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good that a consumer is willing to give up in order to obtain one additional unit of another good. marginal rate of technical substitution (MRTS) (page 218) Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant. marginal rate of transformation (page 614) Amount of one good that must be given up to produce one additional unit of a second good. marginal revenue (pages 284, 358) Change in revenue resulting from a one-unit increase in output. marginal revenue product (page 530) Additional revenue resulting from the sale of output created by the use of one additional unit of an input. marginal social benefit (page 664) Sum of the marginal private benefit plus the marginal external benefit. marginal social cost (page 663) Sum of the marginal cost of production and the marginal external cost. marginal utility (MU) (page 95) Additional satisfaction obtained from consuming one additional unit of a good. marginal value (page 382) Additional benefit derived from purchasing one more unit of a good. market (page 7) Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. market basket (or bundle) (page 68) List with specific quantities of one or more goods. market definition (page 8) Determination of the buyers, sellers, and range of products that should be included in a particular market. method of Lagrange multipliers (page 150) Technique to maximize or minimize a function subject to one or more constraints. microeconomics (page 4) Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise. mixed bundling (page 423) Selling two or more goods both as a package and individually. mixed strategy (page 496) Strategy in which a player makes a random choice among two or more possible actions, based on a set of chosen probabilities. monopolistic competition (page 452) Market in which firms can enter freely, each producing its own brand or version of a differentiated product. monopoly (page 358) Market with only one seller. monopsony (page 358) Market with only one buyer. monopsony power (page 382) Buyer’s ability to affect the price of a good. moral hazard (page 643) When a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event
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. multiple regression analysis (page 700) Statistical procedure for quantifying economic relationships and testing hypotheses about them. mutual fund (page 171) Organization that pools funds of individual investors to buy a large number of different stocks or other financial assets. N Nash equilibrium (page 458) Set of strategies or actions in which each firm does the best it can given its competitors’ actions. market demand curve (page 124) Curve relating the quantity of a good that all consumers in a market will buy to its price. natural monopoly (page 380) Firm that can produce the entire output of the market at a cost lower than what it would be if there were several firms. 714 • GLOSSARY negatively correlated variables (page 171) Variables having a tendency to move in opposite directions. net present value (NPV) criterion (page 569) Rule holding that one should invest if the present value of the expected future cash flow from an investment is larger than the cost of the investment. network externality (page 135) Situation in which each individual’s demand depends on the purchases of other individuals. nominal price (page 12) Absolute price of a good, unad- justed for inflation. parallel conduct (page 390) Form of implicit collusion in which one firm consistently follows actions of another. partial equilibrium analysis (page 596) Determination of equilibrium prices and quantities in a market independent of effects from other markets. payoff (pages 161, 488) Value associated with a possible outcome. payoff matrix (page 470) Table showing profit (or payoff) to each firm given its decision and the decision of its competitor. noncooperative game (pages 470, 488) Game in which negotiation and enforcement of binding contracts are not possible. peak-load pricing (page 410) Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be high. nondiversifiable risk (page 574) Risk that cannot be eliminated by investing in many projects or by holding the stocks of many companies. perfect complements (page 76) Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles. nonexclusive good (page 690) Good that people cannot be excluded from consuming, so that it is difficult or impossible to charge for its use. perfect substitutes (page 76) Two goods for which the marginal rate of substitution of one for the other is a constant. nonrival good (page 690) Good for which the marginal cost of its provision to an additional consumer is zero
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. perfectly competitive market (page 8) Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price. normative analysis (page 7) Analysis examining ques- perpetuity (page 565) Bond paying out a fixed amount tions of what ought to be. of money each year, forever. O oligopoly (page 452) Market in which only a few firms compete with one another, and entry by new firms is impeded. oligopsony (page 382) Market with only a few buyers. opportunity cost (page 230) Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use. opportunity cost of capital (page 570) Rate of return that one could earn by investing in an alternate project with similar risk. optimal strategy (page 488) Strategy that maximizes a player’s expected payoff. ordinal utility function (page 80) Utility function that generates a ranking of market baskets in order of most to least preferred. P Paasche index (page 103) Amount of money at currentyear prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year. Pareto efficient allocation (page 602) Allocation of goods in which no one can be made better off unless someone else is made worse off. point elasticity of demand (page 36) Price elasticity at a particular point on the demand curve. positive analysis (page 6) Analysis describing relation- ships of cause and effect. positively correlated variables (page 171) Variables having a tendency to move in the same direction. predatory pricing (page 390) Practice of pricing to drive current competitors out of business and to discourage new entrants in a market so that a firm can enjoy higher future profits. present discounted value (PDV) (page 561) The current value of an expected future cash flow. price discrimination (page 401) Practice of charging different prices to different consumers for similar goods. price elasticity of demand (page 33) Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price. price elasticity of supply (page 36) Percentage change in quantity supplied resulting from a 1-percent increase in price. price leadership (page 474) Pattern of pricing in which one firm regularly announces price changes that other firms then match. price of risk (page 180) Extra risk that an investor must incur to enjoy a higher expected return
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. price rigidity (page 473) Characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change. price signaling (page 474) Form of implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit. price support (page 332) Price set by government above free-market level and maintained by governmental purchases of excess supply. price taker (page 280) Firm that has no influence over market price and thus takes the price as given. price-consumption curve (page 112) Curve tracing the utility-maximizing combinations of two goods as the price of one changes. principal (page 646) Individual who employs one or more agents to achieve an objective. principal–agent problem (page 645) Problem arising when agents (e.g., a firm’s managers) pursue their own goals rather than the goals of principals (e.g., the firm’s owners). prisoners’ dilemma (page 470) Game theory example in which two prisoners must decide separately whether to confess to a crime; if a prisoner confesses, he will receive a lighter sentence and his accomplice will receive a heavier one, but if neither confesses, sentences will be lighter than if both confess. private-value auction (page 517) Auction in which each bidder knows his or her individual valuation of the object up for bid, with valuations differing from bidder to bidder. probability (page 160) Likelihood that a given outcome will occur. Producer Price Index (page 12) Measure of the aggregate price level for intermediate products and wholesale goods. producer surplus (page 298) Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production. product transformation curve (page 258) Curve showing the various combinations of two different outputs (products) that can be produced with a given set of inputs. production function (page 204) Function showing the highest output that a firm can produce for every specified combination of inputs. production possibilities frontier (page 614) Curve showing the combinations of two goods that can be produced with fixed quantities of inputs. profit (page 284) Difference between total revenue and total cost. property rights (page 684) Legal rules stating what peo- ple or firms may do with their property. GLOSSARY • 715 public good (pages 626, 690) Nonexclusive and nonrival good: the marginal cost of provision to an additional consumer is zero
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and people cannot be excluded from consuming it. pure bundling (page 423) Selling products only as a package. pure strategy (page 496) Strategy in which a player makes a specific choice or takes a specific action. Q quantity forcing (page 443) Use of a sales quota or other incentives to make downstream firms sell as much as possible. R rate-of-return regulation (page 381) Maximum price allowed by a regulatory agency is based on the (expected) rate of return that a firm will earn. reaction curve (page 459) Relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce. real price (page 12) Price of a good relative to an aggregate measure of prices; price adjusted for inflation. real return (page 178) Simple (or nominal) return on an asset, less the rate of inflation. reference point (page 190) The point from which an individual makes a consumption decision. rent seeking (page 378) Spending money in socially unproductive efforts to acquire, maintain, or exercise monopoly. rental rate (page 244) Cost per year of renting one unit of capital. repeated game (page 498) Game in which actions are taken and payoffs received over and over again. reservation price (page 401) Maximum price that a cus- tomer is willing to pay for a good. return (page 177) Total monetary flow of an asset as a fraction of its price. returns to scale (page 223) Rate at which output increases as inputs are increased proportionately. risk averse (page 166) Condition of preferring a certain income to a risky income with the same expected value. risk loving (page 166) Condition of preferring a risky income to a certain income with the same expected value. risk neutral (page 166) Condition of being indifferent between a certain income and an uncertain income with the same expected value. risk premium (pages 166, 573) Maximum amount of money that a risk-averse individual will pay to avoid taking a risk. 716 • GLOSSARY riskless (or risk-free) asset (page 177) Asset that provides a flow of money or services that is known with certainty. risky asset (page 177) Asset that provides an uncertain flow of money or services to its owner. R-squared (R2) (page 704) Percentage of the variation in the dependent variable that is accounted for by all the explanatory variables. S sample (page 702) Set of observations for study,
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drawn from a larger universe. sealed-bid auction (page 517) Auction in which all bids are made simultaneously in sealed envelopes, the winning bidder being the individual who has submitted the highest bid. second-degree price discrimination (page 404) Practice of charging different prices per unit for different quantities of the same good or service. second-price auction (page 517) Auction in which the sales price is equal to the second-highest bid. sequential game (page 502) Game in which players move in turn, responding to each other’s actions and reactions. shirking model (page 655) Principle that workers still have an incentive to shirk if a firm pays them a market-clearing wage, because fired workers can be hired somewhere else for the same wage. short run (page 205) Period of time in which quantities of one or more production factors cannot be changed. speculative demand (page 129) Demand driven not by the direct benefits one obtains from owning or consuming a good but instead by an expectation that the price of the good will increase. Stackelberg model (page 463) Oligopoly model in which one firm sets its output before other firms do. standard deviation (page 162) Square root of the weighted average of the squares of the deviations of the payoffs associated with each outcome from their expected values. standard error of the regression (page 704) Estimate of the standard deviation of the regression error. stock of capital (page 214) Total amount of capital avail- able for use in production. stock externality (page 679) Accumulated result of action by a producer or consumer which, though not accounted for in the market price, affects other producers or consumers. strategy (page 488) Rule or plan of action for playing a game. subsidy (page 348) Payment reducing the buyer’s price below the seller’s price; i.e., a negative tax. substitutes (page 24) Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other. substitution effect (page 120) Change in consumption of a good associated with a change in its price, with the level of utility held constant. sunk cost (page 230) Expenditure that has been made and cannot be recovered. short-run average cost curve (SAC) (page 254) Curve relating average cost of production to output when level of capital is fixed. supply curve (page 22) Relationship between the quantity of a good
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that producers are willing to sell and the price of the good. shortage (page 25) Situation in which the quantity surplus (page 25) Situation in which the quantity sup- demanded exceeds the quantity supplied. plied exceeds the quantity demanded. Slutsky equation (page 156) Formula for decomposing the effects of a price change into substitution and income effects. snob effect (page 137) Negative network externality in which a consumer wishes to own an exclusive or unique good. social rate of discount (page 682) Opportunity cost to society as a whole of receiving an economic benefit in the future rather than the present. social welfare function (page 611) Measure describing the well-being of society as a whole in terms of the utilities of individual members. specific tax (page 345) Tax of a certain amount of money per unit sold. T tariff (page 340) Tax on an imported good. technical efficiency (page 613) Condition under which firms combine inputs to produce a given output as inexpensively as possible. technological change (page 214) Development of new technologies allowing factors of production to be used more effectively. theory of consumer behavior (page 68) Description of how consumers allocate incomes among different goods and services to maximize their well-being. GLOSSARY • 717 theory of the firm (page 202) Explanation of how a firm makes cost-minimizing production decisions and how its cost varies with its output. utility possibilities frontier (page 610) Curve showing all efficient allocations of resources measured in terms of the utility levels of two individuals. third-degree price discrimination (page 404) Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group. tit-for-tat strategy (page 499) Repeated-game strategy in which a player responds in kind to an opponent’s previous play, cooperating with cooperative opponents and retaliating against uncooperative ones. total cost (TC or C) (page 233) Total economic cost of production, consisting of fixed and variable costs. transfer prices (page 439) Internal prices at which parts and components from upstream divisions are “sold” to downstream divisions within a firm. tradeable emissions permits (page 672) System of marketable permits, allocated among firms, specifying the maximum level of emissions that can be generated. two-part tariff (page 414) Form of pricing in which consumers are charged both an entry and a usage fee. tying (page 428) Practice of requiring a customer to
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pur- chase one good in order to purchase another. U user cost of capital (page 243) The annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest. user cost of production (page 585) Opportunity cost of producing and selling a unit today and so making it unavailable for production and sale in the future. utility (page 78) Numerical score representing the satisfaction that a consumer gets from a given market basket. utility function (page 79) Formula that assigns a level of utility to individual market baskets. V value of complete information (page 174) Difference between the expected value of a choice when there is complete information and the expected value when information is incomplete. variability (page 161) Extent to which possible out- comes of an uncertain event differ. variable cost (VC) (page 233) Cost that varies as output varies. variable profit (page 401) Sum of profits on each incremental unit produced by a firm; i.e., profit ignoring fixed costs. vertical integration (pages 439, 651) Organizational form in which a firm contains several divisions, with some producing parts and components that others use to produce finished products. W welfare economics (page 609) Normative evaluation of markets and economic policy. welfare effects (page 319) Gains and losses to consum- ers and producers. winner’s curse (page 520) Situation in which the winner of a common-value auction is worse off as a consequence of overestimating the value of the item and thereby overbidding. Z zero economic profit (page 302) A firm is earning a normal return on its investment—i.e., it is doing as well as it could by investing its money elsewhere. Answers to Selected Exercises CHAPTER 1 3. 1. a. False. There is little or no substitutability across geographical regions of the United States. A consumer in Los Angeles, for example, will not travel to Houston, Atlanta, or New York for lunch just because hamburger prices are lower in those cities. Likewise, a McDonald’s or Burger King in New York cannot supply hamburgers in Los Angeles, even if prices were higher in Los Angeles. In other words, a fast-food price increase in New York will affect neither the quantity demanded nor the quantity supplied in Los Angeles or other parts of the country. b. False. Although consumers are unlikely to travel across the country to buy clothing, suppliers can easily move clothing from one part of the country to another
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. Thus if clothing prices were substantially higher in Atlanta than Los Angeles, clothing companies could shift supplies to Atlanta, which would reduce the price there. c. False. Although some consumers might be die-hard Coke or Pepsi loyalists, there are many consumers who will substitute one for the other based on price differences. Thus there is a single market for colas. CHAPTER 2 2. a. With each price increase of $20, the quantity demanded decreases by 2. Therefore, (QD/P) = -2/20 = -0.1. At P = 80, quantity demanded equals = (8/20)( -0.1) = -0.40. Similarly, 20 and ED at P = 100, quantity demanded equals 18 and ED = (100/18)(-0.1) = -0.56. b. With each price increase of $20, quantity supplied increases by 2. Therefore, (QS/P) = 2/20 = 0.1. At P = 80, quantity supplied equals 16 and ES = (80/16)(0.1) = 0.5. Similarly, at P = 100, quantity = (100/18)(0.1) = 0.56. supplied equals 18 and ES c. The equilibrium price and quantity are found where the quantity supplied equals the quantity demanded at the same price. From the table, the P* = $100 and the Q* = 18 million. d. With a price ceiling of $80, consumers want 20 million, but producers supply only 16 million, for a shortage of 4 million. 718 If Brazil and Indonesia add 200 million bushels of wheat to U.S. wheat demand, the new demand curve = (3244 - 283P) + 200 = will be Q + 200, or QD 3444 - 283P. Equate supply and the new demand to find the new equilibrium price. 1944 + 207P = 3444 - 283P, or 490P = 1500, and thus P $3.06 per bushel. To find the equilibrium quantity, substitute the price into either the supply or demand equation. Using demand, = 3444 - 283(3.06) = 2578 million bushels. QD 5. a. Total demand is Q = 3244 - 283P; domestic = 1700 - 107P; subtracting domestic demand is QD demand from total demand gives export demand = 1544 - 176P. The initial market equilibrium QE
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price (as given in example) is P* = $2.65. With a 40-percent decrease in export demand, total demand becomes Q = QD = 1700 -107P + 0.6(1544 - 176P) = 2626.4 - 212.6P. Demand is equal to supply. Therefore: + 0.6QE 2626.4 - 212.6P = 1944 + 207P 682.4 = 419.6P So P = 682.4 419.6 = $1.626 or $1.63. At this price, Q = 2281. Yes, farmers should be worried. With this drop in quantity and price, revenue goes from $6609 million to $3718 million. b. If the U.S. government supports a price of $3.50, the market is not in equilibrium. At this support price, demand is equal to 2626.4 - 212.6(3.5) = 1882.3 and supply is 1944 + 207(3.5) = 2668.5. There is excess supply (2668.5 - 1882.3 = 786.2) which the government must buy, costing $3.50(786.2) = $2751.7 million. = -b(P*/Q*); substituting ED 8. a. To derive the new demand curve, we follow the same procedure as in Section 2.6. We know that = -0.75, P* = $3, ED and Q* = 18 gives -0.75 = -b(3/18) so that b = 4.5. Substituting this value into the equation for = a - bP, we have the linear demand curve, QD 18 = a - 4.5(3). So a = 31.5. The new demand curve is QD = 31.5 - 4.5P. ANSWERS TO SELECTED EXERCISES • 719 J1 J2 R b. To determine the effect of a 20-percent decline in copper demand, we note that the quantity demanded is 80 percent of what it would be otherwise for every price. Multiplying the right-hand side of the demand = (0.8)(31.5 - 4.5P) = 25.2 - 3.6P. curve by 0.8, QD = -9 + 9P and demand is equal Supply
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is still QS to supply. Solving, P* = $2.71 per pound. A decline in demand of 20 percent, therefore, entails a drop in price of 29 cents per pound, or 9.7 percent. 10. a. First, considering non-OPEC supply: SC = Q* = 19. = d(P*/Q) implies = 0.05 and P* = $80, ES With ES d = 0.012. Substituting for d, SC = 19, and P = 80 in the supply equation gives 19 = c + (0.012)(80), so that c = 18.05. Hence, the supply curve is = 32, = 18.05 + 0.012P. Similarly, since QD SC = -b(P*/Q*) = -0.05 and b = 0.020. Substituting ED for b, QD = 32, and P = 80 in the demand equation gives 32 = a - (0.020)(80), so that a = 33.6. Hence QD = 33.6 - 0.020P. implies + dP and QD b. The long-run elasticities are: ES = -0.30. As above, ES = d(P*/Q*) and ED 0.30 = d(80/19) = 0.30 and = ED -b(P*/Q*), a n d -0.30 = -b(80/32). So d = 0.07 and b = –0.12. Next = a - bP, solve for c and a: SC that 19 = c + (0.07)(80) and which 32 = a - (0.12)(80). Therefore, c = 13.3 and a = 41.6. c. The discovery of new oil fields will increase OPEC supply by 2bb/yr, so SC = 19, SO = 15, and D = 34. The new short-run total supply curve is ST is unchanged: D = 33.6 -.020P. Since supply equals demand, 33.05 + 0.012P = 33.6 -.020P. Solving, P = $17.19 per barrel. An increase in OPEC supply entails a drop in price of $62.81, or 79% in the short-run. = 33.05 + 0.012P. Demand To analyze the long-run, use the new long
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- = 28.3 + 0.071P. Setting run supply curve, ST this equal to long-run demand gives: 28.3 + 0.071 P = 41.6 - 0.120P, so that P = $69.63 per barrel, only $10.37 per barrel (13%) less than the original long-run price. S2 S1 H Slope 0.50 75 M FIGURE 3(a) G 50 45 40 35 30 25 20 15 10 5 Slope 1.00 Slope 0.75 0 25 50 FIGURE 3(b) CHAPTER 3 8. 3. Not necessarily true. Suppose that she has convex preferences (a diminishing marginal rate of substitution), and has a lot of movie tickets. Even though she would give up movie tickets to get another basketball ticket, she does not necessarily like basketball better. 6. a. See Figure 3(a), where R is the number of rock con- certs, and H is the number of hockey games. b. At any combination of R and H, Jones is willing to give up more of R to get some H than Smith is. Thus Jones has a higher MRS of R for H than Smith has. Jones’ indifference curves are steeper than Smith’s at any point on the graph. In Figure 3(b) we plot miles flown, M, against all other goods, G, in dollars. The slope of the budget line is -PM/PG. The price of miles flown changes as number of miles flown changes, so the budget curve is kinked at 25,000 and 50,000 miles. Suppose PM is $1 per mile for … 25,000 miles, then PM = $0.75 for 25,000 6 M … 50,000, and PM = $.50 for M > 50,000. Also, let PG = $1. Then the slope of the first segment is -1, the slope of the second segment is -0.75, and the slope of the last segment is -0.5. 720 • ANSWERS TO SELECTED EXERCISES CHAPTER 4 9. a. For computer chips, EP = - 2, so - 2 = %Q/10, and therefore %Q = -20. For disk drives, EP = - 1, so a 10 percent increase in price will reduce sales by 10 percent. Sales revenue will decrease for computer chips because demand is elastic and price has increased.
