discussion

ch22.pdf

Home >Business & Finance homework help >Economics homework help >discussion

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

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

B. Utility Functions and Indifference Curves Once a consumer describes what his or her preference ordering is, we may derive

a utility function for that consumer. The utility function identifies higher preferences with larger numbers. Suppose that there are only two commodities or services, x and y, available to a given consumer. If we let u stand for the consumer’s utility, then the func- tion describes the utility that the consumer gets from different combina- tions of x and y.

A very helpful way of visualizing the consumer’s utility function is by means of a graph called an indifference map. An example is shown in Figure 2.4. There we have drawn several indifference curves. Each curve represents all the combinations of x and y that give the consumer the same amount of utility or well-being. Alternatively, we might say that the consumer’s tastes are such that he is indifferent among all the combinations of x and y that lie along a given curve—hence, the name indifference curve. Thus, all those combinations of x and y lying along the indifference curve marked give the consumer the same utility. Those combinations lying on the higher indifference curve marked give this consumer similar utility, but this level of utility is higher than that of all those combinations of x and y lying along indiffer- ence curve

The problem of consumer choice arises from the collision of the consumer’s pref- erences with obstacles to his or her satisfaction. The obstacles are the constraints that force decision makers to choose among alternatives. There are many constraints, including time, energy, knowledge, and one’s culture, but foremost among these is

U0.

U1 U0

u = u(x, y)

x0 U0

U1 U2

x0x1

y0 (x0, y0)

FIGURE 2.4 The consumer’s indifference map.

IV. The Theory of Consumer Choice and Demand 21

I = pxx + pyy

FIGURE 2.5 The consumer’s income constraint or budget line.

limited income. We can represent the consumer’s income constraint or budget line by the line in Figure 2.5. The area below the line and the line itself represent all the com- binations of x and y that are affordable, given the consumer’s income, I.5 Presumably, the consumer intends to spend all of her income on purchases of these two goods and services, so that the combinations upon which we shall focus are those that are on the budget line itself.

C. The Consumer’s Optimum We may now combine the information about the consumer’s tastes given by the

indifference map and the information about the income constraint given by the budget line in order to show what combination of x and y maximizes the consumer’s utility, subject to the constraint imposed by her income. See Figure 2.6. There the consumer’s optimum bundle is shown as point M, which contains and Of all the feasible combinations of x and y, that combination gives this consumer the great- est utility.6

y*.x*

5 The equation for the budget line is where is the price per unit of x and is the price per unit of y. As an exercise, you might try to rearrange this equation, with y as the dependent variable, in order to show that the slope of the line is negative. When you do so, you will find that the coefficient of the x-term is equal to Economists refer to this ratio as relative price.-px>py.

pypxI = pxx + pyy,

6 Because we have assumed that the normal indifference curves are convex to the origin, there is a unique bundle of x and y that maximizes the consumer’s utility. For other shapes of the indifference curves it is possible that there is more than one bundle that maximizes utility.

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

D. A Generalization: The Economic Optimum as Marginal Cost ! Marginal Benefit Because of the central importance of constrained maximization in microeconomic

theory, let us take a moment to examine a more general way of characterizing such a maximum:

A constrained maximum, or any other economic optimum, can be described as a point where marginal cost equals marginal benefit.

Let’s see how this rule characterizes maximizing decisions.7 Begin by assuming that the decision maker chooses some initial level of whatever it is he is interested in maximizing. He then attempts to determine whether that initial level is his maximum; is that level as good as he can do, given his constraints? He can answer the question by making very small, what an economist calls marginal, changes away from that initial level. Suppose that the decision maker proposes to increase slightly above his initial level whatever it is he is doing. There will be a cost associated with this small increase called marginal cost. But there will also be a benefit of having or doing more of what- ever it is that he is attempting to maximize. The benefit of this small increase is called marginal benefit. The decision maker will perceive himself as doing better at this new level, by comparison to his initial level, so long as the marginal benefit of the small in- crease is greater than the marginal cost of the change. He will continue to make these small, or marginal, adjustments so long as the marginal benefit exceeds the marginal cost, and he will stop making changes when the marginal cost of the last change made equals (or is greater than) the marginal benefit. That level is the decision maker’s maximum.

