microeconomics

1. lcroeco CDmlC5SEVENTH EDITION ROBERT S. PINDYCK DANIEL L. RUBINFELD

2. TO PIC Markets for Prescription Drugs 10 The Market for Sweeteners 11 The Price of Eggs and the Price of a College Education 13 The Minimum Wage 14 The Price of Eggs and the Price of a College Education Revisited 28 Wage Inequality in the United States 29 The Long-Run Behavior of Natural Resources Prices 30 The Effects of 9/11 on the Supply and Demand for New York City Office Space 32 The Market for Wheat 38 The Demand for Gasoline and Automobiles 44 The Weather in Brazil and the Price of Coffee in New York 46 The Behavior of Copper Prices 52 Upheaval in the World Oil Market 54 Price Controls and Natural Gas Shortages 59 Designing New Automobiles (I) 77 Can Money Buy Happiness? 81 Designing New Automobiles (II) 89 A College Trust Fund 91 Revealed Preference for Recreation 94 Marginal Utility and Happiness 97 Gasoline Rationing 98 The Bias in the CPI 105 Consumer Expenditures in the United States 117 The Effects of a Gasoline Tax 123 The Aggregate Demand for Wheat 129 The Demand for Housing 130 The Value of Clean Air 134 Network Externalities and the Demands for Computers and E-Mail 139 The Demand for Ready-to-Eat Cereal 143 Deterring Crime 164 Business Executives and the Choice of Risk 169 The Value of Title Insurance When Buying a House 173 The Value of Information in the Dairy Industry 175 Doctors, Patients, and the Value of information 175 Investing in the Stock Market 183 New York City Taxicab Drivers 190 Malthus and the Food Crisis 204 Labor Productivity and the Standard of Living 206 A Production Function for Wheat 213 Returns to Scale in the Carpet Industry 217 Choosing the Location for a New Law School Building 223 Sunk, Fixed, and Variable Costs: Computers, Software, and Pizzas 226 The Short-Run Cost of Aluminum Smelting 232 The Effect of Effluent Fees on Input Choices 239 Economies of Scope in the Trucking Industry 251 The Learning Curve in Practice 255 Cost Functions for Electric Power 258 Condominiums versus Cooperatives in New York City 275 The Short-Run Output Decision of an Aluminum Smelting Plant 282 Some Cost Considerations for Managers 283 The Short-Run Production of Petroleum Products 286 The Short-Run World Supply of Copper 289 Constant-, Increasing-, and Decreasing-Cost Industries: Coffee, Oil, and Automobiles 302 The Long-Run Supply of Housing 304 Price Controls and Natural Gas Shortages 314 The Market for Human Kidneys 317 Airline Regulation 321 Supporting the Price of Wheat 327 The Sugar Quota 333 A Tax on Gasoline 340 Real-world examples are key to the applied approach of this book. The seventh edition of Microeconomics incorporates more than 100 detailed examples into the flow of the text. The following is a list of these examples: EXAMPLE 1.1 1.2 1.3 1.4 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 4.1 4.2 4.3 4.4 4.5 4.6 4.7 5.1 5.2 5.3 5.4 5.5 5.6 5.7 6.1 6.2 6.3 6.4 7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1 8.2 8.3 8.4 8.5 8.6 8.7 9.1 9.2 9.3 9.4 9.5 9.6 3. EXAMPLE 10.1 10.2 10.3 10.4 10.5 10.6 11.1 11.2 11.3 11.4 11.5 11.6 11.7 12.1 12.2 12.3 12.4 12.5 12.6 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 14.1 14.2 14.3 14.4 14.5 14.6 14.7 15.1 15.2 15.3 15.4 15.5 15.6 16.1 16.2 16.3 17.1 17.2 17.3 17.4 17.5 17.6 18.1 18.2 18.3 18.4 18.5 18.6 18.7 18.8 TO PIC Astra-Merck Prices Prilosec 356 Markup Pricing: Supermarkets of Designer Jeans 364 The Pricing of Videos 365 Monopsony Power in U.S. Manufacturing 380 A Phone Call About Prices 384 The United Stales versus Microsoft 385 The Economics of Coupons and Rebates 400 Airline Fares 402 How to Price a Best-Selling Novel 406 Polaroid Cameras 410 Pricing Cellular Phone Service 411 The Complete Dinner versus a la Carte: A Restaurant's Pricing Problem 422 Advertising in Practice 427 Monopolistic Competition in the Markets for Colas and Coffee 447 A Pricing Problem for Procter & Gamble 460 Procter & Gamble in a Prisoners' Dilemma 463 Price Leadership and Price Rigidity in Commercial Banking 467 The Cartelization of lntercollegiate Athletics 473 The Milk Cartel 474 Acquiring a Company 481 Oligopolistic Cooperation in the Water Meter Industry 492 Competition and Collusion in the Airline Industry 493 Wal-Mart Stores Preemptive Investment Strategy 501 DuPont Deters Entry in the Titanium Dioxide Industry 507 Diaper Wars 508 Auctioning Legal Services 514 Internet Auctions 515 The Demand for Jet Fuel 528 Labor Supply for One- and Two-Earner Households 533 Pay in the Military 537 Monopsony Power in the Market for Baseball Players 541 Teenage Labor Markets and the Minimum Wage 542 The Decline of Private-Sector Unionism 546 Wage-Inequality-Have Computers Changed the Labor Market? 547 The Value of Lost Earnings 555 The Yields on Corporate Bonds 559 Capital Investment in the Disposable Diaper Industry 566 Choosing an Air Conditioner and a New Car 569 Should You Go to Business School? 572 How Depletable Are Depletable Resources? 576 The Global Market for Ethanol 588 Trading Tasks and iPod Production 608 The Costs and Benefits of Special Protection 609 Lemons in Major League Baseball 622 Working into the Night 627 Reducing Moral Hazard-Warranties of Animal Health 630 CEO Salaries 632 Managers of Nonprofit Hospitals as Agents 634 Efficiency Wages at Ford Motor Company 641 The Costs and Benefits of Sulfur Dioxide Emissions 649 Reducing Sulfur Dioxide Emissions in Beijing 657 Emissions Trading and Clean Air 658 Regulating Municipal Solid Wastes 662 Global Warming 667 The Coase Theorem at Work 672 Crawfish Fishing in Louisiana 674 The Demand for Clean Air 679 4. Microeconomics SEVENTH EDITION 5. tcroeconomtcsSEVENTH EDITION Robert S. Pindyck Massachusetts Institute of Technology Daniel L. Rubinfeld University of California, Berkeley IlEa allUpper Saddle River, New Jersey 07458 6. Library of Congress Cataloging-in-Publication Data Pindyck, Robert S. Microeconomics/Robert S. Pindyck, Daniel L. Rubinfeld. - 7th ed. p. cm. Includes index. ISBN 978-0-13-208023-1 (alk. paper) 1. Microeconomics. I. Rubinfeld, Daniel L. II. Title. HBl72.P532009 338.5-dc22 2008009456 Editorial Director: Sally Yagan AVP/Editor in Chief: Eric Svendsen AVPlExecutive Editor: Chris Rogers VPIDirector of Development: Steve Deitmer Senior Development Editor: Ron Librach Product Development Manager: Ashley Santora Assistant Editor: Susie Abraham Marketing Manager: Andrew Watts Marketing Assistant: Ian Gold Permissions Project Manager: Charles Morris Senior Managing Editor: Judy Leale Associate Managing Editor: Suzanne DeWorken Senior Operations Specialist: Arnold Vila Art Director: Kenny Beck Text and Cover Designer: Maureen Eide Cover Illustration: Corin Skidds Director, Image Resource Center: Melinda Patelli Manager, Rights and Permissions: Zina Arabia Manager, Visual Research: Beth Brenzel Image Permission Coordinator: Annette Linder Composition: GGS Book Services PMG Full-Service Project Management: GGS Book Services PMG Printer/Binder: Courier Kendallville Typeface: 10/11 Palatino Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text (or on pages 723-724). Microsoft'" and Windows are registered trademarks of the Microsoft Corporation in the U.s.A. and other countries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Copyright 2009, 2005, 2001, 1998, 1995 by Pearson Education, Inc., Upper Saddle River, New Jersey, 07458. Pearson Prentice HalL All rights reserved. Printed in the United States of America. This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding perrnissionts), write to: Rights and Permissions Department. Pearson Prentice Hall" is a trademark of Pearson Education, Inc. Pearson'" is a registered trademark of Pearson pic Prentice Hall is a registered trademark of Pearson Education, Inc. Pearson Education Ltd., London Pearson Education Singapore, Pte. Ltd Pearson Education, Canada, Inc. Pearson Education-Japan Pearson Education Australia PTY, Limited Pearson Education North Asia, Ltd., Hong Kong Pearson Educaci6n de Mexico, S.A. de c.v. Pearson Education Malaysia, Pte. Ltd Pearson Education Upper Saddle River, New Jersey PEARSON Prentice Hall 10 9 8 7 6 5 4 3 2 ISBN-13: 978-0-13-208023-1 ISBN-10: 0-13-208023-0 7. To our daughters, Maya, Talia, and Shira Sarah and Rachel 8. _I 1 ABOUT THE AUTHORS FIGURE 0.1 Authors of Microeconomics The authors, back again for a new edition, reflect on their years of successful textbook collaboration. Pindyck is on the right and Rubinfeld on the left. vi Revising a textbook every three or four years takes considerable work, so Pindyck asked, "Why bother? The last edition was clearly written and students loved it." "Don't be silly," replied Rubinfield. "Remember what our publisher said-the old edition was getting stale, and we need some new and jazzy examples." "I guess that makes sense," replied Pindyck, "but do you think it has anything to do with the used book market?" Rubinfield paused. "Could be, but remember that 7 is our lucky number." Robert S. Pindyck is the Bank of Tokyo-Mitsubishi Ltd. Professor of Economics and Finance in the Sloan School of Management at M.LT. Daniel L. Rubinfeld is the Robert L. Bridges Professor of Law and Professor of Economics at the University of California, Berkely, and Visiting Professor of Law at NYU. Both received their Ph.D's from M.LT., Pindyck in 1971 and Rubinfeld in 1972. Professor Pindyck's research and writing have covered a variety of topics in microeconomics, including the effects of uncertainty on firm behavior and market structure, the determinants of market power, the behavior of natural resource, commodity, and financial markets, and criteria for investment decisions. Professor Rubinfeld, who served as chief economist at the Department of Justice in 1997 and 1998,is the author of a variety of articles relating to antitrust, competition policy, law and economics, law and statistics, and public economics. Pindyck and Rubinfeld are alsoco-authors of Econometric Models and Economic Forecasts, another best-selling textbook that may yet be turned into a feature film. Always looking for ways to earn some extra spending money, the two authors recently enrolled as human subjects in a double-blind test of a new hair restora- tion medication. Rubinfeld strongly suspects that he is being given the placebo. This is probably more than you want to know about these authors, but for further information, see their websites: http://web.mit.edu/rpindyck/ www and http://www.1aw.berkeley.edu/aculty/rubineldd. 