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To estimate the change in rev= P1Q1 be revenue before the price enue, let TR1 = P2Q2 be revenue after the price change and TR2 change. Therefore TR = P2Q2 - P1Q1, and thus TR = (1.1P1)(0.8Q1) - P1Q1 = -0.12P1Q1, or a 12 percent decline. Sales revenue for disk drives will remain unchanged because demand elasticity is -1. b. Although we know the responsiveness of demand to change in price, we need to know the quantities and the prices of the products to determine total sales revenues. 11. a. With small changes in price, the point elasticity formula would be appropriate. But here, the price of food increases from $2 to $2.50, so arc elas= (Q/P)(P/Q). We ticity should be used: Ep know that Ep = - 1, P = 2, P =.50, and Q = 5000. So, if there is no change in income, we can solve for Q: -1 = (Q/.50) [((2 +.50)/2)/(5000 + Q/2)] = (Q 2.50)/(10,000 + Q). We find that Q = -1000: she decreases her consumption of food from 5000 to 4000 units. # b. A tax rebate of $2500 implies an income increase of $2500. To calculate the response of demand to the tax rebate, we use the definition of the arc income = (Q/I)(I/Q). We know that elasticity: EI EI = 0.5, I = 25,000, I = 2500, and Q = 4000. We solve for Q:0.5 = (Q/2500)[((25,000 + 27,500)/2)/(4000 + (Q/2)]. Since Q = 195, she increases her consumption of food from 4000 to 4195 units. c. Felicia is better off after the rebate. The amount of the rebate is enough to allow her to purchase her original bundle of food and other goods. Recall that originally she consumed 5000 units of food. When the price went up by fifty cents per unit, she needed an extra (5000)($0.50) = $2500 to afford the same quantity of food without reducing the quantity of the other goods consumed. This is the exact amount of the rebate.
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However, she did not choose to return to her original bundle. We can therefore infer that she found a better bundle that gave her a higher level of utility. 13. a. The demand curve is a straight line with a vertical intercept of P = 15 and a horizontal intercept of Q = 30. b. If there were no toll, the price P would be 0, so that Q = 30. c. If the toll is $5, Q = 20. The consumer surplus lost is the difference between consumer surplus when P = 0 and consumer surplus when P = 5, or $125. CHAPTER 4—APPENDIX 1. 3. The first utility function can be represented as a series of straight lines; the second as a series of hyperbolas in the positive quadrant; and the third as a series of “L”s. Only the second utility function meets the definition of a strictly convex shape. The Slutsky equation is dX/dPX = 0X/0P*|U = U* - X(X/I), where the first term represents the substitution effect and the second term represents the income effect. With this type of utility function the consumer does not substitute one good for the other when the price changes, so the substitution effect is zero. CHAPTER 5 2. The four mutually exclusive states are given in Table 5 below. 4. 8. The expected value is EV = (0.4)(100) + (0.3)(30) + (0.3)( -30) = $40. The variance is s2 = (0.4)(100 - 40)2 + (0.3)(30 - 40)2 + (0.3)(- 30 - 40)2 = 2,940. Initially, total wealth is $450,000. We calculate expected wealth under three options. Under the safe option, E(U) = (450,000 + 1.05*200,000).5 = 678. With the summer corn crop, E(U) =.7(250,000 + 500,000).5 +.3(250,000 + 50,000).5 = 770. Finally, with the drought resistant summer corn crop, E(U) =.7(250,000 + 450,000).5 +.3(250,000 + 350,000).5 = 818. The option with the highest expected utility is planting the drought resistant crop. TABLE 5 CONGR
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ESS PASSES TARIFF CONGRESS DOES NOT PASS TARIFF Slow growth rate State 1: State 2: Slow growth with tariff Slow growth without tariff Fast growth rate State 3: State 4: Fast growth with tariff Fast growth without tariff 20 15 e c i r P 10 5 0 0 FIGURE 5 Total Demand ANSWERS TO SELECTED EXERCISES • 721 isoquant, and hence the MRTS, we need to know the rate at which one input may be substituted for the other. Without the marginal product of each input, we cannot calculate the MRTS. 9. a. Let Q1 be the output of DISK, Inc., Q2 be the output of FLOPPY, Inc., and X be equal amounts of capital and = 10X0.5X0.5 = labor for the two firms. Then, Q1 10X(0.5 + 0.5) = 10X and Q2 = 10X0.6X0.4 = 10X(0.6 + 0.4) = 10X. Because Q1 = Q2, they both generate the same output with the same inputs. 500 1000 1500 Quantity 2000 2500 3000 12. To determine the total demand curve, we add up 100 standard demand curves and 100 rule of thumb demand curves: Q = 100*(20 - P) + 100* (10 if P 6 10 or 0 if P Ú 10) = 3000 - 100P if P < 10 and 2000 - 100P if P Ú 10. The resulting total demand curve is given below. CHAPTER 6 2. a. The average product of labor, AP, is equal to Q/L. The marginal product of labor, MP, is equal to Q/L. The relevant calculations are given in the following table 10 18 24 28 30 28 25 AP — 10 9 8 7 6 4.7 3.6 MP — 10 8 6 4 2 2 3 b. This production process exhibits diminishing returns to labor, which is characteristic of all production functions with one fixed input. Each additional unit of labor yields a smaller increase in output than the last unit of labor. c. Labor’s negative marginal product can arise from congestion in the chair manufacturer’s factory. As more laborers are using a fixed amount of capital, they get in each other’s way, decreasing output. 6. No. If the inputs are perfect substitutes, the isoquants will be linear. However, to calculate the
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slope of the b. L 0 1 2 3 4 With capital fixed at 9 machine units, the production = 37.37L0.4. = 30L0.5 and Q2 functions become Q1 Consider the following table: Q MP Q MP FIRM 1 FIRM 1 FIRM 2 FIRM 2 0 30.00 42.43 51.96 60.00 — 30.00 12.43 9.53 8.04 0 37.37 49.31 57.99 65.07 — 37.37 11.94 8.69 7.07 For each unit of labor above 1 unit, the marginal prod- uct of labor is greater for DISK, Inc. CHAPTER 7 4. a. Total cost, TC, is equal to fixed cost, FC, plus variable cost, VC. Since the franchise fee, FF, is a fixed sum, the firm’s fixed costs increase by the fee. Then average cost, equal to (FC + VC)/Q, and average fixed cost, equal to (FC/Q), increase by the average franchise fee (FF/Q). Average variable cost is unaffected by the fee, as is marginal cost. b. When a tax t is imposed, variable costs increase by tQ. Average variable cost increases by t (fixed cost is constant), as does average (total) cost. Because total cost increases by t with each additional unit, marginal cost increases by t. 5. It is probably referring to accounting profit; this is the standard concept used in most discussions of how firms are doing financially. In this case, the article points to a substantial difference between accounting and economic profits. It claims that, under the current labor contract, automakers must pay many workers even if they are not working. This implies that their wages are sunk for the life of the contract. Accounting profits would subtract wages paid; economic profits would not, since they are sunk costs. Therefore automakers may be earning economic profits on these sales, even if they have accounting losses. 722 • ANSWERS TO SELECTED EXERCISES 10. If the firm can produce one chair with either 4 hours of labor or 4 hours of machinery or any combination, then the isoquant is a straight line with a slope of -1 and intercepts at K = 4 and L = 4. The isocost line, TC = 30L + 15K, has a slope of -2 and intercepts at K = TC/15 and L = TC/30. The cost
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-minimizing point is a corner solution, where L = 0 and K = 4, and TC = $60. CHAPTER 7—APPENDIX 1. a. Returns to scale refers to the relationship between output and proportional increases in all inputs. If F(lL,lK) 7 lF(L,K), there are increasing returns to scale; if F(lL,lK) = lF(L,K), there are constant returns to scale; if F(lL,lK) 6 lF(L,K), there are decreasing returns to scale. Applying this to F(L,K) = K2L, F(lL,lK) = (lK)2(lL) = l3K2L = l3F(L,K) 7 lF(L,K). So, this production function exhibits increasing returns to scale. b. F(lL,lK) = 10lK + 5lL = lF(L,K). The production function exhibits constant returns to scale. c. F(lL,lK) = (lKlL)0.5 = (l2)0.5 = (KL)0.5 = l(KL)0.5 = lF(L,K). The production function exhibits constant returns to scale. 2. The marginal product of labor is 100K. The marginal product of capital is 100L. The marginal rate of technical substitution is K/L. Set this equal to the ratio of the wage rate to the rental rate of capital: K/L = 30/120 or L = 4K. Then substitute for L in the production function and solve for a K that yields an output of 1000 # K = 2.50..50.5, and total cost is equal to $379.20. 1000 = 100K S o, 4K. CHAPTER 8 4. a. Profit is maximized where marginal cost (MC) is equal to marginal revenue (MR). Here, MR is equal to $100. Setting MC equal to 100 yields a profit-maximizing quantity of 25. b. Profit is equal to total revenue (PQ) minus total cost. So profit = PQ - 200 - 2Q2. At P = 100 and Q = 25, profit = $1050. c. The firm produces in the short run if its revenues are greater than its
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variable costs. The firm’s short-run supply curve is its MC curve above minimum AVC. Here, AVC is equal to variable cost, 2Q2, divided by quantity, Q. So, AVC = 2Q. Also, MC is equal to 4Q. So, MC is greater than AVC for any quantity greater than 0. This means that the firm produces in the short run as long as price is positive. 11. The firm should produce where price is equal to marginal cost so that: P = 115 = 15 + 4q = MC and q = 25. Profit is $800. Producer surplus is profit plus fixed cost, which is $1250. 14. a. With the imposition of a $1 tax on a single firm, all its cost curves shift up by $1. b. Because the firm is a price taker, the imposition of the tax on only one firm does not change the market price. Given that the firm’s short-run supply curve is its marginal cost curve (above average variable cost), and that the marginal cost curve has shifted up (or inward), the firm supplies less to the market at every price. c. If the tax is placed on a single firm, that firm will go out of business unless it was earning a positive economic profit before the tax. CHAPTER 9 1. a. In free-market equilibrium, LS = LD. Solving, w = $4 and LS = LD = 40. If the minimum wage is $5, then LS = 50 and LD = 30. The number of people employed will be given by the labor demand. So employers will hire 30 million workers. b. With the subsidy, only w - 1 is paid by the firm. The labor demand becomes LD* = 80 - 10(w - 1). So w = $4.50 and L = 45. 4. a. Equating demand and supply, 28 - 2P = 4 + # 4P P* = 4 and Q* = 20. b. The 25-percent reduction would imply that farmers produce 15 billion bushels. To encourage farmers to withdraw their land from cultivation, the government must give them 5 billion bushels that they can sell on the market. Since the total supply to the market is still 20 billion bushels, the market price remains at $4 per bushel. Farmers gain because they incur no costs for the 5 billion bushels received from the government. We calculate these cost savings
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by taking the area under the supply curve between 15 and 20 billion bushels. The prices when Q = 15 and when Q = 20 are P = $2.75 and P = $4.00. The total cost of producing the last 5 billion bushels is therefore the area of a trapezoid with a base of 20 - 15 = 5 billion and an average height of (2.75 + 4.00)/2 = 3.375. The area is 5(3.375) = $16.875 billion. c. Taxpayers gain because the government does not have to pay to store the wheat for a year and then ship it to an underdeveloped country. The PIK Program can last only as long as wheat reserves last. But PIK assumes that the land removed from production can be restored to production at such time as the stockpiles are exhausted. If this cannot be done, consumers may eventually pay more for wheat-based products. Finally, farmers enjoy a windfall profit because they have no production costs. 10. a. To find the price of natural gas when the price of oil is $60 per barrel, equate the quantity demanded and quantity supplied of natural gas, and solve for PG. The relevant equations are: Supply: + 0.05PO, Demand: Q = 0.02 Q = 15.90 + 0.72PG = $60, we get: 15.90 + 1.8PG + 0.69(60), so the 0.72PG = $8.94. Substituting into price of natural gas is PG the supply or the demand curve gives a free- market quantity of 25.34 Tcf. If a maximum price of natural + 0.69PO. Using PO + 0.05(60) = 0.02 - 1.8PG gas were set at $3, the quantity supplied would be 21.06 Tcf and the quantity demanded would be 36.02 Tcf. To calculate the deadweight loss, we measure the area of triangles B and C (see Figure 9.4). To find area B we must first determine the price on the demand curve when quantity equals 21.1. From the demand equation, 21.1 = 41.42 - 1.8PG. Therefore, PG = $11.29. Area B equals (0.5)(25.3 - 21.1)(11.29 - 8.94) = $4.9 billion, and area C is (0.5
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)(25.3 - 21.1) (8.94 - 3) = $12.5 billion. The deadweight loss is 4.9 + 12.5 = $17.4 billion. b. To find the price of oil that would yield a free market price of natural gas of $3, we set the quantity demanded equal to the quantity supplied, use PG = $3, and solve for PO. Therefore, QS = 15.90 + 0.72(3) + 0.05PO = 0.02 - 1.8(3) + 0.69PO = QD, or 18.06 + 0.05PG = -5.38 + 0.69PO, so that 0.64PO = 23.44 and PO = $36.63. This yields a free market price of natural gas of $3. 11. a. To find the new domestic price, we set the quantity demanded minus the quantity supplied equal to 10. = (29.73 - 0.19P) - ( -7.95 + Therefore, QD 0.66P) = 10. 0.85P = 27.68, meaning that P = 32.56 cents. If imports had been expanded to 10 billion pounds, the U.S. price would have fallen by 3.44 cents. - QS ANSWERS TO SELECTED EXERCISES • 723 b. Substituting the new price of 32.56 cents into the supply and demand equations, we find that the U.S. production of sugar would decrease to 13.54 billion pounds, while demand would increase to 23.54 billion pounds, with the additional 10 billion pounds supplied by imports. In order to find the change in the consumer and producer surpluses, it might help to redraw the graph as Figure 9(a). The gain to producers is given by the area of trapezoid 2 * (32.56 - 24)(8.2)2 + (13.54 - 8.2) A : (32.56 - 24) = $930 million, which is $500 million less than the producer gain when imports were limited to 6.9 billion pounds. A = 1 1 To find the gain to consumers, we must find the change in the lost consumer surplus, given by the sum of trapezoid A, triangles B and C, and rectangle D. We’ve already found the area of trapezoid A. Triangle 2 (32
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.56 - 24)(13.54 - 8.2) = $228.52 million, B = 1 triangle C = 1 2 (32.56 - 24)(25.4 - 23.54) = $79.47 32.56 - 2423.54 - 13.54) = $856.34 million. The sum of A, B, C, and D is $2.09 billion. When imports were limited to 6.9 billion pounds, the loss in consumer surplus is $2.88 billion, meaning that consumers gain about $790 million when imports are raised to 10 billion pounds. A B D PUS 32.56 C 24 Pw ) 50 45 40 35 30 25 20 15 10 5 0 0 5 10 8.2 Qs 15 13.54 Q s 20 25 23.5 Qd Q d 25.4 30 35 Quantity (billions of pounds) FIGURE 9(a) 724 • ANSWERS TO SELECTED EXERCISES c. The deadweight is given by the loss sum of the areas of triangles B and C: B = 1 2 (32.56 - 24)(13.54 - 8.2) = $228.52 million and C = 1 2 (32.56 - 24)(25.4 - 23.54) = $79.47 million. B + C = $228.52 + $79.47 = $308 million. To find the change in deadweight loss from Example 9.6, we subtract this from the original deadweight loss of $614.22 million. $614.22 million – $308 million = $306.22 million. In other words, raising the import quota to 10 billion pounds per year reduces the deadweight loss by $306.22 million. MCm MCc' MCc P MR AR The gain to foreign producers is given by the area of rectangle D. When imports are limited to 6.9 billion pounds, D = $836.4 million; when imports are raised to 10 billion pounds, D = (32.56 - 24)(23.54 - 13.54) = $856.34 million. Because the U.S. price of sugar has increased, foreign producers are able to earn higher profits – about $19.94 million, to be exact. First, equate supply and demand to determine equilibrium quantity: 50 + Q = 200 - 2Q, or QEQ = 50 (million pounds). Substitute QE
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Q = 50 into either the supply or demand equation to determine price: PS = 50 + 50 = 100 and PD = 200 - (2)(50) = 100. Thus, the equilibrium price P is $1 (100 cents). However, the world market price is 60 cents. At this price, the domestic quantity supplied is 60 = 50 - QS or QS = 10, and domestic demand is 60 = 200 - 2QD or QD = 70. Imports equal the difference between domestic demand and supply, or 60 million pounds. If Congress imposes a tariff of 40 cents, the effective price of imports increases to $1. At $1, domestic producers satisfy domestic demand and imports fall to zero. As shown in Figure 9(b), consumer surplus before the tariff is equal to area a + b + c, or (0.5)(200 + 60) (70) = 4,900 million cents or $49 million. After the tariff, the price rises to $1.00 and consumer surplus falls to Qm Qc' Qc FIGURE 10 area a, or (0.5)(200 - 100)(50) = $25 million, a loss of $24 million. Producer surplus increases by area b, or (100 - 60)(10) + (0.5)(100 - 60)(50 - 10) = $12 million. Finally, because domestic production is equal to domestic demand at $1, no hula beans are imported and the government receives no revenue. The difference between the loss of consumer surplus and the increase in producer surplus is deadweight loss which is $12 million. 13. No, they would not. The clearest case is where labor markets are competitive. With either design of the tax, the wedge between supply and demand must total 12.4 percent of the wage paid. It does not matter whether the tax is imposed entirely on the workers (shifting the effective supply curve up by 12.4 percent) or entirely on the employers (shifting the effective demand curve down by 12.4 percent). The same applies to any combination of the two that sums to 12.4 percent. CHAPTER 10 S 2. a b c D 10 50 70 100 Q FIGURE 9(b) There are three important factors: (1) How similar are the products offered by Caterpillar’s competitors? If they are close substitutes, a small increase in price could induce customers to switch to the competition. (2) What is the age of the existing
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stock of tractors? A 5-percent price increase induces a smaller drop in demand with an older population of tractors. (3) As a capital input in agricultural production, what is the expected profitability of the agricultural sector? If expected farm incomes are falling, an increase in tractor prices induces a greater decline in demand than one would estimate with information on past sales and prices. 4. a. Optimal production is found by setting marginal revenue equal to marginal cost. If the demand function is linear, P = a - bQ (here, a = 120 and b = 0.02), so that MR = a 2bQ = 100 2(0.02)Q. 12. P 200 100 60 50 Total cost = 25,000 + 60Q, so MC = 60. Setting MR = MC implies 120 0.04Q = 60, so Q = 1500. Substituting into the demand function, P = 120 (0.02)(1500) = 90 cents. Total profit is (90)(1500) (60)(1500) 25,000, or $200 per week. b. Suppose initially that the consumers must pay the tax. Since the price (including the tax) that consumers would be willing to pay remains unchanged, the demand function can be written P + t = 120 0.02Q t. Because the tax increases the price of each unit, total revenue for the monopolist increases by t, so MR = 120 0.04Q t, where t = 14 cents. To determine the profit-maximizing output with tax, equate marginal revenue and marginal cost: 120 0.04Q - 14 = 60, or Q = 1150 units. From the demand function, average revenue = 120 (0.02)(1150) 14 = 83 cents. Total profit is 1450 cents or $14.50 per week. 7. a. The monopolist’s pricing rule is: (P MC)/P = 1/ED, using 2 for the elasticity and 40 for price, solve to find MC = 20. b. In percentage terms, the mark-up is 50%, since mar- ginal cost is 50% of price. c. Total revenue is price times quantity, or ($40) (800) = $32,000. Total cost is equal to average cost times quantity, or ($15)(800) = $12,000, so profit is $20,000. Producer surplus is profit plus fixed cost, or $22,000.
