Robert S. Pyndick, Daniel L. Rubinfeld - Third Edition
Chapters: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18; Appendix.
Chapter # 1. Introduction: Markets and Prices.
Microeconomics is concerned with the decisions made by small economic units Ė consumers, workers, investors, owners of resources, and business firms. It is also concerned with the interaction of consumers and firms to form markets and industries.
Microeconomics relies heavily on the use of theory, which can (by simplification) help to explain how economic units behave and predict what that behavior will be in the future. Models are mathematical representations of theory that can help in this explanation and prediction process.
Microeconomics is concerned with positive questions that have to do with the explanation and prediction of phenomena. But microeconomics is also important for normative analysis, in which we ask what choices are best Ė for a firm or for society as a whole. Normative analyses must often be combined with individual value judgments because issues of equity and fairness as well as of economic efficiency ma by involved.
A market refers to a collection of buyers and sellers who interact and to the possibility for sales and purchases that results. Microeconomics involves the study of both perfectly competitive markets in which no single buyer or seller has an impact on price and noncompetitive markets in which individual entities can affect price.
The market price is established by the interaction of buyers and sellers. In a perfectly competitive market, a single price will usually prevail. In markets that are not perfectly competitive, different sellers might charge different prices. Then the market price refers to the average prevailing price.
When discussing a market, we must be clear about its extent in terms both of its geographic boundaries and of the range of products to be included in it. Some markets (e.g., housing) are highly localized, whereas others (e.g., gold) are worldwide.
To eliminate the effects of inflation, we measure real (or constant dollar) prices, rather than nominal (or current dollar) prices. Real prices use an aggregate price index, such as the CPI, to correct the inflation.
Chapter # 2. The basics of Supply and Demand.
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Supply-demand analysis is a basic tool of microeconomics. In competitive markets, supply and demand curves tell us how much will be produced by firms and how much will be demanded by consumers as a function of price.
The market mechanism is the tendency for supply and demand to equilibrate (i.e., for price to move to the market-clearing level), so that there is neither excess demand nor excess supply.
Elasticities describe the responsiveness of supply and demand to changes in price, income, or other variables. For example, the price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1 percent increase in price.
Elasticities pertain to a time frame, and for most goods it is important to distinguish between short-run and long run elasticities.
If we can estimate, at least roughly, the supply and demand curves for a particular market, we can calculate the market-clearing price by equating supply and demand. Also, if we know how supply and demand depend on other economic variables, such as income or the prices of other goods, we can calculate how the market-clearing price and quantity will change as these other variables change. This is a means of explaining or predicting market behavior.
Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities. For many markets such data and estimates are available, and simple "back envelope" calculations can help us understand the characteristics and behavior of the market.
Chapter # 3. Consumer Behavior.
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The theory of consumer choice is built on assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services.
Consumer choice has two related parts: the study of the consumerís preferences, and the analysis of the budget line, which constrains the choices a person can make.
Consumers make choices by comparing market baskets or bundles of commodities. Their preferences are assumed to be complete (they can compare all possible market baskets) and transitive (if they prefer market basket A to B, and B to C, then they prefer A to C). In addition, we have assumed that more of each good is always preferred to less.
Indifference curves, which represent all combinations of goods and services that give the same level of satisfaction, are downward-sloping and cannot intersect one another.
Consumer preferences can be completely described by a setoff indifference curves, or an indifference map. This indifference map provides an ordinal ranking of all choices that the consumer might make.
The marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F. The marginal rate of substitution diminishes as we move down along an indifference curve. When there is a diminishing marginal rate of substitution, preferences are convex.
Budget lines represent all combinations of goods for which consumers expend all their income. Budget lines shift outward in response to an increase in consumer income, but they pivot and rotate about a fixed point (on the vertical axis) when the price of one good (on the horizontal axis) changes but income and the price of the other good do not.
Consumers maximize satisfaction subject to budget constraints. When a consumer maximizes satisfaction by consuming some of each of two goods, the marginal rate of substitution is equal to the ratio of the prices of the two goods being purchased.