7 This rule could describe equally well an economic optimum where the goal of the decision maker is to minimize something. In that case, the optimum would still be the point at which but the demonstration of the stylized decision making that got one to that point would be different from that given in the text.

MC = MB,

x* x0

U = xy

FIGURE 2.6 The consumer’s optimum.

IV. The Theory of Consumer Choice and Demand 23

We can characterize the consumer’s income-constrained maximum, M in Figure 2.6, in terms of the equality of marginal cost and benefit. Small changes in either di- rection along the budget line, I, represent a situation in which the consumer spends a dollar less on one good and a dollar more on the other. To illustrate, assume the consumer decides to spend a dollar less on y and a dollar more on x. Purchasing a dollar less of y causes a loss in utility that we may call the marginal cost of the budget reallocation. But the dollar previously spent on y can now be spent on x. More units of x mean greater utility, so that we may call this increase the marginal benefit of the budget reallocation.

Should the consumer spend a dollar less on good y and a dollar more on x? Only if the marginal cost (the decrease in utility from one dollar less of y) is less than the mar- ginal benefit (the increase in utility from having one dollar more of x). The rational consumer will continue to reallocate dollars away from the purchase of y and toward the purchase of x until the marginal benefit of the last change made equals the marginal cost. This occurs at the point M in Figure 2.6.

Figure 2.7 applies constrained maximization to reduce the amount of pollution. Along the vertical axis are dollar amounts. Along the horizontal axis are units of pollu- tion reduction. At the origin there is no effort to reduce pollution. At the vertical line labeled “100%,” pollution has been completely eliminated.

The curve labeled MB shows the marginal benefit to society of reducing pollution. We assume that this has been correctly measured to take into account health, scenic, and all other benefits that accrue to members of society from reducing pollution at var- ious levels. This line starts off high and then declines. This downward slope captures the fact that the very first efforts at pollution reduction confer large benefits on society. The next effort at reducing pollution also confers a social benefit, but not quite as great as the initial efforts. Finally, as we approach the vertical line labeled “100%” and all vestiges of pollution are being eliminated, the benefit to society of achieving those last steps is positive, but not nearly as great as the benefit of the early stages of pollution reduction.

MC = MB

Reduction in pollution

Marginal cost of pollution reduction

Marginal benefit of pollution reduction

0 100%P*

FIGURE 2.7 The socially optimal amount of pollution-reduction effort.

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

The curve labeled MC represents the “social” as opposed to “private” marginal cost of achieving given levels of pollution reduction. The individuals and firms that pol- lute must incur costs to reduce pollution: They may have to adopt cleaner and safer pro- duction processes that are also more expensive; they may have to install monitoring devices that check the levels of pollution they generate; and they may have to defend themselves in court when they are accused of violating the pollution-reduction guide- lines. We have drawn the MC curve to be upward-sloping to indicate that the marginal costs of achieving any given level of pollution-reduction increase. This means that the cost of reducing the very worst pollution may not be very high, but that successive levels of reduction will be ever more expensive.

Given declining marginal benefit and rising marginal cost, the question then arises, “What is the optimal amount of pollution-reduction effort for society?” An examina- tion of Figure 2.7 shows that is the socially optimal amount of pollution-reduction effort. Any more effort will cost more than it is worth. Any less would cause a reduc- tion in benefits that would be greater than the savings in costs.

Note that, according to this particular graph, it would not be optimal for society to try to eliminate pollution entirely. Here it is socially optimal to tolerate some pollution. Specifically, when pollution reduction equals the remaining pollution equals

which is the “optimal amount of pollution.” Few goods are free. Much of the wisdom of economics comes from the recognition of this fact and of the derivation of techniques for computing the costs and benefits.

