Microeconomics PDF 9th Edition by Pindyck & Rubinfeld

Practice, Engage, and Assess with MyLab Economics® Pearson eText—The Pearson eText gives students access to their textbook anytime, anywhere. In addition to note-taking, highlighting, and bookmarking,...

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ALWAYS LEARNING MicroeconoMics ninth edition GLoBAL edition The Pearson series in economics Abel/Bernanke/Croushore† Froyen Klein Perloff/Brander Macroeconomics* Macroeconomics: Theories Mathematical Methods for Managerial Economics and Policies Economics and Strategy* Acemoglu/Laibson/List† Economics* Fusfeld Krugman/Obstfeld/Melitz† Pindyck/Rubinfeld† The Age of the Economist International Economics: Microeconomics* Bade/Parkin† Theory & Policy* Foundations of Economics* Gerber† Riddell/Shackelford/Stamos/ International Economics* Laidler Schneider Berck/Helfand The Demand for Money Economics: A Tool for Critically The Economics of the Gordon Understanding Society Environment Macroeconomics* Lynn † Economic Development: Roberts Bierman/Fernandez Greene Theory and Practice for The Choice: A Fable of Free Game Theory with Economic Econometric Analysis a Divided World Trade and Protection Applications Gregory/Stuart Miller Scherer Blanchard† Russian and Soviet Economic Economics Today* Industry Structure, Strategy, Macroeconomics* Performance and Structure and Public Policy Miller/Benjamin Boyer Hartwick/Olewiler The Economics of Macro Issues Schiller Principles of Transportation The Economics of Natural The Economics of Poverty and Economics Resource Use Miller/Benjamin/North Discrimination The Economics of Public Issues Branson Heilbroner/Milberg Sherman Macroeconomic Theory The Making of the Economic Mishkin† Market Regulation and Policy Society The Economics of Money, Banking, and Financial Stock/Watson† Bruce Heyne/Boettke/Prychitko Markets* Introduction to Econometrics Public Finance and the The Economic Way of Thinking The Economics of Money, American Economy Studenmund† Hubbard/O’Brien† Banking, and Financial Using Econometrics: Carlton/Perloff† Economics* Markets, Business School A Practical Guide Modern Industrial Organization InEcon Edition* Macroeconomics: Policy Todaro/Smith Case/Fair/Oster† Money, Banking, and the and Practice* Economic Development Principles of Economics* Financial System* Murray Walters/Walters/Appel/ Chapman Hubbard/O’Brien/Rafferty Econometrics: A Modern Callahan/Centanni/Maex/ Environmental Economics: Macroeconomics* Introduction O’Neill Theory, Application, and Policy Hughes/Cain Econversations: American Economic History O’Sullivan/Sheffrin/Perez Today’s Students Discuss Daniels/VanHoose Economics: Principles, Today’s Issues International Monetary & Husted/Melvin Applications and Tools* Financial Economics International Economics Williamson† Parkin† Macroeconomics Downs Jehle/Reny Economics* An Economic Theory Advanced Microeconomic of Democracy Perloff† Theory † Microeconomics* Farnham Keat/Young/Erfle Economics for Managers Microeconomics: Theory and Managerial Economics Applications with Calculus* *denotes Pearson MyLab Economics titles † denotes availability of Global Edition titles Visit www.myeconlab.com to learn more. MicroeconoMics ninth edition GLoBAL edition RobeRt S. Pindyck daniel l. Rubinfeld Massachusetts Institute of Technology University of California, Berkeley Harlow, England London New York Boston San Francisco Toronto Sydney Dubai Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Sao Paulo Mexico City Madrid Amsterdam Munich Paris Milan Vice President, Business Publishing: Donna Battista Manufacturing Controller, Director of Portfolio Management: Adrienne D’Ambrosio Global Edition: Kay Holman Portfolio Manager: Ashley Bryan Content Producer: Mary Kate Murray Associate Project Editor, Global Edition: Paromita Banerjee Operations Specialist: Carol Melville Editorial Assistant: Nicole Nedwidek Creative Director: Blair Brown Vice President, Product Marketing: Roxanne McCarley Manager, Learning Tools: Brian Surette Director of Strategic Marketing: Brad Parkins Managing Producer, Digital Studio, Arts Strategic Marketing Manager: Deborah Strickland and Business: Diane Lombardo Product Marketer: Tricia Murphy Digital Studio Producer: Melissa Honig Field Marketing Manager: Ramona Elmer Digital Studio Producer: Alana Coles Field Marketing Assistant: Kristen Compton Digital Content Team Lead: Noel Lotz Product Marketing Assistant: Jessica Quazza Digital Content Project Lead: Noel Lotz Vice President, Production and Digital Studio, Arts Media Production Manager, Global Edition: Vikram Kumar and Business: Etain O’Dea Full-Service Project Management and Composition: Director of Production, Business: Jeff Holcomb Integra Software Services Managing Producer, Business: Alison Kalil Interior Design: Integra Software Services Content Producer, Global Edition: Pooja Aggarwal Cover Art: LeksusTuss/Shutterstock For information regarding permissions, request forms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit www.pearsoned.com/permissions/. Acknowledgments of third-party content appear on page 768, which constitutes an extension of this copyright page. PEARSON, ALWAYS LEARNING, and Pearson MyLab Economics® are exclusive trademarks owned by Pearson Education, Inc. or its affiliates in the U.S. and/or other countries. Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsonglobaleditions.com © Pearson Education Limited 2018 The rights of Robert Pindyck and Daniel Rubinfeld to be identified as the authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Authorized adaptation from the United States edition, entitled Microeconomics, 9th Edition, ISBN 978-0-13-418424-1 by Robert Pindyck and Daniel Rubinfeld, published by Pearson Education © 2018. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a license permitting restricted copying in the United King- dom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN 10: 1-292-21331-0 ISBN 13: 978-1-292-21331-6 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 Typeset in Palatino LT Pro by Integra-PDY IN Printed and bound by Vivar in Malaysia  To our daughters, Maya, Talia, and Shira Sarah and Rachel  abouT The auThors The authors, back again for a new edition, reflect on their years of successful textbook collaboration. Pindyck is on the right and Rubinfeld on the left. R evising a textbook every three or four years is hard work, and the last edition was well-liked by students. “So why is our publisher pushing for a new edition?” the authors wondered. “Were some of the examples becoming stale? Or might it have something to do with the used book market?” Could be both. In any case, here they are again, with a new edition that has sub- stantial improvements and lots of new examples. Robert S. Pindyck is the Bank of Tokyo-Mitsubishi Ltd. Professor of Econom- ics and Finance in the Sloan School of Management at M.I.T. Daniel L. Rubinfeld is the Robert L. Bridges Professor of Law and Professor of Economics Emeritus at the University of California, Berkeley, and Professor of Law at NYU. Both re- ceived their Ph.D.s from M.I.T., Pindyck in 1971 and Rubinfeld in 1972. Professor Pindyck’s research and writing have covered a variety of topics in microeconom- ics, including the effects of uncertainty on firm behavior and market structure; the behavior of natural resource, commodity, and financial markets; environmen- tal economics; and criteria for investment decisions. Professor Rubinfeld, who served as chief economist at the Department of Justice in 1997 and 1998, is the author of a variety of articles relating to antitrust, competition policy, law and economics, law and statistics, and public economics. Pindyck and Rubinfeld are also co-authors of Econometric Models and Economic Forecasts, another best-selling textbook that makes a perfect gift (birthdays, wed- dings, bar mitzvahs, you name it) for the man or woman who has everything. (Buy several—bulk pricing is available.) These two authors are always looking for ways to earn some extra spending money, so they enrolled as human subjects in a double-blind test of a new hair restoration medication. Rubinfeld strongly suspects that he is being given the placebo. This is probably more than you want to know about these authors, but for fur- ther information, see their Web sites: http://web.mit.edu/rpindyck/www/ and https://www.law.berkeley.edu/our-faculty/faculty-profiles/daniel-rubinfeld/ 6 brief conTenTs PArt one introduction: Markets and Prices 23 1 Preliminaries 25 2 The Basics of Supply and Demand 43 PArt two Producers, consumers, and competitive Markets 87 3 Consumer Behavior 89 4 Individual and Market Demand 131 5 Uncertainty and Consumer Behavior 179 6 Production 209 7 The Cost of Production 237 8 Profit Maximization and Competitive Supply 289 9 The Analysis of Competitive Markets 327 PArt three Market Structure and competitive Strategy 367 10 Market Power: Monopoly and Monopsony 369 11 Pricing with Market Power 413 12 Monopolistic Competition and Oligopoly 465 13 Game Theory and Competitive Strategy 501 14 Markets for Factor Inputs 543 15 Investment, Time, and Capital Markets 573 PArt Four information, Market failure, and the Role of Government 607 16 General Equilibrium and Economic Efficiency 609 17 Markets with Asymmetric Information 645 18 Externalities and Public Goods 675 19 Behavioral Economics 713 Appendix: The Basics of Regression 735 Glossary 743 Answers to Selected Exercises 753 Photo Credits 768 Index 769 7 This page intentionally left blank conTenTs Preface 15 PArt one 2.7 Effects of Government Intervention—Price introduction: Markets and Prices 23 Controls 80 Summary 83 1 Preliminaries 25 Questions for Review 83 Exercises 84 1.1 The Themes of Microeconomics 26 Trade-Offs 26 Prices and Markets 27 PArt two Theories and Models 27 Producers, consumers, Positive versus Normative Analysis 28 and competitive Markets 87 1.2 What Is a Market? 