MODERNMICROECONOMICSAnalysis and Applications

SecondEdition

DAVID N. HYMAN

CONTENTS

PARTONEINTRODUCTION TO MICROECONOMICS

1 Modern Microeconomics and its Meth-odology,2

Scarcity and prices, 3Scarcity, choice, and the tasks of the econ-

omy, 3Application 1.1, Coping with scarcity: fire-

wood and deforestation in the ThirdWorld,5

The role of prices in aliocating resources, 6Economic transactions and markets, 7

The purpose and functions of markets, 7Nonmarket activities, 8Property rights: the prerequisites for mar-

ket exchange, 9Transaction costs, 10

Methodology of microeconomics: theoriesand modeis, 12Model building, 13The pursuit and maximization of net gain:

a key behavioral assumption in micro-economic modeis, 14

Marginal analysis of net gains of transac-tions, 15

Positive vs. normative analysis, 16Application 1.2, Can beer taxes and raising

the legal drinking age save your life?Positive economic analysis in action, 17

Summary, 18

2 Market Interaction: Basic Supply andDemand Analysis and its Uses, 22

Market interaction: demand and supply, 23The demand curve, 23Changes in demand, 26The supply curve, 28Changes in supply, 31

Market equilibrium, 31Changes in market equilibrium: comparative

static analysis, 33Market response to a change in demand, 33Market response to a change in supply, 35

Applications of supply and demand analysis,36Analysisof the consequences of taxation, 36Import quotas, tariffs, and the conse-

quences of protecting domestic indus-tries from foreign competition: a morecomplex application, 39

Rent controls: impact of a price ceiling, 41Nonprice rationing of shortages caused by

price controls, 42Application 2.1, Rent regulation in prac-

tice: tenants' rights, warehousing ofapartments, condominium conversions,and flipping in the Big Apple, 44

Minimum wages. the impact of a pricefloor, 45

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xvi Contents

Government and the business of agricul-rure,46

Application 2.2, How sweetening the potfor farmers in the United Srates and Eu-

PART 1WO

rope affects farmers in developingcountries: the international impact ofprice supports, 50

Summary, 51

THE THEORY OF DEMAND

3 Preferences, Budgets, and Prices: TheTheory of Consumer Behavior, 58

Preferences and choices, 59Assumptions about consumer prefer-

ences, 59The utilitv function and indifference

curvesčuThe utilitv function, 61Indifference curves, 61Indifference maps, 63Diminishing marginal rates of substitution

and the curvature of indifferencecurves, 66

The cardinal approach: marginal utilityand the slope of indifference curves, 68

Budgets and prices, 70The budget constraint, 70The economic significance of intercepts of

the budget line with the axes, 7lThe economic significance of the slope of

the budget line, 73Changes in income and prices, 74

Consumer equilibrium, 75Maximization of utility subject to the

budget constraint, 76The equimarginal princip le, 79

Using indifference curve analysis to explainchoices,80Differences in tas tes among con-

sumers,80The choice nor to consume a good: cor-

ner equilibrium, 81Nondirninishing marginal rates of substitu-

tion,82Perfect complements, 84

Application 3.1, The choice to have chil-dren,85

Economic "bads,' 86Further applications of the model of con-

sumer choice, 89Nonprice rationing, 89Preferences for product arrributes: a

business application for marketingproducts, 90

Application 3.2, Estimating the price ofproduct attribures: how much willconsumers pav for housing charac-teristics>, 94

Summary, 94

4 Indifference Curve Analysis and Appli-cations, 100

Expanding the model: the choice betweenbuying a product and spending on allother goods, 101Diminishing marginal benefit of a good,

104Incorne-consurnption curves and Engel

curves, 104Incorne-consurnption curves, 104Normal vs. inferior goods, 105Engel curves, 108

Price-consumption curves and derivation ofde mand curves, 110

Income and substitution effects of pricechanges, 113Income and substitution effects of a price

decrease, 113Income and substitution effects in general

and the demand curve for normalgoods,1l5

Contents

The case of inferior goods, 116Using indifference curve analysis to under-

stand the effects of business practices: in-kind compensation and notched budgetlines, 119Frequem-flyer plans and notched budget

lines, 119Application 4.1, Why some airlines are

having second thoughts about their fre-quent-flyer plans, 122

Compensating employees with fringe ben-efits instead of cash, 123

Using indifference curve analysis tounderstand the effects of governmentpolicies, 127Income and substitution effects of a price

increase: how a rebated tax candecrease consumption of the taxedgood,127

In-kind subsidies: how policies can createnatched budget lines and result in ef-fects opposite to those intended, 128