This maximization is sometimes achieved at a corner solution in which one good is not consumed. In that case the marginal rate of substitution need not equal the ratio of the prices.
The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. When an individual chooses basket A when she could afford B, we know that A is preferred to B.
The theory of the consumer can be presented using either an indifference curve approach, which uses the ordinal properties of utility (that is, which allows for the ranking of alternatives), or a utility function approach. A utility function is obtained by attaching a number to each market basket; if market basket A is preferred to market basket B, A generates more utility than B.
When risky choices are analyzed or when comparisons must be made among individuals, the cardinal properties of the utility function can be important. Usually the utility function will show diminishing marginal utility: As more and more of a good is consumed, the consumer obtains smaller and smaller increments of utility.
When the utility function approach is used and both goods are consumed, utility maximization occurs when the ratio of the marginal utilities of the two goods (which is the marginal rate of substitution) is equal to the ratio of the prices.
Chapter # 4. Individual and Market Demand.
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Individual consumerís demand curves for a commodity can be derived from information about their tastes for all goods and services and from their budget constraints.
Engel curves, which describe the relationship between the quantity of a good consumed and income, can be useful for discussions of how consumer expenditures vary with income.
Two goods are substitutes if an increase in the price of one good leads to an increase in the quantity demanded of the other. In contrast, two goods are complements if an increase in the price of one leads to a decrease in the quantity demanded of the other.
The effect of a price change on the quantity demanded of a good can be broken into two parts Ė a substitution effect, in which satisfaction remains constant but the price changes, and an income effect, in which the price remains constant but satisfaction changes. Because the income effect can be positive or negative, a price change can have a small or a large effect on quantity demanded. In one unusual but interesting case (that of a Giffen good), the quantity demanded may move in the same direction as the price change (leading to an upward-sloping individual demand curve).
The market demand curve is the horizontal summation of the individual demand curves of all consumers in the market for the good. The market demand curve can be used to calculate how much people value the consumption of particular goods and services.
Demand is price inelastic when a 1 percent increase in price leads to a less than 1 percent decrease in quantity demanded, so that the consumerís expenditure increases. Demand is price elastic when a 1 percent increase in price leads to a more than 1 percent decrease in quantity demanded, so that the consumerís expenditure decreases. Demand is unit elastic when a 1 percent increase in price leads to a 1 percent decrease in quantity demanded.
The concept of consumer surplus can be useful in determining the benefits that people receive from the consumption of a product. Consumer surplus is the difference between what a consumer is willing to pay for a good and what he actually pays when buying it.
There is a network externality when one personís demand is affected directly by the purchasing decisions of other consumers. One example of a positive network externality, the bandwagon effect, occurs when a typical consumerís quantity demanded increases because she considers it stylish to buy a product that others have purchased. An example of a negative network externality, the snob effect, occurs when the quantity demanded by a consumer increases the fewer people who own the good.
A number of methods can be used to obtain information about consumer demand. These include interview and experimental approaches, direct marketing experiments, and the more indirect statistical approach. The statistical approach can be very powerful in its application, but it is necessary to determine the appropriate variables that affect demand before the statistical work is done.
Chapter # 5. Choice Under Uncertainty.
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Consumers and managers frequently make decisions in which there is uncertainty about the future. This uncertainty is characterized by the term risk, when each of the possible outcomes and its probability of occurrence is known.
Consumers and investors are concerned about the expected value and the variability of uncertain outcomes. The expected value is a measure of the central tendency of the value of the risky outcomes. The variability is frequently measured by the variance of outcomes, which is the average of the squares of the deviations of each possible outcome from its expected value.
Facing uncertain choices, consumers maximize their expected utility, an average of the utility associated with each outcome, with the associated probabilities serving as weights.
A person who would prefer a certain amount to a risky investment whose expected return is the same amount is risk averse. The maximum amount of money that a risk-averse person would pay to avoid taking a risk is the risk premium.
A person who is indifferent between a risky investment and the certain receipt of the expected return on that investment is risk neutral.