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10. a. Pro: Although Alcoa controlled about 90 percent of primary aluminum production in the United States, secondary aluminum production by recyclers accounted for 30 percent of the total aluminum supply. It should be possible for a much larger proportion of aluminum supply to come from secondary sources. Therefore the price elasticity of demand for Alcoa’s primary aluminum is much higher than we would expect. In many applications, other metals, such as copper and steel, are feasible substitutes for aluminum. Here, the demand elasticity Alcoa faces may be lower than we would otherwise expect. b. Con: The stock of potential supply is limited. Therefore, by keeping a stable high price, Alcoa could reap monopoly profits. Furthermore, since Alcoa had originally produced the metal reappearing as recycled scrap, it would have taken into account in its output decisions the effect of scrap reclamation on future prices. Hence, it exerted effective monopolistic control over the secondary metal supply. c. Alcoa was not ordered to sell any of its U.S. production facilities. Rather, (1) it was barred from bidding for two primary aluminum plants constructed by the government during World War II; and (2) it was ordered to divest itself of its Canadian subsidiary, which became Alcan. 13. No, you should not. In a competitive market, a firm views price as being horizontal and equal to ANSWERS TO SELECTED EXERCISES • 725 average revenue, which is equal to marginal revenue. If Connecticut’s marginal cost increases, price will still be equal to Massachusetts’s marginal cost, total marginal cost, and marginal revenue. Only Connecticut’s quantity is reduced (which, in turn, reduces overall quantity), as shown in Figure 10. CHAPTER 11 1. a. The Saturday-night requirement separates business travelers, who prefer to return home for the weekend, from tourists, who travel on the weekend. b. By basing prices on the buyer’s location, sorting is done by geography. Then prices can reflect transportation charges, which the customer pays for whether delivery is received at the buyer’s location or at the cement plant. c. Rebate coupons with food processors separate consumers into two groups: (1) customers who are less price sensitive (those who have a lower elasticity of demand) do not request the rebate; and (2) customers who are more price sensitive (those who have a higher demand elasticity) request the rebate
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. d. A temporary price cut on bathroom tissue is a form of intertemporal price discrimination. Price-sensitive customers buy more tissue than they would otherwise during the price cut, while non-price-sensitive consumers buy the same amount. e. The plastic surgeon can distinguish a high-income patient from a low-income patient by negotiation. Arbitrage is no problem because plastic surgery cannot be transferred from low-income patients to high-income patients. 8. a. A monopolist with two markets should pick quantities in each market so that the marginal revenues in both markets are equal to one another and equal to marginal cost. Marginal cost is the slope of the total cost curve, 40. To determine marginal revenues in each market, we solve for price as a function of quantity. Then we substitute this expression for price into the equation for = 240 - 4QNY. PNY a n d = 200 - 2QLA. Then PLA total revenues are = TRNY = QLA(200 - 2QLA). The marginal revenues QLAPLA = are the slopes of the total revenue curves: MRNY 240 - 8QNY and MRLA = 200 - 4QLA. Next, we set each marginal revenue to marginal cost (= 40), implying QNY = 25 and QLA = 40. With these quantities, we = 240 - (4)(25) = solve for price in each market: PNY $140 and PLA = QNY(240 - 4QNY), and TRLA = 200 - (2)(40) = $120. = QNYPNY b. With the new satellite, Sal can no longer separate the two markets. The total demand function is the horizontal summation of the two markets. Above a price of $200, the total demand is just the New York demand function. Below a price of $200, we add the two demands: QT = 60 - 0.25P + 100 - 0.50P = 160 - 0.75P. Sal maximizes profit by choosing a quantity 726 • ANSWERS TO SELECTED EXERCISES so that MR = MC. Marginal revenue is 213.33 - 2.67Q. Setting this equal to marginal cost implies a profit-maximizing quantity of 65 with a price of $126.67. In the New York market, quantity is equal to 60 - 0.25(126.67) = 28.3, and in the Los Angeles market, quantity is equal to 100 - 0
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.50(126.67) = 36.7. Together, 65 units are purchased at a price of $126.67. p r o f i t + PLAQLA - [1000 + 40(QNY c. Sal is better off in the situation with the highest profit, which occurs in part (a) with price discrimination. Under price discrimination, profit is equal to p = PNYQNY + QLA)], or p = $140(25) + $120(40) - [1000 + 40(25 + 40)] = $4700. Under the market conditions in part i s p = PQT - [1000 - 40QT], ( b ), or p = $126.67(65) - [1000 + 40(65)] = $4633.33. Therefore, Sal is better off when the two markets are separated. Under the market conditions in (a), the contwo cities are sumer surpluses = CSNY (0.5)(40)(200 - 120) = $1600. Under the market conditions in (b), the respective consumer surpluses are = (0.5)(28.3)(240 - 126.67) = $1603.67, and CSNY = (0.5)(36.7)(200 - 126.67) = $1345.67. New CSLA Yorkers prefer (b) because their price is $126.67 instead of $140, giving them a higher consumer surplus. Customers in Los Angeles prefer (a) because their price is $120 instead of $126.67, and their consumer surplus is greater in (a). the = (0.5)(25)(240 - 140) = $1250, and CSLA in 10. a. With individual demands of Q1 = 10 - P, individual consumer surplus is equal to $50 per week, or $2600 per year. An entry fee of $2600 captures all consumer surplus, even though no court fee would be charged, since marginal cost is equal to zero. Weekly profits would be equal to the number of serious players, 1000, times the weekly entry fee, $50, minus $10,000, the fixed cost, or $40,000 per week. b. When there are two classes of customers, the club owner maximizes profits by charging court fees above marginal cost and by setting the entry fee equal to the remaining consumer surplus of the consumer with the smaller demand—the
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occasional player. The entry fee, T, is equal to the consumer surplus remaining after the court fee is assessed: T = (Q2 - 0)(16 - P)(1/2), = 4 - (1/4)P, or T = (1/2)(4 - (1/4)P) where Q2 (16 - P) = 32 - 4P + P2/8. Entry fees for all players would be 2000 (32 - 4P + P2/8). Revenues from + Q2) = P[1000(10 - P) + court fees equals P (Q1 1000(4 - P/4)] = 14,000P - 1250P2. Then total revenue = TR = 64,000 + 6000P - 1000P2. Marginal cost is zero and marginal revenue is given by the slope of the total revenue curve: TR/P = 6000 - 2000P. Equating marginal revenue and marginal cost implies a price of $3.00 per hour. Total revenue is equal to $73,000. Total cost is equal to fixed costs of $10,000. So profit is $63,000 per week, which is greater than the $40,000 when only serious players become members. c. An entry fee of $50 per week would attract only serious players. With 3000 serious players, total revenues would be $150,000, and profits would be $140,000 per week. With both serious and occasional players, entry fees would be equal to 4000 times the consumer surplus of the occasional player: T = 4000(32 - 4P + P2/8). Court fees are P[3000(10 - P) + 1000(4 - P/4)] = 34,000P 3250P2. Then TR = 128,000 + 18,000P - 2750P2. Marginal cost is zero, so setting TR/P = 18,000 5500P = 0 implies a price of $3.27 per hour. Then total revenue is equal to $157,455 per week, which is more than the $150,000 per week with only serious players. The club owner should set annual dues at $1053, charge $3.27 for court time, and earn profits of $7.67 million per year. 11. Mixed bundling is often the ideal strategy when demands are only somewhat negatively correlated and/or when marginal production costs are significant. The following tables present the reservation
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prices of the three consumers and the profits from the three strategies: RESERVATION PRICE FOR 1 FOR 2 TOTAL Consumer A $ 3.25 $ 6.00 $ 9.25 Consumer B Consumer C 8.25 10.00 3.25 10.00 11.50 20.00 PRICE 1 PRICE 2 BUNDLED PROFIT Sell separately $ 8.25 $6.00 — $28.50 Pure bundling — — $ 9.25 27.75 Mixed bundling 10.00 6.00 11.50 29.00 The profit-maximizing strategy is to use mixed bundling. 15. a. For each strategy, the optimal prices and profits are PRICE 1 PRICE 2 BUNDLED PROFIT Sell separately $80.00 $80.00 — $320.00 Pure bundling — — $120.00 480.00 Mixed bundling 94.95 94.95 120.00 429.00 Pure bundling dominates mixed bundling because with marginal costs of zero, there is no reason to exclude purchases of both goods by all customers. b. With marginal cost of $30, the optimal prices and profits are PRICE 1 PRICE 2 BUNDLED PROFIT Sell separately $80.00 $80.00 — $200.00 Pure bundling — — $120.00 240.00 Mixed bundling 94.95 94.95 120.00 249.90 Now mixed bundling dominates all other strategies. CHAPTER 11—APPENDIX 2. We examine each case, then compare profits. = QA = 2000, PE a. Optimal quantities and prices with no external mar= $8000, = $18,000. For the engine-building division, $8000 = $16M, TC = 2(2000)2 = $8M, = $8M. For the automobile-assembly divi# = $4M. Total profits ket for engines are QE and PA # TR = 2000 and p E sion, TR = 2000 2000 + 16M = $32M, and p are $12M. $18,000 = $36M, TC = $8000 A # = 3000, PE = 1500, QA b. Optimal quantities and prices with an external market = $6000, for engines are QE = $17,000. For the engine-building diviand PA sion, TR = 1500 $6000 = $9M, TC = 2(1500
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)2 = $4.5M, and p = $4.5M. For the automobile# assembly division, TR = 3000 $17,000 = $51M, TC = (8000 + 6000)3000 = $42M, and p = $9M. Total profits are $13.5M. # = $8800, and PA c. Optimal quantities and prices with a monopoly = 1600, = 2200, QA market for engines are QE = $18,400, with 600 engines PE sold in the monopolized market for $9400. For the engine-building division, TR = 1600 $8800 + 9400 = $19.72M, TC = 2(2200)2 = $9.68M, and 600 p = $10.04M. For the automobile-assembly division, TR = 1600 $18,400 = $18,400 = TR = 1600 $29.44M, TC = (8000 + 8800)1600 = $26.88M, and p = $2.56M. Total profits are $12.6M. # # # # The upstream division, building engines, earns the most profit when it has a monopoly on engines. The downstream division, building automobiles, earns the most when there is a competitive market for engines. Given the high cost of engines, the firm does best when engines are produced at the lowest cost with an external, competitive market for engines. CHAPTER 12 ANSWERS TO SELECTED EXERCISES • 727 several brands with different prices and characteristics is one method of splitting the market into sets of customers with different price elasticities. 3. a. To maximize profit p = 53Q - Q2 - 5Q, we find p/Q = -2Q + 48 = 0. Q = 24, so P = 29. Profit is equal to 576. b. P = 53 Q1 Q1Q2 Q1Q2 - 5Q1 - Q2 2 - 5Q2. - Q2, p1 = PQ1 - C(Q) = 53Q1 - Q 1 2 - C(Q2) = 53Q2 - = PQ2 a n d p2 c. The problem facing Firm 1 is to maximize profit, given that the output of Firm 2 will not change in reaction to the output decision of Firm 1. Therefore, Firm 1 chooses Q1 to maximize p 1, as above. The change in p
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with respect to a change in Q1 is 53 - 2Q1 - Q2 - 5 = 0, implying Q1 = 24 - Q2/2. Since the problem is symmetric, the reaction function for Firm 2 is Q2 = 24 - Q1/2. d. Solve for the values of Q1 and Q2 that satisfy both reaction functions: Q1 = 24 - (1/2)(24 - Q1/2). So, Q1 = 16 and Q2 = 16. The price is P = 53 - Q1 - Q2 = 21. Profit is p 2 = P · Qi - C(Qi) = 256. Total profit in the 1 = p industry is p 1 1 + p 2 = 512. 5. True. The reaction curve of Firm 2 will be q2 = 7.5 - 1/2q1 and the reaction curve of Firm 1 will be q1 = 15 - 1/2q2. Substituting yields q2 = 0 and q1 = 15. The price will be 15, which is the monopoly price. 7. a. (i) In a Cournot equilibrium, when firm A has an increase in marginal cost, its reaction function shifts inward. The quantity produced by firm A will decrease and the quantity produced by firm B will increase. Total quantity produced will decrease and price will increase. (ii) In a collusive equilibrium, the two firms will collectively act like a monopolist. When the marginal cost of Firm A increases, Firm A will reduce its production to zero, because Firm B can produce at a lower marginal cost. Because Firm B can produce the entire industry output at a marginal cost of $50, there will be no change in output or price. However, the firms will have to come to some agreement on how to share the profit earned by B. (iii) Because the good is homogeneous, both produce where price equals marginal cost. Firm A increases price to $80 and firm B raises its price to $79.99. Assuming firm B can produce enough output, it will supply the entire market. b. (i) The increase in the marginal cost of both firms shifts both reaction functions inward. Both firms decrease output, and price will increase. (ii) When marginal cost increases, both firms will produce less and price will increase, as in the monopoly case. (iii) Price will increase and quantity produced will decrease. 1. Each firm earns economic profit by distinguishing its brand from all other
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brands. If these competitors merge into a single firm, the resulting monopolist would not produce as many brands as would have been produced before the merger. But, producing c. (i) Both reaction functions shift outward and both firms produce more. Price will increase. (ii) Both firms will increase output, and price will also increase. (iii) Both firms will produce more. Because marginal cost is constant, price will not change. 728 • ANSWERS TO SELECTED EXERCISES = 20 - 2P1 + P2) = 20P1 = P1(20 - P1 11. a. To determine the Nash equilibrium, we calculate the reaction function for each firm, then simultaneously solve for price. Assuming marginal cost is zero, profit + for Firm 1 is P1Q1 + P2. At the profit2 + P2P1. MR1 P1 maximizing price, MR1 = 0. So, P1 = (20 + P2)/2. Because Firm 2 is symmetric to Firm 1, its profit-max= (20 + P1)/2. We substitute Firm imizing price is P2 2’s reaction function into that of Firm 1: P1[20 + (20 + P1)/2]/2 = 15 + P1/4. P1 = 20. By symmetry P2 = 20. Then Q1 = 20, and by symmetry Q2 = 20. Profit for Firm 1 is P1Q1 = 400, and profit for Firm 2 is also 400. b. If Firm 1 sets its price first, it takes Firm 2’s reaction = 1 = 20 + 10 + P1. Setting this expression equal to zero, = 30. We substitute for P1 in Firm 2’s reaction = 20 - 30 + = 20 + 30 - 25 = 25. Profit is = 25. 25 = 625. function into account. Firm 1’s profit is p + (20 + P1)/2]. Then, dp P1[20 - P1 2P1 P1 function, P2 = 25. At these prices, Q1 25 = 15 and Q2 p = 30.15 = 450 and p 1/dP1 2 1 c. Your first choice should be (iii), and your second choice should be (ii). Setting prices above the Cournot equilibrium values is optional for both firms when Stackelberg strategies are followed. From the reaction functions, we know that
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the price leader provokes a price increase in the follower. But the follower increases price less than the price leader, and hence undercuts the leader. Both firms enjoy increased profits, but the follower does best, and both do better than they would in the Cournot equilibrium. CHAPTER 13 1. If games are repeated indefinitely and all players know all payoffs, rational behavior will lead to apparently collusive outcomes. But, sometimes the payoffs of other firms can only be known by engaging in extensive information exchanges. Perhaps the greatest problem to maintaining a collusive outcome is exogenous changes in demand and in the prices of inputs. When new information is not available to all players simultaneously, a rational reaction by one firm could be interpreted as a threat by another firm. 2. Excess capacity can arise in industries with easy entry and differentiated products. Because downward- sloping demand curves for each firm lead to outputs with average cost above minimum average cost, increases in output result in decreases in average cost. The difference between the resulting output and the output at minimum long-run average cost is excess capacity, which can be used to deter new entry. 4. a. There are two Nash equilibria: (100,800) and (900,600). b. Both managers will follow a high-end strategy, and the resulting equilibrium will be (50,50), yielding less profit to both parties. c. The cooperative outcome (900,600) maximizes the joint profit of the two firms. d. Firm 1 benefits the most from cooperation. Compared to the next best opportunity, Firm 1 benefits by 900 - 100 = 800, whereas Firm 2 loses 800 - 600 = 200 under cooperation. Therefore, Firm 1 would need to offer Firm 2 at least 200 to compensate for Firm 2’s loss. 6. a. Yes, there are two: (1) Given Firm 2 chooses A, Firm 1 chooses C; given Firm 1 chooses C, Firm 2 chooses A. (2) Given Firm 2 chooses C, Firm 1 chooses A; given Firm 1 chooses A, Firm 2 chooses C. b. If both firms choose according to maximin, Firm 1 will choose Product A and Firm 2 will choose Product A, resulting in -10 payoff for both. c. Firm 2 will choose Product C in order to maximize payoffs at 10, 20. 12. Although antique auctions often have private-value elements, they are primarily common value because dealers are involved. Our antique dealer is disappointed in the nearby town’s public
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auction because estimates of the value of the antiques vary widely and she has suffered from the winner’s curse. At home, where there are fewer well-informed bidders, the winner’s curse has not been a problem. CHAPTER 14 2. 6. With the new program, the budget line shifts up by the $5000 government grant when the worker does no work at all and takes the maximum amount of leisure hours. As the number of hours worked increases (i.e., leisure decreases), the budget line has half the slope of the original budget line because earned income is taxed at 50 percent. When the after-tax income is $10,000, the new budget line coincides with the original budget line. The result is that the new program will have no effect if the worker originally earned more than $10,000 per year, but it will probably reduce the amount of time worked (i.e., increase leisure) if the worker earned less than $10,000 originally. The demand for labor is given by the marginal revenue product of labor; MRPL = MR · MPL. In a competitive market, price is equal to marginal revenue, so MR = 10. The marginal product of labor is equal to the slope of the production function Q = 12L - L2. This slope is equal to 12 - 2L. The firm’s profit-maximizing quantity of labor occurs where MRPL = w, the wage rate. If w = 30, 8. solving for L yields 4.5 hours per day. Similarly, if w = 60, solving for L yields 3 hours per day. The equilibrium wage is where the quantity of labor supplied is equal to the quantity of labor demanded, or 20w = 1,200 - 10w. Solving, w = $40. Substituting into the labor supply equation, for example, the equilibrium quantity of labor is: LS = (20)(40) = 800. Economic rent is the difference between the equilibrium wage and the wage given by the labor supply curve. Here, it is the area above the labor supply curve up to L = 800 and below the equilibrium wage. This area is (0.5)(800)($40) = $16,000. CHAPTER 15 3. 5. The present discounted value of the first $80 payment one year from now is PDV = 80/(1 + 0.10)1 = $72.73. The value of all these coupon payments can be found the
