Microeconomics

FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
13 The Costs of Production The theory of the firm sheds light on the decisions that lie
behind supply in competitive markets.
14 Firms in Competitive Markets
15 Monopoly
Firms with market power can cause market outcomes to
16 Monopolistic Competition
be inefficient.
17 Oligopoly
THE ECONOMICS OF LABOR MARKETS

18 The Markets for the Factors of Production
These chapters examine the special features of labor markets,
19 Earnings and Discrimination
in which most people earn most of their income.
20 Income Inequality and Poverty
TOPICS FOR FURTHER STUDY

21 The Theory of Consumer Choice Additional topics in microeconomics include household decision
making, asymmetric information, political economy, and
22 Frontiers of Microeconomics behavioral economics.
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PRIN CIPL E S O F
Microeconomics FIF TH EDITION
N. GREGORY MANKIW
HARVARD UNIVERSITY
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N. Gregory Mankiw
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1 2 3 4 5 6 7 12 11 10 09 08
To Catherine, Nicholas, and Peter,
my other contributions to the next generation
About the Author
N. Gregory Mankiw is professor of economics at Harvard University. As a stu-

dent, he studied economics at Princeton University and MIT. As a teacher, he has
taught macroeconomics, microeconomics, statistics, and principles of econom-
ics. He even spent one summer long ago as a sailing instructor on Long Beach
Island.
Professor Mankiw is a prolific writer and a regular participant in
academic and policy debates. His work has been published in schol-
arly journals, such as the American Economic Review, Journal of Politi-
cal Economy, and Quarterly Journal of Economics, and in more popular
forums, such as The New York Times and The Wall Street Journal. He
is also author of the best-selling intermediate-level textbook Macro-
economics (Worth Publishers). In addition to his teaching, research,
and writing, Professor Mankiw has been a research associate of the
National Bureau of Economic Research, an adviser to the Federal
Reserve Bank of Boston and the Congressional Budget Office, and
a member of the ETS test development committee for the Advanced
Placement exam in economics. From 2003 to 2005, he served as chair-
man of the President’s Council of Economic Advisers.
Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah,
three children, Catherine, Nicholas, and Peter, and their border terrier, Tobin.
vi
Brief Contents
PART I INTRODUCTION 1 PART V FIRM BEHAVIOR AND THE

CHAPTER 1 Ten Principles of Economics 3 ORGANIZATION OF INDUSTRY 265
CHAPTER 2 Thinking Like an Economist 21 CHAPTER 13 The Costs of Production 267
CHAPTER 3 Interdependence and the Gains from CHAPTER 14 Firms in Competitive Markets 289
Trade 49 CHAPTER 15 Monopoly 311
CHAPTER 16 Monopolistic Competition 345
PART II HOW MARKETS WORK 63 CHAPTER 17 Oligopoly 365
CHAPTER 4 The Market Forces of Supply
and Demand 65 PART VI THE ECONOMICS OF LABOR
CHAPTER 5 Elasticity and Its Application 89 MARKETS 389
CHAPTER 6 Supply, Demand, and Government CHAPTER 18 The Markets for the Factors of
Policies 113 Production 391
CHAPTER 19 Earnings and Discrimination 413
PART III MARKETS AND WELFARE 135 CHAPTER 20 Income Inequality and Poverty 433
CHAPTER 7 Consumers, Producers, and the Efficiency
of Markets 137 PART VII TOPICS FOR FURTHER
CHAPTER 8 Application: The Costs of Taxation 159 STUDY 455
CHAPTER 9 Application: International Trade 177 CHAPTER 21 The Theory of Consumer
Choice 457
PART IV THE ECONOMICS OF THE PUBLIC CHAPTER 22 Frontiers of Microeconomics 483
SECTOR 201
CHAPTER 10 Externalities 203
CHAPTER 11 Public Goods and Common Resources 225
CHAPTER 12 The Design of the Tax System 241
vii
Preface: To the Student
“Economics is a study of mankind in the ordinary business of life.” So wrote

Alfred Marshall, the great 19th-century economist, in his textbook, Principles of
Economics. Although we have learned much about the economy since Marshall’s
time, this definition of economics is as true today as it was in 1890, when the first
edition of his text was published.
Why should you, as a student at the beginning of the 21st century, embark on
the study of economics? There are three reasons.
The first reason to study economics is that it will help you understand the
world in which you live. There are many questions about the economy that might
spark your curiosity. Why are apartments so hard to find in New York City? Why
do airlines charge less for a round-trip ticket if the traveler stays over a Saturday
night? Why is Johnny Depp paid so much to star in movies? Why are living stan-
dards so meager in many African countries? Why do some countries have high
rates of inflation while others have stable prices? Why are jobs easy to find in
some years and hard to find in others? These are just a few of the questions that a
course in economics will help you answer.
The second reason to study economics is that it will make you a more astute par-
ticipant in the economy. As you go about your life, you make many economic deci-
sions. While you are a student, you decide how many years to stay in school. Once
you take a job, you decide how much of your income to spend, how much to save,
and how to invest your savings. Someday you may find yourself running a small
business or a large corporation, and you will decide what prices to charge for your
products. The insights developed in the coming chapters will give you a new per-
spective on how best to make these decisions. Studying economics will not by itself
make you rich, but it will give you some tools that may help in that endeavor.
The third reason to study economics is that it will give you a better understand-
ing of both the potential and the limits of economic policy. Economic questions
are always on the minds of policymakers in mayors’ offices, governors’ mansions,
and the White House. What are the burdens associated with alternative forms of
taxation? What are the effects of free trade with other countries? What is the best
way to protect the environment? How does a government budget deficit affect
the economy? As a voter, you help choose the policies that guide the allocation of
society’s resources. An understanding of economics will help you carry out that
responsibility. And who knows: Perhaps someday you will end up as one of those
policymakers yourself.
Thus, the principles of economics can be applied in many of life’s situations.
Whether the future finds you reading the newspaper, running a business, or sit-
ting in the Oval Office, you will be glad that you studied economics.
N. Gregory Mankiw
September 2008
ix
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Acknowledgments
In writing this book, I benefited from the input of many talented people. Indeed,
the list of people who have contributed to this project is so long, and their contri-
butions so valuable, that it seems an injustice that only a single name appears on
the cover.
Let me begin with my colleagues in the economics profession. The four edi-
tions of this text and its supplemental materials have benefited enormously from
their input. In reviews and surveys, they have offered suggestions, identified chal-
lenges, and shared ideas from their own classroom experience. I am indebted to
them for the perspectives they have brought to the text. Unfortunately, the list has
become too long to thank those who contributed to previous editions, even though
students reading the current edition are still benefiting from their insights.
Most important in this process have been Ron Cronovich (Carthage College)
and David Hakes (University of Northern Iowa). Ron and David, both dedicated
teachers, have served as reliable sounding boards for ideas and hardworking part-
ners with me in putting together the superb package of supplements.
For this new edition, the following diary reviewers recorded their day-to-day
experience over the course of a semester, offering detailed suggestions about how
to improve the text.
John Crooker, University of Central Francis Kemegue, Bryant University

Missouri Douglas Miller, University of Missouri
Rachel Friedberg, Brown University Babu Nahata, University of Louisville
Greg Hunter, California State Edward Skelton, Southern Methodist
University, Polytechnic, Pomona University
Lillian Kamal, Northwestern University
The following reviewers of the fourth edition provided suggestions for refining
the content, organization, and approach in the fifth.
Syed Ahmed, Cameron University Bruce Brown, California State

Farhad Ameen, State University of New University, Polytechnic, Pomona
York, Westchester Community College Lynn Burbridge, Northern Kentucky
Mohammad Bajwa, Northampton University
Community College Mark Chester, Reading Area
Carl Bauer, Oakton Community College Community College
Roberta Biby, Grand Valley State David Ching, University of Hawaii,
University Manoa
Stephen Billings, University of Colorado Sarah Cosgrove, University of
at Boulder Massachusetts, Dartmouth
xii
ACKNOWLEDGMENTS xiii
Craig Depken, University of North William Mertens, University of

Carolina, Charlotte Colorado
Angela Dzata, Alabama State Francis Mummery, Fullerton College
University David Mushinski, Colorado State
Jose Esteban, Palomar College University
Mark Frascatore, Clarkson University Christopher Mushrush, Illinois State
Satyajit Ghosh, University of Scranton University
Soma Ghosh, Bridgewater State Babu Nahata, University of Louisville
College Laudo Ogura, Grand Valley State
Daniel Giedeman, Grand Valley State University
University Michael Patrono, Okaloosa-Walton
Robert L. Holland, Purdue University College
Anisul Islam, University of Houston, Jeff Rubin, Rutgers University, New
Downtown Brunswick
Nancy Jianakoplos, Colorado State Samuel Sarri, College of Southern
University Nevada
Paul Johnson, University of Alaska, Harinder Singh, Grand Valley State
Anchorage University
Robert Jones, University of David Spencer, University of Michigan
Massachusetts, Dartmouth David Switzer, Saint Cloud State
University Henry Terrell, University of Maryland
Jongsung Kim, Bryant University Ngocbich Tran, San Jacinto College
Marek Kolar, Delta College Miao Wang, Marquette University
Leonard Lardaro, University of Rhode Elizabeth Wheaton, Southern Methodist
Island University
Nazma Latif-Zaman, Providence Martin Zelder, Northwestern
College University
I received detailed feedback on specific elements in the text, including all end-
of-chapter problems and applications, from the following instructors.
Casey R. Abington, Kansas State Joyce J. Chen, The Ohio State University
University Edward A. Cohn, Del Mar College
Seemi Ahmad, Dutchess Community Chad D. Cotti, University of South
College Carolina
Farhad Ameen, State University of New Erik D. Craft, University of Richmond
York, Westchester Community College Eleanor D. Craig, University of
J. J. Arias, Georgia College & State Delaware
University Abdelmagead Elbiali, Rio Hondo
James Bathgate, Willamette University College
Scott Beaulier, Mercer University Harold W. Elder, University of Alabama
Clive Belfield, Queens College Hadi Salehi Esfahani, University of
Calvin Blackwell, College of Charleston Illinois, Urbana-Champaign
Cecil E. Bohanon, Ball State University David Franck, Francis Marion
Douglas Campbell, University of University
Memphis Amanda S. Freeman, Kansas State
Michael G. Carew, Baruch College University
Sewin Chan, New York University J.P. Gilbert, MiraCosta College
xiv ACKNOWLEDGMENTS
Joanne Guo, Dyson College of Pace Nitin V. Paranjpe, Wayne State

University University & Oakland University
Charles E. Hegji, Auburn University Sanela Porča, University of South
at Montgomery Carolina, Aiken
Andrew J. Hussey, University of Walter G. Park, American University
Memphis Reza M. Ramazani, Saint Michael’s
Hans R. Isakson, University of College
Northern Iowa Rhonda Vonshay Sharpe, University
Simran Kahai, John Carroll of Vermont
University Carolyn Fabian Stumph, Indiana
David E. Kalist, Shippensburg University–Purdue University
University Fort Wayne
Mark P. Karscig, University of Rick Tannery, Slippery Rock
Central Missouri University
Theodore Kuhn, Butler University Aditi Thapar, New York University
Dong Li, Kansas State University Michael H. Tew, Troy University
Daniel Lin, George Mason University Jennifer A. Vincent, Champlain College
Nathaniel Manning, Southern Milos Vulanovic, Lehman College
University Bhavneet Walia, Kansas State
Vince Marra, University of Delaware University
Akbar Marvasti, University of Douglas M. Walker, College of
Southern Mississippi Charleston
Heather Mattson, University of Patrick Walsh, Saint Michael’s College
Saint Thomas Larry Wolfenbarger, Macon State
Charles C. Moul, Washington College
University in St. Louis William C. Wood, James Madison
Albert A. Okunade, University of University
Memphis Chiou-nan Yeh, Alabama State
J. Brian O’Roark, Robert Morris University
University
Anthony L. Ostrosky, Illinois State
University
The accuracy of a textbook is critically important. I am responsible for any

remaining errors, but I am grateful to the following professors for reading through
the final manuscript and page proofs with me:
Joel Dalafave, Bucks County Francis Kemegue, Bryant University

Community College Douglas Miller, University of Missouri
Greg Hunter, California State Ed Skelton, Southern Methodist
University – Pomona University
The team of editors who worked on this book improved it tremendously. Jane
Tufts, developmental editor, provided truly spectacular editing—as she always
does. Mike Worls, economics executive editor, did a splendid job of overseeing
the many people involved in such a large project. Jennifer Thomas (senior devel-
opmental editor) and Katie Yanos (developmental editor) were crucial in assem-
bling an extensive and thoughtful group of reviewers to give me feedback on the
ACKNOWLEDGMENTS xv
previous edition, while putting together an excellent team to revise the supple-
ments. Colleen Farmer, senior content project manager, and Katherine Wilson,
senior project manager, had the patience and dedication necessary to turn my
manuscript into this book. Michelle Kunkler, senior art director, gave this book
its clean, friendly look. Michael Steirnagle, the illustrator, helped make the book
more visually appealing and the economics in it less abstract. Carolyn Crabtree,
copyeditor, refined my prose, and Terry Casey, indexer, prepared a careful and
thorough index. Brian Joyner, executive marketing manager, worked long hours
getting the word out to potential users of this book. The rest of the Cengage team,
including Jean Buttrom, Sandra Milewski and Deepak Kumar, was also consis-
tently professional, enthusiastic, and dedicated.
I am grateful also to Josh Bookin, a former Advanced Placement economics
teacher and recently an extraordinary section leader for Ec 10, the introductory
course at Harvard. Josh helped me refine the manuscript and check the page
proofs for this edition.
As always, I must thank my “in-house” editor Deborah Mankiw. As the first
reader of almost everything I write, she continued to offer just the right mix of
criticism and encouragement.
Finally, I would like to mention my three children Catherine, Nicholas, and
Peter. Their contribution to this book was putting up with a father spending too
many hours in his study. The four of us have much in common—not least of which
is our love of ice cream (which becomes apparent in Chapter 4). Maybe sometime
soon one of them will pick up my passion for economics as well.
N. Gregory Mankiw
September 2008
Table of Contents
Preface: To the Student ix How the Economy as a Whole Works 12

Principle 8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services 12
Principle 9: Prices Rise When the Government Prints Too
Much Money 13
IN THE NEWS Why You Should Study Economics 14
Principle 10: Society Faces a Short-Run Trade-off between
Inflation and Unemployment 14
Conclusion 15
FYI How to Read This Book 16
Summary 17
Key Concepts 17
PART I Questions for Review 18
INTRODUCTION 1 Problems and Applications 18
CHAPTER 1 CHAPTER 2
TEN PRINCIPLES OF ECONOMICS 3 THINKING LIKE AN ECONOMIST 21
How People Make Decisions 4 The Economist as Scientist 22

Principle 1: People Face Trade-offs 4 The Scientific Method: Observation, Theory, and
Principle 2: The Cost of Something Is What You Give More Observation 22
Up to Get It 5 The Role of Assumptions 23
Principle 3: Rational People Think at the Margin 6 Economic Models 23
Principle 4: People Respond to Incentives 7
Our First Model: The Circular-Flow Diagram 24
Our Second Model: The Production Possibilities
How People Interact 8
Frontier 25
Principle 5: Trade Can Make Everyone Better Off 8
Principle 6: Markets Are Usually a Good Way to Microeconomics and Macroeconomics 28
Organize Economic Activity 8 FYI Who Studies Economics? 29
IN THE NEWS Incentive Pay 9
The Economist as Policy Adviser 30
Principle 7: Governments Can Sometimes Improve
Positive versus Normative Analysis 30
Market Outcomes 10
Economists in Washington 31
FYI Adam Smith and the Invisible Hand 11
IN THE NEWS Football Economics 32
Why Economists’ Advice Is Not Always Followed 32
xvi
TABLE OF CONTENTS xvii
Why Economists Disagree 34

Differences in Scientific Judgments 34
Differences in Values 34
Perception versus Reality 35
Let’s Get Going 36

IN THE NEWS Environmental Economics 37
Summary 38
Key Concepts 38
Questions for Review 38
Problems and Applications 38 PART II
HOW MARKETS WORK 63
APPENDIX Graphing: A Brief Review 40
Graphs of a Single Variable 40
Graphs of Two Variables: The Coordinate System 41 CHAPTER 4
Curves in the Coordinate System 42 THE MARKET FORCES OF SUPPLY
Slope 44 AND DEMAND 65
Cause and Effect 46
Markets and Competition 66
What Is a Market? 66
CHAPTER 3 What Is Competition? 66
INTERDEPENDENCE AND THE GAINS FROM
TRADE 49 Demand 67
The Demand Curve: The Relationship between Price
A Parable for the Modern Economy 50 and Quantity Demanded 67
Production Possibilities 50 Market Demand versus Individual Demand 68
Specialization and Trade 52 Shifts in the Demand Curve 69
CASE STUDY Two Ways to Reduce the Quantity of
Comparative Advantage: The Driving Force of Smoking Demanded 71
Specialization 54
Absolute Advantage 54 Supply 73
Opportunity Cost and Comparative Advantage 54 The Supply Curve: The Relationship between Price
Comparative Advantage and Trade 55 and Quantity Supplied 73
The Price of the Trade 56 Market Supply versus Individual Supply 73
Shifts in the Supply Curve 74
Applications of Comparative Advantage 57
FYI The Legacy of Adam Smith and David Ricardo 57 Supply and Demand Together 77
Should Tiger Woods Mow His Own Lawn? 58 Equilibrium 77
Should the United States Trade with Other Three Steps to Analyzing Changes in Equilibrium 79
Countries? 58
IN THE NEWS The Changing Face of International Conclusion: How Prices Allocate Resources 83
Trade 59 IN THE NEWS The Helium Market 83
IN THE NEWS Price Increases after Natural
Conclusion 60 Disasters 84
Summary 60
Key Concepts 60 Summary 85
Questions for Review 61 Key Concepts 86
Problems and Applications 61 Questions for Review 86
Problems and Applications 87
xviii TABLE OF CONTENTS
CHAPTER 5 Taxes 123