A risk-loving consumer would prefer a risky investment with a given expected return to the certain receipt of that expected sum.
Risk can be reduced by (a) diversification, (b) purchasing insurance, and (c) obtaining additional information.
The law of large numbers enables insurance companies to provide actuarially fair insurance for which the premium paid equals the expected value of the loss being insured against.
Consumer theory can be applied to decisions to invest in risky assets. The budget line reflects the price of risk, and consumersí indifference curves reflect their attitudes toward risk.
Chapter # 6. Production.
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A production function describes the maximum output a firm can produce for each specified combination of inputs.
An isoquant is a curve that shows all combinations of inputs that yield a given level of output. A firmís production function can be represented by a series of isoquants associated with different levels of output.
In the short run, one or more inputs to the production process are fixed, whereas in the long run all inputs are potentially variable.
Production with one variable input, labor, can be usefully described in terms of the average product of labor (which measures the productivity of the average worker), and the marginal product of labor (which measures the productivity of the last worker added to the production process).
According to the "law of diminishing returns", when one or more inputs are fixed, a variable input (usually labor) is likely to have a marginal product that eventually diminishes as the level of input increases.
Isoquants always slope downward because the marginal product of all inputs is positive. The shape of each isoquant can be described by the marginal rate of technical substitution at each point on the isoquant. The marginal rate of technical substitution of labor for capital (MRTS) is the amount by which the input of capital can be reduced when one extra unit of labor is used, so that output remains constant.
The standard of living that a country can attain for its citizens is closely related to its level of labor productivity. Recent decreases in the rate of productivity growth in developed countries are due in part to the lack of growth of capital investment.
The possibilities for substitution among inputs in the production process range from a production function in which inputs are perfectly substitutable to one in which the proportions of inputs to be used are fixed (a fixed-proportions production function).
In the long-run analysis, we tend to focus on the firmís choice of its scale or size of operation. Constant returns to scale means that doubling all inputs leads to doubling output. Increasing returns to scale occurs when output more than doubles when inputs are doubled, whereas decreasing returns to scale applies when output less than doubles.
Chapter # 7. The Cost of Production.
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Mangers, investors, and economists must take into account the opportunity cost associated with the use of the firmís resources Ė the cost associated with the opportunities foregone when the firm uses its resources in its next best alternative.
In the short run, one ore more of the inputs of the firm are fixed. Total cost can be divided into fixed cost and variable cost. A firmís marginal cost is the additional variable cost associated with each additional unit of output. The average variable cost is the total variable cost divided by the number of units of output.
When there is a single variable input, as in the short run, the presence of diminishing returns determines the shape of the cost curves. In particular, there is an inverse relationship between the marginal product of the variable input and the marginal cost of production. The average variable cost and average total cost curves are U-shaped. The short-run marginal cost curve (U-shaped also) increases beyond a certain point, and cuts both average cost curves from below at their minimum points.
In the long run, all inputs to the production process are variable. As a result, the choice of inputs depends both on the relative costs of the factors of production and on the extent to which the firm can substitute among inputs in its production process. The cost-minimizing input choice is made by finding the point of tangency between the isoquant representing the level of desired output and an isocost line.
The firmís expansion path describes how its cost-minimizing input choices vary as the scale or output of its operation increases. As a result, the expansion path provides useful information relevant for long-run planning decisions.
The long-run average cost curve is the envelope of the firmís short-run average cost curves, and it reflects the presence or absence of returns to scale. When there are constant returns to scale and many plant sizes are possible, the long-run cost curve is horizontal, and the envelope consists of the points of minimum short-run cost. However, when there are increasing returns to scale initially and then decreasing returns to scale, the long-run average cost curve is U-shaped, and the envelope does not include all points of minimum short-run average cost.
A firm enjoys economies of scale when it can double its output at less than twice the cost. Correspondingly, there are diseconomies of scale when a doubling of output requires more than twice the cost. Scale economies and diseconomies apply even when input proportions are variable; returns to scale applies only when input proportions are fixed.
