Schaum's Outline of Microeconomics, 4th Edition PDF

 SCHAUM’S OUTLINE OF MICROECONOMICS Fourth Edition This page intentionally left blank  SCHAUM’S OUTLINE OF MICROECONOMICS Fourth Edition DOMINICK SALVATORE, Ph.D. Professor of Economics...

 SCHAUM’S OUTLINE OF MICROECONOMICS Fourth Edition This page intentionally left blank  SCHAUM’S OUTLINE OF MICROECONOMICS Fourth Edition DOMINICK SALVATORE, Ph.D. Professor of Economics Fordham University SCHAUM’S OUTLINE SERIES McGRAW-HILL New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2006, 1992, 1983, 1974 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-149171-6 The material in this eBook also appears in the print version of this title: 0-07-146236-8. All trademarks are trademarks of their respective owners. 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If you’d like more information about this book, its author, or related books and websites, please click here.  PREFACE Microeconomic theory presents, in a systematic way, some of the basic analytical techniques or “tools of analysis” of economics. As such, it has traditionally been one of the most important courses in all economics and business curricula and is a requirement in practically all colleges and universities. Being highly abstract in nature, microeconomic theory is also one of the most difficult courses and often becomes a stumbling block for many students. The purpose of this book is to help overcome this difficulty by approaching microeconomic theory from a learn-by-doing methodology. While the book is primarily intended as a supplement to all current standard textbooks in microeconomic theory, the statements of theory and principles are sufficiently complete to enable its use for independent study as well. Each chapter begins with a clear statement of theory, principles, or background information, fully illustrated with examples. This is followed by a set of multiple-choice review questions with answers. Subsequently, numerous theoretical and numerical problems are presented with their detailed, step-by-step solutions. These solved problems serve to illustrate and amplify the theory, to bring into sharp focus those fine points without which the student continually feels on unsafe ground, and to provide the applications and the reinforcement so vital to effective learning. The topics are arranged in the order in which they are usually covered in intermediate microeconomic theory courses and texts. As far as content, this book contains more material than is covered in one-semester courses in undergraduate microeconomic theory. Thus, while directed primarily at undergraduates, it can also provide a useful source of reference for M.A. students, M.B.A. students and businesspeople. There is no prerequisite for its study other than a prior course in or some knowledge of elementary economics. The methodology of this book and much of its content have been tested in micro- economic theory classes at Fordham University. The students were enthusiastic and made many valuable suggestions for improvements. To all of them I am deeply grateful. I would like to express my gratitude to the entire Schaum staff of McGraw-Hill for their assistance and especially to Barbara Gibson and Adrinda Kelly. This is the fourth edition of a book that has enjoyed a very gratifying market success and has been translated into nine languages (Spanish, French, Italian, Portuguese, Greek, Chinese, Japanese, Arabic, and Indonesian) and was reprinted in India and Taiwan. All the features that made the first and second editions successful were retained in the third edition. The following revisions were included in this edition:. A brand new chapter (Chapter 12) has been added on Game Theory and Oligopolistic Behavior. Game theory is one of the most important development in microeconomic theory and all texts now include it.. A second new chapter (Chapter 15) has also been added on the Economics of Information. The economics of information is another important development in Copyright © 2006, 1992, 1983, 1974 by The McGraw-Hill Companies, Inc. Click here for terms of use.  PREFACE vi microeconomic theory and reflects the fact that we now do live an information economy.. Chapter 7 was expanded with the inclusion of Section 7.8 on The Cobb-Douglas Production Function, Section 7.9 on X-Inefficiency, and Section 7.10 on Techno- logical Progress.. New Section 11.6 on Transfer Pricing was added to new Chapter 11.. Numerous additional examples, review questions, and problems and applications were included throughout the volume. These additions should be very useful, particularly to the more eager undergraduate student, as well as to M.A. and M.B.A. students. Many other changes were also made throughout to reflect the numerous helpful comments that I received from the many professors and students who used the first two editions. Finally, the glossary of important economic terms and the sample midterm and final examinations were revised and expanded. DOMINICK SALVATORE  For more information about this title, click here CONTENTS Preface v CHAPTER 1 Introduction 1 1.1 The Purpose of Theory 1 1.2 The Problem of Scarcity 1 1.3 The Function of Microeconomic Theory 1 1.4 Markets, Functions, and Equilibrium 2 1.5 Comparative Statics and Dynamics 2 1.6 Partial Equilibrium and General Equilibrium Analysis 2 1.7 Positive Economics and Normative Economics 2 CHAPTER 2 Demand, Supply, and Equilibrium: An Overview 14 2.1 The Individual’s Demand for a Commodity 14 2.2 The Law of Negatively Sloped Demand 15 2.3 Shifts in the Individual’s Demand Curve 15 2.4 The Market Demand for a Commodity 15 2.5 The Single Producer’s Supply of a Commodity 17 2.6 The Shape of the Supply Curve 17 2.7 Shifts in the Single Producer’s Supply Curve 17 2.8 The Market Supply of a Commodity 18 2.9 Equilibrium 18 2.10 Types of Equilibria 19 2.11 Shifts in Demand and Supply, and Equilibrium 19 CHAPTER 3 The Measurement of Elasticities 39 3.1 Price Elasticity of Demand 39 3.2 Arc and Point Elasticity 40 3.3 Point Elasticity and Total Expenditures 41 3.4 Income Elasticity of Demand 42 3.5 Cross Elasticity of Demand 43 3.6 Price Elasticity of Supply 44 CHAPTER 4 Consumer Demand Theory 62 4.1 Total and Marginal Utility 62 4.2 Consumer Equilibrium 63 4.3 Indifference Curves: Definition 64 4.4 The Marginal Rate of Substitution 65 viii CONTENTS 4.5 Characteristics of Indifference Curves 66 4.6 The Budget Constraint Line 67 4.7 Consumer Equilibrium 67 4.8 Exchange 68 4.9 The Income-Consumption Curve and the Engel Curve 68 4.10 The Price-Consumption Curve and the Consumer’s Demand Curve 69 4.11 Separation of the Substitution and Income Effects 70 CHAPTER 5 Advanced Topics in Consumer Demand Theory 102 5.1 The Substitution Effect According to Hicks and Slutsky 102 5.2 The Theory of Revealed Preference 103 5.3 Index Numbers and Changes in the Standard of Living 104 5.4 Utility Theory Under Uncertainty 105 5.5 A New Approach to Consumer Theory—the Demand for Characteristics 106 5.6 Empirical Demand Curves 107 CHAPTER 6 Theory of Production 118 6.1 Production With One Variable Input: Total, Average, and Marginal Product 118 6.2 The Shapes of the Average and Marginal Product Curves 119 6.3 Stages of Production 120 6.4 Production With Two Variable Inputs: Isoquants 121 6.5 The Marginal Rate of Technical Substitution 122 6.6 Characteristics of Isoquants 122 6.7 Isocosts 123 6.8 Producer Equilibrium 124 6.9 Expansion Path 124 6.10 Factor Substitution 125 6.11 Constant, Increasing, and Decreasing Returns To Scale 125 CHAPTER 7 Costs of Production 146 7.1 Short-Run Total Cost Curves 146 7.2 Short-Run Per-Unit Cost Curves 147 7.3 The Geometry of Short-Run Per-Unit Cost Curves 148 7.4 The Long-Run Average Cost Curve 149 7.5 The Shape of The Long-Run Average Cost Curve 150 7.6 The Long-Run Marginal Cost Curve 151 7.7 The Long-Run Total Cost Curve 152 7.8 The Cobb-Douglas Production Function 152  CONTENTS ix 7.9 X-Inefficiency 152 7.10 Technological Progress 153 Midterm Examination 179 CHAPTER 8 Price and Output Under Perfect Competition 184 8.1 Perfect Competition Defined 184 8.2 Price Determination in the Market Period 185 8.3 Short-Run Equilibrium of the Firm: Total Approach 185 8.4 Short-Run Equilibrium of the Firm: Marginal Approach 186 8.5 Short-Run Profit or Loss? 188 8.6 Short-Run Supply Curve 189 8.7 Long-Run Equilibrium of the Firm 189 8.8 Constant Cost Industries 190 8.9 Increasing Cost Industries 191 8.10 Decreasing Cost Industries 192 CHAPTER 9 Price and Output Under Pure Monopoly 212 9.1 Pure Monopoly Defined 212 9.2 The MR Curve and Elasticity 213 9.3 Short-Run Equilibrium Under Pure Monopoly: Total Approach 213 9.4 Short-Run Equilibrium Under Pure Monopoly: Marginal Approach 214 9.5 Long-Run Equilibrium Under Pure Monopoly 215 9.6 Regulation of Monopoly: Price Control 216 9.7 Regulation of Monopoly: Lump-Sum Tax 216 9.8 Regulation of Monopoly: Per-Unit Tax 217 9.9 Price Discrimination 218 CHAPTER 10 Price and Output Under Monopolistic Competition and Oligopoly 238 10.1 Monopolistic Competition Defined 238 10.2 Short-Run Equilibrium Under Monopolistic Competition 238 10.3 Long-Run Equilibrium Under Monopolistic Competition 239 10.4 Oligopoly Defined 239 10.5 The Cournot Model 240 10.6 The Edgeworth Model 240 10.7 The Chamberlin Model 241 x CONTENTS 10.8 The Kinked Demand Curve Model 241 10.9 The Centralized Cartel Model 242 10.10 The Market-Sharing Cartel Model 243 10.11 Price Leadership Model 243 10.12 Long-Run Equilibrium Under Oligopoly 244 CHAPTER 11 Recent and Advanced Topics in Market Structure 262 11.1 The Lerner Index as