9. BRIEF CONTENTS PAR T ONE Introduction: Markets and Prices 1 1 Preliminaries 3 2 The Basics of Supply and Demand 21 PAR T TWO Producers, Consumers, and Competitive Markets 65 3 Consumer Behavior 67 4 Individual and Market Demand 111 5 Uncertainty and Consumer Behavior 159 6 Production 195 7 The Cost of Production 221 8 Profit Maximization and Competitive Supply 271 9 The Analysis of Competitive Markets 309 PAR T THREE Market Structure and Competitive Strategy 347 10 Market Power: Monopoly and Monopsony 349 11 Pricing with Market Power 391 12 Monopolistic Competition and Oligopoly 443 13 Game Theory and Competitive Strategy 479 14 Markets for Factor Inputs 521 15 Investment, Time, and Capital Markets 551 PAR T F 0 U R Information, Market Failure, and the Role of Government 583 16 General Equilibrium and Economic Efficiency 585 17 Markets with Asymmetric Information 617 18 Externalities and Public Goods 645 Appendix: The Basics of Regression 687 Glossary 695 Answers to Selected Exercises 711 Photo Credits 723 Index 725 vii 10. 1.1 The Themes of Microeconomics 4 Trade-Ofts 4 Prices and Markets 5 Theories and Models 5 Positive versus Normative Analysis 6 1.2 What Is a Market? 7 Competitive versus Noncompetitive Markets 8 Market Price 8 Market Definition-The Extent of a Market 9 1.3 Real versus Nominal Prices 12 1.4 Why Study Microeconomics? 15 Corporate Decision Making: Ford's Sport Utility Vehicles 15 Public Policy Design: Automobile Emission Standards for the Twenty-First Century 17 Summary 18 Questions for Review 18 Exercises 18 Preface xxv CONTENTS PAR T ONE Introduction: Markets and Prices 1 1 Preliminaries 3 2 The Basics of Supply and Demand 21 2.1 Supply and Demand 22 The Supply Curve 22 The Demand Curve 23 2.2 The Market Mechanism 25 2.3 Changes in Market Equilibrium 26 2.4 Elasticities of Supply and Demand 34 Point versus Arc Elasticities 37 2.5 Short-Run versus Long-Run Elasticities 40 Demand 40 Supply 45 *2.6 Understanding and Predicting the Effects of Changing Market Conditions 49 2.7 Effects of Government Intervention-Price Controls 58 Summary 61 Questions for Review 61 Exercises 62 ix 11. x CONTENTS PAR T TWO Producers, Consumers, and Competitive Markets 65 3 Consumer Behavior 67 Consumer Behavior 67 3.1 Consumer Preferences 69 Market Baskets 69 Some Basic Assumptions about Preferences 70 Indifference Curves 70 Indifference Maps 72 The Shape of Indifference Curves 74 The Marginal Rate of Substitution 75 Perfect Substitutes and Perfect Complements 76 3.2 Budget Constraints 83 The Budget Line 83 The Effects of Changes in Income and Prices 84 3.3 Consumer Choice 86 Corner Solutions 90 3.4 Revealed Preference 92 3.5 Marginal Utility and Consumer Choice 95 *3.6 Cost-of-Living Indexes 100 Ideal Cost-of-Living Index 101 Laspeyres Index 102 Paasche Index 103 Price Indexes in the United Statics: Chain Weighting 104 Summary 106 Questions for Review 106 Exercises 107 4 Individual and Market Demand 111 4.1 Individual Demand 112 Price Changes 112 The Individual Demand Curve 113 Income Changes 114 Normal versus Inferior Goods 115 Engel Curves 116 Substitutes and Complements 119 4.2 Income and Substitution Effects 120 Substitution Effect 121 Income Effect 121 A Special Case: The Giffen Good 122 4.3 Market Demand 125 From Individual to Market Demand 125 Elasticity of Demand 127 4.4 Consumer Surplus 132 Consumer Surplus and Demand 132 12. CONTENTS. xi 4.5 Network Externalities 136 The Bandwagon Effect 136 The Snob Effect 137 *4.6 Empirical Estimation of Demand 140 The Statistical Approach to Demand Estimation 140 The Form of the Demand Relationship 142 Interview and Experimental Approaches to Demand Determination 144 Summary 144 Questions for Review 145 Exercises 146 Appendix to Chapter 4: Demand Theory-A Mathematical Treatment 149 Utility Maximization 149 The Method of Lagrange Multipliers 150 The Equal Marginal Principle 151 Marginal Rate of Substitution 151 Marginal Utility of Income 152 An Example 152 Duality in Consumer Theory 154 Income and Substitution Effects 155 Exercises 157 5 Uncertainty and Consumer Behavior 159 5.1 Describing Risk 160 Probability 160 Expected Value 161 Variability 161 Decision Making 163 5.2 Preferences Toward Risk 165 Different Preferences Toward Risk 167 5.3 Reducing Risk 170 Diversification 170 Insurance 172 The Value of Information 174 *5.4 The Demand for Risky Assets 176 Assets 177 Risky and Riskless Assets 177 Asset Returns 178 The Trade-Off Between Risk and Return 179 The Investor's Choice Problem 180 5.5 Behavioral Economics 185 More Complex Preferences 186 Rules of Thumb and Biases in Decision Making 188 Probabilities and Uncertainty 189 Summing Up 189 Summary 191 Questions for Review 191 Exercises 191 13. xii CONTENTS 6 Production 195 The Production Decisions of a Firm 195 6.1 The Technology of Production 196 The Production Function 197 The Short Run versus the Long Run 197 6.2 Production with One Variable Input (Labor) 198 Average and Marginal Products 199 The Slopes of the Product Curve 200 The Average Product of Labor Curve 201 The Marginal Product of Labor Curve 202 The Law of Diminishing Marginal Returns 202 Labor Productivity 205 6.3 Production with Two Variable Inputs 207 Isoquants 207 Input Flexibility 209 Diminishing Marginal Returns 209 Substitution Among Inputs 209 Production Functions-Two Special Cases 211 6.4 Returns to Scale 215 Describing Returns to Scale 215 Summary 218 Questions for Review 218 Exercises 219 7 The Cost of Production 221 7.1 Measuring Cost: Which Costs Matter? 221 Economic Cost versus Accounting Cost 222 Opportunity Cost 222 Sunk Costs 222 Fixed Costs and Variable Costs 224 Fixed versus Sunk Costs 225 Marginal and Average Cost 227 7.2 Cost in the Short Run 228 The Determinants of Short-Run Cost 228 The Shapes of the Cost Curves 230 7.3 Cost in the Long Run 234 The User Cost of Capital 234 The Cost-Minimizing Input Choice 235 The Isocost Line 236 Choosing Inputs 237 Cost Minimization with Varying Output Levels 241 The Expansion Path and Long-Run Costs 241 7.4 Long-Run versus Short-Run Cost Curves 243 The Inflexibility of Short-Run Production 243 Long-Run Average Cost 243 Economies and Diseconomies of Scale 245 The Relationship between Short-Run and Long-Run Cost 247 14. CONTENTS xiii 7.5 Production with Two Outputs-Economies of Scope 248 Product Transformation Curves 249 Economies and Diseconomies of Scope 250 The Degree of Economies of Scope 250 *7.6 Dynamic Changes in Costs-The Learning Curve 251 Graphing the Learning Curve 252 Learning versus Economies of Scale 253 *7.7 Estimating and Predicting Cost 256 Cost Functions and the Measurement of Scale Economies 258 Summary 260 Questions for Review 261 Exercises 261 Appendix to Chapter 7: Production and Cost Theory- A Mathematical Treatment 264 Cost Minimization 264 Marginal Rate of Technical Substitution 265 Duality in Production and Cost Theory 266 The Cobb-Douglas Cost and Production Functions 267 Exercises 269 8 Profit Maximization and Competitive Supply 271 8.1 Perfectly Competitive Markets 271 When Is a Market Highly Competitive? 273 8.2 Profit Maximization 274 Do Firms Maximize Profit? 274 Alternative Forms of Organization 275 8.3 Marginal Revenue, Marginal Cost, and Profit Maximization 276 Demand and Marginal Revenue for a Competitive Firm 277 Profit Maximization by a Competitive Firm 279 8.4 Choosing Output in the Short Run 279 Short-Run Profit Maximization by a Competitive Firm 279 The Short-Run Profit of a Competitive Firm 280 8.5 The Competitive Firm's Short-Run Supply Curve 284 The Firm's Response to an Input Price Change 284 8.6 The Short-Run Market Supply Curve 287 Elasticity of Market Supply 288 Producer Surplus in the Short Run 291 8.7 Choosing Output in the Long Run 292 Long-Run Profit Maximization 293 Long-Run Competitive Equilibrium 294 Economic Rent 297 Producer Surplus in the Long Run 297 8.8 The Industry's Long-Run Supply Curve 299 Constant-Cost Industry 299 Increasing-Cost Industry 300 Decreasing-Cost Industry 302 15. xiv CONTENTS The Effects of a Tax 302 Long-Run Elasticity of Supply 303 Summary 305 Questions for Review 306 Exercises 306 9 The Analysis of Competitive Markets 309 9.1 Evaluating the Gains and Losses from Government Policies-Consumer and Producer Surplus 309 Review of Consumer and Producer Surplus 310 Application of Consumer and Producer Surplus 311 9.2 The Efficiency of a Competitive Market 315 9.3 Minimum Prices 319 9.4 Price Supports and Production Quotas 324 Price Supports 324 Production Quotas 325 9.5 Import Quotas and Tariffs 331 9.6 The Impact of a Tax or Subsidy 335 The Effects of a Subsidy 339 Summary 342 Questions for Review 342 Exercises 343 PAR T THREE Market Structure and Competitive Strategy 347 10 Market Power: Monopoly and Monopsony 349 10.1 Monopoly 350 Average Revenue and Marginal Revenue 350 The Monopolist's Output Decision 352 An Example 353 A Rule of Thumb for Pricing 354 Shifts in Demand 357 The Effect of a Tax 357 *The Multiplant Firm 359 10.2 Monopoly Power 361 Measuring Monopoly Power 362 The Rule of Thumb for Pricing 363 10.3 Sources of Monopoly Power 366 The Elasticity of Market Demand 367 The Number of Firms 367 The Interaction Among Firms 368 10.4 The Social Costs of Monopoly Power 368 Rent Seeking 370 Price Regulation 370 Natural Monopoly 372 Regulation in Practice 373 16. 10.5 Monopsony 373 Monopsony and Monopoly Compared 376 10.6 Monopsony Power 376 Sources of Monopsony Power 377 The Social Costs of Monopsony Power 379 Bilateral Monopoly 380 10.7 Limiting Market Power: The Antitrust Laws 381 Enforcement of the Antitrust Laws 383 Antitrust in Europe 384 Summary 387 Questions for Review 387 Exercises 388 11 Pricing with Market Power 391 11.1 Capturing Consumer Surplus 392 11.2 Price Discrimination 393 First-Degree Price Discrimination 393 Second-Degree Price Discrimination 396 Third-Degree Price Discrimination 397 11.3 Intertemporal Price Discrimination and Peak-Load Pricing 403 Intertemporal Price Discrimination 403 Peak-Load Pricing 404 11.4 The Two-Part Tariff 406 *11.5 Bundling 413 Relative Valuations 414 Mixed Bundling 418 Bundling in Practice 421 Tying 423 *11.6 Advertising 424 A Rule of Thumb for Advertising 426 Summary 428 Questions for Review 429 Exercises 429 Appendix to Chapter 11: Transfer Pricing in the Integrated Firm 433 Transfer Pricing When There Is No Outside Market 433 Transfer Pricing with a Competitive Outside Market 436 Transfer Pricing with a Noncompetitive Outside Market 438 A Numerical Example 439 Exercises 441 12 Monopolistic Competition and Oligopoly 443 12.1 Monopolistic Competition 444 The Makings of Monopolistic Competition 444 Equilibrium in the Short Run and the Long Run 445 Monopolistic Competition and Economic Efficiency 446 12.2 Oligopoly 449 Equilibrium in an Oligopolistic Market 449 The Cournot Model 450 CONTENTS. xv 17. xvi CONTENTS The Linear Demand Curve-An Example 453 First Mover Advantage-The Stackelberg Model 455 12.3 Price Competition 456 Price Competition with Homogeneous Products-The Bertrand Model 456 Price Competition with Differentiated Products 458 12.4 Competition versus Collusion: The Prisoners' Dilemma 461 12.5 Implications of the Prisoners' Dilemma for Oligopolistic Pricing 464 Price Rigidity 465 Price Signaling and Price Leadership 465 The Dominant Firm Model 468 12.6 Cartels 469 Analysis of Cartel Pricing 470 Summary 475 Questions for Review 475 Exercises 476 13 Game Theory and Competitive Strategy 479 13.1 Gaming and Strategic Decisions 479 Noncooperative versus Cooperative Games 480 13.2 Dominant