When a firm produces to (or more) outputs, it is important to note whether there are economies of scope in production. Economies of scope arise when the firm can produce any combination of the two outputs more cheaply than could two independent firms that each produced a single product. The degree of economies of scope is measured by the percentage in reduction in cost when one firm produces two products relative to the cost of producing them individually.
A firmís average cost of production can fall over time if the firm "learns" how to produce more effectively. The learning curve describes how much the input needed to produce a given output falls as the cumulative output of the firm increases.
Cost functions relate the cost of production to the level of output of the firm. The functions can be measured in both the short run and the long run by using either data for firms in an industry at a given time or data for an industry over time. A number of functional relationships including linear, quadratic, and cubic can be used to represent cost functions.
Chapter # 8. Profit Maximization and Competitive Supply.
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The managers of firms can operate in accordance with a complex set of objectives and under various constraints. However, we can assume that firms act as if they are maximizing their long-run profit.
Because a firm in a competitive market has a small share of total industry output, it makes its output choice under the assumption that the demand for its own output is horizontal, in which case the demand curve and the marginal revenue curve are identical.
In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost, so long as price is greater than or equal to the firmís minimum average variable cost of production.
The short-run market supply curve is the horizontal summation of the supply curves of the firms in an industry. It can be characterized by the elasticity of supply Ė the percentage change in quantity supplied in response to a percentage change in price.
The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-maximizing output. In both the short run and the long run, producer surplus is the area under the horizontal price line and above the marginal cost of production for the firm.
Economic rent is the payment for a scarce factor of production less the minimum amount necessary to hire the factor. In the long run in a competitive market, producer surplus is equal to the economic rent generated by all scarce factors of production.
In the long run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost.
A long-run competitive equilibrium occurs when (i) firms maximize profit;(ii) all firms earn zero economic profit, so that there is no incentive to enter or exit the industry; and (iii) the quantity of the product demanded is equal to the quantity supplied.
The long-run supply curve for a firm is horizontal when the industry is a constant-cost industry in which the increased demand for inputs to production (associated with an increased demand for the product) has no effect on the market price of the inputs. But the long-run supply curve for a firm is upward sloping in an increasing-cost industry, where the increased demand for inputs causes the market price of some or all inputs to production to rise.
Many markets may approximate perfect competition in that one or more firms act as if they face a nearly horizontal demand curve. However, the number of firms in an industry is not always a good indicator of the extent to which that industry is competitive.
Chapter # 9. The Analysis of Competitive Markets.
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Simple models of supply and demand can be used to analyze a wide variety of government policies. Specific policies that we have examined include price controls, minimum prices, price support programs, production quotas or incentive programs to limit output, import tariffs, and taxes and subsidies.
In each case, consumer and producer are used to evaluate the gains and losses to consumers and producers. Applying the methodology to natural gas price controls, airline regulation, price supports for wheat, and the sugar quota, we found that these gains and losses can be quite large.
When government imposes a tax or subsidies, price usually does not rise or fall by the full amount of the tax or subsidy. Also, the incidence of a tax or subsidy is usually split between producers and consumers. The fraction that each group ends up paying or receiving depends on the relative elasticities of supply and demand.
Government intervention generally leads to a deadweight loss; even if consumer welfare and producer welfare are weighted equally, there will be a net loss from government policies that shifts welfare from one group to the other. In some cases this deadweight loss will be small, but in other cases Ė price supports and import quotas are examples Ė it is large. This deadweight loss is a form of economic inefficiency that must be taken into account when policies are designed and implemented.
Government intervention in a competitive market is not always a bad thing. Government Ė and the society it represents Ė might have other objectives besides economic efficiency. And there are situations in which government intervention can improve economic efficiency. Examples are externalities and cases of market failure. These situations, and the way government can respond to them, are discussed in Chapters 17 and 18.
Chapter # 10. Market Power: Monopoly and Monopsony.
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Market power is the ability of sellers or buyers to affect the price of a good.