a Measure of a Firm’s Monopoly Power 262 11.2 The Herfindahl Index as Measure of Monopoly Power in an Industry 262 11.3 Contestable-Market Theory 262 11.4 Peak-Load Pricing 263 11.5 Cost-Plus Pricing 264 11.6 Transfer Pricing 264 CHAPTER 12 Game Theory and Oligopolistic Behavior 272 12.1 Game Theory: Definitions and Objectives 272 12.2 Dominant Strategy 272 12.3 Nash Equilibrium 273 12.4 The Prisoners’ Dilemma 273 12.5 Price and Nonprice Competition and Cartel Cheating 274 12.6 Repeated Games and Tit-For-Tat Strategy 274 12.7 Strategic Behavior 274 CHAPTER 13 Input Pricing and Employment 283 Perfect Competition in the Product and Input Markets 13.1 Profit Maximization and Least-Cost Input Combinations 283 13.2 The Demand Curve of the Firm for One Variable Input 283 13.3 The Demand Curve of the Firm for One of Several Variable Inputs 284 13.4 The Market Demand Curve for an Input 285 13.5 The Market Supply Curve for an Input 285 13.6 Pricing and Level of Employment of an Input 285 13.7 Rent and Quasi-Rent 286 Perfect Competition in the Market and Monopoly in the Product Market 13.8 Profit Maximization and Least-Cost Input Combinations 286 13.9 The Demand Curve of the Firm for One Variable Input 286  CONTENTS xi 13.10 The Demand Curve of the Firm for One of Several Variable Inputs 287 13.11 The Market Demand Curve and Input Pricing 287 Monopsony 13.12 Input Supply Curve and Marginal Resource Costs 288 13.13 Pricing and Employment for One Variable Input 289 13.14 Pricing and Employment of Several Variable Inputs 289 CHAPTER 14 General Equilibrium and Welfare Economics 312 General Equilibrium 14.1 Partial and General Equilibrium Analysis 312 14.2 General Equilibrium of Exchange 312 14.3 General Equilibrium of Production 313 14.4 The Transformation Curve 314 14.5 The Slope of the Transformation Curve 315 14.6 General Equilibrium of Production and Exchange 315 Welfare Economics 14.7 Welfare Economics Defined 316 14.8 The Utility-Possibility Curve 316 14.9 Grand Utility-Possibility Curve 317 14.10 The Social Welfare Function 317 14.11 The Point of Maximum Social Welfare 318 14.12 Perfect Competition and Economic Efficiency 318 14.13 Externalities and Market Failure 318 14.14 Public Goods 319 CHAPTER 15 The Economics of Information 336 15.1 The Economics of Search 336 15.2 Searching for The Lowest Price 336 15.3 Asymmetric Information: The Market for Lemons and Adverse Selection 337 15.4 Market Signaling 337 15.5 The Problem of Moral Hazard 337 15.6 The Principal-Agent Problem 338 15.7 The Efficiency Wage Theory 338 Final Examination 347 Index 351 This page intentionally left blank  SCHAUM’S OUTLINE OF MICROECONOMICS Fourth Edition This page intentionally left blank  CHAPTER 1 Introduction 1.1 THE PURPOSE OF THEORY The purpose of theory is to predict and explain. A theory is a hypothesis that has been successfully tested. A hypothesis is tested not by the realism of its assumption(s) but by its ability to predict accurately and explain, and also by showing that the outcome follows logically and directly from the assumptions. EXAMPLE 1. From talking to friends and neighbors, from observations in the butcher shop, and from our own behavior, we observe that when the price of a particular cut of meat rises, we buy less of it. From this casual real-world observation, we could construct the following general hypothesis: “If the price of a commodity rises, then the quantity demanded of the commodity declines.” In order to test this hypothesis and arrive at a theory of demand, we must go back to the real world to see whether this hypothesis is indeed true for various commodities, for various people, and at different points in time. Since these outcomes would follow logically and directly from the assumptions (i.e., consumers would want to substitute cheaper for more expensive commodities) we would accept the hypothesis as a theory. 1.2 THE PROBLEM OF SCARCITY The word scarce is closely associated with the word limited or economic as opposed to unlimited or free. Scarcity is the central fact of every society. EXAMPLE 2. Economic resources are the various types of labor, capital, land, and entrepreneurship used in producing goods and services. Since the resources of every society are limited or scarce, the ability of every society to produce goods and services is also limited. Because of this scarcity, all societies face the problems of what to produce, how to produce, for whom to produce, how to ration the commodity over time, and how to provide for the maintenance and growth of the system. In a free-enterprise economy (i.e., one in which the government does not control economic activity), all these problems are solved by the price mechanism (see Problems 1.5 to 1.9). 1.3 THE FUNCTION OF MICROECONOMIC THEORY Microeconomic theory, or price theory, studies the economic behavior of individual decision-making units such as consumers, resource owners, and business firms in a free-enterprise economy. EXAMPLE 3. During the course of business activity, firms purchase or hire economic resources supplied by households in order to produce the goods and services demanded by households. Households then use the income received from the sale of resources (or their services) to business firms to purchase the goods and services supplied by business firms. The “circular flow” of economic activity is now complete (see Problem 1.11). Thus, microeconomic theory, or price theory, studies the flow of goods and services from business firms to households, the composition of such a flow, and how the prices of goods and services in the flow are determined. It also studies the flow of the services of economic resources from resource 1 Copyright © 2006, 1992, 1983, 1974 by The McGraw-Hill Companies, Inc. Click here for terms of use. 2 INTRODUCTION [CHAP. 1 owners to business firms, the particular uses into which these resources flow, and how the prices of these resources are determined. 1.4 MARKETS, FUNCTIONS, AND EQUILIBRIUM A market is the place or context in which buyers and sellers buy and sell goods, services, and resources. We have a market for each good, service, and resource bought and sold in the economy. A function shows the relationship between two or more variables. It indicates how the value of one variable (the dependent variable) depends on and can be found by specifying the value of one or more other (indepen- dent) variables. Equilibrium refers to the market condition which once achieved, tends to persist. Equilibrium results from the balancing of market forces. EXAMPLE 4. The market demand function for a commodity gives the relationship between the quantity demanded of the commodity per time period and the price of the commodity (while keeping everything else constant). By substituting various hypothetical prices (the independent variable) into the demand function, we get the corresponding quantities demanded of the commodity per time period (the dependent variable) (see Problem 1.13). The market supply function for a commodity is an analogous concept—except that we now deal with the quantity supplied rather than the quantity demanded of the commodity (see Problem 1.14). EXAMPLE 5. The market equilibrium for a commodity occurs when the forces of market demand and market supply for the commodity are in balance. The particular price and quantity at which this occurs tend to persist in time and are referred to as the equilibrium price and the equilibrium quantity of the commodity (see Problem 1.15). 1.5 COMPARATIVE STATICS AND DYNAMICS Comparative statics studies and compares two or more equilibrium positions, without regard to the transi- tional period and process involved in the adjustment. Dynamics, on the other hand, deals with the time path and the process of adjustment itself. In this book we deal almost exclusively with comparative statics. EXAMPLE 6. Starting from a position of equilibrium, if the market demand for a commodity, its supply, or both vary, the original equilibrium will be disturbed and a new equilibrium usually will eventually be reached. Comparative statics studies and compares the values of the variables involved in the analysis at these two equilibrium positions (see Problem 1.17), while dynamic analysis studies how these variables change over time as one equilibrium position evolves into another. 1.6 PARTIAL EQUILIBRIUM AND GENERAL EQUILIBRIUM ANALYSIS Partial equilibrium analysis is the study of the behavior of individual decision-making units and the working of individual markets, viewed in isolation. General equilibrium analysis, on the other hand, studies the behavior of all individual decision-making units and all individual markets, simultaneously. This book deals primarily with partial equilibrium analysis. EXAMPLE 7. The change in the equilibrium condition of the commodity in Example 5 was examined only in terms of what happens in the market of that particular commodity. That is, we abstracted from all other markets by implicitly keeping everything else constant (the “ceteris paribus” assumption). We were then dealing with partial equilibrium analysis. However, when the equilibrium condition for this commodity changes, it will affect to a greater or lesser degree and directly or indirectly the market for every other commodity, service, and factor. This is examined in general equilibrium analysis in Chapter 14. 