Strategies 482 13.3 The Nash Equilibrium Revisited 484 Maximin Strategies 486 *Mixed Strategies 488 13.4 Repeated Games 490 13.5 Sequential Games 494 The Extensive Form of a Game 495 The Advantage of Moving First 496 13.6 Threats, Commitments, and Credibility 497 Empty Threats 498 Commitment and Credibility 498 Bargaining Strategy 500 13.7 Entry Deterrence 503 Strategic Trade Policy and International Competition 505 *13.8 Auctions 509 Auction Formats 510 Valuation and Information 510 Private- Value Auctions 511 Common- Value Auctions 512 Maximizing Auction Revenue 513 Bidding and Collusion 514 Summary 517 Questions for Review 517 Exercises 518 14 Markets for Factor Inputs 521 14.1 Competitive Factor Markets 521 Demand for a Factor Input When Only One Input Is Variable 522 Demand for a Factor Input When Several Inputs Are Variable 524 The Market Demand Curve 526 18. The Supply of Inputs to a Firm 529 The Market Supply of Inputs 531 14.2 Equilibrium in a Competitive Factor Market 534 Economic Rent 535 14.3 Factor Markets with Monopsony Power 539 Monopsony Power: Marginal and Average Expenditure 539 Purchasing Decisions with Monopsony Power 540 Bargaining Power 541 14.4 Factor Markets with Monopoly Power 543 Monopoly Power over the Wage Rate 544 Unionized and Nonunionized Workers 545 Summary 549 Questions for Review 549 Exercises 550 15 Investment, Time, and Capital Markets 551 15.1 Stocks versus Flows 552 15.2 Present Discounted Value 553 Valuing Payment Streams 553 15.3 The Value of a Bond 556 Perpetuities 556 The Effective Yield on a Bond 557 15.4 The Net Present Value Criterion for Capital Investment Decisions 560 The Electric Motor Factory 561 Real versus Nominal Discount Rates 562 Negative Future Cash Flows 563 15.5 Adjustments for Risk 564 Diversifiable versus Nondiversifiable Risk 564 The Capital Asset Pricing Model 565 15.6 Investment Decisions by Consumers 568 15.7 Investments in Human Capital 570 *15.8 Intertemporal Production Decisions-Depletable Resources 573 The Production Decision of an Individual Resource Producer 574 The Behavior of Market Price 574 User Cost 575 Resource Production by a Monopolist 576 15.9 How Are Interest Rates Determined? 577 A Variety of Interest Rates 579 Summary 580 Questions for Review 580 Exercises 581 PAR T FOUR Information, Market Failure, and the Role of Government 583 16 General Equilibrium and Economic Efficiency 585 16.1 General Equilibrium Analysis 585 Two Interdependent Markets-Moving to General Equilibrium 586 Reaching General Equilibrium 587 CONTENTS xvii 19. xviii CONTENTS 16.2 Efficiency in Exchange 590 The Advantages of Trade 590 The Edgeworth Box Diagram 591 Efficient Allocations 592 The Contract Curve 593 Consumer Equilibrium in a Competitive Market 594 The Economic Efficiency of Competitive Markets 596 16.3 Equity and Efficiency 597 The Utility Possibilities Frontier 597 Equity and Perfect Competition 599 16.4 Efficiency in Production 600 Input Efficiency 600 The Production Possibilities Frontier 601 Output Efficiency 603 Efficiency in Output Markets 604 16.5 The Gains from Free Trade 605 Comparative Advantage 606 An Expanded Production Possibilities Frontier 607 16.6 An Overview-The Efficiency of Competitive Markets 610 16.7 Why Markets Fail 612 Market Power 612 Incomplete Information 613 Externalities 613 Public Goods 613 Summary 614 Questions for Review 614 Exercises 615 17 Markets with Asymmetric Information 617 17.1 Quality Uncertainty and the Market for Lemons 617 The Market for Used Cars 618 Implications of Asymmetric Information 620 The Importance of Reputation and Standardization 621 17.2 Market Signaling 623 A Simple Model of Job Market Signaling 624 Guarantees and Warranties 627 17.3 Moral Hazard 628 17.4 The Principal-Agent Problem 630 The Principal-Agent Problem in Private Enterprises 631 The Principal-Agent Problem in Public Enterprises 633 Incentives in the Principal-Agent Framework 635 *17.5 Managerial Incentives in an Integrated Firm 636 Asymmetric Information and Incentive Design in the Integrated Firm 637 Applications 639 17.6 Asymmetric Information in Labor Markets: Efficiency Wage Theory 639 Summary 642 Questions for Review 642 Exercises 643 20. CONTENTS xix 18 Externalities and Public Goods 645 18.1 Externalities 645 Negative Externalities and Inefficiency 646 Positive Externalities and Inefficiency 648 18.2 Ways of Correcting Market Failure 651 An Emissions Standard 652 An Emissions Fee 653 Standards versus Fees 654 Tradeable Emissions Permits 656 Recycling 660 18.3 Stock Externalities 663 Stock Buildup and Its Impact 664 18.4 Externalities and Property Rights 669 ProperhJ Rights 669 Bargaining and Economic Efficiency 670 Costly Bargaining-The Role of Strategic Behavior 671 A Legal Solution-Suing for Damages 671 18.5 Common Property Resources 673 18.6 Public Goods 676 Efficiency and Public Goods 677 Public Goods and Market Failure 678, 18.7 Private Preferences for Public Goods 680 Summary 682 Questions for Review 683 Exercises 683 Appendix: The Basics of Regression 687 An Example 687 Estimation 688 Statistical Tests 689 Goodness of Fit 691 Economic Forecasting 691 Summary 694 Glossary 695 Answers to Selected Exercises 711 Photo Credits 723 Index 725 LIST OF EXAMPLES EXAM PLE 1.1 Markets for Prescription Drugs 10 EXAMPLE 1.2 The Market for Sweeteners 11 EXAM PLE 1.3 The Price of Eggs and the Price of a College Education 13 EXAMPLE 1.4 The Minimum Wage 14 21. xx CONTENTS. EXAMPLE 2.1 The Price of Eggs and the Price of a College Education Revisited 28 EXAMPLE 2.2 Wage Inequality in the United States 29 EXAMPLE 2.3 The Long-Run Behavior of Natural Resource Prices 30 EXAM PLE 2.4 The Effects of 9/11 on the Supply and Demand for New YorkCity Office Space 32 EXAMPLE 2.5 The Market for Wheat 38 EXAMPLE 2.6 The Demand for Gasoline and Automobiles 44 EXAMPLE 2.7 The Weather in Brazil and the Price of Coffee in New York 46 EXAMPLE 2.8 The Behavior of Copper Prices 52 EXAMPLE 2.9 Upheaval in the World Oil Market 54 EXAMPLE 2.10 Price Controls and Natural Gas Shortages 59 EXAMPLE 3.1 Designing New Automobiles (I) 77 EXAMPLE 3.2 Can Money Buy Happiness? 81 EXAMPLE 3.3 Designing New Automobiles (II) 89 EXAMPLE 3.4 A College Trust Fund 91 EXAMPLE 3.5 Revealed Preference for Recreation 94 EXAMPLE 3.6 Marginal Utility and Happiness 97 EXAMPLE 3.7 Gasoline Rationing 98 EXAMPLE 3.8 The Bias in the CPI 105 EXAMPLE 4.1 Consumer Expenditures in the United States 117 EXAMPLE 4.2 The Effects of a Gasoline Tax 123 EXAMPLE 4.3 The Aggregate Demand for Wheat 129 EXAM PLE 4.4 The Demand for Housing 130 EXAMPLE 4.5 The Value of Clean Air 134 EXAMPLE 4.6 Network Externalities and the Demands for Computers and E-Mail 139 EXAMPLE 4.7 The Demand for Ready-to-Eat Cereal 143 EXAMPLE 5.1 Deterring Crime 164 EXAMPLE 5.2 Business Executives and the Choice of Risk 169 EXAMPLE 5.3 The Value of Title Insurance When Buying a House 173 EXAMPLE 5.4 The Value of Information in the Dairy Industry 175 EXAMPLE 5.5 Doctors, Patients, and the Value of Information 175 r EXAMPLE 5.6 Investing in the Stock Market 183 EXAMPLE 5.7 New YorkCity Taxicab Drivers 190 EXAMPLE 6.1 Malthus and the Food Crisis 204 EXAMPLE 6.2 Labor Productivity and the Standard of Living 206 EXAM PLE 6.3 A Production Function for Wheat 213 EXAMPLE 6.4 Returns to Scale in the Carpet Industry 217 22. EXAMPLE 7.1 EXAMPLE 7.2 EXAMPLE 7.3 EXAMPLE 7.4 EXAMPLE 7.5 EXAMPLE 7.6 EXAMPLE 7.7 EXAMPLE 8.1 EXAMPLE 8.2 EXAMPLE 8.3 EXAMPLE 8.4 EXAMPLE 8.5 EXAMPLE 8.6 EXAMPLE 8.7 EXAMPLE 9.1 EXAMPLE 9.2 EXAMPLE 9.3 EXAMPLE 9.4 EXAMPLE 9.5 EXAMPLE 9.6 Choosing the Location for a New Law School Building 223 Sunk, Fixed,and VariableCosts:Computers, Software, and Pizzas 226 The Short-Run Cost of Aluminum Smelting 232 The Effect of Effluent Fees on Input Choices 239 Economies of Scope in the Trucking Industry 251 The Learning Curve in Practice 255 Cost Functions for Electric Power 258 Condominiums versus Cooperatives in New YorkCity 275 The Short-Run Output Decision of an Aluminum Smelting Plant 282 Some Cost Considerations for Managers 283 The Short-Run Production of Petroleum Products 286 The Short-Run World Supply of Copper 289 Constant-, Increasing-, and Decreasing-Cost Industries: Coffee, Oil, and Automobiles 302 The Long-Run Supply of Housing 304 Price Controls and Natural Gas Shortages 314 The Market for Human Kidneys 317 Airline Regulation 321 Supporting the Price of Wheat 327 The Sugar Quota 333 A Taxon Gasoline 340 EXAMPLE 10.1 Astra-Merck Prices Prilosec 356 EXAMPLE 10.2 Markup Pricing: Supermarkets to Designer Jeans 364 EXAMPLE 10.3 The Pricing of Videos 365 EXAMPLE 10.4 Monopsony Power in U.S.Manufacturing 380 EXAMPLE 10.5 A Phone Call About Prices 384 EXAMPLE 10.6 The United States versus Microsoft 385 EXAMPLE 11.1 The Economics of Coupons and Rebates 400 EXAMPLE 11.2 Airline Fares 402 EXAMPLE 11.3 How to Price a Best-SellingNovel 406 EXAMPLE 11.4 Polaroid Cameras 410 EXAMPLE 11.5 Pricing Cellular Phone Service 411 EXAMPLE 11.6 The Complete Dinner versus a la Carte: A Restaurant's Pricing Problem 422 EXAMPLE 11.7 Advertising in Practice 427 EXAM PLE 12.1 Monopolistic Competition in the Markets for Colas and Coffee 447 EXAMPLE 12.2 A Pricing Problem for Procter & Gamble 460 EXAMPLE 12.3 Procter & Gamble in a Prisoners' Dilemma 463 CONTENTS. xxi 23. xxii CONTENTS. EXAM PLE 12.4 Price Leadership and Price Rigidity in Commercial Banking 467 EXAM PLE 12.5 The Cartelization of Intercollegiate Athletics 473 EXAMPLE 12.6 The Milk Cartel 474 EXAMPLE 13.1 Acquiring a Company 481 EXAMPLE 13.2 Oligopolistic Cooperation in the Water Meter Industry 492 EXAMPLE 13.3 Competition and Collusion in the Airline Industry 493 EXAMPLE 13.4 Wal-Mart Stores' Preemptive Investment Strategy 501 EXAMPLE 13.5 DuPont Deters Entry in the Titanium Dioxide Industry 507 EXAMPLE 13.6 Diaper Wars 508 EXAMPLE 13.7 Auctioning Legal Services 514 EXAM PLE 13.8 Internet Auctions 515 EXAMPLE 14.1 The Demand for Jet Fuel 528 EXAMPLE 14.2 Labor Supply for One- and Two-Earner Households 533 EXAMPLE 14.3 Pay in the Military 537 EXAMPLE 14.4 Monopsony Power in the Market for Baseball Players 541 EXAMPLE 14.5 Teenage Labor Markets and the Minimum Wage 542 EXAM PLE 14.6 The Decline of Private-Sector Unionism 546 EXAM PLE 14.7 Wage Inequality-Have Computers Changed the Labor Market? 547 EXAMPLE 15.1 The Value of Lost Earnings 555 EXAM PLE 15.2 The Yields on Corporate Bonds 559 EXAMPLE 15.3 Capital Investment in the Disposable Diaper Indu~try 566 EXAMPLE 15.4 Choosing an Air Conditioner and a New Car 569 EXAMPLE 15.5 Should YouGo to Business School? 572 EXAMPLE 15.6 How Depletable Are Depletable Resources? 