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MODERNMICROECONOMICSAnalysis and Applications
SecondEdition
DAVID N. HYMAN
CONTENTS
PARTONEINTRODUCTION TO MICROECONOMICS
1 Modern Microeconomics and its Meth-odology,2
Scarcity and prices, 3Scarcity, choice, and the tasks of the econ-
omy, 3Application 1.1, Coping with scarcity: fire-
wood and deforestation in the ThirdWorld,5
The role of prices in aliocating resources, 6Economic transactions and markets, 7
The purpose and functions of markets, 7Nonmarket activities, 8Property rights: the prerequisites for mar-
ket exchange, 9Transaction costs, 10
Methodology of microeconomics: theoriesand modeis, 12Model building, 13The pursuit and maximization of net gain:
a key behavioral assumption in micro-economic modeis, 14
Marginal analysis of net gains of transac-tions, 15
Positive vs. normative analysis, 16Application 1.2, Can beer taxes and raising
the legal drinking age save your life?Positive economic analysis in action, 17
Summary, 18
2 Market Interaction: Basic Supply andDemand Analysis and its Uses, 22
Market interaction: demand and supply, 23The demand curve, 23Changes in demand, 26The supply curve, 28Changes in supply, 31
Market equilibrium, 31Changes in market equilibrium: comparative
static analysis, 33Market response to a change in demand, 33Market response to a change in supply, 35
Applications of supply and demand analysis,36Analysisof the consequences of taxation, 36Import quotas, tariffs, and the conse-
quences of protecting domestic indus-tries from foreign competition: a morecomplex application, 39
Rent controls: impact of a price ceiling, 41Nonprice rationing of shortages caused by
price controls, 42Application 2.1, Rent regulation in prac-
tice: tenants' rights, warehousing ofapartments, condominium conversions,and flipping in the Big Apple, 44
Minimum wages. the impact of a pricefloor, 45
xv
xvi Contents
Government and the business of agricul-rure,46
Application 2.2, How sweetening the potfor farmers in the United Srates and Eu-
PART 1WO
rope affects farmers in developingcountries: the international impact ofprice supports, 50
Summary, 51
THE THEORY OF DEMAND
3 Preferences, Budgets, and Prices: TheTheory of Consumer Behavior, 58
Preferences and choices, 59Assumptions about consumer prefer-
ences, 59The utilitv function and indifference
curvesčuThe utilitv function, 61Indifference curves, 61Indifference maps, 63Diminishing marginal rates of substitution
and the curvature of indifferencecurves, 66
The cardinal approach: marginal utilityand the slope of indifference curves, 68
Budgets and prices, 70The budget constraint, 70The economic significance of intercepts of
the budget line with the axes, 7lThe economic significance of the slope of
the budget line, 73Changes in income and prices, 74
Consumer equilibrium, 75Maximization of utility subject to the
budget constraint, 76The equimarginal princip le, 79
Using indifference curve analysis to explainchoices,80Differences in tas tes among con-
sumers,80The choice nor to consume a good: cor-
ner equilibrium, 81Nondirninishing marginal rates of substitu-
tion,82Perfect complements, 84
Application 3.1, The choice to have chil-dren,85
Economic "bads,' 86Further applications of the model of con-
sumer choice, 89Nonprice rationing, 89Preferences for product arrributes: a
business application for marketingproducts, 90
Application 3.2, Estimating the price ofproduct attribures: how much willconsumers pav for housing charac-teristics>, 94
Summary, 94
4 Indifference Curve Analysis and Appli-cations, 100
Expanding the model: the choice betweenbuying a product and spending on allother goods, 101Diminishing marginal benefit of a good,
104Incorne-consurnption curves and Engel
curves, 104Incorne-consurnption curves, 104Normal vs. inferior goods, 105Engel curves, 108
Price-consumption curves and derivation ofde mand curves, 110
Income and substitution effects of pricechanges, 113Income and substitution effects of a price
decrease, 113Income and substitution effects in general
and the demand curve for normalgoods,1l5
Contents
The case of inferior goods, 116Using indifference curve analysis to under-
stand the effects of business practices: in-kind compensation and notched budgetlines, 119Frequem-flyer plans and notched budget
lines, 119Application 4.1, Why some airlines are
having second thoughts about their fre-quent-flyer plans, 122
Compensating employees with fringe ben-efits instead of cash, 123
Using indifference curve analysis tounderstand the effects of governmentpolicies, 127Income and substitution effects of a price
increase: how a rebated tax candecrease consumption of the taxedgood,127
