Stand-Up Economics: The Micro Textbook Version 5.01 July 2010 Available with and without calculus at http://www.standupeconomist.com/books Email contact: [email protected] This work is licensed under the Creative Commons Attribution-NonCommercial 3.0 Unported License. To view a copy of this license, visit Creative Commons online at http://creativecommons.org/licenses/by-nc/3.0/. ii Contents README.TXT vii I The optimizing individual 11 1 Introduction 13 2 Decision trees 17 2.1 Decision trees ............................. 17 2.2 Example: Monopoly ......................... 18 3 Time 23 3.1 Lump sums .............................. 24 3.2 Annuities and perpetuities ...................... 25 3.3 Capital theory ............................ 27 3.4 Algebra: Budget constraints ..................... 30 3.5 Algebra: Continuous compounding ................. 31 4 Risk 43 4.1 Reducing risk with diversification .................. 44 4.2 Algebra: Indifference curves ..................... 47 5 From one to some 55 5.1 No arbitrage ............................. 55 5.2 Rush-hour arbitrage ......................... 56 5.3 Financial arbitrage .......................... 57 II Strategic interactions 63 6 Cake cutting 65 6.1 Some applications of game theory .................. 66 6.2 Cake-cutting: The problem of fair division ............. 67 6.3 The importance of trade ....................... 70 iii iv CONTENTS 7 Pareto efficiency 75 7.1 Cost-benefit analysis ......................... 76 7.2 Pareto ................................. 77 7.3 Example: Taxes ............................ 78 8 Simultaneous-move games 83 8.1 Strictly dominant strategies ..................... 84 8.2 The Prisoners’ Dilemma ....................... 84 9 Auctions 91 9.1 Kinds of auctions ........................... 92 9.2 Bid-shading and truth-revelation .................. 93 9.3 Auction equivalences ......................... 94 9.4 Auction miscellany .......................... 96 10 From some to many 105 10.1 Monopolies in the long run .....................106 10.2 Barriers to entry ...........................107 III Market interactions 109 11 Supply and demand 111 11.1 The story of supply and demand ..................112 11.2 Shifts in supply and demand ....................113 11.3 Algebra: The algebra of markets ..................115 12 Taxes 121 12.1 Per-unit taxes on the sellers .....................121 12.2 Per-unit taxes on the buyers .....................123 12.3 Tax equivalence ............................125 12.4 Tax incidence .............................125 12.5 Algebra: The algebra of taxes ....................126 13 Margins 137 13.1 Reinterpreting the supply curve ...................137 13.2 Reinterpreting the demand curve ..................139 13.3 Conclusion: Carrots and sticks ...................141 14 Elasticity 143 14.1 The price elasticity of demand ...................143 14.2 Beyond the price elasticity of demand ...............145 14.3 Applications ..............................147 15 Transition: Welfare economics 151 15.1 From theory to reality ........................153 CONTENTS v IV Supplemental chapters 155 16 Inflation 157 16.1 Nominal and real interest rates ...................157 16.2 Inflation ................................158 16.3 Mathematics .............................160 17 Fisheries 167 17.1 An economic perspective .......................168 17.2 A brief look at government intervention ..............168 17.3 ITQs to the rescue? .........................171 18 Sequential-move games 173 18.1 Backward induction .........................174 19 Iterated dominance and Nash equilibrium 189 19.1 Iterated dominance ..........................189 19.2 Nash equilibrium ...........................192 19.3 Infinitely repeated games ......................194 19.4 Mixed strategies ...........................196 20 Supply and demand details 203 20.1 Deconstructing supply and demand .................203 20.2 Math: The algebra of markets ....................204 20.3 On the shape of the demand curve .................206 20.4 On the shape of the supply curve ..................207 20.5 Comparing supply and demand ...................208 Glossary 213 Index 221 vi CONTENTS README.TXT Jay Leno says that anybody can become a successful stand-up comic if they give it seven years. and the same thing is true about getting an undergraduate degree in economics! This textbook is a companion to The Cartoon Introduction to Economics: Vol- ume One, Microeconomics, by Grady Klein and Yoram Bauman, which you can buy from amazon.com. The first three parts of this textbook cover the same material as the three parts of the cartoon book; the fourth part covers supple- mental material not covered in the cartoon