and income. Rearrange these data into a meaningful order and graph them on the accompanying grid. What is the slope of the line? The vertical inter- cept? Write the equation that represents this line. What would  you predict saving to be at the $12,500 level of income? LO1.8

Income per Year Saving per Year

$15,000 $1,000

0 2500

10,000 500

5,000 0

20,000 1,500

– 500

Sa vi

n g

0

500

1,000

$1,500

$5

Income (thousands)

Graph for Problem 3

10 15 20

the independent variable? Summarize the data in equa- tion form. LO1.8

E x am

s co

re (

p o

in ts

)

20

40

60

80

2

Study time (hours)

4 6 8 100

100

Graph for Problem 4

5. Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2-percentage-point decline in the interest rate. Describe the relevant relationship between the interest rate and investment in a table, on a graph, and as an equation. Put the interest rate on the vertical axis and investment on the horizontal axis. In your equation use the form i 5 a 1 bI, where i is the interest rate, a is the vertical intercept, b is the slope of the line (which is negative), and I is the level of investment. LO1.8

6. Suppose that C 5 a 1 bY, where C 5 consumption, a 5 consumption at zero income, b 5 slope, and Y 5 income. LO1.8

a. Are C and Y positively related or are they negatively related?

b. If graphed, would the curve for this equation slope upward or slope downward?

c. Are the variables C and Y inversely related or directly related?

d. What is the value of C if a 5 10, b 5 0.50, and Y 5 200? e. What is the value of Y if C 5 100, a 5 10, and b 5 0.25?

4. Construct a table from the data shown in the accompany- ing graph. Which is the dependent variable and which is

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CHAPTER ONE APPENDIX30

8. In the accompanying graph, is the slope of curve AA9 posi- tive or negative? Does the slope increase or decrease as we move along the curve from A to A9? Answer the same two questions for curve BB9. LO1.8

B

B9

A9

A

Y

0 X

Graph for Problem 8

7. The accompanying graph shows curve XX9 and tangents at points A, B, and C. Calculate the slope of the curve at these three points. LO1.8

50

40

30

20

10

0 2

(2, 10) (26, 10)

(12, 50) (16, 50)

4 6

a c X X9

A C

b b9 

a9 c9

B

8 10 12 14 16 18 20 22 24 26 28

Graph for Problem 7

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31

LO2.5 Describe the mechanics of the circular flow model.

LO2.6 Explain how the market system deals with risk.

Learning Objectives

LO2.1 Differentiate between laissez-faire capitalism, the command system,

and the market system.

LO2.2 List the main characteristics of the market system.

LO2.3 Explain how the market system answers the five fundamental

questions of what to produce,

how to produce, who obtains

the output, how to adjust to

change, and how to promote

progress.

LO2.4 Explain the operation of the “invisible hand” and why market

economies usually do a better

job than command economies

at efficiently transforming

economic resources into

desirable output.

The Market System and the Circular Flow

CHAPTER 2

You are at the mall. Suppose you were assigned to

compile a list of all the individual goods and ser-

vices there, including the different brands and vari-

ations of each type of product. That task would be

daunting and the list would be long! And even

though a single shopping mall contains a remark-

able quantity and variety of goods, it is only a tiny

part of the national economy.

Who decided that the particular goods and ser-

vices available at the mall and in the broader econ-

omy should be produced? How did the producers

determine which technology and types of re-

sources to use in producing these particular

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PART ONE Introduction to Economics and the Economy32

goods? Who will obtain these products? What ac-

counts for the new and improved products among

these goods? This chapter will answer these and

related questions.

Economic Systems LO2.1 Differentiate between laissez-faire capitalism, the command system, and the market system. Every society needs to develop an economic system—a particular set of institutional arrangements and a coordi- nating mechanism—to respond to the economizing prob- lem. The economic system has to determine what goods are produced, how they are produced, who gets them, how to accommodate change, and how to promote tech- nological progress. Economic systems differ as to (1) who owns the factors of production and (2) the method used to motivate, coor- dinate, and direct economic activity. Economics systems can be classified by the degree to which they rely upon decentralized decision making based upon markets and prices or centralized government con- trol based upon orders and mandates. At one extreme lies laissez-faire capitalism, in which government intervention is at a very minimum and markets and prices are allowed to direct nearly all economic activity. At the other extreme lie command systems, in which governments have total control over all economic activity. The vast majority of national economies lie somewhere in the middle, utilizing some mixture of centralized government regulation and decen- tralized markets and prices. These economies are said to have market systems or mixed economies.

Laissez-Faire Capitalism

In laissez-faire capitalism—or “pure capitalism”—the government’s role would be limited to protecting private property from theft and aggression and establishing a legal environment in which contracts would be enforced and people could interact in markets to buy and sell goods, services, and resources. The term “laissez-faire” is the French for “let it be,” that is, keep the government from interfering with the economy. Proponents of laissez-faire believe that such in- terference reduces human welfare. They maintain that any government that intervenes widely in the economy will end up being corrupted by special interests that will use the government’s economic influence to benefit them- selves rather than society at large. To prevent that from happening, the proponents of laissez-faire argue that government should restrict itself to preventing individuals and firms from coercing each other.

By doing so, it will ensure that only mutually beneficial economic transactions get negotiated and completed. That should lead to the highest possible level of human satisfaction because, after all, who knows better what peo- ple want than the people themselves? It is important to note, however, that no society has ever employed a laissez-faire system. In fact, no government has ever limited its economic actions to the short list of functions that would be al- lowed under laissez-faire. Instead, every government known to history has un- dertaken a wider range of economic activities, many of which are widely popu- lar and which include industrial safety regulations, various taxes and subsidies, occupational licensing requirements, and income redistribution. Thus, you should think of laissez-faire capitalism as a hypothetical system that is viewed by proponents as the ideal to which all economic systems should strive—but which is opposed by those who welcome greater govern- ment intervention in the economy.

The Command System

The polar opposite of laissez-faire capitalism is the command system, in which government owns most property resources and economic decision making is set by a central economic plan created and enforced by the government. The command system is also known as so- cialism or communism. Under the command system, a central planning board appointed by the government makes all the major deci- sions concerning the use of resources, the composition and distribution of output, and the organization of pro- duction. The government owns most of the business firms, which produce according to government directives. The central planning board determines production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise so that it can reach its pro- duction goals. The division of output between capital and consumer goods is centrally decided, and capital goods are allocated among industries on the basis of the central planning board’s long-term priorities.

O2.1

Laissez-faire

ORIGIN OF THE IDEA

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CHAPTER 2 The Market System and the Circular Flow 33

A pure command economy would rely exclusively on a central plan to allocate the government-owned property resources. But, in reality, even the preeminent command economy—the Soviet Union—tolerated some private ownership and incorporated some markets before its col- lapse in 1992. Recent reforms in Russia and most of the eastern European nations have, to one degree or another, transformed their command economies to capitalistic, market-oriented systems. China’s reforms have not gone as far, but they have greatly reduced the reliance on cen- tral planning. Although government ownership of re- sources and capital in China is still extensive, the nation has increasingly relied on free markets to organize and coordinate its economy. North Korea and Cuba are the last prominent remaining examples of largely centrally planned economies. Other countries using mainly the command system include Turkmenistan, Laos, Belarus, Myanmar, and Iran. Later in this chapter, we will explore the main reasons for the general demise of command systems.

The Market System

The vast majority of the world’s economies utilize the market system, which is also known as capitalism or the mixed economy. The market system is characterized by a mixture of cen- tralized government economic initiatives and decentralized actions taken by individuals and firms. The precise mixture varies from country to country, but in each case the system features the private ownership of resources and the use of markets and prices to coordinate and direct economic activity. In the market system, individuals and businesses seek to achieve their economic goals through their own decisions regarding work, consumption, or production. The system allows for the private ownership of capital, communicates through prices, and coordinates economic activity through markets—places where buyers and sellers come together to buy and sell goods, services, and resources. Participants act in their own self-interest and goods and services are produced and resources are supplied by whoever is willing and able to do so. The result is compe- tition among independently acting buyers and sellers of each product and resource and an economic system in which decision making is widely dispersed. The market system also offers high potential monetary rewards that create powerful incentives for existing firms to innovate and for entrepreneurs to pioneer new prod- ucts and processes despite the financial risks involved and despite most innovations failing to catch on with consumers. It is the case, however, that in the capitalism practiced in the United States and most other countries, the government

plays a substantial role in the economy. It not only pro- vides the rules for economic activity but also promotes economic stability and growth, provides certain goods and services that would otherwise be underproduced or not produced at all, and modifies the distribution of income. The government, however, is not the dominant economic force in deciding what to produce, how to produce it, and who will get it. That force is the market.

Characteristics of the Market System LO2.2 List the main characteristics of the market system. An examination of some of the key features of the market system in detail will be very instructive.

Private Property

In a market system, private individuals and firms, not the government, own most of the property resources (land and capital). It is this extensive private ownership of capi- tal that gives capitalism its name. This right of private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to ob- tain, use, and dispose of property resources as they see fit. The right of property owners to designate who will receive their property when they die helps sustain the institution of private property. The most important consequence of property rights is that they encourage people to cooperate by helping to en- sure that only mutually agreeable economic transactions take place. To consider why this is true, imagine a world without legally enforceable property rights. In such a world, the strong could simply take whatever they wanted from the weak without giving them any compensation. But in a world of legally enforceable property rights, any person wanting something from you has to get you to agree to give it to them. And you can say no. The result is that if they really want what you have, they must offer you something that you value more highly in return. That is, they must offer you a mutually agreeable economic transaction—one that benefits you as well as them. Property rights also encourage investment, innovation, exchange, maintenance of property, and economic growth. Nobody would stock a store, build a factory, or clear land for farming if someone else, or the government itself, could take that property for his or her own benefit. Property rights also extend to intellectual property through patents, copyrights, and trademarks. Such long- term protection encourages people to write books, music, and computer programs and to invent new products and

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PART ONE Introduction to Economics and the Economy34

production processes without fear that others will steal them and the rewards they may bring. Moreover, property rights facilitate exchange. The title to an automobile or the deed to a cattle ranch assures the buyer that the seller is the legitimate owner. Also, property rights encourage owners to maintain or improve their property so as to preserve or increase its value. Finally, property rights enable people to use their time and re- sources to produce more goods and services, rather than using them to protect and retain the property they have already produced or acquired.

Freedom of Enterprise and Choice

Closely related to private ownership of property is free- dom of enterprise and choice. The market system requires that various economic units make certain choices, which are expressed and implemented in the economy’s markets:

• Freedom of enterprise ensures that entrepreneurs and private businesses are free to obtain and use economic resources to produce their choice of goods and services and to sell them in their chosen markets.

• Freedom of choice enables owners to employ or dispose of their property and money as they see fit. It also allows workers to try to enter any line of work for which they are qualified. Finally, it ensures that consumers are free to buy the goods and services that best satisfy their wants and that their budgets allow.

These choices are free only within broad legal limita- tions, of course. Illegal choices such as selling human or- gans or buying illicit drugs are punished through fines and imprisonment. (Global Perspective 2.1 reveals that the degree of economic freedom varies greatly from economy to economy.)

Self-Interest

In the market system, self-interest is the motivating force of the various economic units as they express their free choices. Self-interest simply means that each economic unit tries to achieve its own particular goal, which usually requires delivering something of value to others. Entrepreneurs try to maximize profit or minimize loss.

Property owners try to get the highest price for the sale or rent of their re- sources. Workers try to maximize their utility (sat- isfaction) by finding jobs that offer the best combi- nation of wages, hours,

GLOBAL PERSPECTIVE 2.1

Index of Economic Freedom, Selected Economies

The Index of Economic Freedom measures economic free- dom using 10 major groupings such as trade policy, property rights, and government intervention, with each category containing more than 50 specific criteria. The index then ranks 179 economies according to their degree of economic freedom. A few selected rankings for 2012 are listed below.

Source: Used by permission of The Heritage Foundation, www.heritage.org.

MOSTLY UNFREE

REPRESSED

MOSTLY FREE

FREE

1 Hong Kong

3 Australia

5 Switzerland

10 United States

18 Taiwan

26 Germany

99 Brazil

123 India

144 Russia

158 Argentina

171 Iran

179 North Korea

fringe benefits, and working conditions. Consumers try to obtain the products they want at the lowest possible price and apportion their expenditures to maximize their utility. The motive of self-interest gives direction and consistency to what might otherwise be a chaotic economy.

Competition

The market system depends on competition among eco- nomic units. The basis of this competition is freedom of choice exercised in pursuit of a monetary return. Very broadly defined, competition requires

• Two or more buyers and two or more sellers acting independently in a particular product or resource market. (Usually there are many more than two buyers or sellers.)

O2.2

Self-interest

ORIGIN OF THE IDEA

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CHAPTER 2 The Market System and the Circular Flow 35

Those who respond to market signals and heed market dictates are rewarded with greater profit and income; those who do not respond to those signals and choose to ignore market dictates are penalized. Through this mech- anism society decides what the economy should produce, how production can be organized efficiently, and how the fruits of production are to be distributed among the vari- ous units that make up the economy.

• Freedom of sellers and buyers to enter or leave markets, on the basis of their economic self-interest.

Competition among buyers and sellers diffuses eco- nomic power within the businesses and households that make up the economy. When there are many buyers and sellers acting independently in a market, no single buyer or seller can dictate the price of the product or resource because others can undercut that price. Competition also implies that producers can enter or leave an industry; no insurmountable barriers prevent an industry’s expanding or contracting. This freedom of an in- dustry to expand or contract provides the economy with the flexibility needed to remain efficient over time. Freedom of entry and exit enables the economy to adjust to changes in consumer tastes, technology, and resource availability. The diffusion of economic power inherent in competi- tion limits the potential abuse of that power. A producer that charges more than the competitive market price will lose sales to other producers. An employer who pays less than the competitive market wage rate will lose workers to other employers. A firm that fails to exploit new technol- ogy will lose profits to firms that do. A firm that produces shoddy products will be punished as customers switch to higher-quality items made by rival firms. Competition is the basic regulatory force in the market system.

Markets and Prices

We may wonder why an economy based on self-interest does not collapse in chaos. If consumers want breakfast cereal, but businesses choose to produce running shoes and resource suppliers decide to make computer software, production would seem to be deadlocked by the apparent inconsistencies of free choices. In reality, the millions of decisions made by households and businesses are highly coordinated with one another by markets and prices, which are key components of the market system. They give the system its ability to coordinate mil- lions of daily economic decisions. A market is an institution or mechanism that brings buyers (“demanders”) and sellers (“suppliers”) into contact. A market system conveys the deci- sions made by buyers and sellers of products and resources. The decisions made on each side of the market determine a set of product and resource prices that guide resource own- ers, entrepreneurs, and consumers as they make and revise their choices and pursue their self-interest. Just as competition is the regulatory mechanism of the market system, the market system itself is the organizing and coordinating mechanism. It is an elaborate communi- cation network through which innumerable individual free choices are recorded, summarized, and balanced.

Technology and Capital Goods

In the market system, competition, freedom of choice, self- interest, and personal reward provide the opportunity and motivation for technological advance. The monetary rewards for new products or production techniques accrue directly to the innovator. The market system therefore encourages ex- tensive use and rapid development of complex capital goods: tools, machinery, large-scale factories, and facilities for stor- age, communication, transportation, and marketing. Advanced technology and capital goods are important because the most direct methods of production are often the least efficient. The only way to avoid that inefficiency is to rely on capital goods. It would be ridiculous for a farmer to go at production with bare hands. There are huge ben- efits to be derived from creating and using such capital equipment as plows, tractors, and storage bins. More effi- cient production means much more abundant output.

Specialization

The extent to which market economies rely on special- ization is extraordinary. Specialization means using the resources of an individual, firm, region, or nation to pro- duce one or a few goods or services rather than the entire range of goods and services. Those goods and services are then exchanged for a full range of desired products. The

QUICK REVIEW 2.1

• The market system rests on the private ownership of property and on freedom of enterprise and freedom of choice.

• Property rights encourage people to cooperate and make mutually agreeable economic transactions.

• The market system permits consumers, resource sup- pliers, and businesses to pursue and further their self-interest.

• Competition diffuses economic power and limits the actions of any single seller or buyer.

• The coordinating mechanism of capitalism is a system of markets and prices.

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PART ONE Introduction to Economics and the Economy36

producing oranges and other citrus fruits. By specializing, both economies produce more than is needed locally. Then, very sensibly, Nebraskans and Floridians swap some of their surpluses—wheat for oranges, oranges for wheat. Similarly, on an international scale, the United States specializes in producing such items as commercial aircraft and software, which it sells abroad in exchange for video cameras from Japan, bananas from Honduras, and woven baskets from Thailand. Both human specialization and geographic specialization are needed to achieve efficiency in the use of limited resources.

Use of Money

A rather obvious characteristic of any economic system is the extensive use of money. Money performs several func- tions, but first and foremost it is a medium of exchange. It makes trade easier. Specialization requires exchange. Exchange can, and sometimes does, occur through barter—swapping goods for goods, say, wheat for oranges. But barter poses serious problems because it requires a coincidence of wants between the buyer and the seller. In our example, we assumed that Nebraskans had excess wheat to trade and wanted oranges. And we assumed that Floridians had excess oranges to trade and wanted wheat. So an exchange occurred. But if such a coincidence of wants is missing, trade is stymied. Suppose that Nebraska has no interest in Florida’s or- anges but wants potatoes from Idaho. And suppose that Idaho wants Florida’s oranges but not Nebraska’s wheat. And, to complicate matters, suppose that Florida wants some of Nebraska’s wheat but none of Idaho’s potatoes. We summarize the situation in Figure 2.1. In none of the cases shown in the figure is there a co- incidence of wants. Trade by barter clearly would be diffi- cult. Instead, people in each state use money, which is simply a convenient social invention to facilitate exchanges of goods and services. Historically, people have used cattle, cigarettes, shells, stones, pieces of metal, and many other commodities, with varying degrees of success, as money. To serve as money, an item needs to pass only one test: It must be generally acceptable to sellers in exchange for their goods and services. Money is socially defined; what- ever society accepts as a medium of exchange is money. Today, most economies use pieces of paper as money. The use of paper dollars (currency) as a medium of exchange is what enables Nebraska, Florida, and Idaho to overcome their trade stalemate, as demonstrated in Figure 2.1. On a global basis, specialization and exchange are complicated by the fact that different nations have differ- ent currencies. But markets in which currencies are bought

majority of consumers produce virtually none of the goods and services they consume, and they consume little or nothing of the items they produce. The person working nine to five installing windows in commercial aircraft may rarely fly. Many farmers sell their milk to the local dairy and then buy margarine at the local grocery store. Society learned long ago that self-sufficiency breeds in- efficiency. The jack-of-all-trades may be a very colorful individual but is certainly not an efficient producer.

Division of Labor Human specialization—called the division of labor—contributes to a society’s output in several ways:

• Specialization makes use of differences in ability. Specialization enables individuals to take advantage

of existing differences in their abilities and skills. If Peyton is strong, athletic, and good at throwing a football and Beyoncé is beautiful, is agile, and can sing, their distribution of talents can be most efficiently

used if Peyton plays professional football and Beyoncé records songs and gives concerts.

• Specialization fosters learning by doing. Even if the abilities of two people are identical, specialization may still be advantageous. By devoting time to a single task, a person is more likely to develop the skills required and to improve techniques than by working at a number of different tasks. You learn to be a good lawyer by studying and practicing law.

• Specialization saves time. By devoting time to a single task, a person avoids the loss of time incurred in shifting from one job to another. Also, time is saved by not “fumbling around” with tasks that one is not trained to do.

For all these reasons, specialization increases the total output society derives from limited resources.

Geographic Specialization Specialization also works on a regional and international basis. It is conceivable that oranges could be grown in Nebraska, but because of the unsuitability of the land, rainfall, and temperature, the costs would be very high. And it is conceivable that wheat could be grown in Florida, but such production would be costly for similar geographical reasons. So Nebraskans produce products—wheat in particular—for which their resources are best suited, and Floridians do the same,

O2.3

Specialization: division of labor

ORIGIN OF THE IDEA

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CHAPTER 2 The Market System and the Circular Flow 37

Five Fundamental Questions LO2.3 Explain how the market system answers the five fundamental questions of what to produce, how to produce, who obtains the output, how to adjust to change, and how to promote progress. The key features of the market system help explain how market economies respond to five fundamental questions:

• What goods and services will be produced? • How will the goods and services be produced? • Who will get the goods and services? • How will the system accommodate change? • How will the system promote progress?

These five questions highlight the economic choices un- derlying the production possibilities curve discussed in Chapter 1. They reflect the reality of scarce resources in a world of unlimited wants. All economies, whether market or command, must address these five questions.

What Will Be Produced?

How will a market system decide on the specific types and quantities of goods to be produced? The simple answer is this: The goods and services that can be produced at a con- tinuing profit will be produced, while those whose produc- tion generates a continuing loss will be discontinued. Profits and losses are the difference between the total revenue (TR) a firm receives from the sale of its products and the total cost (TC) of producing those products. (For economists, total costs include not only wage and salary payments to

and sold make it possible for people living in different countries to exchange goods and services without resort- ing to barter.

Active, but Limited, Government

An active, but limited, government is the final characteris- tic of market systems in modern advanced industrial econ- omies. Although a market system promotes a high degree of efficiency in the use of its resources, it has certain inher- ent shortcomings, called “market failures.” We will dis- cover in subsequent chapters that governments can often increase the overall effectiveness of a market system in several ways. That being said, governments have their own set of shortcomings that can themselves cause substantial misallocations of resources. Consequently, we will also in- vestigate several types of “government failure.”

FIGURE 2.1 Money facilitates trade when wants do not coincide. The use of money as a medium of exchange permits trade to be accomplished despite a noncoincidence of wants. (1) Nebraska trades the wheat that Florida wants for money from Floridians; (2) Nebraska trades the money it receives from Florida for the potatoes it wants from Idaho; (3) Idaho trades the money it receives from Nebraska for the oranges it wants from Florida.

NEBRASKA Has surplus of

wheat. Wants potatoes.

FLORIDA Has surplus of

oranges. Wants wheat.

IDAHO Has surplus of

potatoes. Wants oranges.

(3) Money

(3) Oranges

(1 ) M

on ey

(1 ) W

he at

(2) M oney

(2) Potatoes

QUICK REVIEW 2.2

• The market systems of modern industrial economies are characterized by extensive use of technologically advanced capital goods. Such goods help these econ- omies achieve greater efficiency in production.

• Specialization is extensive in market systems; it enhances efficiency and output by enabling individuals, regions, and nations to produce the goods and services for which their resources are best suited.

• The use of money in market systems facilitates the ex- change of goods and services that specialization requires.

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PART ONE Introduction to Economics and the Economy38

production be organized? The answer: In combinations and ways that minimize the cost per unit of output. This is true because inefficiency drives up costs and lowers prof- its. As a result, any firm wishing to maximize its profits will make great efforts to minimize production costs. These ef- forts will include using the right mix of labor and capital, given the prices and productivity of those resources. They also mean locating production facilities optimally to hold down production and transportation expenses. Those efforts will be intensified if the firm faces competition, as consumers strongly prefer low prices and will shift their purchases over to the firms that can produce a quality product at the lowest possible price. Any firm foolish enough to use higher-cost production methods will go bankrupt as it is undersold by its more efficient competitors who can still make a profit when

labor, and interest and rental payments for capital and land, but also payments to the entrepreneur for organizing and combining the other resources to produce a product.) Continuing economic profit (TR . TC) in an industry results in expanded production and the movement of re- sources toward that industry. Existing firms grow and new firms enter. The industry expands. Continuing losses (TC . TR) in an industry lead to reduced production and the exit of resources from that industry. Some existing firms shrink in size; others go out of business. The industry con- tracts. In the market system, consumers are sovereign (in command). Consumer sovereignty is crucial in determin- ing the types and quantities of goods produced. Consumers spend their income on the goods they are most willing and able to buy. Through these “dollar votes” they register their wants in the market. If the dollar votes for a certain product are great enough to create a profit, businesses will produce that product and offer it for sale. In contrast, if the dollar votes do not create sufficient revenues to cover costs, businesses will not produce the product. So the consumers are sovereign. They collectively direct resources to indus- tries that are meeting consumer wants and away from in- dustries that are not meeting consumer wants. The dollar votes of consumers determine not only which industries will continue to exist but also which products will survive or fail. Only profitable industries, firms, and products survive. So firms are not as free to pro- duce whatever products they wish as one might otherwise think. Consumers’ buying decisions make the production of some products profitable and the production of other products unprofitable, thus restricting the choice of busi- nesses in deciding what to produce. Businesses must match their production choices with consumer choices or else face losses and eventual bankruptcy. The same holds true for resource suppliers. The em- ployment of resources derives from the sale of the goods and services that the resources help produce. Autoworkers are employed because automobiles are sold. There are few remaining professors of early Latin because there are few people desiring to learn the Latin language. Resource sup- pliers, desiring to earn income, are not truly free to allocate their resources to the production of goods that consumers do not value highly. Consumers register their preferences in the market; producers and resource suppliers, prompted by their own self-interest, respond appropriately.

How Will the Goods and Services Be Produced?

What combinations of resources and technologies will be used to produce goods and services? How will the

CONSIDER THIS . . .

McHits and McMisses

McDonald’s has introduced several new menu items over the decades. Some have been profitable “hits,” while others have been “misses.” In a market system, consumers ultimately decide whether a menu item is profitable and therefore whether it stays on the McDonald’s menu.

• Hulaburger (1962)—McMiss • Filet-O-Fish (1963)—McHit • Strawberry shortcake (1966)—McMiss • Big Mac (1968)—McHit • Hot apple pie (1968)—McHit • Egg McMuffin (1975)—McHit • Drive-thru (1975)—McHit • Chicken McNuggets (1983)—McHit • Extra Value Meal (1991)—McHit • McLean Deluxe (1991)—McMiss • Arch Deluxe (1996)—McMiss • 55-cent special (1997)—McMiss • Big Xtra (1999)—McHit • McSalad Shaker (2000)—McMiss • McGriddle (2003)—McHit • Snack Wrap (2006)—McHit Source: “Polishing the Golden Arches,” Forbes, June 15, 1998, pp. 42–43, updated. Reprinted by permission of Forbes Media LLC © 2010.

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CHAPTER 2 The Market System and the Circular Flow 39

will be produced is answered. They will be produced in a least-cost way. A change in either technology or resource prices, how- ever, may cause a firm to shift from the technology it is using. If the price of labor falls to $0.50, technique 1 be- comes more desirable than technique 2. Firms will find they can lower their costs by shifting to a technology that uses more of the resource whose price has fallen. Exercise: Would a new technique involving 1 unit of labor, 4 of land, 1 of capital, and 1 of entrepreneurial ability be preferable to the techniques listed in Table 2.1, assuming the re- source prices shown there?

Who Will Get the Output?

The market system enters the picture in two ways when determining the distribution of total output. Generally, any product will be distributed to consumers on the basis of their ability and willingness to pay its existing market price. If the price of some product, say, a small sailboat, is $3,000, then buyers who are willing and able to pay that price will “sail, sail away.” Consumers who are unwilling or unable to pay the price will be “sitting on the dock of the bay.” The ability to pay the prices for sailboats and other products depends on the amount of income that consum- ers have, along with the prices of, and preferences for, various goods. If consumers have sufficient income and want to spend their money on a particular good, they can have it. The amount of income they have depends on (1)  the quantities of the property and human resources they supply and (2) the prices those resources command in the resource market. Resource prices (wages, interest, rent, profit) are crucial in determining the size of each person’s income and therefore each person’s ability to buy part of the economy’s output. If a lawyer earning $200 an hour and a janitor earning $10 an hour both work the same number of hours each year, then each year the lawyer will be able to purchase 20 times more of society’s output than the janitor.

selling at a lower price. Simply stated: Competition elimi- nates high-cost producers. Least-cost production means that firms must employ the most economically efficient technique of production in producing their output. The most efficient production technique depends on

• The available technology, that is, the available body of knowledge and techniques that can be used to combine economic resources to produce the desired results.

• The prices of the needed resources.

A technique that requires just a few inputs of resources to produce a specific output may be highly inefficient eco- nomically if those resources are valued very highly in the market. Economic efficiency requires obtaining a particu- lar output of product with the least input of scarce re- sources, when both output and resource inputs are measured in dollars and cents. The combination of re- sources that will produce, say, $15 worth of bathroom soap at the lowest possible cost is the most efficient. Suppose there are three possible techniques for pro- ducing the desired $15 worth of bars of soap. Suppose also that the quantity of each resource required by each pro- duction technique and the prices of the required resources are as shown in Table 2.1. By multiplying the required quantities of each resource by its price in each of the three techniques, we can determine the total cost of producing $15 worth of soap by means of each technique. Technique 2 is economically the most efficient because it is the least costly. It enables society to obtain $15 worth of

output by using a smaller amount of resources—$13 worth—than the $15 worth required by the two other techniques. Competition will dictate that producers use technique 2. Thus, the question of how goods

TABLE 2.1 Three Techniques for Producing $15 Worth of Bar Soap

Units of Resource

Price per Unit Technique 1 Technique 2 Technique 3

Resource of Resource Units Cost Units Cost Units Cost

Labor $2 4 $ 8 2 $ 4 1 $ 2

Land 1 1 1 3 3 4 4

Capital 3 1 3 1 3 2 6

Entrepreneurial ability 3 1 3 1 3 1 3

Total cost of $15 worth of bar soap $15 $13 $15

W2.1

Least-cost production

WORKED PROBLEMS

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PART ONE Introduction to Economics and the Economy40

fundamental changes—for example, to changes in tech- nology and in the prices of various resources.

How Will the System Promote Progress?

Society desires economic growth (greater output) and higher standards of living (greater output per person). How does the market system promote technological improve- ments and capital accumulation, both of which contribute to a higher standard of living for society?

Technological Advance The market system pro- vides a strong incentive for technological advance and enables better products and processes to supplant infe- rior ones. An entrepreneur or firm that introduces a popular new product will gain revenue and economic profit at the expense of rivals. Firms that are highly profitable one year may find they are in financial trouble just a few years later. Technological advance also in- cludes new and improved methods that reduce produc- tion or distribution costs. By passing part of its cost reduction on to the consumer through a lower product price, a firm can increase sales and obtain economic profit at the expense of rival firms. Moreover, the market system promotes the rapid spread of technological advance throughout an industry. Rival firms must follow the lead of the most innovative firm or else suffer immediate losses and eventual failure. In some cases, the result is creative destruction: The creation of new products and production methods completely de- stroys the market positions of firms that are wedded to existing products and older ways of doing business. Example: The advent of compact discs largely demolished long-play vinyl records, and iPods and other digital tech- nologies subsequently supplanted CDs.

Capital Accumulation Most technological advances require additional capital goods. The market system pro- vides the resources necessary to produce additional capital goods through increased dollar votes for those goods. That is, the market system acknowledges dollar voting for capital goods as well as for consumer goods. But who counts the dollar votes for capital goods? Answer: Entrepreneurs and business owners. As receivers of profit income, they often use part of that income to purchase capital goods. Doing so yields even greater profit income in the future if the technological innovation that required the additional capital goods is successful. Also, by paying interest or selling ownership shares, the entrepre- neur and firm can attract some of the income of house- holds as saving to increase their dollar votes for the production of more capital goods.

How Will the System Accommodate Change?

Market systems are dynamic: Consumer preferences, tech- nologies, and resource supplies all change. This means that the particular allocation of resources that is now the most efficient for a specific pattern of consumer tastes, range of technological alternatives, and amount of avail- able resources will become obsolete and inefficient as con- sumer preferences change, new techniques of production are discovered, and resource supplies change over time. Can the market economy adjust to such changes? Suppose consumer tastes change. For instance, assume that consumers decide they want more fruit juice and less milk than the economy currently provides. Those changes in consumer tastes will be communicated to producers through an increase in spending on fruit and a decline in spending on milk. Other things equal, prices and profits in the fruit juice industry will rise and those in the milk in- dustry will fall. Self-interest will induce existing competi- tors to expand output and entice new competitors to enter the prosperous fruit industry and will in time force firms to scale down—or even exit—the depressed milk industry. The higher prices and greater economic profit in the fruit-juice industry will not only induce that industry to expand but will also give it the revenue needed to obtain the resources essential to its growth. Higher prices and profits will permit fruit producers to attract more re- sources from less urgent alternative uses. The reverse oc- curs in the milk industry, where fewer workers and other resources are employed. These adjustments in the econ- omy are appropriate responses to the changes in consumer tastes. This is consumer sovereignty at work. The market system is a gigantic communications sys- tem. Through changes in prices and profits, it communi- cates changes in such basic matters as consumer tastes and elicits appropriate responses from businesses and resource suppliers. By affecting price and profits, changes in con- sumer tastes direct the expansion of some industries and the contraction of others. Those adjustments are conveyed to the resource market. As expanding industries employ more resources and contracting industries employ fewer, the resulting changes in resource prices (wages and sala- ries, for example) and income flows guide resources from the contracting industries to the expanding industries. This directing or guiding function of prices and prof- its is a core element of the market system. Without such a system, a government planning board or some other ad- ministrative agency would have to direct businesses and resources into the appropriate industries. A similar analy- sis shows that the system can and does adjust to other

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CHAPTER 2 The Market System and the Circular Flow 41

resource suppliers maximize their incomes, these groups also help maximize society’s output and income. Of the various virtues of the market system, three merit reemphasis:

• Efficiency The market system promotes the efficient use of resources by guiding them into the production of the goods and services most wanted by society. It forces the use of the most efficient techniques in organizing resources for production, and it encourages the development and adoption of new and more efficient production techniques.

• Incentives The market system encourages skill acquisition, hard work, and innovation. Greater work skills and effort mean greater production and higher incomes, which usually translate into a higher standard of living. Similarly, the assuming of risks by entrepreneurs can result in substantial profit incomes. Successful innovations generate economic rewards.

• Freedom The major noneconomic argument for the market system is its emphasis on personal freedom. In contrast to central planning, the market system coordinates economic activity without coercion. The market system permits—indeed, it thrives on— freedom of enterprise and choice. Entrepreneurs and workers are free to further their own self-interest, subject to the rewards and penalties imposed by the market system itself.

Of course, no economic system, including the market system, is flawless. In Chapter 4 we will explain two well- known shortcomings of the market system and examine the government policies that try to remedy them.

The Demise of the Command Systems

Our discussion of how a market system answers the five fundamental questions provides insights on why the com- mand systems of the Soviet Union, eastern Europe, and China (prior to its market reforms) failed. Those systems encountered two insurmountable problems.

The Coordination Problem The first difficulty was the coordination problem. The central planners had to co- ordinate the millions of individual decisions by consumers, resource suppliers, and businesses. Consider the setting up of a factory to produce tractors. The central planners had to establish a realistic annual production target, for exam- ple, 1,000 tractors. They then had to make available all the necessary inputs—labor, machinery, electric power, steel, tires, glass, paint, transportation—for the production and delivery of those 1,000 tractors.

The “Invisible Hand” LO2.4 Explain the operation of the “invisible hand” and why market economies usually do a better job than command economies at efficiently transforming economic resources into desirable output. In his 1776 book The Wealth of Nations, Adam Smith first noted that the operation of a market system creates a curi- ous unity between private interests and social interests. Firms and resource suppliers, seeking to further their own self-interest and operating within the framework of a highly competitive market system, will simultaneously, as though guided by an “invisible hand,” promote the pub- lic or social interest. For example, we have seen that in a competitive environment, businesses seek to build new and improved products to increase profits. Those en- hanced products increase society’s well-being. Businesses also use the least costly combination of resources to pro- duce a specific output because doing so is in their self- interest. To act otherwise would be to forgo profit or even to risk business failure. But, at the same time, to use scarce resources in the least costly way is clearly in the social in- terest as well. It “frees up” resources to produce other things that society desires. Self-interest, awakened and guided by the competitive market system, is what induces responses appropriate to the changes in society’s wants. Businesses seeking to make higher profits and to avoid losses, and resource suppliers pursuing greater monetary rewards, negotiate changes in the allocation of resources and end up with the output that society wants. Competition controls or guides self-interest such that self-interest automatically and quite uninten- tionally furthers the best interest of society. The invisible hand ensures that when firms maximize their profits and

QUICK REVIEW 2.3

• The output mix of the market system is determined by profits, which in turn depend heavily on consumer preferences. Economic profits cause industries to ex- pand; losses cause industries to contract.

• Competition forces industries to use the least costly production methods.

• Competitive markets reallocate resources in response to changes in consumer tastes, technological ad- vances, and changes in availability of resources.

• In a market economy, consumer income and product prices determine how output will be distributed.

• Competitive markets create incentives for technologi- cal advance and capital accumulation, both of which contribute to increases in standards of living.

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PART ONE Introduction to Economics and the Economy42

they misjudged how many automobiles, shoes, shirts, and chickens were wanted at the government-determined prices, persistent shortages and surpluses of those prod- ucts arose. But as long as the managers who oversaw the production of those goods were rewarded for meeting their assigned production goals, they had no incentive to adjust production in response to the shortages and sur- pluses. And there were no fluctuations in prices and profit- ability to signal that more or less of certain products was desired. Thus, many products were unavailable or in short supply, while other products were overproduced and sat for months or years in warehouses. The command systems of the former Soviet Union and China before its market reforms also lacked entre- preneurship. Central planning did not trigger the profit motive, nor did it reward innovation and enterprise. The route for getting ahead was through participation in the political hierarchy of the Communist Party. Moving up the hierarchy meant better housing, better

Because the outputs of many industries serve as inputs to other industries, the failure of any single industry to achieve its output target caused a chain reaction of reper- cussions. For example, if iron mines, for want of machin- ery or labor or transportation, did not supply the steel industry with the required inputs of iron ore, the steel mills were unable to fulfill the input needs of the many industries that depended on steel. Those steel-using in- dustries (such as tractor, automobile, and transportation) were unable to fulfill their planned production goals. Eventually the chain reaction spread to all firms that used steel as an input and from there to other input buyers or final consumers. The coordination problem became more difficult as the economies expanded. Products and production pro- cesses grew more sophisticated and the number of indus- tries requiring planning increased. Planning techniques that worked for the simpler economy proved highly inad- equate and inefficient for the larger economy. Bottlenecks and production stoppages became the norm, not the ex- ception. In trying to cope, planners further suppressed product variety, focusing on one or two products in each product category. A lack of a reliable success indicator added to the coordination problem in the Soviet Union and China prior to its market reforms. We have seen that market economies rely on profit as a success indicator. Profit depends on consumer demand, production efficiency, and product quality. In contrast, the major success indi- cator for the command economies usually was a quanti- tative production target that the central planners assigned. Production costs, product quality, and product mix were secondary considerations. Managers and workers often sacrificed product quality and variety be- cause they were being awarded bonuses for meeting quantitative, not qualitative, targets. If meeting produc- tion goals meant sloppy assembly work and little prod- uct variety, so be it. It was difficult at best for planners to assign quantita- tive production targets without unintentionally producing distortions in output. If the plan specified a production target for producing nails in terms of weight (tons of nails), the enterprise made only large nails. But if it specified the target as a quantity (thousands of nails), the firm made all small nails, and lots of them! That is precisely what hap- pened in the centrally planned economies.

The Incentive Problem

The command economies also faced an incentive prob- lem. Central planners determined the output mix. When

CONSIDER THIS . . .

The Two Koreas

North Korea is one of the few command economies still standing. After the Second World War, the Korean peninsula was di- vided into North Korea and South Korea. North Korea, under the influence of the Soviet Union, established a command economy that emphasized government ownership and central g o v e r n m e n t p l a n n i n g. South Korea, protected by

the United States, established a market economy based upon private ownership and the profit motive. Today, the differences in the economic outcomes of the two systems are striking:

North Korea South Korea

GDP $40 billion* $1.6 trillion*

GDP per capita $1,800* $32,100*

Exports $2.5 billion $556.5 billion

Imports $3.5 billion $524.4 billion

Agrculture as % of GDP 23 percent 2.6 percent

*Based on purchasing power equivalencies to the U.S. dollar.

Source: CIA World Fact Book, 2011, www.cia.gov.

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43

QUICK QUIZ FOR FIGURE 2.2

1. The resource market is the place where: a. households sell products and businesses buy products. b. businesses sell resources and households sell products. c. households sell resources and businesses buy resources (or the

services of resources). d. businesses sell resources and households buy resources (or the

services of resources). 2. Which of the following would be determined in the product

market? a. a manager’s salary. b. the price of equipment used in a bottling plant. c. the price of 80 acres of farmland. d. the price of a new pair of athletic shoes.

3. In this circular flow diagram: a. money flows counterclockwise. b. resources flow counterclockwise. c. goods and services flow clockwise. d. households are on the selling side of the product market.

4. In this circular flow diagram: a. households spend income in the product market. b. firms sell resources to households. c. households receive income through the product market. d. households produce goods.

Answers: 1.c; 2. d; 3. b; 4. a

G o

o d s

and servicesRevenue

Good s a

nd

se rv

ic e s

Cons um

pti on

ex pe

nd it

u re

s

Money incom

e (w

ages, ren

ts,

interest, profits)

neurial ability

C os

ts

R es

ou rc

es

BUSINESSES HOUSEHOLDS

PRODUCT MARKET

RESOURCE MARKET

Labor, land, capital, entrepre-

• Households sell • Businesses buy

• Businesses sell • Households buy

• buy resources • sell products

• sell resources • buy products

FIGURE 2.2 The circular flow diagram. Resources flow from households to businesses through the resource market, and products flow from businesses to households through the product market. Opposite these real flows are monetary flows. Households receive income from businesses (their costs) through the resource market, and businesses receive revenue from households (their expenditures) through the product market.

KEY GRAPH

access to health care, and the right to shop in special stores. Meeting production targets and maneuvering through the minefields of party politics were measures of success in “business.” But a definition of business success based solely on political savvy was not condu- cive to technological advance, which is often disruptive to existing products, production methods, and organi- zational structures.

The Circular Flow Model LO2.5 Describe the mechanics of the circular flow model. The dynamic market economy creates continuous, repeti- tive flows of goods and services, resources, and money. The circular flow diagram, shown in Figure 2.2 (Key Graph), illustrates those flows for a simplified economy in which there is no government. Observe that in the

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PART ONE Introduction to Economics and the Economy44

losses that the business may generate. Many law firms and dental practices are organized as part- nerships, as are a wide variety of firms in many other industries.

• A corporation is an independent legal entity that can—on its own behalf—acquire resources, own assets, produce and sell products, incur debts, extend credit, sue and be sued, and otherwise engage in any legal business activity.

The fact that a corporation is an independent legal en- tity means that its owners bear no personal financial re- sponsibility for the fulfillment of the corporation’s debts and obligations. For instance, if a corporation has failed to repay a loan to a bank, the bank can sue the corporation but not its owners. Professional managers run most corpo- rations. They are hired and supervised by a board of direc- tors that is elected annually by the corporation’s owners. Google, Ford, and American Airlines are examples of large corporations, but corporations come in all sizes and oper- ate in every type of industry. There currently are about 30 million businesses in the United States, ranging from enormous corporations like Walmart, with 2012 sales of $444 billion and 2.2 million employees, to single-person sole proprietorships with sales of less than $100 per day. Businesses sell goods and services in the product mar- ket in order to obtain revenue, and they incur costs in the resource market when they purchase the labor, land, capi- tal, and entrepreneurial ability that they need to produce their respective goods and services.

Product Market

The red rectangle at the bottom of the diagram repre- sents the product market, the place where the goods and services produced by businesses are bought and sold. Households use the income they receive from the sale of resources to buy goods and services. The money that they spend on goods and services flows to busi- nesses as revenue.

Resource Market

Finally, the red rectangle at the top of the circular flow diagram represents the resource market in which house- holds sell resources to businesses. The households sell re- sources to generate income, and the businesses buy resources to produce goods and services. Productive re- sources flow from households to businesses, while money flows from businesses to households in the form of wages, rents, interest, and profits.

diagram we group this economy’s decision mak- ers into businesses and households. Additionally, we divide this economy’s mar- kets into the resource mar- ket and the product market.

Households

The blue rectangle on the right side of the circular flow diagram in Figure 2.2 represents households, which are defined as one or more persons occupying a housing unit. There are currently about 118 million households in the U.S. economy. Households buy the goods and services that businesses make available in the product market. Households obtain the income needed to buy those prod- ucts by selling resources in the resource market. All the resources in our no-government economy are ultimately owned or provided by households. For in- stance, the members of one household or another di- rectly provide all of the labor and entrepreneurial ability in the economy. Households also own all of the land and all of the capital in the economy either directly, as per- sonal property, or indirectly, as a consequence of owning all of the businesses in the economy (and thereby con- trolling all of the land and capital owned by businesses). Thus, all of the income in the economy—all wages, rents, interest, and profits—flows to households because they provide the economy’s labor, land, capital, and entrepreneurial ability.

Businesses

The blue rectangle on the left side of the circular flow dia- gram represents businesses, which are commercial estab- lishments that attempt to earn profits for their owners by offering goods and services for sale. Businesses fall into three main categories.

• A sole proprietorship is a business owned and managed by a single person. The proprietor (the owner) may work alone or have employees. Examples include a woman who runs her own tree-cutting business and an independent accountant who, with two assistants, helps his clients with their taxes.

• The partnership form of business organization is a natural outgrowth of the sole proprietorship. In a partnership, two or more individuals (the partners) agree to own and operate a business together. They pool their financial resources and business skills to operate the business, and they share any profits or

O2.4

Circular flow diagram

ORIGIN OF THE IDEA

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CHAPTER 2 The Market System and the Circular Flow 45

system because the entrepreneurs who must deal with risk and uncertainty gain profits if they choose wisely but suf- fer losses if they choose poorly. That provides them with a large financial incentive to avoid unnecessary risks and make prudent decisions. By contrast, risk management tends to be done very poorly in command economies because the central planners who must allocate resources and deal with risk do not them- selves face the possibility of losing money if they make bad decisions. As government employees, they tend to receive the same salaries whether things go well or poorly.

Shielding Employees and Suppliers from Business Risk

Under the market system, only a firm’s owners are subject to business risk and the possibility of losing money. By contrast, the firm’s employees and suppliers are shielded from business risk because they are legally entitled to re- ceive their contracted wages and payments on time and in full regardless of whether the firm is earning a profit or generating a loss. To see how this works, consider a pizza parlor that is be- ing started in a small town. Its investors put up $50,000 to get it going. They rent a storefront, lease ovens, purchase computers, and leave some money set aside as a reserve. The firm then has to attract employees. To do so, it will offer wage contracts that promise to pay employees every two weeks without regard to whether the firm is making a profit or generating a loss. This guarantee shields the firm’s employees from the risks of owning and operating the business. They will get paid even if the pizza parlor is losing money. In the same way, the contracts that the firm signs with its suppliers and with anyone who loans the firm money (for instance, the local bank) will also specify that they will be paid on time and in full no matter how the firm is doing in terms of profitability.

Dealing with Losses So what happens if the firm starts losing money? In that case, the owners will take the financial hit. To be concrete, suppose that the pizza parlor loses $1,500 during the month of October because it runs up $11,500 in costs but generates only $10,000 in reve- nue. In that situation, the investors’ wealth will shrink by $1,500 as the firm is forced to dip into its reserve to cover the loss. If the firm continues to lose money in subse- quent months and exhausts the reserve, the owners will then have to decide whether they want to close the shop or put in additional money in the hope that things will turn around.

To summarize, the circular flow model depicts a com- plex web of economic activity in which businesses and households are both buyers and sellers. Businesses buy re- sources and sell products. Households buy products and sell resources. The counterclockwise flow of economic re- sources and finished products that is illustrated by the red arrows in Figure 2.2 is paid for by the clockwise flow of money income and consumption expenditures illustrated by the blue arrows.

How the Market System Deals with Risk LO2.6 Explain how the market system deals with risk. Producing goods and services is risky. Input shortages can suddenly arise. Consumer preferences can quickly change. Natural disasters can destroy factories and crip- ple supply chains. For an economic system to maximize its potential, it must develop methods for assessing and managing risk. The market system does so by confronting business own- ers with the financial consequences of their decisions. If they manage risks well, they may prosper. If they manage risks poorly, they may lose everything.

The Profit System

As explained in Chapter 1, entrepreneurial ability is the economic resource that organizes and directs the other three resources of land, labor, and capital toward produc- tive uses. The owners of a firm may attempt to supply the entrepreneurial ability themselves. Or they can hire pro- fessional managers to supply the necessary leadership and decision making. Either way, it falls to those acting as the firm’s entrepreneurs to deal with risk. They are guided toward sensible decisions by the so- called profit system. This system is actually a profit and loss

QUICK REVIEW 2.4

• Competition directs individuals and firms to unwit- tingly promote the social interest, as if guided by a benevolent “invisible hand.”

• The command systems of the Soviet Union and pre- reform China failed as a result of the coordination problem and the incentive problem.

• The circular flow model illustrates how resources flow from households to businesses and how payments for those resources flow from businesses to households.

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PART ONE Introduction to Economics and the Economy46

Benefits of Restricting Business Risk to Owners

There are two major benefits that arise from the market system’s restriction of business risk to owners and investors.

Attracting Inputs Many people deeply dislike risk and would not be willing to participate in a business ven- ture if they were exposed to the possibility of losing money. That is the case with many workers, who just want to do their jobs and get paid twice a month without having to worry about whether their employer is doing well or not. The same is true for most suppliers, who just want to get paid on time and in full for the inputs they supply to the firm. For both groups, the concentration of business risk on owners and investors is very welcome because they can supply their resources to a firm without having to worry about the firm’s profitability. That sense of security makes it much easier for firms to attract labor and other inputs, which in turn helps the economy innovate and grow.

Focusing Attention The profit system helps to achieve prudent risk management by focusing both the responsibility and the rewards for successfully managing risk onto a firm’s owners. They can provide the risk- managing input of entrepreneurial ability themselves or hire it by paying a skilled manager. But either way, some individual’s full-time job includes the specialized task of managing risk and making prudent decisions about the allocation of resources. By contrast, in a command sys- tem, the responsibility for managing risk tends to be spread out over several layers of government and many different committees so that nobody is personally re- sponsible for bad outcomes.

CONSIDER THIS . . .

Insurance

Insurance promotes economic growth and investment by trans- ferring risk from those who have a low toler- ance for risk to those who have a high tol- erance for risk.

Consider fire insurance. Homeowners pay a monthly pre- mium in exchange for which their insurance company guar- antees to reimburse them if their house burns down. That guarantee transfers the risk of fire damage from the home- owners (who do not want to bear the risk) to the insurance company’s owners (who are happy to bear the risk as a busi- ness proposition). The insurance company will save the premiums that it re- ceives from homeowners to help cover the rebuilding costs of any homes that do end up burning down. But it is quite possible that there will be so many fires that the insurance company will spend more money repairing fire damage than it received in premiums. If that happens, the insurance company will suffer a loss that will fall upon the insurance company’s owners. Their per- sonal wealth will decline in order to make up for the unex- pectedly high number of fires. Thus, the insurance company’s owners ultimately bear the fire risk; it is to them that the in- surance contract transfers risk. But if the number of fires is unexpectedly small, the insurance company will turn a nice profit and the insur- ance company’s owners will benefit from having been will- ing to bear the fire risk that the homeowners did not wish to bear. More importantly, the economy’s overall level of invest- ment rises because the availability of insurance means that those who dislike risk are much more willing to invest their savings into the construction and purchase of capital goods like houses, cars, and factories.

But throughout all those months of losses, the sup- pliers and employees are safeguarded. Because they are paid on time and in full, they are shielded from the firm’s business risks and whether it is generating a profit or a loss. As a result, however, they are not legally entitled to share in the profits if the firm does end up being profit- able. That privilege is reserved under the market system for the firm’s owners as their reward for bearing business risk. In exchange for making sure that everyone else is shielded if things go badly, the owners are legally entitled to take all of the profits if things go well.

QUICK REVIEW 2.5

• The market system incentivizes the prudent manage- ment of business risk by concentrating any profit or loss upon a firm’s owners and investors.

• The market system shields employees, suppliers, and lenders from business risks, but in exchange for that protection, they are excluded from any profit that may be earned.

• By focusing risk on owners and investors, the market system (a) creates an incentive for owners and inves- tors to hire managerial and entrepreneurial specialists to prudently manage business risks and (b) encour- ages the participation of workers, suppliers, and lend- ers who dislike risk.

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Shuffling the Deck

In The Future and Its Enemies, Virginia Postrel notes the astonish- ing fact that if you thoroughly shuffle an ordinary deck of 52 playing cards, chances are practically 100 percent that the result- ing arrangement of cards has never before existed. Never. Every time you shuffle a deck, you produce an arrangement of cards that exists for the first time in history. The arithmetic works out that way. For a very small number of items, the number of possible arrangements is small. Three items, for example, can be arranged only six different ways. But the number of possible arrangements grows very large very quickly. The number of different ways to arrange five items is 120 . . . for ten items it’s 3,628,800 . . . for fifteen items it’s 1,307,674,368,000. The number of different ways to arrange 52 items is 8.066 3 1067. This is a big number. No human can comprehend its enor- mousness. By way of comparison, the number of possible ways to arrange a mere 20 items is 2,432,902,008,176,640,000—a num- ber larger than the total number of seconds that have elapsed since the beginning of time ten billion years ago—and this num- ber is Lilliputian compared to 8.066 3 1067. What’s the significance of these facts about numbers? Consider the number of different resources available in the world—my labor, your labor, your land, oil, tungsten, cedar, cof- fee beans, chickens, rivers, the Empire State Building, [Microsoft] Windows, the wharves at Houston, the classrooms at Oxford, the airport at Miami, and on and on and on. No one can possibly count all of the different productive resources available for our use. But we can be sure that this number is at least in the tens of billions. When you reflect on how incomprehensibly large is the number of ways to arrange a deck containing a mere 52 cards, the mind boggles at the number of different ways to arrange all the world’s resources. If our world were random—if resources combined together haphazardly, as if a giant took them all into his hands and tossed them down like so many [cards]—it’s a virtual certainty that the resulting combination of resources would be useless. Unless this chance arrangement were quickly rearranged according to some productive logic, nothing worthwhile would be produced. We would all starve to death. Because only a tiny fraction of

possible arrangements serves human ends, any arrangement will be useless if it is chosen randomly or with inadequate knowledge of how each and every resource might be productively combined with each other. And yet, we witness all around us an arrangement of re- sources that’s productive and serves human goals. Today’s ar- rangement of resources might not be perfect, but it is vastly superior to most of the trillions upon trillions of other possible arrangements. How have we managed to get one of the minuscule number of arrangements that works? The answer is private property—a social institution that encourages mutual accommodation. Private property eliminates the possibility that resource ar- rangements will be random, for each resource owner chooses a course of action only if it promises rewards to the owner that exceed the rewards promised by all other available courses. [The result] is a breathtakingly complex and productive ar- rangement of countless resources. This arrangement emerged over time (and is still emerging) as the result of billions upon billions of individual, daily, small decisions made by people seek- ing to better employ their resources and labor in ways that other people find helpful.

Source: Abridged from Donald J. Boudreaux, “Mutual Accommodation,” Ideas on Liberty, May 2000, pp. 4–5. Used by permission of The Freeman.

Economist Donald Boudreaux Marvels at the Way the Market System Systematically and Purposefully

Arranges the World’s Tens of Billions of Individual Resources.

LAST WORD

47

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LO2.1 Differentiate between laissez-faire capitalism, the command system, and the market

system.

Laissez-faire capitalism is a hypothetical economic system in which government’s role would be restricted to protecting pri- vate property and enforcing contracts. All real-world economic systems have featured a more extensive role for government. Governments in command systems own nearly all property and resources and make nearly all decisions about what to produce, how to produce it, and who gets the output. Most countries to- day, including the United States, have market systems in which the government does play a large role, but in which most prop- erty and resources are privately owned and markets are the major force in determining what to produce, how to produce it, and who gets it.

LO2.2 List the main characteristics of the market system.

The market system is characterized by the private ownership of resources, including capital, and the freedom of individuals to engage in economic activities of their choice to advance their material well-being. Self-interest is the driving force of such an economy and competition functions as a regulatory or control mechanism.

In the market system, markets, prices, and profits organize and make effective the many millions of individual economic de- cisions that occur daily.

Specialization, use of advanced technology, and the extensive use of capital goods are common features of market systems. Functioning as a medium of exchange, money eliminates the problems of bartering and permits easy trade and greater spe- cialization, both domestically and internationally.

LO2.3 Explain how the market system answers the five fundamental questions of what to produce,

how to produce, who obtains the output, how

to adjust to change, and how to promote

progress.

Every economy faces five fundamental questions: (a) What goods and services will be produced? (b) How will the goods and services be produced? (c) Who will get the goods and ser- vices? (d) How will the system accommodate change? (e) How will the system promote progress?

The market system produces products whose production and sale yield total revenue sufficient to cover total cost. It does not produce products for which total revenue continuously falls short of total cost. Competition forces firms to use the lowest- cost production techniques.

Economic profit (total revenue minus total cost) indicates that an industry is prosperous and promotes its expansion. Losses signify that an industry is not prosperous and hasten its contraction.

Consumer sovereignty means that both businesses and re- source suppliers are subject to the wants of consumers. Through their dollar votes, consumers decide on the composi- tion of output.

The prices that a household receives for the resources it sup- plies to the economy determine that household’s income. This income determines the household’s claim on the economy’s out- put. Those who have income to spend get the products produced in the market system.

By communicating changes in consumer tastes to entrepre- neurs and resource suppliers, the market system prompts ap- propriate adjustments in the allocation of the economy’s resources. The market system also encourages technological advance and capital accumulation, both of which raise a nation’s standard of living.

LO2.4 Explain the operation of the “invisible hand” and why market economies usually do a

better job than command economies at efficiently

transforming economic resources into desirable

output.

Competition, the primary mechanism of control in the market economy, promotes a unity of self-interest and social interests. As if directed by an invisible hand, competition harnesses the self- interested motives of businesses and resource suppliers to further the social interest.

The command systems of the Soviet Union and prereform China met their demise because of coordination difficulties caused by central planning and the lack of a profit incentive. The coordination problem resulted in bottlenecks, inefficiencies, and a focus on a limited number of products. The incentive problem discouraged product improvement, new product development, and entrepreneurship.

LO2.5 Describe the mechanics of the circular flow model.

The circular flow model illustrates the flows of resources and products from households to businesses and from businesses to households, along with the corresponding monetary flows. Businesses are on the buying side of the resource market and the selling side of the product market. Households are on the selling side of the resource market and the buying side of the product market.

LO2.6 Explain how the market system deals with risk.

By focusing business risks onto owners, the market system en- courages the participation of workers and suppliers who dislike risk while at the same time creating a strong incentive for owners to manage business risks prudently.

SUMMARY

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CHAPTER 2 The Market System and the Circular Flow 49

D I S C U S S I O N Q U E S T I O N S

1. Contrast how a market system and a command economy try to cope with economic scarcity. LO2.1

2. How does self-interest help achieve society’s economic goals? Why is there such a wide variety of desired goods and services in a market system? In what way are entrepreneurs and businesses at the helm of the economy but commanded by consumers? LO2.2

3. Why is private property, and the protection of property rights, so critical to the success of the market system? How do property rights encourage cooperation? LO2.2

4. What are the advantages of using capital in the production process? What is meant by the term “division of labor”? What are the advantages of specialization in the use of hu- man and material resources? Explain why exchange is the necessary consequence of specialization. LO2.2

5. What problem does barter entail? Indicate the economic sig- nificance of money as a medium of exchange. What is meant by the statement “We want money only to part with it”? LO2.2

6. Evaluate and explain the following statements: LO2.2 a. The market system is a profit-and-loss system. b. Competition is the disciplinarian of the market economy. 7. Some large hardware stores, such as Home Depot, boast of

carrying as many as 20,000 different products in each store. What motivated the producers of those individual products

to make them and offer them for sale? How did the produc- ers decide on the best combinations of resources to use? Who made those resources available, and why? Who de- cides whether these particular hardware products should continue to be produced and offered for sale? LO2.3

8. What is meant by the term “creative destruction”? How does the emergence of MP3 (or iPod) technology relate to this idea? LO2.3

9. In a sentence, describe the meaning of the phrase “invisible hand.” LO2.4

10. In market economies, firms rarely worry about the availabil- ity of inputs to produce their products, whereas in com- mand economies input availability is a constant concern. Why the difference? LO2.4

11. Distinguish between the resource market and the product market in the circular flow model. In what way are busi- nesses and households both sellers and buyers in this model? What are the flows in the circular flow model? LO2.5

12. How does shielding employees and suppliers from business risk help to improve economic outcomes? Who is responsible for managing business risks in the market system? LO2.6

13. LAST WORD What explains why millions of economic re- sources tend to get arranged logically and productively rather than haphazardly and unproductively?

The following and additional problems can be found in

R E V I E W Q U E S T I O N S

1. Decide whether each of the following descriptions most closely corresponds to being part of a command system, a market system, or a laissez-faire system. LO2.1

a. A woman who wants to start a flower shop finds she cannot do so unless the central government has already decided to allow a flower shop in her area.

b. Shops stock and sell the goods their customers want but the government levies a sales tax on each transaction in

order to fund elementary schools, public libraries, and welfare programs for the poor.

c. The only taxes levied by the government are to pay for national defense, law enforcement, and a legal system designed to enforce contracts between private citizens.

TERMS AND CONCEPTS economic system laissez-faire capitalism command system market system private property freedom of enterprise freedom of choice self-interest competition

market specialization division of labor medium of exchange barter money consumer sovereignty dollar votes creative destruction

“invisible hand” circular flow diagram households businesses sole proprietorship partnership corporation product market resource market

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PART ONE Introduction to Economics and the Economy50

Resource Units Required

Price per

Unit of Technique Technique Technique

Resource Resource 1 2 3

Labor $3 5 2 3

Land 4 2 4 2

Capital 2 2 4 5

Entrepreneurial ability 2 4 2 4

5. Identify each of the following quotes as being an exam- ple  of either: the coordination problem, the invisible hand, creative destruction, or the incentive problem. LO2.4

a. “If you compare a list of today’s most powerful and profitable companies with a similar list from 30 years ago, you will see lots of new entries.”

b. “Managers in the old Soviet Union often sacrificed product quality and variety because they were being awarded bonuses for quantitative, not qualitative, targets.”

c. “Each day, central planners in the old Soviet Union were tasked with setting 27 million prices—correctly.”

d. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

6. True or False: Households sell finished products to busi- nesses. LO2.6

7. Franklin, John, Henry, and Harry have decided to pool their financial resources and business skills in order to open up and run a coffee shop. They will share any prof- its or losses that the business generates and will be per- sonally responsible for making good on any debt that their business undertakes. Their business should be clas- sified as a: LO2.6

a. Corporation. b. Sole proprietorship. c. Partnership. d. None of the above. 8. Ted and Fred are the owners of a gas station. They invested

$150,000 each and pay an employee named Lawrence $35,000 per year. This year revenues are $900,000, while costs are $940,000. Who is legally responsible for bearing the $40,000 loss? LO2.6

a. Lawrence. b. Ted. c. Fred. d. Ted and Fred. c. Lawrence, Ted, and Fred.

2. Match each term with the correct definition. LO2.2 private property freedom of enterprise mutually agreeable freedom of choice self-interest competition market a. An institution that brings buyers and sellers together. b. The right of private persons and firms to obtain, control,

employ, dispose of, and bequeath land, capital, and other property.

c. The presence in a market of independent buyers and sellers who compete with one another and who are free to enter and exit the market as they each see fit.

d. The freedom of firms to obtain economic resources, decide what products to produce with those resources, and sell those products in markets of their choice.

e. What each individual or firm believes is best for itself and seeks to obtain.

f. Economic transactions willingly undertaken by both the buyer and the seller because each feels that the transaction will make him or her better off.

g. The freedom of resource owners to dispose of their resources as they think best; of workers to enter any line of work for which they are qualified; and of consumers to spend their incomes in whatever way they feel is most appropriate.

3. True or False: Money must be issued by a government for people to accept it. LO2.2

4. Assume that a business firm finds that its profit is greatest when it produces $40 worth of product A. Suppose also that each of the three techniques shown in the table to the right will produce the desired output. LO2.3

a. With the resource prices shown, which technique will the firm choose? Why? Will production using that technique entail profit or loss? What will be the amount of that profit or loss? Will the industry expand or contract? When will that expansion or contraction end?

b. Assume now that a new technique, technique 4, is developed. It combines 2 units of labor, 2 of land, 6 of capital, and 3 of entrepreneurial ability. In view of the resource prices in the table, will the firm adopt the new technique? Explain your answer.

c. Suppose that an increase in the labor supply causes the price of labor to fall to $1.50 per unit, all other resource prices remaining unchanged. Which technique will the producer now choose? Explain.

d. “The market system causes the economy to conserve most in the use of resources that are particularly scarce in supply. Resources that are scarcest relative to the demand for them have the highest prices. As a result, producers use these resources as sparingly as is possible.” Evaluate this statement. Does your answer to part c, above, bear out this contention? Explain.

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CHAPTER 2 The Market System and the Circular Flow 51

P R O B L E M S

1. Table 2.1 contains information on three techniques for producing $15 worth of bar soap. Assume that we said “$15 worth of bar soap” because soap cost $3 per bar and all three techniques produce 5 bars of soap ($15 5 $3 per bar 3 5 bars). So you know each technique produces 5 bars of soap. LO2.3

a. What technique will you want to use if the price of a bar of soap falls to $2.75? What if the price of a bar of soap rises to $4? To $5?

b. How many bars of soap will you want to produce if the price of a bar of soap falls to $2.00?

c. Suppose that the price of soap is again $3 per bar but that the prices of all four resources are now $1 per unit. Which is now the least-profitable technique?

d. If the resource prices return to their original levels (the ones shown in the table), but a new technique is invented that can produce 3 bars of soap (yes, 3 bars, not 5 bars!), using 1 unit of each of the four resources, will firms prefer the new technique?

2. Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV company. She then develops two possible entrepreneurial business opportunities. In one, she will quit her job to start an organic soap company. In the other, she will try to develop an Internet-based competitor to the local cable company. For the soap-making opportu- nity, she anticipates annual revenue of $465,000 and costs for the necessary land, labor, and capital of $395,000 per year.

For the Internet opportunity, she anticipates costs for land, labor, and capital of $3,250,000 per year as compared to rev- enues of $3,275,000 per year. (a) Should she quit her current job to become an entrepreneur? (b) If she does quit her cur- rent job, which opportunity would she pursue? LO2.3

3. With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also assume that the least-cost combination of resources in producing those loaves is 5 units of labor, 7 units of land, 2 units of capital, and 1 unit of en- trepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 loaves at $2 per unit, what is its total revenue? Its total cost? Its profit or loss? Will it continue to produce banana bread? If this firm’s situation is typical for the other makers of banana bread, will resources flow toward or away from this bakery good? LO2.3

4. Let’s put dollar amounts on the flows in the circular flow diagram of Figure 2.2. LO2.5

a. Suppose that businesses buy a total of $100 billion of the four resources (labor, land, capital, and entrepreneurial ability) from households. If households receive $60 billion in wages, $10 billion in rent, and $20 billion in interest, how much are households paid for providing entrepreneurial ability?

b. If households spend $55 billion on goods and $45 billion on services, how much in revenues do businesses receive in the product market?

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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PART TWO

CHAPTER 3 Demand, Supply, and Market Equilibrium

CHAPTER 4 Market Failures: Public Goods and Externalities

CHAPTER 5 Government’s Role and Government Failure

PRICE, QUANTITY, AND EFFICIENCY

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53

LO3.7 (Appendix) Illustrate how supply and demand analysis can provide insights

on actual-economy situations.

CHAPTER 3

Demand, Supply, and Market Equilibrium

Learning Objectives

LO3.1 Characterize and give examples of markets.

LO3.2 Describe demand and explain how it can change.

LO3.3 Describe supply and explain how it can change.

LO3.4 Relate how supply and demand interact to determine market

equilibrium.

LO3.5 Explain how changes in supply and demand affect equilibrium prices

and quantities.

LO3.6 Identify what government-set prices are and how they can

cause product surpluses and

shortages.

O3.1

Demand and supply

ORIGIN OF THE IDEAThe model of supply

and demand is the

economics profession’s

greatest contribution to

human understanding

because it explains the operation of the markets on

which we depend for nearly everything that we eat,

drink, or consume. The model is so powerful and so

widely used that to many people it is economics.

This chapter explains how the model works and

how it can explain both the quantities that are

bought and sold in markets as well as the prices at

which they trade.

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PART TWO Price, Quantity, and Efficiency54

Markets LO3.1 Characterize and give examples of markets. Markets bring together buyers (“demanders”) and sellers (“suppliers”). The corner gas station, an e-commerce site, the local music store, a farmer’s roadside stand—all are fa- miliar markets. The New York Stock Exchange and the Chicago Board of Trade are markets in which buyers and sellers from all over the world communicate with one an- other to buy and sell bonds, stocks, and commodities. Auctioneers bring together potential buyers and sellers of art, livestock, used farm equipment, and, sometimes, real estate. In labor markets, new college graduates “sell” and employers “buy” specific labor services. Some markets are local; others are national or interna- tional. Some are highly personal, involving face-to-face contact between demander and supplier; others are faceless, with buyer and seller never seeing or knowing each other. To keep things simple, we will focus in this chapter on markets in which large numbers of independently acting buyers and sellers come together to buy and sell standardized products. Markets with these characteris- tics are the economy’s most highly competitive. They include the wheat market, the stock market, and the market for foreign currencies. All such markets involve demand, supply, price, and quantity. As you will soon see, the price is “discovered” through the interacting deci- sions of buyers and sellers.

Demand LO3.2 Describe demand and explain how it can change. Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.1 Demand shows the quantities of a product that will be purchased at various possible prices, other things equal. Demand can easily be shown in table form. The table in Figure 3.1 is a hypothetical demand schedule for a single consumer purchasing bushels of corn. The table reveals the relationship between the various prices of corn and the quantity of corn a particular con- sumer would be willing and able to purchase at each of these prices. We say “willing and able” because willingness alone is not effective in the market. You may be willing to buy a plasma television set, but if that willingness is not backed by the necessary dollars, it will not be effective and, therefore, will not be reflected in the market. In the table in Figure 3.1, if the price of corn were $5 per bushel, our consumer would be willing and able to buy 10 bushels per week; if it were $4, the consumer would be willing and able to buy 20 bushels per week; and so forth.

FIGURE 3.1 An individual buyer’s demand for corn. Because price and quantity demanded are inversely related, an individual’s demand schedule graphs as a downsloping curve such as D. Other things equal, consumers will buy more of a product as its price declines and less of the product as its price rises. (Here and in later figures, P stands for price and Q stands for quantity demanded or supplied.)

0 Q

P ri

ce (

p e r

b u sh

e l)

1

2

3

4

5

$6

Quantity demanded (bushels per week)

10 20 30 40 50 60 70 80

P

D

1This definition obviously is worded to apply to product markets. To ad- just it to apply to resource markets, substitute the word “resource” for “product” and the word “businesses” for “consumers.”

Demand for Corn

Price per Quantity Demanded

Bushel per Week

$5 10

4 20

3 35

2 55

1 80

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CHAPTER 3 Demand, Supply, and Market Equilibrium 55

each successive unit of the product consumed. The second Big Mac will yield less satisfaction to the consumer than the first, and the third still less than the second. That is, consumption is subject to diminishing marginal utility. And because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price of those units is progressively reduced.

• We can also explain the law of demand in terms of income and substitution effects. The income effect indicates that a lower price increases the purchasing power of a buyer’s money income, enabling the buyer to purchase more of the product than before. A higher price has the opposite effect. The substitution effect suggests that at a lower price buyers have the incentive to substitute what is now a less expensive product for other products that are now relatively more expensive. The product whose price has fallen is now “a better deal” relative to the other products.

For example, a decline in the price of chicken will in- crease the purchasing power of consumer incomes, enabling people to buy more chicken (the income effect). At a lower price, chicken is rela- tively more attractive and consumers tend to substi- tute it for pork, lamb, beef, and fish (the substitution effect). The income and substitution effects com- bine to make consumers able and willing to buy more of a product at a low price than at a high price.

The Demand Curve

The inverse relationship between price and quantity de- manded for any product can be represented on a simple graph, in which, by convention, we measure quantity de- manded on the horizontal axis and price on the vertical axis. In the graph in Figure 3.1 we have plotted the five price-quantity data points listed in the accompanying table and connected the points with a smooth curve, labeled D. Such a curve is called a demand curve. Its downward slope reflects the law of demand—people buy more of a product, service, or resource as its price falls. The relationship be- tween price and quantity demanded is inverse (or negative).

The table does not tell us which of the five possible prices will actually exist in the corn market. That depends on the interaction between demand and supply. Demand is simply a statement of a buyer’s plans, or intentions, with respect to the purchase of a product. To be meaningful, the quantities demanded at each price must relate to a specific period—a day, a week, a month. Saying “A consumer will buy 10 bushels of corn at $5 per bushel” is meaningless. Saying “A consumer will buy 10 bushels of corn per week at $5 per bushel” is mean- ingful. Unless a specific time period is stated, we do not know whether the demand for a product is large or small.

Law of Demand

A fundamental characteristic of demand is this: Other things equal, as price falls, the quantity demanded rises, and

as price rises, the quantity demanded falls. In short, there is a negative or in- verse relationship between price and quantity de- manded. Economists call this inverse relationship the law of demand.

The other-things-equal assumption is critical here. Many factors other than the price of the product being considered affect the amount purchased. For example, the quantity of Nikes purchased will depend not only on the price of Nikes but also on the prices of such substitutes as Reeboks, Adidas, and New Balances. The law of demand in this case says that fewer Nikes will be purchased if the price of Nikes rises and if the prices of Reeboks, Adidas, and New Balances all remain constant. In short, if the relative price of Nikes rises, fewer Nikes will be bought. However, if the price of Nikes and the prices of all other competing shoes increase by some amount—say, $5—consumers might buy more, fewer, or the same number of Nikes. Why the inverse relationship between price and quan- tity demanded? Let’s look at three explanations, beginning with the simplest one:

• The law of demand is consistent with common sense. People ordinarily do buy more of a product at a low price than at a high price. Price is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the price obstacle, the more they will buy. The fact that businesses have “sales” to clear out unsold items is evidence of their belief in the law of demand.

• In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) from

O3.2

Law of demand

ORIGIN OF THE IDEA

O3.3

Diminishing marginal utility

ORIGIN OF THE IDEA

O3.4

Income and substitution effects

ORIGIN OF THE IDEA

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PART TWO Price, Quantity, and Efficiency56

each of the possible prices. Then we just multiply those amounts by the number of buyers to obtain the market de- mand. That is how we arrived at the demand schedule and demand curve D1 in Figure 3.3 for a market of 200 corn buy- ers, each with a demand as shown in the table in Figure 3.1. In constructing a demand curve such as D1 in Figure 3.3, economists assume that price is the most important influ- ence on the amount of any product purchased. But econo- mists know that other factors can and do affect purchases. These factors, called determinants of demand, are as- sumed to be constant when a demand curve like D1 is drawn. They are the “other things equal” in the relation- ship between price and quantity demanded. When any of these determinants changes, the demand curve will shift to the right or left. For this reason, determinants of demand are sometimes referred to as demand shifters. The basic determinants of demand are (1) consumers’ tastes (preferences), (2) the number of buyers in the market, (3) consumers’ incomes, (4) the prices of related goods, and (5) consumer expectations.

Changes in Demand

A change in one or more of the determinants of demand will change the demand data (the demand schedule) in the table accompanying Figure 3.3 and therefore the location of the demand curve there. A change in the

The table and graph in Figure 3.1 contain exactly the same data and reflect the same relationship between price and quantity demanded. But the graph shows that rela- tionship much more simply and clearly than a table or a description in words.

Market Demand

So far, we have concentrated on just one consumer. But competition requires that more than one buyer be present in each market. By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand. If there are just three buyers in the market, as represented in the table in Figure 3.2, it is relatively easy to determine the total quantity demanded at each price. Figure 3.2 shows the graphical summing procedure: At each price we sum hori- zontally the quantities demanded by Joe, Jen, and Jay to obtain the total quantity demanded at that price; we then plot the price and the total quantity demanded as one point on the market demand curve. At the price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels (5 35 1 39 1 26). Competition, of course, ordinarily entails many more than three buyers of a product. To avoid hundreds or thou- sands or millions of additions, we suppose that all the buyers in a market are willing and able to buy the same amounts at

FIGURE 3.2 Market demand for corn, three buyers. The market demand curve D is the horizontal summation of the individual demand curves (D1, D2, and D3) of all the consumers in the market. At the price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels (5 35 1 39 1 26).

Market Demand for Corn, Three Buyers

Total

Price Quantity Demanded

Quantity

per Demanded

Bushel Joe Jen Jay per Week

$5 10 1 12 1 8 5 30

4 20 1 23 1 17 5 60

3 35 1 39 1 26 5 100

2 55 1 60 1 39 5 154

1 80 1 87 1 54 5 221

Q

PP P P

Q Q Q

$3

350

$3

390

$3

260

$3

1000

(Market) (Joe) (Jen)

1 1 5

D1 D2 D3

D

(= 35 + 39 + 26)

(Jay)

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CHAPTER 3 Demand, Supply, and Market Equilibrium 57

demand for touch-screen mobile phones and fuel- efficient hybrid vehicles.

Number of Buyers An increase in the number of buy- ers in a market is likely to increase demand; a decrease in the number of buyers will probably decrease demand. For example, the rising number of older persons in the United States in recent years has increased the demand for motor homes, medical care, and retirement communities. Large- scale immigration from Mexico has greatly increased the demand for a range of goods and services in the Southwest, including Mexican food products in local grocery stores. Improvements in communications have given financial markets international range and have thus increased the demand for stocks and bonds. International trade agreements have reduced foreign trade barriers to American farm commodities, increasing the number of buyers and therefore the demand for those products. In contrast, emigration (out-migration) from many small rural communities has reduced the population and thus the demand for housing, home appliances, and auto repair in those towns.

Income How changes in income affect demand is a more complex matter. For most products, a rise in in- come causes an increase in demand. Consumers typically buy more steaks, furniture, and electronic equipment as their incomes increase. Conversely, the demand for such

demand schedule or, graphically, a shift in the demand curve is called a change in demand. If consumers desire to buy more corn at each possible price than is reflected in column 2 in the table in Fig- ure 3.3, that increase in demand is shown as a shift of the demand curve to the right, say, from D1 to D2. Conversely, a decrease in demand occurs when consumers buy less corn at each possible price than is indicated in column 2. The leftward shift of the demand curve from D1 to D3 in Figure 3.3 shows that situation. Now let’s see how changes in each determinant affect demand.

Tastes A favorable change in consumer tastes (preferences) for a product—a change that makes the product more desir- able—means that more of it will be demanded at each price. Demand will increase; the demand curve will shift right- ward. An unfavorable change in consumer preferences will decrease demand, shifting the demand curve to the left. New products may affect consumer tastes; for exam- ple, the introduction of digital cameras greatly decreased the demand for film cameras. Consumers’ concern over the health hazards of cholesterol and obesity have in- creased the demand for broccoli, low-calorie beverages, and fresh fruit while decreasing the demand for beef, veal, eggs, and whole milk. Over the past several years, the demand for coffee drinks and table wine has greatly increased, driven by a change in tastes. So, too, has the

0

P ri

ce (

p e r

b u sh

e l)

1

2

3

4

5

$6

Quantity demanded (thousands of bushels per week)

2 4 6 8 10 12 14 16 18

P

Q

D1

D2

D3

a

b

Increase in demand

Decrease in demand

Market Demand for

Corn, 200 Buyers, (D 1 )

(2)

(1) Total

Price Quantity

per Demanded

Bushel per Week

$5 2,000

4 4,000

3 7,000

2 11,000

1 16,000

FIGURE 3.3 Changes in the demand for corn. A change in one or more of the determinants of demand causes a change in demand. An increase in demand is shown as a shift of the demand curve to the right, as from D1 to D2. A decrease in demand is shown as a shift of the demand curve to the left, as from D1 to D3. These changes in demand are to be distinguished from a change in quantity demanded, which is caused by a change in the price of the product, as shown by a movement from, say, point a to point b on fixed demand curve D1.

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PART TWO Price, Quantity, and Efficiency58

Consumer Expectations Changes in consumer ex- pectations may shift demand. A newly formed expectation of higher future prices may cause consumers to buy now in order to “beat” the anticipated price rises, thus increas- ing current demand. That is often what happens in so- called hot real estate markets. Buyers rush in because they think the price of new homes will continue to escalate rap- idly. Some buyers fear being “priced out of the market” and therefore not obtaining the home they desire. Other buyers—speculators—believe they will be able to sell the houses later at a higher price. Whichever their motivation, these buyers increase the current demand for houses. Similarly, a change in expectations concerning future income may prompt consumers to change their current spending. For example, first-round NFL draft choices may splurge on new luxury cars in anticipation of lucrative professional football contracts. Or workers who become fearful of losing their jobs may reduce their demand for, say, vacation travel. In summary, an increase in demand—the decision by consumers to buy larger quantities of a product at each possible price—may be caused by:

• A favorable change in consumer tastes. • An increase in the number of buyers. • Rising incomes if the product is a normal good. • Falling incomes if the product is an inferior good. • An increase in the price of a substitute good. • A decrease in the price of a complementary good. • A new consumer expectation that either prices or

income will be higher in the future.

You should “reverse” these generalizations to explain a decrease in demand. Table 3.1 provides additional illustra- tions of the determinants of demand.

Changes in Quantity Demanded

A change in demand must not be confused with a change in quantity demanded. A change in demand is a shift of the demand curve to the right (an increase in demand) or to the left (a decrease in demand). It occurs because the con- sumer’s state of mind about purchasing the product has been altered in response to a change in one or more of the determinants of demand. Recall that “demand” is a sched- ule or a curve; therefore, a “change in demand” means a change in the schedule and a shift of the curve. In contrast, a change in quantity demanded is a movement from one point to another point—from one price-quantity combination to another—on a fixed de- mand curve. The cause of such a change is an increase or

products declines as their incomes fall. Products whose demand varies directly with money income are called superior goods, or normal goods. Although most products are normal goods, there are some exceptions. As incomes increase beyond some point, the demand for used clothing, retread tires, and third-hand automobiles may decrease because the higher incomes enable consumers to buy new versions of those products. Rising incomes may also decrease the demand for soy- enhanced hamburger. Similarly, rising incomes may cause the demand for charcoal grills to decline as wealthier con- sumers switch to gas grills. Goods whose demand varies inversely with money income are called inferior goods.

