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ContentsNOT FOR SALE

Preface xiii CHAPTER 3 The Behavior of Consumers 45 3.1 Tastes 45 CHAPTER 1 Indifference Curves 45 Supply, Demand, Marginal Values 48 and Equilibrium 1 More on Indifference Curves 53 1.1 Demand 1 3.2 The Budget Line and the Demand versus Quantity Consumer’s Choice 53 Demanded 1 The Budget Line 54 Demand Curves 2 The Consumer’s Choice 56 Changes in Demand 3 Market Demand 7 3.3 Applications of Indifference The Shape of the Demand Curve 7 Curves 59 The Wide Scope of Economics 10 Standards of Living 59 The Least Bad Tax 64 1.2 Supply 10 Summary 69 Supply versus Quantity Supplied 10 Author Commentary 69 1.3 Equilibrium 13 Review Questions 70 The Equilibrium Point 13 Numerical Exercises 70 Changes in the Equilibrium Point 15 Problem Set 71 Summary 23 Appendix to Chapter 3 77 Author Commentary 24 Cardinal Utility 77 Review Questions 25 The Consumer’s Optimum 79 Numerical Exercises 25 Problem Set 26 CHAPTER 4 Consumers in the Marketplace 81 CHAPTER 2 4.1 Changes in Income 81 Prices, Costs, and the Gains Changes in Income and Changes in the from Trade 31 Budget Line 81 Changes in Income and Changes in the 2.1 Prices 31 Optimum Point 82 Absolute versus Relative Prices 32 The Engel Curve 84 Some Applications 34 4.2 Changes in Price 85 2.2 Costs, Efficiency, and Gains from Changes in Price and Changes in the Trade 35 Budget Line 85 Costs and Efficiency 35 Changes in Price and Changes in the Optimum Point 86 Specialization and the Gains from Trade 37 The Demand Curve 88 Why People Trade 39 4.3 Income and Substitution Summary 41 Effects 90 Author Commentary 41 Two Effects of a Price Increase 90 Review Question 41 Why Demand Curves Slope Numerical Exercises 42 Downward 94 Problem Set 42 The Compensated Demand Curve 99

45185_00_fm_pi-xxii.indd vi 14/07/10 7:49 AM CONTENTS NOT FOR SALE vii 4.4 Elasticities 100 Short-Run Average Cost versus Income Elasticity of Demand 100 Long-Run Average Cost 163 Price Elasticity of Demand 102 Summary 164 Summary 105 Author Commentary 165 Author Commentary 106 Review Questions 165 Review Questions 106 Numerical Exercises 166 Numerical Exercises 107 Problem Set 167 Problem Set 109 CHAPTER 7

CHAPTER 5 Competition 171

The Behavior of Firms 115 7.1 The Competitive Firm 171 5.1 Weighing Costs and Revenue 173 The Firm’s Supply Decision 174 Benefits 116 Shutdowns 177 A Farmer’s Problem 116 The Elasticity of Supply 180 The Equimarginal Principle 120 7.2 The Competitive Industry in the 5.2 Firms in the Marketplace 121 Revenue 122 Short Run 180 Defining the Short Run 180 Costs 125 The Competitive Industry’s Short-Run Summary 131 Supply Curve 181 Author Commentary 131 Supply, Demand, and Equilibrium 182 Review Questions 131 Competitive Equilibrium 182 Numerical Exercises 132 The Industry’s Costs 185 Problem Set 133 7.3 The Competitive Firm in the Long Run 186 CHAPTER 6 Long-Run Marginal Cost and Production and Costs 137 Supply 186 Profit and the Exit Decision 186 6.1 Production and Costs in the The Firm’s Long-Run Supply Short Run 137 Curve 188 The Total, Marginal, and Average Products of Labor 138 7.4 The Competitive Industry in the Costs in the Short Run 141 Long Run 189 The Long-Run Supply Curve 190 6.2 Production and Costs in the Equilibrium 193 Long Run 147 Changes in Equilibrium 195 Isoquants 147 Application: The Government as a Choosing a Production Process 151 Supplier 198 The Long-Run Cost Curves 154 Some Lessons Learned 199 Returns to Scale and the Shape of the Long-Run Cost Curves 157 7.5 Relaxing the Assumptions 199 The Break-Even Price 200 6.3 Relations Between the Short Run Constant-Cost Industries 201 and the Long Run 159 Increasing-Cost Industries 201 From Isoquants to Short-Run Total Decreasing-Cost Industries 203 Cost 159 Equilibrium 204 From Isoquants to Long-Run Total Cost 160 7.6 Applications 204 Short-Run Total Cost versus Long-Run Removing a Rent Control 204 Total Cost 161 A Tax on Motel Rooms 207 A Multitude of Short Runs 162 Tipping the Busboy 208

45185_00_fm_pi-xxii.indd vii 14/07/10 7:49 AM viii NOTCONTENTS FOR SALE 7.7 Using the Competitive Model 209 9.2 Asymmetric Information 297 Summary 211 Signaling: Should Colleges Be Author Commentary 212 Outlawed? 297 Review Questions 212 Adverse Selection and the Market for Lemons 300 Numerical Exercises 213 Moral Hazard 302 Problem Set 217 Principal–Agent Problems 303 A Theory of Unemployment 306 CHAPTER 8 Welfare Economics and the Gains 9.3 Financial Markets 308 Efficient Markets for Financial

from Trade 223 Securities 308 8.1 Measuring the Gains from Stock Market Crashes 310 Trade 224 Summary 311 Consumers’ and Producers’ Author Commentary 311 Surplus 224 Review Questions 311 8.2 The Efficiency Criterion 233 Problem Set 312 Consumers’ Surplus and the Efficiency Criterion 234 Understanding Deadweight Loss 238 CHAPTER 10 Other Normative Criteria 241 Monopoly 317 8.3 Examples and Applications 242 Subsidies 242 10.1 Price and Output under Price Ceilings 244 Monopoly 318 Tariffs 247 Monopoly Pricing 318 Theories of Value 252 Elasticity and Marginal Revenue 319 8.4 General Equilibrium and the Measuring Monopoly Invisible Hand 254 Power 320 The Fundamental Theorem of Welfare Welfare 323 Economics 255 Monopoly and Public Policy 324 An Edgeworth Box Economy 257 General Equilibrium with 10.2 Sources of Monopoly Production 260 Power 328 Summary 265 Natural Monopoly 328 Author Commentary 266 Patents 330 Review Questions 266 The History of Photography: Patents in Problem Set 267 the Public Domain 331 Appendix to Chapter 8 275 Resource Monopolies 332 Normative Criteria 275 Economies of Scope 332 Some Normative Criteria 276 Legal Barriers to Entry 332 Optimal Population 280 Author Commentary 281 10.3 Price Discrimination 333 First-Degree Price Discrimination 334 Third-Degree Price Discrimination 336 CHAPTER 9 Two-Part Tariffs 345 Knowledge and Information 283 Summary 348 9.1 The Informational Content of Author Commentary 349 Prices 283 Review Questions 349 Prices and Information 283 Numerical Exercises 350 The Costs of Misallocation 288 Problem Set 351

45185_00_fm_pi-xxii.indd viii 14/07/10 7:49 AM CONTENTS NOT FOR SALE ix CHAPTER 11 Pareto Optima versus Nash Market Power, Collusion, Equilibria 410 and Oligopoly 357 12.2 Sequential Games 411 An Oligopoly Problem 411 11.1 Acquiring Market Power 358 Summary 413 Mergers 358 Author Commentary 414 Horizontal Integration 358 Problem Set 414 Vertical Integration 361 Predatory Pricing 363 Resale Price Maintenance 365 CHAPTER 13 11.2 Collusion and the Prisoner’s External Costs and Benefits 417 Dilemma: An Introduction to 13.1 The Problem of Pollution 417 Game Theory 369 Private Costs, Social Costs, and Game Theory and the Prisoner’s Externalities 417 Dilemma 370 Government Policies 420 The Prisoner’s Dilemma and the Breakdown of Cartels 373 13.2 The Coase Theorem 424 The Doctor and the Confectioner 425 11.3 Regulation 377 The Coase Theorem 427 Examples of Regulation 377 The Coase Theorem in the What Can Regulators Regulate? 382 Marketplace 429 Creative Response and Unexpected External Benefits 432 Consequences 382 Income Effects and the Coase Positive Theories of Regulation 384 Theorem 433 11.4 Oligopoly 385 13.3 Transactions Costs 436 Contestable Markets 385 Trains, Sparks, and Crops 436 Oligopoly with a Fixed Number The Reciprocal Nature of the of Firms 387 Problem 438 11.5 Monopolistic Competition and Sources of Transactions Costs 439 Product Differentiation 390 13.4 The Law and Economics 443 Monopolistic Competition 390 The Law of Torts 443 The Economics of Location 392 A Positive Theory of the Common Summary 392 Law 446 Author Commentary 393 Normative Theories of the Common Review Questions 393 Law 448 Numerical Exercises 394 Optimal Systems of Law 449 Problem Set 396 Summary 449 Author Commentary 450 Review Questions 450 CHAPTER 12 Problem Set 451 The Theory of Games 399 CHAPTER 14 12.1 Game Matrices 399 Pigs in a Box 399 Common Property and Public The Prisoner’s Dilemma Revisited 401 Goods 459 Pigs in a Box Revisited 402 The Copycat Game 405 14.1 The Tragedy of the Nash Equilibrium as a Solution Commons 459 Concept 405 The Springfield Aquarium 459 Mixed Strategies 407 It Can Pay to Be Different 463 Pareto Optima 408 Common Property 465

45185_00_fm_pi-xxii.indd ix 14/07/10 7:49 AM x NOTCONTENTS FOR SALE 14.2 Public Goods 467 16.2 Labor Market Equilibrium 509 Some Market Failures 467 Changes in Nonlabor Income 510 The Provision of Public Goods 468 Changes in Productivity 510 The Role of Government 469 16.3 Differences in Wages 514 Schemes for Eliciting Information 471 Human Capital 514 Reaching the Efficient Outcome 471 Compensating Differentials 515 Summary 472 Access to Capital 516 Review Questions 473 Numerical Exercises 473 16.4 Discrimination 517 Problem Set 473 Theories of Discrimination 518 Wage Differences Due to Worker Preferences 519 CHAPTER 15 Human Capital Inheritance 519 The Demand for Factors of Summary 520 Review Questions 521 Production 477 Problem Set 521 15.1 The Firm’s Demand for Factors in the Short Run 477 CHAPTER 17 The Marginal Revenue Product of Labor 477 Allocating Goods Over The Algebra of Profit Maximization 479 Time 525 The Effect of Plant Size 482 17.1 Bonds and Interest Rates 525 15.2 The Firm’s Demand for Factors Relative Prices, Interest Rates, and in the Long Run 483 Present Values 526 Constructing the Long-Run Labor Bonds Denominated in Dollars 529 Demand Curve 483 Default Risk 530 Substitution and Scale Effects 485 17.2 Applications 531 Relationships Between the Short Run Valuing a Productive Asset 531 and the Long Run 488 Valuing Durable Commodities: Is Art a Good Investment? 532 15.3 The Industry’s Demand Curve for Should You Pay with Cash or Credit? 533 Factors of Production 490 Government Debt 534 Monopsony 490 Planned Obsolescence 535 15.4 The Distribution of Artists’ Royalties 536 Income 492 Old Taxes Are Fair Taxes 537 Factor Shares and Rents 492 The Pricing of Exhaustible Resources 538 Producers’ Surplus 494 Summary 496 17.3 The Market for Current Review Questions 497 Consumption 539 Numerical Exercises 498 The Consumer’s Choice 539 Problem Set 499 The Demand for Current Consumption 542 Equilibrium and the Representative Agent 544 CHAPTER 16 Changes in Equilibrium 546 The Market for Labor 501 17.4 Production and Investment 552 16.1 Individual Labor Supply 501 The Demand for Capital 552 Consumption versus Leisure 501 The Supply of Current Changes in the Budget Line 504 Consumption 553 The Worker’s Supply of Labor 506 Equilibrium 554

45185_00_fm_pi-xxii.indd x 14/07/10 7:49 AM CONTENTS NOT FOR SALE xi Summary 556 19.2 The Rationality Assumption 603 Author Commentary 556 The Role of Assumptions in Science 603 Review Questions 556 All We Really Need: No Unexploited Problem Set 557 Profit Opportunities 604 19.3 What Is an Economic CHAPTER 18 Explanation? 606 Celebrity Endorsements 606 Risk and Uncertainty 563 The Size of Shopping Carts 607 18.1 Attitudes Toward Risk 563 Why Is There Mandatory Characterizing Baskets 565 Retirement? 608 Opportunities 566 Why Rock Concerts Sell Out 609 Preferences and the Consumer’s 99¢ Pricing 610 Optimum 568 Rationality Revisited 611 Gambling at Favorable Odds 573 19.4 The Scope of Economic Risk and Society 575 Analysis 611 18.2 The Market for Insurance 576 Laboratory Animals as Rational Imperfect Information 576 Agents 611 Uninsurable Risks 578 Author Commentary 615 Problem Set 615 18.3 Futures Markets 578 Speculation 579 18.4 Markets for Risky Assets 581 APPENDIX A Portfolios 582 Calculus Supplement 619 The Geometry of Portfolios 583 The Investor’s Choice 585 APPENDIX B Constructing a Market Portfolio 588 Answers to All the Exercises 645

18.5 Rational Expectations 589 APPENDIX C A Market with Uncertain Demand 589 Answers to Problem Sets 657 Why Economists Make Wrong Predictions 592 Summary 595 Glossary 673 Author Commentary 596 Review Questions 596 Index 681 Problem Set 597

CHAPTER 19 What Is Economics? 599 19.1 The Nature of Economic Analysis 599 Stages of Economic Analysis 599 The Value of Economic Analysis 602

45185_00_fm_pi-xxii.indd xi 14/07/10 7:49 AM PrefaceNOT FOR SALE

To the Student

Price theory is a challenging and rewarding subject. The student who masters price theory acquires a powerful tool for understanding a remarkable range of social phenomena. How does a sales tax affect the price of coffee? Why do people trade? What happens to ticket prices when a baseball player gets a raise? How does free agency affect the allocation of baseball players to teams? Why might the revenue of orange growers increase when there is an unexpected frost—and what may we infer about the existence of monopoly power if it does? Price theory teaches you how to solve similar puzzles. Better yet, it poses new ones. You will learn to be intrigued by phenomena you might previously have considered unremarkable. When rock concerts predictably sell out in advance, why don’t the pro- moters raise prices? Why are bank buildings fancier than supermarkets? Why do ski resorts sell lift tickets on a per-day basis rather than a per-ride basis? Throughout this book, such questions are used to motivate a careful and rigorous development of microeconomic theory. New concepts are immediately illustrated with entertaining and informative examples, both verbal and numerical. Ideas and techniques are allowed to arise naturally in the discussion, and they are given names (like “marginal value”) only after you have discovered their usefulness. You are encouraged to develop a strong economic intuition and then to test your intuition by submitting it to rigorous graphical and verbal analysis. I think that you will find this book inviting. There are neither mathematical demands nor prerequisites and no lists of axioms to memorize. At the same time, the level of economic rigor and sophistication is quite high. In many cases, I have carried analysis beyond what is found in most other books at this level. There are digressions, examples, and especially problems that will challenge even the most ambitious and talented students.

Using This Book

This is a book about how the world works. When you finish the first chapter, you will know how to analyze the effects of sales and excise taxes, and you will have discovered the surprising result that a tax on buyers and a tax on sellers have exactly the same effects. When you finish the second chapter, you will understand why oranges, on average, taste better in New York than in Florida. In each succeeding chapter, you will be exposed to new ideas in economics and to their surprising consequences for the world around you. To learn what price theory is, dig in and begin reading. The next few paragraphs give you a hint of what it’s all about. Price theory, or microeconomics, is the study of the ways in which individuals and firms make choices, and the ways in which these choices interact with each other. We assume that individuals have certain well-defined preferences and limits to their behavior. For example, you might enjoy eating both cake and ice cream, but the size of your xiii

45185_00_fm_pi-xxii.indd xiii 14/07/10 7:50 AM xiv NOTPREFACE FOR SALE stomach limits your ability to pursue these pleasures; moreover, the amount of cake that you eat affects the amount of ice cream you can eat, and vice versa. In predicting behavior, we assume that individuals behave rationally, which is to say that they make themselves as well-off as possible, as measured by their own preferences, and within the limitations imposed on them. While this assumption (like any assumption in any science) is only an approximation to reality, it is an extraordinarily powerful one, and it leads to many profound and surprising conclusions. Price theory is made richer by the fact that each individual’s choices can affect the opportunities available to others. If you decide to eat all of the cake, your roommate cannot decide to eat some too. An equilibrium is an outcome in which each person’s behavior is compatible with the restrictions imposed by everybody else’s behavior. In many situations, it is possible to say both that there is only one possible equilibrium and that there are good reasons to expect that equilibrium to actually come about. This enables the economist to make predictions about the world. Thus, price theory is most often concerned with two sorts of questions: those that are positive and those that are normative. A positive question is a question about what is or will be, whereas a normative question is a question about what ought to be. Positive questions have definite, correct answers (which may or may not be known), whereas the answers to normative questions depend on values. For example, suppose that a law is proposed that would prohibit any bank from foreclosing on any farmer’s mortgage. Some positive questions are: How will this law affect the incomes of bankers? How will it affect the incomes of farmers? What effect will it have on the number of people who decide to become farmers and on the number of people who decide to start banks? Will it indirectly affect the average size of farms or of banks? Will it indirectly affect the price of land? How will it affect the price of food and the well-being of people who are neither farmers nor bankers? and so forth. A normative question is: Is this law, on balance, a good thing? Economics can, at least in principle, provide answers to the positive questions. Economics by itself can never answer a normative question; in this case your answer to the normative question must depend on how you feel about the relative merits of helping farmers and helping bankers. Therefore, we will be concerned in this book primarily with positive questions. However, price theory is relevant in the consideration of normative questions as well. This is so in two ways. First, even if you are quite sure of your own values, it is often impossible to decide whether you consider some course of action desirable unless you know its consequences. Your decision about whether to support the antiforeclosure law will depend not only on your feelings about farmers and bankers, but also on what effects you believe the law will have. Thus, it can be important to study positive questions even when the questions of ultimate interest are normative ones. For another example, suppose that you have decided to start recycling newspapers to help preserve large forests. One of your friends tells you that in fact recycling leads to smaller forests because it lowers the demand for trees and induces paper companies to do less planting. Whether or not your friend is correct is a positive question. You might want the answer to that positive question before returning to the normative question: Should I continue to recycle? The second way in which price theory can assist us in thinking about normative questions is by showing us the consequences of consistently applying a given normative criterion. For example, if your criterion is “I am always for anything that will benefit

45185_00_fm_pi-xxii.indd xiv 14/07/10 7:50 AM PREFACE NOT FOR SALE xv farmers, provided that it does not drive any bankers out of business,” the price theorist might be able to respond, “In that case, you must support such-and-such law, because I can use economic reasoning to show that such-and-such law will indeed benefit farmers without driving any bankers out of business.” If such-and-such law does not sound like a good idea to you, you might want to rethink your normative criterion. In the first seven chapters of this book, you will receive a thorough ground- ing in the positive aspects of price theory. You will learn how consumers make decisions, how firms make decisions, and how these decisions interact in the competitive marketplace. In Chapter 8, you will examine the desirability of these outcomes from the viewpoints of various normative criteria. Chapter 9 rounds out the discussion of the competitive price system by examining the role of prices as conveyors of information. In Chapters 10 through 14, you will learn about various situations in which the competitive model does not fully apply. These include conditions of monopoly and oligopoly, and circumstances in which the activities of one person or firm affect others involuntarily (e.g., factories create pollution that their neighbors must breathe). The first 14 chapters complete the discussion of the market for goods, which are supplied by firms and purchased by individuals. In Chapters 15 through 17 you will learn about the other side of the economy: the market for inputs to the production process (such as labor) that are supplied by individuals and purchased by firms. In Chapter 17, you will study the market for the productive input called capital and examine the way that individuals allocate goods across time, consuming less on one day so that they can consume more on another. Chapter 18 concerns a special topic: the role of risk. Chapter 19 provides an overview of what economics in general, and price theory in particular, is all about. Most of the discussion in that final chapter could have been included here. However, we believe that the discussion will be more meaningful after you have seen some examples of price theory in action, rather than before. Therefore, we make the following suggestion: Dip into Chapter 19. Not all of it will make sense at this point, but much of it will. After you have been through a few chapters of the book, dip into Chapter 19 again. Even the parts you understood the first time will be more meaningful now. Later on—say, after you have finished Chapter 7—try it yet again. You will get the most from the final chapter if you read it one last time, thoroughly, at the end of the course.

Features

This book provides many tools to help you learn. Here are a few hints on how to use them.

Exhibits Most of the exhibits have extensive explanatory captions that summarize key points from the discussion in the text.

Exercises Exercises are sprinkled throughout the text. They are intended to slow you down and make sure that you understand one paragraph before going on to the next. If

45185_00_fm_pi-xxii.indd xv 14/07/10 7:50 AM xvi NOTPREFACE FOR SALE you cannot do an exercise quickly and accurately, you have probably missed an important point. In that case, it is wise to pause and reread the preceding few paragraphs. Answers to all of the exercises are provided in Appendix B at the back of the book.

Dangerous Curves The dangerous curve symbol appears periodically to warn you against the most common misunderstandings. Passages marked with this symbol describe mistakes that students and theorists often make and explain how to avoid them.

Marginal Glossary Each new term is defined in bold in the text and in the margin, where you can easily find it. All of the definitions in the margin glossary are gathered in alphabetical order in the Glossary at the back of the book.

Chapter Summaries The summaries at the end of each chapter provide concise descriptions of the main ideas. You will find them useful in organizing your study.

Author Commentaries I’ve written a number of magazine articles that use price theory to illuminate every aspect of human behavior. Many of these can be found on the text Web site at http:// www.cengage.com/economics/landsburg. Click on the companion site for the text, select a chapter from the drop-down list at the left of the screen, and click on the Author Commentaries link in the left menu. Finally, click the download link to download the commentary. Slate articles can also be accessed on this companion site. Additional articles can be found through an archive search on the Slate magazine home page at http://slate.msn.com. Magazine articles, featuring examples that are relevant to many chapters, are noted on the inside cover of this text. The author regularly blogs at www.TheBigQuestions.com/blog, where you will often find material directly related to what you are learning in this book.

Review Questions The Review Questions at the end of each chapter test to see whether you have learned and can repeat the main ideas of the chapter.

Numerical Exercises About half of the chapters have Numerical Exercises at the end. By working these, you apply economic theory to data to make precise predictions. For example, at the end of Chapter 7, you are given some information about the costs of producing kites and the demand for kites. Using this and the theory that you have learned, you will be able to deduce the price of kites, the number of kites sold by each firm, and the number of firms in the industry.

45185_00_fm_pi-xxii.indd xvi 14/07/10 7:50 AM PREFACE NOT FOR SALE xvii Problem Sets The extensive Problem Sets at the end of each chapter occupy a wide range of difficulty. Some are quite straightforward. Others are challenging and open-ended and give you the opportunity to think deeply and creatively. Often, problems require additional assumptions that are not explicitly stated. Learning to make additional assumptions is a large part of learning to do economics. In some cases there will be more than one correct answer, depending on what assumptions you made. Thus, in answering problems you should always spell out your reasoning very carefully. This is particularly important in “true or false” problems, where the quality of your explanations will usually matter far more than your conclusion. About one third of the problems are discussed in Appendix C at the end of the book. These problems are indicated by a shaded box around the problem number. The discussions in Appendix C range from hints to complete answers. In many cases, the answer section lists only conclusions without the reasoning necessary to support them; your instructor will probably require you to provide that reasoning. If your instructor allows it, you will learn a lot by working on problems together with your classmates. You may find that you and they have different answers to the same problem, and that both you and they are equally sure of your answers. In attempting to convince each other, and in trying to pinpoint the spot at which your thinking diverged, you will be forced to clarify your ideas and you will discover which concepts you need to study further. Now you are ready to begin.

To the Instructor

One advantage of teaching the same course every semester is that you constantly discover new ways to help students understand and enjoy the subject. I’ve taught price theory 50 times now, and am eager to share the best of my recent discoveries. The seventh edition of this book, like the six that preceded it, was well received by both students and instructors. I’ve therefore continued to preserve the book’s basic structure and the many features that have been recognized as highlights—the clarity of the writing, the careful pedagogy (including “Dangerous Curves” signals to warn students of common misunderstandings), the lively examples, and the wide range of exercises and problems. At the same time, I’ve continued my practice of rewriting several sections for even greater clarity. These include discussions of Giffen goods in Chapter 4 and a of long run competitive equilibrium (including the break-even condition) in Chapter 7. In Chapter 8, I’ve added a passage to emphasize that economic inefficiency always entails a missed opportunity to do good, and in Chapter 9 I’ve added some discussion of the extraordinary series of economic events that began in 2008. The biggest change is in Chapter 13, on externalities, which I’ve extensively reorganized to emphasize the importance of both Pigovian and Coasian insights. But I’ll repeat here what I said in the previous edition: While I am very pleased with these improvements and innovations, I have not tampered with the fundamental structure and content of the book, which I expect will be as satisfactory to the next generation of students as it was to the previous. The standard topics of intermediate price theory are covered in this edition, and in the previous versions. I have retained all of the book’s unique features, of which the following are the most important.

45185_00_fm_pi-xxii.indd xvii 14/07/10 7:50 AM xviii NOTPREFACE FOR SALE Use of Social Welfare as a Unifying Concept Consumers’ and producers’ surplus are introduced in Chapter 8, immediately following the theory of the competitive. There they are used to analyze the effects of various forms of market interference. Thereafter, most new concepts are related to social welfare and analyzed in this light.

The Economics of Information Chapter 9 (Knowledge and Information) surveys the key role of prices in disseminat- ing information and relates this to their key role in equilibrating markets. Section 9.1 emphasizes the price system’s remarkable success in this regard while Section 9.3 surveys some of its equally remarkable failures. Section 9.2 studies information in financial markets.

Treatment of Theory of the Firm It is often difficult for students to understand the importance of production functions, average cost curves, and the like until after they have been asked to study them for several weeks. To remedy this, Chapter 5 (The Behavior of Firms) provides an overview of how firms make decisions, introducing the general principle of equating marginal costs with marginal benefits and relating this principle back to the consumer theory that the student has just learned. Having seen the importance of cost curves, students may be more motivated to study their derivation in Chapter 6 (Production and Costs). The material on firms is presented in a manner that gives a lot of flexibility to the instructor. Those who prefer the more traditional approach of starting immediately with production can easily skip Chapter 5 or postpone it until after Chapter 6. Chapter 6 itself has been organized to rigorously separate the short-run theory (in Section 6.1) from the long-run theory (in Section 6.2). Relations between the short and the long run are thoroughly explored in Section 6.3. Instructors who want to defer the more difficult topic of long-run production will find it easy to simply cover Section 6.1 and then move directly on to Chapter 7.

Extended Analysis of Market Failures, Property Rights, and Rules of Law This is the material of Chapter 13, which I have found to be very popular with students. The theory of externalities is developed in great detail, using a series of extended examples and illustrated with actual court cases. Section 13.4 (The Law and Economics) analyzes various legal theories from the point of view of economic efficiency.

Relationships to Macroeconomics The topic coverage provides a solid preparation for a rigorous course in macroeconomics. In addition, several purely “micro” topics are illustrated with “macro” applications. (None of these applications is central to the book, and all can be skipped easily by instructors who wish to do so.) There are sections on information, intertemporal decision making, labor markets in general equilibrium, and rational expectations. In the chapter on interest rates, there is a purely microeconomic analysis of the effects

45185_00_fm_pi-xxii.indd xviii 14/07/10 7:50 AM PREFACE NOT FOR SALE xix of federal deficits, including Ricardian Equivalence, the hypotheses necessary for it to hold, and the consequences of relaxing these hypotheses. (This material has been extensively rewritten and simplified for this edition.) The section on rational expectations, in Chapter 18, is presented in the context of a purely micro problem, involving agricultural prices, but it includes a discussion of “why economists make wrong predictions” with a moral that applies to macroeconomics.

Other Nontraditional Topics There are extensive sections devoted to topics excluded from many standard intermediate textbooks. Among these are alternative normative criteria, efficient asset markets, contestable markets, antitrust law, mechanisms for eliciting private information about the demand for public goods, human capital (including the external effects of human capital accumulation), the role of increasing returns in economic growth, the Capital Asset Pricing Model, and the pricing of stock options. The book concludes with a chapter on the methods and scope of economic analysis (titled What Is Economics?), with examples drawn from biology, sociology, and history.

Supplements

The Instructor’s Manual contains the following features in each chapter: general discussion, teaching suggestions, suggested additional problems, and solutions to all of the end-of-chapter problems in the textbook. The Manual can be downloaded by instructors from the text Web site. The Test Bank, prepared by Brett Katzman, Kennesaw State University, Kennesaw, GA, offers true/false questions, multiple-choice questions, and essay questions for each chapter. It has been significantly expanded for this edition. The Study Guide, prepared by William V. Weber, Eastern Illinois University, Charleston, IL, has chapters that correspond to the textbook. Each chapter contains key terms, key ideas, completion exercises, graphical analyses, multiple-choice questions, questions for review, and problems for analysis. Artwork from the text is reprinted in the Study Guide, with ample space to take notes during classroom discussion. PowerPoint slides of exhibits from the text are also available for classroom use, and can be accessed® at the text Web site. PowerPoint slides incorporating lecture notes and exhibits, also available on the Web site, were prepared by Raymonda Burgman, DePauw University, Greencastle, IN.

Text Web Site The text Web site is located at http://www.cengage.com/economics/landsburg. On the Price Theory Web site are several of the text supplements, teaching resources, learning resources, links to the Author Commentary articles, and additional Slate articles. In addition, easy access is provided to the EconNews, EconDebate, EconData, and EconLinks Online features at the South-Western Economics Resource Center.

45185_00_fm_pi-xxii.indd xix 14/07/10 7:50 AM xx NOTPREFACE FOR SALE Acknowledgments

I first learned economics at the University of Chicago in the 1970s, which means that I learned most of it, directly or indirectly, from Dee McCloskey. Generations of Chicago graduate students were infected by Dee’s enthusiasm for economics as a tool for understanding the world, and the members of one generation communicated their exuberance to me. They, and consequently I, learned from Dee that the world is full of puzzles—not the abstract or technical puzzles of formal economic theory, but puzzles like: Could the advent of free public education cause less education to be consumed? We learned to see puzzles everywhere and to delight in their solutions. Later, I had the privilege to know Dee as a friend, a colleague, and the greatest of my teachers. Without Dee, this book would not exist. The exuberance that Dee personifies is endemic at Chicago, and I had the great good fortune to encounter it every day. I absorbed ideas and garnered examples in cafeterias, the library’s coffee lounge, and especially in all- night seminars at Jimmy’s Woodlawn Tap. Many of those ideas and examples appear in this book, their exact sources long forgotten. To all who contributed, thank you. Among the many Chicago students who deserve explicit mention are Craig Hakkio, Eric Hirschhorn, and Maury Wolff, who were there from the beginning. John Martin and Russell Roberts taught me much and contributed many valuable suggestions specifically for this book. Ken Judd gave me a theory of executive compensation. Dan Gressell taught me the two ways to get a chicken to lay more eggs. I received further education, and much encouragement, from the Chicago faculty. I thank Gary Becker, who enticed me to think more seriously about economics; Sherwin Rosen, who had planted the seeds of all this years before; and José Scheinkman, who listened to my ideas even when they were foolish. Above all, Bob Lucas can have no idea of how grateful I have been for his many gracious kindnesses. I remember them all, and value his generosity as I value the inspiration of his intellectual depth, honesty, and rigor. Since leaving Chicago, my good fortune in colleagues followed me to Iowa and Cornell, and especially to Rochester, where this book was written. There is no faculty member in economics at Rochester who did not contribute to this book in one way or another. Some suggested examples and problems; others helped me learn material that I had thought I understood until I tried to write about it; and many did both. I should name them all, but have space for only a few. William Thomson taught me about mechanisms for revealing the demand for public goods and suggested that they belonged in a book at this level. Walter Oi contributed more entertaining ideas and illustrations than I can remember and told me how Chinese bargemen were paid. Ken McLaughlin dazzled me with insights on pretty much a daily basis. And the late Alan Stockman started teaching me both economics and the joys of economics from the day I met him until the day he died. I must also mention the contributions of the daily lunch group at the Hillside Restaurant, where no subject is off limits and no opinion too outrageous for consideration. The daily discussions about how society is or should be structured were punctu- ated by numerous tangential discussions of how various ideas could best be presented in an intermediate textbook. I thank especially Stockman, McLaughlin, Mark Bils, John Boyd, Jim Kahn, Marvin Goodfriend (the first inductee into the Hillside Hall of Fame), and various part-time members. Harold Winter’s extensive written criticism of Chapter 11 led to substantial improvements. His many contributions specifically for this edition are acknowledged

45185_00_fm_pi-xxii.indd xx 14/07/10 7:50 AM PREFACE NOT FOR SALE xxi above and gratefully acknowledged again here. Wendy Betts gave me the epigram for Section 9.3. We gratefully acknowledge the contributions of the following reviewers whose comments and suggestions have improved this project:

Ted Amato, University of North Carolina—Charlotte John Antel, University of Houston Charles A. Berry, University of Cincinnati Jay Bloom, SUNY—New Paltz James Bradfield, Hamilton College Victor Brajer, California State University—Fullerton Raymonda Burgman, DePauw University Satyajit Chatterjee, University of Iowa Jennifer Coats, St. Louis University John Conant, Indiana State University John P. Conley, University of Illinois John Conley, University of Illinois—Urbana John Devereux, University of Miami Arthur M. Diamond, University of Nebraska—Omaha John Dodge, Calvin College Richard Eastin, University of Southern California Carl E. Enomoto, New Mexico State University Claire Holton Hammond, Wake Forest University Dean Hiebert, Illinois State University John B. Horowitz, Ball State University Roberto Ifill, Williams College Paul Jonas, University of New Mexico Kenneth Judd, University of Chicago Elizabeth Sawyer Kelly, University of Wisconsin—Madison Edward R. Kittrell, Northern Illinois University Vicky C. Langston, Austin Peay State University Daniel Y. Lee, Shippensburg University Luis Locay, University of Miami Barry Love, Emory & Henry College Chris Brown Mahoney, University of Minnesota Devinder Malhotra, University of Akron Joseph A. Martellaro, Northern Illinois University John Martin, Baruch College Scott Masten, University of Michigan J. Peter Mattila, Iowa State University Sharon Megdal, Northern Arizona University Jack Meyer, Michigan State University Robert J. Michaels, California State University—Fullerton John Miller, Clarkson University David Mills, University of Virginia H. Brian Moehring, Ball State University Robert Molina, Colorado State University John Mullen, Clarkson University Kathryn A. Nantz, Fairfield University

45185_00_fm_pi-xxii.indd xxi 14/07/10 7:50 AM xxii NOTPREFACE FOR SALE Jon P. Nelson, Penn State University Craig M. Newmark, North Carolina State University Margaret Oppenheimer, De Paul University Lydia Ortega, San Jose State University Debashis Pal, University of Cincinnati Michael Peddle, Holy Cross College James Pinto, Northern Arizona University Anil Puri, California State University—Fullerton Libby Rittenberg, Colorado College Russell Roberts, Washington University—Los Angeles Peter Rupert, SUNY—Buffalo Leslie Seplaki, Rutgers University David Sisk, San Francisco State University Hubert Spraberry, Howard Payne University Annette Steinacker, University of Rochester Douglas O. Stewart, Cleveland State University Della Lee Sue, Marist College Vasant Sukhatme, Macalester College Beck Taylor, Baylor University Paul Thistle, University of Alabama Mark Walbert, Illinois State University Paula Worthington, Northwestern University Gregory D. Wozniak, University of Tulsa David Zervos, University of Rochester And special thanks to Jana Lewis, the content project manager without who got pretty much everything right, made it sure it all got done, and, most remarkably of all, put up with me. Steven E. Landsburg

45185_00_fm_pi-xxii.indd xxii 14/07/10 7:50 AM NOT FOR SALECHAPTER 4 Consumers in the Marketplace

In Chapter 1, we told a simple but powerful story about demand, summarized in a single phrase: When the price goes up, the quantity demanded goes down. In Chapter 3, we told a far more sophisticated story about demand: When the price goes up, the budget line pivots inward and the consumer moves from one tangency to another. Our next task is to understand how these stories fit together. Do they always make the same predictions? If so, why? If not, which should we believe? This chapter will tackle those questions. We will use the indifference curves and budget lines of Chapter 3 to reach a deeper understanding of the law of demand from Chapter 1. Along the way, we’ll learn a lot about how consumers respond to changing market conditions. It turns out that income changes are a little easier to analyze than price changes, so we’ll start by studying income changes in Section 4.1. In Sections 4.2 and 4.3, we’ll turn to the effects of price changes. Finally, in Section 4.4, we’ll talk about some numerical measures of all these effects.

4.1 Changes in Income

In this section, we consider the effects of a change in income. In order to focus on a single good—call it X, which might stand for soft drinks or coffee or eggs—we will use the composite-good convention, lumping together everything except X into a single category called all other goods. This allows us to maintain the useful fiction that there are only two goods in the economy: There is X, and there is “all other goods,” which we label Y.

Changes in Income and Changes in the Budget Line Let’s think about how your budget line moves when your income rises. Suppose you start with the Original budget line in Exhibit 4.1. You can afford any basket on this budget line, including, for example, the illustrated basket G. If your income rises by $5, you can now afford to buy basket G plus $5 worth of good Y. That is, you can afford point H. So point H is on your new budget line.

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EXHIBIT 4.1 A Rise in Income

H $5 worth

Y G

New Original

When your income increases by $5, the budget line shifts out parallel to itself. For each point on the original budget line (like G), there is a point on the new budget line (like H) which consists of basket G plus an additional $5 worth of Y.

(If the price of Y is $1 per unit, then the vertical arrow in Exhibit 4.1 has length 5; if the price of Y is $2 per unit, then the vertical arrow has length 2½; if the price of Y is 1¢ per unit, then the vertical arrow has length 500.) More generally, given any point on your old budget line, you can add $5 worth of Y and get a point on your new budget line. So the vertical distance between the two budget lines is always the same “$5 worth.” Because this distance is always the same, it follows that the new budget line is parallel to the original. A change in income causes a parallel shift of the budget line.

Exercise 4.1 Draw the new budget line that would result from a $5 fall in income.

There is another way to see that a change in income causes a parallel shift of the budget line. Recall from Section 3.2 that the equation of the budget line can be written P I y = X · x + P P Y Y

so that a change in income (I) does not affect the slope (−PX/PY). A change in income affects only the Y-intercept of the budget line, which is another way of saying that a change in income causes a parallel shift.

Changes in Income and Changes in the Optimum Point When your income rises by $5, your budget line shifts out as in Exhibit 4.1. What happens to your optimum point? In Exhibit 4.2, we suppose that your original optimum point is A, where the original budget line (in black) is tangent to the black indifference curve. Now your income

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EXHIBIT 4.2 A Rise in Income

O M

Y B A

N New Original P X

An increase in income causes the budget line to shift outward. If the original tangency is at A, then the new tangency cannot be at O or P, as either possibility would require two indifference curves to cross. (The curves that are shown tangent at these points cannot be indifference curves because they must cross the original black indifference curve.) Instead, the new tangency is at a point like B.

rises by $5, causing your budget line to shift out; the new budget line is shown in color. Where can the new tangency be? The tangency cannot be at point O. Here’s why: If an indifference curve were tangent at O, it would be forced to cross the black indifference curve, which cannot happen. (The lightly colored curve shown tangent at O cannot be an indifference curve, because it crosses the black indifference curve that is tangent at A.) Likewise, the tangency cannot be at point P. Instead, the tangency must occur somewhere between points M and N on the new budget line, at a point like B.

Normal and Inferior Goods If point B is located as in Exhibit 4.2, then a rise in income causes your consumption of X to rise. This is because point B is to the right of point A, so it corresponds to a basket Normal good with more X. A good that you But alternative pictures are possible. Exhibit 4.3 shows two possibilities. Point B consume more of when could be to the right of A, as in the first panel, or point B could be to the left of A, as in your income rises. the second panel. In the first case, a rise in income leads you to consume more X, and we say that X is a normal good. In the second case, a rise in income leads you to con- Inferior good sume less X, and we say that X is an inferior good. A good that you For example, it is entirely likely that if your income rises, you will consume less consume less of when Hamburger Helper. That makes Hamburger Helper an inferior good. your income rises.

The word inferior is used differently here than in ordinary English. In ordinary English, inferior is a term of comparison; you can’t call something inferior without saying what it is inferior to; as a student, you can be inferior to some of your classmates and superior to others. But in economics, a good either is or is not inferior, and inferiority does not Dangerous have the negative connotations that it has in everyday speech. Curve

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EXHIBIT 4.3 Normal and Inferior Goods

Y Y B A A

New New Original Original X X

Suppose your original tangency is at A and your income increases. Then your new tangency B could be either to the right of A (as in the first panel) or to the left of A (as in the second panel). In the first case, a rise in income leads you to consume more X and we call X a normal good. In the second case, a rise in income leads you to consume less X and we call X an inferior good.

Exercise 4.2 In the first panel of Exhibit 4.3, is Y an inferior good? What about in the second panel? Where must the tangency B be located if Y is an inferior good?

The Engel Curve Engel curve Beth is a consumer who buys eggs and root beer. Her Engel curve for eggs is a graph A curve showing, that shows how many eggs she’ll consume at each level of income. You can see her Engel for fixed prices, the curve in the second panel of Exhibit 4.4. When her income is $4, she consumes 3 eggs; relationship between when her income is $8, she consumes 6 eggs, and so on. income and the It turns out that if we know the prices of eggs and root beer, and if we know Beth’s quantity of a good indifference curves, then we can figure out the coordinates of the points on her Engel consumed. curve. For example, suppose we know that the price of an egg is 50¢, the price of a root beer is $1, and Beth’s indifference curves are the curves shown in Exhibit 4.4A. To construct a point on Beth’s Engel curve, we follow a five-step process: 1. Imagine an income for Beth—say, $4. 2. Draw the corresponding budget line. In this case, given our assumptions about the prices of eggs and root beer, Beth can afford up to 8 eggs (with no root beer) or 4 root beers (with no eggs). Therefore, her budget line is the one labeled “$4 income” in Exhibit 4.4A. 3. Find the tangency between this budget line and an indifference curve. (We can do this because we’ve assumed that we know Beth’s indifference curves.) In this case, the tangency occurs at point A. 4. Read off the corresponding quantity of eggs—in this case, 3. 5. Plot the point on the Engel curve, relating the income in step 1 to the quantity in step 4. In this case, we get the point A′ = ($4, 3), illustrated in Exhibit 4.4B. To get another point on Beth’s Engel curve, repeat the entire five-step process, beginning with a different income. If you imagine the income $8 in step 1, you’ll be led to the quantity 6 in step 4, and you’ll plot the point B′ in step 5.