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same way: PDV = 80[1/(1.10)1 + 1/(1.10)2 + 1/(1.10)3 + 1/(1.10)4 + 1/(1.10)5] = $303.26. The present value of the final payment of $1000 in the sixth year is 1000/1.16 = $564.47. So the present value of this bond is $303.26 + $564.47 = $867.73. With an interest rate of 15 percent, PDV = $700.49. Using R = 0.04, we can substitute the appropriate values into Equation 15.5. We find that NPV = -5 - 4.808 - 0.925 - 0.445 + 0.821 + 0.789 + 0.759 + 0.730 + 0.701 + 0.674 + 0.649 + 0.624 + 0.600 + 0.577 + 0.554 + 0.533 + 0.513 + 0.493 + 0.474 + 0.456 + 0.438 + 0.456 = –0.338. The investment loses $338,000 and is not worthwhile. However, were the discount rate 3%, the NPV = $866,000, and the investment would be worth undertaking. 9. a. If we buy a bottle and sell it after t years, we pay $100 now and receive 100t0.5 when it is sold. The NPV of -rt100t0.5 = this investment is NPV = -100 + e -100 + e -0.1t100t0.5. If we do buy a bottle, we will choose t to maximize the NPV. The necessary condition is dNPV/dt = e -0.1t (50 - t -0.5) - 0.1e -0.1t · 100t0.5 = 0. Solving, t = 5. If we hold the bottle 5 years, the NPV is -100 + e -0.1·5100 · 50.5 = 35.62. Since each bottle is a good investment, we should buy all 100 bottles. b. You are offered $130 for resale, so you would make an immediate profit of $30. However, if you hold the wine for 5 years, the NPV of your profit is $35.62 as shown
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in part (a). Therefore, the NPV if you sell immediately rather than hold for 5 years is $30 - 35.62 = -$5.62, and you should not sell. c. If the interest rate changes from 10 percent to 5 percent, the NPV calculation changes to NPV = -100 + e- 0.05t # 100t0.5. If we hold the bottle 10 years, the maximum NPV is -100 + e- 0.05·10 # 100 100.5 = $91.80. # 11. a. Compare buying the car to leasing the car, with r = 0.04. The present value net cost of buying is -20,000 + ANSWERS TO SELECTED EXERCISES • 729 12,000/(1 + 0.04)6 = -10,516.22. The present value cost of leasing the car is -3600 - 3600/(1 + 0.04)1 - 3600/(1 + 0.04)2 = -10,389.94. You are better off leasing the car if r = 4 percent. b. Again, compare buying to leasing: 20,000 + 12,000/ (1 + 0.12)6 = -13,920.43 with buying, versus -3600 - 3600/(1 + 0.12)1 - 3600/(1 + 0.12)2 = -9,684.18 with leasing. You are better off leasing the car if r = 12 percent. c. Consumers will be indifferent when the present value cost of buying and later selling the car equals the present value cost of leasing: -20,000 + 12,000/ (1 + r)6 = -3600 - 3600/(1 + r)1 - 3600/(1 + r)2. This is true when r = 3.8 percent. You can solve this equation using a graphing calculator or computer spreadsheet, or by trial and error. CHAPTER 16 6. 7. 10. Even with identical preferences, the contract curve may or may not be a straight line. This can easily be shown graphically. For example, when both individuals have utility functions U = x2y, the marginal rate of substitution is given by 2y/x. It is not difficult to show that the MRS’s of both individuals are equal for all points on the contract curve y = (Y/X)x, where X
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and Y are the total quantities of both goods. One example in which the contract curve is not a straight line is when the two individuals have different incomes and one good is inferior. The marginal rate of transformation is equal to the ratio of the marginal costs of producing the two goods. Most production possibilities frontiers are “bowed outward.” However, if the two goods are produced with constant returns to scale production functions, the production possibilities frontier is a straight line. A change from a constant-returns-to-scale production process to a sharply-increasing-returns-to-scale process does not imply a change in the shape of the isoquants. One can simply redefine the quantities associated with each isoquant such that proportional increases in inputs yield greater than proportional increases in outputs. Under this assumption, the marginal rate of technical substitution would not change, and there would be no change in the production contract curve. CHAPTER 17 5. a. In the recent past, American automobiles appeared to customers to be of low quality. To reverse this trend, American companies invested in quality control, improving the potential repair records of their products. They signaled the improved quality of their products through improved warranties. b. Moral hazard occurs when the party to be insured (the owner of an American automobile with an extensive 7. 730 • ANSWERS TO SELECTED EXERCISES warranty) can influence the probability or the magnitude of the event that triggers payment (the repair of the automobile). Covering all parts and labor associated with mechanical problems reduces the incentive to maintain the automobile. Hence, a moral hazard problem is created with extensive warranties. Moral hazard problems arise with fire insurance when the insured party can influence the probability of a fire. The property owner can reduce the probability of a fire or its impact by inspecting and replacing faulty wiring, installing warning systems, etc. After purchasing complete insurance, the insured has little incentive to reduce either the probability or the magnitude of the loss, so the moral hazard problem can be severe. In order to compare a $10,000 deductible and 90 percent coverage, we need information on the value of the potential loss. Both policies reduce the moral hazard problem of complete coverage. However, if the property is worth less (more) than $100,000, the total loss will be less (more) with 90 percent coverage than with the $10,000 deductible. As the value of the property increases above $100,000, the owner is more likely to engage in fire prevention efforts under the
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policy that offers 90 percent coverage than under the one that offers the $10,000 deductible. CHAPTER 18 not high enough to permit swimming, the fee could be increased. The setting of a standard will be efficient only if the policymaker has complete information regarding the marginal costs and benefits of abatement. Further, the standard will not encourage firms to reduce effluent further if new filtering technologies become available. A transferable effluent permit system still requires the policymaker to determine the efficient effluent standard. Once the permits are distributed, a market will develop and firms with a higher cost of abatement will purchase permits from firms with lower abatement costs. However, unless permits are sold initially, no revenue will be generated. 9. a. Profit is maximized when marginal revenue is equal to marginal cost. With a constant marginal revenue of $40 and a marginal cost of 10 + 5Q, Q = 6. b. If bees are not forthcoming, the farmer must pay $10 per acre for artificial pollination. Since the farmer would be willing to pay up to $10 to the beekeeper to maintain each additional hive, the marginal social benefit of each is $50, which is greater than the marginal private benefit of $40. Equating the marginal social benefit to the marginal cost, Q = 80. 4. One needs to know the value to homeowners of swimming in the river, and the marginal cost of abatement. The choice of a policy tool will depend on the marginal benefits and costs of abatement. If firms are charged an equal rate effluent fee, the firms will reduce effluent to the point where the marginal cost of abatement is equal to the fee. If this reduction is c. The most radical change that would lead to more efficient operations would be the merger of the farmer’s business with the beekeeper’s business. This merger would internalize the positive externality of bee pollination. Short of a merger, the farmer and beekeeper should enter into a contract for pollination services. Photo Credits CHAPTER 1 p. 11 Natsuki Sakai/AFLO/Newscom CHAPTER 2 p. 28 Joegough/Dreamstime p. 29 Vladislav Gajic/Shutterstock p. 37 Orientaly/Shutterstock p. 46 Bajinda/Shutterstock p. 54 Slavoljub Pantelic/Shutterstock CHAPTER 3 p. 77 Hakan Caglav/iStockphoto p. 90 Alexander Rath
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s/Shutterstock p. 94 Kzenon/Shutterstock p. 97 Sharon Dominick/iStockphoto CHAPTER 4 p. 117 Cultura Limited/SuperStock p. 129 Richard Goldberg/Shutterstock p. 131 Konstantin Sutyagin/Shutterstock p. 134 Dudarev Mikhail/Shutterstock p. 138 Chris Price/iStockphoto p. 142 Frank Franklin II/AP Images CHAPTER 5 p. 173 Amy Etra/PhotoEdit, Inc. p. 175 Antonia Reeve/Photo Researchers, Inc. p. 183 Gerald Holubowicz/Alamy p. 186 Robyn Beck/AFP/Getty Images/ Newscom p. 188 Corbis/SuperStock p. 196 Quavondo/iStockphoto CHAPTER 6 p. 211 Konstantin Chagin/Shutterstock p. 215 iQoncept/Shutterstock p. 221 Svetlana Gajic/Shutterstock p. 225 Image Source/Alamy CHAPTER 7 p. 247 Andrey Kekyalyaynen/Shutterstock p. 260 Gary Blakeley/Shutterstock p. 264 Pavel Kosek/Shutterstock p. 268 Arogant/Shutterstock CHAPTER 8 p. 290 Steven Gullen/iStockphoto p. 294 Natalia Bratslavsky/Shutterstock p. 313 Robophobic/Shutterstock CHAPTER 9 p. 325 Antonia Reeve/Photo Researchers, Inc. p. 330 Michael Rosa/Shutterstock p. 335 David Frazier/Corbis p. 342 Tim Page/Corbis p. 349 Heather A. Craig/Shutterstock CHAPTER 10 p. 364 Leonard Lessin/Photo Researchers, Inc. p. 372 Ryan McVay/Photodisc p. 388 Nataliya Hora/Shutterstock p. 393 Moodboard/Alamy p. 394 Chunche/Dreamstime CHAPTER 11 p. 408 Catherine Lane/iStockphoto p. 413 Bosca78/iStockphoto p. 417 Donna Beeler/iStockphoto p. 427 Warren Millar/Fotolia p. 432 Michael Newman/PhotoEdit, Inc. CHAPTER 12 p. 455 Jack Plekan/Fundamental Photographs p. 480 AP Wide World Photos p. 481 EyeWire Collection/Getty Images CHAPTER 13 p. 501 Tony Freeman/PhotoEdit, Inc. p. 501 John Connell/Corbis p. 509 Spencer Tirey/AP Images p. 515 Blend Images/SuperStock p
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. 522 David Young-Wolff/PhotoEdit, Inc. CHAPTER 14 p. 536 Corbis Royalty-Free p. 545 Les Stone/Sygma/Corbis p. 548 Mark Peterson/Saba/Corbis p. 549 Spencer Grant/PhotoEdit, Inc. p. 554 Dennis MacDonald/PhotoEdit, Inc. CHAPTER 15 p. 576 Michael Newman/PhotoEdit, Inc. p. 579 Mark Antman/The Image Works p. 582 Aaron Bacall/Images.com p. 587 Grahame McConnell/Photolibrary New York/ Getty Images CHAPTER 16 p. 598 James Shaffer/PhotoEdit, Inc. p. 622 Voisin/Photo Researchers, Inc. CHAPTER 17 p. 637 Mike Powell/Getty Images p. 642 Scott Stulberg/SuperStock p. 645 Exactostock/SuperStock p. 649 Doug Martin/Photo Researchers, Inc. p. 656 Everett Collection/Alamy CHAPTER 18 p. 672 EyeWire Collection/Getty Images p. 678 Picsfive/Shutterstock.com p. 682 Carrieanne/Dreamstime p. 689 Christian Goupi/AGE Fotostock p. 693 Jeff Greenberg/PhotoEdit, Inc. 731 Index A Abadie, Alberto, 3n6 Absolute advantage, 618–619 Accounting costs, 230 Accounting profit, long-run competitive equilibrium and, 301–302 Ackerman, Frank, 677n12 Acreage limitation programs, 334 Actual returns, 178 Actuarial fairness, 172–173 Adams, Frank A., III, 327n4 Ad valorem tax, 345 Adverse selection, 634 Advertising, 429–433 effects of, 430 elasticity of demand and, 431 in practice, 432–433 rule of thumb for, 431–432 Advertising game, 491 Advertising-to-sales ratio, 431 Agency relationships, 645–651 Aggregate demand, 128–129 Agostini, Claudio, 51n15 Airbus, 513–514 Airline/aircraft industries competition and collusion in, 501–502 jet fuel demand and, 536–537 learning curves and, 265 price discrimination and fares, 409–410 regulation and, 330–331 strategic policy and, 512–514 Akerlof, George A., 194n29, 632n1 Allen, Mike, 337
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n9 Allocations, efficient, 604–606 Aluminum smelting short-run cost of, 240–242 short-run output of, 290–291 American Airlines, 392–393, 501–502 Amortization, 234–235 Anchoring, 194–195 Andreyeva, T., 370n6 Animal health warranties, 645 Antitrust laws, 389–395 anticompetitive conduct and, 391 Antitrust Division of Department of Justice and, 391 enforcement of, 391–392 in Europe, 392 Federal Trade Commission and, 391, 392 illegal combinations and, 389–390 parallel conduct and, 390 732 predatory pricing and, 390 private proceedings and, 391 Apple, 8, 390 Apple iPod, 621–622 Arbitrage, definition of, 8 Arc elasticity of demand, 36–37 Archer Daniels Midland Company, 10, 379, 393 Asset beta, 575 Asset returns, 177–179 Assets definition of, 176 expected vs. actual returns, 178 risky and riskless, 177 Astra-Merck, 364–365 Asymmetric information adverse selection and, 634 cost-benefit comparison, 640–641 efficiency wage theory and, 654–656 equilibrium, 640 guarantees and warranties, 642 implications of, 634–635 integrated firms and, 652–654 labor markets and, 654–656 managerial incentives and, 652–654 market signaling and, 638–643 moral hazard and, 643–645 principal-agent problem, 645–651 quality uncertainty and, 632–638 reputation and, 636 standardization and, 636 AT&T, 417–419 Auction markets, defined, 516 Auctions, 516–524 bidding and collusion and, 521 common-value auctions, 519–520 formats, 517 Internet, 522–524 legal services and, 522 maximizing auction revenue, 520–521 private-value auctions, 517–518 valuation and information and, 517–518 winner’s curse and, 519–520 Automobile industry. See also specific companies choosing new car, 579–580 demand and, 40–45 design and, 77–78, 88–89 emission standards and, 17–18 hybrid cars, 16 product differentiation and, 452 variable cost curve and, 266 Autor, David H., 554n10 Average costs, 239 Average expenditure curve, 537, 546, 547 definition of, 383 monop
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Laurits, 268n19 Christie’s auction house, 521, 522 Chrystal, K. Alec, 622n9 Cigliano, Joseph M., 536n2 Cinemax, 426 Civil Aeronautics Board (CAB), 330 Clayton Act (1914), 390 Clean Air Act, 134–135, 674 Clinton Corn Processing Company, 10 Coal, demand for (multiple regression analysis), 706–707 Coase, Ronald, 203n2, 685n20, 691n23 Coase theorem, 685, 687 Cobb-Douglas production function, 276–278 Cobb-Douglas utility function, 153 Coffee markets monopolistic competition in, 455–456 weather conditions and pricing, 46–48 Cohen, Alma, 648n15 Cola markets, monopolistic competition in, 455–456 College education costs of, 13–14, 28 net present value of, 581 INDEX • 733 Commercial banking, price rigidity and leadership in, 475 Commercial paper rate, 590 Commercial real estate, September 11 effects on, 31–32 Commitment, credibility and, 506–508 Common property resources, 687–690 Common-value auctions, 518, 519–520 Company cost of capital, 576 Comparative advantage, 618–619 Compensation, executive, 647–648 Competition Directorate, 392 Competition vs. collusion, 469–472 Competitive buyer, competitive seller compared, 383 Competitive equilibrium, 301–304, 607–609 Competitive firms. See also Profit maximization demand and marginal revenue for, 285–287 economic rent and, 304–305 incurring losses and, 289 input price changes and, 293–294 long-run equilibrium and, 301–304 long-run profit maximization and, 300–301 long-run supply and, 306–314 producer surplus in long run and, 305–306 producer surplus in short run and, 298–300 profit maximization by, 287 short-run profit maximization by, 287–289 short-run supply curve and, 292–295 Competitive markets consumer and producer surplus and, 318–323 consumer equilibrium and, 607–609 deadweight loss and, 321 economic efficiency of, 323–328, 609–610 efficiency of, 623–625 failure and, 625–627 government policies and, 317–323 incentive programs and, 334–335 market failure and, 323–325 minimum prices and, 328–331 perfectly competitive markets, 279–281
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demand competitive firms and, 285–287 consumer surplus and, 132–134 cyclical industries and, 41–43 durability and, 40–41 elasticity of, 126–127 income elasticities and, 40–43 short-run vs. long-run elasticities, 39–48 speculative, 129 Demand curves, 23–25. See also Supply and demand; Individual demand competitive firms and, 285–288 complementary goods and, 24–25 individual demand curves, 112–114 market demand curves, 124–132 monopolies and, 365 shifting of, 24 substitute goods and, 24–25 Demand estimation, 139–143 demand relationship form and, 140–142 interview and experimental approaches to, 143 statistical approach to, 139–140 Demand for loanable funds, 588 Demand shifts, monopolies and, 365–366 Demand theory, 149–157 Cobb-Douglas utility function and, 153 duality in consumer theory and, 154–155 equal margin principle, 151 income and substitution effects and, 155–157 marginal rate of substitution and, 151–152 marginal utility of income and, 152 method of Lagrange multipliers and, 150–151 utility maximization and, 149–150 Department of Justice Antitrust Division, 391, 394 Depletable resources, 584–587 Deposits, refundable, 677 Depreciation, 243–244 Deregulation, 330–331 Derived demands, 530 Dermisi, Sofia, 32n6 Developed countries, labor productivity in, 215 Deviations, risk and, 161–163 Diaper wars, 515–516 Differentiated products, price competition and, 465–467 Diminishing marginal returns, 217–219 Diminishing marginal utility, 95 Direct marketing experiments, 143 Discount bonds, 589 Discounted present value, 561, 562 Discount rate commercial banks and, 589 determination of, 569–570 real vs. nominal, 571–572 risk-adjusted, 575–576 Discounts, quantity, 404 Discrimination, price. See Price discrimination Diseconomies of scale, 255–256, 308 Diseconomies of scope, 259 Disequilibrium, market, 608 Disney Channel, 426 Disneyland, 416 Disposable diaper industry, capital investment in, 576–578 DiTella, Raphael, 81n4 Diversifiable risk, 574–575 Diversification risk and, 170–171 stock market and, 171 Dividend yields for S&P 500, 184 Dixit,
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Avinash, 492n5, 516n19, 570n10 Dollar bill game, 489 Dominant firm model, 476–477 Dominant strategy, 490–491 Double marginalization, 442–443 Dranove, David, 176n9 Dreyfus, Mark K., 580n15 Duality, 154–155 Dulberger, Ellen R., 105n15 Duopoly, 458, 462 DuPont, 514–515 Durability demand and, 40–41 supply and, 45–46 Durable equipment consumption of, 43 investment in, 42–43 Dutch auction, 517 DVD rentals, effect on movie theater tickets, 596–597 E eBay, 522–524 Economic efficiency bargaining and, 685–686 of competitive markets, 323–328, 609–610 equity and, 610–613 exchange and, 602–610, 624 free trade and, 618–623 market failure and, 625–627 monopolistic competition and, 454–455 production and, 613–618, 624 Economic forecasting, 704–705 Economic inefficiency, moral hazard and, 645 Economic rent definition of, 305 factor markets and, 542–544 Economic theories, 5–6 Economies of scale, 255–256 barriers to entry and, 376 learning versus, 262–264 Economies of scope, 258–261 Edgeworth box, 603–604 Education benefits of, 640–642 college costs and, 13–14, 28 determining spending levels of, 694–695 net present value and, 581 public, 691 Effective yield, bond, 566–567 Efficiency, public goods and, 691–692 Efficiency wage theory, 654–656 Efficient allocations, 602, 604–606 Effluent fees, 247–249 Egalitarian view of equity, 611, 612 Eggs, cost of, 13–14, 28 Elasticity in supply and demand, 33–39, 126–128. See also Price elasticity advertising and, 431 arc elasticity of demand, 36–37 cross-price elasticity of demand, 35 definition of, 33 income elasticity of demand, 34–35, 40–43 linear demand curve, 34 long-run, 311–312 monopolies and, 376 monopsony and, 385–389 oil and, 56–58 point vs. arc elasticities, 36–37 price markup and, 373 short-run market and, 296–297