ELASTICITY AND ITS APPLICATION 89 How Taxes on Sellers Affect Market Outcomes 124
How Taxes on Buyers Affect Market Outcomes 125
The Elasticity of Demand 90 CASE STUDY Can Congress Distribute the Burden
The Price Elasticity of Demand and Its Determinants 90 of a Payroll Tax? 127
Computing the Price Elasticity of Demand 91 Elasticity and Tax Incidence 128
The Midpoint Method: A Better Way to Calculate CASE STUDY Who Pays the Luxury Tax? 130
Percentage Changes and Elasticities 91
The Variety of Demand Curves 92 Conclusion 130
Total Revenue and the Price Elasticity of Demand 94 Summary 131
Key Concepts 131
Elasticity and Total Revenue along a Linear Demand
Curve 95 Problems and Applications 132
Other Demand Elasticities 97
IN THE NEWS Energy Demand 98
The Elasticity of Supply 99

The Price Elasticity of Supply and Its Determinants 99
Computing the Price Elasticity of Supply 100
The Variety of Supply Curves 100
Three Applications of Supply, Demand, and

Elasticity 102
Can Good News for Farming Be Bad News for
Farmers? 103
Why Did OPEC Fail to Keep the Price of Oil High? 105
Does Drug Interdiction Increase or Decrease
Drug-Related Crime? 106 PART III
Conclusion 108
MARKETS AND WELFARE 135
Summary 108
Key Concepts 109 CHAPTER 7
Questions for Review 109 CONSUMERS, PRODUCERS, AND THE EFFICIENCY
OF MARKETS 137
CHAPTER 6 Consumer Surplus 138

SUPPLY, DEMAND, AND GOVERNMENT Willingness to Pay 138
POLICIES 113 Using the Demand Curve to Measure Consumer
Surplus 139
Controls on Prices 114 How a Lower Price Raises Consumer Surplus 140
How Price Ceilings Affect Market Outcomes 114 What Does Consumer Surplus Measure? 141
CASE STUDY Lines at the Gas Pump 116
Producer Surplus 143
CASE STUDY Rent Control in the Short Run and the
Cost and the Willingness to Sell 143
Long Run 117
Using the Supply Curve to Measure Producer
How Price Floors Affect Market Outcomes 118
Surplus 144
CASE STUDY The Minimum Wage 119
How a Higher Price Raises Producer Surplus 145
Evaluating Price Controls 121
IN THE NEWS President Chavez versus the Market Efficiency 147
Market 122 The Benevolent Social Planner 147
TABLE OF CONTENTS xix
Evaluating the Market Equilibrium 148 Other Benefits of International Trade 186
CASE STUDY Should There Be a Market in IN THE NEWS Should the Winners from Free Trade
Organs? 150 Compensate the Losers? 187
IN THE NEWS Ticket Scalping 151
The Arguments for Restricting Trade 188
Conclusion: Market Efficiency and Market Failure 152 The Jobs Argument 188
IN THE NEWS The Miracle of the Market 153 IN THE NEWS Offshore Outsourcing 189
The National-Security Argument 190
Summary 154 The Infant-Industry Argument 190
Key Concepts 155
The Unfair-Competition Argument 191
Problems and Applications 155 The Protection-as-a-Bargaining-Chip Argument 191
IN THE NEWS Second Thoughts about Free
Trade 192
CHAPTER 8 CASE STUDY Trade Agreements and the World Trade
APPLICATION: THE COSTS OF TAXATION 159 Organization 192
The Deadweight Loss of Taxation 160 Conclusion 194

How a Tax Affects Market Participants 161 Summary 195
Deadweight Losses and the Gains from Trade 163 Key Concepts 196
The Determinants of the Deadweight Loss 164 Problems and Applications 196
CASE STUDY The Deadweight Loss Debate 166
Deadweight Loss and Tax Revenue as Taxes Vary 167

FYI Henry George and the Land Tax 169
CASE STUDY The Laffer Curve and Supply-Side
Economics 169
IN THE NEWS On the Way to France 170
Conclusion 172
Summary 172
Key Concepts 173
PART IV
CHAPTER 9 THE ECONOMICS OF THE PUBLIC
APPLICATION: INTERNATIONAL TRADE 177 SECTOR 201
The Determinants of Trade 178
The Equilibrium without Trade 178 CHAPTER 10
The World Price and Comparative Advantage 179 EXTERNALITIES 203
The Winners and Losers from Trade 180 Externalities and Market Inefficiency 204
The Gains and Losses of an Exporting Country 180 Welfare Economics: A Recap 205
The Gains and Losses of an Importing Country 181 Negative Externalities 205
The Effects of a Tariff 183 Positive Externalities 207
The Lessons for Trade Policy 185 CASE STUDY Technology Spillovers, Industrial Policy,
FYI Import Quotas: Another Way to Restrict and Patent Protection 208
Trade 185
xx TABLE OF CONTENTS
Public Policies toward Externalities 209 CASE STUDY The Fiscal Challenge Ahead 246
Command-and-Control Policies: Regulation 209 State and Local Government 248
Market-Based Policy 1: Corrective Taxes and
Subsidies 210 Taxes and Efficiency 249
CASE STUDY Why Is Gasoline Taxed So Heavily? 211 Deadweight Losses 250
Market-Based Policy 2: Tradable Pollution Permits 212 CASE STUDY Should Income or Consumption Be
Objections to the Economic Analysis of Pollution 214 Taxed? 251
Administrative Burden 251
Private Solutions to Externalities 215 Marginal Tax Rates versus Average Tax Rates 252
The Types of Private Solutions 215 Lump-Sum Taxes 253
IN THE NEWS The Case for Taxing Carbon 216
The Coase Theorem 217 Taxes and Equity 253
Why Private Solutions Do Not Always Work 218 The Benefits Principle 254
The Ability-to-Pay Principle 254
Conclusion 219 CASE STUDY How the Tax Burden Is Distributed 255
Summary 220 Tax Incidence and Tax Equity 256
Key Concepts 221 CASE STUDY Who Pays the Corporate Income
Tax? 257
IN THE NEWS Questions and Answers about Tax
Reform 258
CHAPTER 11
PUBLIC GOODS AND COMMON Conclusion: The Trade-off between Equity and
RESOURCES 225 Efficiency 258
Summary 260
The Different Kinds of Goods 226 Key Concepts 260
Public Goods 227 Problems and Applications 261
The Free-Rider Problem 228
Some Important Public Goods 228
CASE STUDY Are Lighthouses Public Goods? 230
The Difficult Job of Cost–Benefit Analysis 230
CASE STUDY How Much Is a Life Worth? 231
Common Resources 232

The Tragedy of the Commons 232
Some Important Common Resources 233
IN THE NEWS The Bloomberg Plan 234
CASE STUDY Why the Cow Is Not Extinct 236
Conclusion: The Importance of Property Rights 237

Summary 238
Key Concepts 238 PART V
Questions for Review 238 FIRM BEHAVIOR AND THE
ORGANIZATION OF INDUSTRY 265
CHAPTER 12
THE DESIGN OF THE TAX SYSTEM 241 CHAPTER 13
THE COSTS OF PRODUCTION 267
A Financial Overview of the U.S. Government 242
What Are Costs? 268
The Federal Government 243
TABLE OF CONTENTS xxi
Total Revenue, Total Cost, and Profit 268 The Short Run: Market Supply with a Fixed Number
Costs as Opportunity Costs 268 of Firms 301
The Cost of Capital as an Opportunity Cost 269 The Long Run: Market Supply with Entry and Exit 301
Economic Profit versus Accounting Profit 270 Why Do Competitive Firms Stay in Business If They
Make Zero Profit? 302
Production and Costs 271 A Shift in Demand in the Short Run and Long Run 303
The Production Function 271 Why the Long-Run Supply Curve Might Slope
From the Production Function to the Total-Cost Upward 304
Curve 273
Conclusion: Behind the Supply Curve 306
The Various Measures of Cost 274 Summary 307
Fixed and Variable Costs 274 Key Concepts 307
Average and Marginal Cost 275 Questions for Review 307
Cost Curves and Their Shapes 276
Typical Cost Curves 278
CHAPTER 15
Costs in the Short Run and in the Long Run 280 MONOPOLY 311
The Relationship between Short-Run and Long-Run
Average Total Cost 280 Why Monopolies Arise 312
Economies and Diseconomies of Scale 281 Monopoly Resources 313
FYI Lessons from a Pin Factory 282 Government-Created Monopolies 313
Natural Monopolies 314
Conclusion 282
Summary 283 How Monopolies Make Production and Pricing
Key Concepts 284 Decisions 315
Questions for Review 284 Monopoly versus Competition 315
A Monopoly’s Revenue 316
Profit Maximization 319
CHAPTER 14 FYI Why a Monopoly Does Not Have a Supply
FIRMS IN COMPETITIVE MARKETS 289 Curve 320
A Monopoly’s Profit 320
What Is a Competitive Market? 290 CASE STUDY Monopoly Drugs versus Generic
The Meaning of Competition 290 Drugs 321
The Revenue of a Competitive Firm 290
The Welfare Cost of Monopolies 322
Profit Maximization and the Competitive Firm’s Supply
The Deadweight Loss 323
Curve 292
The Monopoly’s Profit: A Social Cost? 325
A Simple Example of Profit Maximization 292
The Marginal-Cost Curve and the Firm’s Supply
Price Discrimination 326
Decision 293
A Parable about Pricing 326
The Firm’s Short-Run Decision to Shut Down 295
The Moral of the Story 327
Spilt Milk and Other Sunk Costs 296
The Analytics of Price Discrimination 328
CASE STUDY Near-Empty Restaurants and Off-Season
Examples of Price Discrimination 329
Miniature Golf 297
IN THE NEWS TKTS and Other Schemes 330
The Firm’s Long-Run Decision to Exit or Enter a
Market 298 Public Policy toward Monopolies 332
Measuring Profit in Our Graph for the Competitive Increasing Competition with Antitrust Laws 332
Firm 299 Regulation 333
IN THE NEWS Airline Mergers 333
The Supply Curve in a Competitive Market 300
xxii TABLE OF CONTENTS
IN THE NEWS Public Transport and Private The Economics of Cooperation 370
Enterprise 334 The Prisoners’ Dilemma 370
Public Ownership 336 Oligopolies as a Prisoners’ Dilemma 372
Doing Nothing 336 CASE STUDY OPEC and the World Oil Market 373
Other Examples of the Prisoners’ Dilemma 373
Conclusion: The Prevalence of Monopolies 337 The Prisoners’ Dilemma and the Welfare of Society 375
Summary 338
Why People Sometimes Cooperate 376
Key Concepts 339
Questions for Review 339 CASE STUDY The Prisoners’ Dilemma Tournament 376
Problems and Applications 340 IN THE NEWS Aumann and Schelling 377
Public Policy toward Oligopolies 378

CHAPTER 16 Restraint of Trade and the Antitrust Laws 378
MONOPOLISTIC COMPETITION 345 CASE STUDY An Illegal Phone Call 379
Controversies over Antitrust Policy 379
Between Monopoly and Perfect Competition 346
IN THE NEWS Public Price Fixing 380
Competition with Differentiated Products 348 IN THE NEWS A Reversal of Policy 382
The Monopolistically Competitive Firm in the CASE STUDY The Microsoft Case 383
Short Run 348
Conclusion 384
The Long-Run Equilibrium 348 Summary 385
Monopolistic versus Perfect Competition 351 Key Concepts 385
Monopolistic Competition and the Welfare of Questions for Review 385
Society 352 Problems and Applications 386
IN THE NEWS Insufficient Variety as a Market
Failure 354
Advertising 355
The Debate over Advertising 356
CASE STUDY Advertising and the Price of
Eyeglasses 357
Advertising as a Signal of Quality 357
FYI Galbraith versus Hayek 358
Brand Names 359
Conclusion 361
Summary 362
Key Concepts 362
Questions for Review 362 PART VI
Problems and Applications 363 THE ECONOMICS OF LABOR
MARKETS 389
CHAPTER 17
OLIGOPOLY 365
CHAPTER 18
Markets with Only a Few Sellers 366 THE MARKETS FOR THE FACTORS OF
A Duopoly Example 366 PRODUCTION 391
Competition, Monopolies, and Cartels 366
The Demand for Labor 392
The Equilibrium for an Oligopoly 368
The Competitive Profit-Maximizing Firm 393
How the Size of an Oligopoly Affects the Market
Outcome 369
TABLE OF CONTENTS xxiii
The Production Function and the Marginal Product of The Economics of Discrimination 422
Labor 393 Measuring Labor-Market Discrimination 422
The Value of the Marginal Product and the Demand for CASE STUDY Is Emily More Employable than
Labor 395 Lakisha? 424
What Causes the Labor-Demand Curve to Shift? 397 Discrimination by Employers 424
FYI Input Demand and Output Supply: Two Sides CASE STUDY Segregated Streetcars and the Profit
of the Same Coin 397 Motive 425
FYI The Luddite Revolt 398 IN THE NEWS Gender Differences 426
Discrimination by Customers and Governments 426
The Supply of Labor 399 CASE STUDY Discrimination in Sports 428
The Trade-off between Work and Leisure 399
What Causes the Labor-Supply Curve to Shift? 399 Conclusion 429
Summary 429
Equilibrium in the Labor Market 400 Key Concepts 430
Shifts in Labor Supply 400 Questions for Review 430
IN THE NEWS The Economics of Immigration 402
Shifts in Labor Demand 403
CASE STUDY Productivity and Wages 404 CHAPTER 20
INCOME INEQUALITY AND POVERTY 433
The Other Factors of Production: Land and Capital 405
FYI Monopsony 406 The Measurement of Inequality 434
Equilibrium in the Markets for Land and Capital 406 U.S. Income Inequality 434
Linkages among the Factors of Production 407 Inequality around the World 435
FYI What Is Capital Income? 408 The Poverty Rate 437
CASE STUDY The Economics of the Black Death 409 Problems in Measuring Inequality 438
CASE STUDY Alternative Measures of Inequality 439
Conclusion 409 Economic Mobility 440
Summary 410
IN THE NEWS What to Make of Rising Inequality 441
Key Concepts 410
The Political Philosophy of Redistributing Income 442
Utilitarianism 442
Liberalism 443
CHAPTER 19 Libertarianism 444
EARNINGS AND DISCRIMINATION 413
Policies to Reduce Poverty 445
Some Determinants of Equilibrium Wages 414 Minimum-Wage Laws 446
Compensating Differentials 414 Welfare 446
Human Capital 414 Negative Income Tax 447
CASE STUDY The Increasing Value of Skills 415 In-Kind Transfers 447
Ability, Effort, and Chance 416 IN THE NEWS Child Labor 448
IN THE NEWS The Loss of Manufacturing Jobs 417 Antipoverty Programs and Work Incentives 449
CASE STUDY The Benefits of Beauty 418
An Alternative View of Education: Signaling 419 Conclusion 451
The Superstar Phenomenon 419 Summary 452
IN THE NEWS The Human Capital of Terrorists 420 Key Concepts 452
Above-Equilibrium Wages: Minimum-Wage Laws,
Unions, and Efficiency Wages 421
xxiv TABLE OF CONTENTS
How Do Interest Rates Affect Household Saving? 477
Conclusion: Do People Really Think This Way? 479

Summary 480
Key Concepts 480
CHAPTER 22
FRONTIERS OF MICROECONOMICS 483
PART VII Asymmetric Information 484

TOPICS FOR FURTHER STUDY 455 Hidden Actions: Principals, Agents, and Moral
Hazard 484
Hidden Characteristics: Adverse Selection and the
CHAPTER 21 Lemons Problem 485
THE THEORY OF CONSUMER CHOICE 457 FYI Corporate Management 486
Signaling to Convey Private Information 487
The Budget Constraint: What the Consumer Can
Afford 458 CASE STUDY Gifts as Signals 487
Screening to Induce Information Revelation 488
Preferences: What the Consumer Wants 459 Asymmetric Information and Public Policy 489
Representing Preferences with Indifference Curves 460
Four Properties of Indifference Curves 461 Political Economy 489
Two Extreme Examples of Indifference Curves 462 The Condorcet Voting Paradox 490
Arrow’s Impossibility Theorem 491
Optimization: What the Consumer Chooses 464 The Median Voter Is King 491
The Consumer’s Optimal Choices 464 Politicians Are People Too 493
FYI Utility: An Alternative Way to Describe Preferences IN THE NEWS Farm Policy and Politics 494
and Optimization 465
How Changes in Income Affect the Consumer’s Behavioral Economics 494
Choices 466 People Aren’t Always Rational 494
How Changes in Prices Affect the Consumer’s People Care about Fairness 497
Choices 467 People Are Inconsistent over Time 497
Income and Substitution Effects 468 IN THE NEWS This Is Your Brain on Economics 498
Deriving the Demand Curve 470
Conclusion 500
Summary 501
Three Applications 471
Key Concepts 501
Do All Demand Curves Slope Downward? 472 Questions for Review 501
CASE STUDY The Search for Giffen Goods 473 Problems and Applications 502
How Do Wages Affect Labor Supply? 473
CASE STUDY Income Effects on Labor Supply: Glossary 505
Historical Trends, Lottery Winners, and the Carnegie Index 509
Conjecture 476
PART I
Introduction
1
CHAPTER
Ten Principles of Economics
T he word economy comes from the Greek word oikonomos, which means
“one who manages a household.” At first, this origin might seem peculiar.
But in fact, households and economies have much in common.
A household faces many decisions. It must decide which members of the house-
hold do which tasks and what each member gets in return: Who cooks dinner?
Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose
what TV show to watch? In short, the household must allocate its scarce resources
among its various members, taking into account each member’s abilities, efforts,
and desires.
Like a household, a society faces many decisions. A society must find some
way to decide what jobs will be done and who will do them. It needs some peo-
ple to grow food, other people to make clothing, and still others to design com-
puter software. Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must also allocate the output of goods and services
they produce. It must decide who will eat caviar and who will eat potatoes. It
must decide who will drive a Ferrari and who will take the bus.
The management of society’s resources is important because resources are
scarce. Scarcity means that society has limited resources and therefore cannot scarcity
produce all the goods and services people wish to have. Just as each member of the limited nature of
a household cannot get everything he or she wants, each individual in a society society’s resources
cannot attain the highest standard of living to which he or she might aspire.
3
4 PART I INTRODUCTION
economics Economics is the study of how society manages its scarce resources. In most
the study of how society societies, resources are allocated not by an all-powerful dictator but through the
manages its scarce combined actions of millions of households and firms. Economists therefore study
resources how people make decisions: how much they work, what they buy, how much
they save, and how they invest their savings. Economists also study how people
interact with one another. For instance, they examine how the multitude of buyers
and sellers of a good together determine the price at which the good is sold and
the quantity that is sold. Finally, economists analyze forces and trends that affect
the economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central
ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you
don’t understand them all at first or if you aren’t completely convinced. We will
explore these ideas more fully in later chapters. The ten principles are introduced
here to give you an overview of what economics is all about. Consider this chapter
a “preview of coming attractions.”
HOW PEOPLE MAKE DECISIONS