576 EXAM PLE 16.1 The Global Market for Ethanol 588 EXAMPLE 16.2 Trading Tasks and iPod Production 608 EXAMPLE 16.3 The Costs and Benefits of Special Protection 609 EXAM PLE 17.1 Lemons in Major League Baseball 622 EXAMPLE 17.2 Working into the Night 627 EXAM PLE 17.3 Reducing Moral Hazard: Warranties of Animal Health 630 EXAMPLE 17.4 CEO Salaries 632 EXAMPLE 17.5 Managers of Nonprofit Hospitals as Agents 634 ( EXAM PLE 17.6 Efficiency Wages at Ford Motor Company 641 EXAMPLE 18.1 The Costs and Benefits of Sulfur Dioxide Emissions 649 EXAM PLE 18.2 Reducing Sulfur Dioxide Emissions in Beijing 657 EXAMPLE 18.3 Emissions Trading and Clean Air 658 EXAMPLE 18.4 Regulating Municipal Solid Wastes 662 24. CONTENTS xxiii EXAMPLE 18.5 Global Warming 667 EXAM PLE 18.6 The Coase Theorem at Work 672 EXAMPLE 18.7 Crawfish Fishing in Louisiana 674 EXAMPLE 18.8 The Demand for Clean Air 679 EXAMPLE A.1 The Demand for Coal 693 25. PREFACE For students who care about how the world works, microeconomics is one of the most relevant and interesting subjects they can study. A good grasp of microeconomics is vital for managerial decision making, for designing and understanding public policy, and more generally for appreciating how a modern economy functions. Wewrote this book, Microeconomics, because we believe that students need to be exposed to the new topics that have come to playa central role in microeconomics over the years-topics such as game theory and competitive strategy, the roles of uncertainty and information, and the analysis of pricing by firms with market power. We also felt that students need to be shown how microeconomics can help us to understand what goes on in the world and how it can be used as a practical tool for decision making. Microeconomics is an exciting and dynamic subject, but students need to be given an appreciation of its relevance and usefulness. They want and need a good understanding of how microeconomics can actually be used outside the classroom. To respond to these needs, the seventh edition of Microeconomics provides a treatment of microeconomic theory that stresses its relevance and application to both managerial and public policy decision making. This applied emphasis is accomplished by including 118extended examples that cover such topics as the analysis of demand, cost, and market efficiency; the design of pricing strategies; investment and production decisions; and public policy analysis. Because of the importance that we attach to these examples, they are included in the flow of the text. (A complete list is included on the endpapers inside the front cover.) The coverage in this edition of Microeconomics incorporates the dramatic changes that have occurred in the field in recent years. There has been growing interest in game theory and the strategic interactions of firms (Chapters 12 and 13), in the role and implications of uncertainty and asymmetric information (Chapters 5 and 17), in the pricing strategies of firms with market power (Chapters 10 and 11),and in the design of policies to deal efficiently with externalities such as environmental pollution (Chapter 18). These topics, which receive only limited attention in most books, are covered extensively here. That the coverage in Microeconomics is comprehensive and up-to-date does not mean that it is "advanced" or difficult. We have worked hard to make the exposition clear and accessible as well as lively and engaging. Webelieve that the study of microeconomics should be enjoyable and stimulating. Wehope that our book reflects this belief. Except for appendices and footnotes, Microeconomics uses no calculus. As a result, it should be suitable for students with a broad range of backgrounds. (Those sections that are more demanding are marked with an asterisk and can be easily omitted.) xxv 26. xxvi PREFACE CHANGES IN THE SEVENTH EDITION Each new edition of this book has built on the success of prior editions by adding a number of new topics, by adding and updating examples, and by improving the exposition of existing materials. The seventh edition continues that tradition. Wehave expanded and updated Chapter 18 (Externalities and Public Goods), so that it now includes a more thorough and up-to-date treatment of environmental economics, a topic that has been receiving increasing coverage in many intermediate microeconomics courses. In particular, we have rewritten and improved the clarity of the sections on externalities, included a new section on stock externalities (of the kind that arise with greenhouse gases and global warming), and added an example on pollution control in China. Wehave also introduced new material on alternative forms of organizations in Chapter 8, substantially revised and updated our coverage of behavioral economics in Chapter 5, and improved the exposition of some of the core material on production and cost in Chapters 6, 7, and 8, including the mathematical appendix to Chapter 7. In Chapter 14, we added new material to clarify the distinction between monopsony power and bargaining power. In addition, we have added several new examples, replaced a number of older examples with new ones, and updated most of the other examples. These improvements aside, we have maintained our prior chapter organization. This should make it easy for those who have been loyal users in the past to make the transition to the new edition. As always, we have attempted to make the text as clear, accessible, and engaging as possible. _ The layout of this edition is similar to that of the prior edition. This has allowed us to continue to define key terms in the margins (as well as in the Glossary at the end of the book), and also to use the margins to include Concept Links that relate newly developed ideas to concepts introduced previously in the text. ALTERNATIVE COURSE DESIGNS This new edition of Microeconomics offers instructors considerable flexibility in course design. For a one-quarter or one-semester course stressing the basic core material, we would suggest using the following chapters and sections of chapters: 1 through 6,7.1-7.4,8 through 10, 11.1-11.3,12,14,15.1-15.4,18.1-18.2, and 18.5. A somewhat more ambitious course might also include parts of Chapters 5 and 16 and additional sections in Chapters 7 and 9. To emphasize uncertainty and market failure, an instructor should also include substantial parts of Chapters 5 and 17. Depending on one's interests and the goals of the course, other sections could be added or used to replace the materials listed above. A course empha- sizing modern pricing theory and business strategy would include all of Chapters It 12, and 13 and the remaining sections of Chapter 15.A course in managerial economics might also include the appendices to Chapters 4, 7, and 11, as well as the appendix on regression analysis at the end of the book. A course stressing welfare economics and public policy should include Chapter 16 and additional sections of Chapter 18. Finally, we want to stress that those sections or subsections that are more demanding and/or peripheral to the core material have been marked with an asterisk. These sections can easily be omitted without detracting from the flow of the book. 27. SUPPLEMENTARY MATERIALS Ancillaries of an exceptionally high quality are available to instructors and students using this book. The Instructor's Manual, prepared by Duncan M. Holthausen of North Carolina State University provides detailed solutions to all end-of-chapter Questions for Review and Exercises.The seventh edition contains many entirely new review questions and exercises, and a number of exercises have been revised and updated. The new instructor's manual has been revised accordingly. Each chapter also contains Teaching Tips to summarize key points. The Test Bank, prepared by Douglas J. Miller of the University of Missouri, contains approximately 2,000multiple-choice and short-answer questions with solutions. All of this material has been thoroughly reviewed, accuracy checked, and revised for this edition. The print version of the Test Bank is designed for use with the new TestGen test-generating software. This computerized package allows instructors to custom-design, save, and generate classroom tests. The test program permits instructors to edit, add, or delete questions from the test banks; edit existing graphics and create new graphics; analyze test results; and organize a database of tests and student results. This new software allows for greater flexibility and ease of use. It provides many options for organizing and displaying tests, along with a search and sort feature. The PowerPoint Lecture Presentation has been completely revised for this edition by Fernando and Yvonn Quijano of Dickinson State University. Instructors can edit the detailed outlines to create their own full-color, professional-looking presentations and customized handouts for students. The PowerPoint Presentation is downloadable from the Instructor Resources link at www.prenhall.com/pindyck. A set of four-color Acetates of selected figures and tables from the text is available for instructors using the seventh edition. The Study Guide, prepared by Valerie Suslow of the University of Michigan and Jonathan Hamilton of the University of Florida, provides a wide variety of review materials and exercises for students. Each chapter contains a list of important concepts, chapter highlights, a concept review, problem sets, and a self-test quiz. Worked-out answers and solutions are provided for all exercises, problem sets, and self-test questions. Online Resources The Companion Website (http://www.prenhall.com/pindyck) is a content-rich website with exercises, activities, and resources related specifically to the seventh edition of Microeconomics. The Online Study Guide offers students another opportunity to sharpen their problem-solving skills and to assess their understanding of text material. It contains a set of both multiple-choice and essay quizzes. Each question submitted by the student is graded and immediate feedback is provided for correct and incorrect answers. The online study guide also allows students to e-mail results to up to four e-mail addresses. The website also provides current events articles and exercises related to topics in the book. These exercises help show students the relevance of economics in today's world. They may also direct students to appropriate updated economics-related websites to gather data and analyze specific economic problems. For instructors, the Companion Website provides a Syllabus Manager. This feature allows instructors to enhance their lectures with all the resources available with this text. Instructors can post their syllabus to the site and download supplements and lecture aids. Instructors should log in under Instructor Resources in order to access this material. PREFACE xxvii 28. xxviii PREFACE ACKNOWLEDGMENTS As the saying goes, it takes a village to revise a textbook. Because the seventh edition of Microeconomics has been the outgrowth of years of experience in the classroom, we owe a debt of gratitude to our students and to the colleagues with whom we often discuss microeconomics and its presentation. We have also had the help of capable research assistants. For the first six editions of the book, these included Peter Adams, Walter Athier, Phillip Gibbs, Salar [ahedi Jamie Jue, Rashmi