Prices of Related Goods A change in the price of a related good may either increase or decrease the demand for a product, depending on whether the related good is a substitute or a complement:

• A substitute good is one that can be used in place of another good.

• A complementary good is one that is used together with another good.

Substitutes Häagen-Dazs ice cream and Ben & Jerry’s ice cream are substitute goods or, simply, substitutes. When two products are substitutes, an increase in the price of one will increase the demand for the other. Conversely, a decrease in the price of one will decrease the demand for the other. For example, when the price of Häagen-Dazs ice cream rises, consumers will buy less of it and increase their demand for Ben & Jerry’s ice cream. When the price of Colgate toothpaste declines, the demand for Crest de- creases. So it is with other product pairs such as Nikes and Reeboks, Budweiser and Miller beer, or Chevrolets and Fords. They are substitutes in consumption.

Complements Because complementary goods (or, simply, complements) are used together, they are typically de- manded jointly. Examples include computers and software, cell phones and cellular service, and snowboards and lift tickets. If the price of a complement (for example, lettuce) goes up, the demand for the related good (salad dressing) will decline. Conversely, if the price of a complement (for example, tuition) falls, the demand for a related good (textbooks) will increase.

Unrelated Goods The vast majority of goods are not re- lated to one another and are called independent goods. Examples are butter and golf balls, potatoes and automo- biles, and bananas and wristwatches. A change in the price of one has little or no effect on the demand for the other.

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CHAPTER 3 Demand, Supply, and Market Equilibrium 59

decrease in the price of the product under consideration. In the table in Figure 3.3, for example, a decline in the price of corn from $5 to $4 will increase the quantity de- manded of corn from 2,000 to 4,000 bushels. In Figure 3.3 the shift of the demand curve D1 to ei- ther D2 or D3 is a change in demand. But the movement from point a to point b on curve D1 represents a change in quantity demanded: Demand has not changed; it is the entire curve, and it remains fixed in place.

TABLE 3.1 Determinants of Demand: Factors That Shift the Demand Curve

Determinant Examples

Change in buyer Physical fitness rises in popularity, tastes increasing the demand for jogging

shoes and bicycles; cell phone popularity rises, reducing the demand for landline phones.

Change in number A decline in the birthrate reduces of buyers the demand for children’s toys.

Change in income A rise in incomes increases the demand for normal goods such as

restaurant meals, sports tickets, and necklaces while reducing the demand for inferior goods such as cabbage, turnips, and inexpensive wine.

Change in the prices A reduction in airfares reduces the of related goods demand for bus transportation

(substitute goods); a decline in the price of DVD players increases the demand for DVD movies (complementary goods).

Change in consumer Inclement weather in South America expectations creates an expectation of higher

future coffee bean prices, thereby increasing today’s demand for coffee beans.

Supply LO3.3 Describe supply and explain how it can change. Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices dur- ing a specific period.2 The table in Figure 3.4 is a hypo- thetical supply schedule for a single producer of corn. It shows the quantities of corn that will be supplied at vari- ous prices, other things equal.

Law of Supply

The table in Figure 3.4 shows that a positive or direct re- lationship prevails between price and quantity supplied. As price rises, the quantity supplied rises; as price falls, the quantity supplied falls. This relationship is called the law of supply. A supply schedule tells us that, other things equal, firms will produce and offer for sale more of their product at a high price than at a low price. This, again, is basically common sense. Price is an obstacle from the standpoint of the con- sumer, who is on the paying end. The higher the price, the less the consumer will buy. But the supplier is on the receiving end of the product’s price. To a supplier, price represents revenue, which serves as an incentive to produce and sell a product. The higher the price, the greater this incentive and the greater the quantity supplied. Consider a farmer who is deciding on how much corn to plant. As corn prices rise, as shown in the table in Figure 3.4, the farmer finds it profitable to plant more corn. And the higher corn prices enable the farmer to cover the increased costs associated with more intensive cultivation and the use of more seed, fertilizer, and pesti- cides. The overall result is more corn. Now consider a manufacturer. Beyond some quantity of production, manufacturers usually encounter increases in marginal cost—the added cost of producing one more unit of output. Certain productive resources—in particular, the firm’s plant and machinery—cannot be expanded quickly, so the firm uses more of other resources such as labor to pro- duce more output. But as labor becomes more abundant relative to the fixed plant and equipment, the additional workers have relatively less space and access to equipment. For example, the added workers may have to wait to gain access to machines. As a result, each added worker produces less added output, and the marginal cost of successive units of output rises accordingly. The firm will not produce the

2This definition is worded to apply to product markets. To adjust it to apply to resource markets, substitute “resource” for “product” and “owners” for “producers.”

QUICK REVIEW 3.1

• Demand is a schedule or a curve showing the amount of a product that buyers are willing and able to pur- chase, in a particular time period, at each possible price in a series of prices.

• The law of demand states that, other things equal, the quantity of a good purchased varies inversely with its price.

• The demand curve shifts because of changes in (a) con- sumer tastes, (b) the number of buyers in the market, (c) consumer income, (d) the prices of substitute or complementary goods, and (e) consumer expectations.

• A change in demand is a shift of the demand curve; a change in quantity demanded is a movement from one point to another on a fixed demand curve.

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PART TWO Price, Quantity, and Efficiency60

Determinants of Supply

In constructing a supply curve, we assume that price is the most significant influence on the quantity supplied of any product. But other factors (the “other things equal”) can and do affect supply. The supply curve is drawn on the as- sumption that these other things are fixed and do not change. If one of them does change, a change in supply will occur, meaning that the entire supply curve will shift. The basic determinants of supply are (1) resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5) producer expectations, and (6) the number of sellers in the market. A change in any one or more of these determinants of supply, or supply shifters, will move the supply curve for a product either right or left. A shift to the right, as from S1 to S2 in Figure 3.5, signifies an increase in supply: Producers supply larger quantities of the product at each possible price. A shift to the left, as from S1 to S3, indicates a decrease in supply: Producers offer less output at each price.

Changes in Supply

Let’s consider how changes in each of the determinants af- fect supply. The key idea is that costs are a major factor un- derlying supply curves; anything that affects costs (other than changes in output itself) usually shifts the supply curve.

Resource Prices The prices of the resources used in the production process help determine the costs of production incurred by firms. Higher resource prices raise

more costly units unless it receives a higher price for them. Again, price and quantity supplied are directly related.

The Supply Curve

As with demand, it is convenient to represent individual sup- ply graphically. In Figure 3.4, curve S is the supply curve that corresponds with the price–quantity supplied data in the accompanying table. The upward slope of the curve re- flects the law of supply—producers offer more of a good, service, or resource for sale as its price rises. The relationship between price and quantity supplied is positive, or direct.

Market Supply

Market supply is derived from individual supply in exactly the same way that market demand is derived from indi- vidual demand. We sum the quantities supplied by each producer at each price. That is, we obtain the market supply curve by “horizontally adding” the supply curves of the individual producers. The price–quantity supplied data in the table accompanying Figure 3.5 are for an assumed 200 identical producers in the market, each willing to supply corn according to the supply schedule shown in Figure 3.4. Curve S1 in Figure 3.5 is a graph of the market supply data. Note that the values of the axes in Figure 3.5 are the same as those used in our graph of market demand (Figure 3.3). The only difference is that we change the label on the horizontal axis from “quantity demanded” to “quantity supplied.”

0

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ce (

p e r

b u sh

e l)

1

2

3

4

5

$6

Quantity supplied (bushels per week)

10 20 30 40 50 60 70

P

Q

S

FIGURE 3.4 An individual producer’s supply of corn. Because price and quantity supplied are directly related, the supply curve for an individual producer graphs as an upsloping curve. Other things equal, producers will offer more of a product for sale as its price rises and less of the product for sale as its price falls.

Supply of Corn

Quantity Supplied

Price per Bushel per Week

$5 60

4 50

3 35

2 20

1 5

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CHAPTER 3 Demand, Supply, and Market Equilibrium 61

goods” may entice soccer ball producers to switch produc- tion to those other goods in order to increase profits. This substitution in production results in a decline in the supply of soccer balls. Alternatively, when the prices of basketballs and volleyballs decline relative to the price of soccer balls, producers of those goods may decide to produce more soccer balls instead, increasing their supply.

Producer Expectations Changes in expectations about the future price of a product may affect the pro- ducer’s current willingness to supply that product. It is dif- ficult, however, to generalize about how a new expectation of higher prices affects the present supply of a product. Farmers anticipating a higher wheat price in the future might withhold some of their current wheat harvest from the market, thereby causing a decrease in the current sup- ply of wheat. In contrast, in many types of manufacturing industries, newly formed expectations that price will in- crease may induce firms to add another shift of workers or to expand their production facilities, causing current supply to increase.

Number of Sellers Other things equal, the larger the number of suppliers, the greater the market supply. As more firms enter an industry, the supply curve shifts to the right. Conversely, the smaller the number of firms in the industry, the less the market supply. This means that as firms leave an industry, the supply curve shifts to the left. Example: The United States and Canada have imposed re- strictions on haddock fishing to replenish dwindling stocks. As part of that policy, the federal government has bought the boats of some of the haddock fishers as a way of putting

production costs and, assuming a particular product price, squeeze profits. That reduction in profits reduces the in- centive for firms to supply output at each product price. For example, an increase in the price of sand, crushed rock, or Portland cement will increase the cost of produc- ing concrete and reduce its supply. In contrast, lower resource prices reduce production costs and increase profits. So when resource prices fall, firms sup- ply greater output at each product price. For example, a de- crease in the price of iron ore will decrease the price of steel.

Technology Improvements in technology (techniques of production) enable firms to produce units of output with fewer resources. Because resources are costly, using fewer of them lowers production costs and increases sup- ply. Example: Technological advances in producing flat- panel computer monitors have greatly reduced their cost. Thus, manufacturers will now offer more such monitors than previously at the various prices; the supply of flat- panel monitors has increased.

Taxes and Subsidies Businesses treat most taxes as costs. An increase in sales or property taxes will increase production costs and reduce supply. In contrast, subsidies are “taxes in reverse.” If the government subsidizes the production of a good, it in effect lowers the producers’ costs and increases supply.

Prices of Other Goods Firms that produce a particu- lar product, say, soccer balls, can sometimes use their plant and equipment to produce alternative goods, say, basket- balls and volleyballs. The higher prices of these “other

0

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ce (

p e r

b u sh

e l)

1

2

3

4

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$6

Quantity supplied (thousands of bushels per week)

2 4 6 8 10 12 14 16

P

Q

S2

S1S3

Decrease in supply

Increase in supply

a

b

FIGURE 3.5 Changes in the supply of corn. A change in one or more of the determinants of supply causes a change in supply. An increase in supply is shown as a rightward shift of the supply curve, as from S1 to S2. A decrease in supply is depicted as a leftward shift of the curve, as from S1 to S3. In contrast, a change in the quantity supplied is caused by a change in the product’s price and is shown by a movement from one point to another, as from b to a on fixed supply curve S1.

Market Supply of Corn, 200

Producers, (S 1 )

(2)

(1) Total

Price Quantity

per Supplied

Bushel per Week

$5 12,000

4 10,000

3 7,000

2 4,000

1 1,000

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PART TWO Price, Quantity, and Efficiency62

them out of business and decreasing the catch. The result has been a decline in the market supply of haddock. Table 3.2 is a checklist of the determinants of supply, along with further illustrations.

Changes in Quantity Supplied

The distinction between a change in supply and a change in quantity supplied parallels the distinction between a change in demand and a change in quantity demanded. Because supply is a schedule or curve, a change in supply means a change in the schedule and a shift of the curve. An increase in supply shifts the curve to the right; a decrease in supply shifts it to the left. The cause of a change in supply is a change in one or more of the determinants of supply. In contrast, a change in quantity supplied is a move- ment from one point to another on a fixed supply curve. The cause of such a movement is a change in the price of the specific product being considered. Consider supply curve S1 in Figure 3.5. A decline in the price of corn from $4 to $3 decreases the quantity of corn supplied per week from 10,000 to 7,000 bushels. This movement from point b to point a along S1 is a change in quantity supplied, not a change in supply. Supply is the full schedule of prices and quantities shown, and this schedule does not change when the price of corn changes.

TABLE 3.2 Determinants of Supply: Factors That Shift the Supply Curve

Determinant Examples

Change in resource A decrease in the price of microchips prices increases the supply of computers; an increase in the price of crude oil reduces the supply of gasoline.

Change in The development of more effective technology wireless technology increases the supply of cell phones.

Changes in taxes An increase in the excise tax on and subsidies cigarettes reduces the supply of cigarettes; a decline in subsidies to state universities reduces the supply of higher education.

Change in prices An increase in the price of cucumbers of other goods decreases the supply of watermelons.

Change in producer An expectation of a substantial rise in expectations future log prices decreases the supply of logs today.

Change in number An increase in the number of tattoo of suppliers parlors increases the supply of tattoos; the formation of women’s professional basketball leagues increases the supply of women’s

professional basketball games.

Market Equilibrium LO3.4 Relate how supply and demand interact to determine market equilibrium. With our understanding of demand and supply, we can now show how the decisions of buyers of corn and sellers of corn interact to determine the equilibrium price and quantity of corn. In the table in Figure 3.6, columns 1 and 2 repeat the market supply of corn (from the table in Figure 3.5), and columns 2 and 3 repeat the market demand for corn (from the table in Figure 3.3). We assume this is a competitive market so that neither buyers nor sellers can set the price.

Equilibrium Price and Quantity

We are looking for the equilibrium price and equilibrium quantity. The equilibrium price (or market-clearing price) is the price where the intentions of buyers and sellers match. It is the price where quantity demanded equals quantity supplied. The table in Figure 3.6 reveals that at $3, and only at that price, the number of bushels of corn that sellers wish to sell (7,000) is identical to the number consumers want to buy (also 7,000). At $3 and 7,000 bushels of corn, there is neither a shortage nor a surplus of corn. So 7,000 bushels of corn is the equilibrium quantity: the quantity at which the intentions of buyers and sellers match, so that the quantity demanded and the quantity supplied are equal. Graphically, the equilibrium price is indicated by the intersection of the supply curve and the demand curve in Figure 3.6 (Key Graph). (The horizontal axis now measures both quantity demanded and quantity supplied.) With neither a shortage nor a surplus at $3, the market is in equilibrium, meaning “in balance” or “at rest.” Competition among buyers and among sellers drives the price to the equilibrium price; once there, it will remain there unless it is subsequently disturbed by changes in de- mand or supply (shifts of the curves). To better understand the uniqueness of the equilibrium price, let’s consider other

QUICK REVIEW 3.2

• A supply schedule or curve shows that, other things equal, the quantity of a good supplied varies directly with its price.

• The supply curve shifts because of changes in (a) re- source prices, (b) technology, (c) taxes or subsidies, (d) prices of other goods, (e) expectations of future prices, and (f ) the number of suppliers.

• A change in supply is a shift of the supply curve; a change in quantity supplied is a movement from one point to another on a fixed supply curve.

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63

QUICK QUIZ FOR FIGURE 3.6

1. Demand curve D is downsloping because: a. producers offer less of a product for sale as the price of the

product falls. b. lower prices of a product create income and substitution ef-

fects that lead consumers to purchase more of it. c. the larger the number of buyers in a market, the lower the

product price. d. price and quantity demanded are directly (positively) related.

2. Supply curve S: a. reflects an inverse (negative) relationship between price and

quantity supplied. b. reflects a direct (positive) relationship between price and

quantity supplied. c. depicts the collective behavior of buyers in this market.

d. shows that producers will offer more of a product for sale at a low product price than at a high product price.

3. At the $3 price: a. quantity supplied exceeds quantity demanded. b. quantity demanded exceeds quantity supplied. c. the product is abundant and a surplus exists. d. there is no pressure on price to rise or fall.

4. At price $5 in this market: a. there will be a shortage of 10,000 units. b. there will be a surplus of 10,000 units. c. quantity demanded will be 12,000 units. d. quantity demanded will equal quantity supplied.

Answers: 1. b; 2. b; 3. d; 4. b

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p er

b u sh

el )

1

2

3

4

5

$6

Bushels of corn (thousands per week)

2 4 6 8 10 12 14 16 18

6,000-bushel surplus

7,000-bushel shortage

P

Q 7

D

S

FIGURE 3.6 Equilibrium price and quantity. The intersection of the downsloping demand curve D and the upsloping supply curve S indicates the equilibrium price and quantity, here $3 and 7,000 bushels of corn. The shortages of corn at below-equilibrium prices (for example, 7,000 bushels at $2) drive up price. The higher prices increase the quantity supplied and reduce the quantity demanded until equilibrium is achieved. The surpluses caused by above-equilibrium prices (for example, 6,000 bushels at $4) push price down. As price drops, the quantity demanded rises and the quantity supplied falls until equilibrium is established. At the equilibrium price and quantity, there are neither shortages nor surpluses of corn.

KEY GRAPH ➔

➔

➔ ➔

*Arrows indicate the effect on price.

Market Supply of and Demand for Corn

(1) (3)

Total (2) Total (4)

Quantity Price Quantity Surplus (1) Supplied per Demanded or

per Week Bushel per Week Shortage (2)*

12,000 $5 2,000 110,000

10,000 4 4,000 16,000

7,000 3 7,000 0

4,000 2 11,000 27,000

1,000 1 16,000 215,000

prices. At any above-equilibrium price, quantity supplied exceeds quantity demanded. For example, at the $4 price, sellers will offer 10,000 bushels of corn, but buyers will pur- chase only 4,000. The $4 price encourages sellers to offer lots of corn but discourages many consumers from buying it. The result is a surplus (or excess supply) of 6,000 bushels. If corn sellers produced them all, they would find them- selves with 6,000 unsold bushels of corn. Surpluses drive prices down. Even if the $4 price existed temporarily, it could not persist. The large surplus would

prompt competing sellers to lower the price to encourage buyers to take the surplus off their hands. As the price fell, the incentive to produce corn would decline and the incen- tive for consumers to buy corn would increase. As shown in Figure 3.6, the market would move to its equilibrium at $3. Any price below the $3 equilibrium price would create a shortage; quantity demanded would exceed quantity sup- plied. Consider a $2 price, for example. We see both from column 2 of the table and from the demand curve in Figure 3.6 that quantity demanded exceeds quantity supplied at

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PART TWO Price, Quantity, and Efficiency64

persist as the equilibrium price. Many consumers who want to buy corn at this price will not obtain it. They will express a willingness to pay more than $2 to get corn. Competition among these buyers will drive up the price, eventually to the $3 equilibrium level. Unless disrupted by changes of supply or demand, this $3 price of corn will continue to prevail.

Rationing Function of Prices

The ability of the competitive forces of supply and de- mand to establish a price at which selling and buying deci- sions are consistent is called the rationing function of prices. In our case, the equilibrium price of $3 clears the market, leaving no burdensome surplus for sellers and no inconvenient shortage for potential buyers. And it is the combination of freely made individual decisions that sets this market-clearing price. In effect, the market outcome says that all buyers who are willing and able to pay $3 for a bushel of corn will obtain it; all buyers who cannot or will not pay $3 will go without corn. Similarly, all produc- ers who are willing and able to offer corn for sale at $3 a bushel will sell it; all producers who cannot or will not sell for $3 per bushel will not sell their product.

Efficient Allocation

A competitive market such as that we have described not only rations goods to consumers but also allocates society’s resources efficiently to the particular product. Competition among corn producers forces them to use the best technol- ogy and right mix of productive resources. If they didn’t, their costs would be too high relative to the market price, and they would be unprofitable. The result is productive efficiency: the production of any particular good in the least costly way. When society produces corn at the lowest achievable per-unit cost, it is expending the least-valued combination of resources to produce that product and therefore is making available more-valued resources to pro- duce other desired goods. Suppose society has only $100 worth of resources available. If it can produce a bushel of corn using $3 of those resources, then it will have available $97 of resources remaining to produce other goods. This is clearly better than producing the corn for $5 and having only $95 of resources available for the alternative uses. Competitive markets also produce allocative efficiency: the particular mix of goods and services most highly valued by society (minimum-cost production assumed). For exam- ple, society wants land suitable for growing corn used for that purpose, not to grow dandelions. It wants diamonds to be used for jewelry, not crushed up and used as an additive to give concrete more sparkle. It wants iPods and MP4 players, not cassette players and tapes. Moreover, society does not

that price. The result is a shortage (or excess demand) of 7,000 bushels of corn. The $2 price discourages sellers from devoting resources to corn and encourages consumers to desire more bushels than are available. The $2 price cannot

CONSIDER THIS . . .

Ticket Scalping: A Bum Rap!

Ticket prices for athletic events and musical concerts are usually set far in advance of the events. Sometimes the original ticket price is too low to be the equilibrium price. Lines form at the ticket window and a severe short- age of tickets occurs at the printed price. What happens next? Buyers who are willing to pay more than the origi- nal price bid up the ticket price in resale ticket markets.

Tickets sometimes get resold for much greater amounts than the original price—market transactions known as “scalp- ing.” For example, an original buyer may resell a $75 ticket to a concert for $200. Reporters sometimes denounce scalpers for “ripping off” buyers by charging “exorbitant” prices. But is scalping really a rip-off? We must first recognize that such ticket resales are voluntary transactions. If both buyer and seller did not expect to gain from the exchange, it would not occur! The seller must value the $200 more than seeing the event, and the buyer must value seeing the event at $200 or more. So there are no losers or victims here: Both buyer and seller benefit from the transaction. The scalping market simply redistributes assets (game or concert tickets) from those who would rather have the money (and the other things that the money can buy) to those who would rather have the tickets. Does scalping impose losses or injury on the sponsors of the event? If the sponsors are injured, it is because they ini- tially priced tickets below the equilibrium level. Perhaps they did this to create a long waiting line and the attendant news media publicity. Alternatively, they may have had a genuine desire to keep tickets affordable for lower-income, ardent fans. In either case, the event sponsors suffer an opportunity cost in the form of less ticket revenue than they might have otherwise received. But such losses are self-inflicted and separate and distinct from the fact that some tickets are later resold at a higher price. So is ticket scalping undesirable? Not on economic grounds! It is an entirely voluntary activity that benefits both sellers and buyers.

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CHAPTER 3 Demand, Supply, and Market Equilibrium 65

trast, if supply decreases, as in Figure 3.7d, equilibrium price rises while equilibrium quantity declines.

Complex Cases

When both supply and demand change, the effect is a combination of the individual effects.

Supply Increase; Demand Decrease What effect will a supply increase and a demand decrease for some good (for example, apples) have on equilibrium price? Both changes decrease price, so the net result is a price drop greater than that resulting from either change alone. What about equilibrium quantity? Here the effects of the changes in supply and demand are opposed: the increase

want to devote all its resources to corn, diamonds, and por- table digital media players. It wants to assign some resources to wheat, gasoline, and cell phones. Competitive markets make those allocatively efficient assignments. The equilibrium price and quantity in competitive markets usually produce an assignment of resources that is “right” from an economic perspective. Demand essentially reflects the marginal benefit (MB) of the good, based on the utility received. Supply reflects the marginal cost (MC) of producing the good. The market ensures that firms produce all units of goods for which MB exceeds MC and no units for which MC exceeds MB. At the intersection of the demand and supply curves, MB equals MC and alloca- tive efficiency results. As economists say, there is neither an “underallocaton of resources” nor an “overallocation of resources” to the product.

Changes in Supply, Demand, and Equilibrium LO3.5 Explain how changes in supply and demand affect equilibrium prices and quantities. We know that demand might change because of fluctuations in consumer tastes or incomes, changes in consumer expec- tations, or variations in the prices of related goods. Supply might change in response to changes in resource prices, technology, or taxes. What effects will such changes in sup- ply and demand have on equilibrium price and quantity?

Changes in Demand

Suppose that the supply of some good (for example, health care) is constant and demand increases, as shown in Fig- ure 3.7a. As a result, the new intersection of the supply and demand curves is at higher values on both the price and the quantity axes. Clearly, an increase in demand raises both equilibrium price and equilibrium quantity. Conversely, a decrease in demand such as that shown in Figure 3.7b reduces both equilibrium price and equilib- rium quantity. (The value of graphical analysis is now ap- parent: We need not fumble with columns of figures to determine the outcomes; we need only compare the new and the old points of intersection on the graph.)

Changes in Supply

What happens if the demand for some good (for exam- ple, flash drives) is constant but supply increases, as in Fig ure 3.7c? The new intersection of supply and demand is located at a lower equilibrium price but at a higher equilibrium quantity. An increase in supply reduces equi- librium price but increases equilibrium quantity. In con-

CONSIDER THIS . . .

Salsa and Coffee Beans

If you forget the other- things-equal assumption, you can encounter situations that seem to be in conflict with the laws of demand and supply. For example, sup- pose salsa manufacturers sell 1 million bottles of salsa at $4 a bottle in one year; 2 million bottles at $5 in the next year; and 3 million at $6 in the year thereafter. Price and quantity purchased vary directly, and these data

seem to be at odds with the law of demand. But there is no conflict here; the data do not refute the law of demand. The catch is that the law of demand’s other-things- equal assumption has been violated over the three years in the example. Specifically, because of changing tastes and rising in- comes, the demand for salsa has increased sharply, as in Figure 3.7a. The result is higher prices and larger quantities purchased. Another example: The price of coffee beans occasionally shoots upward at the same time that the quantity of coffee beans harvested declines. These events seemingly contradict the direct relationship between price and quantity denoted by supply. The catch again is that the other-things-equal as- sumption underlying the upsloping supply curve is violated. Poor coffee harvests decrease supply, as in Figure 3.7d, in- creasing the equilibrium price of coffee and reducing the equilibrium quantity. The laws of demand and supply are not refuted by obser- vations of price and quantity made over periods of time in which either demand or supply curves shift.

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PART TWO Price, Quantity, and Efficiency66

in supply increases equilibrium quantity, but the decrease in demand reduces it. The direction of the change in equilib- rium quantity depends on the relative sizes of the changes in supply and demand. If the increase in supply is larger than the decrease in demand, the equilibrium quantity will increase. But if the decrease in demand is greater than the increase in supply, the equilibrium quantity will decrease.

Supply Decrease; Demand Increase A decrease in supply and an increase in demand for some good (for ex- ample, gasoline) both increase price. Their combined ef- fect is an increase in equilibrium price greater than that caused by either change separately. But their effect on the equilibrium quantity is again indeterminate, depending on

D increase: P↑, Q↑

S

D2

D1

0

P

Q

(a) Increase in demand

D4

D3

S

0

P

Q

(b) Decrease in demand

D decrease: P↓, Q↓

D

S1 S2

0

P

Q

(c) Increase in supply

S increase: P↓, Q↑

D

S4 S3

0

P

Q

(d) Decrease in supply

S decrease: P↑, Q↓

FIGURE 3.7 Changes in demand and supply and the effects on price and quantity. The increase in demand from D1 to D2 in (a) increases both equilibrium price and equilibrium quantity. The decrease in demand from D3 to D4 in (b) decreases both equilibrium price and equilibrium quantity. The increase in supply from S1 to S2 in (c) decreases equilibrium price and increases equilibrium quantity. The decline in supply from S3 to S4 in (d) increases equilibrium price and decreases equilibrium quantity. The boxes in the top right corners summarize the respective changes and outcomes. The upward arrows in the boxes signify increases in equilibrium price (P) and equilibrium quantity (Q); the downward arrows signify decreases in these items.

the relative sizes of the changes in supply and demand. If the decrease in supply is larger than the increase in de- mand, the equilibrium quantity will decrease. In contrast, if the increase in demand is greater than the decrease in supply, the equilibrium quantity will increase.

Supply Increase; Demand Increase What if supply and demand both increase for some good (for example, cell phones)? A supply increase drops equilibrium price, while a demand increase boosts it. If the increase in supply is greater than the increase in demand, the equilibrium price will fall. If the opposite holds, the equilibrium price will rise. The effect on equilibrium quantity is certain: The in- creases in supply and demand both raise the equilibrium

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CHAPTER 3 Demand, Supply, and Market Equilibrium 67

“essential” good or service that they could not afford at the equilibrium price. Examples are rent controls and usury laws, which specify maximum “prices” in the forms of rent and interest that can be charged to borrowers.

Graphical Analysis We can easily show the effects of price ceilings graphically. Suppose that rapidly rising world income boosts the purchase of automobiles and shifts the de- mand for gasoline to the right so that the market equilibrium price reaches $3.50 per gallon, shown as P0 in Figure 3.8. The rapidly rising price of gasoline greatly burdens low- and moderate-income households, which pressure government to “do something.” To keep gasoline prices down, the govern- ment imposes a ceiling price P

c of $3 per gallon. To impact

the market, a price ceiling must be below the equilibrium price. A ceiling price of $4, for example, would have had no effect on the price of gasoline in the current situation. What are the effects of this $3 ceiling price? The ra- tioning ability of the free market is rendered ineffective. Because the ceiling price P

c is below the market-clearing

price P0, there is a lasting shortage of gasoline. The quan- tity of gasoline demanded at P

c is Q

d and the quantity sup-

plied is only Q s ; a persistent excess demand or shortage of

amount Q d 2 Q

s occurs.

The price ceiling P c prevents the usual market adjust-

ment in which competition among buyers bids up price, inducing more production and rationing some buyers out of the market. That process would normally continue until the shortage disappeared at the equilibrium price and quantity, P0 and Q0. By preventing these market adjustments from occur- ring, the price ceiling poses two related problems.

Rationing Problem How will the available supply Q s

be apportioned among buyers who want the greater

quantity. Therefore, the equilibrium quantity will increase by an amount greater than that caused by either change alone.

Supply Decrease; Demand Decrease What about decreases in both supply and demand for some good (for example, new homes)? If the decrease in supply is greater than the decrease in demand, equilibrium price will rise. If the reverse is true, equilibrium price will fall. Because the decreases in supply and demand each reduce equilibrium quantity, we can be sure that equilibrium quantity will fall. Table 3.3 summarizes these four cases. To understand them fully, you should draw supply and demand diagrams for each case to confirm the effects listed in this table. Special cases arise when a decrease in demand and a de- crease in supply, or an increase in demand and an increase in supply, exactly cancel out. In both cases, the net effect on equilibrium price will be zero; price will not change. The optional appendix accompanying this chapter provides additional examples of situations in which both supply and demand change at the same time.

Application: Government- Set Prices LO3.6 Identify what government-set prices are and how they can cause product surpluses and shortages. Prices in most markets are free to rise or fall to their equi- librium levels, no matter how high or low those levels might be. However, government sometimes concludes that supply and demand will produce prices that are un- fairly high for buyers or unfairly low for sellers. So gov- ernment may place legal limits on how high or low a price or prices may go. Is that a good idea?

Price Ceilings on Gasoline

A price ceiling sets the maximum legal price a seller may charge for a product or service. A price at or below the ceil- ing is legal; a price above it is not. The rationale for estab- lishing price ceilings (or ceiling prices) on specific products is that they purportedly enable consumers to obtain some

TABLE 3.3 Effects of Changes in Both Supply and Demand

Effect on Effect on

Change in Change in Equilibrium Equilibrium

Supply Demand Price Quantity

1. Increase Decrease Decrease Indeterminate

2. Decrease Increase Increase Indeterminate

3. Increase Increase Indeterminate Increase

4. Decrease Decrease Indeterminate Decrease

Shortage

S

D

P

0

Ceiling

Qs QdQ0 Q

Pc

P0

3.00

$3.50

FIGURE 3.8 A price ceiling. A price ceiling is a maximum legal price such as Pc. When the ceiling price is below the equilibrium price, a persistent product shortage results. Here that shortage is shown by the horizontal distance between Qd and Qs.

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68

A Legal Market for Human Organs?

It has become increasingly commonplace in medicine to trans- plant kidneys, lungs, livers, corneas, pancreases, and hearts from deceased individuals to those whose organs have failed or are failing. But surgeons and many of their pa- tients face a growing problem: There are shortages of donated organs available for transplant. Not everyone who needs a transplant can get one. In 2012, there were 116,000 Americans on the waiting list for transplants. Indeed, an inadequate supply of donated organs causes an estimated 6,900 deaths in the United States each year.

Why Shortages? Seldom do we hear of shortages of desired goods in market economies. What is different about organs for transplant? One difference is that no legal market exists for human organs. To understand this situation, observe the de- mand curve D1 and supply curve S1 in the accompanying figure. The downward slope of the demand curve tells us that if there

A Legal Market Might Eliminate the Present Shortage of Human Organs for Transplant. But There Are

Many Serious Objections to “Turning Human Body Parts into Commodities” for Purchase and Sale.

LAST WORD

were a market for human organs, the quantity of organs de- manded would be greater at lower prices than at higher prices. Vertical supply curve S1 represents the fixed quantity of human

organs now donated via consent before death. Because the price of these donated organs is in effect zero, quantity de- manded Q3 exceeds quantity supplied Q1. The shortage of Q3 2 Q1 is rationed through a waiting list of those in medical need of transplants. Many people die while still on the waiting list.

Use of a Market A market for human organs would increase the incentive to donate organs. Such a market might work like this: An individual might specify in a legal document that he or she is willing to sell one or more usable human organs upon death or near-death. The person could specify where the money from the

sale would go, for example, to family, a church, an educational institution, or a charity. Firms would then emerge to purchase

P

P0 Q2 Q3Q1 Q

P1

S1 S2

D1

amount Q d ? Should gasoline be distributed on a first-

come, first-served basis, that is, to those willing and able to get in line the soonest or stay in line the longest? Or should gas stations distribute it on the basis of favoritism? Since an unregulated shortage does not lead to an equita- ble distribution of gasoline, the government must estab- lish some formal system for rationing it to consumers. One option is to issue ration coupons, which authorize bearers to purchase a fixed amount of gasoline per month. The rationing system might entail first the printing of coupons for Q

s gallons of gasoline and then the equal dis-

tribution of the coupons among consumers so that the wealthy family of four and the poor family of four both receive the same number of coupons.

Black Markets But ration coupons would not prevent a second problem from arising. The demand curve in Fig- ure 3.8 reveals that many buyers are willing to pay more than the ceiling price P

c . And, of course, it is more profit-

able for gasoline stations to sell at prices above the ceiling. Thus, despite a sizable enforcement bureaucracy that would have to accompany the price controls, black markets in which gasoline is illegally bought and sold at prices above the legal limits will flourish. Counterfeiting of ra- tion coupons will also be a problem. And since the price of gasoline is now “set by government,” government might face political pressure to set the price even lower.

Rent Controls

About 200 cities in the United States, including New York City, Boston, and San Francisco, have at one time or an- other enacted rent controls: maximum rents established by law (or, more recently, maximum rent increases for ex- isting tenants). Such laws are well intended. Their goals are to protect low-income families from escalating rents caused by perceived housing shortages and to make hous- ing more affordable to the poor.

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69

organs and resell them where needed for profit. Under such a system, the supply curve of usable organs would take on the nor- mal upward slope of typical supply curves. The higher the ex- pected price of an organ, the greater the number of people who would be willing to have their organs sold at death. Suppose that the supply curve is S2 in the figure. At the equilibrium price P1, the number of organs made available for transplant (Q2) would equal the number pur- chased for transplant (also Q2). In this generalized case, the shortage of organs would be eliminated and, of particular importance, the number of or- gans available for transplanting would rise from Q1 to Q2. This means more lives would be saved and enhanced than under the present donor system.

Objections In view of this positive outcome, why is there no such market for human or- gans? Critics of market-based solutions have two main objections. The first is a moral objection: Critics feel that turning human organs into commodities commercializes human beings and di- minishes the special nature of human life. They say there is some- thing unseemly about selling and buying body organs as if they were bushels of wheat or ounces of gold. (There is, however, a

market for blood!) Moreover, critics note that the market would ration the available organs (as represented by Q2 in the figure) to people who either can afford them (at P1) or have health insur- ance for transplants. The poor and uninsured would be left out. Second, a health-cost objection suggests that a market for body organs would greatly increase the cost of health care. Rather than

obtaining freely donated (al- though “too few”) body organs, patients or their insurance com- panies would have to pay market prices for them, further increas- ing the cost of medical care.

R e b u t t a l S u p p o r t e r s o f market-based solutions to organ shortages point out that the laws against selling organs are simply driving the market underground. Worldwide, an estimated $1 billion-per-year illegal market in human organs has emerged. As in other illegal markets, the unscrupulous tend

to thrive. This fact is dramatized by the accompanying photo, in which four Pakistani villagers show off their scars after they each sold a kidney to pay off debts. Supporters say that legalization of the market for human organs would increase organ supply from legal sources, drive down the price of organs, and reduce the abuses such as those now taking place in illegal markets.

What have been the actual economic effects? On the demand side, the below-equilibrium rents attract a larger number of renters. Some are locals seeking to move into their own places after sharing housing with friends or fam- ily. Others are outsiders attracted into the area by the arti- ficially lower rents. But a large problem occurs on the supply side. Price controls make it less attractive for land- lords to offer housing on the rental market. In the short run, owners may sell their rental units or convert them to condominiums. In the long run, low rents make it unprof- itable for owners to repair or renovate their rental units. (Rent controls are one cause of the many abandoned apartment buildings found in larger cities.) Also, insurance companies, pension funds, and other potential new inves- tors in housing will find it more profitable to invest in office buildings, shopping malls, or motels, where rents are not controlled. In brief, rent controls distort market signals and thus resources are misallocated: Too few resources are allocated

to rental housing and too many to alternative uses. Ironically, although rent controls are often legislated to lessen the effects of perceived housing shortages, controls in fact are a primary cause of such shortages. For that rea- son, most American cities either have abandoned or are in the process of dismantling rent controls.

Price Floors on Wheat

A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not. Price floors above equilibrium prices are usually invoked when society feels that the free functioning of the market sys- tem has not provided a sufficient income for certain groups of resource suppliers or producers. Supported prices for agri- cultural products and current minimum wages are two ex- amples of price (or wage) floors. Let’s look at the former. Suppose that many farmers have extremely low incomes when the price of wheat is at its equilibrium value of $2 per

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PART TWO Price, Quantity, and Efficiency70

but distort resource allocation. Without the price floor, the $2 equilibrium price of wheat would cause financial losses and force high-cost wheat producers to plant other crops or abandon farming altogether. But the $3 price floor allows them to continue to grow wheat and remain farmers. So society devotes too many of its scarce re- sources to wheat production and too few to producing other, more valuable, goods and services. It fails to achieve allocative efficiency. That’s not all. Consumers of wheat-based products pay higher prices because of the price floor. Taxpayers pay higher taxes to finance the government’s purchase of the surplus. Also, the price floor causes potential environmental damage by encouraging wheat farmers to bring hilly, erosion-prone “marginal land” into production. The higher price also prompts imports of wheat. But, since such imports would increase the quantity of wheat supplied and thus undermine the price floor, the government needs to erect tariffs (taxes on imports) to keep the foreign wheat out. Such tariffs usu- ally prompt other countries to retaliate with their own tariffs against U.S. agricultural or manufacturing exports. So it is easy to see why economists “sound the alarm” when politicians advocate imposing price ceilings or price floors such as price controls, rent controls, interest-rate lids, or agricultural price supports. In all these cases, good intentions lead to bad economic outcomes. Government- controlled prices cause shortages or surpluses, distort resource allocation, and produce negative side effects.

bushel. The government decides to help out by establishing a legal price floor or price support of $3 per bushel. What will be the effects? At any price above the equilibrium price, quantity supplied will exceed quantity demanded—that is, there will be a persistent excess supply or surplus of the product. Farmers will be willing to produce and offer for sale more than private buyers are willing to purchase at the price floor. As we saw with a price ceiling, an imposed legal price disrupts the rationing ability of the free market.

Graphical Analysis Figure 3.9 illustrates the effect of a price floor graphically. Suppose that S and D are the supply and demand curves for wheat. Equilibrium price and quan- tity are P0 and Q0, respectively. If the government imposes a price floor of P

f , farmers will produce Q

s but private buyers

will purchase only Q d . The surplus is the excess of Q

s over Q

d .

The government may cope with the surplus resulting from a price floor in two ways:

• It can restrict supply (for example, by instituting acreage allotments by which farmers agree to take a certain amount of land out of production) or increase demand (for example, by researching new uses for the product involved). These actions may reduce the difference between the equilibrium price and the price floor and that way reduce the size of the resulting surplus.

• If these efforts are not wholly successful, then the government must purchase the surplus output at the $3 price (thereby subsidizing farmers) and store or otherwise dispose of it.

Additional Consequences Price floors such as P f in

Figure 3.9 not only disrupt the rationing ability of prices

Pf

P0

Surplus Floor

P

Qd Q0 Qs0 Q

S

D

2.00

$3.00

FIGURE 3.9 A price floor. A price floor is a minimum legal price such as Pf. When the price floor is above the equilibrium price, a persistent product surplus results. Here that surplus is shown by the horizontal distance between Qs and Qd.

QUICK REVIEW 3.3

• In competitive markets, prices adjust to the equilib- rium level at which quantity demanded equals quan- tity supplied.

• The equilibrium price and quantity are those indicated by the intersection of the supply and demand curves for any product or resource.

• An increase in demand increases equilibrium price and quantity; a decrease in demand decreases equilibrium price and quantity.

• An increase in supply reduces equilibrium price but in- creases equilibrium quantity; a decrease in supply in- creases equilibrium price but reduces equilibrium quantity.

• Over time, equilibrium price and quantity may change in directions that seem at odds with the laws of demand and supply because the other-things-equal assumption is violated.

• Government-controlled prices in the form of ceilings and floors stifle the rationing function of prices, distort resource allocations, and cause negative side effects.

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71

SUMMARY causes a change in the quantity supplied, which is shown as a move- ment from one point to another point on a fixed supply curve.

LO3.4 Relate how supply and demand interact to determine market equilibrium.

The equilibrium price and quantity are established at the in- tersection of the supply and demand curves. The interaction of market demand and market supply adjusts the price to the point at which the quantities demanded and supplied are equal. This is the equilibrium price. The corresponding quantity is the equilibrium quantity. The ability of market forces to synchronize selling and buying decisions to eliminate potential surpluses and shortages is known as the rationing function of prices. The equilibrium quantity in competitive markets reflects both productive efficiency (least-cost production) and allocative efficiency (producing the right amount of the product relative to other products).

LO3.5 Explain how changes in supply and demand affect equilibrium prices and quantities.

A change in either demand or supply changes the equilibrium price and quantity. Increases in demand raise both equilibrium price and equilibrium quantity; decreases in demand lower both equilibrium price and equilibrium quantity. Increases in supply lower equilibrium price and raise equilibrium quantity; decreases in supply raise equilibrium price and lower equilib- rium quantity. Simultaneous changes in demand and supply affect equilib- rium price and quantity in various ways, depending on their di- rection and relative magnitudes (see Table 3.3).

LO3.6 Identify what government-set prices are and how they can cause product surpluses and

shortages.

A price ceiling is a maximum price set by government and is designed to help consumers. Effective price ceilings produce per sis- tent product shortages, and if an equitable distribution of the prod- uct is sought, government must ration the product to consumers. A price floor is a minimum price set by government and is designed to aid producers. Effective price floors lead to persis- tent product surpluses; the government must either purchase the product or eliminate the surplus by imposing restrictions on pro- duction or increasing private demand. Legally fixed prices stifle the rationing function of prices and distort the allocation of resources.

LO3.1 Characterize and give examples of markets.

Markets bring buyers and sellers together. Some markets are local, others international. Some have physical locations while others are online. For simplicity, this chapter focuses on highly competitive markets in which large numbers of buyers and sellers come together to buy and sell standardized products. All such markets involve de- mand, supply, price, and quantity, with price being “discovered” through the interacting decisions of buyers and sellers.

LO3.2 Describe demand and explain how it can change.

Demand is a schedule or curve representing the willingness of buy- ers in a specific period to purchase a particular product at each of various prices. The law of demand implies that consumers will buy more of a product at a low price than at a high price. So, other things equal, the relationship between price and quantity demanded is negative or inverse and is graphed as a downsloping curve. Market demand curves are found by adding horizontally the demand curves of the many individual consumers in the market. Changes in one or more of the determinants of demand (consumer tastes, the number of buyers in the market, the money incomes of consumers, the prices of related goods, and consumer expectations) shift the market demand curve. A shift to the right is an increase in demand; a shift to the left is a decrease in de- mand. A change in demand is different from a change in the quantity demanded, the latter being a movement from one point to another point on a fixed demand curve because of a change in the product’s price.

LO3.3 Describe supply and explain how it can change.

Supply is a schedule or curve showing the amounts of a product that producers are willing to offer in the market at each possible price during a specific period. The law of supply states that, other things equal, producers will offer more of a product at a high price than at a low price. Thus, the relationship between price and quantity supplied is positive or direct, and supply is graphed as an upsloping curve. The market supply curve is the horizontal summation of the supply curves of the individual producers of the product. Changes in one or more of the determinants of supply (re- source prices, production techniques, taxes or subsidies, the prices of other goods, producer expectations, or the number of sellers in the market) shift the supply curve of a product. A shift to the right is an increase in supply; a shift to the left is a decrease in supply. In contrast, a change in the price of the product being considered

TERMS AND CONCEPTS demand demand schedule law of demand diminishing marginal utility

income effect substitution effect demand curve determinants of demand

normal goods inferior goods substitute good complementary good

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PART TWO Price, Quantity, and Efficiency72

R E V I E W Q U E S T I O N S

1. What effect will each of the following have on the de- mand for small automobiles such as the Mini-Cooper and Fiat 500? LO3.2

a. Small automobiles become more fashionable. b. The price of large automobiles rises (with the price of

small autos remaining the same). c. Income declines and small autos are an inferior good. d. Consumers anticipate that the price of small autos will

greatly come down in the near future. e. The price of gasoline substantially drops. 2. True or False: A “change in quantity demanded” is a shift of

the entire demand curve to the right or to the left. LO3.2 3. What effect will each of the following have on the supply of

auto tires? LO3.3 a. A technological advance in the methods of producing tires. b. A decline in the number of firms in the tire industry. c. An increase in the prices of rubber used in the produc-

tion of tires. d. The expectation that the equilibrium price of auto tires

will be lower in the future than currently.

e. A decline in the price of the large tires used for semi trucks and earth-hauling rigs (with no change in the price of auto tires).

f. The levying of a per-unit tax on each auto tire sold. g. The granting of a 50-cent-per-unit subsidy for each auto

tire produced. 4. “In the corn market, demand often exceeds supply and sup-

ply sometimes exceeds demand.” “The price of corn rises and falls in response to changes in supply and demand.” In which of these two statements are the terms “supply” and “demand” used correctly? Explain. LO3.3

5. Suppose that in the market for computer memory chips, the equilibrium price is $50 per chip. If the current price is $55 per chip, then there will be ______________ of memory chips. LO3.4

a. A shortage. b. A surplus. c. An equilibrium quantity. d None of the above.

change in demand change in quantity demanded supply supply schedule law of supply supply curve

determinants of supply change in supply change in quantity supplied equilibrium price equilibrium quantity surplus

shortage productive efficiency allocative efficiency price ceiling price floor

D I S C U S S I O N Q U E S T I O N S

1. Explain the law of demand. Why does a demand curve slope downward? How is a market demand curve derived from individual demand curves? LO3.2

2. What are the determinants of demand? What happens to the demand curve when any of these determinants change? Distinguish between a change in demand and a movement along a fixed demand curve, noting the cause(s) of each. LO3.2

3. Explain the law of supply. Why does the supply curve slope upward? How is the market supply curve derived from the supply curves of individual producers? LO3.3

4. What are the determinants of supply? What happens to the supply curve when any of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each. LO3.3

5. In 2001 an outbreak of hoof-and-mouth disease in Europe led to the burning of millions of cattle carcasses. What im- pact do you think this had on the supply of cattle hides, hide

prices, the supply of leather goods, and the price of leather goods? LO3.5

6. For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm’s shares demanded equals the quantity supplied. So, if this equality always occurs, why do the prices of stock shares ever change? LO3.5

7. What do economists mean when they say “price floors and ceilings stifle the rationing function of prices and distort re- source allocation”? LO3.6

8. LAST WORD In some countries, such as France, every corpse is available for doctors to “harvest” for organs unless the de- ceased, while still alive, signed a form forbidding the organs to be harvested. In the United States, it is the opposite: No harvesting is allowed unless the deceased had signed, while still alive, an organ donor form authorizing doctors to harvest any needed organs. Use supply and demand figures to show in which country organ shortages are likely to be less severe.

The following and additional problems can be found in

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CHAPTER 3 Demand, Supply, and Market Equilibrium 73

8. Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as shown in the table below. Suppose that the government estab- lishes a price ceiling of $3.70 for wheat. What might prompt the government to establish this price ceiling? Explain care- fully the main effects. Demonstrate your answer graphically. Next, suppose that the government establishes a price floor of $4.60 for wheat. What will be the main effects of this price floor? Demonstrate your answer graphically. LO3.6

6. Critically evaluate: “In comparing the two equilibrium posi- tions in Figure 3.7b, I note that a smaller amount is actually demanded at a lower price. This refutes the law of demand.” LO3.5

7. Label each of the following scenarios with the set of sym- bols that best indicates the price change and quantity change that occur in the scenario. In some scenarios, it may not be possible from the information given to determine the direc- tion of a particular price change or a particular quantity change. We will symbolize those cases as, respectively, “P?” and “Q?” The four possible combinations of price and quantity changes are:. LO3.5

Pw Q? P? Qw PxQ? P? Qx a. On a hot day, both the demand for lemonade and the

supply of lemonade increase. b. On a cold day, both the demand for ice cream and the

supply of ice cream decrease. c. When Hawaii’s Mt. Kilauea erupts violently, the demand

on the part of tourists for sightseeing flights increases but the supply of pilots willing to provide these danger- ous flights decreases.

d. In a hot area of Arizona where they generate a lot of their electricity with wind turbines, the demand for elec- tricity falls on windy days as people switch off their air conditioners and enjoy the breeze. But at the same time, the amount of electricity supplied increases as the wind turbines spin faster.

9. A price ceiling will result in a shortage only if the ceiling price is ____________ the equilibrium price. LO3.6

a. Less than. b. Equal to. c. Greater than. d. Louder than.

Thousands of

Bushels

Demanded Price per Bushel

Thousands of

Bushels Supplied

85 80 75 70 65 60

$3.40 3.70 4.00 4.30 4.60

4.90

72 73 75 77 79 81

P R O B L E M S

1. Suppose there are three buyers of candy in a market: Tex, Dex, and Rex. The market demand and the individual demands of Tex, Dex, and Rex are shown on the next page. LO3.2

a. Fill in the table for the missing values. b. Which buyer demands the least at a price of $5? The

most at a price of $7? c. Which buyer’s quantity demanded increases the most

when the price is lowered from $7 to $6? d. Which direction would the market demand curve shift if

Tex withdrew from the market? What if Dex doubled his purchases at each possible price?

e. Suppose that at a price of $6, the total quantity de- manded increases from 19 to 38. Is this a “change in the quantity demanded” or a “change in demand”?

Price Total

per Individual Quantities Demanded

Quantity

Candy Tex Dex Rex Demanded

$8 3 1 1 1 0 5 ___

7 8 1 2 1 ___ 5 12

6 ___ 1 3 1 4 5 19

5 17 1 ___ 1 6 5 27

4 23 1 5 1 8 5 ___

Use the figure and the table below to give your answers to the following questions. LO3.3

0

P ri

ce

1

2

$3

Quantity supplied 5 10 15

S1

a. Use the figure to fill in the quantity supplied on supply curve S1 for each price in the table below.

2. The figure on the right shows the supply curve for tennis balls, S1, for Drop Volley Tennis, a producer of tennis equipment.

S 1 S

2 Change in

Quantity Quantity Quantity

Price Supplied Supplied Supplied

$3 _______ 4 _______

2 _______ 2 _______

1 _______ 0 _______

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PART TWO Price, Quantity, and Efficiency74

b. If production costs were to increase, the quantities supplied at each price would be as shown by the third column of the table (“S2 Quantity Supplied”). Use those data to draw supply curve S2 on the same graph as supply curve S1.

c. In the fourth column of the table, enter the amount by which the quantity supplied at each price changes due to the increase in product costs. (Use positive numbers for increases and negative numbers for decreases.)

d. Did the increase in production costs cause a “decrease in supply” or a “decrease in quantity supplied”?

3. Refer to the expanded table below from review question 8. LO3.4

a. What is the equilibrium price? At what price is there nei- ther a shortage nor a surplus? Fill in the surplus-shortage column and use it to confirm your answers.

b. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly. Label equi- librium price P and equilibrium quantity Q.

c. How big is the surplus or shortage at $3.40? At $4.90? How big a surplus or shortage results if the price is 60 cents higher than the equilibrium price? 30 cents lower than the equilibrium price?

g. Demand increases and supply decreases. h. Demand decreases and supply decreases. 5. Use two market diagrams to explain how an increase in state

subsidies to public colleges might affect tuition and enroll- ments in both public and private colleges. LO3.5

6. ADVANCED ANALYSIS Assume that demand for a commod- ity is represented by the equation P 5 10 2 .2Q

d and supply

by the equation P 5 2 1 .2Q s , where Q

d and Q

s are quantity

demanded and quantity supplied, respectively, and P is price. Using the equilibrium condition Q

s 5 Q

d , solve the equa-

tions to determine equilibrium price. Now determine equi- librium quantity. LO3.5

7. Suppose that the demand and supply schedules for rental apartments in the city of Gotham are as given in the table below. LO3.6

Thousands Thousands Surplus (1) of Bushels Price per of Bushels or

Demanded Bushel Supplied Shortage (2)

85 $3.40 72 _______

80 3.70 73 _______

75 4.00 75 _______

70 4.30 77 _______

65 4.60 79 _______

60 4.90 81 _______

a. What is the market equilibrium rental price per month and the market equilibrium number of apartments de- manded and supplied?

b. If the local government can enforce a rent-control law that sets the maximum monthly rent at $1,500, will there be a surplus or a shortage? Of how many units? And how many units will actually be rented each month?

c. Suppose that a new government is elected that wants to keep out the poor. It declares that the minimum rent that can be charged is $2,500 per month. If the government can enforce that price floor, will there be a surplus or a shortage? Of how many units? And how many units will actually be rented each month?

d. Suppose that the government wishes to decrease the mar- ket equilibrium monthly rent by increasing the supply of housing. Assuming that demand remains unchanged, by how many units of housing would the government have to increase the supply of housing in order to get the market equilibrium rental price to fall to $1,500 per month? To $1,000 per month? To $500 per month?

4. How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market; that is, do price and quantity rise, fall, or remain unchanged, or are the answers indeterminate be- cause they depend on the magnitudes of the shifts? Use sup- ply and demand to verify your answers. LO3.5

a. Supply decreases and demand is constant. b. Demand decreases and supply is constant. c. Supply increases and demand is constant. d. Demand increases and supply increases. e. Demand increases and supply is constant. f. Supply increases and demand decreases.

Monthly Apartments Apartments

Rent Demanded Supplied

$2,500 10,000 15,000

2,000 12,500 12,500

1,500 15,000 10,000

1,000 17,500 7,500

500 20,000 5,000

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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CHAPTER THREE APPENDIX 75

LO3.7 Illustrate how supply and demand analysis can provide insights on actual-economy situations. Our discussion has clearly demonstrated that supply and demand analysis is a powerful tool for understanding equi- librium prices and quantities. The information provided in the main body of this chapter is fully sufficient for moving forward in the book, but you may find that additional ex- amples of supply and demand are helpful. This optional appendix provides several concrete illustrations of changes in supply and demand. Your instructor may assign all, some, or none of this appendix, depending on time availability and personal preference.

Changes in Supply and Demand As Figure 3.7 of this chapter demonstrates, changes in supply and demand cause changes in price, quantity, or both. The following applications illustrate this fact in sev- eral real-world markets. The simplest situations are those in which either supply changes while demand remains constant or demand changes while supply remains con- stant. Let’s consider two such simple cases first, before looking at more complex applications.

Lettuce

Every now and then we hear on the news that extreme weather has severely reduced the size of some crop. Suppose, for example, that a severe freeze destroys a siz- able portion of the lettuce crop. This unfortunate situa- tion implies a significant decline in supply, which we represent as a leftward shift of the supply curve from S1 to S2 in Figure 1. At each price, consumers desire as much lettuce as before, so the freeze does not affect the demand for lettuce. That is, demand curve D1 does not shift. What are the consequences of the reduced supply of lettuce for equilibrium price and quantity? As shown in Figure 1, the leftward shift of the supply curve disrupts the previous equilibrium in the market for lettuce and drives the equilibrium price upward from P1 to P2. Consumers respond to that price hike by reducing the quantity of lettuce de- manded from Q1 to Q2. Equilibrium is restored at P2 and Q2.

Consumers who are willing and able to pay price P2 obtain lettuce; consumers unwilling or unable to pay that price do not. Some consumers continue to buy as much lettuce as before, even at the higher price. Others buy some lettuce but not as much as before, and still others opt out of the market completely. The latter two groups use the money they would have spent on lettuce to obtain other products, say, carrots. (Because of our other-things- equal assumption, the prices of other products have not changed.)

Exchange Rates

Exchange rates are the prices at which one currency can be traded (exchanged) for another. Exchange rates are nor- mally determined in foreign exchange markets. One of the largest foreign exchange markets is the euro-dollar market in which the currency used in most of Europe, the euro, is exchanged for U.S. dollars. In the United States, this mar- ket is set up so that euros are priced in dollars—that is, the “product” being traded is euros and the “price” to buy that product is quoted in dollars. Thus, the market equilibrium price one day might be $1.25 to buy 1 euro, while on an- other day it might be $1.50 to buy 1 euro.

Additional Examples of Supply and Demand

FIGURE 1 The market for lettuce. The decrease in the supply of lettuce, shown here by the shift from S1 to S2, increases the equilibrium price of lettuce from P1 to P2 and reduces the equilibrium quantity from Q1 to Q2.

S1S2

D1

P2

P1

0 Q2 Q1 Quantity (pounds)

P ri

ce (

p er

p o

u n d )

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CHAPTER THREE APPENDIX76

value—relative to the dollar, because one euro now buys $1.50 rather than $1.25.

Pink Salmon

Now let’s see what happens when both supply and demand change at the same time. Several decades ago, people who caught salmon earned as much as $1 for each pound of pink salmon—the type of salmon most commonly used for canning. In Figure 3 that price is represented as P1, at the intersection of supply curve S1 and demand curve D1. The corresponding quantity of pink salmon is shown as Q1 pounds. As time passed, supply and demand changed in the market for pink salmon. On the supply side, improved technology in the form of larger, more efficient fishing boats greatly increased the catch and lowered the cost of obtaining it. Also, high profits at price P1 encouraged many new fishers to enter the industry. As a result of these changes, the supply of pink salmon greatly increased and the supply curve shifted to the right, as from S1 to S2 in Figure 3. Over the same years, the demand for pink salmon de- clined, as represented by the leftward shift from D1 to D2 in Figure 3. That decrease was caused by increases in con- sumer income and reductions of the price of substitute products. As buyers’ incomes rose, consumers shifted de- mand away from canned fish and toward higher-quality fresh or frozen fish, including more-valued Atlantic, chi- nook, sockeye, and coho salmon. Moreover, the emer- gence of fish farming, in which salmon are raised in ocean

Foreign exchange markets are used by individuals and companies that need to make purchases or payments in a different currency. U.S. companies exporting goods to Germany, for instance, wish to be paid in U.S. dollars. Thus, their German customers will need to convert euros into dollars. The euros that they bring to the euro-dollar market will become part of the overall market supply of euros. Conversely, an American mutual fund may wish to purchase some French real estate outside of Paris. But to purchase that real estate, it will need to pay in euros be- cause the current French owners will only accept payment in euros. Thus, the American mutual fund has a demand to purchase euros that will form part of the overall market demand for euros. The fund will bring dollars to the euro- dollar foreign exchange market in order to purchase the euros it desires. Sometimes, the demand for euros increases. This might be because a European product surges in popularity in foreign countries. For example, if a new German-made automobile is a big hit in the United States, American car dealers will demand more euros with which to pay for more units of that new model. This will shift the demand curve for euros to the right, as from D1 to D2 in Figure 2. Given the fixed euro supply curve S1, the increase in de- mand raises the equilibrium exchange rate (the equilibrium number of dollars needed to purchase 1 euro) from $1.25 to $1.50. The equilibrium quantity of euros purchased in- creases from Q1 to Q2. Because a higher dollar amount is now needed to purchase one euro, economists say that the dollar has depreciated—gone down in value—relative to the euro. Alternatively, the euro has appreciated—gone up in

S1

D2

$1.50

$1.25

0 Q1 Q2 Quantity of euros

D o

lla r

p ri

ce o

f 1 e

u ro

D1

FIGURE 2 The market for euros. The increase in the demand for euros, shown here by the shift from D1 to D2, increases the equilibrium price of one euro from $1.25 to $1.50 and increases the equilibrium quantity of euros that are exchanged from Q1 to Q2. The dollar has depreciated.

S1

S2

D1

D2

P1

P2

0 Q1 Q2 Quantity (pounds)

P ri

ce (

p er

p o

u n d )

FIGURE 3 The market for pink salmon. In the last several decades, the supply of pink salmon has increased and the demand for pink salmon has decreased. As a result, the price of pink salmon has declined, as from P1 to P2. Because supply has increased by more than demand has decreased, the equilibrium quantity of pink salmon has increased, as from Q1 to Q2.

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CHAPTER THREE APPENDIX 77

leftward shift of the supply curve from S1 to S2 in Figure 4. At times refinery breakdowns in the United States also contributed to this reduced supply. While the supply of gasoline declined between October 2010 and May 2011, the demand for gasoline in- creased, as depicted by the rightward shift of the demand curve from D1 to D2. Incomes in general were rising over this period because the U.S. economy was expanding. Rising incomes raise demand for all normal goods, includ- ing gasoline. An increased number of low-gas- mileage SUVs and light trucks on the road also contributed to growing gas demand. The combined decline in gasoline supply and increase in gasoline demand boosted the price of gasoline from $2.60 to $3.90, as represented by the rise from P1 to P2 in Figure 4. Because the demand increase outweighed the supply decrease, the equilibrium quantity expanded, here from Q1 to Q2. In other periods the price of gasoline has declined as the demand for gasoline has increased. Test your under- standing of the analysis by explaining how such a price decrease could occur.

Sushi

Sushi bars are springing up like Starbucks in American cit- ies (well, maybe not that fast!). Consumption of sushi, the raw-fish delicacy from Japan, has soared in the United States in recent years. Nevertheless, the price of sushi has remained relatively constant. Supply and demand analysis helps explain this circum- stance of increased quantity and constant price. A change in tastes has increased the U.S. demand for sushi. Many consumers of sushi find it highly tasty when they try it. And, as implied by the growing number of sushi bars in the United States, the supply of sushi has also expanded. We represent these supply and demand changes in Figure 5 as the rightward shift of the demand curve from D1 to D2 and the rightward shift of the supply curve from S1 to S2. Observe that the equilibrium quantity of sushi increases from Q1 to Q2 and equilibrium price remains constant at P1. The increase in supply, which taken alone would reduce price, has perfectly offset the increase in de- mand, which taken alone would raise price. The price of sushi does not change, but the equilibrium quantity greatly increases because both the increase in demand and the in- crease in supply expand purchases and sales. Simultaneous increases in demand and supply can cause price to either rise, fall, or remain constant, depend- ing on the relative magnitudes of the supply and demand increases. In this case, price remained constant.

net pens, lowered the prices of these substitute species. That, too, reduced the demand for pink salmon. The altered supply and demand reduced the price of pink salmon to as low as $0.10 per pound, as represented by the drop in price from P1 to P2 in Figure 3. Both the supply increase and the demand decrease helped reduce the equi- librium price. However, in this particular case the equilib- rium quantity of pink salmon increased, as represented by the move from Q1 to Q2. Both shifts reduced the equilib- rium price, but equilibrium quantity increased because the increase in supply exceeded the decrease in demand.

Gasoline

The price of gasoline in the United States has increased rapidly several times during the past several years. For ex- ample, the average price of a gallon of gasoline rose from around $2.60 in October 2010 to about $3.90 in May 2011. What caused this 50 percent rise in the price of gas- oline? How would we diagram this increase? We begin in Figure 4 with the price of a gallon of gas- oline at P1, representing the $2.60 price. Simultaneous supply and demand factors disturbed this equilibrium. Supply uncertainties relating to Middle East politics and warfare and expanded demand for oil by fast-growing countries such as China pushed up the price of a barrel of oil from under $80 per barrel in October 2010 to well over $100 per barrel in May 2011. Oil is the main input for producing gasoline, so any sustained rise in its price boosts the per-unit cost of producing gasoline. Such cost rises decrease the supply of gasoline, as represented by the

S1

D2

P2

P1

0 Q1 Q2 Quantity (gallons)

P ri

ce (

p er

g al

lo n )

D1

S2

FIGURE 4 The market for gasoline. An increase in the demand for gasoline, as shown by the shift from D1 to D2, coupled with a decrease in supply, as shown by the shift from S1 to S2, boosts equilibrium price (here from P1 to P2). In this case, equilibrium quantity increases from Q1 to Q2 because the increase in demand outweighs the decrease in supply.

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CHAPTER THREE APPENDIX78

equilibrium price to change; the equilibrium quantity re- mains the same because the quantity supplied is fixed and cannot adjust. Consider Figure 6, in which the supply of land in San Francisco is fixed at quantity Q0. If demand increases from D1 to D2, the movement from the initial equilibrium at point a to the final equilibrium at point b is accomplished solely by a rise in the equilibrium price from P1 to P2. Because the quantity of land is fixed, the increase in de- mand cannot cause any change in the equilibrium quantity supplied. The entire adjustment from the initial equilib- rium to the final equilibrium has to come in the form of a higher equilibrium price. This fact explains why real estate prices are so high in San Francisco and other major cities. Any increase in de- mand cannot be met by a combination of increases in price and increases in quantity. With the quantity of land in fixed supply, any increase in demand results solely in higher equilibrium land prices.

Preset Prices In the body of this chapter, we saw that an effective government-imposed price ceiling (legal maximum price) causes quantity demanded to exceed quantity supplied—a shortage. An effective government-imposed price floor (legal minimum price) causes quantity supplied to exceed quantity demanded—a surplus. Put simply: Shortages result

Upsloping versus Vertical Supply Curves As you already know, the typical good or service possesses an upsloping supply curve because a higher market price will cause producers to increase the quantity supplied. There are, however, some goods and services whose quan- tities supplied are fixed and totally unresponsive to changes in price. Examples include the amount of land in a given area, the number of seats in a stadium, and the limited part of the electromagnetic spectrum that is re- served for cellular telephone transmissions. These sorts of goods and services have vertical supply curves because the same fixed amount is available no matter what price is offered to suppliers.

Reactions to Demand Shifts

Markets react very differently to a shift in demand de- pending upon whether they have upsloping or vertical supply curves.

Upsloping Supply Curves When a market has an upsloping supply curve, any shift in demand will cause both the equilibrium price and the equilibrium quantity to adjust. Consider Figure 2. When the demand for euros in- creases, the movement from the initial equilibrium to the final equilibrium involves the equilibrium price rising from $1.25 to $1.50 while the equilibrium quantity in- creases from Q1 to Q2. Price and quantity both change.

Vertical Supply Curves When a market has a vertical supply curve, any shift in demand will cause only the

S1 S2

D1

D2

P1

0 Q1 Q2 Quantity (pounds)

P ri

ce (

p er

p o

u n d )

S

D1

D2

P2

P1

0 Q0 Quantity (acres)

P ri

ce (

p er

a cr

e) b

a

FIGURE 5 The market for sushi. Equal increases in the demand for sushi, as from D1 to D2, and in the supply of sushi, as from S1 to S2, expand the equilibrium quantity of sushi (here from Q1 to Q2) while leaving the price of sushi unchanged at P1.

FIGURE 6 The market for land in San Francisco. Because the quantity of land in San Francisco is fixed at Q0, the supply curve is vertical above Q0 in order to indicate that the same quantity of land will be supplied no matter what the price is. As demand increases from D1 to D2, the equilibrium price rises from P1 to P2. Because the quantity of land is fixed at Q0, the movement from equilibrium a to equilibrium b involves only a change in the equilibrium price; the equilibrium quantity remains at Q0 due to land being in fixed supply.

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CHAPTER THREE APPENDIX 79

and supply curve S represents the supply of tickets. The supply curve is vertical because a fixed number of tickets are printed to match the capacity of the arena. At the printed ticket price of P1, the quantity of tickets demanded, Q2, exceeds the quantity supplied, Q1. The result is a short- age of ab—the horizontal distance between Q2 and Q1 in the primary market. If the printed ticket price had been the higher equilib- rium price P2, no shortage of tickets would have occurred. But at the lower price P1, a shortage and secondary ticket market will emerge among those buyers willing to pay more than the printed ticket price and those sellers willing to sell their purchased tickets for more than the original price. Wherever there are shortages and secondary mar- kets, it is safe to assume the original price was set below the equilibrium price.

Olympic Curling Preliminaries

Contrast the shortage of tickets for the women’s figure skating finals at the Olympics to the surplus of tickets for one of the preliminary curling matches. For the uniniti- ated, curling is a sport in which participants slide a heavy round object called a “stone” down the ice toward a target while teammates called “sweepers” use brooms to alter the course of the stone when desired. Curling is a popular spectator sport in a few nations such as Canada, but it does not draw many fans in most countries. So the demand for tickets to most of the pre- liminary curling events is not very strong. We demonstrate this weak demand as D in Figure 8. As in our previous

when prices are set below, and surpluses result when prices are set above, equilibrium prices. We now want to establish that shortages and surpluses can occur in markets other than those in which govern- ment imposes price floors and ceilings. Such market im- balances happen when the seller or sellers set prices in advance of sales and the prices selected turn out to be be- low or above equilibrium prices. Consider the following two examples.

Olympic Figure Skating Finals

Tickets for the women’s figure skating championship at the Olympics are among the world’s “hottest tickets.” The popularity of this event and the high incomes of buyers translate into tremendous ticket demand. The Olympic officials set the price for the tickets in advance. Invariably, the price, although high, is considerably below the equi- librium price that would equate quantity demanded and quantity supplied. A severe shortage of tickets therefore occurs in this primary market—the market involving the official ticket office. The shortage, in turn, creates a secondary market in which buyers bid for tickets held by initial purchasers rather than the original seller. Scalping tickets—selling them above the original ticket price—may be legal or il- legal, depending on local laws. Figure 7 shows how the shortage in the primary ticket market looks in terms of supply and demand analysis. Demand curve D represents the strong demand for tickets

S

D

P2

P1

0 Q1 Q2 Quantity (tickets)

P ri

ce (

p er

t ic

ke t)

ab

Shortage

FIGURE 7 The market for tickets to the Olympic women’s figure skating finals. The demand curve D and supply curve S for the Olympic women’s figure skating finals produce an equilibrium price that is above the P1 price printed on the ticket. At price P1 the quantity of tickets demanded, Q2, greatly exceeds the quantity of tickets available, Q1. The resulting shortage of ab (5 Q2 2 Q1) gives rise to a legal or illegal secondary market.

FIGURE 8 The market for tickets to the Olympic curling preliminaries. The demand curve D and supply curve S for the Olympic curling preliminaries produce an equilibrium price below the P1 price printed on the ticket. At price P1 the quantity of tickets demanded is less than the quantity of tickets available. The resulting surplus of ba (5 Q1 2 Q2) means the event is not sold out.

S

D

P1

P2

0 Q2 Q1 Quantity (tickets)

P ri

ce (

p er

t ic

ke t)

a b

Surplus

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CHAPTER THREE APPENDIX80

example, the supply of tickets is fixed by the size of the arena and is shown as vertical line S. We represent the printed ticket price as P1 in Figure 8. In this case the printed price is much higher than the equi- librium price of P2. At the printed ticket price, quantity supplied is Q1 and quantity demanded is Q2. So a surplus of tickets of ba (5 Q12Q2) occurs. No ticket scalping oc- curs and there are numerous empty seats. Only if the

Olympic officials had priced the tickets at the lower price P2 would the event have been a sellout. (Actually, the Olympic officials try to adjust to demand realities for curl- ing contests by holding them in smaller arenas and by charging less for tickets. Nevertheless, the stands are rarely full for the preliminary contests, which compete against final events in other winter Olympic sports.)

LO3.7 Illustrate how supply and demand analysis can provide insights on actual-economy

situations.

A decrease in the supply of a product increases its equilibrium price and reduces its equilibrium quantity. In contrast, an in- crease in the demand for a product boosts both its equilibrium price and its equilibrium quantity.

Simultaneous changes in supply and demand affect equilib- rium price and quantity in various ways, depending on the rela- tive magnitudes of the changes in supply and demand. Equal increases in supply and demand, for example, leave equilibrium price unchanged.

Products (such as land) whose quantities supplied do not vary with price have vertical supply curves. For these products, any shift in demand will lead to a change in the equilibrium price but no change in the equilibrium quantity.

Sellers set prices of some items such as tickets in advance of the event. These items are sold in the primary market that in- volves the original sellers and buyers. If preset prices turn out to be below the equilibrium prices, shortages occur and scalping in legal or illegal secondary markets arises. The prices in the second- ary market then rise above the preset prices. In contrast, surpluses occur when the preset prices happen to exceed the equilibrium prices.

APPENDIX SUMMARY

A P P E N D I X D I S C U S S I O N Q U E S T I O N S

1. Why are shortages or surpluses more likely with preset prices, such as those on tickets, than flexible prices, such as those on gasoline? LO3.7

2. Most scalping laws make it illegal to sell—but not to buy— tickets at prices above those printed on the tickets. Assuming that is the case, use supply and demand analysis to explain why the equilibrium ticket price in an illegal sec- ondary market tends to be higher than in a legal secondary market. LO3.7

3. Go to the Web site of the Energy Information Administration, www.eia.doe.gov, and follow the links to find the current retail price of gasoline. How does the current price of regu- lar gasoline compare with the price a year ago? What must have happened to either supply, demand, or both to explain the observed price change? LO3.7

4. Suppose the supply of apples sharply increases because of perfect weather conditions throughout the growing season. Assuming no change in demand, explain the effect on the

equilibrium price and quantity of apples. Explain why quan- tity demanded increases even though demand does not change. LO3.7

5. Assume the demand for lumber suddenly rises because of a rapid growth of demand for new housing. Assume no change in supply. Why does the equilibrium price of lumber rise? What would happen if the price did not rise under the demand and supply circumstances described? LO3.7

6. Assume that both the supply of bottled water and the de- mand for bottled water rise during the summer but that supply increases more rapidly than demand. What can you conclude about the directions of the impacts on equilibrium price and equilibrium quantity? LO3.7

7. When asked for investment advice, humorist Will Rogers joked that people should “[b]uy land. They ain’t making any more of the stuff.” Explain his advice in terms of the supply and demand model. LO3.7

The following and additional problems can be found in

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CHAPTER THREE APPENDIX 81

A P P E N D I X R E V I E W Q U E S T I O N S

A P P E N D I X P R O B L E M S

1. Will the equilibrium price of orange juice increase or de- crease in each of the following situations? LO3.7

a. A medical study reporting that orange juice reduces can- cer is released at the same time that a freak storm de- stroys half of the orange crop in Florida.

b. The prices of all beverages except orange juice fall by half while unexpectedly perfect weather in Florida re- sults in an orange crop that is 20 percent larger than normal.

2. Consider the market for coffee beans. Suppose that the prices of all other caffeinated beverages go up 30 percent while at the same time a new fertilizer boosts production at coffee plantations dramatically. Which of the following best describes what is likely to happen to the equilibrium price and quantity of coffee beans? LO3.7

a. Both the equilibrium price and the quantity will rise. b. The equilibrium price will rise but the equilibrium quan-

tity will fall. c. The equilibrium price may rise or fall but the equilib-

rium quantity will rise for certain. d. Neither the price change nor the quantity change can be

determined for certain. e. None of the above. 3. A price ceiling will result in a shortage only if the ceiling

price is the equilibrium price. LO3.7 a. Less than. b. Equal to. c. Greater than. d. Faster than.

1. Demand and supply often shift in the retail market for gaso- line. Here are two demand curves and two supply curves for gallons of gasoline in the month of May in a small town in Maine. Some of the data are missing. LO3.7

4. Suppose that you are the economic advisor to a local gov- ernment that has to deal with a politically embarrassing sur- plus that was caused by a price floor that the government recently imposed. Your first suggestion is to get rid of the price floor, but the politicians don’t want to do that. Instead, they present you with the following list of options that they hope will get rid of the surplus while keeping the price floor. Identify each one as either could work or can’t work. LO3.7

a. Restricting supply. b. Decreasing demand. c. Purchasing the surplus at the floor price. 5. Suppose both the demand for olives and the supply of olives

decline by equal amounts over some time period. Use graphical analysis to show the effect on equilibrium price and quantity. LO3.7

6. Governments can use subsidies to increase demand. For instance, a government can pay farmers to use organic fertilizers rather than traditional fertilizers. That subsidy increases the demand for organic fertilizer. Consider two industries, one in which supply is nearly vertical and the other in which supply is nearly horizontal. Assume that firms in both industries would prefer a higher market equi- librium price because a higher market equilibrium price would mean higher profits. Which industry would probably spend more resources lobbying the government to increase the demand for its output? (Assume that both industries have similarly sloped demand curves.) LO3.7

a. The industry with a nearly flat supply curve. b. The industry with a nearly vertical supply curve.

demand of 4,000 gallons per month at a price of $1.00 per gallon. If demand is D1 and supply is S2, the equilib- rium quantity is 8,000 gallons per month.

b. Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second, demand is D1 and supply is S2. By how much does the equilibrium quantity change? By how much does the equilibrium price change?

c. If supply falls from S2 to S1 while demand declines from D2 to D1, does the equilibrium price rise, fall, or stay the same? What if only supply falls? What if only demand falls?

d. Suppose that supply is fixed at S1 and that demand starts at D1. By how many gallons per month would demand have to increase at each price level such that the equilib- rium price per gallon would be $3.00? $4.00?

2. The table at the top of the next page shows two demand schedules for a given style of men’s shoe—that is, how many pairs per month will be demanded at various prices at a men’s clothing store in Seattle called Stromnord.

a. Use the following facts to fill in the missing data in the table. If demand is D1 and supply is S1, the equilibrium quantity is 7,000 gallons per month. When demand is D2 and supply is S1, the equilibrium price is $3.00 per gallon. When demand is D2 and supply is S1, there is an excess

Quantities Demanded Quantities Supplied

Price D 1

D 2

S 1

S 2

$4.00 5,000 7,500 9,000 9,500

6,000 8,000 8,000 9,000

2.00 8,500 8,500

9,000 5,000

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CHAPTER THREE APPENDIX82

Suppose that Stromnord has exactly 65 pairs of this style of shoe in inventory at the start of the month of July and will not receive any more pairs of this style until at least August 1. LO3.7

a. If demand is D1, what is the lowest price that Stromnord can charge so that it will not run out of this model of shoe in the month of July? What if demand is D2?

b. If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, how many pairs of shoes should Stromnord order if it wants to end the month of August with exactly zero pairs of shoes in its inventory? What if the price is set at $55 for both months?

3. Use the table below to answer the questions that follow: LO3.7

a. If this table reflects the supply of and demand for tickets to a particular World Cup soccer game, what is the sta- dium capacity?

b. If the preset ticket price is $45, would we expect to see a secondary market for tickets? Would the price of a ticket in the secondary market be higher than, the same as, or lower than the price in the primary (original) market?

c. Suppose for some other World Cup game the quantity of tickets demanded is 20,000 lower at each ticket price than shown in the table. If the ticket price remains $45, would the event be a sellout?

D 1 D

2

Quantity Quantity

Price Demanded Demanded

$75 53 13

70 60 15

65 68 18

60 77 22

55 87 27

Quantity Demanded, Quantity Supplied,

Thousands Price Thousands

80 $25 60

75 35 60

70 45 60

65 55 60

60 65 60

55 75 60

50 85 60

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83

eliminate every last bit of a negative

externality such as air pollution.

LO4.6 (Appendix) Describe how information failures may justify government

intervention in some markets.

Competitive markets usually do a remarkably ef-

fective job of allocating society’s scarce resources

to their most highly valued uses. Thus, we begin

this chapter by demonstrating how properly func-

tioning markets efficiently allocate resources. We

then explore what happens when markets don’t

function properly. In some circumstances, eco-

nomically desirable goods are not produced at all.

In other situations, they are either overproduced

or underproduced. This chapter focuses on these

situations, which economists refer to as market

failures.

Learning Objectives

LO4.1 Differentiate between demand-side market failures and supply-side

market failures.

LO4.2 Explain the origin of both consumer surplus and producer surplus, and

explain how properly functioning

markets maximize their sum, total

surplus, while optimally allocating

resources.

LO4.3 Describe free riding and public goods, and illustrate why private

firms cannot normally produce

public goods.

LO4.4 Explain how positive and negative externalities cause under- and

overallocations of resources.

LO4.5 Show why we normally won’t want to pay what it would cost to

CHAPTER 4

Market Failures: Public Goods and Externalities

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PART TWO Price, Quantity, and Efficiency84

In such situations, an economic role for gov-

ernment may arise. We will examine that role as it

relates to public goods and so-called externali-

ties—situations where market failures lead to sub-

optimal outcomes that the government may be

able to improve upon by using its powers to tax,

spend, and regulate. The government may, for in-

stance, pay for the production of goods that the

private sector fails to produce. It may also act to

reduce the production of those goods and ser-

vices that the private sector overproduces.

Implementing such policies can, however, be both

costly and complicated. Thus, we conclude the

chapter by noting the government inefficiencies

that can hinder government efforts to improve

economic outcomes.