There is no mystery to what an economy is. Whether we are talking about the
economy of Los Angeles, the United States, or the whole world, an economy is just
a group of people dealing with one another as they go about their lives. Because
the behavior of an economy reflects the behavior of the individuals who make up
the economy, we begin our study of economics with four principles of individual
decision making.
PRINCIPLE 1: PEOPLE FACE TRADE-OFFS

You may have heard the old saying, “There ain’t no such thing as a free lunch.”
Grammar aside, there is much truth to this adage. To get one thing that we like,
we usually have to give up another thing that we like. Making decisions requires
trading off one goal against another.
Consider a student who must decide how to allocate her most valuable
resource—her time. She can spend all her time studying economics, spend all of
it studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour that she could have
spent napping, bike riding, watching TV, or working at her part-time job for some
extra spending money.
Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend an
extra dollar on one of these goods, they have one less dollar to spend on some
other good.
When people are grouped into societies, they face different kinds of trade-offs.
The classic trade-off is between “guns and butter.” The more a society spends
on national defense (guns) to protect its shores from foreign aggressors, the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Also important in modern society is the trade-off between a clean environment
and a high level of income. Laws that require firms to reduce pollution raise the
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5
cost of producing goods and services. Because of the higher costs, these firms end
up earning smaller profits, paying lower wages, charging higher prices, or some
combination of these three. Thus, while pollution regulations yield the benefit of
a cleaner environment and the improved health that comes with it, they have the
cost of reducing the incomes of the firms’ owners, workers, and customers.
Another trade-off society faces is between efficiency and equality. Efficiency efficiency
means that society is getting the maximum benefits from its scarce resources. the property of society
Equality means that those benefits are distributed uniformly among society’s getting the most it can
members. In other words, efficiency refers to the size of the economic pie, and from its scarce resources
equality refers to how the pie is divided into individual slices.
equality
When government policies are designed, these two goals often conflict. Con-
the property of distribut-
sider, for instance, policies aimed at equalizing the distribution of economic ing economic prosperity
well-being. Some of these policies, such as the welfare system or unemployment uniformly among the
insurance, try to help the members of society who are most in need. Others, such members of society
as the individual income tax, ask the financially successful to contribute more
than others to support the government. While achieving greater equality, these
policies reduce efficiency. When the government redistributes income from the
rich to the poor, it reduces the reward for working hard; as a result, people work
less and produce fewer goods and services. In other words, when the government
tries to cut the economic pie into more equal slices, the pie gets smaller.
Recognizing that people face trade-offs does not by itself tell us what deci-
sions they will or should make. A student should not abandon the study of psy-
chology just because doing so would increase the time available for the study of
economics. Society should not stop protecting the environment just because envi-
ronmental regulations reduce our material standard of living. The poor should
not be ignored just because helping them distorts work incentives. Nonetheless,
people are likely to make good decisions only if they understand the options they
have available. Our study of economics, therefore, starts by acknowledging life’s
trade-offs.
PRINCIPLE 2: THE COST OF SOMETHING

IS WHAT YOU GIVE UP TO GET IT
Because people face trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action. In many cases, however, the cost of
an action is not as obvious as it might first appear.
Consider the decision to go to college. The main benefits are intellectual enrich-
ment and a lifetime of better job opportunities. But what are the costs? To answer
this question, you might be tempted to add up the money you spend on tuition,
books, room, and board. Yet this total does not truly represent what you give up
to spend a year in college.
There are two problems with this calculation. First, it includes some things that
are not really costs of going to college. Even if you quit school, you need a place
to sleep and food to eat. Room and board are costs of going to college only to the
extent that they are more expensive at college than elsewhere. Second, this cal-
culation ignores the largest cost of going to college—your time. When you spend
a year listening to lectures, reading textbooks, and writing papers, you cannot
spend that time working at a job. For most students, the earnings given up to
attend school are the largest single cost of their education. opportunity cost
The opportunity cost of an item is what you give up to get that item. When whatever must be given
making any decision, decision makers should be aware of the opportunity costs up to obtain some item
that accompany each possible action. In fact, they usually are. College athletes
who can earn millions if they drop out of school and play professional sports are
well aware that their opportunity cost of college is very high. It is not surprising
that they often decide that the benefit is not worth the cost.
PRINCIPLE 3: R ATIONAL PEOPLE THINK AT THE M ARGIN

rational people Economists normally assume that people are rational. Rational people systemati-
people who systematically and purposefully do the best they can to achieve their objectives, given the
cally and purposefully available opportunities. As you study economics, you will encounter firms that
do the best they can to decide how many workers to hire and how much of their product to manufacture
achieve their objectives and sell to maximize profits. You will also encounter individuals who decide how
much time to spend working and what goods and services to buy with the result-
ing income to achieve the highest possible level of satisfaction.
Rational people know that decisions in life are rarely black and white but usu-
ally involve shades of gray. At dinnertime, the decision you face is not between
fasting or eating like a pig but whether to take that extra spoonful of mashed pota-
toes. When exams roll around, your decision is not between blowing them off or
studying 24 hours a day but whether to spend an extra hour reviewing your notes
marginal changes instead of watching TV. Economists use the term marginal changes to describe
small incremental adjust- small incremental adjustments to an existing plan of action. Keep in mind that
ments to a plan of action margin means “edge,” so marginal changes are adjustments around the edges of
what you are doing. Rational people often make decisions by comparing marginal
benefits and marginal costs.
For example, consider an airline deciding how much to charge passengers who
fly standby. Suppose that flying a 200-seat plane across the United States costs the
airline $100,000. In this case, the average cost of each seat is $100,000/200, which is
$500. One might be tempted to conclude that the airline should never sell a ticket
for less than $500. In fact, a rational airline can often find ways to raise its profits
by thinking at the margin. Imagine that a plane is about to take off with ten empty
seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should
the airline sell the ticket? Of course it should. If the plane has empty seats, the cost
of adding one more passenger is tiny. Although the average cost of flying a pas-
senger is $500, the marginal cost is merely the cost of the bag of peanuts and can
of soda that the extra passenger will consume. As long as the standby passenger
pays more than the marginal cost, selling the ticket is profitable.
Marginal decision making can help explain some otherwise puzzling economic
phenomena. Here is a classic question: Why is water so cheap, while diamonds
are so expensive? Humans need water to survive, while diamonds are unneces-
sary; but for some reason, people are willing to pay much more for a diamond
than for a cup of water. The reason is that a person’s willingness to pay for any
good is based on the marginal benefit that an extra unit of the good would yield.
The marginal benefit, in turn, depends on how many units a person already has.
Water is essential, but the marginal benefit of an extra cup is small because water
is plentiful. By contrast, no one needs diamonds to survive, but because diamonds
are so rare, people consider the marginal benefit of an extra diamond to be large.
A rational decision maker takes an action if and only if the marginal benefit of the
action exceeds the marginal cost. This principle can explain why airlines are will-
ing to sell a ticket below average cost and why people are willing to pay more for
diamonds than for water. It can take some time to get used to the logic of marginal
thinking, but the study of economics will give you ample opportunity to practice.
PRINCIPLE 4: PEOPLE R ESPOND TO INCENTIVES

An incentive is something that induces a person to act, such as the prospect of a incentive
punishment or a reward. Because rational people make decisions by comparing something that induces
costs and benefits, they respond to incentives. You will see that incentives play a a person to act
central role in the study of economics. One economist went so far as to suggest
that the entire field could be simply summarized: “People respond to incentives.
The rest is commentary.”
Incentives are crucial to analyzing how markets work. For example, when the
price of an apple rises, people decide to eat fewer apples. At the same time, apple
orchards decide to hire more workers and harvest more apples. In other words,
a higher price in a market provides an incentive for buyers to consume less and
an incentive for sellers to produce more. As we will see, the influence of prices on
the behavior of consumers and producers is crucial for how a market economy
allocates scarce resources.
Public policymakers should never forget about incentives: Many policies change
the costs or benefits that people face and, therefore, alter their behavior. A tax on
gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars.
That is one reason people drive smaller cars in Europe, where gasoline taxes are
high, than in the United States, where gasoline taxes are low. A gasoline tax also
encourages people to carpool, take public transportation, and live closer to where
they work. If the tax were larger, more people would be driving hybrid cars, and
if it were large enough, they would switch to electric cars.
When policymakers fail to consider how their policies affect incentives, they
often end up with unintended consequences. For example, consider public policy
regarding auto safety. Today, all cars have seat belts, but this was not true 50 years
ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public
concern over auto safety. Congress responded with laws requiring seat belts as
standard equipment on new cars.
How does a seat belt law affect auto safety? The direct effect is obvious: When
a person wears a seat belt, the probability of surviving an auto accident rises. But
that’s not the end of the story because the law also affects behavior by altering
incentives. The relevant behavior here is the speed and care with which drivers
operate their cars. Driving slowly and carefully is costly because it uses the driv-
er’s time and energy. When deciding how safely to drive, rational people compare,
©SHELLY LENNON/AI WIRE/LANDOV
perhaps unconsciously, the marginal benefit from safer driving to the marginal
cost. As result, they drive more slowly and carefully when the benefit of increased
safety is high. For example, when road conditions are icy, people drive more
attentively and at lower speeds than they do when road conditions are clear.
Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly because they reduce the likelihood of injury or death.
In other words, seat belts reduce the benefits of slow and careful driving. People
respond to seat belts as they would to an improvement in road conditions—by
driving faster and less carefully. The result of a seat belt law, therefore, is a larger
BASKETBALL STAR LEBRON
number of accidents. The decline in safe driving has a clear, adverse impact on
JAMES UNDERSTANDS OPPOR-
pedestrians, who are more likely to find themselves in an accident but (unlike the
TUNITY COST AND INCENTIVES.
drivers) don’t have the benefit of added protection. HE DECIDED TO SKIP COLLEGE
At first, this discussion of incentives and seat belts might seem like idle specula- AND GO STRAIGHT TO THE
tion. Yet in a classic 1975 study, economist Sam Peltzman argued that auto-safety PROS, WHERE HE HAS EARNED
laws have had many of these effects. According to Peltzman’s evidence, these MILLIONS OF DOLLARS AS ONE
laws produce both fewer deaths per accident and more accidents. He concluded OF THE NBA’S TOP PLAYERS.
that the net result is little change in the number of driver deaths and an increase
in the number of pedestrian deaths.
Peltzman’s analysis of auto safety is an offbeat example of the general prin-
ciple that people respond to incentives. When analyzing any policy, we must con-
sider not only the direct effects but also the less obvious indirect effects that work
through incentives. If the policy changes incentives, it will cause people to alter
their behavior.
Q Q
UICK UIZ Describe an important trade-off you recently faced. • Give an example of
some action that has both a monetary and nonmonetary opportunity cost. • Describe an
incentive your parents offered to you in an effort to influence your behavior.
HOW PEOPLE INTERACT

The first four principles discussed how individuals make decisions. As we go
about our lives, many of our decisions affect not only ourselves but other people
as well. The next three principles concern how people interact with one another.
PRINCIPLE 5: TRADE CAN M AKE EVERYONE BETTER OFF

You have probably heard on the news that the Japanese are our competitors in
the world economy. In some ways, this is true because American and Japanese
firms produce many of the same goods. Ford and Toyota compete for the same
customers in the market for automobiles. Apple and Sony compete for the same
customers in the market for digital music players.
Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and Japan is not like a sports contest in which
one side wins and the other side loses. In fact, the opposite is true: Trade between
two countries can make each country better off.
To see why, consider how trade affects your family. When a member of your
family looks for a job, he or she competes against members of other families who
are looking for jobs. Families also compete against one another when they go
shopping because each family wants to buy the best goods at the lowest prices. In
a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself from
all other families. If it did, your family would need to grow its own food, make its
own clothes, and build its own home. Clearly, your family gains much from its
ability to trade with others. Trade allows each person to specialize in the activities
he or she does best, whether it is farming, sewing, or home building. By trading
with others, people can buy a greater variety of goods and services at lower cost.
Countries as well as families benefit from the ability to trade with one another.
CARTOON: FROM THE WALL STREET JOURNAL—
PERMISSION, CARTOON FEATURES SYNDICATE
Trade allows countries to specialize in what they do best and to enjoy a greater
variety of goods and services. The Japanese, as well as the French and the Egyp-
tians and the Brazilians, are as much our partners in the world economy as they
are our competitors.
PRINCIPLE 6: M ARKETS A RE USUALLY A GOOD WAY

“FOR $5 A WEEK YOU CAN TO ORGANIZE ECONOMIC ACTIVITY
WATCH BASEBALL WITHOUT
BEING NAGGED TO CUT THE The collapse of communism in the Soviet Union and Eastern Europe in the 1980s
GRASS!” may be the most important change in the world during the past half century.
Incentive Pay
How people are paid affects their incentives and the decisions
they make.
Where the Buses Run ing around the congestion. And when buses lar people do. They take shortcuts when the
on Time get delayed in heavy traffic, it wreaks havoc traffic is bad. They take shorter meal breaks
By Austan Goolsbee on the scheduled service. Instead of arriving and bathroom breaks. They want to get on
once every 10 minutes, three buses come in the road and pick up more passengers as
On a summer afternoon, the drive home at the same time after half an hour. That sort quickly as they can. In short, their productiv-
from the University of Chicago to the north of bunching is the least efficient way to run ity increases….
side of the city must be one of the most a public transportation system. So, why not Not everything about incentive pay is
beautiful commutes in the world. On the take the surface streets if that would keep perfect, of course. When bus drivers start
left on Lake Shore Drive you pass Grant Park, the schedule properly spaced and on time? moving from place to place more quickly,
some of the world’s first skyscrapers, and the You might think at first that the prob- they get in more accidents (just like the rest
Sears Tower. On the right is the intense blue lem is that the drivers aren’t paid enough of us). Some passengers also complain that
of Lake Michigan. But for all the beauty, the to strategize. But Chicago bus drivers are the rides make them nauseated because the
traffic can be hell. So, if you drive the route the seventh-highest paid in the nation; drivers stomp on the gas as soon as the last
every day, you learn the shortcuts. You know full-timers earned more than $23 an hour, passenger gets on the bus. Yet when given
that if it backs up from the Buckingham according to a November 2004 survey. The the choice, people overwhelmingly choose
Fountain all the way to McCormick Place, problem may have to do not with how the bus companies that get them where
you’re better off taking the surface streets much they are paid, but how they are paid. they’re going on time. More than 95 percent
and getting back onto Lake Shore Drive a At least, that’s the implication of a new study of the routes in Santiago use incentive pay.
few miles north. of Chilean bus drivers by Ryan Johnson and Perhaps we should have known that
A lot of buses, however, wait in the traf- David Reiley of the University of Arizona and incentive pay could increase bus driver pro-
fic jams. I have always wondered about that: Juan Carlos Muñoz of Pontificia Universidad ductivity. After all, the taxis in Chicago take
Why don’t the bus drivers use the shortcuts? Católica de Chile. the shortcuts on Lake Shore Drive to avoid
Surely they know about them—they drive Companies in Chile pay bus drivers one the traffic that buses just sit in. Since taxi
the same route every day, and they probably of two ways: either by the hour or by the drivers earn money for every trip they make,
avoid the traffic when they drive their own passenger. Paying by the passenger leads they want to get you home as quickly as
cars. Buses don’t stop on Lake Shore Drive, to significantly shorter delays. Give them possible so they can pick up somebody else.
so they wouldn’t strand anyone by detour- incentives, and drivers start acting like regu-
Source: Slate.com, March 16, 2006.
Communist countries worked on the premise that government officials were in

market economy
the best position to allocate the economy’s scarce resources. These central plan-
an economy that allo-
ners decided what goods and services were produced, how much was produced, cates resources through
and who produced and consumed these goods and services. The theory behind the decentralized deci-
central planning was that only the government could organize economic activity sions of many firms and
in a way that promoted economic well-being for the country as a whole. households as they inter-
Most countries that once had centrally planned economies have abandoned the act in markets for goods
system and are instead developing market economies. In a market economy, the and services
decisions of a central planner are replaced by the decisions of millions of firms and
households. Firms decide whom to hire and what to make. Households decide
which firms to work for and what to buy with their incomes. These firms and
households interact in the marketplace, where prices and self-interest guide their
decisions.
At first glance, the success of market economies is puzzling. In a market econ-
omy, no one is looking out for the economic well-being of society as a whole. Free
markets contain many buyers and sellers of numerous goods and services, and all
of them are interested primarily in their own well-being. Yet despite decentral-
ized decision making and self-interested decision makers, market economies have
proven remarkably successful in organizing economic activity to promote overall
economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided by an “invis-
ible hand” that leads them to desirable market outcomes. One of our goals in this
book is to understand how this invisible hand works its magic.
As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers look at
the price when determining how much to demand, and sellers look at the price
when deciding how much to supply. As a result of the decisions that buyers and
sellers make, market prices reflect both the value of a good to society and the cost
to society of making the good. Smith’s great insight was that prices adjust to guide
these individual buyers and sellers to reach outcomes that, in many cases, maxi-
mize the well-being of society as a whole.
Smith’s insight has an important corollary: When the government prevents
prices from adjusting naturally to supply and demand, it impedes the invisible
hand’s ability to coordinate the decisions of the households and firms that make up
the economy. This corollary explains why taxes adversely affect the allocation of
resources, for they distort prices and thus the decisions of households and firms. It
also explains the great harm caused by policies that directly control prices, such as
rent control. And it explains the failure of communism. In Communist countries,
prices were not determined in the marketplace but were dictated by central plan-
ners. These planners lacked the necessary information about consumers’ tastes
and producers’ costs, which in a market economy are reflected in prices. Central
planners failed because they tried to run the economy with one hand tied behind
their backs—the invisible hand of the marketplace.
PRINCIPLE 7: GOVERNMENTS CAN SOMETIMES