29 Competitive versus Noncompetitive Markets 30 3 consumer behavior 89 Market Price 30 Market Definition—The Extent of a Market 31 Consumer Behavior 89 1.3 Real versus Nominal Prices 34 3.1 Consumer Preferences 91 1.4 Why Study Microeconomics? 39 Market Baskets 91 Corporate Decision Making: The Toyota Some Basic Assumptions about Preferences 92 Prius 39 Indifference Curves 93 Public Policy Design: Fuel Efficiency Standards for Indifference Maps 94 the Twenty-First Century 40 The Shape of Indifference Curves 95 Summary 41 The Marginal Rate of Substitution 96 Questions for Review 41 Perfect Substitutes and Perfect Complements 98 Exercises 42 3.2 Budget Constraints 104 The Budget Line 104 The Effects of Changes in Income and Prices 106 2 The basics of supply and 3.3 Consumer Choice 108 Demand 43 Corner Solutions 111 2.1 Supply and Demand 44 3.4 Revealed Preference 114 The Supply Curve 44 3.5 Marginal Utility and Consumer Choice 117 The Demand Curve 45 Rationing 120 2.2 The Market Mechanism 47 *3.6 Cost-of-Living Indexes 122 2.3 Changes in Market Equilibrium 48 Ideal Cost-of-Living Index 123 2.4 Elasticities of Supply and Demand 55 Laspeyres Index 124 Point versus Arc Elasticities 58 Paasche Index 125 2.5 Short-Run versus Long-Run Elasticities 62 Price Indexes in the United States: Chain Demand 62 Weighting 126 Supply 67 Summary 127 *2.6 Understanding and Predicting the Effects of Questions for Review 128 Changing Market Conditions 71 Exercises 128 9  10 contents 4 individual and market The Trade-Off Between Risk and Return 199 The Investor’s Choice Problem 200 Demand 131 Summary 205 4.1 Individual Demand 132 Questions for Review 205 Price Changes 132 Exercises 205 The Individual Demand Curve 132 Income Changes 134 Normal versus Inferior Goods 135 6 Production 209 Engel Curves 136 The Production Decisions of a Firm 209 Substitutes and Complements 138 6.1 Firms and Their Production Decisions 210 4.2 Income and Substitution Effects 139 Why Do Firms Exist? 211 Substitution Effect 140 The Technology of Production 212 Income Effect 141 The Production Function 212 A Special Case: The Giffen Good 142 The Short Run versus the Long Run 213 4.3 Market Demand 144 6.2 Production with One Variable Input (Labor) 214 From Individual to Market Demand 144 Average and Marginal Products 214 Elasticity of Demand 146 The Slopes of the Product Curve 215 Speculative Demand 149 The Average Product of Labor Curve 217 4.4 Consumer Surplus 152 The Marginal Product of Labor Curve 217 Consumer Surplus and Demand 152 The Law of Diminishing Marginal Returns 218 4.5 Network Externalities 155 Labor Productivity 222 Positive Network Externalities 155 6.3 Production with Two Variable Inputs 224 Negative Network Externalities 157 Isoquants 224 *4.6 Empirical Estimation of Demand 159 Input Flexibility 226 The Statistical Approach to Demand Estimation 160 Diminishing Marginal Returns 226 The Form of the Demand Relationship 161 Substitution Among Inputs 226 Interview and Experimental Approaches to Demand Production Functions—Two Special Cases 228 Determination 163 6.4 Returns to Scale 231 Summary 164 Describing Returns to Scale 232 Questions for Review 164 Summary 234 Exercises 165 Questions for Review 234 Exercises 235 5 uncertainty and consumer behavior 179 7 The cost of Production 237 5.1 Describing Risk 180 7.1 Measuring Cost: Which Costs Matter? 237 Probability 180 Economic Cost versus Accounting Cost 238 Expected Value 181 Opportunity Cost 238 Variability 181 Sunk Costs 239 Decision Making 183 Fixed Costs and Variable Costs 241 5.2 Preferences Toward Risk 185 Fixed versus Sunk Costs 242 Different Preferences Toward Risk 186 Marginal and Average Cost 244 5.3 Reducing Risk 190 7.2 Cost in the Short Run 245 Diversification 190 The Determinants of Short-Run Cost 245 Insurance 191 The Shapes of the Cost Curves 246 The Value of Information 194 7.3 Cost in the Long Run 251 *5.4 The Demand for Risky Assets 196 The User Cost of Capital 251 Assets 196 The Cost-Minimizing Input Choice 252 Risky and Riskless Assets 197 The Isocost Line 253 Asset Returns 197 Choosing Inputs 253  contents 11 Cost Minimization with Varying Output Levels 257 Long-Run Competitive Equilibrium 311 The Expansion Path and Long-Run Costs 258 Economic Rent 314 7.4 Long-Run versus Short-Run Cost Curves 261 Producer Surplus in the Long Run 315 The Inflexibility of Short-Run Production 261 8.8 The Industry’s Long-Run Supply Curve 316 Long-Run Average Cost 262 Constant-Cost Industry 317 Economies and Diseconomies of Scale 263 Increasing-Cost Industry 318 The Relationship between Short-Run Decreasing-Cost Industry 319 and Long-Run Cost 266 The Effects of a Tax 320 7.5 Production with Two Outputs—Economies Long-Run Elasticity of Supply 321 of Scope 267 Summary 324 Product Transformation Curves 267 Questions for Review 324 Economies and Diseconomies of Scope 268 Exercises 325 The Degree of Economies of Scope 269 *7.6 Dynamic Changes in Costs— The Learning 9 The analysis of competitive Curve 270 markets 327 Graphing the Learning Curve 270 9.1 Evaluating the Gains and Losses from Learning versus Economies of Scale 271 Government Policies—Consumer and Producer *7.7 Estimating and Predicting Cost 275 Surplus 327 Cost Functions and the Measurement of Scale Review of Consumer and Producer Surplus 328 Economies 276 Application of Consumer and Producer Summary 278 Surplus 329 Questions for Review 279 9.2 The Efficiency of a Competitive Market 333 Exercises 280 9.3 Minimum Prices 338 9.4 Price Supports and Production Quotas 342 8 Profit maximization and Price Supports 342 Production Quotas 344 competitive supply 289 9.5 Import Quotas and Tariffs 351 8.1 Perfectly Competitive Markets 289 9.6 The Impact of a Tax or Subsidy 355 When Is a Market Highly Competitive? 291 The Effects of a Subsidy 359 8.2 Profit Maximization 292 Summary 362 Do Firms Maximize Profit? 292 Questions for Review 362 Alternative Forms of Organization 293 Exercises 363 8.3 Marginal Revenue, Marginal Cost, and Profit Maximization 294 Demand and Marginal Revenue for a Competitive PArt three Firm 295 Market Structure and competitive Profit Maximization by a Competitive Firm 297 8.4 Choosing Output in the Short Run 297 Strategy 367 Short-Run Profit Maximization by a Competitive Firm 297 10 market Power: monopoly and When Should the Firm Shut Down? 299 monopsony 369 8.5 The Competitive Firm’s Short-Run Supply 10.1 Monopoly 370 Curve 302 Average Revenue and Marginal Revenue 370 The Firm’s Response to an Input Price Change 303 The Monopolist’s Output Decision 371 8.6 The Short-Run Market Supply Curve 305 An Example 373 Elasticity of Market Supply 306 A Rule of Thumb for Pricing 375 Producer Surplus in the Short Run 308 Shifts in Demand 377 8.7 Choosing Output in the Long Run 310 The Effect of a Tax 378 Long-Run Profit Maximization 310 *The Multiplant Firm 379  12 contents 10.2 Monopoly Power 380 12 monopolistic competition and Production, Price, and Monopoly Power 383 oligopoly 465 Measuring Monopoly Power 383 The Rule of Thumb for Pricing 384 12.1 Monopolistic Competition 466 10.3 Sources of Monopoly Power 387 The Makings of Monopolistic Competition 466 The Elasticity of Market Demand 388 Equilibrium in the Short Run and the Long Run 467 The Number of Firms 388 Monopolistic Competition and Economic The Interaction Among Firms 389 Efficiency 468 10.4 The Social Costs