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EXHIBIT 4.4 Constructing the Engel Curve

Root Quantity Beer of Eggs

12 12 C'

8 C B $8 Income 6 B' 4 $12 Income A 3 A'

0 3 68 12 16 24 0 4 8 12 16 $4 Income Eggs Income ($) A. Beth's indifference curve B. Beth's Engel curve

Points A, B, and C in the first panel show Beth’s optima at a variety of incomes. (The prices of eggs and root beer are held fixed at 50¢ and $1, respectively.) Points A′, B′, and C′ in the second panel record the quantity of eggs that Beth consumes for each of three incomes; these quantities are the horizontal coordinates of points A, B, and C. The curve through A′, B′, and C′ is Beth’s Engel curve for eggs.

Exercise 4.3 Explain how to derive the coordinates of point C′ in Exhibit 4.4B.

The moral of this story is that the Engel curve contains no information that is not already encoded in the indifference curve diagram. Once we know the indifference curves, we can generate the Engel curve by a purely mechanical process.

The Shape of the Engel Curve The Engel curve in Exhibit 4.4B is upward sloping. In other words, when Beth’s income rises, she consumes more eggs. Thus, eggs are a normal good for Beth. In general, the Engel curve will slope upward for a normal good and downward for an inferior good. If eggs were an inferior good for Beth, then the tangency B in Exhibit 4.4A would occur somewhere to the left of the tangency A—say, with a horizontal coordinate of 2. This would yield the point B′ = ($8, 2) in Exhibit 4.4B, and the curve through A′ and B′ would slope downward.

4.2 Changes in Price

We now shift our attention from changes in income to changes in the price of X.

Changes in Price and Changes in the Budget Line To focus attention on changes in the price of X, we assume that your income and the price of Y remain fixed. For example, suppose the price of Y remains fixed at $3 per unit

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EXHIBIT 4.5 Changes in the Price of X

Y P X = $3

P X = $2

P X = $6 4812 X

The price of Y is fixed at $3 and income is fixed at $24. A rise in the price of X causes the budget line to pivot inward around its Y-intercept, and a fall in price causes the budget line to pivot outward around its Y-intercept.

and your income remains fixed at $24. Exhibit 4.5 shows the budget lines that result when the price of X is $2, $3, and $6.

Exercise 4.4 Verify that the budget lines have been drawn correctly. There are two important things to notice in Exhibit 4.5. First, a change in the price of X has no effect on the Y-intercept of the budget line. When you buy zero Xs, you can always afford exactly 8 Ys, regardless of what happens to the price of X. Thus: A change in the price of X causes the budget line to pivot around its Y-intercept. The second important thing to notice is the direction in which the budget line pivots. When the price of X is low (like $2), the budget line extends out to a high quantity of X (in this case, 12); when the price of X is high (like $6), the budget line extends out only to a low quantity of X (in this case, 4). Thus: A rise in the price of X causes the budget line to pivot inward. A fall in the price of X causes the budget line to pivot outward.

Changes in Price and Changes in the Optimum Point When the price of X rises, your budget line pivots inward, as shown in Exhibit 4.6. The geometry of Exhibit 4.6 places no restrictions on the location of the new optimum point; it could be anywhere at all on the new budget line. Now we’re going to think a little more deeply about the location of that new optimum.

Giffen and Ordinary Goods Exhibit 4.7 illustrates two possibilities. In both cases, a rise in the price of X causes the optimum point to shift from A to B. In the first panel, B lies to the left of A; in the second panel, B lies to the right of A.

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EXHIBIT 4.6 A Price Increase

A Y

Original New X

A rise in price causes the budget line to pivot inward. The original optimum is at A, and the new optimum could be anywhere at all on the new (brown) budget line.

In the first panel, you can see that when the price of X goes up, the quantity

demanded goes down (from QA to QB). That statement should sound familiar; it is the same law of demand that we met in Chapter 1. Giffen good In the second panel, you can see that when the price of X goes up, the quantity A good that violates demanded goes up! In this case, X violates the law of demand. the law of demand, so Goods that violate the law of demand (like good X in the second panel of that when the price Exhibit 4.7) are called Giffen goods. Goods that obey the law of demand (like good X goes up, the quantity in the first panel of Exhibit 4.7) are called ordinary goods. demanded goes up.

Do not confuse the question “Is X Giffen?” with the question “Is X inferior?” To determine whether X is inferior, you must ask what happens when income changes, so that the budget line undergoes a parallel shift (as in the two panels of Exhibit 4.3). To

determine whether X is Giffen, you must ask what happens when the price of X changes, Dangerous so that the budget line pivots around its Y-intercept, as in the two panels of Exhibit 4.7. Curve

In the panels of Exhibit 4.7, it is not possible to tell by inspection whether Y is a Giffen good. To determine whether Y is Giffen, we have to ask what happens to the consumption of Y when there is a change in the price of Y. But the graphs in Exhibit 4.7 illustrate a change in the price of X, not a change in the price of Y. Dangerous Curve

Exercise 4.5 Draw a graph illustrating how the budget line shifts when the price of Y rises. Draw the original optimum. Where is the new optimum located if Y is not a Giffen good? Where is the new optimum located if Y is a Giffen good? Ordinary good A good that obeys the A Puzzle: Why Are Giffen Goods so Rare? law of demand: When Giffen goods are extremely uncommon; in fact, they are so uncommon that the author the price goes up, the of your textbook does not know of a single actual instance. That’s why the law of quantity demanded demand is called a law—it is virtually always obeyed. goes down.

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EXHIBIT 4.7 Ordinary Goods and Giffen Goods

A A Y Y B B Original Original New New

QB QA QA QB X X

When the price of X goes up, the budget line pivots inward. The optimum moves from point A to point B

and the quantity of X that you demand changes from QA to QB. In the first panel, QB is less than QA; in other words “when the price goes up the quantity demanded goes down,” as required by the law of demand. In

the second panel, QB is greater than QA, so that “when the price goes up the quantity demanded goes up,” in violation of the law of demand. When the law of demand is violated, X is called a Giffen good.

The theory of indifference curves tells us that there can be exceptions to the law of demand—in other words, it is possible to draw a picture like the second panel of Exhibit 4.7. But experience tells us that although such exceptions are possible, they are either extremely rare or completely nonexistent. And therein lies a puzzle. If the theory allows Giffen goods to exist, why don’t they? We will return to this puzzle—and solve it—near the end of Section 4.3.

The Demand Curve Let us return our attention to Beth, who buys eggs and root beer. Just as Beth’s Engel curve shows the relation between her income and her egg consumption, so her demand curve shows the relation between the price of eggs and her egg consumption.

The Engel curve plots income on the horizontal axis versus egg consumption on the vertical; the demand curve plots the price of eggs on the vertical axis versus egg Dangerous consumption on the horizontal. Curve Like the Engel curve, the demand curve can be derived from the indifference curve diagram. If we know Beth’s income, the price of root beer, and her indifference curves, then we can construct her demand curve for eggs. The process is illustrated in Exhibit 4.8, where we assume that the price of root beer is $3 and Beth’s income is $24; thus, the vertical intercept of her budget line is at 8 root beers. To construct a point on Beth’s demand curve, we follow a five-step process: 1. Imagine a price for eggs—say, $2. 2. Draw the corresponding budget line. Given our assumption that Beth’s income is $24, she can afford up to 12 eggs (with no root beer). Thus, her budget line has horizontal intercept 12, as illustrated in Exhibit 4.8A.

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EXHIBIT 4.8 Constructing the Demand Curve

Root Price of 8 Beer Eggs ($)

6 CЈ B A Px = $3 C BЈ 3 AЈ Px = $2 2

Px 5 $6 0 234 5 8 12 0 2 35 Eggs Quantity of Eggs A. Beth's inﬂuence curves B. Beth's demand curve

When the price of eggs is $2 apiece, Beth chooses basket A, with 5 eggs. This information is recorded by point A′ in the second panel. Points B′ and C′ are derived similarly. The curve through A′, B′, and C′ is Beth’s demand curve for eggs.

3. Find the tangency between this budget line and an indifference curve. In this case, the tangency occurs at point A. 4. Read off the corresponding quantity of eggs—in this case, 5. 5. Plot a point on the demand curve relating the price in step 1 to the quantity in step 4. In this case we get the point A′ in Exhibit 4.8B. To get another point on Beth’s demand curve, repeat the entire five-step process, beginning with a different price for eggs. If you imagine the price $3 in step 1, you’ll be led to the quantity 3 in step 4, and you’ll plot the point B′ in step 5.

Exercise 4.6 Explain how to derive the coordinates of point C′ in Exhibit 4.8B.

As with the Engel curve, we now know that the demand curve contains no information that is not already encoded in the indifference curve diagram. Once we know the indifference curves, we can generate the demand curve by a purely mechanical process.

Students sometimes attempt to draw the demand curve and the indifference curves on the same graph. This cannot be done correctly because the two diagrams require different axes (quantities of goods X and Y for the indifference curves; quantity and price of good X for the demand curve). Other students sometimes think that the labeled points in Exhibit 4.8A illustrate the shape of the demand curve. This is also incorrect. It is true that each point on the Dangerous demand curve arises from a point in the indifference curve diagram, but translating Curve from one diagram to the other is not simply a matter of copying points. The only way to go from one diagram to the other is via the five-step process just described.

45185_04_ch04_p081-114.indd 89 20/05/10 5:24 AM 90 NOTCHAPTER 4 FOR SALE The Shape of the Demand Curve In Exhibit 4.8, eggs obey the law of demand; therefore, the demand curve for eggs slopes down. If eggs were a Giffen good, then the tangency B would be to the right of A, say, at a quantity of 7. Then the point B′ on the demand curve would have horizontal coordinate 7 and the demand curve would slope upward.

4.3 Income and Substitution Effects

We have a puzzle to solve: Why, in the real world, do there seem to be essentially no Giffen goods? It would be very satisfying to answer this question by saying that the geometry of indifference curves makes Giffen goods impossible. Unfortunately, that is not the case. Exhibit 4.7 showed that there is no geometric obstruction to the existence of a Giffen good. So the solution to our puzzle will require an argument that goes beyond geometry. We will start with a purely verbal discussion of two distinct reasons why the law of demand “ought” to hold. After we’ve understood these effects in words, we will translate our words into geometry and then tie the two approaches together.

Two Effects of a Price Increase When the price of a good goes up, we typically expect the quantity demanded to fall. There are two separate, good reasons for this expectation, called the substitution effect and the income effect.

The Substitution Effect Suppose you’re in the habit of buying 5 hamburgers a day at $2 apiece. If the price goes up to $3 apiece, you might decide that fifth hamburger is simply not worth the money, Substitution effect and therefore cut back to 4 hamburgers a day. That’s the substitution effect of a price of a price increase increase. A change in To put this a little more precisely: We know that each of your five hamburgers must consumption due to have a marginal value (to you) of at least $2; otherwise you wouldn’t have been buying the fact that you won’t them all along. But their marginal values are not all identical; the second hamburger buy goods whose is worth less than the first, and the third is worth less than the second. So it’s entirely marginal value is below possible that the first four hamburgers are worth more than $3 each (to you) and the the new price. fifth hamburger is worth less than $3. That’s why you still eat some hamburgers, but not as many as before. So the substitution effect comes down to this: When the price of a good rises, you adjust your consumption downward so as to avoid buying goods whose price is now above their marginal value. When the price of a good goes up, the substitution effect leads you to consume less of it.

The Income Effect Now we will describe the income effect of a price increase. Suppose the price of hamburgers rises. Then, because you can’t spend more than your entire income, you’ll have to consume less of something. (Another way to say this is that your old basket is outside your new budget line, so you’ll have to choose a new

45185_04_ch04_p081-114.indd 90 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 91 basket.) It’s then quite likely—though not certain—that hamburgers themselves will be among the goods you cut back on. We can be more precise about this: The fact that you can no longer afford your original basket is tantamount to a change in income; in a very real sense, a price increase makes you poorer. When you become poorer, you reduce your consumption of all normal goods, though you increase your consumption of inferior goods. That’s the income effect of a price increase: When the price of hamburgers rises, Income effect you are effectively poorer and therefore consume either fewer hamburgers (if ham- of a price increase burgers are a normal good) or more hamburgers (if hamburgers are an inferior good). A change in When the price of a good goes up, the income effect leads you to consume either less of consumption due to it (this happens if the good is normal) or more of it (this happens if the good is inferior). the fact that you can no longer afford your original basket and are Isolating the Substitution Effect: An Imaginary Experiment therefore effectively poorer. When the price of candy bars goes up, Albert buys fewer candy bars. At the old (low) price, he might have bought 8, but at the new (high) price, he buys only 3. Question: How much of that reduction is due to the income effect and how much to the substitution effect? So far, we have no way to tell. As soon as the price rises, Albert feels both effects simultaneously and responds to both of them simultaneously. All we see is the combined response. Of the 5 candy bars he gave up, were 2 due to the income effect and 3 to the substitution effect? Or 3 and 2? Or 1 and 4? Anything is possible. So let’s try a little experiment. Our goal is to make the income effect go away so that we can observe the substitution effect in isolation. How can we do this? Well, why is there an income effect in the first place? It’s because Albert, faced with higher prices, feels poorer. How can we make that effect go away? Obviously, by making him feel richer. How can we do that? Obviously, by giving him money. So let’s arrange the following experiment. We raise the price of candy bars. At the same time, we leave a few quarters on the ground for Albert to find. When he pushes his shopping cart down the candy aisle, he gets two surprises at once: The price has risen (which makes him feel poorer) and he’s found some money (which makes him feel richer). If we leave him exactly the right amount of money, those effects will cancel, and he’ll feel just as rich as he felt an hour ago. He’ll feel no income effect. Now whatever he does is due to the pure substitution effect. If he puts, say, 5 candy bars in his cart instead of his usual 8, then we can conclude that the substitution effect causes him to give up exactly 3 candy bars. At this point, we can walk up to Albert, tap him on the shoulder, and say: “Excuse me, but I believe those are my quarters.” He returns the money, goes back to feeling poorer, and returns 2 of his 5 candy bars to the shelf, keeping 3. This movement is entirely a result of his feeling poorer, so we’re seeing the pure income effect, which we now know is responsible for his giving up exactly 2 candy bars.

Visualizing the Imaginary Experiment Exhibit 4.9 illustrates our imaginary experiment. In panel A, Albert enters the grocery store expecting to find candy bars on sale at their traditional price. He therefore expects to have the Original budget line, where his tangency is at point A and he buys 8 candy bars. But when he arrives at the candy aisle, he sees that the price has risen. This causes his budget line to pivot in to the location of the New budget line, where his tangency is at B. He therefore buys 3 candy bars. The reduction from 8 to 3 is due to the income and substitution effects combined.

45185_04_ch04_p081-114.indd 91 20/05/10 5:24 AM 92 NOTCHAPTER 4 FOR SALE That didn’t help us distinguish one effect from the other, so we start all over again. This time, we leave some quarters for Albert to find just at the moment when he notices the price increase. The price increase still pivots his budget line in to the New location, but then the cash windfall shifts that budget line outward, parallel to itself. How far out does the budget line shift? That depends on how much cash we give him. How much cash should we give him? Enough to just cancel the income effect. How much is that? Enough to leave him feeling neither richer nor poorer than he was an hour ago. What exactly does that mean? The notion of “feeling richer” is a little vague, but we can interpret it to mean that Albert should be exactly as happy as he was an hour ago. In other words, we give him just enough cash so that he can reach a tangency on his Original budget line. In panel B of Exhibit 4.9, this means that we give him just enough cash to shift his New budget line until it’s tangent to his original indifference curve. Think of the New line as gradually shifting outward as we leave more and more money for Albert to find; we stop adding to the pile when the budget line just touches the upper indifference curve at a tangency which we label C. The resulting budget line is called Albert’s Compensated budget line, because the additional income exactly compensates for the price increase (in the sense that it leaves him just as happy as he was an hour ago).

When they shift the New budget line outward, students sometimes try to make it tangent to the upper indifference curve at point A. This can’t be correct, because the Original budget line is already tangent there. Two different lines cannot be tangent to Dangerous the same curve at the same point. Curve Having discovered both the price increase and the cash, Albert is now on his Compensated budget line, where he chooses point C, with 5 candy bars. The movement from A to C—that is, the movement from 8 candy bars to 5—is a pure substitution effect. Now is when we give Albert the bad news that he doesn’t get to keep the change. This shifts his budget line back from the Compensated location to the New location. He shifts from point C to point B, or in other words from 5 candy bars to 3. This is the pure income effect.

Sorting It All Out In ordinary circumstances, Albert does his shopping without a mad experimenter following in his wake. Therefore, in ordinary circumstances, panel A of Exhibit 4.9 tells the whole story. The price of candy rises, Albert feels two effects at once, and he moves to point B because of the two effects combined—as indicated by the horizontal arrow in panel C of the exhibit. But even though Albert moves directly from A to B, we can always imagine that for a brief moment he received some additional cash, moving him to C, and then the additional cash was taken away from him, moving him back to B again. The first move is the pure substitution effect and the second move is the pure income effect, as indicated by the other two arrows in panel C.

Notice that a price change causes two effects whereas a price change accompanied by an offsetting income increase causes one effect. Dangerous Curve

45185_04_ch04_p081-114.indd 92 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 93

EXHIBIT 4.9 Income and Substitution Effects

All All Other Other Goods Goods

B B

A A

Original

New New Original Compensated

0 3 8 0 35 8 Candy Bars Candy Bars A. A price increase B. Income compensation

Price rises A (Income + Substitution) B

Substitution Prices rises and income Income falls rises (Income)

C C. Schematic

Albert starts with the Original budget line and chooses tangency A. If the price of candy bars increases, the budget line pivots in to the New location and he chooses tangency B. The move from A to B is caused by the income and substitution effects together, as indicated by the horizontal arrow in panel C. In panel B, we imagine that Albert’s income rises at the same moment that he discovers the candy price increase. This shifts his New budget line out parallel to itself. The more his income rises, the further the budget line shifts. We assume that either by coincidence or through the design of a mad experimenter, Albert’s budget line shifts until it just touches his original indifference curve, giving him a new tangency at point C. The resulting budget line is labeled Compensated because the income increase just compensates him for the price increase, leaving him just as happy as he was an hour ago. The movement from A to C is a pure substitution effect, as indicated by the downward sloping arrow in panel C. If Albert then loses his newfound income, he returns to the New budget line and point B; this move from C to B is a pure income effect. In reality, Albert is not compensated for price changes, so he moves directly from A to B. But to separate the substitution and income effects, we can always imagine that he moves first to C and then to B.

45185_04_ch04_p081-114.indd 93 20/05/10 5:24 AM 94 NOTCHAPTER 4 FOR SALE Exercise 4.7 Suppose the price of candy bars were to fall. Draw a diagram analogous to Exhibit 4.9 showing how Albert’s consumption changes and separating the change into a substitution effect and an income effect. (Hint: When the price of candy bars falls, Albert feels happier than before. To eliminate the income effect, you have to “ compensate” him negatively, by taking income away until he is no happier than before.)

Why Demand Curves Slope Downward Exhibit 4.10 is a reminder that the shape of the demand curve depends on the configu- ration of the indifference curves. At the original price of candy bars, Albert chooses tangency A and buys 8 candy bars; this is recorded by point A′ on the demand curve. At the higher new price of candy bars, Albert chooses tangency B and buys 3 candy bars. This is recorded by point B′ on the demand curve. Why does the demand curve slope downward? Because point B′ (corresponding to the higher price) is to the left of point A′. (That is, higher prices go with lower quantities.) Why is B′ to the left of A′? Because B is left of A on the indifference curve diagram. So, if you want to know why demand curves slope downward, you’ve got to ask: Why is B to the left of A? Here’s where we can use what we’ve learned about income and substitution effects.

EXHIBIT 4.10 Why Demand Curves Slope Downward

All Other Goods

Price

New price BЈ

Original AЈ New price Original D

0 3 8 0 3 8 Candy Bars Quantity (Candy bars) A. Indifference curves B. The demand curve Points A and B on the indifference curve diagram give rise to points A′ and B′ on the demand curve diagram. The demand curve slopes downward because B′ is to the left of A′. In turn, B′ is to the left of A′ because B is to the left of A. So asking “Why do demand curves slope downward?” is the same as asking “Why is B to the left of A?”

45185_04_ch04_p081-114.indd 94 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 95 The first panel of Exhibit 4.11 reproduces the income and substitution effects that were illustrated in Exhibit 4.9. Remember that when the price of good X rises, the substitution effect is the move from A to C and the income effect is the move from C to B. Now let’s do some geometry. Some Geometric Observations Here are three key observations about the points in Exhibit 4.11: 1. C is always to the left of A. Here’s why: C and A are on the same indifference curve, but C is the tangency with a steeper line, so C must be on a steeper part of the curve. Steeper parts of the curve are always to the left. (Notice that this purely geometric observation is equivalent to something we observed earlier: When the price of a good goes up, the substitution effect always leads you to consume less of it.) 2. If X is a normal good, then B is to the left of C. Here’s why: The move from C to B represents a pure change in income (C and B are tangencies with parallel budget lines). When you move from the Compensated line to the New line, income falls, so you consume less X; that is, you move to the left. 3. If X is an inferior good, then B is to the right of C. In other words, when income falls, you consume more of the inferior good X. (In Exhibit 4.11, B is drawn to the left of C, so in this case X is a normal good.)

EXHIBIT 4.11 Income and Substitution Effects

1. Normal good BC A Income effect Substitution effect

2. Ordinary inferior good C Substitution effect Y B CAB A Income effect

Original 3. Giffen good New C A B Compensated Substitution effect

0 X Income effect

When the price of X rises, the consumer moves from A to B. This move can be broken down into a substitution effect (from A to C) followed by an income effect (from C to B). The move from A to C is always leftward. If X is normal, the move from C to B is also leftward, so the move from A to B is leftward; therefore, X is ordinary. If X is inferior, the move from C to B is rightward. This allows two possibilities: Either B is to the left of A (this happens when the income effect is small), so that X is ordinary, or B is to the right of A (this happens when the income effect is large), so that X is Giffen.

45185_04_ch04_p081-114.indd 95 20/05/10 5:24 AM 96 NOTCHAPTER 4 FOR SALE The Demand Curve for a Normal Good Suppose that X is a normal good. When the price of X goes up, the consumer in Exhibit 4.11 moves from A to B. What is the direction of that move? We know from the first of our geometric observations that C is to the left of A. Because we’ve assumed that X is normal, we know from the second observation that B is to the left of C. Using your best IQ-test skills, what can you conclude about the relative positions of A and B? The answer is revealed in the top row of the right-hand panel in Exhibit 4.11, where you can see that B must be to the left of A. In other words, when the price of X goes up, the quantity demanded goes down. In still other words, X is an ordinary (i.e., non- Giffen) good. Because this argument applies whenever X is normal, we can summarize our conclusion as follows: A normal good cannot be Giffen. We’ve just discovered something truly remarkable. To say that a good is normal is to say something about the response to an income change. To say that a good is Giffen is to say something about the response to a price change. There is no obvious reason why these conditions should have anything to do with one another. But our analysis reveals that they are closely related nevertheless: No normal good can ever be Giffen. The demand curve for a normal good is sure to slope downward. Although we’ve phrased the argument in terms of geometry, we can translate it into economics. When the price of X goes up, the substitution effect (from A to C) must cause the quantity demanded to fall. At the same time, the income effect (from C to B) also causes the quantity demanded to fall. These effects reinforce each other, and the quantity demanded certainly falls.

The Demand Curve for an Inferior Good Now suppose that X is an inferior good. When the price of X goes up, the consumer in Exhibit 4.11 moves from A to B. What is the direction of that move? We know from the first geometric observation that C is to the left of A. Because we’ve assumed that X is inferior, we know from the second observation that B is to the right of C. Bringing your IQ-test skills to bear on this problem, you’ll quickly discover that you can draw no certain conclusion about the relative locations of points A and B. There are two possibilities, illustrated in the second and third rows of the right-hand panel in Exhibit 4.11. When the substitution effect is larger than the income effect, B is to the left of A (so that X is ordinary) but when the income effect is larger than the substitution effect, B is to the right of A (so that X is Giffen). The two panels of Exhibit 4.12 show that each of these possibilities can occur. Therefore: An inferior good is ordinary if the substitution effect exceeds the income effect, but Giffen if the income effect exceeds the substitution effect. The economic interpretation is straightforward: When the price of X goes up, the substitution effect (from A to C) causes the quantity demanded to fall. At the same time, the income effect (from C to B) causes the quantity demanded to rise (because X is an inferior good). These effects work in opposite directions, so the quantity demanded of X can fall or rise, depending on which effect is bigger.

45185_04_ch04_p081-114.indd 96 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 97

EXHIBIT 4.12 Income and Substitution Effects for an Inferior Good

C C

Y Y A A B Compensated

Low price Low High High B price price price Compensated

0 0 X X

In both panels, X is an inferior good; that is, B is to the right of C. In the first panel, X is ordinary (i.e., not Giffen); that is, B is to the left of A. In the second panel, X is Giffen; that is, B is to the right of A.

The Size of the Income Effect Suppose the price of bubble gum rises. Will you feel slightly poorer or a lot poorer? Unless you are a very unusual person—that is, unless you spend a very substantial portion of your income on bubble gum—you will feel only slightly poorer. Therefore, the income effect, which is caused by that sense of being poorer, is likely to be small. On the other hand, suppose the price of college tuition rises. Depending on who’s paying for your education, there’s a good chance you’ll now feel quite substantially poorer. If tuition expenses account for a substantial fraction of your income, the income effect might be considerable. In general, the income effect of a price change is large only for goods that account for a large fraction of your expenditure. The laws of arithmetic dictate that there can’t be very many such goods (for example, there can be no more than 3 goods that account for at least ∕3 of your expenditure). So large income effects are relatively rare.

Giffen Goods Revisited A Giffen good must satisfy two conditions. First, it must be inferior (because a normal good cannot be Giffen). Second, it must account for a substantial fraction of your expenditure (because an inferior good is Giffen only when the income effect exceeds the substitution effect). Each of these conditions is unusual. Many goods are inferior, but most are not. And only very few goods can account for substantial fractions of your expenditure. Thus, in order to be Giffen, a good must satisfy two unusual conditions at once. This explains why Giffen goods are rare.

45185_04_ch04_p081-114.indd 97 20/05/10 5:24 AM 98 NOTCHAPTER 4 FOR SALE In fact, one can make an even stronger argument. We’ve said that a randomly chosen good is likely to be normal. But we can also say that if the randomly chosen good accounts for a large fraction of your expenditure, then it’s particularly likely to be normal. Here’s why: When your income increases, you have to spend the excess on something, and the goods on which you spend relatively little are unlikely to soak up much of that excess. For example, if your income rises by $100 per week, it is unlikely that you’ll devote the entire $100 to bubble gum—to do so would require an implau- Dangerous sibly large percentage increase in your bubble gum expenditures. Instead, some of the Curve $100 will probably go toward the goods that account for the bulk of your expenditure— which means that those goods are probably normal. So not only do Giffen goods have to satisfy two improbable conditions but one of those improbable conditions causes the other to become even more improbable.

Here’s a hypothetical example. Suppose you eat hamburger six days a week and steak on Sunday; suppose also that hamburger is an inferior good. One day the price of hamburger rises. Because you eat so much hamburger, this makes you feel a lot poorer. Because you are now so much poorer, you decide to cut out steak entirely and eat hamburgers seven days a week. When the price of hamburgers goes up, the quantity demanded goes up. In this case, hamburgers are a Giffen good. For this story to work, hamburgers must be inferior and you must spend so much on hamburger that the price increase has a major impact on your lifestyle. The moral of Exhibit 4.11 is that this story about hamburgers is essentially the only story that could ever produce a Giffen good.

Example: “Bad” Cigarettes as Giffen Goods In the real world, big income effects are rare, which is part of why Giffen goods are rare. But in the laboratory, big income effects are easy to create, so the laboratory is where we should look for Giffen goods. In one experiment,1 a group of heavy smokers were given incomes of $6 each. They could purchase puffs on either “good” cigarettes (that is, brands they liked a lot) or “bad” cigarettes (brands they liked less). At a price of 25¢ per good puff and 5¢ per bad puff, a typical subject chose 20 puffs of each. For the duration of the experiment, subjects couldn’t buy anything but cigarette puffs. Therefore, both good and bad puffs accounted for substantial fractions of their spending. (One sixth of their spending went to bad cigarettes; by contrast, very few of us spend anywhere close to one sixth of our incomes on any one thing.) All income effects were therefore large. Also, it’s reasonable to expect that bad puffs should be an inferior good. This makes the conditions exactly right for bad puffs to be not just inferior, but also Giffen. And that’s exactly what happens. When the price of a bad puff is increased to 12.5¢, our typical subject chooses 24 bad puffs instead of 20. This is exactly what we’d expect based on the logic of the hypothetical hamburger/steak example above. That example remains hypothetical because in the real world, the income effect associated with hamburger is unlikely to be extremely large. Thus, the cigarette experiment confirms our conclusion that Giffen goods arise from large income effects, which reinforces our explanation of why they’re rarely observed.

1 R.J. DeGrandpre, Warren Bickel, S. Abu Turab Rizvi, and John Hughes, “Effects of Income on Drug Choice in Humans,” Journal of the Experimental Analysis of Behavior 59 (1993): 483–500.

45185_04_ch04_p081-114.indd 98 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 99 The Compensated Demand Curve When the price of lettuce rises from $1 to $3, Bugs reduces his consumption from 7 heads of lettuce per day to 1 head of lettuce per day. You can see in the first panel of Exhibit 4.13 that his consumption is reduced from 7 to 3 by the substitution effect and from 3 to 1 by the income effect. Bugs’s demand curve, shown in the third panel, records the combined effect by showing that his consumption falls from 7 to 1. But for some applications, it is useful to keep track of the substitution effect independent of the income effect. (We will meet some of these applications in Chapter 8.) In order to do that, we can draw Bugs’s compensated demand curve, which shows that Compensated at a price of $3, he would consume 3 heads of lettuce—in the hypothetical circumstance demand curve where he feels no income effect. A curve showing, You can imagine Bugs as the subject of an imaginary experiment, where every time for each price, the price of lettuce changes, experimenters adjust his income to keep him on his origi- what the quantity nal indifference curve; we summarize this condition by saying that Bugs is income- demanded would be compensated for all price changes. The compensated demand curve shows how much if the consumer were lettuce Bugs would consume if he were the subject of that experiment. income-compensated Because the substitution effect of a price increase always reduces the quantity for all price changes. demanded, it follows that the compensated demand curve must slope down. In terms of Exhibit 4.13, point C in the first panel is always to the left of point A; therefore, point C′ in the second panel is always to the left of point A′. Again, the conclusion is that the compensated demand curve slopes downward. This is in contrast to the ordinary (uncompensated) demand curve, which slopes upward in the case of a Giffen good.

The ordinary (uncompensated) demand curve describes the behavior of actual consumers in actual markets. Whenever we use the unqualified phrase “demand curve,” we

always mean the ordinary (uncompensated) demand curve. Dangerous Curve

EXHIBIT 4.13 Compensated and Uncompensated Demand Curve

All Price of Price of Other Lettuce Lettuce Goods Compensated Ordinary demand curve (uncompensated) demand curve C CЈ BЈ $3 $3

B A

AЈ AЈ Price 5 =1 $1 $1 Price 5 = 3 Compensated 0 1 3 7 0 37 0 17 Quantity of Lettuce Quantity of Lettuce Quantity of Lettuce

When the price of lettuce rises from $1 to $3, Bugs reduces his consumption from 7 heads to 1; this is recorded by the ordinary demand curve in the rightmost panel. If he were income-compensated for the price change, he would reduce his consumption from 7 heads to 3; this is recorded by the compensated demand curve in the center panel.

45185_04_ch04_p081-114.indd 99 20/05/10 5:24 AM 100 NOTCHAPTER 4 FOR SALE 4.4 Elasticities

If you owned a clothing store, you’d want to be able to anticipate changes in your customers’ buying habits. From the material we have developed so far, you’d be able to draw two general conclusions. First, if their income increases, your customers will probably buy more clothes. Second, if the price of clothing falls, your customers will almost surely buy more clothes. As the owner of a business who is trying to foresee market conditions, you might find these revelations unsatisfying. Although they predict the directions of change, they say nothing about the magnitude of change. What you really want to know is: If my customers’ incomes increase by a certain amount, by how much will they increase their expenditures on clothing? If the price falls by a certain amount, by how much will the quantity demanded increase? Elasticities are numbers that answer these questions. In this section, we will learn what elasticities are and see some sample estimates.

Income Elasticity of Demand First we will consider the response to a change in income. This response is depicted by the Engel curve, and one way to measure it is by the slope of that curve. We ask: If your income increased by $1, by how many units would you increase your consumption of X? That number is the slope of your Engel curve. Unfortunately, this slope is arbitrary. For one thing, it depends on the units in which X is measured. When your income goes up by $1, your yearly coffee consumption might go up by 6 cups, which is the same as 1 pot. If coffee is measured in cups, your Engel curve has slope 6; if coffee is measured in pots, it has slope 1. For another thing, the slope depends on the units in which your income is measured. Your coffee consumption will respond differently if your income increases by one Italian lira instead of one U.S. dollar. Therefore, we adopt a different measure, one that does not depend on the choice of units. Instead of asking, “If your income increased by one dollar, by how many units would you increase your consumption of X?” we ask, “If your income increased by 1%, by what percent would you increase your consumption of X?” The answer to this question is a number that does not depend on the choice of units. That number is called the Income elasticity elasticity of your Engel curve, or your income elasticity of demand. of demand If your income I changes by an amount ΔI, then the percent change in your income is The percent change given by 100 × ΔI/I. If the quantity of X that you consume, Q, changes by an amount ΔQ, in consumption that then the percent change in consumption is 100 × ΔQ/Q. The formula for income elasticity is results from a 1% Percent change in quantity increase in income. Income elasticity = Percent change in income 100 · ΔQ/Q = 100 · ΔI/I I · ΔQ = Q · ΔI Suppose, for example, that your Engel curve for X is the one depicted in panel B of Exhibit 4.4. When your income increases from $8 to $12 (a 50% increase), your consumption of X increases from 6 to 12 (a 100% increase). In this region, your income elasticity of demand is 100%/50% =2.

45185_04_ch04_p081-114.indd 100 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 101 On the other hand, when your income increases from $4 to $8, your consumption of X increases from 3 to 6; a 100% increase in income yields a 100% increase in quantity, so your income elasticity of demand in this region is 1.

Exercise 4.8 What would it mean for your income elasticity of demand for X to be negative?

Applications Suppose again that you own a clothing store, you foresee an increase in your customers’ incomes, and you want to anticipate the change in their clothing expenditures. The critical bit of information is the income elasticity of demand for clothing. In fact, that elasticity has been estimated at about .95.2 If your customers’ incomes increase by 10%, you may expect them to increase their expenditures on clothing by about 9.5%. Following an increase in income, it usually takes time for people to fully adjust their spending patterns. Thus, we can estimate both a short-run and a long-run income elasticity, reflecting an initial partial response to an income increase and the ultimate full response. We expect the long-run elasticity to exceed the short-run elasticity, and for clothing this is indeed the case. Although the short-run elasticity is .95, the long-run elasticity is 1.17. Following a 10% increase in income, people initially increase expenditures on clothing by 9.5%, but ultimately increase expenditures by 11.7%. Income elasticities take a wide range of values. The income elasticity of demand for an inferior good is negative. The income elasticity of demand for alcoholic bever- ages is only about .29. (A 10% increase in income leads to a 2.9% increase in expenditure on alcohol.) The income elasticity of demand for jewelry is about 1, so that expenditure on jewelry increases roughly in proportion with income. The income elasticity of demand for household appliances is 2.72. When income increases 10%, expenditure on appliances increases 27.2%. (The estimates in this paragraph are all short-run elasticities.)

The Demand for Quality When people get wealthier, they not only buy more goods, they also buy better goods. If your income goes up by 10 percent, you might replace your microwave or your stereo with a better microwave or a better stereo. When economists estimate income elasticities, they usually count a $2,000 stereo system as the equivalent of two $1,000 stereo systems. So when we say that a 10% increase in income yields a 27.2% increase in expenditure on appliances, that might mean a 27.2% increase in the number of appliances, or a 27.2% increase in the quality of the appliances, or both. (Here we are using price to measure quality, so that by definition a stereo that costs 27.2% more is 27.2% better.) On average over all goods, economists Mark Bils and Pete Klenow estimate that as people become wealthier, quality grows a little more rapidly than quantity. But the ratio of quality changes to quantity changes is very different for different goods. If you’re rich enough to own two microwaves instead of one, they’ll cost, on average, about 25% more than your poorer neighbor’s single unit. The poor family pays (say) $200 for one microwave; the rich family pays $250 apiece for two (presumably better) microwaves.

2 H. Houthakker and L. Taylor, Consumer Demand in the United States, Cambridge: Harvard University Press, 1970. All further elasticity estimates in this chapter are taken from this source.

45185_04_ch04_p081-114.indd 101 20/05/10 5:24 AM 102 NOTCHAPTER 4 FOR SALE But if you’re rich enough to own two living room tables instead of one, the 25% rule no longer holds; now you’ll pay, on average, about 100% more per table. The poor family pays $500 for one living room table while the rich family pays $1,000 apiece for two. A family with twice as many vacuums pays (on average) about 22% more per vacuum; a family with twice as many trucks pays about 140% more per truck.3 These numbers suggest that over time, as families on average become richer, the average quality of living room tables should rise faster than the average quality of microwaves, and the average quality of trucks should rise faster than the average quality of vacuums. Of course, it’s possible that technological consideration will undercut some of these predictions—we could, in principle, reach a point where it’s very hard to make better trucks but still very easy to make better vacuums.

Price Elasticity of Demand When the price of salt goes up, people buy less salt. When the price of fresh tomatoes goes up, people buy fewer tomatoes. But the responses are of very different magnitudes. A 10% increase in the price of salt typically leads to about a 1% decrease in the quantity bought. A 10% increase in the price of fresh tomatoes typically leads to about a 46% decrease in the quantity bought. Price elasticity of We express this contrast by saying that the price elasticity of demand for tomatoes demand is 46 times as great as the price elasticity of demand for salt. The percent change More formally, your price elasticity of demand for a good X (also called the elastic- in consumption that ity of your demand curve for X) is defined by the formula: results from a 1% Percent change in quantity increase in price. Price elasticity = Percent change in price 100 · ΔQ/Q = 100 · ΔP/P P · ΔQ = Q · ΔP If your demand curve for X slopes downward, then the price elasticity is negative, because an increase (that is, a positive change) in price is associated with a decrease (that is, a negative change) in quantity. For example, suppose that a price of $2 corresponds to a quantity of 5 and a price of $3 corresponds to a quantity of 4. Then a 50% price increase yields a 20% quantity decrease, so the price elasticity of demand is (−20%)/50% = −.4 Just as we can talk about your personal price elasticity of demand for X, so we can talk about the market’s price elasticity of demand for X. Again, we divide the percent change in quantity by the percent change in price, only now we take our quantities from the market demand curve instead of your personal demand curve.

Exercise 4.9 Use the formula for price elasticity and the information given at the beginning of this subsection to show that the price elasticities of demand for salt and for fresh tomatoes are −.1 and −4.6.

We say that the demand for a good is highly elastic when the price elasticity of demand for that good has a large absolute value. Thus the demand for tomatoes is

3 The numbers in this paragraph, and the idea of estimating elasticities for “quality Engel curves,” come from M. Bils and P. Klenow, “Quantifying Quality Growth,” American Economic Review, September 2001.

45185_04_ch04_p081-114.indd 102 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 103 highly elastic when compared with the demand for salt. We also say that the demand for tomatoes is more elastic than the demand for salt. The next question is: why? Why are tomato buyers so much more price-sensitive than salt buyers? One key factor is the availability of substitutes. If the price of tomatoes goes up, you can substitute any of a dozen other vegetables in your salad. Whenever a good has many substitutes, the demand tends to be highly elastic. That’s why the elasticity of demand for Chevrolets is about −4.0 even though the elasticity of demand for cars is around −1.3. There are many good substitutes for a Chevrolet (like a Ford) but not so many good substitutes for a car. Likewise, most soft drinks (like Coke, Diet Coke, or Pepsi) have highly elastic demand curves with elasticities in the range of −3 to −4. For the same reason, we expect that the demand for Hostess Twinkies is more elastic than the demand for packaged cakes; the demand for packaged cakes is more elastic than the demand for snack foods; and the demand for snack foods is more elastic than the demand for food generally.

For a given income and quantity of X, high income elasticity is reflected in a relatively steep Engel curve. For a given price and quantity of X, high price elasticity is reflected in a relatively flat demand curve. The apparent paradox occurs because the quantity of X is plotted on the vertical axis for an Engel curve and on the horizontal axis for a Dangerous demand curve. Curve

The price elasticity of demand for electricity is −.13, for water −.20, for jewelry −.41, for shoes −.73, and for tobacco −1.4. If the price of electricity rises by 10%, the quantity demanded falls by 1.3%. If the price of water rises by 10%, the quantity demanded falls by 2%.

Exercise 4.10 If the price of jewelry rises by 10%, by how much does the quantity demanded fall? How about for shoes? For tobacco?

The Relationship between Price Elasticity and Income Elasticity When the price goes up, the quantity demanded goes down, usually for two reasons: a substitution effect and an income effect. So the price elasticity of demand depends both on the size of the substitution effect and on the size and direction of the income effect. The income effect is larger for goods that consume a larger fraction of your income. The income effect is also larger for goods with high income elasticities of demand. The direction of the income effect depends on whether the good is normal or inferior. For normal goods, a larger income effect means a larger price elasticity of demand; for inferior goods the opposite is true. For example, suppose you go to the movies once a week and spend $10 per movie, while you go to the live theater twice a year and spend $50 each time. Then over the course of a year, you’re spending about five times as much on movies as on the theater. This suggests that changes in the price of movies should have larger income effects than changes in the price of live theater performances. So it’s a good guess that your price elasticity of demand is higher for the movies. Similarly, if you eat out at McDonald’s 300 nights a year, spending $5 each time for a total of $1,500, and at the 21 Club once a year, spending $200, then your price elasticity of demand for McDonald’s hamburgers is probably higher than your price elasticity of demand for dinners at the 21 Club. If the 21 Club raises its prices by 10%, it will lose

45185_04_ch04_p081-114.indd 103 20/05/10 5:24 AM 104 NOTCHAPTER 4 FOR SALE some fraction of your business, but if McDonald’s raises its prices by 10%, it will lose a larger fraction of your business.