IMPROVE M ARKET OUTCOMES
If the invisible hand of the market is so great, why do we need government? One
purpose of studying economics is to refine your view about the proper role and
scope of government policy.
One reason we need government is that the invisible hand can work its magic
only if the government enforces the rules and maintains the institutions that are
property rights
key to a market economy. Most important, market economies need institutions
the ability of an individ- to enforce property rights so individuals can own and control scarce resources.
ual to own and exercise A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t
control over scarce serve meals unless it is assured that customers will pay before they leave; and a
resources music company won’t produce CDs if too many potential customers avoid paying
by making illegal copies. We all rely on government-provided police and courts to

enforce our rights over the things we produce—and the invisible hand counts on
our ability to enforce our rights.
Yet there is another reason we need government: The invisible hand is pow-
erful, but it is not omnipotent. There are two broad reasons for a government
to intervene in the economy and change the allocation of resources that people
would choose on their own: to promote efficiency or to promote equality. That is,
most policies aim either to enlarge the economic pie or to change how the pie is market failure
divided. a situation in which a
market left on its own
Consider first the goal of efficiency. Although the invisible hand usually leads
fails to allocate resources
markets to allocate resources to maximize the size of the economic pie, this is not
efficiently
always the case. Economists use the term market failure to refer to a situation in
which the market on its own fails to produce an efficient allocation of resources. externality
As we will see, one possible cause of market failure is an externality, which is the impact of one per-
the impact of one person’s actions on the well-being of a bystander. The classic son’s actions on the well-
example of an externality is pollution. Another possible cause of market failure being of a bystander
Adam Smith and the Invisible Hand
It may be only a coincidence It is not from the benevolence of the butcher, the brewer, or the
that Adam Smith’s great book The Wealth of Nations was published baker that we expect our dinner, but from their regard to their own
in 1776, the exact year American revolutionaries signed the Declara- interest. We address ourselves, not to their humanity but to their
tion of Independence. But the two documents share a point of view self-love, and never talk to them of our own necessities but of their
that was prevalent at the time: Individuals are usually best left to advantages. Nobody but a beggar chooses to depend chiefly upon
their own devices, without the heavy hand of government guiding the benevolence of his fellow-citizens. . . .
their actions. This political philosophy provides the intellectual basis Every individual . . . neither intends to promote the public interest,
for the market economy and for free society more generally. nor knows how much he is promoting it. . . . He intends only his own
Why do decentralized market economies work so well? Is it gain, and he is in this, as in many other cases, led by an invisible hand
because people can be counted on to treat one another with love to promote an end which was no part of his intention. Nor is it always
and kindness? Not at all. Here is Adam Smith’s description of how the worse for the society that it was no part of it. By pursuing his own
people interact in a market economy: interest he frequently promotes that of the society more
effectually than when he really intends to promote it.
Man has almost constant occasion for the help of his
brethren, and it is in vain for him to expect it from their Smith is saying that participants in the economy are
benevolence only. He will be more likely to prevail if he motivated by self-interest and that the “invisible hand”
can interest their self-love in his favour, and show them of the marketplace guides this self-interest into pro-
PHOTO: © BETTMANN/CORBIS
that it is for their own advantage to do for him what moting general economic well-being.
he requires of them. . . . Give me that which I want, and Many of Smith’s insights remain at the center of
you shall have this which you want, is the meaning of modern economics. Our analysis in the coming chap-
every such offer; and it is in this manner that we obtain ters will allow us to express Smith’s conclusions more
from one another the far greater part of those good precisely and to analyze more fully the strengths and
offices which we stand in need of. Adam Smith weaknesses of the market’s invisible hand.
market power is market power, which refers to the ability of a single person (or small group)
the ability of a single to unduly influence market prices. For example, if everyone in town needs water
economic actor (or small but there is only one well, the owner of the well is not subject to the rigorous
group of actors) to have competition with which the invisible hand normally keeps self-interest in check.
a substantial influence on In the presence of externalities or market power, well-designed public policy can
market prices
enhance economic efficiency.
Now consider the goal of equality. Even when the invisible hand is yielding
efficient outcomes, it can nonetheless leave sizable disparities in economic well-
being. A market economy rewards people according to their ability to produce
things that other people are willing to pay for. The world’s best basketball player
earns more than the world’s best chess player simply because people are willing
to pay more to watch basketball than chess. The invisible hand does not ensure
that everyone has sufficient food, decent clothing, and adequate healthcare. This
inequality may, depending on one’s political philosophy, call for government
intervention. In practice, many public policies, such as the income tax and the
welfare system, aim to achieve a more equal distribution of economic well-being.
To say that the government can improve on market outcomes at times does not
mean that it always will. Public policy is made not by angels but by a political pro-
cess that is far from perfect. Sometimes policies are designed simply to reward the
politically powerful. Sometimes they are made by well-intentioned leaders who
are not fully informed. As you study economics, you will become a better judge of
when a government policy is justifiable because it promotes efficiency or equality
and when it is not.
QUICK QUIZ Why is a country better off not isolating itself from all other countries?
• Why do we have markets and, according to economists, what roles should government
play in them?
HOW THE ECONOMY AS A WHOLE WORKS

We started by discussing how individuals make decisions and then looked at how
people interact with one another. All these decisions and interactions together
make up “the economy.” The last three principles concern the workings of the
economy as a whole.
PRINCIPLE 8: A COUNTRY’S STANDARD

OF LIVING DEPENDS ON ITS A BILITY
TO P RODUCE GOODS AND SERVICES
The differences in living standards around the world are staggering. In 2006, the
average American had an income of about $44,260. In the same year, the average
Mexican earned $11,410, and the average Nigerian earned $1,050. Not surpris-
ingly, this large variation in average income is reflected in various measures of
the quality of life. Citizens of high-income countries have more TV sets, more
cars, better nutrition, better healthcare, and a longer life expectancy than citizens
of low-income countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for
changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average income has risen about eightfold.
What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple. Almost all variation in living stan-
dards is attributable to differences in countries’ productivity—that is, the amount productivity
of goods and services produced from each unit of labor input. In nations where the quantity of goods
workers can produce a large quantity of goods and services per unit of time, most and services produced
people enjoy a high standard of living; in nations where workers are less produc- from each unit of labor
tive, most people endure a more meager existence. Similarly, the growth rate of a input
nation’s productivity determines the growth rate of its average income.
The fundamental relationship between productivity and living standards is
simple, but its implications are far-reaching. If productivity is the primary deter-
minant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
for the rise in living standards of American workers over the past century. Yet the
real hero of American workers is their rising productivity. As another example,
some commentators have claimed that increased competition from Japan and
other countries explained the slow growth in U.S. incomes during the 1970s and
1980s. Yet the real villain was not competition from abroad but flagging produc-
tivity growth in the United States.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect liv-
ing standards, the key question is how it will affect our ability to produce goods
and services. To boost living standards, policymakers need to raise productivity
by ensuring that workers are well educated, have the tools needed to produce
goods and services, and have access to the best available technology.
PRINCIPLE 9: PRICES R ISE WHEN THE GOVERNMENT

PRINTS TOO MUCH MONEY
In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two inflation
years later, in November 1922, the same newspaper cost 70,000,000 marks. All an increase in the overall
other prices in the economy rose by similar amounts. This episode is one of his- level of prices in the
tory’s most spectacular examples of inflation, an increase in the overall level of economy
prices in the economy.
Although the United States has never experienced inflation even close to that
in Germany in the 1920s, inflation has at times been an economic problem. Dur-
COMPANY. ALL RIGHTS RESERVED. USED WITH PERMISSION.
ing the 1970s, for instance, when the overall level of prices more than doubled,
President Gerald Ford called inflation “public enemy number one.” By contrast,
CARTOON: COPYRIGHTED 1978. CHICAGO TRIBUNE
inflation in the first decade of the 21st century has run about 21⁄2 percent per year;
at this rate, it would take almost 30 years for prices to double. Because high infla-
tion imposes various costs on society, keeping inflation at a low level is a goal of
economic policymakers around the world.
What causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large
quantities of the nation’s money, the value of the money falls. In Germany in the
early 1920s, when prices were on average tripling every month, the quantity of
money was also tripling every month. Although less dramatic, the economic his- “WELL IT MAY HAVE BEEN 68
tory of the United States points to a similar conclusion: The high inflation of the CENTS WHEN YOU GOT IN LINE,
1970s was associated with rapid growth in the quantity of money, and the low BUT IT’S 74 CENTS NOW!”
Why You Should Study Economics

In this excerpt from a commencement address, the former president
of the Federal Reserve Bank of Dallas makes the case for studying
economics.
The Dismal Science? about how it is that economies work bet- magic of markets and the dangers of tam-
Hardly! ter the fewer people they have in charge. pering with them too much. You know bet-
By Robert D. McTeer, Jr. Who does the planning? Who makes deci- ter what you first learned in kindergarten:
sions? Who decides what to produce? For that you shouldn’t kill or cripple the goose
My take on training in economics is that it my money, Adam Smith’s invisible hand is that lays the golden eggs. . . .
becomes increasingly valuable as you move the most important thing you’ve learned by Economics training will help you
up the career ladder. I can’t imagine a bet- studying economics. You understand how understand fallacies and unintended con-
ter major for corporate CEOs, congressmen, we can each work for our own self-interest sequences. In fact, I am inclined to define
or American presidents. You’ve learned a and still produce a desirable social outcome. economics as the study of how to anticipate
systematic, disciplined way of thinking that You know how uncoordinated activity gets unintended consequences. . . .
will serve you well. By contrast, the eco- coordinated by the market to enhance Little in the literature seems more rel-
nomically challenged must be perplexed the wealth of nations. You understand the evant to contemporary economic debates
inflation of more recent experience was associated with slow growth in the quan-
tity of money.
PRINCIPLE 10: SOCIETY FACES A SHORT-RUN TRADE-OFF

BETWEEN I NFLATION AND UNEMPLOYMENT
Although a higher level of prices is, in the long run, the primary effect of increas-
ing the quantity of money, the short-run story is more complex and controversial.
Most economists describe the short-run effects of monetary injections as follows:
• Increasing the amount of money in the economy stimulates the overall level
of spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a
larger quantity of goods and services.
• More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run trade-
off between inflation and unemployment.
Although some economists still question these ideas, most accept that society
faces a short-run trade-off between inflation and unemployment. This simply
means that, over a period of a year or two, many economic policies push infla-
tion and unemployment in opposite directions. Policymakers face this trade-off
regardless of whether inflation and unemployment both start out at high levels
(as they were in the early 1980s), at low levels (as they were in the late 1990s),
than what usually is called the broken Most voters fall for the broken window real progress comes from job destruction. It
window fallacy. Whenever a government fallacy, but not economics majors. They once took 90 percent of our population to
program is justified not on its merits but by will say, “Hey, wait a minute!” If the baker grow our food. Now it takes 3 percent. Par-
the jobs it will create, remember the broken hadn’t spent his money on window repair, don me, Willie, but are we worse off because
window: Some teenagers, being the little he would have spent it on the new suit he of the job losses in agriculture? The would-
beasts that they are, toss a brick through was saving to buy. Then the tailor would have-been farmers are now college profes-
a bakery window. A crowd gathers and have the new income to spend, and so on. sors and computer gurus. . . .
laments, “What a shame.” But before you The broken window didn’t create net new So instead of counting jobs, we should
know it, someone suggests a silver lining spending; it just diverted spending from make every job count. We will occasionally
to the situation: Now the baker will have to somewhere else. The broken window does hit a soft spot when we have a mismatch
spend money to have the window repaired. not create new activity, just different activ- of supply and demand in the labor market.
This will add to the income of the repair- ity. People see the activity that takes place. But that is temporary. Don’t become a Lud-
man, who will spend his additional income, They don’t see the activity that would have dite and destroy the machinery, or become
which will add to another seller’s income, taken place. a protectionist and try to grow bananas in
and so on. You know the drill. The chain of The broken window fallacy is perpetu- New York City.
spending will multiply and generate higher ated in many forms. Whenever job creation
income and employment. If the broken win- or retention is the primary objective I call it
dow is large enough, it might produce an the job-counting fallacy. Economics majors
economic boom! . . . understand the non-intuitive reality that
Source: The Wall Street Journal, June 4, 2003.
or someplace in between. This short-run trade-off plays a key role in the analy-
sis of the business cycle—the irregular and largely unpredictable fluctuations in business cycle
economic activity, as measured by the production of goods and services or the fluctuations in economic
number of people employed. activity, such as employ-
Policymakers can exploit the short-run trade-off between inflation and unem- ment and production
ployment using various policy instruments. By changing the amount that the
government spends, the amount it taxes, and the amount of money it prints, poli-
cymakers can influence the overall demand for goods and services. Changes in
demand in turn influence the combination of inflation and unemployment that
the economy experiences in the short-run. Because these instruments of economic
policy are potentially so powerful, how policymakers should use these instru-
ments to control the economy, if at all, is a subject of continuing debate.
Q Q
UICK UIZ List and briefly explain the three principles that describe how the economy
as a whole works.
CONCLUSION
You now have a taste of what economics is all about. In the coming chapters, we
develop many specific insights about people, markets, and economies. Mastering
these insights will take some effort, but it is not an overwhelming task. The field
of economics is based on a few big ideas that can be applied in many different
situations.
How to Read This Book
Economics is fun, but it can instructor will assign some of these exercises as homework. If so,
also be hard to learn. My aim in writing this text is to make it as do them. If not, do them anyway. The more you use your new
enjoyable and easy as possible. But you, the student, also have a role knowledge, the more solid it becomes.
to play. Experience shows that if you are actively involved as you 5. Go online. The publisher of this book maintains an extensive web-
study this book, you will enjoy a better outcome both on your exams site to help you in your study of economics. It includes additional
and in the years that follow. Here are a few tips about how best to examples, applications, and problems, as well as quizzes so you
read this book. can test yourself. Check it out. The website is http://academic
.cengage.com/economics/mankiw.
1. Read before class. Students do better when they read the relevant 6. Study in groups. After you’ve read the book and worked problems
textbook chapter before attending a lecture. You will understand on your own, get together with classmates to discuss the mate-
the lecture better, and your questions will be better focused on rial. You will learn from each other—an example of the gains
where you need extra help. from trade.
2. Summarize, don’t highlight. Running a yellow marker over the text 7. Teach someone. As all teachers know, there is no better way
is too passive an activity to keep your mind engaged. Instead, to learn something than to teach it to someone else. Take the
when you come to the end of a section, take a minute and sum- opportunity to teach new economic concepts to a study partner,
marize what you just learned in your own words, writing your a friend, a parent, or even a pet.
summary in the wide margins we’ve provided. When you’ve fin- 8. Don’t skip the real-world examples. In the midst of all the num-
ished the chapter, compare your summaries with the one at the bers, graphs, and strange new words, it is easy to lose sight of
end of the chapter. Did you pick up the main points? what economics is all about. The Case Studies and In the News
3. Test yourself. Throughout the book, Quick Quizzes offer instant boxes sprinkled throughout this book should help remind you.
feedback to find out if you’ve learned what you are supposed to. They show how the theory is tied to events happening in all our
Take the opportunity to write down your answer and then check lives.
it against the answers provided at this book’s website. The quiz- 9. Apply economic thinking to your daily life. Once you’ve read about
zes are meant to test your basic comprehension. If your answer how others apply economics to the real world, try it yourself! You
is incorrect, you probably need to review the section. can use economic analysis to better understand your own deci-
4. Practice, practice, practice. At the end of each chapter, Questions sions, the economy around you, and the events you read about
for Review test your understanding, and Problems and Applica- in the newspaper. The world may never look the same again.
tions ask you to apply and extend the material. Perhaps your
Throughout this book, we will refer back to the Ten Principles of Economics high-
lighted in this chapter and summarized in Table 1. Keep these building blocks in
mind: Even the most sophisticated economic analysis is founded on the ten prin-
ciples introduced here.
T A B L E
1
How People Make Decisions
1: People Face Trade-offs
2: The Cost of Something Is What You Give Up to Get It Ten Principles
3: Rational People Think at the Margin of Economics
4: People Respond to Incentives
How People Interact