Application 4.2, Food stamps and con-sumer choices, 131

Indifference curve analysis of the sale ofnonpurchased goods and services, 132Transaction costs and the incemive to

sell, 132Work, leisure, and the value of time, 134Nonwage incame and work incentive, 136

Summary, 137

5 Market Demand and its Elasticity, 144

Derivation of market demand curves, 145Deterrninants of market demand, 146

Price elasticity of demand, 148Calculating price elasticity of demand, 149Elasticity vs. slope, 149The range of variation of price elasticity of

demand,150Determinants of price elasticity of de-

mand,151'Ernpirical estimates of price elasticities of

demand: how the sensitivity to pricechanges differs among goods, 152

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xvii

Using price elasticities of demand to analyzeconsumer expenditures, 153Price elasticity of demand and changes in

total revenue, 155Application 5.1, Maximizing revenue from

the sale of tickets to sports events: whvpricing to fill the stadium is nat alwaysthe best policy, 156

Unit-elastic demand, 158Application 5.2, The price of the dollar

and the price elasticiry of demand forimported goods and USo exports, 160

Calculating price elasticity of demand forpaims on a demand curve, 161Price elasticity of demand as a ratio of

distances at points on a demandcurve, 161

Comparing point elasticity of two demandcurves, 163

Calculating price elasticity from data cor-responding to two paims on a de mandcurve, 164

Other demand elasticities, 165Incorne elasticiry of demand, 165Cross elasticirv of demand, 166

Demand curves and consumer benefits, 168Consumer surplus, 169Using market demand curves to approxi-

mate consumer surplus, 171Willingness to pay, availabilitv, and

price, 172Using consumer surplus to evaluate the

burden of taxes, 173Using consumer surplus to evaluate the

gains from subsidies, 175Some qualifications, 176

Estimating demand functions andelasticities, 177Market experiments and surveys, 177Statistical methods, 178The identification problem, 179

Summary, 182Appendix: Advanced topics in the theory of

consumer choice and demand, 187Evaluating willingness to pay, 187Measuring changes in the cost of

living, 193" I

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Taxes and economic welfare, 195Subsidies and economic welfare, 197Income elasticity of demand, budget con-

PART THREE

straints, and expenditures, 199Choices under uncertainty, 200

PRODUCTION, COST, AND SUPPLY IN COMPETITIVE MARKETS

6 The Theory of Production, 208

Production, 209Technology, 210The production function, 210Properties of production functions: The

underlying assumptions of the theory ofproduction, 210 .

Application 6.1, Improvements in technol-ogy: Some examples, 211

Isoquants, 212Isoquant maps, 214Application 6.2, An estimated production

function for corn, 216Production options in the short run: the law

of diminishing marginal returns, 217Total, ave rage , and marginal products of a

variable input, 218The tatai product curve, 220The average product curve, 220The marginal product curve, 222The relationship between average and

marginal product, 222The law of diminishing marginal

returns, 223The stages of production, 224A business application: management of a

multidivision operation, 225Input substitution, 227

Marginal rate of technical substitution andthe curvature of isoquants, 227

How variation in the marginal products ofinputs affects their marginal rates oftechnical substitution, 229

Substitution of capital for labor in busi-ness, 230

Input substitution and the shape of iso-quants, 231

How changes in technology can affect iso-quants, 232

Varying the scale of operations, 234Using estimated production functions to

measure returns to scale, 238Summary, 240

7 Cost and Output, 244

Measuring cost: economic cost vs. account-ing cost, 245Calculating economic cost: An example,

245Cost and production, 247

Isocost lines, 248The minimum cost input combination for

a given output, 250The princip le of least cost: equimarginal

products per dollar of outlay on inputservices, 252

An expansion path, 253Short-run cost, 254Application 7.1, measuring fixed costs, 256

Average cost and marginal cost, 257Short-run cost curves, 258

Average variable cost, average fixedcost, ave rage cost, and marginal costcurves, 260

Relationship between marginal cost, aver-age variable cost, and ave rage cost, 262

Diminishing returns, costs, and the stagesof production: more on the relationshipbetween cost functions and productionfunctions, 263

Application 7.2, Advanced technology, vari-able costs, and international competitive-ness of the U.S. steel industry, 265

Conrems

Limiting the use of an input: a business-related application of cost funct-ions, 266