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short-run vs. long-run elasticities, 39–48 soft drinks and, 370 tax impact on, 347 Electric power, cost functions for, 268–269 Ellerman, A.D., 675n10 Ellerman, Denny, 675n10 Elliott, Kimberly Ann, 622n9 Ellis, Gregory M., 587n21 Elobeid, Amani, 598n1 Emissions efficient levels of, 668 emissions trading and clear air, 673–675 marginal external costs of, 666 standards vs. fees and, 669–671 stock externalities and, 678–684 sulfur dioxide, 665–666, 672–673 transferable emissions permits, 671–672 Emissions fee, 668–669 Emissions standard, 668 Empty threats, 506 Endowment effect, 190–191 Energy efficiency, 251–253 through capital substitution for labor, 252 through technological change, 252 Energy Independence and Security Act, 17 Engel curves, 116–118 English (or oral) auction, 517 Enomoto, Carl E., 374n9 INDEX • 735 Entry and exit, competitive equilibrium and, 300, 302–304 Entry barriers competitive strategy and, 376 oligopolies and, 456 Entry deterrence, 510–516 Entry fees, 414 Equal marginal principle, 96, 151 Equilibrium, 25–26, 640 competitive, 301–304, 607–609 consumer, 607–609 Cournot equilibrium, 460–461, 464–465 dominant strategies and, 491 exchange efficiency and, 607–609 factor markets and, 542–545 general analysis and, 595–602 labor market, 542–545 long-run, 301–304, 453–454 market changes and, 26–32 Nash equilibrium, 458, 466, 467, 469, 492–498 oligopoly and, 457–458 short-run, 453–454 Stackelberg equilibrium, 492, 492n6 supply and demand and, 25–26 Equilibrium price, 49 Equilibrium quantity, 49 Equitable allocations, 610–613 egalitarian view of, 611, 612 market-oriented view of, 611, 612 perfect competition and, 612–613 Rawlsian view of, 611, 612 social welfare functions and, 611–612 utilitarian view of, 611, 612 utility possibilities frontier and, 610–612 Equity, four views of, 612 Espe
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y, Molly, 44n11 Ethanol global market, 598–600 European antitrust laws, 392 European Merger Control Act, 392 European Union, 392 ex ante forecasts, 704 Excess demand, 58, 608 Excess supply, 608 Exchange economy, defined, 602 Exchange efficiency, 602–610 advantages of trade and, 602–603 competitive equilibrium and, 607–609 contract curve and, 606–607 Edgeworth box and, 603–604 efficient allocations and, 604–606 Excise tax, effects on monopolies, 367 Executive compensation, 647–648 Exhaustible resources, 584–587 Expansion path, 249–251 Expansion strategy, 509 Expected payoff, 495 Expected returns, 178 Expected utility, 165, 195 Expected value, 161 ex post forecasts, 705 Extensive form of a game, 503–504 736 • INDEX Extent of market, 9–12 External costs, negative, 662–664 Externalities, 661–666 common property resources, 687–690 crawfish fishing in Louisiana, 689–690 emissions example, 667–678 marginal external benefit, 664 marginal external costs, 663 marginal social benefit, 664 marginal social costs, 663 market failure, 323–325, 667–678 municipal solid waste example, 678 negative externalities and inefficiency, 662–664 positive externalities and inefficiency, 664–665 property rights, 684–687 public goods, 690–694 recycling example, 675–677 stock, 678–684 F Facebook, 138–139 Factor inputs demand when one input is variable, 530–533 demand when several inputs are vari- able, 533–534 marginal revenue product, 531 market supply of, 539–541 supply to a firm, 537–539 Factor markets competitive, 529–542 economic rent and, 542–544 equilibrium in, 542–545 market demand curve and, 534–535 with monopoly power, 550–555 with monopsony power, 546–550 Factors of production, 204 Factory, net present value of, 570–571 Fair, Ray C., 541n3 Fairness, 192–194 Farber, Henry S., 196n34 Federal funds rate, 590 Federal Trade Commission Act (1914, amended 1938, 1973, 1975), 391 Financial losses, competitive firm incurring, 289–290 Firm interactions
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490 tit-for-tat strategy, 498–499 winner’s curse and, 519–520 Gasoline long-run demand for, 131–132 prices and per capita consumption, 131 rationing of, 98–100 taxes on, 122–124, 349–351 Gates, Bill, 394 Gateway, 234 General Electric, 43 General equilibrium analysis, 595–602 “contagion” across world stock markets, 600–601 economic efficiency, 601–602 General Foods, 456 General Mills, 67 General Motors, 5, 43, 89, 177, 178, 201, 267, 310, 358, 389 Ghemawat, Pankaj, 509n12, 514n16 Ghosh, Soumendra N., 374n9 Gibson, Robert C., 44n11 Giffen good, 122 Gillette, 417 Gillingham, Kenneth, 251n8 Glaister, Stephen, 44n11 Global warming, 679–684 reducing GHG emissions, 683 Gokhale, Jagadeesh, 105n17 Golden parachutes, 648 Gonik, Jacob, 654n19 Gordon, Robert J., 105n15 Government bailouts, 185 Government intervention competitive markets and, 317–323 price controls, 58–60 price supports and, 332–333 Graham, Daniel, 44n11 Graham, David, 331n7 Greene, David, 44n11 Greene, William H., 269n19 Greenhouse gases. See Global warming Greenstone, Michael, 135n9 Griffin, James M., 55n18, 294n4 Griliches, Zvi, 105n15 Gross domestic product (GDP), 42–43 Grossman, Gene M., 621n7 Guarantees, product, 642 H Hahn, Robert W., 673n8 Haisken-Denew, John P., 81n5 Hall, Robert E., 91n10 Halvorsen, Robert, 587n21 Hamermesh, Daniel, 643n7 Hamilton, James D., 54n19 Hansen, Julia, 130n5 Happiness marginal utility and, 97–98 ordinal scale for, 81–82 Harrison, David, Jr., 693n25 Hauser, John, 467n5 Health care consumer choice of, 90–91 inefficiency in health care system, 626–627 demand for, 40–41, 43–45 production function for, 211–212 Herd behavior,
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n13 Jones, Charles I., 91n10 Jorgenson, Dale W., 105n15 Joskow, Paul, 675n10 Just, Richard E., 222n11 K Kahn, James R., 44n11 Kahneman, Daniel, 98n11, 189n24, 191n27, 194n31 Kao Soap Ltd., 467–469, 471–472 Kaplan, Daniel P., 331n7 Kaplow, Louis, 671n5 Kaserman, David L., 327n4, 327n5 Katz, Lawrence, 554n10 Kessler, Daniel, 176n9 Killinger, Kerry, 647, 648n13–14 Kimberly-Clark, 515–516, 576–578 Kinked demand curve model, 473–474 Klein, Benjamin, 429n19 Klenow, P. J., 265n15 Knetsch, Jack, 189n24, 191n27 Knight, Frank, 160n1 Knittel, Chris, 131n6 Kohlhase, Janet E., 541n3 Kraemer, Kenneth L., 621n8 Kraft General Foods, 142 Krasker, William S., 649n16 Kreps, David, 465n2, 497n7 Krueger, Alan, 16n8, 549n7, 554n10 Krugman, Paul R., 513n14 L Labor curve average product of, 209 marginal product of, 209 738 • INDEX Labor market Long-run costs, 243–253 Marginal rate of substitution, 74–75, 114, asymmetric information in, 654–656 equilibrium in, 542–545 predicting requirements in, 263 productivity and, 214 signaling in, 638–642 Labor supply elasticities of, 541 for one- and two-earner households, 541–542 shifts in, 532 Lagrange multipliers, 150–151 Lagrangian function, 150 Land rent, 544 Langley, Sudchada, 37n8, 129n3 Laspeyres price index, 102–103 Law of diminishing marginal returns, 209–211 Law of large numbers, 172 Law of small numbers, 195 Learning curve changes in cost and, 261–265 versus economies of scale, 262–264 graphing of, 261–262 in practice, 264–265 Least-squares criterion, 701 Least-squares estimator, 702n2 Least-squares
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regression, 266 Lee, Jungmin, 643n7 Lee, William C., 98n12 Legal service auctioning, 522 Legal solutions, property rights and, 686–687 Lehn, Kenneth, 637n3 Lemons problem, 633 Lenovo, 8 Leontief production function, 219–221 Lerner Index of Monopoly Power, 371–373 Levinsohn, James, 89n8 Lewbel, Arthur, 425n17 Lexus, 426 Lieberman, Marvin, 264n13 Lin, William, 39n9 Linden, Greg, 621n8 Linear demand curves, 34 Linear regression, 700 Linear supply and demand curves, 49–52, 127, 461–463 Linux, 390 List, John A., 191n8 Loanable funds, supply and demand of, 588–590 Loewenstein, George, 189n23, 196n34 Long, M.W., 370n6 Long-run average cost curve (LAC), 254 Long-run competitive equilibrium, 303 accounting profit and, 301–302 economic profit and, 301–302 entry and exit and, 300, 302–304 firms having different costs and, 304 firms having identical costs, 304 monopolistic competition and, 453–454 opportunity cost of land and, 304 zero economic profit and, 302 average costs, 254–255 choosing inputs and, 245–247 cost minimization with varying output 151–152 Marginal rate of technical substitution, 218, 247, 274–275 levels and, 249–250 cost minimizing input choice and, Marginal rate of transformation, 614–615 Marginal revenue 244–245 effluent fees and, 247–249 expansion path and, 249–251 isocost line and, 245 price of capital and, 244 relationship with short-run costs, 257–258 rental rate of capital and, 244–245 user cost of capital and, 243–244 Long-run elasticities, 39–48, 311–312 Long-run expansion path, 253 Long-run marginal cost curve, 254–255 Long-run producer surplus, 305–306 Long-run production, 205 Long-run profit maximization, 300–301 Long-run supply, 306–314 constant-cost industries and, 307–308 decreasing-cost industries and, 310 elasticity and, 311–312 increasing-cost industries and, 308–309 tax effects and, 310–311 Loss aversion, 191 Lost earnings, value of, 563–564 Lustgarten, Steven H
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., 389n17 M MacAvoy, Paul W., 59n22 MacCrimmon, Kenneth R., 169n7 MacCulloch, Robert, 81n4 MacKie-Mason, Jeffrey K., 478n12 Macroeconomics, definition of, 3 Macunovich, Diane J., 541n3 Majority-rule voting, 694 Major league baseball asymmetric information and, 638 lemons in, 637–638 monopsony power and, 548–549 Maloney, M. T., 674n9 Malthus, Thomas, 211, 212 Managerial incentives, 652–654 applications, 654 Manthy, Robert S., 30n4 Marginal benefit, 87 Marginal costs average-marginal relationship, 239–240 consumer choice and, 87 estimation of, 291–292 external, 663 monopolies and, 359–361 opportunity, 551 production and, 236–237 profit maximization and, 284–287 short-run, 238 Marginal expenditure, 383, 537, 546–547 Marginal products labor curve and, 209 production process and, 206–207 relationship with average products, 209 monopoly and, 358–359 one variable input and, 530–533 profit maximization and, 284–287, 361–362 several variable inputs and, 533–534 Marginal revenue product, 531 Marginal social cost, 663 Marginal utility consumer choice and, 95–100 of income, 152 utility maximization and, 149 Market baskets (market bundles) budget line and, 83 consumer preferences and, 69–70 Market-clearing price, 25, 326 Market concentration, monopolies and, 376 Market data, fitting supply and demand curves to, 49–52 Market definition, 8, 9–10 Market demand, 124–132 coupons and rebates and, 409 curve of, 534–535 elasticity of demand and, 126–128 from individual to market demand, 124–126 inelastic demand, 126 isoelastic demand, 127–128 Market failure, 323–325 correcting, 667–678 externalities and, 324, 626 incomplete information and, 625–626 lack of information and, 324 market power and, 625 public goods and, 626, 692–693 Marketing experiments, direct, 143 Market mechanism, supply and demand curve and, 21, 25–26 Market-oriented view of equity, 611, 612 Market power, 358, 625 elasticities of
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measuring power of, 371–372 monopsony compared, 385 multiplant firms and, 367–368 natural monopoly, 380–381 number of firms and, 376–377 output decisions and, 359–361 perfect competition versus, 454 power of, 368–375 price regulation and, 379–380 pricing rule of thumb and, 363–364, 372 production with two plants, 369 regulation in practice and, 381–382 rent seeking and, 378–379 resource production by monopolist, 586–587 short and long run equilibrium and, 453–454 social costs of, 377–382 sources of power, 375–377 tax effects and, 366–367 unionized and nonunionized workers and, 552 wage rates and, 551–552 Monopsony, 382–385 bargaining power and, 548 buyer interaction and, 387 deadweight loss from, 387 definition of, 357, 358 elasticity of market supply and, 386–387 factor markets and, 546–550 marginal and averaged expenditure and, 546–547 monopoly compared, 385 monopsonist buyer, 384 number of buyers and, 387 power and, 382–385 purchasing decisions and, 547–548 social costs of, 387–388 sources of power, 386–387 U.S. manufacturing and, 388–389 Montero, J. P., 675n10 Moral hazard, 643–645 Morgan, John, 175n8, 195n32 Morkre, Morris E., 343n13 Morrison, S., 331n7 Movies bundling of, 419–420 DVD rental effect on, 596–597 Mueller, Michael J., 587n21 Multiplant firms, monopolies and, 367–368 Multiple regression analysis, 700–707 demand for coal (example), 706–707 economic forecasting, 704–705 estimation, 701–702 goodness of fit, 704 statistical tests, 702–704 Municipal solid waste regulation, 678 Murphy, Kevin M., 550n8 Mutual funds, diversification and, 171 Myers, Stewart, 574n12 INDEX • 739 National defense, 691 National Organ Transplantation Act, 325, 326 Natural Gas Policy Act of 1978, 59n22 Natural gas shortages, price controls and, 59–60, 322–323 Natural monopoly, 377 Natural resource prices, 29–31 Negative externalities, 662–664 Negatively correlated variables, 171 Negative network externalities, 137–138 Neptune Water Meter Company,
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679–684 recycling and, 675–677 solid waste, 678 value of clean air and, 134–135 Positive analysis, 6–7 Positively correlated variables, 171 Positive network externalities, 135–137 Potential interactions, 8 Predatory pricing, 390 Prediction accuracy, 6 Preemptive investment strategy, 509–510 Present discounted value, 561–564 Price caps, 382 Price changes budget constraints and, 84–86 individual demand and, 112 Price competition, 465 Bertrand model and, 464–465 choosing prices and, 466–467 with differentiated products, 465–467 with homogeneous products, 465–467 Price-consumption curve, 112 Price controls, 58–60, 319–323 Price discrimination, 401–410. See also Bundling consumer group creation and, 405–406 first-degree, 401–404 imperfect, 402–404 intertemporal, 410–412 peak-load pricing and, 410, 412–413 perfect, 402 relative prices and, 406–407 second-degree, 404, 405 third-degree, 404–410 two-part tariffs and, 414–419 Price elasticity. See also Elasticity in supply and demand air travel and, 409–410 consumer expenditures and, 126–128 coupons and, 409 housing demand and, 129–130 Price elasticity of demand, 33 Price elasticity of supply, 36 Price leadership, 474 Price minimums, 328–331 Price of capital, 244 Price of risk, 180 Price regulation, monopolies and, 379–380 Price rigidity, 473–475 Prices, role of, 5 Price setting, by dominant firm, 476–477 Price signaling, 474 Price supports, 332–339 consumers and, 332 government and, 332–333 import quotas and tariffs and, 340–344 producers and, 332 Price taking, 280, 285–287 Pricing, monopolies and, 363–364 Prilosec pricing, 364–365 Prime rate, 475, 590 Principal-agent problem, 645–651 incentives and, 650–651 in private enterprises, 646–647 in public enterprises, 648–649 Prisoners’ dilemma, 470–472, 495–496 Prius, 16 Private proceedings, antitrust laws and, 391 Private-sector unionism, decline of, 553–554 Private-value auctions, 517–518 Probabilities, subjective, 195 Procter & Gamble, 452, 467–469, 471–472,
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515–516, 576–578 Producer Price Index (PPI), 12, 100 Producers, price supports and, 332 Producer surplus, 318–323 change in, 320–321 in long run, 305–306 versus profit, 299–300 short run, 298–300 Production. See also Production costs cost constraints and, 202 decisions of firms and, 201–202 factors of, 201–202 firms and their production decisions, 202–205 flows (inputs and outputs), 204 function of, 202 health care, production function for, 211–212 input choices and, 202 measuring costs of, 229–237 production function, 204 returns to scale and, 223–226 short run vs. long run, 205 technology and, 201–202 Production choice problem, 507 Production costs accounting costs, 230 average costs, 237 Cobb-Douglas production function Products and, 276–278 cost functions and, 266–267 cost minimization and, 273–274 degree of economies of scope, 259–260 diseconomies of scope and, 259 duality in production and cost theory, choice problem, 492–493 curve slopes, 207–209 differentiation, price competition and, 465–467 diversity, monopolistic competition and, 455 275–276 homogeneity, perfect competition dynamic changes in costs, 261–265 economic costs, 230 economies and diseconomies of scale and, 255–256 economies of scope and, 258–261 energy reduction, 251–253 estimating and predicting of, 265–269 fixed costs, 233–234 learning curve and, 261–265 long-run and short-run relationship and, 257–258 long-run average costs and, 254–255 long-run costs, 243–253 marginal costs, 236–237 marginal rate of technical substitution, and, 280 transformation curves, 258–259 Profit maximization, 282–284. See also Competitive firms assumptions of, 282 choosing output in the long run, 300–306 highly competitive markets, 281 long run, 300–301 management cost considerations and, 291–292 marginal cost and revenue and, 284– 287, 362 organizational forms and, 283 short-run by competitive firm, 287–289 274–275 Profits opportunity costs, 230–231 product transformation curves, 258–259 short-run costs, 237–242 short-run production inflexibility, competitive equilibrium and, 301–304 producer surplus versus, 299–300 Property rights, 684–685 bargaining and economic efficiency, 253–254 shutting down and, 233 sunk costs
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, 231–232 total costs, 233 variable costs, 233–234 Production decisions, intertemporal, 584–587 Production efficiency, 613–618 input efficiency, 613–614 marginal rate of transformation and, 614–615 output efficiency and, 615–616 output markets and, 617–618 Production possibilities frontier, 614–615 Production quotas, 333–338 Production technology, 201–202 Production with one variable input (labor), 206–215 average and marginal products and, 206–207 average product of labor curve and, 209 labor productivity and, 214 law of diminishing marginal returns and, 209–211 marginal product of labor curve and, 209 product curve slopes and, 207–209 Production with two variable inputs, 216–223 diminishing marginal returns and, 217–219 fixed-proportions production function and, 219–220 input flexibility and, 217 isoquants and, 216–217 perfect substitutes and, 219, 220 substitution among inputs and, 218–219 685–686 legal solutions and, 686–687 Prospective sunk costs, 232, 234 Protectionism, 622–623 Public education, 691 Public goods, 690–694 definition of, 626 efficiency and, 691–692 market failure and, 692–693 nonexclusive goods, 690–691 private preferences for, 694–696 Public organizations, principal-agent problem and, 648–649 Publishing, price discrimination and, 413 Purchasing decisions, with monopsony power, 547–548 Purchasing power, 85 Pure bundling, 423–424 Pure monopoly, 357, 368 Pure monopsony, 358 Putnam, Howard, 392 Q Quadratic cost function, 267 Quality uncertainty, 632–638 Quantity discounts, 404 Quantity forcing, 443 Quigley, John, 130n4, 314n11 R Rabin, Matthew, 189n23 Range of products, 9 Rapaport, Carol, 32n5 INDEX • 741 Raphael, Stephen S., 314n11 Raphael, Steven, 130n4 Rate of return. See Effective yield, bond Rate-of-return regulation, 381 Rationing, gasoline, 98–100 Rawls, John, 611n3 Rawlsian view of equity, 611, 612 Raw material costs, 23 Reaction curves, Cournot equilibrium and, 460 Real discount rate, 571–572 Real prices, 12–16 Real returns, 178 Rebates, 123–124, 408–409