1.7 POSITIVE ECONOMICS AND NORMATIVE ECONOMICS Positive economics deals with or studies what is, or how the economic problems facing a society are actually solved. CHAP. 1] INTRODUCTION 3 Normative economics, on the other hand, deals with or studies what ought to be, or how the economic problems facing the society should be solved. This book deals primarily with positive economics. EXAMPLE 8. Suppose that a firm pollutes the air in the process of producing its output. If we study how much additional cleaning cost is imposed on the community by this pollution, we are dealing with positive economics. Suppose that the firm threatens to move out rather than pay for installing antipollution equipment. The community must then decide whether it will allow the firm to continue to operate and pollute, pay for the antipollution equipment itself, or just force the firm out with a resulting loss of jobs. In reaching these decisions, the community is dealing with normative economics. Glossary Comparative statics It studies and compares two or more equilibrium positions, without regard to the transitional period and process involved in the adjustment. Dynamics The study of the time path and process of adjustment to disequilibrium. Equilibrium The market condition which once achieved tends to persist. Function The relationship between two or more variables. General equilibrium analysis The study of the behavior of individual decision-making units and all individual markets simultaneously. Hypothesis An “if-then” statement usually obtained from a causal observation of the real world. Market The place or context in which buyers and sellers buy and sell goods, services, and resources. Microeconomic theory or price theory The study of the economic behavior of individual decision-making units such as consumers, resource owners, and business firms in a free-enterprise economy. Normative economics The study of what ought to be, or how the economic problems facing the society should be solved. Partial equilibrium analysis The study of the behavior of individual decision-making units and the working of indi- vidual markets, viewed in isolation. Positive economics The study of what is, or how the economic problems facing a society are actually solved. Scarce Limited, or economic (as opposed to unlimited, or free). Theory A hypothesis that has been successfully tested. Review Questions 1. A theory is (a) an assumption, (b) an “if-then” proposition, (c) a hypothesis, or (d ) a validated hypothesis. Ans. (d ) See Section 1.1 and Example 1. 2. A hypothesis is tested by (a) the realism of its assumption(s), (b) the lack of realism of its assumption(s), (c) its ability to predict accurately an outcome that follows logically from the assumption(s), or (d ) none of the above. Ans. (c) See Section 1.1 and Example 1. 4 INTRODUCTION [CHAP. 1 3. The meaning of the word “economic” is most closely associated with the word (a) free, (b) scarce, (c) unlimited, or (d ) unrestricted. Ans. (b) Economic factors and goods are those factors and goods which are scarce or limited in supply and thus command a price. 4. In a free-enterprise economy, the problems of what, how, and for whom are solved by (a) a planning committee, (b) the elected representatives of the people, (c) the price mechanism, or (d ) none of the above. Ans. (c) See Example 2. 5. Microeconomic theory studies how a free-enterprise economy determines (a) the price of goods, (b) the price of services, (c) the price of economic resources, or (d ) all of the above. Ans. (d ) Because microeconomic theory is primarily concerned with the determination of all prices in a free-enter- prise economy, it is often referred to as price theory. 6. A market (a) necessarily refers to a meeting place between buyers and sellers, (b) does not necessarily refer to a meeting place between buyers and sellers, (c) extends over the entire nation, or (d) extends over a city. Ans. (b) Because of modern communications, buyers and sellers need not come face to face with one another to buy and sell. The market for some commodities extends over a city or a section therein; the market for other commodities may extend over the entire nation or even the world. 7. A function refers to (a) the demand for a commodity, (b) the supply of a commodity, (c) the demand and supply of a commodity, service, or resource, or (d ) the relationship between one dependent variable and one or more indepen- dent variables. Ans. (d ) See Section 1.4. Demand functions and supply functions are examples of functions, but the term “func- tion” is a completely general term and refers to the relationship between any dependent variable and its correspond- ing independent variable(s). 8. The market equilibrium for a commodity is determined by (a) the market demand for the commodity, (b) the market supply of the commodity, (c) the balancing of the forces of demand and supply for the commodity, or (d ) any of the above. Ans. (c) See Section 1.4 and Example 5. 9. Which of the following is incorrect? (a) Microeconomics is concerned primarily with the problem of what, how, and for whom to produce. (b) Microeconomics is concerned primarily with the economic behavior of individual decision-making units when at equilibrium. (c) Microeconomics is concerned primarily with the time path and process by which one equilibrium position evolves into another. (d ) Microeconomics is concerned primarily with comparative statics rather than dynamics. Ans. (c) Choice c is the definition of dynamics. Dynamic microeconomics is still in its infancy. 10. Which of the following statements is most closely associated with general equilibrium analysis? (a) Everything depends on everything else. (b) Ceteris paribus. (c) The equilibrium price of a good or service depends on the balancing of the forces of demand and supply for that good or service. (d ) The equilibrium price of a factor depends on the balancing of the forces of demand and supply for that factor. CHAP. 1] INTRODUCTION 5 Ans. (a) General equilibrium analysis studies how the price of every good, service, and factors depends on the price of every other good, service, and factors. Thus, a change in any price will affect every other price in the system. 11. Which aspect of taxation involves normative economics? (a) the incidence of (i.e., who actually pays for) the tax, (b) the effect of the tax on incentives to work, (c) the “fairness” of the tax, or (d ) all of the above. Ans. (c) See Section 1.7. 12. Microeconomics deals primarily with (a) comparative statics, general equilibrium, and positive economics, (b) comparative statics, partial equilibrium, and normative economics, (c) dynamics, partial equilibrium, and positive economics, or (d ) comparative statics, partial equilibrium, and positive economics. Ans. (d ) See Sections 1.5 to 1.7. Solved Problems THE PURPOSE OF THEORY 1.1 (a) What is the purpose of theory? (b) How do we arrive at a theory? (a) The purpose of theory—not just economics theory but theory in general—is to predict and explain. That is, a theory abstracts from the details of an event; it simplifies, generalizes, and seeks to predict and explain the event. (b) The first step in the process of arriving at an acceptable theory is the construction of a model or a hypothesis. A hypothesis is an “if-then” statement which is usually obtained from a casual observation of the real world. Inferences are then drawn from the hypothesis. If these inferences do not conform to reality, the hypothesis is discarded and a new one is formulated. If the inferences do conform to reality, the hypothesis is accepted as a theory (if it can also be shown that the outcome follows logically and directly from the assumptions). 1.2 (a) What is likely to happen to the quantity supplied of a particular cut of meat when its price rises? (b) Express your answer to part (a) as a general hypothesis of the relationship between the price and the quantity supplied of any commodity. (c) What must we do in order to arrive at a theory of production? (a) When the price of a particular cut of meat rises, its quantity supplied is likely to increase (if a sufficiently long period of time is allowed for farmers to respond). (b) The general hypothesis relating the quantity supplied of any commodity to its price can be stated as follows: “If the price of a commodity rise, then more of it will be supplied per time period, ceteris paribus.” (Ceteris paribus means holding everything else constant.) In the rest of book we will use the word “commodity” to refer to goods (meat, milk, suit, shoes, automobiles, etc.) and services (such as housing, communication, trans- portation, medical, recreational and other services or intangibles). (c) Suppose that through an investigation of the real-world behavior of many farmers (not just meat producers) and other producers, we find that, ceteris paribus, they do indeed increase the quantity of the commodity that they supply when the price of the commodity rises. Since we can also logically understand why a producer would want to increase the quantity supplied of the commodity when its price rises (because the producer’s profits increase), we would then accept the hypothesis of part (b) as a theory. (As we will see in Chapter 6, however, a complete theory of production involves much more than this.) 6 INTRODUCTION [CHAP. 1 1.3 Distinguish between (a) a hypothesis, (b) a theory, and (c) a law. (a) A hypothesis is an “if-then” proposition usually constructed from a casual observation of a real-world event which represents a tentative and yet untested explanation of the event. (b) A theory implies that some successful tests of the corresponding hypothesis have already been undertaken. Thus, a theory implies a greater likelihood of truth than a hypothesis. The greater the number of successful tests (and lack of unsuccessful ones), the greater the degree of confidence we have in the theory. (c) A law is a theory which is always true under the same set of circumstances, as, for example, the law of gravity. THE PROBLEM OF SCARCITY 1.4 Distinguish between (a) economic resources and (b) noneconomic resources. (a) Economic resources, factors of production, or inputs refer to the services of the various types of labor, capital equipment, land (or natural resources), and (in a world of uncertainty) entrepreneurship. Since in every society these resources are not unlimited in supply but are limited or scarce, they command a price (i.e., they are economic resources). (b) Economic resources can be contrasted with noneconomic resources such as air, which (in the absence of pol- lution) is unlimited in supply and free. In economics, our interest lies with economic resources, rather than with noneconomic resources. 