LUÍS M B CABRAL INTRODUCTION TO MICROECONOMICS Introduction to Microeconomics by Luís Cabral is licensed under CC BY-ND 4.0. This license requires that reusers give credit to the creator. It allows reusers to copy and distribute the material in any medium or format in unadapted form only, even for commercial purposes. To view a complete copy of this license, visit https://creativecommons.org/licenses/by-nd/4.0 This book was typeset in LaTeX using the memoir style as well as multiple macros developed by the author. All images included in this book are in the public domain. Whenever appropriate, links to the license and author are included. Cover design based on Arch (2005), oil on canvas (18x18in), by Luís Cabral. Luís Cabral is Paganelli-Bull Professor of Economics at NYU’s Stern School of Business. Updated information about this book will appear at luiscabral.net/economics/books/micro/ Version 1.2 (December 2020) CONTENTS PREFACE PART I: INTRODUCTION 1. THE ECONOMY 1.1. Living standards and happiness ................ 5 1.2. The capitalist revolution .................... 12 1.3. The limits of the market economy ............... 26 1.4. A sustainable economy .................... 32 2. ECONOMICS 2.1. Scope and method ...................... 52 2.2. Behavioral and social science ................. 63 2.3. Central themes ........................ 73 2.4. A force for the good ...................... 85 PART II: SCARCITY AND CHOICE 3. OPTIMAL CHOICE 3.1. Feasible set .......................... 101 3.2. Preferences .......................... 104 3.3. The marginal rule ....................... 113 4. HOUSEHOLDS 4.1. Consumption ......................... 125 4.2. Labor supply ......................... 133 4.3. Other household decisions .................. 142 5. FIRMS 5.1. Production function ...................... 163 5.2. Input mix ........................... 172 5.3. Output level and price ..................... 184 PART III: MARKETS 6. SUPPLY AND DEMAND 6.1. Cost function and supply ................... 212 6.2. Willingness to pay and demand ................ 233 7. EQUILIBRIUM AND EFFICIENCY 7.1. Competitive markets ..................... 258 7.2. Gains from trade and efficiency ................ 278 7.3. Price controls ......................... 295 PART IV: MARKET FAILURE 8. MARKET POWER 8.1. Sources and effects of market power ............. 316 8.2. Antitrust and competition policy ................ 334 8.3. The rise of the tech giants ................... 337 9. EXTERNALITIES 9.1. Internalizing externalities ................... 350 9.2. The COVID-19 pandemic ................... 363 9.3. Climate change ........................ 377 10. INFORMATION 10.1. Asymmetric information .................... 398 10.2. Consumer protection ..................... 409 PART V: SOCIAL JUSTICE 11. EQUITY 11.1. Measuring and explaining inequality .............. 422 11.2. Discrimination ......................... 442 12. SOLIDARITY 12.1. Fairness ........................... 456 12.2. Political economy ....................... 462 12.3. Taxation ........................... 471 13. OPPORTUNITY 13.1. Migration ........................... 495 13.2. Inter-generational mobility ................... 504 13.3. Housing, schooling and family ................. 508 INDEX PREFACE We hear it from politicians, journalists, activists — anyone who’s paying attention. The clamor is near unanimous, or so it seems: We need to break with the capitalist system. Technology and economics have gotten us into a huge mess: (a) The planet is at great risk. (b) From France to Chile to the United States, social tension is at an all- time high, largely the result of increasing income inequality. (c) Sta- ble jobs seem like a thing from the past. The list goes on and on. So, we need to get rid of a system that does not work and of the tech- nocrats who designed it. Economists have not always been at the forefront of policy. How- ever, their influence has increased substantially in the past thirty or forty years. As such, we might say that the problem is not just the market economy but also economics as an academic discipline. Some swear by economics, some swear at economists. As I will argue in the next few hundred pages, both are right in some sense and both are wrong in a different sense. This book is an attempt to correct the way economics is taught and at the same time an attempt to answer the critics’ wake-up call. The book’s motto might be Technology and the market economy got us into the present mess, but technology and the market economy are the only hope of getting us out of the present mess. The world and the world’s economy have changed a lot in the past half century or so. The microeconomics textbook, however, has really 2 not evolved that much since Samuelson’s Economics was first pub- lished in the 1940s. The graphs got better, new examples were added, but the core has remained the same for the longest time. One excep- tion I