If you understand that for economists, the optimum for nearly all decisions occurs at the point at which marginal benefit equals marginal cost, then you have gone a long way toward mastering the microeconomic tools necessary to answer most questions that we will raise in this book.

E. Individual Demand We may use the model of consumer choice of the previous sections to derive a re-

lationship between the price of a good and the amount of that good in a consumer’s op- timum bundle. The demand curve represents this relationship.

100% - P*, P*,

IV. The Theory of Consumer Choice and Demand 25

Starting from point M in Figure 2.6, note that when the price of x is that given by the budget line, the optimal amount of x to consume is But what amount of x will this consumer want to purchase so as to maximize utility when the price of x is lower than that given by the budget line in Figure 2.6? We can answer that question by hold- ing and I constant, letting fall, and writing down the amount of x in the succeed- ing optimal bundles. Not surprisingly, the result of this exercise will be that the price of x and the amount of x in the optimum bundles are inversely related. That is, when the price of x goes up, and I held constant (or ceteris paribus, “all other things equal,” as economists say), the amount of x that the consumer will purchase goes down, and vice versa. This result is the famous law of demand.

We may graph this relationship between and the quantity of x demanded to get the individual demand curve, D, shown in Figure 2.8. The demand curve we have drawn in Figure 2.8 could have had a different slope than that shown; it might have been either flatter or steeper. The steepness of the demand curve is related to an important concept called the price elasticity of demand, or simply elasticity of demand.8

This is an extremely useful concept: It measures how responsive consumer de- mand is to changes in price. And there are some standard attributes of goods that in- fluence how responsive demand is likely to be. For instance, if two goods are similar in their use, then an increase in the price of the first good with no change in the price of the second good causes consumers to buy significantly less of the first good. Generalizing, the most important determinant of the price elasticity of demand for a

PxPy

x*.

8 The measure is frequently denoted by the letter e, and the ranges of elasticity are called inelastic elastic and unitary elastic By convention, e, the price elasticity of demand, is a positive (or absolute) number, even though the calculation we suggested will lead to a negative number. For an in- elastically demanded good, the percentage change in price exceeds the percentage change in quantity demanded. Thus, a good that has is one for which a 50 percent decline in price will cause a 25 percent increase in the quantity demanded, or for which a 15 percent increase in price will cause a 7.5 percent de- cline in quantity demanded. For an elastically demanded good, the percentage change in price is less than the percentage change in quantity demanded. As a result, a good that has is one for which a 50 per- cent decline in price will cause a 75 percent increase in quantity demanded, or for which a 20 percent in- crease in price will cause a 30 percent decline in quantity demanded.

e = 1.5

e = 0.5

(e = 1).(e 7 1), (e 6 1),

x0 x1

FIGURE 2.8 An individual’s demand curve, showing the inverse relationship between price and quantity demanded.

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

good is the availability of substitutes. The more substitutes for the good, the greater the elasticity of demand; the fewer the substitutes, the lower the elasticity. Substitution is easier for narrowly defined goods and harder for broad categories. If the price of cucumbers goes up, switching to peas or carrots is easy; if the price of vegetables goes up, switching to meat is possible; but if the price of food goes up, eating less is hard to do. So, we expect that demand is more elastic for cucumbers than vegetables and more elastic for vegetables than food. Also, demand is more elastic in the long run than the short run. To illustrate, if electricity prices rise rela- tive to natural gas, consumers will increasingly switch to burning gas as they gradu- ally replace furnaces and appliances. Economists often measure and remeasure the price elasticities of demand for numerous goods and services to predict responses to price changes.

V. The Theory of Supply We now turn to a review of the other side of the market: the supply side. The key

institution in supplying goods and services for sale to consumers is the business firm. In this section we shall see what goal the firm seeks and how it decides what to supply. In the following section, we merge our models of supply and demand to see how the inde- pendent maximizing activities of consumers and firms achieve a market equilibrium.

A. The Profit-Maximizing Firm The firm is the institution in which output (products and services) is fabricated

from inputs (capital, labor, land, and so on). Just as we assume that consumers ration- ally maximize utility subject to their income constraint, we assume that firms maximize profits subject to the constraints imposed on them by consumer demand and the tech- nology of production.