Khare, Masaya Okoshi, Kathy O'Regan, Karen Randig, Subi Rangan, Deborah Senior, Ashesh Shah, Nicola Stafford, and Wilson Tai. Kathy Hill helped with the art, while Assunta Kent, Mary Knott, and Dawn Elliott Linahan provided secretarial assistance with the first edition. We especially want to thank Lynn Steele and Jay Tharp who provided considerable editorial support for the second edition. Mark Glickman and Steve Wiggins assisted with the examples in the third edition, while Andrew Guest, Jeanette Sayre, and Lynn Steele provided valuable editorial support for the third, fourth, and fifth editions, as did Brandi Henson and Jeanette Sayre for the sixth edition. Writing this book has been both a painstaking and enjoyable process. At each stage we received exceptionally fine guidance from teachers of microeconomics throughout the country. After the first draft of the first edition of the book had been edited and reviewed, it was discussed at a two-day focus group meeting in New York. This provided an opportunity to get ideas from instructors with a variety of backgrounds and perspectives. We would like to thank the following focus group members for advice and criticism: Carl Davidson of Michigan State University; Richard Eastin of the University of Southern California; Judith Roberts of California State University, Long Beach; and Charles Strein of the University of Northern Iowa. We would like to thank the reviewers who provided comments and ideas that have contributed significantly to the seventh edition of Microeconomics: Ashley Ahrens, Mesa State College Anca Alecsandru, Louisiana State University Albert Assibey-Mensah, Kentucky State University Charles A. Bennett, Gannon University Maharukh Bhiladwalla; Rutgers University Raymonda Burgman, DePauw University H. Stuart Burness, University of New Mexico Peter Calcagno, College of Charleston Eric Chiang, Florida Atlantic University Tom Cooper, Georgetown College Robert Crawford, Marriott School, Brigham Young University Julie Cullen, University of California, San Diego Richard Eastin, University of Southern California Michael Enz, Western New England-College John Francis, Auburn University, Montgomery Delia Furtado, University of Connecticut Craig Gallet, California State University, Sacramento Michele Glower, Lehigh University Tiffani Gottschall, Washington & Jefferson College Adam Grossberg, Trinity College BruceHartman, California State University,The California Maritime Academy Daniel Henderson, Binghamton University 29. Wayne Hickenbottom, University of Texas at Austin Stella Hofrenning, Augsburg College Duncan M. Holthausen, North Carolina State University Brian Jacobsen, Wisconsin Lutheran College [onatan Jelen, New York University Changik Jo, Anderson University Mahbubul Kabir, Lyon College Brian Kench, University of Tampa Paul Koch, Olivet Nazarene University Dennis Kovach, Community College of Allegheny County Sang Lee, Southeastern Louisiana University Peter Marks, Rhode Island College Douglas J Miller, University of Missouri-Columbia Laudo Ogura, Grand Valley State University Ozge Ozay, University of Utah Jonathan Powers, Knox College Lucia Quesada, Universidad Torcuato Di Telia Benjamin Rashford, Oregon State University Fred Rodgers, Medaille College William Rogers, University of Missouri-Saint Louis Menahem Spiegel, Rutgers University Houston Stokes, University of Illinois at Chicago Mira Tsymuk, Hunter College, CUNY Thomas Watkins, Eastern Kentucky University David Wharton, Washington College Beth Wilson, Humboldt State University We would also like to thank all those who reviewed the first six editions at various stages of their evolution: Nii Adote Abrahams, Missouri Southern State College Jack Adams, University of Arkansas, Little Rock Sheri Aggarwal, Dartmouth College Ted Amato, University of North Carolina, Charlotte John J. Antel, University of Houston Kerry Back, Northwestern University Dale Ballou, University of Massachusetts, Amherst William Baxter, Stanford University Gregory Besharov, Duke University Victor Brajer, California State University, Fullerton James A. Brander, University of British Columbia David S. Bullock, University of Illinois Jeremy Bulow, Stanford University Winston Chang, State University of New York, Buffalo Henry Chappel, University of South Carolina Larry A. Chenault, Miami University Harrison Cheng, University of Southern California Kwan Choi, Iowa State University Charles Clotfelter, Duke University Kathryn Combs, California State University, Los Angeles Richard Corwall, Middlebury College John Coupe, University of Maine at Orono Jacques Cremer, Virginia Polytechnic Institute and State University PREFACE xxix 30. !fi xxx PREFACE Carl Davidson, Michigan State University Gilbert Davis, University of Michigan Arthur T. Denzau, Washington University Tran Dung, Wright State University Richard V.Eastin, University of Southern California Maxim Engers, University of Virginia Carl E. Enomoto, New Mexico State University Ray Farrow, Seattle University Gary Ferrier, Southern Methodist University Roger Frantz, San Diego State University Patricia Gladden, University of Missouri Otis Gilley, Louisiana Tech University William H. Greene, New York University Thomas A. Gresik, Notre Dame University John Gross, University of Wisconsin at Milwaukee Jonathan Hamilton, University of Florida Claire Hammond, Wake Forest University James Hartigan, University of Oklahoma George Heitman, Pennsylvania State University George E. Hoffer, Virginia Commonwealth University Robert Inman, The Wharton School, University of Pennsylvania Joyce Jacobsen, Rhodes College B. Patrick Joyce, Michigan Technological University David Kaserman, Auburn University Michael Kende, INSEAD, France Philip G. King, San Francisco State University Tetteh A. Kofi, University of San Francisco Anthony Krautman, DePaul University Leonard Lardaro, University of Rhode Island Robert Lemke, Florida International University Peter Linneman, University of Pennsylvania Leonard Loyd, University of Houston R. Ashley Lyman, University of Idaho James MacDonald, Rensselaer Polytechnical Institute Wesley A. Magat, Duke University Anthony M. Marino, University of Southern Florida Lawrence Martin, Michigan State University John Makum Mbaku, Weber State University Richard D. McGrath, College of William and Mary David Mills, University of Virginia, Charlottesville Richard Mills, University of New Hampshire Jennifer Moll, Fairfield University Michael J. Moore, Duke University W. D. Morgan, University of California at Santa Barbara Julianne Nelson, Stern School of Business, New York University George Norman, Tufts University Daniel Orr, Virginia Polytechnic Institute and State University Christos Paphristodoulou, Malardalen University Sharon J. Pearson, University of Alberta, Edmonton Ivan P'ng, University of California, Los Angeles Michael Podgursky, University of Massachusetts, Amherst Charles Ratliff, Davidson College Judith Roberts, California State University, Long Beach 31. Geoffrey Rothwell, Stanford University Nestor Ruiz, University of California, Davis Edward L. Sattler, Bradley University Roger Sherman, University of Virginia Nachum Sicherman, Columbia University Sigbjern Sedal, Agder University College Houston H. Stokes, University of Illinois, Chicago Richard W. Stratton, University of Akron Charles T.Strein, University of Northern Iowa Charles Stuart, University of California, Santa Barbara Valerie Suslow, University of Michigan Theofanis Tsoulouhas, North Carolina State Abdul Turay, Radford University Sevin Ugural, Eastern Mediterranean University Nora A. Underwood, University of California, Davis Nikolaos Vettas, Duke University David Vrooman, St. Lawrence University Michael Wasylenko, Syracuse University Robert Whaples, Wake Forest University Lawrence J. White, New YorkUniversity Michael F.Williams, University of St. Thomas Arthur Woolf,University of Vermont Chiou-nan Yeh,Alabama State University Peter Zaleski, Villanova University Joseph Ziegler, University of Arkansas, Fayetteville Apart from the formal review process, we are especially grateful to Jean Andrews, Paul Anglin, J. c. K. Ash, Ernst Berndt, George Bittlingmayer, Severin Borenstein, Paul Carlin, Whew on Cho, Setio Angarro Dewo, Frank Fabozzi, Joseph Farrell, Frank Fisher, Jonathan Hamilton, Robert Inman, Joyce Jacobsen, Stacey Kole, Preston McAfee, Jeannette Mortensen, John Mullahy, Krishna Pendakur, Jeffrey Perloff, Ivan P'ng, A. Mitchell Polinsky, Judith Roberts, Geoffrey Rothwell, Garth Saloner, Joel Schrag, Daniel Siegel, Thomas Stoker, David Storey, James Walker, and Michael Williams, who were kind enough to provide comments, criticisms, and suggestions as the various editions of this book developed. There were a number of people who offered helpful comments, corrections, and suggestions for the seventh edition. We owe special thanks to Avinash Dixit, Paul Joskow, and Bob Inman. We also want to thank the following people for their comments and corrections: Smita Brunnermeier, Ralf Faber, Tom Friedland, Volker Grzimek, Phillip L. Hersch, Shirley Hsiao, Narayan D. Lelgiri, Shahram Manouchehri, Jungbein Moon, Abdul Qayum, Jacques Siegers, [org Spenkuch, Menahem Spiegel, Alex Thomas, and Shine Wu. Among those who offered helpful comments, corrections, and suggestions for the Seventh Edition were Steve Allen, Smita Brunnermeier, Tom Friedland, Phillip L. Hersh, Shirley Hsiao, Narayan D. Lelgiri, Shahram Manouchehri, Jungbein Moon, Jacques Siegers,Menahem Spiegel,Alex Thomes, and Shine Wu. Chapter 5 of this seventh edition contains new and updated material on behavioral economics, whose genesis owes much to the thoughtful comments of George Akerlof. We also want to thank Jay Kim, Maciej Kotowski, Smita Brunnerneier, Tammy McGavock, and Shira Pindyck for their superb research assistance on this edition, and Matt.Hartman and Ida Ng for their outstanding editorial assistance, and for carefully reviewing the page proofs of this edition. PREFACE xxxi .