Market Failures in Competitive Markets1

LO4.1 Differentiate between demand-side market failures and supply-side market failures. In Chapter 3 we asserted that “competitive markets usu- ally produce an assignment of resources that is ‘right’ from an economic perspective.” We now want to focus on the word “usually” and discuss exceptions. We must do this because it is unfortunately the case that the presence of robust competition involving many buyers and many sell- ers may not, by itself, be enough to guarantee that a mar- ket will allocate resources correctly. Market failures sometimes happen in competitive markets. The focus of this chapter is to explain how and why such market fail- ures can arise. Fortunately, the broad picture is simple. Market fail- ures in competitive markets fall into just two categories:

• Demand-side market failures happen when demand curves do not reflect consumers’ full willingness to pay for a good or service.

• Supply-side market failures occur when supply curves do not reflect the full cost of producing a good or service.

Demand-Side Market Failures

Demand-side market failures arise because it is impossi- ble in certain cases to charge consumers what they are

willing to pay for a product. Consider outdoor fireworks displays. People enjoy fireworks and would therefore be willing to pay to see a fireworks display if the only way to see it was to have to pay for the right to do so. But be- cause such displays are outdoors and in public, people don’t actually have to pay to see the display because there is no way to exclude those who haven’t paid from also en- joying the show. Private firms will therefore be unwilling to produce outdoor fireworks displays, as it will be nearly impossible for them to raise enough revenue to cover production costs.

Supply-Side Market Failures

Supply-side market failures arise in situations in which a firm does not have to pay the full cost of producing its output. Consider a coal-burning power plant. The firm running the plant will have to pay for all of the land, labor, capital, and entrepreneurship that it uses to generate electricity by burning coal. But if the firm is  not charged for the smoke that it releases into the atmosphere, it will fail to pay another set of costs— the  costs that its pollution imposes on other people. These include future harm from global warming, toxins that affect wildlife, and possible damage to agricultural crops downwind. A market failure arises because it is not possible for the market to correctly weigh costs and benefits in a situation in which some of the costs are completely unaccounted for. The coal-burning power plant pro- duces more electricity and generates more pollution than it would if it had to pay for each ton of smoke that it released into the atmosphere. The extra units that are produced are units of output for which the costs are greater than the benefits. Obviously, these units should not be produced.

1Other market failures arise when there are not enough buyers or sellers to ensure competition. In those situations, the lack of competition allows either buyers or sellers to restrict purchases or sales below optimal levels for their own benefit. As an example, a monopoly—a firm that is the only producer in its industry—can restrict the amount of output that it supplies in order to drive up the market price and thereby increase its own profit.

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CHAPTER 4 Market Failures: Public Goods and Externalities 85

Efficiently Functioning Markets LO4.2 Explain the origin of both consumer surplus and producer surplus, and explain how properly functioning markets maximize their sum, total surplus, while optimally allocating resources. The best way to understand market failure is to first un- derstand how properly functioning competitive markets achieve economic efficiency. We touched on this subject in Chapter 3, but we now want to expand and deepen that analysis, both for its own sake and to set up our discussion of public goods and externalities. Two conditions must hold if a competitive market is to produce efficient out- comes: The demand curve in the market must reflect con- sumers’ full willingness to pay, and the supply curve in the market must reflect all the costs of production. If these conditions hold, then the market will produce only units for which benefits are at least equal to costs. It will also maximize the amount of “benefit surpluses” that are shared between consumers and producers.

Consumer Surplus

The benefit surplus received by a consumer or consumers in a market is called consumer surplus. It is defined as the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price that they do pay. The maximum price that a person is willing to pay for a unit of a product depends on the opportunity cost of that person’s consumption alternatives. Suppose that Ted is offered the chance to purchase an apple. He would of course like to have it for free, but the maximum amount he would be willing to pay depends on the alternative uses to which he can put his money. If his maximum willing- ness to pay for that particular apple is $1.25, then we know that he is willing to forgo up to—but not more than—$1.25 of other goods and services. Paying even one cent more would entail having to give up too much of other goods and services. It also means that if Ted is charged any market price less than $1.25, he will receive a consumer surplus equal to the difference between the $1.25 maximum price that he would have been willing to pay and the lower market price. For instance, if the market price is $0.50 per apple, Ted will receive a consumer surplus of $0.75 per apple (5 $1.25 2 $0.50). In nearly all markets, consumers indi- vidually and collectively gain greater total utility or satis- faction in dollar terms from their purchases than the amount of their expenditures (5 product price 3 quantity). This utility surplus arises because each consumer who buys the product only has to pay the market equilibrium price

even though many of them would have been willing to pay more than the equilibrium price to obtain the product. The concept of maximum willingness to pay also gives us another way to understand demand curves. Consider Table 4.1, where the first two columns show the maximum amounts that six consumers would each be willing to pay for a bag of oranges. Bob, for instance, would be willing to pay a maximum of $13 for a bag of oranges. Betty, by con- trast, would only be willing to pay a maximum of $8 for a bag of oranges. Notice that the maximum prices that these individuals are willing to pay represent points on a demand curve be- cause the lower the market price, the more bags of oranges will be demanded. At a price of $12.50, for instance, Bob will be the only person listed in the table who will pur- chase a bag. But at a price of $11.50, both Bob and Barb will want to purchase a bag. And at a price of $10.50, Bob, Barb, and Bill will each want to purchase a bag. The lower the price, the greater the total quantity demanded as the market price falls below the maximum prices of more and more consumers. Lower prices also imply larger consumer surpluses. When the price is $12.50, Bob only gets $0.50 in consumer surplus because his maximum willingness to pay of $13 is only $0.50 higher than the market price of $12.50. But if the market price were to fall to $8, then his consumer sur- plus would be $5 (5 $13 2 $8). The third and fourth col- umns of Table 4.1 show how much consumer surplus each of our six consumers will receive if the market price of a bag of oranges is $8. Only Betty receives no consumer sur- plus because her maximum willingness to pay exactly matches the $8 equilibrium price. It is easy to show on a graph both the individual con- sumer surplus received by each particular buyer in a mar- ket as well as the collective consumer surplus received by all buyers. Consider Figure 4.1, which shows the market equilibrium price P1 5 $8 as well as the downsloping

(2) (3)

Maximum Actual Price (4)

(1) Price Willing (Equilibrium Consumer

Person to Pay Price) Surplus

Bob $13 $8 $5 (5 $13 ] $8)

Barb 12 8 4 (5 $12 ] $8)

Bill 11 8 3 (5 $11 ] $8) Bart 10 8 2 (5 $10 ] $8) Brent 9 8 1 (5 $9 ] $8)

Betty 8 8 0 (5 $8 ] $8)

TABLE 4.1 Consumer Surplus

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PART TWO Price, Quantity, and Efficiency86

demand curve D for bags of oranges. Demand curve D in- cludes not only the six consumers named in Table 4.1 but also every other consumer of oranges in the market. The individual consumer surplus of each particular person who is willing to buy at the $8 market price is simply the verti- cal distance from the horizontal line that marks the $8 market price up to that particular buyer’s maximum will- ingness to pay. The collective consumer surplus obtained by all of our named and unnamed buyers is found by add- ing together each of their individual consumer surpluses. To obtain the Q1 bags of oranges represented, consumers collectively are willing to pay the total amount shown by the sum of the green triangle and yellow rectangle under the demand curve and to the left of Q1. But consumers need pay only the amount represented by the yellow rect- angle (5 P1 3 Q1). So the green triangle is the consumer surplus in this market. It is the sum of the vertical dis- tances between the demand curve and the $8 equilibrium price at each quantity up to Q1. Alternatively, it is the sum of the gaps between maximum willingness to pay and actual price, such as those we calculated in Table 4.1. Thus, consumer surplus can also be defined as the area that lies below the demand curve and above the price line that extends horizontally from P1. Consumer surplus and price are inversely (negatively) related. Given the demand curve, higher prices reduce con- sumer surplus; lower prices increase it. To test this general- ization, draw in an equilibrium price above $8 in Figure 4.1 and observe the reduced size of the triangle representing

consumer surplus. When price goes up, the gap nar- rows between the maxi- mum willingness to pay and the actual price. Next, draw in an equilibrium price below $8 and see that consumer surplus in- creases. When price declines, the gap widens between max- imum willingness to pay and actual price.

Producer Surplus

Like consumers, producers also receive a benefit surplus in markets. This producer surplus is the difference be- tween the actual price a producer receives (or producers receive) and the minimum acceptable price that a con- sumer would have to pay the producer to make a particu- lar unit of output available. A producer’s minimum acceptable price for a particu- lar unit will equal the producer’s marginal cost of produc- ing that particular unit. That marginal cost will be the sum of the rent, wages, interest, and profit that the producer will need to pay in order to obtain the land, labor, capital, and entrepreneurship required to produce that particular unit. In this section, we are assuming that the marginal cost of producing a unit will include all of the costs of pro- duction. Unlike the coal-burning power plant mentioned previously, the producer must pay for all of its costs, in- cluding the cost of pollution. In later sections, we will ex- plore the market failures that arise in situations where firms do not have to pay all their costs. In addition to equaling marginal cost, a producer’s minimum acceptable price can also be interpreted as the opportunity cost of bidding resources away from the pro- duction of other products. To see why this is true, suppose that Leah is an apple grower. The resources necessary for her to produce one apple could be used to produce other things. To get them directed toward producing an apple, it is necessary to pay Leah what it will cost her to bid the necessary resources away from other entrepreneurs who would like to use them to produce other products. Leah would, naturally, like to get paid as much as possible to produce the apple for you. But her minimum acceptable price is the lowest price you could pay her such that she can just break even after bidding away from other uses the land, labor, capital, and entrepreneurship necessary to pro- duce the apple. The size of the producer surplus earned on any par- ticular unit will be the difference between the market price that the producer actually receives and the producer’s

P1

0 Q1 Quantity (bags)

P ri

ce (

p er

b ag

)

D

Consumer surplus

Equilibrium price = $8

FIGURE 4.1 Consumer surplus. Consumer surplus—shown as the green triangle—is the difference between the maximum prices consumers are willing to pay for a product and the lower equilibrium price, here assumed to be $8. For quantity Q1, consumers are willing to pay the sum of the amounts represented by the green triangle and the yellow rectangle. Because they need to pay only the amount shown as the yellow rectangle, the green triangle shows consumer surplus.

O4.1

Consumer surplus

ORIGIN OF THE IDEA

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CHAPTER 4 Market Failures: Public Goods and Externalities 87

resources. Those lower acceptable prices for each of the units up to Q1 are shown by the portion of the supply curve lying to the left of and below the assumed $8 market price. The individual producer surplus of each of these sell- ers is thus the vertical distance from each seller’s respec- tive minimum acceptable price on the supply curve up to the $8 market price. Their collective producer surplus is shown by the blue triangle in Figure 4.2. In that figure, producers collect revenues of P1 3 Q1, which is the sum of the blue triangle and the yellow area. As shown by the sup- ply curve, however, revenues of only those illustrated by the yellow area would be required to entice producers to offer Q1 bags of oranges for sale. The sellers therefore re- ceive a producer surplus shown by the blue triangle. That surplus is the sum of the vertical distances between the supply curve and the $8 equilibrium price at each of the quantities to the left of Q1. There is a direct (positive) relationship between equilibrium price and the amount of producer surplus. Given the supply curve, lower prices reduce pro- ducer surplus; higher prices increase it. If you pencil in a lower equilibrium price than $8, you will see that the producer surplus tri- angle gets smaller. The gaps between the mini- mum acceptable payments and the actual prices narrow when the price falls. If you pencil in an equilibrium price

minimum acceptable price. Consider Table 4.2, which shows the minimum acceptable prices of six different or- ange growers. With a market price of $8, Carlos, for in- stance, has a producer surplus of $5, which is equal to the market price of $8 minus his minimum acceptable price of $3. Chad, by contrast, receives no producer surplus be- cause his minimum acceptable price of $8 just equals the market equilibrium price of $8. Carlos’s minimum acceptable price is lower than Chad’s minimum acceptable price because Carlos is a more efficient producer than Chad, by which we mean that Carlos produces oranges using a less-costly combi- nation of resources than Chad uses. The differences in efficiency between Carlos and Chad are likely due to differences in the type and quality of resources available to them. Carlos, for instance, may own land perfectly suited to growing oranges, while Chad has land in the desert that requires costly irrigation if it is to be used to grow oranges. Thus, Chad has a higher marginal cost of producing oranges. The minimum acceptable prices that producers are willing to accept form points on a supply curve because the higher the price, the more bags of oranges will be sup- plied. At a price of $3.50, for instance, only Carlos would be willing to supply a bag of oranges. But at a price of $5.50, Carlos, Courtney, and Chuck would all be willing to supply a bag of oranges. The higher the market price, the more oranges will be supplied, as the market price sur- passes the marginal costs and minimum acceptable prices of more and more producers. Thus, supply curves shown in this competitive market are both marginal-cost curves and minimum-acceptable-price curves. The supply curve in Figure 4.2 includes not only the six producers named in Table 4.2 but also every other pro- ducer of oranges in the market. At the market price of $8 per bag, Q1 bags are produced because only those pro- ducers whose minimum acceptable prices are less than $8 per bag will choose to produce oranges with their

(2) (3)

Minimum Actual Price (4)

(1) Acceptable (Equilibrium Producer

Person Price Price) Surplus

Carlos $3 $8 $5 (5 $8 ] $3)

Courtney 4 8 4 (5 $8 ] $4)

Chuck 5 8 3 (5 $8 ] $5)

Cindy 6 8 2 (5 $8 ] $6)

Craig 7 8 1 (5 $8 ] $7)

Chad 8 8 0 (5 $8 ] $8)

TABLE 4.2 Producer Surplus

S

P1

0 Q1 Quantity (bags)

P ri

ce (

p er

b ag

)

Producer surplus

Equilibrium price = $8

FIGURE 4.2 Producer surplus. Producer surplus—shown as the blue triangle—is the difference between the actual price producers receive for a product (here $8) and the lower minimum payments they are willing to accept. For quantity Q1, producers receive the sum of the amounts represented by the blue triangle plus the yellow area. Because they need to receive only the amount shown by the yellow area to produce Q1, the blue triangle represents producer surplus.

W4.1

Consumer and producer surplus

WORKED PROBLEMS

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PART TWO Price, Quantity, and Efficiency88

resources that could have been used to produce other products. Thus, the only way to justify taking any amount of any resource (land, labor, capital, entrepreneurship) away from the production of other products is if it brings more utility or satisfaction when devoted to the produc- tion of oranges than it would if it were used to produce other products. The first way to see why Q1 is the allocatively efficient quantity of oranges is to note that demand and supply curves can be interpreted as measuring marginal benefit (MB) and marginal cost (MC). Recall from the discussion relating to Figure 1.3 that optimal allocation is achieved at the output level where MB 5 MC. We have already seen that supply curves are marginal cost curves. As it turns out, demand curves are marginal benefit curves. This is true because the maximum price that a consumer would be willing to pay for any particular unit is equal to the benefit that she would get if she were to consume that unit. Thus, each point on a demand curve represents both some con- sumer’s maximum willingness to pay as well as the mar- ginal benefit that he or she would get from consuming the particular unit in question. Combining the fact that supply curves are MC curves with the fact that demand curves are MB curves, we see that points on the demand curve in Figure 4.3 measure the marginal benefit of oranges at each level of output, while points on the supply curve measure the marginal cost of oranges at each level of output. As a result, MB 5 MC where the demand and supply curves intersect—which means that the equilibrium quantity Q1 must be alloca- tively efficient. To gain a deeper understanding of why Q1 is alloca- tively efficient, notice that for every unit up to Q1 mar- ginal benefit exceeds marginal cost (MB . MC). And because marginal cost includes the opportunity cost of not making other things with the resources needed to make these units, we know that people are made better off when the resources necessary to make these units are al- located to producing oranges rather than to producing anything else. The second way to see why Q1 is the correct quantity of oranges is based on our analysis of consumer and pro- ducer surplus and the fact that we can interpret demand and supply curves in terms of maximum willingness to pay and minimum acceptable price. In Figure 4.3, the maxi- mum willingness to pay on the demand curve for each bag of oranges up to Q1 exceeds the corresponding minimum acceptable price on the supply curve. Thus, each of these bags adds a positive amount (5 maximum willingness to pay minus minimum acceptable price) to the total of con- sumer and producer surplus.

above $8, the size of the producer surplus triangle in- creases. The gaps between minimum acceptable pay- ments and actual prices widen when the price increases.

Efficiency Revisited

In Figure 4.3 we bring together the demand and supply curves of Figures 4.1 and 4.2 to show the equilibrium price and quantity and the previously described regions of consumer and producer surplus. All markets that have downsloping demand curves and upsloping supply curves yield consumer and producer surplus. Because we are assuming in Figure 4.3 that the de- mand curve reflects buyers’ full willingness to pay and the supply curve reflects all of the costs facing sellers, the equilibrium quantity in Figure 4.3 reflects economic effi- ciency, which consists of productive efficiency and alloca- tive efficiency.

• Productive efficiency is achieved because competi- tion forces orange growers to use the best technol- ogies and combinations of resources available. Doing so minimizes the per-unit cost of the out- put produced.

• Allocative efficiency is achieved because the correct quantity of oranges—Q1—is produced relative to other goods and services.

There are two ways to understand why Q1 is the cor- rect quantity of oranges. Both involve realizing that any resources directed toward the production of oranges are

S

P1

0 Q1 Quantity (bags)

P ri

ce (

p er

b ag

)

D

Producer surplus

Consumer surplus

FIGURE 4.3 Efficiency: maximum combined consumer and producer surplus. At quantity Q1 the combined amount of consumer surplus, shown as the green triangle, and producer surplus, shown as the blue triangle, is maximized. Efficiency occurs because, at Q1, maximum willingness to pay, indicated by the points on the demand curve, equals minimum acceptable price, shown by the points on the supply curve.

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CHAPTER 4 Market Failures: Public Goods and Externalities 89

that maximize the sum of consumer and producer surplus. Allocative efficiency occurs at the market equilibrium quantity where three conditions exist simultaneously:

• MB 5 MC (Figure 1.3). • Maximum willingness to pay 5 minimum acceptable

price. • Total surplus (5 sum of consumer and producer

surplus) is at a maximum.

Economists are enamored of markets because prop- erly functioning markets automatically achieve allocative efficiency. Other methods of allocating resources—such as government central planning—do exist. But because other methods cannot do any better than properly func- tioning markets—and may, in many cases, do much worse—economists usually prefer that resources be allo- cated through markets whenever properly functioning markets are available.

Efficiency Losses (or Deadweight Losses)

Figures 4.4a and 4.4b demonstrate that efficiency losses— reductions of combined consumer and producer surplus— result from both underproduction and overproduction. First, consider Figure 4.4a, which analyzes the case of un- derproduction by considering what happens if output falls from the efficient level Q1 to the smaller amount Q2. When that happens, the sum of consumer and producer surplus, previously abc, falls to adec. So the combined con- sumer and producer surplus declines by the amount of the gray triangle to the left of Q1. That triangle represents an efficiency loss to buyers and sellers. And because buyers

The fact that maximum willingness to pay exceeds minimum acceptable price for every unit up to Q1 means that people gain more utility from producing and consum- ing those units than they would if they produced and con- sumed anything else that could be made with the resources that went into making those units. This is true because both the maximum willingness to pay and the minimum acceptable price take opportunity costs into account. As long as the maximum willingness to pay exceeds the mini- mum acceptable price, people are willing to pay more to consume a unit of the good in question (here, bags of or- anges) than they would pay to consume anything else that could be made with the same resources. Only at the equi- librium quantity Q1—where the maximum willingness to pay exactly equals the minimum acceptable price—does society exhaust all opportunities to produce units for which benefits exceed costs (including opportunity costs). Producing Q1 units therefore achieves allocative efficiency because the market is producing and distributing only those units that make people happier with bags of oranges than they would be with anything else that could be pro- duced with the same resources. Geometrically, producing Q1 units maximizes the combined area of consumer and producer surplus in Figure 4.3. In this context, the combined area is referred to as total surplus. Thus, when Q1 units are produced, total surplus is equal to the large triangle formed by the green consumer-surplus triangle and the blue producer-surplus triangle. When demand curves reflect buyers’ full willingness to pay and when supply curves reflect all the costs facing sell- ers, competitive markets produce equilibrium quantities

S

D

Efficiency loss from underproduction

a

d

b

e

c

Q2 Q1 Quantity (bags)

(a)

P ri

ce (

p er

b ag

)

0

S

D

Efficiency loss from overproduction

a

b

g

f

c

Quantity (bags)

Q1

(b)

Q3

P ri

ce (

p er

b ag

)

0

FIGURE 4.4 Efficiency losses (or deadweight losses). Quantity levels either less than or greater than the efficient quantity Q1 create efficiency losses. (a) Triangle dbe shows the efficiency loss associated with underproduction at output Q2. (b) Triangle bfg illustrates the efficiency loss associated with overproduction at output level Q3.

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PART TWO Price, Quantity, and Efficiency90

the bags from Q1 to Q3 could have generated net bene- fits instead of net losses if they had been directed toward producing other products. The gray triangle bfg to the right of Q1 in Figure 4.4b shows the total efficiency loss from overproduction at Q3. The magic of markets is that when demand reflects consumers’ full willingness to pay and when supply re- flects all costs, the market equilibrium quantity will au- tomatically equal the allocatively efficient output level. Under these conditions, the market equilibrium quan- tity will ensure that there are neither efficiency losses from underproduction nor efficiency losses from over- production. As we are about to see, however, such losses do happen when either demand does not reflect con- sumers’ full willingness to pay or supply does not reflect all costs.

and sellers are members of society, it represents an effi- ciency loss (or a so-called deadweight loss) to society. For output levels from Q2 to Q1, consumers’ maxi- mum willingness to pay (as reflected by points on the de- mand curve) exceeds producers’ minimum acceptable price (as reflected by points on the supply curve). By fail- ing to produce units of this product for which a consumer is willing to pay more than a producer is willing to accept, society suffers a loss of net benefits. As a concrete exam- ple, consider a particular unit for which a consumer is willing to pay $10 and a producer is willing to accept $6. The $4 difference between those values is a net benefit that will not be realized if this unit is not produced. In addition, the resources that should have gone to produc- ing this unit will go instead to producing other products that will not generate as much utility as if those resources had been used here to produce this unit of this product. The triangle dbe in Figure 4.4a shows the total loss of net benefits that results from failing to produce the units from Q2 to Q1. In contrast, consider the case of overproduction shown in Figure 4.4b, in which the number of oranges produced is Q3 rather than the efficient level Q1. In Figure  4.4b the combined consumer and producer sur- plus therefore declines by bfg—the gray triangle to the right of Q1. This triangle subtracts from the total con- sumer and producer surplus of abc that would occur if the quantity had been Q1. That is, for all units from 0 to Q1, benefits exceed costs, so that those units generate the eco- nomic surplus shown by triangle abc. But the units from Q1 to Q3 are such that costs exceed benefits. Thus, they generate an economic loss shown by triangle bfg. The to- tal economic surplus for all units from 0 to Q3 is therefore the economic surplus given by abc for the units from 0 to Q1minus the economic loss given by bfg for the units from Q1 to Q3. Producing any unit beyond Q1 generates an eco- nomic loss because the willingness to pay for such units on the part of consumers is less than the minimum acceptable price to produce such units on the part of producers. As a concrete example, note that producing an item for which the maximum willingness to pay is, say, $7 and the minimum acceptable price is, say, $10 subtracts $3 from society’s net benefits. Such production is uneconomical and creates an efficiency loss (or dead- weight loss) for society. Because the net benefit of each bag of oranges from Q1 to Q3 is negative, we know that the benefits from these units are smaller than the oppor- tunity costs of the other products that could have been produced with the resources that were used to produce these bags of oranges. The resources used to produce

Public Goods LO4.3 Describe free riding and public goods, and illustrate why private firms cannot normally produce public goods. Demand-side market failures arise in competitive markets when demand curves fail to reflect consumers’ full willing- ness to pay for a good or service. In such situations, mar- kets fail to produce all of the units for which there are net benefits because demand curves underreport how much consumers are willing and able to pay. This underreport- ing problem reaches its most extreme form in the case of a

QUICK REVIEW 4.1

• Market failures in competitive markets have two pos- sible causes: demand curves that do not reflect con- sumers’ full willingness to pay and supply curves that do not reflect producers’ full cost of production.

• Consumer surplus is the difference between the maxi- mum price that a consumer is willing to pay for a prod- uct and the lower price actually paid.

• Producer surplus is the difference between the mini- mum price that a producer is willing to accept for a product and the higher price actually received.

• At the equilibrium price and quantity in competitive markets, marginal benefit equals marginal cost, maxi- mum willingness to pay equals minimum acceptable price, and the total of consumer surplus and producer surplus is maximized. Each of these conditions defines allocative efficiency.

• Quantities less than or greater than the allocatively ef- ficient level of output create efficiency losses, often called deadweight losses.

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CHAPTER 4 Market Failures: Public Goods and Externalities 91

Because firms can profitably “tap market demand” for private goods, they will produce and offer them for sale. Consumers demand private goods, and profit-seeking suppliers produce goods that satisfy the demand. Consumers willing to pay the market price obtain the goods; nonpayers go without. A competitive market not only makes private goods available to consumers but also allocates society’s resources efficiently to the particular product. There is neither underproduction nor overpro- duction of the product.

Public Goods Characteristics

Public goods have the opposite characteristics of private goods. Public goods are distinguished by nonrivalry and nonexcludability.

• Nonrivalry (in consumption) means that one person’s consumption of a good does not preclude consumption of the good by others. Everyone can simultaneously obtain the benefit from a public good such as national defense, street lighting, a global positioning system, or environmental protection.

• Nonexcludability means there is no effective way of excluding individuals from the benefit of the good once it comes into existence. Once in place, you cannot exclude someone from benefiting from national defense, street lighting, a global positioning system, or environmental protection.

These two characteristics create a free-rider problem. Once a producer has provided a public good, everyone, including nonpayers, can obtain the benefit. Because most people do not voluntarily pay for something that they can obtain for free, most people be- come free riders. These free riders like the public good and would be willing to pay for it if producers could somehow force them to pay—but nonexcludability means that there is no way for producers to withhold the good from the free riders without also denying it to the few who do pay. As a result, free riding means that the willingness to pay of the free riders is not expressed in the market. From the viewpoint of producers, free riding reduces demand. The more free riding, the less demand. And if all consumers free ride, demand will collapse all the way to zero. The low or even zero demand caused by free riding makes it virtually impossible for private firms to profitably provide public goods. With little or no demand, firms can- not effectively “tap market demand” for revenues and profits. As a result, they will not produce public goods. Society will therefore suffer efficiency losses because

public good: Markets may fail to produce any of the public good because its demand curve may reflect none of its con- sumers’ willingness to pay. To understand public goods, we first need to under- stand the characteristics that define private goods.

Private Goods Characteristics

We have seen that the market system produces a wide range of private goods. These are the goods offered for sale in stores, in shops, and on the Internet. Examples in- clude automobiles, clothing, personal computers, house- hold appliances, and sporting goods. Private goods are distinguished by rivalry and excludability.

• Rivalry (in consumption) means that when one person buys and consumes a product, it is not available for another person to buy and consume. When Adams purchases and drinks a bottle of mineral water, it is not available for Benson to purchase and consume.

• Excludability means that sellers can keep people who do not pay for a product from obtaining its benefits. Only people who are willing and able to pay the market price for bottles of water can obtain these drinks and the benefits they confer.

Consumers fully express their personal demands for pri- vate goods in the market. If Adams likes bottled mineral water, that fact will be known by her desire to purchase the product. Other things equal, the higher the price of bot- tled water, the fewer bottles she will buy. So Adams’s de- mand for bottled water will reflect an inverse relationship between the price of bottled water and the quantity of it demanded. This is simply individual demand, as described in Chapter 3. The market demand for a private good is the horizon- tal summation of the individual demand schedules (review Figure 3.2). Suppose just two consumers comprise the market for bottled water and the price is $1 per bottle. If Adams will purchase 3 bottles and Benson will buy 2, the market demand will reflect consumers’ demand for 5 bot- tles at the $1 price. Similar summations of quantities de- manded at other prices will generate the market demand schedule and curve. Suppose the equilibrium price of bottled water is $1. Adams and Benson will buy a total of 5 bottles, and the sellers will obtain total revenue of $5 (5 $1 3 5). If the sellers’ cost per bottle is $0.80, their total cost will be $4 (5 $0.80 3 5). So sellers charging $1 per bottle will obtain $5 of total revenue, incur $4 of total cost, and earn $1 of profit on the 5 bottles sold.

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PART TWO Price, Quantity, and Efficiency92

lighthouses, public art displays, public music concerts, MP3 music files posted to file-sharing Web sites, and ideas and inventions that are not protected by patents or copy- rights. Each of these goods or services shows both nonri- valry and nonexcludability. In a few special cases, private firms can provide public goods because the production costs of these public goods can be covered by the profits generated by closely related private goods. For instance, private companies can make a profit providing broadcast TV—which is a nonrival, nonexcludable public good—because they control who gets to air TV commercials, which are rival and exclud- able private goods. The money that broadcasters make from selling airtime for ads allows them to turn a profit despite having to give their main product, broadcast TV, away for free. Unfortunately, only a few public goods can be subsi- dized in this way by closely related private goods. For the large majority of public goods, private provision is unprof- itable. As a result, there are only two remaining ways for a public good to be provided: private philanthropy or gov- ernment provision. For many less expensive or less impor- tant public goods like fireworks displays or public art, society may feel comfortable relying on private philan- thropy. But when it comes to public goods like national defense, people normally look to the government. This leads to an important question: Once a government decides to produce a particular public good, how can it de- termine the optimal amount that it should produce? How can it avoid either underallocating or overallocating society’s scarce resources to the production of the public good?

Optimal Quantity of a Public Good

If consumers need not reveal their true demand for a public good in the marketplace, how can society determine the op- timal amount of that good? The answer is that the govern- ment has to try to estimate the demand for a public good through surveys or public votes. It can then compare the marginal benefit (MB) of an added unit of the good against the government’s marginal cost (MC) of providing it. Adhering to the MB 5 MC rule, government can provide the “right,” meaning “efficient,” amount of the public good.

Demand for Public Goods

The demand for a public good is somewhat unusual. Suppose Adams and Benson are the only two people in the society, and their marginal willingness to pay for a public good, national defense, is as shown in columns 1 and 2 and columns 1 and 3 in Table 4.3. Economists might have

goods for which marginal benefits exceed marginal costs are not produced. Thus, if society wants a public good to be produced, it will have to direct government to provide it. Because the public good will still feature nonexclud- ability, the government won’t have any better luck pre- venting free riding or charging people for it. But because the government can finance the provision of the public good through the taxation of other things, the govern- ment does not have to worry about profitability. It can therefore provide the public good even when private firms can’t. Examples of public goods include national defense, outdoor fireworks displays, the light beams thrown out by

CONSIDER THIS . . .

Street Entertainers

Street entertainers are often found in tourist areas of major cities. These enter- tainers illuminate the concepts of free rid- ers and public goods.

Most street entertainers have a hard time earning a liv- ing from their activities (unless event organizers pay them) because they have no way of excluding nonpayers from the benefits of their entertainment. They essentially are providing public, not private, goods and must rely on vol- untary payments. The result is a significant free-rider problem. Only a few in the audience put money in the container or instrument case, and many who do so contribute only token amounts. The rest are free riders who obtain the benefits of the street entertainment and retain their money for purchases that they initiate. Street entertainers are acutely aware of the free-rider problem, and some have found creative ways to lessen it. For example, some entertainers involve the audience directly in the act. This usually creates a greater sense of audience will- ingness (or obligation) to contribute money at the end of the performance. “Pay for performance” is another creative approach to  lessening the free-rider problem. A good example is the  street entertainer painted up to look like a statue. When people drop coins into the container, the “statue” makes a slight movement. The greater the contributions, the greater the movement. But these human “statues” still face a free-rider problem: Nonpayers also get to enjoy the acts.

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CHAPTER 4 Market Failures: Public Goods and Externalities 93

Notice that the schedules in Table 4.3 are price-quantity schedules, implying that they are demand schedules. Rather than depicting demand in the usual way—the quantity of a product someone is willing to buy at each possible price— these schedules show the price someone is willing to pay for an extra unit at each possible quantity. That is, Adams is willing to pay $4 for the first unit of the public good, $3 for the second, $2 for the third, and so on. Suppose the government produces 1 unit of this public good. Because of nonrivalry, Adams’s consumption of the good does not preclude Benson from also consuming it, and vice versa. So both consume the good, and neither volunteers to pay for it. But from Table 4.3 we can find the amount these two people would be willing to pay, to- gether, rather than do without this 1 unit of the good. Columns 1 and 2 show that Adams would be willing to pay $4 for the first unit of the public good; columns 1 and 3 show that Benson would be willing to pay $5 for it. So the two people are jointly willing to pay $9 (5 $4 1 $5) for this first unit. For the second unit of the public good, the collective price they are willing to pay is $7 (5 $3 from Adams 1 $4 from Benson); for the third unit they would pay $5 (5 $2 1 $3); and so on. By finding the collective will- ingness to pay for each additional unit (column 4), we can construct a collective demand schedule (a willingness-to- pay schedule) for the public good. Here we are not adding the quantities demanded at each possible price, as we do when we determine the market demand for a private good. Instead, we are adding the prices that people are willing to pay for the last unit of the public good at each possible quantity demanded. Figure 4.5 shows the same adding procedure graphi- cally, using the data from Table 4.3. Note that we sum Adams’s and Benson’s willingness-to-pay curves vertically to derive the collective willingness-to-pay curve (demand curve). The summing procedure is downward from the top graph to the middle graph to the bottom (total) graph. For example, the height of the collective demand curve D

c

at 2 units of output in the bottom graph is $7, the sum of the amounts that Adams and Benson are each willing to pay for the second unit (5 $3 1 $4). Likewise, the height of the collective demand curve at 4 units of the public good is $3 (5 $1 1 $2). What does it mean in Figure 4.5a that, for example, Adams is willing to pay $3 for the second unit of the pub- lic good? It means that Adams expects to receive $3 of ex- tra benefit or utility from that unit. And we know from our discussion of diminishing marginal utility in Chapter 3 that successive units of any good yield less and less added

CONSIDER THIS . . .

Responding to Digital Free Riding

F o u r t e e n a g e friends start a rock band. They practice hard, master their instruments, write their own songs, and do gig after gig for nearly nothing at local bars to gain e x p e r i e n c e a n d perfect their music.

After nearly five years of effort, they get signed to a major record label. But the year is 2005 and record sales are collaps- ing due to digital piracy. The rise of Internet file sharing has turned music into a public good and sales of recorded music have collapsed as hundreds of millions of music lovers have become digital free riders. At first, the band struggles with the new reality. If they can’t make a living selling music, they might have to quit mu- sic and get regular jobs. But then they realize that while re- corded music is now free for anyone who wants it to be free, live music isn’t. And neither are T-shirts or memorabilia. So the band promotes itself online and allows free down- loads to help propel its popularity. But then it charges steep prices at live concerts and makes sure that its T-shirts and memorabilia also generate substantial revenues. By doing so, the band adjusts to the new reality in which music has be- come a public good, but live concerts and T-shirts have not. They charge for the items that are still private goods.

discovered these schedules through a survey asking hypo- thetical questions about how much each citizen was willing to pay for various types and amounts of public goods rather than go without them.

(1) (2) (3) (4)

Quantity Adams’s Benson’s Collective

of Public Willingness Willingness Willingness

Good to Pay (Price) to Pay (Price) to Pay (Price)

1 $4 1 $5 5 $9

2 3 1 4 5 7

3 2 1 3 5 5

4 1 1 2 5 3

5 0 1 1 5 1

TABLE 4.3 Demand for a Public Good, Two Individuals

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PART TWO Price, Quantity, and Efficiency94

Comparing MB and MC

We can now determine the optimal quantity of the public good. The collective demand curve D

c in Figure 4.5c mea-

sures society’s marginal benefit of each unit of this particular good. The supply curve S in that figure mea- sures society’s marginal cost of each unit. The optimal quantity of this public good occurs where marginal ben- efit equals marginal cost, or where the two curves intersect. In Figure 4.5c that point is 3 units of the public good, where the collective willingness to pay for the last (third) unit—the marginal benefit—just matches that unit’s marginal cost ($5 5 $5). As we saw in Chapter 1, equating marginal benefit and marginal cost ef- ficiently allocates society’s scarce resources.

Cost-Benefit Analysis

The above example suggests a practical means, called cost-benefit analysis, for deciding whether to provide a particular public good and how much of it to provide. Like our example, cost-benefit analysis (or marginal-benefit– marginal-cost analysis) involves a comparison of marginal costs and marginal benefits.

Concept Suppose the federal government is contemplat- ing a highway construction plan. Because the economy’s resources are limited, any decision to use more resources in the public sector will mean fewer resources for the private sector. There will be an opportunity cost, as well as a ben- efit. The cost is the loss of satisfaction resulting from the accompanying decline in the production of private goods; the benefit is the extra satisfaction resulting from the out- put of more public goods. Should the needed resources be shifted from the private to the public sector? The answer is yes if the benefit from the extra public goods exceeds the cost that results from having fewer private goods. The an- swer is no if the cost of the forgone private goods is greater than the benefit associated with the extra public goods. Cost-benefit analysis, however, can indicate more than whether a public program is worth doing. It can also help the government decide on the extent to which a project should be pursued. Real economic questions cannot usu- ally be answered simply by “yes” or “no” but, rather, in- volve questions such as “how much” or “how little.”

Illustration Roads and highways can be run privately, as excludability is possible with toll gates. However, the federal highway system is almost entirely nonexclusive

FIGURE 4.5 The optimal amount of a public good. Two people— Adams and Benson—are the only members of a hypothetical economy. (a) D1 shows Adams’s willingness to pay for various quantities of a particular public good. (b) D2 shows Benson’s willingness to pay pay for these same quantities of this public good. (c) The collective demand for this public good is shown by Dc and is found by summing vertically Adams’s and Benson’s individual willingness-to-pay curves. The supply (S) of the public good is upsloping, reflecting rising marginal costs. The optimal amount of the public good is 3 units, determined by the intersection of Dc and S. At that output, marginal benefit (reflected in the collective demand curve Dc) equals marginal cost (reflected in the supply curve S).

$9

7

5

3

1

1 2 3 40 5

P

Q

Optimal quantity

Collective willingness to pay

(c) Collective demand and supply

$6

5

4

3

2

1

1 2 3 40 5

P

Q

Benson’s willingness to pay

(b) Benson

S

Dc

D2

$6

5

4

3

2

1

1 2 3 40 5

P

Q

D1

Adams’s willingness to pay

(a) Adams

benefit. This is also true for public goods, explaining the downward slope of the willingness-to-pay curves of Adams, Benson, and society. These curves, in essence, are marginal-benefit (MB) curves.

W4.2

Optimal amount of a public good

WORKED PROBLEMS

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CHAPTER 4 Market Failures: Public Goods and Externalities 95

activity at, or as close as possible to, the point at which the marginal benefit equals the marginal cost. Do not undertake a project for which marginal cost exceeds marginal benefit. In this case plan C (building new four-lane highways) is the best plan. Plans A and B are too modest; the mar- ginal benefits exceed the marginal costs, and there is a bet- ter option. Plan D’s marginal cost ($10 billion) exceeds the marginal benefit ($3 billion) and therefore cannot be justi- fied; it overallocates resources to the project. Plan C is closest to the theoretical optimum because its marginal benefit ($10 billion) still exceeds marginal cost ($8 billion) but approaches the MB 5 MC (or MC 5 MB) ideal. This marginal-cost–marginal-benefit rule actually tells us which plan provides the maximum excess of total benefits over total costs or, in other words, the plan that provides society with the maximum net benefit. You can confirm directly in column 6 that the maximum net ben- efit (5 $5 billion) is associated with plan C. Cost-benefit analysis shatters the myth that “economy in government” and “reduced government spending” are synonymous. “Economy” is concerned with using scarce resources efficiently. If the marginal cost of a proposed government program exceeds its marginal benefit, then the proposed public program should not be undertaken. But if the marginal benefit exceeds the marginal cost, then it would be uneconomical or “wasteful” not to spend on that government program. Economy in government does not mean minimization of public spending. It means allo- cating resources between the private and public sectors and among public goods to achieve maximum net benefit.

Quasi-Public Goods

Government provides many goods that fit the economist’s definition of a public good. However, it also provides other goods and services that could be produced and delivered in such a way that exclusion would be possible. Such goods, called quasi-public goods, include education, streets and highways, police and fire protection, libraries and museums, preventive medicine, and sewage disposal. They could all be

because anyone with a car can get on and off most federal highways without restriction anytime they want. Federal highways therefore satisfy one characteristic of a public good, nonexcludability. The other characteristic, nonri- valry, is also satisfied by the fact that unless a highway is already extremely crowded, one person’s driving on the highway does not preclude another person’s driving on the highway. Thus, the federal highway system is effectively a public good. This leads us to ask: Should the federal gov- ernment expand the federal highway system? If so, what is the proper size or scope for the overall project? Table 4.4 lists a series of increasingly ambitious and increasingly costly highway projects: widening existing two-lane highways; building new two-lane highways; building new four-lane highways; building new six-lane highways. The extent to which government should under- take highway construction depends on the costs and ben- efits. The costs are largely the costs of constructing and maintaining the highways; the benefits are improved flows of people and goods throughout the country.2 The table shows that total annual benefit (column 4) exceeds total annual cost (column 2) for plans A, B, and C, indicating that some highway construction is economi- cally justifiable. We see this directly in column 6, where total costs (column 2) are subtracted from total annual benefits (column 4). Net benefits are positive for plans A, B, and C. Plan D is not economically justifiable because net benefits are negative. But the question of optimal size or scope for this project remains. Comparing the marginal cost (the change in total cost) and the marginal benefit (the change in total benefit) relating to each plan determines the answer. The guideline is well known to you from previous discussions: Increase an activity, project, or output as long as the marginal benefit (column 5) exceeds the marginal cost (column 3). Stop the

2Because the costs of public goods typically are immediate while the ben- efits often accrue over longer time periods, economists convert both costs and benefits to present values for comparison. Doing so properly accounts for the time-value of money, discussed at length in later chapters.

(2) (3) (4) (5) (6)

(1) Total Cost Marginal Total Marginal Net Benefit

Plan of Project Cost Benefit Benefit (4) 2 (2)

No new construction $ 0 ] $ 4

$ 0 ] $ 5

$ 0

A: Widen existing highways 4 ] 6

5 ] 8

1

B: New 2-lane highways 10 ] 8

13 ] 10

3

C: New 4-lane highways 18 ] 10

23 ] 3

5

D: New 6-lane highways 28 26 22

TABLE 4.4 Cost-Benefit Analysis for a National Highway Construction Project (in Billions)

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PART TWO Price, Quantity, and Efficiency96

Externalities LO4.4 Explain how positive and negative externalities cause under- and overallocations of resources. In addition to providing public goods, governments can also improve the allocation of resources in the economy by correcting for market failures caused by externalities. An externality occurs when some of the costs or the ben- efits of a good or service are passed onto or “spill over to” someone other than the immediate buyer or seller. Such spillovers are called externalities because they are benefits or costs that accrue to some third party that is external to the market transaction. There are both positive and negative externalities. An example of a negative externality is the cost of breathing polluted air; an example of a positive externality is the benefit of having everyone else inoculated against some disease. When there are negative externalities, an overpro- duction of the related product occurs and there is an over- allocation of resources to this product. Conversely, underproduction and underallocation of resources result when positive externalities are present.

Negative Externalities

Negative externalities cause supply-side market failures. These failures happen because producers do not take into account the costs that their negative externalities impose on others. This failure to account for all production costs causes firms’ supply curves to shift to the right of (or be- low) where they would be if firms properly accounted for all costs. Consider the costs of breathing polluted air that are imposed on third parties living downwind of smoke- spewing factories. Because polluting firms do not take ac- count of such costs, they oversupply the products they make, producing units for which total costs (including those that fall on third parties) exceed total benefits. The same is true when airlines fail to account for the costs that noisy jet engines impose on people living near airports and when biodiesel factories that convert dead animal parts into fuel release foul smelling gases that disgust those liv- ing nearby. Figure 4.6a illustrates how negative externalities affect the allocation of resources. When producers shift some of their costs onto the community as external costs, produc- ers’ marginal costs are lower than they would be if they had to pay for those costs. So their supply curves do not include or “capture” all the costs legitimately associated with the production of their goods. A polluting producer’s supply curve such as S in Figure 4.6a therefore understates the total cost of production. The firm’s supply curve lies to the right of (or below) the total-cost supply curve S

t , which

priced and provided by private firms through the market system. But, because the benefits of these goods flow well beyond the benefit to individual buyers, these goods would be underproduced by the market system. Therefore, gov- ernment often provides them to avoid the underallocation of resources that would otherwise occur.

The Reallocation Process

How are resources reallocated from the production of pri- vate goods to the production of public and quasi-public goods? If the resources of the economy are fully employed, government must free up resources from the production of private goods and make them available for producing public and quasi-public goods. It does so by reducing pri- vate demand for them. And it does that by levying taxes on households and businesses, taking some of their income out of the circular flow. With lower incomes and hence less purchasing power, households and businesses must curtail their consumption and investment spending. As a result, the private demand for goods and services declines, as does the private demand for resources. So by diverting purchasing power from private spenders to government, taxes remove resources from private use. Government then spends the tax proceeds to provide public and quasi-public goods and services. Taxation re- leases resources from the production of private consumer goods (food, clothing, television sets) and private investment goods (printing presses, boxcars, warehouses). Government shifts those resources to the production of public and quasi- public goods (post offices, submarines, parks), changing the composition of the economy’s total output.

QUICK REVIEW 4.2

• Public goods are characterized by nonrivalry and nonexcludability.

• The demand (marginal-benefit) curve for a public good is found by vertically adding the prices that all the members of society are willing to pay for the last unit of output at various output levels.

• The socially optimal amount of a public good is the amount at which the marginal cost and marginal ben- efit of the good are equal.

• Cost-benefit analysis is the method of evaluating alter- native projects or sizes of projects by comparing the marginal cost and marginal benefit and applying the MC 5 MB rule.

• The government uses taxes to reallocate resources from the production of private goods to the produc- tion of public and quasi-public goods.

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CHAPTER 4 Market Failures: Public Goods and Externalities 97

longer contract the disease) but also everyone else around him (because they know that in the future he will never be able to infect them). These other people would presum- ably be willing to pay some positive amount of money for the benefits they receive when John is vaccinated. But be- cause his vaccination is a public good, there is no way to make them pay. To see why his vaccination is a public good, note that the vaccination benefits that John provides to others fea- ture nonrivalry and nonexcludability. There is nonrivalry because the protection his vaccination provides to one person does not lessen the protection that it provides to other people. There is nonexcludability because once he is vaccinated, there is no way to exclude anyone in particular from benefiting from his vacci- nation. Thus, the market demand for vaccinations will only include John’s personal willingness to pay for the benefits that he personally receives from the vaccination. The market demand will fail to include the benefits that others receive. As a result, demand will be too low and vaccinations will be underproduced. Figure 4.6b shows the impact of positive externalities on resource allocation. When external benefits occur, the market demand curve D lies to the left of (or below) the  total-benefits demand curve, D

t . That is, D does

not include the external benefits of the product, whereas D

t does.

The outcome is that the equilibrium output Q e is less

than the optimal output Q o . The market fails to produce

enough vaccinations, and resources are underallocated to this product. The underproduction implies that society is  missing out on a significant amount of potential net

would include the spillover cost. Through polluting and thus transferring costs to society, the firm enjoys lower production costs and has the supply curve S. The outcome is shown in Figure 4.6a, where equilib- rium output Q

e is larger than the optimal output Q

o . This

means that resources are overallocated to the production of this commodity; too many units of it are produced. In fact, there is a net loss to society for every unit from Q

o to

Q e because, for those units, the supply curve that accounts

for all costs, S t , lies above the demand curve. Therefore,

MC exceeds MB for those units. The resources that went into producing those units should have been used else- where in the economy to produce other things. In terms of our previous analysis, the negative external- ity results in an efficiency loss represented by triangle abc.

Positive Externalities

Positive externalities cause demand-side market fail- ures. These failures happen because market demand curves in such cases fail to include the willingness to pay of the third parties who receive the external bene- fits caused by the positive externality. This failure to ac- count for all benefits shifts market demand curves to the left of (or below) where they would be if they in- cluded all benefits and the willingness to pay of both the third parties as well as the primary beneficiaries. Because demand curves fail to take into account all ben- efits when there are positive externalities, markets in such cases fail to produce all units for which benefits (including those that are received by third parties) ex- ceed costs. As a result, products featuring positive exter- nalities are underproduced. Vaccinations are a good example of how positive ex- ternalities reduce demand and shift demand curves down and to the left. When John gets vaccinated against a dis- ease, he benefits not only himself (because he can no

P

Q0

Negative externalities

Qo Qe (a)

Negative externalities

Overallocation

P

Q0

Positive externalities

QoQe (b)

Positive externalities

D

S

St

D

St

Dt

Underallocation

a

y z

x

b

c

FIGURE 4.6 Negative externalities and positive externalities. (a) With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo , and the efficiency loss is abc. (b) When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output Qe is less than the optimal output Qo , and the efficiency loss is xyz.

O4.2

Externalities

ORIGIN OF THE IDEA

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PART TWO Price, Quantity, and Efficiency98

benefits. For every unit from Q e to Q

o , the demand curve

that accounts for all benefits, D t , lies above the supply

curve that accounts for all costs—including the opportu- nity cost of producing other items with the resources that would be needed to produce these units. Therefore, MB exceeds MC for each of these units, and we know that so- ciety should redeploy some of its resources away from the production of other things in order to produce these units that generate net benefits. In terms of our previous analysis, the positive external- ity results in an efficiency loss represented by triangle xyz.

Government Intervention

Government intervention may be called upon to achieve economic efficiency when externalities affect large num- bers of people or when community interests are at stake. Government can use direct controls and taxes to counter negative externalities; it may provide subsidies or public goods to deal with positive externalities.

Direct Controls The direct way to reduce negative ex- ternalities from a certain activity is to pass legislation lim- iting that activity. Such direct controls force the offending firms to incur the actual costs of the offending activity. Historically, direct controls in the form of uniform emis- sion standards—limits on allowable pollution—have dominated American air pollution policy. For example, the Clean Air Act of 1990 (1) forced factories and busi- nesses to install “maximum achievable control technol- ogy” to reduce emissions of 189 toxic chemicals by 90 percent between 1990 and 2000; (2) required a 30 to 60 percent reduction in tailpipe emissions from automo- biles by 2000; (3) mandated a 50 percent reduction in the use of chlorofluorocarbons (CFCs), which deplete the ozone layer (CFCs were used widely as a coolant in re- frigeration, a blowing agent for foam, and a solvent in the electronics industry); and (4) forced coal-burning utilities to cut their emissions of sulfur dioxide by about 50 per- cent to reduce the acid-rain destruction of lakes and forests. Clean-water legislation limits the amount of heavy metals, detergents, and other pollutants firms can discharge into rivers and bays. Toxic-waste laws dictate special procedures and dump sites for disposing of contaminated soil and solvents. Violating these laws means fines and, in some cases, imprisonment. Direct controls raise the marginal cost of production because the firms must operate and maintain pollution- control equipment. The supply curve S in Figure 4.7b, which does not reflect the external costs, shifts leftward to

the total-cost supply curve, S t . Product price increases,

equilibrium output falls from Q e to Q

o , and the initial

overallocation of resources shown in Figure 4.7a is cor- rected. Observe that the efficiency loss shown by triangle abc in Figure 4.7a disappears after the overallocation is corrected in Figure 4.7b.

CONSIDER THIS . . .

The Fable of the Bees

Economist Ronald Coase received the Nobel Prize for his s o - c a l l e d Co a s e theorem, which pointed out that under the right

conditions, private individuals could often negotiate their own mutually agreeable solutions to externality problems through private bargaining without the need for government interventions like pollution taxes. This is a very important insight because it means that we shouldn’t automatically call for government intervention ev- ery time we see a potential externality problem. Consider the positive externalities that bees provide by pollinating farm- ers’ crops. Should we assume that beekeeping will be under- provided unless the government intervenes with, for instance, subsidies to encourage more hives and hence more pollination? As it turns out, no. Research has shown that farmers and beekeepers long ago used private bargaining to develop customs and payment systems that avoid free riding by farmers and en- courage beekeepers to keep the optimal number of hives. Free riding is avoided by the custom that all farmers in an area simultaneously hire bee- keepers to provide bees to pollinate their crops. And farmers always pay the beekeep- ers for their pollination services because if they didn’t, then no beekeeper would ever work with them in the future—a situation that would lead to massively reduced crop yields due to a lack of pollination. The “Fable of the Bees” is a good reminder that it is a fal- lacy to assume that the government must always get in- volved to remedy externalities. In many cases, the private sector can solve both positive and negative externality prob- lems on its own.

O4.3

Coase theorem

ORIGIN OF THE IDEA

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CHAPTER 4 Market Failures: Public Goods and Externalities 99

The equilibrium price rises, and the equilibrium output declines from Q

e to the economically efficient level Q

o .

The tax thus eliminates the initial overallocation of resources and therefore the efficiency loss.

Subsidies and Government Provision Where spillover benefits are large and diffuse, as in our earlier example of inoculations, government has three options for correcting the underallocation of resources:

• Subsidies to buyers Figure 4.8a again shows the supply-demand situation for positive externalities. Government could correct the underallocation of

Specific Taxes A second policy approach to negative externalities is for government to levy taxes or charges specifically on the related good. For example, the govern- ment has placed a manufacturing excise tax on CFCs, which deplete the stratospheric ozone layer protecting the earth from excessive solar ultraviolet radiation. Facing such an excise tax, manufacturers must decide whether to pay the tax or expend additional funds to purchase or de- velop substitute products. In either case, the tax raises the marginal cost of producing CFCs, shifting the private sup- ply curve for this product leftward (or upward). In Figure 4.7b, a tax equal to T per unit increases the firm’s marginal cost, shifting the supply curve from S to S

t .

P

Q0

Negative externalities

(a) Negative externalities

D

S

St

Overallocation

P

Q0

D

S

St

T

(b) Correcting the overallocation of resources via direct controls

or via a tax

QeQo QeQo

a b

c

FIGURE 4.7 Correcting for negative externalities. (a) Negative externalities result in an overallocation of resources. (b) Government can correct this overallocation in two ways: (1) using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo, or (2) imposing a specific tax T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss.

(a) Positive externalities

P

Q0 QoQe

(c) Correcting the

underallocation of resources via a subsidy

to producers

P

Q0

Subsidy

QoQe

Subsidy

U

(b) Correcting the

underallocation of resources via a subsidy

to consumers

D

St

D

St

Dt

S9t

P

Q0

Positive externalities

QoQe

D

St

Dt

Underallocation

y

x

z

FIGURE 4.8 Correcting for positive externalities. (a) Positive externalities result in an underallocation of resources. (b) This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Qo. (c) Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to St9, increasing output from Qe to Qo and eliminating the underallocation, and thus the efficiency loss, shown in graph a.

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PART TWO Price, Quantity, and Efficiency100

Society’s Optimal Amount of Externality Reduction LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative externality such as air pollution. Negative externalities such as pollution reduce the utility of those affected, rather than increase it. These spillovers are not economic goods but economic “bads.” If some- thing is bad, shouldn’t society eliminate it? Why should society allow firms or municipalities to discharge any im- pure waste into public waterways or to emit any pollution into the air? Economists answer these questions by pointing out that reducing pollution and negative externalities is not free. There are costs as well as benefits to reducing pollution. As a result, the correct question to ask when it comes to clean- ing up negative externalities is not, “Do we pollute a lot or pollute zero?” That is an all-or-nothing question that ig- nores marginal costs and marginal benefits. Instead, the correct question is, “What is the optimal amount to clean up—the amount that equalizes the marginal cost of clean- ing up with the marginal benefit of a cleaner environment?” If we ask that question, we see that reducing a nega- tive externality has a “price.” Society must decide how much of a reduction it wants to “buy.” High costs may mean that totally eliminating pollution might not be de- sirable, even if it is technologically feasible. Because of the law of diminishing returns, cleaning up the second 10 per- cent of pollutants from an industrial smokestack normally is more costly than cleaning up the first 10 percent. Eliminating the third 10 percent is more costly than clean- ing up the second 10 percent, and so on. Therefore, clean- ing up the last 10 percent of pollutants is the most costly reduction of all.

resources, for example, to inoculations, by subsidizing consumers of the product. It could give each new mother in the United States a discount coupon to be used to obtain a series of inoculations for her child. The coupon would reduce the “price” to the mother by, say, 50 percent. As shown in Figure 4.8b, this program would shift the demand curve for inocu- lations from too-low D to the appropriate D

t . The

number of inoculations would rise from Q e to the

economically optimal Q o , eliminating the under-

allocation of resources and efficiency loss shown in Figure 4.8a.

• Subsidies to producers A subsidy to producers is a tax in reverse. Taxes are payments to the government that increase producers’ costs. Subsidies are payments from the government that decrease producers’ costs. As shown in Figure 4.8c, a subsidy of U per inoculation to physicians and medical clinics would reduce their marginal costs and shift their supply curve rightward from S

t

to S t 9. The output of inoculations would increase

from Q e to the optimal level Q

o , correcting the

underallocation of resources and efficiency loss shown in Figure 4.8a.

• Government provision Finally, where positive externalities are extremely large, the government may decide to provide the product for free to everyone. The U.S. government largely eradicated the crippling disease polio by administering free vaccines to all children. India ended smallpox by paying people in rural areas to come to public clinics to have their children vaccinated.

Table 4.5 lists several methods for correcting exter- nalities, including those we have discussed thus far.

Resource Allocation

Problem Outcome Ways to Correct

Negative externalities Overproduction of 1. Private bargaining

(spillover costs) output and therefore 2. Liability rules and lawsuits

overallocation 3. Tax on producers

of resources 4. Direct controls

5. Market for externality rights

Positive externalities Underproduction of 1. Private bargaining

(spillover benefits) output and therefore 2. Subsidy to consumers

underallocation 3. Subsidy to producers

of resources 4. Government provision

TABLE 4.5 Methods for Dealing with Externalities

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CHAPTER 4 Market Failures: Public Goods and Externalities 101

there would be greater benefits from using resources in some other way than to further reduce pollution. In reality, it is difficult to measure the marginal costs and benefits of pollution control. Nevertheless, Figure 4.9 demonstrates that some pollution may be economically ef- ficient. This is so not because pollution is desirable but because beyond some level of control, further abatement may reduce society’s net well-being. As an example, it would cost the government billions of dollars to clean up every last piece of litter in America. Thus, it would be bet- ter to tolerate some trash blowing around if the money saved by picking up less trash would yield larger net ben- efits when spent on other things.

Shifts in Locations of the Curves

The locations of the marginal-cost and marginal-benefit curves in Figure 4.9 are not forever fixed. They can, and probably do, shift over time. For example, suppose that the technology of pollution-control equipment improved noticeably. We would expect the cost of pollution abate- ment to fall, society’s MC curve to shift rightward, and the optimal level of abatement to rise. Or suppose that society were to decide that it wanted cleaner air and water because of new information about the adverse health effects of pol- lution. The MB curve in Figure 4.9 would shift rightward, and the optimal level of pollution control would increase beyond Q1. Test your understanding of these statements by drawing the new MC and MB curves in Figure 4.9.

Government’s Role in the Economy

Market failures can be used to justify government inter- ventions in the economy. The inability of private-sector firms to break even when attempting to provide public goods and the over- and underproduction problems caused by positive and negative externalities mean that government can have an important role to play if society’s resources are to be efficiently allocated to the goods and services that people most highly desire. Correcting for market failures is not, however, an easy task. To begin with, government officials must correctly identify the existence and the cause of any given market failure. That by itself may be difficult, time-consuming, and costly. But even if a market failure is correctly identi- fied and diagnosed, government may still fail to take ap- propriate corrective action due to the fact that government undertakes its economic role in the context of politics. To serve the public, politicians need to get elected. To stay elected, officials (presidents, senators, representatives, mayors, council members, school board members) need to satisfy their particular constituencies. At best, the political

The marginal cost (MC) to the firm and hence to society—the opportunity cost of the extra resources used—rises as pollution is reduced more and more. At some point MC may rise so high that it exceeds society’s marginal benefit (MB) of further pollution abatement (reduction). Additional actions to reduce pollution will therefore lower society’s well-being; total cost will rise more than total benefit.

MC, MB, and Equilibrium Quantity

Figure 4.9 shows both the rising marginal-cost curve, MC, for pollution reduction and the downsloping marginal- benefit curve, MB, for pollution reduction. MB slopes downward because of the law of diminishing marginal utility: The more pollution reduction society accom- plishes, the lower the utility (and benefit) of the next unit of pollution reduction. The optimal reduction of an externality occurs when society’s marginal cost and marginal benefit of reducing that externality are equal (MC 5 MB). In Figure 4.9 this optimal amount of pollution abatement is Q1 units. When MB exceeds MC, additional abatement moves society toward economic efficiency; the added ben- efit of cleaner air or water exceeds the benefit of any alter- native use of the required resources. When MC exceeds MB, additional abatement reduces economic efficiency;

Socially optimal amount of pollution abatement

MC

MB

Q10

Amount of pollution abatement

So ci

et y'

s m

ar gi

n al

b en

efi t

an d m

ar gi

n al

co st

o f

p o

llu ti

o n a

b at

em en

t (d

o lla

rs )

FIGURE 4.9 Society’s optimal amount of pollution abatement. The optimal amount of externality reduction—in this case, pollution abatement— occurs at Q1, where society’s marginal cost MC and marginal benefit MB of reducing the spillover are equal.

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102

Carbon Dioxide Emissions, Cap and Trade, and Carbon Taxes

Externality problems are property rights problems. Consider a landfill. Because the owner of the landfill has full rights to his land, people wishing to dump their trash into the landfill have to pay him. This payment implies that there is no externality: He happily accepts their trash in exchange for a dumping fee. By contrast, because nobody owns the atmosphere, all air pollution is an externality, since there is no way for those doing the pollut- ing to work out a payment to compensate those affected by the pollution or for those threatened with pollution to simply refuse to be polluted on. Conventional property rights therefore cannot fix the exter- nalities associated with air pollution. But that does not mean property rights can’t help fight pollution. The trick to making them work is to assign property rights not to the atmosphere it- self, but to polluting the atmosphere. This is done in “cap-and- trade” systems, under which the government sets an annual limit, or cap, to the number of tons of a pollutant that firms can emit into the atmosphere. Consider carbon dioxide, or CO2. It is a colorless, odorless gas that many scientists consider to be a contributing cause of climate change, specifically global warming. To reduce CO2 emissions, the U.S. government might set a cap of 5 billion tons of CO2 emissions per year in the United States (which

Cap-and-trade systems and carbon taxes are two approaches to reducing carbon dioxide (CO 2 ) emissions.

LAST WORD

would be about 25 percent below 2010 emissions levels for that molecule). The government then prints out emissions permits that sum to the limit set in the cap and distributes them to polluting firms. Once they are distributed, the only way a firm can legally emit a ton of CO2 is if it owns a permit to do so. Under this policy, the government can obviously adjust the total amount of air pollution by adjusting the cap. This by itself improves efficiency because the cap imposes scarcity. Because each firm has only a limited number of permits, each firm has a strong incentive to maximize the net benefit that it produces from every ton of pollution that it emits. But the cap-and-trade scheme leads to even greater improvements in efficiency because firms are free to trade (sell) them to each other in what are re- ferred to as markets for externality rights. For instance, suppose Smokestack Toys owns permits for 100 tons of CO2 emissions and that it could use them to pro- duce toy cars that would generate profits of $100,000. There is a power plant, however, that could make up to $1 million of prof- its by using those 100 tons of emissions permits to generate electricity. Because firms can trade their permits, Smokestack Toys will sell its permits to the power plant for more than the $100,000 in profits that it could make if it kept them and

realities complicate government’s role in the economy; at worst, they produce undesirable economic outcomes. In the political context, overregulation can occur in some cases; underregulation, in others. Some public goods and quasi-public goods can be produced not because their benefits exceed their costs but because their benefits ac- crue to firms located in states served by powerful elected officials. Inefficiency can easily creep into government ac- tivities because of the lack of a profit incentive to hold down costs. Policies to correct negative externalities can be politically blocked by the very parties that are produc- ing the spillovers. In short, the economic role of govern- ment, although critical to a well-functioning economy, is not always perfectly carried out. Economists use the term “government failure” to de- scribe economically inefficient outcomes caused by short- comings in the public sector.

QUICK REVIEW 4.3

• Policies for coping with the overallocation of resources, and therefore efficiency losses, caused by negative ex- ternalities are (a) private bargaining, (b) liability rules and lawsuits, (c) direct controls, (d) specific taxes, and (e) markets for externality rights (Last Word).

• Policies for correcting the underallocation of resources, and therefore efficiency losses, associated with posi- tive externalities are (a) private bargaining, (b) subsi- dies to producers, (c) subsidies to consumers, and (d) government provision.

• The optimal amount of negative-externality reduction occurs where society’s marginal cost and marginal benefit of reducing the externality are equal.

• Political pressures often lead government to respond in- efficiently when attempting to correct for market failures.

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SUMMARY LO4.2 Explain the origin of both consumer surplus and producer surplus, and explain how properly

functioning markets maximize their sum, total

surplus, while optimally allocating resources.

Consumer surplus is the difference between the maximum price that a consumer is willing to pay for a product and the lower price actually paid; producer surplus is the difference between the min- imum price that a producer is willing to accept for a product and the higher price actually received. Collectively, consumer surplus is represented by the triangle under the demand curve and above the actual price, whereas producer surplus is shown by the trian- gle above the supply curve and below the actual price.

LO4.1 Differentiate between demand-side market failures and supply-side market failures.

A market failure happens in a particular market when the market produces an equilibrium level of output that either overallocates or underallocates resources to the product being traded in the market. In competitive markets that feature many buyers and many sellers, market failures can be divided into two types: Demand-side market failures occur when demand curves do not reflect consumers’ full willingness to pay; supply-side market failures occur when supply curves do not reflect all production costs, including those that may be borne by third parties.

103

produced toy cars. And the power plant will gladly pay more than $100,000 for those permits because it can turn around and use them to make up to $1 million of profits by using them to generate electricity. Society will benefit hugely from this transaction because while 100 tons of CO2 will be emitted no matter which firm uses the permits, society will receive much greater net benefits when they are used by the power plant, as indicated by the fact that the power plant can pro- duce much larger profits than the toy company when using the same amount of this scarce resource. Several words of caution, however! Cap-and-trade sys- tems have proven very difficult to implement in cases where it is difficult for regulators to ef- fectively check whether firms are obeying the system. This has been a major problem with the European Union’s cap-and- trade system for CO2 emissions. Because nearly every type of industrial activity releases CO2 into the atmosphere, enforce- ment involves monitoring many thousands of factories of all sizes. That is very difficult and cheating has resulted. In addition, politically connected industries got politicians to give them ex- emptions or free permits.

By contrast, a cap-and-trade system on sulfur dioxide emis- sions from coal-burning public utilities has worked well in the United States since the 1980s. But in that case, there were only a few hundred polluting utilities, and they were already being mon- itored for emissions. So there was little ability to cheat. In addi- tion, all of the firms were treated equally, with no firms allowed

exemptions or free permits. Due to the mixed results,

many economists have con- cluded that a cap-and-trade system would not be the best way to curb CO2 emissions in the United States. They believe that there are simply too many sources of pollution to make monitoring either possible or cost-effective. And it seems likely that politically connected industries will be granted ex- emptions. So, instead, many economists favor a carbon tax, which would involve taxing

each ton of coal, each gallon of gasoline, and each barrel of oil on the basis of how much carbon it contains (and thus how much CO2 will eventually be released into the atmosphere when it is used). By raising the cost of polluting, the tax would reduce con- sumption and lessen the externalities associated with CO2 emis- sions. It would also be nearly impossible to evade, so that we would not have to worry about cheating.

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PART TWO Price, Quantity, and Efficiency104

Graphically, the combined amount of producer and con- sumer surplus is represented by the triangle to the left of the in- tersection of the supply and demand curves that is below the demand curve and above the supply curve. At the equilibrium price and quantity in competitive markets, marginal benefit equals marginal cost, maximum willingness to pay equals mini- mum acceptable price, and the combined amount of consumer surplus and producer surplus is maximized.

Output levels that are either less than or greater than the equilibrium output create efficiency losses, also called deadweight losses. These losses are reductions in the combined amount of consumer surplus and producer surplus. Underproduction creates efficiency losses because output is not being produced for which maximum willingness to pay exceeds minimum acceptable price. Overproduction creates efficiency losses because output is being produced for which minimum acceptable price exceeds maximum willingness to pay.

LO4.3 Describe free riding and public goods, and illustrate why private firms cannot normally produce

public goods.

Public goods are distinguished from private goods. Private goods are characterized by rivalry (in consumption) and excludability. One person’s purchase and consumption of a private good pre- cludes others from also buying and consuming it. Producers can exclude nonpayers (free riders) from receiving the benefits. In contrast, public goods are characterized by nonrivalry (in con- sumption) and nonexcludability. Public goods are not profitable to private firms because nonpayers (free riders) can obtain and consume those goods without paying. Government can, however, provide desirable public goods, financing them through taxation.

The collective demand schedule for a particular public good is found by summing the prices that each individual is willing to pay for an additional unit. Graphically, that demand curve is found by summing vertically the individual demand curves for that good. The resulting total demand curve indicates the collec- tive willingness to pay for (or marginal benefit of) any given amount of the public good.

The optimal quantity of a public good occurs where the so- ciety’s willingness to pay for the last unit—the marginal benefit of the good—equals the marginal cost of the good.

LO4.4 Explain how positive and negative externalities cause under- and overallocations of resources.

Externalities, or spillovers, are costs or benefits that accrue to someone other than the immediate buyer or seller. Such costs or

benefits are not captured in market demand or supply curves and therefore cause the output of certain goods to vary from society’s optimal output. Negative externalities (or spillover costs or ex- ternal costs) result in an overallocation of resources to a particu- lar product. Positive externalities (or spillover benefits or external benefits) are accompanied by an underallocaton of re- sources to a particular product.

Direct controls and specific taxes can improve resource allo- cation in situations where negative externalities affect many peo- ple and community resources. Both direct controls (for example, smokestack emission standards) and specific taxes (for example, taxes on firms producing toxic chemicals) increase production costs and hence product price. As product price rises, the exter- nality, overallocation of resources, and efficiency loss are reduced since less of the output is produced.

Government can correct the underallocation of resources and therefore the efficiency losses that result from positive exter- nalities in a particular market either by subsidizing consumers (which increases market demand) or by subsidizing producers (which increases market supply). Such subsidies increase the equilibrium output, reducing or eliminating the positive exter- nality and consequent underallocation of resources and effi- ciency loss.

The Coase theorem suggests that under the right circum- stances private bargaining can solve externality problems. Thus, government intervention is not always needed to deal with exter- nality problems.

LO4.5 Show why we normally won’t want to pay what it would cost to eliminate every last bit of a negative

externality such as air pollution.

The socially optimal amount of externality abatement occurs where society’s marginal cost and marginal benefit of reducing the externality are equal. With pollution, for example, this optimal amount of pollution abatement is likely to be less than a 100 percent reduction. Changes in technology or changes in society’s attitudes toward pollution can affect the optimal amount of pollution abatement.

Market failures present government with opportunities to improve the allocation of society’s resources and thereby en- hance society’s total well-being. But even when government cor- rectly identifies the existence and cause of a market failure, political pressures may make it difficult or impossible for gov- ernment officials to implement a proper solution.

TERMS AND CONCEPTS market failures demand-side market failures supply-side market failures consumer surplus

producer surplus efficiency losses (or deadweight losses) private goods rivalry

excludability public goods nonrivalry nonexcludability

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CHAPTER 4 Market Failures: Public Goods and Externalities 105

free-rider problem cost-benefit analysis marginal-cost–marginal-benefit rule

quasi-public goods externality

Coase theorem optimal reduction of an externality

R E V I E W Q U E S T I O N S

1. Draw a supply and demand graph and identify the areas of consumer surplus and producer surplus. Given the demand curve, what impact will an increase in supply have on the amount of consumer surplus shown in your diagram? Explain why. LO4.2

2. Assume that candle wax is traded in a perfectly competitive market in which the demand curve captures buyers’ full willingness to pay while the supply curve reflects all produc- tion costs. For each of the following situations, indicate whether the total output should be increased, decreased, or kept the same in order to achieve allocative and productive efficiency. LO4.2

a. Maximum willingness to pay exceeds minimum acceptable price.

b. MC . MB.

c. Total surplus is at a maximum. d. The current quantity produced exceeds the market

equilibrium quantity. 3. Efficiency losses . LO4.2 a. Are not possible if suppliers are willing to produce and

sell a product. b. Can only result from underproduction. c. Can only result from overproduction. d. None of the above. 4. Draw a production possibilities curve with public goods on

the vertical axis and private goods on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the production of public goods might be in- creased. How might the output of public goods be increased

D I S C U S S I O N Q U E S T I O N S

1. Explain the two causes of market failures. Given their defi- nitions, could a market be affected by both types of market failures simultaneously? LO4.1

2. Use the ideas of consumer surplus and producer surplus to explain why economists say competitive markets are effi- cient. Why are below- or above-equilibrium levels of output inefficient, according to these two sets of ideas? LO4.2

3. What are the two characteristics of public goods? Explain the significance of each for public provision as opposed to private provision. What is the free-rider problem as it relates to public goods? Is U.S. border patrol a public good or a private good? Why? How about satellite TV? Explain. LO4.3

4. What divergences arise between equilibrium output and ef- ficient output when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text ex- amples) of an external cost and an external benefit. LO4.4

5. Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality? LO4.4

6. An apple grower’s orchard provides nectar to a neighbor’s bees, while the beekeeper’s bees help the apple grower by pollinating his apple blossoms. Use Figure 4.6b to explain

why this situation of dual positive externalities might lead to an underallocation of resources to both apple growing and beekeeping. How might this underallocation get resolved via the means suggested by the Coase theorem? LO4.4

7. The LoJack car recovery system allows the police to track stolen cars. As a result, they not only recover 90 percent of LoJack-equipped cars that are stolen but also arrest many auto thieves and shut down many “chop shops” that take apart stolen vehicles to get at their used parts. Thus, LoJack provides both private benefits and positive externalities. Should the government consider subsidizing LoJack purchases? LO4.4

8. Explain why zoning laws, which allow certain land uses only in specific locations, might be justified in dealing with a problem of negative externalities. Explain why in areas where buildings sit close together tax breaks to property owners for installing extra fire prevention equipment might be justified in view of positive externalities. Explain why ex- cise taxes on beer might be justified in dealing with a prob- lem of external costs. LO4.5

9. LAST WORD Distinguish between a carbon-tax and a cap-and-trade strategy for reducing carbon dioxide and other so-called greenhouse gases (that are believed by many scientists to be causing global warming). Which of the two strategies do you think would have the most po- litical support in an election in your home state? Explain your thinking.

The following and additional problems can be found in

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PART TWO Price, Quantity, and Efficiency106

c. Market demand curves are too far to the left (too low). d. Underallocation of resources. e. Water pollution from a factory forces neighbors to buy

water purifiers. 7. Use marginal cost/marginal benefit analysis to determine

if the following statement is true or false: “The optimal amount of pollution abatement for some substances, say, dirty water from storm drains, is very low; the optimal amount of abatement for other substances, say, cyanide poison, is close to 100 percent.” LO4.5

if the economy is initially operating at a point inside the curve? LO4.3

5. Use the distinction between the characteristics of private and public goods to determine whether the following should be produced through the market system or provided by government: (a) French fries, (b) airport screening, (c) court systems, (d) mail delivery, and (e) medical care. State why you answered as you did in each case. LO4.3

6. Match each of the following characteristics or scenarios with either the term negative externality or the term positive externality. LO4.4

a. Overallocation of resources. b. Tammy installs a very nice front garden, raising the

property values of all the other houses on her block.

P R O B L E M S

1. Refer to Table 4.1. If the six people listed in the table are the only consumers in the market and the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market generate? LO4.2

2. Refer to Table 4.2. If the six people listed in the table are the only producers in the market and the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market generate? LO4.2

3. Look at Tables 4.1 and 4.2 together. What is the total sur- plus if Bob buys a unit from Carlos? If Barb buys a unit from Courtney? If Bob buys a unit from Chad? If you match up pairs of buyers and sellers so as to maximize the total surplus of all transactions, what is the largest total surplus that can be achieved? LO4.2

4. ADVANCED ANALYSIS Assume the following values for Figures 4.4a and 4.4b. Q1 5 20 bags. Q2 5 15 bags. Q3 5 27 bags. The market equilibrium price is $45 per bag. The price at a is $85 per bag. The price at c is $5 per bag. The price at f is $59 per bag. The price at g is $31 per bag. Apply the formula for the area of a triangle (Area 5 ½ 3 Base 3 Height) to answer the following questions. LO4.2

a. What is the dollar value of the total surplus (producer surplus plus consumer surplus) when the allocatively efficient output level is being produced? How large is the dollar value of the consumer surplus at that output level?

b. What is the dollar value of the deadweight loss when output level Q2 is being produced? What is the total surplus when output level Q2 is being produced?

c. What is the dollar value of the deadweight loss when output level Q3 is produced? What is the dollar value of the total surplus when output level Q3 is produced?

5. On the basis of the three individual demand schedules in the following table, and assuming these three people are the only ones in the society, determine (a) the market demand schedule on the assumption that the good is a private good

and (b) the collective demand schedule on the assumption that the good is a public good. LO4.3

P Q d (D

1 ) Q

d (D

2 ) Q

d (D

3 )

$8 0 1 0 7 0 2 0 6 0 3 1 5 1 4 2 4 2 5 3 3 3 6 4 2 4 7 5 1 5 8 6

6. Use your demand schedule for a public good, determined in problem 5, and the following supply schedule to ascertain the optimal quantity of this public good. LO4.3

P Q s

$19 10 16 8 13 6 10 4 7 2 4 1

7. Look at Tables 4.1 and 4.2, which show, respectively, the willingness to pay and willingness to accept of buyers and sellers of bags of oranges. For the following questions, as- sume that the equilibrium price and quantity will depend on the indicated changes in supply and demand. Assume that the only market participants are those listed by name in the two tables. LO4.4

a. What are the equilibrium price and quantity for the data displayed in the two tables?

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CHAPTER 4 Market Failures: Public Goods and Externalities 107

that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers. What is the new equilibrium price and quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges being overproduced before?

b. What if, instead of bags of oranges, the data in the two tables dealt with a public good like fireworks displays? If all the buyers free ride, what will be the quantity supplied by private sellers?

c. Assume that we are back to talking about bags of oranges (a private good), but that the government has decided

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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CHAPTER FOUR APPENDIX108

LO4.6 Describe how information failures may justify government intervention in some markets. This chapter discussed the two most common types of market failure, public goods and externalities. But there is also another, subtler, type of market failure. This one re- sults when either buyers or sellers have incomplete or in- accurate information and their cost of obtaining better information is prohibitive. Technically stated, this market failure occurs because of asymmetric information— unequal knowledge possessed by the parties to a market transaction. Buyers and sellers do not have identical infor- mation about price, quality, or some other aspect of the good or service. Sufficient market information is normally available to ensure that goods and services are produced and purchased efficiently. But in some cases inadequate informa- tion makes it difficult to dis- tinguish trustworthy from untrustworthy sellers or trustworthy from untrust- worthy buyers. In these markets, society’s scarce re- sources may not be used ef- ficiently, thus implying that the government should intervene by increasing the information available to the market participants. Under rare circumstances the govern- ment may itself supply a good for which information prob- lems have prohibited efficient production.

Inadequate Buyer Information about Sellers Inadequate information among buyers about sellers and their products can cause market failure in the form of un- derallocation of resources. Two examples will help you un- derstand this point.

Example: Gasoline Market

Assume an absurd situation: Suppose there is no system of weights and measures established by law, no government inspection of gasoline pumps, and no law against false ad- vertising. Each gas station can use whatever measure it chooses; it can define a gallon of gas as it pleases. A station can advertise that its gas is 87 octane when in fact it is only

75. It can rig its pumps to indicate that it is providing more gas than the amount being delivered. Obviously, the consumer’s cost of obtaining reliable in- formation under such chaotic conditions is exceptionally high, if not prohibitive. Customers or their representatives would have to buy samples of gas from various gas stations, have them tested for octane level, and test the accuracy of calibrations at the pump. And these activities would have to be repeated regularly, since a station owner could alter the product quality and the accuracy of the pump at will. Because of the high cost of obtaining information about the seller, many consumers would opt out of this chaotic market. One tankful of a 50 percent mixture of gasoline and water would be enough to discourage most motorists from further driving. More realistically, the con- ditions in this market would encourage consumers to vote for political candidates who promise to provide a govern- ment solution. The oil companies and honest gasoline sta- tions would most likely welcome government intervention. They would realize that accurate information, by enabling this market to work, would expand their total sales and profits. The government has in fact intervened in the market for gasoline and other markets with similar potential infor- mation difficulties. It has established a system of weights and measures, employed inspectors to check the accuracy of gasoline pumps, and passed laws against fraudulent claims and misleading advertising. Clearly, these govern- ment activities have produced net benefits for society.

Example: Licensing of Surgeons

Suppose now that anyone could hang out a shingle and claim to be a surgeon, much as anyone can become a house painter. The market would eventually sort out the true surgeons from those who are “learning by doing” or are fly-by-night operators who move into and out of an area. As people died from unsuccessful surgeries, lawsuits for malpractice eventually would identify and eliminate most of the medical impostors. People needing surgery for themselves or their loved ones could obtain information from newspaper reports, Internet sites, or people who have undergone similar operations. But this process of obtaining information for those needing surgery would take considerable time and would impose unacceptably high human and economic costs.