In microeconomics, profits are defined as the difference between total revenue and the total costs of production. Total revenue for the firm equals the number of units of output sold multiplied by the price of each unit. Total costs equal the costs of each of the inputs times the number of units of input used, summed over all inputs. The profit- maximizing firm produces that amount of output that leads to the greatest positive dif- ference between the firm’s revenue and its costs. Microeconomic theory demonstrates that the firm will maximize its profits if it produces that amount of output whose mar- ginal cost equals its marginal revenue. (In fact, this is simply an application of the gen- eral rule we discussed in section IV.D earlier: To achieve an optimum, equate marginal cost and marginal benefit.)

These considerations suggest that when marginal revenue exceeds marginal cost, the firm should expand production, and that when marginal cost exceeds marginal rev- enue, it should reduce production. It follows that profits will be maximized for that out- put for which marginal cost and marginal revenue are equal. Note the economy of this rule: To maximize profits, the firm need not concern itself with its total costs or total revenues; instead, it can simply experiment on production unit by unit in order to dis- cover the output level that maximizes its profits.

V. The Theory of Supply 27

In Figure 2.9 the profit-maximizing output of the firm is shown at the point at which the marginal cost curve, labeled MC, and marginal revenue curve of the firm are equal. The profit-maximizing output level is denoted Total profits at this level of production, denoted by the shaded area in the figure, equal the difference between the total revenues of the firm ( p times ) and the total costs of the firm (the average cost of producing times ).

There are several things you should note about the curves in the graph. We have drawn the marginal revenue curve as horizontal and equal to the prevailing price. This implies that the firm can sell as much as it likes at that prevailing price. Doubling its sales will have no effect on the market price of the good or service. This sort of behav- ior is referred to as price-taking behavior. It characterizes industries in which there are so many firms, most of them small, that the actions of no single firm can affect the mar- ket price of the good or service. An example might be farming. There are so many sup- pliers of wheat that the decision of one farmer to double or triple output or cut it in half will have no impact on its market price. (Of course, if all farms decide to double out- put, there will be a substantial impact on market price.) Such an industry is said to be “perfectly competitive.”

B. The Short Run and the Long Run In microeconomics the firm is said to operate in two different time frames: the

short run and the long run. These time periods do not correspond to calendar time. Instead they are defined in terms of the firm’s inputs. In the short run at least one input is fixed (all others being variable), and the usual factor of production that is fixed is capital (the firm’s buildings, machines, and other durable inputs). Because capital is fixed in the short run, all the costs associated with capital are called fixed costs. In the short run the firm can, in essence, ignore those costs: They will be incurred regardless of whether the firm produces nothing at all or 10 million units of output. (The only costs that change in the short run are “variable costs,” which rise or fall depending on how much output the firm produces.) The long run is distinguished by the fact that all factors of production become variable. There are no longer any fixed costs. Established firms may expand their productive capacity or leave the industry entirely, and new firms may enter the business.

q*q* q*

q*.

AC '

Price

q* q0

p = MR

FIGURE 2.9 The profit-maximizing output for a firm.

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

Another important distinction between the long and the short run has to do with the equilibrium level of profits for each firm. At any point in time there is an average rate of return earned by capital in the economy as a whole. When profits being earned in a particular industry exceed the average profit rate for comparable investments, firms will enter the industry, assuming there are no barriers to entry. As entry occurs, the to- tal industry output increases, and the price of the industry output goes down, causing each firm’s revenue to decrease. Also, the increased competition for the factors of pro- duction causes input prices to rise, pushing up each firm’s costs. The combination of these two forces causes each firm’s profits to decline. Entry ceases when profits fall to the average rate.