Long-run cost, 268Analysis of long-run costs: variation in

plant size, 269Return to scale and the shape of long-run

cost curves, 271Changes in input prices and technology, 274Empirical studies of cost, 277Summary, 279

8 Profit Maximization and Short-runSupply in Perfectly CompetitiveMarkets, 286

The business firm and perfect competition,287The social functions and internai organiza-

tion of business firms, 287The single-product profit-maximizing

business firm, 288Application 8.1, Vertical integration and busi-

ness profits, 289Perfect competition, 290Demand as seen by a cornpetitive firm,

291Profit maximization, 292

Tatai revenue, tatai cost, and economicprofit, 292

A numerical example: outpur, cost, reve-nue, and profit, 293

Marginal analysis of profit maximi-zation, 294

Graphic analysis of variation in profit asoutput increases over the short-run pe-riod,296

Price, marginal cost, average cost, and theprofit-maximizing output, 298

Breaking even, 300Minimizing losses when price is below

the minimum possible average cost, 300The decision to shut down operations in

the short run, 303Short-run supply, 306

The competitive firrn's short-run supplycurve, 306

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Short-run market supply and its deterrni-nants, 306

Short-run price elasticity of supply, 309Applying the theory of short-run supply, 313

A reduction in the price of a variable in-put, 313

Change in the price of a fixed input: Theshort-run of license fees and fixed an-nual subsidies, 315

Using supply curves to calculate producersurplus, 317Price changes and producer surplus, 318Using the sum of producer and consumer

surplus as a measure of gains andlosses from economic policies, 319

Are markets competitive? 321Application 8.2, Is US. agriculture cornpeti-

tive?,322Summary, 323

9 Long-run Equilibrium and Supply inPerfectly Competitive Markets, 328

Firms, industries, and perfect cornpe-tition, 329

Long-run competitive equilibrium and sup-ply, 330Equilibrium of the industry, 330Expansion of the firm in the long run, 331Long-run competitive equilibrium, 332Characteristics of long-run competitive

equilibrium, 334The paradox of profits, 334

Long-run supply, 335Industry adjustment to an increase in de-

mand,335Industry adjustment to a decrease in de-

mand,337The long-run industry supply curve: the

case of constant costs, 338Increasing- and decreasing-costs indus-

tries and long-run industry supplycurves, 339

Long-run supply vs. short-run supply, 342Application 9.1, The impact of improved

technology on long-run equilibrium incompetitive rnarkets: international compe-tition, 343

xx Contents

Differences in firm size and costs under per-fect competition, 344

Applications of the competitive model, 346Long-run impact of a license fee, 346The impact of government policies that

limit entry of firms imo competitivemarkets, 347

The long-run impact of rent controls, 350

PART FOUR

Application 9.2, The impact of rent controlon housing quality: some evidence, 352Taxing the output of a constant-costs in-

dustry,352Subsidizing a competitive industry, 354

The competitive model as a benchmark, 357Summary, 357

NONCOMPETITIVE MARKETS

10 Monopoly, 364

Pure monopoly and monopoly power, 365Barriers to entry: how monopoly power is

maintained, 366Application 10.1, De Beers, diamonds and

the central selling organization: some evi-dence, 367

The demand for a monopolist's product, 371The monopolist's marginal revenue, 371

Price, marginal revenue, and price elastic-ity of dernand, 374

Short-run profit maximization by monopolyfirms,377Short-run monopoly equilibrium: graphic

analysis, 379Monopoly equilibrium and price elasticiry

of demand, 380Long-run monopoly equilibrium, 381

A single-plant monopoly, 381Multipiant monopoly, 382Monopoly supply, 385

Monopoly equilibrium vs. competitive equi-librium, 386The consequences of a monopoly take-

over of a competitive industry, 387The social cost of monopoly, 388

Application 10.2, Breaking up the BellSystem, 389Are there any benefits from monopolies

that can offset the social cost ofmonopoly? 391

Monopoly reaction to price ceilings, taxes,and subsidies, 391Price ceilings, 391

Monopoly reaction to taxes on itsoutput,393

Monopoly reaction to subsidi es, 394Price discrimination, 395

Price discrimination in segmentedrnarkets, 398

Summary, 400

11 Monopolistie Competition and Oligop-oly, 404

Between pure monopoly and perfect corn-peti tion, 405

Monopolistic competition, 406Defining the industry, 407Short-run equilibrium of the firm under

monopolistic competition, 408Long-run equilibrium under monopolistic

competition, 410Comparison with the bench mark compet-

itive equilibrium, 412Implications of excess capacity under rno-

nopolistic competition, 414Advertising and product development in

monopolistically competitive markets, 414Costs of nonprice cornpetition, 414Selling costs, 415Long-run equilibrium with advertising un-

der monopolistic competition, 419Oligopoly, 421

Conscious rivalry: oligopolistic pricewars,423

Oligopoly strategies and the theory ofgames,425

Contents

Collusion and cartels, 428Forming a cartel: directions, 428A real cement cartel in action, 430Advertising under oligopoly, 430