5: Trade Can Make Everyone Better Off
6: Markets Are Usually a Good Way to Organize Economic Activity
7: Governments Can Sometimes Improve Market Outcomes
How the Economy as a Whole Works

8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services
9: Prices Rise When the Government Prints Too Much Money
10: Society Faces a Short-Run Trade-off between Inflation and Unemployment
SUMMARY
• The fundamental lessons about individual deci- are usually a good way of coordinating economic
sion making are that people face trade-offs among activity among people, and that the government
alternative goals, that the cost of any action is can potentially improve market outcomes by
measured in terms of forgone opportunities, that remedying a market failure or by promoting
rational people make decisions by comparing greater economic equality.
marginal costs and marginal benefits, and that
people change their behavior in response to the
• The fundamental lessons about the economy as a
whole are that productivity is the ultimate source
incentives they face.
of living standards, that growth in the quantity
• The fundamental lessons about interactions of money is the ultimate source of inflation, and
among people are that trade and interdepen- that society faces a short-run trade-off between
dence can be mutually beneficial, that markets inflation and unemployment.
KEY CONCEPTS
scarcity, p. 3 marginal changes, p. 6 market power, p. 12

economics, p. 4 incentive, p. 7 productivity, p. 13
efficiency, p. 5 market economy, p. 9 inflation, p. 13
equality, p. 5 property rights, p. 10 business cycle, p. 15
opportunity cost, p. 5 market failure, p. 11
rational people, p. 6 externality, p. 11
QUESTIONS FOR REVIEW
1. Give three examples of important trade-offs that 6. What does the “invisible hand” of the market-
you face in your life. place do?
2. What is the opportunity cost of seeing a movie? 7. Explain the two main causes of market failure
3. Water is necessary for life. Is the marginal ben- and give an example of each.
efit of a glass of water large or small? 8. Why is productivity important?
4. Why should policymakers think about 9. What is inflation and what causes it?
incentives? 10. How are inflation and unemployment related
5. Why isn’t trade among countries like a game in the short run?
with some winners and some losers?
PROBLEMS AND APPLICATIONS
1. Describe some of the trade-offs faced by each of reduced the expected sales of your new product
the following: to $3 million. If it would cost $1 million to finish
a. a family deciding whether to buy a new car development and make the product, should you
b. a member of Congress deciding how much to go ahead and do so? What is the most that you
spend on national parks should pay to complete development?
c. a company president deciding whether to 6. Three managers of the Magic Potion Company
open a new factory are discussing a possible increase in production.
d. a professor deciding how much to prepare Each suggests a way to make this decision.
for class
Harry: We should examine whether our
e. a recent college graduate deciding whether to
company’s productivity—gallons
go to graduate school
of potion per worker—would rise
2. You are trying to decide whether to take a vaca-
or fall.
tion. Most of the costs of the vacation (airfare,
Ron: We should examine whether our
hotel, and forgone wages) are measured in dol-
average cost—cost per worker—
lars, but the benefits of the vacation are psycho-
would rise or fall.
logical. How can you compare the benefits to
Hermione: We should examine whether
the costs?
the extra revenue from selling
3. You were planning to spend Saturday working
the additional potion would be
at your part-time job, but a friend asks you to
greater or smaller than the extra
go skiing. What is the true cost of going skiing?
costs.
Now suppose you had been planning to spend
the day studying at the library. What is the cost Who do you think is right? Why?
of going skiing in this case? Explain. 7. The Social Security system provides income
4. You win $100 in a basketball pool. You have for people over age 65. If a recipient of Social
a choice between spending the money now or Security decides to work and earn some income,
putting it away for a year in a bank account that the amount he or she receives in Social Security
pays 5 percent interest. What is the opportunity benefits is typically reduced.
cost of spending the $100 now? a. How does the provision of Social Security
5. The company that you manage has invested affect people’s incentive to save while
$5 million in developing a new product, but working?
the development is not quite finished. At a b. How does the reduction in benefits associ-
recent meeting, your salespeople report that ated with higher earnings affect people’s
the introduction of competing products has incentive to work past age 65?
8. A recent bill reforming the government’s anti- e. imposing higher personal income tax rates on
poverty programs limited many welfare recipi- people with higher incomes
ents to only two years of benefits. f. instituting laws against driving while
a. How does this change affect the incentives intoxicated
for working? 12. Discuss each of the following statements from
b. How might this change represent a trade-off the standpoints of equality and efficiency.
between equality and efficiency? a. “Everyone in society should be guaranteed
9. Your roommate is a better cook than you are, the best healthcare possible.”
but you can clean more quickly than your room- b. “When workers are laid off, they should be
mate can. If your roommate did all the cooking able to collect unemployment benefits until
and you did all the cleaning, would your chores they find a new job.”
take you more or less time than if you divided 13. In what ways is your standard of living different
each task evenly? Give a similar example of how from that of your parents or grandparents when
specialization and trade can make two countries they were your age? Why have these changes
both better off. occurred?
10. Suppose the United States adopted central plan- 14. Suppose Americans decide to save more of
ning for its economy, and you became the chief their incomes. If banks lend this extra savings
planner. Among the millions of decisions that to businesses, which use the funds to build new
you need to make for next year are how many factories, how might this lead to faster growth
compact discs to produce, what artists to record, in productivity? Who do you suppose benefits
and which consumers should receive the discs. from the higher productivity? Is society getting
To make these decisions intelligently, what a free lunch?
information would you need about the compact 15. During the Revolutionary War, the American
disc industry? What information would you colonies could not raise enough tax revenue to
need about each of the people in the United fully fund the war effort; to make up this differ-
States? How well do you think you could do ence, the colonies decided to print more money.
your job? Printing money to cover expenditures is some-
11. Explain whether each of the following govern- times referred to as an “inflation tax.” Who do
ment activities is motivated by a concern about you think is being “taxed” when more money is
equality or a concern about efficiency. In the printed? Why?
case of efficiency, discuss the type of market 16. Imagine that you are a policymaker trying to
failure involved. decide whether to reduce the rate of inflation.
a. regulating cable TV prices To make an intelligent decision, what would
b. providing some poor people with vouchers you need to know about inflation, unemploy-
that can be used to buy food ment, and the trade-off between them?
c. prohibiting smoking in public places
d. breaking up Standard Oil (which once owned
90 percent of all oil refineries) into several
smaller companies
2
CHAPTER
Thinking Like an Economist
E very field of study has its own language and its own way of thinking. Math-
ematicians talk about axioms, integrals, and vector spaces. Psychologists
talk about ego, id, and cognitive dissonance. Lawyers talk about venue,
torts, and promissory estoppel.
Economics is no different. Supply, demand, elasticity, comparative advantage,
consumer surplus, deadweight loss—these terms are part of the economist’s lan-
guage. In the coming chapters, you will encounter many new terms and some
familiar words that economists use in specialized ways. At first, this new lan-
guage may seem needlessly arcane. But as you will see, its value lies in its ability
to provide you with a new and useful way of thinking about the world in which
you live.
The purpose of this book is to help you learn the economist’s way of thinking.
Just as you cannot become a mathematician, psychologist, or lawyer overnight,
learning to think like an economist will take some time. Yet with a combination of
theory, case studies, and examples of economics in the news, this book will give
you ample opportunity to develop and practice this skill.
Before delving into the substance and details of economics, it is helpful to have
an overview of how economists approach the world. This chapter discusses the
field’s methodology. What is distinctive about how economists confront a ques-
tion? What does it mean to think like an economist?
21
THE ECONOMIST AS SCIENTIST

Economists try to address their subject with a scientist’s objectivity. They approach
the study of the economy in much the same way a physicist approaches the study
of matter and a biologist approaches the study of life: They devise theories, collect
data, and then analyze these data in an attempt to verify or refute their theories.
To beginners, it can seem odd to claim that economics is a science. After all,
economists do not work with test tubes or telescopes. The essence of science,
however, is the scientific method—the dispassionate development and testing of
theories about how the world works. This method of inquiry is as applicable to
studying a nation’s economy as it is to studying the earth’s gravity or a species’
evolution. As Albert Einstein once put it, “The whole of science is nothing more
than the refinement of everyday thinking.”
Although Einstein’s comment is as true for social sciences such as economics
as it is for natural sciences such as physics, most people are not accustomed to
looking at society through the eyes of a scientist. Let’s discuss some of the ways in
which economists apply the logic of science to examine how an economy works.
“I’M A SOCIAL SCIENTIST, THE SCIENTIFIC M ETHOD: OBSERVATION,

MICHAEL. THAT MEANS I THEORY, AND MORE OBSERVATION
CAN’T EXPLAIN ELECTRICITY
OR ANYTHING LIKE THAT, BUT Isaac Newton, the famous 17th-century scientist and mathematician, allegedly
IF YOU EVER WANT TO KNOW became intrigued one day when he saw an apple fall from a tree. This observation
ABOUT PEOPLE, I’M YOUR motivated Newton to develop a theory of gravity that applies not only to an apple
MAN.” falling to the earth but to any two objects in the universe. Subsequent testing of
Newton’s theory has shown that it works well in many circumstances (although,
as Einstein would later emphasize, not in all circumstances). Because Newton’s
theory has been so successful at explaining observation, it is still taught in under-
graduate physics courses around the world.
This interplay between theory and observation also occurs in the field of eco-
nomics. An economist might live in a country experiencing rapidly increasing
prices and be moved by this observation to develop a theory of inflation. The the-
ory might assert that high inflation arises when the government prints too much
money. To test this theory, the economist could collect and analyze data on prices
and money from many different countries. If growth in the quantity of money
were not at all related to the rate at which prices are rising, the economist would
start to doubt the validity of this theory of inflation. If money growth and inflation
were strongly correlated in international data, as in fact they are, the economist
would become more confident in the theory.
FROM CARTOONBANK.COM. ALL RIGHTS RESERVED.
Although economists use theory and observation like other scientists, they face CARTOON: © 2002 THE NEW YORKER COLLECTION
an obstacle that makes their task especially challenging: In economics, conduct-
ing experiments is often difficult and sometimes impossible. Physicists studying
gravity can drop many objects in their laboratories to generate data to test their
theories. By contrast, economists studying inflation are not allowed to manipu-
late a nation’s monetary policy simply to generate useful data. Economists, like
astronomers and evolutionary biologists, usually have to make do with whatever
data the world happens to give them.
To find a substitute for laboratory experiments, economists pay close atten-
tion to the natural experiments offered by history. When a war in the Middle East
interrupts the flow of crude oil, for instance, oil prices skyrocket around the world.
CHAPTER 2 THINKING LIKE AN ECONOMIST 23
For consumers of oil and oil products, such an event depresses living standards.
For economic policymakers, it poses a difficult choice about how best to respond.
But for economic scientists, the event provides an opportunity to study the effects
of a key natural resource on the world’s economies. Throughout this book, there-
fore, we consider many historical episodes. These episodes are valuable to study
because they give us insight into the economy of the past and, more important,
because they allow us to illustrate and evaluate economic theories of the present.
THE ROLE OF ASSUMPTIONS

If you ask a physicist how long it would take a marble to fall from the top of a ten-
story building, she will likely answer the question by assuming that the marble
falls in a vacuum. Of course, this assumption is false. In fact, the building is sur-
rounded by air, which exerts friction on the falling marble and slows it down. Yet
the physicist will point out that friction on the marble is so small that its effect is
negligible. Assuming the marble falls in a vacuum simplifies the problem without
substantially affecting the answer.
Economists make assumptions for the same reason: Assumptions can sim-
plify the complex world and make it easier to understand. To study the effects of
international trade, for example, we might assume that the world consists of only
two countries and that each country produces only two goods. In reality, there
are numerous countries, each of which produces thousands of different types of
goods. But by assuming two countries and two goods, we can focus our thinking
on the essence of the problem. Once we understand international trade in this sim-
plified imaginary world, we are in a better position to understand international
trade in the more complex world in which we live.
The art in scientific thinking—whether in physics, biology, or economics—is
deciding which assumptions to make. Suppose, for instance, that we were drop-
ping a beachball rather than a marble from the top of the building. Our physicist
would realize that the assumption of no friction is less accurate in this case: Fric-
tion exerts a greater force on a beachball than on a marble because a beachball is
much larger. The assumption that gravity works in a vacuum is reasonable for
studying a falling marble but not for studying a falling beachball.
Similarly, economists use different assumptions to answer different questions.
Suppose that we want to study what happens to the economy when the govern-
ment changes the number of dollars in circulation. An important piece of this
analysis, it turns out, is how prices respond. Many prices in the economy change
infrequently; the newsstand prices of magazines, for instance, change only every
few years. Knowing this fact may lead us to make different assumptions when
studying the effects of the policy change over different time horizons. For study-
ing the short-run effects of the policy, we may assume that prices do not change
much. We may even make the extreme and artificial assumption that all prices
are completely fixed. For studying the long-run effects of the policy, however,
we may assume that all prices are completely flexible. Just as a physicist uses dif-
ferent assumptions when studying falling marbles and falling beachballs, econo-
mists use different assumptions when studying the short-run and long-run effects
of a change in the quantity of money.
ECONOMIC MODELS
High school biology teachers teach basic anatomy with plastic replicas of the
human body. These models have all the major organs: the heart, the liver, the
kidneys, and so on. The models allow teachers to show their students very simply
how the important parts of the body fit together. Because these plastic models are
stylized and omit many details, no one would mistake one of them for a real per-
son. Despite this lack of realism—indeed, because of this lack of realism—studying
these models is useful for learning how the human body works.
Economists also use models to learn about the world, but instead of being made
of plastic, they are most often composed of diagrams and equations. Like a biol-
ogy teacher’s plastic model, economic models omit many details to allow us to see
what is truly important. Just as the biology teacher’s model does not include all
the body’s muscles and capillaries, an economist’s model does not include every
feature of the economy.
As we use models to examine various economic issues throughout this book,
you will see that all the models are built with assumptions. Just as a physicist
begins the analysis of a falling marble by assuming away the existence of friction,
economists assume away many of the details of the economy that are irrelevant for
studying the question at hand. All models—in physics, biology, and economics—
simplify reality to improve our understanding of it.
OUR FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM

The economy consists of millions of people engaged in many activities—buying,
selling, working, hiring, manufacturing, and so on. To understand how the economy
works, we must find some way to simplify our thinking about all these activities.
In other words, we need a model that explains, in general terms, how the economy
is organized and how participants in the economy interact with one another.
Figure 1 presents a visual model of the economy called a circular-flow diagram.
circular-flow diagram In this model, the economy is simplified to include only two types of decision
a visual model of the makers—firms and households. Firms produce goods and services using inputs,
economy that shows how such as labor, land, and capital (buildings and machines). These inputs are called
dollars flow through mar- the factors of production. Households own the factors of production and consume
kets among households all the goods and services that the firms produce.
and firms
Households and firms interact in two types of markets. In the markets for goods
and services, households are buyers, and firms are sellers. In particular, households
buy the output of goods and services that firms produce. In the markets for the fac-
tors of production, households are sellers, and firms are buyers. In these markets,
households provide the inputs that firms use to produce goods and services. The
circular-flow diagram offers a simple way of organizing the economic transac-
tions that occur between households and firms in the economy.
The two loops of the circular-flow diagram are distinct but related. The inner
loop represents the flows of inputs and outputs. The households sell the use of
their labor, land, and capital to the firms in the markets for the factors of pro-
duction. The firms then use these factors to produce goods and services, which
in turn are sold to households in the markets for goods and services. The outer
loop of the diagram represents the corresponding flow of dollars. The households
spend money to buy goods and services from the firms. The firms use some of the
revenue from these sales to pay for the factors of production, such as the wages
of their workers. What’s left is the profit of the firm owners, who themselves are
members of households.
Let’s take a tour of the circular flow by following a dollar bill as it makes its
way from person to person through the economy. Imagine that the dollar begins
at a household, say, in your wallet. If you want to buy a cup of coffee, you take the
dollar to one of the economy’s markets for goods and services, such as your local
F I G U R E
1
MARKETS
Revenue FOR Spending The Circular Flow
GOODS AND SERVICES This diagram is a sche-
Goods • Firms sell Goods and matic representation of
and services • Households buy services the organization of the
sold bought economy. Decisions are
made by households and
firms. Households and firms
interact in the markets for
FIRMS HOUSEHOLDS goods and services (where
• Produce and sell • Buy and consume
households are buyers and
goods and services goods and services
firms are sellers) and in the
• Hire and use factors • Own and sell factors
of production of production markets for the factors of
production (where firms
are buyers and households
are sellers). The outer set of
arrows shows the flow of
Factors of MARKETS Labor, land, dollars, and the inner set
production and capital
FOR of arrows shows the corre-
FACTORS OF PRODUCTION sponding flow of inputs and
Wages, rent, • Households sell Income outputs.
and profit • Firms buy
Flow of inputs
and outputs
Flow of dollars
Starbucks coffee shop. There you spend it on your favorite drink. When the dollar
moves into the Starbucks cash register, it becomes revenue for the firm. The dollar
doesn’t stay at Starbucks for long, however, because the firm uses it to buy inputs
in the markets for the factors of production. Starbucks might use the dollar to pay
rent to its landlord for the space it occupies or to pay the wages of its workers.
In either case, the dollar enters the income of some household and, once again, is
back in someone’s wallet. At that point, the story of the economy’s circular flow
starts once again.
The circular-flow diagram in Figure 1 is one simple model of the economy. It
dispenses with details that, for some purposes, are significant. A more complex
and realistic circular-flow model would include, for instance, the roles of govern-
ment and international trade. (Some of that dollar you gave to Starbucks might
be used to pay taxes and or to buy coffee beans from a farmer in Brazil.) Yet these
details are not crucial for a basic understanding of how the economy is organized.
Because of its simplicity, this circular-flow diagram is useful to keep in mind when
thinking about how the pieces of the economy fit together.
OUR SECOND MODEL: THE PRODUCTION