Economists have a special way of describing these facts. The average return on capital is treated as part of the costs that are subtracted from revenues to get “economic profits.” Thus, when the rate of return on invested capital in this industry equals the average for the economy as a whole, it is said that “economic profits are zero.”9

This leads to the conclusion that economic profits are zero in an industry that is in long-run equilibrium. Because this condition can occur only at the minimum point of the firm’s average cost curve, where the average costs of production are as low as they can possibly be, inputs will be most efficiently used in long-run equilibrium. Thus, the condition of zero economic profits, far from being a nightmare, is really a desirable state.

VI. Market Equilibrium Having described the behavior of utility-maximizing consumers and profit-

maximizing producers, our next task is to bring them together to explain how they interact. We shall first demonstrate how a unique price and quantity are determined by the interaction of supply and demand in a perfectly competitive market and then show what happens to price and quantity when the market structure changes to one of monopoly. We conclude this section with an example of equilibrium analysis of an important public policy issue.

A. Equilibrium in a Perfectly Competitive Industry An industry in which there are so many firms that no one of them can influence the

market price by its individual decisions and in which there are so many consumers that the individual utility-maximizing decisions of no one consumer can affect the market price is called a perfectly competitive industry. For such an industry the aggregate de- mand for and the aggregate supply of output can be represented by the downward-sloping demand curve, and the upward-sloping supply curve, showns = s(p),d = d(p),

9 When profits in a given industry are less than the average in the economy as a whole, economic profits are said to be negative. When that is the case, firms exit this industry for other industries where the profits are at least equal to the average for the economy. As an exercise, see if you can demonstrate the process by which profits go to zero when negative economic profits in an industry cause exit to take place.

VI. Market Equilibrium 29

in Figure 2.10. The market-clearing or equilibrium price and quantity occur at the point of intersection of the aggregate supply and demand curves. At that combination of price and quantity, the decisions of consumers and suppliers are consistent.

One way to see why the combination in Figure 2.10 is an equilibrium is to see what would happen if a different price-quantity combination were obtained. Suppose that the initial market price was At that price, producers would maximize their profits by supplying of output, and utility-maximizing consumers would be prepared to purchase units of output. These supply and demand decisions are in- consistent: At the amount that suppliers would like to sell exceeds the amount that consumers would like to buy. How will the market deal with this excess supply? Clearly, the market price must fall. As the price falls, consumers will demand more and producers will supply less, so the gap between supply and demand will diminish. Eventually the price may reach And at that price, as we have seen, the amount that suppliers wish to sell and the amount that consumers wish to purchase are equal.

B. Equilibrium in a Monopolistic Market Monopoly is at the other extreme of market structure. In a monopoly there is only

one supplier; so, that firm and the industry are identical. A monopoly can arise and per- sist only where there are barriers to entry that make it impossible for competing firms to appear. In general, such barriers can arise from two sources: first, from statutory and other legal restrictions on entry; and second, from technological conditions of produc- tion known as economies of scale. An example of a statutory restriction on entry was the Civil Aeronautics Board’s refusal from the 1930s until the mid-1970s to permit entry of new airlines into the market for passenger traffic on such major routes as Los Angeles–New York and Chicago–Miami.

The second barrier to entry is technological. Economies of scale are a condition of production in which the greater the level of output, the lower the average cost of pro- duction. Where such conditions exist, one firm can produce any level of output at less cost than multiple firms. A monopolist that owes its existence to economies of scale is sometimes called a natural monopoly. Public utilities, such as local water, telecommu- nications, cable, and power companies, are often natural monopolies. The technological advantages of a natural monopoly would be partially lost if the single firm is allowed

Pc.

P1, qd1

qs1 P1.

Pc, qc

Price

Quantity

s = s(p)

d = d(p)

0 qd1 qc qs1

excess supply

FIGURE 2.10 Market equilibrium in a perfectly competitive market.

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

to restrict its output and to charge a monopoly price. For that reason, natural monopo- lies are typically regulated by the government.