Application 11.1, The OPEC cartel, 431Other oligopoly modeis, 433

Price rigidity and the kinked demandcurve, 434

Price leadership, 435Application 11.2, Pricing decisions in prac-

tice: cost-plus pricing rules 437Entry-limit pricing, 438

Summary, 440Appendix: The Cournot model of

duopoly, 444Reaction curves, 447

12 Market Structure, Efficiency, and Regu-lation, 450

Efficiency, 451Marginal eanditions for efficiency, 452The efficient output of a good maximizes

the sum of producer and consumer sur-plus, 453

Perfectly eampetitive markets and effi-ciency, 455

How the exercise of monopoly power canprevent the efficient output from beingattained, 456

Diagnosing monopoly power, 457Profits as a symptom of rnonopolypower, 457

Application 12.1, Rising concentration in thebeer industry: the causes and conse-quences, 461

PART FIVE

xxi

Contestable rnarkets: can the threat of en-try prevent the exercise of monopolvpower and guarantee efficient outputlevels? 462

Estimating the loss in efficiency from ex-ercise of monopoly power, 464

Are there benefits from monopolypower? 457

Eeanomies of scale, 467Technological progress, 467Product variety and economizing on infor-

mation costs, 468Controlling monopoly power: antitrust po 1-

icy,470Controlling oligopolistic price fixing, 470The rule of reason, 471The relevant market, 471Predatory pricing, 472Recent cases, 472Mergers, 474

Government regulation of pricing and entryin markets, 475Regulating pricing of the output of a natu-

rai monopoly, 475Criticism of government regulation of

pricing by natural monopolies, 476Application 12.2, Peak-load pricing: what it is

and why your electric company wants itapproved, 477Regulating pricing and entry in markets

served by competing sellers, 479The regulatory commissions, 479Deregulation: the case of domestic air

travel markets, 480Summary, 482

INPUT MARKETS

13 Competitive Input Markets and the Eco-nomics of Work and Wages, 488

Perfect competition in input rnarkets, 489The marginal revenue product of an in-

put: a measure of the marginal gainfrom hiring an input, 491

The hiring decision: weighing the mar-ginal gain of additional input useagainst its marginal east, 493

A firrn's input demand curve, 494What can cause a firm's input demand to

change, 495

xxii Contents

Industry and market demand for aninput, 496Derivation of industry input demand

curves, 496Deterrninants of industry input demand

elasticity, 499Market demand, 499

Market supply of inputs and the economicsof work, 501Industry and market supply of inputs, 501The work-leisure choice and labor supply

of an individual worker, 501Deriving a worker's labor supply

curve, 503Income and substitution effects of wage

changes, 503Backward-bending labor supply

curves, 507Market supply of labor services, 507How cash-assistance welfare programs in

the United States affect the labor supplyof recipients, 508

Application 13.1, Labor supply in the UnitedStates, 509

The operation of competitive inputmarkets, 512

Application 13.2, Minimum wages and ern-ployment: the case of teenagers, 514Explaining differences in wages among

occupations and jobs, 516How differences in job quality give rise to

wage differentials, 517Economic rent, 520Input mobility among market sectors, 523Variable input supply, 526

Summary, 526

14 Imperfectly Competitive Input Markets,Work, and Wages, 532

A monopolist's input demand, 533Monopsony, 535

Marginal input cost for monopsony, 536Hiring decisions in monopsonistic input

markets, 539Monopsony power paired with monopoly

power in output markets, 541

Application 14.1, Monopsony power in themarket for professional athletes: a case ofcollusion, 542

Monopoly power of input sellers, 543Labor unions, 543Union control over labor supply, 545Impact of unions on wages, 546The impact of unionization on labor pro-

ductivity, 547Application 14.2, Labor unions and

wages, 548Bilateral monopoly, 549

Union wages, minimum wages, and ern-ployment in monopsonistic labor rnar-kets. some surprising conclusions, 551