Cross Elasticities One other circumstance that can affect your demand for X is a change in the price of Cross elasticity of some other good Y. The cross elasticity of demand for X with respect to Y is a measure demand of the size of this effect; it is the percent change in consumption of X divided by the The percent change percent change in the price of Y. in consumption that A change in the price of Y could cause your consumption of X to either rise or results from a 1% fall. In the first case, your cross elasticity of demand is positive, and in the second it is increase in the price of negative. If X is coffee and Y is tea, the cross elasticity is likely to be positive: When the a related good. price of tea increases by 1%, your coffee consumption is likely to increase. The percent by which it increases (a positive number) is the cross elasticity of demand. But if X is Substitutes coffee and Y is cream, a 1% increase in the price of cream is likely to lead to a decrease Goods for which the (that is, a negative percentage change) in the price of coffee, and so in this case the cross cross elasticity of elasticity of demand is negative. demand is positive. When the cross elasticity of demand for X with respect to Y is positive, we say that X and Y are substitutes. When it is negative, we say that they are complements. Complements Substitutes, as the name indicates, tend to be goods that can be substituted for each Goods for which the other, as in our example of tea and coffee. Other examples might be Coke and Pepsi, or cross elasticity of train tickets and airline tickets. Complements tend to be goods that are used together— demand is negative. each complements the other. We have seen the example of coffee and cream. Other pairs of complements might be computers and floppy disks, or textbooks and college courses.

Example: Is Coke the Same as Pepsi? Coke is quite a good substitute for Pepsi; we know this because the cross elasticity of demand4 is a relatively large .34, that is, when the price of Pepsi rises 1%, sales of Coke rise a hefty .34%. That perhaps is not surprising. What’s more surprising is that (regular) Coke is an even better substitute for Diet Pepsi; here the cross elasticity of demand is an even larger .45. But Coke is above all a close substitute for Diet Coke where the cross elasticity is an enormous 1.15. By and large, Coke and Pepsi are good substitutes for most other soft drinks. When the price of Mountain Dew goes up, a lot of people switch to Pepsi (cross elasticity .77). But the reverse is false; when the price of Pepsi goes up, very few people switch to Mountain Dew (cross elasticity only .08).

Elasticities and Monopoly Power Does the McDonald’s hamburger chain have a monopoly on the products it sells? If consumers think that there is no close substitute for a McDonald’s hamburger, then the answer is yes. On the other hand, if consumers think that a Burger King hamburger and a McDonald’s hamburger are indistinguishable, then McDonald’s faces heavy competition. When courts are called upon to decide whether a firm has monopoly power, they must ask whether competing firms offer products that are close substitutes in the

4 All the cross elasticities in this section are from Jean-Pierre Dube, “Product Differentiation and Mergers in the Carbonated Soft Drink Industry,” Journal of Economics and Management Strategy 14 (2005): 879–904.

45185_04_ch04_p081-114.indd 104 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 105 minds of consumers. But how is the court to tell whether an alternative product is viewed as a close substitute? A solution is to examine the cross elasticity of demand. Suppose that the cross elasticity of demand between McDonald’s and Burger King hamburgers is positive and large. Then the goods are close substitutes and Burger King competes in essentially the same market as McDonald’s. The large cross elasticity means that if McDonald’s tries to raise its prices, a lot of customers will switch to Burger King, so that McDonald’s monopoly power is severely limited. On the other hand, if the cross elasticity is small, McDonald’s needs to worry much less about this kind of competition. Large cross elasticities are evidence of competition and small cross elasticities are evidence of monopoly. Because of the relatively large cross elasticities that are common between soft drinks, regulators have been reluctant to approve mergers between soft drink companies. In recent decades, Coke has been prohibited from acquiring Dr. Pepper, and Pepsi withdrew its interest in acquiring Mountain Dew in anticipation of a negative ruling.

Summary

Changes in the consumer’s opportunities lead to changes in the optimal consumption basket. Changes in opportunities arise from changes in income and changes in prices. A change in income causes a parallel shift in the budget line. When income rises, consumption of the good X can either rise (in which case X is called a normal good) or fall (in which case X is called an inferior good). If we fix the prices of goods X and Y, we can draw budget lines corresponding to various levels of income. If we also know the consumer’s indifference curves, we can find the optimal basket corresponding to each level of income and read off the quantity of X associated with each level of income. We can plot this information on a graph, with income on the horizontal axis and quantity of X on the vertical. The resulting curve is called an Engel curve. The Engel curve slopes upward for a normal good and downward for an inferior good. A change in the price of X causes the budget line to pivot around its Y-intercept—outward for a fall in price and inward for a rise in price. A rise in price can cause the quantity of X demanded to fall (in which case X is called an ordinary good) or rise (in which case X is called a Giffen good). If we fix the price of Y and the consumer’s income, we can draw budget lines corresponding to various prices of X. If we also know the consumer’s indifference curves, we can find the optimal basket associated with each price of X and read off the quantity of X associated with each price. We can plot this information on a graph, with price on the vertical axis and quantity on the horizontal. The resulting curve is the demand curve for X. The demand curve slopes downward if X is not Giffen and upward if X is Giffen. When the price of X goes up, the consumer changes his consumption of X for two reasons. First, there is the substitution effect: Consumers will not purchase goods whose marginal value is below the price. Second, there is the income effect: Consumers are made effectively poorer when a price goes up. The substitution effect always reduces consumption of X. The income effect reduces consumption of X if X is a normal good, but increases consumption of X if X is an inferior good.

45185_04_ch04_p081-114.indd 105 20/05/10 5:24 AM 106 NOTCHAPTER 4 FOR SALE For a normal good, the substitution and income effects work in the same direction, ensuring that when the price goes up the quantity demanded goes down. Thus, a normal good cannot be Giffen. For an inferior good, the substitution and income effects work in opposite directions: If the substitution effect is greater, the good is not Giffen, but if the income effect is greater, the good is Giffen. The compensated demand curve shows, for each price, the quantity of X the consumer would demand if he were income-compensated for every price change. Thus, the compensated demand curve shows only the substitution effect and so must slope downward.

Author Commentary academic.cengage.com/economics/landsburg

AC1. Just as consumers demand more goods when their income rises, they also demand higher quality goods when their income rises. We can measure that demand for quality by starting with the formula for income elasticity and replacing “percentage change in quantity” with “percentage change in quality.”

Review Questions

R1. When income rises, how does the budget line move? R2. What is the definition of an inferior good? What is the definition of a normal good? R3. Suppose the price of X is $3 per unit and the price of Y is $5 per unit. Given the following indifference curve diagram, construct three points on the Engel curve for X.

X 3 5 6 8 10 15

R4. When the price of X goes up, how does the budget line move? R5. What is the definition of a Giffen good?

45185_04_ch04_p081-114.indd 106 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 107 R6. Suppose the price of Y is $6 per unit and your income is $24. Given the following indifference curve diagram, construct three points on the demand curve for X.

X 23 4 56 8

R7. Draw a diagram to illustrate the income and substitution effects of a price increase. R8. When the price of a good increases, what is the direction of the substitution effect? Use the geometry of the indifference curves to justify your answer. R9. When the price of a normal good increases, what is the direction of the income effect? When the price of an inferior good increases, what is the direction of the income effect? R10. Are all Giffen goods inferior? Are all inferior goods Giffen? Justify your answer in terms of the directions of the income and substitution effects. R11. What is the difference between a compensated demand curve and an ordinary demand curve? R12. Must the compensated demand curve always slope downward? Why or why not? R13. Give the formulas for the income elasticity of demand and price elasticity of demand. R14. In review question 3, compute the income elasticity of demand for X as income rises from $15 to $30. R15. In review question 6, compute the price elasticity of demand for X as the price rises from $4 to $8. R16. The price elasticity of demand for coffee is about –.25. Suppose that when the price is 50¢ per cup, consumes demand 1,000 cups per day. If the price rises to 60¢ per cup, how many cups will be demanded?

Numerical Exercises

N1. Suppose your indifference curves are all described by equations of the form x y = constant, with a different constant for each indifference curve. a. Show that for any point P = ( x, y), the indifference curve through P has slope −y/x at P. (This requires calculus. If you don’t know enough calculus, you can just pretend you’ve solved this part and go on to part (b).)

45185_04_ch04_p081-114.indd 107 20/05/10 5:24 AM 108 NOTCHAPTER 4 FOR SALE b. Suppose that your income is $40, the price of X is $1, and the price of Y is $1. How much X do you buy? Hint: The problem is to find your optimal basket (x, y). First write down an equation that says (x, y) is on the budget line. Next write down an equation that says the slope of the indifference curve at (x, y) is equal to the slope of the budget line at (x, y). (Remember that you have a formula for the slope of the budget line from part (a), and that you can compute the slope of the budget line from the prices of X and Y.) Then solve these two equations simultaneously. c. Suppose your income and the price of Y remain as above, but the price of X rises to $4. Now how much X do you consume? (Use the same hint as in part (b).) d. Based on your answers to parts (b) and (c), draw two points on your demand curve for X. e. After the price of X rises from $1 to $4, suppose that your income rises by just enough to bring you back to your original indifference curve. Now how much X do you buy? (Hint: The problem is to find the basket (x, y) where the compensated budget line is tangent to the original indifference curve.) First write down the equation of the original indifference curve (remember that it is of the form xy = constant, and you can figure out the constant because you already know the coordinates of one point on that curve). Next write down an equation that expresses the condition that the slope of the indifference curve must equal the slope of the compensated budget line. Then solve these two equations simultaneously. f. When the price of X rises from $1 to $4, how much of the change in your consumption is due to the substitution effect? How much is due to the income effect?

N2. Suppose that your Engel curve for X is given by the equation

X = a + bI where I is income and a and b are constants. a. If your income increases from I to I + Δ I, by how much does X increase? b. Write down a formula, in terms of X and I, for your income elasticity of demand for X. c. Use the equation X = a + bI to eliminate I from your formula, and write a formula for income elasticity in terms of X alone. d. As your consumption of X increases, what happens to your income elasticity of demand for X? e. If your Engel curve is a line through the origin, what is your income elasticity of demand for X?

N3. Suppose that your demand curve for X is given by the equation

X = c − dP where P is price and c and d are positive constants. a. Derive a formula for your price elasticity of demand for X, and write your formula in terms of X alone. b. When you consume zero units of X, what is your price elasticity of demand? When the price of X is zero, what is your price elasticity of demand?

45185_04_ch04_p081-114.indd 108 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 109 N4. Suppose that your demand curve for X is given by the equation e X = P where P is price and e is a positive constant. Derive a formula for your price elasticity of demand for X.

Problem Set

1. Suppose the only goods you buy are circus tickets and accounting textbooks. One day the price of circus tickets goes up, the price of accounting textbooks goes down, and you notice that you are exactly as happy as you were before the price changes. a. Are you now buying more or fewer circus tickets than before? b. Can you still afford your original market basket? 2. Suppose the only goods you consume are wine and roses. On Tuesday, the price of wine goes up, and at the same time your income increases by just enough so that you are equally as happy as you were on Monday. a. What happens to the quantity of wine that you consume? Illustrate your answer with indifference curves. b. On Tuesday would you still be able to afford the same basket that you were buying on Monday? How do you know? On Wednesday there are no new price changes (so the Tuesday prices are still in effect), but your income changes to the point where you can just exactly afford Monday’s basket. c. Are you happier on Wednesday or on Monday? d. Is it possible to say with certainty whether you buy more wine on Wednesday than on Monday? If not, on what would your answer depend? e. Is it possible to say with certainty whether you buy more wine on Wednesday than on Tuesday? If not, on what would your answer depend? 3. The only goods you consume are wine and roses. Between Monday and Tuesday, your income falls. Between Tuesday and Wednesday, your income remains at the Tuesday level, but the price of roses falls. On Wednesday, you are exactly as happy as on Monday. True or False: If you consume more wine on Wednesday than Tuesday, then wine must be a normal good. 4. For Henry, eggs are inferior but not Giffen. On Henry’s indifference curve diagram, illustrate the income and substitution effects when the price of eggs goes up. How does your diagram illustrate that eggs are inferior? How does it illustrate that eggs are not Giffen? 5. In the following diagrams, the black dots represent points where the illustrated lines are tangent to indifference curves.

Y Y Y Y Y

X X X X X Figure A Figure B Figure C Figure D Figure E

45185_04_ch04_p081-114.indd 109 20/05/10 5:24 AM 110 NOTCHAPTER 4 FOR SALE a. In which figure(s) is X a normal good? b. In which figure(s) is X a Giffen good? c. In which figure(s) is Y an inferior good? d. In which figure(s) is Y a Giffen good?

6. Suppose that the only two goods you purchase are X and Y. One day the price of X goes down. a. Illustrate your old and new budget lines. b. Illustrate the substitution and income effects on your consumption of X. c. What is the direction of the substitution effect? Why? d. If X is a normal good, what is the direction of the income effect? Why? e. If X is an inferior good, what is the direction of the income effect? Why? f. True or False: If X is an inferior good, then a fall in price must lead to a rise in consumption, but if X is a normal good, then a fall in price might lead to a fall in consumption. Justify your answer carefully in terms of income and substitution effects. 7. Suppose the only goods you buy are wine and roses. a. Between Monday and Tuesday, the price of wine goes up (while your income remains fixed). Draw a diagram, with wine on the horizontal axis and roses on the vertical, to illustrate how your budget line moves. Illustrate your optimum points on the two budget lines, labeling Monday’s optimum M and Tuesday’s optimum T. b. On Wednesday, the price of wine returns to its Monday level, but at the same moment your income falls by just enough so that you are just as happy on Wednesday as on Tuesday. Draw Wednesday’s optimum point and label it W. In each of parts (c), (d), and (e), determine whether the statement is (1) true always, (2) false always, (3) true if wine is an inferior good, but otherwise false, (4) false if wine is an inferior good, but otherwise true, (5) true if wine is a Giffen good, but otherwise false, or (6) false if wine is a Giffen good but otherwise true. c. M is to the left of T. d. T is to the left of W. e. M is to the left of W. f. True or False: Every Giffen good is an inferior good. Justify your answers by using the earlier parts of this problem, not by using the argument given in the text. 8. Suppose the only two goods you consume are X and Y. On Tuesday, the price of Y (not X!) goes up. On Wednesday, there are no new price changes, but your income rises by just enough so that you can exactly afford Monday’s basket. a. Use a diagram, with X on the horizontal axis and Y on the vertical, to illustrate your budget lines and optimum points on Monday, Tuesday, and Wednesday. Label the optimum points M, T, and W. b. In terms of the locations of points M, T, and W, what would it mean for X to be an inferior good? c. Is it true that W is always to the right of M? If so, how do you know? If not, what would your answer depend on?

45185_04_ch04_p081-114.indd 110 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 111 d. Call X a Figgen good if it is true that “when the price of Y goes up, the quantity demanded of X goes up.” In terms of points M, T, and W, what would it mean for X to be a Figgen good? e. True or False: Every inferior good is a Figgen good. f. True or False: Every Giffen good is a Figgen good. 9. The only goods you consume are eggs and wine. Between Monday and Tuesday, your income rises. On Wednesday, the price of eggs goes up. On Wednesday, you are just as happy as you are on Monday. True or False: If wine is an inferior good, you certainly buy less wine on Tuesday than on Wednesday. Use your diagram to justify your answer. (Note: The price of eggs rises, but the question asks you about the quantity of wine.) 10. The only goods you consume are eggs and wine. On Tuesday, the price of wine increases. On Wednesday, the price of wine returns to its original level, but the price of eggs increases. You are equally happy on Tuesday and Wednesday. a. Draw a graph showing your budget lines on Monday (before either price changes), Tuesday, and Wednesday, and showing your optimum points. Label them M, T, and W. b. True or False: If eggs are a Giffen good, you will certainly consume more eggs on Tuesday than on Monday. Justify your answer by referring to the points on your graph. 11. The following diagram shows your indifference curves for goods X and Y.

X 485 16

a. Is X an ordinary good or a Giffen good? How do you know? b. Is X a normal good or an inferior good? How do you know? c. Suppose your income is $48 and the price of Y is $4 per unit. Give the coordinates of two points on your demand curve for X. (The coordinates of a point consist of a price and a quantity.) 12. Suppose you buy only X and Y, both of which are normal goods. Suppose also that almost all of your income is spent on Y. When the price of X goes up, does the quantity of Y go up or down? 13. When the price of shoes goes up, Tara goes right on buying just as many shoes as before. True or False: Shoes could not possibly be an inferior good for Tara. 14. Tara buys only shoes and socks. When the price of shoes goes up, Tara continues buying exactly the same number of socks as before. True or False: Socks could not possibly be an inferior good for Tara.

45185_04_ch04_p081-114.indd 111 20/05/10 5:24 AM 112 NOTCHAPTER 4 FOR SALE 15. Sam consumes only green eggs and ham. Ham is an inferior good for Sam. One day the price of green eggs goes up. a. Illustrate Sam’s old and new optimum points, and show both the substitution and the income effects. How does this graph reflect the fact that ham is an inferior good? b. True or False: When the price of green eggs goes up, Sam certainly buys more ham than before. Justify your answer carefully, by considering the directions of both the substitution and income effects.

16. Leopold consumes only kidneys and liver. When the price of kidneys rises, Leopold responds by eating less liver. a. Can you determine whether liver is an inferior good for Leopold? b. Can you determine whether liver is a Giffen good for Leopold? c. Extra Credit: what is Leopold’s last name?

17. Bugs consumes carrots and lettuce, both of which are normal goods. Suppose the price of carrots rises. a. Illustrate the substitution and income effects. b. Does the substitution effect lead to an increase or a decrease in Bugs’s lettuce consumption? Justify your answer. (Note: The price of carrots changed, but you are asked about the effect on the quantity of lettuce.) c. Does the income effect lead to an increase or a decrease in Bugs’s lettuce consumption? Justify your answer. d. Assume Bugs spends very little of his income on carrots. When the price of carrots rises, do you expect his lettuce consumption to go up or down? Why? 18. In January, root beer and orange soda each cost $1 a bottle. Judith’s income is $20. She buys 5 root beers and 15 orange sodas. In February, the price of root beer falls to 50¢, the price of orange soda rises to $2, Judith’s income remains $20, and she still buys exactly 5 root beers. True or False: Root beer is a normal good for Judith. 19. In April, Frieda pays $2 apiece for eggs and $1 apiece for sodas. Her income is $40. She buys 18 eggs and 4 sodas. In May, Frieda pays $1 apiece for eggs and $2 apiece for sodas. Her income is $40. She buys 16 eggs and 12 sodas. a. In which month is Frieda happier? b. Are eggs a normal or an inferior good for Frieda? 20. Herman consumes Munster cheese and no other goods. a. Munster cheese could not possibly be an inferior good for Herman. b. Munster cheese could not possibly be a Giffen good for Herman. 21. Herman consumes Munster cheese and no other goods. a. What is the shape of Herman’s ordinary (uncompensated) demand curve for Munster cheese? b. What is the shape of Herman’s compensated demand curve for Munster cheese? c. What is Herman’s price elasticity of demand for Munster cheese?

45185_04_ch04_p081-114.indd 112 20/05/10 5:24 AM CONSUMERS NOTIN THE MARKETPLACE FOR SALE 113 22. Suppose your indifference curves between X and Y are shaped as in Exhibit 3.10, page XX. a. What is the shape of your ordinary (uncompensated) demand curve for X? b. What is the shape of your compensated demand curve for X? c. What is your price elasticity of demand for X? 23. True or False: For a normal good, the compensated demand curve is steeper than the uncompensated demand curve, but for an inferior good the reverse is true.

24. True or False: Your compensated and uncompensated demand curves for bubble gum are likely to be very similar to each other, but your compensated and uncompensated demand curves for college tuition might be very different.

25. Suppose the only good you ever consume is Nestle’s Crunch bars. What is your income elasticity of demand for Nestle’s Crunch bars? What is your price elasticity of demand for Nestle’s Crunch bars? 26. A luxury is defined to be a good with income elasticity greater than 1. Explain what this means without the technical jargon. Is it possible for all the goods you consume to be luxuries? Why or why not?

27. Which is likely to have a higher elasticity: The demand for gasoline from Gus’s gas station or the demand for gasoline generally? Why?

28. In 2003, tolls were raised on seven bridges across the Delaware River, con- necting Pennsylvania to New Jersey. In the first two months of the year, bridge traffic fell by 17%, but revenue increased by 123% because of the higher tolls. What is the price elasticity of demand for using these bridges to cross the Delaware River?

29. Suppose that without a seat belt, drivers who travel at 0 mph have a 100% chance of staying alive, while drivers who travel at 100 mph have 0% chance of staying alive. Suppose that with a seat belt, drivers who travel at 0 mph have a 100% chance of staying alive, drivers who travel at 100 mph have a 50% chance of staying alive, and drivers who travel at 200 mph have a 0% chance of staying alive. a. Draw an indifference curve diagram relating safety (measured by chance of staying alive) on the horizontal axis and speed (measured in mph) on the vertical. Draw the budget constraints of a driver with a seat belt and a driver without a seat belt. (You may assume these constraints are straight lines.) b. True or False: If speed and safety are both normal goods, then the invention of seat belts will certainly make people drive faster but might or might not save lives. Explain your answer in terms of substitution and income effects.

30. Suppose you have 24 hours per day that you can allocate between leisure and working at a wage of $2 per hour. a. Draw your budget constraint between “leisure hours” on the horizontal axis and “income” on the vertical. b. Draw in your optimum point. Keeping in mind that the number of hours you spend working is equal to 24 minus the number of hours that you spend at leisure, plot a corresponding point on your labor supply curve.

45185_04_ch04_p081-114.indd 113 20/05/10 5:24 AM 114 NOTCHAPTER 4 FOR SALE c. Now suppose that the wage rate rises to $3 per hour. Draw your new budget constraint, your new optimum, and a new point on your labor supply curve. d. On your indifference curve diagram, decompose the effect of the wage increase into a substitution effect and an income effect. What is the direction of the substitution effect? What is the direction of the income effect if leisure is a normal good? What is the direction of the income effect if leisure is an inferior good? e. True or False: If leisure is an inferior good, the labor supply curve must slope upward, but if leisure is a normal good, the labor supply curve could slope either direction. f. Whose labor supply curve is likely to slope upward more steeply: somebody whose income is derived entirely from wages, or somebody who has a large nonwage income? Why? 31. Suppose you have $1,000 today and expect to receive another $1,000 one year from today. Your savings account pays an annual interest rate of 25%, and your bank is willing to lend you money at that same interest rate. a. Suppose that you save all of your money to spend next year. How much will you be able to spend next year? How much will you be able to spend today? b. Suppose you borrow $800 and spend $1,800 today. How much will you be able to spend next year? c. Draw your budget constraint between “spending today” and “spending next year.” What is its slope? How does the slope reflect the relative price of spending today in terms of spending next year? d. How would your budget line shift in each of the following circumstances: You find $400 that you’d forgotten was in your desk drawer. Your boss informs you that you will receive a $500 bonus next year. The interest rate rises to 50%. e. Under which circumstance would you spend more today: finding a forgotten $400 in a desk drawer or being told that you will receive a $500 bonus next year? Under which circumstance would you spend more next year? f. Returning to the assumption that you have $1,000 today and expect to receive $1,000 next year, suppose that you choose neither to borrow nor to lend. Illustrate the tangency of your budget line with an indifference curve. g. In part (f), suppose that the interest rate rises to 50%. Show how your budget line shifts. Do you increase or decrease your current spending? Do you increase or decrease your future spending? Are you better off or worse off than before? h. In part (g), decompose the change in your consumption into a substitution effect followed by an income effect. Can you determine the direction of the substitution effect? Can you determine the direction of the income effect?

45185_04_ch04_p081-114.indd 114 20/05/10 5:24 AM NOT FOR SALECHAPTER 7 Competition

A real organization called the Brotherhood for the Respect, Elevation, and Advancement of Dishwashers encourages restaurant patrons to leave tips not just for the waiters and waitresses but also for the kitchen staff who bus tables and wash dishes. What will happen if this organization achieves its goals? In the short run, life will be better for dishwashers. They’ll collect tips, and they’ll probably decide to work additional hours to collect even more tips. But in the long run, people in other occupations—car wash attendants, grocery baggers, and others—will attempt to get on the gravy train. Restaurant kitchens will be flooded with job applicants, and the wages of dishwashers will be bid down. In fact, wages are likely to be bid down by the full amount of the tips—if tips amount to, say, $2 an hour, then wages fall from $8 an hour to $6 an hour. It turns out that respect, elevation, and advancement don’t show up in take-home pay. Later in this chapter, we’ll do a full analysis of the market for dishwashers and the effect of tipping. We’ll discover the reason why wages are bid down by the full amount of the tips, and we’ll learn something surprising about who does benefit from tipping. The key to the analysis is a recognition that dishwashing constitutes a competitive industry, and this chapter will give us the tools for analyzing competitive industries in general.

7.1 The Competitive Firm

A firm is called perfectly competitive (or sometimes just competitive for short) if it Perfectly can sell any quantity it wants to at the going market price. The standard example is competitive firm a farm. If wheat is selling for a going market price of $5 a bushel, then Farmer One that can sell any Vickers can sell 10 bushels or 1,000 bushels or any other quantity she chooses at that quantity it wants to at price. some going market Microsoft is a good example of a firm that is not perfectly competitive. That’s price. because Microsoft has already served all the customers willing to pay the current price for its Windows operating system. Unlike Farmer Vickers, if Microsoft wants to sell more of its product, it must lower the price. Ordinarily, firms are competitive when they serve a small part of the market. As long as you’re small, you can greatly increase your output and still find customers at

171

45185_07_ch07_p171-222.indd 171 20/05/10 5:33 AM 172 NOTCHAPTER 7 FOR SALE the going price. By contrast, firms with large market shares typically must lower their prices to attract more customers. Another way to say all this is that a competitive firm faces a horizontal demand curve for its product, whereas a noncompetitive firm faces a downward-sloping demand curve for its product. For example, if the going price of wheat is $5 per bushel, then the demand curve for Farmer Vickers’s wheat is horizontal at the $5 price. That’s because she can sell any quantity she wants to at that price, so the demand curve must associate every possible quantity with the going price of $5. Of course, the demand curve for wheat is still downward sloping; it is just the demand for Farmer Vickers’s wheat that is horizontal. To see how this can be, look at the two demand curves depicted in Exhibit 7.1. Notice in particular the units on the quantity axis. When Farmer Vickers increases output from 1 bushel to 10 bushels, she is moving a long distance to the right on her quantity axis. At the same time, she has moved the wheat industry a practically infinitesimal distance to the right—say, from 10,000,000 bushels to 10,000,009 bushels. This tiny change in the industry’s output requires essentially no change in price. Farmer Vickers’s horizontal demand curve results from her being a very small part of a very large industry in which all of the products produced are interchangeable and buyers can quite easily buy from another producer if Farmer Vickers tries to raise her price. All of these conditions tend to lead to perfect competition, but perfect competition can happen even without them. The only requirement for a firm to be called perfectly competitive is that the demand curve for its product be horizontal (for whatever reason).

The Demand Curve for Wheat EXHIBIT 7.1

Price Price

P0 P0 d

0 10,000,000 20,000,000 30,000,000 40,000,000 50,000,000 021357468 9 10 Quantity (bushels) Quantity (bushels)

A. Demand for wheat B. Demand for Farmer Vickers’s wheat

Panel A shows the downward-sloping demand curve for wheat. Panel B shows the horizontal demand curve

for Farmer Vickers’s wheat. If the price of all wheat goes up from P0 to P1, consumers will buy less wheat. If

the price of just Farmer Vickers’s wheat goes up from the market price of P0 to P1, consumers will buy none of it at all; they will shop elsewhere.

45185_07_ch07_p171-222.indd 172 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 173 Revenue Suppose you’re a bicycle manufacturer, selling bicycles at a going price of $50 apiece. If you sell one bicycle, your total revenue is $50; if you sell two, your total revenue is $100, and so forth. Regardless of how many bicycles you sell, your marginal revenue from selling an additional bicycle is always exactly $50, as illustrated in Exhibit 7.2. In general, for any competitive firm we have the equations Total Revenue = Price × Quantity Marginal Revenue = Price As you can see in the second panel of Exhibit 7.2: The competitive firm’s marginal revenue curve is flat at the level of the going market price. In other words, the firm’s marginal revenue curve coincides with the demand curve for the firm’s product, which is also flat at the going market price.

EXHIBIT 7.2 Total and Marginal Revenue at the Competitive Firm

$ TR Price 200 per 80 Bicycles ($) 70 150 60 MR = d 50 100 40 30 50 20 10

0 1 234 0 1 234 Quantity (bushels) Quantity (bushels)

A B

Quantity Total Revenue Marginal Revenue

1 $ 5 $50/item 2 10 50 3 15 50 4 20 50

A firm sells bicycles at a going price of $50 apiece. The firm’s total revenue is given by the equation TR = $50 × Q. The firm’s marginal revenue curve is flat at the going price of $50, hence identical to the demand curve for the firm’s bicycles.

45185_07_ch07_p171-222.indd 173 20/05/10 5:33 AM 174 NOTCHAPTER 7 FOR SALE The Firm’s Supply Decision Continuing to assume you’re a bicycle maker, how do you decide how many bicycles to make? We answered this in Chapter 5: You keep making bicycles until marginal revenue equals marginal cost. If your firm is competitive, we’ve just learned that marginal revenue is always equal to the going market price. So: A competitive firm, if it produces anything at all, produces a quantity where Price = Marginal Cost Suppose, for example, that the going price of a bicycle is $50 and that your marginal cost curve is the simple upward sloping curve shown in Exhibit 7.3. Then you’ll want to produce exactly 4 bicycles because 4 is the quantity where marginal cost = $50. Notice that this makes perfect sense: The first bicycle costs you only $20 to produce and you can sell it for $50; of course you’ll produce it. Similarly for the second, third, and fourth (you just break even on the fourth one). But it would be silly to produce a fifth bicycle, because you’d have to spend $60 to make a bicycle you could sell for only $50.

EXHIBIT 7.3 The Optimum of the Competitive Firm

Price per Bicycle ($) 80 70 MC 60 50 MR = d 40 30 20

0 1 234 56 Quantity (bushels)

Quantity Marginal Cost Marginal Revenue

1 $20/bicycle $50/bicycle 2 30 50 3 40 50 4 50 50 5 60 50 6 70 50

If bicycles sell for $50 apiece, a competitive firm will produce bicycles up to the point where marginal cost = $50. In this example, the firm produces 4 bicycles. But if the price rises from $50 to $70, the firm produces 6 bicycles.

45185_07_ch07_p171-222.indd 174 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 175 What will you do if the market price of bicycles rises to $70? First, of course, you’ll rejoice. Then you’ll rethink how many bicycles you want to make. Now you are willing to produce that fifth bicycle—and a sixth one as well.

The Competitive Firm’s Supply Curve Now let’s construct your supply curve. We’ve said that at a price of $50, you’d want to supply 4 bicycles. And we’ve said that at a price of $70, you’d want to supply exactly 6 bicycles. That gives us two points on your supply curve:

Price Quantity $50 4 $70 6

We’ve plotted these points (among others) in the second panel of Exhibit 7.4. The left panel of Exhibit 7.4 shows the firm’s marginal cost curve (which we take as given); the right panel shows the supply curve (which we are trying to derive). To get a

EXHIBIT 7.4 Marginal Cost and Supply

Price $/bicycle ($/bicycle) 80 MC 80 S 70 d ’’ 70

60 d ’ 60 50 d 50 40 40 30 30 20 20

10 10

0 123456 123456 Quantity (bicycles) Quantity (bicycles)

Marginal Cost Curve Supply Curve Quantity Marginal Cost Price Quantity

1 $20/bicycle $20/bicycle 1 2 30 30 2 3 40 40 3 4 50 50 4 5 60 60 5 6 70 70 6

When the price is $50, the firm faces demand curve d; d is also the marginal revenue curve. To maximize profit, the firm produces 4 bicycles (where MC = MR). Thus, $50 goes with a quantity of 4 on the supply curve. Similarly, $60 goes with 5 and $70 goes with 6. After we plot their points in the right-hand panel, we see that the supply curve looks exactly like the marginal cost curve.

45185_07_ch07_p171-222.indd 175 20/05/10 5:33 AM 176 NOTCHAPTER 7 FOR SALE new point on the supply curve, imagine a new price—say $60. Draw the corresponding flat demand curve (d′ in the Exhibit) and read off the quantity where the price of $60 is equal to the firm’s marginal cost. In this case, that quantity is 5. Therefore, we can plot the point ($60, 5) in the right-hand panel. Proceeding in this way, we discover that each point on the supply curve in the right- hand panel is identical to a point on the marginal cost curve in the left-hand panel; in other words: For a competitive firm with an upward sloping marginal cost curve, the supply curve and the marginal cost curve look exactly the same.

Although the supply and marginal cost curves in Exhibit 7.4 are identical as curves, their interpretations are quite different. To use the marginal cost curve, you “input” a quantity on the horizontal axis and read off the corresponding marginal cost on the vertical. To use the supply curve, you “input” a price on the vertical axis and read off the corresponding quantity on the horizontal. The way to make this distinction mathematically precise is to say that marginal cost (MC) and supply (S) are inverse functions. In Exhibit 7.4, we have: MC (5 bicycles) = $60 per bicycle and S ($60 per bicycle) = 5 bicycles Notice that the marginal cost function MC is plotted just as it would be in a math class—with the input variable on the horizontal axis and the output variable on the Dangerous Curve vertical. By contrast, the supply function is plotted with the input on the vertical and the output on the horizontal—a reversal of the usual “math class” rules. Another thing you might recall from math class is that the graph of an inverse function is the mirror image of the graph of the original function. Therefore you might expect the supply curve to be a mirror image of the marginal cost curve. But the graph of the supply curve is mirror imaged a second time because of the reversal of the axes. Thus, the supply curve is a double mirror image of the marginal cost curve—once because it is an inverse function and once because the axes are reversed. Of course, a double mirror image looks exactly like the original; that’s why the supply curve looks exactly like the marginal cost curve. And in fact that’s why we reverse the axes on the supply curve—so that we only have to draw one curve instead of two.

The Short Run Versus the Long Run In Chapter 6, we learned that firms face different marginal cost curves in the short run and the long run. Which marginal cost curve should we use when we construct the firm’s supply curve? It depends on whether we want to study the firm’s supply responses in the short run or in the long run. When the price of bicycles rises from $50 apiece to $70 apiece, bicycle manufacturers respond in the short run by hiring more workers and producing more bicycles. They respond in the long run by hiring more workers and expanding their factories and buying more machinery and producing even more bicycles. Thus the firm has two different supply curves: One illustrates the short-run response to a price change and the other illustrates the long-run response. If you want

45185_07_ch07_p171-222.indd 176 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 177 to construct the short-run supply curve, use the short-run marginal cost curve; if you want to construct the long-run supply curve, use the long-run marginal cost curve.

∪-shaped Marginal Cost Curves In Exhibit 7.4, the firm has an upward sloping marginal cost curve. But we saw in Chapter 6 that many marginal cost curves are actually cup-shaped (shown as ∪-shaped). How does this affect the analysis? Exhibit 7.5 shows the ∪-shaped marginal cost curve of a competitive firm facing a market price of $50. We know that such a firm, if it produces at all, produces a quantity at which marginal cost and the market price are equal. We can see from the graph that

there are two quantities at which this occurs: Q1 and Q2. Which does the firm choose?

Suppose that it produces Q1 items. Then the firm can produce an additional item at

a marginal cost below the market price. (That is, if the firm goes a little past quantity Q1, the marginal cost of production is below $50.) It follows that the firm can do better by producing another item. It continues producing as long as price exceeds marginal cost,

and then stops; that is, it produces Q2 items. A competitive firm, if it produces at all, will always choose a quantity where price equals marginal cost and the marginal cost curve is upward sloping. Only the upward- sloping part of the marginal cost curve is relevant to the firm’s supply decisions.

Shutdowns In Exhibits 7.3, 7.4, and 7.5, we asked how many bicycles the firm wants to produce. In asking that question, we implicitly assumed that the firm does want to produce bicycles. Now let’s question that assumption. Does the firm want to produce bicycles?

∪ EXHIBIT 7.5 The Supply Decision with a -Shaped Marginal Cost Curve

Price ($) MC

50 MR

Q1 Q2 Quantity

At a market price of $50 the firm produces Q2 items (assuming it produces at all). It takes losses on the first

Q1 of these, all of which are produced at a marginal cost of more than $50, and it earns positive profits on

the others. If those positive profits fail to outweigh the losses on the first Q1 items, the firm will shut down.

45185_07_ch07_p171-222.indd 177 20/05/10 5:33 AM 178 NOTCHAPTER 7 FOR SALE Shutdown The answer, of course, depends on the alternative. In the short run, the alterna- A firm’s decision to stop tive to producing bicycles might be to continue paying rent on an idle factory. In the producing output. Firms long run, the alternative is to terminate your lease and get out of the bicycle business that shut down continue altogether. to incur fixed costs. We distinguish between a shutdown, which means that the firm stops producing bicycles but still has to pay fixed costs such as rent on the factory, and an exit, which Exit means that the firm leaves the industry entirely. We make the following key A firm’s decision to leave assumption: the industry entirely. Firms that exit no longer In the short run, firms can shut down but can’t exit. In the long run, firms can exit. incur any costs. Here we will investigate the firm’s shutdown decision. In Section 7.4, we will investigate the firm’s exit decision.

The Shutdown Decision If you run a bicycle firm, then in the short run you have to decide whether to operate or to shut down. If you operate, you’ll earn a profit equal to TR − TC, where TR stands for total revenue and TC stands for total cost. If this profit is positive, you’ll certainly want to continue operating. If it’s negative, you’ll have to ask which is worse: the negative profit you’re earning now, or the negative profit you’d earn by shutting down. In other words, you must compare your profit from operating, TR − TC, with your profit from shutting down, which is −FC, where FC stands for fixed costs. Operating beats shutting down if: TR − TC > − FC Substituting the identity TC = FC − VC, this condition becomes: TR − FC − VC > − FC or: TR > VC The latter inequality should make good intuitive sense. Fixed costs don’t appear in this inequality because they are irrelevant to the shutdown decision; they are irrelevant to the shutdown decision because you’ve got to pay them whether you shut down or not. By contrast, variable costs are highly relevant to the shutdown decision, because the whole point of shutting down is to avoid paying variable costs. Staying in operation is a good idea precisely if the firm can earn sufficient revenue to cover these costs, in other words, if TR > VC. Remembering now that TR = P • Q (where P is price and Q is quantity), we can rewrite our inequality as: P • Q > VC Then if we divide each side by Q, the inequality becomes: P > AVC where AVC is average variable cost. In other words, the firm continues to operate in the short run if, at the profit- maximizing quantity, the price of output exceeds the average variable cost.

45185_07_ch07_p171-222.indd 178 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 179 The Competitive Firm’s Short-Run Supply Curve In Exhibit 7.4, we studied a firm with an upward-sloping marginal cost curve and con- cluded that the firm’s supply and marginal cost curves are identical. Now that we’re studying firms with ∪-shaped marginal cost curves, we have to modify that discussion slightly. That’s because we’ve just learned that when the price falls below average variable cost, the firm shuts down and produces nothing at all. Exhibit 7.6 shows the cost curves of a typical competitive bicycle manufacturer. If

the price of bicycles falls below P0, the firm cannot cover its variable costs and shuts

down, producing no bicycles. As long as the price is above P0, the firm will want to produce bicycles and will supply quantities taken from the marginal cost curve just as in Exhibit 7.4. Therefore the firm’s supply curve is equal not to the entire marginal cost

curve, but just to that part of the marginal cost curve that lies above the price P0. That is, the supply curve is the boldfaced portion of the marginal cost curve shown in the exhibit. The competitive firm’s short-run supply curve is identical to that part of the short-run marginal cost curve that lies above the average variable cost curve.

Why Supply Curves Slope Up When the competitive firm’s marginal cost curve is ∪-shaped, its supply curve consists of that part of the marginal cost curve that lies above average variable cost. Because the marginal cost curve cuts the average variable cost curve from below, the entire supply curve is upward sloping. To the question “Why do supply curves slope up?” we can answer “Because average and marginal cost curves are ∪-shaped.” This is correct, but it raises another question: “Why are the cost curves ∪-shaped?” The answer, as we saw in Chapter 6, is that this is a consequence of diminishing marginal returns to the variable factors of production. The technological fact of diminishing marginal returns suffices to account for the upward-sloping supply curves of competitive firms.

EXHIBIT 7.6 The Competitive Firm’s Short-Run Supply Curve

Price MC

AVC

0 Quantity

As long as the price exceeds P0, the firm’s supply curve coincides with its marginal cost curve. At prices

below P0, the firm produces nothing. Therefore, the firm’s supply curve is equal to the boldfaced portion of the marginal cost curve.

45185_07_ch07_p171-222.indd 179 20/05/10 5:33 AM 180 NOTCHAPTER 7 FOR SALE The Elasticity of Supply Elasticity of supply We can compute the elasticity of supply at a firm using the same formula that we use The percent change to compute the elasticity of demand: in quantity supplied Percentage change in quantity = resulting from a 1% Elasticity Percentage change in price increase in price. 100 • ΔQ/Q = 100 • ΔP/P P • ΔQ = Q • ΔP The elasticity of supply is positive because an increase in price brings forth an increase in the quantity supplied. Given two supply curves through the same point, the flatter one has the higher elasticity.

7.2 The Competitive Industry in the Short Run

In Section 7.1 we studied the short-run behavior of a single competitive firm. In this Competitive section, we will study the short-run behavior of a competitive industry; that is, an industry industry in which all firms are competitive. An industry in which all firms are competitive. Defining the Short Run We take the short run to be a period of time in which no firm can enter or exit the industry, so that the number of firms cannot change. By contrast, the long run is a period in which any firm that wants to can enter or leave the industry. How long is the long run and how short is the short run? It depends. In the sidewalk flower vending industry, the short run is very short indeed (at least if there is no waiting time for a vendor’s license). The time that it takes to acquire some flowers and walk down to the corner, or for an existing vendor to sell out his stock and go home, is already the long run. By contrast, if Barnes and Noble booksellers were to cease operations, it would face a lengthy process of selling off its inventory and nego- tiating ends to its store leases. For that matter, when the online pet-supply store pets. com went out of business in the year 2000, it had little inventory to dispose of, but its exit was nevertheless delayed while it sought a buyer for the rights to its popular sock puppet mascot. The long run does not arrive until this exiting process is complete.