The monopolist, like the competitive firm, maximizes profit by producing that out- put for which marginal cost equals marginal revenue. Marginal cost of the monopolist, as for the competitive firm, is the cost of producing one more unit of output. This cost curve is represented in Figure 2.11 by the curve labeled MC. But marginal revenue for the monopolist is different from what it was for the competitive firm. Recall that mar- ginal revenue describes the change in a firm’s total revenues for a small, or marginal,

Opportunity Cost and Comparative Advantage

We have been implicitly using one of the most fundamental concepts in microeconomics: opportunity cost. This term refers to the economic cost of an alternative that has been fore- gone. When you decided to attend a college, graduate school, or law school, you gave up certain other valuable alternatives, such as taking a job, training for the Olympics, or traveling around the world on a tramp steamer. In reckoning the cost of going to college, graduate school, or law school, the true economic cost was that of the next best alternative. This point is true of the decisions of all economic actors: When maximizing utility, the consumer must consider the opportunities given up by choosing one bundle of consumer goods rather than another; when maximizing profits, the firm must consider the opportunities foregone by com- mitting its resources to the production of widgets rather than to something else.

In general, the economic notion of opportunity cost is more expansive than the more common notion of accounting cost. An example will make this point.10 Suppose that a rich relative gives you a car whose market value is $15,000. She says that if you sell the car, you may keep the proceeds, but that if you use the car yourself, she’ll pay for the gas, oil, mainte- nance, repairs, and insurance. In short she says, “The use of the car is FREE!” But is it? Suppose that the $15,000 for which the car could be sold would earn 12 percent interest per year in a savings account, giving $1800 per year in interest income. If you use the car for 1 year, its resale value will fall to $11,000—a cost to you of $4000. Therefore, the opportunity cost to you of using the car for 1 year is $4000 plus the foregone interest of $1800—a total of $5800. This is far from being free. The accounting cost of using the car is zero, but the op- portunity cost is positive.

Comparative advantage is another useful economic concept related to the notion of op- portunity cost. The law of comparative advantage asserts that people should engage in those pursuits where their opportunity costs are lower than others. For example, someone who is 7 feet tall has a comparative advantage in pursuing a career in professional basketball. But what about someone whose skills are such that she can do many things well? Suppose, for example, that a skilled attorney is also an extremely skilled typist. Should she do her own typing or hire someone else to do it while she specializes in the practice of law? The notion of comparative advantage argues for specialization: The attorney can make so much more money by specializing in the practice of law than by trying to do both jobs that she could easily afford to hire someone else who is less efficient at typing to do her typing for her.

10 The example is taken from ROY RUFFIN & PAUL GREGORY, PRINCIPLES OF MICROECONOMICS 156 (2d ed. 1986).

VI. Market Equilibrium 31

change in the number of units of output sold. For the competitive firm marginal rev- enue is equal to the price of output. Because the competitive firm can sell as much as it likes at the prevailing price, each additional unit of output sold adds exactly the sale price to the firm’s total revenues. But for the monopolist, marginal revenue declines as the number of units sold increases. This is indicated in Figure 2.11 by the downward- sloping curve labeled MR. Notice that the MR curve lies below the demand curve. This indicates that the marginal revenue from any unit sold by a monopolist is always less than the price. MR is positive but declining for units of output between 0 and thus, the sale of each of those units increases the firm’s total revenues but at a decreasing rate. The unit actually adds nothing to the firm’s total revenues and for each unit of output beyond MR is less than zero, which means that each of those units actually reduces the monopolist’s total revenues.

The reason for this complex relationship between marginal revenue and units sold by the monopolist is the downward-sloping demand curve. The downward-sloping de- mand curve implies that the monopolist must lower the price to sell more units; but in order to sell an additional unit of output he or she must lower the price not just on the last or marginal unit but on all the units sold.11 From this fact it can be shown, using calculus, that the addition to total revenues from an additional unit of output sold will always be less than the price charged for that unit. Thus, because MR is always less than the price for all units of output and because price declines along the demand curve, the MR curve must also be downward sloping and lie below the demand curve.