of Monopoly Power 389 12.2 Oligopoly 470 Rent Seeking 390 Equilibrium in an Oligopolistic Market 471 Price Regulation 391 The Cournot Model 472 Natural Monopoly 392 The Linear Demand Curve—An Example 475 Regulation in Practice 393 First Mover Advantage—The Stackelberg Model 477 10.5 Monopsony 394 12.3 Price Competition 478 Monopsony and Monopoly Compared 397 Price Competition with Homogeneous Products— 10.6 Monopsony Power 398 The Bertrand Model 478 Sources of Monopsony Power 398 Price Competition with Differentiated Products 479 The Social Costs of Monopsony Power 399 12.4 Competition versus Collusion: The Prisoners’ Bilateral Monopoly 400 Dilemma 483 10.7 Limiting Market Power: The Antitrust Laws 401 12.5 Implications of the Prisoners’ Dilemma for Restricting What Firms Can Do 402 Oligopolistic Pricing 486 Enforcement of the Antitrust Laws 404 Price Rigidity 486 Antitrust in Europe 404 Price Signaling and Price Leadership 487 Summary 408 The Dominant Firm Model 490 Questions for Review 409 12.6 Cartels 491 Exercises 409 Analysis of Cartel Pricing 492 Summary 496 Questions for Review 497 11 Pricing with market Power 413 Exercises 497 11.1 Capturing Consumer Surplus 414 11.2 Price Discrimination 415 13 Game Theory and competitive First-Degree Price Discrimination 415 strategy 501 Second-Degree Price Discrimination 418 13.1 Gaming and Strategic Decisions 501 Third-Degree Price Discrimination 418 Noncooperative versus Cooperative Games 502 11.3 Intertemporal Price Discrimination 13.2 Dominant Strategies 504 and Peak-Load Pricing 424 13.3 The Nash Equilibrium Revisited 506 Intertemporal Price Discrimination 425 Maximin Strategies 508 Peak-Load Pricing 426 *Mixed Strategies 510 11.4 The Two-Part Tariff 428 13.4 Repeated Games 512 *11.5 Bundling 433 13.5 Sequential Games 517 Relative Valuations 434 The Extensive Form of a Game 517 Mixed Bundling 436 The Advantage of Moving First 518 Bundling in Practice 440 13.6 Threats, Commitments, and Credibility 519 Tying 443 Empty Threats 520 *11.6 Advertising 443 Commitment and Credibility 520 A Rule of Thumb for Advertising 445 Bargaining Strategy 522 Summary 448 13.7 Entry Deterrence 524 Questions for Review 448 Strategic Trade Policy and International Exercises 449 Competition 527  contents 13 *13.8 Auctions 530 Diversifiable versus Nondiversifiable Risk 588 Auction Formats 531 The Capital Asset Pricing Model 589 Valuation and Information 531 15.6 Investment Decisions by Consumers 592 Private-Value Auctions 532 15.7 Investments in Human Capital 594 Common-Value Auctions 533 *15.8 Intertemporal Production Decisions—Depletable Maximizing Auction Revenue 535 Resources 598 Bidding and Collusion 535 The Production Decision of an Individual Resource Summary 538 Producer 598 Questions for Review 538 The Behavior of Market Price 599 Exercises 539 User Cost 599 Resource Production by a Monopolist 600 14 markets for factor inputs 543 15.9 How Are Interest Rates Determined? 602 A Variety of Interest Rates 603 14.1 Competitive Factor Markets 543 Summary 604 Demand for a Factor Input When Only One Input Is Questions for Review 605 Variable 544 Exercises 605 Demand for a Factor Input When Several Inputs Are Variable 547 The Market Demand Curve 548 PArt Four The Supply of Inputs to a Firm 551 information, Market failure, and the The Market Supply of Inputs 553 Role of Government 607 14.2 Equilibrium in a Competitive Factor Market 556 Economic Rent 556 16 General equilibrium and 14.3 Factor Markets with Monopsony power 560 economic efficiency 609 Monopsony Power: Marginal and Average 16.1 General Equilibrium Analysis 609 Expenditure 560 Two Interdependent Markets—Moving to General Purchasing Decisions with Monopsony Power 561 Equilibrium 610 Bargaining Power 562 Reaching General Equilibrium 611 14.4 Factor Markets with Monopoly Power 564 Economic Efficiency 615 Monopoly Power over the Wage Rate 564 16.2 Efficiency in Exchange 616 Unionized and Nonunionized Workers 566 The Advantages of Trade 617 Summary 569 The Edgeworth Box Diagram 617 Questions for Review 569 Efficient Allocations 618 Exercises 570 The Contract Curve 620 Consumer Equilibrium in a Competitive Market 621 15 investment, Time, and capital The Economic Efficiency of Competitive Markets 623 markets 573 16.3 Equity and Efficiency 624 15.1 Stocks versus Flows 574 The Utility Possibilities Frontier 624 15.2 Present Discounted Value 575 Equity and Perfect Competition 626 Valuing Payment Streams 576 16.4 Efficiency in Production 627 15.3 The Value of a Bond 578 Input Efficiency 627 Perpetuities 579 The Production Possibilities Frontier 628 The Effective Yield on a Bond 580 Output Efficiency 629 15.4 The Net Present Value Criterion for Capital Efficiency in Output Markets 631 Investment Decisions 583 16.5 The Gains from Free Trade 632 The Electric Motor Factory 584 Comparative Advantage 632 Real versus Nominal Discount Rates 585 An Expanded Production Possibilities Frontier 633 Negative Future Cash Flows 586 16.6 An Overview—The Efficiency of Competitive 15.5 Adjustments for Risk 587 Markets 637  14 contents 16.7 Why Markets Fail 638 An Emissions Standard 682 Market Power 639 An Emissions Fee 682 Incomplete Information 639 Standards versus Fees 683 Externalities 639 Tradeable Emissions Permits 686 Public Goods 640 Recycling 689 Summary 641 18.3 Stock Externalities 693 Questions for Review 641 Stock Buildup and Its Impact 694 Exercises 642 18.4 Externalities and Property Rights 699 Property Rights 699 17 markets with asymmetric Bargaining and Economic Efficiency 700 information 645 Costly Bargaining—The Role of Strategic Behavior 701 17.1 Quality Uncertainty and the Market for A Legal Solution—Suing for Damages 701 Lemons 646 18.5 Common Property Resources 703 The Market for Used Cars 646 18.6 Public Goods 705 Implications of Asymmetric Information 648 Efficiency and Public Goods 706 The Importance of Reputation and Public Goods and Market Failure 708 Standardization 649 Summary 709 17.2 Market Signaling 653 Questions for Review 710 A Simple Model of Job Market Signaling 654 Exercises 711 Guarantees and Warranties 656 17.3 Moral Hazard 658 17.4 The Principal–Agent Problem 660 19 behavioral economics 713 The Principal–Agent Problem in Private 19.1 Reference Points and Consumer Enterprises 660 Preferences 714 The Principal–Agent Problem in Public 19.2 Fairness 718 Enterprises 663 19.3 Rules of Thumb and Biases in Decision Incentives in the Principal–Agent Framework 664 Making 719 *17.5 Managerial Incentives in an Integrated 19.4 Bubbles 726 Firm 666 Informational Cascades 728 Asymmetric Information and Incentive Design in the 19.5 Behavioral Economics and Public Integrated Firm 666 Policy 731 Applications 668 Summing Up 733 17.6 Asymmetric Information in Labor Markets: Summary 733 Efficiency Wage Theory 669 Questions for Review 734 Summary 671 Exercises 734 Questions for Review 672 Exercises 672 Appendix: The Basics of Regression 735 18 externalities and Public Glossary 743 Goods 675 Answers to Selected Exercises 753 18.1 Externalities 675 Negative Externalities and Inefficiency 676 Photo Credits 768 Positive Externalities and Inefficiency 678 18.2 Ways of Correcting Market Failure 681 Index 769 Preface F or students who care about how the world works, microeconomics is prob- ably the most relevant, interesting, and important subject they can study. (Macroeconomics is the second-most important subject.) A good grasp of microeconomics is vital for managerial decision making, for designing and understanding public policy, and, more generally, for appreciating how a mod- ern economy functions. In fact, even understanding the news each day often requires knowledge of microeconomics. We wrote this book, Microeconomics, because we believe that students need to be exposed to the new topics that have come to play a central role in microeco- nomics over the years—topics such as game theory and competitive strategy, the roles of uncertainty and information, and the analysis of pricing by firms with market power. We also felt that students need to be shown how microeconomics can help us to understand what goes on in the world and how it can be used as a practical tool for decision making. Microeconomics is an exciting and dynamic subject, but students need to be given an appreciation of its relevance and use- fulness. They want and need a good understanding of how microeconomics can actually be used outside the classroom. To respond to these needs, the ninth edition of Microeconomics provides a treatment of microeconomic theory that stresses its relevance and application to both managerial and public policy decision making. This applied emphasis is