As we’ve already mentioned (in Section 7.1), it is important not to confuse an exit with a shutdown. As soon as Barnes and Noble stops selling books, it has shut down, but as long as it remains in possession of valuable capital, it has still not left the industry. When a firm shuts down, it stops producing but continues to incur fixed costs (in Barnes and Dangerous Noble’s case, the opportunity cost of not yet having sold its inventory). An exit implies Curve that the firm has divested itself of all its fixed costs and thereby severed all of its ties with the industry. Shutdowns are a short-run phenomenon; exits are long-run.

45185_07_ch07_p171-222.indd 180 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 181 The Competitive Industry’s Short-Run Supply Curve In the short run, entry and exit are not possible, so the number of firms in the industry is fixed. Given the short-run supply curves of the individual firms, we simply add them to construct the short-run supply curve for the entire industry. At a given price, we ask what quantities each of the firms will provide; then we add these numbers to get the quantity supplied by the industry. Because different firms have different cost curves, different firms have different shutdown prices. Therefore, the number of firms in operation tends to be small at low prices and large at high prices. As a result, the industry supply curve tends to be more elastic than the supply curves of the individual firms. This can be seen in Exhibit 7.7.

Here firms A, B, and C have the individual supply curves shown. At price P1, only firm A produces, so the quantity supplied by the industry is the same as the quantity sup-

plied by firm A. At the higher price P2, firm B produces as well, and the industry supplies the sum of firm A’s output and firm B’s output. (In fact, firm A produces 2½ units and firm B produces 4½, for an industry total of 7.) At prices high enough for firm C to produce, industry output is correspondingly greater.

Exercise 7.1 At price P3, how much does each firm produce? How much does the industry produce?

The industry supply curve in Exhibit 7.7 jumps rightward each time it passes a firm’s shutdown price. In an industry with many firms, the effect of this is to greatly flatten the industry supply curve relative to those of the individual firms.

EXHIBIT 7.7 The Industry Supply Curve

Price

SA SB SC Industry supply

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Quantity

As the price goes up, two things happen. First, each firm that is producing increases its output. Second, firms that were not previously producing start up their operations. As a result, industry output increases more rapidly than that of any given firm, so the industry supply curve is more elastic than that of any given firm.

45185_07_ch07_p171-222.indd 181 20/05/10 5:33 AM 182 NOTCHAPTER 7 FOR SALE Supply, Demand, and Equilibrium In Chapter 5 we learned that any supplier, if it produces at all, chooses to operate where marginal cost is equal to marginal revenue. In Section 7.1, we learned that for a competitive producer the marginal revenue curve is the same as the demand curve, and, in the region where it produces at all, the marginal cost curve is the same as the supply curve. Therefore, we can just as well say that a competitive supplier chooses to operate at the point where supply is equal to demand. In an industry in which all of the firms are competitive, each firm operates where supply equals demand, and so the industry-wide supply (which is the sum of the individual firms’ supplies) must equal the industry-wide demand (which is the sum of the demands from the individual firms). In other words, such an industry will be at equilibrium, simply as a consequence of optimizing behavior on the part of individuals and firms. In Chapter 1 we gave some “plausibility arguments” for the notion that in many industries prices and quantities would be determined by the intersection of supply and demand. Now we have a much stronger reason to believe the same thing. If an industry is competitive, profit-maximizing firms will be led to the equilibrium outcome—as if by an invisible hand.

Competitive Equilibrium Exhibit 7.8 illustrates the relationship between the competitive industry and the competitive firm. The industry faces a downward-sloping demand curve for its product.

EXHIBIT 7.8 The Competitive Industry and the Competitive Firm

Price Price s

P0 d

0 Q0 0 q0 Quantity Quantity

A. Supply and demand for output of the industry B. Supply and demand for output of the firm

The equilibrium price P0 is determined by the intersection of the industry’s supply curve with the downward- sloping demand curve for the industry’s product. The firm faces a horizontal demand curve at this going

market price and chooses the quantity q0 accordingly. The industry-wide quantity Q0 is the sum of the quantities supplied by all the firms in the industry.

45185_07_ch07_p171-222.indd 182 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 183

The price P0 is determined by industry-wide equilibrium, and this same price P0 is what appears to the individual firm as the “going market price,” at which it faces a flat

demand curve. The firm then produces the quantity q0, at which its supply curve S (that

is, its marginal cost curve) crosses the horizontal line at P0.

Changes in Fixed Costs Now we can investigate the effect of a change in costs. Suppose, first, that there is a rise in fixed costs, such as a general increase in the cost of large machinery or a new licensing fee for the industry. What happens to an individual firm’s supply curve? Nothing, because marginal cost is unchanged. What about the industry’s supply curve? It remains unchanged also, because industry supply is the sum of the individual firms’ supplies and these remain fixed. Thus, no curves shift in Exhibit 7.8, so both price and quantity remain unchanged.

This analysis is correct and complete in the short run. However, we will see in Sections 7.5 and 7.6 that in the long run there is more to be said. The reason for this is that in the long run any increase in costs can drive firms from the industry; their exit can then affect prices and quantities. Dangerous Curve

Changes in Variable Costs Next consider a rise in variable costs, such as a rise in the price of raw materials or the imposition of an excise tax. Here’s what happens: First, the firm’s supply curve shifts leftward. Here’s why: When variable costs rise, marginal costs rise; therefore, the firm’s marginal cost curve shifts vertically upward. But the firm’s supply and marginal cost curves coincide, so we can equally well say that the firm’s supply curve shifts vertically upward, and that’s the same thing as shifting to the left. Second, the industry supply curve shifts leftward. That’s because the industry supply is the sum of the individual firms’ supplies. At any given price, each firm supplies less than before, so the industry in total supplies less than before.

Third, the supply shift causes the equilibrium price to rise from P0 to P2 in the first panel of Exhibit 7.9. Therefore, the demand curve facing the firm rises from d to d′ in the second panel.

The firm’s output changes from q0 to q2. In Exhibit 7.9, q2 is to the left of q0, but if the

curves had been drawn a little differently, q2 could equally well have been to the right

of q0. Thus the firm’s output could go either up or down.

Note, however, that the industry’s output unambiguously falls (from Q0 to Q2 in the first panel). Thus the average firm’s output must fall, even though not every firm’s output must fall.

Exercise 7.2 Draw graphs illustrating the effect of a fall in variable costs.

Changes in Demand Exhibit 7.10 illustrates the effect of an increase in the demand for the industry’s

product. The new market equilibrium price of P3 is taken as given by the firm, which

increases its output to q3.

45185_07_ch07_p171-222.indd 183 20/05/10 5:33 AM 184 NOTCHAPTER 7 FOR SALE

EXHIBIT 7.9 A Rise in Variable Costs

s' Price S' Price s

S P2 d'

P0 d

0 Q2 Q0 0 q2 q0 Quantity Quantity

A. Supply and demand for output of the industry B. Supply and demand for output of the firm

A rise in variable costs causes the firm’s supply curve to shift left from s to s′ in panel B. The industry supply curve shifts left from S to S′ in panel A, both because each firm’s supply curve does and because some ′ firms may shut down. The new market price is P2. The firm operates at the intersection of s with its new hor-

izontal demand curve at P2. Depending on how the curves are drawn, the firm could end up producing either

more or less than it did before the rise in costs. (That is, q2 could be either to the left or to the right of q0.)

EXHIBIT 7.10 A Change in Demand

Price Price s

P3 d' D' P0 d

0 Q0 Q3 0 q0 q3 Quantity Quantity

A. Supply and demand for output of the industry B. Supply and demand for output of the firm

An increase in the demand for the industry’s output raises the equilibrium price to P3 and the firm’s output to q3.

45185_07_ch07_p171-222.indd 184 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 185 Exercise 7.3 Draw graphs illustrating the effect of a fall in demand for the i ndustry’s product.

The Industry’s Costs In the short run the competitive industry consists of a fixed number of firms. These firms collectively produce some quantity of output. The total cost of producing that output is the sum of the total costs of all the individual firms. Suppose that you were appointed the czar of U.S. agriculture and given the power to tell each farmer how much to produce. You would like to maintain the production of wheat at its current level of 1 million bushels per year, but you would like to do this in such a way as to minimize the total costs of the industry. How would you go about this? The equimarginal principle points the way to the answer. Suppose that the marginal cost of growing wheat is $5 per bushel at Farmer Black’s farm and $3 per bushel at Farmer White’s. Then here is something clever you can do: Order Black to produce one less bushel and White to produce one more. In that way, the industry’s total cost is reduced by $2, and the level of output is maintained. You should continue to do this until the marginal costs of production are just equal at both farms. Indeed, as long as any two farms have differing marginal costs, you can use this trick to reduce total costs. Total costs are not minimized until marginal cost is the same at every farm. Now, the miracle: In competitive equilibrium, every farmer chooses to produce a quantity at which price equals marginal cost. Because all farmers face the same market price, it follows that all farmers have the same marginal cost. From this we have the following result: In competitive equilibrium, the industry automatically produces at the lowest possible total cost.

Students sometimes think that this result follows from firms’ attempts to minimize their costs. But no firm has any interest in the costs of the industry as a whole. The minimization of industry-wide costs is a feature of competitive equilibrium that is not sought by any individual firm. Dangerous Curve

What is the marginal cost to the industry of producing a unit of output? You might think that this question is unanswerable, because the industry consists of many firms, each with its own marginal cost curve. How are we to decide which firm to think of as producing the “last” unit of output in the industry? The answer to the last question is that it doesn’t matter. We have just seen that in competitive equilibrium, the cost of producing the last unit of output is the same at every firm. That cost is the industry’s marginal cost of production. At each point along its supply curve, the competitive industry produces a quantity that equates price with marginal cost. Therefore, the industry’s supply curve is identical to the industry’s marginal cost curve, just as each individual firm’s supply curve can be identified with its own marginal cost curve.

45185_07_ch07_p171-222.indd 185 20/05/10 5:33 AM 186 NOTCHAPTER 7 FOR SALE 7.3 The Competitive Firm in the Long Run

There are two differences between the short run and the long run: First, some costs that are fixed in the short run become variable in the long run. It takes time for a restaurant to add grills to the kitchen; therefore, the cost of the grills is fixed in the short run but variable in the long run. Second, and more importantly, firms can enter or exit from the industry in the long run. In this section we will see how these factors determine the firm’s long-run supply curve.

Long-Run Marginal Cost and Supply In the long run, just as in the short run, a competitive firm wants to operate where Price = Marginal Cost; the only difference is that in the long run we must interpret “marginal cost” to mean long-run marginal cost. Thus at any given price, the firm chooses to supply a quantity that can be read off its long-run marginal cost curve. In other words: As long as the firm remains in the industry, its long-run supply curve is identical with its long-run marginal cost curve.

Comparing Short-Run and Long-Run Supply Responses A restaurant produces hamburgers using inputs that include ground beef, short-order cooks, and kitchen grills. How does this restaurant respond to a rise in the price of hamburgers? In the short run, it can increase quantity by purchasing more beef and hiring more cooks. The resulting quantity of hamburgers is recorded on the short-run supply curve. In the long run, however, the restaurant might decide to expand its operation by purchasing more grills. Typically, this means that quantity increases by more in the long run than it does in the short run. In other words, the long-run supply curve is more elastic than the short-run supply curve. Exhibit 7.11 shows the picture. The restaurant has sold hamburgers at a going price

of P0 for a long time and has thus adjusted the number of grills so as to produce Q0

hamburgers at the lowest possible cost. The quantity Q0 can be read from the long-run

supply curve. Because the kitchen hardware is all in place, Q0 is the quantity read from the short-run supply curve as well.

Now suppose that the price rises to P1. In the short run, with the number of grills

fixed, quantity rises to Q1, which we can read off the short-run supply curve. In the long ′ run, after the facilities are expanded, quantity rises further, to Q1 . With its expanded kitchen equipment, the firm has a new short-run marginal cost curve and hence a new short-run supply curve, called S′ in the exhibit. Notice that S′ must go through the new ′ supply point at (P1, Q1 ).

Profit and the Exit Decision These are two differences between the long run and the short run. First, as we’ve seen, the firm’s long run and short run supply curves can be different. The second difference concerns the firm’s decision whether to supply anything at all. In the short run firms

45185_07_ch07_p171-222.indd 186 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 187

EXHIBIT 7.11 Long-Run and Short-Run Supply Responses

Price S S' LRS

0 Q0 Q1 Q1' Quantity

In long-run equilibrium at P0, the firm is on both its long-run and short-run supply curves. A change in price,

to P1, has the immediate effect of causing the firm to move along its short-run supply curve S to the quan-

tity Q1. In the long run, the firm can vary its plant capacity (for example, a hamburger stand can install more ′ grills) and move along its long-run supply curve, LRS, to Q1 . With the new plant capacity, the firm has a ′ ′ new short-run supply curve S . In the new equilibrium at price P1 and quantity Q1 , the firm is again on both its long-run and short-run supply curves.

can shut down (without leaving the industry) but in the long run firms can exit. To understand long-run supply, we must understand the exit decision. Firms leave the industry when their profits are too low to justify sticking around. So to understand the exit decision, we have to make sure we understand profit. Profit is just revenue minus cost. But it’s important to remember that to an economist (though not, perhaps, to an accountant), cost includes all forgone opportunities. For example: Suppose you run a newspaper business, buying 100 newspapers a day for 15¢ each and reselling them for a quarter. Your accountant will calculate your revenue to be $25 and your costs to be $15, leaving a $10 profit. That’s your accounting profit. But to calculate your economic profit, we’ve got to Accounting profit subtract the accounting profit you could have earned by pursuing your next best oppor- Total revenue minus tunity. If instead of delivering newspapers, you could have earned a $7 accounting those costs that an profit selling lemonade, then your economic profit is $10 − $7 = $3. accountant would Or, if you could have earned a $12 accounting profit selling lemonade, then your consider. economic profit in the newspaper business is $10 – 12, or minus $2. When non-economists use the word profit, they usually mean accounting profit. Economic profit But in an economics course or a book about economics, profit means economic profit. Total revenue minus You’ll want to leave the newspaper business if selling lemonade (or some other all costs, including activity) is more attractive than selling newspapers, and this happens exactly when the opportunity cost your economic profit is negative. You’d be well advised to leave that business and sell of being in another lemonade instead. Therefore; industry. Firms want to exit the industry when their economic profits are negative

45185_07_ch07_p171-222.indd 187 20/05/10 5:33 AM 188 NOTCHAPTER 7 FOR SALE Now imagine a world with 1,000 identical newspaper sellers, all earning negative economic profit. You might think that eventually they’ll all leave the industry. But that’s not necessarily true. As firms leave, the price of newspapers will rise—leading to higher profits for the remaining firms. So negative economic profits lead to exit, which leads (eventually) to zero economic profit for the remaining firms. Why are firms willing to stick around and earn zero profit? Because “zero economic profit” is not the same as “zero accounting profits.” Zero economic profit simply means that you’re doing no better—but also no worse—than you could do in some other business.

The Algebra of the Exit Decision Firms want to exit when their economic profits are negative. Profit, of course, is total revenue (TR) minus total cost (TC) (where total cost includes the forgone opportunity to be in some other industry!). Total revenue, in turn, is price times quantity, or P × Q. So firms want to exit when P × Q − TC is negative. Sometimes it’s easier to think about the firm’s profit per item, which we get by taking P × Q − TC and dividing by the quantity produced. Because TC/Q = AC, this gives the expression P − AC and once again, firms want to exit when this quantity is negative, which happens when P < AC In other words: When price is below average cost, firms want to leave the industry. This should make perfect sense. If you sell your widgets at a price that is below the average cost of producing them, you’re in the wrong business.

The Firm’s Long-Run Supply Curve In the long run, as in the short run, firms maximize profit by choosing the quantity where price equals marginal cost. Of course, in the long run, “marginal cost” means “long-run marginal cost.” Therefore, as long as a firm wants to be in business at all, its long-run supply curve coincides with the upward sloping part of its long-run marginal cost curve. And when does the firm not want to be in business? Answer: when profits are negative; that is, when price is below average cost. So those prices are excluded from the long-run supply curve. Exhibit 7.12 shows the long-run marginal and average cost curves at Sam’s House of Widgets. If widgets sell for a going price of $5, the best Sam can do is sell 2 widgets (the quantity where price equals marginal cost). Here the average cost of production exceeds $5, so Sam’s profit is negative and he wants to get out. Therefore, $5 corresponds to no point at all on Sam’s long-run supply curve. But at a price of, say, $11, Sam will produce 6 widgets and earn a positive profit (because at a quantity of 6, average cost is below $11). Therefore, the point with price = $11 and quantity = 6 is on his supply curve. In general, the points on Sam’s supply curve are those that lie above his average cost curve, which is to say they are the boldfaced points in Exhibit 7.12.

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EXHIBIT 7.12 The Firm’s Long-Run Supply Curve

MC Price AC

$11

2 4 6 Quantity

At any given price, Sam’s House of Widgets sells the quantity where price equals marginal cost. Therefore, as long as Sam wants to be in business at all, his (long-run) supply curve coincides with his (long-run) marginal cost curve. But at sufficiently low prices (like $5), Sam prefers to exit the industry. Therefore, the point corresponding to $5 is excluded from the supply curve. The supply curve is the boldfaced portion of the marginal cost curve—the part that lies above average cost.

The firm’s long-run supply curve is the part of its long-run marginal cost curve that lies above its average cost curve.

Note the twin distinctions between the short run and the long run. In the short run, the firm shuts down (without leaving the industry) if price falls below average variable cost. In the long run, the firm exits if price falls below average cost. Dangerous Curve

7.4 The Competitive Industry in the Long Run

Before we study the competitive industry in the long run, let’s briefly recall what we know about the competitive industry in the short run. The key picture is Exhibit 7.8, relating industry-wide supply and demand (in the left panel) to firm-specific supply and demand (in the right). By manipulating the four curves in that picture, we can solve a variety of problems (as in, for example, Exhibits 7.9 and 7.10). Our goal is to construct a similar picture for the long run. Once again we will have four curves. There is an industry-wide demand curve, which slopes downward and reflects consumers’ preferences. There is a firm-specific demand curve, which is flat at the going market price. There is a firm-specific supply curve, which slopes upward and coincides with the firm’s marginal cost curve.

Actually, as we saw in Exhibit 7.12, the firm’s supply curve coincides with only a part of its marginal cost curve, but it will do no harm for us to ignore that subtlety for now. Dangerous Curve

45185_07_ch07_p171-222.indd 189 20/05/10 5:33 AM 190 NOTCHAPTER 7 FOR SALE Because the firm might have different marginal cost curves in the short run and the long run (see Exhibit 7.11), it might have different supply curves in the long run and the short run. But the theory of the supply curve—that is, the fact that it coincides with Dangerous the marginal cost curve—is the same in either case. Curve That accounts for three of our four curves. Next, we need to describe the industry- wide supply curve. That will take a little more work.

The Long-Run Supply Curve In the short run, we got the industry-wide supply curve by adding the supply curves of individual firms (see Exhibit 7.7). In the long run, that procedure won’t work, because firms can enter and exit in the long run. If we were adding the individual firms’ supply curves, which firms would we count? Those currently in the industry? Those that might be poised to enter? Those that might enter someday? Rather than tackle that question, we proceed a different way: We construct the long-run industry supply curve from scratch, exactly as we would construct any supply or demand curve from scratch, namely, one point at a time. We hypothesize a price, figure out the corresponding quantity, and plot a point. Then we hypothesize another price and repeat the process. First we need to know what the suppliers’ cost curves look like. Exhibit 7.13 shows the cost curves of a typical barber, both graphically (in panel A) and numerically (in the chart directly below). We will assume for now that all barbers have the same cost curves; Constant-cost we express this assumption by saying that barbershops form a constant-cost industry. industry In Section 7.5, we will relax this assumption. An industry in which Now we are ready to begin constructing the supply curve. First, we hypothesize a all firms have identical price—say $5 per haircut. How would Floyd the Barber respond to this price? As long as he’s costs. in business, Floyd maximizes profit by choosing the quantity where price equals marginal cost. You can see in the graph (or the chart) in Exhibit 7.13 that this occurs at quantity 2. If this were a short-run problem, we’d be done. But because it’s a long-run problem, we need to think about whether Floyd wants to go on barbering. That means we have to think about his profits. First, Floyd’s total revenue, when he sells 2 haircuts at $5 each, is $10. His total cost, which you can read off the chart in Exhibit 7.13, is $15. So his profit is $10 – 15 = −$5, a negative number. So Floyd wants to leave the industry, and in the long run, that’s exactly what he’ll do. And so will every other barber, because we’ve assumed that all barbers are exactly like Floyd (or at least have exactly the same cost curves). Conclusion: When the price of a haircut is $5, there is no such thing as a barber.

If the price of a haircut were $5, it is not in fact true that all barbers would leave the industry. What would happen is this: Some barbers would leave, and as they left, the price of haircuts would get bid up. Eventually, the price would get bid up high enough to convince some barbers to stay in business. However, and this is a key point, none of that is relevant to the construction of the Dangerous supply curve. A point on the supply curve answers a hypothetical question: If the price Curve of haircuts were $5 (and if it were stuck at $5 and unable to change), then what would happen? Answer: There would be no barbers. So on the supply curve, a price of $5 goes with: nothing at all.

45185_07_ch07_p171-222.indd 190 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 191

EXHIBIT 7.13 Constructing the Long-Run Supply Curve

Price ($/haircut) MC Price ($/haircut) AC 11 11

7 7 S

5 5

2 4 6 Quantity Quantity (Haircuts) (Haircuts) A. Cost curves for a typical barber B. Long-run industry-wide supply

Quantity Total Cost (TC) Marginal Cost (MC) Average Cost (AC)

1 $10 $2/haircut $10/haircut 2 15 5 7.50 3 21 6 7.00 4 28 7 7.00 5 37 9 4.00 6 48 11 8.00

Panel A shows the cost curves of a typical barber, which we take as given. In panel B, we construct the long-run industry supply curve, one point at a time. If the going price of haircuts is $5, each barber provides 2 haircuts, earning a profit of $10 – 15 = −$5. Therefore each barber exits and the haircut industry disappears. If the going price of haircuts is $11, then each barber provides 6 haircuts and earns a positive profit of $66 – 48 = $18. Now every firm in the world becomes a barbershop; the quantity of haircuts provided is equal to 6 per firm times an unlimited number of firms. The corresponding quantity is completely off the chart. If the going price of haircuts is $7, then each barber provides 4 haircuts and breaks even. The total quantity supplied is 4 haircuts per barber times any number of barbers; in other words, it is anything. So a price of $7 goes with every quantity.

Let’s try again. We hypothesize another price—say $11 this time—and we see what happens. Now Floyd chooses the quantity where marginal cost is $11—that is, the quantity 6. His total revenue is 6 × 11 = $66 and his total cost is $48 (read from the chart in Exhibit 7.13). His profit is $18. Remember that this is an economic profit. It means that Floyd can earn more as a barber than in any other industry. And therefore so can anyone else. (Here we are still making the strong assumption that everyone has the same cost curves Floyd does; we’ll relax this assumption in later sections.) In other words, every firm in the Universe wants to convert itself to a barbershop, and in the long run, they all do. Okay, now how many haircuts are provided? Answer: 6 per firm, times the number of firms, and the number of firms is essentially infinite. Therefore, an essentially infinite number of haircuts is supplied. The price of $11 goes with the quantity “infinity”—or at least with a number so large it’s way off our graph. There’s no way to plot this point.

45185_07_ch07_p171-222.indd 191 20/05/10 5:33 AM 192 NOTCHAPTER 7 FOR SALE In reality, when barbershops earn positive profits, firms enter, driving down the price of haircuts until the positive profits are bid away and the flow of entry stops. But once again, this has no relevance to the supply curve. The supply curve asks “What would Dangerous happen if the price of a haircut were stuck at $11?” And the answer is: In that purely Curve hypothetical situation, all of the world’s resources would be devoted to barbering.

We have now tried twice to construct points on our industry supply curve. Let’s try once more. We’ll hypothesize that haircuts sell for $7. Floyd chooses the quantity 4 (where price equals marginal cost) and earns a total revenue of 4 × $7 = $28. His total cost (read from the chart in Exhibit 7.13) is also $28. His (economic) profit is zero. Does Floyd stick with barbering or does he convert his shop into its next best alternative—say a lemonade stand? Answer: He might do either. Both activities are equally profitable (that’s what it means for economic profit to be zero), so there’s no reason for him to prefer one to another. And likewise for other firms. Which will be barbershops and which will be lemonade stands, or gas stations, or whatever is next-best for them? We have absolutely no basis for prediction. So—how many barbershops will there be? Maybe none. Maybe one. Maybe ten, or a hundred, or a thousand, or ten thousand. Anything is possible. And how many haircuts will be provided? Well, 4 per barbershop, times the number of barbershops, which could be anything. In other words, it could be 0, or 4, or 40, or 400, or 4,000, or 40,000, or anything at all. So on the long-run supply curve, every quantity is associated with a price of $7. We’ve plotted this in panel B of Exhibit 7.13, where you can see that: In a constant-cost industry, the long-run industry supply curve is flat.

The Break-Even Price In Exhibit 7.13, barbers who must sell haircuts at $5 earn negative profits; therefore, they exit the industry. Barbers who must sell haircuts at $11 earn positive profits, so at this price every firm in the Universe becomes a barbershop. Barbers who sell haircuts at $7 just break even; that is, they earn zero economic profit. Therefore, the supply Break-even price curve is flat at $7, and $7 is called the break-even price in this industry. The price at which a We calculated the break-even price by trial and error, but there’s also a faster seller earns zero profit. way: The break-even price occurs at the point where the marginal and average cost curves cross. At this price, barbers choose to supply a quantity where price and average cost are equal, so they earn zero profit. (This was essentially the point of Exhibit 7.12.) We’ve gone through the trial and error process here because the author of your textbook believes it goes a long way toward clarifying the issues and the meaning of the supply curve. But the fast way to find the break-even price is to look for the intersection of the marginal and average cost curves.

The Break-Even Price and the Supply Curve Now that we’ve defined the break-even price, we can restate everything we’ve learned in a sentence: In a constant-cost industry, the long-run industry supply curve is flat at the level of the break-even price.

45185_07_ch07_p171-222.indd 192 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 193 Changes in the Break-Even Price What could cause the break-even price to change? The answer is: any change in costs (whether it’s a change in variable costs or in total costs). If you can just break even selling haircuts for $7 apiece on Monday, and if your costs go up on Tuesday, then you can no longer break even selling haircuts for $7 on Tuesday. When costs rise, the break- even price must rise also. This is important to remember, because the long-run supply curve is flat at the break-even price and therefore shifts every time the break-even price changes. So: Any increase in costs will cause the long-run industry supply curve to shift upward. Any decrease in costs will cause the long-run industry supply curve to shift downward.

Notice that this is very different from what happens in the short run. In the short run, only variable costs matter. In the long run, fixed costs matter too. Dangerous Curve Take an example: Suppose you run a bubble gum company. Every day, you sell 100 sticks of bubble gum for $1 apiece, and you just break even; $1 is your break-even price. Now you are suddenly required to pay an excise tax of 20¢ per stick of bubble gum. What happens to your break-even price? Answer: You would need to charge an extra 20¢ per stick of gum to cover the cost of the tax. Your break-even price is now $1.20.

That doesn’t mean demanders would pay $1.20; it means only that $1.20 is what you would have to charge to break even. Whether you can break even is a separate question. Dangerous Curve Or take another example: You sell 100 sticks of bubble gum for $1 apiece and you just break even; once again your break-even price is $1. Now you are subjected to an annual license fee of $20. What is your new break-even price? Answer: To break even, you’d have to charge enough to cover your additional $20 in costs. That comes to approximately an extra 20¢ per stick of gum, making your new break-even price approximately $1.20. Why approximately? Because at a price of $1.20, you’d presumably choose to supply some quantity of gum other than 100. But as long as your quantity stays close to 100, your new break-even price is somewhere around $1.20.

Exercise 7.4 In the example of Exhibit 7.13, suppose every barber must pay an annual license fee of $18. What is the new break-even price?

Equilibrium The relationship between the competitive industry and the competitive firm is the same in the long run as in the short run: The market price is determined by the intersection of the industry-wide supply and demand curves, and the firm faces a flat demand curve at the going market price. You can see the picture in Exhibit 7.14.

The Zero-Profit Condition As you can see in Exhibit 7.14, the long-run equilibrium price is always equal to the break-even price (because that’s the level at which the industry supply curve is flat). If

45185_07_ch07_p171-222.indd 193 20/05/10 5:33 AM 194 NOTCHAPTER 7 FOR SALE

EXHIBIT 7.14 Long-Run Competitive Equilibrium

Price Price MC AC

LRS d

Quantity Quantity Industry Firm

The industry-wide equilibrium occurs at the break-even price. Firms face a demand curve that is flat at that price.

the break-even price for barbershops is $7 per haircut, then the equilibrium price of a haircut will be $7, regardless of where the demand curve lies. Thus, in the long-run equilibrium, all barbers earn exactly zero profit. It’s clear why this must be so. If the price of haircuts were below $7, barbers would earn negative profits and begin leaving the industry. As they left, the price of haircuts would rise, and continue rising until the price reached $7 and there was no reason for further exit. On the other hand, if the price of haircuts were above $7, profits would be positive, firms would enter, and the price of haircuts would fall, driving the price back down to $7. In a constant-cost industry, in long-run equilibrium, all firms earn zero economic profit. Remember, though, that entry and exit take time. In the real world, a firm cannot instantly convert itself from a clothing store to a barbershop. If the demand for haircuts rises, barbers might earn positive profits for quite awhile until enough firms enter the industry to drive profits back down to zero. During that time, the industry is not in long-run equilibrium. Many economists argue that long-run zero-profit equilibrium is almost never reached, because demand curves and cost curves shift so often that the entry and exit process never settles down. Although this is arguably true in many industries, the zero- profit condition remains a useful approximation to the truth.

Cost Minimization The zero-profit condition has an interesting side effect: A firm earning zero profit must be operating at the point where its marginal and average cost curves cross. But we saw way back in Exhibit 6.5 that the marginal and average cost curves cross at the bottom of the average cost curve. Therefore:

45185_07_ch07_p171-222.indd 194 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 195 In long-run equilibrium in a constant-cost industry, every firm produces at the lowest possible average cost.

No firm sets out to minimize average cost. Firms seek only to maximize profit. In Exhibit 7.13, if haircuts were selling for $11 each, Floyd the Barber would cheerfully provide 6 haircuts a day at an average cost of $8, which is well above the minimum of 7. Only when profit is zero—that is, when the price of haircuts falls back to $7—does Dangerous Floyd move to the bottom of his average cost curve. Curve

Changes in Equilibrium The analysis of long-run equilibrium differs from the analysis of short-run equilibrium in two important ways. First, the industry-wide supply curve is flat. Second, the industry-wide supply curve moves in response to any change in costs, whether fixed or variable. Here are some examples.

Changes in Fixed Costs Suppose new legislation requires every barbershop to pay a daily license fee. What happens in the long run? Exhibit 7.15 shows the answer. The firm’s marginal cost curve is unaffected, but the break-even price rises. (Go back to Exercise 7.2 if you need to be reminded of why.) Thus, the industry supply curve shifts vertically upward to the level of the new break-even price. Each firm produces more haircuts than before; the industry as a whole now produces fewer.

A Rise in Fixed Costs EXHIBIT 7.15

Price Price

MC AC' AC

P' d' LRS' P d LRS

Quantity Quantity Industry Firm

If fixed costs rise, the break-even price rises also, so the long-run industry supply curve rises from LRS to LRS′. Quantity increases at each individual firm and decreases in the industry. The firm’s average cost curve rises from AC to AC′, indicating that profit is zero in the new equilibrium.

45185_07_ch07_p171-222.indd 195 20/05/10 5:33 AM 196 NOTCHAPTER 7 FOR SALE If each barber cuts more hair, how can the total number of haircuts go down? The answer is that in the long run, the number of barbers must fall. In the short run, such an outcome would be impossible. There is no way to predict which individual barbers will exit. All we know is that some barbers will exit, and exit continues until the price is bid up to its new break-even level. The right half of Exhibit 7.15 shows the situation at one of those barbershops that happens to remain.

In Chapter 6, we argued that in the long run, firms have no fixed costs because they can vary their employment of any factor of production. As long as the firm’s costs consist entirely of payments to factors, it is correct to say that the firm has no long-run fixed costs. However, the license fee we’ve just considered, because it does not vary with output, is a fixed cost even in the long run. It is important to distinguish a fixed cost from a sunk cost. Although the license fee Dangerous is a fixed cost for any firm that decides to remain in the industry, it is not yet a sunk Curve cost at the point when the entry/exit decision is being made. Thus, it is relevant to the decision. A cost that is truly sunk, in the sense that it cannot be avoided even by leaving the industry, will not affect anything.

Changes in Variable Costs An increase in variable costs has two effects: First, the firm’s marginal cost curve shifts upward. Second, the break-even price increases, so the industry supply curve shifts upward. Exhibit 7.16 shows the consequences. The quantity supplied by individual firms might either increase or decrease, while the quantity supplied by the industry must decrease. There’s one special case where we can say more: Suppose that marginal cost shifts upward by the same amount at every quantity (so that the marginal cost curve shifts upward

EXHIBIT 7.16 A Rise in Variable Costs

Price Price

MC' MC AC'

LRS' d' AC d LRS

Quantity Quantity

If variable costs rise, the firm’s marginal cost curve rises from MC to MC ′. The break-even price rises, so the long-run industry supply curve rises from LRS to LRS ′. The industry quantity falls; the firm quantity can either fall or rise. The average cost curve shifts from AC to AC ′, and the firm earns zero profit at the new equilibrium.

45185_07_ch07_p171-222.indd 196 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 197 parallel to itself). Then the break-even price rises by that same amount (as does the average cost curve). Consequently, the new equilibrium quantity at the firm is unchanged.

Changes in Demand Suppose the demand for haircuts increases. At the top of Exhibit 7.17, you can see the long-run consequence. Industry-wide demand shifts rightward. The market price remains unchanged, so nothing changes in the “firm” part of the picture. Individual

EXHIBIT 7.17 A Rise in Demand

P d 0 LRS

D D'

Q0 Q2 q0

S MC S'

P1 d'

LRS P0 d

D' D

Q0 Q1 Q2 q0 q1

The top of this exhibit shows the long-run effect of an increase in demand for the product of a constant- cost industry. The industry demand curve shifts from D to D′. There is no change in price and hence no change in the “firm” part of the picture. Firms produce exactly as before, but the industry quantity increases. The bottom of the exhibit contrasts the short-run and long-run responses. The industry is initially in both ′ short-run and long-run equilibrium at price P0. When demand shifts from D to D , the price is bid up to P1.

Firms increase their output from q0 to q1, and the industry output rises to Q1. Now firms earn positive profits,

so in the long run there is entry. Entry continues until the price is bid back down to P0. At this point, firms

return to producing quantity q0, and the industry produces quantity Q2. Entry causes the short-run supply curve to shift rightward to S′. The short-run supply curve shifts in the long run, not in the short run.

45185_07_ch07_p171-222.indd 197 20/05/10 5:33 AM 198 NOTCHAPTER 7 FOR SALE barbershops continue producing just as before, but the industry-wide quantity of haircuts increases, because of entry. It is instructive to compare the long run with the short run. At the bottom of Exhibit 7.17 you can see this comparison. The industry is initially in both short-run

and long-run equilibrium at the price P0 and quantity Q0. The increase in demand

initially leads to a movement along the short-run supply curve S to the higher price P1.

Firms now provide q1 haircuts apiece, for an industry-wide total of Q1. The higher price leads to positive profits and attracts entry in the long run. Thereupon the price is bid

back down to P0 and the industry-wide quantity rises further to Q2, although individual

firms return to the original quantity q0.

In Exhibit 7.17, entry causes the short-run industry supply curve to shift rightward from S to S ′. This shift takes place only in the long run; in the short run, there is no Dangerous entry, so the short-run supply curve does not shift. Curve Notice that entry does not cause a shift in the long-run supply curve, because the consequences of entry are already built in to that curve. But the short-run supply curve ignores the effects of entry, and so it must shift to a new location after entry takes place.

Application: The Government as a Supplier Suppose your city’s government decides there is not enough housing available and decides to do something about it by building and operating a new apartment complex. Will this policy succeed in increasing the quantity of housing? In the short run, yes. The new apartment complex causes the short-run housing supply curve to shift to the right. In Exhibit 7.18, you can see that the equilibrium price

of housing falls from P0 to P1 and the quantity increases from Q0 to Q1. But the long-run supply curve does not shift. That’s because the long-run supply curve is determined by the break-even price. For example, if it costs landlords $400 a month to provide an apartment, then the long-run supply curve is flat at $400 a month.

EXHIBIT 7.18 The Government as a Supplier

Price S S'

P0 LRS

Q0 Q1 Quantity

When the government builds an apartment complex, the short-run housing supply curve shifts rightward,

but the long-run housing supply curve remains fixed. Thus, the quantity of housing increases from Q0 to Q1

in the short run, but returns to Q0 in the long run.

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It follows that in the long run, the price of housing must return to P0 and the

quantity must return to Q0. That is, in the long run, the number of privately owned apartments withdrawn from the market must just equal the number of new apartments

built by the government. (Otherwise, the price would remain below P0 and landlords would earn negative profits, prompting further exit.) Thus, in the long run, the government’s new apartment complex adds exactly nothing to the supply of housing.

Some Lessons Learned Ask a non-economist why the price of cheddar cheese is, say, $5 a pound, and you’re likely to get an answer like “that’s what the market will bear,” which suggests that prices are explained by demand. But in fact, in competitive industries in the long run, prices are determined primarily by supply. We’ve just seen that—at least in certain ideal circumstances—the long-run supply curve is flat. Therefore, the supply curve alone determines price. Demand has nothing to do with it. (More precisely, a shift in demand has no effect on price, as we’ve seen in Exhibit 7.17.) Another lesson is that changes in costs don’t benefit suppliers in the long run, because in the long run profits are always zero. Therefore, when costs fall, all of the benefits are ultimately transferred to consumers. You might think that, if it became cheaper to feed cows, for example, dairy farmers would benefit. In the long run they won’t, because the price of dairy products falls until profits return to zero. The winners are the consumers of milk and cheese. What’s true of cost reductions is also true of subsidies. A government subsidy to, say, corner grocery stores would not, in the long run, benefit the owners of grocery stores; because of the long-run flat supply curve, the full benefit of the subsidy would be transferred to consumers. And conversely, a tax on grocery stores (or on milk or cheese) would, in the long run, fall entirely on consumers. One additional lesson to take from our analysis is that you’ll never get rich by imitating the successes of others. If those successes were easy to imitate, everybody would imitate them and they’d garner no rewards. If you want to get rich, you have to break out of the model (which assumes all firms are identical) by identifying needs nobody else has identified, or by finding solutions nobody else has thought of, or by finding genuinely new ways to make people understand that your solutions are worth adopting.

7.5 Relaxing the Assumptions

When you travel by car, the other drivers on the road are both a blessing and a curse. On the one hand, they compete with you for resources: They take up space on the road, and they bid up the price of gasoline. On the other hand, those other drivers are a large part of the reason why it was worth someone’s while to pave the road, and worth someone else’s while to set up gas stations and roadside rest stops. Likewise, if you start, say, a printing business, competing firms are both a blessing and a curse. On the one hand, they might bid up the price of ink. On the other hand, they might entice inkmakers into existence. Our analysis so far has ignored these effects. We’ve assumed that all firms are identical, so that the break-even price is the same at every firm. In this section, we will see what happens when we relax these assumptions.

45185_07_ch07_p171-222.indd 199 20/05/10 5:33 AM 200 NOTCHAPTER 7 FOR SALE The Break-Even Price The cornerstone of our theory is that in long-run equilibrium, firms must earn zero profit and therefore must sell their output at the break-even price. For such a theory to make sense, there must be a single break-even price that applies to all firms and that does not change as a result of entry and exit. In other words, we need to assume:

Assumption 1: All firms are identical; that is, all firms have identical cost curves. Assumption 2: Those cost curves do not change as the industry expands or contracts. Assumption 1 is probably true for sidewalk flower vendors and false for breeders of world-class orchids. There are a lot of people who can run sidewalk flower stands about equally well; thus, all of them have the same cost curves. But only very few people have the delicate skills to breed orchids efficiently. Those with fewer skills will find it substantially more costly to produce a given quantity of orchids. (If ½ of your flowers die before you can bring them to market, that adds substantially to the average cost of producing a marketable orchid.) In general, Assumption 1 will be true in industries that do not require unusual skills, and false in industries where unusual skills are required. Hamburger stands satisfy Assumption 1; gourmet restaurants do not. Assumption 2 is also probably true for sidewalk flower vendors. If you’re selling flowers, there’s no reason why the arrival of new competitors should affect your costs. (New arrivals can affect your profits by competing for customers, but that’s not the same thing as affecting your costs.) However, Assumption 2 is probably false for farmers. Here’s why: An influx of new farmers bids up the rental price of land, and the rental price of land is one of the costs of farming. The key difference is this: Sidewalk flower vendors cannot significantly bid up the wholesale price of flowers, because sidewalk flower vendors, taken as a whole, do not use a significant fraction of the world’s flowers. Farmers, by contrast, can bid up the price of land, because farmers, taken as a whole, do use a significant fraction of the world’s arable land.

When you think about flower vendors, be sure to distinguish between the retail price of sidewalk flowers (the price at which the vendors sell their wares) and the wholesale price of flowers (the price at which vendors buy their wares). To affect costs, competi- Dangerous tors must affect the wholesale price of flowers. Curve

Here’s an exception: Suppose that instead of buying their flowers from reputable deal- ers, the flower vendors pick their flowers from a small public park. Then the arrival of new competitors will make it harder to find flowers in the park, which increases Dangerous the cost of acquiring flowers. In this case, sidewalk flower vending does not satisfy Curve Assumption 2.

In general, Assumption 2 will be true in industries that are not large enough to affect the price of any input (where inputs are things like wholesale flowers or arable land), and false in industries that are large enough to affect the price of some input. Here the phrase “large enough” must be interpreted relative to the size of the market for the input in question. For example, the jewelry industry is large enough to affect the price of diamonds, because a substantial fraction of the world’s diamonds are used

45185_07_ch07_p171-222.indd 200 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 201 in jewelry. By contrast, hamburger stands use a lot of meat, but probably not enough to affect its price: Only a small fraction of the world’s meat is used to make fast food hamburgers. Thus, hamburger stands, like sidewalk flower vendors, are likely to satisfy Assumptions 1 and 2.

The Significance of the Assumptions Assumptions 1 and 2 make it possible to talk unambiguously about the break-even price. Without Assumption 1, different firms would have different cost curves and therefore different break-even prices. Without Assumption 2, a given firm’s cost curves—and hence its break-even price—would change as other firms entered or left the industry. But given both assumptions, all firms have the same break-even price and that break-even price is unaffected by entry or exit; it is the break-even price for the industry.