POSSIBILITIES FRONTIER
Most economic models, unlike the circular-flow diagram, are built using the tools
of mathematics. Here we use one of the simplest such models, called the produc-
tion possibilities frontier, to illustrate some basic economic ideas.
Although real economies produce thousands of goods and services, let’s assume
an economy that produces only two goods—cars and computers. Together, the
car industry and the computer industry use all of the economy’s factors of pro-
production possibilities duction. The production possibilities frontier is a graph that shows the various
frontier combinations of output—in this case, cars and computers—that the economy can
a graph that shows the possibly produce given the available factors of production and the available pro-
combinations of output duction technology that firms use to turn these factors into output.
that the economy can Figure 2 shows this economy’s production possibilities frontier. If the economy
possibly produce given
uses all its resources in the car industry, it produces 1,000 cars and no computers.
the available factors
of production and the
If it uses all its resources in the computer industry, it produces 3,000 computers
available production and no cars. The two endpoints of the production possibilities frontier represent
technology these extreme possibilities.
More likely, the economy divides its resources between the two industries, and
this yields other points on the production possibilities frontier. For example, it
can produce 600 cars and 2,200 computers, shown in the figure by point A. Or, by
moving some of the factors of production to the car industry from the computer
industry, the economy can produce 700 cars and 2,000 computers, represented by
point B.
Because resources are scarce, not every conceivable outcome is feasible. For
example, no matter how resources are allocated between the two industries, the
economy cannot produce the amount of cars and computers represented by point
C. Given the technology available for manufacturing cars and computers, the
economy does not have enough of the factors of production to support that level
of output. With the resources it has, the economy can produce at any point on or
inside the production possibilities frontier, but it cannot produce at points outside
the frontier.
An outcome is said to be efficient if the economy is getting all it can from the
scarce resources it has available. Points on (rather than inside) the production pos-
sibilities frontier represent efficient levels of production. When the economy is
producing at such a point, say point A, there is no way to produce more of one
2 F I G U R E
Quantity of
Computers
Produced
The Production Possibilities Frontier
The production possibilities frontier shows the
combinations of output—in this case, cars and
computers—that the economy can possibly 3,000 F C
produce. The economy can produce any combi-
nation on or inside the frontier. Points outside
2,200 A
the frontier are not feasible given the economy’s B
2,000
resources.
Production
possibilities
frontier
1,000 D
0 300 600 700 1,000 Quantity of

Cars Produced
good without producing less of the other. Point D represents an inefficient out-
come. For some reason, perhaps widespread unemployment, the economy is pro-
ducing less than it could from the resources it has available: It is producing only
300 cars and 1,000 computers. If the source of the inefficiency is eliminated, the
economy can increase its production of both goods. For example, if the economy
moves from point D to point A, its production of cars increases from 300 to 600,
and its production of computers increases from 1,000 to 2,200.
One of the Ten Principles of Economics discussed in Chapter 1 is that people face
trade-offs. The production possibilities frontier shows one trade-off that society
faces. Once we have reached the efficient points on the frontier, the only way of
getting more of one good is to get less of the other. When the economy moves
from point A to point B, for instance, society produces 100 more cars but at the
expense of producing 200 fewer computers.
This trade-off helps us understand another of the Ten Principles of Economics:
The cost of something is what you give up to get it. This is called the opportunity
cost. The production possibilities frontier shows the opportunity cost of one good
as measured in terms of the other good. When society moves from point A to
point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the
opportunity cost of 100 cars is 200 computers. Put another way, the opportunity
cost of each car is two computers. Notice that the opportunity cost of a car equals
the slope of the production possibilities frontier. (If you don’t recall what slope is,
you can refresh your memory with the graphing appendix to this chapter.)
The opportunity cost of a car in terms of the number of computers is not con-
stant in this economy but depends on how many cars and computers the economy
is producing. This is reflected in the shape of the production possibilities frontier.
Because the production possibilities frontier in Figure 2 is bowed outward, the
opportunity cost of a car is highest when the economy is producing many cars
and fewer computers, such as at point E, where the frontier is steep. When the
economy is producing few cars and many computers, such as at point F, the fron-
tier is flatter, and the opportunity cost of a car is lower.
Economists believe that production possibilities frontiers often have this
bowed shape. When the economy is using most of its resources to make comput-
ers, such as at point F, the resources best suited to car production, such as skilled
autoworkers, are being used in the computer industry. Because these workers
probably aren’t very good at making computers, the economy won’t have to lose
much computer production to increase car production by one unit. The opportu-
nity cost of a car in terms of computers is small, and the frontier is relatively flat.
By contrast, when the economy is using most of its resources to make cars, such as
at point E, the resources best suited to making cars are already in the car industry.
Producing an additional car means moving some of the best computer techni-
cians out of the computer industry and making them autoworkers. As a result,
producing an additional car will mean a substantial loss of computer output. The
opportunity cost of a car is high, and the frontier is steep.
The production possibilities frontier shows the trade-off between the outputs
of different goods at a given time, but the trade-off can change over time. For
example, suppose a technological advance in the computer industry raises the
number of computers that a worker can produce per week. This advance expands
society’s set of opportunities. For any given number of cars, the economy can
make more computers. If the economy does not produce any computers, it can
still produce 1,000 cars, so one endpoint of the frontier stays the same. But the rest
of the production possibilities frontier shifts outward, as in Figure 3.
3 F I G U R E
Quantity of
Computers
Produced
A Shift in the Production
Possibilities Frontier
A technological advance in the computer 4,000
industry enables the economy to produce more
computers for any given number of cars. As a
result, the production possibilities frontier shifts
3,000
outward. If the economy moves from point A to
point G, then the production of both cars and
2,300 G
computers increases.
2,200
A
0 600 650 1,000 Quantity of

Cars Produced
This figure illustrates economic growth. Society can move production from a
point on the old frontier to a point on the new frontier. Which point it chooses
depends on its preferences for the two goods. In this example, society moves from
point A to point G, enjoying more computers (2,300 instead of 2,200) and more
cars (650 instead of 600).
The production possibilities frontier simplifies a complex economy to highlight
some basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost,
and economic growth. As you study economics, these ideas will recur in vari-
ous forms. The production possibilities frontier offers one simple way of thinking
about them.
MICROECONOMICS AND M ACROECONOMICS

Many subjects are studied on various levels. Consider biology, for example.
Molecular biologists study the chemical compounds that make up living things.
Cellular biologists study cells, which are made up of many chemical compounds
and, at the same time, are themselves the building blocks of living organisms.
microeconomics Evolutionary biologists study the many varieties of animals and plants and how
the study of how house- species change gradually over the centuries.
holds and firms make Economics is also studied on various levels. We can study the decisions of indi-
decisions and how they
vidual households and firms. Or we can study the interaction of households and
interact in markets
firms in markets for specific goods and services. Or we can study the operation
macroeconomics of the economy as a whole, which is the sum of the activities of all these decision
the study of economy- makers in all these markets.
wide phenomena, The field of economics is traditionally divided into two broad subfields.
including inflation, Microeconomics is the study of how households and firms make decisions and
unemployment, and how they interact in specific markets. Macroeconomics is the study of economy-
economic growth wide phenomena. A microeconomist might study the effects of rent control on
housing in New York City, the impact of foreign competition on the U.S. auto
industry, or the effects of compulsory school attendance on workers’ earnings. A
macroeconomist might study the effects of borrowing by the federal government,
the changes over time in the economy’s rate of unemployment, or alternative poli-
cies to promote growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because changes
in the overall economy arise from the decisions of millions of individuals, it is
impossible to understand macroeconomic developments without considering the
associated microeconomic decisions. For example, a macroeconomist might study
the effect of a federal income tax cut on the overall production of goods and ser-
vices. But to analyze this issue, he or she must consider how the tax cut affects the
decisions of households about how much to spend on goods and services.
Who Studies Economics?
As a college student, you Arnold Schwarzenegger Governor of California

might be asking yourself: How many economics classes should I Sandra Day-O’Connor Former Supreme Court Justice
take? How useful will this stuff be to me later in life? Economics can Scott Adams Cartoonist
seem abstract at first, but the field is fundamentally very practical, Mick Jagger Singer for The Rolling Stones
and the study of economics is useful in many different career paths.
Having studied at the London School of Economics may not help
Here is a small sampling of some well-known people who majored
Mick Jagger hit the high notes, but it has probably given him some
in economics when they were in college.
insight about how to invest the substantial sums he has earned dur-
Meg Whitman President and Chief Executive Officer, ing his rock-’n’-roll career.
eBay
Ronald Reagan Former President of the United States
William F. Buckley Jr. Journalist
Danny Glover Actor
Barbara Boxer U.S. Senator
John Elway NFL Quarterback
Kofi Annan Former Secretary General, United Nations
Ted Turner Founder of CNN and Owner of
Atlanta Braves
Lionel Richie Singer
Diane von Furstenberg Fashion Designer
Michael Kinsley Journalist
PHOTO: ©AP/ASSOCIATED PRESS
Ben Stein Political Speechwriter, Actor, and

Game Show Host When asked in 2005 why The Rolling Stones
Cate Blanchett Actor were going on tour again, former econom-
Anthony Zinni General (ret.), U.S. Marine Corps ics major Mick Jagger replied, “Supply and
Tiger Woods Golfer demand.” Keith Richards added, “If the
Steve Ballmer Chief Executive Officer, Microsoft demand’s there, we’ll supply.”
Despite the inherent link between microeconomics and macroeconomics, the

two fields are distinct. Because they address different questions, each field has its
own set of models, which are often taught in separate courses.
Q Q
UICK UIZ In what sense is economics like a science? • Draw a production possibili-
ties frontier for a society that produces food and clothing. Show an efficient point, an
inefficient point, and an infeasible point. Show the effects of a drought. • Define micro-
economics and macroeconomics.
THE ECONOMIST AS POLICY ADVISER

Often, economists are asked to explain the causes of economic events. Why, for
example, is unemployment higher for teenagers than for older workers? Some-
times, economists are asked to recommend policies to improve economic out-
comes. What, for instance, should the government do to improve the economic
well-being of teenagers? When economists are trying to explain the world, they
are scientists. When they are trying to help improve it, they are policy advisers.
POSITIVE VERSUS NORMATIVE ANALYSIS

To help clarify the two roles that economists play, let’s examine the use of lan-
guage. Because scientists and policy advisers have different goals, they use lan-
guage in different ways.
For example, suppose that two people are discussing minimum-wage laws.
Here are two statements you might hear:
Polly: Minimum-wage laws cause unemployment.
Norm: The government should raise the minimum wage.
Ignoring for now whether you agree with these statements, notice that Polly and
Norm differ in what they are trying to do. Polly is speaking like a scientist: She
is making a claim about how the world works. Norm is speaking like a policy
adviser: He is making a claim about how he would like to change the world.
In general, statements about the world are of two types. One type, such as
positive statements Polly’s, is positive. Positive statements are descriptive. They make a claim about
claims that attempt to how the world is. A second type of statement, such as Norm’s, is normative.
describe the world as Normative statements are prescriptive. They make a claim about how the world
it is ought to be.
A key difference between positive and normative statements is how we judge
normative statements
their validity. We can, in principle, confirm or refute positive statements by exam-
claims that attempt to
prescribe how the world
ining evidence. An economist might evaluate Polly’s statement by analyzing data
should be on changes in minimum wages and changes in unemployment over time. By con-
trast, evaluating normative statements involves values as well as facts. Norm’s
statement cannot be judged using data alone. Deciding what is good or bad policy
is not just a matter of science. It also involves our views on ethics, religion, and
political philosophy.
Positive and normative statements are fundamentally different, but they are
often intertwined in a person’s set of beliefs. In particular, positive views about
how the world works affect normative views about what policies are desirable.
Polly’s claim that the minimum wage causes unemployment, if true, might lead
her to reject Norm’s conclusion that the government should raise the minimum
wage. Yet normative conclusions cannot come from positive analysis alone; they
involve value judgments as well.
As you study economics, keep in mind the distinction between positive and
normative statements because it will help you stay focused on the task at hand.
Much of economics is positive: It just tries to explain how the economy works. Yet
those who use economics often have normative goals: They want to learn how to
improve the economy. When you hear economists making normative statements,
you know they are speaking not as scientists but as policy advisers.
ECONOMISTS IN WASHINGTON
President Harry Truman once said that he wanted to find a one-armed economist.
When he asked his economists for advice, they always answered, “On the one
hand, . . . On the other hand, . . . ”
Truman was right in realizing that economists’ advice is not always straight-
forward. This tendency is rooted in one of the Ten Principles of Economics: People
face trade-offs. Economists are aware that trade-offs are involved in most policy
decisions. A policy might increase efficiency at the cost of equality. It might help
future generations but hurt current generations. An economist who says that all
policy decisions are easy is an economist not to be trusted.
Truman was also not alone among presidents in relying on the advice of econo-
mists. Since 1946, the president of the United States has received guidance from
the Council of Economic Advisers, which consists of three members and a staff
of several dozen economists. The council, whose offices are just a few steps from
the White House, has no duty other than to advise the president and to write the
annual Economic Report of the President, which discusses recent developments in
the economy and presents the council’s analysis of current policy issues.
The president also receives input from economists in many administrative
departments. Economists at the Department of the Treasury help design tax policy.
Economists at the Department of Labor analyze data on workers and those look-
ing for work to help formulate labor-market policies. Economists at the Depart-
ment of Justice help enforce the nation’s antitrust laws.
Economists are also found outside the administrative branch of government.
To obtain independent evaluations of policy proposals, Congress relies on the
advice of the Congressional Budget Office, which is staffed by economists. The
Federal Reserve, the institution that sets the nation’s monetary policy, employs
hundreds of economists to analyze economic developments in the United States
and throughout the world.
The influence of economists on policy goes beyond their role as advisers: Their
CARTOON: © 2002 THE NEW YORKER COLLECTION
research and writings often affect policy indirectly. Economist John Maynard
Keynes offered this observation:
The ideas of economists and political philosophers, both when they are right
and when they are wrong, are more powerful than is commonly understood.
Indeed, the world is ruled by little else. Practical men, who believe themselves
to be quite exempt from intellectual influences, are usually the slaves of some
defunct economist. Madmen in authority, who hear voices in the air, are distill-
ing their frenzy from some academic scribbler of a few years back.
“LET’S SWITCH. I’LL MAKE THE
Although these words were written in 1935, they remain true. Indeed, the “aca- POLICY, YOU IMPLEMENT IT,
demic scribbler” now influencing public policy is often Keynes himself. AND HE’LL EXPLAIN IT.”
Football Economics
Economists often offer advice to policymakers. Sometimes
those policymakers are coaches.
Go for It on Fourth Down, actual behavior regularly departs from the

Coach? Maybe You Should optimal path to reach that goal.
Ask an Egghead. In his analysis of football teams, Romer
By Shankar Vedantam specifically looked at a single question—
whether teams should punt or kick the foot-
With just over five minutes to play in yester- ball on fourth down, or take a chance and
day’s game against the New York Jets, the run or throw the ball. Romer’s calculations
Washington Redskins found themselves on don’t necessarily tell teams what to do in
their own 23-yard line facing a fourth and specific situations such as yesterday’s game.
one. The team, which was ahead by just But on average, teams that take the risk
three points, elected to do what teams nor- seem to win more often than lose.
mally do in such situations: They played it versity of California, who has concluded that Data from a large number of NFL games
PHOTO: © DAVE KAUP/REUTERS/LANDOV
safe and punted rather than try to keep the football teams are far too conservative in show that coaches rarely follow what
drive alive. play calling in fourth-down situations. Romer’s calculations predict would give
The Jets promptly came back to kick a You don’t have to be particularly inter- them the best chance of victory. While fans
field goal, tying the game and sending it ested in sports to find Romer’s conclusion often suggest more aggressive play call-
into overtime. While this particular story had intriguing: His hunch about human behav- ing, even fans usually don’t go as far as the
a happy ending for Washington, which won, ior in general was that although people say economist does—his calculations show that
23–20, it illustrated the value of an analysis they have a certain goal and are willing to teams should regularly be going for it on
by David Romer, an economist at the Uni- do everything they can to achieve it, their fourth down, even if it is early in the game,
WHY ECONOMISTS’ A DVICE IS NOT A LWAYS FOLLOWED