Information Failures

O4.4

Information failures

ORIGIN OF THE IDEA

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CHAPTER FOUR APPENDIX 109

There is a fundamental difference between getting an am- ateurish paint job on one’s house and being on the receiv- ing end of heart surgery by a bogus physician. The marginal cost of obtaining information about sellers in the surgery market would be excessively high. The risk of pro- ceeding without good information would result in much less surgery than desirable—an underallocation of re- sources to surgery. The government has remedied this market failure through a system of qualifying tests and licensing. The li- censing provides consumers with inexpensive information about a service they only infrequently buy. The govern- ment has taken a similar role in several other areas of the economy. For example, it approves new medicines, regu- lates the securities industry, and requires warnings on con- tainers of potentially hazardous substances. It also requires warning labels on cigarette packages and disseminates in- formation about communicable diseases. And it issues warnings about unsafe toys and inspects restaurants for health-related violations.

Inadequate Seller Information about Buyers Just as inadequate information about sellers can keep mar- kets from achieving economic efficiency, so can inadequate information about buyers. The buyers may be consumers who buy products or firms that buy resources.

Moral Hazard Problem

Private markets may underallocate resources to a particu- lar good or service for which there is a severe moral haz- ard problem. The moral hazard problem is the tendency of one party to a contract or agreement to alter her or his behavior, after the contract is signed, in ways that could be costly to the other party. Suppose a firm offers an insurance policy that pays a set amount of money per month to people who suffer di- vorces. The attractiveness of such insurance is that it would pool the economic risk of divorce among thousands of people and, in particular, would protect spouses and children from the economic hardship that divorce often brings. Unfortunately, the moral hazard problem reduces the likelihood that insurance companies can profitably provide this type of insurance. After taking out such insurance, some people would alter their behavior in ways that impose heavy costs on the insurer. For example, married couples would have less of an incentive to get along and to iron out marital difficul- ties. At the extreme, some people might be motivated to

obtain a divorce, collect the insurance, and then continue to live together. Such insurance could even promote di- vorce, the very outcome that it is intended to protect against. The moral hazard problem would force the in- surer to charge such high premiums for this insurance that few policies would be bought. If the insurer could identify in advance those people most prone to alter their behavior, the firm could exclude them from buying it. But the firm’s marginal cost of getting such information is too high compared with the marginal benefit. Thus, this market would fail. Although divorce insurance is not available in the mar- ketplace, society recognizes the benefits of insuring against the hardships of divorce. It has corrected for this underal- location of “hardship insurance” through child-support laws that dictate payments to the spouse who retains the children, when the economic circumstances warrant them. Alimony laws also play a role. The government also supplies “divorce insurance” of a sort through the Temporary Assistance for Needy Families (TANF) program. Though aimed at helping poor children in general rather than children of divorce specifically, par- ents with children can receive TANF payments if they are left destitute by divorce. Because government does not have to earn a profit when supplying services, it can offer this type of “divorce insurance” despite the fact that it, too, may be susceptible to the moral hazard problem. The moral hazard problem is also illustrated in the fol- lowing statements:

• Drivers may be less cautious because they have car insurance.

• Medical malpractice insurance may increase the amount of malpractice.

• Guaranteed contracts for professional athletes may reduce the quality of their performance.

• Unemployment compensation insurance may lead some workers to shirk.

• Government insurance on bank deposits may encourage banks to make risky loans.

Adverse Selection Problem

Another information problem resulting from inadequate information about buyers is the adverse selection prob- lem. This problem arises when information known by the first party to a contract or agreement is not known by the second and, as a result, the second party incurs major costs. Unlike the moral hazard problem, which arises after a person signs a contract, the adverse selection problem arises at the time a person signs a contract.

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CHAPTER FOUR APPENDIX110

are most likely to need the minimum benefits that Social Security provides are automatically participants in the program. So, too, are those not likely to need the benefits. Consequently, no adverse selection problem emerges.

Qualification Households and businesses have found many ingenious ways to overcome information difficulties without govern- ment intervention. For example, many firms offer product warranties to overcome the lack of information about themselves and their products. Franchising also helps overcome this problem. When you visit a Wendy’s or a Marriott, you know what you are going to get, as opposed to stopping at Slim’s Hamburger Shop or the Triple Six Motel. Also, some private firms and organizations specialize in providing information to buyers and sellers. Consumer Reports, Mobil Travel Guide, and numerous Internet sites provide product information; labor unions collect and dis- seminate information about job safety; and credit bureaus provide information about credit histories and past bank- ruptcies to lending institutions and insurance companies. Brokers, bonding agencies, and intermediaries also pro- vide information to clients. Economists agree, however, that the private sector cannot remedy all information problems. In some situa- tions, government intervention is desirable to promote an efficient allocation of society’s scarce resources.

In insurance, the adverse selection problem is that people who are most likely to need insurance payouts are those who buy insurance. For example, those in poorest health will seek to buy the most generous health insurance policies. Or, at the extreme, a person planning to hire an arsonist to “torch” his failing business has an incentive to buy fire insurance. Our hypothetical divorce insurance sheds further light on the adverse selection problem. If the insurance firm sets the premiums on the basis of the average divorce rate, many married couples who are about to obtain a divorce will buy insurance. An insurance premium based on aver- age probabilities will make a great buy for those about to get divorced. Meanwhile, those in highly stable marriages will not buy it. The adverse selection problem thus tends to eliminate the pooling of low and high risks, which is the basis of prof- itable insurance. Insurance rates then must be so high that few people would want to (or be able to) buy such insurance. Where private firms underprovide insurance because of information problems, the government often estab- lishes some type of social insurance. It can require that ev- eryone in a particular group take the insurance and thereby can overcome the adverse selection problem. Example: Although the Social Security system in the United States is partly insurance and partly an income transfer program, in its broadest sense it is insurance against poverty during old age. The Social Security pro- gram requires nearly universal participation: People who

LO4.6 Describe how information failures may justify government intervention in some

markets.

Asymmetric information occurs when buyers and sellers do not have the same information about a product. It is a source of po- tential market failure, causing society’s scarce resources to be al- located inefficiently.

Asymmetric information can cause a market to fail if the party that has less information decides to withdraw from the market because it fears that its lack of knowledge may be exploited by the party that has more information.

If the party that has less information reduces its participation in a market, the reduction in the size of the market may cause an

underallocation of resources to the product produced for the market.

The moral hazard problem is the tendency of one party to a contract or agreement to alter its behavior in ways that are costly to the other party; for example, a person who buys insurance may willingly incur added risk.

The adverse selection problem arises when one party to a contract or agreement has less information than the other party and incurs a cost because of that asymmetrical information. For example, an insurance company offering “no medical-exam- required” life insurance policies may attract customers who have life-threatening diseases.

APPENDIX SUMMARY

APPENDIX TERMS AND CONCEPTS asymmetric information moral hazard problem adverse selection problem

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CHAPTER FOUR APPENDIX 111

A P P E N D I X D I S C U S S I O N Q U E S T I O N S

1. Because medical records are private, an individual applying for health insurance will know more about his own health conditions than will the insurance companies to which he is applying for coverage. Is this likely to increase or decrease the insurance premium that he will be offered? Why? LO4.6

2. Why is it in the interest of new homebuyers and builders of new homes to have government building codes and building inspectors? LO4.6

3. Place an “M” beside the items in the following list that de- scribe a moral hazard problem and an “A” beside those that describe an adverse selection problem. LO4.6

a. A person with a terminal illness buys several life insurance policies through the mail.

b. A person drives carelessly because she has automobile insurance.

c. A person who intends to torch his warehouse takes out a large fire insurance policy.

d. A professional athlete who has a guaranteed contract fails to stay in shape during the off season.

e. A woman who anticipates having a large family takes a job with a firm that offers exceptional childcare benefits.

A P P E N D I X R E V I E W Q U E S T I O N S

1. People drive faster when they have auto insurance. This is an example of: LO4.6

a. Adverse selection. b. Asymmetric information. c. Moral hazard. 2. Government inspectors who check on the quality of services

provided by retailers as well as government requirements

for licensing in various professions are both attempts to resolve: LO4.6

a. The moral hazard problem. b. The asymmetric information problem. 3. True or False: A market may collapse and have relatively few

transactions between buyers and sellers if buyers have more information than sellers. LO4.6

A P P E N D I X P R O B L E M S

1. Consider a used car market with asymmetric information. The owners of used cars know what their vehicles are worth but have no way of credibly demonstrating those values to potential buyers. Thus, potential buyers must always worry that the used car they are being offered may be a low quality “lemon.” LO4.6

a. Suppose that there are equal numbers of good and bad used cars in the market and that good used cars are worth $13,000 while bad used cars are worth $5,000. What is the average value of a used car?

b. By how much does the average value exceed the value of a bad used car? By how much does the value of a good used car exceed the average value?

c. Would a potential seller of a good used car be willing to accept the average value as payment for her vehicle?

d. If a buyer negotiates with a seller to purchase the seller’s used car for a price equal to the average value, is the car more likely to be good or bad?

e. Will the used-car market come to feature mostly—if not exclusively—lemons? How much will used cars end up costing if all the good cars are withdrawn?

The following and additional problems can be found in

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112

CHAPTER 5

Government’s Role and Government Failure

Learning Objectives

LO5.1 Describe how government’s power to coerce can be economically

beneficial and list some of the

difficulties associated with managing

and directing the government.

LO5.2 Discuss “government failure” and explain why it happens.

LO5.3 (Appendix) Explain the difficulties of conveying economic preferences

through majority voting.

Governments in market economies perform several

economic tasks. As discussed in various places in the

book, these include promoting production and

trade by defining property rights, enforcing con-

tracts, and settling disputes; enforcing laws designed

to maintain competition; redistributing income via

taxes and transfers; reallocating resources by pro-

ducing public goods and intervening to correct

negative and positive externalities; and promoting

economic growth and full employment.

In this chapter, we deepen our understanding

of government’s role in the market economy by

examining some of the difficulties that demo-

cratic governments face when making specific

laws related to the economy. We will find that

governments sometimes pursue policies for

which costs outweigh benefits. These inefficient

outcomes happen often enough that we need

to be just as vigilant in looking for instances of

government failure as we are in looking for in-

stances of market failure.

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CHAPTER 5 Government’s Role and Government Failure 113

Government’s Economic Role LO5.1 Describe how government’s power to coerce can be economically beneficial and list some of the difficulties associated with managing and directing the government. As discussed in Chapter 2, the U.S. economy is a market system that uses mostly markets and prices to coordinate and direct economic activity. But the government also has a prominent role in how the economy functions. Among other things, the government sets the laws gov- erning economic activity, provides goods and services that would otherwise be underproduced by private firms, and modifies the distribution of income. The govern- ment also promotes both economic stability and eco- nomic growth.

Government’s Right to Coerce

One key difference between the economic activities of government and those of private firms and individuals is that government possesses the legal right to force peo- ple to do things. Whereas private-sector economic ac- tivities consist primarily of voluntary transactions, government has the legal right to enforce involuntary transactions. Among other things, the government can put you in jail if you do not pay your taxes, fine you if you violate pollution laws, jail you if you commit fraud, and remove your business license if you violate health and safety regulations.

Force and Economic Efficiency From an economic perspective, the government’s ability to force people to do things can be quite beneficial because it can be used to increase economic efficiency.

Correcting for Market Failures Consider public goods and externalities. As discussed in Chapter 4, these market fail- ures cause resource misallocations. When it comes to both public goods and products offering positive externalities, private producers fail to produce enough output because it is impossible to charge many of the beneficiaries for the benefits that they receive from the producers’ products. In such cases, the government can improve economic effi- ciency by using involuntarily collected tax money to subsi- dize production. By contrast, products that generate negative exter- nalities are overproduced by the private sector because many of their costs are borne by third parties rather than by their producers. The government can reduce that overproduction and improve economic efficiency by us- ing involuntary policies such as direct controls, pollution

taxes, and cap-and-trade schemes to force producers to bear higher costs.

Reducing Private-Sector Economic Risks Government’s ability to force people to do things is also crucial in re- ducing private-sector economic risks. To begin with, the government helps to ensure that only mutually agree- able transactions take place by making blackmail, extor- tion, and other forms of private coercion illegal. The government also uses its legal powers to outlaw various forms of theft, deception, and discrimination as well as restraints on trade, price-fixing, and refusal to honor a contract. These limitations encourage economic activity by giv- ing greater security to both individuals and firms. Because they know that the government will use its massive re- sources to arrest and punish those who break the law, they know that other individuals and firms are less likely to try to take advantage of them. That reduction in risk encour- ages higher levels of investment, the formation of more new businesses, and the introduction of more new goods and services. In economic terminology, both allocative and productive efficiency increase.

The Problem of Directing and Managing Government

As just discussed, the government can substantially im- prove allocative and productive efficiency if it directs its awesome coercive powers toward rectifying market fail- ures and providing a low-risk economic environment for the private sector. However, it has only been in recent centuries that democratic political institutions have been able to tame government and direct it toward those goals. Until that happened, most governments were tyrannical, with their powers almost always directed toward enriching the small minority that controlled each government. Because modern democratic governments serve much broader constituencies, they are much more likely to pursue economic policies with widespread social benefits. Their ability to deliver economically optimal outcomes is hindered, however, by the wide variety of government failures that this chapter will discuss in detail. But before discussing them, it will be useful to first point out that governing a nation is not easy. In particu- lar, governments face the daunting challenge of organiz- ing millions of employees to carry out thousands of tasks—everything from cleaning sewers to researching cures for cancer to delivering the mail. An understanding

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PART TWO Price, Quantity, and Efficiency114

of those challenges and complexities will give you a better sense of how well most governments manage to do despite all of the problems associated with govern- ment failure.

No Invisible Hand Government economic polices are not self-correcting. Unlike the private sector—where competitive forces and Adam Smith’s “invisible hand” help to automatically direct resources to their best uses— poorly designed government policies can misallocate resources indefinitely unless active steps are taken by leg- islators or administrators.

Massive Size and Scope Identifying and correct- ing  inefficient government policies is hampered by government’s massive size and scope. Consider the U.S. federal government. In 2010, it had 4.4 million employ- ees spread over 500 agencies that were collectively charged with enforcing hundreds of thousands of pages

of laws and regulations while attempting to wisely spend $3.4 trillion.

The Need for Bureaucracy By law, those 4.4 mil- lion federal employees are ultimately supervised and directed by just 536 elected officials: one president, 435 representatives, and 100 senators. Since 536 elected of- ficials could never hope to directly supervise 4.4 million people, governments rely on many layers of supervisors and supervisors-of-supervisors to manage the govern- ment’s affairs. They collectively form a massive, hierar- chical, many-layered bureaucracy.

The Need for Paperwork and Inflexibility To make sure that laws are uniformly enforced and do not vary at the whim of individual bureaucrats, the bureau- cracy is regulated by detailed rules and regulations gov- erning nearly every possible action that any individual bureaucrat might be called upon to make. These rules and regulations ensure that laws and regulations are uniformly applied. But they do so at the cost of massive amounts of paperwork and an inability to expeditiously process non- routine situations and requests.

The Information Aggregation Problem Because of their massive size and scope, bureaucracies have diffi- culty with effectively aggregating and conveying informa- tion from their bottom layers to their top layers. As a result, top officials will tend to make many inefficient choices because they do not have enough information to sensibly compare the marginal benefits and marginal costs of individual programs and because they are unable to comprehensively assess opportunity costs and where to best spend funds across the wide variety of programs run by the government.

Lack of Accountability Governments also struggle with accountability. Democratic elections do take place for the elected officials at the top, but because the government undertakes so many activities simultane- ously, it is difficult for the electorate to know the details of even a small fraction of what the government is up to at any particular time. As a result, hundreds or even thousands of individual programs may be poorly run without affecting the reelection chances of the incum- bent politicians who are supposed to be supervising everything. Within the bureaucracy itself, individual accountabil- ity is also hard to enforce because most bureaucrats have civil service protections that effectively guarantee them a job for life. Those protections reduce corruption by

CONSIDER THIS . . .

Does Big Government Equal Bad Government?

You will sometimes h e a r p o l i t i c i a n s (and maybe your g r u m p y u n c l e ) complaining about

Big Government. Their implication is that large government initiatives are inherently inefficient or incompetent. Since economics is focused on efficiency, you might won- der where economists stand on the subject. The answer is that economists focus not on bigness or smallness per se, but on marginal benefit (MB) and marginal cost (MC). Spending should be increased up to the point where MB 5 MC. For some programs, that will be a small dol- lar amount. For other programs, that will be a large dollar amount. Thus, economists don’t see much point in having an ab- stract debate over “big government” versus “small govern- ment.” What matters is allocative and productive efficiency and directing government’s limited resources toward the programs that generate the largest net benefits for society. From that vantage point, we should not condemn large government programs just for being large. We must first compare MB with MC. Only if MB , MC should large pro- grams be reduced or eliminated.

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CHAPTER 5 Government’s Role and Government Failure 115

Government Failure LO5.2 Discuss “government failure” and explain why it happens. The term government failure refers to economically in- efficient outcomes caused by shortcomings in the public sector. One cause of government failure is the voting problems that we discuss at length in this chapter’s appen- dix. But government failures caused by voting problems are somewhat unique in that they are driven by a lack of information about voter preferences. By contrast, most in- stances of government failure happen despite government officials knowing what voters prefer. In these situations, government failures occur because the incentive structures facing government officials lead them to either put their own interests ahead of voter inter- ests or to put the interests of a minority of voters ahead of those of the majority of voters. Let’s examine what eco- nomic theory has to say about these situations.

Representative Democracy and the Principal-Agent Problem

Our system of representative democracy has the advantage of allowing us to elect full-time representatives who can specialize in understanding the pros and cons of different potential laws and who have more time to digest their de- tails than the average citizen. But the system also suffers from principal-agent problems.

Principal-agent problems are conflicts that arise when tasks are delegated by one group of people (princi- pals) to another group of people (agents). The conflicts arise because the interests of the agents may not be the same as the interests of the principals, so that the agents may end up taking actions that are opposed by the princi- pals whom they are supposed to be representing. In the business world, principal-agent problems often arise when the company’s managers (the agents) take ac- tions that are not in the best interests of the company’s shareholders (the principals). Examples include the man- agers spending huge amounts of company money on ex- ecutive jets and lavish offices or holding meetings at expensive resorts. These luxuries are obviously enjoyable to managers but are, of course, not in the best interest of shareholders because the money spent on them could ei- ther be reinvested back into the firm to increase future profits or paid out to shareholders immediately as divi- dends. But to the extent that managers are free to follow their own interests rather than those of their shareholders, they may indeed take these and other actions that are not  in the better interests of their shareholders. Hence the conflicts. In a representative democracy, principal-agent prob- lems often arise because politicians have goals such as re- election that may be inconsistent with pursuing the best interests of their constituents. Indeed, casual reflection sug- gests that “sound economics” and “good politics” often dif- fer. Sound economics calls for the public sector to pursue various programs as long as marginal benefits exceed mar- ginal costs. Good politics, however, suggests that politicians support programs and policies that will maximize their chances of getting reelected. The result may be that the government will promote the goals of groups of voters that have special interests to the detriment of the larger public. Economic inefficiency is the likely outcome.

Special-Interest Effect Efficient public decision mak- ing is often impaired by the special-interest effect. This is any outcome of the political process whereby a small number of people obtain a government program or policy that gives them large gains at the expense of a much greater number of persons who individually suffer small losses. The small group of potential beneficiaries is well in- formed and highly vocal on the issue in question, and they press politicians for approval. The large number of people facing the very small individual losses, however, are gener- ally uninformed on the issue. Politicians feel they will lose the campaign contributions and votes of the small special- interest group that backs the issue if they legislate against it but will lose very little support from the large group of

shielding bureaucrats from political pressures. But they also severely constrain the ability of elected officials to hold individual bureaucrats personally responsible for bad decisions.

QUICK REVIEW 5.1

• Government’s ability to enforce nonvoluntary transac- tions can improve economic outcomes by compensat- ing for resource misallocations and by providing a low-risk economic environment for individuals and firms.

• Government economic actions are not automatically self-correcting (as with the “invisible hand” in competi- tive markets.)

• Democratic governments face several challenges in di- recting and supervising government’s actions, includ- ing inflexibility, information aggregation, comparing marginal costs with marginal benefits, assessment of opportunity costs, and accountability.

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PART TWO Price, Quantity, and Efficiency116

win political favor because they are highly valued by con- stituents and the costs are borne mainly by taxpayers located elsewhere. At the federal level, pork-barrel politics often consist of congressional members inserting specific provisions that authorize spending for local projects (that will benefit only local constituents) into comprehensive legislation (that is supposed to be about making laws for the entire country). Such narrow, specifically designated authoriza- tions of expenditure are called earmarks. In 2012, legisla- tion contained 152 such earmarks, totaling $3.3 billion. These earmarks enable senators and representatives to provide benefits to in-state firms and organizations with- out subjecting the proposals to the usual evaluation and competitive bidding. Although some of the earmarked projects deliver benefits that exceed costs, many others are questionable, at best. These latter expenditures very likely reallocate some of society’s scarce resources from higher- valued uses to lower-valued uses. Moreover, logrolling, discussed in the chapter appendix, typically enters the pic- ture. “Vote for my special local project and I will vote for yours” becomes part of the overall strategy for securing “pork” and remaining elected. Finally, a politician’s inclination to support the smaller group of special beneficiaries is enhanced because special- interest groups are often quite willing to help finance the campaigns of “right-minded” politicians and politicians who “bring home the pork.” The result is that politicians may support special-interest programs and projects that cannot be justified on economic grounds.

Rent-Seeking Behavior The appeal to government for special benefits at taxpayers’ or someone else’s ex- pense is called rent seeking. The term “rent” in “rent seeking” is used loosely to refer to any payment in excess of the minimum amount that would be needed to keep a resource employed in its current use. Those engaged in “rent seeking” are attempting to use government influ- ence to get themselves into a situation in which they will get paid more for providing a good or service than the minimum amount you would actually have to pay them to provide that good or service. (These excess, or surplus, payments are akin to land rent, which is also a surplus payment.) Rent seeking goes beyond the usual profit seeking through which firms try to increase their profits by adjust- ing their output levels, improving their products, and in- corporating cost-saving technologies. Rent seeking looks to obtain extra profit or income by influencing government policies. Corporations, trade associations, labor unions, and  professional organizations employ vast resources to

uninformed voters, who are likely to evaluate the politi- cians on other issues of greater importance to them. The special-interest effect is also evident in so-called pork-barrel politics, a means of securing a government project that yields benefits mainly to a single political district and its political representative. In this case, the special-interest group comprises local constituents, while the larger group consists of relatively uninformed taxpayers scattered across a much larger geographic area. Politicians clearly have a strong incentive to secure government projects (“pork”) for their local constituents. Such projects

CONSIDER THIS . . .

Mohair and the Collective- Action Problem

Smaller groups can sometimes achieve political vic tories against larger groups by taking advantage of the collective -

action problem—the fact that larger groups are more diffi- cult to organize and motivate than smaller groups. Larger groups are harder to organize and motivate for two main reasons. First, the larger the group, the smaller each member’s share of the benefits if the group gets its way. Second, the larger the group, the higher its organizing costs, as it will have to contact and recruit large numbers of strang- ers via e-mails, telephone calls, and mass mailings. Smaller groups can take advantage of these difficulties and generally get their way against larger groups as long as they are pressing for policies that only cause small amounts of harm to the members of the larger groups. Consider the infamous subsidy for mohair, the wool pro- duced by Angora goats. Each year the federal government provides millions of dollars in subsidized loans to Angora goat farmers in Texas, Arizona, and New Mexico. The federal government began the subsidy in the late 1940s to ensure a large supply of insulation for the jackets needed to keep pi- lots and other crew members warm in the unheated air- planes used during that period. The mohair subsidy should have ended in the 1950s when heated cabins were developed, but it survives because it costs taxpayers only a few cents each. This means that it would cost them more to organize and defeat the mohair subsidy than they would save by having the subsidy terminated. More generally, the collective-action problem explains why nearly every example of the special-interest effect is characterized by “concentrated benefits and diffuse costs.” Concentrated benefits make proponents easy to organize, while diffuse costs make opponents difficult to organize.

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CHAPTER 5 Government’s Role and Government Failure 117

The most famous example of an unfunded liability be- longs to the Social Security program, under which the U.S. federal government supplements the incomes of the elderly and the disabled. The government does collect Social Security taxes to help defray the expected future costs of the program, but the current tax rates will not generate nearly enough revenue to pay for all of the expected out- lays. In fact, it is estimated that Social Security has an un- funded liability (5 total value of spending commitments minus expected value of tax revenues) of $20.5 trillion. Social Security is not the only major unfunded govern- ment liability. Medicare, which provides healthcare to the elderly and disabled in the United States, has an unfunded liability of $4.8 trillion, while state and local governments are estimated to have $4.6 trillion in unfunded retirement and healthcare commitments.

Chronic Budget Deficits

A government runs an annual budget deficit whenever its tax revenues are less than its spending during a particular year. To make up for the shortfall, the government must borrow money, usually by issuing bonds. Whatever it bor- rows in a given year gets added to its overall pile of debt, which is the accumulation of all past budget deficits and budget surpluses. Many governments run budget deficits year after year. These chronic deficits can be attributed to a pair of con- flicting incentives that confront politicians. On the one hand, many government programs are highly popular with voters, so that there is almost always political pressure to either maintain or increase spending. On the other hand, hardly anyone likes paying taxes, so there is almost always political pressure to reduce taxes. Faced with those two conflicting pressures, politicians tend to opt for spending levels that exceed tax revenues. That may be problematic because chronic deficits can pose several economic challenges, including

• Economic Inefficiency Deficits may allow the government to control and direct an inefficiently large fraction of the economy’s resources. To the extent that deficit spending facilitates an underallocation of resources to the private sector and an overallocation of resources to the government sector, there will be a tendency to underproduce private goods and overproduce public goods. If that occurs, the economy will experience a decrease in both allocative and productive efficiency.

• Debt Crises A government’s accumulated debt level may rise so high that investors lose faith in the government’s ability or willingness to repay its debts.

secure favorable government policies that result in rent— higher profit or income than would otherwise occur. The government is able to dispense such rent directly or indi- rectly through laws, rules, hiring, and purchases. Elected officials are willing to provide such rent because they want to be responsive to the key constituents who can help them remain in office. Here are some examples of “rent-providing” legislation or policies: tariffs on foreign products that limit competition and raise prices to consumers; tax breaks that benefit specific corporations; government construction projects that create union jobs but cost more than the benefits they yield; occu- pational licensing that goes beyond what is needed to pro- tect consumers; and large subsidies to farmers by taxpayers. None of these is justified by economic efficiency.

Clear Benefits, Hidden Costs

Some critics say that vote-seeking politicians will ignore economic rationality by failing to objectively weigh costs and benefits when deciding which programs to support. Because political officeholders must seek voter support ev- ery few years, they favor programs that have immediate and clear-cut benefits and vague or deferred costs. Conversely, politicians will reject programs with immedi- ate and easily identifiable costs but with less measurable but very high long-term benefits. Such biases may lead politicians to reject economically justifiable programs and to accept programs that are eco- nomically irrational. Example: A proposal to construct or expand mass-transit systems in large metropolitan areas may be economically rational on the basis of cost-benefit analysis. But if (1) the program is to be financed by imme- diate increases in highly visible income or sales taxes and (2) benefits will occur only years from now when the proj- ect is completed, then the vote-seeking politician may op- pose the program. Assume, on the other hand, that a program of federal aid to municipal police forces is not justifiable on the basis of cost-benefit analysis. But if the cost is paid for from budget surpluses, the program’s modest benefits may seem so large that it will gain approval.

Unfunded Liabilities

The political tendency to favor spending priorities that have immediate payouts but deferred costs also leads to many government programs having unfunded liabilities. A government creates an unfunded liability when it com- mits to making a series of future expenditures without si- multaneously committing to collect enough tax revenues to pay for those expenditures.

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PART TWO Price, Quantity, and Efficiency118

and there are calls to stimulate the economy through lower taxes or increased spending, politicians often spend more time attempting to target any tax cuts or spending increases toward special interests than they do making sure that their fiscal policy actions will actually stimulate the overall economy. The recession also provides political cover for increasing the size of the deficit. Monetary policy can be similarly politicized, with the biggest problem being that incumbent politicians will want to cut interest rates to boost the economy right before they are up for reelection. That is problem- atic because monetary stimulus is only helpful if the economy is in recession. If the economy is doing well, monetary stimulus can actually make things worse be- cause it can raise the rate of inflation and drive up prices all over the economy. To prevent that, most countries have put politically in- dependent central banks in charge of monetary policy. In the United States, the Federal Reserve serves this func- tion. Other top central banks include the Bank of Japan, the Bank of England, and the European Central Bank. Each is run by professional economists who are insulated from political pressures so that they may use their inde- pendent expertise and judgment to decide if and when monetary stimulus should be used.

If that happens, the government will find itself in the middle of a debt crisis, unable to borrow any more money. Cut off from borrowing, the government will be forced to undertake some combination of drastic spending cuts or massive tax increases. Either of those actions will tend to plunge the economy into a recessionary period in which unemployment rises and output falls.

To prevent politicians from succumbing to voter pref- erences for deficits, many state and local governments have balanced-budget laws that make deficits illegal. No such law exists at the national level, however. As a result, federal politicians were able to run budget deficits in 47 of the 52 years between 1960 and 2012.

Misdirection of Stabilization Policy

Economies go through alternating periods of expansion and recession. Multiyear periods during which output ex- pands, employment increases, and living standards rise alternate with periods during which output contracts, em- ployment decreases, and living standards fall. Governments often attempt to smooth out these so- called business cycles by using two types of macroeconomic stabilization policy:

• Fiscal policy attempts to use changes in tax rates and spending levels to offset the business cycle. For example, if the economy is going into a recessionary period with falling output and rising unemployment, the government may attempt to stimulate the economy by lowering tax rates or increasing government spending. Either action should increase spending on goods and services and consequently induce business to produce more output and hire more workers.

• Monetary policy attempts to use changes in interest rates to regulate the economy. In particular, the government can use its control over the money supply to lower interest rates during a recession. The lower interest rates stimulate spending by making it cheaper for individuals and businesses to borrow money to pay for capital goods such as houses, cars, and machinery. As spending on those items increases, firms are induced to produce more output and hire more workers.

Politicization of Fiscal and Monetary Policy Fiscal and monetary policy are both subject to politicization. In the case of fiscal policy, if the economy goes into recession

Limited and Bundled Choice

Economic theory points out that the political process forces citizens and their elected representatives to be less selective in choosing public goods and services than they are in choosing private goods and services.

QUICK REVIEW 5.2

• Principal-agent problems are conflicts that occur when the agents who are supposed to be acting in the best interests of their principals instead take actions that help themselves but hurt their principals.

• Because larger groups are more difficult to organize and motivate than smaller groups, special inter- ests  can often obtain what they want politically even when what they want is opposed by a majority of voters.

• Rent seeking involves influencing government policies so that one can get paid more for providing a good or service than it costs to produce.

• Political pressures cause politicians to favor policies such as unfunded liabilities and budget deficits that have immediate benefits and delayed costs.

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CHAPTER 5 Government’s Role and Government Failure 119

In the marketplace, the citizen as a consumer can ex- actly satisfy personal preferences by buying certain goods and not buying others. However, in the public sector the citizen as a voter is confronted with, say, only two or three candidates for an office, each representing a different “bundle” of programs (public goods and services). None of these bundles of public goods is likely to fit exactly the preferences of any particular voter. Yet the voter must choose one of them. The candidate who comes closest to voter Smith’s preference may endorse national health in- surance, increases in Social Security benefits, subsidies to tobacco farmers, and tariffs on imported goods. Smith is likely to vote for that candidate even though Smith strongly opposes tobacco subsidies. In other words, the voter must take the bad with the good. In the public sector, people are forced to “buy” goods and services they do not want. It is as if, in going to a sporting-goods store, you were forced to buy an un- wanted pool cue to get a wanted pair of running shoes. This is a situation where resources are not being used ef- ficiently to satisfy consumer wants. In this sense, the pro- vision of public goods and services is inherently inefficient. Congress is confronted with a similar limited-choice, bundled-goods problem. Appropriations legislation com- bines hundreds, even thousands, of spending items into a single bill. Many of these spending items may be com- pletely unrelated to the main purpose of the legislation. Yet congressional representatives must vote on the entire package—yea or nay. Unlike consumers in the market- place, they cannot be selective.

Bureaucracy and Inefficiency

Some economists contend that public agencies are gener- ally less efficient than private businesses. The reason is not that lazy and incompetent workers somehow end up in the public sector while ambitious and capable people gravitate to the private sector. Rather, it is that the market system creates incentives for internal efficiency that are absent from the public sector. Private enterprises have a clear goal—profit. Whether a private firm is in a com- petitive or monopolistic market, efficient management means lower costs and higher profit. The higher profit not only benefits the firm’s owners but enhances the promotion prospects of the firm’s managers. Moreover, part of the managers’ pay may be tied to profit via profit- sharing plans, bonuses, and stock options. There is no similar gain to government agencies and their managers— no counterpart to profit—to create a strong incentive to achieve efficiency.

CONSIDER THIS . . .

Unintended Consequences

A s e x p l a i n e d i n Chapters 2 and 4, the “invisible hand” of a properly functioning market will allocate resources to their best uses without

anyone being in charge or intentionally aiming for efficiency. By contrast, governments are willful and intentional. They de- liberately create and enforce laws to try to make improve- ments in society. In some cases, however, government actions can have unintended consequences that offset some or all of the intended benefits. • Government fuel-efficiency requirements for automo-

biles have forced automakers to produce smaller, lighter vehicles. But when smaller, lighter vehicles get into ac- cidents, their occupants are more likely to be killed or severely injured. Some estimates put the death toll at over 120,000 additional deaths in the United States since 1970.

• San Francisco banned plastic grocery bags in 2007. This led to about 5 additional deaths per year from food- borne illnesses because reusable grocery bags almost never get washed out. Drippings from one trip often fester and contaminate whatever they touch on subse- quent trips.

• The main point of the 2010 healthcare reform law (com- monly known as Obamacare) was to get health insur- ance coverage for all Americans. To that end, the law required larger companies to either pay for extremely costly health insurance policies for their full-time work- ers or face massive fines. But since that requirement only applied to full-time workers, many firms responded by cutting a lot of their employees’ work hours down from full time to part time. Thus, millions of workers went from lacking health insurance but having a full-time job to still lacking health insurance but only having a part- time job.

The market system imposes a very obvious test of performance on private firms: the test of profit and loss. An efficient firm is profitable and therefore successful; it survives, prospers, and grows. An inefficient firm is un- profitable and unsuccessful; it declines and in time goes out of business. But there is no similar, clear-cut test with which to assess the efficiency or inefficiency of public agencies. How can anyone determine whether a public

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PART TWO Price, Quantity, and Efficiency120

regulated industry works in the industry. So when it comes time for the regulatory agency to find qualified people to help write intelligent regulations, it ends up hiring a lot of people from regulated firms. Those individuals bring their old opinions and sympathies with them when they become bureaucrats. As a result, many regulations end up favoring the interests of the regulated firms.

Regulatory Capture in the Railroad Industry The classic example of regulatory capture is that of railroad regula- tion during the nineteenth and twentieth centuries. In response to public complaints that the nation’s railroads were often charging exorbitant rates, the federal govern- ment established the Interstate Commerce Commission (ICC) in 1887 as the government agency charged with regulating competition and prices within the railroad industry. Within a generation, railroad executives had achieved regulatory capture by manipulating the ICC into a pol- icy that simultaneously fixed rates at profitable levels while also eliminating competition between different railroad companies. The public justification for these policies was that competition had to be restricted in or- der to prevent larger railroads from bankrupting smaller railroads and thereby becoming monopolies that could easily exploit the public. But the railroad industry’s true motive was to establish a regulatory regime in which both larger and small railroads were guaranteed steady, competition-free profits. These days, activists often complain that various government bureaucracies are subject to regulatory cap- ture. At the federal level, complaints are voiced about the Food and Drug Administration’s supervision of the pharmaceutical industry, the Securities and Exchange Commission’s supervision of Wall Street financial firms, and the Bureau of Land Management’s policies with re- spect to leasing federal lands for oil drilling, mining, and forestry.

Deregulation as an Alternative Economists are divided about the intensity and inefficiency of regulatory capture as well as what to do about it. One potential solution is for the government to engage in deregulation and intention- ally remove most or even all of the regulations governing an industry. Deregulation solves the problem of regulatory cap- ture because there is no regulatory agency left to capture. But it only works well in terms of economic efficiency if the deregulated industry becomes competitive and is au- tomatically guided toward allocative and productive effi- ciency by competitive forces and the invisible hand. If the

hydroelectricity provider, a state university, a local fire department, the Department of Agriculture, or the Bureau of Indian Affairs is operating efficiently? Cynics even argue that a public agency that ineffi- ciently uses its resources is likely to survive and grow! In the private sector, inefficiency and monetary loss lead to the abandonment of certain activities or products or even firms. But the government, they say, does not like to abandon activities in which it has failed. Some suggest that the typical response of the government to a pro- gram’s failure is to increase its budget and staff. This means that public sector inefficiency just continues on a larger scale. Furthermore, economists assert that government em- ployees, together with the special-interest groups they serve, often gain sufficient political clout to block attempts to pare down or eliminate their agencies. Politicians who attempt to reduce the size of huge federal bureaucracies such as those relating to agriculture, education, health and welfare, and national defense incur sizable political risk because bureaucrats and special-interest groups will team up to defeat them. Finally, critics point out that government bureaucrats tend to justify their continued employment by looking for and eventually finding new problems to solve. It is not sur- prising that social “problems,” as defined by government, persist or even expand. The Last Word at the end of this chapter highlights several recent media-reported examples of the special- interest effect (including earmarks), the problem of limited and bundled choices, and problems of govern- ment bureaucracy.

Inefficient Regulation and Intervention

Governments regulate many aspects of the market economy. Examples include health and safety regulations, environ- mental laws, banking supervision, restrictions on monopoly power, and the imposition of wage and price controls. These interventions are designed to improve economic outcomes, but several forms of regulation and interven- tion have been known to generate outcomes that are less beneficial than intended.

Regulatory Capture A government agency that is supposed to supervise a particular industry is said to have suffered from regulatory capture if its regulations and enforcement activities come to be heavily influenced by the industry that it is supposed to be regulating. Regulatory capture is often facilitated by the fact that nearly everyone who knows anything about the details of a

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CHAPTER 5 Government’s Role and Government Failure 121

would not be able to compete with those made by the in- dustry’s more established firms. At that point, Solyndra turned to a federal loan-guarantee program under which the Department of Energy told potential investors that it would cosign any loan taken out by Solyndra and thereby guarantee that if Solyndra went bankrupt, the federal government would use taxpayer money to repay the loan. With that loan guarantee in place, the otherwise- reluctant private investors were willing to put in $535 mil- lion. After all, they had nothing to lose and everything to gain. If Solyndra went bankrupt, they would get their money back from the government. But if Solyndra some- how did well, they would collect substantial returns. Unfortunately, the investors’ original doubts proved to be well founded. Solyndra was unable to compete effec- tively with incumbent firms and went bankrupt in 2011, leaving taxpayers on the hook for the full $535 million.

Socializing Losses, Privatizing Gains Government loan guarantees can be socially beneficial if they help to in- crease the production of beneficial products that are be- ing underproduced by the private sector—as would be the case for products that generated positive externalities. But the loan guarantees also provide an inducement toward reckless investing because they remove from private in- vestors any consideration of losses. Indeed, loan guaran- tees are often criticized for “socializing losses and privatizing gains” because if things go wrong, any losses go to the taxpayer, while if things go well, any profits go to private investors. In addition, the process by which loan guarantees are awarded is often criticized for being highly politicized and likely to award loan guarantees not to the firms whose projects are the most likely to increase economic effi- ciency but to those with the best political connections. On the other hand, there may be legitimate cases where a new technology that would generate net benefits cannot be developed without government loan guarantees, so proponents of loan-guarantee programs argue that the programs should remain in place, but with tight controls against rent seeking and the special-interest effect.

Corruption

Political corruption is the unlawful misdirection of gov- ernmental resources or actions that occurs when govern- ment officials abuse their entrusted powers for personal gain. For instance, a police supervisor engages in political corruption if she accepts a bribe in exchange for illegally freeing a thief who had been lawfully arrested by another

deregulated industry instead tends toward monopoly or ends up generating substantial negative externalities, con- tinued regulation might be the better option. Proponents of deregulation often cite the deregula- tion of interstate trucking, railroads, and airlines in the 1970s and 1980s as examples of competition successfully replacing regulation. They do so because after regula- tion was removed, robust competition led to lower prices, increased output, and higher levels of productiv- ity and efficiency. But for government agencies tasked with environmen- tal protection, human safety, and financial regulation, there is less confidence as to whether competitive pres- sures might be able to replace regulation. For those indus- tries, regulation may always be necessary. If so, then some amount of regulatory capture may always be likely due to the fact that regulated firms will always want to capture their regulators.

Government’s Poor Investment Track Record Governments are often asked to use taxpayer money to directly invest in private businesses that have been unable to secure funding from private sources such as banks. Unfortunately, researchers have found that low and nega- tive rates of return are the norm for government invest- ments. In addition, government funding often allows inefficient firms to persist in operation long after compet- itive forces would have put them out of operation and freed up their resources for higher-valued projects else- where in the economy. Critics also note that many government investments look like prime examples of rent seeking and the special- interest effect, especially when the firms receiving govern- ment investments are found to have made substantial financial contributions to influential politicians. In too many cases, the government’s investment decisions appear to be based on political connections rather than on whether specific investments can produce substantial net benefits for society.

Loan Guarantees The government also tends to earn low or negative returns when it subsidizes private- sector investments with loan guarantees. The startup company named Solyndra provides a good example of what can go wrong.

The Solyndra Subsidy In 2009, Solyndra was unable to convince private investors to lend it enough money to start producing solar panels with its new technology. The private investors sensibly feared that the company’s new technology was too expensive and that its solar panels

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PART TWO Price, Quantity, and Efficiency122

with the police supervisor in our earlier example who ille- gally freed a thief. If a candidate accepts campaign contributions from a special-interest group and then shows subsequent support for that group’s legislative goals, has a subtle form of po- litical corruption taken place? While there are strong opinions on both sides of the issue, it is often hard to tell in any particular case whether a special interest’s campaign contribution amounts to a bribe. On the one hand, the special interest may indeed be trying to influence the poli- tician’s vote. On the other hand, the special interest may simply be trying to support and get elected a person who already sees things their way and who would vote the way they wanted no matter what. That being said, the impression of impropriety lingers, and so laws have been passed in the United States limiting the amount of money that individuals can donate to spe- cific candidates and making it illegal for certain groups such as companies to donate money directly to individual politicians (as distinct from directing funds toward sup- porting specific issues or advocacy groups—which is both legal and unrestricted). Proponents of these laws hope that the limitations strike a good balance—allowing contribu- tions to be large enough that individuals and groups can meaningfully support candidates they agree with but keep- ing contributions small enough that no one individual or group can singlehandedly donate enough money to sway a politician’s vote.

Imperfect Institutions

It is possible to argue that the wide variety of criticisms of public sector inefficiency that we have discussed in this chapter are exaggerated and cynical. Perhaps they are. Nevertheless, they do tend to shatter the concept of a benevolent government that responds with precision and efficiency to the wants of its citizens. The market system of the private sector is far from perfectly efficient, and government’s economic function is mainly to correct that system’s shortcomings. But the public sector is also subject to deficiencies in fulfilling its economic function. “The relevant comparison is not between perfect markets and imperfect governments, nor between faulty markets and all-knowing, rational, benevolent governments, but between inevitably imperfect institutions.”1 Because markets and governments are both imperfect, it is sometimes difficult to determine whether a particular activity can be performed with greater success in the private

officer. Similarly, a government bureaucrat engages in po- litical corruption if he refuses to issue a building permit to a homebuilder who is in full compliance with the law un- less the homebuilder makes a “voluntary contribution” to the bureaucrat’s favorite charity. While relatively uncommon in the United States, po- litical corruption is a daily reality in many parts of the world, as can be seen in Global Perspective 5.1, which gives the percentages of survey respondents in 15 countries who reported that they or someone else in their respective households paid a bribe during the previous 12 months. Political corruption comes in two basic forms. In the first, a government official must be bribed to do what he should be doing as part of his job—as with the bureaucrat in our earlier example who demands a bribe to issue a per- mit to a homebuilder who is in full compliance with the law. In the second, a government official demands a bribe to do something that she is not legally entitled to do—as

GLOBAL PERSPECTIVE 5.1

Percentage of Households Paying a Bribe in the Past Year

The Global Corruption Barometer is an international survey that asks individuals about their personal experiences with government corruption. The 2010–2011 survey of 105,507 people in 100 countries included a question that asked participants whether they or anyone in their respective households had paid a bribe in any form during the previous 12 months. Here are the results for 10 selected countries.

Source: Adapted from Global Corruption Barometer. Copyright 2011 Transparency International: the global coalition against corruption. Used with permission. For more information, visit www.transparency.org.

United States

Italy

Russia

Nigeria

Liberia

Kenya

Mexico

Iraq

Pakistan

Germany

20 40 60 80 1000

Percent of Households Paying a Bribe in the Past Year

1Otto Eckstein, Public Finance, 3d ed. (Englewood Cliffs, N.J.: Prentice- Hall, 1973), p. 17.

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“Government Failure” in the News

Examples: • A 2004 spending bill set aside $1 million for the

Norwegian American Foundation; $443,000 to develop salmon-fortified baby food; $350,000 for music education programs at the Rock and Roll Hall of Fame in Cleveland; and $250,000 for sidewalks, street furniture, and façade improvements in Boca Raton, Florida. (Associated Press)

• The corporate tax relief bill of 2004 contained 633 pages, with 276 special provisions. Included were provisions that benefited “restaurant owners and Hollywood producers; makers of bows, arrows, tackle boxes, and sonar fish finders; NASCAR track owners; native Alaska whalers; and even importers of Chinese fans.” (The Washington Post)

• Government investigations determined that millions of dollars of disaster relief for victims of Hurricane Katrina were squandered. For example, investigators discovered that the Federal Emergency Management Agency (FEMA) made payouts on as many as 900,000 claims for disaster relief that contained invalid Social Security numbers or false names and addresses. (The Seattle Times)

• The $878 billion American Recovery and Reinvestment Act of 2009 was laden with many dubious spending projects, including $10 million to renovate a train station in Elizabethtown, Pennsylvania, that hadn’t been used in 30 years; $1.15 million to build a guardrail for an artificial lake in Woodward, Oklahoma, that had never been filled with water; and an unrequested $587,661 grant that was given to the upscale town of Union, New York, to fight a homeless problem that it didn’t have. (Lancaster Newspapers, newson6.com, Binghamton Press & Sun Union)

• The year 2009 also saw Congress approve a $2.5 billion earmark to purchase ten C-17 aircraft despite the Department of Defense adamantly stating that its existing fleet of 205 C-17s was “sufficient to meet the Department’s future airlift needs—even under the most stressing situations.” (investinganswers.com)

• In 2011, Congress funded a sanctuary for white squirrels, an antique bicycle museum, and a giant roadside coffee pot as part of 2011 federal highway spending. It also spent $765,828 to subsidize the construction of an IHOP restaurant and $113,277 to aid in the historical preservation of video games. (Human Events, Washington Examiner, Gamasutra)

• A 2011 audit revealed that the federal government had paid $600 million in retirement benefits to deceased federal retirees over the previous five years. Checks had been illegally cashed by living relatives. One son received cumulative payments of $515,000 over the 37 years after his father died in 1971. The fraud was only discovered after the son died in 2008. (Associated Press)

The Media Continually Report Government Actions That Illustrate Pork-Barrel Politics, Limited and

Bundled Choices, or Bureaucratic Inefficiency.

LAST WORD

sector or in the public sector. It is easy to reach agreement on opposite extremes: National defense must lie with the public sector, while automobile production can best be ac- complished by the private sector. But what about health insurance? Parks and recreation areas? Fire protection? Garbage collection? Housing? Education? It is hard to as- sess every good or service and to say absolutely that it should be assigned to either the public sector or the pri- vate sector. Evidence: All the goods and services just men- tioned are provided in part by both private enterprises and public agencies.

QUICK REVIEW 5.3

• Unlike the private sector—where the profit motive helps to ensure efficiency and variety—government lacks a strong incentive to be efficient and typically offers only limited and bundled choices.

• Regulatory capture occurs when a regulated industry can control its government regulator and get it to implement policies that favor the industry.

• Political corruption occurs when government officials abuse their powers for personal gain.

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LO5.1 Describe how government’s power to coerce can be economically beneficial and list some of the

difficulties associated with managing and directing

the government.

Government’s legal right to use coercion and force can help to improve economic efficiency by correcting for market failures and by enforcing laws and regulations that reduce the risk that individuals and firms will be taken advantage of.

LO5.2 Discuss “government failure” and explain why it happens.

Special interests can succeed in perpetuating policies that are op- posed by the majority of voters because the costs of organizing and motivating groups to take political action increase with group size. This collective-action problem implies that special interests can perpetuate unpopular policies as long as the costs of organizing an opposition exceed the costs that the general public is currently suffering as a result of those policies.

There are powerful incentives for politicians to accommo- date rent seeking and support special-interest legislation.

Because voters like receiving the benefits of government programs but do not like having to pay the taxes necessary to fi- nance them, politicians tend to favor programs that offer easily identified immediate benefits but vague or deferred costs. This tendency helps to explain the unfunded liabilities of programs including Social Security as well as the federal government’s ten- dency to run budget deficits.

When the economy goes into recession, politicians often use the need for fiscal policy stimulus as political cover to direct lower taxes or increased spending toward politically powerful

special-interest groups. To prevent politicians from using lower interest rates and monetary stimulus as a way of increasing their reelection chances, most governments have put politically inde- pendent central banks in charge of monetary policy.

Economic theorists cite several reasons why government might be inefficient in providing public goods. (a) Citizens as voters and congressional representatives face limited and bun- dled choices as to public goods, whereas consumers in the private sector can be highly selective in their choices. (b) Government bureaucracies have less incentive to operate efficiently than do private businesses. (c) Regulated industries may sometimes cap- ture their government regulatory agencies and mold government polices toward their own best interests.

Government’s track record as an investor in private-sector firms is very poor, with most government investments into private sector businesses generating low or negative returns for taxpayers.

Government attempts to increase private investment by of- fering loan guarantees often cause resources to be misdirected toward high-risk projects that have an extremely low likelihood of success. These arrangements “socialize losses and privatize gains” because if the businesses go bankrupt, the government bears the losses, but if they do well, private individuals receive the profits.

Political corruption may cause governmental resources or actions to be misdirected.

Neither governments nor markets are perfect economic in- stitutions. Each has its own set of shortcomings and citizens should be aware of where each is likely to fail and where each is likely to succeed.

SUMMARY

TERMS AND CONCEPTS government failure principal-agent problems collective-action problem special-interest effect earmarks rent seeking

unfunded liability budget deficit debt crisis fiscal policy monetary policy unintended consequences

regulatory capture deregulation loan guarantees political corruption

D I S C U S S I O N Q U E S T I O N S

1. Why might citizens interested in maximizing economic ef- ficiency be happy to invest their government with the right to coerce them in at least some situations? LO5.1

2. Jean-Baptiste Colbert was the Minister of Finance under King Louis XIV of France. He famously observed, “The art of taxation consists in so plucking the goose as to obtain the

The following and additional problems can be found in

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CHAPTER 5 Government’s Role and Government Failure 125

R E V I E W Q U E S T I O N S

1. Select all of the following that are true. To an economist, a coercive government can be useful in order to: LO5.1

a. Reallocate resources in order to improve efficiency. b. Fight negative externalities. c. Ensure low gasoline prices. d. Provide a low-risk economic environment for individuals

and firms. 2. To an economist, a government program is too big if an

analysis of that program finds that MB _______ MC. LO5.1 a. Is greater than. b. Is less than. c. Is equal to. d. Is less than twice as large as. e. Is more than twice as large as. 3. Tammy Hall is the mayor of a large U.S. city. She has just es-

tablished the Office of Window Safety. Because windows sometimes break and spray glass shards, every window in the city will now have to pass an annual safety inspection. Property owners must pay the $5-per-window cost—and by the way, Tammy has made her nephew the new head of the Office of Window Safety. This new policy is an example of: LO5.2

a. Political corruption. b. Earmarks. c. Rent seeking. d. Adverse selection.

4. A few hundred U.S. sugar makers lobby the U.S. govern- ment each year to make sure that the government taxes im- ported sugar at a high rate. They do so because the policy drives up the domestic price of sugar and increases their profits. It is estimated that the policy benefits U.S. sugar producers by about $1 billion per year while costing U.S. consumers upwards of $2 billion per year. Which of the fol- lowing concepts apply to the U.S. sugar tax? LO5.2

Select one or more of the choices shown. a. Political corruption. b. Rent-seeking behavior. c. The collective-action problem. d. The special-interest effect. 5. ___________________ occur when politicians commit to

making a series of future expenditures without simultane- ously committing to collect enough tax revenues to pay for those expenditures. LO5.2

a. Budget deficits. b. Debt crises. c. Loan guarantees. d. Unfunded liabilities.

largest possible amount of feathers with the smallest possi- ble amount of hissing.” How does his comment relate to special interests and the collective-action problem? LO5.2

3. What is rent seeking and how does it differ from the kinds of profit maximization and profit seeking that we discussed in previous chapters? Provide an actual or hypothetical ex- ample of rent seeking by firms in an industry. By a union. By a professional association (for example, physicians, school teachers, or lawyers). Why do elected officials often accommodate rent-seeking behavior, particularly by firms, unions, and professional groups located in their home states? LO5.2

4. How does the problem of limited and bundled choice in the public sector relate to economic efficiency? Why are

public bureaucracies possibly less efficient than business firms? LO5.2

5. Discuss the political incentives that helped motivate federal politicians to approve budget deficits in all but four years between 1960 and 2012. LO5.2

6. Explain: “Politicians would make more rational economic decisions if they weren’t running for reelection every few years.” LO5.2

7. Critique: “Thank goodness we have so many govern- ment  regulatory agencies. They keep Big Business in check.” LO5.2

8. LAST WORD How do the concepts of pork-barrel politics and the special-interest effect relate to the items listed in the Last Word?

P R O B L E M S

1. Suppose that there are 1 million federal workers at the low- est level of the federal bureaucracy and that above them there are multiple layers of supervisors and supervisors-of- supervisors. Assume that each higher level is one-tenth the size of the one below it because the government is using a 10:1 ratio of supervisees to supervisors. That is, for every 10 workers at the bottom, there is 1 supervisor; for every 10 of those supervisors, there is 1 supervisor-of-supervisors; for every one of those supervisors-of-supervisors, there is a

supervisor-of-supervisors-of-supervisors; and so on, all the way up the bureaucratic pyramid to the president. LO5.1

a. How many supervisors will there be in each supervisory layer of the federal bureaucracy? Start with the layer of supervisors directly above the 1 million workers at the bottom.

b. How many supervisors are there in total at all levels of  the federal bureaucratic pyramid, including the president?

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PART TWO Price, Quantity, and Efficiency126

inspector works 52 weeks a year and gets bribed for every house he inspects.)

b. There is a provincial construction supervisor who gets to hire all of the housing inspectors. He himself is corrupt and expects his housing inspectors to share their bribes with him. Suppose that 20 inspectors work for him and that each passes along half the bribes collected from builders. How much will the construction supervisor collect each year?

c. Corrupt officials may have an incentive to reduce the provision of government services to help line their own pockets. Suppose that the provincial construction supervisor decides to cut the total number of housing inspectors from 20 to 10 in order to decrease the supply of new housing permits. This decrease in the supply of permits raises the equilibrium bribe from $1,000 to $2,500. How much per year will the construction supervisor now receive if he is still getting half of all the bribes collected by the 10 inspectors? How much more is the construction supervisor getting now than when he had 20 inspectors working in part b? Will he personally be happy with the reduction in government services?

d. What if reducing the number of inspectors from 20 to 10 only increased the equilibrium bribe from $1,000 to $1,500? In this case, how much per year would the construction supervisor collect from his 10 inspectors? How much less is the construction supervisor getting than when he had 20 inspectors working in part b? In this case, will the construction supervisor be happy with the reduction in government services? Will he want to go back to using 20 inspectors?

c. If you count the 1 million workers at the bottom as the first layer of the federal bureaucracy, how many total layers are there, including the president?

d. How many federal employees are there in total at all layers, including the president?

e. What fraction of all federal employees are supervisory, including the president?

2. Consider a specific example of the special-interest effect and the collective-action problem. In 2009, it was estimated that the total value of all corn production subsidies in the United States was about $4 billion. The population of the United States was approximately 300 million people that year. LO5.2

a. On average, how much did corn subsidies cost per person in the United States in 2009? (Hint: A billion is a 1 followed by nine zeros. A million is a 1 followed by six zeros.)

b. If each person in the United States is only willing to spend $0.50 to support efforts to overturn the corn subsidy, and if antisubsidy advocates can only raise funds from 10 percent of the population, how much money will they be able to raise for their lobbying efforts?

c. If the recipients of corn subsidies donate just one percent of the total amount that they receive in subsidies, how much could they raise to support lobbying efforts to continue the corn subsidy?

d. By how many dollars does the amount raised by the recipients of the corn subsidy exceed the amount raised by the opponents of the corn subsidy?

3. Consider a corrupt provincial government in which each housing inspector examines two newly built structures each week. All the builders in the province are unethical and want to increase their profits by using substandard construction materials, but they can’t do that unless they can bribe a hous- ing inspector into approving a substandard building. LO5.2

a. If bribes cost $1,000 each, how much will a housing inspector make each year in bribes? (Assume that each

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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127CHAPTER FIVE APPENDIX

LO5.3 Explain the difficulties of conveying economic preferences through majority voting.

Public Choice Theory Market failures, such as public goods and externalities, im- pede economic efficiency and justify government inter- vention in the economy. But the government’s response to market failures is not without its own problems and pitfalls. In fact, government can sometimes fail as badly or even worse than markets in terms of delivering economic efficiency and directing resources to the uses where they will bring the largest net benefits. That is why it is important to study public choice theory—the economic analysis of government decision

making, politics, and elec- tions. Just as the study of market failure helps us to understand how regulat- ing markets may help to improve the allocation of resources, the study of government failure can help us to understand how

changes in the way government functions might help it to operate more efficiently. As we will discuss shortly, many instances of govern- ment failure can be traced to incentive structures that lead political representatives to pursue policies that go against the preferences of the people that they are representing. But an even more fundamental problem exists. The major- ity voting systems that we rely upon may make it difficult or even impossible to correctly discern voter preferences. In such cases, it is not surprising that government fails to deliver what the voters actually want.

Revealing Preferences through Majority Voting Through some process, society must decide which public goods it wants and in what amounts. It also must deter- mine the extent to which it wants government to inter- vene in private markets to correct externalities. Decisions

need to be made about the extent and type of regulation of business that is necessary, the amount of income redis- tribution that is desirable, what policies the government might enact to mitigate asymmetric information prob- lems, and other such choices. Furthermore, society must determine the set of taxes it thinks is best for financing government. How should government apportion (divide) the total tax burden among the public? Decisions such as these are made collectively in the United States through a democratic process that relies heavily on majority voting. Candidates for office offer al- ternative policy packages, and citizens elect people who they think will make the best decisions on their collective behalf. Voters “retire” officials who do not adequately rep- resent their collective wishes and elect persons they think do. Also, citizens periodically have opportunities at the state and local levels to vote directly on public expendi- tures or new legislation. Although the democratic process does a reasonably good job of revealing society’s preferences, it is imperfect. Public choice theory demonstrates that majority voting can produce inefficiencies and inconsistencies.

Inefficient Voting Outcomes

Society’s well-being is enhanced when government pro- vides a public good whose total benefit exceeds its total cost. Unfortunately, majority voting does not always de- liver that outcome.

Illustration: Inefficient “No” Vote Assume that the gov- ernment can provide a public good, say, national defense, at a total expense of $900. Also assume that there are only three individuals—Adams, Benson, and Conrad—in the society and that they will share the $900 tax expense equally, each being taxed $300 if the proposed public good is provided. And assume, as Figure 1a illustrates, that Adams would receive $700 worth of benefits from having this public good; Benson, $250; and Conrad, $200. What will be the result if a majority vote determines whether or not this public good is provided? Although peo- ple do not always vote strictly according to their own eco- nomic interest, it is likely Benson and Conrad will vote “no”

Public Choice Theory and Voting Paradoxes

O5.1

Public choice theory

ORIGIN OF THE IDEA

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CHAPTER FIVE APPENDIX128

would be willing to purchase a vote from either Benson or Conrad if buying votes were legal. That way Adams could be assured of obtaining the national defense she so highly values. But since buying votes is illegal, many people with strong preferences for certain public goods may have to go without them. When individual consumers have a strong preference for a specific private good, they usually can find that good in the marketplace even though it may be unpopular with the majority of consumers. A consumer can buy beef tongue, liver, and squid in some supermarkets, although it is doubtful that any of these products would be available if majority voting stocked the shelves. But a person cannot easily “buy” a public good such as national defense once the majority has decided against it. Conversely, a consumer in the marketplace can decide against buying a particular product, even a popular one. But although you may not want national defense, you must “buy” it through your tax payments when the major- ity have decided they want it. Conclusion: Because majority voting fails to incorpo- rate the strength of the preferences of the individual voter, it may produce economically inefficient outcomes.

Interest Groups and Logrolling Some, but not all, of the inefficiencies of majority voting get resolved through the political process. Two examples follow.

Interest Groups People who share strong preferences for a public good may band together into interest groups and use advertisements, mailings, and direct persuasion to convince others of the merits of that public good. Adams might try to persuade Benson and Conrad that it is in their best interest to vote for national defense—that national defense is much more valuable to them than their $250 and $200 valuations. Such appeals are common in democratic politics. Sometimes they are successful; sometimes they are not.

because they will incur tax costs of $300 each while gaining benefits of only $250 and $200, respectively. Adams will vote “yes.” So the majority vote will defeat the proposal even though the total benefit of $1,150 (5 $700 for Adams 1 $250 for Benson 1 $200 for Conrad) exceeds the total cost of $900. Resources should be devoted to this good, but they will not be. Too little of this public good will be produced.

Illustration: Inefficient “Yes” Vote Now consider a situa- tion in which the majority favors a public good even though its total cost exceeds its total benefit. Figure 1b shows the details. Again, Adams, Benson, and Conrad will equally share the $900 cost of the public good; each will be taxed $300. But since Adams’ benefit now is only $100 from the public good, she will vote against it. Meanwhile, Benson and Conrad will benefit by $350 each. They will vote for the public good because that benefit ($350) exceeds their tax payments ($300). The majority vote will provide a pub- lic good costing $900 that produces total benefits of only $800 (5 $100 for Adams 1 $350 for Benson 1 $350 for Conrad). Society’s resources will be inefficiently allocated to this public good. Too much of it will be produced.

Implications The point is that an inefficient outcome may occur as either an overproduction or an underpro- duction of a specific public good, and therefore as an over- allocation or underallocation of resources for that particular use. In Chapter 4 we saw that government can improve economic efficiency by providing public goods that the market system will not make available. Now we have extended that analysis to reveal that government may not provide some of those public goods or may provide them in the wrong amounts. In other cases, it may provide public goods that are not economically warranted. In our examples, each person has only a single vote, no matter how much he or she might gain or lose from a pub- lic good. In the first example (inefficient “no” vote), Adams

Benson

Adams

Conrad

$700

$250 $200

Total benefit = $1,150 Total cost = $900

$300

0

$300 per- person tax

(a) Inefficient majority “no” vote

(b) Inefficient majority “yes” vote

B en

ef it

; T ax

$300

0 Adams (No)

Benson Conrad

$100

$350 $350

Total benefit = $800 Total cost = $900

$300 per- person tax

B en

ef it

; T ax

(Yes) (No) (No) (Yes) (Yes)(Votes)

FIGURE 1 Inefficient voting outcomes. Majority voting can produce inefficient decisions. (a) Majority voting leads to rejection of a public good that would entail a greater total benefit than total cost. (b) Majority voting results in acceptance of a public good that has a higher total cost than total benefit.

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CHAPTER FIVE APPENDIX 129

The data indicate that Adams prefers national defense to the road and the road to the weather warning system. This implies also that Adams prefers national defense to the weather warning system. Benson values the road more than the weather warning system and the warning system more than national defense. Conrad’s order of preference is weather warning system, national defense, and road.

Voting Outcomes The lower part of Table 1 shows the outcomes of three hypothetical elections decided through majority vote. In the first, national defense wins against the road because a majority of voters (Adams and Conrad) prefer national defense to the road. In the second election, to see whether this community wants a road or a weather warning system, a majority of voters (Adams and Benson) prefer the road. We have determined that the majority of people in this community prefer national defense to a road and prefer a road to a weather warning system. It seems logical to con- clude that the community prefers national defense to a weather warning system. But it does not! To demonstrate this conclusion, we hold a direct elec- tion between national defense and the weather warning system. Row 3 shows that a majority of voters (Benson and Conrad) prefer the weather warning system to national defense. As listed in Table 1, then, the three paired-choice majority votes imply that this community is irrational: It seems to prefer national defense to a road and a road to a weather warning system, but would rather have a weather warning system than national defense. The problem is not irrational community preferences but rather a flawed procedure for determining those preferences. We see that the outcome from paired-choice majority voting may depend on the order in which the votes are taken. Different sequences of majority votes can lead to different outcomes, many of which may fail to

Political Logrolling Perhaps surprisingly, logrolling—the trading of votes to secure desired outcomes—can also turn an inefficient outcome into an efficient one. In our first example (Figure 1a), suppose that Benson has a strong preference for a different public good, for example, a new road, which Adams and Conrad do not think is worth the tax expense. That would provide an opportunity for Adams and Benson to trade votes to ensure provision of both na- tional defense and the new road. That is, Adams and Benson would each vote “yes” on both measures. Adams would get the national defense and Benson would get the road. Without the logrolling, both public goods would have been rejected. This logrolling will add to society’s well-being if, as was true for national defense, the road creates a greater overall benefit than cost. But logrolling need not increase economic efficiency. Even if national defense and the road each cost more than the total benefit each produces, both might still be pro- vided if there is vote trading. Adams and Benson might still engage in logrolling if each expects to secure a sufficient net gain from her or his favored public good, even though the gains would come at the clear expense of Conrad. Logrolling is very common in state legislatures and Congress. It can either increase or diminish economic ef- ficiency, depending on the circumstances.

Paradox of Voting Another difficulty with majority voting is the par- adox of voting, a situation in which society may not be able to rank its prefer- ences consistently through paired-choice majority voting.

Preferences Consider Table 1, in which we again assume a community of three voters: Adams, Benson, and Conrad. Suppose the community has three alternative public goods from which to choose: national defense, a road, and a weather warning system. We expect that each member of the community prefers the three alternatives in a cer- tain order. For example, one person might prefer national defense to a road and a road to a weather warning system. We can attempt to determine the preferences of the com- munity through paired-choice majority voting. Specifically, a vote can be held between any two of the public goods, and the winner of that vote can then be matched against the third public good in another vote. The three goods and the assumed individual prefer- ences of the three voters are listed in the top part of Table 1.

TABLE 1 Paradox of Voting

Preferences

Public Good Adams Benson Conrad

National defense 1st choice 3d choice 2d choice

Road 2d choice 1st choice 3d choice

Weather warning system 3d choice 2d choice 1st choice

Election Voting Outcomes: Winner

1. National defense National defense vs. road (preferred by Adams and Conrad)

2. Road vs. weather Road warning system (preferred by Adams and Benson)

3. National defense vs. Weather warning system weather warning system (preferred by Benson and Conrad)

O5.2

Paradox of voting

ORIGIN OF THE IDEA

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CHAPTER FIVE APPENDIX130

amount of taxation, or degree of government regulation, while half have weaker or negative preferences. The ex- treme voters on each side of an issue prefer the median choice rather than the other extreme position, so the me- dian voter’s choice predominates.

Example Suppose a society composed of Adams, Benson, and Conrad has reached agreement that as a society it needs a weather warning system. Each person indepen- dently is to submit a total dollar amount he or she thinks should be spent on the warning system, assuming each will be taxed one-third of that amount. An election will deter- mine the size of the system. Because each person can be expected to vote for his or her own proposal, no majority will occur if all the proposals are placed on the ballot at the same time. Thus, the group decides on a paired-choice vote: They will first vote between two of the proposals and then match the winner of that vote against the remaining proposal. The three proposals are as follows: Adams desires a $400 system; Benson wants an $800 system; Conrad opts for a $300 system. Which proposal will win? The median- voter model suggests it will be the $400 proposal submit- ted by the median voter, Adams. Half the other voters favor a more costly system; half favor a less costly system. To understand why the $400 system will be the outcome, let’s conduct the two elections. First, suppose that the $400 proposal is matched against the $800 proposal. Adams naturally votes for her $400 proposal, and Benson votes for his own $800 pro- posal. Conrad, who proposed the $300 expenditure for the warning system, votes for the $400 proposal because it is closer to his own. So Adams’ $400 proposal is selected by a 2-to-1 majority vote. Next, we match the $400 proposal against the $300 proposal. Again the $400 proposal wins. It gets a vote from Adams and one from Benson, who proposed the $800 ex- penditure and for that reason prefers a $400 expenditure to a $300 one. Adams, the median voter in this case, is in a sense the person who has decided the level of expenditure on a weather warning system for this society.

Real-World Applicability Although our illustration is simple, it explains a great deal. We do note a tendency for public choices to match most closely the median view. Political candidates, for example, take one set of positions to win the nomination of their political par- ties; in so doing, they tend to appeal to the median voter within the party to get the nomination. They then shift their views more closely to the political center when they square off against opponents from the opposite po- litical party. In effect, they redirect their appeal toward

reflect the electorate’s underlying preferences. As a con- sequence, government may find it difficult to provide the “correct” public goods by acting in accordance with ma- jority voting. Important note: This critique is not meant to suggest that some better procedure exists. Majority voting is much more likely to reflect community prefer- ences than decisions by, say, a dictator or a group of self- appointed leaders.

Median-Voter Model

One other aspect of majority voting reveals further in- sights into real-world phenomena. The median-voter model suggests that, under majority rule and consistent voting preferences, the median voter will in a sense deter- mine the outcomes of elections. The median voter is the person holding the middle position on an issue: Half the other voters have stronger preferences for a public good,

CONSIDER THIS . . .

Voter Failure

Inefficient voting outcomes and the paradox of voting imply that govern- ments may some- times fail to deliver the best combi- nation of public

goods because it may be very difficult for politicians to dis- cern what voters actually want. In other cases, though, econ- omists worry that governments may end up failing to deliver allocative and productive efficiency not because politicians can’t tell what people want—but because they can. The problem is that voters sometimes support policies that reduce rather than enhance allocative and productive efficiency. Examples include several types of wage and price controls, punitive tariffs on foreign products, and various in- dustrial and agricultural subsidies. These policies almost always reduce economic effi- ciency, but they are also extremely popular with voters in many countries. Faced with that reality, a politician may well end up supporting such policies even if he personally understands that they will create more economic harm than benefit. That behavior makes some observers wish for braver poli- ticians who might be willing to oppose these instances of “voter failure.” But others argue that it is too much to hope for braver politicians. Instead, efforts should be directed toward educating the public and convincing them to support gov- ernment policies that are economically efficient.

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CHAPTER FIVE APPENDIX 131

and new highway projects that the median voter prefers.

• Some people may “vote with their feet” by moving into political jurisdictions where the median voter’s preferences are closer to their own. They may move from the city to a suburb where the level of government services, and therefore taxes, is lower. Or they may move into an area known for its excellent, but expensive, school system. Some may move to other states; a few may even move to other countries.

For these reasons, and because our personal preferences for publicly provided goods and services are not static, the median preference shifts over time. Moreover, informa- tion about people’s preferences is imperfect, leaving much room for politicians to misjudge the true median position. When they do, they may have a difficult time getting elected or reelected.

the median voter within the total population. They also try to label their opponents as being too liberal, or too conservative, and out of touch with “mainstream America.” And they conduct polls and adjust their posi- tions on issues accordingly.

Implications The median-voter model has two impor- tant implications:

• At any point in time, many people will be dissatisfied by the extent of government involvement in the economy. The size of government will largely be determined by the median preference, leaving many people desiring a much larger, or a much smaller, public sector. In the marketplace you can buy no zucchinis, 2 zucchinis, or 200 zucchinis, depending on how much you enjoy them. In the public sector you will tend to get the number of Stealth bombers

LO5.3 Explain the difficulties of conveying economic preferences through majority voting.

Public choice theory suggests that governments may sometimes suffer from government failures because majority voting fails to correctly indicate voter preferences.

Majority voting creates the possibility of (a) underalloca- tions or overallocations of resources to particular public goods

and (b) inconsistent voting outcomes that make it impossible for a democratic political system to definitively determine the will of the people.

The median-voter model predicts that, under majority rule, the person holding the middle position on an issue will deter- mine the outcome of an election involving that issue.

APPENDIX SUMMARY

APPENDIX TERMS AND CONCEPTS public choice theory logrolling

paradox of voting median-voter model

A P P E N D I X D I S C U S S I O N Q U E S T I O N S

1. Explain how affirmative and negative majority votes can sometimes lead to inefficient allocations of resources to public goods. Is this problem likely to be greater under  a benefits-received or an ability-to-pay tax system? Use the information in Figures 1a and 1b to show how society might be better off if Adams were allowed to buy votes. LO5.3

2. “Majority voting ensures that government will produce only those public goods for which benefits exceed costs.” Discuss. LO5.3

3. “The problem with our democratic institutions is that they don’t correctly reflect the will of the people! If the people— rather than self-interested politicians or lobbyists—had control, we wouldn’t have to worry about government tak- ing actions that don’t maximize allocative and productive efficiency.” Critique. LO5.3

The following and additional problems can be found in

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CHAPTER FIVE APPENDIX132

A P P E N D I X R E V I E W Q U E S T I O N S

1. Explain the paradox of voting through reference to the ac- companying table, which shows the ranking of three public goods by voters Jay, Dave, and Conan: LO5.3

Rankings

Public Good Jay Dave Conan

Courthouse 2nd choice 1st choice 3d choice

School 3d choice 2d choice 1st choice

Park 1st choice 3d choice 2d choice

2. We can apply voting paradoxes to the highway construction example of Chapter 4. Suppose there are only five people in a society and each favors one of the five highway construc- tion options listed in Table 4.4 (“No new construction” is one of the five options). Explain which of these highway op- tions will be selected using a majority paired-choice vote. Will this option be the optimal size of the project from an economic perspective? LO5.3

3. True or False: The median-voter model explains why politi- cians so often stake out fringe positions that appeal only to a small segment of the electorate. LO5.3

A P P E N D I X P R O B L E M S

1. Look back at Figures 1a and 1b, which show the costs and benefits to voters Adams, Benson, and Conrad of two differ- ent public goods that the government will produce if a ma- jority of Adams, Benson, and Conrad support them. Suppose that Adams, Benson, and Conrad have decided to have one single vote at which the funding for both of those public goods will be decided simultaneously. LO5.3

a. Given the $300 cost per person of each public good, what are Adams’ net benefits for each public good individually and for the two combined? Will he want to vote yes or no on the proposal to fund both projects simultaneously?

b. What are Conrad’s net benefits for each public good individually and for the two combined? Will he want to vote yes or no on the proposal to fund both projects simultaneously?

c. What are Benson’s net benefits for each public good individually and for the two combined? Will he want to vote yes or no on the proposal to fund both projects simultaneously—or will he be indifferent?

d. Who is the median voter here? Who will the two other voters be attempting to persuade?

2. Political advertising is often directed at winning over so- called swing voters, whose votes might go either way. Suppose that two political parties—the Freedom Party and

the Liberty Party—disagree on whether to build a new road. Polling shows that of 1,000 total voters, 450 are firmly for the new road and 450 are firmly against the new road. Thus, each party will try to win over a majority of the 100 remain- ing swing voters. LO5.3

a. Suppose that each party spends $5,000 on untargeted TV, radio, and newspaper ads that are equally likely to reach any and all voters. How much per voter will be spent by both parties combined?

b. Suppose that, instead, each party could direct all of its spending toward just the swing voters by using targeted ads that exploit Internet social media. If all of the two parties’ combined spending was targeted at just swing voters, how much would be spent per swing voter?

c. Suppose that only the Freedom Party knows how to target voters using social media. How much per swing voter will it be spending? If at the same time the Liberty Party is still using only untargeted TV, radio, and newspaper ads, what portion of its total spending is likely to be reaching the 100 swing voters? How much per swing voter does that portion amount to?

d. Looking at your answers to part c, how much more per swing voter will the Freedom Party be spending than the Liberty Party? If spending per swing voter influences elections, which party is more likely to win?

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PART THREE

CHAPTER 6 Elasticity

CHAPTER 7 Utility Maximization

CHAPTER 8 Behavioral Economics

CONSUMER BEHAVIOR

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134

CHAPTER 6

Elasticity

increases by substantially reducing their purchases

while buyers of other products (say, gasoline) re-

spond by only slightly cutting back their purchases?

Why do higher market prices for some products (for

example, chicken) cause producers to greatly in-

crease their output while price rises for other prod-

ucts (say, gold) cause only limited increases in

output? Why does the demand for some products

(for example, books) rise a great deal when house-

hold income increases while the demand for other

products (say, milk) rises just a little?

Elasticity extends our understanding of mar-

kets by letting us know the degree to which

changes in prices and incomes affect supply and

demand. Sometimes the responses are substan-

tial, other times minimal or even nonexistent. But

by knowing what to expect, businesses and the

government can do a better job in deciding what

to produce, how much to charge, and, surpris-

ingly, what items to tax.

Learning Objectives:

LO6.1 Discuss price elasticity of demand and how it is calculated.

LO6.2 Explain the usefulness of the total revenue test for price elasticity of

demand.

LO6.3 List the factors that affect price elasticity of demand and describe

some applications of price elasticity

of demand.

LO6.4 Describe price elasticity of supply and how it can be applied.

LO6.5 Apply cross elasticity of demand and income elasticity of demand.

In this chapter we extend Chapter 3’s discussion of

demand and supply by explaining elasticity, an ex-

tremely important concept that helps us answer

such questions as: Why do buyers of some prod-

ucts (for example, ocean cruises) respond to price

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CHAPTER 6 Elasticity 135

Price Elasticity of Demand LO6.1 Discuss price elasticity of demand and how it is calculated. The law of demand tells us that, other things equal, con- sumers will buy more of a product when its price declines and less when its price increases. But how much more or less will they buy? The amount varies from product to product and over different price ranges for the same prod- uct. It also may vary over time. And such variations matter. For example, a firm contemplating a price hike will want to know how consumers will respond. If they remain highly loyal and continue to buy, the firm’s revenue will rise. But if consumers defect en masse to other sellers or other products, the firm’s revenue will tumble. The responsiveness (or sensitivity) of consumers to a price change is measured by a product’s price elasticity of

demand. For some prod- ucts—for example, restau- rant meals—consumers are highly responsive to price changes. Modest price changes cause very large changes in the quan- tity purchased. Economists

say that the demand for such products is relatively elastic or simply elastic. For other products—for example, toothpaste— consumers pay much less attention to price changes. Substantial price changes cause only small changes in the amount purchased. The demand for such products is rela- tively inelastic or simply inelastic.

The Price-Elasticity Coefficient and Formula

Economists measure the degree to which demand is price elastic or inelastic with the coefficient E

d , defined as

E d

5

percentage change in quantity demanded of product X

percentage change in price of product X

The percentage changes in the equation are calculated by dividing the change in quantity demanded by the original quantity demanded and by dividing the change in price by the original price. So we can restate the formula as

E d

5 change in quantity demanded of X original quantity demanded of X

4 change in price of X original price of X

Using Averages Unfortunately, an annoying problem arises in computing the price-elasticity coefficient. A price change from, say, $4 to $5 along a demand curve is a 25 percent (5 $1y$4) increase, but the opposite price change from $5 to $4 along the same curve is a 20 percent (5 $1y$5) decrease. Which percentage change in price should we use in the denominator to compute the price- elasticity coefficient? And when quantity changes, for ex- ample, from 10 to 20, it is a 100 percent (510y10) increase. But when quantity falls from 20 to 10 along the identical demand curve, it is a 50 percent (510y20) decrease. Should we use 100 percent or 50 percent in the numerator of the elasticity formula? Elasticity should be the same whether price rises or falls! The simplest solution to the problem is to use the midpoint formula for calculating elasticity. This for- mula simply averages the two prices and the two quan- tities as the reference points for computing the percentages. That is,

E d

5 change in quantity sum of quantitiesy2

4 change in price sum of pricesy2

For the same $5–$4 price range, the price reference is $4.50 [5 ($5 1 $4)y2], and for the same 10–20 quantity range, the quantity refer- ence is 15 units [5 (10 1 20)y2]. The percentage change in price is now $1y$4.50, or about 22 per- cent, and the percentage change in quantity is 1015, or about 67 percent. So E

d

is about 3. This solution eliminates the “up versus down” problem. All the price- elasticity coefficients that follow are calculated using this midpoint formula.