am aware of is the core-econ project, in particular the eBook The Economy. learned a lot from reading The Economy. In fact, I have adopted or adapted several features from that book. However, I have different ideas regarding the optimal organization of a textbook. To this I turn next. STRUCTURE Introduction to Microeconomics is divided into five parts. Parts II and III correspond to the “traditional” approach to microeconomics. I have no interest in throwing out the baby with the bathwater: The ba- sic economics model of rational, optimizing behavior remains an im- portant tool to understand economic agency (not so much how they should behave but rather how they actually behave). Part IV deals with market failure. While competitive markets represent an im- portant reference point, most markets today deviate from that ideal model in fundamental ways. Part V, arguably the most innovative part of the book, is devoted to social justice: equity, solidarity, op- portunity. Finally, Part I corresponds to a longish introduction to the economy (the real-world phenomenon) and to economics (the aca- demic discipline). NAVIGATING THE BOOK Introduction to Microeconomics is primarily intended to be read as a pdf-based eBook. Other formats, such as ePub, have the great ad- vantage of being easily scalable. However, they are very poor at han- dling graphs; and it’s nearly impossible to write an economics text without graphs. I chose font size and page size so as to allow for com- fortable reading on a tablet and even on a large-screen smartphone. Naturally, you are free to print the pdf file if you are so inclined, but there is a loss in the process: One of the advantages of electronic pub- lishing is the inclusion of hyperlinks. In the present context, a simple rule applies: if it’s blue, it will link for you. Data and photo sources, article and book references, individuals and events, and so on, are typeset in blue and accompanied by an external internet link. Chap- 3 ter, section, figure, table and page numbers, in turn, correspond to internal links and are also typeset in blue. A special reference should be made to the page number (top right corner of each page), which functions as a “button” linking to the table of contents. From the table of contents, in turn, you can link to any chapter or section of the book by pressing the chapter or section name (typeset in blue). FEEDBACK Introduction to Microeconomics is a free, open access text primarily in- tended for college undergraduate courses. I plan to develop addi- tional materials and will be happy to share them with instructors. I will also be very happy to receive any feedback you might have. The current version may be found on the first page after the cover. The latest version, as well as the version history, may be found on the book page. Please submit comments, corrections, typos, etc, to [email protected]. Roger W PART I INTRODUCTION CHAPTER 1 THE ECONOMY 1.1. LIVING STANDARDS AND HAPPINESS Popular wisdom has given us a number of jokes about money and happiness. Playwright George Bernard Shaw misquoted Paul of Tar- sus by claiming that “lack of money is the root of all evil.” Alexander Hamilton, first US Secretary of the Treasury — and inspiration for the Broadway smash hit “Hamilton” — wisely remarked that “money isn’t everything, but it certainly keeps you in touch with your chil- dren.” Novelist Gertrude Stein assures us that “whoever said money can’t buy happiness didn’t know where to shop.” Addressing specif- ically the issue of happiness, actor Alan Alda teaches us that “it isn’t necessary to be rich and famous to be happy, it’s only necessary to be rich.” Spike Milligan, in turn, pleads, “all I ask is the chance to prove that money can’t make me happy.” And finally, a quote (of uncertain origin) that summarizes much of what this chapter is about: I’ve been rich and I’ve been poor. And, believe me, rich is better. All joking aside, a general principle that most if not all agree on is that a minimum living standard is a necessary condition for happi- ness. Not a sufficient condition, but certainly a necessary one. As Franklin D. Roosevelt famously stated, “We have come to a clear re- alization of the fact that true individual freedom cannot exist without 1.1. LIVING STANDARDS AND HAPPINESS 6 economic security and independence.” Economics is about manag- ing — individually, as a household, as a country, as a planet — the limited resources we have so as to achieve a reasonable living stan- dard for all. MEASURING LIVING STANDARDS Economics is largely a quantitative discipline. Of the many mea- sures used to describe the level of economic activity and living stan- dards, the most important is probably that of Gross Domestic Prod- uct (GDP). GDP measures the total goods and services produced in the economy at market prices and in a given period. If you get a hair- cut and pay $20 for it, then an extra $20 is added to GDP.