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Robinson-Patman Act (1936), 391 Roche A.G. of Switzerland, 393 Rockwell International, 501 Rose, Nancy L., 331n7 Rose-Ackerman, Susan, 327n5 Rossi-Hansberg, Esteban, 621n7 Rotemberg, Julio J., 194n30, 474n10 Roth, Alvin E., 327n4 R-squared (R2), 704 Rubinfeld, Daniel L., 134n8, 142n12, 693n25, 700n1 Rule-of-thumb, 194–195 S Saft, Lester F., 429n19 Salaries. See Wages Salathe, Larry, 37n8, 129n3 Sales jobs, income from, 161, 164 Salesperson incentives, 654 Saloner, Garth, 474n10 Sample, 702 Sanford, Scott, 39n9 Sanger, David E., 337n9 Satterthwaite, Mark, 176n9 Saudi Arabia oil production, 56–58 Scale economies index (SCI), 267 Schaller, Bruce, 338n11 Scheinkman, Jose, 465n2 Schelling, Thomas, 512n13 Scherer, F. M., 10n4, 343n13 Schill, Michael H., 284n2 Schmalensee, R., 675n10 Schmalensee, Richard L., 425n17 Scholten, Patrick, 175n8 Sealed-bid auction, 517 Secondary supply, 45 Second-degree price discrimination, 404, 405 September 11 terrorist attacks, 31–32 Sequential games, 502–505 Shavell, Steven, 164n5, 671n5 Sherman Act (1890), 390, 391 Sherwin, Robert A., 10n3 Shields, Dennis, 39n9 Shields, Michael A., 81n5 Shirking model, 655 Shortage, price pressures and, 25–26 Short-run average cost curve (SAC), 254 Short-run costs, 237–242 average-marginal relationship, 239–240 cost curves and, 238–240 determinants of, 237–238 diminishing marginal returns and, 238 inflexibility and, 253–254 marginal costs and, 238 relationship with long-run costs, 257–258 total cost as a flow, 240 Short-run elasticities, 39–48 Short-run equilibrium, monopolistic competition and, 453–454 Short-run expansion path, 254 Short
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-run production, 205 Short-run profit maximization, 285, 287–289 Short-run supply curves, 295–300 Shubik, Martin, 489, 489n3 Shut downs, 233, 289–290 Sibley, David S., 331n7 Signaling, 641 market, 638–643 price, 474 Simonsohn, Uri, 190n25 Sinai, Todd, 195n33 Skeath, Susan, 492n5, 516n19 Skinner, Robert, 39n9 Slutsky equation, 156 Small, Kenneth, 44n11 Smith, Adam, 609 Smith, Vernon, 190n25 Smith, W. James, 130n5 Snob effect, 137 Snow shovel demand, 193 Social costs monopolies and, 377–382 monopsonies and, 387–388 Social rate of discount, 682 Social Security system solvency, 105 Social welfare functions, 611–612 Soft drinks, elasticities of demand for, 370 Software, production costs of, 235–236 Sönmez, Tayfun, 327n4 Sotheby’s auction house, 521, 522 Specific taxes, effects of, 345–348 Speculative demand, 129 Spence, Michael, 638n4 Sprint, 417–419 Stackelberg equilibrium, 492, 492n6 Stackelberg model, 463–464, 502, 505 Standard and Poor’s/Case-Shiller Housing Price Index, 186, 188 Standard deviation, 162–163 Standard error of forecast (SEF), 705 Standard error of the regression, 704 Standard of living, labor productivity and, 214–215 Statistical tests, 702–704 Steel production, 247–249 Sterner, Thomas, 44n11 Stigler, George J., 10n3 Stiglitz, Joseph E., 654n20 Stock externalities, 678–684 stock buildup and impact of, 679–682 Stockholder control, 647 Stock of capital, 214 Stocks and stock market buying on margin, 183 “contagion,” 600–601 diversification and, 171 investing in, 183–184 risk and, 177–179 stock prices in U.S. and Europe, 601 Stocks vs. flows, 560–561 Stollery, Kenneth R., 587n21 Strategic behavior, 686 Strategic decisions, gaming and, 487–490 Strategic trade policy, international competition and,
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512–514 Strategy, defined, 488 Subjective probability, 160 Subsidies, effects of, 348–349 Substitute goods, 24–25, 118–119 Substitution among inputs, 218–219 Substitution effects, 120–121, 155–157 Sugar quota, 342–344 Sulfur dioxide emissions, 665–666, 672–673. See also Emissions Sumner, Daniel A., 347n14 Sunk costs, 231–232 amortizing of, 234–235 entry deterrence and, 509, 510 versus fixed costs, 234–235 Supermarket chains advertising and, 432–433 markup pricing and, 372–373 Supplemental Security Income, 105 Supply. See also Supply and demand durability and, 45–46 elasticities of, 36 of loanable funds, 588–590 long-run, 306–314 restrictions, 333–334 supply curves, 22–23 variables affecting, 23 Supply and demand. See also Elasticity in supply and demand changing market conditions and, 48–52 demand curves, 23–25 equilibrium and, 25–26 linear curves and, 49–52 market equilibrium changes and, 26–32 market mechanism and, 25–26 price controls and, 58–60 supply curves, 22–23 Surplus consumer, 132–135 market clearance and, 25–26 Systematic risk, 574n12 T Takeda Chemical Industries of Japan, 393 Tariffs, 340–342 two-part tariffs, 414–419 world ethanol market and, 598–600 Tarr, David G., 343n13 Taubenslag, Nancy, 501n10 Taubman, Alfred, 521 Taxes effects of, 345–348 firm output and, 311 monopolies and, 366–367 specific, 345–348 Taxes, and transfer pricing, 448–449 Tax-exempt status, 649 Taxicab drivers, 196–197 Taxicab supply, in New York, 312–313, 338–339, 573 Technical efficiency, 613 Technical feasibility, 205 Technological change, 214 Technological improvements, effect of, 210 Technology, production, 201, 204 Teece, David J., 55n18 Teenage labor markets, minimum wage and, 549–550 Thaler, Richard, 189n24, 191n27, 196n34 Theory of the firm, 5, 201 Third-degree price discrimination, 404–410 Tirole, Jean, 492n5 Titanium dioxide industry, entry deterrence and, 514–
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Minimum Wage 14 Electronics Market 175 5.5 Doctors, Patients, and the Value of Information 175 5.6 Investing in the Stock Market 183 5.7 The Housing Price Bubble (I) 186 2.1 The Price of Eggs and the Price of a College 5.8 The Housing Price Bubble (II) 188 Education Revisited 28 2.2 Wage Inequality in the United States 29 2.3 The Long-Run Behavior of Natural Resources Prices 29 2.4 The Effects of 9/11 on the Supply and Demand for 5.9 Selling a House 192 5.10 New York City Taxicab Drivers 196 6.1 A Production Function for Health Care 211 6.2 Malthus and the Food Crisis 212 New York City Office Space 31 6.3 Labor Productivity and the Standard of Living 215 2.5 The Market for Wheat 37 6.4 A Production Function for Wheat 221 2.6 The Demand for Gasoline and Automobiles 43 6.5 Returns to Scale in the Carpet Industry 225 2.7 The Weather in Brazil and the Price of Coffee in 7.1 Choosing the Location for a New Law School New York 46 Building 232 2.8 The Behavior of Copper Prices 52 7.2 Sunk, Fixed, and Variable Costs: Computers, 2.9 Upheaval in the World Oil Market 54 2.10 Price Controls and Natural Gas Shortages 59 3.1 Designing New Automobiles (I) 77 3.2 Can Money Buy Happiness? 81 3.3 Designing New Automobiles (II) 88 3.4 Consumer Choice of Health Care 90 3.5 A College Trust Fund 92 3.6 Revealed Preference for Recreation 94 3.7 Marginal Utility and Happiness 97 Software, and Pizzas 235 7.3 The Short-Run Cost of Aluminum Smelting 240 7.4 The Effect of Effluent Fees on Input Choices 247 7.5 Reducing the Use of Energy 251 7.6 Economies of Scope in the Trucking Industry 260 7.7 The Learning Curve in Practice 264 7.8 Cost Functions for Electric Power 268 8.1 Condominiums versus Cooperatives in New York City 283 8.2 The Short-Run Output Decision of an Aluminum 3.8 The Bias in the CPI 105 Smelting Plant 290 4.1 Consumer Expenditures in the United States 117 8.3 Some Cost Considerations for Managers 291 4.2 The Effects of a Gasoline Tax 122 8.4 The Short-Run Production of Petroleum
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Products 294 4.3 The Aggregate Demand for Wheat 128 8.5 The Short-Run World Supply of Copper 297 4.4 The Demand for Housing 129 4.5 The Long-Run Demand for Gasoline 131 4.6 The Value of Clean Air 134 4.7 Facebook 138 4.8 The Demand for Ready-to-Eat Cereal 142 5.1 Deterring Crime 164 5.2 Business Executives and the Choice of Risk 169 5.3 The Value of Title Insurance When Buying a House 173 8.6 Constant-, Increasing-, and Decreasing-Cost Industries: Coffee, Oil, and Automobiles 310 8.7 The Supply of Taxicabs in New York 312 8.8 The Long-Run Supply of Housing 313 9.1 Price Controls and Natural Gas Shortages 322 9.2 The Market for Human Kidneys 325 9.3 Airline Regulation 330 9.4 Supporting the Price of Wheat 335 9.5 Why Can’t I Find a Taxi? 338 LIST OF EXAMPLES 9.6 The Sugar Quota 342 9.7 A Tax on Gasoline 349 10.1 Astra-Merck Prices Prilosec 364 10.2 Elasticities of Demand for Soft Drinks 370 10.3 Markup Pricing: Supermarkets to Designer Jeans 372 10.4 The Pricing of Videos 374 14.2 Labor Supply for One- and Two-Earner Households 541 14.3 Pay in the Military 545 14.4 Monopsony Power in the Market for Baseball Players 548 14.5 Teenage Labor Markets and the Minimum Wage 549 14.6 The Decline of Private-Sector Unionism 553 10.5 Monopsony Power in U.S. Manufacturing 388 10.6 A Phone Call about Prices 392 14.7 Wage Inequality Revisited 554 15.1 The Value of Lost Earnings 563 10.7 Go Directly to Jail. Don’t Pass Go. 393 15.2 The Yields on Corporate Bonds 567 10.8 The United States and the European Union versus 15.3 The Value of a New York City Taxi Medallion 573 Microsoft 394 15.4 Capital Investment in the Disposable Diaper 11.1 The Economics of Coupons and Rebates 408 Industry 576 11.2 Airline Fares 409 15.5 Choosing an Air Conditioner and a New Car 579 11.3 How to Price a Best-Selling Novel 413
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15.5 Should You Go to Business School? 582 11.4 Pricing Cellular Phone Service 417 11.5 The Complete Dinner versus á la Carte: A Restaurant’s Pricing Problem 427 11.6 Advertising in Practice 432 12.1 Monopolistic Competition in the Markets for Colas 15.6 How Depletable are Depletable Resources? 587 16.1 The Global Market for Ethanol 598 16.2 “Contagion” across Stock Markets around the World 600 16.3 Trading Tasks and iPod Production 621 and Coffee 455 16.4 The Costs and Benefits of Special Protection 622 12.2 A Pricing Problem for Procter & Gamble 467 16.5 Inefficiency in the Health Care System 626 12.3 Procter & Gamble in a Prisoners’ Dilemma 471 17.1 Medicare 636 12.4 Price Leadership and Price Rigidity in Commercial 17.2 Lemons in Major League Baseball 637 Banking 475 17.3 Working into the Night 642 12.5 The Prices of College Textbooks 476 17.4 Reducing Moral Hazard: Warranties of Animal 12.6 The Cartelization of lntercollegiate Athletics 480 12.7 The Milk Cartel 481 13.1 Acquiring a Company 490 13.2 Oligopolistic Cooperation in the Water Meter Industry 501 13.3 Competition and Collusion in the Airline Industry 501 Health 645 17.5 CEO Salaries 647 17.6 Managers of Nonprofit Hospitals as Agents 649 17.7 Efficiency Wages at Ford Motor Company 656 18.1 The Costs and Benefits of Sulfur Dioxide Emissions 665 18.2 Reducing Sulfur Dioxide Emissions in Beijing 672 13.4 Wal-Mart Stores’ Preemptive Investment Strategy 509 18.3 Emissions Trading and Clean Air 673 13.5 DuPont Deters Entry in the Titanium Dioxide 18.4 Regulating Municipal Solid Wastes 678 Industry 514 13.6 Diaper Wars 515 13.7 Auctioning Legal Services 522 13.8 Internet Auctions 522 18.5 Global Warming 682 18.6 The Coase Theorem at Work 687 18.7 Crawfish Fishing in Louisiana 689 18.8 The Demand for Clean Air 693 14.1 The Demand for Jet Fuel 536 A.1 The Demand for Coal 706o live? Does everyone have
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access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as Figure 1.2 shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics. The Problem of Scarcity Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it? Visit this website (http://openstax.org/l/drought) to read about how the United States is dealing with scarcity in resources. 12 Chapter 1 | Welcome to Economics! Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (Figure
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1.3) in his book, The Wealth of Nations. Figure 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons) The Division of and Specialization of Labor The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person. To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not! Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 13 connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (Figure 1.4), or a hospital can have hundreds of job classifications. Figure 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons) Why the Division of Labor Increases Production When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000
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pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons. First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not. Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better. A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products. Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work
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in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of his or her own goods and services. The division and specialization of labor has been a force against the problem of scarcity. 14 Chapter 1 | Welcome to Economics! Trade and Markets Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade. You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy. Why Study Economics? Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles. If the economics “bug” has not bitten you yet, there are other reasons why you should study economics. • Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial. • It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know? • A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will
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understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics. The study of economics does not dictate the answers, but it can illuminate the different choices. 1.2 | Microeconomics and Macroeconomics By the end of this section, you will be able to: • Describe microeconomics • Describe macroeconomics • Contrast monetary policy and fiscal policy Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption. It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 15 To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake's ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are
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useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint. Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live. In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy's performance ultimately depends on the microeconomic decisions that individual households and businesses make. Microeconomics What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means? What determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly. Macroeconomics What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term? We can determine an economy's macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation's central bank conducts monetary policy, which involves policies that affect bank lending
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, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation's legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government's main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book. 1.3 | How Economists Use Theories and Models to Understand Economic Issues By the end of this section, you will be able to: Interpret a circular flow diagram • • Explain the importance of economic theories and models • Describe goods and services markets and labor markets 16 Chapter 1 | Welcome to Economics! Figure 1.5 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons) John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (Figure 1.5) famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think. Watch this video (http://openstax.org/l/Keynes) about John Maynard Keynes and his influence on economics. Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying. Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a
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more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably. For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work. A good model to start with in economics is the circular flow diagram (Figure 1.6). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 17 Figure 1.6 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits. Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market. Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they
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sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand. This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports). Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others. 18 Chapter 1 | Welcome to Economics! 1.4 | How To Organize Economies: An Overview of Economic Systems By the end of this section, you will be able to: • Contrast traditional economies, command economies, and market economies • Explain gross domestic product (GDP) • Assess the importance and effects of globalization Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who insures that, for example, the number of televisions a society
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provides is the same as the amount it needs and wants? Who insures that the right number of employees work in the electronics industry? Who insures that televisions are produced in the best way possible? How does it all get done? There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development. Figure 1.7 A Command Economy Ancient Egypt was an example of a command economy. (Credit: Jay Bergesen/ Flickr Creative Commons) Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in Figure 1.7, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies. In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 19 Figure 1.8 A Market Economy Nothing says “market” more than The New York Stock Exchange. (Credit: Erik Drost/ Flickr Creative Commons) Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (Figure 1.8) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups
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of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands. A person’s income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, market forces, not governments, determine economic decisions. Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides information about how free and thus market-oriented different countries' are, as the following Clear It Up feature discusses. For a similar ranking, but one that defines freedom more broadly, see the Cato Foundation's Human Freedom Index (https://openstax.org/l/cato). What countries are considered economically free? Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. The 2016 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world: Table 1.1 lists some examples of the most free and the least free countries. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen. The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77
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of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world. 20 Chapter 1 | Welcome to Economics! Most Economic Freedom Least Economic Freedom 1. Hong Kong 2. Singapore 3. New Zealand 4. Switzerland 5. Australia 6. Canada 7. Chile 8. Ireland 9. Estonia 10. United Kingdom 11. United States 12. Denmark 167. Timor-Leste 168. Democratic Republic of Congo 169. Argentina 170. Equatorial Guinea 171. Iran 172. Republic of Congo 173. Eritrea 174. Turkmenistan 175. Zimbabwe 176. Venezuela 177. Cuba 178. North Korea Table 1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking) Regulations: The Rules of the Game Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval. The question of how to organize economic institutions is typically not a black-or-white choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 21 Figure 1.9 Globalization Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons) The Rise of Globalization Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows. Global