Using Percentages Why use percentages rather than absolute amounts in measuring consumer responsiveness? There are two reasons. First, if we use absolute changes, the choice of units will arbitrarily affect our impression of buyer respon- siveness. To illustrate: If the price of a bag of popcorn at the local softball game is reduced from $3 to $2 and consumers increase their purchases from 60 to 100 bags, it will seem that consumers are quite sensitive to price changes and therefore that demand is elastic. After all, a price change of 1 unit has caused a change in the amount demanded of 40 units. But by changing the monetary unit from dollars to pennies (why not?), we find that a price change of 100 units (pennies) causes a

O6.1

Price elasticity of demand

ORIGIN OF THE IDEA

W6.1

Elasticity of demand

WORKED PROBLEMS

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PART THREE Consumer Behavior136

in the price of cut flowers results in a 4 percent increase in quantity demanded. Then demand for cut flowers is elastic and

E d

5 .04 .02

5 2

Inelastic Demand If a specific percentage change in price produces a smaller percentage change in quantity demanded, demand is inelastic. In such cases, E

d will be

less than 1. Example: Suppose that a 2 percent decline in the price of coffee leads to only a 1 percent increase in quantity demanded. Then demand is inelastic and

E d

5 .01 .02

5 .5

Unit Elasticity The case separating elastic and inelastic demands occurs where a percentage change in price and the resulting percentage change in quantity demanded are the same. Example: Suppose that a 2 percent drop in the price of chocolate causes a 2 percent increase in quantity demanded. This special case is termed unit elasticity because E

d is exactly 1, or unity. In this example,

E d

5 .02 .02

5 1

Extreme Cases When we say demand is “inelastic,” we do not mean that consumers are completely unresponsive to a price change. In that extreme situation, where a price change results in no change whatsoever in the quantity de- manded, economists say that demand is perfectly inelas- tic. The price-elasticity coefficient is zero because there is no response to a change in price. Approximate examples include an acute diabetic’s demand for insulin or an ad- dict’s demand for heroin. A line parallel to the vertical axis, such as D1 in Figure 6.1a, shows perfectly inelastic de- mand graphically. Conversely, when we say demand is “elastic,” we do not mean that consumers are completely responsive to a price change. In that extreme situation, where a small price re- duction causes buyers to increase their purchases from zero to all they can obtain, the elasticity coefficient is infi- nite (5 `) and economists say demand is perfectly elas- tic. A line parallel to the horizontal axis, such as D2 in Figure 6.1b, shows perfectly elastic demand. You will see in Chapter 10 that such a demand applies to a firm—say, a mining firm—that is selling its output in a purely com- petitive market.

quantity change of 40 units. This may falsely lead us to believe that demand is inelastic. We avoid this prob- lem by using percentage changes. This particular price decline is the same whether we measure it in dollars or pennies. Second, by using percentages, we can correctly compare consumer responsiveness to changes in the prices of different products. It makes little sense to compare the effects on quantity demanded of (1) a $1 increase in the price of a $10,000 used car with (2) a $1 increase in the price of a $1 soft drink. Here the price of the used car has increased by 0.01 percent while the price of the soft drink is up by 100 percent. We can more sen- sibly compare the consumer responsiveness to price increases by using some common percentage increase in price for both.

Elimination of Minus Sign We know from the downsloping demand curve that price and quantity de- manded are inversely related. Thus, the price-elasticity coefficient of demand E

d will always be a negative number.

As an example, if price declines, then quantity demanded will increase. This means that the numerator in our for- mula will be positive and the denominator negative, yield- ing a negative E

d . For an increase in price, the numerator

will be negative but the denominator positive, again yield- ing a negative E

d .

Economists usually ignore the minus sign and simply present the absolute value of the elasticity coefficient to avoid an ambiguity that might otherwise arise. It can be confusing to say that an E

d of 24 is greater than one of

22. This possible confusion is avoided when we say an E d

of 4 reveals greater elasticity than one of 2. So, in what follows, we ignore the minus sign in the coefficient of price elasticity of demand and show only the absolute value. Incidentally, the ambiguity does not arise with sup- ply because price and quantity supplied are positively re- lated. All elasticity of supply coefficients therefore are positive numbers.

Interpretations of Ed We can interpret the coefficient of price elasticity of demand as follows.

Elastic Demand Demand is elastic if a specific per- centage change in price results in a larger percentage change in quantity demanded. In such cases, E

d will be

greater than 1. Example: Suppose that a 2 percent decline

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CHAPTER 6 Elasticity 137

elastic or inelastic is to employ the total-revenue test. Here is the test: Note what happens to total revenue when price changes. If total revenue changes in the opposite direction from price, demand is elastic. If total revenue changes in the same direction as price, demand is inelastic. If total revenue does not change when price changes, demand is unit-elastic.

Elastic Demand

If demand is elastic, a decrease in price will increase total revenue. Even though a lesser price is received per unit, enough additional units are sold to more than make up for the lower price. For an example, look at demand curve D1

The Total-Revenue Test LO6.2 Explain the usefulness of the total revenue test for price elasticity of demand. The importance of elasticity for firms relates to the effect of price changes on total revenue and thus on profits (5 total revenue minus total costs). Total revenue (TR) is the total amount the seller re- ceives from the sale of a product in a particular time pe- riod; it is calculated by multiplying the product price (P) by the quantity sold (Q). In equation form:

TR 5 P 3 Q

Graphically, total revenue is represented by the P 3 Q rectangle lying below a point on a demand curve. At point a in Figure 6.2a, for example, price is $2 and quantity de- manded is 10 units. So total revenue is $20 (5 $2 3 10), shown by the rectangle composed of the yellow and green areas under the demand curve. We know from basic geom- etry that the area of a rectangle is found by multiplying one side by the other. Here, one side is “price” ($2) and the other is “quantity demanded” (10 units). Total revenue and the price elasticity of demand are related. In fact, the easiest way to infer whether demand is

FIGURE 6.1 Perfectly inelastic and elastic demands. Demand curve D1 in (a) represents perfectly inelastic demand (Ed 5 0). A price increase will result in no change in quantity demanded. Demand curve D2 in (b) represents perfectly elastic demand. A price increase will cause quantity demanded to decline from an infinite amount to zero (Ed 5 `).

Q

P

Perfectly inelastic demand (Ed = 0)

0

D1

(a) Perfectly inelastic demand

(b) Perfectly elastic demand

Q

P

Perfectly elastic demand (Ed = `)

0

D2

CONSIDER THIS . . .

A Bit of a Stretch

The following anal- ogy might help you remember the d i s t i n c t i o n b e - tween “elastic” and “inelastic.” Imagine two objects—one an Ace elastic ban- dage used to wrap injured joints and the other a rela- tively firm rubber

tie-down (rubber strap) used for securing items for trans- port. The Ace bandage stretches a great deal when pulled with a particular force; the rubber tie-down stretches some, but not a lot. Similar differences occur for the quantity demanded of various products when their prices change. For some prod- ucts, a price change causes a substantial “stretch” of quantity demanded. When this stretch in percentage terms exceeds the percentage change in price, demand is elastic. For other prod- ucts, quantity demanded stretches very little in response to the price change. When this stretch in percentage terms is less than the percentage change in price, demand is inelastic. In summary: • Elastic demand displays considerable “quantity stretch”

(as with the Ace bandage). • Inelastic demand displays relatively little “quantity stretch”

(as with the rubber tie-down). And through extension: • Perfectly elastic demand has infinite quantity stretch. • Perfectly inelastic demand has zero quantity stretch.

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PART THREE Consumer Behavior138

the higher-priced units will be more than offset by the revenue lost from the lower quantity sold. Bottom line: Other things equal, when price and total revenue move in opposite directions, demand is elastic. E

d is greater than 1,

meaning the percentage change in quantity demanded is greater than the percentage change in price.

Inelastic Demand

If demand is inelastic, a price decrease will reduce total revenue. The increase in sales will not fully offset the de- cline in revenue per unit, and total revenue will decline. To see this, look at demand curve D2 in Figure 6.2b. At point c on the curve, price is $4 and quantity demanded is 10. Thus total revenue is $40, shown by the combined yellow

in Figure 6.2a. We have already established that at point a, total revenue is $20 (5 $2 3 10), shown as the yellow plus green area. If the price declines from $2 to $1 (point b), the quantity demanded becomes 40 units and total reve- nue is $40 (5 $1 3 40). As a result of the price decline, total revenue has increased from $20 to $40. Total revenue has increased in this case because the $1 decline in price applies to 10 units, with a consequent revenue loss of $10 (the yellow area). But 30 more units are sold at $1 each, resulting in a revenue gain of $30 (the blue area). Visually, the gain of the blue area clearly exceeds the loss of the yel- low area. As indicated, the overall result is a net increase in total revenue of $20 (5 $30 2 $10). The analysis is reversible: If demand is elastic, a price increase will reduce total revenue. The revenue gained on

FIGURE 6.2 The total-revenue test for price elasticity. (a) Price declines from $2 to $1, and total revenue increases from $20 to $40. So demand is elastic. The gain in revenue (blue area) exceeds the loss of revenue (yellow area). (b) Price declines from $4 to $1, and total revenue falls from $40 to $20. So, demand is inelastic. The gain in revenue (blue area) is less than the loss of revenue (yellow area). (c) Price declines from $3 to $1, and total revenue does not change. Demand is unit- elastic. The gain in revenue (blue area) equals the loss of revenue (yellow area).

$3

2

1

0 10 20 30 40 (a)

Elastic

D1

a

P

Q

b

$4

2

3

1

0 10 20

(b) Inelastic

D2

d

c

P

Q

$3

2

1

0 10 20 30

(c) Unit-elastic

D3 f

e

Q

P

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CHAPTER 6 Elasticity 139

Other things equal, when price changes and total rev- enue remains constant, demand is unit-elastic (or unitary). E

d is 1, meaning the percentage change in quantity equals

the percentage change in price.

Price Elasticity along a Linear Demand Curve

Now a major confession! Although the demand curves de- picted in Figure 6.2 nicely illustrate the total-revenue test for elasticity, two of the graphs involve specific movements along linear (straight-line) demand curves. That presents no prob- lem for explaining the total-revenue test. However, you need to know that elasticity typically varies over different price ranges of the same demand curve. (The exception is the curve in Figure 6.2c. Elasticity is 1 along the entire curve.) Table 6.1 and Figure 6.3 demonstrate that elasticity typically varies over different price ranges of the same de- mand schedule or curve. Plotting the hypothetical data for movie tickets shown in columns 1 and 2 of Table 6.1 yields demand curve D in Figure 6.3. Observe that the demand curve is linear. But we see from column 3 of the table that the price elasticity coefficient for this demand curve de- clines as we move from higher to lower prices. For all downsloping straight-line and most other demand curves, demand is more price-elastic toward the upper left (here, the $5–$8 price range of D) than toward the lower right (here, the $4–$1 price range of D). This is the consequence of the arithmetic properties of the elasticity measure. Specifically, in the upper-left segment of the demand curve, the percentage change in quantity is large because the original reference quantity is small. Similarly, the percentage change in price is small in that segment because the original reference price is large. The relatively large percentage change in quantity divided

and green rectangle. If the price drops to $1 (point d), total revenue declines to $20, which obviously is less than $40. Total revenue has declined because the loss of revenue (the yellow area) from the lower unit price is larger than the gain in revenue (the blue area) from the accompanying increase in sales. Price has fallen, and total revenue has also declined. Our analysis is again reversible: If demand is inelastic, a price increase will increase total revenue. So, other things

equal, when price and total revenue move in the same direction, demand is in- elastic. E

d is less than 1,

meaning the percentage change in quantity de- manded is less than the percentage change in price.

Unit Elasticity

In the special case of unit elasticity, an increase or a de- crease in price leaves total revenue unchanged. The loss in revenue from a lower unit price is exactly offset by the gain in revenue from the accompanying increase in sales. Conversely, the gain in revenue from a higher unit price is exactly offset by the revenue loss associated with the ac- companying decline in the amount demanded. In Figure 6.2c (demand curve D3) we find that at the price of $3, 10 units will be sold, yielding total revenue of $30. At the lower $1 price, a total of 30 units will be sold, again resulting in $30 of total revenue. The $2 price reduc- tion causes the loss of revenue shown by the yellow area, but this is exactly offset by the revenue gain shown by the blue area. Total revenue does not change. In fact, that would be true for all price changes along this particular curve.

(1)

Total Quantity of (3) (4) (5)

Tickets Demanded (2) Elasticity Total Revenue, Total-Revenue

per Week, Thousands Price per Ticket Coefficient (E d ) (1) 3 (2) Test

1 $8 ] 5.00

$ 8,000 ] Elastic

2 7 ] 2.60

14,000 ] Elastic

3 6 ] 1.57

18,000 ] Elastic

4 5 ] 1.00

20,000 ] Unit-elastic

5 4 ] 0.64

20,000 ] Inelastic

6 3 ] 0.38

18,000 ] Inelastic

7 2 ] 0.20

14,000 ] Inelastic

8 1 8,000

TABLE 6.1 Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test

W6.2

Total-revenue test

WORKED PROBLEMS

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PART THREE Consumer Behavior140

is small because the original reference quantity is large; similarly, the percentage change in price is large because the original reference price is small. The relatively small percentage change in quantity divided by the relatively large percentage change in price results in a small E

d —an

inelastic demand. The demand curve in Figure 6.3a also illustrates that the slope of a demand curve—its flatness or steepness—is not a sound basis for judging elasticity. The catch is that the slope of the curve is computed from absolute changes in price and quantity, while elasticity involves relative or per- centage changes in price and quantity. The demand curve in Figure 6.3a is linear, which by definition means that the slope is constant throughout. But we have demonstrated that such a curve is elastic in its high-price ($8–$5) range and inelastic in its low-price ($4–$1) range.

Price Elasticity and the Total-Revenue Curve

In Figure 6.3b we plot the total revenue per week to the theater owner that corresponds to each price-quantity combination indicated along demand curve D in Figure 6.3a. The price–quantity-demanded combination represented by point a on the demand curve yields total revenue of $8,000 (5 $8 3 1,000 tickets). In Figure 6.3b, we plot this $8,000 amount vertically at 1 unit (1,000 tickets) de- manded. Similarly, the price–quantity-demanded combina- tion represented by point b in the upper panel yields total revenue of $14,000 (5 $7 3 2,000 tickets). This amount is graphed vertically at 2 units (2,000 tickets) demanded in the lower panel. The ultimate result of such graphing is total-revenue curve TR, which first slopes upward, then reaches a maximum, and finally turns downward. Comparison of curves D and TR sharply focuses the relationship between elasticity and total revenue. Lowering the ticket price in the elastic range of demand— for example, from $8 to $5—increases total revenue. Conversely, increasing the ticket price in that range re- duces total revenue. In both cases, price and total revenue change in opposite directions, confirming that demand is elastic. The $5–$4 price range of demand curve D reflects unit elasticity. When price either decreases from $5 to $4 or increases from $4 to $5, total revenue remains $20,000. In both cases, price has changed and total revenue has re- mained constant, confirming that demand is unit-elastic when we consider these particular price changes. In the inelastic range of demand curve D, lowering the price—for example, from $4 to $1—decreases total reve- nue, as shown in Figure 6.3b. Raising the price boosts

by the relatively small change in price yields a large E d —

an elastic demand. The reverse holds true for the lower-right segment of the demand curve. Here the percentage change in quantity

Unit- elastic Ed = 1

Inelastic Ed < 1

Elastic Ed > 1

a

b

c

d

e

f

g

h D

$8

7

6

5

4

3

2

1

0

Quantity demanded (thousands)

1 2 3 4 5 6 7 8

(a) Demand curve

P ri

ce

$20

18

16

14

12

10

8

6

4

2

1 2 3 4 5 6 7 8

Quantity demanded (thousands)

TR

(b) Total-revenue curve

To ta

l re

ve nu

e (t

h o

u sa

n d s

o f

d o

lla rs

)

0 9

FIGURE 6.3 The relation between price elasticity of demand for movie tickets and total revenue. (a) Demand curve D is based on Table 6.1 and is marked to show that the hypothetical weekly demand for movie tickets is elastic at higher price ranges and inelastic at lower price ranges. (b) The total-revenue curve TR is derived from demand curve D. When price falls and TR increases, demand is elastic; when price falls and TR is unchanged, demand is unit-elastic; and when price falls and TR declines, demand is inelastic.

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CHAPTER 6 Elasticity 141

expenditures of perhaps $3,000 or $20,000, respec- tively. These price increases are significant fractions of the annual incomes and budgets of most families, and quantities demanded will likely diminish significantly. The price elasticities for such items tend to be high.

• Luxuries versus Necessities In general, the more that a good is considered to be a “luxury” rather than a “necessity,” the greater is the price elasticity of demand. Electricity is generally regarded as a necessity; it is difficult to get along without it. A price increase will not significantly reduce the amount of lighting and power used in a household. (Note the very low price-elasticity coefficient of this good in Table 6.3.) An extreme case: A person does not decline an operation for acute appendicitis because the physician’s fee has just gone up.

On the other hand, vacation travel and jewelry are luxuries, which, by definition, can easily be forgone. If the prices of vacation travel and jewelry rise, a consumer need not buy them and will suffer no great hardship without them.

What about the demand for a common product like salt? It is highly inelastic on three counts: Few good substitutes are available; salt is a negligible item in the family budget; and it is a “necessity” rather than a luxury.

• Time Generally, product demand is more elastic the longer the time period under consideration. Consumers often need time to adjust to changes in prices. For example, when the price of a product rises, time is needed to find and experiment with other products to see if they are acceptable. Consumers may not immediately reduce their purchases very much when the price of beef rises by 10 percent, but in time they may shift to chicken, pork, or fish.

Another consideration is product durability. Studies show that “short-run” demand for gasoline is more inelastic

total revenue. In both cases, price and total revenue move in the same direction, confirming that demand is inelastic. Table 6.2 summarizes the characteristics of price elas- ticity of demand. You should review it carefully.

Determinants of Price Elasticity of Demand LO6.3 List the factors that affect price elasticity of demand and describe some applications of price elasticity of demand. We cannot say just what will determine the price elasticity of demand in each individual situation. However, the fol- lowing generalizations are often helpful.

• Substitutability Generally, the larger the number of substitute goods that are available, the greater the price elasticity of demand. Various brands of candy bars are generally substitutable for one another, making the demand for one brand of candy bar, say Snickers, highly elastic. Toward the other extreme, the demand for tooth repair (or tooth pulling) is quite inelastic because there simply are no close substitutes when those procedures are required.

The elasticity of demand for a product depends on how narrowly the product is defined. Demand for Reebok sneakers is more elastic than is the overall demand for shoes. Many other brands are readily substitutable for Reebok sneakers, but there are few, if any, good substitutes for shoes.

• Proportion of Income Other things equal, the higher the price of a good relative to consumers’ incomes, the greater the price elasticity of demand. A 10 per- cent increase in the price of low-priced pencils or chewing gum amounts to a few more pennies relative to a consumer’s income, and quantity demanded will probably decline only slightly. Thus, price elasticity for such low-priced items tends to be low. But a 10 percent increase in the price of relatively high- priced automobiles or housing means additional

TABLE 6.2 Price Elasticity of Demand: A Summary

Impact on Total Revenue of a:

Absolute Value of

Elasticity Coefficient Demand Is: Description Price Increase Price Decrease

Greater than 1 (Ed . 1) Elastic or relatively Quantity demanded changes by a Total revenue Total revenue elastic larger percentage than does price decreases increases

Equal to 1 (Ed 5 1) Unit- or unitary elastic Quantity demanded changes by the Total revenue is Total revenue is same percentage as does price unchanged unchanged

Less than 1 (Ed , 1) Inelastic or relatively Quantity demanded changes by a Total revenue Total revenue inelastic smaller percentage than does price increases decreases

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PART THREE Consumer Behavior142

$1.50, but the higher price that results reduces sales to 4,000 because of elastic demand, tax revenue will decline to $6,000 (5 $1.50 3 4,000 units sold). Because a higher tax on a product with elastic demand will bring in less tax  revenue, legislatures tend to seek out products that have inelastic demand—such as liquor, gasoline, and cigarettes—when levying excises.

Decriminalization of Illegal Drugs In recent years proposals to legalize drugs have been widely debated. Proponents contend that drugs should be treated like al- cohol; they should be made legal for adults and regulated for purity and potency. The current war on drugs, it is argued, has been unsuccessful, and the associated costs— including enlarged police forces, the construction of more prisons, an overburdened court system, and untold human costs—have increased markedly. Legalization would alleg- edly reduce drug trafficking significantly by taking the profit out of it. Crack cocaine and heroin, for example, are cheap to produce and could be sold at low prices in legal markets. Because the demand of addicts is highly inelastic, the amounts consumed at the lower prices would increase only modestly. Addicts’ total expenditures for cocaine and heroin would decline, and so would the street crime that finances those expenditures. Opponents of legalization say that the overall de- mand for cocaine and heroin is far more elastic than proponents think. In addition to the inelastic demand of  addicts, there is another market segment whose de- mand is relatively elastic. This segment consists of the

(E d 5 0.2) than is “long-run” demand (E

d 5 0.7). In the short

run, people are “stuck” with their present cars and trucks, but with rising gasoline prices they eventually replace them with smaller, more fuel-efficient vehicles. They also switch to mass transit where it is available. Table 6.3 shows estimated price-elasticity coefficients for a number of products. Each reflects some combination of the elasticity determinants just discussed.

Applications of Price Elasticity of Demand

The concept of price elasticity of demand has great practi- cal significance, as the following examples suggest.

Large Crop Yields The demand for most farm prod- ucts is highly inelastic; E

d is perhaps 0.20 or 0.25. As a result,

increases in the supply of farm products arising from a good growing season or from increased productivity tend to depress both the prices of farm products and the total revenues (incomes) of farmers. For farmers as a group, the inelastic demand for their products means that large crop yields may be undesirable. For policymakers it means that achieving the goal of higher total farm income requires that farm output be restricted.

Excise Taxes The government pays attention to elastic- ity of demand when it selects goods and services on which to levy excise taxes. If a $1 tax is levied on a product and 10,000 units are sold, tax revenue will be $10,000 (5 $1 3 10,000 units sold). If the government raises the tax to

TABLE 6.3 Selected Price Elasticities of Demand

Coefficient of Price Coefficient of Price

Elasticity of Elasticity of

Product or Service Demand (E d ) Product or Service Demand (E

d )

Newspapers .10 Milk .63

Electricity (household) .13 Household appliances .63

Bread .15 Liquor .70

Major League Baseball tickets .23 Movies .87

Cigarettes .25 Beer .90

Telephone service .26 Shoes .91

Sugar .30 Motor vehicles 1.14

Medical care .31 Beef 1.27

Eggs .32 China, glassware, tableware 1.54

Legal services .37 Residential land 1.60

Automobile repair .40 Restaurant meals 2.27

Clothing .49 Lamb and mutton 2.65

Gasoline .60 Fresh peas 2.83

Source: Compiled from numerous studies and sources reporting price elasticity of demand.

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CHAPTER 6 Elasticity 143

Price Elasticity of Supply LO6.4 Describe price elasticity of supply and how it can be applied. The concept of price elas- ticity also applies to supply. If the quantity supplied by producers is relatively re- sponsive to price changes, supply is elastic. If it is rel- atively insensitive to price changes, supply is inelastic. We measure the degree of price elasticity or inelastic- ity of supply with the coefficient E

s , defined almost like E

d

except that we substitute “percentage change in quantity supplied” for “percentage change in quantity demanded”:

E s 5

percentage change in quantity supplied of product X

percentage change in price of product X

For reasons explained earlier, the averages, or mid- points, of the before and after quantities supplied and the before and after prices are used as reference points for the percentage changes. Suppose an increase in the price of a good from $4 to $6 increases the quantity supplied from 10 units to 14 units. The percentage change in price would be 25, or 40 percent, and the percentage change in quantity would be 412, or 33 percent. Consequently,

E s 5

.33

.40 5 .83

In this case, supply is inelastic because the price-elasticity coefficient is less than 1. If E

s is greater than 1, supply is

elastic. If it is equal to 1, supply is unit-elastic. Also, E s is

never negative, since price and quantity supplied are di- rectly related. Thus, there are no minus signs to drop, as was necessary with elasticity of demand. The degree of price elasticity of supply depends on how easily—and therefore quickly—producers can shift resources between alternative uses. The easier and more rapidly producers can shift resources between alternative uses, the greater the price elasticity of supply. Take the case of Christmas trees. A firm’s response to, say, an in- crease in the price of trees depends on its ability to shift resources from the production of other products (whose prices we assume remain constant) to the production of trees. And shifting resource takes time: The longer the time, the greater the “shiftability.” So we can expect a greater response, and therefore greater elasticity of supply, the longer a firm has to adjust to a price change.

occasional users or “dabblers,” who use hard drugs when their prices are low but who abstain or substitute, say, alcohol when their prices are high. Thus, the lower prices associated with the legalization of hard drugs would increase consumption by dabblers. Also, removal of the legal prohibitions against using drugs might make drug use more socially acceptable, increasing the demand for cocaine and heroin. Many economists predict that the legalization of co- caine and heroin would reduce street prices by up to 60 per- cent, depending on if and how much they were taxed. According to an important study, price declines of that size would increase the number of occasional users of her- oin by 54 percent and the number of occasional users of cocaine by 33 percent. The total quantity of heroin de- manded would rise by an estimated 100 percent, and the quantity of cocaine demanded would rise by 50 percent.1 Moreover, many existing and first-time dabblers might in time become addicts. The overall result, say the opponents of legalization, would be higher social costs, possibly in- cluding an increase in street crime.

1Henry Saffer and Frank Chaloupka, “The Demand for Illegal Drugs,” Economic Inquiry, July 1999, pp. 401−411.

QUICK REVIEW 6.1

• The price elasticity of demand coefficient Ed is the ra- tio of the percentage change in quantity demanded to the percentage change in price. The averages of the two prices and two quantities are used as the base references in calculating the percentage changes.

• When Ed is greater than 1, demand is elastic; when Ed is less than 1, demand is inelastic; when Ed is equal to 1, demand is of unit elasticity.

• When price changes, total revenue will change in the opposite direction if demand is price-elastic, in the same direction if demand is price-inelastic, and not at all if demand is unit-elastic.

• Demand is typically elastic in the high-price (low- quantity) range of the demand curve and inelastic in the low-price (high-quantity) range of the demand curve.

• Price elasticity of demand is greater (a) the larger the number of substitutes available; (b) the higher the price of a product relative to one’s budget; (c) the greater the extent to which the product is a luxury; and (d) the longer the time period involved.

O6.2

Price elasticity of supply

ORIGIN OF THE IDEA

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PART THREE Consumer Behavior144

price with a change in quantity supplied. Suppose the owner of a small farm brings to market one truckload of tomatoes that is the entire season’s output. The supply curve for the tomatoes is perfectly inelastic (vertical); the farmer will sell the truckload whether the price is high or low. Why? Because the farmer can offer only one truck- load of tomatoes even if the price of tomatoes is much higher than anticipated. The farmer might like to offer more tomatoes, but tomatoes cannot be produced over- night. Another full growing season is needed to respond to a higher-than-expected price by producing more than one truckload. Similarly, because the product is perishable, the farmer cannot withhold it from the market. If the price is lower than anticipated, the farmer will still sell the entire truckload. The farmer’s costs of production, incidentally, will not enter into this decision to sell. Though the price of toma- toes may fall far short of production costs, the farmer will nevertheless sell everything he brought to market to avoid a total loss through spoilage. In the immediate market pe- riod, both the supply of tomatoes and the quantity of to- matoes supplied are fixed. The farmer offers only one truckload no matter how high or low the price. Figure 6.4a shows the farmer’s vertical supply curve during the immediate market period. Supply is perfectly inelastic because the farmer does not have time to respond to a change in demand, say, from D1 to D2. The resulting price increase from P0 to Pm simply determines which buyers get the fixed quantity supplied; it elicits no increase in output. However, not all supply curves are perfectly inelastic immediately after a price change. If the product is not perishable and the price rises, producers may choose to increase quantity supplied by drawing down their inven- tories of unsold, stored goods. This will cause the market supply curve to attain some positive slope. For our to- mato farmer, the immediate market period may be a full growing season; for producers of goods that can be inex- pensively stored, there may be no immediate market pe- riod at all.

Price Elasticity of Supply: The Short Run

The short run in microeconomics is a period of time too short to change plant capacity but long enough to use the fixed-sized plant more or less intensively. In the short run, our farmer’s plant (land and farm machinery) is fixed. But he does have time in the short run to cultivate tomatoes more intensively by applying more labor and more fertil- izer and pesticides to the crop. The result is a somewhat greater output in response to a presumed increase in

In analyzing the impact of time on elasticity, econo- mists distinguish among the immediate market period, the short run, and the long run.

Price Elasticity of Supply: The Immediate Market Period

The immediate market period is the length of time over which producers are unable to respond to a change in

CONSIDER THIS . . .

Elasticity and College Costs

Why does college cost so much? Elasticity of- fers some clues.

From the end of World War II through the 1970s, the supply of higher education increased massively as state and local govern- ments spent billions of dollars expanding

their higher education systems. This massive increase in sup- ply helped to offset the huge increase in demand that took place as the large Baby Boom generation flooded the higher education system starting in the early 1960s. With supply in- creasing nearly as fast as demand, the equilibrium price of higher education only increased modestly. Things changed dramatically beginning in the early 1980s. With respect to supply, state and local govern- ments slowed the growth of higher education spending, so that many college and university systems saw only modest subsequent increases in capacity. At the same time, the federal government dramatically increased both subsidized student lending and the volume of federal stu- dent grant money. Those policy innovations were of great benefit to poor and middle-class students, but they also meant that the demand curve for higher education con- tinued to shift to the right. That turned out to be problematic because, with the sup- ply of seats largely fixed by the changing priorities of state and local governments, the supply of higher education was highly inelastic even in the long run. As a result, the increases in demand caused by student loans and grant money re- sulted in substantially higher equilibrium prices for higher education. In response, some economists propose that the best way to increase affordability and access would be to put more pri- ority on the pre-1980 policies that increased supply rather than demand.

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CHAPTER 6 Elasticity 145

Antiques and Reproductions Antiques Roadshow is a popular PBS television program in which people bring an- tiques to a central location for appraisal by experts. Some people are pleased to learn that their old piece of furniture or funky folk art is worth a large amount, say, $30,000 or more. The high price of an antique results from strong de- mand and limited, highly inelastic supply. Because a genu- ine antique can no longer be reproduced, its quantity supplied either does not rise or rises only slightly as price goes up. The higher price might prompt the discovery of a few more of the remaining originals and thus add to the quantity available for sale, but this quantity response is usually quite small. So the supply of antiques and other collectibles tends to be inelastic. For one-of-a-kind an- tiques, the supply is perfectly inelastic. Factors such as increased population, higher income, and greater enthusiasm for collecting antiques have in- creased the demand for antiques over time. Because the supply of antiques is limited and inelastic, those increases in demand have greatly boosted the prices of antiques. Contrast the inelastic supply of original antiques with the elastic supply of modern “made-to-look-old” repro- ductions. Such faux antiques are quite popular and widely available at furniture stores and knickknack shops. When the demand for reproductions increases, the firms making them simply boost production. Because the supply of re- productions is highly elastic, increased demand raises their prices only slightly.

Volatile Gold Prices The price of gold is quite volatile, sometimes shooting upward one period and plummeting

demand; this greater output is reflected in a more elastic supply of tomatoes, as shown by S

s in Figure 6.4b. Note

now that the increase in demand from D1 to D2 is met by an increase in quantity (from Q0 to Qs), so there is a smaller price adjustment (from P0 to Ps) than would be the case in the immediate market period. The equilibrium price is therefore lower in the short run than in the immediate market period.

Price Elasticity of Supply: The Long Run

The long run in microeconomics is a time period long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry. In the “tomato industry,” for example, our farmer has time to acquire additional land and buy more machinery and equipment. Furthermore, other farmers may, over time, be attracted to tomato farming by the increased demand and higher price. Such adjustments create a larger supply re- sponse, as represented by the more elastic supply curve S

L

in Figure 6.4c. The outcome is a smaller price rise (P0 to P

l ) and a larger output increase (Q0 to Ql) in response to

the increase in demand from D1 to D2. There is no total-revenue test for elasticity of supply. Supply shows a positive or direct relationship between price and amount supplied; the supply curve is upsloping. Regardless of the degree of elasticity or inelasticity, price and total revenue always move together.

Applications of Price Elasticity of Supply

The idea of price elasticity of supply has widespread ap- plicability, as suggested by the following examples.

(a) Immediate market period

Pm

Po

Qo Q

D1 D2

Sm

0

P

(b) Short run

Ps Po

Qo Q

Ss

0

P

Qs

D1 D2

(c) Long run

Pl Po

Qo Q

D1 D2

0

P

QI

SL

FIGURE 6.4 Time and the elasticity of supply. The greater the amount of time producers have to adjust to a change in demand, here from D1 to D2, the greater will be their output response. (a) In the immediate market period, there is insufficient time to change output, and so supply is perfectly inelastic. (b) In the short run, plant capacity is fixed, but changing the intensity of its use can alter output; supply is therefore more elastic. (c) In the long run, all desired adjustments, including changes in plant capacity, can be made, and supply becomes still more elastic.

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146

Elasticity and Pricing Power: Why Different Consumers Pay Different Prices

All the buyers of a product traded in a highly competitive mar- ket pay the same market price for the product, regardless of their individual price elasticities of demand. If the price rises, Jones may have an elastic demand and greatly reduce her pur- chases. Green may have a unit-elastic demand and reduce his purchases less than Jones. Lopez may have an inelastic demand and hardly curtail his purchases at all. But all three consumers will pay the single higher price regardless of their respective de- mand elasticities. In later chapters we will find that not all sellers must passively accept a “one-for-all” price. Some firms have “market power” or “pricing power” that allows them to set their product prices in their best interests. For some goods and services, firms may find it advantageous to determine differences in price elasticity of de- mand and then charge different prices to different buyers. It is extremely difficult to tailor prices for each customer on the basis of price elasticity of demand, but it is relatively easy to observe differences in group elasticities. Consider airline tickets. Business travelers generally have inelastic demand for air travel.

Firms and Nonprofit Institutions Often Recognize and Exploit Differences in

Price Elasticity of Demand.

LAST WORD

downward the next. The main sources of these fluctua- tions are shifts in demand interacting with highly inelastic supply. Gold production is a costly and time-consuming process of exploration, mining, and refining. Moreover, the physical availability of gold is highly limited. For both reasons, increases in gold prices do not elicit substantial increases in quantity supplied. Conversely, gold mining is costly to shut down and existing gold bars are expensive to store. Price decreases therefore do not produce large drops in the quantity of gold supplied. In short, the supply of gold is inelastic. The demand for gold is partly derived from the de- mand for its uses, such as for jewelry, dental fillings, and coins. But people also demand gold as a speculative finan- cial investment. They increase their demand for gold when they fear general inflation or domestic or interna- tional turmoil that might undermine the value of currency and more traditional investments. They reduce their de- mand when events settle down. Because of the inelastic supply of gold, even relatively small changes in demand

produce relatively large changes in price. (This chapter’s Web-based question 1 that is posted online provides an Internet source for finding current and past prices of gold.)

Cross Elasticity and Income Elasticity of Demand LO6.5 Apply cross elasticity of demand and income elasticity of demand. Price elasticities measure the responsiveness of the quan- tity of a product demanded or supplied when its price changes. The consumption of a good also is affected by a change in the price of a related product or by a change in income.

Cross Elasticity of Demand

The cross elasticity of demand measures how sensitive consumer purchases of one product (say, X) are to a change

Because their time is highly valuable, they do not see slower modes of transportation as realistic substitutes. Also, their em- ployers pay for their tickets as part of their business expenses. In contrast, leisure travelers tend to have elastic demand. They have the option to drive rather than fly or to simply not travel at all. They also pay for their tickets out of their own pockets and thus are more sensitive to price. Airlines recognize the difference between the groups in terms of price elasticity of demand and charge business travelers more than leisure travelers. To accomplish that, they have to dis- suade business travelers from buying the less expensive round- trip tickets aimed at leisure travelers. One way to do this is by placing restrictions on the lower-priced tickets. For instance, airlines have at times made such tickets nonrefundable, required at least a 2-week advance purchase, and required Saturday-night stays. These restrictions chase off most business travelers who engage in last-minute travel and want to be home for the week- end. As a result, a business traveler often pays hundreds of dollars more for a ticket than a leisure traveler on the same plane.

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147

Discounts for children are another example of pricing based on group differences in price elasticity of demand. For many products, children have more elastic demands than adults be- cause children have low budgets, often financed by their parents. Sellers recognize the elasticity difference and price accordingly. The barber spends as much time cutting a child’s hair as an adult’s but charges the child much less. A child takes up a full seat at the baseball game but pays a lower price than an adult. A child snow- boarder occupies the same space on a chairlift as an adult snowboarder but quali- fies for a discounted lift ticket. Finally, consider pricing by colleges and universities. Price elasticity of demand for higher education is greater for prospective students from low-income families than similar students from high- income families. This makes sense because tuition is a much larger proportion of household income for a low-income student or family than for his or her high-income counterpart. Desiring a diverse student body, colleges charge different net prices (5

tuition minus financial aid) to the two groups on the basis of price elasticity of demand. High-income students pay full tu- ition, unless they receive merit-based scholarships. Low-income students receive considerable financial aid in addition to merit- based scholarships and, in effect, pay a lower net price.

It is common for colleges to announce a large tuition increase and immediately cushion the news by empha- sizing that they also are in- creasing financial aid. In effect, the college is increas- ing the tuition for students who have inelastic demand by the full amount and rais- ing the net tuition of those with elastic demand by some lesser amount or not at all. Through this strategy, col- leges boost revenue to cover rising costs while maintain- ing affordability for a wide range of students. There are a number of

other examples of dual or multiple pricing. All relate directly to price elasticity of demand. We will revisit this topic again in Chapter 12 when we analyze price discrimination—charging dif- ferent prices to different customers for the same product.

in the price of some other product (say, Y). We calculate the coefficient of cross elasticity of demand Exy just as we do the coefficient of simple price elasticity, except that we relate the percentage change in the consumption of X to the percentage change in the price of Y:

E xy

5

percentage change in quantity demanded of product X

percentage change in price of product Y

This cross-elasticity (or cross-price-elasticity) concept allows us to quantify and more fully understand substitute and complementary goods, introduced in Chapter 3. Unlike price elasticity, we allow the coefficient of cross elasticity of demand to be either positive or negative.

Substitute Goods If cross elasticity of demand is posi- tive, meaning that sales of X move in the same direction as a change in the price of Y, then X and Y are substitute

goods. An example is Evian water (X) and Dasani water (Y). An increase in the price of Evian causes consumers to buy more Dasani, resulting in a positive cross elasticity. The larger the positive cross-elasticity coefficient, the greater is the substitutability between the two products.

Complementary Goods When cross elasticity is neg- ative, we know that X and Y “go together”; an increase in the price of one decreases the demand for the other. So the two are complementary goods. For example, a de- crease in the price of digital cameras will increase the number of memory sticks purchased. The larger the nega- tive cross-elasticity coefficient, the greater is the comple- mentarity between the two goods.

Independent Goods A zero or near-zero cross elasticity suggests that the two products being considered are unre- lated or independent goods. An example is walnuts and plums: We would not expect a change in the price of walnuts to have any effect on purchases of plums, and vice versa.

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PART THREE Consumer Behavior148

is about 13, while income elasticity for most farm prod- ucts is only about 10.20.

Inferior Goods A negative income-elasticity coefficient designates an inferior good. Retread tires, cabbage, long- distance bus tickets, used clothing, and muscatel wine are likely candidates. Consumers decrease their purchases of inferior goods as incomes rise.

Insights Coefficients of income elasticity of demand provide insights into the economy. For example, when re- cessions (business downturns) occur and incomes fall, in- come elasticity of demand helps predict which products will decline in demand more rapidly than others. Products with relatively high income elasticity coeffi- cients, such as automobiles (E

i 5 13), housing (E

i 5

11.5), and restaurant meals (E i 5 11.4), are generally hit

hardest by recessions. Those with low or negative income elasticity coefficients are much less affected. For example, food products prepared at home (E

i 5 10.20) respond rela-

tively little to income fluctuations. When incomes drop, purchases of food (and toothpaste and toilet paper) drop little compared to purchases of movie tickets, luxury vaca- tions, and plasma screen TVs. Products we view as essen- tial tend to have lower income elasticity coefficients than products we view as luxuries. When our incomes fall, we cannot easily eliminate or postpone the purchase of essen- tial products. In Table 6.4 we provide a convenient synopsis of the cross-elasticity and income-elasticity concepts.

Application The degree of substitutability of products, measured by the cross-elasticity coefficient, is important to businesses and government. For example, suppose that Coca-Cola is considering whether or not to lower the price of its Sprite brand. Not only will it want to know something about the price elasticity of demand for Sprite (will the price cut increase or decrease total revenue?), but it will also be interested in knowing if the increased sales of Sprite will come at the expense of its Coke brand. How sensitive are the sales of one of its products (Coke) to a change in the price of another of its products (Sprite)? By how much will the increased sales of Sprite “cannibalize” the sales of Coke? A low cross elasticity would indicate that Coke and Sprite are weak substitutes for each other and that a lower price for Sprite would have little effect on Coke sales. Government also implicitly uses the idea of cross elasticity of demand in assessing whether a proposed merger between two large firms will substantially reduce competition and therefore violate the antitrust laws. For  example, the cross elasticity between Coke and Pepsi is high, making them strong substitutes for each other. In addition, Coke and Pepsi together sell about 70  percent of all carbonated cola drinks consumed in the  United States. Taken together, the high cross elas- ticities and the large market shares suggest that the government would likely block a merger between Coke and Pepsi because the merger would substantially lessen competition. In contrast, the cross elasticity between cola and gasoline is low or zero. A merger between Coke and Shell oil company would have a minimal effect on  competition. So government would let that merger happen.

Income Elasticity of Demand

Income elasticity of demand measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. The coefficient of income elasticity of demand E

i is determined with the

formula

E i 5

percentage change in quantity demanded percentage change in income

Normal Goods For most goods, the income-elasticity coefficient E

i is positive, meaning that more of them are

demanded as incomes rise. Such goods are called normal or superior goods (and were first described in Chapter 3). But the value of E

i varies greatly among normal goods.

For example, income elasticity of demand for automobiles

QUICK REVIEW 6.2

• Price elasticity of supply measures the sensitivity of suppliers to changes in the price of a product. The price-elasticity-of-supply coefficient Es is the ratio of the percentage change in quantity supplied to the per- centage change in price. The elasticity of supply varies directly with the amount of time producers have to re- spond to the price change.

• The cross-elasticity-of-demand coefficient Exy is com- puted as the percentage change in the quantity de- manded of product X divided by the percentage change in the price of product Y. If the cross-elasticity coefficient is positive, the two products are substitutes; if negative, they are complements.

• The income-elasticity coefficient Ei is computed as the percentage change in quantity demanded divided by the percentage change in income. A positive coeffi- cient indicates a normal or superior good. The coeffi- cient is negative for an inferior good.

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CHAPTER 6 Elasticity 149

Value of Coefficient Description Type of Good(s)

Cross elasticity: Positive (Ewz . 0) Quantity demanded of W changes in same Substitutes direction as change in price of Z

Negative (Exy , 0) Quantity demanded of X changes in opposite Complements direction from change in price of Y

Income elasticity: Positive (Ei . 0) Quantity demanded of the product changes Normal or superior

in same direction as change in income

Negative (Ei , 0) Quantity demanded of the product changes Inferior in opposite direction from change in income

TABLE 6.4 Cross and Income Elasticities of Demand

SUMMARY The number of available substitutes, the size of an item’s price relative to one’s budget, whether the product is a luxury or a ne- cessity, and length of time to adjust are all determinants of elas- ticity of demand.

LO6.4 Describe price elasticity of supply and how it can be applied.

The elasticity concept also applies to supply. The coefficient of price elasticity of supply is found by the formula

E s 5

percentage change in quantity supplied of X

percentage change in price of X

The averages of the prices and quantities under consideration are used as reference points for computing percentage changes. Elasticity of supply depends on the ease of shifting resources be- tween alternative uses, which varies directly with the time pro- ducers have to adjust to a price change.

LO6.5 Apply cross elasticity of demand and income elasticity of demand.

Cross elasticity of demand indicates how sensitive the pur- chase of one product is to changes in the price of another product. The coefficient of cross elasticity of demand is found by the formula

E xy

5

percentage change in quantity demanded of X

percentage change in price of Y

Positive cross elasticity of demand identifies substitute goods; negative cross elasticity identifies complementary goods.

LO6.1 Discuss price elasticity of demand and how it is calculated.

Price elasticity of demand measures consumer response to price changes. If consumers are relatively sensitive to price changes, demand is elastic. If they are relatively unresponsive to price changes, demand is inelastic.

The price-elasticity coefficient E d measures the degree of

elasticity or inelasticity of demand. The coefficient is found by the formula

E d

5

percentage change in quantity demanded of X

percentage change in price of X

Economists use the averages of prices and quantities under con- sideration as reference points in determining percentage changes in price and quantity. If E

d is greater than 1, demand is elastic. If

E d is less than 1, demand is inelastic. Unit elasticity is the special

case in which E d equals 1.

Perfectly inelastic demand is graphed as a line parallel to the vertical axis; perfectly elastic demand is shown by a line above and parallel to the horizontal axis.

Elasticity varies at different price ranges on a demand curve, tending to be elastic in the upper-left segment and inelastic in the lower-right segment. Elasticity cannot be judged by the steepness or flatness of a demand curve.

LO6.2 Explain the usefulness of the total revenue test for price elasticity of demand.

If total revenue changes in the opposite direction from prices, demand is elastic. If price and total revenue change in the same direction, demand is inelastic. Where demand is of unit elasticity, a change in price leaves total revenue unchanged.

LO6.3 List the factors that affect price elasticity of demand and describe some applications of price

elasticity of demand.

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PART THREE Consumer Behavior150

The coefficient is positive for normal goods and negative for inferior goods.

Industries that sell products that have high income elasticity of demand coefficients are particularly hard hit by recessions. Those with products that have low or negative income elasticity of demand coefficients fare much better.

Income elasticity of demand indicates the responsiveness of consumer purchases to a change in income. The coefficient of income elasticity of demand is found by the formula

E i 5

percentage change in quantity demanded of X

percentage change in income

TERMS AND CONCEPTS price elasticity of demand midpoint formula elastic demand inelastic demand unit elasticity

perfectly inelastic demand perfectly elastic demand total revenue (TR) total-revenue test price elasticity of supply

immediate market period short run long run cross elasticity of demand income elasticity of demand

R E V I E W Q U E S T I O N S

1. Suppose that the total revenue received by a company selling basketballs is $600 when the price is set at $30 per basketball and $600 when the price is set at $20 per basketball. Without using the midpoint formula, can you tell whether demand is elastic, inelastic, or unit-elastic over this price range? LO6.2

2. What are the major determinants of price elasticity of de- mand? Use those determinants and your own reasoning in judging whether demand for each of the following products is probably elastic or inelastic: (a) bottled water; (b) tooth- paste, (c) Crest toothpaste, (d ) ketchup, (e) diamond brace- lets, ( f ) Microsoft’s Windows operating system. LO6.3

3. Calculate total-revenue data from the demand schedule in review question 1. Graph total revenue below your demand curve. Generalize about the relationship between price elas- ticity and total revenue. LO6.2

4. How would the following changes in price affect total reve- nue? That is, would total revenue increase, decrease, or re- main unchanged? LO6.2

a. Price falls and demand is inelastic. b. Price rises and demand is elastic. c. Price rises and supply is elastic. d. Price rises and supply is inelastic. e. Price rises and demand is inelastic. f. Price falls and demand is elastic. g. Price falls and demand is of unit elasticity. 5. In 2006, Willem de Kooning’s abstract painting Woman III

sold for $137.5 million. Portray this sale in a demand and supply diagram and comment on the elasticity of supply. Comedian George Carlin once mused, “If a painting can be forged well enough to fool some experts, why is the original so valuable?” Provide an answer. LO6.4

6. Suppose the cross elasticity of demand for products A and B is 13.6 and for products C and D is 25.4. What can you conclude about how products A and B are related? Products C and D? LO6.5

D I S C U S S I O N Q U E S T I O N S

1. Explain why the choice between 1, 2, 3, 4, 5, 6, 7, and 8 “units,” or 1,000, 2,000, 3,000, 4,000, 5,000, 6,000, 7,000, and 8,000 movie tickets, makes no difference in determining elasticity in Table 6.1. LO6.1

2. What effect would a rule stating that university students must live in university dormitories have on the price elastic- ity of demand for dormitory space? What impact might this in turn have on room rates? LO6.1

3. The income elasticities of demand for movies, dental ser- vices, and clothing have been estimated to be 13.4, 11, and 1 0.5, respectively. Interpret these coefficients. What does it mean if an income elasticity coefficient is negative? LO6.5

4. Research has found that an increase in the price of beer would reduce the amount of marijuana consumed. Is cross elasticity of demand between the two products posi- tive or negative? Are these products substitutes or comple- ments? What might be the logic behind this rela- tionship? LO6.5

5. LAST WORD What is the purpose of charging different groups of customers different prices? Supplement the three broad examples in the Last Word with two additional ex- amples of your own. Hint: Think of price discounts based on group characteristics or time of purchase.

The following and additional problems can be found in

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CHAPTER 6 Elasticity 151

P R O B L E M S

1. Look at the demand curve in Figure 6.2a. Use the midpoint formula and points a and b to calculate the elasticity of de- mand for that range of the demand curve. Do the same for the demand curves in Figures 6.2b and 6.2c using, respec- tively, points c and d for Figure 6.2b and points e and f for Figure 6.2c. LO6.1

2. Investigate how demand elastiticities are affected by in- creases in demand. Shift each of the demand curves in Figures 6.2a, 6.2b, and 6.2c to the right by 10 units. For ex- ample, point a in Figure 6.2a would shift rightward from location (10 units, $2) to (20 units, $2), while point b would shift rightward from location (40 units, $1) to (50 units, $1). After making these shifts, apply the midpoint formula to calculate the demand elasticities for the shifted points. Are they larger or smaller than the elasticities you calculated in problem 1 for the original points? In terms of the midpoint formula, what explains the change in elasticities? LO6.1

3. Graph the accompanying demand data, and then use the midpoint formula for E

d to determine price elasticity of

demand for each of the four possible $1 price changes. What can you conclude about the relationship between the slope of a curve and its elasticity? Explain in a non- technical way why demand is elastic in the northwest seg- ment of the demand curve and inelastic in the southeast segment. LO6.1

Product Quantity

Price Demanded

$5 1

4 2

3 3

2 4

1 5

4. Danny “Dimes” Donahue is a neighborhood’s 9-year-old entrepreneur. His most recent venture is selling homemade brownies that he bakes himself. At a price of $1.50 each, he sells 100. At a price of $1 each, he sells 300. Is demand elas- tic or inelastic over this price range? If demand had the same elasticity for a price decline from $1.00 to $0.50 as it does for the decline from $1.50 to $1, would cutting the price from $1.00 to $0.50 increase or decrease Danny’s total revenue? LO6.2

5. What is the formula for measuring the price elasticity of supply? Suppose the price of apples goes up from $20 to $22

a box. In direct response, Goldsboro Farms supplies 1,200 boxes of apples instead of 1,000 boxes. Compute the coeffi- cient of price elasticity (midpoints approach) for Goldsboro’s supply. Is its supply elastic, or is it inelastic? LO6.4

6. ADVANCED ANALYSIS Currently, at a price of $1 each, 100 popsicles are sold per day in the perpetually hot town of Rostin. Consider the elasticity of supply. In the short run, a price increase from $1 to $2 is unit-elastic (E

s 51.0). So how

many popsicles will be sold each day in the short run if the price rises to $2 each? In the long run, a price increase from $1 to $2 has an elasticity of supply of 1.50. So how many popsicles will be sold per day in the long run if the price rises to $2 each? (Hint: Apply the midpoints approach to the elasticity of supply.) LO6.4

7. Lorena likes to play golf. The number of times per year that she plays depends on both the price of playing a round of golf as well as Lorena’s income and the cost of other types of entertainment—in particular, how much it costs to go see a movie instead of playing golf. The three demand schedules in the table below show how many rounds of golf per year Lorena will demand at each price under three different sce- narios. In scenario D1, Lorena’s income is $50,000 per year and movies cost $9 each. In scenario D2, Lorena’s income is also $50,000 per year, but the price of seeing a movie rises to $11. And in scenario D3, Lorena’s income goes up to $70,000 per year, while movies cost $11. LO6.5

Quantity Demanded

Price D 1 D

2 D

3

$50 15 10 15

35 25 15 30

20 40 20 50

a. Using the data under D1 and D2, calculate the cross elasticity of Lorena’s demand for golf at all three prices. (To do this, apply the midpoints approach to the cross elasticity of demand.) Is the cross elasticity the same at all three prices? Are movies and golf substitute goods, complementary goods, or independent goods?

b. Using the data under D2 and D3, calculate the income elasticity of Lorena’s demand for golf at all three prices. (To do this, apply the midpoints approach to the income elasticity of demand.) Is the income elasticity the same at all three prices? Is golf an inferior good?

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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152

CHAPTER 7

LO7.6 (Appendix) Relate how the indifference curve model of

consumer behavior derives demand

curves from budget lines,

indifference curves, and utility

maximization.

Learning Objectives

LO7.1 Define and explain the relationship between total utility, marginal

utility, and the law of diminishing

marginal utility.

LO7.2 Describe how rational consumers maximize utility by comparing the

marginal utility-to-price ratios of all

the products they could possibly

purchase.

LO7.3 Explain how a demand curve can be derived by observing the outcomes

of price changes in the utility-

maximization model.

LO7.4 Discuss how the utility-maximization model helps highlight the income

and substitution effects of a price

change.

LO7.5 Give examples of several real-world phenomena that can be explained

by applying the theory of consumer

behavior.

Utility Maximization

If you were to compare the shopping carts of al-

most any two consumers, you would observe strik-

ing differences. Why does Paula have potatoes,

peaches, and Pepsi in her cart, while Sam has sugar,

saltines, and 7-Up in his? Why didn’t Paula also buy

pasta and plums? Why didn’t Sam have soup and

spaghetti on his grocery list?

In this chapter, you will see how individual con-

sumers allocate their incomes among the various

goods and services available to them. Given a cer-

tain budget, how does a consumer decide which

goods and services to buy? This chapter will de-

velop a model to answer this question.

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CHAPTER 7 Utility Maximization 153

Law of Diminishing Marginal Utility LO7.1 Define and explain the relationship between total utility, marginal utility, and the law of diminishing marginal utility. The simplest theory of consumer behavior rests squarely on the law of diminishing marginal utility. This princi- ple, first discussed in Chapter 3, is that added satisfaction declines as a consumer acquires additional units of a given product. Although consumer wants in general may be in- satiable, wants for particular items can be satisfied. In a specific span of time over which consumers’ tastes remain unchanged, consumers can obtain as much of a particular good or service as they can afford. But the more of that product they obtain, the less they want still more of it. Consider durable goods, for example. A consumer’s de- sire for an automobile, when he or she has none, may be very strong. But the desire for a second car is less intense; and for a third or fourth, weaker and weaker. Unless they are collectors, even the wealthiest families rarely have more than a half-dozen cars, although their incomes would allow them to purchase a whole fleet of vehicles.

Terminology

Evidence indicates that consumers can fulfill specific wants with succeeding units of a product but that each added unit provides less utility than the last unit pur- chased. Recall that a consumer derives utility from a prod- uct if it can satisfy a want: Utility is want-satisfying power. The utility of a good or service is the satisfaction or plea- sure one gets from consuming it. Keep in mind three characteristics of this concept:

• “Utility” and “usefulness” are not synonymous. Paint- ings by Picasso may offer great utility to art connois- seurs but are useless functionally (other than for hid- ing a crack on a wall).

• Utility is subjective. The utility of a specific product may vary widely from person to person. A lifted pick- up truck may have great utility to someone who drives off-road but little utility to someone unable or unwilling to climb into the rig. Eyeglasses have tre- mendous utility to someone who has poor eyesight but no utility to a person with 20-20 vision.

• Utility is difficult to quantify. But for purposes of illustration we assume that people can measure satisfaction with units called utils (units of utility). For example, a particular consumer may get 100 utils of satisfaction from a smoothie, 10 utils of

satisfaction from a candy bar, and 1 util of satisfaction from a stick of gum. These imaginary units of satisfaction are convenient for quantifying consumer behavior for explanatory purposes.

Total Utility and Marginal Utility

Total utility and marginal utility are related, but different, ideas. Total utility is the total amount of satisfaction or pleasure a person derives from consuming some specific quantity—for example, 10 units—of a good or service. Marginal utility is the extra satisfaction a consumer real- izes from an additional unit of that product—for example, from the eleventh unit. Alternatively, marginal utility is the change in total utility that results from the consump- tion of 1 more unit of a product.

Figure 7.1(Key Graph) and the accompanying table demonstrate the re lation between total utility and mar- ginal utility. The curves reflect the data in the ta- ble. Column 2 shows the total utility associated with each level of consumption of tacos. Column 3 shows the marginal utility—the change in total utility— that results from the con- sumption of each successive taco. Starting at the origin in Figure 7.1a, observe that each of the first five units in- creases total utility (TU), but by a diminishing amount. Total utility reaches a maximum with the addition of the sixth unit and then declines. So in Figure 7.1b marginal utility (MU) remains pos- itive but diminishes through the first five units (because total utility increases at a declining rate). Marginal utility is zero for the sixth unit (because that unit doesn’t change total utility). Marginal utility then becomes negative with the seventh unit and beyond (because total utility is fall- ing). Figure 7.1b and table column 3 reveal that each suc- cessive taco yields less extra utility, meaning fewer utils, than the preceding taco.1 That is, the table and graph il- lustrate the law of diminishing marginal utility.

Marginal Utility and Demand

The law of diminishing marginal utility explains why the demand curve for a given product slopes downward. If

O7.1

Diminishing marginal utility

ORIGIN OF THE IDEA

1Technical footnote: In Figure 7.1b we graphed marginal utility at half- units. For example, we graphed the marginal utility of 4 utils at 312 units because “4 utils” refers neither to the third nor the fourth unit per se but to the addition or subtraction of the fourth unit.

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154

KEY GRAPH

QUICK QUIZ FOR FIGURE 7.1

1. Marginal utility: a. is the extra output a firm obtains when it adds another unit of

labor. b. explains why product supply curves slope upward. c. typically rises as successive units of a good are consumed. d. is the extra satisfaction from the consumption of 1 more unit

of some good or service. 2. Marginal utility in Figure 7.1b is positive, but declining, when

total utility in Figure 7.1a is positive and: a. rising at an increasing rate. b. falling at an increasing rate. c. rising at a decreasing rate. d. falling at a decreasing rate.

3. When marginal utility is zero in graph (b), total utility in graph (a) is:

a. also zero. b. neither rising nor falling. c. negative. d. rising, but at a declining rate. 4. Suppose the person represented by these graphs experienced a

diminished taste for tacos. As a result the: a. TU curve would get steeper. b. MU curve would get flatter. c. TU and MU curves would shift downward. d. MU curve, but not the TU curve, would collapse to the hori-

zontal axis.

Answers: 1. d; 2. c; 3. b; 4. c 30

20

10

0 1 2 3 4 5 6 7

TU

Units consumed per meal

(a) Total utility

To ta

l u ti

lit y

(u ti

ls )

MU

10

8 6 4

2

–2

0

1 2 3 4 5 6 7

Units consumed per meal

(b) Marginal utility

M ar

gi n al

u ti

lit y

(u ti

ls )

FIGURE 7.1 Total and marginal utility. Curves TU and MU are graphed from the data in the table. (a) As more of a product is consumed, total utility increases at a diminishing rate, reaches a maximum, and then declines. (b) Marginal utility, by definition, reflects the changes in total utility. Thus marginal utility diminishes with increased consumption, becomes zero when total utility is at a maximum, and is negative when total utility declines. As shown by the shaded rectangles in (a) and (b), marginal utility is the change in total utility associated with each additional taco. Or, alternatively, each new level of total utility is found by adding marginal utility to the preceding level of total utility.

(1) (2) (3)

Tacos Total Marginal

Consumed Utility, Utility,

per Meal Utils Utils

0 0 ] 10

1 10 ] 8

2 18 ] 6

3 24 ] 4

4 28 ] 2

5 30 ] 0

6 30 ] –2

7 28

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CHAPTER 7 Utility Maximization 155

additional tacos with less utility are not worth buying un- less the price declines. (When marginal utility becomes negative, Taco Bell would have to pay you to consume an- other taco!) Thus, diminishing marginal utility supports the idea that price must decrease in order for quantity de- manded to increase. In other words, consumers behave in ways that make demand curves downsloping.

CONSIDER THIS . . .

Vending Machines and Marginal Utility

Newspaper dispensing de- vices and soft-drink vending machines are similar in their basic operations. Both en- able consumers to buy a product by inserting coins. But there is an important dif- ference in the two devices. The newspaper dispenser opens to the full stack of pa-

pers and seemingly “trusts” the customer to take only a single copy, whereas the vending machine displays no such “trust,” requiring the consumer to buy one can at a time. Why the difference? The idea of diminishing marginal utility is key to solving this puzzle. Most consumers take only single copies from the newspaper box because the marginal utility of a second newspaper is nearly zero. They could grab a few extra papers and try to sell them on the street, but the revenue obtained would be small relative to their time and effort. So, in selling their product, newspaper publishers rely on “zero marginal utility of the second unit,” not on “consumer honesty.” Also, newspapers have little “shelf life”; they are obsolete the next day. In contrast, soft-drink sellers do not allow buyers to make a single payment and then take as many cans as they want. If they did, consumers would clean out the machine because the marginal utility of successive cans of soda dimin- ishes slowly and buyers could take extra sodas and consume them later. Soft-drink firms thus vend their products on a pay-per-can basis. In summary, newspaper publishers and soft-drink firms use alternative vending techniques because of the highly dif- ferent rates of decline in marginal utility for their products. The newspaper seller uses inexpensive dispensers that open to the full stack of papers. The soft-drink seller uses expen- sive vending machines that limit the consumer to a single can at a time. Each vending technique is optimal under the particular economic circumstance.

successive units of a good yield smaller and smaller amounts of marginal, or extra, utility, then the consumer will buy additional units of a product only if its price falls. The consumer for whom Figure 7.1 is relevant may buy two tacos at a price of $1 each. But because he or she ob- tains less marginal utility from additional tacos, the con- sumer will choose not to buy more at that price. The consumer would rather spend additional dollars on prod- ucts that provide more utility, not less utility. Therefore,

Theory of Consumer Behavior LO7.2 Describe how rational consumers maximize utility by comparing the marginal utility-to-price ratios of all the products they could possibly purchase. In addition to explaining the law of demand, the idea of diminishing marginal utility explains how consumers al- locate their money incomes among the many goods and services available for purchase.

Consumer Choice and the Budget Constraint

For simplicity, we will assume that the situation for the typical consumer has the following dimensions.

• Rational behavior The consumer is a rational person, who tries to use his or her money income to derive the greatest amount of satisfaction, or utility, from it. Consumers want to get “the most for their money” or, technically, to maximize their total utility. They engage in rational behavior.

• Preferences Each consumer has clear-cut preferences for certain of the goods and services that are available in the market. Buyers also have a good idea of how much marginal utility they will get from successive units of the various products they might purchase.

• Budget constraint At any point in time the consumer has a fixed, limited amount of money income. Since each consumer supplies a finite amount of human and property resources to society, he or she earns only limited income. Thus, as noted in Chapter 1,

QUICK REVIEW 7.1

• Utility is the benefit or satisfaction a person receives from consuming a good or a service.

• The law of diminishing marginal utility indicates that gains in satisfaction become smaller as successive units of a specific product are consumed.

• Diminishing marginal utility provides a simple ratio- nale for the law of demand.

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PART THREE Consumer Behavior156

marginal utility, which, in this example, is assumed to begin with the second unit of each product purchased.

Marginal Utility per Dollar To see how the utility- maximizing rule works, we must put the marginal-utility information in columns 2a and 3a on a per-dollar-spent basis. A consumer’s choices are influenced not only by the extra utility that successive apples will yield but also by how many dollars (and therefore how many oranges) she must give up to obtain additional apples. The rational consumer must compare the extra utility from each product with its added cost (that is, its price). Switching examples for a moment, suppose that you prefer a pizza whose marginal utility is, say, 36 utils to a movie whose marginal utility is 24 utils. But if the pizza’s price is $12 and the movie costs only $6, you would choose the movie rather than the pizza! Why? Because the marginal utility per dollar spent would be 4 utils for the movie (5 24 utils/$6) com- pared to only 3 utils for the pizza (5 36 utils/$12). You could see two movies for $12 and, assuming that the marginal util- ity of the second movie is, say, 16 utils, your total utility would be 40 utils. Clearly, 40 units of satisfaction (5 24 utils 1 16 utils) from two movies are superior to 36 utils from the same $12 expenditure on one pizza. To make the amounts of extra utility derived from dif- ferently priced goods comparable, marginal utilities must be put on a per-dollar-spent basis. We do this in columns 2b and 3b by dividing the marginal-utility data of columns 2a and 3a by the prices of apples and oranges—$1 and $2, respectively.

every consumer faces a budget constraint, even consumers who earn millions of dollars a year. Of course, this budget limitation is more severe for a consumer with an average income than for a consumer with an extraordinarily high income.

• Prices Goods are scarce relative to the demand for them, so every good carries a price tag. We assume that the price of each good is unaffected by the amount of it that is bought by any particular person. After all, each person’s purchase is a tiny part of total demand. Also, because the consumer has a limited number of dollars, he or she cannot buy everything wanted. This point drives home the reality of scarcity to each consumer.

So the consumer must compromise; he or she must choose the most personally satisfying mix of goods and services. Different individuals will choose different mixes.

Utility-Maximizing Rule

Of all the different combinations of goods and services a consumer can obtain within his or her budget, which spe- cific combination will yield the maximum utility or satis- faction? To maximize satisfaction, the consumer should allocate his or her money income so that the last dollar spent on each product yields the same amount of extra (marginal) utility. We call this the utility-maximizing rule. When the con- sumer has “balanced his margins” using this rule, he has achieved consumer equilibrium and has no incentive to alter his expenditure pattern. In fact, any person who has achieved consumer equilibrium would be worse off—total utility would decline—if there were any alteration in the bundle of goods purchased, providing there is no change in taste, income, products, or prices.

Numerical Example

An illustration will help explain the utility-maximizing rule. For simplicity we limit our example to two prod- ucts, but the analysis also applies if there are more. Suppose consumer Holly is analyzing which combina- tion of two products she should purchase with her fixed daily income of $10. Let’s suppose these products are apples and oranges. Holly’s preferences for apples and oranges and their prices are the basic data determining the combination that will maximize her satisfaction. Table 7.1 summarizes those data, with column 2a showing the amounts of marginal utility she will derive from each successive unit of A (ap- ples) and with column 3a showing the same thing for prod- uct B (oranges). Both columns reflect the law of diminishing

(2) (3)

Apple (Product A): Orange (Product B):

Price 5 $1 Price 5 $2

(b) (b)

(a) Marginal (a) Marginal

(1) Marginal Utility Marginal Utility

Unit of Utility, per Dollar Utility, per Dollar

Product Utils (MU/Price) Utils (MU/Price)

First 10 10 24 12

Second 8 8 20 10

Third 7 7 18 9

Fourth 6 6 16 8

Fifth 5 5 12 6

Sixth 4 4 6 3

Seventh 3 3 4 2

TABLE 7.1 The Utility-Maximizing Combination of Apples and Oranges Obtainable with an Income of $10*

*It is assumed in this table that the amount of marginal utility received from additional units of each of the two products is independent of the quantity of the other product. For example, the marginal-utility schedule for apples is independent of the number of oranges obtained by the consumer.

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CHAPTER 7 Utility Maximization 157

Table 7.2 summarizes our step-by-step process for maximizing Holly’s utility. Note that we have implicitly assumed that Holly spends her entire income. She neither borrows nor saves. However, saving can be regarded as a “commodity” that yields utility and can be incorporated into our analysis. In fact, we treat it that way in problem 4 at the end of this chapter.

Inferior Options Holly can obtain other combinations of apples and oranges with $10, but none will yield as great a total utility as do 2 apples and 4 oranges. As an example, she can obtain 4 apples and 3 oranges for $10. But this combina- tion yields only 93 utils, clearly inferior to the 96 utils provided by 2 apples and 4 oranges. True, there are other combinations of apples and oranges (such as 4  apples and 5 oranges or 1  apple and 2 oranges) in which the marginal utility of the last dollar spent is the same for both goods. But all such combinations either are unobtainable with Holly’s lim- ited money income (as 4 apples and 5 oranges) or do not exhaust her money income (as 1 apple and 2 oranges) and therefore do not yield the maximum utility attainable.

Algebraic Generalization

Economists generalize the utility-maximizing rule by say- ing that a consumer will maximize her satisfaction when she allocates her money income so that the last dollar spent on product A, the last on product B, and so forth, yield equal amounts of additional, or marginal, utility. The marginal utility per dollar spent on A is indicated by the MU of product A divided by the price of A (column 2b in Table 7.1), and the marginal utility per dollar spent on B by the MU of product B divided by the price of B (column 3b in Table 7.1). Our utility-maximizing rule merely

Decision-Making Process Table 7.1 shows Holly’s preferences on a unit basis and a per-dollar basis as well as the price tags of apples and oranges. With $10 to spend, in what order should Holly allocate her dollars on units of apples and oranges to achieve the highest amount of util- ity within the $10 limit imposed by her income? And what specific combination of the two products will she have ob- tained at the time she uses up her $10? Concentrating on columns 2b and 3b in Table 7.1, we find that Holly should first spend $2 on the first orange because its marginal utility per dollar of 12 utils is higher than the first apple’s 10 utils. But now Holly finds herself indifferent about whether to buy a second orange or the first apple because the marginal utility per dollar of both is 10 utils per dollar. So she buys both of them. Holly now has 1 apple and 2 oranges. Also, the last dollar she spent on each good yielded the same marginal utility per dollar (10). But this combination of apples and oranges does not represent the maximum amount of utility that Holly can obtain. It cost her only $5 [5 (1 3 $1) 1 (2 3 $2)], so she has $5 remaining, which she can spend to achieve a still higher level of total utility. Examining columns 2b and 3b again, we find that Holly should spend the next $2 on a third orange because mar- ginal utility per dollar for the third orange is 9 compared with 8 for the second apple. But now, with 1 apple and 3 oranges, she is again indifferent between a second apple and a fourth orange because both provide 8 utils per dollar. So Holly purchases 1 more of each. Now the last dollar spent on each product provides the same marginal utility per dol- lar (8), and Holly’s money income of $10 is exhausted. The utility-maximizing combination of goods attainable by Holly is 2 apples and 4 oranges. By summing marginal- utility information from columns 2a and 3a, we find that Holly is obtaining 18 (5 10 1 8) utils of satisfaction from the 2 apples and 78 (5 24 1 20 1 18 1 16) utils of satis- faction from the 4 oranges. Her $10, optimally spent, yields 96 (5 18 1 78) utils of satisfaction.

Choice Marginal Utility Income

Number Potential Choices per Dollar Purchase Decision Remaining

1 First apple 10 First orange for $2 $8 5 $10 2 $2

First orange 12

2 First apple 10 First apple for $1 $5 5 $8 2 $3

Second orange 10 and second orange for $2

3 Second apple 8 Third orange for $2 $3 5 $5 2 $2

Third orange 9

4 Second apple 8 Second apple for $1 $0 5 $3 2 $3

Fourth orange 8 and fourth orange for $2

TABLE 7.2 Sequence of Purchases to Achieve Consumer Equilibrium, Given the Data in Table 7.1

W7.1

Consumer choice

WORKED PROBLEMS

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PART THREE Consumer Behavior158

FIGURE 7.2 Deriving an individual demand curve. The consumer represented by the data in the table maximizes utility by purchasing 4 oranges at a price of $2. The decline in the price of oranges to $1 disrupts the consumer’s initial utility-maximizing equilibrium. The consumer restores equilibrium by purchasing 6 rather than 4 oranges. Thus, a simple price-quantity schedule emerges, which locates two points on a downsloping demand curve.

$2

1

0 4 6

Quantity demanded of oranges

P ri

ce p

er o

ra n ge

Do

Price per Orange Quantity Demanded

$2 4

1 6

Deriving the Demand Schedule and Curve

We can derive a single consumer’s demand schedule for oranges by considering alternative prices at which oranges might be sold and then determining the quantity the con- sumer will purchase. We already know one such price- quantity combination in the utility-maximizing example: Given tastes, income, and the prices of other goods, Holly will purchase 4 oranges at $2. Now let’s assume the price of oranges falls to $1. The marginal-utility-per-dollar data of column 3b in Table 7.1 will double because the price of oranges has been halved; the new data for column 3b are (by coincidence) identical to the data in column 3a. The doubling of the MU per dollar for each successive orange means that the purchase of 2 apples and 4 oranges is no longer an equilibrium combination. By applying the same reasoning we used previously, we now find that Holly’s utility-maximizing combination is 4 apples and 6 oranges. As summarized in the table in Figure 7.2,

requires that these ratios be equal for the last dollar spent on A and the last dollar spent on B. Algebraically,

MU of product A Price of A

5 MU of product B

Price of B

And, of course, the consumer must exhaust her avail- able income. Table 7.1 shows us that the combination of 2  units of A (apples) and 4 of B (oranges) fulfills these conditions in that

8 utils $1

5 16 utils

$2

and the consumer’s $10 income is all spent. If the equation is not fulfilled, then some reallocation of the consumer’s expenditures between A and B (from the low to the high marginal-utility-per-dollar product) will increase the consumer’s total utility. For example, if the consumer spent $10 on 4 of A (apples) and 3 of B (or- anges), we would find that

MU of A of 6 utils Price of A of $1

, MU of B of 18 utils

Price of B of $2

Here the last dollar spent on A provides only 6 utils of satisfaction, while the last dollar spent on B provides 9 (5 18y$2). So the consumer can increase total satisfac- tion by purchasing more of B and less of A. As dollars are reallocated from A to B, the marginal utility per dollar of A will increase while the marginal utility per dollar of B will decrease. At some new combination of A and B the two will be equal and consumer equilibrium will be achieved. Here that combination is 2 of A (apples) and 4 of B (oranges).

Utility Maximization and the Demand Curve LO7.3 Explain how a demand curve can be derived by observing the outcomes of price changes in the utility- maximization model. Once you understand the utility-maximizing rule, you can easily see why product price and quantity demanded are inversely related. Recall that the basic determinants of an individual’s demand for a specific product are (1) prefer- ences or tastes, (2) money income, and (3) the prices of other goods. The utility data in Table 7.1 reflect our con- sumer’s preferences. We continue to suppose that her money income is $10. And, concentrating on the construc- tion of an individual demand curve for oranges, we assume that the price of apples, now representing all “other goods,” is still $1.

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CHAPTER 7 Utility Maximization 159

come caused by the reduc- tion in the price of oranges will cause Holly to end up buying more oranges than before the price reduction. Any such increase in or- ange purchases is referred to as the income effect of the reduction in the price of oranges and it, too, helps to explain why demand curves are downward sloping: When the price of oranges falls, the income effect causes Holly to buy more oranges.

Holly will purchase 6 oranges when the price of oranges is $1. Using the data in this table, we can sketch the down- ward-sloping demand curve for oranges, D

o , shown in

Figure 7.2. This exercise, then, clearly links the utility- maximizing behavior of a consumer and that person’s downsloping demand curve for a particular product.

Income and Substitution Effects LO7.4 Discuss how the utility-maximization model helps highlight the income and substitution effects of a price change. Recall from Chapter 3 that the income effect is the impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of that good. In contrast, the substitution effect is the impact that a change in a product’s price has on its relative expensiveness and consequently  on the quantity demanded. Both effects help explain why a de- mand curve such as that in Figure 7.2 is downsloping. Let’s first look at the substitution effect. Recall that be- fore the price of oranges declined, Holly was in equilib- rium when purchasing 2 apples and 4 oranges because

MU of apples of 8 Price of apples of $1

5 MU of oranges of 16 Price of oranges of $2

But after the price of oranges declines from $2 to $1,

MU of apples of 8 Price of apples of $1

, MU of oranges of 16 Price of oranges of $1

Clearly, the last dollar spent on oranges now yields greater utility (16 utils) than does the last dollar spent on apples (8 utils). This will lead Holly to switch, or substitute, pur- chases away from apples and toward oranges so as to restore consumer equilibrium. This substitution effect con- tributes to the inverse relationship between price and quantity that is found along her demand curve for oranges: When the price of oranges declines, the substitution effect causes Holly to buy more oranges. What about the income effect? The decline in the price of oranges from $2 to $1 increases Holly’s real income. Before the price decline, she maximized her util- ity and achieved consumer equilibrium by selecting 2 ap- ples and 4 oranges. But at the lower $1 price for oranges, Holly would have to spend only $6 rather than $10 to buy that particular combination of goods. That means that the lower price of oranges has freed up $4 that can be spent on buying more apples, more oranges, or more of both. How many more of each fruit she ends up buying will be deter- mined by applying the utility-maximizing rule to the new situation. But it is quite likely that the increase in real in-

O7.2

Income and substitution effects

ORIGIN OF THE IDEA

Applications and Extensions LO7.5 Give examples of several real-world phenomena that can be explained by applying the theory of consumer behavior. Many real-world phenomena can be explained by applying the theory of consumer behavior.

iPads

Every so often a new product totally captures consumers’ imaginations. One such product is Apple’s iPad, which de- buted in April 2010. Less than three years later, Apple sold its 100-millionth unit. The swift ascendancy of the iPad resulted mainly from a leapfrog in technology. It was the first touchscreen tablet computer and became a hit because it was much better for the consumption of digital media—music, pictures, videos, and many games—than existing laptop or desktop com- puters. Those larger machines still held the advantage if a consumer wanted to create content or edit documents, but

• The theory of consumer behavior assumes that, with lim- ited income and a set of product prices, consumers make rational choices on the basis of well-defined preferences.

• A consumer maximizes utility by allocating income so that the marginal utility per dollar spent is the same for every good purchased.

• A downsloping demand curve can be derived by changing the price of one product in the consumer- behavior model and noting the change in the utility- maximizing quantity of that product demanded.

• By providing insights on the income effect and substitution effect of a price decline, the utility- maximization model helps explain why demand curves are downsloping.

QUICK REVIEW 7.2

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PART THREE Consumer Behavior160

gallons of water consumed, including the trillions of gal- lons that have far higher marginal utilities than the last unit consumed. In contrast, the total utility derived from diamonds is low since their high price means that rela- tively few of them are bought. Thus the water- diamond “paradox” is solved: Water has much more total utility (roughly, usefulness) than diamonds even though the price of diamonds greatly exceeds the price of water. These rela- tive prices relate to marginal utility, not total utility.

Opportunity Cost and the Value of Time

The theory of consumer behavior has been generalized to account for the economic value of time. Both consump- tion and production take time. Time is a valuable eco- nomic commodity; by using an hour in productive work a person can earn $6, $10, $50, or more, depending on her or his education and skills. By using that hour for leisure or in consumption activities, the individual incurs the op- portunity cost of forgone income; she or he sacrifices the $6, $10, or $50 that could have been earned by working. Imagine a self-employed consumer named Linden who is considering buying a round of golf, on the one hand, and a concert, on the other. The market price of the golf game is $30 and that of the concert is $40. But the golf game takes more time than the concert. Suppose Linden spends 4 hours on the golf course but only 2 hours at the concert. If her time is worth $10 per hour, as evidenced by the $10 wage she can obtain by working, then the “full price” of the golf game is $70 (the $30 market price plus $40 worth of time). Similarly, the full price of the concert is $60 (the $40 market price plus $20 worth of time). We find that, contrary to what market prices alone indicate, the full price of the concert is really less than the full price of the golf game. If we now assume that the marginal utilities derived from successive golf games and concerts are identical, tra- ditional theory would indicate that Linden should con- sume more golf games than concerts because the market price of the former ($30) is lower than that of the latter ($40). But when time is taken into account, the situation is reversed and golf games ($70) are more expensive than concerts ($60). So it is rational for Linden to consume more concerts than golf games. By accounting for the opportunity cost of a consumer’s time, we can explain certain phenomena that are otherwise quite puzzling. It may be rational for the unskilled worker

O7.3

Diamond-water paradox

ORIGIN OF THE IDEA

for consuming digital content the iPad was far superior in the eyes of millions of consumers. In the language of our analysis, Apple’s introduction of the iPad severely disrupted consumer equilibrium. Consumers en masse concluded that iPads had a higher marginal-utility-to-price ratio (5 MU/P) than the ratios for alternative products. They therefore shifted spending away from those other products and toward iPads as a way to increase total utility. Of course, for most people the marginal utility of a second or third iPad relative to price is quite low, so most consumers purchased only a single iPad. But Apple continued to enhance the iPad, enticing some of the buyers of older models to buy new models. This example demonstrates a simple but important point: New products succeed by enhancing consumers’ to- tal utility. This “delivery of value” generates a revenue stream. If revenues exceed production costs, substantial profits can result—as they have for Apple.