accomplished by including examples that cover such topics as the analysis of demand, cost, and market efficiency; the design of pricing strategies; investment and production decisions; and public policy analysis. Because of the importance that we attach to these examples, they are included in the flow of the text. (A complete list is included on the endpapers inside the front cover.) The coverage in this edition of Microeconomics incorporates the dramatic chang- es that have occurred in the field in recent years. There has been growing interest in game theory and the strategic interactions of firms (Chapters 12 and 13), in the role and implications of uncertainty and asymmetric information (Chapters 5 and 17), in the pricing strategies of firms with market power (Chapters 10 and 11), in the design of policies to deal efficiently with externalities such as environmental pollution (Chapter 18), and in behavioral economics (Chapter 19). That the coverage in Microeconomics is comprehensive and up to date does not mean that it is “advanced” or difficult. We have worked hard to make the exposition clear and accessible as well as lively and engaging. We believe that the study of microeconomics should be enjoyable and stimulating. We hope that our book reflects this belief. Except for appendices and footnotes, Microeconom- ics uses no calculus. As a result, it should be suitable for students with a broad range of backgrounds. (Those sections that are more demanding are marked with an asterisk and can be easily omitted.) 15 16 PreFAce Changes in the Ninth Edition E ach new edition of this book is built on the success of prior editions by adding some new topics, by adding and updating examples, and by im- proving the exposition of existing materials. We continue that tradition in this ninth edition. We have made a number of changes throughout the book, but the most important are the following: We added a new chapter (Chapter 19) on behavioral economics. Behav- ioral economics goes beyond the simple paradigm of maximizing some- thing (e.g., utility, output, profit) subject to a constraint (e.g., income, cost, demand and cost). While this paradigm has been extremely powerful in helping us understand how markets work, it does not accurately describe how real-world consumers and firms behave. The new and flourishing field of behavioral economics incorporates findings from psychology into our descriptions of how consumers and firms make decisions. Although the previous edition of this book had a section on behavioral economics (that appeared in Chapter 5), we decided that this topic was sufficiently impor- tant to deserve a chapter of its own. We have updated many of the examples (as we do in every new edition), but we also added several new ones. We now have several examples of taxicab markets that include the entry of “ride-share” services like Uber and Lyft (Chapters 9 and 13). We added an example about Tesla’s new battery factory (its “Gigafactory”) and how scale economies will reduce the cost of batteries for electric cars (Chapter 7). We added an example on merger policy (Chapter 10) and one on the Auto Parts Cartel (Chapter 12). We even have two examples (in Chapters 1 and 12) that deal with the pricing of this textbook. As part of the new Chapter 19, we added several examples that are “behav- ioral” in nature, including consumers’ use of credit card debt (and apparent willingness to pay extremely high interest rates) and decisions to join and use health clubs. With the exception of the new Chapter 19, the layout of this edition is simi- lar to that of the prior edition. This has allowed us to continue to define key terms in the margins (as well as in the Glossary at the end of the book) and to use the margins to include Concept Links that relate newly developed ideas to concepts introduced previously in the text. Alternative Course Designs T his new edition of Microeconomics offers instructors considerable flexibil- ity in course design. For a one-quarter or one-semester course stressing the basic core material, we would suggest using the following chapters and sections of chapters: 1 through 6, 7.1–7.4, 8 through 10, 11.1–11.3, 12, 14, 15.1–15.4, 18.1–18.2, and 18.5. A somewhat more ambitious course might also in- clude parts of Chapters 5, 16, and 19 and additional sections in Chapters 7 and 9.  PreFAce 17 To emphasize uncertainty and market failure, an instructor should also include substantial parts of Chapters 5 and 17. Depending on one’s interests and the goals of the course, other sections could be added or used to replace the materials listed above. A course emphasizing modern pricing theory and business strategy would include all of Chapters 11, 12, and 13 and the remaining sections of Chapter 15. A course in managerial economics might also include the appendices to Chapters 4, 7, and 11, as well as the appendix on regression analysis at the end of the book. A course stressing welfare economics and public policy should include Chapter 16 and additional sections of Chapters 18 and 19. Finally, we want to stress that those sections or subsections that are more demanding and/or peripheral to the core material have been marked with an asterisk. These sections can easily be omitted without detracting from the flow of the book. Supplementary Materials A ncillaries of an exceptionally high quality are available to instructors and students using this book. The Instructor’s Manual, prepared by Duncan M. Holthausen of North Carolina State University, provides detailed so- lutions to all end-of-chapter Questions for Review and Exercises. The ninth edi- tion contains many entirely new review questions and exercises, and a number of exercises have been revised and updated. The new instructor’s manual has been revised accordingly. Each chapter also contains Teaching Tips to summa- rize key points. The Test Item File contains approximately 2,000 multiple-choice and short- answer questions with solutions. All of this material has been thoroughly reviewed, accuracy checked, and revised for this edition. TestGen is a com- puterized test generation program, available exclusively from Pearson, that allows instructors to easily create and administer tests on paper, electronically, or online. Instructors can select test items from the publisher-supplied test bank, which is organized by chapter and based on the associated textbook ma- terial, or create their own questions from scratch. With both quick and simple test creation and flexible and robust editing tools, TestGen is a complete test generator system for today’s educators. The PowerPoint Presentation has been revised for this edition by Fernando Quijano. Instructors can edit the detailed outlines to create their own full-color, professional-looking presentations and customized handouts for students. The PowerPoint Presentation also contains lecture notes and a complete set of animated textbook figures. For your convenience, all instructor resources are available online via our centralized supplements Web site, the Instructor Resource Center (www.pearsonglobaleditions.com/Pindyck). For access or more information, con- tact your local Pearson representative or request access online at the Instruc- tor Resource Center. 18 PreFAce Pearson MyLab Economics is a content-rich Web site with homework, quiz, test, and tutorial options related to the ninth edition of Microeconomics. Pearson MyLab Economics offers students an opportunity to sharpen their problem- solving skills and to assess their understanding of text material in one program. Similarly, instructors can manage all assessment needs in one program. Pearson MyLab Economics contains: End-of-chapter exercises available for practice or auto-graded assignment. These exercises include algorithmic, numerical, and draw-graph exercises. Additional exercises for assignment that draws upon material in the text. Instant tutorial feedback on a student’s problem and graphing responses. Interactive Learning Aids including Help Me Solve This step-by-step tutorials and graph animations. Auto Graded Problems and Graphs for all assignments. Digital Interactives are engaging assessment activities that promote critical thinking and application of key economic principles. Test Item File questions for homework assignment. A Custom Exercise Builder that allows instructors to create their own problems. A Gradebook that records student performance and generates reports by student or chapter. Experiments in two versions, Single Player (for easy, asynchronous, interac- tive homework assignments) and Multiplayer (for a fast paced, instructor- led, synchronous, interactive experience). The Pearson eText gives students access to their textbook anytime, any- where. Students actively read, with access to note-taking, highlighting, and bookmarking. Instructors can share comments or highlights, and students can add their own, for a tight community of learners in any class. Communication tools that enable students and instructors to communicate through email, discussion board, chat, and ClassLive. Customization options that provide additional ways to share documents and add content. Prebuilt courses offer a turn-key way for instructors to create a course that includes pre-built assignments distributed by chapter. A fourteen-day grace period that offers students temporary access as they wait for financial aid. The Pearson MyLab Economics exercises for Microeconomics were created by Duncan M. Holthausen at North Carolina State University. For additional infor- mation and a demonstration, visit www.myeconlab.com. Acknowledgments A s the saying goes, it takes a village to revise a textbook. Because the ninth edition of Microeconomics has been the outgrowth of years of experience in the classroom, we owe a debt of gratitude to our students and to the colleagues with whom we often discuss microeconomics and its presentation.  