1.5 (a) Why is “what to produce” a problem in every economy? (b) How does the price mechanism solve this problem in a free-enterprise economy? (c) In a mixed enterprise economy? (d) In a centralized economy? (a) “What to produce” refers to thoese goods and services and the quantity of each that the economy should produce. Since resources are scarce or limited, no economy can produce as much of every good or service as desired by all members of society. More of one good or service usually means less of others. Therefore, every society must choose exactly which goods and services to produce and how much of each to produce. (b) In a free-enterprise economy, the “what to produce” problem is solved by the price mechanism. Only those commodities for which consumers are willing to pay a price per unit sufficiently high to cover at least the full cost of producing them will be supplied by producers in the long run. By paying a higher price, consumers can normally induce producers to increase the quantity of a commodity that they supply per unit of time. On the other hand, a reduction in price will normally result in a reduction in the quantity supplied. (c) In a mixed-enterprise economy such as ours, the government (through taxes, subsidies, etc.) modifies and, in some instances (through direct controls), replaces the operation of the price mechanism in its function of deter- mining what to produce. (d ) In a completely centralized economy, the dictator, or more likely a planning committee appointed by the dic- tator or the party, determines what to produce. We in the West believe that this is inefficient. Even the Soviet Union (never a completely centralized economy) has been moving recently toward more decentralized control of the economy and toward greater reliance on the price mechanism to decide what to produce. 1.6 (a) Why is “how to produce” a problem in every economy? (b) How does the price mechanism solve this problem in a free-enterprise economy? (c) In a mixed-enterprise economy? (d) In a centralized economy? (a) “How to produce” refers to the choice of the combination of factors and the particular technique to use in pro- ducing a good or service. Since a good or service can normally be produced with different factor combinations and different techniques, the problem arises as to which of these to use. Since resources are limited in every economy, when more of them are used to produce some goods and services, less are available to produce others. Therefore, society faces the problem of choosing the technique which results in the least possible cost (in terms of resources used) to produce each unit of the good or service it wants. (b) In a free-enterprise economy, the “how to produce” problem is solved by the price mechanism. Because the price of a factor normally represents its relative scarcity, the best technique to use in producing a good or service is the one that results in the least dollar cost of production. If the price of a factor rises in relation CHAP. 1] INTRODUCTION 7 to the price of others used in the production of the good or service, producers will switch to a technique which uses less of the more expensive factor in order to minimize their costs of production. The opposite occurs when the price of a factor falls in relation to the price of others. (c) In a mixed-enterprise economy, the operation of the price mechanism in solving the “how to produce” problem is modified and sometimes replaced by a government action. (d ) In a centralized economy, this problem is solved by a planning committee. 1.7 (a) Why is “for whom to produce” a problem in every economy? (b) How does the price mechanism solve this problem? (c) Why does the government in a mixed-enterprise economy modify the operation of the price mechanism in its function of determining for whom to produce? (a) “For whom to produce” refers to how the total output is to be divided among different consumers. Since resources and thus goods and services are scarce in every economy, no society can satisfy all the wants of all its people. Thus, a problem of choice arises. (b) In the absence of government regulation or control of the economy, the problem of “for whom to produce” is also solved by the price mechanism. The economy will produce those commodities that satisfy the wants of those people who have the money to pay for them. The higher the income of an individual, the more the economy will be geared to produce the commodities the consumers want (if they are also willing to pay for them). (c) In the name of equity and fairness, governments usually modify the workings of the price mechanism by taking from the rich (through taxation) and redistributing to the poor (through subsidies and welfare pay- ments). They also raise taxes in order to provide for certain “public” goods, such as education, law and other, and defense. 1.8 (a) Identify the two types of rationing that the price mechanism performs over the time in which the supply of a commodity is fixed, (b) explain how the price mechanism performs the first of these two rationing functions, and (c) explain how the price mechanism performs its second rationing function. (a) In a free-enterprise economy, the price mechanism performs two closely related types of rationing. First, it restricts the total level of consumption to the available output. Second, it restricts the current level of consump- tion so the commodity will last for the entire time period over which its supply is fixed. (b) The price mechanism performs the first rationing as follows: If the prevailing price of a commodity would lead to a shortage of the commodity, that price would rise. At higher prices, consumers would buy less and pro- ducers would supply more of the commodity until the total level of consumption equaled the available output. The opposite would occur if the prevailing price of the commodity would lead to a surplus of the com- modity. Thus, the price mechanism restricts the total level of consumption to the available production. (c) The price of a commodity such as wheat is not so low immediately after harvest as to lead to the exhaustion of the entire amount of wheat available before the next harvest. Thus, the price mechanism rations a commodity over the entire time period during which its supply is fixed. 1.9 (a) In a free-enterprise economy, how does the price mechanism provide for the maintenance of the economic system? (b) How does it provide for economic growth? (c) Why and how does the govern- ment attempt to influence the nation’s rate of economic growth? (a) The maintenance of the economic system is accomplished by providing for the replacement of the machinery, buildings, etc., that are used up in the course of producing the current outputs. In a free-enterprise economy, output prices are usually sufficiently high to allow producers not only to cover their day-to-day production expenditures but also to replace depreciating capital goods. (b) Economic growth refers to increases in real per capita income. An economy’s rate of economic growth depends on the rate of growth of its resources and on the rate of improvement in its techniques of production or technology. In a free-enterprise economy, it is the price mechanism that to a large extent determines the rate of economic growth. For example, the prospect of higher wages motivates labor to acquire more skills. Capital accumulation and technological improvements also respond to expectations of profits. 8 INTRODUCTION [CHAP. 1 (c) In the modern world, governments have made economic growth one of their top priorities. Economic growth is often wanted for its own sake. This is true for developed and underdeveloped nations, regardless of their form of organization. Serious concern for the environment has only been voiced recently. Governments have used tax incentives, subsidies, sponsored basic research, etc., to stimulate economic growth. THE FUNCTION OF MICROECONOMIC THEORY 1.10 (a) Distinguish between microeconomics and macroeconomics. (b) What basic underlying assumption is made in studying microeconomics? (a) Microeconomic theory or price theory deals with the economic behavior of individual decision-making units such as consumers, resource owners, and business firms as well as individual markets in a free-enterprise economy. This is to be contrasted with macroeconomic theory, which studies the aggregate levels of output, national income, employment, and prices for the economy viewed as a whole. (b) In studying microeconomic theory, the implicit assumption is made that all economic resources are fully employed. This does not preclude the possibility of temporary disturbances, but monetary and fiscal policies are supposed to assure us a tendency toward full employment without inflation. During periods of great unemployment and inflation, microeconomics is overshadowed by the aggregate problems. 