Even though we have stressed that there is just one break-even price for the industry, that break-even price can change if cost curves change for some reason other than entry or exit—such as an increase in the cost of some raw material, or a new annual license fee that every firm in the industry must pay. Dangerous Curve Constant-cost industry Constant-Cost Industries A competitive industry An industry is called a constant-cost industry if it satisfies Assumptions 1 and 2. in which all firms have Constant-cost industries are the industries to which the analysis of Section 7.4 applies. In identical cost curves, and the remainder of this section, we will examine some alternative types of competitive those cost curves do not industry. change as the industry expands or contracts.

In Section 7.4, we said that an industry is constant-cost if all firms have the same cost curves. Here we are calling an industry constant-cost if all firms have the same cost curves and those cost curves are unaffected by entry and exit. In fact, the analysis of Section 7.4 used both assumptions, though we didn’t state them explicitly. Dangerous Curve

Increasing-Cost Industries An increasing-cost industry is a competitive industry where the break-even price for Increasing-cost new entrants increases as the industry expands. industry There are two reasons why an industry might be increasing-cost. First, some firms A competitive industry might have higher break-even prices because they are less efficient. Second, an expansion where the break-even of the industry might bid up the price of some factor of production and thereby raise the price for new entrants break-even price for everyone—as when an expansion of the farming industry bids up increases as the the price of land (this is the factor-price effect, which we also encountered in the short industry expands. run). In either case, we shall see that the long-run industry supply curve slopes upward.

Less-Efficient Firms Suppose that Floyd the barber can break even selling haircuts at $7 apiece. His less-efficient cousin Lloyd has to charge $9 per haircut to break even. In this case, Assumption 1 is violated.

45185_07_ch07_p171-222.indd 201 20/05/10 5:33 AM 202 NOTCHAPTER 7 FOR SALE When the market price of haircuts is $7, Floyd cuts hair but Lloyd does something else. If the price rises to $9, Lloyd enters the barbering industry. Between them, Floyd and Lloyd cut more hair than Floyd alone. Thus, a higher price of haircuts leads to a greater quantity of haircuts supplied. In other words, the long-run supply curve slopes upward.

The Factor-Price Effect Suppose instead that Floyd and Lloyd are equally efficient. Either one can break even selling haircuts at $7 apiece. But suppose also that if Floyd and Lloyd both become barbers, they bid up the price of razors—because two barbers demand more razors than one barber. This adds to their costs and makes it impossible for them to continue breaking even at $7. Thus, as long as haircuts sell for $7, only one barber can survive. If the price of haircuts rises to $9, it becomes possible for Floyd and Lloyd to break even simultaneously. In this case, Assumption 2 is violated. Once again, a higher price of haircuts leads to more haircuts being supplied. Once again, the long-run supply curve slopes upward.

This example is entirely unrealistic, because in reality barbers cannot bid up the price of razors. That’s because the entire world population of barbers accounts for only a small fraction of the world’s demand for sharpened steel. We’ve used this example only Dangerous for easy contrast with earlier examples. Curve

The moral of both Floyd/Lloyd examples is this: In an increasing-cost industry, the long-run supply curve slopes upward.

An Intermediate Case: A Few Super-Efficient Firms One case of interest is that in which a few firms are especially efficient and a great number of other firms are essentially identical. In this case, a few efficient firms will be willing to enter the industry even when the price is low, yielding a small but nonzero quantity supplied. When the price rises high enough for the “ordinary” firms to break even, any quantity can be supplied. Thus, the long-run supply curve slopes upward for a short while and then becomes flat, as in Exhibit 7.19. In such an industry, when there is sufficient demand for equilibrium to occur on the flat part of the supply curve, it is usually harmless to assume (for simplicity) that the entire supply curve is flat.

Example: The Motel Industry In the motel industry, there might well be a few super-efficient firms, but there are also a vast number of essentially interchangeable motels with (it is reasonable to assume) pretty much the same cost curves. Therefore, to a reasonable approximation, Assumption 1 is satisfied. What about Assumption 2? Assumption 2 is violated if there is a factor-price effect—in other words, if the price of some input changes when the motel industry expands or contracts. Should we expect to see such a violation? One of the major inputs into the motel industry is land. Motels take up space, and that space has to be paid for. (Of course, it doesn’t matter whether the motel owns the land it sits on or rents it from a landlord. Rent paid to the landlord is a cost; rent forgone by using your own land is equally a cost.)

45185_07_ch07_p171-222.indd 202 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 203

EXHIBIT 7.19 Long-Run Supply with a Few Efficient Firms

Price

P S

0 Quantity

Suppose there are a few exceptionally efficient firms and a great number of identical “ordinary” firms. At low prices, only the efficient firms enter and the quantity supplied is small. At the break-even price of the ordinary firms (P), the supply curve becomes flat.

So: Does the expansion (or contraction) of the motel industry change the price of land? It depends. If we’re talking about the industry consisting of motels in, say, downtown Dayton, Ohio, probably not. Most of downtown Dayton is populated by shopping malls, office buildings, and parking lots. Motels use a very small fraction of the land, so even a substantial expansion of the motel industry won’t have a noticeable effect on land prices. New motels can enter without changing the break-even price (say $70 per motel room per night). These motels form a constant-cost industry. But if we’re talking about the industry consisting of motels clustered around a particular highway exit, the story is very different. It’s not uncommon for half the land near a highway exit to be populated by motels. Expand the motel industry and the rental price of land goes up. When a new motel enters the market, existing motels might find that they can no longer break even selling rooms for $70 a night; maybe the new break-even price is $80 instead. Assumption 2 is violated, the industry is increasing-cost, and the long-run supply curve slopes upward.

Decreasing-Cost Industries In 2001, the average laptop computer sold for $1,640; in 2004 it sold for $1,250 and by 2005 the price was down to $1,000—though by then you could get a perfectly usable machine, complete with the latest wireless technology, for as little as $650. The reason, according to an article in the Wall Street Journal,1 was increasing demand. For years, laptops were used pretty much exclusively by businesspeople, a relatively small market that prevented manufacturers from achieving economies of scale. Now that most college students have laptops, the market has expanded, laptops are produced more efficiently, and prices have fallen.

1 Gary McWilliams, “Laptop Prices Hit New Lows,” Wall Street Journal, August 31, 2005.

45185_07_ch07_p171-222.indd 203 20/05/10 5:33 AM 204 NOTCHAPTER 7 FOR SALE Decreasing-cost The computer industry is an example of a decreasing-cost industry where costs industry (and therefore break-even prices) fall as the industry expands. At one time, manufac- A competitive industry turers like Dell and Gateway produced many of their own internal components. where the break-even Nowadays, components (like disk drives) tend to be supplied by specialists, freeing up price for new entrants Dell and Gateway to concentrate on the things they do best. But a drive manufacturer falls as the industry can survive only when the industry is big enough to support it, so the growth of the expands. industry drives down break-even prices. Thus, on the industry supply curve, a greater quantity is associated with a lower price; that is: In a decreasing-cost industry, the long-run supply curve slopes downward. At the end of Chapter 2, we briefly discussed the gains from trade that are due simply to the scale of operations, as opposed to those that are due to comparative advantage. Decreasing-cost industries provide examples of such gains. Suppose that each of two isolated countries has a small computer industry, insufficient to support a specialized drive manufacturer. If these two countries begin to trade with each other, the combined market for computers might suffice to bring a drive manufacturer into the market. By concentrating on the production of drives in large quantities, the drive manufacturer can produce at a lower average cost than any of the computer manufacturers can, thereby reducing the average cost of a laptop computer. Residents of both countries can benefit from the savings.

Equilibrium The analysis of long-run equilibrium in the increasing-cost and decreasing-cost cases is just as in the constant-cost case; the only thing that differs is the shape of the long-run industry supply curve. Several examples are provided in Exhibit 7.20 and Exhibit 7.21.

7.6 Applications

Removing a Rent Control In the town of Llareggub, apartments rent for $400 per month. The town passes a law setting a maximum rent of $200 a month. Some years later, the law is repealed. Nothing changes in the interim. Does the rent on apartments return all the way up to its old level of $400 per month? To analyze this problem, look at Exhibit 7.22. The market is initially in both

short-run and long-run equilibrium at a price of $400 and a quantity of Q0. When the price is artificially lowered to $200, landlords’ short-run response is to provide fewer apartments. The new quantity can be read off the short-run supply curve S at a price of $200. (This quantity is not marked on the graph.) In the long run, as landlords seize additional opportunities to convert apartments to commercial or other uses, or just decide not to keep some existing apartments in adequate repair, the quantity

falls still further, to Q1, which is read off the long-run supply curve at a price of $200.

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EXHIBIT 7.20 An Increase in Costs in an Increasing-Cost Industry

A. An in crease in fixed costs

Price Price MC LRS' LRS AC' AC

P' d'

P d

Quantit y Quantit y

Industry Firm

B. An in crease in variable costs

Price LRS' Price MC' LRS MC

AC'

P' d' AC P d

Quantity Quantity

Industry Firm

The top panels show an increase in fixed costs and the bottom panels show an increase in marginal costs. In both cases, the break-even price increases, so the long-run industry supply curve shifts. The firm’s marginal cost curve shifts only in the second of the two examples. In both examples, the price rises and the industry supplies a smaller quantity. In the first example, the firm’s quantity surely increases; in the second, the firm’s quantity could increase or decrease.

45185_07_ch07_p171-222.indd 205 20/05/10 5:33 AM 206 NOTCHAPTER 7 FOR SALE

EXHIBIT 7.21 A Change in Demand

Price Price S S S'

P1 P1 S' LRS P2 P0 P0

P2 LRS D' D' D D

0 Q0 Q1 Q2 0 Q0 Q1 Q2 Quantity Quantity Increasing-cost industry Decreasing-cost industry

When demand increases, price rises in an increasing-cost industry, but it falls in a decreasing-cost industry. In both cases, the industry-wide quantity increases.

EXHIBIT 7.22 Removing a Rent Control

Price ($) S' S

LRS

500

400

200

Q1 Q2

Quantity

The market is initially in both short-run and long-run equilibrium at a price of $400. A maximum legal rent of $200 is imposed. Eventually, quantity falls to Q1 and the short-run supply curve falls from S to S ′. When the rent control is removed, the market moves to a new short-run equilibrium at a price of $500, above the original uncontrolled price. Eventually, it returns to the long-run equilibrium.

45185_07_ch07_p171-222.indd 206 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 207 With the stock of apartments reduced, there is a new short-run supply curve S ′. When the rent control is lifted, the new equilibrium is at $500 and a quantity some-

where between Q0 and Q1. Thus, the answer to the question “Does the rent return all the way up to $400?” is no; actually, it goes above $400. At $500, landlords earn positive profits and slowly they reconvert commercial buildings to use as apartments. Eventually, the market does return to the old long-run

equilibrium at a price of $400 and a quantity of Q0. The reason for this is quite simple: Neither the demand curve nor the long-run supply curve has shifted, so the equilibrium can’t change.

A Tax on Motel Rooms Suppose your town imposes a $5-per-night sales tax on motel rooms. Who pays the tax? In the short run, the number of motel rooms is nearly fixed so the supply curve is nearly vertical. (It is not completely vertical because, for example, a motel owner might be able to provide more clean rooms per night by hiring a larger maintenance staff.) Therefore, the tax is paid almost entirely by suppliers (i.e., motel owners) as you can ′ see in panel A of Exhibit 7.23, where the price falls from P to P , almost the full amount of the tax. In the long run, the answer depends on exactly which motel industry we’re talking about. We saw on page XXX that downtown motels are likely to form a constant-cost industry and motels near a highway exit are likely to form an increasing-cost industry. So for downtown motels, the long-run supply curve is flat, the price of a room is unaffected by the tax, and therefore the tax is paid entirely by demanders. You can see this

EXHIBIT 7.23 A Tax on Motel Rooms

Price Price Price

S S

P P S P P P' S D D D $5 $5 $5

D D D

0 Quantity (motel rooms) 0 Quantity (motel rooms) 0 Quantity (motel rooms)

A. The short run B. The long run downtown C. The long run near a highway exit

In the short run, the number of motel rooms is nearly fixed, so a sales tax is paid almost entirely by suppliers (panel A). In the long run, the supply curve is flat for downtown motels (where the industry is constant- cost) but upward sloping for motels near a highway exit (where the industry is increasing-cost). So in the long run, demanders pay the entire tax at downtown motels (panel B), and part of the tax at highway-exit motels (panel C).

45185_07_ch07_p171-222.indd 207 20/05/10 5:33 AM 208 NOTCHAPTER 7 FOR SALE in Exhibit 7.23B. For highway-exit motels, the relevant picture is Exhibit 7.23C, where in the long run, the tax is split between suppliers and demanders.

Exercise 7.5 Illustrate the short-run and long-run effects of a government program that subsidizes motel visits.

Tipping the Busboy Let us return to the Brotherhood for the Respect, Elevation, and Advancement of Dishwashers (bread), mentioned in the introduction to this chapter. The organization’s purpose is to encourage people to give tips to busboys. Who will benefit if they succeed in establishing this custom? A partial answer is: not busboys. The talents required of a busboy are reasonably widespread in society. A grocery bagger or a parking lot attendant can easily decide to become a busboy. Because there are no (or very few) individuals with special “busboy skills,” busboys’ services are provided at a constant cost. It follows that the total compensation of busboys cannot change. If tips increase, wages must decrease by the same amount. The increase in tips causes positive profits; the positive profits cause grocery baggers to become busboys; the entry of the grocery baggers causes wages to fall; and the whole process continues until grocery bagging and busing tables are again equally attractive.

Students sometimes argue that as grocery baggers leave their own industry to become busboys, the wage of baggers will rise. This would be true if bagging were the only other unskilled occupation. But because the new busboys come from many other industries, Dangerous the number coming from any one other industry is negligibly small. Curve Another way to make the same point is this: Because potential busboys are all pretty much identical, the supply curve of busboys is a horizontal line at the entry price determined by the condition that busing be just as attractive as bagging. If the supply curve for a good is horizontal, then changes in demand cannot change its price. If busboys don’t gain, who does? Tipping reduces the costs of restaurant owners, who now pay lower wages. Suppose that customers leave a tip of size T at each meal. Then busboys’ wages are reduced by T per meal served, which lowers the industry’s supply curve by the amount T. The short-run effect is illustrated in panel A of

Exhibit 7.24. The fall in costs leads to a fall in the price of restaurant meals, to P1. Who benefits? The restaurateurs and, ironically, the customers themselves.2 In the long run, there are two possibilities to consider, both of which are shown in Exhibit 7.24. In each case, the long-run supply curve falls by T. If the restaurant industry has constant costs, as in panel B, then the price of a meal drops by exactly T, the full amount of the tip. Although the customers would like to tip the busboys, the entire value of their tips is returned to them in the form of lower meal prices! The other possibility is that there are increasing costs in the restaurant industry. This would be the case, for example, if the potential entrants have varying aptitudes for restaurant management. That case is shown in panel C. Here the price of restaurant meals drops, but not by the full amount of the tips. The tips are split between the

2 There may be an additional effect as restaurateurs decide to hire a larger number of busboys at the lower wage. This effect is irrelevant to anything we are considering in this example.

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EXHIBIT 7.24 Tipping the Busboy

Price Price Price S S

P P P T 0 0 S 0 S P T U 1 P P 2 S 3

D D D T

0 Quantity (restaurant meals) 0 Quantity (restaurant meals) 0 Quantity (restaurant meals)

A. The short run B. The long run if all restaurateurs C. The long run if restaurateurs are identical have varying abilities Suppose that people decide to start tipping busboys. Because busing services are provided at constant cost (there are many essentially identical busboys), the total compensation of busboys cannot change. Therefore, wages are reduced by the amount of the tip, T. The marginal cost of serving meals falls by this amount. In the short run (panel A), price falls, but by less than T. Part of the tip is returned to the customer through the lower price, and the rest goes to the restaurant owner. In the long run, if all restaurateurs are identical (panel B), entry bids profits back down to zero only when the price of meals falls by the full amount T. We can see this geometrically: The horizontal supply curve falls by T, and the price falls by this full amount. If not all restaurateurs are identical, then entry by less-efficient firms can drive profits to zero even though the price is reduced by less than the full amount of the tip. This is shown in panel C, where the upward- sloping long-run supply curve drops by the amount T, but the price of meals falls by something less, which we label U. Those restaurateurs who were in the industry originally gain T – U per meal served (their marginal costs fall by T but their price falls by U, so they gain the difference), while customers get back U in the form of a lower price. The tip is split between the restaurateur and the customer; the busboy gets nothing.

restaurateurs and their customers, with the customers getting back more in the long run than they do in the short run.

Our analysis assumes that BREAD is successful in making diners feel good about tipping the busboy. An alternative assumption is that BREAD makes diners feel guilty about not tipping the busboy. In that case, the tip is essentially a tax on diners, and the demand for restaurant meals falls by the amount of the tip. Dangerous Curve

7.7 Using the Competitive Model

Exhibits 7.9 and 7.10 illustrate changes in short-run competitive equilibrium; Exhibits 7.15, 7.16, and 7.17 illustrate changes in long-run competitive equilibrium for a constant-cost industry; and Exhibits 7.20 and 7.21 illustrate changes in long-run competitive equilibrium for other sorts of industries. Problems 4, 10, 11, and 12 at the end of the chapter call for you to provide a large number of similar analyses. Here we will list the most important principles to keep in mind when you work problems of this type.

45185_07_ch07_p171-222.indd 209 20/05/10 5:33 AM 210 NOTCHAPTER 7 FOR SALE As in the exhibits, you should begin by drawing supply and demand curves for both the industry and the firm. The industry supply curve is always upward sloping in the short run. In the long run, it can be either flat (if the industry is constant-cost) or upward sloping (if the industry is increasing-cost). There is also the possibility of a downward-sloping long-run industry supply curve, but we will not discuss that case here. The firm’s demand curve should be drawn flat at the price determined by industry-wide equilibrium. To analyze a change in equilibrium, you must decide how the curves shift. Usually this means thinking about each curve separately. Here are the fundamental principles to keep in mind.

Shifts in the Firm’s Supply Curve The firm’s supply curve coincides with its marginal cost curve. Therefore, only a change in marginal costs can affect it. A cost is marginal only if it varies with output. In the short run, marginal costs include labor and raw materials. In the long run, they also include those items of capital equipment that can be varied in the long run. For example, if a restaurant decides to serve more hamburgers, it will use more meat and more waiters in the short run and will expand its kitchen facilities in the long run. Therefore, a change in the price of meat or the wages of waiters causes the firm’s supply curve to shift in both the short-run analysis and the long- run analysis, whereas a change in the price of kitchen facilities causes the supply curve to shift only in the long-run analysis. Some costs (e.g., annual license fees) do not vary with output even in the long run and so do not shift the firm’s supply curve even in the long run (unless they cause the firm to exit altogether). Shifts in the Short-Run Industry Supply Curve In the short run, the industry supply curve is the sum of the individual firm’s supply curves. Therefore, it shifts only if there is a change in supply at the individual firms. Shifts in the Long-Run Industry Supply Curve The long-run industry supply curve shifts in response to any change in profitability—unless the change in profitability is due to a change in the price of output, in which case it is reflected by a movement along, rather than of, the long-run supply curve. However, remember that sunk costs are sunk, so only future costs are relevant. Costs that have been paid and are irretrievable do not affect future profits; therefore, they do not affect entry and exit decisions, and therefore they do not affect the industry supply curve. The Individual Firm’s Exit Decision: The Constant-Cost Case In a constant-cost industry, every firm is completely indifferent about whether to remain in the industry. Thus, anything that reduces profits at just one firm must drive that firm from the industry. For example, suppose that newsstands constitute a constant-cost industry and a single newsstand owner is notified of a rent increase. The owner will certainly leave the industry. On the other hand, if all newsstand owners are notified of rent increases, then the industry supply curve shifts, some firms exit, the industry-wide price of newspapers rises until zero profits are restored, and any particular newsstand might very well remain in business. There is no way to predict which firms exit under these circumstances. Note again that sunk costs are sunk. A fire at an individual newsstand is not like a rent increase. The costs of the fire are sunk (even if the firm exits, it continues to bear the costs via a reduction in the resale value of its merchandise); the rent increase can be avoided by exit and is therefore not sunk. The fire, therefore, has no effect, while the rent increase drives the firm from the industry.

45185_07_ch07_p171-222.indd 210 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 211 In an increasing-cost industry, some firms might be particularly efficient and therefore prefer this industry over any of the alternatives. Such a firm might decide to remain in the industry even following an individual rent increase. Demand Curves After shifting the firm’s and the industry’s supply curves, and after deciding whether the firm remains in the industry, determine whether there is any shift in the industry demand curve. Then if there has been a shift in industry equilibrium (due to shifts in either industry supply, industry demand, or both), draw the new firm demand curve as horizontal at the new industry equilibrium price. Exceptions The rules listed here will serve you well most of the time. As you work the problems at the end of the chapter, you will find a few exceptions due to unusual circumstances. As always, each problem needs to be considered individually.

Summary

A perfectly competitive firm is one that faces a horizontal demand curve for its product; that is, it can sell any quantity it wants to at the going market price. The total revenue curve for such a firm is a straight line through the origin, and the marginal revenue curve is a horizontal line at the going market price. Thus, the marginal revenue curve is identical to the demand curve. Like any producer, competitive or not, the competitive firm produces, if it produces at all, where marginal cost equals marginal revenue. Because marginal revenue equals price for a competitive firm, we can say that such a firm produces, if it produces at all, where marginal cost equals price. To see what the firm will produce in the short run, we use its short-run marginal cost curve; and to see what it will produce in the long run, we use its long-run marginal cost curve. In the short run, the firm operates only if its revenue exceeds its variable costs. This is the same as saying that the firm operates only if the market price exceeds its average variable cost. Thus, the firm’s short-run supply curve is that portion of its marginal cost curve that lies above average variable cost. A competitive industry is one in which all firms are competitive. To derive the short-run industry supply curve, we assume a fixed number of firms and add their quantities supplied at each price. The competitive industry operates at the point where supply and demand are equal, because each individual firm maximizes profits at this point. In competitive equilibrium, the total cost of producing any quantity of output is minimized. This is because each firm has the same marginal cost (equal to the market price). In the long run, the firm operates where price is equal to long-run marginal cost, provided that it earns positive profits. If profits are negative (which happens when price falls below average cost) the firm leaves the industry. Therefore, the firm’s long-run supply curve is that part of its long-run marginal cost curve that lies above its long-run average cost curve. To study long-run equilibrium, we must account for the possibility of entry and exit. Entry and exit are driven by profit. If all firms are identical, then all firms must earn zero profit in long-run equilibrium.

45185_07_ch07_p171-222.indd 211 20/05/10 5:33 AM 212 NOTCHAPTER 7 FOR SALE In the simplest analysis, we assume that all firms share a single break-even price, and that the break-even price is unaffected by entry and exit. In that case, the break-even price is the only price that can prevail in long-run equilibrium; therefore, the long-run supply curve is flat at the break-even price. A second possibility is that the industry is increasing-cost, which means that the break-even price for new entrants increases as the industry expands. This could happen either because new entrants are less efficient than existing firms or because new entrants bid up the price of inputs, causing everyone’s costs to increase. In this case, the industry supply curve slopes upward. A third possibility is that the industry is decreasing-cost, which means that the break-even price for new entrants falls as the industry expands. For example, when the industry reaches a certain size, specialized sub-industries can be formed. In this case, there is a downward-sloping long-run supply curve.

Author Commentary academic.cengage.com/economics/landsburg

AC1. In a perfectly competitive market, there is a single going market price that everyone takes as given. In many markets, prices are determined by bargaining and through auctions—for example, eBay. Read this article for a discussion of eBay bidding strategy.

Review Questions

R1. Which of the following are true for all firms? Which are true for competitive firms only? Which are false for all firms? a. The firm faces a flat demand for its product. b. The firm faces a flat marginal revenue curve. c. The firm seeks to operate where marginal revenue equals marginal cost. d. The firm seeks to operate where price equals marginal cost. R2. If a competitive firm fails to maximize profits, which of the following statements are true and which are false? a. Price equals marginal cost. b. Price equals marginal revenue. c. Marginal cost equals marginal revenue. R3. What is the difference between a shutdown and an exit? R4. True or False: A firm shuts down whenever its profits are negative. R5. Suppose a competitive widget firm has an upward-sloping marginal cost curve, and that the marginal cost of producing 6 items is $12 per widget. Explain carefully why the point with coordinates ($12, 6 widgets) must be on the firm’s supply curve. R6. What determines the short-run industry-wide supply curve in a competitive industry?

45185_07_ch07_p171-222.indd 212 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 213 R7. In short-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in fixed costs? R8. In short-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in variable costs? R9. In short-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in demand? R10. What is the difference between accounting profit and economic profit? R11. Assuming that all firms are identical, explain why all firms must earn zero profit in long-run equilibrium. R12. Explain why the long-run industry supply curve must be flat in a constant-cost industry. R13. In long-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in fixed costs? (Assume a constant-cost industry if necessary.) R14. In long-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in variable costs? (Assume a constant-cost industry if necessary.) R15. In long-run competitive equilibrium, what happens to output at an individual firm following an industry-wide rise in demand? (Assume a constant-cost industry if necessary.) R16. What are the two key assumptions in the definition of a constant-cost industry? R17. What is the shape of the long-run industry supply curve in an increasing-cost industry? Why? R18. What is the shape of the long-run industry supply curve in a decreasing-cost industry? Why?

Numerical Exercises

N1. Every firm in the widget industry has fixed costs of $6 and faces the following marginal cost curve:

Quantity Marginal Cost

1$2 24 36 48 510

a. Suppose the price of widgets is $10. How many widgets does each firm produce? How much profit does the firm earn? Is the industry in long-run equilibrium? How do you know? b. In the long run, will there be entry or exit from this industry? What will be the price of widgets in the long run? How many widgets will each firm produce?

45185_07_ch07_p171-222.indd 213 20/05/10 5:33 AM 214 NOTCHAPTER 7 FOR SALE N2. Moose-nose pies are produced by a constant-cost industry where all firms are identical and each firm has fixed costs of $15. The following chart shows the industry-wide demand curve and the marginal cost curve of a typical firm:

Industry-Wide Demand Firm’s Marginal Cost Curve Price Quantity Quantity Marginal Cost $5 750 1 $5 10 600 2 10 15 450 3 15 20 300 4 20 25 150 5 25

Suppose the industry is in long-run equilibrium. a. What is the price of moose-nose pies? b. What is the number of firms in the industry? c. On the industry-wide short-run supply curve, what quantity corresponds to a price of $10?

N3. Widgets are produced by a constant-cost industry. The following chart shows the industry-wide demand curve and the marginal cost curve of each firm.

Demand Firm’s Marginal Cost Curve Price Quantity Quantity Marginal Cost $5 1500 1 $5 10 1200 2 10 15 900 3 15 20 600 4 20 25 300 5 25

There are currently 600 firms in the industry. Each firm has fixed costs of $30. a. What is the price of widget today? b. What is the profit of a widget firm today? c. In the long run, what is the price of a widget? d. In the long run, how many firms exit the industry?

N4. Widgets are provided by a competitive constant-cost industry where each firm has fixed costs of $30. The following chart shows the industry-wide demand curve and the marginal cost curve of a typical firm.

Industry-Wide Demand Firm’s Marginal Cost Curve Price Quantity Quantity Marginal Cost $5 1500 1 $5 10 1200 2 10 15 900 3 15 20 600 4 20 25 300 5 25 30 200 6 30 35 140 7 35 40 50 8 40

45185_07_ch07_p171-222.indd 214 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 215 a. What is the price of a widget? b. How many firms are in the industry? For the remaining four parts of this problem, suppose the government imposes an excise tax of $15 per widget. c. In the short run, what is the new price of widgets? d. In the short run, how many firms leave the industry? e. In the long run, what is the new price of widgets? f. In the long run, how many firms leave the industry?

N5. In the widget industry, each firm has fixed costs of $10 and faces the following marginal cost curve:

Quantity Marginal Cost

1 $2 per widget 24 35 47 511 613

The industry-wide demand curve is given by the following chart:

Price Quantity

$2 60 per widget 448 536 724 11 12 13 0

Assume the industry is in long-run equilibrium. a. What is the price of a widget? b. What quantity is produced by each firm? c. How many firms are in the industry? Now suppose that the demand curve shifts outward as follows:

Price Quantity

$2 96 per widget 484 572 760 11 48 13 36

d. In the short run, what is the new price of widgets, and how many does each firm produce? e. In the long run, what is the new price of widgets and how many does each firm produce? How many firms will enter or leave the industry?

45185_07_ch07_p171-222.indd 215 20/05/10 5:33 AM 216 NOTCHAPTER 7 FOR SALE N6. In the gadget industry, each firm must have one gadget press, regardless of how many gadgets it produces. The cost of a gadget press is the only fixed cost that firms face in this industry. Entry by gadget firms can bid up the cost of gadget presses. The following charts show (1) the demand for gadgets; (2) the marginal cost of producing gadgets at each individual firm; and (3) the cost of a gadget press as a function of the number of firms in the industry:

Price Quantity Demanded

1 800 2 700 3 600 4 500 5 400 6 300

Quantity Marginal Cost

1$1 2 2 3 3 4 4 5 5 6 6

Number of Firms Cost of Gadget Press

0–75 $6

76–150 10 151–225 15 226–300 18 >300 21

What is the long-run equilibrium price of gadgets? (Hint: Start by figuring out, for each price, the number of firms and the profits at each firm.)

N7. Kites are manufactured by identical firms. Each firm’s long-run average and marginal costs of production are given by: 100 AC = Q + and MC = 2Q Q where Q is the number of kites produced. a. In long-run equilibrium, how many kites will each firm produce? Describe the long-run supply curve for kites. b. Suppose that the demand for kites is given by the formula: Q = 8,000 − 50P where Q is the quantity demanded and P is the price. How many kites will be sold? How many firms will there be in the kite industry? c. Suppose that the demand for kites unexpectedly goes up to:

Q = 9,000 − 50P

45185_07_ch07_p171-222.indd 216 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 217 In the short run, it is impossible to manufacture any more kites than those already in existence. What will the price of kites be? How much profit will each kitemaker earn? d. In the long run, what will the price of kites be? How many new firms will enter the kite-making industry? How much profit will they earn?

N8. Suppose that a law is passed requiring each kite maker to have one fire extin- guisher on the premises. (These are the same kite makers we met in the preceding exercise.) The supply curve of fire extinguishers to kitemakers is

Q = P For example, at a price of $3, 3 fire extinguishers would be provided. Suppose that the kite industry reaches a new long-run equilibrium. a. Let F be the number of firms in the kite industry. Explain why each now has long-run cost curves given by

100 F AC = Q + + and MC = 2Q Q Q b. How many kites will each firm produce? (You will have to express your answer in terms of F.) How many kites will the entire industry produce? (Again, you will have to express your answer in terms of F.) What will the price of kites be? c. If the price of kites is P, what is the number of firms F? How many kites will the industry produce in terms of P? Write a formula for the long-run industry supply curve. d. Suppose, as in Exercise N6, that the demand for kites is

Q = 8,000 − 50P What will be the price of kites? How many kites will be produced? By how many firms? How much profit does each firm earn?

Problem Set

1. Gus the cab driver rents a cab and pays for gas. In each of the following circumstances, describe the short-run effect on the price and quantity of rides Gus offers. a. The price of gas falls. b. The rental price of cabs falls. c. Word gets out that Gus is a really lousy driver. d. A new bus company opens up. e. Gus gets the bill for the new upholstery he installed in his back seat last month and discovers it’s 15% more than he expected. f. The wages of factory workers go up, though this ends up having no effect on the demand for cab rides. g. A huge fire destroys half the cabs in town, not including Gus’s.

45185_07_ch07_p171-222.indd 217 20/05/10 5:33 AM 218 NOTCHAPTER 7 FOR SALE h. The city imposes a $1 excise tax on cab rides, but exempts Gus from the tax because he is a good friend of the mayor. i. The city imposes a $100 annual license fee on cab drivers, but gives Gus a free license because he is a good friend of the mayor. j. The city starts a new free taxi service, which offers free rides to 500 customers per day. k. The city offers to subsidize gas purchases for every cab driver except Gus because he is a special enemy of the mayor. l. The city announces that it will start fining cab drivers who play loud music; Gus (unlike most cab drivers) loves loud music, so he has to pay a lot of fines. m. A customer who was almost killed by Gus’s recklessness agrees to accept a large payment in exchange for keeping quiet about the incident. 2. True or False: If a firm in a competitive industry discovers a cheaper way to produce output, it might lower its price in order to steal its competitors’ customers. 3. True or False: When price equals marginal cost, profit equals zero. 4. True or False: In the short run, any firm earning a negative profit will shut down. 5. In the Woody Allen film Radio Days, a character who has never been successful in business decides to start a career engraving gold jewelry. He argues that this should be especially lucrative, because the engraver gets to keep the gold dust from other people’s jewelry. Comment. 6. Books with many mathematical formulas are generally more expensive than similar books written entirely in prose. True or False: Because typesetting is not part of the marginal cost of producing a book, the cost of typesetting mathematical formulas cannot explain this price difference. 7. True or False: In a competitive constant-cost industry, an excise tax is partly passed on to demanders in the short run but completely passed on to demanders in the long run. 8. If New York City provides better shelters for the homeless, then in the long run homeless New Yorkers will be better off. 9. The town of Whoville has 100 identical consumers and 50 identical car washes. Each consumer has an income of $24. The diagram and chart below show the

All Other Goods Quantity MC

1$3 2 4 3 5 4 6 5 7 6 8 Car Washes 7 9 12 34 8 12 810 CONSUMER'S INDIFFERENCE CURVES FIRM’S MARGINAL COSTS

45185_07_ch07_p171-222.indd 218 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 219 indifference curves of a typical consumer and the marginal cost curve of a typical car wash. a. What is the price of a car wash today? b. Suppose that in the long run there is no entry or exit from the car wash industry. What can you conclude about the fixed costs at an individual car wash? 10. Redo all the parts of Problem 1, describing the long-run effects instead of the short-run effects. Assume that cab driving is a constant-cost industry. 11. Redo all the parts of Problem 1, describing the long-run effects instead of the short-run effects. Assume that cab driving is an increasing-cost industry. 12. Redo all the parts of Problem 1, describing the long-run effects instead of the short-run effects. Assume that cab driving is a decreasing-cost industry. 13. Suppose the government institutes a new sales tax on shoes, which are provided by a competitive constant-cost industry. a. Does the price of shoes change by more in the short run or in the long run? b. Does the industry-wide quantity change by more in the short run or in the long run? c. Does the quantity provided by each shoemaker change by more in the short run or in the long run? d. Do the profits of shoemakers change by more in the short run or in the long run? 14. Suppose that shoes are provided by a competitive constant-cost industry. Suppose the government starts requiring each shoemaker to pay an annual license fee. a. Does the price of shoes change by more in the short run or in the long run? b. Does the industry-wide quantity change by more in the short run or in the long run? c. Does the quantity provided by each shoemaker change by more in the short run or in the long run? d. Do the profits of shoemakers change by more in the short run or in the long run? 15. Suppose there is a fall in the demand for shoes, which are provided by a competitive constant-cost industry. a. Does the price of shoes change by more in the short run or in the long run? b. Does the industry-wide quantity change by more in the short run or in the long run? c. Does the quantity provided by each individual shoemaker change by more in the short run or in the long run? d. Do the profits of shoemakers change by more in the short run or in the long run? 16. Widgets are provided by a constant-cost industry. Each firm employs one executive and a variable number of workers. a. Executive salaries rise, causing the price of a widget to rise by $5 in the long run. b. Workers’ salaries rise, causing the price of a widget to rise by $5 in the long run.

45185_07_ch07_p171-222.indd 219 20/05/10 5:33 AM 220 NOTCHAPTER 7 FOR SALE Of the two scenarios, which leads to a larger quantity of widgets per firm in the long run? 17. Suppose the government imposes an excise tax of $10 per pair of shoes, but simultaneously launches a program of giving a gift of $10,000 per year to each shoestore. a. In the short run, what happens to the price of shoes, the number of shoes sold in total, and the number of shoes at any particular shoestore? b. Suppose that by coincidence, the long-run effect of the two programs combined is to return the price of shoes right back to its original level. In the long run, what happens to the number of shoes sold in total, the number sold at any given store, and the number of stores in the industry? 18. Suppose health clinics form a competitive constant-cost industry. One day, the government unexpectedly opens a new clinic, which treats 800 patients a day for free. a. In the short run, what happens to the number of patients served by private clinics? Does it rise or fall? By more or less than 800 per day? b. In the long run, what happens to the number of patients served by private clinics? Does it rise or fall? By more or less than 800 per day? 19. The widget industry is a constant-cost industry, so that all firms are identical. The following chart shows the industry-wide demand curve and the marginal cost curve of a typical firm:

Industry-Wide Demand Firm’s Marginal Cost Curve Price Quantity Quantity Marginal Cost $2 500 1$2 3 400 2 3 5 300 3 5 6 200 4 6 8 100 5 8 9 50 6 9 12 25 712 15 10 815

The industry is in long-run equilibrium and there are a hundred firms. a. What are the fixed costs at each firm? b. What is the price of a widget? 20. In problem 19, suppose that the city imposes a license fee of $11 per firm. a. In the short run, what is the new price of a widget? b. In the long run, what is the new price of a widget? c. In the long run, how many firms leave the industry? 21. In problem 19, suppose the city imposes a sales tax of $6 per widget. a. In the short run, what is the new price of a widget? b. In the long run, what is the new price of a widget? c. In the long run, how many firms leave the industry?

45185_07_ch07_p171-222.indd 220 20/05/10 5:33 AM COMPETITIONNOT FOR SALE 221 22. In problem 19, suppose the city imposes an excise subsidy of $3 per widget. (That is, widget manufacturers receive $3 from the government for each widget they produce.) a. In the short run, what is the new price of a widget? b. In the long run, what is the new price of a widget? c. In the long run, how many firms enter the industry? 23. In problem 19, suppose that the demand for widgets doubles (so that, for example, on the new demand curve, prices of $2, $3, and $5 go with quantities of 1,000, 800, and 600). a. In the short run, what is the new price of a widget? b. In the long run, what is the new price of a widget? 24. Widgets are made only in America. They are provided by a constant-cost industry, which is in long-run equilibrium. The following charts show the American demand curve for widgets, the foreign demand curve for widgets, and the marginal cost curve of a typical American widget firm.

American Demand Foreign Demand Firm’s Marginal Cost Curve Price Quantity Price Quantity Quantity Marginal Cost $3 200 $3 150 1$2 5 160 5 140 2 5 7 75 7 120 3 7 9 60 9 100 4 9 11 45 11 90 511 13 30 13 80 613 15 15 15 70 715 17 10 17 60 817

Initially, American firms are not allowed to sell to foreigners. (Thus, the foreign demand curve is irrelevant.) In the United States, the industry is in long-run equilibrium and widgets sell for $7 apiece. Now the government decides to issue 10 export licenses; a firm with an export license can sell as many widgets to foreigners as it wants to. The export licenses are sold at auction to the highest bidders. a. What is the price of an American widget sold on the foreign market? b. What is the price of an export license? c. In the short run, what is the new price of a widget sold in America? Be sure to justify your answer. d. In the long run, what is the new price of a widget sold in America? (Hint: A firm that can sell as much as it wants to foreigners at a high price will not choose to sell anything at all to Americans at a low price.) 25. True or False: In the long run, profit-maximizing firms seek to minimize their average cost. 26. Suppose the wholesale price of gasoline falls by 50¢ a gallon. Does the retail price fall by more than 50¢, by 50¢, or by less than 50¢?

45185_07_ch07_p171-222.indd 221 20/05/10 5:33 AM 222 NOTCHAPTER 7 FOR SALE a. Answer assuming that gas stations constitute a competitive constant-cost industry. b. Answer assuming that gas stations constitute a competitive increasing-cost industry. 27. Upper, Middle, and Lower Slobbovia are distant countries that do not trade with each other or the rest of the world. In Upper Slobbovia, kites are provided by a competitive constant-cost industry. In Middle Slobbovia, kites are provided by a competitive increasing-cost industry. In Lower Slobbovia, kites are provided by a single monopolist. All three countries have just imposed a new tax on kite producers of $1,000 per firm per year. Rank the three countries in terms of what fraction of this tax is passed on to consumers in the long run. Justify your answer carefully. 28. True or False: An excise tax on the product of a decreasing-cost industry would raise the price by more than the amount of the tax. 29. Suppose the demand for seafood increases one year and then unexpectedly returns to its former level the following year. True or False: As soon as the demand returns to its former level, price and quantity will return to their former levels too.

45185_07_ch07_p171-222.indd 222 20/05/10 5:33 AM NOT FOR SALECHAPTER 8 Welfare Economics and the Gains from Trade

Should some people be taxed to pay for other people’s health care and education? If so, how much? Should the government subsidize purchases of home insulation? Should foreign goods be taxed to protect American workers and manufacturers? Should governments pass laws to lower the prices of some goods and raise the prices of others? How do we know which policies are best for the economy? The answer is that there is no answer, because there is no such thing as what’s “best for the economy.” Every policy you can imagine is good for some people and bad for others. How then can you know which policies to support? Perhaps you’re guided partly by self-interest. Or perhaps you prefer to balance your self-interest against what you think is fair and just for your fellow citizens. But when a tax or a subsidy or a new law benefits some of those fellow citizens at the expense of others, how can you decide whether that policy is on net good or bad? What you need is a normative criterion—a way of balancing the benefits that accrue to some people against the costs that are imposed on others. Economic theory can’t tell you what your normative criterion should be. It can, however, suggest some candidates for normative criteria and help you understand what it would mean to adopt one criterion or another. In this chapter, we’ll make a particularly detailed analysis of one candidate, called the efficiency criterion. But before we can talk about weighing benefits against costs, we need a way of measuring benefits and costs. We’ll start by measuring the gains from trade. When a consumer purchases a dozen eggs from a farmer, each is better off (or at least not worse off)—otherwise no trade would have occurred in the first place. The question we will address is: How much better off are they? Once we know how to measure the gains from trade, we can ask how these gains are affected by various changes in market conditions. Such changes include taxes, price controls, subsidies, quotas, rationing, and so forth. We will be able to see who gains and who loses from such policies and to evaluate the size of these gains and losses. Finally, we will learn one of the most remarkable facts in economics: In a competitive equilibrium, the sum of all the gains to all the market participants is as large as possible. This fact, called the invisible hand theorem, suggests one normative standard by which market outcomes can be judged. In the appendix to the chapter, we will compare this normative standard with a variety of alternatives.

223

45185_08_ch08_p223-282.indd 223 29/04/10 9:48 PM 224 NOTCHAPTER 8 FOR SALE 8.1 Measuring the Gains from Trade

When a consumer buys eggs from a farmer, each one gains from the trade. Our first task is to measure the extent of these gains.