Any economist who advises presidents or other elected leaders knows that his or
her recommendations are not always heeded. Frustrating as this can be, it is easy
to understand. The process by which economic policy is made differs in many
ways from the idealized policy process assumed in economics textbooks.
Throughout this text, whenever we discuss economic policy, we often focus on
one question: What is the best policy for the government to pursue? We act as if
policy were set by a benevolent king. Once the king figures out the right policy,
he has no trouble putting his ideas into action.
In the real world, figuring out the right policy is only part of a leader’s job,
sometimes the easiest part. After a president hears from his economic advisers
about what policy is best from their perspective, he turns to other advisers for
related input. His communications advisers will tell him how best to explain the
proposed policy to the public, and they will try to anticipate any misunderstand-
even if the score is tied, and even if the ball he has been told to mind his own business tings that have nothing to do with sports.
is on their own side of the field. in the ivory tower. Why do coaches persist in doing something
Romer’s calculations have been backed Indeed, since Romer wrote his paper a that is less than optimal, when they say
up by independent analyses. Coaches have couple of years ago, NFL coaches seem to their only goal is to win? One theory that
not raised a serious challenge to Romer’s have gotten even more conservative in their Romer has heard is that coaches—like gen-
analysis, but they have simply ignored his play calling, which the economist attributes erals, stock fund directors and managers in
finding. to their unwillingness to follow the advice of general—actually have different goals than
New England Patriots coach Bill Belichick an academic, however useful it might be. the people they lead and the people they
is among those who has said he agrees with “It used to be that going for it on fourth must answer to. Everyone wants to win, but
Romer, and Belichick happens to be one of down was the macho thing to do,” Romer managers are held to different standards
the more successful coaches in the league. said. But after his findings were widely pub- than followers when they lose, especially
Two Sundays ago, as the Patriots were piling licized in sports circles, he said: “Now going when they lose after trying something that
up an astronomical score against Washing- for it on fourth down is the egghead thing few others are doing.
ton, Belichick took a chance on a fourth- to do. Would you rather be macho or an Wayne Stewart, an associate professor of
down play and got his team seven points egghead?” management at Clemson University, said his
instead of the three he might have gotten The interesting question raised by own research backs up the idea that own-
had the team tried a field goal. Romer’s research applies to a range of set- ers and managers in general have different
When asked by reporters why he took approaches to risk. While owners tend to be
the chance, Belichick’s response was the entrepreneurial and focused on outcomes,
response of someone who really means he said, managers are often principally
what he says about maximizing points: focused on not screwing up.
“What do you want us to do, kick a field Stewart said this might explain why
PHOTO: COURTESY OF DAVID ROMER

goal?” coaches’ approach to risk diverges from that
Owners and fans have been receptive of owners and fans, who are principally inter-
to Romer’s ideas. However, in informal con- ested in outcomes. Stewart said successful
versations Romer has had with the coaching managers understand that the fear of failure
staffs of various teams, the economist said David Romer is itself often the principal cause of failure.
Source: The Washington Post, November 5, 2007.
ings that might arise to make the challenge more difficult. His press advisers will
tell him how the news media will report on his proposal and what opinions will
likely be expressed on the nation’s editorial pages. His legislative affairs advisers
will tell him how Congress will view the proposal, what amendments members of
Congress will suggest, and the likelihood that Congress will pass some version of
the president’s proposal into law. His political advisers will tell him which groups
will organize to support or oppose the proposed policy, how this proposal will
affect his standing among different groups in the electorate, and whether it will
affect support for any of the president’s other policy initiatives. After hearing and
weighing all this advice, the president then decides how to proceed.
Making economic policy in a representative democracy is a messy affair—and
there are often good reasons presidents (and other politicians) do not advance the
policies that economists advocate. Economists offer crucial input into the policy
process, but their advice is only one ingredient of a complex recipe.
QUICK QUIZ Give an example of a positive statement and an example of a normative

statement that somehow relates to your daily life. • Name three parts of government
that regularly rely on advice from economists.
WHY ECONOMISTS DISAGREE

“If all economists were laid end to end, they would not reach a conclusion.” This
quip from George Bernard Shaw is revealing. Economists as a group are often
criticized for giving conflicting advice to policymakers. President Ronald Reagan
once joked that if the game Trivial Pursuit were designed for economists, it would
have 100 questions and 3,000 answers.
Why do economists so often appear to give conflicting advice to policymakers?
There are two basic reasons:
• Economists may disagree about the validity of alternative positive theories
about how the world works.
• Economists may have different values and therefore different normative
views about what policy should try to accomplish.
Let’s discuss each of these reasons.
DIFFERENCES IN SCIENTIFIC JUDGMENTS

Several centuries ago, astronomers debated whether the earth or the sun was at
the center of the solar system. More recently, meteorologists have debated whether
the earth is experiencing global warming and, if so, why. Science is a search for
understanding about the world around us. It is not surprising that as the search
continues, scientists can disagree about the direction in which truth lies.
Economists often disagree for the same reason. Economics is a young science,
and there is still much to be learned. Economists sometimes disagree because they
have different hunches about the validity of alternative theories or about the size
of important parameters that measure how economic variables are related.
For example, economists disagree about whether the government should tax a
household’s income or its consumption (spending). Advocates of a switch from
the current income tax to a consumption tax believe that the change would encour-
age households to save more because income that is saved would not be taxed.
Higher saving, in turn, would free resources for capital accumulation, leading to
more rapid growth in productivity and living standards. Advocates of the current
income tax system believe that household saving would not respond much to a
change in the tax laws. These two groups of economists hold different normative
views about the tax system because they have different positive views about the
responsiveness of saving to tax incentives.
DIFFERENCES IN VALUES
Suppose that Peter and Paula both take the same amount of water from the town
well. To pay for maintaining the well, the town taxes its residents. Peter has income
of $50,000 and is taxed $5,000, or 10 percent of his income. Paula has income of
$10,000 and is taxed $2,000, or 20 percent of her income.
Is this policy fair? If not, who pays too much and who pays too little? Does it
matter whether Paula’s low income is due to a medical disability or to her decision
to pursue a career in acting? Does it matter whether Peter’s high income is due to
a large inheritance or to his willingness to work long hours at a dreary job?
These are difficult questions on which people are likely to disagree. If the town
hired two experts to study how the town should tax its residents to pay for the
well, we would not be surprised if they offered conflicting advice.
This simple example shows why economists sometimes disagree about public
policy. As we learned earlier in our discussion of normative and positive analysis,
policies cannot be judged on scientific grounds alone. Economists give conflicting
advice sometimes because they have different values. Perfecting the science of
economics will not tell us whether Peter or Paula pays too much.
PERCEPTION VERSUS R EALITY

Because of differences in scientific judgments and differences in values, some
disagreement among economists is inevitable. Yet one should not overstate the
amount of disagreement. Economists agree with one another far more than is
sometimes understood.
Table 1 contains 14 propositions about economic policy. In surveys of profes-
sional economists, these propositions were endorsed by an overwhelming major-
ity of respondents. Most of these propositions would fail to command a similar
consensus among the public.
T A B L E
1
Proposition (and percentage of economists who agree)
1. A ceiling on rents reduces the quantity and quality of housing available. (93%)
2. Tariffs and import quotas usually reduce general economic welfare. (93%) Propositions about
3. Flexible and floating exchange rates offer an effective international monetary arrangement. Which Most Economists
(90%) Agree
4. Fiscal policy (e.g., tax cut and/or government expenditure increase) has a significant
stimulative impact on a less than fully employed economy. (90%)
5. The United States should not restrict employers from outsourcing work to foreign countries.
(90%)
6. The United States should eliminate agricultural subsidies. (85%)
7. Local and state governments should eliminate subsidies to professional sports franchises.
(85%)
8. If the federal budget is to be balanced, it should be done over the business cycle rather than
yearly. (85%)
9. The gap between Social Security funds and expenditures will become unsustainably large
within the next 50 years if current policies remain unchanged. (85%)
10. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-
kind of equal cash value. (84%)
11. A large federal budget deficit has an adverse effect on the economy. (83%)
12. A minimum wage increases unemployment among young and unskilled workers. (79%)
13. The government should restructure the welfare system along the lines of a “negative income
tax.” (79%)
14. Effluent taxes and marketable pollution permits represent a better approach to pollution
control than imposition of pollution ceilings. (78%)
Source: Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in
the 1990s?” American Economic Review (May 1992): 203–209; Robert Whaples, “Do Economists Agree on
Anything? Yes!” Economists’ Voice (November 2006): 1–6.
The first proposition in the table is about rent control, a policy that sets a legal
maximum on the amount landlords can charge for their apartments. Almost all
economists believe that rent control adversely affects the availability and qual-
ity of housing and is a costly way of helping the neediest members of society.
Nonetheless, many city governments ignore the advice of economists and place
ceilings on the rents that landlords may charge their tenants.
The second proposition in the table concerns tariffs and import quotas, two
policies that restrict trade among nations. For reasons we discuss more fully later
in this text, almost all economists oppose such barriers to free trade. Nonetheless,
over the years, presidents and Congress have chosen to restrict the import of cer-
tain goods.
Why do policies such as rent control and trade barriers persist if the experts are
united in their opposition? It may be that the realities of the political process stand
as immovable obstacles. But it also may be that economists have not yet convinced
enough of the public that these policies are undesirable. One purpose of this book
is to help you understand the economist’s view of these and other subjects and,
perhaps, to persuade you that it is the right one.
QUICK QUIZ Why might economic advisers to the president disagree about a question
of policy?
LET’S GET GOING

The first two chapters of this book have introduced you to the ideas and methods
of economics. We are now ready to get to work. In the next chapter, we start learn-
ing in more detail the principles of economic behavior and economic policy.
As you proceed through this book, you will be asked to draw on many of your
intellectual skills. You might find it helpful to keep in mind some advice from the
great economist John Maynard Keynes:
The study of economics does not seem to require any specialized gifts of an
unusually high order. Is it not . . . a very easy subject compared with the higher
branches of philosophy or pure science? An easy subject, at which very few
excel! The paradox finds its explanation, perhaps, in that the master-economist
must possess a rare combination of gifts. He must be mathematician, historian,
statesman, philosopher—in some degree. He must understand symbols and
speak in words. He must contemplate the particular in terms of the general,
and touch abstract and concrete in the same flight of thought. He must study
the present in the light of the past for the purposes of the future. No part of
man’s nature or his institutions must lie entirely outside his regard. He must be
purposeful and disinterested in a simultaneous mood; as aloof and incorrupt-
ible as an artist, yet sometimes as near the earth as a politician.
It is a tall order. But with practice, you will become more and more accustomed to
thinking like an economist.
Environmental Economics
Some economists are helping to save the planet.
Green Groups See Potent Environmental economists are on the gasoline. It wasn’t until the 1990 amend-
Tool in Economics payroll of government agencies (the Envi- ment to the Clean Air Act, however, that
By Jessica E. Vascellaro ronmental Protection Agency had about most environmentalists started to take eco-
164 on staff in 2004, up 36% from 1995) nomics seriously.
Many economists dream of getting high- and groups like the Wilderness Society, a The amendment implemented a system
paying jobs on Wall Street, at prestigious Washington-based conservation group, of tradable allowances for acid rain, a pro-
think tanks and universities or at power- which has four of them to work on projects gram pushed by Environmental Defense.
ful government agencies like the Federal such as assessing the economic impact Under the law, plants that can reduce their
Reserve. of building off-road driving trails. Environ- emissions more cost-effectively may sell
But a growing number are choosing to mental Defense, also based in Washington, their allowances to more heavy polluters.
use their skills not to track inflation or inter- was one of the first environmental-advocacy Today, the program has exceeded its goal
est rates but to rescue rivers and trees. These groups to hire economists and now has of reducing the amount of acid rain to half
are the “green economists,” more formally about eight, who do such things as develop its 1980 level and is celebrated as evidence
known as environmental economists, who market incentives to address environmental that markets can help achieve environmen-
use economic arguments and systems to problems like climate change and water tal goals.
persuade companies to clean up pollution shortages. . . . Its success has convinced its former
and to help conserve natural areas. “There used to be this idea that we critics, who at the time contended that
Working at dozens of advocacy groups shouldn’t have to monetize the environ- environmental regulation was a matter of
and a myriad of state and federal environment because it is invaluable,” says Caroline ethics, not economics, and favored install-
mental agencies, they are helping to for- Alkire, who in 1991 joined the Wilderness ing expensive acid rain removal technology
mulate the intellectual framework behind Society, an advocacy group in Washington, in all power plants instead.
approaches to protecting endangered spe- D.C., as one of the group’s first economists. Greenpeace, the international environ-
cies, reducing pollution and preventing cli- “But if we are going to engage in debate on mental giant, was one of the leading oppo-
mate change. They also are becoming a link the Hill about drilling in the Arctic we need nents of the 1990 amendment. But Kert
between left-leaning advocacy groups and to be able to combat the financial argu- Davies, research director for Greenpeace
the public and private sectors. ments. We have to play that card or we are USA, said its success and the lack of any sig-
“In the past, many advocacy groups going to lose.” nificant action on climate policy throughout
interpreted economics as how to make a The field of environmental econom- [the] early 1990s brought the organization
profit or maximize income,” says Lawrence ics began to take form in the 1960s when around to the concept. “We now believe
Goulder, a professor of environmental and academics started to apply the tools of eco- that [tradable permits] are the most straight-
resource economics at Stanford University nomics to the nascent green movement. forward system of reducing emissions and
in Stanford, Calif. “More economists are real- The discipline grew more popular through- creating the incentives necessary for mas-
izing that it offers a framework for resource out the 1980s when the Environmental sive reductions.”
allocation where resources are not only labor Protection Agency adopted a system of
and capital but natural resources as well.” tradable permits for phasing out leaded
Source: The Wall Street Journal, August 23, 2005.

SUMMARY
• Economists try to address their subject with a sci- • A positive statement is an assertion about how
entist’s objectivity. Like all scientists, they make the world is. A normative statement is an asser-
appropriate assumptions and build simplified tion about how the world ought to be. When
models to understand the world around them. economists make normative statements, they are
Two simple economic models are the circular- acting more as policy advisers than as scientists.
flow diagram and the production possibilities
frontier.
• Economists who advise policymakers offer con-
flicting advice either because of differences in
• The field of economics is divided into two sub- scientific judgments or because of differences
fields: microeconomics and macroeconomics. in values. At other times, economists are united
Microeconomists study decision making by in the advice they offer, but policymakers may
households and firms and the interaction among choose to ignore it.
households and firms in the marketplace. Mac-
roeconomists study the forces and trends that
affect the economy as a whole.
KEY CONCEPTS
circular-flow diagram, p. 24 microeconomics, p. 28 normative statements, p. 30

production possibilities frontier, macroeconomics, p. 28
p. 26 positive statements, p. 30
1. How is economics like a science? cookies. What happens to this frontier if disease
2. Why do economists make assumptions? kills half of the economy’s cows?
3. Should an economic model describe reality 7. Use a production possibilities frontier to
exactly? describe the idea of “efficiency.”
4. Name a way that your family interacts in the 8. What are the two subfields into which eco-
factor market, and a way that it interacts in the nomics is divided? Explain what each subfield
product market. studies.
5. Name one economic interaction that isn’t cov- 9. What is the difference between a positive and a
ered by the simplified circular-flow diagram. normative statement? Give an example of each.
6. Draw and explain a production possibilities 10. Why do economists sometimes offer conflicting
frontier for an economy that produces milk and advice to policymakers?
1. Draw a circular-flow diagram. Identify the parts a. Selena pays a storekeeper $1 for a quart of
of the model that correspond to the flow of milk.
goods and services and the flow of dollars for b. Stuart earns $4.50 per hour working at a fast-
each of the following activities. food restaurant.
c. Shanna spends $30 to get a haircut. • All three spend half their time on each
d. Sally earns $10,000 from her 10 percent own- activity. (C)
ership of Acme Industrial. • Larry spends half his time on each activ-
2. Imagine a society that produces military goods ity, while Moe only washes cars and Curly
and consumer goods, which we’ll call “guns” only mows lawns. (D)
and “butter.” b. Graph the production possibilities frontier
a. Draw a production possibilities frontier for for this economy. Using your answers to part
guns and butter. Using the concept of oppor- (a), identify points A, B, C, and D on your
tunity cost, explain why it most likely has a graph.
bowed-out shape. c. Explain why the production possibilities
b. Show a point that is impossible for the econ- frontier has the shape it does.
omy to achieve. Show a point that is feasible d. Are any of the allocations calculated in part
but inefficient. (a) inefficient? Explain.
c. Imagine that the society has two political 5. Classify the following topics as relating to
parties, called the Hawks (who want a strong microeconomics or macroeconomics.
military) and the Doves (who want a smaller a. a family’s decision about how much income
military). Show a point on your production to save
possibilities frontier that the Hawks might b. the effect of government regulations on auto
choose and a point the Doves might choose. emissions
d. Imagine that an aggressive neighboring c. the impact of higher national saving on eco-
country reduces the size of its military. As a nomic growth
result, both the Hawks and the Doves reduce d. a firm’s decision about how many workers to
their desired production of guns by the same hire
amount. Which party would get the bigger e. the relationship between the inflation rate
“peace dividend,” measured by the increase and changes in the quantity of money
in butter production? Explain. 6. Classify each of the following statements as
3. The first principle of economics discussed in positive or normative. Explain.
Chapter 1 is that people face trade-offs. Use a a. Society faces a short-run trade-off between
production possibilities frontier to illustrate inflation and unemployment.
society’s trade-off between two “goods”—a b. A reduction in the rate of money growth will
clean environment and the quantity of industrial reduce the rate of inflation.
output. What do you suppose determines the c. The Federal Reserve should reduce the rate
shape and position of the frontier? Show what of money growth.
happens to the frontier if engineers develop d. Society ought to require welfare recipients to
a new way of producing electricity that emits look for jobs.
fewer pollutants. e. Lower tax rates encourage more work and
4. An economy consists of three workers: Larry, more saving.
Moe, and Curly. Each works ten hours a day 7. Classify each of the statements in Table 1 as
and can produce two services: mowing lawns positive, normative, or ambiguous. Explain.
and washing cars. In an hour, Larry can either 8. If you were president, would you be more inter-
mow one lawn or wash one car; Moe can either ested in your economic advisers’ positive views
mow one lawn or wash two cars; and Curly can or their normative views? Why?
either mow two lawns or wash one car. 9. Find a recent copy of the Economic Report of
a. Calculate how much of each service is pro- the President at your library or on the Internet
duced under the following circumstances, (http://www.gpoaccess.gov/eop/index.html).
which we label A, B, C, and D: Read a chapter about an issue that interests you.
• All three spend all their time mowing Summarize the economic problem at hand and
lawns. (A) describe the council’s recommended policy.
• All three spend all their time washing cars.
(B)
AP P E NDIX
GRAPHING: A BRIEF REVIEW