In-kind subsidies: how policies can createnatched budget lines and result in ef-fects opposite to those intended, 128
Application 4.2, Food stamps and con-sumer choices, 131
Indifference curve analysis of the sale ofnonpurchased goods and services, 132Transaction costs and the incemive to
sell, 132Work, leisure, and the value of time, 134Nonwage incame and work incentive, 136
Summary, 137
5 Market Demand and its Elasticity, 144
Derivation of market demand curves, 145Deterrninants of market demand, 146
Price elasticity of demand, 148Calculating price elasticity of demand, 149Elasticity vs. slope, 149The range of variation of price elasticity of
demand,150Determinants of price elasticity of de-
mand,151'Ernpirical estimates of price elasticities of
demand: how the sensitivity to pricechanges differs among goods, 152
J •
xvii
Using price elasticities of demand to analyzeconsumer expenditures, 153Price elasticity of demand and changes in
total revenue, 155Application 5.1, Maximizing revenue from
the sale of tickets to sports events: whvpricing to fill the stadium is nat alwaysthe best policy, 156
Unit-elastic demand, 158Application 5.2, The price of the dollar
and the price elasticiry of demand forimported goods and USo exports, 160
Calculating price elasticity of demand forpaims on a demand curve, 161Price elasticity of demand as a ratio of
distances at points on a demandcurve, 161
Comparing point elasticity of two demandcurves, 163
Calculating price elasticity from data cor-responding to two paims on a de mandcurve, 164
Other demand elasticities, 165Incorne elasticiry of demand, 165Cross elasticirv of demand, 166
Demand curves and consumer benefits, 168Consumer surplus, 169Using market demand curves to approxi-
mate consumer surplus, 171Willingness to pay, availabilitv, and
price, 172Using consumer surplus to evaluate the
burden of taxes, 173Using consumer surplus to evaluate the
gains from subsidies, 175Some qualifications, 176
Estimating demand functions andelasticities, 177Market experiments and surveys, 177Statistical methods, 178The identification problem, 179
Summary, 182Appendix: Advanced topics in the theory of
consumer choice and demand, 187Evaluating willingness to pay, 187Measuring changes in the cost of
living, 193" I
xviii Contenrs
Taxes and economic welfare, 195Subsidies and economic welfare, 197Income elasticity of demand, budget con-
PART THREE
straints, and expenditures, 199Choices under uncertainty, 200
PRODUCTION, COST, AND SUPPLY IN COMPETITIVE MARKETS
6 The Theory of Production, 208
Production, 209Technology, 210The production function, 210Properties of production functions: The
underlying assumptions of the theory ofproduction, 210 .
Application 6.1, Improvements in technol-ogy: Some examples, 211
Isoquants, 212Isoquant maps, 214Application 6.2, An estimated production
function for corn, 216Production options in the short run: the law
of diminishing marginal returns, 217Total, ave rage , and marginal products of a
variable input, 218The tatai product curve, 220The average product curve, 220The marginal product curve, 222The relationship between average and
marginal product, 222The law of diminishing marginal
returns, 223The stages of production, 224A business application: management of a
multidivision operation, 225Input substitution, 227
Marginal rate of technical substitution andthe curvature of isoquants, 227
How variation in the marginal products ofinputs affects their marginal rates oftechnical substitution, 229
Substitution of capital for labor in busi-ness, 230
Input substitution and the shape of iso-quants, 231
How changes in technology can affect iso-quants, 232
Varying the scale of operations, 234Using estimated production functions to
measure returns to scale, 238Summary, 240
7 Cost and Output, 244
Measuring cost: economic cost vs. account-ing cost, 245Calculating economic cost: An example,
245Cost and production, 247
Isocost lines, 248The minimum cost input combination for
a given output, 250The princip le of least cost: equimarginal
products per dollar of outlay on inputservices, 252
An expansion path, 253Short-run cost, 254Application 7.1, measuring fixed costs, 256
Average cost and marginal cost, 257Short-run cost curves, 258
Average variable cost, average fixedcost, ave rage cost, and marginal costcurves, 260
Relationship between marginal cost, aver-age variable cost, and ave rage cost, 262
Diminishing returns, costs, and the stagesof production: more on the relationshipbetween cost functions and productionfunctions, 263
Application 7.2, Advanced technology, vari-able costs, and international competitive-ness of the U.S. steel industry, 265
Conrems