1.11 (a) Draw a diagram showing the direction of the flows of goods, services, resources, and money between business firms and households. (b) Explain why what is a cost to households represents income for business firms, and vice versa. (a) A simple schematic model of the economy is shown in Fig. 1-1. Fig. 1-1 (b) The top loop in Fig. 1-1 shows that households purchase goods and services from business firms. Thus, what is a cost or a consumption expenditure from the point of view of households represents the income or the money receipts of business firms. On the other hand, the bottom loop shows that business firms purchase the services of economic resources from households. Thus, what is a cost of production from the point of view of business firms represents the money income of households. 1.12 (a) With which of the five problems faced by every society is microeconomics primarily concerned? (b) With reference to the circular-flow diagram in Problem 1.11, explain how the prices of goods, services, and resources are determined in a free-enterprise economy. (a) Of the five problems faced by every society, microeconomics is concerned primarily with the first three (i.e., what to produce, how to produce, and for whom to produce). The crucial step in solving these problems is the determination of the prices of the goods, services, and economic resources that enter the flows shown in the diagram of Problem 1.11 (hence the name “price theory”). CHAP. 1] INTRODUCTION 9 (b) Households give rise to the demand for goods and services, while business firms respond by supplying goods and services. The demand and the supply of each good and service determine its price. In order to produce goods and services, business firms demand economic resources or their services. These are supplied by house- holds. The demand and supply of each factor then determine its price. In microeconomics we study some of the best available models that explain and predict the behavior of individual decision-making units and prices. The empirical testing of these models is examined in other courses. MARKETS, FUNCTIONS, AND EQUILIBRIUM 1.13 Suppose that (keeping everything else constant) the demand function of a commodity is given by QD ¼ 6000 2 1000P, where QD stands for the market quantity demanded of the commodity per time period and P for the price of the commodity. (a) Derive the market demand schedule for this com- modity. (b) Draw the market demand curve for this commodity. (a) By substituting various prices for the commodity into its market demand function, we get the market demand schedule for the commodity as shown in Table 1.1. Table 1.1 Price ($) 1 2 3 4 5 6 Quantity Demanded 5000 4000 3000 2000 1000 0 ( per unit of time) (b) By plotting each pair of price-quantity values in the above market demand schedule as a point on a graph and joining the resulting points, we get the corresponding market demand curve for this commodity shown in Fig. 1-2. Fig. 1-2 (A more detailed discussion of demand functions, demand schedules, and demand curves is presented in Sections 2.1 to 2.4.) 1.14 Suppose that (keeping everything else constant) the supply function for the commodity in Problem 1.13 is given by QS ¼ 1000P, where QS stands for the market quantity supplied of the commodity per time period and P for the price of the commodity. (a) Derive the market supply schedule for this commodity and (b) draw the market supply curve for this commodity. (a) By substituting various prices for the commodity into its market supply function, we get the market supply schedule for this commodity as shown in Table 1.2. 10 INTRODUCTION [CHAP. 1 Table 1.2 Price ($) 0 1 2 3 4 5 6 Quantity Supplied 0 1000 2000 3000 4000 5000 6000 (per unit of time) (b) By plotting each pair of price-quantity values in Table 1.2 as a point on a graph and joining the resulting points, we get the corresponding market supply curve for this commodity shown in Fig. 1-3. Fig. 1-3 (A more detailed discussion of supply functions, supply schedules, and supply curves is presented in Sections 2.2 to 2.8.) 1.15 (a) On one set of axes, redraw the market demand curve of Problem 1.13 and the market supply curve of Problem 1.14. (b) At what point are demand and supply in equilibrium? Why? (c) Starting from a position at which this market is not in equilibrium, indicate how equilibrium is reached. (a) Fig. 1-4 (b) Demand and supply are in equilibrium when the market demand curve intersects the market supply curve for the commodity. Thus, at the price of $3, the quantity demanded of this commodity in the market is 3000 units per time period. This equals the quantity supplied at the price of $3. As a result, there is no tendency for the price and the quantity bought and sold of this commodity to change. The price of $3 and the quantity of 3000 units represent, respectively, the equilibrium price and the equilibrium quantity of this commodity. CHAP. 1] INTRODUCTION 11 (c) At P. $3, QS. QD and a surplus of the commodity develops. This will cause P to fall toward $3. At P , $3, QD. QS and a shortage of the commodity develops. This will push P up toward $3 (the symbol “.” means “larger than,” while “,” means “smaller than”). (A more detailed discussion of equilibrium is presented in Sections 2.9 to 2.11.) COMPARATIVE STATICS AND DYNAMICS 1.16 In what aspect of the variable involved in the analysis is (a) comparative statics interested? (b) dynamics interested? (a) Comparative statics is interested only in the equilibrium values of the variables involved in the analysis. In microeconomics, these are the equilibrium price and the equilibrium quantity. Comparative statics thus implies an instantaneous adjustment to disturbances to equilibrium. (b) Dynamics on the other hand, studies the movement over time of the variables involved in the analysis, as one equilibrium position evolves into another. More specifically, dynamic microeconomics studies how the price and quantity of a commodity change during the period of adjustment from one equilibrium point to another. 1.17 Suppose that the demand function for the commodity in Problem 1.13 changes to QD0 ¼ 8000 – 1000P. (a) Define the new market demand schedule for the commodity. (b) Draw the new market demand curve on a figure identical to that in Problem 1.15. (c) What are the new equilibrium price and quantity for this commodity? (a) Table 1.3 Price ($) 1 2 3 4 5 6 7 8 QD 0 7000 6000 5000 4000 3000 2000 1000 0 (b) Fig. 1-5 (c) The new equilibrium price is $4 and the new equilibrium quantity is 4000 units per time period. Comparative statics compares the value of P and Q at equilibrium points E and E 0. 12 INTRODUCTION [CHAP. 1 PARTIAL EQUILIBRIUM AND GENERAL EQUILIBRIUM ANALYSIS 1.18 (a) How does partial equilibrium analysis deal with the interconnections that exist between the various markets in the economy? (b) How does general equilibrium analysis deal with them? (c) Why do we deal primarily with partial analysis? (a) In partial equilibrium analysis, we isolate for study specific decision-making units and markets, and abstract from the interconnections that exist between them and the rest of the economy. More specifically, we assume that the changes in the equilibrium conditions in our market do not affect any of the other markets in the economy and that changes in other markets do not affect the market under consideration. (b) General equilibrium analysis examines the interconnections that exist among all decision-making units and markets, and shows how all parts of the economy are linked together into an integrated system. Thus, a change in the equilibrium conditions in one market will affect the equilibrium conditions in every other market, and these will themselves cause additional changes in or affect the market in which the process orig- inally started. The economy will be in general equilibrium when all of these effects have worked themselves out and all markets are simultaneously in equilibrium. (c) General equilibrium analysis is very complicated and time-consuming. We deal primarily with partial equili- brium analysis to keep the analysis manageable. Partial equilibrium analysis gives a first approximation to the results wanted. This approximation is better (and partial analysis more useful), the weaker the links between the market under study and the rest of the economy. 1.19 Suppose that the demand for commodity X rises in an economy in which there is no economic growth, and which is originally in general equilibrium. Discuss what happens (a) in the commodity markets and (b) in the factor markets. (a) If, from an initial position of general equilibrium in the economy, the demand for commodity X rises, a new and higher equilibrium point for the commodity will be defined (see Problem 1.17). If we were interested in partial equilibrium analysis, we would stop at this point. However, the rise in the demand for commodity X will cause an increase in the demand for those commodities which are used together with X and a fall in the demand for the commodities which are substitutes for X. Thus, the equilibrium position of commodity X and its complements and substitutes will change. (b) Some of this society’s resources will shift from the production of substitutes of X to the production of more of commodity X and its complements. This affects the income distribution of factors of production which, in turn, will affect the demand of every commodity and factor in the economy. Thus, every market is affected by the initial change in the demand for X. In the next 10 chapters, we will deal with partial equilibrium analy- sis, and a very simple general equilibrium model of the economy (and its welfare implications) will be presented in Chapter 14. POSITIVE AND NORMATIVE ECONOMICS 1.20 (a) Are ethical or value judgments involved in positive economics? (b) What is the relation between positive and normative economics? (a) Positive economics is devoid of any ethical position or value judgment, is primarily empirical or statistical in nature, and is independent of normative economics. (b) Normative economics, on the other hand, is based on positive economics and the value judgments of the society. It provides guidelines for policies to increase and possibly maximize the social welfare. 