Market power comes in two forms. When sellers charge a price that is above marginal cost, we say that they have monopoly power, and we measure the amount of monopoly power by the extent to which price exceeds marginal cost. When buyers can obtain a price that is below their marginal value of the good, we say they have monopsony power, and we measure the amount of monopsony power by the extent to which marginal value exceeds price.
Monopoly power is determined in part by the number of firms competing in the market. If there is only one firm Ė a pure monopoly Ė monopoly power depends entirely on the elasticity of market demand. The less elastic demand is, the more monopoly power the firm will have. When there are several firms, monopoly power also depends on how the firms interact. The more aggressively they compete, the less monopoly power each firm will have.
Monopsony power is determined in part by the number of buyers in the market. If there is one buyer Ė a pure monopsony Ė monopsony power depends on the elasticity of market supply. The less elastic supply is, the more monopsony power the buyer will have. When there are several buyers, monopsony power also depends on how aggressively buyers compete for supplies.
Market power can impose costs on society. Monopoly and monopsony power both cause production to be below the competitive level, so that there is a deadweight loss of consumers and producers surplus.
Sometimes, scale economies make pure monopoly desirable. But the government will still want to regulate price to maximize social welfare.
More generally, we rely on antitrust laws to prevent firms from obtaining excessive market power.
Chapter # 11. Pricing With Market Power.
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Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firmís pricing strategy. Even if the firm sets a single price, it needs an estimate of the elasticity of demand for its output. More complicated strategies, which can involve setting several different prices, require even more information about demand.
A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible. There are a number of ways to do this, and they usually involve setting more than a single price.
Ideally, the firm would like to perfectly price discriminate, i.e., charge each customer his/her reservation price. In practice this almost always impossible. On the other hand, various forms of imperfect price discrimination are often used to increase profits.
The two-part tariff is another means of capturing consumer surplus. Customers must pay an "entry" fee, which allows them to buy the good at a per-unit price. The two-part tariff is most effective when customer demands are relatively homogeneous.
When demands are heterogeneous and negatively correlated, bundling can increase profits. With pure bundling, two or more different goods are sold only as a package. With mixed bundling, the customer can buy the goods individually or as a package.
Bundling is a special case of tying, a requirement that products be bought or sold in some combination. Tying can be used to meter demand or to protect customer goodwill associated with a brand name.
Advertising can further increase profits. The profit-maximizing advertising-to-sales ratio (A/PQ= -(Ea/Ep)) is equal to magnitude to the ratio of the advertising and price elasticities of demand.
Chapter # 12. Monopolistic Competition and Oligopoly.
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In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable. New firms can enter or exit easily. Firms have only a small amount of monopoly power. In the long run, entry will occur until profits are driven to zero. Firms then produce with excess capacity (i.e., at output levels below those that minimize average cost).
In an oligopolistic market, only a few firms account for most or all of production. Barriers to entry allow some firms to earn substantial profits, even over the long run. Economic decisions involve strategic considerations Ė each firm must consider how its actions will affect its rivals, and how they are likely to react.
In the Cournot model of oligopoly, firms make their output decisions at the same time, each taking the otherís output as fixed. In equilibrium, each firm is maximizing its profit, given the output of its competitor, so no firm has an incentive to change its output. The firms are therefore in a Nash equilibrium. Each firmís profit is higher than under perfect competition, but less than what it would earn by colluding.
In the Stackelberg model, one firm sets its output first. That firm has a strategic advantage and earns a higher profit. It knows it can choose small output, and its competitors will have to choose small outputs if they want to maximize profits.
The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price. In equilibrium, each firm maximizes its profit, given the prices of its competitors, and so has no incentive to change price.
Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this. They might all set a high price without colluding, each hoping its competitors will do the same, but they are in a Prisonersí Dilemma, which makes this unlikely. Each firm has an incentive to cheat by lowering its price and capturing sales from its competitors.
The Prisonersí Dilemma creates price rigidity in oligopolistic markets. Firms are reluctant to change prices for fear of setting off a round of price warfare.
Price leadership is a form of implicit collusion that sometimes gets around the Prisonersí Dilemma. One firm sets price, and the other firms follow with the same price.