~ 32. xxxii PREFACE We also wish to express our sincere thanks for the extraordinary effort those at Macmillan and Prentice Hall made in the development of the various editions of our book. Throughout the writing of the first edition, Bonnie Lieberman provided invaluable guidance and encouragement; Ken MacLeod kept the progress of the book on an even keel; Gerald Lombardi provided mas- terful editorial assistance and advice; and John Molyneux ably oversaw the book's production. In the development of the second edition, we were fortunate to have the encouragement and support of David Boelio,and the organizational and editorial help of two Macmillan editors, Caroline Carney and Jill Lectka. The second edition also benefited greatly from the superb development editing of Gerald Lombardi, and from John Travis, who managed the book's production. Jill Lectka and Denise Abbott were our editors for the third edition, and we benefited greatly from their input. We thank Valerie Ashton, John Sollami, and Sharon Lee for their superb handling of the production of the third edition. Leah Jewell was our editor for the fourth edition; her patience, thoughtful- ness, and perseverance were greatly appreciated. Wealso thank our Production Editor, Dee Josephson, for managing the production process so effectively,and our Design Manager, Patricia Wosczyk, for her help with the book's design. We appreciate the outstanding efforts of our Senior Development Editor, Ron Librach; Associate Managing Editor, Suzanne DeWorken; Art Director, Kenny Beck;Project Manager with GGS Book Services PMG, Jeanine Furino; Editor in Chief, Eric Svendsen; Executive Editor, Chris Rogers; Assistant Editor, Susie Abraham; EditorialAssistant, VanessaBain;and Marketing Manager,Andy Watts. We owe a special debt of thanks to Catherine Lynn Steele, whose superb editorial work carried us through five editions of this book. Lynn passed away on December 10,2002.Wewill miss her very much. R.S.P. D.L.R. 33. PART-ONE Introduction: Markets and Prices Part 1 surveys the scope of microeconomics and introduces some basic concepts and tools. Chapter 1 discusses the range of problems that microeconomics addresses, and the kinds of answers it can provide. It also explains what a market is, how we determine the boundaries of a market, and how we measure market price. Chapter 2 covers one of the most important tools of microeconomics: supply-demand analysis. We explain how a competitive market works and how supply and demand determine the prices and quantities of goods and services. We also show how supply-demand analysis can be used to determine the effects of changing market conditions, including government intervention. CHAPTERS 1 Preliminaries 3 2 The Basics of Supply and Demand 21 34. 4 PART 1 Introduction: Markets and Prices microeconomics Branch III]of economics that deals with THE THEMES OF MICROECONOMICS the behavior of individual economic units-consumers .. r hi . firms, workers, and investors~ The Rolling Stones once said: "You can't always get what you want.' T IS IS as well as the markets that true. For most people (even Mick Jagger), that there are limits to what you can these units comprise. have or do is a simple fact of life learned in early childhood. For economists, however, it can be an obsession. Much of microeconomics is aboutdimu-s-the limited incomes that consumers can spend on goods and services, the limited budgets and technical know-how that firms can use to produce things, and the limited number of hours in a week that workers can allocate to labor or leisure. But microeconomics is also about 'ays to make the most of these limits. More precisely, it is about the allocatiOn of Bearce resources. For example, microeconomics explains how consumers can best allocate their limited incomes to the various goods and services available for purchase. It explains how workers can best allocate their time to labor instead of leisure, or to one job instead of another. And it explains how firms can best allocate limited financial resources to hiring additional workers versus buying new machinery, and to producing one set of products versus another. In a planned economy such as that of Cuba, North Korea, or the former Soviet Union, these allocation decisions are made mostly by the government. Firms are told what and how much to produce, and how to produce it; workers have little flexibility in choice of jobs, hours worked, or even where they live; and consumers typically have a very limited set of goods to choose from. As a result, many of the tools and concepts of microeconomics are of limited relevance in those countries. macroeconomics Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, inter est rates, unemployment, and inflation. Trade-Offs In modern market economies, consumers, workers, and firms have much more flexibilityand choicewhen it comesto allocatingscarceresources.Microeconomics describesthf4;[aae-6ffs that consumers, workers, and firms face,and shows how these trade-offs are best made. The idea of I"ijlaking optimal trade-offs is an important theme in microeconomics-one that you will encounter throughout this book. Let's look at it in more detail. Consumers Consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future. Consumer theory, the subject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based on their preferences, maximize their well-being by trading off the purchase of more of some goods for the purchase of less of others. We will also see how consumers decide how much of their incomes to save, thereby trading off current consumption for future consumption. Workers Workers also face constraints and make trade-offs.tl'ifst, people must decide whether and when to enter the workforce. Because the kinds of jobs- and corresponding pay scales-available to a worker depend in part on educa- tional attainment and accumulated skills, one must trade off working now (and earning an immediate income) for continued education (and the hope of earning a higher future income). 5eCQnd.,-.wQI"kw-s..ace-.tr.ad.e.;Q[is,..in.JheiL;.hoic....of :emplomenn-.For example, while some people choose to work for large corpora- tions that offer job security but limited potential for advancement, others prefer to work for small companies where there is more opportunity for advancement 35. CHAPTER 1 Preliminaries 5 but less security. J'iinaILy,WOllers must somtimes deciae flow manx hours j2@r e.ekthey' wish to wor thereby trading off labor for leisure. Firms-Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them. General Motors, for example, is very good at producing cars and trucks, but it does not have the ability to produce airplanes, computers, or pharmaceuticals. It is also con- strained in terms of financial resources and the current production capacity of its factories. Given these constraints, GMmust decide how many of each type of vehicle to produce. If it wants to produce a larger total number of cars and trucks next year or the year after, it must decide whether to hire more workers, build new factories, or do both. The theory of the firm, the subject matter of Chapters 6 and 7, describes how these trade-offs can best be made. Prices and Markets .A::seccmld.mporrant theme of microeconomics .s Hm wIe of p"ricoo. All of the trade-offs described above are eased em the :{2ricesfacet1iJby consumers, workers, or firms. For example, a consumer trades offbeef for chicken based partly on his or her preferences for each one, but also on their prices. Likewise, workers trade off labor for leisure based in part on the "price" that they can get for their labor-i.e., the wage. And firms decide whether to hire more workers or purchase more machines based in part on wage rates and machine prices. ic:t:(1)economicsalso describes how: priees are e ermine6i. In a centrally planned economy, prices are set by the government. In a market (;onom)liprices are-determined by the interactions of consumers: workers, ana firms. These interactions occur in markets-collections of buyers and sellers that together determine the price of a good. In the automobile market, for example, car prices are affected by competition among Ford, General Motors, Toyota, and other manufacturers, and also by the demands of consumers. {1J@ central role ef markets is the third irtl120rfantmeme of microeconomlGs. We will say more about the nature and operation of markets shortly. Theories and Models Like any science, economics is concerned with the explanations of observed phenomena. Why, for example, do firms tend to hire or layoff workers when the prices of their raw materials change? How many workers are likely to be hired or laid offby a firm or an industry if the price of raw materials increases by, say, 10 percent? In economics, as in other sciences, ex lanatiElftand recliction are asecl' on tlie@rif?S.Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. The theory of the firm, for example, begins with a simple assumption-firms try to maximize their profits. The theory uses this assumption to explain how firms choose the amounts of labor, capital, and raw materials that they use for production and the amount of output they produce. It also explains how these choicesdepend on the prices of inputs, such as labor, capital, and raw materials, and the prices that firms can receivefor their outputs. Economic theories are also the basis for .a -~ g predictions. Thus the theory of the firm tells us whether a firm's output level will increase or decrease in response to an increase in wage rates or a decrease in the price of raw materials. With the application of statistical and econometric techniques, theories can be used to construct models from which quantitative predictions ca!! be made. 36. 6 PART 1 Introduction: Markets and Prices positive analysis Analysis describing relationships of cause and effect. .oaeEs.amatliematicalrep..!,esentatiorl,based on economic theory, of a firm, a market, or some other entity. For example, we might develop a model of a particular firm and use it to predict by how much the firm's output level will change as a result of, say,a IO-percent drop in the price of raw materials. S~cs~aria econometrics also let Us measure the accuracy of our prea.'ic- e.For example, suppose we predict that a Ill-percent drop in the price of raw materials will lead to a 5-percent increase in output. Are we sure that the increase in output will be exactly 5 percent, or might it be somewhere between 3 and 7percent? Quantifying the accuracy of a prediction can be as important as the prediction itself. No theory, whether in economics, physics, or any other science, is perfectly correct. The usefulness and validity of a theory depend on whether it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observation. As a result of this testing, they are often modified or refined and occasionally even discarded.tTfie process of testing and refining theories is central to the de~elop- merit-of economics as a science. When evaluating a theory, it is important to keep in mind that it is invariably imperfect. This is the case in every branch of science. In physics, for example, Boyle's law relates the volume, temperature, and pressure of a gas.2 The law is based on the assumption that individual molecules of a gas behave as though they were tiny, elastic billiard balls. Physicists today know that gas molecules do not, in fact, always behave like billiard balls, which is why Boyle's law breaks down under extremes of pressure and temperature. Under most conditions, however, it does an excellent job of predicting how the temperature of a gas will change when the pressure and volume change, and it is therefore an essential tool for engineers and scientists. . The situation is much the same in economics. For example, because firms do not maximize their profits all the time, the theory of the firm has had only limited success in explaining certain aspects of firms' behavior, such as the timing of capital investment decisions. Nonetheless, the theory does explain a broad range of phenomena regarding the behavior, growth, and evolution of firms and industries, and has thus become an important tool for managers and policymakers. ~ositive versus Normative Analysis :-=~~~~-:-:-~-:- - -- -- - licroeconomics is concerned with both positive and normative questions. Positive questions deal with explanation and prediction, normative questions with what ought to bee Suppose the U.S, government imposes a quota on the Imp0TtoHoreign cars. What will happen to the price, production, and sales of cars? What impact will this policy change have on American consumers? On workers in the automobile industry? These questions belong to the realm of positive analysis: statements that describe relationships of cause and effect. Positive analysis is central to microeconomics. As we explained above, theories are developed to explain phenomena, tested against observations, and used to construct models from which predictions are made. The use of economic theory for prediction is important both for the managers of firms and for public 2Robert Boyle (1627-1691) was a British chemist and physicist who discovered experimentally that pressure CPl,volume CV),' and temperature cn were related in the following way: PV = RT, where R is a constant. Later, physicists derived this relationship as a consequence of the kinetic theory of gases, which describes the movement of gas molecules in statistical terms. 