1.21 What aspects of minimum wage regulations deal with (a) positive economics? (b) normative economics? (a) The study of the actual or anticipated effect of minimum wage regulations on the economy is a study in posi- tive economics. It involves the examination of which occupations (mostly unskilled) are or will be affected by the regulations, the extent of substitution of capital equipment for labor in production, which communities are or will be most affected, and what happens to the displaced workers. CHAP. 1] INTRODUCTION 13 (b) Having studied the actual or anticipated effect of minimum wages on the economy, society must decide if the trade-off between higher wages for some but less opportunity of employment for others is acceptable. At the same time, society must decide how much more taxes it wants to impose on the working population to raise the money to cover the resulting additional welfare payments for early retirement or for retraining the displaced workers. To answer these questions, society must make value judgments. (Welfare questions of this type will often be in the background of our discussion in subsequent chapter. A formal introduction to welfare economics will be presented in Chapter 14.)  CHAPTER 2 Demand, Supply, and Equilibrium: An Overview 2.1 THE INDIVIDUAL’S DEMAND FOR A COMMODITY The quantity of a commodity that an individual is willing to purchase over a specific time period is a func- tion of or depends on the price of the commodity, the person’s money income, the prices of other commodities, and individual tastes. By varying the price of the commodity under consideration while keeping constant the individual’s money income and tastes and the prices of other commodities (the assumption of ceteris paribus), we get the individual’s demand schedule for the commodity. The graphic representation of the individual’s demand schedule gives us that person’s demand curve. EXAMPLE 1. Suppose that an individual’s demand function for commodity X is Qdx ¼ 8 2 Px ceteris paribus. By sub- stituting various prices of X into this demand function, we get the individual’s demand schedule shown in Table 2.1. The individual’s demand schedule for commodity X shows the alternative quantities of commodity X that the person is willing to purchase at various alternative prices for commodity X, while keeping everything else constant. Table 2.1 Px ($) 8 7 6 5 4 3 2 1 0 Qdx 0 1 2 3 4 5 6 7 8 EXAMPLE 2. Plotting each pair of values as a point on a graph and joining the resulting points, we get the individual’s demand curve for commodity X (which will be referred to as dx) shown in Fig. 2-1. The demand curve in Fig. 2-1 shows that at a particular point in time, if the price of X is $7, the individual is willing to purchase one unit of X over the period of time specified. (The time period specified may be a week, a month, a year, or any other “relevant” length of time.) If the price of X is $6, the individual is willing to purchase two units of X over the specified time period, and so on. Thus, the points on the demand curve represent alternatives as seen by the individual at a particular point in time. 14 Copyright © 2006, 1992, 1983, 1974 by The McGraw-Hill Companies, Inc. Click here for terms of use. CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 15 Fig. 2-1 2.2 THE LAW OF NEGATIVELY SLOPED DEMAND In the demand schedule of Table 2.1, we see that the lower the price of X, the greater the quantity of X demanded by the individual. This inverse relationship between price and quantity is reflected in the negative slope of the demand curve of Fig. 2-1. With the exception of a very rare case (to be discussed in Chapter 4), the demand curve always slopes downward, indicating that at lower prices of a commodity, more of it is purchased. This is usually referred to as the law of demand. 2.3 SHIFTS IN THE INDIVIDUAL’S DEMAND CURVE When any of the ceteris paribus conditions changes, the entire demand curve shifts. This is referred to as a change in demand as opposed to a change in the quantity demanded, which is movement along the same demand curve. EXAMPLE 3. When an individual’s money income rises (while everything else remains constant), the person’s demand for a commodity usually increases (i.e., the individual’s demand curve shifts up), indicating that at the same price that person will purchase more units of the commodity per unit of time. Thus, if the individual’s money income rises, the individual’s demand curve for steaks will shift up so that at the unchanged steak price, that person will purchase more steaks per month. Steak is called a normal good. There are, however, some commodities (such as bread and potatoes) whose demand curve usually shifts down when the individual’s income rises. These are called inferior goods. EXAMPLE 4. A change in the individual’s tastes for a commodity also causes a shift in that person’s demand curve for the commodity. For example, a greater desire on the part of an individual to consume ice cream causes an upward shift in the individual’s demand curve for ice cream. A reduced desire is reflected in a downward shift. Similarly, the individual’s demand curve for a commodity shifts up when the price of a substitute commodity rises, but shifts down when the price of a complement (a commodity used together with the one considered) rises. Thus, the demand for tea shifts up when the price of coffee (a substitute) rises but shifts down when the price of lemons (a complement of tea) rises (see Problems 2.7, 2.8, and 2.9). 2.4 THE MARKET DEMAND FOR A COMMODITY The market or aggregate demand for a commodity gives the alternative amounts of the commodity demanded per time period, at various alternative prices, by all the individuals in the market. The market demand for a commodity thus depends on all the factors that determine the individual’s demand and, in addition, on the number of buyers of the commodity in the market. Geometrically, the market demand 16 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 curve for a commodity is obtained by the horizontal summation of all the individuals’ demand curves for the commodity. EXAMPLE 5. If there are two identical individuals (1 and 2) in the market, each with a demand for commodity X given by Qdx ¼ 8 2 Px (see Example 1), the market demand (QDx) is obtained as indicated in Table 2.2 and Fig. 2-2. Table 2.2 Px ($) Qd1 Qd2 QDx 8 0 0 0 4 4 4 8 0 8 8 16 Fig. 2-2 EXAMPLE 6. If there are 1000 identical individuals in the market, each with the demand for commodity X given by Qdx ¼ 8 – Px ceteris paribus (cet. par.), the market demand schedule and the market demand curve for commodity X are obtained as follows (see also Table 2.3 and Fig. 2-3): Qdx ¼ 8
Px cet: par: (individual’s d x ) QDx ¼ 1000(Qdx ) cet: par: (market Dx ) ¼ 8000
1000Px Table 2.3 Px ($) Qdx 8 0 7 1000 6 2000 5 3000 4 4000 3 5000 2 6000 1 7000 0 8000 Fig. 2-3 The market demand curve for commodity X (Dx) will shift when the individual’s demand curves shift (unless the shifts of the latter neutralize each other) and will change with time as the number of consumers in the market for X changes. CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 17 2.5 THE SINGLE PRODUCER’S SUPPLY OF A COMMODITY The quantity of a commodity that a single producer is willing to sell over a specific time period is a function of or depends on the price of the commodity and the producer’s costs of production. In order to get a producer’s supply schedule and supply curve of a commodity, certain factors which influence costs of production must be held constant (ceteris paribus). These are technology, the prices of the inputs necessary to produce the commodity, and for agricultural commodities, climate and weather conditions. By keeping all of the above factors constant while varying the price of the commodity, we get the individual producer’s supply schedule and supply curve. EXAMPLE 7. Suppose that a single producer’s supply function for commodity X is Qsx ¼ – 40 þ 20Px cet. par. By substituting various “relevant” prices of X into this supply function, we get the producer’s supply schedule shown in Table 2.4. Table 2.4 Px ($) QSx 6 80 5 60 4 40 3 20 2 0 Fig. 2-4 EXAMPLE 8. Plotting each pair of values from the supply schedule in Table 2.4 on a graph and joining the resulting points, we get the producer’s supply curve (see Fig. 2-4). As in the case of demand, the points on the supply curve represent alternatives as seen by the producer at a particular point in time. 2.6 THE SHAPE OF THE SUPPLY CURVE In the supply schedule of Table 2.4, we see that the lower the price of X, the smaller the quantity of X offered by the supplier. The reverse is, of course, also true. This direct relationship between price and quantity is reflected in the positive slope of the supply curve in Fig. 2-4. However, while in the case of the demand curve we can talk about “the law of negatively sloped demand,” in the case of the supply curve we cannot talk of “the law of positively sloped supply.” Even though the supply curve is usually positively sloped, it could also have a zero, infinite, or even negative slope, and no generalizations are possible. 