In a cartel, producers explicitly collude in setting prices and output levels. Successful cartelization requires that the total demand not be very price elastic, and that either the cartel control most supply or else the supply of noncartel producers be inelastic.
Chapter # 13. Game Theory and Competitive Strategy.
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A game is cooperative if the players can communicate and arrange binding contracts; otherwise it is noncooperative. In either kind of game, the most important aspect of strategy design is understanding your opponentís position, and (if your opponent is rational) correctly deducing the likely response to your actions. Misjudging an opponentís position is a common mistake.
A Nash equilibrium is a set of strategies such that each player is doing the best it can, given the strategies of the other players. An equilibrium in dominant strategies is a special case of a Nash equilibrium; a dominant strategy is optimal no matter what the other players do. A Nash equilibrium relies on the rationality of each player. A maximin strategy is more conservative because it maximizes the minimum possible outcome.
Some games have no Nash equilibria in pure strategies, but have one or more equilibria in mixed strategies. A mixed strategy is one in which the player makes a random choice among two or more possible actions, based on a set of chosen probabilities.
Strategies that are not optimal for a one-shot game may be optimal for a repeated game. Depending on the number of repetitions, a "tit-for-tat" strategy, in which one plays cooperatively as long as oneís competitor does the same, may be optimal for the repeated Prisonersí Dilemma.
In a sequential game, the players move in turn. In some cases, the player who moves first has an advantage. Players may then have an incentive to try to precommit themselves to particular actions before their competitors can do the same.
An empty threat is a threat that one would have no incentive to carry out. If oneís competitors are rational, empty threats are of no value. To make a threat credible, it is sometimes necessary to make a strategic move by constraining oneís later behavior, so that there would be an incentive to carry out the threat.
To deter entry, an incumbent firm must convince any potential competitor that entry will by unprofitable. This may be done by investing, and thereby giving credibility to the threat that entry will be met by price warfare. Strategic trade policies by governments sometimes have this objective.
Bargaining situations are examples of cooperative games. As with noncooperative games, in bargaining one can sometimes gain a strategic advantage by limiting oneís flexibility.
Chapter # 14. Markets For Factor Inputs.
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In a competitive input market, the demand for an input is given by the marginal revenue product, the product of the firmís marginal revenue and the marginal product of the input.
A firm in a competitive labor market will hire workers to the point at which the marginal revenue product of labor is equal to the wage rate. This is analogous to the profit-maximizing output condition that production be increased to the point at which marginal revenue is equal to marginal cost.
The market demand for an input is the horizontal sum of the industry demands for that input. Industry demand, however, is not horizontal sum of the demands of all firms in the industry. An appropriate determination of industry demand must take into account that the market price of the product will change in response to the change in the price of an output.
When factor markets are competitive, the buyer of an input assumes that its purchases will have no effect on the price of the input. As a result, the marginal expenditure and average expenditure curves that the firm faces are both perfectly elastic.
The market supply of a factor need not be upward sloping. A backward-bending labor supply curve can result if the income effect associated with a higher wage rate (more leisure is demanded because leisure is normal good) is greater than the substitution effect (less leisure is demanded because the price of leisure has gone up).
Economic rent is the difference between the payments to factors of production and the minimum payment that would be needed to employ those factors. In a labor market, rent is measured by the area below the wage level and above the marginal expenditure curve.
When a buyer of an input has monopsony power, the marginal expenditure curve lies above the average expenditure curve, which reflects that the monopsonist must pay a higher price to attract more of the input into employment.
When the input seller is a monopolist such as a labor union, the seller chooses the point on the marginal revenue product curve that best suits its objective. Maximization of employment, economic rent, and wages are three plausible objectives for labor unions.
When a monopolistic union bargains with a monopolistic employer, the wage rate depends on the nature of the bargaining process. There is little reason to believe that the competitive outcome will be achieved.
Chapter # 15. Investment, Time, And Capital Markets.
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A firmís holding of capital is measured as a stock, but inputs of labor and raw materials are flows. Its stock of capital enables a firm to earn a flow of profits over time.