Limiting the use of an input: a business-related application of cost funct-ions, 266
Long-run cost, 268Analysis of long-run costs: variation in
plant size, 269Return to scale and the shape of long-run
cost curves, 271Changes in input prices and technology, 274Empirical studies of cost, 277Summary, 279
8 Profit Maximization and Short-runSupply in Perfectly CompetitiveMarkets, 286
The business firm and perfect competition,287The social functions and internai organiza-
tion of business firms, 287The single-product profit-maximizing
business firm, 288Application 8.1, Vertical integration and busi-
ness profits, 289Perfect competition, 290Demand as seen by a cornpetitive firm,
291Profit maximization, 292
Tatai revenue, tatai cost, and economicprofit, 292
A numerical example: outpur, cost, reve-nue, and profit, 293
Marginal analysis of profit maximi-zation, 294
Graphic analysis of variation in profit asoutput increases over the short-run pe-riod,296
Price, marginal cost, average cost, and theprofit-maximizing output, 298
Breaking even, 300Minimizing losses when price is below
the minimum possible average cost, 300The decision to shut down operations in
the short run, 303Short-run supply, 306
The competitive firrn's short-run supplycurve, 306
xix
Short-run market supply and its deterrni-nants, 306
Short-run price elasticity of supply, 309Applying the theory of short-run supply, 313
A reduction in the price of a variable in-put, 313
Change in the price of a fixed input: Theshort-run of license fees and fixed an-nual subsidies, 315
Using supply curves to calculate producersurplus, 317Price changes and producer surplus, 318Using the sum of producer and consumer
surplus as a measure of gains andlosses from economic policies, 319
Are markets competitive? 321Application 8.2, Is US. agriculture cornpeti-
tive?,322Summary, 323
9 Long-run Equilibrium and Supply inPerfectly Competitive Markets, 328
Firms, industries, and perfect cornpe-tition, 329
Long-run competitive equilibrium and sup-ply, 330Equilibrium of the industry, 330Expansion of the firm in the long run, 331Long-run competitive equilibrium, 332Characteristics of long-run competitive
equilibrium, 334The paradox of profits, 334
Long-run supply, 335Industry adjustment to an increase in de-
mand,335Industry adjustment to a decrease in de-
mand,337The long-run industry supply curve: the
case of constant costs, 338Increasing- and decreasing-costs indus-
tries and long-run industry supplycurves, 339
Long-run supply vs. short-run supply, 342Application 9.1, The impact of improved
technology on long-run equilibrium incompetitive rnarkets: international compe-tition, 343
xx Contents
Differences in firm size and costs under per-fect competition, 344
Applications of the competitive model, 346Long-run impact of a license fee, 346The impact of government policies that
limit entry of firms imo competitivemarkets, 347
The long-run impact of rent controls, 350
PART FOUR
Application 9.2, The impact of rent controlon housing quality: some evidence, 352Taxing the output of a constant-costs in-
dustry,352Subsidizing a competitive industry, 354
The competitive model as a benchmark, 357Summary, 357
NONCOMPETITIVE MARKETS
10 Monopoly, 364
Pure monopoly and monopoly power, 365Barriers to entry: how monopoly power is
maintained, 366Application 10.1, De Beers, diamonds and
the central selling organization: some evi-dence, 367
The demand for a monopolist's product, 371The monopolist's marginal revenue, 371
Price, marginal revenue, and price elastic-ity of dernand, 374
Short-run profit maximization by monopolyfirms,377Short-run monopoly equilibrium: graphic
analysis, 379Monopoly equilibrium and price elasticiry
of demand, 380Long-run monopoly equilibrium, 381
A single-plant monopoly, 381Multipiant monopoly, 382Monopoly supply, 385
Monopoly equilibrium vs. competitive equi-librium, 386The consequences of a monopoly take-
over of a competitive industry, 387The social cost of monopoly, 388
Application 10.2, Breaking up the BellSystem, 389Are there any benefits from monopolies
that can offset the social cost ofmonopoly? 391
Monopoly reaction to price ceilings, taxes,and subsidies, 391Price ceilings, 391
Monopoly reaction to taxes on itsoutput,393
Monopoly reaction to subsidi es, 394Price discrimination, 395
Price discrimination in segmentedrnarkets, 398
Summary, 400
11 Monopolistie Competition and Oligop-oly, 404
Between pure monopoly and perfect corn-peti tion, 405
Monopolistic competition, 406Defining the industry, 407Short-run equilibrium of the firm under
monopolistic competition, 408Long-run equilibrium under monopolistic
competition, 410Comparison with the bench mark compet-