2.7 SHIFTS IN THE SINGLE PRODUCER’S SUPPLY CURVE When the factors that we kept constant in defining a supply schedule and a supply curve (the ceteris paribus condition) change, the entire supply curve shifts. This is referred to as a change or shift in supply and must be clearly distinguished from a change in the quantity supplied (which is a movement along the same supply curve). EXAMPLE 9. If there is an improvement in technology (so that the producer’s costs of production fall) the supply curve shifts downward. Thus downward shift is referred to as an increase in supply. It means that at the same price for the commodity, the producer offers more of it for sale per time period (see Problems 2.14 and 2.15). 18 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 2.8 THE MARKET SUPPLY OF A COMMODITY The market or aggregate supply of a commodity gives the alternative amounts of the commodity supplied per time period at various alternative prices by all the producers of this commodity in the market. The market supply of a commodity depends on all the factors that determine the individual producer’s supply and, in addition, on the number of producers of the commodity in the market. EXAMPLE 10. If there are 100 identical producers in the market, each with a supply of commodity X given by Qsx ¼
40 þ 20Px cet: par. (see Example 7), the market supply (QSx ) is obtained as follows (see also Table 2.5 and Fig. 2-5): Qsx ¼
40 þ 20Px cet: par: (single producer’s sx ) QSx ¼ 100(Qsx ) cet: par: (market Sx ) ¼
400 þ 2000Px Table 2.5 Px ($) QSx 6 8000 5 6000 4 4000 3 2000 2 0 Fig. 2-5 The market supply curve (Sx) will shift when the individual producer’s supply curves shift and when, over time, some pro- ducers enter or leave the market. 2.9 EQUILIBRIUM Equilibrium refers to the market condition which, once achieved, tends to persist. In economics this occurs when the quantity of a commodity demanded in the market per unit of time equals the quantity of the commod- ity supplied to the market over the same time period. Geometrically, equilibrium occurs at the intersection of the commodity’s market demand curve and market supply curve. The price and quantity at which equilibrium exists are known, respectively, as the equilibrium price and the equilibrium quantity. EXAMPLE 11. From the market demand curve of Example 6 and the market supply curve of Example 10, we can deter- mine the equilibrium price and the equilibrium quantity for commodity X as shown in Table 2.6 and Fig. 2-6. At the equili- brium point, there exists neither a surplus nor a shortage of the commodity and the market clears itself. Ceteris paribus, the equilibrium price and the equilibrium quantity tend to persist in time. Table 2.6 Px ($) QDx QSx 6 2000 8000 5 3000 6000 4 4000 4000 Equilibrium 3 5000 2000 2 6000 0 CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 19 Fig. 2-6 EXAMPLE 12 Since we know that at equilibrium QDx ¼ QSx , we can determine the equilibrium price and the equili- brium quantity mathematically: QDx ¼ QSx 8000
1000Px ¼
4000 þ 2000Px 12,000 ¼ 3000Px Px ¼ $4 (equilibrium price) Substituting this equilibrium price either into the demand equation or into the supply equation, we get the equilibrium quantity. QDx ¼ 8000
1000(4) or QSx ¼
4000 þ 2000(4) ¼ 8000
4000 ¼
4000 þ 8000 ¼ 4000 (units of X) ¼ 4000 (units of X) 2.10 TYPES OF EQUILIBRIA An equilibrium condition is said to be stable if any deviation from the equilibrium will bring into operation market forces which push us back toward equilibrium (see Example 13). If instead we move further away from equilibrium, we have a situation of unstable equilibrium. For unstable equilibrium to occur, the market supply curve must be negatively sloped and less steeply inclined than the (negatively sloped) market demand curve (see Problem 2.19). EXAMPLE 13. The equilibrium condition for commodity X shown in Table 2.6 and Fig. 2-6 of Example 11 is stable. This is because, if for some reason the price of X rises above the equilibrium price of $4, QSx. QDx and a surplus of commodity X arises which will automatically push us back toward the equilibrium price of $4. Similarly, if the price of X falls below the equilibrium price, the resulting shortage will automatically cause the price of X to rise toward its equilibrium level. 2.11 SHIFTS IN DEMAND AND SUPPLY, AND EQUILIBRIUM If the market demand curve, the market supply curve, or both shift, the equilibrium point will change. Ceteris paribus, an increase in demand (an upward shift) causes an increase in both the equilibrium price and the equilibrium quantity. On the other hand, given the market demand for a commodity, an increase in the market supply (a downward shift in supply) causes a reduction in the equilibrium price but an increase in the equilibrium quantity. The opposite occurs for a decrease in demand or supply. If both the market demand and the market supply increase, the equilibrium quantity rises but the equilibrium price may rise, fall or remain unchanged (see Problem 2.23). 20 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 Glossary Change in demand A shift in the entire demand curve of a commodity resulting from a change in the individual’s money income or tastes, or prices of other commodities. Change in the quantity demanded A movement along a given demand curve for a commodity as a result of a change in its price. Change in the quantity supplied A movement along a given supply curve for a commodity as a result of a change in its price. Change in supply A shift in the entire supply curve of a commodity resulting from a change in technology, the prices of the inputs necessary to produce the commodity, and (for agricultural commodities) climate and weather conditions. Equilibrium The market condition which, once achieved, tends to persist. This occurs when the quantity of a commodity demanded equals the quantity supplied to the market. Law of demand The inverse relationship between price and quantity reflected in the negative slope of a demand curve. Stable equilibrium The type of equilibrium where any deviation from equilibrium brings into operation market forces which push us back toward equilibrium. Unstable equilibrium The type of equilibrium where any deviation from the equilibrium position brings into operation forces which push us further away from equilibrium. Review Questions 1. In drawing an individual’s demand curve for a commodity, all but which one of the following are kept constant? (a) The individual’s money income, (b) the price of other commodities, (c) the price of the commodity under consideration, or (d ) the tastes of the individual. Ans. (c) See Section 2.1. 2. The individual’s demand curve for a commodity represents (a) a maximum boundary of the individual’s intentions, (b) a minimum boundary of the individual’s intentions, (c) both a maximum and a minimum boundary of the individual’s intentions, or (d ) neither a maximum nor a minimum boundary of the individual’s intentions. Ans. (a) For the various alternative prices of a commodity, the demand curve shows the maximum quantities of the commodity the individual intends to purchase per unit of time (one will take less if that is all one can get). We could similarly say that for various alternative quantities of a commodity per time period, the demand curve shows the maximum prices the individual is willing to pay. 3. A fall in the price of a commodity, holding everything else constant, results in and is referred to as (a) an increase in demand, (b) a decrease in demand, (c) an increase in the quantity demanded, or (d ) a decrease in the quantity demanded. Ans. (c) See Section 2.3. 4. When an individual’s income rises (while everything else remains the same), that person’s demand for a normal good (a) rises, (b) falls, (c) remains the same, or (d ) any of the above. Ans. (a) See Section 2.3. 5. When an individual’s income falls (while everything else remains the same), that person’s demand for an inferior good (a) increases, (b) decreases, (c) remains unchanged, or (d ) we cannot say without additional information. Ans. (a) See Section 2.3. CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 21 6. When the price of a substitute of commodity X falls, the demand for X (a) rises, (b) falls, (c) remains unchanged, or (d ) any of the above. Ans. (b) See Section 2.3. 7. When both the price of a substitute and the price of a complement of commodity X rise, the demand for X (a) rises, (b) falls, (c) remains unchanged, or (d ) all of the above are possible. Ans. (d ) An increase in the price of a substitute, by itself, causes an increase in the demand for X. An increase in the price of a complement, by itself, causes a decrease in the demand for X. When both the price of a substitute and the, price of a complement of commodity X rise, the demand curve for X can rise, fall, or remain unchanged depending on the relative strength of the two opposing forces. 8. In drawing a farmer’s supply curve for a commodity, all but which one of the following are kept constant? (a) Technology, (b) the prices of inputs, (c) features of nature such as climate and weather conditions, or (d ) the price of the commodity under consideration. Ans. (d ) See Section 2.5. 