PreFAce 19 We have also had the help of capable research assistants. For the first eight editions of the book, these included Peter Adams, Walter Athier, Smita Brun- nerneier, Corola Conces, Phillip Gibbs, Matt Hartman, Salar Jahedi, Jamie Jue, Rashmi Khare, Jay Kim, Maciej Kotowski, Catherine Martin, Tammy McGav- ock, Masaya Okoshi, Kathy O’Regan, Shira Pindyck, Karen Randig, Subi Ran- gan, Deborah Senior, Ashesh Shah, Nicola Stafford, and Wilson Tai. Kathy Hill helped with the art, while Assunta Kent, Mary Knott, and Dawn Elliott Linahan provided secretarial assistance with the first edition. We especially want to thank Lynn Steele and Jay Tharp, who provided considerable editorial support for the second edition. Mark Glickman and Steve Wiggins assisted with the examples in the third edition, while Andrew Guest, Jeanette Sayre, and Lynn Steele provided valuable editorial support for the third, fourth, and fifth editions, as did Brandi Henson and Jeanette Sayre for the sixth edition, Ida Ng for the seventh edition, and Ida Ng and Dagmar Trantinova for the eighth and ninth editions. In addi- tion, Caterina Castellano and Sarah Tang provided superb research assistance on this ninth edition. Writing this book has been both a painstaking and enjoyable process. At each stage we received exceptionally fine guidance from teachers of microeconomics throughout the country. After the first draft of the first edition of the book had been edited and reviewed, it was discussed at a two-day focus group meeting in New York. This provided an opportunity to get ideas from instructors with a variety of backgrounds and perspectives. We would like to thank the follow- ing focus group members for advice and criticism: Carl Davidson of Michigan State University; Richard Eastin of the University of Southern California; Judith Roberts of California State University, Long Beach; and Charles Strein of the University of Northern Iowa. We would like to thank the reviewers who provided comments and ideas that have contributed significantly to the ninth edition of Microeconomics: Bahram Adrangi, University of Portland Muhammad Husain, Georgia State University Richard Anderson, Texas A&M University Siew Hoon Lim, North Dakota State University Bryan D. Buckley, University of Illinois Frank Limehouse, DePaul University at Urbana-Champaign Edward Scahill, The University of Scranton Michael Enz, Framingham State University Kimberly Sims, University of Tennessee Knoxville Darrin Gulla, University of Kentucky Ralph Sonenshine, American University John Horn, Washington University in St. Louis Tom Vukina, North Carolina State University Robert Horn, James Madison University Roger E. Wehr, The University of Texas at Arlington We would also like to thank all those who reviewed the first eight editions at various stages of their evolution: Nii Adote Abrahams, Missouri Southern State William Baxter, Stanford University College Charles A. Bennett, Gannon University Jack Adams, University of Arkansas, Little Rock Gregory Besharov, Duke University Sheri Aggarwal, Dartmouth College Maharukh Bhiladwalla, Rutgers University Anca Alecsandru, Louisiana State University Victor Brajer, California State University, Fullerton Anita Alves Pena, Colorado State University James A. Brander, University of British Columbia Ted Amato, University of North Carolina, Charlotte David S. Bullock, University of Illinois John J. Antel, University of Houston Jeremy Bulow, Stanford University Albert Assibey-Mensah, Kentucky State University Donald L. Bumpass, Sam Houston State University Kerry Back, Northwestern University Raymonda Burgman, DePauw University Dale Ballou, University of Massachusetts, Amherst H. Stuart Burness, University of New Mexico  20 PreFAce Peter Calcagno, College of Charleston James Hartigan, University of Oklahoma Winston Chang, State University of New York, Daniel Henderson, Binghamton University Buffalo George Heitman, Pennsylvania State University Henry Chappel, University of South Carolina Wayne Hickenbottom, University of Texas at Austin Joni Charles, Texas State University–San Marcos George E. Hoffer, Virginia Commonwealth Larry A. Chenault, Miami University University Harrison Cheng, University of Southern California Stella Hofrenning, Augsburg College Eric Chiang, Florida Atlantic University Donald Holley, Boise State University Kwan Choi, Iowa State University Duncan M. Holthausen, North Carolina State Charles Clotfelter, Duke University University Ben Collier, Northwest Missouri State University Robert Inman, The Wharton School, University of Kathryn Combs, California State University, Pennsylvania Los Angeles Brian Jacobsen, Wisconsin Lutheran College Tom Cooper, Georgetown College Joyce Jacobsen, Rhodes College Richard Corwall, Middlebury College Jonatan Jelen, New York University John Coupe, University of Maine at Orono Changik Jo, Anderson University Robert Crawford, Marriott School, Brigham Young B. Patrick Joyce, Michigan Technological University University Mahbubul Kabir, Lyon College Jacques Cremer, Virginia Polytechnic Institute and Folke Kafka, University of Pittsburgh State University David Kaserman, Auburn University Julie Cullen, University of California, San Diego Brian Kench, University of Tampa Carl Davidson, Michigan State University Michael Kende, INSEAD, France Gilbert Davis, University of Michigan Philip G. King, San Francisco State University Arthur T. Denzau, Washington University Paul Koch, Olivet Nazarene University Tran Dung, Wright State University Tetteh A. Kofi, University of San Francisco Richard V. Eastin, University of Southern California Dennis Kovach, Community College of Allegheny Lee Endress, University of Hawaii County Maxim Engers, University of Virginia Anthony Krautman, DePaul University Carl E. Enomoto, New Mexico State University Leonard Lardaro, University of Rhode Island Ray Farrow, Seattle University Sang Lee, Southeastern Louisiana University Tammy R. Feldman, University of Michigan Robert Lemke, Florida International University Gary Ferrier, Southern Methodist University Peter Linneman, University of Pennsylvania Todd Matthew Fitch, University of San Francisco Leonard Loyd, University of Houston John Francis, Auburn University, Montgomery R. Ashley Lyman, University of Idaho Roger Frantz, San Diego State University James MacDonald, Rensselaer Polytechnical Delia Furtado, University of Connecticut Institute Craig Gallet, California State University, Sacramento Wesley A. Magat, Duke University Patricia Gladden, University of Missouri Peter Marks, Rhode Island College Michele Glower, Lehigh University Anthony M. Marino, University of Southern Otis Gilley, Louisiana Tech University California Tiffani Gottschall, Washington & Jefferson College Lawrence Martin, Michigan State University William H. Greene, New York University John Makum Mbaku, Weber State University Thomas J. Grennes, North Carolina State University Richard D. McGrath, College of William and Mary Thomas A. Gresik, Notre Dame University Douglas J. Miller, University of Missouri–Columbia John Gross, University of Wisconsin at Milwaukee David Mills, University of Virginia, Charlottesville Adam Grossberg, Trinity College Richard Mills, University of New Hampshire Philip Grossman, Saint Cloud State University Jennifer Moll, Fairfield University Nader Habibi, Brandeis University Michael