The monopolist maximizes his profit by choosing that output level for which mar- ginal revenue and marginal cost are equal. This output level, is shown in Figure 2.11. The demand curve indicates that consumers are willing to pay for that amount of output. Notice that if this industry were competitive instead of monopolized, the profit-maximizing actions of the firms would have resulted in an equilibrium price and quantity at the intersection of the aggregate supply curve, S, and the industry demand curve, D. The competitive price, is lower than the monopolistic price, and thePc,

Pm qm,

qc, (MR = 0),q0

qc;

Price

Quantity

d = d(p)

0 qm qc

FIGURE 2.11 Profit-maximizing output and price for a monopolist.

11 This assumes that the monopolist cannot price-discriminate (that is, charge different prices to different consumers for the same product).

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

quantity of output produced and consumed under competition, is greater than under monopoly.

Economists distinguish additional market structures that are intermediate between the extremes of perfect competition and monopoly. The most important among these are oligopoly and imperfect competition. An oligopolistic market is one containing a few firms that recognize that their individual profit-maximizing decisions are interde- pendent. That means that what is optimal for firm A depends not only on its marginal costs and the demand for its output but also on what firms B, C, and D have decided to produce and the prices they are charging. The economic analysis of this interdepen- dence requires a knowledge of game theory, which we discuss below.

An imperfectly competitive market is one that shares most of the characteristics of a perfectly competitive market—for example, free entry and exit of firms and the pres- ence of many firms—but has one important monopolistic element: Firms produce differentiable output rather than the homogeneous output produced by perfectly com- petitive firms. Thus, imperfectly competitive firms distinguish their output by brand names, colors, sizes, quality, durability, and so on.

C. An Example of Equilibrium Analysis It is useful to have an example applying this theory to a real problem. Let us imag-

ine a market for rental housing like the one shown in Figure 2.12. The demand for rental housing is given by the curve D, and the supply of rental housing is given by the upward-sloping supply curve S. Assuming that the rental housing market is competi- tive, then the independent actions of consumers and of profit-maximizing housing own- ers will lead to a rental rate of being charged and of units of rental housing being supplied and demanded. Note that this is an equilibrium in the sense we discussed above: The decisions of those demanding the product and of those supplying it are con- sistent at the price Unless something causes the demand curve or the supply curve to shift, this price and output combination will remain in force.

But now suppose that the city government feels that is too high and passes an ordinance that specifies a maximum rental rate for housing of considerably belowrm,

r1.

h1r1

qc,

Rental rate

Housing0 hs h1 hd

excess demand

FIGURE 2.12 The consequences of a rent-control ordinance that prescribes rents below the market-clearing rental rate.

VII. Game Theory 33

the equilibrium market rate. The hope of the government is that at least the same amount of housing will be consumed by renters but at a lower rental rate. A look at Figure 2.12, however, leads one to doubt that result. At consumers demand units of rental housing, an increase over the quantity demanded at the higher rate, But at this lower rate suppliers are only prepared to supply units of rental housing. Apparently it does not pay them to devote as much of their housing units to renters at that lower rate; perhaps if is all one can get from renting housing units, suppliers prefer to switch some of their units to other uses, such as occupancy by the owner’s family or their sale as condominiums. The result of the rate ceiling imposed by the gov- ernment is a shortage of, or excess demand for, rental units equal to

If the rate ceiling is strictly enforced, the shortage will persist. Some non-price methods of determining who gets the units of rental housing must be found, such as queuing. Eventually, the shortage may be eased if either the demand curve shifts inward or the supply curve shifts outward. It is also possible that landlords will let their prop- erty deteriorate by withholding routine maintenance and repairs, so that the quality of their property falls to such an extent that provides a competitive rate of return to them.

If, however, the rate ceiling is not strictly enforced, then consumers and suppliers will find a way to erase the shortage. For example, renters could offer free services or secret payments (sometimes called side payments) to landlords in order to get the ef- fective rental rate above and induce the landlord to rent to them rather than to those willing to pay only Those services and side payments could amount to per housing unit.

(r2 - rm)rm. rm

(hd - hs).

hs r1. hdrm,