9. A producer’s positively sloped supply curve for a commodity represents (a) a maximum boundary of the producer’s intentions, (b) a minimum boundary of the producer’s intentions, (c) in one sense a maximum and in another sense a minimum boundary of the producer’s intentions, or (d ) none of the above. Ans. (c) For various alternative prices of a commodity, the supply curve shows the maximum quantities of the commodity the producer intends to offer per unit of time. On the other hand, for various alternative quantities of the commodity per time period, the supply curve shows the minimum prices the producer must be given to offer the specified quantities. 10. If the supply curve of a commodity is positively sloped, a rise in the price of the commodity, ceteris paribus, results in and is referred to as (a) an increase in supply, (b) an increase in the quantity supplied, (c) a decrease in supply, or (d ) a decrease in the quantity supplied. Ans. (b) See Section 2.7. 11. When the market supply curve for a commodity is negatively sloped, we have a case of (a) stable equilibrium, (b) unstable equilibrium, or (c) any of the above is possible and we cannot say without additional information. Ans. (c) See Section 2.10. 12. If, from a position of stable equilibrium, the market supply of a commodity decreases while the market demand remains unchanged, (a) the equilibrium price falls, (b) the equilibrium quantity rises, (c) both the equilibrium price and the equilibrium quantity decrease, or (d ) the equilibrium price rises but the equilibrium quantity falls. Ans. (d ) A decrease in the market supply of a commodity refers to an upward shift in the market supply curve. With an unchanged market demand curve for the commodity, the new equilibrium point will be higher and to the left of the previous equilibrium point. This involves a higher equilibrium price but a lower equilibrium quantity than before. Solved Problems DEMAND 2.1 (a) Express in simple mathematical language what was discussed in Section 2.1. (b) How do we arrive at the expression Qdx ¼ f (Px ) cet. par.? 22 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 (a) What was said in Section 2.1 can be expressed in simple mathematical language as follows: Qdx ¼ f (Px , M, P0 , T) where Qdx ¼ the quantity of commodity X Px ¼ the price of commodity X demanded by the individual, M ¼ the money income of the individual over the specified time period P0 ¼ the prices of other commodities f ¼ a function of, or depends on T ¼ the tastes of the individual (b) By keeping constant the individual’s money income, the prices of other commodities, and the individual’s tastes, we can write
P
0 , T) Qdx ¼ f (Px , M,
where the bar on top of M, P0, and T means that they are kept constant. The last mathematical expression is usually abbreviated as Qdx ¼ f (Px )cet: par: This reads: The quantity of commodity X demanded by an individual over a specified time period is a function of or depends on the price of that commodity while holding constant everything else that affects the individ- ual’s demand for the commodity. 2.2 (a) What is the relationship between the expression Qdx ¼ f (Px) cet. par. and the expression Qdc ¼ 8 2 Px cet. par. in Example 1? (b) What is the relationship between “need” or “want” and “demand”? (a) The expression Qdx ¼ f (Px ) cet: par: is a general functional relationship indicating simply that Qdx is a function of or depends on Px when everything else that affects the individual’s demand for the commodity is held constant. The expression Qdx ¼ 8 2 Px cet. par. is a specific functional relationship indicating precisely how Qdx depends on Px. That is, by substituting various prices of commodity X into this specific demand function, we get the particular quantity of commodity X demanded by the individual per unit of time at these various prices. Thus, we get the individual’s demand schedule and from it, the demand curve. (b) The demand for a particular commodity arises because of its ability to satisfy a need or a want. However, the demand for a commodity, in an economic sense, arises when there is both a need for the commodity and consumers have the money to pay for it. Thus, demand really refers to effective demand rather than to simple need. 2.3 From the demand function Qdx ¼ 12 2 2Px (Px is given in dollars), derive (a) the individual’s demand schedule and (b) the individual’s demand curve, (c) What is the maximum quantity this individual will ever demand of commodity X per time period? (a) Table 2.7 Px ($) 6 5 4 3 2 1 0 Qdx 0 2 4 6 8 10 12 (b) It should be noted that in economics, contrary to usual mathematical usage, price (the independent or explanatory variable) is plotted on the vertical axis while the quantity demanded per unit of time (the dependent or “explained” variable) is plotted on the horizontal axis (see Fig. 2-7). The reason for the negative slope of the individual’s demand curve will be explained in Chapter 4. CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 23 Fig. 2-7 (c) The maximum quantity of this commodity that the individual will ever demand per unit of time is 12 units. This occurs at a zero price. This is called the saturation point for the individual. Additional units of X result in a storage and disposal problem for the individual. Thus the “relevant” points on a demand curve are all in the first quadrant. 2.4 From the Individual’s Demand Schedule (Table 2.8) for commodity X, (a) draw the individual’s demand curve. (b) In what way is this demand curve different from the one in Problem 2.3? Table 2.8 Individual’s Demand Schedule Px ($) 6 5 4 3 2 1 Q dx 18 20 24 30 40 60 (a) Fig. 2-8 (b) In this problem, the individual’s demand is given by a curve, while in Problem 2.3 it was given by a straight line. In the real world, a demand curve can be a straight line, a smooth curve, or any other irregular (but usually negatively sloped) curve. For simplicity, in Problem 2.3 (and in the text) we dealt with a straight- line demand curve. 24 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 2.5 From the demand function Qdx ¼ 8/Px (Px is given in dollars), derive (a) the individual’s demand sche- dule and (b) the individual’s demand curve, (c) What type of demand curve is this? (a) Table 2.9 (b) Px ($) 1 2 4 8 Qx 8 4 2 1 Fig. 2-9 (c) The demand curve in this problem is a rectangular hyperbola. As we move further away from the origin along either axis, the demand curve gets closer and closer to the axis but never quite touches it. This type of curve is said to be asymptotic to the axes. Economists sometimes use this type of demand curve because of its special characteristics. We will examine some of these special characteristics in the next chapter. 2.6 Table 2.10 gives two demand schedules of an individual for commodity X. The first of these (Qdx) is the same as the demand schedule in Problem 2.4. The second (Qdx0 ) resulted from an increase in the individual’s money income (while keeping everything else constant), (a) Plot the points of the two demand schedules on the same set of axes and get the two demand curves, (b) What would happen if the price of X fell from $5 to $3 before the individual’s income rose? (c) At the unchanged price of $5 for commodity X, what happens when the individual’s income rises? (d ) What happens if at the same time that the individual’s money income rises, the price of X falls from $5 to $3? (e) What type of good is commodity X? Why? (a) Table 2.10 Px ($) 6 5 4 3 2 1 Qdx 18 20 24 30 40 60 Qdx0 38 40 46 55 70 100 Fig. 2-10 CHAP. 2] DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW 25 (b) When the price of X falls from $5 to $3 before the individual’s income rises, the quantity of X demanded by the individual increases from 20 to 30 units per time period. (This is movement along dx in a downward direction, from point A to point B in the figure.) (c) When the individual’s income rises, that person’s entire demand curve shifts up and to the right from dx to d0x. This is referred to as an increase in demand. At the unchanged price of $5, the individual will now (i.e., after the shift) buy 40 units of X rather than 20 (i.e., the individual goes from point A to point C). (d ) When the individual’s income rises while the price of X falls (from $5 to $3), the individual purchases 35 additional units of X (i.e., the individual goes from point A to point D). (e) Since dx , shifted up (to d0x ) when the individual’s income rose, commodity X is a normal good for this individual. If dx has shifted down as the individual’s income rose, commodity X would have been an inferior good for this individual. In some cases, a commodity may be normal for one individual over some ranges of his or her income and inferior for another individual or for the same individual over different ranges of income (more will be said on this in Chapter 3). 2.7 The values in Table 2.11 refer to the change in an individual’s consumption of coffee and tea at home when the price of coffee rises (everything else, including the price of tea, remains the same). (a) Draw a figure showing these changes, and (b) explain the figure drawn. Table 2.11 Before After Price Quantity Price Quantity (cents/cup) (cups/month) (cents/cup) (cups/month) Coffee 40 50 60 30 Tea 20 40 20 50 (a) Fig. 2-11 26 DEMAND, SUPPLY, AND EQUILIBRIUM: AN OVERVIEW [CHAP. 2 (b) In Fig. 2-11 (a), we see that when the price of coffee rises; from 40¢ to 60¢ per cup (with everything else affecting the demand for coffee remaining the same), the qua