The Diamond-Water Paradox

Early economists such as Adam Smith were puzzled by the fact that some “essential” goods had much lower prices than some “unimportant” goods. Why would water, essen- tial to life, be priced below diamonds, which have much less usefulness? The paradox is resolved when we acknowl- edge that water is in great supply relative to demand and thus has a very low price per gallon. Diamonds, in con- trast, are rare. Their supply is small relative to demand and, as a result, they have a very high price per carat. Moreover, the marginal utility of the last unit of water consumed is very low. The reason follows from our utility- maximizing rule. Consumers (and producers) respond to the very low price of water by using a great deal of it—for generating electricity, irrigating crops, heating buildings, watering lawns, quenching thirst, and so on. Consumption is expanded until marginal utility, which declines as more water is consumed, equals its low price. On the other hand, relatively few diamonds are purchased because of their prohibitively high price, meaning that their marginal utility remains high. In equilibrium:

MU of water 1low2 Price of water 1low2

5 MU of diamonds 1high2 Price of diamonds 1high2

Although the marginal utility of the last unit of water consumed is low and the marginal utility of the last dia- mond purchased is high, the total utility of water is very high and the total utility of diamonds quite low. The total utility derived from the consumption of water is large because of the enormous amounts of water consumed. Total utility is the sum of the marginal utilities of all the

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Criminal Behavior

The theory of rational consumer behavior can be extended to provide some useful insights on criminal behavior. Both the law- ful consumer and the criminal try to maximize their total utility (or net benefit). For example, you can remove a textbook from the campus bookstore by either purchasing it or stealing it. If you buy the book, your action is legal; you have fully compensated the bookstore for the product. (The bookstore would rather have your money than the book.) If you steal the book, you have bro- ken the law. Theft is outlawed because it imposes uncompen- sated costs on others. In this case, your action reduces the bookstore’s revenue and profit and also may impose costs on other buyers who now must pay higher prices for their textbooks. Why might someone engage in a criminal activity such as stealing? Just like the consumer who compares the marginal util- ity of a good with its price, the potential criminal compares the marginal benefit from his or her action with the “price” or cost. If the marginal benefit (to the criminal) exceeds the price or marginal cost (also to the criminal), the individual undertakes the criminal activity. Most people, however, do not engage in theft, burglary, or fraud. Why not? The answer is that they perceive the personal price of engaging in these illegal activities to be too high relative to the marginal benefit. The price or marginal cost to the poten- tial criminal has several facets. First, there are the “guilt costs,” which for many people are substantial. Such individuals would not steal from others even if there were no penalties for doing so. Their moral sense of right and wrong would entail too great a guilt cost relative to the benefit from the stolen good. Other types of costs include the direct cost of the criminal activity (sup- plies and tools) and the forgone income from legitimate activities (the opportunity cost to the criminal). Unfortunately, guilt costs, direct costs, and forgone income are not sufficient to deter some people from stealing. So society imposes other costs, mainly fines and imprisonment, on lawbreak- ers. The potential of being fined increases the marginal cost to the criminal. The potential of being imprisoned boosts marginal cost still further. Most people highly value their personal freedom and lose considerable legitimate earnings while incarcerated. Given these types of costs, the potential criminal estimates the marginal cost and benefit of committing the crime. As a sim- ple example, suppose that the direct cost and the opportunity cost of stealing an $80 textbook are both zero. The probability of

Although Economic Analysis Is Not Particularly Relevant in Explaining Some Crimes of Passion and

Violence (for Example, Murder and Rape), It Does Provide Interesting Insights on Such Property Crimes

as Robbery, Burglary, and Auto Theft.

LAST WORD

getting caught is 10 percent and, if apprehended, there will be a $500 fine. The potential criminal will estimate the marginal cost of stealing the book as $50 (5 $500 fine 3 .10 chance of appre- hension). Someone who has a guilt cost of zero will choose to steal the book because the marginal benefit of $80 would exceed the marginal cost of $50. In contrast, someone having a guilt cost of, say, $40 will not steal the book. The marginal benefit of $80 will not be as great as the marginal cost of $90 (5 $50 of penalty cost 1 $40 of guilt cost). This perspective on illegal behavior has some interesting implications. For example, other things equal, crime will rise (more of it will be “bought”) when its price falls. This explains, for instance, why some people who do not steal from stores un- der normal circumstances participate in looting stores during riots, when the marginal cost of being apprehended has substan- tially declined. Another implication is that society can reduce unlawful be- havior by increasing the “price of crime.” It can nourish and in- crease guilt costs through family, educational, and religious efforts. It can increase the direct cost of crime by using more sophisticated security systems (locks, alarms, video surveillance) so that criminals will have to buy and use more sophisticated tools. It can undertake education and training initiatives to en- hance the legitimate earnings of people who might otherwise engage in illegal activity. It can increase policing to raise the probability of being apprehended for crime. And it can impose greater penalties for those who are caught and convicted.

161

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PART THREE Consumer Behavior162

today’s high expenditures on health care and the historical growth of such spending as a percentage of domestic output. Similar reasoning applies to purchases of buffet meals. If you buy a meal at an all-you-can-eat buffet, you will tend to eat more than if you purchased it item by item. Why not eat that second dessert? Its marginal utility is positive and its “price” is zero!

Cash and Noncash Gifts

Marginal-utility analysis also helps us understand why peo- ple generally prefer cash gifts to noncash gifts costing the same amount. The reason is simply that the noncash gifts may not match the recipient’s preferences and thus may not add as much as cash to total utility. Thought of differently, consumers know their own preferences better than the gift giver does, and the $100 cash gift provides more choices. Look back at Table 7.1. Suppose Holly has zero earned income but is given the choice of a $2 cash gift or a noncash gift of 2 apples. Because 2 apples can be bought with $2, these two gifts are of equal monetary value. But by spending the $2 cash gift on the first orange, Holly could obtain 24 utils. The noncash gift of the first 2 apples would yield only 18 (5 10 1 8) units of utility. Conclusion: The noncash gift yields less utility to the beneficiary than does the cash gift. Since giving noncash gifts is common, a considerable value of those gifts is potentially lost because they do not match their recipients’ tastes. For example, Uncle Fred may have paid $15 for the Frank Sinatra CD he gave you for the holidays, but you would pay only $7.50 for it. Thus, a $7.50, or 50 percent, value loss is involved. Multiplied by billions of gifts a year, the total potential loss of value is huge. But some of that loss is avoided by the creative ways individuals handle the problem. For example, newlyweds set up gift registries for their weddings to help match up their wants to the noncash gifts received. Also, people ob- tain cash refunds or exchanges for gifts so they can buy goods that provide more utility. And people have even been known to “recycle gifts” by giving them to someone else at a later time. All three actions support the proposition that individuals take actions to maximize their total utility.

or retiree whose time has little market value to ride a bus from Chicago to Pittsburgh. But the corporate executive, whose time is very valuable, will find it cheaper to fly, even though bus fare is only a fraction of plane fare. It is sensible for the retiree, living on a modest company pension and a Social Security check, to spend many hours shopping for bargains at the mall or taking long trips in a motor home. It is equally intelligent for the highly paid physician, working 55 hours per week, to buy a new personal computer over the Internet and take short vacations at expensive resorts. People in other nations often feel affluent Americans are “wasteful” of food and other material goods but “overly economical” in their use of time. Americans who visit de- veloping countries find that time is used casually or “squandered,” while material goods are very highly prized and carefully used. These differences are not a paradox or a case of radically different temperaments. The differences are primarily a rational reflection of the fact that the high productivity of labor in an industrially advanced society gives time a high market value, whereas the opposite is true in a low-income, developing country.

Medical Care Purchases

The method of payment for certain goods and services af- fects their prices at the time we buy them and significantly changes the amount purchased. Let’s go back to Table 7.1. Suppose the $1 price for apples is its “true” value or op- portunity cost. But now, for some reason, its price is only, say, $0.20. A rational consumer clearly would buy more ap- ples at the $0.20 price than at the $1 price. That is what happens with medical care. People in the United States who have health insurance pay a fixed pre- mium once a month that covers, say, 80 percent of all in- curred health care costs. This means that when they actually need health care, its price to them will be only 20 percent of the actual market price. How would you act in such a situa- tion? When you are ill, you would likely purchase a great deal more medical care than you would if you were con- fronted with the full price. As a result, financing health care through insurance is an important factor in explaining

SUMMARY LO7.2 Describe how rational consumers maximize utility by comparing the marginal utility-to-price

ratios of all the products they could possibly

purchase.

The utility-maximization model assumes that the typical consumer is rational and acts on the basis of well-defined

LO7.1 Define and explain the relationship between total utility, marginal utility, and the law of

diminishing marginal utility.

The law of diminishing marginal utility states that beyond a cer- tain quantity, additional units of a specific good will yield declin- ing amounts of extra satisfaction to a consumer.

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CHAPTER 7 Utility Maximization 163

preferences. Because income is limited and goods have prices, the consumer cannot purchase all the goods and services he or she might want. The consumer therefore selects the attainable combination of goods that maximizes his or her utility or satisfaction.

A consumer’s utility is maximized when income is allocated so that the last dollar spent on each product purchased yields the same amount of extra satisfaction. Algebraically, the utility- maximizing rule is fulfilled when

MU of product A Price of A

5 MU of product B

Price of B and the consumer’s total income is spent.

LO7.3 Explain how a demand curve can be derived by observing the outcomes of price changes in the

utility-maximization model.

The utility-maximizing rule and the demand curve are logically consistent. Because marginal utility declines, a lower price is needed to induce the consumer to buy more of a particular product.

LO7.4 Discuss how the utility-maximization model helps highlight the income and substitution effects of

a price change.

The utility-maximization model illuminates the income and sub- stitution effects of a price change. The income effect implies that a decline in the price of a product increases the consumer’s real income and enables the consumer to buy more of that product with a fixed money income. The substitution effect implies that a lower price makes a product relatively more attractive and there- fore increases the consumer’s willingness to substitute it for other products.

LO7.5 Give examples of several real-world phenomena that can be explained by applying the

theory of consumer behavior.

The theory of consumer behavior can explain many real world phenomena, including the rapid adoption of popular consumer goods like the iPad that feature disruptive technologies, the over- consumption of products like health care that have artificially low prices, and why people often prefer gifts of cash to receiving par- ticular items or objects of the same monetary value as gifts.

TERMS AND CONCEPTS law of diminishing marginal utility utility total utility marginal utility

rational behavior budget constraint utility-maximizing rule

consumer equilibrium income effect substitution effect

D I S C U S S I O N Q U E S T I O N S

1. Complete the following table and answer the questions below: LO7.1

Units

Consumed Total Utility Marginal Utility

0 0

1 10 10

2 8

3 25

4 30

5 3

6 34

a. At which rate is total utility increasing: a constant rate, a decreasing rate, or an increasing rate? How do you know?

b. “A rational consumer will purchase only 1 unit of the product represented by these data, since that amount

maximizes marginal utility.” Do you agree? Explain why or why not.

c. “It is possible that a rational consumer will not purchase any units of the product represented by these data.” Do you agree? Explain why or why not.

2. Mrs. Simpson buys loaves of bread and quarts of milk each week at prices of $1 and 80 cents, respectively. At present she is buying these products in amounts such that the mar- ginal utilities from the last units purchased of the two prod- ucts are 80 and 70 utils, respectively. Is she buying the utility-maximizing combination of bread and milk? If not, how should she reallocate her expenditures between the two goods? LO7.2

3. How can time be incorporated into the theory of consumer behavior? Explain the following comment: “Want to make millions of dollars? Devise a product that saves Americans lots of time.” LO7.2

4. Explain: LO7.2 a. Before economic growth, there were too few goods; after

growth, there is too little time.

The following and additional problems can be found in

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PART THREE Consumer Behavior164

R E V I E W Q U E S T I O N S

1. True or false. The law of diminishing marginal utility pre- dicts the consumption behavior of addicts quite well. LO7.1

2. Frank spends $75 on 10 magazines and 25 newspapers. The magazines cost $5 each and the newspapers cost $2.50 each. Suppose that his MU from the final magazine is 10 utils while his MU from the final newspaper is also 10 utils. According to the utility-maximizing rule, Frank should: LO7.2

a. Reallocate spending from magazines to newspapers. b. Reallocate spending from newspapers to magazines. c. Be satisfied because he is already maximizing his total utility. d. None of the above. 3. Demand curves slope downward because, other things held

equal, LO7.3 a. An increase in a product’s price lowers MU. b. A decrease in a product’s price lowers MU. c. A decrease in a product’s price raises MU per dollar and

makes consumers wish to purchase more units.

d. An increase in a product’s price raises MU per dollar and makes consumers wish to purchase more units.

4. Jermaine spends his money on cucumbers and lettuce. If the price of cucumbers falls, the MU per dollar of cucumbers will and Jermaine will cucumbers for lettuce. LO7.4

a. Fall; substitute b. Rise; substitute c. Fall; supply d. Rise; demand 5. Tammy spends her money on lemonade and iced tea. If the

price of lemonade falls, it is as though her income . LO7.4

a. Increases. b. Decreases. c. Stays the same.

b. It is irrational for an individual to take the time to be completely rational in economic decision making.

c. Telling your spouse where you would like to go out to eat for your birthday makes sense in terms of utility maximization.

5. In the last decade or so, there has been a dramatic expansion of small retail convenience stores (such as 7-Eleven, Kwik Shop, and Circle K), although their prices are generally much higher than prices in large supermarkets. What ex- plains the success of the convenience stores? LO7.2

6. Many apartment-complex owners are installing water me- ters for each apartment and billing the occupants according to the amount of water they use. This is in contrast to the former procedure of having a central meter for the entire complex and dividing up the collective water expense as part of the rent. Where individual meters have been installed, water usage has declined 10 to 40 percent. Explain that drop, referring to price and marginal utility. LO7.3

7. Using the utility-maximization rule as your point of refer- ence, explain the income and substitution effects of an in- crease in the price of product B, with no change in the price of product A. LO7.4

8. ADVANCED ANALYSIS A “mathematically fair bet” is one in which the amount won will on average equal the amount bet, for example, when a gambler bets, say, $100 for a 10 percent chance to win $1,000 ($100 5 0.10 3 $1,000). Assuming diminishing marginal utility of dollars, explain why this is not a fair bet in terms of utility. Why is it even a less fair bet when the “house” takes a cut of each dollar bet? So is gam- bling irrational? LO7.4

9. LAST WORD In what way is criminal behavior similar to consumer behavior? Why do most people obtain goods via legal behavior as opposed to illegal behavior? What are so- ciety’s main options for reducing illegal behavior?

P R O B L E M S

1. Mylie’s total utility from singing the same song over and over is 50 utils after one repetition, 90 utils after two repeti- tions, 70 utils after three repetitions, 20 utils after four rep- etitions, 250 utils after five repetitions, and 2200 utils after six repetitions. Write down her marginal utility for each repetition. Once Mylie’s total utility begins to decrease, does each additional singing of the song hurt more than the previous one or less than the previous one? LO7.1

2. John likes Coca-Cola. After consuming one Coke, John has a total utility of 10 utils. After two Cokes, he has a total util- ity of 25 utils. After three Cokes, he has a total utility of 50 utils. Does John show diminishing marginal utility for Coke, or does he show increasing marginal utility for Coke?

Suppose that John has $3 in his pocket. If Cokes cost $1 each and John is willing to spend one of his dollars on pur- chasing a first can of Coke, would he spend his second dol- lar on a Coke, too? What about the third dollar? If John’s marginal utility for Coke keeps on increasing no matter how many Cokes he drinks, would it be fair to say that he is addicted to Coke? LO7.1

3. Suppose that Omar’s marginal utility for cups of coffee is constant at 1.5 utils per cup no matter how many cups he drinks. On the other hand, his marginal utility per dough- nut is 10 for the first doughnut he eats, 9 for the second he eats, 8 for the third he eats, and so on (that is, declining by 1 util per additional doughnut). In addition, suppose

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CHAPTER 7 Utility Maximization 165

Column 1 Column 2 Column 3 Column 4 Column 5

Units Units Units Units Number of

of A MU of B MU of C MU of D MU Dollars Saved MU

1 72 1 24 1 15 1 36 1 5

2 54 2 15 2 12 2 30 2 4

3 45 3 12 3 8 3 24 3 3

4 36 4 9 4 7 4 18 4 2

5 27 5 7 5 5 5 13 5 1

6 18 6 5 6 4 6 7 6 12 7 15 7 2 7 312 7 4 7

1 4

8 12 8 1 8 3 8 2 8 18

that coffee costs $1 per cup, doughnuts cost $1 each, and Omar has a budget that he can spend only on doughnuts, coffee, or both. How big would that budget have to be before he would spend a dollar buying a first cup of coffee? LO7.2

4. Columns 1 through 4 in the table at the top of the page show the marginal utility, measured in utils, that Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows the marginal utility Ricardo gets from saving. Assume that the prices of A, B, C, and D are, respec- tively, $18, $6, $4, and $24 and that Ricardo has an income of $106. LO7.2

a. What quantities of A, B, C, and D will Ricardo purchase in maximizing his utility?

b. How many dollars will Ricardo choose to save? c. Check your answers by substituting them into the

algebraic statement of the utility-maximizing rule. 5. You are choosing between two goods, X and Y, and your mar-

ginal utility from each is as shown in the table to the right. If your income is $9 and the prices of X and Y are $2 and $1, respectively, what quantities of each will you purchase to maximize utility? What total utility will you realize? Assume that, other things remaining unchanged, the price of X falls to $1. What quantities of X and Y will you now purchase? Using the two prices and quantities for X, derive a demand schedule (a table showing prices and quantities demanded) for X. LO7.3

Units of X MU x Units of Y MU

y

1 10 1 8

2 8 2 7

3 6 3 6

4 4 4 5

5 3 5 4

6 2 6 3

6. ADVANCED ANALYSIS Let MU A 5 z 5 10 2 x and MU

B 5

z 5 21 2 2y, where z is marginal utility per dollar measured in utils, x is the amount spent on product A, and y is the amount spent on product B. Assume that the consumer has $10 to spend on A and B—that is, x 1 y 5 10. How is the $10 best allocated between A and B? How much utility will the marginal dollar yield? LO7.3

7. Suppose that with a budget of $100, Deborah spends $60 on sushi and $40 on bagels when sushi costs $2 per piece and bagels cost $2 per bagel. But then, after the price of bagels falls to $1 per bagel, she spends $50 on sushi and $50 on bagels. How many pieces of sushi and how many bagels did Deborah consume before the price change? At the new prices, how much money would it have cost Deborah to buy those same quantities (the ones that she consumed before the price change)? Given that it used to take Deborah’s en- tire $100 to buy those quantities, how big is the income ef- fect caused by the reduction in the price of bagels? LO7.4

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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CHAPTER SEVEN APPENDIX166

LO7.6 Relate how the indifference curve model of consumer behavior derives demand curves from budget lines, indifference curves, and utility maximization. The utility-maximization rule previously discussed re- quires individuals to measure and compare utility, much as a business would measure and compare costs or revenues. Such cardinal utility is measured in units such as 1, 2, 3, and 4 and can be added, subtracted, multiplied, and divided, just like the cardinal numbers in mathematics. More im- portantly, cardinal utility allows precise quantification of the marginal utilities upon which the utility-maximizing rule depends. In fact, the marginal-utility theory of con- sumer demand that we explained in the body of this chap- ter rests squarely on the assumption that economists be able to measure cardinal utility. The reality, however, is that measuring cardinal utility is highly difficult, at best. (Can you, for instance, state exactly how many utils you are getting from reading this book right now or how many utils you would get from watching a sunset?) To avoid this measurement problem, economists have developed an alternative explanation of consumer behav- ior and equilibrium in which cardinal measurement is not required. In this more-advanced analysis, the con- sumer must simply rank various combinations of goods in terms of preference. For instance, Sally can simply re- port that she prefers 4 units of A to 6 units of B without having to put number values on how much she likes either option. The model of consumer behavior that is  based upon such ordinal utility rankings is called

indifference curve analysis. It has two main elements: budget lines and indifference curves.

The Budget Line: What Is Attainable We know from Chapter 1 that a budget line (or, more technically, a budget constraint) is a schedule or curve show- ing various combinations of two products a consumer can purchase with a specific money income. If the price of product A is $1.50 and the price of product B is $1, a con- sumer could purchase all the combinations of A and B shown in the table in Figure 1 with $12 of money income. At one extreme, the consumer might spend all of his or her income on 8 units of A and have nothing left to spend on B. Or, by giving up 2 units of A and thereby “freeing” $3, the consumer could have 6 units of A and 3 of B. And so on to the other extreme, at which the consumer could buy 12 units of B at $1 each, spending his or her entire money income on B with nothing left to spend on A. Figure 1 also shows the budget line graphically. Note that the graph is not restricted to whole units of A and B as is the table. Every point on the graph represents a possible combi- nation of A and B, including fractional quantities. The slope of the graphed budget line measures the ratio of the price of B to the price of A; more precisely, the absolute value of the slope is P

B yP

A 5 $1.00y$1.50 5 23. This is the mathematical

way of saying that the consumer must forgo 2 units of

Indifference Curve Analysis

Units of A Units of B

(Price 5 $1.50) (Price 5 $1) Total Expenditure

8 0 $12 (5 $12 1 $0)

6 3 $12 (5 $9 1 $3)

4 6 $12 (5 $6 1 $6)

2 9 $12 (5 $3 1 $9)

0 12 $12 (5 $0 1 $12)

Income = $12 PA = $1.50

12

10

8

6

4

2

2 4 6 8 10 12

Quantity of B

Q u an

ti ty

o f A

(Unattainable)

(Attainable)

Income = $12 PB = $1

= 12

= 8

0

FIGURE 1 A consumer’s budget line. The budget line shows all the combinations of any two products that someone can purchase, given the prices of the products and the person’s money income.

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CHAPTER SEVEN APPENDIX 167

Note what happens if P B changes while P

A and

money income remain constant. In particular, if P B

drops, say, from $1 to $0.50, the lower end of the budget line fans outward to the right. Conversely, if P

B in-

creases, say, from $1 to $1.50, the lower end of the line fans inward to the left. In both instances the line remains “anchored” at 8 units on the vertical axis because P

A has

not changed.

Indifference Curves: What Is Preferred Budget lines reflect “objective” market data, specifically income and prices. They reveal combinations of products A and B that can be purchased, given current money in- come and prices. Indifference curves, on the other hand, reflect “subjec- tive” information about consumer preferences for A and B. An indifference curve shows all the combinations of two products A and B that will yield the same total satis- faction or total utility to a consumer. The table and graph in Figure 2 present a hypothetical indifference curve for products A and B. The consumer’s subjective preferences are such that he or she will realize the same total utility from each com- bination of A and B shown in the table or on the curve. So the consumer will be indifferent (will not care) as to which combination is actually obtained. Indifference curves have several important characteristics.

A (measured on the vertical axis) to buy 3 units of B (mea- sured on the horizontal axis). In moving down the budget or price line, 2 units of A (at $1.50 each) must be given up to obtain 3 more units of B (at $1 each). This yields a slope of 23. Note that all combinations of A and B that lie on or in- side the budget line are attainable from the consumer’s $12 of money income. He can afford to buy not only the combi- nations of A and B that lie along the budget line itself but also those that lie below it. He could, for instance, afford to buy 2 units of A and 4 units of B, thereby using up only $7 (5 $3 spent on 2 units of A at a price of $1.50 each 1 $4 spent on 4 units of B at a price of $1 each). That combina- tion is clearly attainable because it would use up only half of the consumer’s $12 budget. But to achieve maximum utility, the consumer will want to spend the full $12. The budget line shows all combinations that cost exactly the full $12. The budget line has two other significant characteristics:

• Income changes The location of the budget line varies with money income. An increase in money income shifts the budget line to the right; a decrease in money income shifts it to the left. To verify this, recalculate the table in Figure 1, assuming that money income is (a) $24 and (b) $6, and plot the new budget lines in Figure 1.

• Price changes A change in product prices also shifts the budget line. A decline in the prices of both products—the equivalent of an increase in real income—shifts the curve to the right. (You can verify this by recalculating the table in Figure 1 and replotting Figure 1 assuming that P

A 5 $0.75 and

P B 5 $0.50.) Conversely, an increase in the prices of A

and B shifts the curve to the left. (Assume P A 5 $3

and P B 5 $2, and rework the table and Figure 1 to

substantiate this statement.)

Combination Units of A Units of B

j 12 2

k 6 4

l 4 6

m 3 8

0

2

4

6

8

10

12

2 4 6 8 10 12

Quantity of B

Q u an

ti ty

o f A

I

m

l

k

j

FIGURE 2 A consumer’s indifference curve. Every point on indifference curve I represents some combination of products A and B, and all those combinations are equally satisfactory to the consumer. That is, each combination of A and B on the curve yields the same total utility.

O7.4

Indifference curves

ORIGIN OF THE IDEA

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CHAPTER SEVEN APPENDIX168

is willing to give up only 2 units of A to get 2 more units of B, so the MRS is only 22, or 1. Having still less of A and more of B at point l, the consumer is willing to give up only 1 unit of A in return for 2 more units of B and the MRS falls to 12 between l and m.1 In general, as the amount of B increases, the marginal utility of additional units of B decreases. Similarly, as the quantity of A decreases, its marginal utility increases. In Figure 2 we see that in moving down the curve, the con- sumer will be willing to give up smaller and smaller amounts of A to offset acquiring each additional unit of B. The result is a curve with a diminishing slope, a curve that is convex to the origin. The MRS declines as one moves southeast along the indifference curve.

The Indifference Map The single indifference curve of Figure 2 reflects some con- stant (but unspecified) level of total utility or satisfaction. It is possible and useful to sketch a whole series of indifference curves or an indifference map, as shown in Figure 3. Each curve reflects a different level of total utility and therefore never crosses another indifference curve. Specifically, each curve to the right of our original curve (labeled I3 in

Indifference Curves Are Downsloping

An indifference curve slopes downward because more of one product means less of the other if total utility is to remain unchanged. Suppose the consumer moves from one combination of A and B to another, say, from j to k in Figure 2. In so doing, the consumer obtains more of prod- uct B, increasing his or her total utility. But because total utility is the same everywhere on the curve, the consumer must give up some of the other product, A, to reduce total utility by a precisely offsetting amount. Thus “more of B” necessitates “less of A,” and the quantities of A and B are inversely related. A curve that reflects inversely related variables is downsloping.

Indifference Curves Are Convex to the Origin

Recall from the appendix to Chapter 1 that the slope of a curve at a particular point is measured by drawing a straight line that is tangent to that point and then measuring the “rise over run” of the straight line. If you drew such straight lines for several points on the curve in Figure 2, you would find that their slopes decline (in absolute terms) as you move down the curve. An indifference curve is therefore convex (bowed inward) to the origin of the graph. Its slope diminishes or becomes flatter as we move down the curve from j to k to l, and so on. Technically, the slope of an indif- ference curve at each point measures the marginal rate of substitution (MRS) of the combi nation of two goods rep- resented by that point. The slope or MRS shows the rate at which the consumer who possesses the combination must substitute one good for the other (say, B for A) to remain equally satisfied. The diminishing slope of the indifference curve means that the willingness to substitute B for A di- minishes as more of B is obtained. The rationale for this convexity—that is, for a diminish- ing MRS—is that a consumer’s subjective willingness to substitute B for A (or A for B) will depend on the amounts of B and A he or she has to begin with. Consider the table and graph in Figure 2 again, beginning at point j. Here, in relative terms, the consumer has a substantial amount of A and very little of B. Within this combination, a unit of B is very valuable (that is, its marginal utility is high), while a unit of A is less valuable (its marginal utility is low). The consumer will then be willing to give up a substantial amount of A to get, say, 2 more units of B. In this case, the consumer is willing to forgo 6 units of A to get 2 more units of B; the MRS is 62, or 3, for the jk segment of the curve. But at point k the consumer has less A and more B. Here A is somewhat more valuable, and B less valuable, “at the margin.” In a move from point k to point l, the consumer

1MRS declines continuously between j and k, k and l, and l and m. Our numerical values for MRS relate to the curve segments between points and are not the actual values of the MRS at each point. For example, the MRS at point l is 23.

0

2

4

6

8

10

12

2 4 6 8 10

I2 I1

I3

I4

12

Quantity of B

Q u an

ti ty

o f A

FIGURE 3 An indifference map. An indifference map is a set of indifference curves. Curves farther from the origin indicate higher levels of total utility. Thus any combination of products A and B represented by a point on I4 has greater total utility than any combination of A and B represented by a point on I3, I2, or I1.

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CHAPTER SEVEN APPENDIX 169

indifference curve, I1. By moving “up” the budget line—by reallocating dollars from B to A—the consumer can get on higher indifference curve I3 and increase total utility. How about point W on indifference curve I4? While it is true that W would yield a greater total utility than X, point W is beyond (outside) the budget line and hence is not at- tainable by the consumer. Point X represents the optimal attainable combination of products A and B. Note that at the equilibrium position, X, the definition of tangency implies that the slope of the highest attainable indifference curve equals the slope of the budget line. Because the slope of the indifference curve reflects the MRS (marginal rate of sub- stitution) and the slope of the budget line is P

B yP

A , the con-

sumer’s optimal or equilibrium position is the point where

MRS 5 P

B

P A

(You may benefit by trying Appendix Discussion Question 3 at this time.)

Equivalency at Equilibrium As indicated at the beginning of this appendix, an impor- tant difference exists between the marginal-utility theory of consumer demand and the indifference curve theory. The marginal-utility theory assumes that utility is numeri- cally measurable, that is, that the consumer can say how much extra utility he or she derives from each extra unit of A or B. The consumer needs that information to deter- mine the utility-maximizing (equilibrium) position, which is defined by

Marginal utility of A Price of A

5 Marginal utility of B

Price of B

The indifference curve approach imposes a less stringent requirement on the consumer. He or she need only specify whether a particular combination of A and B will yield more than, less than, or the same amount of utility as some other combination of A and B will yield. The consumer need only say, for example, that 6 of A and 7 of B will yield more (or less) satisfaction than will 4 of A and 9 of B. Indifference curve theory does not require that the consumer specify how much more (or less) satisfaction will be realized. That being said, it is a remarkable mathematical fact that both models of consumer behavior will, in any given situa- tion, point to exactly the same consumer equilibrium and, consequently, exactly the same demand behavior. This fact allows us to combine the separate pieces of information that each theory gives us about equilibrium in order to deduce an interesting property about marginal utilities that must also hold true in equilibrium. To see this, note that when we

Figure 3) reflects combinations of A and B that yield more utility than I3. Each curve to the left of I3 reflects less total utility than I3. As we move out from the origin, each succes- sive indifference curve represents a higher level of utility. To demonstrate this fact, draw a line in a northeasterly direc- tion from the origin; note that its points of intersection with successive curves entail larger amounts of both A and B and therefore higher levels of total utility.

Equilibrium at Tangency Since the axes in Figures 1 and 3 are identical, we can super- impose a budget line on the consumer’s indifference map, as shown in Figure 4. By definition, the budget line indicates all the combinations of A and B that the consumer can attain with his or her money income, given the prices of A and B. Of these attainable combinations, the consumer will prefer the combination that yields the greatest satisfaction or util- ity. Specifically, the utility-maximizing combination will be the combination lying on the highest attainable indifference curve. It is called the consumer’s equilibrium position. In Figure 4 the consumer’s equilibrium position is at point X, where the budget line is tangent to I3. Why not point Y? Because Y is on a lower indifference curve, I2. By moving “down” the budget line—by shifting dollars from purchases of A to purchases of B—the consumer can attain an indifference curve farther from the origin and thereby increase the total utility derived from the same income. Why not point Z? For the same reason: Point Z is on a lower

12

10

8

6

4

2

20 4 6 8 10 12

Quantity of B

Q u an

ti ty

o f A

X

Z

W Y

I1 I2 I3

I4

FIGURE 4 The consumer’s equilibrium position. The consumer’s equilibrium position is represented by point X, where the black budget line is tangent to indifference curve I3. The consumer buys 4 units of A at $1.50 per unit and 6 of B at $1 per unit with a $12 money income. Points Z and Y represent attainable combinations of A and B but yield less total utility, as is evidenced by the fact that they are on lower indifference curves. Point W would entail more utility than X, but it requires a greater income than the $12 represented by the budget line.

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CHAPTER SEVEN APPENDIX170

The Derivation of the Demand Curve We noted earlier that with a fixed price for A, an increase in the price of B will cause the bottom of the budget line to fan inward to the left. We can use that fact to derive a demand curve for product B. In Figure 5a we reproduce the part of Figure 4 that shows our initial consumer equi- librium at point X. The budget line determining this

compare the equilibrium situations in the two theories, we find that in the indifference curve analysis the MRS equals P

B yP

A at equilibrium; however, in the marginal-utility ap-

proach the ratio of marginal utilities equals P B yP

A . We

therefore deduce that at equilibrium the MRS is equivalent in the marginal-utility approach to the ratio of the marginal utilities of the last purchased units of the two products.2

CONSIDER THIS . . .

Indifference Maps and Topographical Maps

The familiar topographi- cal map may help you un- derstand the idea of indifference curves and indifference maps. Each line on a topographical map represents a particu- lar elevation above sea level, such as 500 feet. Similarly, an indifference curve represents a particu-

lar level of total utility. When you move from one point on a specific elevation line to another, the elevation remains the same. So it is with an indifference curve. A move from one po- sition to another on the curve leaves total utility unchanged. Neither elevation lines nor indifference curves can intersect. If they did, the meaning of each line or curve would be violated. An elevation line is “an equal-elevation line”; an indifference curve is “an equal-total-utility curve.” Like the topographical map, an indifference map contains not just one line but a series of lines. That is, the topographical map may have elevation lines representing successively higher elevations of 100, 200, 300, 400, and 500 feet. Similarly, the in- difference curves on the indifference map represent succes- sively higher levels of total utility. The climber whose goal is to maximize elevation wants to get to the highest attainable ele- vation line; the consumer desiring to maximize total utility wants to get to the highest attainable indifference curve. Finally, both topographical maps and indifference maps show only a few of the many such lines that could be drawn. The topographical map, for example, leaves out the elevation lines for 501 feet, 502, 503, and so on. The indifference map leaves out all the indifference curves that could be drawn be- tween those that are displayed.

2Technical footnote: If we begin with the utility-maximizing rule, MU A

/ P

A 5 MU

B /P

B , and then multiply through by P

B and divide through by

MU A , we obtain P

B /P

A 5 MU

B /MU

A . In indifference curve analysis we

know that at the equilibrium position MRS 5 P B /P

A . Hence, at equilib-

rium, MRS also equals MU B /MU

A .

PB = $1

PB = $1.50

12

10

8

6

4

2

20 4 6 8 10 12

Quantity of B

(a) Two equilibrium positions

2 4 6 8 10 12

Quantity of B

(b) The demand curve for product B

10 3 5 7 9 11

Q u an

ti ty

o f A

P ri

ce o

f B $1.50

1.00

.50

XX9

I3

I2

DB

FIGURE 5 Deriving the demand curve. (a) When the price of product B is increased from $1 to $1.50, the equilibrium position moves from X to X9, decreasing the quantity demanded of product B from 6 to 3 units. (b) The demand curve for product B is determined by plotting the $1–6-unit and the $1.50–3-unit price-quantity combinations for product B.

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CHAPTER SEVEN APPENDIX 171

vertical reference lines from Figure 5a down to the hori- zontal axis of Figure 5b. On the vertical axis of Figure 5b we locate the two chosen prices of B. Knowing that these prices yield the relevant quantities demanded, we locate two points on the demand curve for B. By simple manipu- lation of the price of B in an indifference curve–budget line context, we have obtained a downward-sloping demand curve for B. We have thus again derived the law of demand assuming “other things equal,” since only the price of B was changed (the price of A and the consumer’s money income and tastes remained constant). But, in this case, we have derived the demand curve without resorting to the ques- tionable assumption that consumers can measure utility in units called “utils.” In this indifference curve approach, consumers simply compare combinations of products A and B and determine which combination they prefer, given their incomes and the prices of the two products.

equilibrium position assumes that money income is $12 and that P

A 5 $1.50 and P

B 5 $1. Let’s see what happens

to the equilibrium position when we increase P B to $1.50

and hold both money income and the price of A constant. The result is shown in Figure 5a. The budget line fans to the left, yielding a new equilibrium point X9 where it is tangent to lower indifference curve I2. At X9 the consumer buys 3 units of B and 5 of A, compared with 4 of A and 6 of B at X. Our interest is in B, and we now have sufficient information to locate two points on the demand curve for product B. We know that at equilibrium point X the price of B is $1 and 6 units are purchased; at equilibrium point X9 the price of B is $1.50 and 3 units are purchased. These data are shown graphically in Figure 5b as points on the consumer’s demand curve for B. Note that the hori- zontal axes of Figures 5a and 5b are identical; both mea- sure the quantity demanded of B. We can therefore drop

APPENDIX SUMMARY An indifference map consists of a number of indifference

curves; the farther from the origin, the higher the total utility associated with a curve.

The consumer is in equilibrium (utility is maximized) at the point on the budget line that lies on the highest attainable indif- ference curve. At that point the budget line and indifference curve are tangent.

Changing the price of one product shifts the budget line and determines a new equilibrium point. A downsloping demand curve can be determined by plotting the price- quantity combinations associated with two or more equilib- rium points.

LO7.6 Relate how the indifference curve model of consumer behavior derives demand curves from

budget lines, indifference curves, and utility

maximization.

The indifference curve approach to consumer behavior is based on the consumer’s budget line and indifference curves.

The budget line shows all combinations of two products that the consumer can purchase, given product prices and his or her money income. A change in either product prices or money in- come moves the budget line.

An indifference curve shows all combinations of two products that will yield the same total utility to a consumer. Indifference curves are downsloping and convex to the origin.

APPENDIX TERMS AND CONCEPTS budget line indifference curve

marginal rate of substitution (MRS) indifference map

equilibrium position

A P P E N D I X D I S C U S S I O N Q U E S T I O N S

1. What information is embodied in a budget line? What shifts occur in the budget line when money income (a) increases and (b) decreases? What shifts occur in the budget line

when the price of the product shown on the vertical axis (c) increases and (d ) decreases? LO7.6

The following and additional problems can be found in

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CHAPTER SEVEN APPENDIX172

equilibrium position. Explain why any point where the budget line intersects an indifference curve is not equilib- rium. Explain: “The consumer is in equilibrium where MRS 5 P

B yP

A .” LO7.6

2. What information is contained in an indifference curve? Why are such curves (a) downsloping and (b) convex to the origin? Why does total utility increase as the consumer moves to indifference curves farther from the origin? Why can’t indifference curves intersect? LO7.6

3. Using Figure 4, explain why the point of tangency of the budget line with an indifference curve is the consumer’s

A P P E N D I X R E V I E W Q U E S T I O N S

1. Consider two bundles of coffee and chocolate and how Ted feels about them. The first bundle consists of two cups of coffee and two chocolate bars. The second bundle consists of one cup of coffee and three chocolate bars. If the first bundle gives Ted a total utility of 18 utils while the sec- ond bundle gives Ted a total utility of 19 bundles, could the two bundles be on the same indifference curve? Answer yes or no. LO7.6

2. Bill spends his money on flowers and cookies so as to maxi- mize his total utility. Both flowers and cookies start off cost- ing $2 each. At that price, Bill buys three flowers and two

cookies. When the price of flowers is lowered to $1, Bill buys eight flowers and one cookie. Which of the following statements about Bill’s reaction to the price change is not true? LO7.6

a. Bill’s budget line shifted outward when the price of flowers fell.

b. Bill moved to a higher indifference curve after the price of flowers fell.

c. Bill’s demand curve for flowers shifted to the right. d. Bill’s attainable set was smaller before the price of

flowers fell.

A P P E N D I X P R O B L E M S

1. Assume that the data in the accompanying table give an in- difference curve for Mr. Chen. Graph this curve, putting A on the vertical axis and B on the horizontal axis. Assuming that the prices of A and B are $1.50 and $1, respectively, and that Mr. Chen has $24 to spend, add his budget line to your graph. What combination of A and B will Mr. Chen pur- chase? Does your answer meet the MRS 5 P

B yP

A rule for

equilibrium? LO7.6

Units of A Units of B

16 6

12 8

8 12

4 24

2. Explain graphically how indifference analysis can be used to derive a demand curve. LO7.6

3. ADVANCED ANALYSIS First, graphically illustrate a dou- bling of income without price changes in the indifference curve model. Next, on the same graph, show a situation in which the person whose indifference curves you are drawing buys considerably more of good B than good A after the in- come increase. What can you conclude about the relative coefficients of the income elasticity of demand for goods A and B (Chapter 6)? LO7.6

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173

CHAPTER 8

Behavioral Economics

Learning Objectives

LO8.1 Define behavioral economics and explain how it contrasts with

neoclassical economics.

LO8.2 Discuss the evidence for the brain being modular, computationally

restricted, reliant on heuristics, and

prone to various forms of cognitive

error.

LO8.3 Relate how prospect theory helps to explain many consumer

behaviors, including framing

effects, mental accounting,

anchoring, loss aversion, and the

endowment effect.

LO8.4 Describe how time inconsistency and myopia cause people to make

suboptimal long-run decisions.

LO8.5 Define fairness and give examples of how it affects behavior in the

economy and in the dictator and

ultimatum games.

Scientific theories are judged by the accuracy of

their predictions. As an example, nobody would

take physics seriously if it weren’t possible to use

the equations taught in college physics classes

to predict the best trajectory for putting a satel-

lite into orbit or the best radio frequency to pen-

etrate buildings and provide good indoor cellular

service.

Conventional neoclassical economics makes

many accurate predictions about human choice

behavior, especially when it comes to financial in-

centives and how consumers and businesses re-

spond to changing prices. On the other hand, a

number of neoclassical predictions fail quite dra-

matically. These include predictions about how

people deal with risk and uncertainty; choices that

require willpower or commitment; and decisions

that involve fairness, reciprocity, or trust.

Behavioral economics attempts to make

better predictions about human choice behavior

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highlights is prospect theory, which was such

a large advance on our understanding of how

people deal with risk and uncertainty that its in-

ventor, Daniel Kahneman, received the Nobel

Prize in economics.

by combining insights from economics, psychol-

ogy, and biology. This chapter introduces you

to behavioral economics and the areas in which

it has most dramatically increased our under-

standing of economic behavior. Among the

Systematic Errors and the Origin of Behavioral Economics LO8.1 Define behavioral economics and explain how it contrasts with neoclassical economics. We tend to think of ourselves as being very good at mak- ing decisions. While we may make a few mistakes here and there, we generally proceed through life with confidence, believing firmly that we will react sensibly and make good choices whenever decisions have to be made. In terms of  economic terminology, we feel that our decisions are rational, meaning that they maximize our chances of achiev- ing what we want. Unfortunately, scientists have amassed overwhelming evidence to the contrary. People constantly make decision errors that reduce—rather than enhance—the likelihood of getting what they want. In addition, many errors are systematic errors, meaning that people tend to repeat them over and over, no matter how many times they en- counter a similar situation. Behavioral economics developed as a separate field of study because neoclassical economics could not explain why people make so many systematic errors. The underly- ing problem for neoclassical economics is that it assumes that people are fundamentally rational. Under that world- view, people might make some initial mistakes when en- countering a new situation. But as they gain experience, they should learn and adapt to the situation. As a result, decision errors should be rare—and definitely not system- atic or regularly repeated. When evidence began to pile up in the late 20th cen- tury that even highly experienced people made systematic errors, neoclassical economists assumed that people were just ignorant of what was in their best interests. They as- sumed that a little education would fix everything. But people often persisted in making the same error even after they were informed that they were behaving against their own interests. As a result, several researchers realized that it would be necessary to drop the neoclassical assumption that people are fundamentally rational. With that assumption

relaxed, economists could develop alternative theories that could make more accurate predictions about human behavior—including the tendency people have toward making systematic errors in certain situations. The result of those efforts is what we today refer to as behavioral economics. Its distinguishing feature is that it is based upon people’s actual behavior—which is in many cases substantially irrational, prone to systematic errors, and difficult to modify.

Comparing Behavioral Economics with Neoclassical Economics

While rationality is the most fundamental point of dis- agreement between behavioral economics and neoclassical economics, it is not the only one. Behavioral economics also contends that neoclassical economics makes a number of highly unrealistic assumptions about human capabilities and motivations, including

• People have stable preferences that aren’t affected by context.

• People are eager and accurate calculating machines. • People are good planners who possess plenty of

willpower. • People are almost entirely selfish and self-interested.

Neoclassical economics made these “simplifying assump- tions” for two main reasons. First, they render neoclassical models of human behavior both mathematically elegant and easy enough to solve. Second, they enable neoclassical models to generate very precise predictions about human behavior. Unfortunately, precision is not the same thing as ac- curacy. As noted behavioral economist Richard Thaler has written, “Would you rather be elegant and precisely wrong—or messy and vaguely right?” Behavioral economists err on the side of being messy and vaguely right. As a result, behavioral economics re- places the simplifying assumptions made by neoclassical economics with much more realistic and complex models of human capabilities, motivations, and mental processes.

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• It should provide guidance about how to get people to make better decisions.

Improving Outcomes by Improving Decision- Making Neoclassical economics and behavioral eco- nomics differ on how to improve human welfare. Neoclassical economics focuses its attention on providing people with more options. That’s because a fully rational person can be trusted to select from any set of options the one that will make him best off. As a result, the only way to make him even happier would be to provide an additional option that is even better. By contrast, the existence of irrationality leads behav- ioral economists to conclude that it may be possible to make people better off without providing additional options. In particular, improvements in utility and happiness may be possible simply by getting people to make better selections from the set of options that is already available to them. This focus on improving outcomes by improving deci- sions is one of the distinguishing characteristics of behav- ioral economics. This chapter’s Last Word reviews several instances where substantial benefits arise from helping people to make better choices from among the options that they already have.

Viewing Behavioral Economics and Neoclassical Economics as Complements It would be hasty to view behavioral economics and neoclassical economics as fundamentally opposed or mutually exclusive. Instead, many economists prefer to think of them as complementary approaches that can be used in conjunction to help improve our understanding of human behavior.

Table 8.1 summarizes how the two approaches differ in several areas.

Focusing on the Mental Processes behind Decisions Another major difference between behavioral economics and neoclassical economics is in the amount of weight and importance that they attach to predicting deci- sions on the one hand and in understanding the mental processes used to reach those decisions on the other. While neoclassical economics focuses almost entirely on predicting behavior, behavioral economics puts significant emphasis on the mental processes driving behavior. Neoclassical economics focuses its attention on pre- diction because its assumption that people are rational al- lows it to fully separate what people do from how they do it. In particular, perfectly rational people will always choose the course of action that will maximize the likeli- hood of getting what they want. How they actually come to those optimal decisions might be interesting—but you don’t need to know anything about that process to predict a perfectly rational person’s behavior. He will simply end up doing whatever it is that will best advance his interests. Consequently, neoclassical economists have felt free to ig- nore the underlying mental processes by which people make decisions. Behavioral economists disagree sharply with the neo- classical neglect of mental processes. To them, the fact that people are not perfectly rational implies two important reasons for understanding the underlying mental pro- cesses that determine decisions: • It should allow us to make better predictions about

behavior.

TABLE 8.1 Major Differences between Behavioral Economics and Conventional Neoclassical Economics

Topic Neoclassical Economics Behavioral Economics

Rationality People are fundamentally rational and will People are irrational and make many errors that adjust their choices and behaviors to best reduce their chances of achieving their goals. achieve their goals. Consequently, they will Some errors are regularly repeated systematic not make systematic errors. errors.

Stability of preferences People’s preferences are completely stable and People’s preferences are unstable and often unaffected by context. inconsistent because they depend on context

(framing effects).

Capability for making People are eager and accurate calculators. People are bad at math and avoid difficult mental calculations computations if possible.

Ability to assess future People are just as good at assessing future People place insufficient weight on future options and possibilities options as current options. events and outcomes.

Strength of willpower People have no trouble resisting temptation. People lack sufficient willpower and often fall prey to temptation.

Degree of selfishness People are almost entirely self-interested and People are often selfless and generous. self-centered.

Fairness People do not care about fairness and only treat Many people care deeply about fairness and others well if doing so will get them something will often give to others even when doing so they want. will yield no personal benefits.

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irrational behaviors as the result of a wide variety of un- derlying factors, including cognitive biases, heuristics, and ongoing battles between different areas of the brain. You will learn about these underlying factors in the remainder of this chapter. But for now, take to heart the idea that we typically need both neoclassical and behav- ioral methods to figure out what people are doing. Some behaviors—including the fact that shoppers respond strongly to incentives and prices—can be explained very well by neoclassical models that assume people are per- fectly rational. But other behaviors—including impulse buying—are very much inconsistent with rationality and are therefore better explained by using the methods of behavioral economics.

As an example of their complementary nature, con- sider how using the two approaches in tandem can help us achieve a better understanding of how customers behave at a local supermarket.

Neoclassical Economics at the Supermarket The major neoclassical contribution to our understanding of the cus- tomers’ shopping behavior can be summarized by the phrase “incentives matter.” In particular, the customers will care a great deal about prices. When prices go up, they buy less. When prices go down, they buy more. That insight goes a long way toward explaining how customers behave. But there are other shopping behaviors that neoclassical economics cannot explain with its em- phasis on people reacting rationally to incentives and prices. In those cases, behavioral economics may be able to help us figure out what people are up to.

Behavioral Economics at the Supermarket A good exam- ple of a shopping behavior that neoclassical economics can’t explain very well is that people tend to buy what they happen to see. This behavior is called impulse buying and it contradicts the neoclassical assumption that con- sumers carefully calculate marginal utilities and compare prices before making their purchases. On the other hand, it is a very common behavior that is regularly exploited by retailers. For instance, nearly all supermarkets attempt to take advantage of impulse buying by placing staple products like milk and eggs against the back walls of their stores. Placing those products at the rear increases impulse buying by forcing customers to walk past hundreds of other items on the way to the milk and eggs. A few of those items will catch their eyes and thereby increase sales as customers end up purchasing products that they had no intention of buying when they first entered the store. Marketers also know that impulse purchases are highest for items that are stacked on shelves at eye level. So, believe it or not, food manufacturers actively bid against each other and pay supermarkets for the privi- lege of having their brands stacked at eye level. In cereal aisles, the most expensive shelf space isn’t at eye level for an adult, but a foot or two lower—at the eye level of a toddler sitting in a shopping cart or of a child walking with a parent. Because kids are even more prone to im- pulse buying than adults, cereal makers are more than happy to pay to have their products stacked at kid- friendly eye levels.

Complementar y Explanations at the Supermarket Behavioral economics explains impulse buying and other

CONSIDER THIS . . .

Wannamaker’s Lament

Marketing experts try to increase sales or launch new products by applying what they think they know about consumer behavior. Many people find those efforts spooky and wonder if they are be- ing constantly manipulated into purchasing products that they don’t want. But how much do the marketing experts really know?

Judging by their success rate, not so much. Most advertis- ing campaigns show little effect on sales. Eighty percent of newly launched consumer products fail within just three months. And the vast majority of Hollywood films end up as flops despite studios spending billions of dollars each year on market research and advertising. The difficulties facing marketers were best described in the late 19th century by John Wannamaker, the marketing genius and department store entrepreneur who, among other things, invented the price tag and the money-back guarantee. He famously complained, “Half the money I spend on advertising is wasted—the trouble is, I don’t know which half!” A recent response to Wannamaker’s lament has been to run lots of simple experiments to see if anything at all can increase sales. Amazon.com runs hundreds of experiments per month, systematically showing different groups of cus- tomers different versions of its website in order to see if any of those different versions can increase sales. Las Vegas casi- nos also run experiments, systematically varying the scents injected into their air-conditioning systems to see which ones cause the largest increases in gambling. Vanilla appar- ently works very well and some scents are said to increase revenues by up to 20 percent.

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had to hunt and gather and scavenge to survive, getting enough energy was a constant challenge. In response, the brain evolved many low-energy men- tal shortcuts, or heuristics. Because they are shortcuts, heuristics are not the most accurate mental-processing op- tions. But in a world where calories were hard to come by, a low-energy “good enough” heuristic was superior to a “perfect but costly” alternative. Your brain’s susceptibility to the visual-processing fail- ure demonstrated in Figure 8.1 is the result of your brain using a host of error-prone heuristics to process visual in- formation. But think about what a good trade-off you are getting. In everyday life, the visual-processing failure demonstrated in Figure 8.1 hardly ever comes up. So, it would be a waste of resources to devote more brainpower to fixing the issue. Put in economic terms, there are di- minishing returns to employing additional units of brain- power. Heuristics are used because the opportunity cost of perfection is too high.

Some Common Heuristics The following examples will give you a sense of how the brain employs heuristics for nearly every type of action and decision we make.

Catching a Baseball with the Gaze Heuristic Consider the problem faced by a centerfielder in a baseball game when a ball is hit in his general direction. The mentally expensive way to catch the ball would be for the player to use the laws of physics to determine where the ball is heading so that he could run to that spot before the ball arrives. What baseball players actually do is lock their eyes on the ball and then adjust their position on the field as nec- essary to keep the ball in front of them and at the same angle as when they first locked their eyes on it. Just as long as they can run fast enough, this gaze heuristic always gets them to the correct place to make the catch. You don’t need to learn physics to catch a baseball!

Riding a Bicycle with the Steering Heuristic There is a sim- ple heuristic for staying upright as you ride a bicycle: if you begin to fall, steer in the direction you are falling. This steering heuristic works because turning in the direc- tion of a fall generates a centrifugal force that can be used to hold you up long enough for you to steady the bike. This heuristic is almost never articulated, but it is pre- cisely what little kids subconsciously learn to do when they are using training wheels.

Guesstimating Ranks with the Recognition Heuristic Which German city has the larger population, Munich or Stuttgart?

Our Efficient, Error-Prone Brains LO8.2 Discuss the evidence for the brain being modular, computationally restricted, reliant on heuristics, and prone to various forms of cognitive error. The human brain is the most complex object in the uni- verse. One hundred billion neurons share 10,000 times as many connections. Working together, they allow you to observe your environment, think creatively, and interact with people and objects. The brain, however, is rather error-prone. Its many weaknesses are most dramatically illustrated by visual illu- sions, such as the one shown in Figure 8.1. If you follow the instructions printed in that figure, you will quickly dis- cover that your brain can’t consistently tell what color an object is. This inability to properly process visual information is especially informative about the brain’s limitations because the brain devotes more neurons toward processing and in- terpreting visual information than it does anything else. So, if the brain makes errors with visual processing, we should expect to find errors in everything else it does, too.

Heuristics Are Energy Savers

The brain’s information-processing limitations are the re- sult of evolutionary pressures. In particular, it was nor- mally very difficult for our ancestors to get enough food to eat. That matters because our brains are extremely energy intensive. In fact, while your brain accounts for just five percent of your body weight, it burns 20 percent of all the energy you consume each day. So back when our ancestors

Are the two boxes really colored differently?

Lay a finger horizontally across the middle of the page to see for yourself.

FIGURE 8.1 A visual illusion. The human brain uses a large number of heuristics (shortcuts) to process both visual and other types of information. Many of them utilize context to interpret specific bits of information. When that context changes (as it does here when you put your finger horizontally across the middle of the image), so does the brain’s heuristic-filtered interpretation.

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Because your brain applies the shadow heuristic no matter what, you are tricked into believing that the shaded circles in Figure 8.2 are three-dimensional and either humps or holes depending upon whether they are shaded on the top or on the bottom.

The Implications of Hardwired Heuristics As you study the rest of the chapter, keep in mind that most heu- ristics appear to be hardwired into the brain, and, conse- quently, impossible to unlearn or avoid. That possibility has three important implications:

1. It may be very difficult for people to alter detrimental behaviors or routines even after you point out what they’re doing wrong.

2. People may be easy prey for those who understand their hardwired tendencies.

3. If you want people to make a positive behavioral change, it might be helpful to see if you can put them in a situation where a heuristic will kick in and sub- consciously lead them toward the desired outcome.

Brain Modularity

The modern human brain is modular, so that specific areas deal with specific sensations, activities, and emotions— such as vision, breathing, and anger. This modular structure is the result of millions of years of evolution, with the modern human brain evolving in stages from the much less complex brains of our hominid ancestors. The oldest parts of the brain are located in the back of the head, where the spine enters the skull. The newest parts are up front, near the forehead. The older parts control subconscious activities like breathing and sweating as well as automatic emotional re- actions such as fear and joy. The newer parts allow you to think creatively, imagine the future, and keep track of ev- eryone in your social network. They are largely under conscious control.

System 1 and System 2 It is useful to think of the brain’s decision-making systems as falling into two catego- ries, which are informally referred to as System 1 and System 2. System 1 uses a lot of heuristics in the older parts of your brain to produce quick, unconscious reac- tions. If you ever get a “gut instinct,” System 1 is respon- sible. By contrast, System 2 uses the newer parts of your brain to undertake slow, deliberate, and conscious calcula- tions of costs and benefits. If you ever find yourself “think- ing things over,” you are using System 2. Conflicts may sometimes arise between our uncon- scious System 1 intuitions and our conscious System 2

Even people who know nothing about Germany tend to get the right answer to this question. They correctly guess “Munich” by employing the recognition heuristic, which says to assume that if one option is more easily recognized, it is probably more important or more highly ranked. The recognition heuristic isn’t foolproof, but it tends to work because relatively important people and places are much more likely to be mentioned in the media. Thus, whichever option is easier to recognize will probably be larger or more important. Much of advertising is based on exploiting the recog- nition heuristic. Indeed, companies spend billions to en- sure that consumers are familiar with their products because when it comes time to buy, consumers will be bi- ased toward the products that seem the most familiar.

Interpreting Depth with the Shadow Heuristic The world is three-dimensional, but the light-sensing surfaces at the back of our eyes are two-dimensional. As a result, our brains are forced to use a cluster of heuristics to estimate depth when interpreting the two-dimensional images reg- istered by our eyes. Figure 8.2 shows how the shadow heuristic causes you to interpret shaded, two-dimensional circles as either humps or holes depending upon whether each circle is shaded on the top or on the bottom. Look at Figure 8.2 and count how many of the six shaded circles look like humps rather than holes. Now turn the picture upside down and count again. If your vision is typical, you will find that all the humps have become holes, and vice versa. Here’s what’s happening. The shadow heuristic evolved back when sunlight was the only important source of light. As a result, it presumes that light always falls from above. Under that assumption, anything that sticks out from a surface will cast a shadow below it while anything in- dented will have a shadow on top due to the top of the recessed area casting a shadow on whatever lies below.

FIGURE 8.2 The shadow heuristic. The brain processes light with a heuristic that assumes that light always comes from above. Under that assumption, anything that sticks out will have a shadow on the bottom while anything that is recessed will have a shadow on top. As a result, your brain interprets five of the six shaded circles as humps that stick out while the bottom middle circle is interpreted as a recess. See what happens when you turn the picture upside down. Surprised?

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Self-Serving Bias The term self-serving bias refers to peo- ple’s tendency to attribute their successes to personal ef- fort or personal character traits while at the same time attributing any failures to factors that were out of their control. While helping to preserve people’s self-esteem, this bias makes it difficult for people to learn from their mistakes because they incorrectly assume that anything that went wrong was beyond their control.

Overconfidence Effect The overconfidence effect refers to peo- ple’s tendency to be overly confident about how likely their judgments and opinions are to be correct. As an example, people who rated their answers to a particular quiz as being “99 percent likely to be right” were in fact wrong more than 40 percent of the time. Such overconfidence can lead to bad decisions because people will tend to take actions without pausing to verify if their initial hunches are actually true.

Hindsight Bias People engage in hindsight bias when they retroactively believe that they were able to predict past events. As an example, consider an election between candi- dates named Terence and Philip. Before the election hap- pens, many people will predict that Terence will lose. But after Terence ends up winning, many of those same people will convince themselves that they “knew all along” that Terence was going to win. This faulty “I-knew-it-all- along” perspective causes people to massively overestimate their predictive abilities.

Availability Heuristic The availability heuristic causes people to base their estimates about the likelihood of an event not on objective facts but on whether or not similar events come to mind quickly and are readily available in their memories. Because vivid, emotionally charged images come to mind more easily, people tend to think that events like homicides, shark attacks, and lightning strikes are much more common than they actually are. At the same time, they underestimate the likelihood of unmemorable events. As an example, you are five times more likely to die of stomach cancer than be murdered, but most people rate the likelihood of being murdered as much higher. They do this because they have many vivid memories of both real and fictional murders but almost no recollections whatso- ever of anyone dying of stomach cancer. The availability heuristic causes people to spend too much of their time and effort attempting to protect them- selves against charismatic dangers of low actual probabil- ity while neglecting to protect themselves against dull threats of substantially higher probability.

Planning Fallacy The planning fallacy is the tendency peo- ple have to massively underestimate the time needed to

deliberations. For example, System 1 may urge you to eat an entire pile of cookies as fast as possible, while System 2 admonishes you to stick to your diet and have only one. That being said, a large body of evidence suggests that most decisions are probably either fully or mostly the re- sult of System 1 intuitions and heuristics. That matters because those unconscious mental processes suffer from a variety of cognitive biases.

Cognitive Biases Cognitive biases are the mispercep- tions or misunderstandings that cause systematic errors. There are a wide variety of cognitive biases, but they can be placed into two general categories. The first are mental-processing errors that result from faulty heuristics. As previously discussed, faulty heuristics are the result of evolution trading off accuracy for speed and efficiency. The second category of cognitive biases consists of mental-processing errors that result from our brains not having any evolved capacities for dealing with modern problems and challenges, such as solving calculus prob- lems or programming computers. Because our ancestors never encountered things like math, engineering, or statis- tics, our brains have a total absence of System 1 heuristics for dealing with those sorts of problems. In addition, our slower and more deliberative System 2 mental processes are also of only limited assistance because they were evolved to deal with other types of problems, such as keep- ing track of everyone in a social network or attempting to think through whether it would be better to go hunting in the morning or in the evening. As a result, most people find recently developed men- tal challenges like math and physics to be very tiresome. In addition, cognitive biases often result because the System 2 processes that we are recruiting to solve modern problems were in fact designed for other purposes and don’t work particularly well when directed at modern problems. Psychologists have identified scores of cognitive bi- ases.  Here are a few that are relevant to economics and decision-making.

Confirmation Bias The term confirmation bias refers to the human tendency to pay attention only to information that agrees with one’s preconceptions. Information that con- tradicts those preconceptions is either ignored completely or rationalized away. Confirmation bias is problematic be- cause it allows bad decisions to continue long after an im- partial weighing of the evidence would have put a stop to them. When you see someone persisting with a failed pol- icy or incorrect opinion despite overwhelming evidence that he or she should try something else, confirmation bias is probably at work.

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and meat sells faster if it is packaged in shiny plastic con- tainers. At a high-end retailer, expensive packaging in- creases the perceived value of the shop’s merchandise. So does having a nice physical space in which to shop. Thus, high-end retailers spend a lot on architecture and displays.

complete a task. A good example is when last-minute test cramming gets really frantic. The student doing the cram- ming probably underestimated by many hours how much time he needed to prepare for the exam. The planning fal- lacy also helps to explain why construction projects, busi- ness initiatives, and government reform efforts all tend to come in substantially behind schedule.

Framing Effects Framing effects occur when a change in context (frame) causes people to react differently to a par- ticular piece of information or to an otherwise identical situation. Figure 8.3 gives an example of a framing effect. The middle symbol is identical in both rows, but it is inter- preted differently depending upon whether it is sur- rounded by letters or numbers. When surrounded by letters in the top row, the brain tends to interpret the sym- bol as the letter B. When surrounded by numbers in the bottom row, the brain tends to interpret the symbol as the number 13. Changes in context can also cause extraordinary changes in behavior. Experiments have shown that ordi- nary people are twice as likely to litter, steal, or trespass if experimenters tag an area with graffiti and scatter lots of trash around. By changing the area’s appearance from neat and orderly to rundown and chaotic, experimenters got ordinary people to subconsciously choose to engage in more crime. Framing effects can also cause consumers to change their purchases. At the local supermarket, apples com- mand a higher price if each one comes with a pretty sticker

FIGURE 8.3 The letter illusion is the result of a framing effect. In each row, the middle symbol is the same. When that symbol is surrounded by the letters A and C in the top row, our brains tend to register the symbol as the letter B. But when it is surrounded by the numbers 12 and 14 in the bottom row, our brains tend to register it as the number 13. What our brain “sees” is largely a matter of context (frame).

• Behavioral economics differs from neoclassical eco- nomics because its models of decision-making take into account the fact that heuristics and cognitive bi- ases cause people to make systematic errors.

• To conserve energy, the brain relies on low-energy mental shortcuts, or heuristics, that will usually pro- duce the correct decision or answer.

• Cognitive biases are systematic misperceptions or bad decisions that arise because (1) heuristics are error- prone in certain situations or (2) evolution did not pre- pare our brains to handle many modern tasks such as solving calculus problems.

QUICK REVIEW 8.1

Prospect Theory LO8.3 Relate how prospect theory helps to explain many consumer behaviors, including framing effects, mental accounting, anchoring, loss aversion, and the endowment effect. Neoclassical economics focuses much of its attention on consumer-choice situations in which people only have to deal with “goods” as opposed to “bads.” When deciding on how to spend a budget, a consumer only considers items that would bring her positive marginal utility—that is, “good” things. She then uses the utility-maximizing rule to select how much of each of those good things she should consume to get as much utility as possible from her limited budget. Unfortunately, life often forces us to deal with bad things, too. Our houses may burn down. A potential in- vestment may go bad. The money we lend out may not be repaid. How people cope with negative possibilities is a cen- tral focus of behavioral economics. Many thousands of observations have been cataloged as to how people actu- ally deal with the prospect of bad things as well as good things. Three very interesting facts summarize how people deal with goods and bads:

• People judge good things and bad things in relative terms, as gains and losses relative to their current situation, or status quo.

• People experience both diminishing marginal utility for gains (meaning that each successive unit of gain

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These three facts about how people deal with goods and bads form the basis of prospect theory, which sheds important light on how consumers plan for and deal with life’s ups and downs as well as why they often appear narrow-minded and fail to “see the big picture.” To give you an idea of how powerful prospect theory is—and why its pioneer, Daniel Kahneman, was awarded the Nobel Prize in Economics—let’s go through some examples of con- sumer behavior that would be hard to explain without the insights provided by prospect theory.

Losses and Shrinking Packages

Because people see the world in terms of gains and losses relative to the status quo situations that they are used to, businesses have to be very careful about increasing the prices they charge for their products. This is because once consumers become used to a given price, they will view any increase in the price as a loss relative to the status quo price they had been accustomed to. The fact that consumers may view a price increase as a loss explains the otherwise curious fact that many food producers react to rising input costs by shrinking the sizes of their products. The company most famous for doing this is Hershey’s chocolates. During its first decades of operation about 100 years ago, it would always charge ex- actly 5 cents for one of its Hershey’s chocolate bars. But the size of the bars would increase or decrease depending on the cost of the company’s inputs. When the cost of raw materials rose, the company would keep the price fixed at 5 cents but decrease the size of the bar. When the cost of raw materials fell, it would again keep the price fixed at 5 cents but increase the size of the bar. This seems rather bizarre when you consider that consumers were not in any way actually being shielded from the changes in input prices. That is because what should rationally matter to consumers is the price per ounce that they are paying for Hershey’s Bars. And that does go up and down when the price remains fixed but the size of the bars changes. But people aren’t being fully rational here. They men- tally fixate on the product’s price because that is the char- acteristic that they are used to focusing on when making their purchasing decisions. And because the 5-cent price had become the status quo that they were used to, Hershey’s understood that any price increase would be mentally categorized as a loss. Thus, Hershey’s wisely

feels good, but not as good as the previous unit) as well as diminishing marginal disutility for losses (meaning that each successive unit of loss hurts, but less painfully than the previous unit).

• People experience loss aversion, meaning that for losses and gains near the status quo, losses are felt much more intensely than gains—in fact, about 2.5 times more intensely. Thus, for instance, the pain experienced by an investor who loses one dollar from his status quo level of wealth will be about 2.5 times more intense than the pleasure he would have felt if he had gained one dollar relative to his status quo level of wealth.

CONSIDER THIS . . .

Rising Consumption and the Hedonic Treadmill

For many sensations, people’s brains are wired to notice changes rather than states. For example, your brain can sense acceleration—your change in speed—but not

speed itself. As a result, standing still feels the same as mov- ing at a constant 50 miles per hour. And if you accelerate from one constant speed to another—say, from 50 miles per hour to 70 miles per hour—you will feel the acceleration only while it’s happening. Once you settle down at the new higher speed, it will feel like you are standing still again. Consumption appears to work in much the same way. If you are used to a given level of consumption—say, $50,000 per year—then you will get a lot of enjoyment for a while if your consumption accelerates to $100,000 per year. But, as time passes, you will get used to that higher level of con- sumption, so that $100,000 per year seems ordinary and doesn’t bring you any more pleasure than $50,000 per year used to bring you when it was your status quo. Economist Richard Easterlin coined the term hedonic treadmill (pleasure treadmill) to describe this phenomenon. Just as a person walking on a real treadmill gets nowhere, people trying to make themselves permanently happier by consuming more also get nowhere because they end up get- ting used to any higher level of consumption. Indeed, except for the extremely poor, people across the income spectrum report similar levels of happiness and satisfaction with their lives. This has led several economists, including Robert Frank, to argue that we should all stop trying to consume more be- cause doing so doesn’t make us any happier in the long run. What do you think? Should we all step off of the hedonic treadmill?

O8.1

Prospect theory

ORIGIN OF THE IDEA

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who take it live or if you were told that 0.1 percent of the people who take it die? Continuing to live is a gain, whereas dying is clearly a loss. Which frame sounds better to you? Framing effects have major consequences for con- sumer behavior because any frame that alters whether consumers consider a situation to be a gain or a loss will affect their consumption decisions!

Anchoring and Credit Card Bills

Before people can calculate their gains and losses, they must first define the status quo from which to measure those changes. But it turns out that irrelevant information can unconsciously influence people’s feelings about the status quo. Here’s a striking example. Find a group of peo- ple and ask each person to write down the last two digits of his or her Social Security number. Then ask each per- son to write down his or her best estimate of the value of some object that you display to them—say, a nice wireless keyboard. What you will find is that the people whose Social Security numbers end in higher numbers—say, 67 or 89—will give higher estimates for the value of the key- board than people whose Social Security numbers end in smaller numbers like 18 or 37. The effect can be huge. Among students in one MBA class at MIT, those with Social Security numbers ending between 80 and 99 gave an average estimate of $56 for a wireless keyboard, while their classmates whose Social Security numbers ended be- tween 00 and 20 gave an average estimate of just $16. Psychologists and behavioral economists refer to this phenomenon as anchoring because people’s estimates about the value of the keyboard are influenced, or “an- chored,” by the recently considered information about the last two digits of their Social Security numbers. Why ir- relevant information can anchor subsequent valuations is not fully understood. But the anchoring effect is real and can lead people to unconsciously alter how they evaluate different options. Unfortunately, credit card companies have figured this out. They use anchoring to increase their profits by show- ing very small minimum-payment amounts on borrowers’ monthly credit card statements. The companies could re- quire larger minimum payments, but the minimum-payment numbers that they present are only typically about 2 per- cent of what a customer owes. Why such a small amount? Because it acts as an anchor that causes people to uncon- sciously make smaller payments each month. This can make a huge difference in how long it takes to pay off their bill and how much in total interest they will end up paying. For a customer who owes $1,000 on a credit card that charges the typical interest rate of 19 percent per year, it will

chose to keep the price of its product fixed at 5 cents even when input prices were rising. Other companies employ the same strategy today. In the years following the 2007–2008 recession, the prices of many raw materials, including sugar, soybeans, and corn, rose substantially. Many major manufacturers reacted by reducing product sizes while keeping prices fixed. Häagen- Dazs reduced the size of its supermarket ice cream tubs from 16 to 14 ounces. Kraft reduced the number of slices of cheese in a package of Kraft Singles from 24 to 22 slices. A bottle of Tropicana orange juice shrank from 64 ounces (the traditional half-gallon size) to just 59 ounces. And Procter and Gamble reduced the size of Bounty paper towel rolls from 60 to 52 sheets.

Framing Effects and Advertising

Because people evaluate situations in terms of gains and losses, their decision-making can be very sensitive to the mental frame that they use to evaluate whether a possible outcome should be viewed as a gain or a loss. Here are a couple of examples in which differences in the context or “frame” change the perception of whether a situation should be treated as a gain or loss. See how you react to them.

• Would you be happy with a salary of $100,000 per year? You might say yes. But what if your salary last year had been $140,000? Are you still going to say yes? Now that you know you are taking a $40,000 pay cut, does that $100,000 salary seem as good as it did before?

• Similarly, suppose you have a part-time job. One day, your boss Joe walks in and says that he is going to give you a 10 percent raise. Would that please you? Now, what if he also mentioned that everyone else at your firm would be getting a 15 percent raise. Are you still going to be just as pleased? Or does your raise now seem like a loss compared to what everyone else will be getting?

Prospect theory takes into account the fact that people’s preferences can change drastically depending on whether contextual information causes them to define a situation as a gain or a loss. These framing effects are important to rec- ognize because they can be manipulated by advertisers, lawyers, and politicians to try to alter people’s decisions. For instance, would an advertising company be better off marketing a particular brand of hamburger as “20% fat” or as “80% lean”? Both phrases describe the same meat, but one frames the situation as a loss (20 percent fat) while the other frames it as a gain (80 percent lean). And would you be more willing to take a particular medicine if you were told that 99.9 percent of the people

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CHAPTER 8 Behavioral Economics 183

they do not own but might purchase. For instance, if we show a person a new coffee mug and ask him what the maximum amount is that he would pay to buy it, he might say $10. But if we then give the mug to him so that he now owns it, and we then ask how much we would have to pay him to buy it back, he will very likely report a much higher value—say, $15. The interesting thing is that he is not just bluffing or driving a hard bargain. Rather, the human brain appears wired to put a higher value on things we own than on things we don’t. Economist John List has shown that this tendency can moderate if people are used to buying things for resale—that is, buying them with the intention of get- ting rid of them. But without such experience, the endow- ment effect can be quite strong. If it is, it can make market transactions between buyers and sellers harder because sellers will be demanding higher prices for the items they are selling (“Hey, my mug is worth $15 to me!”) than the values put on those items by potential buyers (“Dude, your mug is only worth $10 to me”). Several researchers have suggested that loss aversion may be responsible for the endowment effect and the higher values demanded by sellers. They argue that once a person possesses something, the thought of parting with it seems like a potential loss. As a result, the person will de- mand a lot of money as compensation if he or she is asked to sell the item. On the other hand, potential purchasers do not feel any potential sense of loss, so they end up as- signing lower values to the same items.

Status Quo Bias

Prospect theory also explains status quo bias, which is the tendency that people have to favor any option that is pre- sented to them as being the default (status quo) option. As an example, consider Global Perspective 8.1. It shows, for a selection of European countries, the percentages of their respective populations that have indicated their willing- ness to participate in organ-donation programs. As you can see, seven of the 11 countries have very high participation rates while the other four have low participation rates. You might suspect that cultural differ- ences are at play, but that doesn’t make sense when you note that countries like Germany and Austria that are cul- turally very similar still have massively different participa- tion rates. What is actually going on is a difference in the default option that people are presented with when they are asked whether they wish to participate. In the seven countries with high participation rates, the default option is partici- pation, so that those who don’t want to participate must

take 22 years and $3,398.12 in total payments (including accumulated interest) to pay off the debt if he only makes 2 percent monthly payments. By showing such small minimum-payment amounts, credit card companies anchor many customers into the expensive habit of paying off their debts slowly rather than quickly.

Mental Accounting and Overpriced Warranties

The utility-maximizing rule (Chapter 7) assumes that peo- ple will look at all of their potential consumption options simultaneously when trying to maximize the total utility that they can get from spending their limited incomes. But economist Richard Thaler famously noted that people sometimes look at consumption options in isolation, thereby irrationally failing to look at all their options si- multaneously. Thaler coined the term mental accounting to describe this behavior because it was as if people arbi- trarily put certain options into totally separate “mental ac- counts” that they dealt with without any thought to options outside of those accounts. As an example of where this suboptimal tendency leads, consider the extended warranties offered by big electronic stores whenever customers purchase expensive products like plasma TVs. These warranties are very much overpriced given that the products they insure hardly ever break down. Personal financial experts universally tell people not to buy them. Yet many people do buy them because they engage in mental accounting. They do this by mentally labeling their purchase of the TV as an isolated, individual transaction, sticking it into a separate mental account in their brain that might have a title like “Purchase of New TV.” Viewing the purchase in isolation exaggerates the size of the potential loss that would come from a broken TV. Customers who view the transaction in isolation see the possibility of a $1,000 loss on their $1,000 purchase as a potential total loss— “Holy cow! I could lose $1,000 on a $1,000 TV!” By contrast, people who can see the big picture are able to compare the potential $1,000 loss with the much larger value of their entire future income stream. That allows them to realize that the potential loss is relatively minor—and thus not a good enough reason to purchase an expensive warranty.

The Endowment Effect and Market Transactions

Prospect theory also offers an explanation for the endow- ment effect, which is the tendency that people have to put a higher valuation on anything that they currently possess (are endowed with) than on identical items that

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PART THREE Consumer Behavior184

As a result, the way the options are framed becomes very important because if any of them is presented as the default option, people will tend to treat it as an endowment that they wish to hold on to. At the same time, they will treat any other option as a prospect that could potentially cause a loss. Loss aversion then kicks in and causes most people to stick with the default option in order to avoid the possi- bility of incurring a loss. The result is a bias toward the status quo. Status quo bias can be used to explain several con- sumer behaviors. Consider brand loyalty. If you have got- ten used to eating Heinz ketchup, then status quo bias will make you reluctant to purchase any other brand of ketchup. Overcoming that feeling of potential loss is a dif- ficult challenge for competing brands, as attested to by the fact that rivals seeking to challenge an established brand are often forced to resort to deep discounts or free sam- ples to get consumers to even try their products.

Myopia and Time Inconsistency LO8.4 Describe how time inconsistency and myopia cause people to make suboptimal long-run decisions. Our ancient ancestors had little cause to spend much time worrying about anything that would happen in the distant future. Infectious diseases, predatory animals, and the con- stant threat of starvation made life extremely precarious. Consequently, they had to be almost entirely focused on the present moment and how to get through the next few weeks or the next few months. Today, however, people living in industrialized coun- tries only rarely die from infectious diseases, mostly see predatory animals in zoos, and are under no threat at all of starvation. Living past 80 is now routine and most of us will die of old age. As a result, long-run challenges like planning for retirement and saving for college are now common tasks that nearly everyone faces. Unfortunately, our brains were designed for our an- cestors’ more immediate concerns. Thus, we often have difficulty with long-run planning and decisions that in- volve trade-offs between the present and the future. Two of the major stumbling blocks are myopia and time inconsistency.

Myopia

In biology, myopia, or nearsightedness, refers to a defect of the eye that makes distant objects appear fuzzy, out of focus, and hard to see. By analogy, economists use the word myopia to describe the fact that our brains have a hard time conceptualizing the future. Compared with

explicitly check off a box indicating that they don’t want to participate. By contrast, in the four countries with low participation rates, the default option is not participating, so that those wishing to participate must explicitly check off a box indicating that they want to participate. What we see in all countries is that nearly everyone chooses to do nothing. They almost never check off the box that would indicate doing the opposite of the default option. Consequently, they end up agreeing to whatever the default option happens to be. Thus, the huge differ- ences in participation rates among the 11 countries are driven almost entirely by what the default option hap- pens to be. Prospect theory explains this and other examples of sta- tus quo bias as a combination of the endowment effect and loss aversion. When people are put into a novel situation, they have no preexisting preferences for any of the options.

GLOBAL PERSPECTIVE 8.1

Percent of Population Consenting to Be Organ Donors

People tend to stick with whatever option is presented as the default option. Thus, the seven countries with high percent- ages consenting to be organ donors have organ-donation programs in which the default option is participation. By con- trast, the four countries with low percentages consenting to be organ donors have organ-donation programs where the default option is not participating.

Source: Eric Johnson and Daniel Goldstein, “Defaults and Donation Decisions,” Transplantation 78, no. 12, December 27, 2004. Used by per- mission of Wolters Kluwer Health via Copyright Clearance Center.

Sweden

Hungary

France

Netherlands

Denmark

Austria

Belgium

United Kingdom

Germany

Portugal

Poland

20 40 60 80 1000

Percent of Population Consenting to Be Organ Donors

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CHAPTER 8 Behavioral Economics 185

before is the essence of time inconsistency. Your future self ends up disagreeing with your current self.

Self-Control Problems Time inconsistency is im- portant because it is a major cause of self-control prob- lems. To see why, imagine that before heading out to a restaurant with friends, you think that you will be happy sticking to your diet and only ordering a salad. After all, that particular restaurant has very tasty salads. But then, after you get there, you find the dessert menu over- whelmingly attractive and end up ordering two servings of cheesecake. Because you were time inconsistent and didn’t under- stand what your future self would want, you placed your- self into a situation in which it was very difficult for you to stick to your diet. If you had, instead, been able to cor- rectly predict what your future self would want, you might have decided to stay home for the evening rather than putting yourself in temptation’s way. Alternatively, you could have gone, but not before making your friends promise to prevent you from ordering dessert. Time inconsistency also makes it hard for many work- ers to save money. Before their paychecks arrive, they mis- takenly assume that their future selves will want to save money as much as their current selves do. But once the money becomes available, their future selves end up want- ing to spend everything and save nothing.

Fighting Self-Control Problems with Pre - commitments The key to fighting time inconsistency and self-control problems is to have a good understanding of what your future self is likely to want. You can then make precommitments and take actions ahead of time to prevent your future self from doing much damage.

Hiding the Alarm Clock Consider again the problem of wanting to wake up 90 minutes early on Wednesday morning so that you can work out before starting the rest of your day. If you understand that your future self is not going to want to cooperate, you can take steps to prevent that future self from flaking out. Some people set multiple alarms. Others put their alarms on the other side of the room, underneath a pile of stuff that will have to be moved if the future self wants to turn the damned thing off. But the point is that each of these methods ensures that it will be nearly impossible for the future self to easily get back to sleep. They set things up so that the future self will be forced to do what the present self desires.

Automatic Payroll Deductions Precommitment strategies have also been used to help future selves save more. Consider automatic payroll deductions. If a worker named

the present, the future seems fuzzy, out of focus, and hard to see. As an example, our brains are very good at weighing current benefits against current costs in order to make immediate decisions. But our brains almost seem “future blind” when it comes to conceptualizing either future costs or future benefits. As a result, we have difficulty eval- uating possibilities that will occur more than a few weeks or months into the future. The primary consequence of myopia is that when people are forced to choose between something that will generate benefits quickly and something that won’t yield benefits for a long time, they will have a very strong ten- dency to favor the more immediate option. As an exam- ple, imagine that Terence has $1,000 that he can either spend on a vacation next month or save for his retirement in 30 years. Myopia will cause him to have great difficulty imagin- ing the additional spending power that he will be able to enjoy in 30 years if he saves the money. On the other hand, it is very easy for him to imagine all the fun he could have next month if he were to go on vacation. As a result, he will be strongly biased toward spending the money next month. With myopia obscuring the benefits of the long-term option, the short-term option will seem much more attractive. Myopia also makes it hard to stick with a diet or follow an exercise plan. Compared with the immediate and clearly visible pleasures of eating doughnuts or hanging out, the future benefits from eating better or exercising consistently are just too hazy in most people’s minds to be very attractive.