When a firm makes a capital investment, it spends money now, so that it can earn profits in the future. To decide whether the investment is worthwhile, the firm must determine the present value of future profits by discounting them.
The present discounted value (PDV) of $1 paid one year from now is $1/(1+R), where R is the interest rate. The PDV of $1 paid n years from now is $1/(1+R)n.
A bond is a contract in which a lender agrees to pay the bondholder a stream of money. The value of the bond is the PDV of that stream. The effective yield on a bond is the interest rate that equates that value with the bondís market price. Bond yields differ because of differences in riskiness and time to maturity.
Firms can decide whether to undertake a capital investment by applying the Net Present Value (NPV) criterion: invest if the present value of the expected future cash flows from an investment is larger than the cost of the investment.
The discount rate that a firm uses to calculate the NPV for an investment should be the opportunity cost of capital, i.e., the return the firm could earn on a similar investment.
When calculating NPVs, if cash flows are in nominal terms (i.e., include inflation), the discount rate should also be normal, but if cash flows are in real terms (i.e., are net of inflation), a real discount rate should be used.
An adjustment for risk can be made by adding a risk premium to the discount rate. However, the risk premium should reflect only nondiversifiable risk. Using the Capital Asset Pricing Model (CAPM), the risk premium is the "beta" for the project times the risk premium on the stock market as a whole. The "beta" measures the sensitivity of the projectís return to movements in the market. ri Ė rf = B(rm Ė rf).
Consumers are also faced with investment decisions that require the same kind of analysis as those of firms. When deciding whether to buy a durable good like a car or a major appliance, the consumer must consider the present value of future operating costs.
An exhaustible resource in the ground is like money in the bank and must earn a comparable return. Therefore, if the market is competitive, price less marginal extraction cost will grow at the rate of interest. The difference between price and marginal cost is called user cost Ė it is the opportunity cost of depleting a unit of the resource,
Market interest rates are determined by the demand and supply of loanable funds. Households supply funds so they can consume more in the future. Households, firms, and the government demand funds. Changes in demand or supply cause changes in interest rate.
Chapter # 16. General Equilibrium And Economic Efficiency.
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Partial equilibrium analyses of markets assume that related markets are unaffected. General equilibrium analyses examine all markets simultaneously, taking into account feedback effects of other markets on the market being studied.
An allocation is efficient when no consumer can be made better of by trade without making someone else worse off. When consumers make all mutually advantageous trades, the outcome is efficient and lies on the contract curve.
A competitive equilibrium describes a set of prices and quantities, so that when each consumer chooses his/her most preferred allocation, the quantity demanded is equal to the quantity supplied in every market. All competitive equilibrium allocations lie on the exchange contract curve and are Pareto efficient.
The utility possibilities frontier measures all efficient allocations in terms of the levels of utility that each person achieves. Although both individuals prefer some allocations to an inefficient allocation, not every efficient allocation must be so preferred. Thus, an inefficient allocation can be more equitable than an efficient one.
Because a competitive equilibrium need not be equitable, the government may wish to help redistribute wealth from rich to poor. Because such redistribution is costly, there is some conflict between equity and efficiency.
An allocation of production inputs is technically efficient if the output of one good cannot be increased without decreasing the output of some other good. All points of technical efficiency lie on the production contract curve and represent points of tangency of the isoquants for the two goods.
A competitive equilibrium in input markets occurs when the marginal rate of technical substitution between pairs of inputs is equal to the ratio of the prices of the inputs.
The production possibilities frontier measures all efficient allocations in terms of the levels of output that can be produced with a given combination of inputs. The marginal rate of transformation of food for clothing increases as more food and less clothing are produced. The marginal rate of transformation is equal to the ratio of the marginal cost of producing food to the marginal cost of producing clothing.
Efficiency in the allocation of goods to consumers is achieved only when the marginal rate of substitution of one good for another in consumption (which is the same for all consumers) is equal to the marginal rate of transformation of one good for another in production.