Discrimination in labor markets, 553Extreme discrimination: qualified workers

are barred from entering the labor rnar-ket, 554

Less extreme discrirnination: entry intothe market is permitted only if workerssubject to discrimination accept lowerwages,555

Profit maximization, competition, and theimpact of these forces on discrimina-tory wage differentials, 556

Is discrimination actually practiced? 556The issue of comparable worth, 557

Summary, 559

15 Interest Rates, Rents, and the Creationof Capita1, 564

Capital, investment, and interest, 565Capital flows and the capital stock, 565Interest and the supply and demand of

loanable funds, 566How the interest rate affects invest-

ment decisions: a single-periodinvestment, 566

Multiperiod investments, 571Market demand for loanable funds, 573

The supply of savings, 574Time preference, 574

Application 15.1, Human capital, 575The inrerternporal budget constraint, 577IntertemporaI equilibrium, 577

Conrenrs

Incame and substitution effects of achange in the interest rate, 579

The market supply of savings, 579Determination of the market rate of interest

under perfect competition, 581The market rate of interest and business

investment, 582The market rate of interest and the price

of existing capital assets, 582Application 15.2, Corporate takeovers and

the relevance of the concept of presentvalue, 584

PART SIX

xxiii

Explaining differences in the return on in-vestments and in lending rates, 586Risk, 586Taxes, 586Differences in interest rates, 588

Land rnarkets, 589Location, land use, and land rents, 589Land price and rent differentials, 591

Summary, 591

GENERAL EQUILIBRIUM, EFFICIENCY, AND PUBLIC GOODS

16 General Equilibrium Analysis and Effi-ciency, 598

Partial equilibrium analysis vs. general equi-librium analysis, 599

General equilibrium and efficiency, 601The resource constraint, 601Analysis of production with an Edgeworth

box, 602Productive efficiencv, 604The production possibiliry curve, 605The marginal rate of transfonnation, 606General equilibrium in competitive input

markets and efficiency, 607Application 16.1, Are economic decisions

within business firms efficient? The spec-ter of X-inefficiency, 608

Exchange and allocative efficiency, 609Efficiency in Production and Allocation of

Products, 612General equilibrium, perfect competition,

and the distribution of welfare, 614Prices, profit maximization, utility maximi-

zation, and efficiency, 614The distribution of welfare in competitive

markets, 616Changes in the distribution of in-

came, 617Efficiency vs. equiry, 618Growth in resource availabiliry or produc-

tiviry, 620

Application 16.2, Free trade and efficiency:the net gains and redistributive effects offree international trade, 621

General equilibrium analysis of market dis-tortions, 624Monopoly power and losses in effi-

ciency, 624Tax-induced distortions, 625Balancing distortions: the theory of see-

and best, 626Other distortions, 627

Summary, 627

17 The Theory of Externalities, 632

Externalities, 633Negative externalities, 634Positive externalities, 638

Internalization of externalities: correctivetaxes and subsidies, 640Corrective taxes, 640Corrective subsidi es, 641

Application 17.1, Use of corrective taxes andeffluem charges, 642Administering corrective taxes and subsi-

dies: problems of measurement andidenrification, 643

What causes negative externalities? 644Properry right disputes, 644Transaction costs, 644

The Coase Theorem, 645

xxiv Contents

Application 17.2, Evolution of propertyrights: grazing rights, 646A numerical example, 647Case 1: The emitter has the right to dump

wastes, 649Case 2: The emitter does not have the

right to dump waste, 650Additional alternatives and profits, 651Significance of the Coase theorem, 652

Applications of the theory of exter-nalities, 652Pollution control policy, 652Emissions standards: using regulations

instead of charges to controlpollution, 653

Pollution rights, 657Summary, 660

18 Public Goods, 664

Public goods vs. private goods, 665Characteristics of pure public goods, 665Public goods vs. government-supplied

goods, 666Positive externalities and the efficient out-

put of pure public goods, 667Application 18.1, Government expenditures

in the United States, 667

The demand and supply of pure publicgoods, 670The demand curve for pure public

goods, 670Cooperative supply of pure public

goods,672The free-rider problem, 673

The supply of public goods through politicalinstitutions, 676Voting decisions, 676Political equilibrium under majority rule,

678Majority rule and efficient output of pub-

lic goods, 680Application 18.2, The demand for public

goods, 681Some qualifications, 682

Congestible and exc1udable publicgoods, 682Congestible public goods, 683Excludable public goods, 685

Summary, 686

Glossary, GI

Answers to Even-Numbered Problems, Al