Time Inconsistency

Time inconsistency is the tendency to systematically misjudge at the present time what you will want to do at some future time. This misperception causes a disconnect between what you currently think you will want to do at some particular point in the future and what you actually end up wanting to do when that moment arrives. It is as though your present self does not understand what your future self will want. Waking up early is a good example. At 8 p.m. on a Tuesday, you may really like the idea of waking up early the next morning so that you can exercise before starting the rest of your day. So you set your alarm 90 minutes earlier than you normally do. But when your alarm goes off the next morning at that earlier time, you loath the concept, throw the alarm across the room, and go back to sleep. That switch in your preferences from the night

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PART THREE Consumer Behavior186

Blaire signs up for such a program, a fixed percentage will be automatically deducted from each of her paychecks and deposited directly into her retirement savings account. Because that money never gets to her checking account, there is no way for Blaire’s future self to fall prey to temp- tation and spend it. As the old saying goes, “Out of sight, out of mind.”

Salary Smoothing School teachers and college professors often have the choice of having their annual salaries paid out over 9 larger monthly installments (to match the length of the school year) or 12 smaller monthly install- ments (to match the length of the calendar year). If we observe which option they actually choose, we find that the vast majority opt to have their salaries spread out over 12 months rather than 9 months. They do so because they fear self-control problems. In particular, they are afraid that if they opt to be paid over 9 months, they won’t have the self control to save enough money during the 9-month period when they will be getting paid to last them through the three months of summer vacation when they won’t be getting paid. To avoid that situation, they opt to have their sala- ries spread out evenly over the entire calendar year. That precommitment ensures that their future selves are never given the chance to blow through all the money too quickly.

Early Withdrawal Penalties Sometimes, one cognitive bias can be used to offset another. Retirement accounts that have early-withdrawal penalties are a good example. They use loss aversion to offset time inconsistency and self- control problems. In some cases, the penalties on these sorts of accounts are as high as 25 percent, meaning that if a saver wanted to withdraw $1,000 before reaching retirement, he would have to give up an additional $250 (5 25 percent of $1,000) as a penalty. While that amount is substantial in itself, loss aversion makes it even more painful to contemplate. As a result, most people can’t bring themselves to make an early withdrawal.

Weight-Loss Competitions Loss aversion also drives the effectiveness of weight-loss competitions. For a person who has agreed to participate, the prospect of losing the competition can be a great motivator because loss aversion applies just as much to future selves as to present selves. Even after the future rolls around and the future self is in charge, the future self won’t like the prospect of losing ei- ther. Thus, the present self can be confident that the fu- ture self will also be motivated to stick to the weight-loss goals that the present self wants to achieve.

CONSIDER THIS . . .

Betting Against Yourself

The website StickK.com makes it easy for people to set up financial incentives that can help them reach their goals. Strangely enough, it does that by getting people to bet against themselves.

Founded by behavioral econo- mist Dean Karlan and fellow Yale University professor Alan Iyers, StickK.com lets each user specify a goal, such as losing 30 pounds in the next year. The user then sets

up a “commitment contract” that specifies an amount of money that he or she will have to pay via credit card as a pen- alty for not reaching his or her goal. That potential penalty gets loss aversion to kick in, thereby helping the user follow through and achieve his or her goal. As a fun twist, StickK.com also requires each user to spec- ify a recipient for the penalty money. Some users specify that their penalty money go to a charity that they like. But many choose to increase their motivation by designating an “anti- charity” as the recipient. What is an anti-charity? It’s a person or group that the user hates. By letting people designate anti-charities, StickK.com uses deeply seated personal animosities in addition to loss aversion to help people overcome time inconsistency and self-control issues. Those incentives appear to work quite well, as 70 per- cent of StikK.com users report success in reaching their goals.

• Prospect theory models decision-making by account- ing for the fact that people’s choices are affected by whether a possible outcome is perceived as a prospec- tive gain or a prospective loss relative to the current status quo situation.

• Because our ancestors were focused on short-term survival, our brains suffer from myopia and are not good at dealing with decisions that involve the future.

• Precommitments can be used to compensate for time inconsistency and the self-control problems that arise when the future self doesn’t want to do what the pres- ent self prefers.

QUICK REVIEW 8.2

The nearby Consider This piece illustrates another effective way to use loss aversion to help overcome self- control problems.

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CHAPTER 8 Behavioral Economics 187

and economists generally take no stand on what people consider to be right or wrong. But fairness has been stud- ied extensively because many everyday economic behav- iors indicate that people care substantially about fairness and not just about maximizing what they can get for themselves. Consider the following examples—none of which would be undertaken by a purely self-interested person.

• Giving to Charity Each year, U.S. charities receive over $300 billion of cash donations and 8 billion hours of free labor. These donations of time and money are inconsistent with the idea that people are only interested in themselves. What is more, many of the cash donations are anonymous. That suggests that many donors have extremely pure motives and are not donating just to make themselves look good.

• Obeying the Law In many countries, the large majority of citizens are law-abiding despite having many opportunities to break the law without getting caught. In the same way, the large majority of taxpayers complete their tax returns honestly despite having many opportunities to cut corners and hide income.

• Fixing Prices During hurricanes and other natural disasters, shortages of crucial products such as gasoline and electric generators often develop. The shortages imply that retailers could raise prices, but they mostly keep prices fixed because they do not want to be thought of as taking advantage of the situation.

• Purchasing “Fair-Trade” Products Many consumers are willing to pay premium prices to purchase products that have been certified by the Fair Trade organization as having been produced by companies that meet high standards with respect to workers’ rights and environmental sustainability. These customers clearly care about more than just getting the lowest price.

Experimental Evidence for Fairness

Our understanding of fairness and how it affects economic transactions has been reinforced and refined in recent de- cades by examining experimental games that were specifi- cally designed to test people’s feelings about fairness. The most important feature of these games is that they are played for real money. That matters because if people were only motivated by self-interest, you would expect ev- eryone playing the games to utilize only those strategies that are most likely to maximize their own winnings.

Fairness and Self-Interest LO8.5 Define fairness and give examples of how it affects behavior in the economy and in the dictator and ultimatum games. Neoclassical models assume that people are purely self- interested. They do so because “pure self-interest” seems like a good basis for predicting many economic behav- iors, especially those happening in market situations where people are dealing mostly with strangers and are, consequently, unlikely to be particularly sentimental or charity-minded. Adam Smith, the founder of modern economics, put this line of thinking into words. The most-quoted passage from The Wealth of Nations reads,

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their human- ity but to their self-love, and never talk to them of our own necessities but of their advantages.

Smith, however, did not believe that people are exclu- sively focused on self-love and their own interests. He be- lieved that we are also strongly motivated by emotions such as charity, selflessness, and the desire to work for the common good. He expressed this view at length in his other influential book, The Theory of Moral Sentiments. The most-famous passage from that book reads:

How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the for- tune of others and render their happiness necessary to him though he derives nothing from it except the pleasure of seeing it.

What behavioral economists have discovered is that this human propensity to care about others extends into every type of economic behavior. While self-interest is al- ways present, most people care deeply about others and how they are interacting with others. As a result, eco- nomic transactions are heavily influenced by moral and ethical factors.

Field Evidence for Fairness

Many real-world behaviors support the contention that economic transactions are heavily influenced by beliefs and values. This “field evidence” has helped behavioral economists identify the ethical and moral factors that ap- pear to have the largest influence on economic behavior. Fairness is among the most important. Fairness is a person’s opinion as to whether a price, wage, or allocation is considered morally or ethically ac- ceptable. Standards of fairness vary from person to person

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Nudging People Toward Better Decisions

Behavioral economics began as a descriptive science, meaning that its first goal was to develop theories that accurately de- scribed human economic behavior. In particular, it sought to ex- plain a number of behaviors that at first glance seemed irrational. Now that behavioral economics has made significant headway in explaining many of those behaviors, some economists are sug- gesting that its insights be used to nudge people toward choices that are better for themselves and others. A key feature of “nudges” is that they are subtle. This subtlety means that nudges can cause large changes in behavior without making people feel bullied or coerced—and also without imposing stringent new rules or having to offer people big monetary incentives or disincentives to get them to do what you want.

Behavioral Economists Have Recently Found Success in Using People’s Behavioral Biases to “Nudge”

Them Toward Making Better Decisions.*

LAST WORD

Take retirement savings. Myopia and time inconsistency cause many people to consume too much in the present and therefore undersave for retirement. But as it turns out, this unfortunate behavioral tendency can be easily offset by utiliz-

ing status quo bias and people’s tendency to stick with default options. In terms of retirement savings, this comes down to designing corporate retirement pro- grams in which each worker is “defaulted into” her company’s retirement savings program.

Under those savings programs, money is automatically deducted each month from a worker’s paycheck and de- posited in her retirement savings ac-

count. It used to be the case that the default for such programs was for workers to start out not enrolled in them. To get en- rolled, they would have to request to join the program. That is, they would have to choose to go against the default option of not being enrolled.

*The term “nudge” was popularized by Richard Thaler and Cass Sunstein in their book Nudge: Improving Decisions about Health, Wealth, and Happiness, Yale University Press, 2008.

other player. It could be to split it in any other possible way, such as $8.67 for himself and $1.33 for the other person. Because the game is fully anonymous, the dictator doesn’t have to worry about retaliation by the other per- son. He can get away with being as selfish as he wants.

How Players Behave So what actually happens when people play the dictator game? After running the experiment many thousands of times in many different countries, experiment- ers have found that only one-third of dictators keep all of the money for themselves. The other two-thirds show sub- stantial generosity, allocating an average of 42 percent of the money to the other player. In addition, 17 percent of all dictators split the money perfectly evenly and a little over five percent of all dictators give the other player everything.

Implications for Fairness The way dictators behave sug- gests two important things about fairness. First, the majority of people appear to be genuinely concerned about being fair to other people. They are willing to take less for themselves in order to ensure that the other

As it turns out, however, only a few people behave that way. The majority actually play fairly and generously, of- ten going out of their way to share with less-fortunate players even when they are under no compulsion to do so. That being said, their kindness only goes so far. If other players are acting selfishly, the average person will with- hold cooperation and may even retaliate.

The Dictator Game The strongest experimental evi- dence against the idea that people are only interested in what they can get for themselves comes from the dicta- tor game.

The Rules In the game, two people interact anonymously. One of them is randomly designated as the “dictator.” It is his job to split an amount of money that is put up for that purpose by the researcher running the game. A typical amount is $10. The defining feature of the game is that the dictator can dictate whatever split he prefers. It could be to keep all the money for himself. It could be to give all the money to the

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And because people have the behavioral tendency of sticking with whatever option is presented to them as the default, rela- tively few workers would make the change and enroll in their company’s savings program. That was disappointing. But instead of being deterred, behavioral economists saw an opportunity. Why not change the default? Why not make automatic enroll- ment the default option? By making that change, people’s ten- dency to stick with default options would work in their own favor—they would stay enrolled and save money for retirement. When this strategy of switching the default was actually im- plemented, the number of workers participating in retirement savings programs skyrocketed—jumping from 60 percent to 98 percent. Those workers can now look forward to much more pleasant retirements thanks to this simple change that works with people’s preference to stick with default options. People’s tendency to look around them for social cues as to what constitutes good behavior can also be exploited to modify their consumption behavior. But you have to be careful about how you do it, as was discovered by Opower, an energy con- sulting firm that wanted to encourage customers to conserve electricity. Its first attempt to use social cues involved sending each customer in a California town a bill that showed not only his or her own usage of electricity in kilowatt-hours, but also the average usage of nearby houses. Opower hoped that by showing the average usage of neighbors, customers would re- ceive a subtle hint about their own usage. In particular, it was hoped that customers who used more than their neighbors

would feel that they were being wasteful and would thus cut back on their usage. And that did indeed happen. But their reduction in electricity usage ended up being completely swamped by an increase in electricity usage on the part of the customers who had previously been below-average users. Those customers interpreted the new information that they were below-average electricity users to mean that they should feel free to consume more. After all, why should they use so little when their neighbors were using so much more? Taking that into account, Opower finally hit upon a solution that worked. Smilies. Yes, symbols like J and L. In addition to printing people’s own usage and the average usage of their neigh- bors, Opower also started printing a J on a customer’s bill if his usage was below average and a L on his bill if his usage was above average. The unhappy smilies embarrassed the heavy users into reducing their consumption even more, while the happy smilies gave a pat on the back to the light users—a pat on the back that kept their usage low. Bear in mind that both the electricity customers and the workers saving for retirement were being manipulated by the people who designed the nudges. This fact is perhaps even more disturbing when you consider that the changes in behavior that were caused by the nudges were most likely unconscious on the part of those being manipulated. Keep this in mind as you con- sider for yourself when and if it is morally or ethically acceptable to use nudges to guide people’s behavior.

player receives something, too. And they are willing to give substantially to the other player even though the game’s guarantee of anonymity would allow them to take everything for themselves without fear of retaliation. Second, generosity varies quite widely. Between the third of dictators who keep everything for themselves and the five percent who give everything to the other person lie the large majority who allocate some but not all of the money to the other person. Within that group, every possible split of the money can be found. As a result, behavioral economists believe that individuals vary widely in their beliefs about fairness. Some are incredibly selfish. Others are incredibly generous. And most of us lie some- where in between. To help get a better handle on how those widely diver- gent beliefs affect behavior in more realistic situations, economists designed a slightly more complex game.

The Ultimatum Game Like the dictator game, the ultimatum game involves two players anonymously

splitting an amount of money. But there is no longer a dictator who can arbitrarily decide how the money is spilt. Instead, both players need to agree on any proposed split if it is to take place. That difference in the rules ensures that the ultimatum game mirrors the many real-world situations in which a project or proposal must obtain the consent and support of all parties if it is to be undertaken. As an example, con- sider a business transaction between a potential seller and a potential buyer. Even if there are substantial net benefits available to both parties, no transaction will take place un- less the buyer and the seller can come to an agreement on the selling price.

The Rules As with the dictator game, the researcher puts up an amount of money to be split. This pot of money is similar in spirit to the net benefits that a buyer and a seller can split if they can agree on a price. It also represents the net benefits that will be forgone if the two parties cannot reach an agreement.

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But what we actually see is responders continuing to reject splits that they consider to be unfair. Their preference for fair treatment is so strong that they will reject unfair offers even when doing so means giving up a lot of money.

Why the Threat of Rejection Increases Cooperation Some people won’t offer anything to other people unless they are coerced into doing so. This is best understood by com- paring the behavior of dictators in the dictator game with the behavior of proposers in the ultimatum game. In the dictator game, a full third of dictators award themselves all the money and leave nothing for the other player. In the ultimatum game, by contrast, nearly every proposer offers a substantial split to the responder. That dramatic increase in generosity and fairness is, of course, related to the different rules used in the two games. When one person has total control over the split, selfish tendencies are given free reign. But when rejections become possible, the player in charge of proposing the split has to take the other player’s feelings into account. That causes even selfish proposers to make generous offers because they quickly realize that the only way they can get any money for themselves is by making proposals that will not be rejected.

Implications for Market Efficiency The willingness of pro- posers to make more generous offers when faced with the threat of rejection can be thought of as the simplest ex- pression of the invisible hand. As we discussed in Chapter 2, the invisible hand is a metaphor that summarizes the tendency of the market sys- tem to align private interests with social interests and get people behaving in ways that benefit not only themselves but other people, too. In the case of the ultimatum game, the threat of rejection helps to align private interests with social interests. It does so by motivating selfish people to make substantially more gen- erous offers. The result is a higher level of cooperation and utility as offers get accepted and players split the money. A similar process can be seen in the real world with respect to consumer sovereignty. As discussed in Chapter 2, consumer sovereignty is the right of consumers to spend their incomes on the goods and services that they are most willing and able to buy. Crucially, that right includes the ability to reject any product that does not meet the con- sumer’s expectations. That right of rejection leads to substantial social ben- efits because it motivates producers to work hard at pro- ducing products that will be acceptable to consumers. Over time, those efforts lead to increased allocative and productive efficiency as better products get produced at lower prices.

At the start of the experiment, one of the players is randomly assigned to be “the proposer” while the other player is randomly assigned to be “the responder.” The game begins with the proposer proposing a split. As in the dictator game, the proposed split can range anywhere from suggesting that all the money go to the proposer to suggesting that all the money go to the responder. The responder examines the proposed split and de- cides whether to accept it or reject it. If she accepts it, the split is made and both players are immediately paid their shares by the researcher. But if the responder rejects the proposed split, neither player gets anything. The game simply ends and both players go home without receiving any money at all—a situation similar to when a business negotiation fails and all the potential benefits are forgone.

How Players Behave When the ultimatum game is played, two behaviors stand out. The more important is that the splits proposed by proposers in the ultimatum game are much more equal on average than the splits imposed by dictators in the dic- tator game. This is best seen by noting that whereas one- third of dictators keep all the money for themselves in the dictator game, almost no proposers suggest allocating all the money to themselves in the ultimatum game. This extremely large difference in behavior arises be- cause the people acting as proposers in the ultimatum game realize that suggesting a highly unequal split is al- most certain to greatly offend a responder’s sense of fair- ness and lead to a rejection. In addition, most proposers also seem to understand that even moderately unfair offers might also offend responders. As a result, the large major- ity of proposers suggest either perfectly equal splits or splits that are only slightly biased in the proposer’s favor (such as 55 percent going to the proposer). The second behavior that stands out is the decisiveness and emotional intensity with which responders reject of- fers that they consider unfair. Of particular interest is the fact that rejection decisions are not made in a cool and calculating fashion. Responders do not calmly weigh the costs and benefits of accepting an unfair offer. They actu- ally become extremely angry and reject as a way of retali- ating against the proposer. Their rejections are not just negative responses; they are acts of vengeance designed to hurt the proposer by denying him money. The full extent to which unfair offers make responders angry can be gauged by looking at high-stakes versions of the ultimatum game in which proposers and responders at- tempt to split hundreds or even thousands of dollars. You might think that when such large amounts of money are on the line, responders would be willing to accept unfair splits.

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LO8.1 Define behavioral economics and explain how it contrasts with neoclassical economics.

Neoclassical economics bases its predictions about human be- havior on the assumption that people are fully rational decision- makers who have no trouble making mental calculations and no problems dealing with temptation. While some of its predictions are accurate, many are not.

The key difficulty facing neoclassical economics is that peo- ple make systematic errors, meaning that they regularly and re- peatedly engage in behaviors that reduce their likelihood of achieving what they want.

Behavioral economics attempts to explain systematic errors by combining insights from economics, psychology, and biology. Its goal is to make more accurate predictions about human choice behavior by taking into account the mental mistakes that lead to systematic errors.

LO8.2 Discuss the evidence for the brain being modular, computationally restricted, reliant on

heuristics, and prone to various forms of cognitive

error.

Our brains make systematic errors for two reasons. First, our brains were not prepared by evolution for dealing with many modern problems, especially those having to do with math, phys- ics, and statistics. Second, our brains also make mistakes when dealing with long-standing challenges (like interpreting visual in- formation) because caloric limitations forced our brains to adopt low-energy heuristics (shortcuts) for completing mental tasks.

Heuristics sacrifice accuracy for speed and low energy usage. In most cases, the lack of accuracy is not important because the errors that result are relatively minor. However, in some cases, those er- rors can generate cognitive biases that substantially impede rational decision-making. Examples include confirmation bias, the overcon- fidence effect, the availability heuristic, and framing effects.

LO8.3 Relate how prospect theory helps to explain many consumer behaviors, including framing effects,

mental accounting, anchoring, loss aversion, and the

endowment effect.

Prospect theory is the behavioral economics theory that attempts to accurately describe how people deal with risk and uncertainty. Its key feature is that it models a person’s preferences about uncertain outcomes as being based on whether those outcomes will cause gains or losses relative to the current status quo situa- tion to which the person has become accustomed.

Prospect theory also accounts for loss aversion and the fact that most people perceive the pain of losing a given amount of money as being about 2.5 times more intense than the pleasure they would receive from an equal-sized gain.

LO8.4 Describe how time inconsistency and myopia cause people to make suboptimal long-run

decisions.

Myopia refers to the difficulty that most people have in concep- tualizing the future. It causes people to put insufficient weight on future outcomes when making decisions.

Time inconsistency refers to the difficulty that most people have in correctly predicting what their future selves will want. It causes self-control problems because people are not able to cor- rectly anticipate the degree to which their future selves may fall prey to various sorts of temptation.

People sometimes utilize precommitments to help them overcome self-control problems. Precommitments are courses of action that would be very difficult for the future self to alter. They consequently force the future self to do what the present self desires.

LO8.5 Define fairness and give examples of how it affects behavior in the economy and in the dictator

and ultimatum games.

Behavioral economists have found extensive evidence that people are not purely self-interested. Rather, they care substantially about fairness and are often willing to give up money and other possessions in order to benefit other people.

The field evidence for fairness includes donations to charity, law-abiding behavior, the reluctance of retailers to raise prices during natural disasters, and the willingness of many consumers to pay premium prices for Fair Trade products.

The dictator and ultimatum games provide experimental evidence on fairness by showing how pairs of people interact to split a pot of money that is provided by the researcher. In the dictator game, one person has total control over the split. In the ultimatum game, both players must agree to the split.

The dictator game shows that many people will share with others even when anonymity would allow them to be perfectly selfish and keep all the money for themselves. The ultimatum game shows that people put a very high value on being treated fairly. They would rather reject an unfair offer and get nothing than accept it and get something.

SUMMARY

TERMS AND CONCEPTS neoclassical economics behavioral economics

rational systematic errors

heuristics cognitive biases

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PART THREE Consumer Behavior192

framing effects status quo loss aversion prospect theory anchoring

mental accounting endowment effect status quo bias myopia time inconsistency

self-control problems precommitments fairness dictator game ultimatum game

D I S C U S S I O N Q U E S T I O N S

1. Suppose that Joe enjoys and repeatedly does stupid things like getting heavily into debt and insulting police officers. Do these actions constitute systematic errors? If he gets what he wants each time, are his stupid actions even consid- ered to be errors by economists? Explain. LO8.1

2. Why do behavioral economists consider it helpful to base a theory of economic behavior on the actual mental processes that people use to make decisions? Why do neoclassical economists not care about whether a theory incorporates those actual mental processes? LO8.1

3. Economist Gerd Gigerenzer characterizes heuristics as “fast and frugal” ways of reaching decisions. Are there any costs to heuristics being “fast and frugal”? Explain and give an example of how a fast and frugal method for doing some- thing in everyday life comes at some costs in terms of other attributes forgone. LO8.2

4. “There’s no such thing as bad publicity.” Evaluate this state- ment in terms of the recognition heuristic. LO8.2

5. For each of the following cognitive biases, come up with at least one example from your own life. LO8.2

a. Confirmation bias. b. Self-serving bias. c. The overconfidence effect. d. Hindsight bias. e. The availability heuristic. f. The planning fallacy. g. Framing effects. 6. Suppose that Ike is loss averse. In the morning, Ike’s stock-

broker calls to tell him that he has gained $1,000 on his stock portfolio. In the evening, his accountant calls to tell him that he owes an extra $1,000 in taxes. At the end of the day, does Ike feel emotionally neutral since the dollar value of the gain in his stock portfolio exactly offsets the amount of extra taxes he has to pay? Explain. LO8.3

7. You just accepted a campus job helping to raise money for your school’s athletic program. You are told to draft a fund- raising letter. The bottom of the letter asks recipients to write down a donation amount. If you want to raise as much money as possible, would it be better if the text of that sec- tion mentioned that your school is ranked third in the na- tion in sports or that you are better than 99 percent of other schools at sports? Explain. LO8.3

8. In the early 1990s, New Jersey and Pennsylvania both re- formed their automobile insurance systems so that citizens could opt for either a less-expensive policy that did not al- low people to sue if they got into accidents or a more- expensive policy that did allow people to sue if they got into accidents. In New Jersey, the default option was the less- expensive policy that did not allow suing. In Pennsylvania, the default option was the more-expensive policy that did allow suing. Given those options, which policy do you think most people in New Jersey ended up with? What about in Pennsylvania? Explain. LO8.3

9. Give an example from your own life of a situation where you or someone you know uses a precommitment to overcome a self-control problem. Describe why the precommitment is useful and what it compensates for. Avoid any precommit- ment that was mentioned in the book. LO8.4

10. What does behavioral economics have to say about each of the following statements? LO8.5

a. “Nobody is truly charitable—they just give money to show off.”

b. “America has a ruthless capitalist system. Considerations of fairness are totally ignored.”

c. “Selfish people always get ahead. It’s like nobody even notices!”

11. Do people playing the dictator game show only self-interested behavior? How much divergence is there in the splits given by dictators to the other player? LO8.5

12. Evaluate the following statement. “We shouldn’t generalize from what people do in the ultimatum game because $10 is a trivial amount of money. When larger amounts of money are on the line, people will act differently.” LO8.5

13. LAST WORD What do you think of the ethics of using unconscious nudges to alter people’s behavior? Before you answer, consider the following argument made by econo- mists Richard Thaler and Cass Sunstein, who favor the use of nudges. They argue that in most situations, we couldn’t avoid nudging even if we wanted to because whatever policy we choose will contain some set of un- conscious nudges and incentives that will influence peo- ple. Thus, they say, we might as well choose the wisest set of nudges.

The following and additional problems can be found in

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CHAPTER 8 Behavioral Economics 193

R E V I E W Q U E S T I O N S

1. Which of the following are systematic errors? LO8.1 a. A colorblind person who repeatedly runs red lights. b. An accountant whose occasional math errors are sometimes

on the high side and sometimes on the low side. c. The tendency many people have to see faces in clouds. d. Miranda paying good money for a nice-looking apple

that turns out to be rotten inside. e. Elvis always wanting to save more but then spending his

whole paycheck, month after month. 2. Identify each statement as being associated with neoclassical

economics or behavioral economics. LO8.1 a. People are eager and accurate calculators. b. People are often selfless and generous. c. People have no trouble resisting temptation. d. People place insufficient weight on future events and

outcomes. e. People only treat others well if doing so will get them

something they want. 3. Label each of the following behaviors with the correct bias

or heuristic. LO8.3 a. Your uncle says that he knew all along that the stock

market was going to crash in 2008. b. When Fred does well at work, he credits his intelligence.

When anything goes wrong, he blames his secretary.

c. Ellen thinks that being struck dead by lightning is much more likely than dying from an accidental fall at home.

d. The sales of a TV that is priced at $999 rise after another very similar TV priced at $1,300 is placed next to it at the store.

e. The sales of a brand of toothpaste rise after new TV commercials announce that the brand “is preferred by 4 out of 5 dentists.”

4. Erik wants to save more, but whenever a paycheck arrives, he ends up spending everything. One way to help him over- come this tendency would be to: LO8.4

a. Teach him about time inconsistency. b. Tell him that self-control problems are common. c. Have him engage in precommitments that will make it

difficult for his future self to overspend. 5. Many proposers in the ultimatum game offer half to the re-

sponder with whom they are paired. This behavior could be motivated by (select as many as might apply): LO8.5

a. Fear that an unequal split might be rejected by a fair- minded responder.

b. A desire to induce the responder to reject the offer. c. A strong sense of fairness on the part of the proposers. d. Unrestrained greed on the part of the proposers.

P R O B L E M S

1. One type of systematic error arises because people tend to think of benefits in percentage terms rather than in absolute dollar amounts. As an example, Samir is willing to drive 20 minutes out of his way to save $4 on a grocery item that costs $10 at a local market. But he is unwilling to drive 20 min- utes out of his way to save $10 on a laptop that costs $400 at a local store. In percentage terms, how big is the savings on the grocery item? On the laptop? In absolute terms, how big is the savings on the grocery item? On the laptop? If Samir is willing to sacrifice 20 minutes of his time to save $4 in one case, shouldn’t he also be willing to sacrifice 20 minutes of his time to save $10? LO8.2

2. Anne is a bargain-minded shopper. Normally, her favorite toothpaste costs the same at both of her local supermar- kets, but the stores are having competing sales this week. At one store, there is a bonus offer: buy 2, get 1 free. At the other store, toothpaste is being sold at 40 percent off. Anne instantly opts for the first offer. Was that really the less-expensive choice? (Hint: Is “buy 2, get 1 free” the same as 50 percent off?) LO8.2

3. The coffee shop near the local college normally sells 10 ounces of roasted coffee beans for $10. But the shop sometimes puts the beans on sale. During some sales, it offers “33 per- cent more for free.” Other weeks, it takes “33 percent off” the normal price. After reviewing the shop’s sales data,

the  shop’s manager finds that “33 percent more for free” sells a lot more coffee than “33 percent off.” Are the store’s customers making a systematic error? Which is actually the better deal? LO8.2

4. Angela owes $500 on a credit card and $2,000 on a student loan. The credit card has a 15 percent annual interest rate and the student loan has a 7 percent annual interest rate. Her sense of loss aversion makes her more anxious about the larger loan. As a result, she plans to pay it off first—despite the fact that professional financial advisors always tell peo- ple to pay off their highest-interest-rate loans first. Suppose Angela has only $500 at the present time to help pay down her loans and that this $500 will be the only money she will have for making debt payments for at least the next year. If she uses the $500 to pay off the credit card, how much inter- est will accrue on the other loan over the coming year? On the other hand, if she uses the $500 to pay off part of the student loan, how much in combined interest will she owe over the next year on the remaining balances on the two loans? By how many dollars will she be better off if she uses the $500 to completely pay off the credit card rather than partly paying down the student loan? (Hint: If you owe X dollars at an annual interest rate of Y percent, your annual interest payment will be X 3 Y, where the interest rate Y is expressed as a decimal.) LO8.3

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PART THREE Consumer Behavior194

c. What is the marginal value of going from $0 to losing $1? Of going from losing $1 to losing $2? Does the typical person experience diminishing marginal disutility from losses?

d. Suppose that a person simultaneously gains $1 from one source and loses $1 from another source. What is the person’s total utility after summing the values from these two events? Can a combination of events that leaves a person with the same wealth as they started with be perceived negatively? Does this shed light on status quo bias?

e. Suppose that an investor has one investment that gains $2 while another investment simultaneously loses $1. What is the person’s total utility after summing the values from these two events? Will an investor need to have gains that are bigger than her losses just to feel as good as she would if she did not invest at all and simply remained at the status quo?

6. Ted has always had difficulty saving money, so on June 1, Ted enrolls in a Christmas savings program at his local bank and deposits $750. That money is totally locked away until December 1 so that Ted can be certain that he will still have it once the holiday shopping season begins. Suppose that the annual rate of interest is 10 percent on ordinary savings accounts (that allow depositors to with- draw their money at any time). How much interest is Ted giving up by precommitting his money into the Christmas savings account for six months instead of depositing it into an ordinary savings account? (Hint: If you invest X dollars at an annual interest rate of Y percent, you will receive in- terest equal to X 3 Y, where the interest rate Y is expressed as a decimal.) LO8.4

5. ADVANCED ANALYSIS In the algebraic version of prospect theory, the variable x represents gains and losses. A positive value for x is a gain, a negative value for x is a loss, and a zero value for x represents remaining at the status quo. The so- called value function, v(x), has separate equations for trans- lating gains and losses into, respectively, positive values (utility) and negative values (disutility). The gain or loss is typically measured in dollars while the resulting value (utility or disutility) is measured in utils. A typical person values gains (x . 0) using the function v(x) 5 x0.88 and losses (x , 0) using the function v(x) 5 22.5*(2x)0.88. In addition, if she stays at the status quo (x 5 0), then v(x) 5 0. First use a scientific calculator (or a spreadsheet program) and the typi- cal person’s value functions for gains and losses to fill out the missing spaces in the nearby table. Then answer the ques- tions that follow. LO8.3

Total Value of Marginal Value of

Gain or Loss Gain or Loss Gain or Loss

23 26.57

22 22.10

21 22.50 22.50

0 0.00 —

1 1.00

2 1.84

3 0.79

a. What is the total value of gaining $1? Of gaining $2? b. What is the marginal value of going from $0 to gaining

$1? Of going from gaining $1 to gaining $2? Does the typical person experience diminishing marginal utility from gains?

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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CHAPTER 9 Businesses and the Costs of Production

CHAPTER 10 Pure Competition in the Short Run

CHAPTER 11 Pure Competition in the Long Run

CHAPTER 12 Pure Monopoly

CHAPTER 13 Monopolistic Competition and Oligopoly

CHAPTER 13W Technology, R&D, and Efficiency

MICROECONOMICS OF PRODUCT MARKETS

PART FOUR

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196

CHAPTER 9

Our attention now turns from the behavior of con-

sumers to the behavior of producers. In market econ-

omies, a wide variety of businesses produce an even

wider variety of goods and services. Each of those

businesses requires economic resources in order to

produce its products. In obtaining and using re-

sources, a firm makes monetary payments to resource

owners (for example, workers) and incurs opportunity

costs when using resources it already owns (for ex-

ample, entrepreneurial talent). Those payments and

opportunity costs together make up the firm’s costs of

production, which we discuss in this chapter.

Then, in the next several chapters, we bring

product demand, product prices, and revenue back

into the analysis and explain how firms compare

revenues and costs in determining how much to

produce. Our ultimate purpose is to show how

those comparisons relate to economic efficiency.

Learning Objectives

LO9.1 Explain why economic costs include both explicit (revealed and

expressed) costs and implicit

(present but not obvious) costs.

LO9.2 Relate the law of diminishing returns to a firm’s short-run

production costs.

LO9.3 Describe the distinctions between fixed and variable costs

and among total, average, and

marginal costs.

LO9.4 Use economies of scale to link a firm’s size and its average costs in

the long run.

LO9.5 Give business examples of short-run costs, economies

of scale, and minimum efficient

scale (MES).

Businesses and the Costs of Production

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CHAPTER 9 Businesses and the Costs of Production 197

Economic Costs LO9.1 Explain why economic costs include both explicit (revealed and expressed) costs and implicit (present but not obvious) costs. Firms face costs because the resources they need to pro- duce their products are scarce and have alternative uses. Because of scarcity, firms wanting a particular resource have to bid it away from other firms. That process is costly for firms because it requires a payment to the resource owner. This reality causes economists to define an eco- nomic cost as the payment that must be made to obtain and retain the services of a resource. It is the income the firm must provide to resource suppliers to attract re- sources away from alternative uses. This section explains how firms incorporate opportu- nity costs to calculate economic costs. If you need a re- fresher on opportunity costs, a brief review of the section on opportunity costs in Chapter 1 might be useful before continuing on with the rest of this section.

Explicit and Implicit Costs

To properly calculate a firm’s economic costs, you must remember that each of the resources used by the firm has an opportunity cost. This is true both for the resources that a firm purchases from outsiders as well as for the re- sources that it already owns. As an example, consider a table-making firm that starts this month with $5,000 in cash as well as ownership of a small oak forest from which it gets the oak that it turns into tables. Suppose that during the month the firm uses the entire $5,000 of cash to pay its workers. Clearly, the $5,000 it spends purchasing their labor comes at the opportunity cost of forgoing the best alternatives that could have been bought with that money. Less obvious, however, is the opportunity cost of the oak that the firm grows itself and which it uses to make tables. Suppose that the oak has a market value of $1,500, meaning that our table-making firm could sell it to outsid- ers for $1,500. This implies that using the oak to make tables has an opportunity cost of $1,500. Choosing to con- vert the oak into tables means giving up the best alterna- tives that the firm could have purchased with the $1,500. As a result, keep in mind that all of the resources that a firm uses—whether purchased from outside or already owned—have opportunity costs and thus economic costs. Economists refer to these two types of economic costs as explicit costs and implicit costs:

• A firm’s explicit costs are the monetary payments it makes to those from whom it must purchase

resources that it does not own. Because these costs involve an obvious cash transaction, they are referred to as explicit costs. Be sure to remember that explicit costs are opportunity costs because every monetary payment used to purchase outside resources necessarily involves forgoing the best alternatives that could have been purchased with the money.

• A firm’s implicit costs are the opportunity costs of using the resources that it already owns to make the firm’s own product rather than selling those resources to outsiders for cash. Because these costs are present but not obvious, they are referred to as implicit costs.

A firm’s economic costs are the sum of its explicit costs and its implicit costs:

Economic costs

5 explicit costs

1 implicit

costs

The following example makes clear how both ex- plicit costs and implicit costs affect firm profits and firm behavior.

Accounting Profit and Normal Profit

Suppose that after many years working as a sales represen- tative for a large T-shirt manufacturer, you decided to strike out on your own. After considering many potential business ventures, you decide to open a retail T-shirt shop. As we explain in Chapter 2, you will be providing two dif- ferent economic resources to your new enterprise: labor and entrepreneurial ability. The part of your job that in- volves providing labor includes any of the routine tasks that are needed to help run the business—things like an- swering customer e-mails, taking inventory, and sweeping the floor. The part of your job that involves providing en- trepreneurial ability includes any of the nonroutine tasks involved with organizing the business and directing its strategy—things like deciding on whether to use Internet ads or in-person events to promote your business, whether to include children’s clothing in your product mix, and how to decorate your store to maximize its appeal to po- tential customers. You begin providing entrepreneurial ability to your new firm by making some initial organizational decisions. You decide to work full time at your new business, so you quit your old job that paid you $22,000 per year. You in- vest $20,000 of savings that has been earning $1,000 per year. You decide that your new firm will occupy a small retail space that you own and had been previously renting

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PART FOUR Microeconomics of Product Markets198

The answer is given by estimating a normal profit, the typical (or “normal”) amount of accounting profit that you would most likely have earned in one of these other ventures. For the sake of argument, let us assume that with your particular set of skills and talents your entre- preneurial abilities would have on average yielded a nor- mal profit of $5,000 in one of the other potential ventures. Knowing that value, we can take all of your implicit costs properly into account by subtracting them from your ac- counting profit:

out for $5,000 per year. Finally, you decide to hire one clerk to help you in the store. She agrees to work for you for $18,000 per year. After a year in business, you total up your accounts and find the following:

Total sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Cost of T-shirts . . . . . . . . . . . . . . . . . . $40,000

Clerk’s salary . . . . . . . . . . . . . . . . . . . . . 18,000

Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Total (explicit) costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,000

Accounting profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000

These numbers look very good. In particular, you are happy with your $57,000 accounting profit, the profit number that accountants calculate by subtracting total ex- plicit costs from total sales revenue. This is the profit (or “net income”) that would appear on your accounting state- ment and that you would report to the government for tax purposes. But don’t celebrate yet! Your $57,000 accounting profit overstates the economic success of your business because it ignores your implicit costs. Success is not defined as “having a total sales revenue that exceeds total explicit costs.” Rather, the true measure of success is doing as well as you possibly can—that is, making more money in your new venture selling T-shirts than you could pursuing any other business venture. To figure out whether you are achieving that goal, you must take into account all of your opportunity costs—both your implicit costs as well as your explicit costs. Doing so will indicate whether your new business venture is earning more money than what you could have earned in any other business venture. To see how these calculations are made, let’s continue with our example. By providing your own financial capital, retail space, and labor, you incurred three different implicit costs dur- ing the year: $1,000 of forgone interest, $5,000 of forgone rent, and $22,000 of forgone wages. But don’t forget that there is another implicit cost that you must also take ac- count of—how much income you chose to forgo by apply- ing your entrepreneurial abilities to your current retail T-shirt venture rather than applying them to other poten- tial business ventures. But what dollar value should we place on the size of  the profits that you might have made if you had provided your entrepreneurial ability to one of those other ventures?

Accounting profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $57,000

Forgone interest . . . . . . . . . . . . . . . . . . $ 1,000

Forgone rent . . . . . . . . . . . . . . . . . . . . . . 5,000

Forgone wages . . . . . . . . . . . . . . . . . . . 22,000

Forgone entrepreneurial income . . . . . . . 5,000

Total implicit costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

Economic profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Economic Profit

After subtracting your $33,000 of implicit costs from your accounting profit of $57,000, we are left with an economic profit of $24,000. Please distinguish clearly between accounting profit and economic profit. Accounting profit is the result of sub- tracting only explicit costs from revenue: Accounting Profit 5 Revenue 2 Explicit Costs. By contrast, economic profit is the result of sub- tracting all of your eco- nomic costs—both explicit costs and implicit costs— from revenue: Economic Profit 5 Revenue 2 Explicit Costs 2 Implicit Costs. By subtracting all of your economic costs from your revenue, you determine how your current business ven- ture compares with your best alternative business venture. In our example, the fact that you are generating an eco- nomic profit of $24,000 means that you are making $24,000 more than you could expect to make in your best alternative business venture. By contrast, suppose that you had instead done poorly in business, so that this year your firm generated an economic loss (a negative economic profit) of $8,000. This would mean that you were doing worse in your current venture than you could have done in your best alternative venture. You would, as a result, wish to switch to that alternative.

W9.1

Economic profit

WORKED PROBLEMS

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CHAPTER 9 Businesses and the Costs of Production 199

Short Run and Long Run

When the demand for a firm’s product changes, the firm’s profitability may depend on how quickly it can adjust the amounts of the various resources it employs. It can easily and quickly adjust the quantities employed of many resources such as hourly labor, raw materials, fuel, and power. It needs much more time, however, to adjust its plant capacity—the size of the factory building, the amount of machinery and equipment, and other capital resources. In some heavy industries such as air- craft manufacturing, a firm may need several years to alter plant capacity. Because of these differences in ad- justment time, economists find it useful to distinguish between two conceptual periods: the short run and the long run. We will discover that costs differ in these two time periods.

Short Run: Fixed Plant In microeconomics, the short run is a period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the de- gree to which the plant’s current capacity is used. The firm’s plant capacity is fixed in the short run. However, the firm can vary its output by applying larger or smaller amounts of labor, materials, and other resources to that plant. It can use its existing plant capacity more or less intensively in the short run.

Long Run: Variable Plant In microeconomics, the long run is a period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity. From the industry’s viewpoint, the long run also includes enough time for existing firms to dissolve and leave the industry or for new firms to be created and enter the industry. While the short run is a “fixed-plant” period, the long run is a “variable-plant” period.

Illustrations If Boeing hires 100 extra workers for one of its commercial airline plants or adds an entire shift of workers, we are speaking of the short run. If it adds a new production facility and installs more equipment, we are re- ferring to the long run. The first situation is a short-run adjustment; the second is a long-run adjustment. The short run and the long run are conceptual periods rather than calendar time periods. In light-manufacturing industries, changes in plant capacity may be accomplished almost overnight. A small T-shirt manufacturer can in- crease its plant capacity in a matter of days by ordering and installing two or three new cutting tables and several extra sewing machines. But for heavy industry the long run is a different matter. Shell Oil may need several years to construct a new gasoline refinery.

Generalizing this point, we see that there is an impor- tant behavioral threshold at $0 of economic profit. If a firm is breaking even (that is, earning exactly $0 of eco- nomic profit), then its entrepreneurs know that they are doing exactly as well as they could expect to do in their best alternative business venture. They are earning enough to cover all their explicit and implicit costs, in- cluding the normal profit that they could expect to earn in other business ventures. Thus, they have no incentive to change. By contrast, anyone running a positive eco- nomic profit knows they are doing better than they could in alternative ventures and will want to continue doing what they are doing or maybe even expand their business. And anyone running an economic loss (a negative eco- nomic profit) knows that they could do better by switch- ing to something else. It is for this reason that economists focus on eco- nomic profits rather than accounting profits. Simply put, economic profits direct how resources are allocated in the economy. Entrepreneurs running economic losses close their current businesses, thereby liberating the land, labor, capital, and entrepreneurial ability that they had been using. These resources are freed up to be used by firms that are generating positive economic profits or that are at least breaking even. Resources thus flow from producing goods and services with lower net benefits to- ward producing goods and services with higher net ben- efits. Allocative efficiency increases as firms are led by their profit signals to produce more of what consumers want the most. Figure 9.1 shows the relationship among the various cost and profit concepts that we have just discussed. To test yourself, you might want to enter the cost numbers used in our example in the appropriate blocks.

Economic profit

Implicit costs (including a

normal profit)

Explicit costs

Accounting profit

Accounting costs (explicit

costs only)

T o

ta l re

ve n u e

E co

n o

m ic

( o

p p o

rt u n it

y)

co st

s

FIGURE 9.1 Economic profit versus accounting profit. Economic profit is equal to total revenue less economic costs. Economic costs are the sum of explicit and implicit costs and include a normal profit to the entrepreneur. Accounting profit is equal to total revenue less accounting (explicit) costs.

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PART FOUR Microeconomics of Product Markets200

fixed and thus the techniques of production do not change. It states that as successive units of a variable resource (say, labor) are added to a fixed resource (say, capital or land), beyond some point the extra, or marginal, product that can be attrib- uted to each additional unit of the variable resource will decline. For example, if ad- ditional workers are hired to work with a constant amount of capital equipment, out- put will eventually rise by smaller and smaller amounts as more workers are hired.

Rationale Suppose a farmer has a fixed resource—80 acres of land—planted in corn. If the farmer does not cul- tivate the cornfields (clear the weeds) at all, the yield will be 40 bushels per acre. If he cultivates the land once, out- put may rise to 50 bushels per acre. A second cultivation may increase output to 57 bushels per acre, a third to 61, and a fourth to 63. Succeeding cultivations will add less and less to the land’s yield. If this were not so, the world’s needs for corn could be fulfilled by extremely intense cul- tivation of this single 80-acre plot of land. Indeed, if di- minishing returns did not occur, the world could be fed out of a flowerpot. Why not? Just keep adding more seed, fertilizer, and harvesters! The law of diminishing returns also holds true in nonag- ricultural industries. Assume a wood shop is manufacturing furniture frames. It has a specific amount of equipment such as lathes, planes, saws, and sanders. If this shop hired just one or two workers, total output and productivity (output per worker) would be very low. The workers would have to per- form many different jobs, and the advantages of specializa- tion would not be realized. Time would be lost in switching from one job to another, and machines would stand idle much of the time. In short, the plant would be understaffed, and production would be inefficient because there would be too much capital relative to the amount of labor. The shop could eliminate those difficulties by hiring more workers. Then the equipment would be more fully used, and workers could specialize on doing a single job. Time would no longer be lost switching from job to job. As more workers were added, production would become more efficient and the marginal product of each succeed- ing worker would rise. But the rise could not go on indefinitely. Beyond a cer- tain point, adding more workers would cause overcrowd- ing. Since workers would then have to wait in line to use the machinery, they would be underused. Total output

Short-Run Production Relationships LO9.2 Relate the law of diminishing returns to a firm’s short-run production costs. A firm’s costs of producing a specific output depend on both the prices and the quantities of the resources (inputs) needed to produce that output. Resource supply and demand de- termine resource prices. The technological aspects of pro- duction, specifically the relationships between inputs and output, determine the quantities of resources needed. Our focus will be on the labor-output relationship, given a fixed plant capacity. But before examining that relationship, we need to define three terms:

• Total product (TP) is the total quantity, or total output, of a particular good or service produced.

• Marginal product (MP) is the extra output or added product associated with adding a unit of a variable resource, in this case labor, to the production process. Thus,

Marginal product 5 change in total product change in labor input

• Average product (AP), also called labor productivity, is output per unit of labor input:

Average product 5 total product units of labor

In the short run, a firm can for a time increase its output by adding units of labor to its fixed plant. But by how much will output rise when it adds more labor? And why do we say “for a time”?

Law of Diminishing Returns

The answers are provided in general terms by the law of diminishing returns. This law assumes that technology is

QUICK REVIEW 9.1

• Explicit costs are money payments a firm makes to out- side suppliers of resources; implicit costs are the opportu- nity costs associated with a firm’s use of resources it owns.

• Normal profit is the implicit cost of entrepreneurship. Economic profit is total revenue less all explicit and implicit costs, including a normal profit.

• In the short run, a firm’s plant capacity is fixed; in the long run, a firm can vary its plant size and firms can enter or leave the industry.

O9.1

Law of diminishing returns

ORIGIN OF THE IDEA

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CHAPTER 9 Businesses and the Costs of Production 201

CONSIDER THIS . . .

Diminishing Returns from Study

Here is a noneco- nomic example of a r e l a t i o n s h i p b e - tween “inputs” and “output” that may help you better un- derstand the idea of

diminishing returns. Suppose for an individual that

Total course learning 5 f (intelligence, quality of course materials, instructor effectiveness, class time, and study time)

where f means “function of ” or “depends on.” So this rela- tionship supposes that total course learning depends on intelligence (however defined), quality of course materials such as the textbook, the effectiveness of the instructor, the amount of class time, and the amount of personal study time outside the class. For analytical purposes, let’s assume that one’s intelli- gence, the quality of course materials, the effectiveness of  the instructor, and the amount of class time are fixed— meaning they do not change over the length of the course. Now let’s add units of study time per day over the length of the course to “produce” greater course learning. The first hour of study time per day increases total course learning. Will the second hour enhance course learning by as much as the first? By how much will the third, fourth, fifth, . . . fifteenth hour of study per day contribute to total course learning relative to the immediate previous hour? We think you will agree that eventually diminishing re- turns to course learning will set in as successive hours of study are added each day. At some point the marginal prod- uct of an extra hour of study time will decline and, at some further point, become zero. This is also true of production relationships within firms. As successive units of a variable input (say, labor) are added to a fixed input (say, capital), the marginal product of the variable input eventually declines. In short, diminishing returns will occur sooner or later. Total product eventually will rise at a di- minishing rate, reach a maximum, and then decline.

would increase at a diminishing rate because, given the fixed size of the plant, each worker would have less capital equipment to work with as more and more labor was hired. The marginal product of additional workers would decline because there would be more labor in proportion to the fixed amount of capital. Eventually, adding still more workers would cause so much congestion that mar- ginal product would become negative and total product

would decline. At the extreme, the addition of more and more labor would exhaust all the standing room, and total product would fall to zero. Note that the law of diminishing returns assumes that all units of labor are of equal quality. Each successive worker is presumed to have the same innate ability, motor coordination, education, training, and work experience. Marginal product ultimately diminishes, but not because successive workers are less skilled or less energetic. It de- clines because the firm is using more workers relative to the amount of plant and equipment available.

Tabular Example Table 9.1 is a numerical illustration of the law of diminishing returns. Column 2 shows the total product, or total output, resulting from combining each level of a variable input (labor) in column 1 with a fixed amount of capital. Column 3 shows the marginal product (MP), the change in total product associated with each additional unit of labor. Note that with no labor input, total product is zero; a plant with no work- ers will produce no output. The first three units of labor generate increasing marginal returns, with marginal products of 10, 15, and 20 units, respec- tively. But beginning with the fourth unit of labor, marginal product diminishes continuously, becoming zero with the seventh unit of labor and negative with the eighth. Average product, or output per labor unit, is shown in column 4. It is calculated by dividing total product (col- umn 2) by the number of labor units needed to produce it (column 1). At 5 units of labor, for example, AP is 14 (5 70/5).

Graphical Portrayal Figure 9.2 (Key Graph) shows the diminishing-returns data in Table 9.1 graphically and further clarifies the relationships between total, marginal, and average products. (Marginal product in Figure 9.2b is plotted halfway between the units of labor since it applies to the addition of each labor unit.) Note first in Figure 9.2a that total product, TP, goes through three phases: It rises initially at an increasing rate; then it increases, but at a diminishing rate; finally, after reaching a maximum, it declines. Geometrically, marginal product—shown by the MP curve in Figure 9.2b—is the slope of the total-product curve. Marginal product measures the change in total product associated with each succeeding unit of labor. Thus, the three phases of total product are also reflected

W9.2

Total, marginal, and average product

WORKED PROBLEMS

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PART FOUR Microeconomics of Product Markets202

exceeds the average product of all workers currently em- ployed, average product will rise. Conversely, when the amount an extra worker adds to total product is less than the current average product, average product will decrease. The law of diminishing returns is embodied in the shapes of all three curves. But, as our definition of the law of diminishing returns indicates, economists are most con- cerned with its effects on marginal product. The regions of increasing, diminishing, and negative marginal product (returns) are shown in Figure 9.2b.

Short-Run Production Costs LO9.3 Describe the distinctions between fixed and variable costs and among total, average, and marginal costs. Production information such as that provided in Table 9.1 and Figures 9.2a and 9.2b must be coupled with resource prices to determine the total and per-unit costs of produc- ing various levels of output. We know that in the short run, resources associated with the firm’s plant are fixed. Other resources, however, are variable in the short run. As a result, short-run costs can be either fixed or variable.

Fixed, Variable, and Total Costs

Let’s see what distinguishes fixed costs, variable costs, and total costs from one another.

Fixed Costs Fixed costs are those costs that do not vary with changes in output. Fixed costs are associated with the very existence of a firm’s plant and therefore must be paid even if its output is zero. Such costs as rental payments, in- terest on a firm’s debts, a portion of depreciation on equip- ment and buildings, and insurance premiums are generally fixed costs; they are fixed and do not change even if a firm

(3) (4)

(1) Marginal Product (MP), Average

Units of the Variable (2) Change in (2)y Product (AP), Resource (Labor) Total Product (TP) Change in (1) (2)y(1)

0 0 10 Increasing

—

1 10 15 marginal

10.00

2 25 20

returns

12.50

3 45 15 Diminishing

15.00

4 60 10 marginal

15.00

5 70 5

returns

14.00

6 75 0 Negative

12.50

7 75 25 marginal

10.71

8 70 returns 8.75

TABLE 9.1 Total, Marginal, and Average Product: The Law of Diminishing Returns

in marginal product. Where total product is increasing at an increasing rate, marginal product is rising. Here, extra units of labor are adding larger and larger amounts to total product. Similarly, where total product is increasing but at a decreasing rate, marginal product is positive but falling. Each additional unit of labor adds less to total product than did the previous unit. When total product is at a max- imum, marginal product is zero. When total product de- clines, marginal product becomes negative. Average product, AP (Figure 9.2b), displays the same tendencies as marginal product. It increases, reaches a maximum, and then decreases as more and more units of labor are added to the fixed plant. But note the relation- ship between marginal product and average product: Where marginal product exceeds average product, average product rises. And where marginal product is less than av- erage product, average product declines. It follows that marginal product intersects average product where aver- age product is at a maximum. This relationship is a mathematical necessity. If you add a larger number to a total than the current average of that total, the average must rise. And if you add a smaller num-

ber to a total than the cur- rent average of that total, the average must fall. You raise your average exami- nation grade only when your score on an additional (marginal) examination is greater than the average of all your past scores. You

lower your average when your grade on an additional exam is below your current average. In our production example, when the amount an extra worker adds to total product

O9.2

Production relationship

ORIGIN OF THE IDEA

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KEY GRAPH

QUICK QUIZ FOR FIGURE 9.2

1. Which of the following is an assumption underlying these figures?

a. Firms first hire “better” workers and then hire “poorer” workers.

b. Capital and labor are both variable, but labor increases more rapidly than capital.

c. Consumers will buy all the output (total product) produced. d. Workers are of equal quality. 2. Marginal product is: a. the change in total product divided by the change in the quan-

tity of labor. b. total product divided by the quantity of labor. c. always positive. d. unrelated to total product.

3. Marginal product in graph (b) is zero when: a. average product in graph (b) stops rising. b. the slope of the marginal-product curve in graph (b) is zero. c. total product in graph (a) begins to rise at a diminishing rate. d. the slope of the total-product curve in graph (a) is zero. 4. Average product in graph (b): a. rises when it is less than marginal product. b. is the change in total product divided by the change in the

quantity of labor. c. can never exceed marginal product. d. falls whenever total product in graph (a) rises at a diminishing

rate.

Answers: 1. d; 2. a; 3. d; 4. a

FIGURE 9.2 The law of diminishing returns. (a) As a variable resource (labor) is added to fixed amounts of other resources (land or capital), the total product that results will eventually increase by diminishing amounts, reach a maximum, and then decline. (b) Marginal product is the change in total product associated with each new unit of labor. Average product is simply output per labor unit. Note that marginal product intersects average product at the maximum average product.

75

50

25

0 1 2 3 4 5 6 7 8 9

TP

To ta

l p ro

d u ct

, T P

Quantity of labor

(a) Total product

0 1 2 3 4 5 6 7 8 9

M ar

gi n al

p ro

d u ct

, M P

Quantity of labor

(b) Marginal and average product

AP

MP

Increasing marginal returns

Diminishing marginal returns

Negative marginal returns20

10

203

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PART FOUR Microeconomics of Product Markets204

produces more. In column 2 of Table 9.2 we assume that the firm’s total fixed cost is $100. By definition, this fixed cost is incurred at all levels of output, including zero. The firm cannot avoid paying fixed costs in the short run.

Variable Costs Variable costs are those costs that change with the level of output. They include payments for materials, fuel, power, transportation services, most labor, and similar variable resources. In column 3 of Table 9.2 we find that the total of variable costs changes directly with output. But note that the increases in variable cost associated with succeeding one-unit increases in out- put are not equal. As production begins, variable cost will for a time increase by a decreasing amount; this is true through the fourth unit of output in Table 9.2. Beyond the fourth unit, however, variable cost rises by increasing amounts for succeeding units of output. The reason lies in the shape of the marginal-product curve. At first, as in Figure 9.2b, marginal product is increasing, so smaller and smaller increases in the amounts of variable resources are needed to produce successive units of output. Hence the variable cost of successive units of output decreases. But when, as diminishing returns are encountered, marginal product begins to decline, larger and larger additional amounts of variable resources are needed to produce successive units of output. Total vari- able cost therefore increases by increasing amounts.

Total Cost Total cost is the sum of fixed cost and vari- able cost at each level of output:

TC 5 TFC 1 TVC

TC is shown in column 4 of Table 9.2. At zero units of output, total cost is equal to the firm’s fixed cost. Then for each unit of the 10 units of production, total cost increases by the same amount as variable cost. Figure 9.3 shows graphically the fixed-, variable-, and total-cost data given in Table 9.2. Observe that total variable cost, TVC, is measured vertically from the hori- zontal axis at each level of output. The amount of fixed

TABLE 9.2 Total-, Average-, and Marginal-Cost Schedules for an Individual Firm in the Short Run

(5) (6) (7) (8)

Average Average Average Marginal

(1) (2) (3) (4) Fixed Variable Total Cost Cost

Total Total Total Total Cost (AFC) Cost (AVC) (ATC) (MC)

Product Fixed Variable Cost (TC) AFC 5

TFC

Q

AVC 5

TVC

Q

ATC 5

TC

Q

MC 5

change in TC

change in Q (Q) Cost (TFC) Cost (TVC) TC 5 TFC 1 TVC

0 $100 $ 0 $ 100 $ 90

1 100 90 190 $100.00 $90.00 $190.00 80

2 100 170 270 50.00 85.00 135.00 70

3 100 240 340 33.33 80.00 113.33 60

4 100 300 400 25.00 75.00 100.00 70

5 100 370 470 20.00 74.00 94.00 80

6 100 450 550 16.67 75.00 91.67 90

7 100 540 640 14.29 77.14 91.43 110

8 100 650 750 12.50 81.25 93.75 130

9 100 780 880 11.11 86.67 97.78 150

10 100 930 1,030 10.00 93.00 103.00

Total-Cost Data

Average-Cost Data Marginal Cost

$1,100

1,000

900

800

700

600

500

400

300

200

100

0 1 2 3 4 5 6 7 8 9 10 Q

Fixed cost

Variable cost Total cost

TC

TVC

TFC

C o

st s

FIGURE 9.3 Total cost is the sum of fixed cost and variable cost. Total variable cost (TVC) changes with output. Total fixed cost (TFC) is independent of the level of output. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that output.

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CHAPTER 9 Businesses and the Costs of Production 205

fewer and fewer additional variable resources are needed to produce each of the first four units of output. As a result, variable cost per unit declines. AVC hits a mini- mum with the fifth unit of output, and beyond that point AVC rises as diminishing returns require more and more variable resources to produce each additional unit of output. Rephrased, production is relatively inefficient—and therefore costly—at low levels of output. Because the firm’s fixed plant is understaffed, average variable cost is relatively high. As output expands, however, greater spe- cialization and better use of the firm’s capital equipment yield more efficiency, and variable cost per unit of output declines. As still more variable resources are added, a point is reached where crowding causes diminishing re- turns to set in. Once diminishing returns start, each ad- ditional unit of input does not increase output by as much as preceding units did. This means that AVC even- tually increases. You can verify the U or saucer shape of the AVC curve by returning to Table 9.1. Assume the price of labor is $10 per unit. Labor cost per unit of output is then $10 (the price per labor unit in this example) divided by average product (output per labor unit). Because we have assumed labor to be the only variable input, the labor cost per unit of output is the variable cost per unit of output, or AVC. When average product is initially low, AVC is high. As workers are added, average product rises and AVC falls. When average product is at its maximum, AVC is at its minimum. Then, as still more workers are added and average product declines, AVC rises. The “hump” of the

cost, shown as TFC, is added vertically to the total- variable-cost curve to obtain the points on the total-cost curve TC. The distinction between fixed and variable costs is significant to the business manager. Variable costs can be controlled or altered in the short run by changing produc- tion levels. Fixed costs are beyond the business manager’s current control; they are incurred in the short run and must be paid regardless of output level.

Per-Unit, or Average, Costs

Producers are certainly interested in their total costs, but they are equally concerned with per-unit, or average, costs. In particular, average-cost data are more meaning- ful for making comparisons with product price, which is always stated on a per-unit basis. Average fixed cost, aver- age variable cost, and average total cost are shown in col- umns 5 to 7, Table 9.2.

AFC Average fixed cost (AFC) for any output level is found by dividing total fixed cost (TFC) by that amount of output (Q). That is,

AFC 5 TFC

Q

Because the total fixed cost is, by definition, the same re- gardless of output, AFC must decline as output increases. As output rises, the total fixed cost is spread over a larger and larger output. When output is just 1 unit in Table 9.2, TFC and AFC are the same at $100. But at 2 units of out- put, the total fixed cost of $100 becomes $50 of AFC or fixed cost per unit; then it becomes $33.33 per unit as $100 is spread over 3 units, and $25 per unit when spread over 4 units. This process is sometimes referred to as “spreading the overhead.” Figure 9.4 shows that AFC graphs as a continuously declining curve as total output is increased.

AVC Average variable cost (AVC) for any output level is calculated by dividing total variable cost (TVC) by that amount of output (Q):

AVC 5 TVC

Q

Due to increasing and then diminishing returns, AVC de- clines initially, reaches a minimum, and then increases again. A graph of AVC is a U-shaped or saucer-shaped curve, as shown in Figure 9.4. Because total variable cost reflects the law of dimin- ishing returns, so must AVC, which is derived from total variable cost. Because marginal returns increase initially,

$200

150

100

50

0 1 2 3 4 5 6 7 8 9 10 Q

ATC

AVC

AVC

AFC

AFC

C o

st s

FIGURE 9.4 The average-cost curves. AFC falls as a given amount of fixed costs is apportioned over a larger and larger output. AVC initially falls because of increasing marginal returns but then rises because of diminishing marginal returns. Average total cost (ATC) is the vertical sum of average variable cost (AVC) and average fixed cost (AFC).

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PART FOUR Microeconomics of Product Markets206

indicates that ATC is $100. But the firm does not increase its total costs by $100 by producing the fourth unit, nor does it save $100 by not producing that unit. Rather, the change in costs involved here is only $60, as the MC col- umn in Table 9.2 reveals. A firm’s decisions as to what output level to produce are typically marginal decisions, that is, decisions to pro- duce a few more or a few less units. Marginal cost is the change in costs when one more or one less unit of output is produced. When coupled with marginal revenue (which, as you will see in Chapter 10, indicates the change in rev- enue from one more or one less unit of output), marginal cost allows a firm to determine if it is profitable to expand

average-product curve is reflected in the saucer or U shape of the AVC curve. As you will soon see, the two are mirror images of each other.

ATC Average total cost (ATC) for any output level is found by dividing total cost (TC) by that output (Q) or by adding AFC and AVC at that output:

ATC 5 TC Q

5 TFC

Q 1

TVC Q

5 AFC 1 AVC

Graphically, ATC can be found by adding vertically the AFC and AVC curves, as in Figure 9.4. Thus the vertical distance between the ATC and AVC curves measures AFC at any level of output.

Marginal Cost

One final and very crucial cost concept remains: Marginal cost (MC) is the extra, or additional, cost of producing one more unit of output. MC can be determined for each added unit of output by noting the change in total cost entailed by that unit’s production:

MC 5 change in TC change in Q

Calculations In column 4 of Table 9.2, production of the first unit of output increases total cost from $100 to $190. Therefore, the additional, or marginal, cost of that first unit is $90 (column 8). The marginal cost of the second unit is $80 (5 $270 2 $190); the MC of the third is $70 (5 $340 2 $270); and so forth. The MC for each of the 10 units of output is shown in column 8. MC can also be calculated from the total-variable-cost column because the only difference between total cost and total variable cost is the constant amount of fixed costs ($100). Thus, the change in total cost and the change in total variable cost associated with each additional unit of output are always the same.

Marginal Decisions Marginal costs are costs the firm can control directly and immediately. Specifically, MC

designates all the cost in- curred in producing the last unit of output. Thus, it also designates the cost that can be “saved” by not producing that last unit. Average-cost figures do not provide this informa-

tion. For example, suppose the firm is undecided whether to produce 3 or 4  units of output. At 4 units Table 9.2

CONSIDER THIS . . .

Ignoring Sunk Costs

It is a deep-seated hu- man tendency to drag past costs—so called s u n k c o s t s — i n t o marginal-benefit ver- s u s m a r g i n a l - c o s t calculations. Doing so is known as the sunk cost fallacy.

As an example of this error, suppose a

family that’s on vacation stops at a roadside stand to buy some apples. After driving a bit, the family discovers that the apples are mushy and gross. Would it be logical for the father to insist that everyone eat the apples “because we paid a pre- mium price for them”? Absolutely not. In making a new decision, you should ig- nore all costs that are not affected by that new decision. The prior bad decision (in retrospect) to buy the apples should not dictate a subsequent decision for which marginal benefit is less than marginal cost. Consider a business example. Suppose that a firm spends $1 million on R&D to bring out a new product, only to dis- cover that the product sells very poorly. Should the firm con- tinue to produce the product at a loss even when there is no realistic hope for future success? Obviously, it should not. In making this decision, the firm should realize that the amount it spent developing the product is irrelevant; it should stop production and cut its losses. The emotional tendency that drives the sunk cost fallacy is the desire to “get one’s money’s worth” out of a past expendi- ture. But giving in to that emotion can lead to “throwing good money after bad.” Instead, you should ignore all past costs and focus solely on those that depend on the decision at hand.

W9.3

Per-unit cost

WORKED PROBLEMS

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207

KEY GRAPH FIGURE 9.5 The relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves. The marginal- cost (MC) curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their minimum points. When MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average variable cost, AVC falls; when MC is above average variable cost, AVC rises.

$200

150

100

50

0 1 2 3 4 5 6 7 8 9 10 Q

MC

ATC

AVC

AFC

Quantity

C o

st s

QUICK QUIZ FOR FIGURE 9.5

1. The marginal-cost curve first declines and then increases be- cause of:

a. increasing, then diminishing, marginal utility. b. the decline in the gap between ATC and AVC as output

expands. c. increasing, then diminishing, marginal returns. d. constant marginal revenue. 2. The vertical distance between ATC and AVC measures: a. marginal cost. b. total fixed cost. c. average fixed cost. d. economic profit per unit.

3. ATC is: a. AVC 2 AFC. b. MC 1 AVC. c. AFC 1 AVC. d. (AFC 1 AVC) 1 Q. 4. When the marginal-cost curve lies: a. above the ATC curve, ATC rises. b. above the AVC curve, ATC rises. c. below the AVC curve, total fixed cost increases. d. below the ATC curve, total fixed cost falls.

Answers: 1. c; 2. c; 3. c; 4. a

or contract its production. The analysis in the next four chapters focuses on those marginal calculations.

Graphical Portrayal Marginal cost is shown graphically in Figure 9.5 (Key Graph). Marginal cost at first declines sharply, reaches a minimum, and then rises rather abruptly. This reflects the fact that variable cost, and therefore total cost, increase at first by decreasing amounts and then by increasing amounts (see columns 3 and 4, Table 9.2).

MC and Marginal Product The marginal-cost curve’s shape is a consequence of the law of diminishing returns. Looking back at Table 9.1, we can see the relationship be- tween marginal product and marginal cost. If all units of a variable resource (here labor) are hired at the same price, the marginal cost of each extra unit of output will fall as long as the marginal product of each additional worker is rising. This is true because marginal cost is the (constant)

cost of an extra worker divided by his or her marginal product. Therefore, in Table 9.1, suppose that each worker can be hired for $10. Because the first worker’s marginal product is 10 units of output, and hiring this worker in- creases the firm’s costs by $10, the marginal cost of each of these 10 extra units of output is $1 (5 $10/10 units). The second worker also increases costs by $10, but the marginal product is 15, so the marginal cost of each of these 15 extra units of output is $0.67 (5 $10/15 units). Similarly, the MC of each of the 20 extra units of output contributed by the third worker is $.50 (5 $10/20 units). To generalize, as long as marginal product is rising, marginal cost will fall. But with the fourth worker diminishing returns set in and marginal cost begins to rise. For the fourth worker, mar- ginal cost is $0.67 (5 $10/15 units); for the fifth worker, MC is $1 ($10/10 units); for the sixth, MC is $2 (5 $10/5 units); and so on. If the price (cost) of the variable resource

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PART FOUR Microeconomics of Product Markets208

result of playing a fourth (marginal) game will depend on whether the additional points he scores in that game are fewer or more than his current 20-point average. If in the fourth game he scores fewer than 20 points, his average will fall. For example, if he scores 16 points in the fourth game, his total points will rise from 60 to 76 and his aver- age will fall from 20 to 19 (5 76/4). Conversely, if in the fourth (marginal) game he scores more than 20 points, say, 24, his total will increase from 60 to 84 and his average will rise from 20 to 21 (5 84/4). So it is with costs. When the amount (the marginal cost) added to total cost is less than the current average total cost, ATC will fall. Conversely, when the marginal cost exceeds ATC, ATC will rise. This means in Figure 9.5 that as long as MC lies below ATC, ATC will fall, and whenever MC lies above ATC, ATC will rise. Therefore, at the point of intersection where MC equals ATC, ATC has just ceased to fall but has not yet begun to rise. This, by definition, is the minimum point on the ATC curve. The marginal-cost curve intersects the average-total-cost curve at the ATC curve’s minimum point. Marginal cost can be defined as the addition either to total cost or to total variable cost resulting from one more unit of output; thus this same rationale explains why the MC curve also crosses the AVC curve at the AVC curve’s minimum point. No such relationship exists between the MC curve and the average-fixed-cost curve because the two are not related; marginal cost includes only those costs that change with output, and fixed costs by definition are those that are independent of output.

Shifts of the Cost Curves

Changes in either resource prices or technology will cause costs to change and cost curves to shift. If fixed costs dou- ble from $100 to $200, the AFC curve in Figure 9.5 would be shifted upward. At each level of output, fixed costs are higher. The ATC curve would also move upward because AFC is a component of ATC. But the positions of the AVC and MC curves would be unaltered because their locations are based on the prices of variable rather than fixed re- sources. However, if the price (wage) of labor or some other variable input rose, AVC, ATC, and MC would rise and those cost curves would all shift upward. The AFC curve would remain in place because fixed costs have not changed. And, of course, reductions in the prices of fixed or variable resources would reduce costs and produce shifts of the cost curves exactly opposite to those just described. The discovery of a more efficient technology would increase the productivity of all inputs. The cost figures in Table 9.2 would all be lower. To illustrate, if labor is the

remains constant, increasing marginal returns will be re- flected in a declining marginal cost, and diminishing mar- ginal returns in a rising marginal cost. The MC curve is a mirror reflection of the marginal-product curve. As you can see in Figure 9.6, when marginal product is rising, marginal cost is necessarily falling. When marginal product is at its maximum, marginal cost is at its minimum. And when marginal product is falling, marginal cost is rising.

Relation of MC to AVC and ATC Figure 9.5 shows that the marginal-cost curve MC intersects both the AVC and the ATC curves at their respective minimum points. As noted earlier, this marginal-average relationship is a mathematical necessity, which a simple illustration will reveal. Suppose an NBA basketball player has scored an average of 20 points a game over the first three games of the season. Now, whether his average rises or falls as a

A ve

ra ge

p ro

d u ct

a n d

m ar

gi n al

p ro

d u ct

Quantity of labor

Quantity of output

C o

st (

d o

lla rs

)

MC AVC

AP MP

0

0

(a) Production curves

(b) Cost curves

FIGURE 9.6 The relationship between productivity curves and cost curves. The marginal-cost (MC) curve and the average-variable-cost (AVC) curve in (b) are mirror images of the marginal-product (MP) and average- product (AP) curves in (a). Assuming that labor is the only variable input and that its price (the wage rate) is constant, then when MP is rising, MC is falling, and when MP is falling, MC is rising. Under the same assumptions, when AP is rising, AVC is falling, and when AP is falling, AVC is rising.

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CHAPTER 9 Businesses and the Costs of Production 209

smaller plant than that assumed in Table 9.2. The industry also can change its overall capacity; the long run allows suf- ficient time for new firms to enter or for existing firms to leave an industry. We will discuss the impact of the entry and exit of firms to and from an industry in the next chap- ter; here we are concerned only with changes in plant ca- pacity made by a single firm. Let’s couch our analysis in terms of average total cost (ATC), making no distinction between fixed and variable costs because all resources, and therefore all costs, are variable in the long run.

Firm Size and Costs

Suppose a manufacturer with a single plant begins on a small scale and, as the result of successful operations, ex- pands to successively larger plant sizes with larger output capacities. What happens to average total cost as this oc- curs? For a time, successively larger plants will reduce av- erage total cost. However, eventually the building of a still larger plant will cause ATC to rise. Figure 9.7 illustrates this situation for five possible plant sizes. ATC-1 is the short-run average-total-cost curve for the smallest of the five plants, and ATC-5, the curve for the largest. Constructing larger plants will lower the minimum average total costs through plant size 3. But then larger plants will mean higher minimum average total costs.

The Long-Run Cost Curve

The vertical lines perpendicular to the output axis in Figure 9.7 indicate the outputs at which the firm should change plant size to realize the lowest attainable average total costs of production. These are the outputs at which the per-unit costs for a larger plant drop below those for the current, smaller plant. For all outputs up to 20 units, the lowest average total costs are attainable with plant size 1. However, if the firm’s volume of sales expands beyond

only variable input, if wages are $10 per hour, and if aver- age product is 10 units, then AVC would be $1. But if a technological improvement increases the average product of labor to 20 units, then AVC will decline to $0.50. More generally, an upward shift in the productivity curves shown in Figure 9.6a means a downward shift in the cost curves portrayed in Figure 9.6b.

QUICK REVIEW 9.2

• The law of diminishing returns indicates that, beyond some point, output will increase by diminishing amounts as more units of a variable resource (labor) are added to a fixed resource (capital).

• In the short run, the total cost of any level of output is the sum of fixed and variable costs (TC 5 TFC 1 TVC).

• Average fixed, average variable, and average total costs are fixed, variable, and total costs per unit of out- put; marginal cost is the extra cost of producing one more unit of output.

• Average fixed cost declines continuously as output in- creases; the average-variable-cost and average-total- cost curves are U-shaped, reflecting increasing and then diminishing returns; the marginal-cost curve falls but then rises, intersecting both the average-variable- cost curve and the average-total-cost curve at their minimum points.

Long-Run Production Costs LO9.4 Use economies of scale to link a firm’s size and its average costs in the long run. In the long run an industry and its individual firms can un- dertake all desired resource adjustments. That is, they can change the amount of all inputs used. The firm can alter its plant capacity; it can build a larger plant or revert to a

A ve

ra ge

t o

ta l co

st s ATC -1 ATC - 2 ATC -3

ATC - 4

ATC -5

0 20 30 50 60 Q

Output

FIGURE 9.7 The long-run average-total- cost curve: five possible plant sizes. The long-run average-total-cost curve is made up of segments of the short-run cost curves (ATC-1, ATC-2, etc.) of the various-size plants from which the firm might choose. Each point on the bumpy planning curve shows the lowest unit cost attainable for any output when the firm has had time to make all desired changes in its plant size.

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210

KEY GRAPH FIGURE 9.8 The long-run average-total- cost curve: unlimited number of plant sizes. If the number of possible plant sizes is very large, the long-run average-total-cost curve approximates a smooth curve. Economies of scale, followed by diseconomies of scale, cause the curve to be U-shaped.

QUICK QUIZ FOR FIGURE 9.8

1. The unlabeled red curves in this figure illustrate the: a. long-run average-total-cost curves of various firms constitut-

ing the industry. b. short-run average-total-cost curves of various firms constitut-

ing the industry. c. short-run average-total-cost curves of various plant sizes

available to a particular firm. d. short-run marginal-cost curves of various plant sizes available

to a particular firm. 2. The unlabeled red curves in this figure derive their shapes from: a. decreasing, then increasing, short-run returns. b. increasing, then decreasing, short-run returns. c. economies, then diseconomies, of scale. d. diseconomies, then economies, of scale.

3. The long-run ATC curve in this figure derives its shape from: a. decreasing, then increasing, short-run returns. b. increasing, then decreasing, short-run returns. c. economies, then diseconomies, of scale. d. diseconomies, then economies, of scale. 4. The long-run ATC curve is often called the firm’s: a. planning curve. b. capital-expansion path. c. total-product curve. d. production possibilities curve.

Answers: 1. c; 2. b; 3. c; 4. a

A ve

ra ge

t o

ta l co

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Output

Long-run ATC

0 Q

bumpy curve is the firm’s long-run ATC curve or, as it is often called, the firm’s planning curve. In most lines of production the choice of plant size is much wider than in our illustration. In many industries the number of possible plant sizes is virtually unlimited, and in time quite small changes in the volume of output will lead to changes in plant size. Graphically, this implies an unlim- ited number of short-run ATC curves, one for each output level, as suggested by Figure 9.8 (Key Graph). Then, rather than being made up of segments of short-run ATC curves as in Figure 9.7, the long-run ATC curve is made up of all the points of tangency of the unlimited number of short-run ATC curves from which the long-run ATC curve is derived. Therefore, the planning curve is smooth rather than bumpy. Each point on it tells us the minimum ATC of producing the corresponding level of output.

20 units but less than 30, it can achieve lower per-unit costs by constructing a larger plant, size 2. Although total cost will be higher at the expanded levels of production, the cost per unit of output will be less. For any output be- tween 30 and 50 units, plant size 3 will yield the lowest average total costs. From 50 to 60 units of output, the firm must build the size-4 plant to achieve the lowest unit costs. Lowest average total costs for any output over 60 units require construction of the still larger plant, size 5. Tracing these adjustments, we find that the long-run ATC curve for the enterprise is made up of segments of the short-run ATC curves for the various plant sizes that can be constructed. The long-run ATC curve shows the lowest average total cost at which any output level can be produced after the firm has had time to make all appropri- ate adjustments in its plant size. In Figure 9.7 the blue,

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CHAPTER 9 Businesses and the Costs of Production 211

assumes that resource prices are constant. Second, the law of diminishing returns does not apply to production in the long run. This is true because the law of diminishing returns only deals with situations in which a productive resource or input is held constant. Under our definition of “long run,” all re- sources and inputs are variable.

Economies of Scale Economies of scale, or econo- mies of mass production, explain the downsloping part of the long-run ATC curve, as indicated in Figure 9.9, graphs (a), (b), and (c). As plant size increases, a number of factors will for a time lead to lower average costs of production.

Economies and Diseconomies of Scale

We have assumed that, for a time, larger and larger plant sizes will lead to lower unit costs but that, beyond some point, successively larger plants will mean higher average to- tal costs. That is, we have assumed the long-run ATC curve is U-shaped. But why should this be? It turns out that the U shape is caused by economies and diseconomies of large- scale production, as we explain in a moment. But before we do, please understand that the U shape of the long-run average- total-cost curve cannot be the result of rising resource prices or the law of diminishing returns. First, our discussion

Economies of scale

Constant returns to scale

Diseconomies of scale

Long-run ATCA

ve ra

ge t

o ta

l co

st s

Output

0 q1 q2

A ve

ra ge

t o

ta l co

st s

Output0

(a)

(b)

(c)

Long-run ATC

A ve

ra ge

t o

ta l co

st s

Output0

Long-run ATC

FIGURE 9.9 Various possible long-run average- total-cost curves. (a) Economies of scale are rather rapidly obtained as plant size rises, and diseconomies of scale are not encountered until a considerably large scale of output has been achieved. Thus, long-run average total cost is constant over a wide range of output. (b) Economies of scale are extensive, and diseconomies of scale occur only at very large outputs. Average total cost therefore declines over a broad range of output. (c) Economies of scale are exhausted quickly, followed immediately by diseconomies of scale. Minimum ATC thus occurs at a relatively low output.

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PART FOUR Microeconomics of Product Markets212

Other Factors Many products entail design and develop- ment costs, as well as other “start-up” costs, which must be incurred regardless of projected sales. These costs decline per unit as output is increased. Similarly, advertising costs decline per auto, per computer, per stereo system, and per box of detergent as more units are produced and sold. Also, the firm’s production and marketing expertise usu- ally rises as it produces and sells more output. This learn- ing by doing is a further source of economies of scale. All these factors contribute to lower average total costs for the firm that is able to expand its scale of operations. Where economies of scale are possible, an increase in all  resources of, say, 10 percent will cause a more-than- proportionate increase in output of, say, 20 percent. The result will be a decline in ATC. In many U.S. manufacturing industries, economies of scale have been of great significance. Firms that have ex- panded their scale of operations to obtain economies of mass production have survived and flourished. Those un- able to expand have become relatively high-cost produc- ers, doomed to struggle to survive.