When input and output markets are perfectly competitive, the marginal rate of substitution (which equals the ratio of the prices of the goods) will equal the marginal rate of transformation (which equals the ratio of the marginal costs of producing the goods).
Free international trade expands a countryís production possibilities frontier. As a result, consumers will be better off.
Competitive markets may be inefficient for four reasons. First, firms or consumers may have market power in input or output markets. Second, consumers or producers may have incomplete information and may therefore err in their consumption and production decision. Third, externalities may be present. Fourth, some socially desirable public goods may not be produced.
Chapter # 17. Markets with Asymmetric Information.
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The seller of a product often has better information about its quality than the buyer. Asymmetric information of this type creates a market failure in which bad products tend to drive good products out of the market. The market failure can be eliminated if sellers offer standardized products, provide guarantees or warranties, or find other ways to maintain a good reputation for their product.
Insurance market frequently involve asymmetric information because the insuring party has better information about the risk involved than the insurance company. This can lead to adverse selection, in which the poorer risks choose to insure, and good risks do not. Another problem for insurance markets is moral hazard, in which the insuring party takes less care to avoid losses after insuring than before.
Sellers can deal with the problem of asymmetric information by sending buyers signals about quality of their product. For example, workers can signal their high productivity by obtaining a high level of education.
Asymmetric information my make it costly for the owners of firms (the principal) to monitor accurately the behavior of the firmís manager (the agent). Manager may seek higher fringe benefits for themselves, or a goal of sales maximization, even though the shareholders would prefer to maximize profit.
Owners can avoid some of the principal-agent problems by designing contracts that give their agents the incentive to perform productively.
Asymmetric information can explain why labor markets have substantial unemployment when some workers are actively seeking work. According to efficiency wage theory, a wage higher than the competitive wage (the efficiency wage) increases worker productivity by discouraging workers from shirking on the job.
Chapter # 18. Externalities And Public Goods.
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There is externality when a producer or a consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market. Externalities cause market inefficiencies because they inhibit the ability of market prices to convey accurate information about how much to produce and how much to buy.
Pollution is a common example of an externality that leads to market failure. It can be corrected by emission standards, emission fees, marketable emission permits, or by encouraging recycling. When there is uncertainty about costs and benefits, any of these mechanisms can be preferable, depending on the shapes of the marginal social cost and marginal benefit curves.
Inefficiencies due to market failure may be eliminated through private bargaining among the affected parties. According to Coase Theorem, the bargaining solution will be efficient when property rights are clearly specified, when transactions costs are zero, and when there is no strategic behavior. But bargaining is unlikely to generate an efficient outcome because parties frequently behave strategically.
Common property resources are not controlled by a single person and can be used without a price being paid. As a result of the free usage, an externality is created in which the current overuse of the resource harms those who might use it in the future.
Goods that private markets are not likely to produce efficiently are either nonrival or nonexclusive. Public goods are both. A good is nonrival if for any given level of production, the marginal cost of providing it to an additional consumer is zero. A good is nonexclusive if it is expensive or impossible to exclude people from consuming it.
A public good is provided efficiently when the vertical sum of the individual demands for the public good is equal to the marginal cost of producing it.
Majority rule voting is one way for citizens to voice their presence for public goods. Under majority rule, the level of spending provided will be that preferred by the median voter. This need not be the efficient outcome.
Appendix. The Basics Of Regression.
Multiple regression is a means of fitting economic relationships to data.
The linear regression model, which relates one dependent variable to one or more independent variables, is usually estimated by choosing the intercept and slope parameters that minimize the sum of the squared residuals between the actual and predicted values of the dependent variable.
In a multiple-regression model, each slope coefficient measures the effect on the dependent variable of a change in the corresponding independent variable, holding the effects of all other interdependent variables constant.
A t-test can be used to test the hypothesis that a particular slope coefficient is different from zero.
The overall fit of the regression equation can be evaluated using the standard error of the regression (a value close to zero means a good fit), or R2 (a value close to one means a good fit).
Regression models can be used to forecast future values of the dependent variable. The standard error of forecast (SEF) measures the accuracy of the forecast.