book. Both books try to apply three lessons from stand-up comedy to the world of economics: Make it short Most of the work of stand-up comedy involves boiling down 10 minutes of material that has promise into 2 minutes of material that kills. This book is short, and the Cartoon Introduction is even shorter. Make it funny Look, this book is not a laugh riot—the Cartoon Introduction is funnier, and the videos at http://www.standupeconomist.com are much funnier—but it tries. Tell a story Stand-up comedy is less about one-liners and more about stories. The story in this book is about the big question in microeconomics: “Under what circumstances does individual self-interest lead to good outcomes for the group as a whole?” In looking at this question, we’ll follow a path that is not unlike a hiking trip. We start out by putting our boots on and getting our gear together: in Part I we study the optimizing individual. Then we set out on our path and immediately find ourselves hacking through some pretty thick jungle: even simple interactions between just two people (Part II) can be very compli- cated! As we add even more people (in studying auctions, for example), things get even more complicated, and the jungle gets even thicker. Then a miracle occurs: we add even more people, and a complex situation suddenly becomes simple. After hacking through thick jungle, we find ourselves in a beautiful clearing: competitive markets (Part III) are remarkably easy to analyze and understand. vii viii README.TXT Part I The optimizing individual 11 Chapter 1 Introduction Two monks walking through a garden stroll onto a small bridge over a goldfish pond and stop to lean their elbows on the railing and look contemplatively down at the fish. One monk turns to the other and says, “I wish I were a fish; they are so happy and content.” The second monk scoffs: “How do you know fish are happy? You’re not a fish!” The reply of the first monk: “Ah, but how do you know what I know, since you are not me?” (Adapted from a story told by the Chinese philosopher Zhuangzi in the 4th century BCE.) Economics is a social science, and as such tries to explain human behavior. Different disciplines—psychology, sociology, political science, anthropology— take different approaches, each with their own strengths and weaknesses; but all try to shed some light on human behavior and (as the joke suggests) all have to make assumptions about how people work. The basic assumption of economics is that decisions are made by optimizing individuals. Decisions Economics studies the act and implications of choosing. Without choice, there is nothing to study. As Mancur Olson put it in The Logic of Collective Action: “To say a situation is ‘lost’ or hopeless is in one sense equivalent to saying it is perfect, for in both cases efforts at improvement can bring no positive results.” Individuals Economics assumes that the power to make choices resides in the hands of individuals. The approach that economists take in studying the behavior of groups of individuals (consumers, businesses, countries, etc.) is to study the incentives and behaviors of each individual in that group. The key question in economics is whether—and under what circumstances— individual decision-making leads to results that are good for the group as a 13 14 CHAPTER 1. INTRODUCTION whole. For a pessimistic view on this issue, see the Prisoners’ Dilemma game in Chapter 8. For an optimistic view, see Chapter 15 or consider the words of Adam Smith, who wrote in 1776 that “[man is] led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.” Optimization Economics assumes that individuals try to do the best they can. Although economics is unwavering in the assumption that individuals are optimizing— i.e., that each has some objective—there is flexibility in determining exactly what those objectives are. In particular, economics does not need to assume that individuals are selfish or greedy; their objectives may well involve friends or family, or people they’ve never met, or even plants and animals. Economics also does not make value judgments about different types of in- dividuals; for example, economists do not say that people who avoid risk are better or worse than people who seek out risk. We simply note that, given identical choices, different people act in different ways. In all cases, we assume that each individual is making the decision that is in their best interest. An aside about individual firms Economists often treat companies as opti- mizing individuals with a goal of profit maximization. (For our purposes, profit is simply money in minus money out.1) Although the assumption of profit max- imization is useful, it does have some problems.