37. CHAPTER 1 Preliminaries 7 policy. Suppose the federal government is considering raising the tax on gasoline. The change would affect the price of gasoline, consumers' purchasing choices for small OJ large cars, the amount of driving that people do, and so on. Toplan.sensibly, oil companies, automobile companies, producers of automobile parts, and firms in the tourist industry would all need to estimate the impact of the change. Government policymakers would also need quantitative estimates of the effects. They would want to determine the costs imposed on consumers (perhaps broken down by income categories); the effects on profits and employment in the oil, automobile, and tourist industries; and the amount of tax revenue likely to be collected each year. Sometimes we want to go beyond explanation and prediction to ask such questions as' "What is best?" This involves normative analysis, which is also important for both managers of firms and those making public policy. Again, consider a new tax on gasoline. Automobile companies would want to determine the best (profit-maximizing) mix of large and small cars to produce once the tax is in place. Specifically,how much money should be invested to make cars more fuel-efficient? For policymakers, the primary issue is likely to be whether the tax is in the public interest. The same policy objectives (say, an increase in tax revenues and a decrease in dependence on imported oil) might be met more cheaply with a different kind of tax, such as a tariff on im]2ortedoil. Normaflve analysis is not only'concerned with alternative policy options; it also involves tne aesign of particular policy choices. For example, suppose it has been decided that a gasoline tax is desirable. Balancing costs and benefits, we then ask what is the optimal size of the tax. Normative analysis is often supplemented by value judgments. For example, a comparison between a gasoline tax and an oil import tariff might conclude that the gasoline tax will be easier to administer but will have a greater impact on lower-income consumers. At that point, society must make a value judg- ment, wei hin e uit a ain t e onomic efficien . When value judgments are involved, microeconomics cannot tell us what the best policy is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the debate.J lIB WHAT IS A MARKET? c We can divide individual economic units into two broad groups according to function-buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services; workers, who sell their labor services; and resource owners, who rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers, but we will find it helpful to think of them as simply buyers when they are buying something and sellers when they are selling something. Together,buyers and sellers interact to form markets. . arket is the collecfion of buyers and sellers that, thy.ough their actual or 120tentinl interactions, aeter 1 e ne l2,ce ata product or set of pfOducts. n the market for personal computers, for example, the buyers are business firms, households, and students; the sellers are Hewlett- Packard, Lenovo, Dell, Apple, and a number of other firms. ote tllaf a market includes ID0I'ethan an industry. An industry. isa collection affirms that sell file same 011 closely related products. In effect,an industry is the supply side of tli:em:-rket. " normative analysis Analysis examining questions of what ought to be. "market Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. 38. 8 PART 1 Introduction: Markets and Prices market definition Determination of the buyers, sellers, and range of products that should be included in a particular market. arbitrage Practice of buying at a low price at one location and selling at a higher price in another. perfectly competitive market Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price. market price Price prevail- ing in a competitive market. Economists are often concerned with market definition-with determining which buyers and sellers should be included in a particular market. When defining a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold in New York will interact only with sellers in New York. But because the cost of transporting gold is small relative to its value, buyers of gold in New York could purchase their gold in Zurich if the prices there were significantly lower. S'ignWcanraTfferences in the price of-a-commooity create a potentiar"for ~ag!r: buying at a low price in one location and selling at a higher price somewhere else. The possibility of arbitrage prevents the prices of gold in New York and Zurich from differing significantly and creates a world market for gold. . . ~ - arl CP* and:C2*. The second set consists of the price elasticities of supply and demand for the market (at or near the equilibrium), which we cl~nC)teby-:E$and ED' as before. These numbers may come from a statistical study done by someone else; they may be numbers that we simply think are reasonable; or they may be numbers that we want to tryout on a "what if" basis. Our goal is to write down the supply and demand curves that fit (i.e., are consistent with) these numbers. We can then determine numerically how a change in a variable such as GDP, the price of another good, or some cost of production will cause supply or demand to shift and thereby affect market price and quantity. Let's begin with the linear curves shown in Figure 2.19. We can write these curves algebraically as follows: Demand: Q = a - bP Supply: Q = c + dP (2.5a) (2.5b) Our problem is to choose numbers for the constants a, b, c, and d. This is done, for supply and for demand, in a two-step procedure: Step 1: Recall that each price elasticity, whether of supply or demand, can be written as 'WV ere 't1.(;2i;rrP is the ~h:angein quantity demanded 0 suppliea resulting fro'H"__ .... a small change in"Price. For linear curves, !J.Qj Mis constant. Fron; equations 79. 50 PART 1 Introduction: Markets and Prices Price alb =cld Q* a Quantity FIGURE 2.19 Fitting Linear Supply and Demand Curves to Data Linear supply and demand curves provide a convenient tool for analysis. Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the elasticities of demand and supply EDand Es' we can calculate the parameters c and d for the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The curves can then be used to analyze the behavior of the market quantitatively. (2.5a)and (2.5b),we see that b.Q/ M' = d for supply and b.Q/ M' = -b for demand. Now, let's substitute these values for b.Q/ M' into the elasticity formula: Demand: ED = -b(P* / Q*) Supply: Es= d(P*/Q*) (2.6a) (2.6b) where P* and Q* are the equilibrium price and quantity for which we have data and to which we want to fit the curves. Because we have numbers for Es' ED' P*, and Q*, we can substitute these numbers in equations (2.6a) and (2.6b) and solve for band d. Step 2: Since we now know band d, we can substitute these numbers, as well as P* and Q*, into equations (2.5a) and (2.5b) and solve for the remaining constants a and c. For example, we can rewrite equation (2.5a) as a = Q* + bP* and then use our data for Q* and P*, together with the number we calculated in Step 1 for b, to obtain a. 80. CHAPTER 2 The Basics of Supply and Demand 51 Let's apply this procedure to a specific example : long-run supply and demand for the world copper market. The relevant numbers for this market are as follows: Quantity Q*= 12million metric tons per year (mmt /yr) Price P*= $2.00per pound Elasticity of suppy Es= 1.5 Elasticity of demand Eo= -0.5. (The price of copper has fluctuated during the past few decades between $0.60 and more than $3.50,but $2.00is a reasonable average price for 2005-2007.) We begin with the supply curve equation (2.5b)and use our two-step procedure to calculate numbers for c and d. The long-run price elasticity of supply is 1.5, P* = $2.00,and Q* = 12. Step 1: Substitute these numbers in equation (2.6b)to determine d: 1.5 = d(2/12) = d/6 So that d = (1.5)(6)= 9 Step 2: Substitute this number for d, together with the numbers for P* and Q*, into equation (2.5b)to determine c: 12 = c + (9)(2.00)= c + 18 so that c = 12- 18= -6. Wenow know c and d, so we can write our supply curve: We can now follow the same steps for the demand curve equation (2.5a). An estimate for the long-run elasticity of demand is -0.5.14 First, substitute this number, as well as the values for P* and Q*, into equation (2.6a) to determine b: -0.5 = -b(2/12) = -b/6 so that b = (0.5)(6)= 3. Second, substitute this value for b and the values for p* and Q* in equation (2.5a)to determine a: 12 = a - (3)(2)= a - 6 so that a = 12 + 6 = 18.Thus, our demand curve is = 18-3PJ To check that we have not made a mistake, let's set the quantity supplied equal to the quantity demanded and calculate the resulting equilibrium price: Supply = - 6 + 9P = 18 - 3P = Demand 9P + 3P = 18 + 6 or P = 24/12 = 2.00,which is indeed the equilibrium price with which we began. Although we have written supply and demand so that they depend only on price, they could easily depend on other variables as well. Demand, for 14SeeClaudio Agostini, "Estimating Market Power in the U.S. Copper Industry," Review of Industrial Organization 28 (2006). 81. 