Diseconomies of Scale In time the expansion of a firm may lead to diseconomies and therefore higher aver- age total costs. The main factor causing diseconomies of scale is the difficulty of efficiently controlling and coordinating a firm’s operations as it becomes a large-scale producer. In a small plant a single key executive may make all the basic decisions for the plant’s operation. Because of the firm’s small size, the executive is close to the production line, un- derstands the firm’s operations, and can make efficient de- cisions because the small plant size requires only a relatively small amount of information to be examined and understood in order to optimize production. This neat picture changes as a firm grows. One per- son cannot assemble, digest, and understand all the infor- mation essential to decision-making on a large scale. Authority must be delegated to many vice presidents, second vice presidents, and so forth. This expansion of the management hierarchy leads to problems of commu- nication and cooperation, bureaucratic red tape, and the possibility that decisions will not be coordinated. At the same time, each new manager must be paid a salary. Thus, declining efficiency in making and executing deci- sions goes hand-in-hand with rising average total costs as bureaucracy expands beyond a certain point. Also, in massive production facilities workers may feel alienated from their employers and care little about work- ing efficiently. Opportunities to shirk, by avoiding work in favor of on-the-job leisure, may be greater in large plants than in small ones. Countering worker alienation and

Labor Specialization Increased specialization in the use of labor becomes more achievable as a plant increases in size. Hiring more workers means jobs can be divided and sub- divided. Each worker may now have just one task to per- form instead of five or six. Workers can work full-time on the tasks for which they have special skills. By contrast, skilled machinists in a small plant may spend half their time performing unskilled tasks, leading to higher produc- tion costs. Further, by working at fewer tasks, workers become even more proficient at those tasks. The jack-of-all-trades doing five or six jobs is not likely to be efficient in any of them. Concentrating on one task, the same worker may become highly efficient. Finally, greater labor specialization eliminates the loss of time that occurs whenever a worker shifts from one task to another.

Managerial Specialization Large-scale production also means better use of, and greater specialization in, manage- ment. A supervisor who can handle 20 workers is under- used in a small plant that employs only 10 people. The production staff could be doubled with no increase in su- pervisory costs. Small firms cannot use management specialists to best advantage. For example, a marketing specialist working in a small plant may have to spend some of her time on func- tions outside of her area of expertise—for example, ac- counting, personnel, and finance. A larger scale of operations would allow her to supervise marketing full time, while other specialists perform other managerial functions. Greater productivity and efficiency, along with lower unit costs, would be the net result.

Efficient Capital Small firms often cannot afford the most efficient equipment. In many lines of production such ma- chinery is available only in very large and extremely ex- pensive units. Furthermore, effective use of the equipment demands a high volume of production, and that again re- quires large-scale producers. In the automobile industry the most efficient fabrica- tion method employs robotics and elaborate assembly-line equipment. Effective use of this equipment demands an annual output of several hundred thousand automobiles. Only very large-scale producers can afford to purchase and use this equipment efficiently. The small-scale pro- ducer is faced with a dilemma. To fabricate automobiles using other equipment is inefficient and therefore more costly per unit. But so, too, is buying and underutilizing the equipment used by the large manufacturers. Because it cannot spread the high equipment cost over very many units of output, the small-scale producer will be stuck with high costs per unit of output.

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CHAPTER 9 Businesses and the Costs of Production 213

in which average total cost is minimized when only one firm produces the particular good or service. Where economies of scale are few and diseconomies come into play quickly, the minimum efficient size occurs at a low level of output, as shown in Figure 9.9c. In such in- dustries a particular level of consumer demand will support a large number of relatively small producers. Many retail trades and some types of farming fall into this category. So do certain kinds of light manufacturing such as the baking, clothing, and shoe industries. Fairly small firms are more efficient than larger-scale producers in such industries. Our point here is that the shape of the long-run average-total-cost curve is determined by technology and the economies and diseconomies of scale that result. The shape of the long-run ATC curve, in turn, can be significant in determining whether an industry is populated by a rela- tively large number of small firms or is dominated by a few large producers, or lies somewhere in between. But we must be cautious in our assessment because in- dustry structure does not depend on cost conditions alone. Government policies, the geographic size of markets, man- agerial strategy and skill, and other factors must be consid- ered in explaining the structure of a particular industry.

shirking may require additional worker supervision, which increases costs. Where diseconomies of scale are operative, an increase in all inputs of, say, 10 percent will cause a less-than- proportionate increase in output of, say, 5 percent. As a consequence, ATC will increase. The rising portion of the long-run cost curves in Figure 9.9 illustrates diseconomies of scale.

Constant Returns to Scale In some industries a rather wide range of output may exist between the output at which economies of scale end and the output at which disecono- mies of scale begin. That is, there may be a range of con- stant returns to scale over which long-run average cost does not change. The q1q2 output range of Figure 9.9a is an example. Here a given percentage increase in all inputs of, say, 10 percent will cause a proportionate 10 percent in- crease in output. Thus, in this range ATC is constant.

Minimum Efficient Scale and Industry Structure

Economies and diseconomies of scale are an important de- terminant of an industry’s structure. Here we introduce the concept of minimum efficient scale (MES), which is the lowest level of output at which a firm can minimize long-run average costs. In Figure 9.9a that level occurs at q1 units of output. Because of the extended range of constant returns to scale, firms producing substantially greater outputs could also realize the minimum attainable long-run average costs. Specifically, firms within the q1 to q2 range would be equally efficient. So we would not be surprised to find an industry with such cost conditions to be populated by firms of quite different sizes. The apparel, food processing, furniture, wood products, snowboard, banking, and small-appliance indus- tries are examples. With an extended range of constant re- turns to scale, relatively large and relatively small firms can coexist in an industry and be equally successful. Compare this with Figure 9.9b, where economies of scale continue over a wide range of outputs and disecono- mies of scale appear only at very high levels of output. This pattern of declining long-run average total cost oc- curs in the automobile, aluminum, steel, and other heavy industries. The same pattern holds in several of the new industries related to information technology, for example, computer microchips, operating system software, and Internet service provision. Given consumer demand, efficient production will be achieved with a few large-scale producers. Small firms cannot realize the minimum efficient scale and will not be able to compete. In the extreme, economies of scale might extend beyond the market’s size, resulting in what is termed natural monopoly, a relatively rare market situation

QUICK REVIEW 9.3

• Most firms have U-shaped long-run average-total-cost curves, reflecting economies and then diseconomies of scale.

• Economies of scale are the consequence of greater specialization of labor and management, more effi- cient capital equipment, and the spreading of start-up costs over more units of output.

• Diseconomies of scale are caused by the problems of co- ordination and communication that arise in large firms.

• Minimum efficient scale (MES) is the lowest level of output at which a firm’s long-run average total cost is at a minimum.

Applications and Illustrations LO9.5 Give business examples of short-run costs, economies of scale, and minimum efficient scale (MES). The business world offers many examples relating to short-run costs, economies of scale, and minimum effi- cient scale (MES). Here are just a few.

O9.3

Minimum efficient scale and natural monopoly

ORIGIN OF THE IDEA

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Successful Start-Up Firms

The U.S. economy has greatly benefited over the past several decades from the explosive growth of scores of highly successful start-up firms. These firms typically reduce their costs by moving from higher to lower points on their short-run cost curves and by downward and to-the-right shifts of their short-run cost curves via economies of scale. That has certainly been the case for such former start-up firms as Intel (microchips), Starbucks (coffee), Microsoft (software), Dell (personal computers), Google (Internet searches), and Cisco Systems (Internet switching). A major source of lower average total cost for rapidly growing firms is the ability to spread huge product devel- opment and advertising costs over a larger number of units of output. These firms also achieve economies of scale from learning by doing and through increased spe- cialization of labor, management, and equipment. After

Rising Gasoline Prices

As we discuss in the appendix to Chapter 3, changes in sup- ply and demand often lead to rapid increases in the price of gasoline. Because gasoline is used to power the vast major- ity of all motor vehicles, including those used by businesses, increases in the price of gasoline lead to increases in firms’ short-run variable costs, marginal costs, and average total costs. In terms of our analysis, their AVC, MC, and ATC curves all shift upward when an increase in the price of gasoline increases production costs. The extent of these upward shifts depends upon the relative importance of gasoline as a variable input in the various firms’ individual production processes. Package- delivery companies like FedEx that use a lot of gasoline- powered vehicles will see substantial upward shifts while software companies like Symantec (Norton) that mainly deliver their products through Internet downloads may see only small upward shifts.

3-D Printers

Both a billionaire and your Average Joe can buy a pocketknife for $10. They can also both buy an iPhone for $199. And they can both purchase a new compact car for under $15,000. The fact that all of these items are affordable to both a bil- lionaire and your Average Joe is due to mass production and economies of scale. The iPhone, for instance, is one of the most complicated devices ever made. It contains cutting-edge technol- ogies for graphics, voice recognition, battery length, screen dura- bility, and many other features. Most of those technologies took hundreds of millions—if not billions—of dollars to develop and the factories that manufacture the iPhone and its components themselves cost many billions of dollars to set up. Yet, the iPhone is so inexpensive that Average Joes can afford to buy one. That mass affordability is the result of mass production cou- pled with mass sales. Marginal costs are typically quite low with mass production. So if manufacturers can tap mass markets and sell their products in large numbers, they can achieve low per- unit costs by spreading the massive fixed costs (for developing the new technologies and setting up the factories) over many units. Doing so results in economies of scale, low average total costs per unit, and low prices that even average folks can afford. Mass production and mass sales first became possible during the Industrial Revolution, which began in England during the late 1700s

and then spread through most of the rest of the world during the next two centuries. The Industrial Revolution occurred when steam- powered engines became powerful enough to drive factory equip- ment, propel ships, and pull trains. Engineers and inventors used steam power to automate factories and initiate the low-cost mass production of consumer goods. That process only accelerated when, in the late 19th century, the so-called Second Industrial Revolution saw electricity harnessed to drive factories and provide lighting.

3-D Printers Are Poised to Replace Mass Production with Mass Customization.

LAST WORD

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Mass sales, however, are not easy. They require large distri- bution networks, massive advertising budgets, and, perhaps most importantly, cheap ways of shipping products from factories to consumers. Thus, it was crucially important that transportation was also vastly improved during the first and second Industrial Revolutions. If not for better ships, smoother roads, and cheap transportation by railroad, transportation costs would have been so high that consumers would not have been able to afford mass- produced products shipped from distant factories. Now, a new technology promises to deliver a Third Industrial Revolution that will feature not only low production costs but also zero transportation costs. Even better, both of those highly attractive features will be possible even if you make only a single unit of a product. In addition, each unit can be fully customized to a consumer’s wants and needs. As a result, our world of affordable mass production may soon be replaced by a world of affordable mass customization. The new technology is called additive manufacturing and it creates objects using computer-controlled devices known as “3-D printers.” The 3-D (three-dimensional) printers contain a fine powder of metal or plastic particles that sit in a bin. A laser moves rapidly over the powder, the heat of its beam fusing small clumps of the powder together. Guided by a computerized blue- print, the rapidly moving laser can fuse a single layer of a compli- cated object together in just a few seconds. The bin is then lowered a bit, another layer of powder is placed on top, and the laser again begins to shoot, this time fus- ing together both the previous layer as well as the current layer. Doing this over and over, one layer atop another, results in a solid object whose shape is limited only by the complexity of the

blueprint. Any of the powder that is not struck by the laser and incorporated into the object is simply recycled for later use. Because 3-D printers are inexpensive, they could potentially be located anywhere. Thus, there is no need to worry about transportation costs since objects could be manufactured by consumers in their own homes or in local workshops located only a short drive away. And because the powders are cheap and the machines only require a modest amount of electricity, anything that could be made using a 3-D printer would be inexpensive even if you were only making a single unit. The First Industrial Revolution delivered low prices by spreading massive fixed costs over many units. The Third Industrial Revolution is set to deliver even lower prices by elimi- nating two types of costs—the massive fixed costs necessary to set up large factories and the transportation costs needed to ship resources to factories and then finished goods to consumers. One major cost might still remain, however. That is the cost of paying people to make the blueprints that drive the 3-D printers. But just as digital file sharing has pushed the price of recorded music toward zero, many analysts suspect that digital file sharing will also drive the price of blueprints very low. If so, the cost of manufactured goods may soon plunge to levels even lower than what has been achieved through mass production. So far, only relatively simple objects can be made with 3-D printers. But some engineers see a day in the not-so-distant fu- ture when it may be possible to create even complicated devices like an iPhone using additive manufacturing. If so, people will simply download inexpensive blueprints, make a few changes to customize the product, and then “print” what they want.

starting up, such firms experience declining average total costs over the years or even decades it takes them to even- tually reach their respective MESs.

The Verson Stamping Machine

In 1996 Verson (a U.S. firm located in Chicago) intro- duced a 49-foot-tall metal-stamping machine that is the size of a house and weighs as much as 12 locomotives. This $30 million machine, which cuts and sculpts raw sheets of steel into automobile hoods and fenders, en- ables automakers to make new parts in just 5 minutes, compared with 8 hours for older stamping presses. A single machine is designed to make 5 million auto parts per year. So, to achieve the cost saving from the machine, an auto manufacturer must have sufficient auto produc- tion to use all these parts. By allowing the use of this cost-saving piece of equipment, large firm size achieves economies of scale.

The Daily Newspaper

Daily newspapers have been going bankrupt in rapid suc- cession over the past several years as both advertising dol- lars and news readership have shifted to the Internet. The falling circulation numbers have caused average fixed costs to rise significantly as newspapers are forced to spread their substantial fixed costs over fewer and fewer papers. The spike in average fixed costs has, in turn, forced news- papers to sharply increase their prices. Between July 2007 and July 2009, for instance, the New York Times had to raise its cover price three times as advertising revenues plunged and fixed costs had to be spread over fewer and fewer pa- pers. Starting at $1 per copy, the cover price had to be raised to $1.25, then $1.50, and then $2.00. With readership continuing to fall, newspapers face an average-fixed-cost death spiral. The more they raise their prices, the less they will sell. But the less their sales, the higher their average fixed costs and thus the more they

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PART FOUR Microeconomics of Product Markets216

SUMMARY Average fixed, average variable, and average total costs are

fixed, variable, and total costs per unit of output. Average fixed cost declines continuously as output increases because a fixed sum is being spread over a larger and larger number of units of production. A graph of average variable cost is U-shaped, reflect- ing increasing returns followed by diminishing returns. Average total cost is the sum of average fixed and average variable costs; its graph is also U-shaped.

Marginal cost is the extra, or additional, cost of producing one more unit of output. It is the amount by which total cost and total variable cost change when one more or one less unit of out- put is produced. Graphically, the marginal-cost curve intersects the ATC and AVC curves at their minimum points.

Lower resource prices shift cost curves downward, as does tech- nological progress. Higher input prices shift cost curves upward.

LO9.4 Use economies of scale to link a firm’s size and its average costs in the long run.

The long run is a period of time sufficiently long for a firm to vary the amounts of all resources used, including plant size. In the long run all costs are variable. The long-run ATC, or planning, curve is composed of segments of short-run ATC curves, and it represents the various plant sizes a firm can construct in the long run.

The long-run ATC curve is generally U-shaped. Economies of scale are first encountered as a small firm expands. Greater spe- cialization in the use of labor and management, the ability to use the most efficient equipment, and the spreading of start-up costs among more units of output all contribute to economies of scale. As the firm continues to grow, it will encounter diseconomies of scale stemming from the managerial complexities that accompany large-scale production. The output ranges over which economies and diseconomies of scale occur in an industry are often an im- portant determinant of the structure of that industry.

LO9.1 Explain why economic costs include both explicit (revealed and expressed) costs and implicit

(present but not obvious) costs.

The economic cost of using a resource to produce a good or ser- vice is the value or worth that the resource would have had in its best alternative use. Economic costs include explicit costs, which flow to resources owned and supplied by others, and implicit costs, which are payments for the use of self-owned and self-employed resources. One implicit cost is a normal profit to the entrepreneur. Economic profit occurs when total revenue exceeds total cost (5 explicit costs 1 implicit costs, including a normal profit).

In the short run a firm’s plant capacity is fixed. The firm can use its plant more or less intensively by adding or subtracting units of variable resources, but it does not have sufficient time in the short run to alter plant size.

LO9.2 Relate the law of diminishing returns to a firm’s short-run production costs.

The law of diminishing returns describes what happens to out- put as a fixed plant is used more intensively. As successive units of a variable resource such as labor are added to a fixed plant, beyond some point the marginal product associated with each additional unit of a resource declines.

LO9.3 Describe the distinctions between fixed and variable costs and among total, average, and

marginal costs.

Because some resources are variable and others are fixed, costs can be classified as variable or fixed in the short run. Fixed costs are independent of the level of output; variable costs vary with output. The total cost of any output is the sum of fixed and vari- able costs at that output.

must raise their prices. As a result, printed newspapers could ultimately be a thing of the past, with both advertis- ing and news delivery shifting mainly to the Internet.

Aircraft and Concrete Plants

Why are there only two plants in the United States (both operated by Boeing) that produce large commercial air- craft and thousands of plants (owned by hundreds of firms) that produce ready-mixed concrete? The simple answer is that MES is radically different in the two industries. Why is that? First, while economies of scale are extensive in as- sembling large commercial aircraft, they are only very modest in mixing concrete. Manufacturing airplanes is a complex process that requires huge facilities, thousands of

workers, and very expensive, specialized machinery. Economies of scale extend to huge plant sizes. But mixing portland cement, sand, gravel, and water to produce con- crete requires only a handful of workers and relatively in- expensive equipment. Economies of scale are exhausted at relatively small size. The differing MESs also derive from the vastly differ- ent sizes of the geographic markets. The market for com- mercial airplanes is global, and aircraft manufacturers can deliver new airplanes anywhere in the world by flying them there. In contrast, the geographic market for a con- crete plant is roughly the 50-mile radius within which the concrete can be delivered before it “sets up.” So thousands of small concrete plants locate close to their customers in hundreds of small and large cities in the United States.

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CHAPTER 9 Businesses and the Costs of Production 217

A firm’s minimum efficient scale (MES) is the lowest level of output at which it can minimize its long-run average cost. In some industries, MES occurs at such low levels of output that numerous firms can populate the industry. In other industries, MES occurs at such high output levels that only a few firms can exist in the long run.

LO9.5 Give business examples of short-run costs, economies of scale, and minimum efficient scale (MES).

Rising gasoline prices increase (shift upward) the AVC, ATC, and MC cost curves of firms like FedEx that use gasoline as an input in their production processes.

Starbucks, Facebook, and many other successful start-up firms that experienced rapid growth reduced costs and shifted their cost curves down and to the right by spreading product- development and advertising costs over larger numbers of units and by exploiting the economies of scale that can be generated through learning by doing and increased specialization of labor, management, and equipment.

Because minimum efficient scale (MES) is extremely large for commercial aircraft, Boeing only has two production facilities in the United States. By contrast, MES is very small in concrete manufacturing. So there are thousands of concrete makers in the United States.

TERMS AND CONCEPTS economic cost explicit costs implicit costs accounting profit normal profit economic profit short run long run

total product (TP) marginal product (MP) average product (AP) law of diminishing returns fixed costs variable costs total cost average fixed cost (AFC)

average variable cost (AVC) average total cost (ATC) marginal cost (MC) economies of scale diseconomies of scale constant returns to scale minimum efficient scale (MES) natural monopoly

D I S C U S S I O N Q U E S T I O N S

1. Distinguish between explicit and implicit costs, giving ex- amples of each. What are some explicit and implicit costs of attending college? LO9.1

2. Distinguish between accounting profit, economic profit, and normal profit. Does accounting profit or economic profit determine how entrepreneurs allocate resources be- tween different business ventures? Explain. LO9.1

3. Complete the table below by calculating marginal product and average product.

Inputs of Total Marginal Average

Labor Product Product Product

0 0

1 15

2 34

3 51

4 65

5 74

6 80

7 83

8 82

Plot the total, marginal, and average products and explain in detail the relationship between each pair of curves. Explain

why marginal product first rises, then declines, and ulti- mately becomes negative. What bearing does the law of di- minishing returns have on short-run costs? Be specific. “When marginal product is rising, marginal cost is falling. And when marginal product is diminishing, marginal cost is rising.” Illustrate and explain graphically. LO9.2

4. Why can the distinction between fixed costs and variable costs be made in the short run? Classify the following as fixed or variable costs: advertising expenditures, fuel, inter- est on company-issued bonds, shipping charges, payments for raw materials, real estate taxes, executive salaries, insur- ance premiums, wage payments, depreciation and obsoles- cence charges, sales taxes, and rental payments on leased office machinery. “There are no fixed costs in the long run; all costs are variable.” Explain. LO9.3

5. List several fixed and variable costs associated with owning and operating an automobile. Suppose you are considering whether to drive your car or fly 1,000 miles to Florida for spring break. Which costs—fixed, variable, or both—would you take into account in making your decision? Would any implicit costs be relevant? Explain. LO9.3

6. Use the concepts of economies and diseconomies of scale to explain the shape of a firm’s long-run ATC curve. What is the concept of minimum efficient scale? What bearing can

The following and additional problems can be found in

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PART FOUR Microeconomics of Product Markets218

the shape of the long-run ATC curve have on the structure of an industry? LO9.4

7. LAST WORD Does additive manufacturing rely on econo- mies of scale to deliver low costs? What are two ways in

which additive manufacturing lowers costs? Besides what’s written in the book, might there be another reason to expect 3-D blueprints to be inexpensive? (Hint: Think in terms of supply and demand.)

R E V I E W Q U E S T I O N S

1. Linda sells 100 bottles of homemade ketchup for $10 each. The cost of the ingredients, the bottles, and the labels was $700. In addition, it took her 20 hours to make the ketchup and to do so she took time off from a job that paid her $20  per hour. Linda’s accounting profit is _____________ while her economic profit is ______________. LO9.1

a. $700; $400 b. $300; $100 c. $300; negative $100 d. $1,000; negative $1,100 2. Which of the following are short-run and which are long-

run adjustments? LO9.1 a. Wendy’s builds a new restaurant. b. Harley-Davidson Corporation hires 200 more pro-

duction workers. c. A farmer increases the amount of fertilizer used on his

corn crop. d. An Alcoa aluminum plant adds a third shift of workers. 3. A firm has fixed costs of $60 and variable costs as indicated

in the table at the bottom of this page. Complete the table and check your calculations by referring to problem 4 at the end of Chapter 10. LO9.3

a. Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing returns influences the shapes of the variable-cost and total-cost curves.

b. Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves and their relationships to one another. Specifically, explain in nontechnical terms why the MC curve intersects both the AVC and the ATC curves at their minimum points.

c. Explain how the location of each curve graphed in question 3b would be altered if (1) total fixed cost had

been $100 rather than $60 and (2) total variable cost had been $10 less at each level of output.

4. Indicate how each of the following would shift the (1) marginal-cost curve, (2) average-variable-cost curve, (3) average-fixed-cost curve, and (4) average-total-cost curve of a manufacturing firm. In each case specify the direction of the shift. LO9.3

a. A reduction in business property taxes. b. An increase in the nominal wages of production workers. c. A decrease in the price of electricity. d. An increase in insurance rates on plant and equipment. e. An increase in transportation costs. 5. True or false. The U shape of the long-run ATC curve is the

result of diminishing returns. LO9.4 6. Suppose a firm has only three possible plant-size options,

represented by the ATC curves shown in the accompanying figure. What plant size will the firm choose in producing (a) 50, (b) 130, (c) 160, and (d ) 250 units of output? Draw the firm’s long-run average-cost curve on the diagram and describe this curve. LO9.4

ATC ATC3

ATC2

ATC1

0 80 150 240 Q

Total Total Total Total Average Average Average Marginal

Product Fixed Cost Variable Cost Cost Fixed Cost Variable Cost Total Cost Cost

0 $ $ 0 $ $

1 45 $ $ $

2 85

3 120

4 150

5 185

6 225

7 270

8 325

9 390

10 465

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CHAPTER 9 Businesses and the Costs of Production 219

P R O B L E M S

1. Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entre- preneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate the ac- counting profit and the economic profit for Gomez’s pot- tery firm. LO9.1

2. Imagine you have some workers and some handheld com- puters that you can use to take inventory at a warehouse. There are diminishing returns to taking inventory. If one worker uses one computer, he can inventory 100 items per hour. Two workers sharing a computer can together inven- tory 150 items per hour. Three workers sharing a com- puter can together inventory 160 items per hour. And four or more workers sharing a computer can together inven- tory fewer than 160 items per hour. Computers cost $100 each and you must pay each worker $25 per hour. If you assign one worker per computer, what is the cost of inven- torying a single item? What if you assign two workers per computer? Three? How many workers per computer

should you assign if you wish to minimize the cost of in- ventorying a single item? LO9.2

3. You are a newspaper publisher. You are in the middle of a one-year rental contract for your factory that requires you to pay $500,000 per month, and you have contractual labor obligations of $1 million per month that you can’t get out of. You also have a marginal printing cost of $0.25 per paper as well as a marginal delivery cost of $0.10 per paper. If sales fall by 20 percent from 1 million papers per month to 800,000 papers per month, what happens to the AFC per paper, the MC per paper, and the minimum amount that you must charge to break even on these costs? LO9.3

4. There are economies of scale in ranching, especially with re- gard to fencing land. Suppose that barbed-wire fencing costs $10,000 per mile to set up. How much would it cost to fence a single property whose area is one square mile if that prop- erty also happens to be perfectly square, with sides that are each one mile long? How much would it cost to fence exactly four such properties, which together would contain four square miles of area? Now, consider how much it would cost to fence in four square miles of ranch land if, instead, it comes as a single large square that is two miles long on each side. Which is more costly—fencing in the four, one-square-mile properties or the single four-square-mile property? LO9.4

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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220

Pure Competition in the Short Run

CHAPTER 10

LO10.6 Explain why a competitive firm’s marginal cost curve is the same as

its supply curve.

Learning Objectives

LO10.1 Give the names and summarize the main characteristics of the four

basic market models.

LO10.2 List the conditions required for purely competitive markets.

LO10.3 Explain how demand is seen by a purely competitive seller.

LO10.4 Convey how purely competitive firms can use the total-revenue–

total-cost approach to maximize

profits or minimize losses in the

short run.

LO10.5 Explain how purely competitive firms can use the marginal-

revenue–marginal-cost approach

to maximize profits or minimize

losses in the short run.

In Chapter 6 we examined the relationship be-

tween product demand and total revenue, and in

Chapter 9 we discussed production costs. Now we

want to connect revenues and costs to see how a

business decides what price to charge and how

much output to produce. A firm’s decisions con-

cerning price and production depend greatly on

the character of the industry in which it is operat-

ing. There is no “average” or “typical” industry. At one

extreme is an industry in which a single producer

dominates the market; at the other extreme are in-

dustries in which thousands of firms each produces

a tiny fraction of market supply. Between these

extremes are many other types of industries.

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CHAPTER 10 Pure Competition in the Short Run 221

also will help you evaluate the efficiency or ineffi-

ciency of those markets. Finally, these four models

will provide a crucial background for assessing pub-

lic policies (such as antitrust policy) relating to cer-

tain firms and industries.

Since we cannot examine each industry individ-

ually, we will focus on four basic models of market

structure. Together, these models will help you

understand how price and output are determined

in the many product markets in the economy. They

Four Market Models LO10.1 Give the names and summarize the main characteristics of the four basic market models. Economists group industries into four distinct market structures: pure competition, pure monopoly, monopolis- tic competition, and oligopoly. These four market models differ in several respects: the number of firms in the indus- try, whether those firms produce a standardized product or try to differentiate their products from those of other firms, and how easy or how difficult it is for firms to enter the industry. Very briefly the four models are as follows:

• Pure competition involves a very large number of firms producing a standardized product (that is, a product like cotton, for which each producer’s output is virtually identical to that of every other producer.) New firms can enter or exit the industry very easily.

• Pure monopoly is a market structure in which one firm is the sole seller of a product or service (for example, a local electric utility). Since the entry of additional firms is blocked, one firm constitutes the

entire industry. The pure monopolist produces a single unique product, so product differentiation is not an issue.

• Monopolistic competition is characterized by a relatively large number of sellers producing differentiated products (clothing, furniture, books). Present in this model is widespread nonprice competition, a selling strategy in which a firm does not try to distinguish its product on the basis of price but instead on attributes like design and workmanship (an approach called product differentiation). Either entry to or exit from monopolistically competitive industries is quite easy.

• Oligopoly involves only a few sellers of a standardized or differentiated product, so each firm is affected by the decisions of its rivals and must take those decisions into account in determining its own price and output.

Table 10.1 summarizes the characteristics of the four mod- els for easy comparison and later reference. In discussing these market models, we will occasionally distinguish the

Market Model

Characteristic Pure Competition Monopolistic Competition Oligopoly Pure Monopoly

Number of firms A very large number Many Few One

Type of product Standardized Differentiated Standardized or Unique; no close differentiated substitutes

Control over price None Some, but within rather Limited by mutual Considerable narrow limits interdependence; considerable with collusion

Conditions of entry Very easy, no Relatively easy Significant obstacles Blocked obstacles

Nonprice None Considerable emphasis Typically a great deal, Mostly public competition on advertising, brand particularly with product relations names, trademarks differentiation advertising

Examples Agriculture Retail trade, dresses, Steel, automobiles, farm Local utilities shoes implements, many household appliances

TABLE 10.1 Characteristics of the Four Basic Market Models

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PART FOUR Microeconomics of Product Markets222

characteristics of pure competition from those of the three other basic market structures, which together we will des- ignate as imperfect competition.

Pure Competition: Characteristics and Occurrence LO10.2 List the conditions required for purely competitive markets. Although pure competition is relatively rare in the real world, this market model is highly relevant to several in- dustries. In particular, we can learn much about markets for agricultural goods, fish products, foreign exchange, basic metals, and stock shares by studying the pure-competition model. Also, pure competition is a meaningful starting point for any discussion of price and output determination. Moreover, the operation of a purely competitive economy provides a standard, or norm, for evaluating the efficiency of the real-world economy. Let’s take a fuller look at pure competition, the focus of the remainder of this chapter:

• Very large numbers A basic feature of a purely competitive market is the presence of a large number of independently acting sellers, often offering their products in large national or international markets. Examples: markets for farm commodities, the stock market, and the foreign exchange market.

• Standardized product Purely competitive firms produce a standardized (identical or homogeneous) product. As long as the price is the same, consumers will be indifferent about which seller to buy the product from. Buyers view the products of firms B, C, D, and E as perfect substitutes for the product of firm A. Because purely competitive firms sell standardized products, they make no attempt to differentiate their products and do not engage in other forms of nonprice competition.

• “Price takers” In a purely competitive market, individual firms do not exert control over product price. Each firm produces such a small fraction of total output that increasing or decreasing its output will not perceptibly influence total supply or, therefore, product price. In short, the competitive firm is a price taker: It cannot change market price; it can only adjust to it. That means that the individual competitive producer is at the mercy of the market. Asking a price higher than the market price would be futile. Consumers will not buy from firm A at $2.05 when its 9,999 competitors are selling an identical

product, and therefore a perfect substitute, at $2 per unit. Conversely, because firm A can sell as much as it chooses at $2 per unit, it has no reason to charge a lower price, say, $1.95. Doing that would shrink its profit.

• Free entry and exit New firms can freely enter and existing firms can freely leave purely competitive industries. No significant legal, technological, financial, or other obstacles prohibit new firms from selling their output in any competitive market.

Demand as Seen by a Purely Competitive Seller LO10.3 Explain how demand is seen by a purely competitive seller. We begin by examining demand from a purely competi- tive seller’s viewpoint to see how it affects revenue. This seller might be a wheat farmer, a strawberry grower, a sheep rancher, a foreign-currency broker, or some other pure competitor. Because each purely competitive firm of- fers only a negligible fraction of total market supply, it must accept the price determined by the market; it is a price taker, not a price maker.

Perfectly Elastic Demand

The demand schedule faced by the individual firm in a purely competitive industry is perfectly elastic at the mar- ket price, as demonstrated in Figure 10.1. As shown in col- umn 1 of the table in Figure 10.1, the market price is $131. The firm represented cannot obtain a higher price by re- stricting its output, nor does it need to lower its price to increase its sales volume. Columns 1 and 2 show that the firm can produce and sell as many or as few units as it likes at the market price of $131. We are not saying that market demand is perfectly elastic in a competitive market. Rather, market demand graphs as a downsloping curve. An entire industry (all firms producing a particular product) can affect price by changing industry output. For example, all firms, acting independently but simultaneously, can increase price by reducing output. But the individual competitive firm can- not do that because its output represents such a small fraction of its industry’s total output. For the individual competitive firm, the market price is therefore a fixed value at which it can sell as many or as few units as it cares to. Graphically, this implies that the individual competi- tive firm’s demand curve will plot as a straight, horizontal line such as D in Figure 10.1.

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CHAPTER 10 Pure Competition in the Short Run 223

Average, Total, and Marginal Revenue

The firm’s demand schedule is also its average-revenue schedule. Price per unit to the purchaser is also revenue per unit, or average revenue, to the seller. To say that all buyers must pay $131 per unit is to say that the revenue per unit, or average revenue received by the seller, is $131. Price and average revenue are the same thing. The total revenue for each sales level is found by mul- tiplying price by the corresponding quantity the firm can

sell. (Column 1 multiplied by column 2 in the table in Figure 10.1 yields column 3.) In this case, total revenue increases by a constant amount, $131, for each additional unit of sales. Each unit sold adds exactly its constant price—no more or no less—to total revenue. When a firm is pondering a change in its output, it will consider how its total revenue will change as a result. Marginal revenue is the change in total revenue (or the extra revenue) that results from selling one more unit of

Firm’s Demand Schedule Firm’s Revenue Data

(1) (2) (3) (4)

Product Price (P) Quantity Total Revenue Marginal

(Average Revenue) Demanded (Q) (TR), (1) 3 (2) Revenue (MR)

$131 0 $ 0 ] $131

131 1 131 ] 131

131 2 262 ] 131

131 3 393 ] 131

131 4 524 ] 131

131 5 655 ] 131

131 6 786 ] 131

131 7 917 ] 131

131 8 1048 ] 131

131 9 1179 ] 131

131 10 1310

FIGURE 10.1 A purely competitive firm’s demand and revenue curves. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve.

TR

D = MR = AR

$1,179

1,048

917

786

655

524

393

262

131

0 2 4 6 8 10 12

Quantity demanded (sold)

P ri

ce a

n d r

ev en

u e

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PART FOUR Microeconomics of Product Markets224

output. In column 3 of the table in Figure 10.1, total rev- enue is zero when zero units are sold. The first unit of output sold increases total revenue from zero to $131, so marginal revenue for that unit is $131. The second unit sold increases total revenue from $131 to $262, and mar- ginal revenue is again $131. Note in column 4 that mar- ginal revenue is a constant $131, as is price. In pure competition, marginal revenue and price are equal. Figure 10.1 shows the purely competitive firm’s total- revenue, demand, marginal-revenue, and average-revenue curves. Total revenue (TR) is a straight line that slopes up- ward to the right. Its slope is constant because each extra unit of sales increases TR by $131. The demand curve (D) is horizontal, indicating perfect price elasticity. The marginal-revenue (MR) curve coincides with the demand curve because the product price (and hence MR) is con- stant. The average revenue (AR) curve equals price and therefore also coincides with the demand curve.

variable resources to achieve the output level that maxi- mizes its profit or minimizes its loss. There are two ways to determine the level of output at which a competitive firm will realize maximum profit or minimum loss. One method is to compare total revenue and total cost; the other is to compare marginal revenue and marginal cost. Both approaches apply to all firms, whether they are pure competitors, pure monopolists, mo- nopolistic competitors, or oligopolists.1 We begin by examining profit maximization using the total-revenue–total-cost approach. Confronted with the market price of its product, the competitive producer will ask three questions: (1) Should we produce this product? (2) If so, in what amount? (3) What economic profit (or loss) will we realize? Let’s demonstrate how a pure competitor answers these questions, given a particular set of cost data and a specific market price. Our cost data are already familiar because they are the fixed- cost, variable-cost, and total-cost data in Table 9.2, repeated in columns 1 to 4 of the table in Figure 10.2. (Recall that these data re- flect explicit and implicit costs, including a normal profit.) Assuming that the market price is $131, the total revenue for each output level is found by multiplying output (total product) by price. Total-revenue data are in column 5. Then in column 6 we find the profit or loss at each output level by sub- tracting total cost, TC (column 4), from total revenue, TR (column 5). Should the firm produce? Definitely. It can obtain a profit by doing so. How much should it produce? Nine units. Column 6 tells us that this is the output at which total economic profit is at a maximum. What economic profit (or loss) will it realize? A $299 economic profit— the difference between total revenue ($1,179) and total cost ($880). Figure 10.2a compares total revenue and total cost graphically for this profit-maximizing case. Observe again that the total-revenue curve for a purely competitive firm is a straight line (Figure 10.1). Total cost increases with

Profit Maximization in the Short Run: Total-Revenue–Total-Cost Approach LO10.4 Convey how purely competitive firms can use the total-revenue–total-cost approach to maximize profits or minimize losses in the short run. Because the purely competitive firm is a price taker, it can- not attempt to maximize its profit by raising or lowering the price it charges. With its price set by supply and de- mand in the overall market, the only variable that the firm can control is its output. As a result, the purely competi- tive firm attempts to maximize its economic profit (or minimize its economic loss) by adjusting its output. And, in the short run, the firm has a fixed plant. Thus it can adjust its output only through changes in the amount of variable resources (materials, labor) it uses. It adjusts its

1To make sure you understand these two approaches, we will apply both of them to output determination under pure competition. But since we want to emphasize the marginal approach, we will limit our graphical application of the total-revenue approach to a situation where the firm maximizes profits. We will then use the marginal approach to examine three cases: profit maximization, loss minimization, and shutdown.

QUICK REVIEW 10.1

• In a purely competitive industry a large number of firms produce a standardized product and there are no significant barriers to entry.

• The demand seen by a purely competitive firm is per- fectly elastic—horizontal on a graph—at the market price.

• Marginal revenue and average revenue for a purely competitive firm coincide with the firm’s demand curve; total revenue rises by the product price for each additional unit sold.

W10.1

Profit maximization: TR2TC approach

WORKED PROBLEMS

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225

$1,800

1,700

1,600

1,500

1,400

1,300

1,200

1,100

1,000

900

800

700

600

500

400

300

200

100

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

To ta

l re

ve nu

e an

d t

o ta

l co

st

(a) Profit-maximizing case

Quantity demanded (sold)

P = $131

Break-even point (normal profit)

Total revenue, TR

Maximum economic profit $299

Total cost, TC

Break-even point (normal profit)

$500

400

300

200

100

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

To ta

l ec

o n o

m ic

p ro

fi t

Total economic profit

(b) Total economic profit

Quantity demanded (sold)

$299

FIGURE 10.2 Total-revenue–total-cost approach to profit maximization for a purely competitive firm. (a) The firm’s profit is maximized at that output (9 units) where total revenue, TR, exceeds total cost, TC, by the maximum amount. (b) The vertical distance between TR and TC in (a) is plotted as a total-economic-profit curve. Maximum economic profit is $299 at 9 units of output.

PRICE: $131

(1) (2) (3) (4) (5) (6)

Total Product Total Fixed Total Variable Total Cost Total Revenue Profit (1) (Output) (Q) Cost (TFC) Cost (TVC) (TC) (TR) or Loss (2)

0 $100 $ 0 $ 100 $ 0 $2100 1 100 90 190 131 259

2 100 170 270 262 28

3 100 240 340 393 153

4 100 300 400 524 1124

5 100 370 470 655 1185

6 100 450 550 786 1236

7 100 540 640 917 1277

8 100 650 750 1,048 1298

9 100 780 880 1,179 1299

10 100 930 1,030 1,310 1280

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PART FOUR Microeconomics of Product Markets226

output because more production requires more resources. But the rate of increase in total cost varies with the effi- ciency of the firm, which in turn varies with the amount of variable inputs that are being combined with the firm’s current amount of capital (which is fixed in the short run). Stated slightly differently, the cost data reflect Chapter 9’s law of diminishing returns. From zero to four units of out- put, total cost increases at a decreasing rate as the firm temporarily experiences increasing returns. At higher lev- els of output, however, efficiency falls as crowding causes diminishing returns to set in. Once that happens, the firm’s total cost increases at an increasing rate because each additional unit of input yields less output than the previous unit. Total revenue and total cost are equal where the two curves in Figure 10.2a intersect (at roughly 2 units of out- put). Total revenue covers all costs (including a normal profit, which is included in the cost curve), but there is no economic profit. For this reason economists call this out- put a break-even point: an output at which a firm makes a normal profit but not an economic profit. If we extended the data beyond 10 units of output, another break-even point would occur where total cost catches up with total revenue, somewhere between 13 and 14 units of output in Figure 10.2a. Any output within the two break-even points identified in the figure will yield an economic profit. The firm achieves maximum profit, however, where the vertical distance between the total-revenue and total-cost curves is greatest. For our particular data, this is at 9 units of out- put, where maximum profit is $299. The profit-maximizing output is easier to see in Figure 10.2b, where total profit is graphed for each level of output. Where the total-revenue and total-cost curves intersect in Figure 10.2a, economic profit is zero, as shown by the total-profit line in Figure 10.2b. Where the vertical distance between TR and TC is greatest in the upper graph, economic profit is at its peak ($299), as shown in the lower graph. This firm will choose to produce 9 units since that output maximizes its profit.

Profit Maximization in the Short Run: Marginal-Revenue– Marginal-Cost Approach LO10.5 Explain how purely competitive firms can use the marginal-revenue–marginal-cost approach to maximize profits or minimize losses in the short run. In the second approach, the firm compares the amounts that each additional unit of output would add to total reve- nue and to total cost. In other words, the firm compares the

marginal revenue (MR) and the marginal cost (MC) of each successive unit of output. Assuming that producing is pref- erable to shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal cost because the firm would gain more in revenue from selling that unit than it would add to its costs by producing it. Conversely, if the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit. Producing it would add more to costs than to revenue, and profit would decline or loss would increase. In the initial stages of production, where output is rela- tively low, marginal revenue will usually (but not always) exceed marginal cost. So it is profitable to produce through this range of output. But at later stages of production, where output is relatively high, rising marginal costs will exceed marginal revenue. Obviously, a profit-maximizing firm will want to avoid output levels in that range. Separating these two production ranges is a unique point at which marginal revenue equals marginal cost. This point is the key to the output-determining rule: In the short run, the firm will maximize profit or minimize loss by producing the output at which marginal revenue equals marginal cost (as long as producing is preferable to shutting down). This profit- maximizing guide is known as the MR 5 MC rule. Keep in mind these features of the MR 5 MC rule:

• For most sets of MR and MC data, MR and MC will be precisely equal at a fractional level of output. In such instances the firm should produce the last complete unit of output for which MR exceeds MC.

• As noted, the rule applies only if producing is preferable to shutting down. We will show shortly that if marginal revenue does not equal or exceed average variable cost, the firm will shut down rather than produce the amount of output at which MR 5 MC.

• The rule is an accurate guide to profit maximization for all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.

• The rule can be restated as P 5 MC when applied to a purely competitive firm. Because the demand schedule faced by a competitive seller is perfectly elastic at the going market price, product price and marginal revenue are equal. So under pure competition (and only under pure competition) we may substitute P for MR in the rule: When producing is preferable to shutting down, the competitive firm that wants to maximize its profit or minimize its loss should produce at that point where price equals marginal cost (P 5 MC).

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CHAPTER 10 Pure Competition in the Short Run 227

Now let’s apply the MR 5 MC rule or, because we are considering pure competition, the P 5 MC rule, first us- ing the same price as used in our total-revenue–total-cost approach to profit maximization. Then, by considering other prices, we will demonstrate two additional cases: loss minimization and shutdown. It is crucial that you under- stand the MR 5 MC analysis that follows since it reap- pears in Chapters 12, 13, and 14.

Profit-Maximizing Case

The first five columns of the table in Figure 10.3 (Key Graph) reproduce the AFC, AVC, ATC, and MC data de- rived for our product in Table 9.2. It is the marginal-cost data of column 5 that we will compare with price (equals marginal revenue) for each unit of output. Suppose first that the market price, and therefore marginal revenue, is $131, as shown in column 6. What is the profit-maximizing output? Every unit of output up to and including the ninth unit represents greater marginal revenue than marginal cost of output. Each of the first 9 units therefore adds to the firm’s profit and should be produced. The tenth unit, however, should not be produced. It would add more to cost ($150) than to revenue ($131). So 9 units is the profit-maximizing output. The economic profit realized by producing 9 units can be calculated by subtracting total cost from total revenue. Multiplying price ($131) by output (9), we find that total rev- enue is $1,179. From the average-total-cost data in column 4, we see that ATC is $97.78 at 9 units of output. Multiplying $97.78 by 9 gives us total cost of $880.2 The difference of $299 (5 $1,179 2 $880) is the economic profit. Clearly, this firm will prefer to operate rather than shut down. Perhaps an easier way to calculate the economic profit is to use this simple equation, in which A is average total cost:

Profit 5 (P 2 A) 3 Q

So by subtracting the average total cost ($97.78) from the product price ($131), we obtain a per-unit profit of $33.22.

Multiplying that amount by 9 units of output, we determine that the profit is $299. Take some time now to verify the numbers in column 7. You will find that any output other than

that which adheres to the MR 5 MC rule will mean either profits below $299 or losses. The graph in Figure 10.3 shows price (5 MR) and marginal cost graphically. Price equals marginal cost at the profit-maximizing output of 9 units. There the per-unit economic profit is P 2 A, where P is the market price and A is the average total cost for an output of 9 units. The total economic profit is 9 3 (P 2 A), shown by the green rectangular area. Note that the firm wants to maximize its total profit, not its per-unit profit. Per-unit profit is greatest at 7 units of output, where price exceeds average total cost by $39.57 (5 $131 2 $91.43). But by producing only 7 units, the firm would be forgoing the production of 2 additional units of output that would clearly contribute to total profit. The firm is happy to accept lower per-unit profits for additional units of output because they nonetheless add to total profit.

Loss-Minimizing Case

Now let’s assume that the market price is $81 rather than $131. Should the firm still produce? If so, how much? And what will be the resulting profit or loss? The answers, re- spectively, are “Yes,” “Six units,” and “A loss of $64.” The first five columns of the table in Figure 10.4 are the same as the first five columns of the table in Figure 10.3. But column 6 of the table in Figure 10.4 shows the new price (equal to MR), $81. Comparing columns 5 and 6, we find that the first unit of output adds $90 to total cost but only $81 to total revenue. One might conclude: “Don’t produce—close down!” But that would be hasty. Remember that in the very early stages of production, marginal product is low, making marginal cost unusually high. The price–marginal cost relationship improves with increased production. For units 2 through 6, price exceeds marginal cost. Each of these 5 units adds more to revenue than to cost, and as shown in column 7, they decrease the total loss. Together they more than compensate for the “loss” taken on the first unit. Beyond 6 units, however, MC exceeds MR (5 P). The firm should therefore pro- duce 6 units. In general, the profit-seeking producer should always compare marginal revenue (or price under pure competition) with the rising portion of the marginal- cost schedule or curve. Will production be profitable? No, because at 6 units of output the average total cost of $91.67 exceeds the price of $81 by $10.67 per unit. If we multiply that by the 6 units of output, we find the firm’s total loss is $64. Alternatively, comparing the total revenue of $486 (5 6 3 $81) with the total cost of $550 (5 6 3 $91.67), we see again that the firm’s loss is $64.

2Most of the unit-cost data are rounded figures. Therefore, economic profits calculated from them will typically vary by a few cents from the profits determined in the total-revenue–total-cost approach. Here we simply ignore the few-cents differentials to make our answers consistent with the results of the total-revenue–total-cost approach.

W10.2

Profit maximization: MR 5 MC approach

WORKED PROBLEMS

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KEY GRAPH

QUICK QUIZ FOR FIGURE 10.3

1. Curve MR is horizontal because: a. product price falls as output increases. b. the law of diminishing marginal utility is at work. c. the market demand for this product is perfectly elastic. d. the firm is a price taker. 2. At a price of $131 and 7 units of output: a. MR exceeds MC, and the firm should expand its output. b. total revenue is less than total cost. c. AVC exceeds ATC. d. the firm would earn only a normal profit. 3. In maximizing profits at 9 units of output, this firm is adhering

to which of the following decision rules?

a. Produce where MR exceeds MC by the greatest amount. b. Produce where P exceeds ATC by the greatest amount. c. Produce where total revenue exceeds total cost by the greatest

amount. d. Produce where average fixed costs are zero. 4. Suppose price declined from $131 to $100. This firm’s: a. marginal-cost curve would shift downward. b. economic profit would fall to zero. c. profit-maximizing output would decline. d. total cost would fall by more than its total revenue.

Answers: 1. d; 2. a; 3. c; 4. c FIGURE 10.3 Short-run profit maximization for a purely competitive firm. The MR 5 MC output enables the purely competitive firm to maximize profits or to minimize losses. In this case MR (5 P in pure competition) and MC are equal at an output Q of 9 units. There, P exceeds the average total cost A 5 $97.78, so the firm realizes an economic profit of P 2 A per unit. The total economic profit is represented by the green rectangle and is 9 3 (P 2 A).

$200

150

100

50

MR = MC

MR = P MC

ATC AVC

0 1 2 3 4 5 6 7 8 9 10

C o

st a

n d r

ev en

u e

A = $97.78

Economic profit

Output

P = $131

(1) (2) (3) (4) (5) (6) (7)

Total Product Average Fixed Average Variable Average Total Marginal Price 5 Marginal Total Economic (Output) Cost (AFC) Cost (AVC) Cost (ATC) Cost (MC) Revenue (MR) Profit (1) or Loss (2)

0 $2100

1 $100.00 $90.00 $190.00 $ 90 $131

259

2 50.00 85.00 135.00 80 131

28

3 33.33 80.00 113.33 70 131

153

4 25.00 75.00 100.00 60 131

1124

5 20.00 74.00 94.00 70 131

1185

6 16.67 75.00 91.67 80 131

1236

7 14.29 77.14 91.43 90 131

1277

8 12.50 81.25 93.75 110 131

1298

9 11.11 86.67 97.78 130 131

1299

10 10.00 93.00 103.00 150 131

1280

228

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CHAPTER 10 Pure Competition in the Short Run 229

FIGURE 10.4 Short-run loss minimization for a purely competitive firm. If price P exceeds the minimum AVC (here, $74 at Q 5 5) but is less than ATC, the MR 5 MC output (here, 6 units) will permit the firm to minimize its losses. In this instance the loss is A 2 P per unit, where A is the average total cost at 6 units of output. The total loss is shown by the red area and is equal to 6 3 (A 2 P).

0 1 2 3 4 5 6 7 8 9 10

C o

st a

n d r

ev en

u e

Loss

MC

ATC AVC MR = P

A = $91.67

P = $81

V = $75

Output

$200

150

100

50

Loss-Minimizing Case Shutdown Case

(1) (2) (3) (4) (6) (7) (8) (9)

Total Average Average Average (5) $81 Price 5 Profit (1) $71 Price 5 Profit (1) Product Fixed Variable Total Marginal Marginal or Loss (2), Marginal or Loss (2), (Output) Cost (AFC) Cost (AVC) Cost (ATC) Cost (MC) Revenue (MR) $81 Price Revenue (MR) $71 Price

0 $2100 $2100

1 $100.00 $90.00 $190.00 $ 90 $81

2109 $71

2119

2 50.00 85.00 135.00 80 81

2108 71

2128

3 33.33 80.00 113.33 70 81

297 71

2127

4 25.00 75.00 100.00 60 81

276 71

2116

5 20.00 74.00 94.00 70 81

265 71

2115

6 16.67 75.00 91.67 80 81

264 71

2124

7 14.29 77.14 91.43 90 81

273 71

2143

8 12.50 81.25 93.75 110 81

2102 71

2182

9 11.11 86.67 97.78 130 81

2151 71

2241

10 10.00 93.00 103.00 150 81

2220 71

2320

Then why produce? Because this loss is less than the firm’s $100 of fixed costs, which is the $100 loss the firm would incur in the short run by closing down. The firm receives enough revenue per unit ($81) to cover its average variable costs of $75 and also provide $6 per unit, or a to- tal of $36, to apply against fixed costs. Therefore, the firm’s loss is only $64 (5 $100 2 $36), not $100. This loss-minimizing case is illustrated in the graph in Figure 10.4. Wherever price P exceeds average variable cost AVC but is less than ATC, the firm can pay part, but not all, of its fixed costs by producing. The loss is mini- mized by producing the output at which MC 5 MR (here,

6 units). At that output, each unit contributes P 2 V to covering fixed cost, where V is the AVC at 6 units of out- put. The per-unit loss is A 2 P 5 $10.67, and the total loss is 6 3 (A 2 P), or $64, as shown by the red area.

Shutdown Case

Suppose now that the market yields a price of only $71. Should the firm produce? No, because at every output level the firm’s average variable cost is greater than the price (compare columns 3 and 8 of the table in Figure 10.4). The smallest loss it can incur by producing is greater

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PART FOUR Microeconomics of Product Markets230

than the $100 fixed cost it will lose by shutting down (as shown by column 9). The best action is to shut down. You can see this shutdown situation in Figure 10.5. Price comes closest to covering average variable costs at the MR (5 P) 5 MC output of 5 units. But even here, price or revenue per unit would fall short of average vari- able cost by $3 (5 $74 2 $71). By producing at the MR (5 P) 5 MC output, the firm would lose its $100 worth of fixed cost plus $15 ($3 of variable cost on each of the 5 units), for a total loss of $115. This compares unfavorably with the $100 fixed-cost loss the firm would incur by shut- ting down and producing no output. So it will make sense for the firm to shut down rather than produce at a $71 price—or at any price less than the minimum average vari- able cost of $74. The shutdown case reminds us of the qualifier to our MR (5 P) 5 MC rule. A competitive firm will maximize profit or minimize loss in the short run by producing that output at which MR (5 P) 5 MC, provided that market price exceeds minimum average variable cost.

Marginal Cost and Short-Run Supply LO10.6 Explain why a competitive firm’s marginal cost curve is the same as its supply curve. In the preceding section we simply selected three different prices and asked what quantity the profit-seeking com- petitive firm, faced with certain costs, would choose to of- fer in the market at each price. This set of product prices and corresponding quantities supplied constitutes part of the supply schedule for the competitive firm. Table 10.2 summarizes the supply schedule data for those three prices ($131, $81, and $71) and four others. This table confirms the direct relationship between prod- uct price and quantity supplied that we identified in Chapter 3. Note first that the firm will not produce at price $61 or $71 because both are less than the $74 mini- mum AVC. Then note that quantity supplied increases as price increases. Observe finally that economic profit is higher at higher prices.

C o

st a

n d r

ev en

u e

$200

150

100

P = $7150

0 1 2 3 4 5 6 7 8 9 10

MC

ATC AVC

MR = P

Output

FIGURE 10.5 The short-run shutdown case for a purely competitive firm. If price P falls below the minimum AVC (here, $74 at Q 5 5), the competitive firm will minimize its losses in the short run by shutting down. There is no level of output at which the firm can produce and incur a loss smaller than its total fixed cost.

Quantity Maximum Profit (1) Price Supplied or Minimum Loss (2)

$151 10 $1480

131 9 1299

111 8 1138

91 7 23

81 6 264

71 0 2100

61 0 2100

TABLE 10.2 The Supply Schedule of a Competitive Firm Confronted with the Cost Data in the table in Figure 10.3QUICK REVIEW 10.2

• A firm will choose to produce if it can at least break even and generate a normal profit.

• Profit is maximized, or loss minimized, at the output at which marginal revenue (or price in pure competition) equals marginal cost, provided that price exceeds vari- able cost.

• If the market price is below the minimum average variable cost, the firm will minimize its losses by shut- ting down.

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231

KEY GRAPH

QUICK QUIZ FOR FIGURE 10.6

1. Which of the following might increase product price from P3 to P5?

a. An improvement in production technology. b. A decline in the price of a substitute good. c. An increase in the price of a complementary good. d. Rising incomes if the product is a normal good. 2. An increase in price from P3 to P5 would: a. shift this firm’s MC curve to the right. b. mean that MR5 exceeds MC at Q3 units, inducing the firm to

expand output to Q5. c. decrease this firm’s average variable costs. d. enable this firm to obtain a normal, but not an economic,

profit.

3. At P4: a. this firm has no economic profit. b. this firm will earn only a normal profit and thus will shut

down. c. MR4 will be less than MC at the profit-maximizing output. d. the profit-maximizing output will be Q5. 4. Suppose P4 is $10, P5 is $15, Q4 is 8 units, and Q5 is 10 units.

This firm’s: a. supply curve is elastic over the Q4–Q5 range of output. b. supply curve is inelastic over the Q4–Q5 range of output. c. total revenue will decline if price rises from P4 to P5. d. marginal-cost curve will shift downward if price falls from P5

to P4.

Answers: 1. d; 2. b; 3. a; 4. b

FIGURE 10.6 The P 5 MC rule and the competitive firm’s short-run supply curve. Application of the P 5 MC rule, as modified by the shutdown case, reveals that the (solid) segment of the firm’s MC curve that lies above AVC is the firm’s short-run supply curve. More specifically, at price P1, P 5 MC at point a, but the firm will produce no output because P1 is less than minimum AVC. At price P2 the firm will operate at point b, where it produces Q2 units and incurs a loss equal to its total fixed cost. At P3 it operates at point c, where output is Q3 and the loss is less than total fixed cost. With the price of P4, the firm operates at point d; in this case the firm earns a normal profit because at output Q4 price equals ATC. At price P5 the firm operates at point e and maximizes its economic profit by producing Q5 units.

C o

st a

n d r

ev en

u es

( d o

lla rs

)

P5

P4

P3

P2

P1

0 Q3Q2 Q4 Q5

e

d

c

b

a

Break-even point (normal profit)

Shutdown point (if P is below)

MR5

MR4

MR3

MR2

MR1

ATC

MC

AVC

Quantity supplied

Generalized Depiction

Figure 10.6 (Key Graph) generalizes the MR 5 MC rule and the relationship between short-run production costs and the firm’s supply behavior. The ATC, AVC, and MC curves are shown, along with several marginal-revenue lines drawn at possible market prices. Let’s observe quan- tity supplied at each of these prices:

• Price P1 is below the firm’s minimum average variable cost, so at this price the firm won’t operate

at all. Quantity supplied will be zero, as it will be at all other prices below P2.

• Price P2 is just equal to the minimum average variable cost. The firm will supply Q2 units of output (where MR2 5 MC) and just cover its total variable cost. Its loss will equal its total fixed cost. (Actually, the firm would be indifferent as to shutting down or supplying Q2 units of output, but we assume it produces.)

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PART FOUR Microeconomics of Product Markets232

• The firm will just break even at price P4. There it will supply Q4 units of output (where MR4 5 MC), earning a normal profit but not an economic profit. Total revenue will just cover total cost, including a normal profit, because the revenue per unit (MR4 5 P4) and the total cost per unit (ATC) are the same.

• At price P5 the firm will realize an economic profit by producing and supplying Q5 units of output. In fact, at any price above P4 the firm will obtain economic profit by producing to the point where MR (5 P) 5 MC.

Note that each of the MR (5 P) 5 MC intersection points labeled b, c, d, and e in Figure 10.6 indicates a possible product price (on the vertical axis) and the corresponding quantity that the firm would supply at that price (on the horizontal axis). Thus, points such as these are on the upsloping supply curve of the competitive firm. Note, too, that quantity supplied would be zero at any price below the minimum average variable cost (AVC). We can conclude that the portion of the firm’s marginal-cost curve lying above its average-variable-cost curve is its short-run supply curve. In Figure 10.6, the solid segment of the marginal-cost curve MC is this firm’s short-run supply curve. It tells us the amount of output the firm will supply at each price in a series of prices. Table 10.3 summarizes the MR 5 MC approach to de- termining the competitive firm’s profit-maximizing output level. It also shows the equivalent analysis in terms of total revenue and total cost.

Diminishing Returns, Production Costs, and Product Supply

We have now identified the links between the law of di- minishing returns (Chapter 9), production costs, and product supply in the short run. Because of the law of

CONSIDER THIS . . .

The “Still There” Motel

Have you ever driven by a poorly maintained business facility and wondered why the owner does not either fix up the property or go out of business? The somewhat surprising reason is that it may be unprofitable to im- prove the facility yet profit- able to continue to operate the business as it deterio- rates. Seeing why will aid your understanding of the

“stay open or shut down” decision facing firms experiencing declining demand. Consider the story of the Still There Motel on Old Highway North, Anytown, USA. The owner built the motel on the basis of traffic patterns and competition existing several decades ago. But as interstate highways were built, the motel found itself located on a relatively untraveled stretch of road. Also, it faced severe competition from “chain” motels located much closer to the interstate highway. As demand and revenue fell, Still There moved from prof- itability to loss (P , ATC). But at first its room rates and an- nual revenue were sufficient to cover its total variable costs and contribute some to the payment of fixed costs such as insurance and property taxes (P . AVC). By staying open, Still There lost less than it would have if it shut down. But since its total revenue did not cover its total costs (or P , ATC), the owner realized that something must be done in the long run. The owner decided to lower total costs by reducing annual maintenance. In effect, the owner opted to allow the motel to deteriorate as a way of temporarily regaining profitability. This renewed profitability of Still There cannot last be- cause in time no further reduction of maintenance costs will be possible. The deterioration of the motel structure will pro- duce even lower room rates, and therefore even less total revenue. The owner of Still There knows that sooner or later total revenue will again fall below total cost (or P will again fall below ATC), even with an annual maintenance expense of zero. When that occurs, the owner will close down the busi- ness, tear down the structure, and sell the vacant property. But, in the meantime, the motel is still there—open, deterio- rating, and profitable.

• At price P3 the firm will supply Q3 units of output to minimize its short-run losses. At any of the other prices between P2 and P4 the firm will also minimize its losses by producing and supplying the quantity at which MR (5 P) 5 MC.

Question Answer

Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost.

What quantity should this Produce where MR (5 P) 5 MC; firm produce? there, profit is maximized (TR

exceeds TC by a maximum amount) or loss is minimized.

Will production result in Yes, if price exceeds average economic profit? total cost (so that TR exceeds

TC). No, if average total cost exceeds price (so that TC exceeds TR).

TABLE 10.3 Output Determination in Pure Competition in the Short Run

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CHAPTER 10 Pure Competition in the Short Run 233

diminishing returns, marginal costs eventually rise as more units of output are produced. And because marginal costs rise with output, a purely competitive firm must get suc- cessively higher prices to motivate it to produce additional units of output. Viewed alternatively, higher product prices and mar- ginal revenue encourage a purely competitive firm to ex- pand output. As its output increases, the firm’s marginal costs rise as a result of the law of diminishing returns. At some now greater output, the higher MC equals the new product price and MR. Profit once again is maximized, but at a greater total amount. Quantity supplied has increased in direct response to an increase in product price and the desire to maximize profit.

Changes in Supply

In Chapter 9 we saw that changes in such factors as the prices of variable inputs or in technology will alter costs and shift the marginal-cost or short-run supply curve to a new location. All else equal, for example, a wage increase would increase marginal cost and shift the supply curve in Figure 10.6 upward as viewed from the horizontal axis (leftward as viewed from the vertical axis). That is, supply would decrease. Similarly, technological progress that in- creases the productivity of labor would reduce marginal cost and shift the marginal-cost or supply curve down- ward as viewed from the horizontal axis (rightward as viewed from the vertical axis). This represents an increase in supply.

Firm and Industry: Equilibrium Price

In the preceding section we established the competitive firm’s short-run supply curve by applying the MR (5 P) 5 MC rule. But which of the various possible prices will ac- tually be the market equilibrium price? From Chapter 3 we know that the market equilibrium price will be the price at which the total quantity supplied of the product equals the total quantity demanded. So to determine the equilibrium price, we first need to obtain a total supply schedule and a total demand schedule. We find the total supply schedule by assuming a particular number of firms in the industry and supposing that each firm has the same individual supply schedule as the firm represented in Figure 10.6. Then we sum the quantities supplied at each price level to obtain the total (or market) supply schedule. Columns 1 and 3 in Table 10.4 repeat the supply schedule for the individual competitive firm, as de- rived in Table 10.2. Suppose 1,000 firms compete in this industry, all having the same total and unit costs as the single firm we discussed. This lets us calculate the market

supply schedule (columns 2 and 3) by multiplying the quantity-supplied figures of the single firm (column 1) by 1,000.

Market Price and Profits To determine the equilib- rium price and output, these total-supply data must be compared with total-demand data. Let’s assume that total demand is as shown in columns 3 and 4 in Table 10.4. By comparing the total quantity supplied and the total quan- tity demanded at the seven possible prices, we determine that the equilibrium price is $111 and the equilibrium quantity is 8,000 units for the industry—8 units for each of the 1,000 identical firms. Will these conditions of market supply and demand make this a profitable or unprofitable industry? Multiplying product price ($111) by output (8 units), we find that the total revenue of each firm is $888. The total cost is $750, found by looking at column 4 of the table in Figure 10.2. The $138 difference is the economic profit of each firm. For the industry, total economic profit is $138,000. This, then, is a profitable industry. Another way of calculating economic profit is to deter- mine per-unit profit by subtracting average total cost ($93.75) from product price ($111) and multiplying the difference (per-unit profit of $17.25) by the firm’s equilib- rium level of output (8). Again we obtain an economic profit of $138 per firm and $138,000 for the industry. Figure 10.7 shows this analysis graphically. The individ- ual supply curves of each of the 1,000 identical firms—one of which is shown as s 5 MC in Figure 10.7a—are summed horizontally to get the total-supply curve S 5 SMC of Figure 10.7b. With total-demand curve D, it yields the equi- librium price $111 and equilibrium quantity (for the indus- try) 8,000 units. This equilibrium price is given and unalterable to the individual firm; that is, each firm’s demand curve is perfectly elastic at the equilibrium price, as indicated

TABLE 10.4 Firm and Market Supply and Market Demand

(1) (2)

Quantity Total (4)

Supplied, Quantity (3) Total

Single Supplied, Product Quantity

Firm 1,000 Firms Price Demanded

10 10,000 $151 4,000

9 9,000 131 6,000

8 8,000 111 8,000

7 7,000 91 9,000

6 6,000 81 11,000

0 0 71 13,000

0 0 61 16,000

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234

Fixed Costs: Digging Yourself Out of a Hole

A firm with fixed costs starts each month standing at the bottom of a deep financial hole. The depth of that “money pit” is equal to the dollar value of all the payments that the firm is legally obligated to make even if it is producing nothing. These fixed costs include contractually guaranteed salaries, interest payments on loans, and equipment rental fees that are locked-in by long- term contracts. As the firm stands at the bottom of this fixed-cost financial hole and stares upward looking for a way out, it has to ask itself the following question: Will producing output make the hole even deeper? Naturally, the firm hopes that producing output will gener- ate positive cash flows that will offset its fixed costs and start fill- ing in the hole. If those positive flows are large enough, they may completely offset the firm’s fixed costs and fill up the hole, thereby allowing the firm to break even. And if they are just a bit larger, they will not only fill up the hole but also accumulate a nice little pile of profits above ground. But those are just the firm’s hopes. The firm’s reality may be quite unpleasant. In particular, the firm may be facing a situation

For Firms Facing Losses Due to Fixed Costs, Shutting Down in the Short Run Does Not Mean Shutting

Down Forever.

LAST WORD

in which producing output would make its financial situation worse rather than better. As explained in this chapter, if the price of the firm’s output falls too low, then producing output will yield cash flows that are negative rather than positive because revenues will be less than variable costs. If that happens, produc- ing output will lose money for the firm so that the firm would be

p

$111

Economic profit

0 8 q

s = MC

ATC

AVC d

(a) Single firm

P

$111

0 8,000 Q

S = �MCs

D

(b) Industry

FIGURE 10.7 Short-run competitive equilibrium for (a) a firm and (b) the industry. The horizontal sum of the 1,000 firms’ individual supply curves (s) determines the industry supply curve (S). Given industry demand (D), the short-run equilibrium price and output for the industry are $111 and 8,000 units. Taking the equilibrium price as given, the individual firm establishes its profit- maximizing output at 8 units and, in this case, realizes the economic profit represented by the green area.

by d in Figure 10.7a. Because the individual firm is a price taker, the marginal-revenue curve coincides with the firm’s demand curve d. This $111 price exceeds the average total cost at the firm’s equilibrium MR 5 MC output of 8 units,

so the firm earns an economic profit represented by the green area in Figure 10.7a. Assuming no changes in costs or market demand, these diagrams reveal a genuine equilibrium in the short run.

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better off shutting down production rather than producing out- put. By shutting down, it will lose only its fixed costs. By shutting down, its financial hole won’t get even deeper. A crucial thing to understand, however, is that the low prices that cause firms to shut down production are often temporary— so that shutdowns are also often temporary. Just because a firm shuts down at a given moment to prevent its financial hole from getting any deeper does not mean that the firm will go out of business forever. To the contrary, many industries are character- ized by firms that regularly switch production on and off de- pending upon the market price they can get for their output and, consequently, whether producing output will generate positive or negative cash flows. Oil production is a good example. Different wells have dif- ferent variable production costs. If the price of oil drops below a given well’s variable costs, then it would be better to halt produc- tion on that well and just lose the value of its fixed costs rather than pumping oil whose variable cost exceeds the revenue that it generates when sold. Seasonal resorts are another good example of turning pro- duction on and off depending on the price. The demand for hotel rooms near ski resorts in New Hampshire, for instance, is much higher during the winter ski season than it is during the summer. As a result, the market price of hotel rooms falls so low during the summer that many inns and resorts close during the warmer months. They have all sorts of fixed costs, but it makes more

sense for them to shut down rather than remain open because operating in the summer would cost more in variable costs than it would generate in revenues. Better to lose only their fixed costs. Numerous other examples of temporary shutdowns occur during recessions, the occasional economy-wide economic slow- downs during which demand declines for nearly all goods and services. The 2007–2009 recession in the United States, for in- stance, saw many manufacturing companies temporarily shut down and mothball their production facilities. The recession wit- nessed the mothballing of electric generating plants, factories that make fiber optic cable, automobile factories, chemical plants, textile mills, and even the plant in McIntosh, Alabama, that makes the artificial sweetener Splenda. Many other firms also shut down production to wait out the recession—so many, in fact, that there was a mini-boom for consulting firms that spe- cialized in helping firms mothball their factories (the main prob- lem being how to properly store idle machinery so that it will work again when it is eventually brought back into service). Firms that mothball factories or equipment during a reces- sion do so expecting to eventually turn them back on. But the lengths of recessions vary, as do the specific circumstances of in- dividual firms. So while many firms shut down in the short run with the expectation of reopening as soon as their particular business conditions improve, sometimes their business condi- tions do not improve. Sometimes the only way to terminate fixed costs is to terminate the firm.

No shortages or surpluses occur in the market to cause price or total quantity to change. Nor can any firm in the industry increase its profit by altering its output. Note, too, that higher unit and marginal costs, on the one hand, or weaker market demand, on the other, could change the situation so that Figure 10.7a resembles Figure 10.4 or Figure 10.5.

Firm versus Industry Figure 10.7 underscores a point made earlier: Product price is a given fact to the individual

competitive firm, but the supply plans of all com- petitive producers as a group are a basic determi- nant of product price. If we recall the fallacy of composition (Last Word, Chapter 1), we find there is no inconsistency here.

Although one firm, supplying a negligible fraction of total supply, cannot affect price, the sum of the supply curves

W10.3

Short-run competitive equilibrium

WORKED PROBLEMS

QUICK REVIEW 10.3

• A competitive firm’s short-run supply curve is the por- tion of its marginal cost (MC) curve that lies above its average variable cost (AVC) curve.

• If price P is greater than minimum average variable cost, the firm will produce the amount of output where MR (5 P) 5 MC in order to either maximize its profit (if price exceeds minimum ATC) or minimize its loss (if price lies between minimum AVC and mini- mum ATC).

• Market supply in a competitive industry is the hori- zontal sum of the individual supply curves of all of the firms in the industry. The market equilibrium price is determined by where the industry’s market supply curve intersects the industry’s market de- mand curve.

of all the firms in the industry constitutes the industry supply curve, and that curve does have an important bear- ing on price.

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LO10.1 Give the names and summarize the main characteristics of the four basic market models.

Economists group industries into four models based on their market structures: (a) pure competition, (b) pure monopoly, (c) monopolistic competition, and (d ) oligopoly.

LO10.2 List the conditions required for purely competitive markets.

A purely competitive industry consists of a large number of inde- pendent firms producing a standardized product. Pure competi- tion assumes that firms and resources are mobile among different industries.

LO10.3 Explain how demand is seen by a purely competitive seller.

In a competitive industry, no single firm can influence market price. This means that the firm’s demand curve is perfectly elastic and price equals marginal revenue.

LO10.4 Convey how purely competitive firms can use the total-revenue–total-cost approach to maximize

profits or minimize losses in the short run.

We can analyze short-run profit maximization by a competitive firm by comparing total revenue and total cost or by applying marginal analysis. A firm maximizes its short-run profit by producing the out- put at which total revenue exceeds total cost by the greatest amount.

LO10.5 Explain how purely competitive firms can use the marginal-revenue–marginal-cost approach to

maximize profits or minimize losses in the short run.

Provided price exceeds minimum average variable cost, a com- petitive firm maximizes profit or minimizes loss in the short run

by producing the output at which price or marginal revenue equals marginal cost.

If price is less than minimum average variable cost, a competi- tive firm minimizes its loss by shutting down. If price is greater than average variable cost but is less than average total cost, a com- petitive firm minimizes its loss by producing the P 5 MC amount of output. If price also exceeds average total cost, the firm maxi- mizes its economic profit at the P 5 MC amount of output.

LO10.6 Explain why a competitive firm’s marginal cost curve is the same as its supply curve.

Applying the MR (5 P) 5 MC rule at various possible market prices leads to the conclusion that the segment of the firm’s short-run marginal-cost curve that lies above the firm’s average- variable-cost curve is its short-run supply curve.

A competitive firm shuts down production at least tempo- rarily if price is less than minimum average variable cost be- cause, in those situations, producing any amount of output will always result in variable costs exceeding revenues. Shutting down therefore results in a smaller loss because the firm will lose only its fixed cost, whereas, if it operated, it would lose its fixed cost plus whatever money is lost due to variable costs ex- ceeding revenues.

Competitive firms choose to operate rather than shut down whenever price is greater than average variable cost but less than average total cost because, in those situations, revenues will al- ways exceed variable costs. The amount by which revenues ex- ceed variable costs can be used to help pay down some of the firm’s fixed costs. Thus, the firm loses less money by operating (and paying down some of its fixed costs) than it would if it shut down (in which case it would suffer a loss equal to the full amount of its fixed costs).

SUMMARY

TERMS AND CONCEPTS market structure pure competition pure monopoly monopolistic competition oligopoly

imperfect competition price taker average revenue total revenue

marginal revenue break-even point MR 5 MC rule short-run supply curve

D I S C U S S I O N Q U E S T I O N S

1. Briefly state the basic characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Under which of these market classifications does each of the following most accurately fit? (a) a supermarket in your hometown; (b) the steel industry; (c) a Kansas wheat farm;

(d ) the commercial bank in which you or your family has an account; (e) the automobile industry. In each case, justify your classification. LO10.1

2. Strictly speaking, pure competition is relatively rare. Then why study it? LO10.2

The following and additional problems can be found in

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CHAPTER 10 Pure Competition in the Short Run 237

Explain why price can be substituted for marginal reve- nue  in the MR 5 MC rule when an industry is purely competitive. LO10.5

6. “That segment of a competitive firm’s marginal-cost curve that lies above its average-variable-cost curve constitutes the short-run supply curve for the firm.” Explain using a graph and words. LO10.6

7. LAST WORD If a firm’s current revenues are less than its current variable costs, when should it shut down? If the firm decides to shut down, should we expect that decision to be final? Explain using an example that is not in the book.

3. “Even if a firm is losing money, it may be better to stay in business in the short run.” Is this statement ever true? Under what condition(s)? LO10.5

4. Consider a firm that has no fixed costs and that is cur- rently losing money. Are there any situations in which it would want to stay open for business in the short run? If a firm has no fixed costs, is it sensible to speak of the firm distinguishing between the short run and the long run? LO10.5

5. Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures?

R E V I E W Q U E S T I O N S

1. Suppose that the paper clip industry is perfectly competi- tive. Also assume that the market price for paper clips is 2 cents per paper clip. The demand curve faced by each firm in the industry is: LO10.3

a. A horizontal line at 2 cents per paper clip. b. A vertical line at 2 cents per paper clip. c. The same as the market demand curve for paper clips. d. Always higher than the firm’s MC curve. 2. Use the demand schedule below to determine total revenue

and marginal revenue for each possible level of sales: LO10.3 a. What can you conclude about the structure of the

industry in which this firm is operating? Explain.

Product Quantity Total Marginal

Price Demanded Revenue Revenue

$2 0 $

2 1 $

2 2

2 3

2 4

2 5

b. Graph the demand, total-revenue, and marginal-revenue curves for this firm.

c. Why do the demand and marginal-revenue curves coincide?

d. “Marginal revenue is the change in total revenue associated with additional units of output.” Explain verbally and graphically, using the data in the table.

3. A purely competitive firm whose goal is to maximize profit will choose to produce the amount of output at which: LO10.4

a. TR and TC are equal. b. TR exceeds TC by as much as possible. c. TC exceeds TR by as much as possible. d. none of the above. 4. If it is possible for a perfectly competitive firm to do better

financially by producing rather than shutting down, then it should produce the amount of output at which: LO10.5

a. MR , MC. b. MR 5 MC. c. MR . MC. d. none of the above. 5. A perfectly competitive firm that makes car batteries has a

fixed cost of $10,000 per month. The market price at which it can sell its output is $100 per battery. The firm’s mini- mum AVC is $105 per battery. The firm is currently pro- ducing 500 batteries a month (the output level at which MR 5 MC). This firm is making a _____________ and should _______________ production. LO10.5

a. profit; increase b. profit; shut down c. loss; increase d. loss; shut down 6. Consider a profit-maximizing firm in a competitive indus-

try. For each of the following situations, indicate whether the firm should shut down production or produce where MR 5 MC. LO10.5

a. P , minimum AVC. b. P . minimum ATC. c. Minimum AVC , P , minimum ATC.

P R O B L E M S

1. A purely competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units. Does price exceed average variable cost for the first 50 units? What about for the first 100 units? What is the marginal cost per unit for the first 50 units?

What about for units 51 and higher? For each of the first 50  units, does MR exceed MC? What about for units 51 and higher? What output level will yield the largest possible profit for this purely competitive firm? (Hint: Draw a graph similar to Figure 10.2 using data for this firm.) LO10.5

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PART FOUR Microeconomics of Product Markets238

the profit-maximizing or loss-minimizing output? What economic profit or loss will the firm realize per unit of output?

b. Answer the questions of 4a assuming product price is $41. c. Answer the questions of 4a assuming product price is $32. d. In the table below, complete the short-run supply

schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).

2. A purely competitive wheat farmer can sell any wheat he grows for $10 per bushel. His five acres of land show dimin- ishing returns because some are better suited for wheat pro- duction than others. The first acre can produce 1,000 bushels of wheat, the second acre 900, the third 800, and so on. Draw a table with multiple columns to help you answer the following questions. How many bushels will each of the farmer’s five acres produce? How much revenue will each acre generate? What are the TR and MR for each acre? If the marginal cost of planting and harvesting an acre is $7,000 per acre for each of the five acres, how many acres should the farmer plant and harvest? LO10.5

3. Karen runs a print shop that makes posters for large compa- nies. It is a very competitive business. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1,000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters. What is her AFC per poster (not per thousand!) if she prints 1,000 posters? 2,000? 10,000? What is her ATC per poster if she prints 1,000? 2,000? 10,000? If the market price fell to 70 cents per poster, would there be any output level at which Karen would not shut down pro- duction immediately? LO10.5

4. Assume that the cost data in the following table are for a purely competitive producer: LO10.5

Total Average Average Average Marginal

Product Fixed Cost Variable Cost Total Cost Cost

0

1 $60.00 $45.00 $105.00 $45

2 30.00 42.50 72.50 40

3 20.00 40.00 60.00 35

4 15.00 37.50 52.50 30

5 12.00 37.00 49.00 35

6 10.00 37.50 47.50 40

7 8.57 38.57 47.14 45

8 7.50 40.63 48.13 55

9 6.67 43.33 50.00 65

10 6.00 46.50 52.50 75

(2) (4)

Quantity (3) Quantity

(1) Supplied, Profit (1) Supplied Price Single Firm or Loss (2) 1,500 Firms

$26 $

32

38

41

46

56

66

e. Now assume that there are 1,500 identical firms in this competitive industry; that is, there are 1,500 firms, each of which has the cost data shown in the table. Complete the industry supply schedule (column 4).

f. Suppose the market demand data for the product are as follows:

Total Quantity

Price Demanded

$26 17,000

32 15,000

38 13,500

41 12,000

46 10,500

56 9,500

66 8,000

What will be the equilibrium price? What will be the equilibrium output for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?

a. At a product price of $56, will this firm produce in the short run? If it is preferable to produce, what will be

F U R T H E R T E S T YO U R K N O W L E D G E AT w w w. m c c o n n e l l 2 0 e . c o m Practice quizzes, student PowerPoints, worked problems, Web-based questions, and additional materials are available at the text’s Online Learning Center (OLC), www.mcconnell20e.com, or scan here. Need a barcode reader? Try ScanLife, available in your app store.

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The previous chapter discussed how pure competi-

tion operates in the short run, the time period dur-

ing which the individual firms in an industry are

stuck with their current plant sizes and fixed-cost

commitments. As you know, pure competitors shut

down production if prices are too low or, if prices

are high enough, produce where MR 5 MC to min-

imize their losses or maximize their profits. Whether

they make a profit or a loss depends on how high

the market price is relative to their costs.

That being said, profits and losses cannot be the

end of the pure competition story because one of

the key characteristics of pure competition is the

freedom of firms to enter or exit the industry. We

know from Chapter 2 that profits attract entry and

losses prompt exit.

In this chapter, we are keenly interested in how

entry and exit relate to allocative and productive

Learning Objectives

LO11.1 Explain how the long run differs from the short run in pure

competition.

LO11.2 Describe how profits and losses drive the long-run

adjustment process of pure

competition.

LO11.3 Explain the differences between constant-cost, increasing-cost,

and decreasing-cost industries.

LO11.4 Show how long-run equilibrium in pure competition produces

an efficient allocation of

resources.

LO11.5 Discuss creative destruction and the profit incentives for

innovation.