itive equilibrium, 412Implications of excess capacity under rno-
nopolistic competition, 414Advertising and product development in
monopolistically competitive markets, 414Costs of nonprice cornpetition, 414Selling costs, 415Long-run equilibrium with advertising un-
der monopolistic competition, 419Oligopoly, 421
Conscious rivalry: oligopolistic pricewars,423
Oligopoly strategies and the theory ofgames,425
Contents
Collusion and cartels, 428Forming a cartel: directions, 428A real cement cartel in action, 430Advertising under oligopoly, 430
Application 11.1, The OPEC cartel, 431Other oligopoly modeis, 433
Price rigidity and the kinked demandcurve, 434
Price leadership, 435Application 11.2, Pricing decisions in prac-
tice: cost-plus pricing rules 437Entry-limit pricing, 438
Summary, 440Appendix: The Cournot model of
duopoly, 444Reaction curves, 447
12 Market Structure, Efficiency, and Regu-lation, 450
Efficiency, 451Marginal eanditions for efficiency, 452The efficient output of a good maximizes
the sum of producer and consumer sur-plus, 453
Perfectly eampetitive markets and effi-ciency, 455
How the exercise of monopoly power canprevent the efficient output from beingattained, 456
Diagnosing monopoly power, 457Profits as a symptom of rnonopolypower, 457
Application 12.1, Rising concentration in thebeer industry: the causes and conse-quences, 461
PART FIVE
xxi
Contestable rnarkets: can the threat of en-try prevent the exercise of monopolvpower and guarantee efficient outputlevels? 462
Estimating the loss in efficiency from ex-ercise of monopoly power, 464
Are there benefits from monopolypower? 457
Eeanomies of scale, 467Technological progress, 467Product variety and economizing on infor-
mation costs, 468Controlling monopoly power: antitrust po 1-
icy,470Controlling oligopolistic price fixing, 470The rule of reason, 471The relevant market, 471Predatory pricing, 472Recent cases, 472Mergers, 474
Government regulation of pricing and entryin markets, 475Regulating pricing of the output of a natu-
rai monopoly, 475Criticism of government regulation of
pricing by natural monopolies, 476Application 12.2, Peak-load pricing: what it is
and why your electric company wants itapproved, 477Regulating pricing and entry in markets
served by competing sellers, 479The regulatory commissions, 479Deregulation: the case of domestic air
travel markets, 480Summary, 482
INPUT MARKETS
13 Competitive Input Markets and the Eco-nomics of Work and Wages, 488
Perfect competition in input rnarkets, 489The marginal revenue product of an in-
put: a measure of the marginal gainfrom hiring an input, 491
The hiring decision: weighing the mar-ginal gain of additional input useagainst its marginal east, 493
A firrn's input demand curve, 494What can cause a firm's input demand to
change, 495
xxii Contents
Industry and market demand for aninput, 496Derivation of industry input demand
curves, 496Deterrninants of industry input demand
elasticity, 499Market demand, 499
Market supply of inputs and the economicsof work, 501Industry and market supply of inputs, 501The work-leisure choice and labor supply
of an individual worker, 501Deriving a worker's labor supply
curve, 503Income and substitution effects of wage
changes, 503Backward-bending labor supply
curves, 507Market supply of labor services, 507How cash-assistance welfare programs in
the United States affect the labor supplyof recipients, 508
Application 13.1, Labor supply in the UnitedStates, 509
The operation of competitive inputmarkets, 512
Application 13.2, Minimum wages and ern-ployment: the case of teenagers, 514Explaining differences in wages among
occupations and jobs, 516How differences in job quality give rise to
wage differentials, 517Economic rent, 520Input mobility among market sectors, 523Variable input supply, 526
Summary, 526
14 Imperfectly Competitive Input Markets,Work, and Wages, 532
A monopolist's input demand, 533Monopsony, 535
Marginal input cost for monopsony, 536Hiring decisions in monopsonistic input
markets, 539Monopsony power paired with monopoly
power in output markets, 541
Application 14.1, Monopsony power in themarket for professional athletes: a case ofcollusion, 542
Monopoly power of input sellers, 543Labor unions, 543Union control over labor supply, 545Impact of unions on wages, 546The impact of unionization on labor pro-
ductivity, 547Application 14.2, Labor unions and
wages, 548Bilateral monopoly, 549
Union wages, minimum wages, and ern-ployment in monopsonistic labor rnar-kets. some surprising conclusions, 551
Discrimination in labor markets, 553Extreme discrimination: qualified workers
are barred from entering the labor rnar-ket, 554