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ization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in Figure 1.9, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade. Table 1.2 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries. Country 2010 2011 2012 2013 2014 2015 Higher Income Countries United States Belgium Canada France Middle Income Countries Brazil Mexico South Korea 12.4 76.2 29.1 26.0 10.9 29.9 49.4 13.6 81.4 30.7 27.8 11.9 31.2 55.7 13.6 82.2 30.0 28.1 12.6 32.6 56.3 13.5 82.8 30.1 28.3 12.6 31.7 53.9 13.5 84.0 31.7 29.0 11.2 32.3 50.3 12.6 84.4 31.5 30.0 13.0 35.3 45.9 Table 1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/) 22 Chapter 1 | Welcome to Economics! Country 2010 2011 2012 2013 2014 2015 Lower Income Countries Chad China India Nigeria 36.8 29.4 22.0 25.3 38.9 28.5 23.9 31.3 36.9 27.3 24.0 31.4 32.2 26.4 24.8 18.0 34.2 23.9 22.9 18.
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4 29.8 22.4 - - Table 1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/) In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries. Table 1.2 indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections. Despite the rise in globalization over the last few decades, in recent years we've seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States. Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics. Decisions... Decisions in the Social Media Age The world we live in today provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of
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crop harvested. Some relatively new information forums, such as Facebook, are rapidly changing how information is distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of online adults use Facebook. This social media forum posts topics ranging from the National Basketball Association, to celebrity singers and performers, to farmers. Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an accident, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics! This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 23 KEY TERMS circular flow diagram a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market command economy an economy where economic decisions are passed down from government authority and where the government owns the resources division of labor the way in which different workers divide required tasks to produce a good or service economics the study of how humans make choices under conditions of scarcity economies of scale when the average cost of producing each individual unit declines as total output increases exports products (goods and services) made domestically and sold abroad fiscal policy economic policies that involve government spending and taxes globalization the trend in which buying and selling in markets have increasingly crossed national borders goods and services market a market in which firms are sellers of what they produce and households are buyers gross domestic product (GDP) measure of the size of total production in an economy imports products (goods and services) made abroad and then sold domestically labor market the market in which households sell their labor as workers to business firms or other employers macroeconomics the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance market interaction between potential buyers and sellers; a combination of demand and supply market economy an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand microeconomics the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms model see theory monetary policy policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing private enterprise system where
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private individuals or groups of private individuals own and operate the means of production (resources and businesses) scarcity when human wants for goods and services exceed the available supply specialization when workers or firms focus on particular tasks for which they are well-suited within the overall production process theory a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation traditional economy typically an agricultural economy where things are done the same as they have always been done underground economy a market where the buyers and sellers make transactions in violation of one or more 24 Chapter 1 | Welcome to Economics! government regulations KEY CONCEPTS AND SUMMARY 1.1 What Is Economics, and Why Is It Important? Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker. 1.2 Microeconomics and Macroeconomics Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy. 1.3 How Economists Use Theories and Models to Understand Economic Issues Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer. 1.4 How To Organize Economies: An Overview of Economic Systems We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen
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globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent. SELF-CHECK QUESTIONS 1. What is scarcity? Can you think of two causes of scarcity? 2. Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum amount of ham the residents can consume in a month? 3. A consultant works for $200 per hour. She likes to eat vegetables, but is not very good at growing them. Why does it make more economic sense for her to spend her time at the consulting job and shop for her vegetables? 4. A computer systems engineer could paint his house, but it makes more sense for him to hire a painter to do it. Explain why. 5. What would be another example of a “system” in the real world that could serve as a metaphor for micro and macroeconomics? 6. Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram. 7. What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 1 | Welcome to Economics! 25 8. The chapter defines private enterprise as a characteristic of market-oriented economies. What would public enterprise be? Hint: It is a characteristic of command economies. 9. Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than the United States? REVIEW QUESTIONS 10. Give the three reasons that explain why the division of increases an economy’s level of production. labor 11. What are three reasons to study economics? How did 15. economics? John Maynard Keynes define 16. Are households primarily buyers or sellers in the goods and services market? In the labor market? 12. What is the difference between microeconomics and macroeconomics? 17. Are firms primarily buyers or sellers in the goods and services market? In the labor market? 13. What are examples of agents? individual economic 18. What are the three ways that societies can organize themselves
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economically? What 14. macroeconomics? are the three main goals of 19. What is globalization? How do you think it might have affected the economy over the past decade? CRITICAL THINKING QUESTIONS 20. Suppose you have a team of two workers: one is a baker and one is a chef. Explain why the kitchen can produce more meals in a given period of time if each worker specializes in what they do best than if each worker tries to do everything from appetizer to dessert. 24. Macroeconomics is an aggregate of what happens at the microeconomic level. Would it be possible for what happens at the macro level to differ from how economic agents would react to some stimulus at the micro level? Hint: Think about the behavior of crowds. 21. Why would division of labor without trade not work? 25. Why is it unfair or meaningless to criticize a theory as “unrealistic?” 22. Can you think of any examples of free goods, that is, goods or services that are not scarce? 23. A balanced federal budget and a balance of trade are secondary goals of macroeconomics, while growth in the standard of living (for example) is a primary goal. Why do you think that is so? 26. Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation? 27. Why do you think that most modern countries’ economies are a mix of command and market types? 28. Can you think of ways that globalization has helped you economically? Can you think of ways that it has not? 26 Chapter 1 | Welcome to Economics! This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 27 2 | Choice in a World of Scarcity Figure 2.1 Choices and Tradeoffs In general, the higher the degree, the higher the salary, so why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs. (Credit: modification of work by “Jim, the Photographer”/Flickr Creative Commons) Choices... To What Degree? In 2015, the median income for workers who hold master's degrees varies from males to females. The average of the two is $2,951
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weekly. Multiply this average by 52 weeks, and you get an average salary of $153,452. Compare that to the median weekly earnings for a full-time worker over 25 with no higher than a bachelor’s degree: $1,224 weekly and $63,648 a year. What about those with no higher than a high school diploma in 2015? They earn just $664 weekly and $34,528 over 12 months. In other words, says the Bureau of Labor Statistics (BLS), earning a bachelor’s degree boosted salaries 54% over what you would have earned if you had stopped your education after high school. A master’s degree yields a salary almost double that of a high school diploma. Given these statistics, we might expect many people to choose to go to college and at least earn a bachelor’s degree. Assuming that people want to improve their material well-being, it seems like they would make those choices that provide them with the greatest opportunity to consume goods and services. As it turns out, the analysis is not nearly as simple as this. In fact, in 2014, the BLS reported that while almost 88% of the population in the United States had a high school diploma, only 33.6% of 25–65 year olds had bachelor’s degrees, and only 7.4% of 25–65 year olds in 2014 had earned a master’s. This brings us to the subject of this chapter: why people make the choices they make and how economists explain those choices. 28 Chapter 2 | Choice in a World of Scarcity Introduction to Choice in a World of Scarcity In this chapter, you will learn about: • How Individuals Make Choices Based on Their Budget Constraint • The Production Possibilities Frontier and Social Choices • Confronting Objections to the Economic Approach You will learn quickly when you examine the relationship between economics and scarcity that choices involve tradeoffs. Every choice has a cost. In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled, because they had been singing a similar tune for decades. English economist Lionel Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in 1932, described not always getting what you want in this way: The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose between the different uses to which they may be
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put.... Everywhere we turn, if we choose one thing we must relinquish others which, in different circumstances, we would wish not to have relinquished. Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature. Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society. This chapter will continue our discussion of scarcity and the economic way of thinking by first introducing three critical concepts: opportunity cost, marginal decision making, and diminishing returns. Later, it will consider whether the economic way of thinking accurately describes either how we make choices and how we should make them. 2.1 | How Individuals Make Choices Based on Their Budget Constraint By the end of this section, you will be able to: • Calculate and graph budget constraints • Explain opportunity sets and opportunity costs • Evaluate the law of diminishing marginal utility • Explain how marginal analysis and utility influence choices Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. We can see Alphonso's budget problem in Figure 2.2. Figure 2.2 The Budget Constraint: Alphonso’s Consumption Choice Opportunity Frontier Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10. The relative price of burgers and bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 29 The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0
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.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers). If we connect all the points between A and F, we get Alphonso's budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount. If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget. The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso. The Concept of Opportunity Cost Economists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more. View this website (http://openstaxcollege.org/l/linestanding) for an example of opportunity cost—paying someone else to wait in line for you. A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning
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you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence. The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that we further explain in the appendix The Use of Mathematics in Principles of Economics. 30 Chapter 2 | Choice in a World of Scarcity Understanding Budget Constraints Budget constraints are easy to understand if you apply a little math. The appendix The Use of Mathematics in Principles of Economics explains all the math you are likely to need in this book. Therefore, if math is not your strength, you might want to take a look at the appendix. Step 1: The equation for any budget constraint is: Budget = P1 × Q1 + P2 × Q2 where P and Q are the price and quantity of items purchased (which we assume here to be two items) and Budget is the amount of income one has to spend. Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be: Budget = P1 × Q1 + P2 × Q2 $10 budget = $2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of bus tickets $10 = $2 × Qburgers + $0.50 × Qbus tickets Step 3. Using a little algebra, we can turn this into the familiar equation of a line: y = b + mx For Alphonso, this is: Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2: $10 = $2 × Qburgers + $0.50 × Qbus tickets 2 × 10 = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 20 = 4 × Qburgers + 1 × Qbus tickets Step 5. Subtract one bus ticket from both sides: 20 – Qbus tickets = 4 × Qburgers Divide each side by 4 to yield the answer: 5 – 0.25 × Qbus tickets = Qburgers or Qburgers = 5 – 0.25 × Qbus tickets Step 6. Notice that this equation fits the budget constraint in Figure 2.2. The vertical intercept is 5 and the slope is –0.25
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, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results (see Table 2.1), which are the points on Alphonso’s budget constraint. Point Quantity of Burgers (at $2) Quantity of Bus Tickets (at 50 cents) A B C D 5 4 3 2 Table 2.1 0 4 8 12 This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 31 Point Quantity of Burgers (at $2) Quantity of Bus Tickets (at 50 cents) E F 1 0 Table 2.1 16 20 Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is −0.25, indicating that for every bus ticket he buys, he must give up 1/4 burger. To phrase it differently, for every four tickets he buys, Alphonso must give up 1 burger. There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, we define the slope as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case $0.50/$2 = 0.25. If you want to determine the opportunity cost quickly, just divide the two prices. Identifying Opportunity Cost In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved. For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants
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. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work. Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings. What is the opportunity cost associated with increased airport security measures? After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another $2 billion. However, the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), there were 895.5 million systemwide (domestic and international) scheduled service passengers in 2015. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends 32 Chapter 2 | Choice in a World of Scarcity an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these backof-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million × 0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending. In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that
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you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “$5 a day,” you might make different choices. Marginal Decision-Making and Diminishing Marginal Utility The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics. We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on Consumer Choices, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. However, later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is
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ravenously hungry. However, if Alphonso has a burger every single day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth. The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less. A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost. Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further. As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase. Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he won’t purchase more bus tickets once the marginal utility just equals the opportunity cost. While we can’t (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20. Sunk Costs In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 33 you consume, how many hours will
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you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision. Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options. For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future. From a Model with Two Goods to One of Many Goods The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world. 2.2 | The Production Possibilities Frontier and Social Choices By the end of this section, you will be able to: Interpret production possibilities frontier graphs • • Contrast a budget constraint and a production possibilities
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frontier • Explain the relationship between a production possibilities frontier and the law of diminishing returns • Contrast productive efficiency and allocative efficiency • Define comparative advantage Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities. Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in Figure 2.3 illustrates this situation. 34 Chapter 2 | Choice in a World of Scarcity Figure 2.3 A Healthcare vs. Education Production Possibilities Frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education. Figure 2.3 shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF. Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonso’s budget constraint, the slope of the production possibilities
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frontier shows the opportunity cost. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature. What’s the difference between a budget constraint and a PPF? There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer, are fixed, so the slope doesn't change. In contrast, the PPF has a curved shape because of the law of the diminishing returns. Thus, the slope is different at various points on the PPF. The second major difference is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available. Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. We measure the additional education by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 35 The Shape of the PPF and the Law of Diminishing Returns The budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape? To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are
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left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education. Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education. The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains. This pattern is common enough that economists have given it a name: the law of diminishing returns, which holds that as additional increments of resources are added to a certain purpose, the marginal benefit from those additional increments will decline. (The