J. Moore, Duke University Jonathan Hamilton, University of Florida W. D. Morgan, University of California at Santa Claire Hammond, Wake Forest University Barbara Robert G. Hansen, Dartmouth College Julianne Nelson, Stern School of Business, New York Bruce Hartman, California State University, University The California Maritime Academy George Norman, Tufts University  PreFAce 21 Laudo Ogura, Grand Valley State University Houston H. Stokes, University of Illinois, Chicago June Ellenoff O’Neill, Baruch College Richard W. Stratton, University of Akron Daniel Orr, Virginia Polytechnic Institute and State Houston Stokes, University of Illinois at Chicago University Charles T. Strein, University of Northern Iowa Ozge Ozay, University of Utah Charles Stuart, University of California, Santa Christos Paphristodoulou, Mälardalen University Barbara Lourenço Paz, Syracuse University Valerie Suslow, University of Michigan Sharon J. Pearson, University of Alberta, Edmonton Theofanis Tsoulouhas, North Carolina State Ivan P’ng, University of California, Los Angeles Mira Tsymuk, Hunter College, CUNY Michael Podgursky, University of Massachusetts, Abdul Turay, Radford University Amherst Sevin Ugural, Eastern Mediterranean University Jonathan Powers, Knox College Nora A. Underwood, University of California, Davis Lucia Quesada, Universidad Torcuato Di Telia Nikolaos Vettas, Duke University Benjamin Rashford, Oregon State University David Vrooman, St. Lawrence University Charles Ratliff, Davidson College Michael Wasylenko, Syracuse University Judith Roberts, California State University, Thomas Watkins, Eastern Kentucky University Long Beach Robert Whaples, Wake Forest University Fred Rodgers, Medaille College David Wharton, Washington College William Rogers, University of Missouri–Saint Louis Lawrence J. White, New York University Geoffrey Rothwell, Stanford University Michael F. Williams, University of St. Thomas Nestor Ruiz, University of California, Davis Beth Wilson, Humboldt State University Edward L. Sattler, Bradley University Arthur Woolf, University of Vermont Roger Sherman, University of Virginia Chiou-nan Yeh, Alabama State University Nachum Sicherman, Columbia University Philip Young, University of Maryland Sigbjørn Sødal, Agder University College Peter Zaleski, Villanova University Menahem Spiegel, Rutgers University Joseph Ziegler, University of Arkansas, Fayetteville Apart from the formal review process, we are especially grateful to Jean Andrews, Paul Anglin, J. C. K. Ash, Ernst Berndt, George Bittlingmayer, Severin Borenstein, Paul Carlin, Whewon Cho, Setio Angarro Dewo, Avinash Dixit, Frank Fabozzi, Joseph Farrell, Frank Fisher, Jonathan Hamilton, Robert Inman, Joyce Jacobsen, Paul Joskow, Stacey Kole, Preston McAfee, Jeannette Mortensen, John Mullahy, Krishna Pendakur, Jeffrey Perloff, Ivan P’ng, A. Mitchell Polinsky, Judith Roberts, Geoffrey Rothwell, Garth Saloner, Joel Schrag, Daniel Siegel, Thomas Stoker, David Storey, James Walker, and Michael Williams, who were kind enough to provide comments, criticisms, and suggestions as the various editions of this book developed. Chapter 19 of this edition contains new and updated material on behavioral economics, whose genesis owes much to the thoughtful comments of George Akerlof. We also want to thank Caterina Castellano, who helped update the examples, created new examples and end-of-chapter questions and exercises, provided editorial assistance at all stages of the book’s production, and carefully reviewed the page proofs of this edition. We also wish to express our sincere thanks for the extraordinary effort those at Macmillan, Prentice Hall, and Pearson made in the development of the vari- ous editions of our book. Throughout the writing of the first edition, Bonnie Lieberman provided invaluable guidance and encouragement; Ken MacLeod kept the progress of the book on an even keel; Gerald Lombardi provided mas- terful editorial assistance and advice; and John Molyneux ably oversaw the book’s production. In the development of the second edition, we were fortunate to have the encouragement and support of David Boelio, and the organizational and 22 PreFAce editorial help of two Macmillan editors, Caroline Carney and Jill Lectka. The second edition also benefited greatly from the superb development editing of Gerald Lombardi and from John Travis, who managed the book’s production. Jill Lectka and Denise Abbott were our editors for the third edition, and we ben- efited greatly from their input. Leah Jewell was our editor for the fourth edition; her patience, thoughtfulness, and perseverance were greatly appreciated. Chris Rogers provided continual and loyal guidance through editions five through seven. With respect to this ninth edition, we are grateful to our Portfolio Manager Ashley Bryan who has worked diligently through this major revision. We also ap- preciate the efforts of our Content Producer, Mary Kate Murray; Project Manager with Integra, Gina Linko; Product Marketer, Tricia Murphy; Field Marketing Manager, Ramona Elmer; Digital Content Project Lead, Noel Lotz; and Digital Studio Producer, Melissa Honig. We owe a special debt of thanks to Catherine Lynn Steele, whose superb edi- torial work carried us through five editions of this book. Lynn passed away on December 10, 2002. We miss her very much. R.S.P. D.L.R. ParT One Introduction: Markets and Prices Part 1 surveys the scope of microeconomics and intro- ChaPTerS duces some basic concepts and tools. 1 Preliminaries Chapter 1 discusses the range of problems that microeconomics 25 addresses, and the kinds of answers it can provide. It also explains 2 The Basics of Supply what a market is, how we determine the boundaries of a market, and Demand 43 and how we measure market price. Chapter 2 covers one of the most important tools of microeco- nomics: supply-demand analysis. We explain how a competitive market works and how supply and demand determine the prices and quantities of goods and services. We also show how supply- demand analysis can be used to determine the effects of changing market conditions, including government intervention. This page intentionally left blank ChaPTer 1 Preliminaries e conomics is divided into two main branches: microeconomics ChaPTer OuTLIne and macroeconomics. Microeconomics deals with the behavior of individual economic units. These units include consumers, 1.1 The Themes of Microeconomics 26 workers, investors, owners of land, business firms—in fact, any indi- vidual or entity that plays a role in the functioning of our economy.1 1.2 What Is a Market? 29 Microeconomics explains how and why these units make economic 1.3 real versus nominal decisions. For example, it explains how consumers make purchasing Prices 34 decisions and how their choices are affected by changing prices and 1.4 Why Study incomes. It also explains how firms decide how many workers to hire Microeconomics? 39 and how workers decide where to work and how much work to do. Another important concern of microeconomics is how eco- nomic units interact to form larger units—markets and industries. LIST Of exaMPLeS Microeconomics helps us to understand, for example, why the 1.1 The Market for Sweeteners 32 American automobile industry developed the way it did and how producers and consumers interact in the market for automobiles. It ex- 1.2 a Bicycle Is a Bicycle. Or Is It? 33 plains how automobile prices are determined, how much automobile companies invest in new factories, and how many cars are produced 1.3 The Price of eggs and each year. By studying the behavior and interaction of individual firms the Price of a College education 35 and consumers, microeconomics reveals how industries and markets operate and evolve, why they differ from one another, and how they 1.4 The authors Debate the are affected by government policies and global economic conditions. Minimum Wage 36 By contrast, macroeconomics deals with aggregate economic 1.5 health Care and quantities, such as the level and growth rate of national output, inter- College Textbooks 37 est rates, unemployment, and inflation. But the boundary between macroeconomics and microeconomics has become less and less distinct in recent years. The reason is that macroeconomics also in- volves the analysis of markets—for example, the aggregate markets for goods and services, labor, and corporate bonds. To understand how these aggregate markets operate, we must first understand the behavior of the firms, consumers, workers, and investors who constitute them. Thus macroeconomists have become increasingly concerned with the microeconomic foundations of aggregate eco- nomic phenomena, and much of macroeconomics is actually an ex- tension of microeconomic analysis. 