Consumers’ and Producers’ Surplus First we consider the gains to the consumer. We begin by developing a geometric measure of the value that the consumer places on his purchases.

Marginal Value and Demand Suppose you’re so hungry that you’re willing to pay up to $15 for an egg. Does it follow that you’d be willing to pay up to $30 for 2 eggs? Probably not. Once you’ve eaten your first egg, you might be willing to pay only $10 for a second, or, in other words, $25 total for 2 eggs. Marginal value In this case we say that (to you) the marginal value of the first egg is $15 and the The maximum amount marginal value of the second is $10. The total value (again to you) of 1 egg is $15 and a consumer would the total value of 2 eggs is $25. be willing to pay to In general, we expect the marginal value of your second egg to be less than the acquire one additional marginal value of your first, and the marginal value of your third egg to be even lower. item. Why? Because when you have only 1 egg, you put it to the most valuable use you can think of. Depending on your tastes, that might mean frying it for breakfast. When you Total value have a second egg, you put it to the second most valuable use you can think of—maybe The maximum amount by making egg salad for lunch. Even if you combine your 2 eggs to make an omelet, a consumer would it’s reasonable to think that the second half of that omelet is worth less to you than the be willing to pay first half. to acquire a given As you acquire more eggs, their marginal value continues to fall. Consider a quantity of items. consumer whose marginal values are given by Table A in Exhibit 8.1. If the market price is $7 per egg, how many eggs does this consumer buy? He certainly buys a first egg: He values it at $15 and can get it for $7. He also buys a second egg, which he values at $13 and can also get for $7. Likewise, he buys a third egg. The fourth egg, which he values at $7 and can buy for $7, is a matter of indifference; we will assume that the consumer buys this egg as well. The fifth egg would be a bad buy for our consumer; it provides only $5 worth of additional value and costs $7 to acquire. He buys 4 eggs.

Exercise 8.1 Add to Table A in Exhibit 8.1 a “Net Gain” column displaying the difference between total value and total cost. Verify that the consumer is best off when he buys 4 eggs.

Exercise 8.2 How many eggs does the consumer buy when the market price is $5 per egg? Explain why.

There is nothing new in this reasoning; it is just an application of the equimarginal principle. The consumer buys eggs as long as the marginal value of an egg exceeds its price and stops when the two become equal. In other words, he chooses that quantity at which price equals marginal value. In Table B of Exhibit 8.1 we record the number of eggs the consumer will purchase at each price. Table B is the consumer’s demand

45185_08_ch08_p223-282.indd 224 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 225

EXHIBIT 8.1 Demand and Marginal Value

Value Price per Egg ($) per Egg ($) 15 15 13 13 11 11 9 9 7 7

5 5 3 3 MV D 1 1

0 1 234 56 0 1 234 56 Quantity (eggs) Quantity (eggs)

A B

Table A. Total and Marginal Value Table B. Demand Total Marginal Quantity Value Value Price Quantity

1 $15 $15/egg $15/egg 1 22813132 33810103 445774 550555 652226

At a given market price the consumer will choose a quantity that equates price with marginal value. As a result, his demand curve for eggs is identical with his marginal value curve.

schedule, and the corresponding graph is a picture of his demand curve for eggs.1 (Compare this reasoning with the derivation of Farmer Vickers’s supply curve in Exhibit 7.4.) The graphs in Exhibit 8.1 display both the consumer’s marginal value curve and his demand curve for eggs. The curves are identical, although they differ conceptually. To read the marginal value curve, take a given quantity and read the corresponding marginal value off the vertical axis. To read the demand curve, take a given price and read the corresponding quantity off the horizontal axis. Again, what we have learned is not new. The marginal value of an egg, measured in dollars, is the same thing as the consumer’s marginal rate of substitution between

1 More precisely, the graph is a picture of his compensated demand curve. When we talk about “willingness to pay” for an additional egg, we are asking what number of dollars the consumer could sacrifice for that egg and remain equally happy. The points on the marginal value curve all represent points on the same indifference curve for the consumer. All of the demand curves in this chapter are really compensated demand curves. However, the compensated and uncompensated demand curves coincide when income effects are small, so measurements using the ordinary (uncompensated) demand curve are good approximations for most purposes.

45185_08_ch08_p223-282.indd 225 29/04/10 9:48 PM 226 NOTCHAPTER 8 FOR SALE eggs and dollars: It is the number of dollars for which he would be just willing to trade an egg. In an indifference curve diagram between eggs and dollars, the marginal value is the slope of an indifference curve and the price is the slope of the budget line. We saw in Section 3.2 that the consumer’s optimum occurs at a point where the marginal value is equal to the price and that this is the source of the consumer’s demand curve.

Total Value as an Area Suppose the consumer of Exhibit 8.1 acquires 4 eggs. We would like to depict geometrically their total value. We begin by depicting the $15 in value represented by the first egg. This $15 is the area of rectangle 1 in panel A of Exhibit 8.2. The height of the rectangle is 15, and the width of the rectangle (which stretches from a quantity of 0 to a quantity of 1) is 1. Thus, the area is 15 × 1 = 15. The $13 in value that the consumer receives from the second egg is represented by rectangle 2 in the same graph. The height of this rectangle is 13 and its width is 1, so its area is 13 × 1 = 13. The area of rectangle 3 is the marginal value of the third egg, and the area of rectangle 4 is the marginal value of the fourth egg. The total value of the 4 eggs is the sum of the 4 marginal values, or the total area of the 4 rectangles. That is, the total value is $(15 + 13 + 10 + 7) = $45. Actually, what we have done is only approximately correct. That is because the marginal value table in Exhibit 8.1 omits some information. It does not show the value of 11/2 eggs or 31/4 eggs, for example.2 In order to consider such quantities, we might make our measurements not in eggs, but in quarter-eggs. If we do so, the quantity of quarter-eggs bought is 16, and the four rectangles of panel A of Exhibit 8.2 are replaced by the 16 rectangles of panel B, each one-quarter as wide as the original ones. Refining things even further, we could measure quantities in hundredth-eggs, making 400 rectangles. As our fundamental units get smaller, our approximation to the total value of 4 eggs gets better. The total value of the consumer’s 4 eggs is exactly equal to the shaded area in panel C. The total value of the consumer’s purchases is equal to the area under the demand curve out to the quantity demanded.3

The total value of 4 eggs is completely independent of their market price. Imagine offering the consumer a choice of living in two worlds, both identical except for the fact that in one world he has no eggs and in the other he has 4 eggs. Ask him what is Dangerous the most he would be willing to pay to live in the second world rather than the first. His Curve answer to that question is the total value that he places on 4 eggs.

2 You might think it is impossible to buy just one-quarter of an egg, but this is not so. Remember that every demand curve has a unit of time implicitly associated with it. If our demand curves are per week, then the way to buy exactly one-quarter of an egg per week is to buy one every four weeks. 3 If you have had a course in calculus, you might be interested to know that we have just “proven” the fundamental theorem of calculus! Think of total value as a function (where quantity is the variable). The marginal value is the addition to total value when quantity is increased by one small unit. In other words, marginal value is the derivative of total value. The area under the marginal value curve out to a given quantity is the integral of marginal value from zero out to that quantity. We have argued that this integral is equal to the total value associated with that quantity. In other words, integrating the derivative brings you back to the original function. Perhaps you knew the fundamental theorem of calculus but always accepted it as a mysterious fact of nature. If so, thinking about the economics of total and marginal values should give you some real insight into why the fundamental theorem is true.

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EXHIBIT 8.2 Total Value

Price Price per per Egg ($) Egg ($) 15 15 13 13 11 11 9 9 7 7

5 1234 5 D = MV D = MV 3 3

1 1

0 1 234 56 24681012141618202224(Quarter-eggs) 0 1 234 56(Eggs) Quantity (eggs) Quantity

A B

Price per Egg ($) 15 13 11 9 7 5 D = MV 3 1 0 1 234 56 Quantity (eggs)

When the consumer buys 4 eggs, their marginal values ($15, $13, $10, and $7) can be read off the demand curve. Their values are represented by the areas of rectangles 1 through 4 in panel A. Therefore, their total value is the sum of the areas of the rectangles, or $45. We can get a more accurate estimate of total value if we measure eggs in smaller units. Panel B shows the calculation of total value when we measure by the quarter-egg instead of by the whole egg. As we take smaller and smaller units, we approach the shaded area in panel C, which is the exact measure of total value when the consumer buys 4 eggs.

45185_08_ch08_p223-282.indd 227 29/04/10 9:48 PM 228 NOTCHAPTER 8 FOR SALE The Consumer’s Surplus Suppose the market price of an egg is $7. At this price, the consumer of Exhibit 8.1 buys 4 eggs, with a total value of (approximately) $45, which is represented by the entire shaded area in Exhibit 8.3.4 When the consumer buys those eggs, his total expenditure is only 4 × $7 = $28—a bargain, considering that he’d have been willing to pay up to $45. That $28 is represented in Exhibit 8.3 by area B, which is a rectangle with height 7 and width 4. The extent of the bargain is measured by the difference $45 − $28 = $17, which is Consumer’s area A. We call that area the consumer’s surplus in the market for eggs. It is the total surplus value (to him) of the eggs he buys, minus what he actually pays for them. In summary, The consumer’s gain we have: from trade; the amount Total Value = A + B = $45 by which the value of Expenditure = B = $28 his purchases exceeds what he actually pays Consumer’s Surplus = A = $17 for them. This consumer would be willing to pay up to $17 for a ticket to enter a grocery store where he can buy eggs. If the store lets him in for free, it’s as if the consumer has received a gift (that is, a free admission ticket) that he valued at $17. You can think of the consumer’s surplus as the value of that gift. Geometrically, we have seen that The consumer’s surplus is the area under the demand curve down to the price paid and out to the quantity demanded.

EXHIBIT 8.3 The Consumer’s Surplus

Price per Egg ($)

15 13 11 A 9 7

5 B D = MV 3 1 0 1 234 56 Quantity (eggs)

In order to acquire 4 eggs, the consumer would be willing to pay up to the entire shaded area, A + B. At a price of $7 per egg, his actual expenditure for 4 eggs is $28, which is area B. The difference, area A, is his consumer’s surplus.

4 $45 is the area of the four rectangles in Exhibit 8.2A, which is approximately the same as the shaded regions in Exhibits 8.2C and 8.3. The approximation is good enough that from now on, we will say that the area of the shaded region is $45.

45185_08_ch08_p223-282.indd 228 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 229 Notice that the consumer’s surplus is measured in units of dollars. In general, horizontal distances represent quantities, vertical distances represent prices (in units of, for example, dollars per egg), and areas represent numbers of dollars. Dangerous Curve

The Producer’s Surplus The consumer is not the only party to a transaction and not the only one to gain from it. We can also calculate the producer’s gains from trade. Imagine a producer with the marginal cost curve shown in Exhibit 8.4. Suppose that this producer supplies 4 eggs to the marketplace. What is the cost of supplying these 4 eggs? It is the sum of the marginal cost of supplying the first egg ($1), the marginal cost of the second ($3), the marginal cost of the third ($5), and the marginal cost of the fourth ($7). These numbers are represented by the 4 rectangles in panel A of Exhibit 8.4. Their heights are 1, 3, 5, and 7, and they each have width 1. As with the consumer’s total value, we must realize that the rectangles of panel A provide only an approximation, because we are making the faulty assumption that eggs can be produced only in whole-number quantities. A more accurate picture would include very thin rectangles, and the sum of their areas would be the area labeled D in the second panel. This is the cost of providing 4 eggs.5 Area D is approximately equal to $ (1 + 3 + 5 + 7) = $16.

EXHIBIT 8.4 The Producer’s Surplus

Price Price per per Egg ($) Egg ($) 15 15

13 S = MC 13 S = MC 11 11 9 9 7 7

5 5 C 3 3 D 1 1

0 1 234 56 0 1 234 56 Quantity (eggs) Quantity (eggs)

A B

If the producer supplies 4 eggs, his cost is the sum of the 4 marginal costs, which are represented by the rectangles in panel A. If we measure eggs in very small units, we find that an exact measure of his cost is area D in panel B. At a market price of $7, revenue is $7 × 4 = $28, which is the area of rectangle C + D. Thus, the producer’s surplus is area C.

5 By adding up the producer’s marginal costs, we are excluding any fixed costs that the producer might have. This is because we are considering only how the producer is affected by trade, whereas the producer would incur the fixed costs even without trading. This makes the fixed costs irrelevant to the discussion.

45185_08_ch08_p223-282.indd 229 29/04/10 9:48 PM 230 NOTCHAPTER 8 FOR SALE Next we depict the producer’s total revenue. This is easy: He sells 4 eggs at $7 apiece, so his revenue is 4 × $7 = $28, which is the area of the rectangle C + D in Exhibit 8.4. Now we can compute the producer’s gains from trade: Total revenues are C + D and Producer’s surplus production costs are D. The difference, area C, is called the producer’s surplus and The producer’s gain represents the gains to the producer as a result of his participation in the marketplace. from trade; the amount In this example, we have by which his revenue Total Revenue = C + D = $28 exceeds his variable – Production Costs = D = $16 production costs. Producer’s Surplus = C = $12 This producer would be willing to pay up to $12 for a license to sell eggs. If no license is required, it’s as if the producer has received a gift (that is, a free license) that he valued at $12. You can think of the producer’s surplus as the value of that gift. If the producer is competitive, his marginal cost curve can be identified with his supply curve. Therefore: The producer’s surplus is the area above the supply curve up to the price received and out to the quantity supplied. For a noncompetitive producer, we would want to change supply curve to marginal cost curve in the preceding sentence, but for a competitive producer these are the same thing.

Social Gain In panel A of Exhibit 8.5 we have drawn both the supply and the demand curve on the same graph. The consumer’s surplus is taken from Exhibit 8.3 and the producer’s surplus is taken from Exhibit 8.4. The consumer’s and producer’s surpluses depicted in Exhibit 8.5 provide a measure Social gain or of the gains to both parties. Their sum is called the social gain, or welfare gain, due to welfare gain the existence of the market. Students sometimes want to know where these gains are The sum of the gains coming from: If the consumer and the producer have both gained, then who has lost? from trade to all The answer is nobody. The process of trade creates welfare gains, which simply did not participants. exist before the trading took place. The fact that the world as a whole can be made better off should not strike you as surprising: Imagine the total value of all the goods in the world 100 years ago and compare it with the value of what you see around you today. In a very real sense the difference can be thought of as the sum of all the little triangles of surplus that have been created by consumers and producers over the passage of time. There is another way to measure the welfare gains created by the marketplace. Rather than separately computing a consumer’s surplus and a producer’s surplus, we can calculate the total welfare gain created by each egg. This is shown in panel B of Exhibit 8.5. The first rectangle represents the difference between the marginal value of the first egg and the marginal cost of producing it, which is precisely the welfare gain due to that egg. The height of the rectangle is 15 − 1 = 14, and its width is 1, giving an area of 14. The second rectangle has a height of 13 − 3 = 10 and a width of 1, giving an area of 10, which is the welfare gain from the second egg. The welfare gain due to the exchange of 4 eggs is the sum of the 4 rectangles (the fourth “rectangle” has height zero!). As usual, our focus on whole numbers has forced us to approximate: The total welfare gain is actually the entire shaded area between the supply and demand curves out to the equilibrium point.

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EXHIBIT 8.5 Welfare Gains

Price ($) Price ($)

15 13 S S 11 Consumer’s surplus 9 7 7 Producer’s surplus 5 3 D D 1 0 4 0 4 Quantity Quantity

A B

Panel A shows the consumer’s surplus and the producer’s surplus when 4 eggs are sold at a price of $7. The sum of these areas is the total welfare gain. The second panel shows another way to calculate the welfare gain. The first egg creates a gain equal to the area of the first rectangle, the second creates a gain equal to the area of the second rectangle, and so on. When units are taken to be small, the sum of these areas is the shaded region, which is the sum of the consumer’s and producer’s surpluses.

Notice that the total welfare gain (shown in panel B) is the sum of the consumer’s and producer’s surpluses (shown in panel A). This is as it should be: All of the gains have to go somewhere, and there are only the consumer and the producer to collect them.

Social Gains and Markets Next we want to consider markets with more than one consumer and with more than one producer. It turns out that consumers’ and producers’ surpluses can again be computed in exactly the same way. Imagine a world with three consumers: Larry, Moe, and Curly. Exhibit 8.6 displays each man’s marginal value schedule for eggs. In this world, when the price is $15, Larry buys 1 egg and Moe and Curly each buy 0 eggs. The total quantity demanded is 1. At a price of $13, Larry and Moe buy 1 each and Curly buys 0; the quantity demanded is 2. At a price of $11, Larry buys 1, Moe buys 2, and Curly buys 0 for a total of 3, and so on. The resulting demand curve is also shown in Exhibit 8.6. The rectangles below the demand curve represent the marginal values of the eggs that are bought. Each rectangle is labeled with the name of the man who consumes the corresponding egg: The first egg sold is bought by Larry, the second and third by Moe, the fourth by Larry, the fifth and sixth by Curly. Now suppose that the price of eggs is $7. How many eggs are sold, and what is their total value? Larry buys 2 (the first and fourth), Moe buys 2 (the second and third), and Curly buys 1 (the fifth). The values of these eggs are given by the areas of the

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EXHIBIT 8.6 Consumers’ Surplus in the Market

Price ($)

15 13 11 9 7

3 D 1 Larry MoeMoe Larry Curly Curly 0 1 234 56 Quantity

Larry Moe Curly Quantity Marginal Value Quantity Marginal Value Quantity Marginal Value

1 $15/egg 1 $13/egg 1 $7/egg 2 8 2 11 2 3

The demand curve is constructed from the marginal value curves of the three individuals. At a price of $7, Larry buys 2 eggs that he values at $15 and $8, Moe buys 2 that he values at $13 and $11, and Curly buys 1 that he values at $7. These marginal values are represented by the first 5 rectangles under the demand curve, each labeled with the appropriate consumer’s name. The total value of the 5 eggs to the consumers is the sum of the areas of the first 5 rectangles. The cost to the consumers is the darker area. The consumers’ surplus is what remains; it is the area under the demand curve down to the price paid and out to the quantity purchased.

corresponding rectangles, and the total value to the consumers is the sum of the 5 areas, which are shaded in Exhibit 8.6. From this must be subtracted the total amount that the consumers pay for the 5 eggs, which is represented by the darker, lower portions of the rectangles. The remaining portion, above the $7 price line, is the consumers’ surplus. The consumers’ surplus is composed of many rectangles, and each consumer receives some of these rectangles as his share of the welfare gain. But, just as before, the total consumers’ surplus is represented by the area under the demand curve down to the price paid and out to the quantity demanded. An analogous statement holds for producers’ surplus. Suppose that three different firms have the marginal cost schedules shown in Exhibit 8.7. The total supply curve is given by the graph. The colored rectangles corresponding to individual eggs are labeled with the names of the firms that produce them. Producers’ surplus is given by total revenue (the entire shaded region) minus the sum of the areas of these rectangles, out to the quantity produced. That is, the producers’ surplus is the gray part of the shaded region in the exhibit. This surplus is divided up among the producers, but the total of all the producers’ surplus is still given by the area above the supply curve up to the price received and out to the quantity supplied.

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EXHIBIT 8.7 Producers’ Surplus in the Market

Price ($)

11 S

1 AA BCCB 0 1 2 345 6 Quantity

Firm A Firm B Firm C Quantity Marginal Value Quantity Marginal Value Quantity Marginal Cost

1 $11$51$6 2 32 1127

The market supply curve is the industry’s marginal cost curve. When the price is $7, Firm A produces 2 items at marginal costs of $1 and $3, Firm B produces 1 at a marginal cost of $5, and Firm C produces 2 at marginal costs of $6 and $7. These costs are represented by the colored rectangles below the supply curve. The revenue earned by producers is the entire shaded region. The gray portion of that region above the supply curve is the producers’ surplus.

8.2 The Effi ciency Criterion

Suppose the government decides to impose a sales tax on coffee and give away the tax revenue (say, as welfare payments or Social Security payments). Is that a good or a bad policy? Both coffee drinkers and coffee sellers will tend to oppose this policy, because a sales tax simultaneously raises the price to demanders and lowers the price to suppliers. On the other hand, the citizens who are slated to receive the tax revenue will tend to favor the policy. How should we weigh the interests of one group against those of another? A normative criterion is a general method for making this sort of decision. One Normative example of a normative criterion is majority rule: Every citizen gets one vote to cast for criterion or against the tax, and we bow to the will of the majority. In this case, the tax will prob- A general method ably be defeated if the coffee buyers and coffee sellers outnumber the tax recipients, and for choosing among the tax will probably pass if the tax recipients outnumber the buyers and sellers. alternative social One problem with the majority rule criterion is that it allows the slight preference policies. of a majority to overrule the strong preference of a minority. For example, suppose

45185_08_ch08_p223-282.indd 233 29/04/10 9:48 PM 234 NOTCHAPTER 8 FOR SALE that you and nine of your fellow students vote to burn down your economics professor’s house for amusement. By the majority rule criterion, your 10 votes in favor of this activity outweigh the professor’s 1 vote against. Nevertheless, most people would agree that burning down the house is a bad thing to do. So there is apparently something wrong with unrestricted majority rule. Efficiency An alternative to majority rule is the efficiency criterion. According to the effi- criterion ciency criterion, everyone is permitted to cast a number of votes proportional to his A normative criterion stake in the outcome, where your stake in the outcome is measured by how much you’d according to which be willing to pay to get your way. So, for example, if 10 students each think it would be your votes are worth $10 to watch the professor’s house go up in flames, while the professor thinks it weighted according would be worth $1,000 to prevent that outcome, then each of the students gets 10 votes to your willingness to and the professor gets 1,000 votes. The house burning is defeated by a vote of 1,000 pay for your preferred to 100. outcome. Is that the right outcome? Most people seem to think so, for several reasons. Here’s one of those reasons: The house burning essentially takes $1,000 from the professor in order to give the students $100 worth of enjoyment. But as long as you’re willing to take $1,000 from the professor, wouldn’t it make more sense to take it in cash, hand out $100 to the students (making them just as happy as the house burning would), and then have $900 left over to do more good? You could, for example, give even more money to the students, give some back to the professor, or give it all to someone else, or any combination of those things. The house burning is inefficient in the sense that it takes $1,000 worth of house, converts it into $100 worth of pleasure, and effectively throws $900 away. The efficiency criterion says precisely that this kind of inefficiency is a bad thing. One advantage of the efficiency criterion is that when it is applied consistently, you’ll have the most influence on the issues you care about the most. In the appendix to this chapter, we will consider several alternatives to the efficiency criterion. In this section, we will explore the consequences of accepting the efficiency criterion and applying it to evaluate public policies. This will enable us to judge various policies—such as the sales tax on coffee—to be either “good” or “bad” as judged by the efficiency criterion. Of course, it does not follow that those policies are necessarily either good or bad in a larger sense. The efficiency criterion is one possible method of choosing among policies, and it is a method that you might come either to approve or disapprove. To help you decide whether you like the efficiency criterion, it will be useful to see what it recommends in a variety of specific circumstances. That’s what we’ll do in this section.

Consumers’ Surplus and the Efficiency Criterion Suppose that we are deciding whether it should be legal to produce, sell, and buy eggs. Among the parties who will be interested in the outcome of this debate are the people who like to eat eggs for breakfast. They’ll want to vote for legal egg sales. How many votes should we give them? The answer, according to the efficiency criterion, is that they should receive votes in proportion to their willingness to pay for the right to buy eggs. That willingness to pay is measured by the consumers’ surplus. For example, consider the consumer depicted back in Exhibit 8.3; this consumer receives a number of votes proportional to area A. If we want to know how many votes should be allocated to all egg consumers (as opposed to the single egg consumer of Exhibit 8.3), we can use the market demand

45185_08_ch08_p223-282.indd 234 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 235 curve to measure the total consumers’ surplus. For example, suppose the area under the market demand curve, out to the quantity of eggs consumed and down to the market price of eggs, is equal to $10,000. Then we know that egg consumers as a group should receive 10,000 pro-egg votes. (In other words, each consumer receives a number of votes proportional to his individual consumer’s surplus, and we know that the sum of all these numbers is 10,000.) Likewise, we can use the producers’ surplus to compute the number of pro-egg votes cast by egg producers. If there are any anti-egg votes (say, from people who hate living next door to chicken farms), their number is a bit harder to calculate in practice. But in principle, the farmer’s neighbors get a number of votes proportional to what they would be willing to pay to make the chickens go away. (The easiest case is the case where there are no unhappy neighbors; then there might be zero votes in favor of ban- ning egg production.)

The Effect of a Sales Tax Now let’s return to the issue of a sales tax on coffee and evaluate that policy according to the efficiency criterion. Panel A of Exhibit 8.8 shows the supply and demand for coffee. Panel B shows the same market after a 5¢-per-cup sales tax is placed on consumers. As we know from Chapter 1, this has the effect of lowering the demand curve vertically a distance of 5¢. Before the sales tax is imposed, the consumers’ and producers’ surpluses are as shown in panel A. The sum of these is the total welfare gained by all members of society, and we will refer to it as the social gain. In terms of the areas in panel B, we have: Consumers’ Surplus = A + B + C + D + E Producers’ Surplus = F + G + H + I Social Gain = A + B + C + D + E + F + G + H + I Once the sales tax is imposed, we need to recompute the consumers’ and producers’ surpluses. The consumers’ surplus is the area below the demand curve down to the price paid and out to the quantity demanded. The question now arises: Which demand curve? The answer is: The original demand curve, because this is the curve that reflects the consumers’ true marginal values. Which price? The price paid by

demanders: Pd. Which quantity? The quantity that is bought when the tax is in effect: Q′. The consumers’ surplus is area A + B. In other words, the sales tax causes the consumers’ surplus to fall by the amount C + D + E. Thus, consumers would collectively be willing to pay up to C + D + E to prevent the tax, and we will eventually allow them to cast C + D + E votes against it. What about producers’ surplus? We need to look at the area above the supply curve up to the price received and out to the quantity supplied. The relevant price to suppliers

is Ps, and the relevant quantity is the quantity being sold in the presence of the sales tax: Q′. The producers’ surplus is I. The tax costs producers F + G + H, so we will allow them to cast F + G + H votes against the tax. We can now make the following tabulation: Before Sales Tax After Sales Tax Consumers’ Surplus A + B + C + D + EA + B Producers’ Surplus F + G + H + I I Social Gain A + B + C + D + E ? + F + G + H + I

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EXHIBIT 8.8 The Effect of a Sales Tax

Price Price S S

A B Consumers’ Pd surplus CDE F G H Producers’ Ps surplus I 5¢

D D' D 0 Q 0 Q' Q Quantity Quantity

A B

Before Sales Tax After Sales Tax

Consumers’ Surplus A + B + C + D + EA + B Producers’ Surplus F + G + H + II Tax Revenue — C + D + F + G

Social Gain A + B + C + D + E + F + G + H + IA + B + C + D + F + G + I Deadweight Loss — E + H

Before the sales tax is imposed, consumers’ and producers’ surpluses are as shown in panel A. The first column of the chart shows these surpluses in terms of the labels in panel B. The second column shows the gains to consumers and producers after the imposition of the sales tax and includes a row for the gains to the recipients of the tax revenue. The total social gain after the tax is less than the social gain before the tax. The difference between the two is area E + H, the deadweight loss.

What about the social gain after the sales tax is imposed? Can’t we find it by simply adding the consumers’ and producers’ surpluses? The answer is no, because there is now an additional component to consider. We must ask what becomes of the tax revenue that is collected by the government. The simplest assumption is that it is given to somebody (perhaps as a welfare or Social Security payment). Alternatively, it might be spent to purchase goods and services that are then given to somebody. In some form or another, some individual (or group of individuals) ultimately collects the tax revenue, and that individual is part of society. The revenue that the recipients collect is welfare gained. How much tax revenue is there? The answer: It is equal to the tax per cup (5¢) times the number of cups sold (Q′). Because the vertical distance between the two demand curves is 5¢, the amount of this revenue is equal to the area of the rectangle C + D + F + G (height = 5¢, width = Q′). The recipients of the tax revenue gain C + D + F + G

45185_08_ch08_p223-282.indd 236 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 237 as a result of the tax, and so will be allowed to cast C + D + F + G votes in its favor. The final version of our table is this: Before Sales Tax After Sales Tax Consumers’ Surplus A + B + C + D + EA + B Producers’ Surplus F + G + H + I I Tax Revenue — C + D + F + G Social Gain A + B + C + D + E A + B + C + D + F + F + G + H + I + G + I

The social gain entry is obtained by adding the entries in the preceding three rows. Even after the tax revenue is taken into account, the total gain to society is still less after the tax than it was before. The reduction in total gain is called the deadweight loss due Deadweight loss + to the tax. In this example, the deadweight loss is equal to the area E H. Other terms A reduction in social for the deadweight loss are social loss, welfare loss, and efficiency loss. gain. Let’s tabulate the votes for and against this tax. Consumers cast C + D + E votes against; producers cast F + G + H votes against, and the recipients of tax revenue cast C + D + F + G votes in favor. The tax is defeated by a margin of E + H votes, so, according to the efficiency criterion, the tax is a bad thing. It is no coincidence that the margin of defeat (E + H) is equal to the deadweight loss. The efficiency criterion always recommends the policy that creates the greatest social gain. If an alternative policy creates a smaller social gain, the difference is equal to the deadweight loss from that policy and to the margin by which that policy loses in the election prescribed by the efficiency criterion.

In doing the computations, we have considered three separate groups: consumers, producers, and the recipients of tax revenue. Some individuals might belong to two or even all three of these groups. A seller of coffee might also be a drinker of coffee; a drinker of coffee might be one of the group of people to whom the government gives the tax proceeds. Such an individual receives shares of more than one of the areas in the graph. Someone who both supplies and demands coffee will get a piece of the producers’ Dangerous surplus in his role as a producer and a piece of the consumers’ surplus in his role as Curve a consumer. Nevertheless, we keep track of the consumers’ and producers’ surpluses separately.

The Hidden and Nonhidden Assumptions Our rejection of the sales tax is based on several hidden assumptions. First, we assumed that in the absence of the sales tax, the market price would be determined by the intersection of supply and demand. (We used this assumption when we computed the consumers’ and producers’ surpluses in the “no tax” column.) Although that assumption holds in competitive markets, we will see in Chapter 10 that it need not hold when there are firms with monopoly power. Second, we assumed that the government simply gives away the tax revenue, as opposed to using it for some purpose that is even more valuable. We used this assumption when we entered the value of tax revenue at C + D + F + G. That’s the amount of revenue collected, and it’s certainly still the value of the revenue if it’s simply given away. But if, for example, C + D + F + G = $100, and if the government uses that $100 to construct a post office that has a value of $300 (measured by people’s willingness to pay

45185_08_ch08_p223-282.indd 237 29/04/10 9:48 PM 238 NOTCHAPTER 8 FOR SALE for the post office), then our calculation of social gain in the “after sales tax” column is off by $200. In Chapter 14, we will discuss the circumstances in which governments might be able to spend money more efficiently than individuals can. Third, we assumed that the production and consumption of coffee does not affect anyone but the producers and consumers. But suppose that coffee producers use heavy machinery that keeps their neighbors awake at night or that coffee drinkers use styro- foam cups that they throw by the roadside when they’re done. Then there should be additional rows in our chart to reflect the concerns of sleep-deprived neighbors and Sunday motorists who prefer not to confront other people’s litter. By omitting these rows, we assumed that there are no significant concerns of this kind. In Chapter 13, we will discuss how to incorporate such concerns in the analysis. In addition to these hidden assumptions, we have made the nonhidden assumption that the efficiency criterion is an appropriate way to judge a policy. If any one of these assumptions is violated, we might need to reconsider the desirability of the sales tax on coffee.

Understanding Deadweight Loss Exhibit 8.9 presents another view of the deadweight loss. The prices and quantities are the same as in panel B of Exhibit 8.8. At the original equilibrium quantity Q, the social gain is the sum of all the rectangles. At Q′, which is the quantity with the tax, the social gain consists of only the color rectangles. The next cup of coffee after Q′ would increase welfare if it were produced, because the marginal value it provides (read off the demand curve) exceeds the marginal cost of producing it (read off the supply curve). However, that cup is not produced and an opportunity to add to welfare is lost.

EXHIBIT 8.9 Deadweight Loss

Price S

D 0 Q' Q Quantity

If the market operates at the equilibrium quantity Q, all of the rectangles are included in the social gain. If for any reason the market operates at the quantity Q′ (for example, because of a tax), then only the color rectangles are included. The units of output that could create the gray rectangles are never produced, and those rectangles of gain are never created. The gray rectangles, representing gains that could have been created but weren’t, constitute the deadweight loss.

45185_08_ch08_p223-282.indd 238 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 239 The deadweight loss calculated in Exhibit 8.9 is the same as the deadweight loss calculated in Exhibit 8.8, where it corresponds to the area E + H. If we think of the social gain as a pie divided among various groups, then a tax has two effects: It changes the way the pie is distributed, and it simultaneously changes the size of the entire pie. Thus, in Exhibit 8.8, the pie originally consists of all the lettered areas. The tax reduces the consumers’ and producers’ pieces. On the other hand, the recipients of the tax revenue, who get nothing in the absence of the tax, now receive a piece of the pie. After adding up everyone’s pieces, we find that the total pie has shrunk; the losses to the losers exceed the gains to the winners. The shrinkage in the pie is the deadweight loss.

The deadweight loss is not due in any way to the costs of collecting the tax. We have been assuming that these costs are negligible. If, in fact, it is necessary to hire tax collectors, to provide them with office space, and to buy them computers, or if it is costly for citizens to compute their taxes or to deliver them to the government, these Dangerous are additional losses that are not included in our computation of the deadweight loss. Curve

Exercise 8.3 In Exhibit 8.8 how much does each group of losers lose? How much does each group of winners win? Is the excess of losses over gains equal to the deadweight loss?

A moral of this story is that “taxes are bad”—though not in the sense you might think. You might think that taxes are bad because paying them makes you poorer. True, but collecting them makes somebody else richer. In Exhibit 8.8 the areas C + D + F + G that are paid in taxes do end up in somebody’s pocket. Whether this is a good thing or a bad thing depends on whose pocket you care about most. The aspect of the tax that is unambiguously “bad” is the deadweight loss. This is a loss to consumers and producers that is not offset by a gain to anybody.

Exercise 8.4 Work out the effects of an excise tax of 5¢ per cup of coffee. (Hint: We already know that an excise tax has exactly the same effects as a sales tax, so you will know your answer is right if it gives exactly the same results as in Exhibit 8.8.)

Whenever a policy creates a deadweight loss, it is possible to imagine an alternative policy that would be better for everybody. Exhibit 8.10 revisits the effect of a 5¢ sales tax. The tax costs consumers the amount C + D + E, costs producers the amount F + G + H, and delivers C + D + F + G to the tax recipients. Suppose that instead of the 5¢ sales tax, we adopt the following plan: One night, without warning, the tax collector breaks into the homes of the consumers and steals a total of C + D + E dollars from their dresser drawers; then he breaks into the homes of the producers and steals a total of F + G + H. As far as the consumers and producers are concerned, this is neither better nor worse than being taxed. The tax collector then gives C + D + F + G dollars to the tax recipients—the same amount they’d have received in tax revenue. The tax collector now has E + H dollars left over to do some additional good with. The collector can return part of it to the consumers and producers, give part of it to the tax recipients, give part of it to charity, keep part of it, or do any combination of these things. If he wants to, he can give everyone a small sliver of that E + H and make everyone better off. By eliminating the deadweight loss of E + H dollars, the tax collector can do exactly an additional E + H dollars worth of good. This isn’t too surprising: When there’s more surplus to go around, we can always find a way to increase everyone’s share. Or in other words: When the pie is bigger, you can always give everyone a bigger piece.

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EXHIBIT 8.10 Eliminating Deadweight Loss

No Tax With Sales Tax

Consumers’ Surplus A + B + C + D + E A + B Producer’s Surplus F + G + H + I I Tax Revenue — C + D + F + G

Social Gain A + B + C + D + E + F A + B + C + D + G + H + I + F + G + I

Deadweight Loss — E + H

Price S

A B Pd CDE F G H Ps

I 5¢

D ′ D 0 Q′ Q Quantity

The sales tax costs consumers C + D + E and producers F + G + H. If, instead of imposing a sales tax, the collector simply steals these amounts from the consumers and the producers, he can give C + D + F + G to the tax recipients ( just as they’d receive under the sales tax) and still have E + H left over to do some additional good.

An important feature of our alternative policy is that it is totally unexpected and nobody can do anything to avoid it. If people know in advance, for example, that the tax collector will be stealing from all producers of coffee, the producers will react to this as they would to a tax and produce less. Their exact reaction will depend on the collector’s exact policy: If he steals more from those who produce more, he is effectively imposing an excise tax, which causes each firm to reduce its quantity. If he steals equally from all pro ducers, the main effect will be to drive some producers out of the industry altogether. Dangerous When people anticipate the collector’s actions, they will take steps to avoid them. Curve These steps will include producing and consuming less coffee, and this will create a deadweight loss. The only way to avoid a deadweight loss is for the market to produce the equilibrium quantity of coffee, and this happens only if nobody is given a chance to alter his or her behavior in order to reduce the tax burden.

45185_08_ch08_p223-282.indd 240 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 241 As with the tax policy, we are ignoring any costs involved with implementing the alternative policy (such as the collector’s expenditure on burglar tools or the value of his time). Any such costs would lessen the social gain. Dangerous Curve

It would be enormously impractical to subject consumers and producers to random unexpected thefts. That’s one reason we still have taxes, despite the deadweight loss. When a tax creates a reasonably small deadweight loss, we might be willing to live with it; when another tax creates a much larger deadweight loss, we might be more inclined Dangerous to think hard about alternatives. Curve

Other Normative Criteria The simplest of all normative criteria is the Pareto criterion, according to which one Pareto criterion policy is “better” than another when it is preferred unanimously. In Exhibit 8.10, this A normative criterion means that the alternative policy is better than the sales tax, because everyone—con- according to which sumers, producers, and recipients of tax revenue—agrees on this assessment. But one policy is better according to the Pareto criterion, there is no way to decide between the “no tax” policy than another when it is in the first column and the “sales tax” policy in the second column. Consumers and preferred unanimously. producers prefer the first, while tax recipients prefer the second. There is no unanimity; therefore, the Pareto criterion remains silent. The great advantage of the Pareto criterion is that its recommendations, when it makes them, are extremely noncontroversial. Who can disagree with the outcome of a unanimous election? The offsetting disadvantage is that the Pareto criterion usually makes no recommendation at all, because unanimity is rarely found. One modification of the Pareto criterion is the potential Pareto criterion, accord- Potential Pareto ing to which any proposal that could be unanimously defeated should be rejected— criterion even if the proposal that defeats it is not really in the running. For example, suppose in A normative criterion Exhibit 8.10 that we are asked to choose between the “no tax” proposal in the first col- according to which umn and the “sales tax” proposal in the second. According to the potential Pareto cri- any proposal that terion, we should reject the sales tax because it loses unanimously to the alternative can be unanimously proposal in the third column—and that’s enough to disqualify it, even if the alternative defeated—even by a policy is not under serious consideration. candidate not under In all of our examples, the potential Pareto criterion and the efficiency criterion will consideration—should make identical recommendations. It’s easy to see why if you return to the pie analogy: be rejected. The efficiency criterion says that we should always try to make the total “pie” of social gain as big as possible. The potential Pareto criterion says that if there’s a way to make everyone’s piece of pie bigger, you’re not doing things right. But to say that everyone’s piece could be made bigger is the same thing as saying that the pie could be made bigger—so whatever the potential Pareto criterion rejects, the efficiency criterion will reject as well. Many economists regard the potential Pareto criterion and the efficiency criterion as good rough guides to policy choices, though few would defend them as the sole basis on which to make such decisions. Regardless of your feelings on this issue, calculations of social gains and deadweight losses can still be useful in understanding the consequences of various alternatives. If a policy causes a large deadweight loss, it is at least worth considering whether there is some good way to revise the policy so that the loss can be made smaller.

45185_08_ch08_p223-282.indd 241 29/04/10 9:48 PM 242 NOTCHAPTER 8 FOR SALE 8.3 Examples and Applications

The machinery of consumers’ and producers’ surpluses is widely applicable, as the following sequence of examples will illustrate. All of them use just one basic procedure, which is summarized in Exhibit 8.11.

Subsidies Suppose that the government institutes a new program whereby buyers of home insulation receive a rebate of $50 for every unit of insulation they purchase. This has the effect of shifting the demand curve upward a vertical distance $50, from D to D′ in Exhibit 8.12. ′ With the subsidy, the quantity sold is Q , at a market price of Ps. This is the price suppliers receive for insulation. However, consumers actually pay less, because they receive a payment of $50 from the government, so that the consumer’s actual cost is − = Ps $50 Pd. To calculate consumers’ and producers’ surpluses before the subsidy, we use the equilibrium price and quantity. This is shown in the first column of the table in Exhibit 8.12. ′ After the subsidy, consumers purchase quantity Q at a price to them of Pd. Their consumers’ surplus is the area under the original demand curve D out to this quantity and down to this price. We use the original demand curve because it is this curve that represents the true marginal value of insulation to consumers. The intrinsic value of home insulation is not changed by the subsidy. Therefore, the consumers’ surplus is the area A + C + F + G, as recorded in the second column of the table. ′ To calculate producers’ surplus, we use the quantity Q and the producers’ price Ps. This yields the area C + D + F + H, which is also recorded in the table. We are still not finished. The subsidy being paid to consumers must come from somewhere, presumably from tax revenues. This represents a cost to taxpayers equal to the number of units of insulation sold times $50 per unit. Geometrically, this is

EXHIBIT 8.11 Calculating the Consumers’ and Producers’ Surpluses

You will often be asked to calculate the effects of governmental policies on consumers’ and producers’ surpluses. Here are some rules to help you: 1. Begin by drawing a supply and demand diagram showing equilibrium both before and after the policy is imposed. Draw horizontal and vertical lines from the interesting points in your diagram to the axes. After a while you will get a feel for which lines to draw and which to omit. It never hurts to draw more than you need. 2. Before you proceed, label every area that is even possibly relevant. 3. When calculating consumers’ surplus, use only the demand curve and prices and quantities that are relevant to the consumer. When calculating producers’ surplus, use only the supply curve and prices and quantities relevant to the producer. 4. Remember that the demand and supply curves are relevant only because they are equal to the marginal value and marginal cost curves. If for some reason the demand curve should separate from the marginal value curve, continue to use the marginal value for calculating consumers’ surplus. Do likewise if the supply curve should separate from the marginal cost curve. 5. Check your work with a picture like Exhibit 8.9: Calculate the social gain directly by drawing rectangles of “welfare gains” for each item actually produced and by summing the areas of these rectangles. The sum should equal the total of the gains to all of the individuals involved.