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law of diminishing marginal utility that we introduced in the last section is a more specific case of the law of diminishing returns.) When government spends a certain amount more on reducing crime, for example, the original gains in reducing crime could be relatively large. However, additional increases typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to nothing at all would be tremendously expensive. The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original gains are fairly large, but gradually diminish. Thus, the slope of the PPF is relatively flat. By contrast, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier. Productive Efficiency and Allocative Efficiency The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget. The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2.4 illustrates these ideas using a production possibilities frontier between healthcare and 36 education. Chapter 2 | Choice in a World of Scarcity Figure 2.4 Productive and Allocative Efficiency Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires. Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced
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of another good. All choices on the PPF in Figure 2.4, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods. For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1). We can show the particular mix of goods and services produced—that is, the specific combination of selected healthcare and education along the production possibilities frontier—as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray. Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole. Why Society Must Choose In Welcome to Economics! we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma. Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford
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more of all goods. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 37 However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy. The PPF and Comparative Advantage While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills. Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in Figure 2.5. Figure 2.5 Production Possibility Frontier for the U.S. and Brazil The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.
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S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane. When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger 38 Chapter 2 | Choice in a World of Scarcity amount than the U.S., at point B. The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In the chapter on International Trade you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties. 2.3 | Confronting Objections to the Economic Approach By the end of this section, you will be able to: • Analyze arguments against economic approaches to decision-making • • Contrast normative statements and positive statements Interpret a tradeoff diagram It is one thing to understand the economic approach to decision-making and another thing to feel comfortable applying it. The sources of discomfort typically fall into two categories: that people do not act in the way that fits the economic way of thinking, and that even if people did act that way, they should try not to. Let’s consider these arguments in turn. First Objection: People, Firms, and Society Do
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Not Act Like This The economic approach to decision-making seems to require more information than most individuals possess and more careful decision-making than most individuals actually display. After all, do you or any of your friends draw a budget constraint and mutter to yourself about maximizing utility before you head to the shopping mall? Do members of the U.S. Congress contemplate production possibilities frontiers before they vote on the annual budget? The messy ways in which people and societies operate somehow doesn’t look much like neat budget constraints or smoothly curving production possibilities frontiers. However, the economics approach can be a useful way to analyze and understand the tradeoffs of economic decisions. To appreciate this point, imagine for a moment that you are playing basketball, dribbling to the right, and throwing a bounce-pass to the left to a teammate who is running toward the basket. A physicist or engineer could work out the correct speed and trajectory for the pass, given the different movements involved and the weight and bounciness of the ball. However, when you are playing basketball, you do not perform any of these calculations. You just pass the ball, and if you are a good player, you will do so with high accuracy. Someone might argue: “The scientist’s formula of the bounce-pass requires a far greater knowledge of physics and far more specific information about speeds of movement and weights than the basketball player actually has, so it must be an unrealistic description of how basketball passes actually occur.” This reaction would be wrongheaded. The fact that a good player can throw the ball accurately because of practice and skill, without making a physics calculation, does not mean that the physics calculation is wrong. Similarly, from an economic point of view, someone who shops for groceries every week has a great deal of practice with how to purchase the combination of goods that will provide that person with utility, even if the shopper does not phrase decisions in terms of a budget constraint. Government institutions may work imperfectly and slowly, but in general, a democratic form of government feels pressure from voters and social institutions to make the choices that are most widely preferred by people in that society. Thus, when thinking about the economic actions of groups of people, firms, and society, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis. For more on this, read about behavioral economics in the chapter on Consumer Choices. Second Objection: People, Firms, and Society Should Not Act This Way The economics approach portrays
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people as self-interested. For some critics of this approach, even if self-interest is an accurate description of how people behave, these behaviors are not moral. Instead, the critics argue that people should be taught to care more deeply about others. Economists offer several answers to these concerns. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 39 First, economics is not a form of moral instruction. Rather, it seeks to describe economic behavior as it actually exists. Philosophers draw a distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Positive statements are factual. They may be true or false, but we can test them, at least in principle. Normative statements are subjective questions of opinion. We cannot test them since we cannot prove opinions to be true or false. They just are opinions based on one's values. For example, an economist could analyze a proposed subway system in a certain city. If the expected benefits exceed the costs, he concludes that the project is worthy—an example of positive analysis. Another economist argues for extended unemployment compensation during the Great Depression because a rich country like the United States should take care of its less fortunate citizens—an example of normative analysis. Even if the line between positive and normative statements is not always crystal clear, economic analysis does try to remain rooted in the study of the actual people who inhabit the actual economy. Fortunately however, the assumption that individuals are purely self-interested is a simplification about human nature. In fact, we need to look no further than to Adam Smith, the very father of modern economics to find evidence of this. The opening sentence of his book, The Theory of Moral Sentiments, puts it very clearly: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” Clearly, individuals are both self-interested and altruistic. Second, we can label self-interested behavior and profit-seeking with other names, such as personal choice and freedom. The ability to make personal choices about buying, working, and saving is an important personal freedom. Some people may choose high-pressure, high-paying jobs so that they can earn and spend considerable amounts of money on themselves
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. Others may allocate large portions of their earnings to charity or spend it on their friends and family. Others may devote themselves to a career that can require much time, energy, and expertise but does not offer high financial rewards, like being an elementary school teacher or a social worker. Still others may choose a job that does consume much of their time or provide a high level of income, but still leaves time for family, friends, and contemplation. Some people may prefer to work for a large company; others might want to start their own business. People’s freedom to make their own economic choices has a moral value worth respecting. Is a diagram by any other name the same? When you study economics, you may feel buried under an avalanche of diagrams. Your goal should be to recognize the common underlying logic and pattern of the diagrams, not to memorize each one. This chapter uses only one basic diagram, although we present labels. The consumption budget constraint and the production possibilities frontier for society, as a whole, are the same basic diagram. Figure 2.6 shows an individual budget constraint and a production possibilities frontier for two goods, Good 1 and Good 2. The tradeoff diagram always illustrates three basic themes: scarcity, tradeoffs, and economic efficiency. it with different sets of The first theme is scarcity. It is not feasible to have unlimited amounts of both goods. Even if the budget constraint or a PPF shifts, scarcity remains—just at a different level. The second theme is tradeoffs. As depicted in the budget constraint or the production possibilities frontier, it is necessary to forgo some of one good to gain more of the other good. The details of this tradeoff vary. In a budget constraint we determine, the tradeoff is determined by the relative prices of the goods: that is, the relative price of two goods in the consumption choice budget constraint. These tradeoffs appear as a straight line. However, a curved line represents the tradeoffs in many production possibilities frontiers because the law of diminishing returns holds that as we add resources to an area, the marginal gains tend to diminish. Regardless of the specific shape, tradeoffs remain. The third theme is economic efficiency, or getting the most benefit from scarce resources. All choices on the production possibilities frontier show productive efficiency because in such cases, there is no way to increase the quantity of one good without decreasing the quantity of the other. Similarly, when an individual makes a choice along a budget constraint, there is no way to increase the quantity of one good without decreasing the
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quantity of the other. The choice on a production possibilities set that is socially preferred, or the choice on an 40 Chapter 2 | Choice in a World of Scarcity individual’s budget constraint that is personally preferred, will display allocative efficiency. The basic budget constraint/production possibilities frontier diagram will recur throughout this book. Some examples include using these tradeoff diagrams to analyze trade, environmental protection and economic output, equality of incomes and economic output, and the macroeconomic tradeoff between consumption and investment. Do not allow the different labels to confuse you. The budget constraint/production possibilities frontier diagram is always just a tool for thinking carefully about scarcity, tradeoffs, and efficiency in a particular situation. Figure 2.6 The Tradeoff Diagram Both the individual opportunity set (or budget constraint) and the social production possibilities frontier show the constraints under which individual consumers and society as a whole operate. Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other. Third, self-interested behavior can lead to positive social results. For example, when people work hard to make a living, they create economic output. Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. Adam Smith, writing in The Wealth of Nations, named this property the invisible hand. In describing how consumers and producers interact in a market economy, Smith wrote: Every individual…generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions. Fourth, even people who focus on their own self-interest in the economic part of their life often set aside their own narrow self-interest in other parts of life. For example, you might focus on your own self-interest when asking your employer for a raise or negotiating to buy a car. Then you might turn around and focus on other people when you volunteer to read stories at the local library, help a
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friend move to a new apartment, or donate money to a charity. Selfinterest is a reasonable starting point for analyzing many economic decisions, without needing to imply that people never do anything that is not in their own immediate self-interest. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of Scarcity 41 Choices... To What Degree? What have we learned? We know that scarcity impacts all the choices we make. An economist might argue that people do not obtain a bachelor’s or master’s degree because they do not have the resources to make those choices or because their incomes are too low and/or the price of these degrees is too high. A bachelor’s or a master’s degree may not be available in their opportunity set. The price of these degrees may be too high not only because the actual price, college tuition (and perhaps room and board), is too high. An economist might also say that for many people, the full opportunity cost of a bachelor’s or a master’s degree is too high. For these people, they are unwilling or unable to make the tradeoff of forfeiting years of working, and earning an income, to earn a degree. Finally, the statistics we introduced at the start of the chapter reveal information about intertemporal choices. An economist might say that people choose not to obtain a college degree because they may have to borrow money to attend college, and the interest they have to pay on that loan in the future will affect their decisions today. Also, it could be that some people have a preference for current consumption over future consumption, so they choose to work now at a lower salary and consume now, rather than postponing that consumption until after they graduate college. 42 Chapter 2 | Choice in a World of Scarcity KEY TERMS allocative efficiency when the mix of goods produced represents the mix that society most desires budget constraint all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set comparative advantage when a country can produce a good at a lower cost in terms of other goods; or, when a country has a lower opportunity cost of production invisible hand Adam Smith's concept that individuals' self-interested behavior can lead to positive social outcomes law of diminishing marginal utility as we consume more of a good or service, the utility we get from additional units of the
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good or service tends to become smaller than what we received from earlier units law of diminishing returns as we add additional increments of resources to producing a good or service, the marginal benefit from those additional increments will decline marginal analysis examination of decisions on the margin, meaning a little more or a little less from the status quo normative statement statement which describes how the world should be opportunity cost measures cost by what we give up/forfeit in exchange; opportunity cost measures the value of the forgone alternative opportunity set all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income positive statement statement which describes the world as it is production possibilities frontier (PPF) a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available. productive efficiency when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service) sunk costs costs that we make in the past that we cannot recover utility satisfaction, usefulness, or value one obtains from consuming goods and services KEY CONCEPTS AND SUMMARY 2.1 How Individuals Make Choices Based on Their Budget Constraint Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must forgo something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of available choices. The relative price of the choices determines the slope of the budget constraint. Choices beyond the budget constraint are not affordable. Opportunity cost measures cost by what we forgo in exchange. Sometimes we can measure opportunity cost in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that we must forfeit. Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 2 | Choice in a World of
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Scarcity 43 additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions. 2.2 The Production Possibilities Frontier and Social Choices A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a growing economy will tend to shift the PPF outwards. The law of diminishing returns holds that as increments of additional resources are devoted to producing something, the marginal increase in output will become increasingly smaller. All choices along a production possibilities frontier display productive efficiency; that is, it is impossible to use society’s resources to produce more of one good without decreasing production of the other good. The specific choice along a production possibilities frontier that reflects the mix of goods society prefers is the choice with allocative efficiency. The curvature of the PPF is likely to differ by country, which results in different countries having comparative advantage in different goods. Total production can increase if countries specialize in the goods in which they have comparative advantage and trade some of their production for the remaining goods. 2.3 Confronting Objections to the Economic Approach The economic way of thinking provides a useful approach to understanding human behavior. Economists make the careful distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Even when economics analyzes the gains and losses from various events or policies, and thus draws normative conclusions about how the world should be, the analysis of economics is rooted in a positive analysis of how people, firms, and governments actually behave, not how they should behave. SELF-CHECK QUESTIONS 1. Suppose Alphonso’s town raised the price of bus tickets to $1 per trip (while the price of burgers stayed at $2 and his budget remained $10 per week.) Draw Alphonso’s new budget constraint. What happens to the opportunity cost of bus tickets? 2. Return to the example in Figure 2.4. Suppose there is an improvement in medical technology that enables more healthcare with the same amount of resources. How would this affect the production possibilities curve and, in particular, how would it affect the opportunity cost of education? 3. Could a nation be producing in a way that is allocatively efficient, but product
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