1 The prefix micro- is derived from the Greek word meaning “small.” However, many of the individual economic units that we will study are small only in relation to the U.S. economy as a whole. For example, the annual sales of General Motors, IBM, or Microsoft are larger than the gross national products of many countries. 25  26 ParT 1 Introduction: Markets and Prices microeconomics Branch of economics that deals with the behavior of individual economic 1.1 The Themes of Microeconomics units—consumers, firms, workers, and investors—as well as the The Rolling Stones once said: “You can’t always get what you want.” This is markets that these units comprise. true. For most people (even Mick Jagger), that there are limits to what you can have or do is a simple fact of life learned in early childhood. For economists, macroeconomics Branch however, it can be an obsession. of economics that deals with aggregate economic variables, Much of microeconomics is about limits—the limited incomes that consum- such as the level and growth rate ers can spend on goods and services, the limited budgets and technical know- of national output, interest rates, how that firms can use to produce things, and the limited number of hours in unemployment, and inflation. a week that workers can allocate to labor or leisure. But microeconomics is also about ways to make the most of these limits. More precisely, it is about the alloca- tion of scarce resources. For example, microeconomics explains how consumers can best allocate their limited incomes to the various goods and services avail- able for purchase. It explains how workers can best allocate their time to labor instead of leisure, or to one job instead of another. And it explains how firms can best allocate limited financial resources to hiring additional workers versus buying new machinery, and to producing one set of products versus another. In a planned economy such as that of Cuba, North Korea, or the former Soviet Union, these allocation decisions are made mostly by the government. Firms are told what and how much to produce, and how to produce it; workers have little flexibility in choice of jobs, hours worked, or even where they live; and consumers typically have a very limited set of goods to choose from. As a result, many of the tools and concepts of microeconomics are of limited rel- evance in those countries. Trade-Offs In modern market economies, consumers, workers, and firms have much more flexibility and choice when it comes to allocating scarce resources. Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these trade-offs are best made. The idea of making optimal trade-offs is an important theme in micro- economics—one that you will encounter throughout this book. Let’s look at it in more detail. Consumers Consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future. Consumer theory, the sub- ject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based on their preferences, maximize their well-being by trading off the purchase of more of some goods for the purchase of less of others. We will also see how con- sumers decide how much of their incomes to save, thereby trading off current consumption for future consumption. Workers Workers also face constraints and make trade-offs. First, people must decide whether and when to enter the workforce. Because the kinds of jobs—and corresponding pay scales—available to a worker depend in part on educational attainment and accumulated skills, one must trade off working now (and earning an immediate income) for continued education (and the hope of earning a higher future income). Second, workers face trade-offs in their choice of employment. For example, while some people choose to work for large corporations that offer job security but limited potential for advancement, others prefer to work for small companies where there is more opportunity for  ChaPTer 1 PreLIMInarIeS 27 advancement but less security. Finally, workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure. Firms Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them. General Motors, for ex- ample, is very good at producing cars and trucks, but it does not have the abil- ity to produce airplanes, computers, or pharmaceuticals. It is also constrained in terms of financial resources and the current production capacity of its factories. Given these constraints, GM must decide how many of each type of vehicle to produce. If it wants to produce a larger total number of cars and trucks next year or the year after, it must decide whether to hire more workers, build new factories, or do both. The theory of the firm, the subject matter of Chapters 6 and 7, describes how these trade-offs can best be made. Prices and Markets A second important theme of microeconomics is the role of prices. All of the trade-offs described above are based on the prices faced by consumers, work- ers, or firms. For example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but also on their prices. Likewise, work- ers trade off labor for leisure based in part on the “price” that they can get for their labor—i.e., the wage. And firms decide whether to hire more workers or purchase more machines based in part on wage rates and machine prices. Microeconomics also describes how prices are determined. In a centrally planned economy, prices are set by the government. In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets—collections of buyers and sellers that to- gether determine the price of a good. In the automobile market, for example, car prices are affected by competition among Ford, General Motors, Toyota, and other manufacturers, and also by the demands of consumers. The central role of markets is the third important theme of microeconomics. We will say more about the nature and operation of markets shortly. Theories and Models Like any science, economics is concerned with the explanations of observed phe- nomena. Why, for example, do firms tend to hire or lay off workers when the prices of their raw materials change? How many workers are likely to be hired or laid off by a firm or an industry if the price of raw materials increases by, say, 10 percent? In economics, as in other sciences, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. The theory of the firm, for example, begins with a simple assumption—firms try to maximize their profits. The theory uses this assumption to explain how firms choose the amounts of labor, capital, and raw materials that they use for production and the amount of output they produce. It also explains how these choices depend on the prices of inputs, such as labor, capital, and raw materials, and the prices that firms can receive for their outputs. Economic theories are also the basis for making predictions. Thus the theory of the firm tells us whether a firm’s output level will increase or decrease in response to an increase in wage rates or a decrease in the price of raw materi- als. With the application of statistical and econometric techniques, theories can be used to construct models from which quantitative predictions can be made. A model is a mathematical representation, based on economic theory, of a firm, a  28 ParT 1 Introduction: Markets and Prices market, or some other entity. For example, we might develop a model of a par- ticular firm and use it to predict by how much the firm’s output level will change as a result of, say, a 10-percent drop in the price of raw materials. Statistics and econometrics also let us measure the accuracy of our predictions. For example, suppose we predict that a 10-percent drop in the price of raw materi- als will lead to a 5-percent increase in output. Are we sure that the increase in out- put will be exactly 5 percent, or might it be somewhere between 3 and 7 percent? Quantifying the accuracy of a prediction can be as important as the prediction itself. No theory, whether in economics, physics, or any other science, is perfectly correct. The usefulness and validity of a theory depend on whether it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observation. As a result of this testing, they are often modified or refined and occasionally even discarded. The process of testing and refining theories is central to the develop- ment of economics as a science. When evaluating a theory, it is important to keep in mind that it is invariably imperfect. This is the case in every branch of science. In physics, for example, Boyle’s law relates the volume, temperature, and pressure of a gas.2 The law is based on the assumption that