50 PART 1 Introduction: Markets and Prices Price a/b =cld Q* a Quantity FIGURE 2.19 Fitting Linear Supply and Demand Curves to Data Linear supply and demand curves provide a convenient tool for analysis. Given data for the equilibrium price and quantity P* and Q*, as well as estimates of the elasticities of demand and supply EDand Es, we can calculate the parameters c and d for the supply curve and a and b for the demand curve. (In the case drawn here, c < 0.) The curves can then be used to analyze the behavior of the market quantitatively. (2.5a)and (2.5b),we see that !1Q/ t,.p = d for supply and !1Q/ t,.p = -b for demand. Now, let's substitute these values for !1Q/ t,.p into the elasticity formula: Demand: ED = -b(P* / Q*) Supply: Es = d(P*/ Q*) (2.6a) (2.6b) where P* and Q* are the equilibrium price and quantity for which we have data and to which we want to fit the curves. Because we have numbers for Es' ED' P*, and Q*, we can substitute these numbers in equations (2.6a) and (2.6b) and solve for band d. Step 2: Since we now know band d, we can substitute these numbers, as well as P* and Q*, into equations (2.5a) and (2.5b) and solve for the remaining constants a and c. For example, we can rewrite equation (2.5a) as a = Q* + bP* and then use our data for Q*and P*, together with the number we calculated in Step 1 for b, to obtain a. 82. CHAPTER 2 The Basics of Supply and Demand 51 Let's apply this procedure to a specific example: long-run supply and demand for the world copper market. The relevant numbers for this market are as follows: Quantity Q*= 12million metric tons per year (mmt/yr) Price P*= $2.00per pound Elasticity of suppy Es= 1.5 Elasticity of demand ED= -0.5. (The price of copper has fluctuated during the past few decades between $0.60 and more than $3.50,but $2.00is a reasonable average price for 2005-2007.) We begin with the supply curve equation (2.5b)and use our two-step procedure to calculate numbers for c and d. The long-run price elasticity of supply is 1.5, P* = $2.00,and Q* = 12. Step 1: Substitute these numbers in equation (2.6b)to determine d: 1.5 = d(2/12) = d/6 So that d = (1.5)(6)= 9 Step 2: Substitute this number for d, together with the numbers for P* and Q*, into equation (2.5b)to determine c: 12 = c + (9)(2.00)= c + 18 so that c = 12- 18= -6. Wenow know c and d, so we can write our supply curve: We can now follow the same steps for the demand curve equation (2.5a). An estimate for the long-run elasticity of demand is -0.5:14 First, substitute this number, as well as the values for P* and Q*, into equation (2.6a) to determine b: -0.5 = -b(2/12) = -b/6 so that b = (0.5)(6)= 3. Second, substitute this value for b and the values for p* and Q* in equation (2.5a)to determine a: 12 = a - (3)(2)= a - 6 so that a = 12 + 6 = 18.Thus, our demand curve is To check that we have not made a mistake, let's set the quantity supplied equal to the quantity demanded and calculate the resulting equilibrium price: Supply = - 6 + 9P = 18 - 3P = Demand 9P + 3P = 18 + 6 or P = 24/12 = 2.00,which is indeed the equilibrium price with which we began. Although we have written supply and demand so that they depend only on price, they could easily depend on other variables as well. Demand, for 14SeeClaudio Agostini, "Estimating Market Power in the U.S. Copper Industry," Review of Industrial Organization 28 (2006). 83. (2.7) 52 PART 1 Introduction: Markets and Prices example, might depend on income as well as price. We would then write demand as where I is an index of aggregate income or GDl? For Example, I might equal 1.0 in a base year and then rise or fall to reflect percentage increases or decreases in aggregate income. For our copper market example, a reasonable estimate for the long-run income elasticity of demand is 1.3.For the linear demand curve (2.7),we can then calculate [by using the formula for the income elasticity of demand: E = (I/Q)(b.Q/M). Taking the base value of I as 1.0,we have 1.3= (1.0/12)([) Thus i= (1.3)(12)/(1.0) = 15.6.Finally, substituting the values b = 3, i= 15.6, P* = 2.00,and Q* = 12 in equation (2.7),we can calculate that a must equal 2.4. We have seen how to fit linear supply and demand curves to data. Now, to see how these curves can be used to analyze markets, let's look at Example 2.8, which deals with the behavior of copper prices, and Example 2.9, which concerns the world oil market. _ The Behavior of Copper Prices After reaching a level of about $1.00per pound in 1980, the price of copper fell sharply to about 60 cents per pound in 1986. In real (inflation-adjusted) terms, this price was even lower than during the Great Depression 50 years earlier. Prices increased in 1988-1989and in 1995;largely as a result of strikes by miners in Peru and Canada that disrupted supplies, but then fell again from 1996 through 2003. Prices increased sharply, however, during 2005-2007.Figure 2.20 shows the behavior of copper prices during 1965-2007in both real and nominal terms. Worldwide.recessions in 1980-ancl1982 contributed to the decline of copper prices.sas mentioned above, the income elasticity of copper demand is about 1.3.But copper demand did not pick up as the industrial economies recovered during the mid-1980s. Instead, the 1980s saw a steep decline in demand. The price decline through 2003 occurred for two reasons. First, a large part of copper consumption is for the construction of equipment for electric power generation and transmission. But by the late 1970s,the growth rate of electric power generation had fallen dramatically in most industrialized countries. In the United States, for example, the growth rate fell from over 6 percent per annum in the 1960sand early 1970sto less than 2 percent in the late 1970sand 1980s.This decline meant a big drop in what had been a major source of copper demand. Second, in the 1980s,other materials, such as aluminum and fiber optics, were increasingly substituted for copper. Why did the price increase sharply in 2005-20077First, the demand for copper from China and other Asian countries began increasing dramatically, replacing the demand from Europe and the U.S. Chinese copper consumption, for example, increased by 32 percent from 2002 to 2006. Second, because prices had dropped so much from 1996through 2003, producers in the U.S., Canada, and 84. CHAPTER 2 The Basics of Supply and Demand 53 340 320 300 280 ;0 260 240 o e- 220 (J) 0.. 200 ~ 180 ~ 160(J) .~ 140c, 120 100 80 60 40 20 O~rT'-rT'-rT'-rT'-rT'-rT'-rT'-rT'-rT'-rT-'rT-'''-'''-'''-'''' 1965 Nominal Price 1970 1975 1980 1985 1990 1995 2000 2005 FIGURE 2.20 Copper Prices, 1965-2007 Copper prices are shown in both nominal (no adjustment for inflation) and real (inflation- adjusted) terms. In real terms, copper prices declined steeply from the early 1970s through the mid-1980s as demand fell. In 1988-1990, copper prices rose in response to supply disruptions caused by strikes in Peru and Canada but later fell after the strikes ended. Prices declined during the 1996-2002period but then increased sharply during 2005-2007. Chile closed unprofitable mines and cut production. Between 2000 and 2003, for example, U.S. mine production of copper declined by 23 percent.P One might expect the high prices of 2005-2007 to stimulate investments in new mines and increases in production, and that is indeed what has happened. Arizona, for example, experienced a copper boom as Phelps Dodge opened a major new mine in 2007.16 By 2007, producers began to worry that prices would decline again, either as a result of these new investments or because demand from Asia would level off or even drop. What would a decline in demand do to the price of copper? To find out, we can use the linear supply and demand curves that we just derived. Let's calculate the effect on price of a 20-percent decline in demand. Because we are not concerned here with the effects of COP growth, we can leave the income term, fI, out of the demand equation. We want to shift the demand curve to the left by 20 percent. In other words, we want the quantity demanded to be 80 percent of what it would be otherwise for every value of price. For our linear demand curve, we simply multiply the right-hand side by 0.8: Q = (0.8)(18 - 3P) = 14.4 - 2.4P 150ur thanks to Patricia Foley, Executive Director of the American Bureau of Metal Statistics, for supplying the data on China. Other data are from the Monthly Reports of the U.S.Geological Survey Mineral Resources Program-http://minerals.usgs.gov/minerals/pubs/copper. 16Theboom created hundreds of new jobs, which in turn led to increases in housing prices: "Copper Boom Creates Housing Crunch," The Arizona Republic, July 12,2007. 2010 85. S4 PART 1 Introduction: Markets and Prices 20 Supply is again Q = -6 + 9P. Now we can equate the quantity supplied and the quantity demanded and solve for price: -6 + 9P = 14.4 - 2.4P or P = 20.4 /11.4 = $1.79 per pound. A decline in demand of 20 percent, therefore, entails a drop in price of roughly 21 cents per pound, or 10.5 percent. Figure 2.21 shows how this shift in the demand curve affects the equilibrium price and quantity of copper.l" The shift in the demand curve corresponding to a 20-percent decline in demand leads to a lO.5-percent decline in price. 4 3.5 ~ 3 "Cl ~ 8.. 2.5 Iii ;; 2 ~o ~ 1.5 OJ .~ p.. 1 0.5 5 10 15 Quantity (million metric tons/year) FIGURE 2.21 Copper Supply and Demand EXAMPLE 2.9 Upheaval in the World Oil Market Since the early 1970s, the world oil market has been btgfeted by the OPEC cartel and by political"'t'ID-moil in the Persian Gulf. In 1974, by collectively restraining output, OPEC (the Organization of Petroleum Exporting Countries) pushed world oil prices well above what they would have been in a competitive market. OPEC could do this because it accounted for much of 17Notethat because we have multiplied the demand function by 0.8-i.e., reduced the quantity demanded at every price by 20 percent-the new demand curve is not parallel to the old one. Instead, the curve rotates downward at its intersection with the price axis. 86. CHAPTER 2 The Basics of Supply and Demand 55 world oil production. During 1979-1980 , oil prices shot up again, as the Iranian revolution and the outbreak of the Iran-Iraq war sharply reduced Iranian and Iraqi production. During the 1980s,the price gradually declined, as demand fell and competitive (i.e., non-OPEC) supply rose in response to price. Prices remained relatively stable during 1988-2001, except for a tempo- rary spike in 1990 following the Iraqi invasion of Kuwait. Prices increased again in 2002-2003 as a result of a strike in Venezuela and then the war with Iraq in the spring of 2003; they continued to increase during 2005-2007 as a result of rising oil demand in Asia and reductions in OPEC output. Figure 2.22 shows the world price of oil from 1970 to 2007, in both nominal and real terms. 80 70 Real Price (2000$) /]' 60 ..to .n 50 iiJ0.. ~ 40 ~ ~ 30 Q) u ..: c, 20 10 o~~~~~~~~~~~~~~~~~~~~~ 1970 1975 1980 1985 1990 1995 2000 2005 FIGURE 2.22 Price of Crude Oil IThe OPEC cartel and political event, caused the price of oil to rise sharply at times. It later fell as supply and demand adjusted. The Persian Gulf is one of the less stable regions of the world-a fact that has led to

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