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EXHIBIT 8.12 The Effect of a Subsidy

Before Subsidy After Subsidy

Consumers’ Surplus A + C A + C + F + G Producer’s Surplus F + H C + D + F + H Cost to T axpayers — − (C + D + E + F + G)

Social Gain A + C + F + H A + C + F + H − E

Deadweight Loss — E

Price Price

S S

B A

Ps Ps C D E F G Pd Pd

H D ′ D ′

D D 0 QQ ′ 0 Q Q ′ Quantity Quantity

A B

The table shows the gains to consumers and producers before and after the institution of a $50-per-unit government subsidy to home insulation. With the subsidy in effect, there is a cost to taxpayers that must be subtracted when we calculate the social gain. We find that the social gain with the subsidy is lower by E than the social gain without the subsidy. E is the deadweight loss. To check our work, we can consider the social gain created by each individual unit of insulation, shown in panel B. Each unit up to the equilibrium quantity Q creates a rectangle of social gain. After Q units have been produced, we enter a region where marginal cost exceeds marginal value. Each unit produced in this region creates a social loss equal to the excess of marginal cost over marginal value; these losses are represented by the gray rectangles, which stop at the quantity Q′ that is actually produced. The social gain is equal to the sum of the colored rectangles minus the sum of the gray ones. Because the social gain without the subsidy is just the sum of the colored rectangles, the gray rectangles represent the deadweight loss.

represented by the rectangle C + D + E + F + G. This cost is a loss to the taxpayers and so must be subtracted in the computation of social gain. The deadweight loss of E is the difference between social gain before and after the subsidy. According to the efficiency criterion, the subsidy should be rejected: It gathers F + G votes in favor from consumers and C + D votes in favor from producers, but

45185_08_ch08_p223-282.indd 243 29/04/10 9:48 PM 244 NOTCHAPTER 8 FOR SALE C + D + E + F + G votes opposed from taxpayers. Thus, it loses by a margin of E, which (noncoincidentally) is the deadweight loss.

Exercise 8.5 Verify the calculation of social gain in Exhibit 8.12.

Students often want to know how areas C and F can be part of both the consumers’ surplus and the producers’ surplus. The answer is that surplus is not an area at all—the area is just a measure of surplus. The fact that you have 12 yards of carpet and your friend has 12 yards of carpet does not mean that you both own the same “yards,” only Dangerous that each of you owns carpeting that can be measured by the same yardstick. The Curve areas of surplus are yardsticks with which we measure different individuals’ gains from trade.

Panel B in Exhibit 8.12 provides a way to check our work. The colored rectangles to the left of equilibrium represent gains to social welfare just as in Exhibit 8.9. In this case, however, more than the equilibrium quantity is produced. Consider the first item produced after equilibrium. The marginal value of this item to consumers (read off the original demand curve) is less than the marginal cost of producing it. The difference between the two is the area of the first gray rectangle. This area therefore represents a net welfare loss to society. Similarly, the next item produced represents a welfare loss in the amount of the area of the second gray rectangle, and so on out to the quantity Q′. The total welfare loss is the sum of these rectangles, which is equal to the area E in panel A. Therefore, area E should be the deadweight loss, and the calculation in the table is confirmed. An alternative way to calculate the consumers’ surplus is shown in Exhibit 8.13. For most purposes, it suffices to use either the method of Exhibit 8.12 or that of Exhibit 8.13. Because both always lead to the same answers, you need to master only one of them. However, there will be a few occasions later on in this book where you will find it much easier to use the alternative method of Exhibit 8.13.

Price Ceilings Price ceiling A price ceiling is a legally mandated maximum price at which a good may be sold. The A maximum price at effect of a price ceiling depends on its level. If the legal maximum is above the equilib- which a product can be rium price that prevails anyway, then the price ceiling has no effect (a law forbidding legally sold. any piece of bubble gum to sell for more than $2,000 will not change anyone’s behav-

ior). An effective price ceiling is one set below the equilibrium price, like the price P0 Effective price in Exhibit 8.14.

ceiling At the price P0, producers want to sell the quantity Qs and consumers want to buy

A price ceiling set the quantity Qd. What quantity actually gets traded? The answer is Qs, because as soon

below the equilibrium as Qs units are sold, the sellers pack up and go home. When buyers and sellers disagree price. about quantity, the group wanting to trade fewer items always wins, because trading stops as soon as either party loses interest. Another, and very real, possibility must be considered: Because buyers are frus-

trated, they will be willing to offer prices higher than P0, and sellers may accept these prices in violation of the law. For purposes of our simple analysis, we will assume that the law is perfectly enforced and this does not occur. We will also assume that the

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EXHIBIT 8.13 Another Way to Do It

Price

B A

Ps C D E F G Pd

H D ′

0 Q Q′ Quantity

The method that we have been using to calculate social gain is adequate for most problems. However, there is an alternate method that may occasionally be more convenient. We illustrate with the “subsidy” example from Exhibit 8.12. The graph here is identical to panel A in that exhibit. There are two ways of viewing a $50 rebate for home insulation. The first way, which we adopted in Exhibit 8.12, is to say that the rebate does not alter the value of home insulation. Consumers benefit from the subsidy by being able to buy insulation at a lower price. This is why we use the old demand curve (the true

marginal value curve) and the price paid by consumers (Pd) as boundaries for the area of consumer surplus. This gives the shaded area A + C + F + G. An alternative and equally valid point of view is to say that a subsidy is like a $50 bill taped to each unit of insulation. This raises the marginal value of the insulation by $50. However, we now have to view the insulation

as being purchased at the market price Ps. If we said that the insulation has increased in value and that the consumer is paying less than market price for his insulation, we would be wrongly double-counting the $50 rebate. From the alternative point of view, the consumer surplus is the area under the new demand curve down ′ + to the market price Ps and out to the quantity Q . That is, the striped area A B. If both points of view are equally valid, how can they give different answers? The answer is: They don’t. In fact, area A + B is equal to area A + C + F + G. They have to be equal, because each represents the consumers’ surplus calculated correctly, and there can be only one consumers’ surplus. If you find that argument unconvincing, try proving directly that the two areas are equal. This is an exercise in high school geometry if you assume all curves are straight lines; it is an exercise in calculus otherwise.

enforcement is costless (otherwise, the cost of enforcement would have to be subtracted from social gain).6

The quantity sold is Qs. What price do consumers pay? You may think the answer is

obviously P0, but this is incorrect. At a price of P0, consumers want to buy more goods than are available. Therefore, they compete with each other to acquire the limited supply.

6 Here is an interesting puzzle. Why is it that in “victimless crimes” like prostitution and the sale of drugs, both parties are held criminally liable, whereas in the equally “victimless” crime of violating a price control, only the seller faces legal consequences? For an interesting discussion of this puzzle, see J. Lott and R. Roberts, “Why Comply: One-Sided Enforcement of Price Controls and Victimless Crime Laws,” Journal of Legal Studies 18 (1989).

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EXHIBIT 8.14 A Price Ceiling

Price

A P1 B C

E D

P0 F D

0 Qs Q d Quantity

Before Ceiling After Ceiling

Consumers’ Surplus A + B + C A Producers’ Surplus D + E + FF

Social Gain A + B + C + D + E + FA + F Deadweight Loss — B + C + D + E

At a maximum legal price of P0, demanders want to buy more than suppliers want to sell. Therefore, they compete against each other for the available supply, by waiting in line, advertising, and so forth. This increases the actual

price to consumers. The full price to consumers must be bid all the way up to P1 because at any lower price the quantity demanded still exceeds the quantity supplied, leading to increases in the lengths of waiting lines. The deadweight loss comes about for two reasons. First, there is the reduction in quantity from equilibrium + to Qs. This loss is the area C E. Second, there is the value of the consumers’ time spent waiting in line. This − + is equal to P1 P0 times the quantity of items purchased, which is the rectangle B D.

Depending on the nature of the good, this may take the form of standing in line, search- ing from store to store, advertising, or any of a number of other possibilities. All of these activities are costly, in time, gasoline, energy, and other currency, and these costs must be added to the “price” that consumers actually pay for the item.

How high does the price go? It must go to exactly P1 in Exhibit 8.14. At any lower

price the quantity demanded still exceeds Qs, and consumers intensify their efforts.

Only when the “price” reaches P1 does the market equilibrate.

Of course, even though P1 is the price paid by consumers, the price received by sup-

pliers is still P0. Therefore, we use P1 to calculate consumers’ surplus and P0 to calculate

producers’ surplus. In each case, the appropriate quantity is Qs, the quantity actually traded. The computations are shown in Exhibit 8.14.

Exercise 8.6 Verify the correctness of the table in Exhibit 8.14.

45185_08_ch08_p223-282.indd 246 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 247 The deadweight loss calculated in Exhibit 8.14 comes about for two reasons.

First, there is the reduction in quantity from Q to Qs, which leads to a social loss of C + E, just as in the case of a tax. However, now there is another sort of loss as well. The value of the time people spend waiting in lines is equal to the value of − the time-per-unit-purchased (P1 P0) times the quantity of units purchased (Qs), which is the rectangle B + D. Taken together, these effects account for the entire deadweight loss. Notice that from a social point of view there is a great difference between a price

control that drives the demanders’ price up to P1 and a tax that drives the demanders’

price up to P1. Because the revenue from a tax is wealth transferred from one individual to another, it is neither a gain nor a loss to society as a whole. But the value of the time spent waiting in lines is wealth lost and never recovered by anyone. Some of the deadweight loss can be avoided if there is a class of people whose time is relatively inexpensive. Those people will offer their services as “searchers” or “line- − standers” and consumers will pay them up to P1 P0 per item for their services. The income to the line-standers, minus the value of their time, is a gain that offsets part of the lost area B + D.

Of course, some consumers whose time has low value might stand in line to make their own purchases. We view these consumers as having purchased line-standing services − from themselves at the going price of P1 P0. Such a consumer earns part of area A as a consumer and part of area B + D as a line-stander. Dangerous Curve

The reduction in deadweight loss through the use of line-standers doesn’t work if too many people have low time values. In that case, all of those people attempt to become line-standers and the lines get longer, so that the value of the time each one spends waiting gets bid back up to P − P . Dangerous 1 0 Curve

Tariffs Suppose that Americans buy all of their cameras from Japanese companies. It is proposed that a tariff of $10 per camera be imposed on all such imports and that the proceeds be distributed to Americans chosen at random. What areas must we measure to see whether the tariff makes Americans as a whole better off? Exhibit 8.15 shows the market for cameras, with both the original and post-tariff supply curves. The table shows the gains to Americans before and after the tariff. These

gains are calculated using the pretariff price and quantity of P0 and Q0 and the posttariff

price and quantity of P1 and Q1. Notice that we do not include the producers’ surplus, because this is earned by the Japanese companies and the question asks only about the welfare of Americans. If we had been asked about the welfare of the entire world, we would have included producers’ surplus in our calculations.

Exercise 8.7 Calculate the social gains to the entire world before and after the tariff is imposed.

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EXHIBIT 8.15 A Tax on Imported Cameras

Price S’ S

$10

P1 B CD P0 FE

0 Q1 Q0 Quantity

Before Tariff After Tariff

Consumers’ Surplus A + B + C + D A Tariff Revenue —B + C + E + F

Social Gain A + B + C + DA + B + C + E + F

If cameras are supplied by foreigners and purchased by Americans, then a tariff affects Americans through the consumers’ surplus and through the tax revenue that it generates.

Now we return to the question: What areas must we measure? The answer is evidently that one must compare area D with area E + F. If E + F is bigger, the tariff improves the welfare of Americans; otherwise it reduces their welfare. In practice, these areas can be estimated if the supply and demand curves can be estimated, and, as we remarked in Chapter 1, there are econometric methods available for this. Therefore, an economist can contribute meaningfully to a debate about tariffs by computing the relevant areas and reporting which policy is better—provided that the goal is to maximize Americans’ welfare. It is often a reasonable assumption that a country faces flat supply curves for imported items. The reason for this is that Japanese firms sell cameras in many foreign countries, and the United States is only a small part of their market. Thus, changes in quantity that appear big (from our point of view) may in fact correspond only to very small movements along the Japanese supply curves and hence to small changes in price. Exhibit 8.16 shows the analysis of a tariff when the supply curve is flat. In this case, you can see that the tariff always reduces Americans’ welfare.

Tariffs and Domestic Industries A more interesting example involves tariffs on a product that is produced both domestically and abroad. Suppose that Americans buy cars from Japan subject to a

flat Japanese supply curve at a price P0, and that domestic car manufacturers have

45185_08_ch08_p223-282.indd 248 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 249

EXHIBIT 8.16 A Tariff on Imported Cameras That Are Elastically Supplied

Price

A S ’ B $10 C S

0 Quantity

Before Tariff After Tariff

Consumers’ Surplus A + B + C A Tariff Revenue __ B

Social Gain A + B + C A + B Deadweight Loss __ C

If the United States is a small part of the market to which the Japanese sell cameras, then Americans will face a flat supply curve. In this case, a tariff always reduces the welfare of Americans.

the upward-sloping supply curve shown in panel A of Exhibit 8.17. Assuming that

all cars are identical, no consumer will be willing to pay more than P0 for a domestic car, because the consumer can always buy an import instead. Therefore, all cars sell

at a price of P0. At this price, domestic manufacturers produce Q0 cars and domestic − consumers buy Q1. The difference, Q1 Q0, is the number of imports. Table A in Exhibit 8.17 shows the consumers’ and producers’ surpluses. Now suppose that we impose a tariff of $500 on each imported car. This raises the + + foreign supply curve $500 to a level of P0 $500. The price of cars goes up to P0 $500, ′ the quantity supplied domestically goes up to Q0 (in panel B of Exhibit 8.17), and the ′ − ′ quantity demanded falls to Q1 . The quantity imported falls to Q1 Q0 . In Exhibit 8.17 Table B shows the consumers’ and producers’ surpluses both before and after the tariff. (The “before” column, of course, simply repeats the calculation from Table A.) What about revenue from the tariff? The number of imported cars is ′ − ′ Q1 Q0 , and the tariff is $500 on each of these. Thus, the tariff revenue (which ends ′ − ′ × up in American pockets) is (Q1 Q0 ) $500, and this is the area of rectangle I. This is recorded in Table B, along with a comparison of social gains. We can see that even when there is a domestic industry that benefits from the tariff, and even though the tariff revenue is a gain to the country, tariffs still cause a deadweight loss (we say that they are inefficient) because consumers lose more than all other groups gain.

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EXHIBIT 8.17 A Tariff When There Is a Domestic Industry

Price Price S S

E A F P0 + $500 B G I H J P0 P0 C K D D

0 Q 0 Q 1 0 Q 0 Q 0’ Q 1’ Q 1

Quantity imported Quantity Quantity

A B

Table A Table B Before Tariff After Tariff Consumers’ Surplus A + B Producers’ Surplus C Consumers’ Surplus E + F + G + H + I + JE + F Social Gain A + B + C Producers’ Surplus KG + K Tax Revenue ___ I

Social Gain E + F + G + H + I + J + KE + F + G + K + I Deadweight Loss ___ H + J

We assume that Americans can buy any number of cars from Japan at the price P0. The supply curve S

shows how many cars American manufacturers will provide at each price. At the price P0, American produc- − ers supply Q0 cars and American consumers purchase Q1 cars. The difference, Q1 Q0, is the number of cars imported. Table A shows the gains to Americans. + In panel B we see the effect of a $500 tariff on imported cars. The price of a foreign car rises to P0 $500, ′ − ′ and the number of imports falls to Q1 Q0 . Table B compares gains before and after the tariff. Note that the first column of Table B is identical to Table A except that it uses the labels from panel B rather than panel A. ′ − ′ × The tariff revenue is computed by observing that the area of rectangle I is (Q1 Q0 ) $500.

Exercise 8.8 Suppose that the government wants to benefit domestic auto producers and the recipients of tax revenue at the expense of car buyers. Devise an efficient (though perhaps impractical) way of doing this that makes everybody happier than a tariff does.

Robbery From the point of view of economic efficiency (that is, the maximization of the total gains to all members of society), a loss to one group that is exactly offset by a gain to another group is a “wash.” To one who is interested only in maximizing social gain,

45185_08_ch08_p223-282.indd 250 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 251 such a transfer is neither a good thing nor a bad thing. How, then, should such a one feel about robbery? Many people think that robbery constitutes a social loss equal to the value of what is stolen. Their reasoning is simple but faulty: They notice the loss to the victim without noticing the offsetting gain to the robber. A more sophisticated answer would be that robbery is a matter of indifference, because stolen goods do not disappear from society; they only change ownership. However, this more sophisticated answer is also wrong. There is a social cost to robbery. It is the opportunity cost of the robber’s time and energy. The robber who steals your bicycle could, perhaps, with the same expenditure of energy, be building a bicycle of his own. If he did, society would have two bicycles; when he steals yours instead, society has only one. The option to steal costs society a bicycle. This shows that robbery is socially costly; we still have to ask: How costly? To answer this, it is reasonable to treat robbery as a competitive industry: Robbers continue to rob until the marginal cost (in time, energy, and so on) of committing an additional crime is equal to the marginal revenue (in loot). The cost is what interests us, the loot is observable, and we know that the two are equal. So, at the margin, we can reckon the cost of a robbery as approximately equal to the value of what is stolen. This tells us that the amount stolen is a correct measure of the cost of the last robbery committed. In Exhibit 8.18 we calculate the total social cost of all robberies. Suppose that a robber can expect to earn $R each time he commits a robbery. Then robbers steal until the marginal cost of stealing is equal to $R; that is, they commit Q robberies. The amount stolen is $R × Q, the area A + B. However, the robbers’ total costs are given by the area under the supply curve, A. This cost to the robbers is society’s cost as well. Therefore, the total social cost of all robberies (A) is less than the value of what is taken (A + B).

This analysis ignores the very real possibility that people will take costly steps to protect themselves from robbery—installing burglar alarms, deadbolt locks, and the like. These additional costs are also due to the existence of robbery and must be added to area A in Dangerous order to calculate the full social cost of robberies. Curve

The more general lesson of this example is that effort expended in nonproductive activity is social loss. Accountants devising new methods of tax avoidance, lawyers in litigation, lobbyists seeking laws to transfer wealth to their clients, and all of the resources that they employ (secretaries, file clerks, photocopy machines, telephone services, and so on) are often unproductive from a social point of view. Whatever they win for their clients is a loss for their adversaries. In the absence of this activity, all of these resources could be employed elsewhere, making society richer. On the other hand, some of this seemingly unproductive activity serves hidden and valuable purposes. Suppose that a law is passed requiring that all owners of apple orchards donate $5,000 each to the president’s brother. The owners of apple orchards might hire a lobbyist to assist them in having this law overturned. If the effort is successful, apple growers win only what the president’s brother loses, and so at one level of analysis the lobbyist’s time contributes nothing to the welfare of society. On the other hand, if all orange growers were made very nervous by this law and planned to burn down their orange trees as a precaution against their being next, then the lobbyist saves a lot of valuable orange trees through his efforts. Insofar as redistributing income affects the incentives to engage in productive activities, it can indirectly affect society’s welfare.

45185_08_ch08_p223-282.indd 251 29/04/10 9:48 PM 252 NOTCHAPTER 8 FOR SALE

EXHIBIT 8.18 The Social Cost of Robbery

Cost per robbery ($) MC

0 Q Quantity (robberies)

Producers’ Surplus (Earned by Robber) B Loss to Victim A + B

Social Loss A

We suppose that a robber can expect to earn $R for each robbery he commits. Then robberies will take place until the robbers’ marginal cost (the opportunity cost of their time, energy, and so on) equals $R. The number of robberies committed is Q, and robbers earn a producers’ surplus of B. However, victims lose the amount stolen, which is A + B. There is a net social loss of A. If society pursues economic efficiency, A is the maximum amount it would be willing to spend to prevent all robberies.

Theories of Value We have defined value in terms of consumers’ willingness to pay, and we have discovered that the price of an item is equal to its marginal value. Other theories of value have arisen in the history of economics, only to be abandoned when careful analysis revealed them as erroneous. Because such errors are still common in much discussion by noneconomists, it is worth examining them to see why they should be avoided.

The Diamond–Water Paradox Many classical economists were puzzled by the so-called diamond–water paradox. How can it be that water, which is essential for life and therefore as “valuable” a thing as can be imagined, is so inexpensive relative to diamonds, which are used primarily for decoration and the production of nonessential goods? If price reflects value, shouldn’t a gallon of water be worth innumerable diamonds? The paradox is resolved when you realize that price reflects not total value, but marginal value. Exhibit 8.19 depicts the demand curves for water and for diamonds, together with their market prices and the corresponding consumer’s surpluses. The marginal value of your first gallon of water is indeed much higher than the marginal value of your first diamond, and this is reflected by the heights of the demand curves

45185_08_ch08_p223-282.indd 252 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 253

EXHIBIT 8.19 The Diamond–Water Paradox Resolved

Price Price

PW D

0 Quantity 0 Quantity

A. Water B. Diamonds

If you had no water and no diamonds, you would be willing to pay far more for a first bucket of water than for a first diamond. Therefore, your marginal value (= demand) curve for water starts out much higher than your

marginal value curve for diamonds. At the market prices PW and PD, you consume QW buckets of water and QD

diamonds, so that the marginal value of a bucket of water (PW) is much less than the marginal value of a dia-

mond (PD). It is true that the total value of all your water (the shaded area in panel A) is greater than the total value of all your diamonds (the shaded area in panel B). The graphs show that this is perfectly consistent with a low marginal value for water and a high marginal value for diamonds. The price, which is equal to the marginal value, should not be expected to reflect the total value.

at low quantities. But this has nothing to do with the price of water; the price is equal to the marginal value of the last bucket consumed, and this may be very low if you consume many gallons. Notice that the total value (the colored area) in the market for water is much higher than in the market for diamonds: If you lost all of your water and all of your diamonds, you would be willing to pay more to retrieve the water than to retrieve the diamonds. In consequence, the consumers’ surplus is much higher in the market for water than in Labor theory the market for diamonds. Exhibit 8.19 shows that there is nothing paradoxical about a of value low price and a large consumers’ surplus existing simultaneously. The assertion that the value of an The Labor Theory of Value object is determined The labor theory of value is an error that deceived such diverse economists as Adam by the amount of Smith and Karl Marx. In its simplest form it says that the price of an item is determined labor involved in its by the amount of labor used in its production.7 In this form it is clearly false: You can production.

7 Of course, this is a simpler form than economists have ever believed; typical versions restrict attention to “socially necessary” labor and include the labor of previous generations who built machines used in current production.

45185_08_ch08_p223-282.indd 253 29/04/10 9:48 PM 254 NOTCHAPTER 8 FOR SALE expend an enormous quantity of labor digging a gigantic hole in your backyard, and the price that hole commands in the marketplace may be far less than the price of a short story produced by a good writer in an afternoon, sitting at a word processor in an air- conditioned house sipping lemonade.8 For a theory so evidently false, the labor theory of value (even in this simple form) is remarkably pervasive. You will hear it argued that doctors “ought to” earn high salaries because of all the effort involved in earning their medical degrees, or that people in occupation A “ought to” earn as much as people in occupation B because they work equally hard. Such arguments ignore the fact that value is determined not by the cost of inputs, but by demand—the consumer’s willingness to pay for the good or service being offered. Another common belief that embodies the labor theory fallacy is that a meaning can be attached to the “book value” of a firm. A firm’s “book value” is a measure of what it would cost to produce the actual physical assets of the firm. It is computed, for example, by adding up the cost of the bricks used to build the firm’s plants and office buildings, the desks and chairs in the executive offices, the machines along the assem- bly line, and the letterhead stationery in the cabinets. This book value can be compared to the actual price at which one could acquire the entire firm (say, by purchasing all its stock). It sometimes happens that a firm can be acquired for less than book value, and it is widely believed that this represents a bargain. Not so. The fact that a factory is built from $1 million worth of bricks does not make that factory worth $1 million, any more than your application of $1 million worth of labor would make a hole in your backyard worth $1 million. If your labor is devoted to the production of something that nobody wants, or if the bricks are glued together to form a factory that produces nothing useful, this will be reflected in the price. What we have here is a brick theory of value, different perhaps from the labor theory of value, but perfectly analogous and just as false. A final example illustrates both the diamond–water and the labor theory paradoxes. It is sometimes argued that something must be wrong with society’s values when a baseball player (for example) earns a seven-figure salary for playing a game that (1) he enjoys anyway and (2) produces little social value compared with something like teaching elementary school, which is far less lucrative. The first point is the labor theory of value again. It errs by assuming that how hard the baseball player works determines the value of what he produces. The second point uses the erroneous reasoning that under- lies the diamond–water paradox. It may very well be that teachers (like water) produce far more total social value than star baseball players. But it can be simultaneously true that one additional teacher produces less social value than one additional star baseball player. This can be the case, for example, if there are many teachers and few star baseball players. We should not expect the price of a teacher or a baseball player to tell us anything about the total value to society of the two professions.

8.4 General Equilibrium and the Invisible Hand

Based on the examples in Section 8.3, you might have begun to suspect that any devia- tion from competitive equilibrium leads to a reduction in social gain. In this section, we will see that this is, in fact, the case.

8 It is true, of course, that in a competitive market, price equals marginal cost (and a competitive producer will not choose to dig a hole in his backyard for sale in the marketplace). But marginal cost is not labor cost. Some labor costs may be sunk (and therefore irrelevant), and many relevant costs have nothing to do with labor. The relevant costs, as always, are the opportunity costs—the writer could be writing a movie script instead.

45185_08_ch08_p223-282.indd 254 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 255 The Fundamental Theorem of Welfare Economics Exhibit 8.20 shows the competitive market for potatoes. We can ask two questions about this market ostensibly as different as questions can be: 1. What is the quantity of potatoes actually produced and sold? 2. Suppose you were a benevolent dictator, concerned only with maximizing the total welfare gains to all of society. What quantity of potatoes would you order produced and sold? Note well the dissimilarity between these questions. One is a question about what is; the other is a question about what ought to be. We know the answers to each of these questions. They are:

1. The quantity of potatoes produced and sold is at Q0, where supply equals demand. We have seen that individual suppliers and demanders, seeking to maximize their own profits and their own happiness, choose to operate at this point. 2. To maximize social gains, you would continue ordering potatoes to be produced as long as their marginal value exceeds the marginal cost of producing them. You would

stop when marginal cost equals marginal value, that is, at Q0. + The choice of Q0 yields a social gain of A B in Exhibit 8.20. A despot who made

the mistake of ordering only Q1 potatoes produced would limit social gain to area A.

If the same benevolent dictator made the mistake of ordering Q2, area C would be subtracted from the social gain, because it is made up of rectangles whose areas represent an excess of marginal cost over marginal value.

EXHIBIT 8.20 The Invisible Hand

Price S

AB C

0 Q1 Q0 Q2 Quantity

Under competition, the quantity produced is Q0, where supply equals demand. A benevolent dictator who wanted to maximize social gain would employ the equimarginal principle and order potatoes to be produced

to a quantity where marginal cost equals marginal value. This also occurs at quantity Q0.

If the dictator ordered Q1 potatoes produced, social gain would be area A; if he ordered Q2, social gain + − + would be A B C. The maximum social gain, at Q0, is A B.

45185_08_ch08_p223-282.indd 255 29/04/10 9:48 PM 256 NOTCHAPTER 8 FOR SALE It is astounding that the two questions have identical answers. The coincidence results from the prior coincidences of the supply curve with the marginal cost curve, and of the demand curve with the marginal value curve. It is not only astounding that the two answers are identical but it is fortunate. It means that people living in a competitive world achieve the maximum possible social gain without any need of a benevolent despot. The market alone achieves an outcome that is economically efficient. To say the same thing in different words, competitive equilibrium is Pareto-optimal. The eighteenth-century economist Adam Smith was so struck by this observation that he described it with one of the world’s most enduring metaphors. Of the individual participant in the marketplace, he said: “He intends only his own gain, and he is . . . led by an invisible hand to promote an end which was no part of his intention.”9 Noneconomists frequently misunderstand what Smith meant by the invisible hand. Some think it is a metaphor for an ideology or a philosophical point of view; the notion has even been described as a theological one! In fact, the invisible hand expresses what is at bottom a mathematical truth. The point of equilibrium (where competitive suppliers operate “intending only their own gain”) is also the point of maximum social gain (an end that is no part of any individual participant’s intention).

The Idea of a General Equilibrium The preceding analysis is striking, but it is incomplete. By participating in the potato market, people change conditions in other markets as well. When he grows more or fewer potatoes, a farmer consequently grows less or more of something else. The amount of labor that he hires changes. When a consumer changes his potato consumption, he probably also changes his consumption of rice, and of butter. At one further remove, any change in the potato market affects the potato farmer’s income, which affects his purchases of shoes, which affects the market for leather, which affects the market for something else, ad infinitum. If we really want to understand the welfare consequences of competitive equilibrium in the potato industry, we need to consider its effects in all of these other markets as well. Could it be that by maximizing welfare gains in one market, we are imposing a net welfare loss in the totality of all other markets? It was not until the 1950s, nearly 200 years after Adam Smith, that economists developed the mathematical tools necessary to deal fully with this complicated question. In that decade, economists such as Kenneth Arrow, Gerard Debreu, and Lionel McKenzie devised techniques that make it possible to study all the markets in the economy at one time. In this they were advancing a subject called General equilibrium general equilibrium analysis, first invented by the nineteenth-century economist analysis Lèon Walras. One of the great and powerful results of general equilibrium theory is A way of modeling the that even in view of the effects of all markets on all other markets, competitive economy so as to take equilibrium is still Pareto-optimal. This discovery is usually called the first fundamental account of all markets theorem of welfare economics, or the invisible hand theorem. at once and of all the The invisible hand theorem says, in essence, that in competitive markets, people interactions among who selfishly pursue their own interests end up achieving an outcome that is socially them. desirable. Outside of competitive markets, such good fortune is not to be expected. The governor of Colorado recently told of walking down a suburban street where each homeowner was out blowing leaves onto his neighbor’s lawn. Each homeowner acted

9 From Book 4 of Smith’s monumental work The Wealth of Nations, first published in 1776.

45185_08_ch08_p223-282.indd 256 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 257 selfishly, and the outcome was highly undesirable. If the homeowners had all agreed to spend the afternoon watching football, they would have enjoyed themselves more and had the same number of leaves on their lawns at the end of the day. Because the decision to blow leaves takes place outside of the market system, there is no reason to expect it to yield outcomes that are in any sense desirable. In Chapters 10 through 14 we will see many more such examples. The fact that the invisible hand theorem fails so easily in so many contexts makes it utterly remarkable that it succeeds in the particular context of competitive markets. The Pareto optimality of competitive equilibrium is a deep and wondrous fact about the price system. No analogous statement is true in the absence of competition or in the absence of prices. The invisible hand theorem is a remarkable truth.

An Edgeworth Box Economy The invisible hand theorem is true in very complex economies with many participants and many markets, but we will illustrate it (and the basic ideas of general equilibrium analysis) only in the simplest possible case. Assume a world with two people (Aline and Bob) and two goods (food and clothing). We will simplify further by assuming that there is no production in this world; Aline and Bob can only trade the goods that already exist. These assumptions will enable us to present a complete general equilibrium model and to illustrate the invisible hand theorem. Because there is no production in this world, there is only a fixed, unchangeable amount of food and clothing. In panel A of Exhibit 8.21 we draw a box that has a width equal to the amount of food in existence, and a height equal to the amount of clothing. Such a box is called an Edgeworth box.10 Using the lower left-hand corner as the origin, Edgeworth box we draw Aline’s indifference curves between food and clothing. We also mark one point A certain diagrammatic of special interest: It is Aline’s endowment point, O, representing the basket of food representation of an and clothing that she owns at the beginning of the story. economy with two In panel B we do a strange thing: We turn the entire page upside down, and we draw individuals, two goods, Bob’s (black) indifference curves in the same box. For him, the food axis is the line that and no production. Aline views as the top of the box, and the clothing axis is the line that Aline views as the right side of the box. Endowment point To plot Bob’s endowment point, remember that the width of the box is equal to The point representing the sum of Bob’s and Aline’s food endowments and that the height is equal to the sum the initial holdings of their clothing endowments. A moment’s reflection should convince you that Bob’s of an individual in an endowment point (measured along his axes) is the same as Aline’s endowment point Edgeworth box. (measured along her axes). Panel C shows a piece of panel B: All but two indifference curves have been elimi- nated. We have retained only those indifference curves (one of Aline’s and one of Bob’s) that pass through the endowment point. Now suppose that Bob and Aline discuss the possibility of trade. Aline vetoes any trade that moves her into region A, C, or E, because these all represent moves to lower Region of mutual indifference curves from her point of view. Similarly, Bob vetoes any trade that moves advantage him into region A, B, or E. (Hold the book upside down for help in seeing this!) The set of points that However, a movement anywhere inside region D benefits both Aline and Bob. For this are considered at least reason, region D is called the region of mutual advantage, and Aline and Bob can as good as the initial arrange a trade that moves them into this area. endowment.

10 The Edgeworth box is named after the nineteenth-century British economist F. Y. Edgeworth.

45185_08_ch08_p223-282.indd 257 29/04/10 9:48 PM 258 NOTCHAPTER 8 FOR SALE

EXHIBIT 8.21 Trade in an Edgeworth Box Economy

Food Bob

O O Clothing

Clothing Clothing

Aline Food Aline Food

A B

Food Food Bob Bob A O O B Clothing Clothing O'

P D

Clothing C Clothing E

Aline Food Aline Food

C D

Panel A shows Aline’s indifference curves and her Food endowment point O. Panel B adds Bob’s (black) Bob indifference curves, using the northeast corner of Contract curve the box as origin. Measuring along Bob’s axes, his O Clothing endowment point is also O. Panel C shows only those indifference curves that pass through the endowment point. Movements into the region of mutual advantage, D, benefit both parties. Moves into any other Clothing region will be vetoed by one or both of the parties. Panel D shows the situation after Aline and Bob make the mutually beneficial trade to point O′. The shaded region is the new region of mutual advantage. Aline Food Trade will continue until they reach a point like P in panel D, where there is no region of mutual advantage. E Such points are on the contract curve, consisting of the tangencies between Aline’s and Bob’s indifference curves. The points on the contract curve are precisely those that are Pareto-optimal. In panel E the shaded region is the original region of mutual advantage. Trade leads to the choice of a point on the contract curve in this region. The darker segment of the contract curve is the set of possible outcomes.

45185_08_ch08_p223-282.indd 258 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 259 After moving to a new point, O′, inside the region of mutual advantage, Aline and Bob face a new, smaller region of mutual advantage, as shown in panel D. They will move to a new point in this new region and will continue this process until no region of mutual advantage remains. This occurs precisely when they reach a point where their indifference curves are tangent to each other, such as the point P in panel D. A point of tangency between Aline’s and Bob’s indifference curves is a point from which no further mutually beneficial trade is possible. In other words, such a point is Pareto-optimal; from that point no change can improve both parties’ welfare. The collection of all Pareto-optimal points forms a curve, which is called the contract curve Contract curve and is illustrated in panel E. The set of Pareto- We do not know in advance exactly what point Aline and Bob will reach through optimal points. the trading process. We know only that it will be somewhere within the original region of mutual advantage, and that it will be on the contract curve. The set of possible outcomes is the darker segment of the contract curve shown in panel E.

Competitive Equilibrium in the Edgeworth Box Our analysis has revealed an infinite variety of possible outcomes for the bargaining process. Next we ask what can happen if Aline and Bob play according to a far more restrictive set of rules. Instead of letting them bargain in whatever way they choose, we require them to bargain through the mechanism of a price system. The new rules of the game work this way: Aline and Bob decide on a relative price for food and clothing. At this price, each decides how much of each commodity he or she would like to buy or sell. If their desires are compatible (that is, if Aline wants to buy just as much food as Bob wants to sell), they carry out the transaction. If their desires are not compatible, they decide on a new relative price and try again. This process continues until they find a relative price that “clears the market” in the sense that quantities demanded equal quantities supplied. Why would Aline and Bob ever agree to such a strange and restricted set of rules? They wouldn’t, because two people can bargain far more effectively without introducing the artifice of market-clearing prices. But our interest in Aline and Bob is not personal; we are concerned with them only because we are interested in the workings of much larger markets, and such markets do operate through a price mechanism. So we shall force Aline and Bob to behave the way people in large markets behave, hoping that their responses will teach us something about those large markets. Suggesting a relative price is equivalent to suggesting a slope for Aline’s budget line. Once we know this slope, we know her entire budget line. This is because her budget line must pass through her endowment point, in view of the fact that she can always achieve this point by refusing to trade. Bob’s budget line (viewed from his upside-down perspective) is the same as Aline’s. In panel A of Exhibit 8.22 a relative price has been suggested that leads Aline to choose point X and Bob to choose point Y. The total quantity of food demanded is more than exists in the world; the total quantity of clothing demanded fails to exhaust the available supply. The market has not cleared and a new relative price must be tried. In view of the outcome at the current price, it seems sensible to raise the relative price of food. That is, we try a steeper Competitive budget line, as in panel B. This time Aline and Bob both choose the same point Z and equilibrium the market clears. A point that everyone The mutually acceptable point Z in panel B is called a competitive equilibrium will choose to trade to, for this economy. It requires finding a budget line that goes through the original for some appropriate endowment point and leads to the same optimum point for Aline that it does for Bob. market prices.

45185_08_ch08_p223-282.indd 259 29/04/10 9:48 PM 260 NOTCHAPTER 8 FOR SALE

EXHIBIT 8.22 Competitive Equilibrium in an Edgeworth Box Economy

Food Food Bob Bob O Clothing Clothing

Y Z X O

Clothing Clothing

Aline Food Aline Food

A B

In panel A a relative price has been suggested that leads to the budget line pictured. (This is Aline’s budget line from her perspective and Bob’s budget line from his.) Aline chooses point X and Bob chooses point Y. But these points are not the same; the quantities that Aline wants to buy and sell are not the same quantities that Bob wants to sell and buy. In panel B a different relative price has been suggested. At this price Aline’s desires are compatible with Bob’s. Point Z is a competitive equilibrium.

It is not immediately obvious that a competitive equilibrium should even exist, but it turns out to be possible to prove this.11

The Invisible Hand in the Edgeworth Box At the competitive equilibrium Z of Exhibit 8.22, Aline’s indifference curve is tangent to the budget line, and Bob’s indifference curve is tangent to the same budget line. It follows that Aline’s and Bob’s indifference curves are tangent to each other. This, in turn, means that the competitive equilibrium is a point on the contract curve—that is, it is Pareto-optimal. This reasoning shows that in an Edgeworth box economy, any competitive equilibrium is Pareto-optimal. That is, the invisible hand theorem is true. We began this section by noticing that competitive equilibrium is Pareto-optimal in the context of a single market. We have just seen that the same is true in the context of an entire economy (albeit an extraordinarily simple economy in which no production takes place). The same is also true in far more complex models involving many markets and incorporating production, though this requires advanced mathematics to prove.

General Equilibrium with Production In the Edgeworth box economy there is no production. Next we will study general equilibrium in an economy where production is possible.

11 In fact, you can prove it, if you have had a course in calculus. Define the aggregate excess demand for food as the sum of the quantities demanded by Bob and Aline, minus the world supply of food. At a price of zero, draw the budget line and compute the aggregate excess demand. Do the same at an infinite price. Now use the intermediate value theorem to complete the proof.

45185_08_ch08_p223-282.indd 260 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 261 Robinson Crusoe Robinson Crusoe lives alone on an island where the only foods he can produce are tomatoes and fish. He grows the tomatoes and catches the fish. Because each activity takes time, he can have more of one only by accepting less of the other. Exhibit 8.23 shows the various combinations of tomatoes and fish that Robinson could produce in a week. If he grows no tomatoes, he can catch 15 fish. If he catches no fish, he can grow 18 tomatoes. The curve displaying all of his options is called Robinson’s production possibility curve. Production If Robinson starts at point E in the diagram and gives up a single tomato, he can possibility curve catch ΔF additional fish. We can think of ΔF as the relative price of tomatoes in terms The curve displaying of fish. ΔF is also the slope of the production possibility curve at E. Therefore, the all baskets that can be slope of the production possibility curve is equal to the relative price of tomatoes in produced. terms of fish. At point E, Robinson grows a lot of tomatoes. Because of diminishing marginal returns to farming on a fixed quantity of land, it takes a lot of effort to grow one more tomato. By giving up his last tomato, Robinson frees up a lot of time and catches a large number (ΔF) of fish. By contrast, if Robinson started out at a point near the northwest corner of the production possibility curve, the marginal tomato would require less effort. Giving it up would only free a small amount of time; moreover, diminishing marginal returns to fishing render that time relatively unproductive. (Notice that Robinson is already catching a lot of fish.) In consequence, the price of a tomato in terms of fish is very low near the northwest corner, just as it is very high near the southeast corner. Remembering that price equals slope, this tells us that The production possibility curve bows outward from the origin.

EXHIBIT 8.23 The Production Possibility Curve

Fish

15 B

ΔF

E 1

0 18 Tomatoes

The curve shows the various combinations of tomatoes and fish that Robinson can produce. Its slope shows how many fish he can have in exchange for one tomato and can therefore be thought of as the relative price of tomatoes. At point E that relative price is the distance ΔF. Robinson chooses a point of tangency with an indifference curve; that is, he chooses point B.

45185_08_ch08_p223-282.indd 261 29/04/10 9:48 PM 262 NOTCHAPTER 8 FOR SALE To complete the analysis, we must bring Robinson’s indifference curves into the picture. Robinson chooses his favorite point on his production possibility curve, which is the tangency B. At this point, Robinson equates the relative price of tomatoes (the slope of the production possibility curve) with the marginal rate of substitution between tomatoes and fish (the slope of the indifference curve).