individual molecules of a gas behave as though they were tiny, elastic billiard balls. Physicists today know that gas molecules do not, in fact, always behave like billiard balls, which is why Boyle’s law breaks down under extremes of pressure and temperature. Under most condi- tions, however, it does an excellent job of predicting how the temperature of a gas will change when the pressure and volume change, and it is therefore an essential tool for engineers and scientists. The situation is much the same in economics. For example, because firms do not maximize their profits all the time, the theory of the firm has had only limited success in explaining certain aspects of firms’ behavior, such as the timing of capital investment decisions. Nonetheless, the theory does explain a broad range of phenomena regarding the behavior, growth, and evolution of firms and indus- tries, and has thus become an important tool for managers and policymakers. Positive versus Normative Analysis Microeconomics is concerned with both positive and normative questions. Positive questions deal with explanation and prediction, normative questions with what ought to be. Suppose the U.S. government imposes a quota on the import of foreign cars. What will happen to the price, production, and sales of cars? What impact will this policy change have on American consumers? On workers in the automobile industry? These questions belong to the realm of positive analysis analysis positive analysis: statements that describe relationships of cause and effect. describing relationships of cause Positive analysis is central to microeconomics. As we explained above, theo- and effect. ries are developed to explain phenomena, tested against observations, and used to construct models from which predictions are made. The use of economic theory for prediction is important both for the managers of firms and for pub- lic policy. Suppose the federal government is considering raising the tax on gasoline. The change would affect the price of gasoline, consumers’ purchasing choices for small or large cars, the amount of driving that people do, and so on. 2 Robert Boyle (1627–1691) was a British chemist and physicist who discovered experimentally that pressure (P), volume (V), and temperature (T) were related in the following way: PV = RT, where R is a constant. Later, physicists derived this relationship as a consequence of the kinetic theory of gases, which describes the movement of gas molecules in statistical terms.  ChaPTer 1 PreLIMInarIeS 29 To plan sensibly, oil companies, automobile companies, producers of auto- mobile parts, and firms in the tourist industry would all need to estimate the impact of the change. Government policymakers would also need quantitative estimates of the effects. They would want to determine the costs imposed on consumers (perhaps broken down by income categories); the effects on profits and employment in the oil, automobile, and tourist industries; and the amount of tax revenue likely to be collected each year. Sometimes we want to go beyond explanation and prediction to ask such questions as “What is best?” This involves normative analysis, which is also normative analysis analysis important for both managers of firms and those making public policy. Again, examining questions of what ought to be. consider a new tax on gasoline. Automobile companies would want to deter- mine the best (profit-maximizing) mix of large and small cars to produce once the tax is in place. Specifically, how much money should be invested to make cars more fuel-efficient? For policymakers, the primary issue is likely to be whether the tax is in the public interest. The same policy objectives (say, an in- crease in tax revenues and a decrease in dependence on imported oil) might be met more cheaply with a different kind of tax, such as a tariff on imported oil. Normative analysis is not only concerned with alternative policy options; it also involves the design of particular policy choices. For example, suppose it has been decided that a gasoline tax is desirable. Balancing costs and benefits, we then ask what is the optimal size of the tax. Normative analysis is often supplemented by value judgments. For example, a comparison between a gasoline tax and an oil import tariff might conclude that the gasoline tax will be easier to administer but will have a greater impact on lower-income consumers. At that point, society must make a value judgment, weighing equity against economic efficiency. When value judgments are involved, microeconomics cannot tell us what the best policy is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the debate. 1.2 What Is a Market? Business people, journalists, politicians, and ordinary consumers talk about markets all the time—for example, oil markets, housing markets, bond markets, labor markets, and markets for all kinds of goods and services. But often what they mean by the word “market” is vague or misleading. In economics, markets are a central focus of analysis, so economists try to be as clear as possible about what they mean when they refer to a market. It is easiest to understand what a market is and how it works by dividing individual economic units into two broad groups according to function— buyers and sellers. Buyers include consumers, who purchase goods and ser- vices, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services; workers, who sell their labor services; and resource owners, who rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers, but we will find it helpful to think of them as simply buyers when they are buying something and sellers when they are selling something. Together, buyers and sellers interact to form markets. A market is the collec- market Collection of buyers tion of buyers and sellers that, through their actual or potential interactions, determine and sellers that, through their actual or potential interactions, the price of a product or set of products. In the market for personal computers, for determine the price of a product example, the buyers are business firms, households, and students; the sellers are or set of products.  30 ParT 1 Introduction: Markets and Prices Hewlett-Packard, Lenovo, Dell, Apple, and a number of other firms. Note that a market includes more than an industry. An industry is a collection of firms that sell the same or closely related products. In effect, an industry is the supply side of the market. market definition Economists are often concerned with market definition—with determining Determination of the buyers, which buyers and sellers should be included in a particular market. When de- sellers, and range of products that should be included in a particular fining a market, potential interactions of buyers and sellers can be just as impor- market. tant as actual ones. An example of this is the market for gold. A New Yorker who wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold in New York will interact only with sellers in New York. But because the cost of transporting gold is small relative to its value, buyers of gold in New York could purchase their gold in Zurich if the prices there were significantly lower. Significant differences in the price of a commodity create a potential for arbitrage Practice of buying arbitrage: buying at a low price in one location and selling at a higher price some- at a low price at one location where else. The possibility of arbitrage prevents the prices of gold in New York and selling at a higher price in another. and Zurich from differing significantly and creates a world market for gold. Markets are at the center of economic activity, and many of the most interest- ing issues in economics concern the functioning of markets. For example, why do only a few firms compete with one another in some markets, while in others a great many firms compete? Are consumers necessarily better off if there are many firms? If so, should the government intervene in markets with only a few firms? Why have prices in some markets risen or fallen rapidly, while in other markets prices have hardly changed at all? And which markets offer the best opportunities for an entrepreneur thinking of going into business? Competitive versus Noncompetitive Markets In this book, we study the behavior of both competitive and noncompetitive perfectly competitive markets. A perfectly competitive market has many buyers and sellers, so that market Market with many no single buyer or seller has any impact on price. Most agricultural markets are buyers and sellers, so that no single buyer or seller has a close to being perfectly competitive. For example,