Less extreme discrirnination: entry intothe market is permitted only if workerssubject to discrimination accept lowerwages,555
Profit maximization, competition, and theimpact of these forces on discrimina-tory wage differentials, 556
Is discrimination actually practiced? 556The issue of comparable worth, 557
Summary, 559
15 Interest Rates, Rents, and the Creationof Capita1, 564
Capital, investment, and interest, 565Capital flows and the capital stock, 565Interest and the supply and demand of
loanable funds, 566How the interest rate affects invest-
ment decisions: a single-periodinvestment, 566
Multiperiod investments, 571Market demand for loanable funds, 573
The supply of savings, 574Time preference, 574
Application 15.1, Human capital, 575The inrerternporal budget constraint, 577IntertemporaI equilibrium, 577
Conrenrs
Incame and substitution effects of achange in the interest rate, 579
The market supply of savings, 579Determination of the market rate of interest
under perfect competition, 581The market rate of interest and business
investment, 582The market rate of interest and the price
of existing capital assets, 582Application 15.2, Corporate takeovers and
the relevance of the concept of presentvalue, 584
PART SIX
xxiii
Explaining differences in the return on in-vestments and in lending rates, 586Risk, 586Taxes, 586Differences in interest rates, 588
Land rnarkets, 589Location, land use, and land rents, 589Land price and rent differentials, 591
Summary, 591
GENERAL EQUILIBRIUM, EFFICIENCY, AND PUBLIC GOODS
16 General Equilibrium Analysis and Effi-ciency, 598
Partial equilibrium analysis vs. general equi-librium analysis, 599
General equilibrium and efficiency, 601The resource constraint, 601Analysis of production with an Edgeworth
box, 602Productive efficiencv, 604The production possibiliry curve, 605The marginal rate of transfonnation, 606General equilibrium in competitive input
markets and efficiency, 607Application 16.1, Are economic decisions
within business firms efficient? The spec-ter of X-inefficiency, 608
Exchange and allocative efficiency, 609Efficiency in Production and Allocation of
Products, 612General equilibrium, perfect competition,
and the distribution of welfare, 614Prices, profit maximization, utility maximi-
zation, and efficiency, 614The distribution of welfare in competitive
markets, 616Changes in the distribution of in-
came, 617Efficiency vs. equiry, 618Growth in resource availabiliry or produc-
tiviry, 620
Application 16.2, Free trade and efficiency:the net gains and redistributive effects offree international trade, 621
General equilibrium analysis of market dis-tortions, 624Monopoly power and losses in effi-
ciency, 624Tax-induced distortions, 625Balancing distortions: the theory of see-
and best, 626Other distortions, 627
Summary, 627
17 The Theory of Externalities, 632
Externalities, 633Negative externalities, 634Positive externalities, 638
Internalization of externalities: correctivetaxes and subsidies, 640Corrective taxes, 640Corrective subsidi es, 641
Application 17.1, Use of corrective taxes andeffluem charges, 642Administering corrective taxes and subsi-
dies: problems of measurement andidenrification, 643
What causes negative externalities? 644Properry right disputes, 644Transaction costs, 644
The Coase Theorem, 645
xxiv Contents
Application 17.2, Evolution of propertyrights: grazing rights, 646A numerical example, 647Case 1: The emitter has the right to dump
wastes, 649Case 2: The emitter does not have the
right to dump waste, 650Additional alternatives and profits, 651Significance of the Coase theorem, 652
Applications of the theory of exter-nalities, 652Pollution control policy, 652Emissions standards: using regulations
instead of charges to controlpollution, 653
Pollution rights, 657Summary, 660
18 Public Goods, 664
Public goods vs. private goods, 665Characteristics of pure public goods, 665Public goods vs. government-supplied
goods, 666Positive externalities and the efficient out-
put of pure public goods, 667Application 18.1, Government expenditures
in the United States, 667
The demand and supply of pure publicgoods, 670The demand curve for pure public
goods, 670Cooperative supply of pure public
goods,672The free-rider problem, 673
The supply of public goods through politicalinstitutions, 676Voting decisions, 676Political equilibrium under majority rule,
678Majority rule and efficient output of pub-
lic goods, 680Application 18.2, The demand for public
goods, 681Some qualifications, 682
Congestible and exc1udable publicgoods, 682Congestible public goods, 683Excludable public goods, 685
Summary, 686
Glossary, GI
Answers to Even-Numbered Problems, Al