The Open Economy Now suppose that Robinson establishes contact with the natives of a large nearby Open economy island. His own island is transformed into an open economy, one that can trade with An economy that outsiders at prices determined in world markets. The going price of a tomato on this trades with outsiders other island is P fish dinners. at prices determined in Robinson now faces two separate choices. First, how should he allocate his time world markets. between farming and fishing? Second, how should he allocate his consumption between tomatoes and fish? We know how to answer the second question. Robinson chooses the tangency between his budget line and an indifference curve. What is his budget line? It is a line with absolute slope P (P being the relative price of tomatoes) and passing through the point representing Robinson’s production. Why must it pass through that point? Because Robinson can always consume at that point by simply not trading with his neighbors. Since that point is available to him, it must be on his budget line. Panel A of Exhibit 8.24 shows several lines with absolute slope P. If Robinson produces either basket A or basket E, his budget line is the lightest of these. If he produces B or D, his budget line is the middle one. If he produces C, the dark line is his budget line. It is best to have a budget line as far from the origin as possible, so C is Robinson’s best choice. That is, Production occurs at the point where the production possibility curve is tangent to a line of slope P. The line of tangency becomes the budget line. Panel B of Exhibit 8.24 shows Robinson’s consumption choice. Having produced basket C, he has the budget line shown; along this budget line he selects basket X. Notice that X is superior to the basket B that Robinson would consume in the absence of trade. Robinson gains from trade with his neighbors. We can go on to ask: How much does he gain? To answer this question, we must compare two different prices. One is the Autarkic relative autarkic relative price that would prevail on Robinson’s island if there were no trade. price With no trade, Robinson would choose point B in Exhibit 8.25 and would have the The relative price that budget line shown in color. The slope of that line is the autarkic relative price of would prevail if there tomatoes. were no trade with The second interesting price is the world relative price at which Robinson can trade foreigners. with his neighbors. Suppose first that the world relative price happens by chance to equal the autarkic relative price. In that case, Robinson’s budget line must be tangent to World relative the production possibility curve and parallel to the colored line; that is, his budget line price is the colored line itself. He produces at the point B and consumes at the point B. But The relative price this is exactly the same point that Robinson chose in Exhibit 8.23, when there was no that prevails in the opportunity to trade. In other words, presence of trade with If the autarkic and world relative prices are equal, then there is no gain from trade. foreigners. Suppose, alternatively, that the world relative price is given by the slope of the black line in Exhibit 8.25. Then Robinson produces at C and consumes at X, which makes him happier than if he were to consume at B. In this case, he gains from trade.

45185_08_ch08_p223-282.indd 262 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 263

EXHIBIT 8.24 Production and Consumption with Foreign Trade

Fish Fish

B A B C C

0 Tomatoes 0 Tomatoes

A B

When Robinson can trade with his neighbors at a relative price of P fish per tomato, he faces a budget line of absolute slope P. All of the lines in panel A have that slope. By choosing a basket to produce, Robinson can choose his budget line from among the lines pictured. If he produces basket A or basket E, he has the light budget line; if he produces basket B or basket D, he has the middle budget line; if he produces basket C, he has the dark budget line. The dark budget line is the best one to have, so Robinson produces basket C. He then trades along the budget line to his optimal basket X, shown in panel B. Without trade, Robinson would choose basket B. Since basket X is preferred to basket B, Robinson gains from trade.

EXHIBIT 8.25 Autarkic versus World Relative Prices

Fish

Y X

0 Tomatoes

The slope of the brown line represents the autarkic relative price on Robinson’s island. If the world relative price is the same as the autarkic relative price, then Robinson both produces and consumes basket B, just as he would with no opportunity to trade. If, instead, the world relative price is given by the slope of the black line, then Robinson produces basket C and consumes basket X, which is an improvement over basket B. If the world relative price goes up to the slope of the gray line, then Robinson produces basket D and consumes basket Y, which is a further improvement.

45185_08_ch08_p223-282.indd 263 29/04/10 9:48 PM 264 NOTCHAPTER 8 FOR SALE Next, suppose that the world relative price differs even more from the autarkic relative price, being given by the slope of the gray line in Exhibit 8.25. Then Robinson produces D and consumes Y, which is better even than X. The more the world relative price differs from the autarkic relative price, the more Robinson gains from trade.

Exercise 8.9 The black and gray lines in Exhibit 8.25 represent world relative prices that are greater than the autarkic relative price. Draw some budget lines that result when world relative prices are less than the autarkic relative price. Check that it remains true that the gains from trade are greater when the world relative price is further from the autarkic relative price.

What determines the world relative price? The answer is: supply and demand by everyone in the world, including Robinson. Thus, the world price is a sort of average of the autarkic relative prices on all of the various islands in Robinson’s trading group. If Robinson’s supply and demand constitute a large percentage of the world’s supply and demand, then his own autarkic relative price counts quite heavily in this average, bringing the world relative price closer to the autarkic one. This, in turn, reduces Robinson’s gains from trade. If, on the other hand, Robinson is an insignificant player in the world market, then there is a greater chance that the world relative price differs substantially from his autarkic one. In this case, Robinson’s gains from trade are greater. All of this serves to illustrate a point we made back in Chapter 2: To gain from trade, it pays to be different from the world. Small countries are more likely to be different from the world than large countries are. Therefore, small countries have more to gain from international trade than large ones do. For many goods, world relative prices do not differ significantly from U.S. relative prices, so the United States has relatively little to gain from trade in these goods. But New Zealand, for example, where the autarkic relative price of wool is quite low, benefits greatly from being able to trade its wool for other goods at the comparatively high world relative price.

The World Economy We have seen how Robinson Crusoe reacts to world prices, and we have asserted that these world prices are determined by supply and demand. To complete the picture of the world economy, we have only to understand exactly how the world supply and demand curves are determined. To derive a point on the supply curve for tomatoes, we imagine a price and ask what quantity Robinson supplies. Referring again to Exhibit 8.25, suppose that the colored budget line has absolute slope P. Then Robinson produces basket B, and the quantity of tomatoes he supplies is the horizontal coordinate of this point (whether he supplies them to himself or to someone else is not relevant here). The price P corresponds to this quantity on the supply curve. To get another point on the supply curve, suppose the black budget line has absolute slope P ′. At this price, Robinson produces at point C, and the corresponding quantity of tomatoes is paired with price P ′ on his supply curve. A similar procedure generates points on Robinson’s demand curve. When the price is P, he has the colored budget line and demands a quantity of tomatoes given by the horizontal coordinate of point B. When the price is P ′, he has the black budget line and demands a quantity given by the horizontal coordinate of point X.

45185_08_ch08_p223-282.indd 264 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 265 In this way, we can generate Robinson’s supply and demand curves for tomatoes. We can do the same for all his trading partners. We get world supply and demand curves by adding the individual supply and demand curves, and these determine a world equilibrium price.

Summary

Consumers and producers both gain from trade. Consumers’ and producers’ surpluses are measures of the extent of their gains. When the consumer buys a good X, the total value of his purchase is given by the area under his demand curve out to the quantity. This area is the most that he would be willing to pay in exchange for that quantity of X. After we subtract the total cost to the consumer, we are left with the area under his demand curve down to the price paid and out to the quantity consumed. This area is his consumer’s surplus. It is the amount that the consumer would be willing to pay in exchange for being allowed to purchase good X. The producer’s surplus is the excess of the producer’s revenues over his costs. It is measured by the area above the supply curve up to the price received and out to the quantity supplied. When there is more than one consumer or more than one producer, the total surplus to all consumers is given by the area under the market demand curve down to the price paid and out to the quantity demanded. The total surplus to all producers is given by the area above the market supply curve up to the price received and out to the quantity sold. Policies such as taxes or price controls can change prices and quantities and consequently change the consumers’ and producers’ surpluses. They also sometimes generate tax revenue (which is a gain to somebody) or impose a cost on taxpayers (which is a loss). Social gain is the sum of consumers’ and producers’ surpluses, plus any other gains, minus any losses. If a policy reduces social gain below what it might have been, the amount of the reduction is known as a deadweight loss. Whenever there is deadweight loss, it is possible to devise an alternative policy that is Pareto-preferred (that is, preferred by everybody) to the current policy. A policy is said to be Pareto-optimal, or efficient, if no other policy is Pareto- preferred. The efficiency criterion is a normative criterion asserting that we should prefer policies that maximize social gain, or, equivalently, minimize deadweight loss. Few (if any) would argue that the efficiency criterion should be the sole guide to policy, but many economists consider it reasonable to use it as a rough guideline. When a policy creates large deadweight losses, there may be a Pareto-preferred policy that is actually possible to implement. The invisible hand theorem states that competitive equilibrium is Pareto- optimal. That is, in a competitive market where each individual seeks only his own personal gains, it turns out to be the case that social gains are maximized. This is true in individual markets and remains true when the entire economy is taken into account. The Edgeworth box presents an example of a complete economy that can be used to illustrate the workings of the invisible hand.

45185_08_ch08_p223-282.indd 265 29/04/10 9:48 PM 266 NOTCHAPTER 8 FOR SALE It is also possible to study general equilibrium in economies with production. The opportunity to trade with outsiders confers benefits on the members of such an economy. The more world prices differ from autarkic relative prices, the greater those benefits tend to be.

Author Commentary academic.cengage.com/economics/landsburg

AC1. Read about the conflict between the Pareto criterion and individual freedom. Also read about how good voting systems are hard to find, both in politics and in sports.

Review Questions

R1. Explain why a consumer’s demand curve is identical to his marginal value curve. R2. What geometric areas represent the value of the goods that a consumer purchases and the cost of producing those goods? What geometric area represents the social gain from the goods’ production, and why? R3. What geometric areas represent the consumers’ and producers’ surpluses, and why? R4. Analyze the effect on social welfare of a sales tax. R5. Analyze the effect on social welfare of a subsidy. R6. Analyze the effect on social welfare of a price ceiling. R7. Analyze the effect on social welfare of a tariff, assuming that the country imposing the tariff constitutes a small part of the entire market. First answer assuming that the good in question is available only from abroad, then repeat your answer assuming that there is a domestic industry. R8. “The fact that secretaries are paid less than corporate executives shows that society values secretarial services less than it values the work of executives.” Comment. R9. State the invisible hand theorem. Illustrate its meaning using supply and demand curves. R10. Explain the difference between the allocation of resources and the distribution of income. With which is the efficiency criterion concerned? R11. Using an Edgeworth box, illustrate the region of mutual advantage and the contract curve. Explain why trade will always lead to a point that is both in the region and on the curve. R12. Using an Edgeworth box, illustrate the competitive equilibrium. Explain how you know that the competitive equilibrium is on the contract curve. How does this illustrate the invisible hand theorem? R13. Show how Robinson Crusoe chooses his consumption point when he is unable to trade. Show how he chooses his production and consumption points when trade becomes an option.

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1. True or False: If consumers buy 1,000 heads of lettuce per week, and if the price of lettuce falls by 10¢ per head, then the consumer’s surplus will increase by $100. 2. Suppose that your demand curves for gadgets and widgets are both straight lines but your demand curve for gadgets is much more elastic than your demand curve for widgets. Each is selling at a market price of $10, and at that price you choose to buy exactly 30 gadgets and 30 widgets. a. From which transaction do you gain more surplus? b. If forced at gunpoint to buy either an extra gadget or an extra widget, which would you buy? c. Illustrate the change in your consumer’s surplus as a result of the forced transaction of part (b). 3. Adam and Eve consume only apples. Of the following allocations of apples, which are preferred to which others according to (a) the Pareto criterion, and (b) the efficiency criterion? a. Adam has 12 apples and Eve has 0 apples. b. Adam has 9 apples and Eve has 3 apples. c. Adam has 6 apples and Eve has 6 apples. d. Adam has 0 apples and Eve has 12 apples. e. Adam has 5 apples and Eve has 5 apples. 4. True or False: Cheap foreign goods hurt American producers and are therefore bad according to the efficiency criterion. 5. True or False: If there is a fixed amount of land in Wyoming, then a sales tax on Wyoming land will have no effect on social welfare. 6. Home insulation is currently subsidized. Draw a graph (as in Exhibit 8.12) that shows the gains and losses to all relevant groups. Explain how you could, in principle, make everyone happier by eliminating the subsidy and instead transferring income from some people to others. Be explicit about exactly who you’d take income from, how much you would take, and how you would distribute it. 7. The demand and supply curves for gasoline are the same in Upper Slobbovia as in Lower Slobbovia. However, in Upper Slobbovia everybody’s time is worth just $1 per hour, while in Lower Slobbovia everybody’s time is worth $10 per hour. True or False: If both countries impose a price ceiling on gasoline, the value of time wasted in waiting lines will be higher in Lower Slobbovia than in Upper Slobbovia. 8. In the preceding problem, suppose that there is also a country of Middle Slobbovia, where the value of various people’s time ranges between $1 and $10. If Middle Slobbovia imposes a price ceiling on gasoline, how will the value of time wasted in waiting lines compare to the time wasted in Upper and Lower Slobbovia? 9. Suppose the equilibrium price of potatoes is $5 per pound, but the government imposes a price ceiling of $2 per pound, creating a deadweight loss. True or False: If the government imposes an excise tax of $1 per pound of potatoes (while continuing to maintain the price ceiling), then the deadweight loss will get even larger.

45185_08_ch08_p223-282.indd 267 29/04/10 9:48 PM 268 NOTCHAPTER 8 FOR SALE 10. Suppose the equilibrium price of potatoes is $5 per pound, but the government imposes a price ceiling of $2 per pound, creating a deadweight loss. True or False: If the government imposes a sales tax of $1 per pound of potatoes (while continuing to maintain the price ceiling), then the deadweight loss will get even larger. 11. Suppose there is a federal excise tax on gasoline of 4.3¢ per gallon. A United States senator has proposed eliminating this tax, but requiring oil companies to pass all of the savings on to the consumer (by maintaining a new price at the pump that is 4.3¢ lower than the current price). Show the deadweight loss under the current tax and under the senator’s plan. Can you tell which is bigger? 12. True or False: A price ceiling on wheat would cause the price of bread to fall. 13. In equilibrium, 500 pounds of potatoes are sold each week. However, the government prints up and randomly distributes 250 non-reusable ration tickets each week, and requires that buyers present one ration ticket for each pound of potatoes they buy. Therefore consumers can purchase only 250 pounds of potatoes per week. Ration tickets can be freely bought and sold. Draw a graph illustrating the market for potatoes, and on your graph indicate: a. The price of a pound of potatoes. b. The price of a ration ticket. c. The consumer and producer surplus in the potato market. d. The value of the ration tickets to the citizens who are randomly chosen to receive them. e. The deadweight loss. 14. The American supply and demand curves for potatoes cross at $5 a pound, but potatoes are available in any quantity from abroad at $2 a pound. Each week, American sellers produce 500 pounds of potatoes and American buyers purchase a total of 1,200 pounds. Suppose the government prints and randomly distributes 250 non-reusable ration tickets each week, and requires that buyers present one ration ticket for each pound of imported potatoes that they buy. (You don’t need a ration ticket to buy an American potato.) Ration tickets can be freely bought and sold. Draw a graph illustrating the market for potatoes, and on your graph indicate the price Americans now pay for potatoes, the price of a ration ticket, the gains and losses to all relevant groups, and the deadweight loss. 15. Widgets are produced by a competitive industry and sold for $5 apiece. The government requires each widget firm to have a license, and charges the highest license fee firms are willing to pay. If the government were to impose an excise tax of $3 per widget, how much would the license fee have to change? (Illustrate your answer as an area on a graph). Would total government revenue (that is, excise tax revenue plus revenue from license fees) rise or fall as a result of the excise tax? 16. In equilibrium, 2,000 pounds of potatoes are sold each month. A new law requires sellers to buy permits before they can sell potatoes. One permit allows you to sell one pound, and permits can’t be reused. The government creates only 1,000 permits and sells them to the highest bidders. Use a graph to show the new price of potatoes, the price of a permit, the gains and losses to all relevant groups, and the deadweight loss. 17. Toys are produced by a competitive industry. Santa Claus gives away one million free toys each year. Illustrate Santa’s effect on a) the price of toys, b) the consumer

45185_08_ch08_p223-282.indd 268 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 269 surplus, c) the producer surplus earned by commercial toy manufacturers, and d) social gain. (Don’t worry about gains or losses to Santa.) (Hint: Remember that the toys Santa distributes are free.) 18. Suppose the government sets an effective price floor (that is, a price above equilibrium) in the market for oranges and agrees to buy all oranges that go unsold at that price. The oranges purchased by the government are discarded. Illustrate the number of oranges purchased by the government. Illustrate the gains and losses to all relevant groups of Americans and the deadweight loss. 19. The American demand and supply curves for oranges cross at a price of $8, but all Americans are free to buy or sell oranges on the world market ata price of $5. One day, the U.S. government announces that it will pay $6 apiece for American oranges and will buy as many oranges as Americans want to sell at that price. The government then takes these oranges and resells them on the world market at $5 apiece. Illustrate the gains and losses to all relevant groups of Americans, and illustrate the deadweight loss. 20. In the tariff example of Exhibit 8.17, divide the two triangles of deadweight loss into individual rectangles of loss, as in Exhibit 8.9. Give an intuitive explanation of the loss that each of those rectangles represents. 21. Suppose the U.S. supply and demand curves for automobiles cross at a price of $15,000 but (identical) automobiles can be purchased from abroad for $10,000. Now suppose the government imposes a $2,000 sales tax on every American who buys a car (regardless of whether the car is produced domestically or abroad). a. What price must Americans pay for cars before the tax is imposed? What price must Americans pay for cars after the tax is imposed? (Hint: American suppliers can always sell cars abroad for $10,000 and so will never sell cars for less.) What prices do U.S. producers receive for their cars before and after the tax is imposed? b. Before and after the tax is imposed, calculate the gains to all relevant groups of Americans. What is the deadweight loss due to the tax? 22. The equilibrium price of an apple is 25¢. The government sets a price ceiling of 15¢ per apple, and requires sellers to provide as many apples as buyers want to buy at that price. Draw a graph to illustrate the price ceiling and answer the following questions in terms of areas on your graph: a. What areas would you measure to determine whether sellers continue selling apples in the short run? (To answer this, you can assume that all sellers are identical.) b. If sellers continue selling apples, what area represents the deadweight loss and why? c. If sellers don’t continue selling apples, what area represents the deadweight loss and why? 23. Suppose the U.S. supply and demand curves for automobiles cross at a price of $15,000 but (identical) automobiles can be purchased from abroad for $10,000. Now suppose the government imposes a $2,000 excise tax on every car produced in the United States (regardless of whether the car is sold in the United States or abroad). a. What price must Americans pay for cars before the tax is imposed? What price must Americans pay for cars after the tax is imposed? (Hint: Americans

45185_08_ch08_p223-282.indd 269 29/04/10 9:48 PM 270 NOTCHAPTER 8 FOR SALE can always buy cars on the world market and so will never pay more than the world price for a car.) What prices do U.S. producers receive for their cars before and after the tax is imposed? b. Before and after the tax is imposed, calculate the gains to all relevant groups of Americans. What is the deadweight loss due to the tax? 24. Suppose the U.S. supply and demand curves for automobiles cross at a price of $15,000 but (identical) automobiles can be purchased from abroad for $10,000. Now suppose the government offers a subsidy of $2,000 to each American who buys an imported car. Buyers of domestic cars receive no subsidy. a. What price do Americans pay for domestic cars before the subsidy is offered? What is the most an American will pay for a domestic car after the subsidy is offered? b. Given your answer to part (a), and given that anyone can buy or sell cars abroad at the world price of $10,000, how many cars will U.S. producers want to sell in the United States? c. Before and after the subsidy is offered, calculate the gains to all relevant groups of Americans. What is the deadweight loss due to the subsidy? d. How does your answer change if U.S. producers are prohibited from selling cars abroad? 25. Suppose the U.S. supply and demand curves for automobiles cross at a price of $15,000 but (identical) automobiles can be purchased from abroad for $10,000. Now suppose the government offers U.S. producers a $2,000 subsidy for every car they produce (regardless of whether the car is sold in the United States or abroad). a. What prices must Americans pay for cars before and after the subsidy is offered? What prices do U.S. producers feel they are receiving before and after the subsidy is offered? b. Before and after the subsidy is offered, calculate the gains to all relevant groups of Americans. What is the deadweight loss due to the subsidy? 26. Suppose the U.S. supply and demand curves for automobiles cross at a price of $15,000 and that (identical) automobiles can be purchased from abroad for $10,000. Now suppose the government offers a $2,000 subsidy to every American who buys a car (regardless of whether the car is foreign or domestic). a. At what prices do U.S. producers sell their cars before and after the subsidy is offered? What prices do U.S. consumers feel like they are paying before and after the subsidy is offered? b. Before and after the subsidy is offered, calculate the gains to all relevant groups of Americans. What is the deadweight loss due to the subsidy? 27. The American supply and demand curves for cars cross at $15,000. Foreigners will sell us any number of cars at the world price of $10,000. Now the government announces two new taxes: a sales tax of $1,000 on each American car, and a sales tax (that is, a tariff) of $3,000 on each foreign car. Illustrate the gains and/ or losses to all relevant groups of Americans as a result of the combined tax program, and illustrate the deadweight loss. 28. There is currently a sales tax on all cars, foreign and domestic. In order to help the American car industry, the government is thinking of eliminating the sales tax.

45185_08_ch08_p223-282.indd 270 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 271 Plan A is to eliminate the tax for domestic cars only; Plan B is to eliminate the tax for both domestic and foreign cars. a. Which plan is better for domestic car makers? b. True or False: Plan B, combined with an appropriate redistribution of income, can make everybody happier than Plan A. If your answer is true, explicitly describe the appropriate redistribution of income. If your answer is false, explain carefully why no such redistribution is possible. 29. The American supply and demand curves for bananas cross at $5. Foreigners will buy as many bananas as Americans want to sell at $10. The government subsidizes exports by giving sellers $2 for each banana they sell abroad. Bananas cannot be imported into the United States. a. Illustrate the deadweight loss from the subsidy. b. Devise a program that everyone—buyers, sellers, and the recipients of the revenue—prefers to the subsidy. 30. The American supply and demand curves for widgets are illustrated at the top of the next page. Foreign widget makers will sell any quantity of widgets to Americans at a price of $2 apiece.

Supply (American) 12 11 10 9 8 Price 7 ($ per widget) 6 5 4 3 2 Demand 1 (American)

123456789 101112131415 Quantity (100s of widgets)

Suppose the government distributes 500 ration coupons, which can be freely bought and sold. To buy a foreign-made widget, you must present a ration coupon. (An American widget requires no coupon.) What is the price of a ration coupon? (Your answer should be a number.)

31. Suppose that the government successfully maintains a price P0 for wheat that

is above the equilibrium price. At this price, consumers want to purchase Qd

bushels of wheat and farmers want to produce Qs. The way that the government

maintains the price P0 is by offering farmers a cash reward for limiting their production. a. By how much must farmers agree to cut back production in order for the program to be successful? b. Show on a graph the minimum payment that the government must make to farmers in order for them to agree to the deal.

45185_08_ch08_p223-282.indd 271 29/04/10 9:48 PM 272 NOTCHAPTER 8 FOR SALE c. Assuming that the government makes this minimum payment, use your graph to show the gains and losses to consumers, producers, and taxpayers from this arrangement. Calculate the deadweight loss. 32. The American demand and supply curves for labor cross at a wage rate of $25 per hour. However, American firms can hire as many foreign workers as they want to at a wage of $15 per hour. (Assume that foreign workers are exactly as productive as American workers.) A new law requires American firms to pay $25 an hour to Americans and to hire every American who wants to work at that wage. Firms may still hire any number of foreigners at $15 per hour. a. Before the law is enacted, what wage do American workers earn? Illustrate the consumers’ and producers’ surpluses earned by American workers and American firms. b. After the law is enacted, illustrate the number of Americans hired and the number of foreigners hired, the consumers’ and producers’ surpluses earned by American workers and American firms, and the deadweight loss. 33. Widgets are produced by a constant-cost industry. Suppose the government decides to institute an annual subsidy of $8,000 per year to every firm that produces widgets. a. Explain why, in the long run, each firm’s producer surplus must fall by $8,000. b. Suppose the subsidy causes the price of widgets to fall by $1. With the subsidy in place, does each firm produce more than, fewer than, or exactly 8,000 widgets a year? c. Suppose the government replaces the per-firm subsidy with a per-widget subsidy of $1 per widget produced. In the long run, is this change good or bad for consumers? Is it good or bad for producers? (Hint: Remember the zero-profit condition!) Is it good or bad for taxpayers? Is it good or bad according to the efficiency criterion? 34. True or False: If all thieves are identical, then the social cost of robbery is equal to the value of the stolen goods. 35. Popeye and Wimpy trade only with each other. Popeye has 8 hamburgers and 2 cans of spinach, and Wimpy has 2 hamburgers and 8 cans of spinach. Their indifference curves (see next page), somewhat unusually, are all straight lines, Popeye’s being much steeper than Wimpy’s: Hamburgers Hamburgers

Spinach Spinach Popeye’s indifference curves Wimpy’s indifference curves

45185_08_ch08_p223-282.indd 272 29/04/10 9:48 PM WELFARE ECONOMICSNOT AND THE GAINS FROMFOR TRADE SALE 273 In an Edgeworth box, show the initial endowment, the region of mutual advantage, the contract curve, and the competitive equilibrium. 36. Robinson Crusoe lives alone on an island, producing nuts and berries and trading with people on other islands. If his production possibility curve is a straight line, what can you conclude about the quantities of nuts and berries he will produce? 37. Robinson Crusoe lives alone on an island, producing nuts and berries and trading with people on other islands. True or False: If nuts are an inferior good for Robinson, then his supply curve for nuts must be upward sloping.

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Appendix to Chapter 8

Normative Criteria

Suppose that by ordering the execution of one innocent man you could save the lives of five others, equally innocent. Should you do it? Consequentialist moral theories assert that the correctness of an act depends only Consequentialist on its consequences. A simple consequentialist position might be that one lost life is moral theories less bad than five lost lives, so the execution should proceed. Moral theories that Other views are possible. You might argue that if the one man to be executed is assert that the happy and fulfilled, while the other five lead barely tolerable lives, then it would be correctness of an act better to spare the one and sacrifice the five. This position is still consequentialist, can be judged by its because it judges an action by its consequences: The sacrifice of one happy life versus consequences. the sacrifice of five unhappy lives. There are also moral theories that are not consequentialist. Some are based on natural rights. One could argue that a man has a natural right to live and that there can be no justification for depriving him of this right, regardless of the consequences. There can be no execution, even if it would save a hundred innocent lives. In the heated public debate about abortion, both sides have tended to make arguments that go beyond consequentialism. One side defends a “right to choose,” while the other defends a “right to life.” A strictly consequentialist view would discard any discussion of “rights” and judge the desirability of legalized abortion strictly on the basis of its implications for human happiness. This is not enough to settle the issue; one must still face extraordinarily difficult questions about how to trade off different people’s happiness and potential happiness. Consequentialism, like natural rights doc- trine, accommodates many precepts and conclusions. The efficiency criterion is an example of a consequentialist normative theory. Which kind of world is better: One with 10 people, each earning $50,000 per year, or one with 10 people, of whom 3 earn $30,000 and 7 earn $100,000? According to a strict application of the efficiency criterion, the second world is better, because total income is $790,000 instead of $500,000. The world with more wealth is the better world. There are many other possible viewpoints, some consequentialist and some not. One might argue that certain people are more deserving of high income than others, and so there is no way to choose between the two income distributions without know- ing more about the characteristics of the people involved. Such a position introduces criteria other than the ultimate consequences for human happiness, and so can be characterized as nonconsequentialist. Judging the desirability of outcomes requires a normative theory. Economics can help us understand the implications of various theories, and perhaps help us choose among them. For the most part, economic analysis tends to focus on the various

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45185_08_ch08_p223-282.indd 275 29/04/10 9:49 PM 276 NOTCHAPTER 8 FOR SALE consequentialist theories. This is not because natural rights doctrines are uninteresting; it just seems to be the case that (so far) economics has less to say about them.

Some Normative Criteria Here are a few of the normative criteria that economists have thought about.

Majority Rule According to this simple criterion, the better of two outcomes is the one that most people prefer. A number of objections can be raised. One is that majority rule does not provide a coherent basis for choosing among three or more possible outcomes. Sharon, Lois, and Bram plan to order a pizza with one topping. Their preferences are shown in the following table: Sharon Lois Bram First Choice Peppers Anchovies Onions Second Choice Anchovies Onions Peppers Third Choice Onions Peppers Anchovies

A majority (Sharon and Bram) prefers peppers to anchovies, a different majority (Sharon and Lois) prefers anchovies to onions, and a third (Lois and Bram) prefers onions to peppers. No matter what topping is chosen, there is some majority that prefers a different one. A more fundamental objection to majority rule is that it forces us to accept outcomes that almost all people agree are undesirable. If 60% of the people vote to torture and maim the other 40% for their own amusement, a true believer in majority rule is forced to admit the legitimacy of their decision. A less flamboyant example is a proposed tax policy that would have the effect of increasing 51% of all household incomes by $1 per year while decreasing 49% of all household incomes by $10,000 per year. The majority supports the proposal. Do you think it should be implemented?

The Kaldor–Hicks Potential Compensation Criterion The British economists Nicholas Kaldor and Sir John Hicks suggest a normative criterion under which a change is a good thing if it would be possible in principle for the winners to compensate the losers for their losses and still remain winners. If a policy increases Jack’s income by $10, reduces Jill’s by $5, and has no other effects, should it be implemented? According to Kaldor–Hicks, the answer is yes, because Jack could in principle reimburse Jill for her loss and still come out ahead. On the other hand, a policy that increases Jack’s income by $10 while reducing Jill’s by $15 is a bad thing, because there is no way for Jack to reimburse Jill out of his winnings. In applications like this, the Kaldor–Hicks criterion and the efficiency criterion amount to the same thing. When Jack gains $10 and Jill loses $5, social gains increase by $5, so the policy is a good one. When Jack gains $10 and Jill loses $15, there is a deadweight loss of $5, so the policy is bad. However, there are potential subtleties that we did not address when we discussed the efficiency criterion in Section 8.1. Suppose that Jack has a stamp collection that he values very highly. Aside from his stamp collection, he owns nothing of great value and

45185_08_ch08_p223-282.indd 276 29/04/10 9:50 PM Welfare EconomicsNOT and the Gains from TradeFOR SALE 277 in fact barely gets enough to eat. Nevertheless, he would be unwilling to sell his stamp collection for anything less than $100,000. On the other hand, if the collection were taken from him, he would be willing to pay only $100 to get it back; any higher payment would mean starvation. Jill values Jack’s stamp collection at $50,000, regardless of who currently owns it. Should the collection be taken from Jack and given to Jill? If so, she would gain $50,000 in surplus, which is not enough to compensate Jack for his $100,000 loss. The Kaldor– Hicks criterion opposes such a move. On the other hand, suppose that the stamp collection has already found its way into Jill’s hands. If it is restored to Jack, he gains something that he values at $100, not enough to compensate Jill for her $50,000 loss. Kaldor–Hicks opposes this move also. Thus, we get the somewhat paradoxical result that Jack gets to keep his stamp collection, unless it accidentally finds its way into Jill’s hands, in which case Jack is not allowed to get it back. Such paradoxes did not arise when we applied the efficiency criterion in Section 8.1. Why not? When we experimented with changing government policies, making some people better off and others worse off, we implicitly assumed that there were no resulting income effects on demand. If there are income effects, they cause the demand curve to shift at the moment when the policy is implemented. (In the present example, Jack’s demand for stamps shifts dramatically depending on whether he already owns them or not.) This makes welfare analysis ambiguous: Should we calculate surplus using the old demand curve or the new one? However, when the changes being contemplated do not affect large fractions of people’s income, the Kaldor–Hicks criterion becomes unambiguous and equivalent to the efficiency criterion we have already studied.

The Veil of Ignorance Let us repeat an earlier question. Is it better for everyone to earn $50,000 or for 70% of us to earn $100,000 while the rest earn $30,000? The philosopher John Rawls has popularized a way to think about such problems.1 Imagine two planets: On Planet X everyone earns $50,000; on Planet Y 70% earn $100,000 and the rest earn $30,000. On which planet would you rather be born? Your honest answer reveals which income distribution is morally preferable. When you choose where to be born, it is important that you not know who you will be. If you knew that you’d be rich on Planet Y, you would presumably choose Y; if you knew you’d be poor on Y you would presumably choose X. But Rawls insists that we imagine making the decision from behind a veil of ignorance, deprived of any knowledge of whose life we will live. A potential problem with the “veil of ignorance” criterion is that there might be honest disagreements about which is the better world. But Rawls contends that such disagreements arise because of different circumstances in our present lives. If we take seriously the presumption of the veil, that we have not yet lived and are all equally likely to live one life as another, then the reasons for disagreement will vanish and we will achieve unanimity. The unanimous decision is the right decision. Suppose that a potential change in policy would enrich one billionaire by $10,000 while costing eight impoverished people $1,000 each. The efficiency criterion

1 See J. Rawls, A Theory of Justice (Harvard University Press, 1971). A similar idea had appeared in J. C. Harsanyi; “Cardinal Utility in Welfare Economics and the Theory of Risk Taking,” Journal of Political Economy 61 (1953): 434–435.

45185_08_ch08_p223-282.indd 277 29/04/10 9:50 PM 278 NOTCHAPTER 8 FOR SALE pronounces such a policy a good one. Rawls’s criterion probably would not. If you did not yet know whether you were going to be the billionaire or one of the impoverished, it seems likely that you would oppose this policy, on a variety of grounds. First, $10,000 is unlikely to make much difference in a billionaire’s life, while a loss of $1,000 can be devastating if you are very poor. Second, it is 8 times more likely that you will be poor than rich. Rawls would argue that behind the veil of ignorance, the vote against this policy would be unanimous. Therefore, the policy is bad. The veil of ignorance can be used to justify various forms of social insurance, in which income is redistributed from the more to the less fortunate. Some misfortunes do not usually strike until late in life, and we can buy insurance against them at our leisure. But other misfortunes are evident from birth, making insurance impossible. You can’t insure against being born into poverty, or with below-average intelligence. There is a plausible case that behind the veil, we would insure ourselves, by agreeing that those born into the best circumstances will transfer income to those born into the worst. Because everyone behind the veil would want this agreement, it is a good thing and should be enforced.

The Maximin Criterion The maximin criterion says that we should always prefer that outcome which maximizes the welfare of the worst-off member of society. Taken to the extreme, this means that a world in which everyone is a millionaire, except for one man who has only $200, is not as good as a world in which everyone has only $300 except for one man who has $201. Perhaps nobody would want to apply the maximin criterion in a circumstance quite so extreme as this. But John Rawls believes that for the most part, souls living behind the veil of ignorance would want the maximin criterion to be applied. This is because people abhor risk and worry about the prospect of being born unlucky. Therefore, while still behind the veil, their primary concern is to improve the lot of the least fortunate members of society. According to Rawls, then, the maximin criterion is not really a new criterion at all, but instead prescribes essentially the same outcomes that the veil of ignorance criterion prescribes.2

The Ideal Participant Criterion This is a slight variant on the veil of ignorance criterion, developed by Professor Tyler Cowen for the purpose of thinking about the problem of population but applicable more generally. (We will briefly address the population problem later in this appendix.) According to this criterion, we should imagine living many lives in succession, one each in the circumstances of every person on earth. The right outcomes are the ones we would choose before setting out on this long journey. In comparing the ideal participant criterion with the more standard veil of ignorance criterion, you might want to consider two critical questions. First, in what

2 A complete statement of Rawls’s position would have to incorporate at least two additional subtleties. First, Rawls believes that from behind the veil, people’s first priority would be to design social institutions that guarantee individual liberty. Having narrowed down to this set of institutions, they would then choose among them according to the maximin criterion. Second, Rawls does not want to apply the maximin criterion to particular details of the income distribution or human interactions. He wants to apply it instead to the design of social institutions. Thus, a Rawlsian might focus not on designing the ideal income distribution but rather on designing an ideal tax structure, from which the income distribution would arise. Rawls seeks that tax structure, among all of those that are consistent with individual liberty, which maximizes benefits to the least well-off members of society.

45185_08_ch08_p223-282.indd 278 29/04/10 9:50 PM Welfare EconomicsNOT and the Gains from TradeFOR SALE 279 circumstances would these criteria lead to the same choices and in what circumstances would they disagree? Second, is there some more fundamental moral principle from which we can deduce a preference for one of the two criteria over the other? So far, economists have not found much to say about either of these issues.

Utilitarianism Utilitarianism, a creation of the philosopher Jeremy Bentham, asserts that it is mean- Utilitarianism ingful to measure each person’s utility, or happiness, by a number. This makes it pos- The belief that utility, sible to make meaningful comparisons across people: If your utility is 4 and mine is 3, or happiness, can be then you are happier than I am. (By contrast, many modern economists deny that meaningfully measured any precise meaning can be attached to the statement “Person X is happier than and that it is desirable Person Y.”)3 to maximize the sum of Starting from the assertion that utilities are meaningful, utilitarians argue that the everyone’s utility. best outcome is the one that maximizes the sum of everybody’s utilities. By this criterion, it is often better to augment the income of a poor man than a rich man, because an extra dollar contributes more to the poor man’s utility than to the rich man’s. This conclusion need not follow, however. One can imagine that the poor man has for some reason a much lower capacity for happiness than the rich man has, so that additional income contributes little to his enjoyment of life. A generalized form of utilitarianism proposes that we assign a weight to each person and maximize the weighted sum of their utilities. If Jack has weight 2 and Jill has weight 3, then we choose the outcome that maximizes twice Jack’s utility plus 3 times Jill’s. The source of the weights themselves is left open, or is determined by any of various auxiliary theories.4 Under quite general circumstances, it is possible to prove that utilitarianism, with any choice of weights, always leads to a Pareto-optimal outcome and that utilitarian criteria are the only criteria that always lead to Pareto-optimal outcomes. This is so even if we drop the assumption that it is meaningful to compare different people’s utilities.

Fairness Economists have attempted to formalize the notion of fairness in a variety of ways, usually in the context of allocating fixed supplies of more than one good. In a world with 6 apples and 6 oranges, it seems absurd to insist that Jack and Jill each end up with 3 of each fruit; after all Jack might have a strong preference for apples and Jill for oranges. On the other hand, it seems quite unfair for either Jack or Jill to have all of the food while the other one starves. What precisely distinguishes those allocations that we Envy-free think are equitable? allocation A widely studied criterion is that allocations should be envy-free, which means An outcome in which that no person would prefer somebody else’s basket of goods to his own. Any alloca- nobody would prefer tion of apples and oranges is envy-free if neither Jack nor Jill would want to trade to trade baskets with places with the other, given the choice. anybody else.

3 Utilitarians are not the only ones who believe that they can compare different people’s happiness. In order to apply the maximin criterion, for example, it is necessary to make sense of the notion of the “least well-off” member of society. 4 The primary proponents of utilitarianism among economists were H. Sidgwick and F. Y. Edgeworth (the same Edgeworth of the Edgeworth box). For a very interesting attempt to reconstruct the weights that Sidgwick and Edgeworth had in mind, see M. Yaari, ‘Rawls, Edgeworth, Shapley, Nash: Theories of Distributive Justice Re-examined,’ Journal of Economic Theory 24 (1981): 1–39.

45185_08_ch08_p223-282.indd 279 29/04/10 9:50 PM 280 NOTCHAPTER 8 FOR SALE In an Edgeworth box economy, it is possible to show that if each trading partner starts with equal shares of everything (3 apples and 3 oranges each), then any competitive equilibrium is envy-free. This is an important result, because we already know that any competitive equilibrium is efficient as well; that is, it satisfies the efficiency criterion. This implies that in such an economy, it is always possible to achieve an outcome that is simultaneously efficient and envy-free, satisfying two criteria at once.

Optimal Population What is the right number of people?5 If large populations imply crowding and unpleas- antness, then how much is too much? Would it be better if there were only 10 people, each deliriously happy, or if there were 1 billion people, each slightly less happy? Where should we draw the line? It should first be noted that the implied premise is at least debatable. A 10% increase in the current world population would change a lot of things, some for the better and some for the worse. The new arrivals would consume resources (which is bad for the rest of us) and produce output (which is good for the rest of us); it is unclear whether we’d be better or worse off on balance. Still, it is probable that beyond some point—though it might be very far beyond the point we’re at now—increases in population will make life less pleasant for everyone. At what point does the population become ‘too big’? The population problem tends to confound the usual normative criteria, which are designed to address the problem of allocating resources among a fixed number of people. We could adopt the utilitarian prescription, attempting to maximize total utility. A world of 1 billion reasonably happy people is better than a world with 100 extremely happy people, because total utility is higher in the first of these worlds. But the same criterion dictates that a world of 10 trillion people, each leading a barely tolerable existence, can be superior to the world of 1 billion who are reasonably happy. To some economists, this conclusion is self-evidently absurd. Professor Derek Parfit has endowed it with a proper name: He calls it the Repugnant Conclusion.6 To Parfit and others, any moral theory that entails the Repugnant Conclusion must be rejected. There are others, though, who think that the repugnance of the Repugnant Conclusion is far from evident. An alternative is to maximize average (as opposed to total) utility. In practice, people are probably happier on average when the population is reasonably large (so that there is greater efficiency in production, a wider range of consumer goods, and a better chance of finding love). Therefore, a world of 1 billion might lead to higher average utility than a world of 100, even though a grossly overcrowded world of 1 trillion is worse than either. An objection to the average utility criterion is that it always implies that the world would be a better place if everyone with below-average utility were removed. Alternatively, we can step behind the veil of ignorance and ask how many of us should be born. The trade-off is this: If the population is too large, the world is an unpleasant place, but if it is too small, most of us never get a chance to live. The con- ceptual problem here is to decide exactly how many souls there are behind the veil. Is there one for every person who might be born? Is that an infinite number? If so, then

5 This entire section owes much to Tyler Cowen’s paper “Normative Population Theory,” Social Choice and Welfare 6 (1989): 33–43. 6 D. Parfit, Reasons and Persons (Oxford University Press, 1984).

45185_08_ch08_p223-282.indd 280 29/04/10 9:50 PM Welfare EconomicsNOT and the Gains from TradeFOR SALE 281 each has effectively zero chance of being among the finitely many lucky ones who do get born, rendering each indifferent to what the world is like. If instead there is a large, finite number of souls behind the veil, what determines that large, finite number? Tyler Cowen has raised an additional objection to the veil of ignorance criterion. He asks a form of the following question: Suppose that you were offered a bet, whereby there is a 1% chance that 100 duplicate copies of earth will be created and a 99% chance that all human life will disappear. Would you take the bet? Behind the veil you would, because it actually increases the chance of your birth without changing the average quality of human life. Yet, Cowen argues, the bet is obviously a bad one.7 Because the veil criterion leads us to choose a bad bet, it must be a bad criterion. Cowen has argued that the Ideal Participant Criterion is the ideal criterion for considering problems of population. You can read his arguments in the paper cited in the footnote at the beginning of this section. But the issue is very far from settled. In a world where we can’t agree on what the speed limit should be, a consensus on population size will probably be a long time coming.

Author Commentary academic.cengage.com/economics/landsburg

AC1 A-1. Good voting systems are hard to find, both in politics and in sports. AC1 A-2. If we take the veil of ignorance seriously, what does it dictate? For some back-of-the-envelope calculations, read this article. AC1 A-3. Read about one point of view on various normative criteria applied to tax policy. AC1 A-4. What does utilitarianism say about the case for environmental conservation? AC1 A-5. For more on optimal population, see this article. AC1 A-6. This is an article on optimal population.

7 It should perhaps be mentioned that what is obvious to Cowen is not obvious to everyone, among them the author of your textbook.

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