Many of the concepts that economists study can be expressed with numbers—the
price of bananas, the quantity of bananas sold, the cost of growing bananas, and
so on. Often, these economic variables are related to one another. When the price
of bananas rises, people buy fewer bananas. One way of expressing the relation-
ships among variables is with graphs.
Graphs serve two purposes. First, when developing economic theories, graphs
offer a way to visually express ideas that might be less clear if described with
equations or words. Second, when analyzing economic data, graphs provide a
powerful way of finding and interpreting patterns. Whether we are working with
theory or with data, graphs provide a lens through which a recognizable forest
emerges from a multitude of trees.
Numerical information can be expressed graphically in many ways, just as
there are many ways to express a thought in words. A good writer chooses words
that will make an argument clear, a description pleasing, or a scene dramatic. An
effective economist chooses the type of graph that best suits the purpose at hand.
In this appendix, we discuss how economists use graphs to study the math-
ematical relationships among variables. We also discuss some of the pitfalls that
can arise in the use of graphical methods.
GRAPHS OF A SINGLE VARIABLE

Three common graphs are shown in Figure A-1. The pie chart in panel (a) shows
how total income in the United States is divided among the sources of income,
including compensation of employees, corporate profits, and so on. A slice of the
pie represents each source’s share of the total. The bar graph in panel (b) compares
A-1 F I G U R E The pieof

Types
sources.
Graphs
chart
The pie chart
in panel (a) shows how U.S. national income is derived from various
The bar graph(a)inshows
in panel panel how
(b) compares the average
U.S. national income
income is in from
derived four countries.
various
The time-series
sources. The bargraph
graphininpanel
panel(c)(b)shows the productivity
compares the averageofincome
labor in
in U.S.
fourbusinesses
countries.
Types of Graphs from 1950 to 2000.
The time-series graph in panel (c) shows the productivity of labor in U.S. businesses
from 1950 to 2000.
(a) Pie Chart (b) Bar Graph (c) Time-Series Graph
Corporate Income per Productivity

profits (12%) Person in 2006 United Index
States
Proprietors’ $50,000 ($44,260)
United
income (8%) Kingdom
40,000 ($35,580) 115
Interest 95
income (6%) 30,000
Mexico
75
Compensation 20,000
Rental ($11,410) 55
of employees India
income (2%) 10,000 35
(72%) ($3,800)
0
1950 1960 1970 1980 1990 2000
income for four countries. The height of each bar represents the average income
in each country. The time-series graph in panel (c) traces the rising productivity in
the U.S. business sector over time. The height of the line shows output per hour in
each year. You have probably seen similar graphs in newspapers and magazines.
GRAPHS OF TWO VARIABLES: THE COORDINATE SYSTEM

Although the three graphs in Figure A-1 are useful in showing how a variable
changes over time or across individuals, such graphs are limited in how much they
can tell us. These graphs display information only on a single variable. Economists
are often concerned with the relationships between variables. Thus, they need to
display two variables on a single graph. The coordinate system makes this possible.
Suppose you want to examine the relationship between study time and grade
point average. For each student in your class, you could record a pair of numbers:
hours per week spent studying and grade point average. These numbers could
then be placed in parentheses as an ordered pair and appear as a single point on the
graph. Albert E., for instance, is represented by the ordered pair (25 hours/week,
3.5 GPA), while his “what-me-worry?” classmate Alfred E. is represented by the
ordered pair (5 hours/week, 2.0 GPA).
We can graph these ordered pairs on a two-dimensional grid. The first num-
ber in each ordered pair, called the x-coordinate, tells us the horizontal location of
the point. The second number, called the y-coordinate, tells us the vertical location
of the point. The point with both an x-coordinate and a y-coordinate of zero is
known as the origin. The two coordinates in the ordered pair tell us where the
point is located in relation to the origin: x units to the right of the origin and
y units above it.
Figure A-2 graphs grade point average against study time for Albert E., Alfred
E., and their classmates. This type of graph is called a scatterplot because it plots
scattered points. Looking at this graph, we immediately notice that points farther
to the right (indicating more study time) also tend to be higher (indicating a better
Grade
F I G U R E A-2
Point
Average
Using the Coordinate System
4.0 Grade point average is measured on
3.5 the vertical axis and study time on
Albert E.
3.0 the horizontal axis. Albert E., Alfred
(25, 3.5)
E., and their classmates are repre-
2.5 sented by various points. We can
Alfred E. see from the graph that students
2.0
(5, 2.0)
1.5
who study more tend to get higher
grades.
1.0
0.5
0 5 10 15 20 25 30 35 40 Study
Time
(hours per week)
grade point average). Because study time and grade point average typically move
in the same direction, we say that these two variables have a positive correlation.
By contrast, if we were to graph party time and grades, we would likely find that
higher party time is associated with lower grades; because these variables typically
move in opposite directions, we call this a negative correlation. In either case, the
coordinate system makes the correlation between the two variables easy to see.
CURVES IN THE COORDINATE SYSTEM

Students who study more do tend to get higher grades, but other factors also influ-
ence a student’s grade. Previous preparation is an important factor, for instance,
as are talent, attention from teachers, even eating a good breakfast. A scatterplot
like Figure A-2 does not attempt to isolate the effect that study has on grades from
the effects of other variables. Often, however, economists prefer looking at how
one variable affects another, holding everything else constant.
To see how this is done, let’s consider one of the most important graphs in eco-
nomics: the demand curve. The demand curve traces out the effect of a good’s price
on the quantity of the good consumers want to buy. Before showing a demand
curve, however, consider Table A-1, which shows how the number of novels that
Emma buys depends on her income and on the price of novels. When novels are
cheap, Emma buys them in large quantities. As they become more expensive, she
instead borrows books from the library or chooses to go to the movies rather than
read. Similarly, at any given price, Emma buys more novels when she has a higher
income. That is, when her income increases, she spends part of the additional
income on novels and part on other goods.
We now have three variables—the price of novels, income, and the number
of novels purchased—which are more than we can represent in two dimensions.
To put the information from Table A-1 in graphical form, we need to hold one of
the three variables constant and trace out the relationship between the other two.
Because the demand curve represents the relationship between price and quantity
demanded, we hold Emma’s income constant and show how the number of nov-
els she buys varies with the price of novels.
A-1 T A B L E
Income
Novels Purchased
Price $20,000 $30,000 $40,000
by Emma
This table shows the num-
ber of novels Emma buys at $10 2 novels 5 novels 8 novels
various incomes and prices. 9 6 9 12
For any given level of 8 10 13 16
income, the data on price 7 14 17 20
and quantity demanded 6 18 21 24
can be graphed to produce 5 22 25 28
Emma’s demand curve for Demand curve, D3 Demand curve, D1 Demand curve, D2
novels, as shown in Figures
A-3 and A-4.
Suppose that Emma’s income is $30,000 per year. If we place the number of
novels Emma purchases on the x-axis and the price of novels on the y-axis, we can
graphically represent the middle column of Table A-1. When the points that rep-
resent these entries from the table—(5 novels, $10), (9 novels, $9), and so on—are
connected, they form a line. This line, pictured in Figure A-3, is known as Emma’s
demand curve for novels; it tells us how many novels Emma purchases at any
given price. The demand curve is downward sloping, indicating that a higher
price reduces the quantity of novels demanded. Because the quantity of novels
demanded and the price move in opposite directions, we say that the two vari-
ables are negatively related. (Conversely, when two variables move in the same
direction, the curve relating them is upward sloping, and we say the variables are
positively related.)
Now suppose that Emma’s income rises to $40,000 per year. At any given price,
Emma will purchase more novels than she did at her previous level of income.
Just as earlier we drew Emma’s demand curve for novels using the entries from
the middle column of Table A-1, we now draw a new demand curve using the
entries from the right column of the table. This new demand curve (curve D2) is
pictured alongside the old one (curve D1) in Figure A-4; the new curve is a similar
line drawn farther to the right. We therefore say that Emma’s demand curve for
novels shifts to the right when her income increases. Likewise, if Emma’s income
were to fall to $20,000 per year, she would buy fewer novels at any given price and
her demand curve would shift to the left (to curve D3).
In economics, it is important to distinguish between movements along a curve
and shifts of a curve. As we can see from Figure A-3, if Emma earns $30,000 per
year and novels cost $8 apiece, she will purchase 13 novels per year. If the price of
Price of
F I G U R E
A-3
Novels
$11 Demand Curve
(5, $10)
10 The line D1 shows how Emma’s pur-
chases of novels depend on the price
9 (9, $9)
of novels when her income is held
8
(13, $8) constant. Because the price and the
quantity demanded are negatively
7 (17, $7)
related, the demand curve slopes
6
(21, $6) downward.
5 (25, $5)
4 Demand, D1
0 5 10 15 20 25 30 Quantity
of Novels
Purchased
A-4 F I G U R E
Price of
Novels
Shifting Demand Curves $11
The location of Emma’s demand 10
curve for novels depends on (13, $8)
how much income she earns. The 9
(16, $8)
more she earns, the more novels 8 When income increases,
she will purchase at any given (10, $8)
the demand curve
price, and the farther to the right 7 shifts to the right.
her demand curve will lie. Curve 6
D1 represents Emma’s original When income D3
demand curve when her income 5 decreases, the (income = D1 D2 (income =
is $30,000 per year. If her income 4 demand curve $20,000) (income = $40,000)
rises to $40,000 per year, her shifts to the left.
$30,000)
demand curve shifts to D2. If her 3
income falls to $20,000 per year,
2
her demand curve shifts to D3.
1
0 5 10 13 15 16 20 25 30 Quantity
of Novels
Purchased
novels falls to $7, Emma will increase her purchases of novels to 17 per year. The
demand curve, however, stays fixed in the same place. Emma still buys the same
number of novels at each price, but as the price falls, she moves along her demand
curve from left to right. By contrast, if the price of novels remains fixed at $8 but
her income rises to $40,000, Emma increases her purchases of novels from 13 to 16
per year. Because Emma buys more novels at each price, her demand curve shifts
out, as shown in Figure A-4.
There is a simple way to tell when it is necessary to shift a curve: When a vari-
able that is not named on either axis changes, the curve shifts. Income is on neither the
x-axis nor the y-axis of the graph, so when Emma’s income changes, her demand
curve must shift. The same is true for any change that affects Emma’s purchasing
habits besides a change in the price of novels. If, for instance, the public library
closes and Emma must buy all the books she wants to read, she will demand more
novels at each price, and her demand curve will shift to the right. Or if the price
of movies falls and Emma spends more time at the movies and less time reading,
she will demand fewer novels at each price, and her demand curve will shift to the
left. By contrast, when a variable on an axis of the graph changes, the curve does
not shift. We read the change as a movement along the curve.
SLOPE
One question we might want to ask about Emma is how much her purchasing
habits respond to price. Look at the demand curve pictured in Figure A-5. If this
curve is very steep, Emma purchases nearly the same number of novels regard-
less of whether they are cheap or expensive. If this curve is much flatter, Emma
purchases many fewer novels when the price rises. To answer questions about
how much one variable responds to changes in another variable, we can use the
concept of slope.
The slope of a line is the ratio of the vertical distance covered to the horizontal
distance covered as we move along the line. This definition is usually written out
in mathematical symbols as follows:
∆y
slope = ,
∆x
where the Greek letter ∆ (delta) stands for the change in a variable. In other words,
the slope of a line is equal to the “rise” (change in y) divided by the “run” (change
in x). The slope will be a small positive number for a fairly flat upward-sloping
line, a large positive number for a steep upward-sloping line, and a negative num-
ber for a downward-sloping line. A horizontal line has a slope of zero because in
this case the y-variable never changes; a vertical line is said to have an infinite
slope because the y-variable can take any value without the x-variable changing
at all.
What is the slope of Emma’s demand curve for novels? First of all, because the
curve slopes down, we know the slope will be negative. To calculate a numerical
value for the slope, we must choose two points on the line. With Emma’s income
at $30,000, she will purchase 21 novels at a price of $6 or 13 novels at a price of
$8. When we apply the slope formula, we are concerned with the change between
these two points; in other words, we are concerned with the difference between
Price of
F I G U R E
A-5
Novels
$11 Calculating the Slope of a Line
10 To calculate the slope of the demand
curve, we can look at the changes in
9 the x- and y-coordinates as we move
8
(13, $8) from the point (21 novels, $6) to the
point (13 novels, $8). The slope of
7 6 8 2 the line is the ratio of the change in
6
(21, $6) the y-coordinate (–2) to the change
21 13 8 in the x-coordinate (+8), which
5 Demand, D1 equals –1⁄4.
4
0 5 10 13 15 20 21 25 30 Quantity
of Novels
Purchased
them, which lets us know that we will have to subtract one set of values from the
other, as follows:
∆y first y-coordinate – second y-coordinate 6–8 –2 –1

slope = = = = =
∆x first x-coordinate – second x-coordinate 21 – 13 8 4
Figure A-5 shows graphically how this calculation works. Try computing the
slope of Emma’s demand curve using two different points. You should get exactly
the same result, –1⁄4. One of the properties of a straight line is that it has the same
slope everywhere. This is not true of other types of curves, which are steeper in
some places than in others.
The slope of Emma’s demand curve tells us something about how responsive
her purchases are to changes in the price. A small slope (a number close to zero)
means that Emma’s demand curve is relatively flat; in this case, she adjusts the
number of novels she buys substantially in response to a price change. A larger
slope (a number farther from zero) means that Emma’s demand curve is rela-
tively steep; in this case, she adjusts the number of novels she buys only slightly
in response to a price change.
CAUSE AND EFFECT

Economists often use graphs to advance an argument about how the economy
works. In other words, they use graphs to argue about how one set of events
causes another set of events. With a graph like the demand curve, there is no doubt
about cause and effect. Because we are varying price and holding all other vari-
ables constant, we know that changes in the price of novels cause changes in the
quantity Emma demands. Remember, however, that our demand curve came
from a hypothetical example. When graphing data from the real world, it is often
more difficult to establish how one variable affects another.
The first problem is that it is difficult to hold everything else constant when
studying the relationship between two variables. If we are not able to hold other
variables constant, we might decide that one variable on our graph is causing
changes in the other variable when actually those changes are caused by a third
omitted variable not pictured on the graph. Even if we have identified the correct
two variables to look at, we might run into a second problem—reverse causality.
In other words, we might decide that A causes B when in fact B causes A. The
omitted-variable and reverse-causality traps require us to proceed with caution
when using graphs to draw conclusions about causes and effects.
Omitted Variables To see how omitting a variable can lead to a deceptive graph,
let’s consider an example. Imagine that the government, spurred by public con-
CARTOON: © THE WALL STREET JOURNAL
cern about the large number of deaths from cancer, commissions an exhaustive
study from Big Brother Statistical Services, Inc. Big Brother examines many of the
items found in people’s homes to see which of them are associated with the risk of
cancer. Big Brother reports a strong relationship between two variables: the num-
ber of cigarette lighters that a household owns and the probability that someone
in the household will develop cancer. Figure A-6 shows this relationship.
What should we make of this result? Big Brother advises a quick policy
response. It recommends that the government discourage the ownership of ciga-
rette lighters by taxing their sale. It also recommends that the government require
Risk of
F I G U R E A-6
Cancer
Graph with an Omitted Variable
The upward-sloping curve shows that
members of households with more
cigarette lighters are more likely to
develop cancer. Yet we should not
conclude that ownership of lighters
0 causes cancer because the graph
Number of Lighters in House
does not take into account the num-
ber of cigarettes smoked.
warning labels: “Big Brother has determined that this lighter is dangerous to your
health.”
In judging the validity of Big Brother’s analysis, one question is paramount:
Has Big Brother held constant every relevant variable except the one under con-
sideration? If the answer is no, the results are suspect. An easy explanation for Fig-
ure A-6 is that people who own more cigarette lighters are more likely to smoke
cigarettes and that cigarettes, not lighters, cause cancer. If Figure A-6 does not
hold constant the amount of smoking, it does not tell us the true effect of owning
a cigarette lighter.
This story illustrates an important principle: When you see a graph used to
support an argument about cause and effect, it is important to ask whether the
movements of an omitted variable could explain the results you see.
Reverse Causality Economists can also make mistakes about causality by

misreading its direction. To see how this is possible, suppose the Association of
American Anarchists commissions a study of crime in America and arrives at Fig-
ure A-7, which plots the number of violent crimes per thousand people in major
cities against the number of police officers per thousand people. The anarchists
note the curve’s upward slope and argue that because police increase rather than
decrease the amount of urban violence, law enforcement should be abolished.
If we could run a controlled experiment, we would avoid the danger of reverse
causality. To run an experiment, we would set the number of police officers in dif-
ferent cities randomly and then examine the correlation between police and crime.
Figure A-7, however, is not based on such an experiment. We simply observe that
more dangerous cities have more police officers. The explanation for this may be
that more dangerous cities hire more police. In other words, rather than police
causing crime, crime may cause police. Nothing in the graph itself allows us to
establish the direction of causality.
It might seem that an easy way to determine the direction of causality is to
examine which variable moves first. If we see crime increase and then the police
force expand, we reach one conclusion. If we see the police force expand and then
crime increase, we reach the other. Yet there is also a flaw with this approach:
Often, people change their behavior not in response to a change in their present
conditions but in response to a change in their expectations of future conditions. A
A-7 F I G U R E
Violent
Crimes
(per 1,000
Graph Suggesting Reverse
people)
Causality
The upward-sloping curve
shows that cities with a higher
concentration of police are
more dangerous. Yet the
graph does not tell us whether
police cause crime or crime- 0 Police Officers
(per 1,000 people)
plagued cities hire more
police.
city that expects a major crime wave in the future, for instance, might hire more
police now. This problem is even easier to see in the case of babies and minivans.
Couples often buy a minivan in anticipation of the birth of a child. The minivan
comes before the baby, but we wouldn’t want to conclude that the sale of mini-
vans causes the population to grow!
There is no complete set of rules that says when it is appropriate to draw causal
conclusions from graphs. Yet just keeping in mind that cigarette lighters don’t
cause cancer (omitted variable) and minivans don’t cause larger families (reverse
causality) will keep you from falling for many faulty economic arguments.
3
CHAPTER
Interdependence and the

Gains from Trade
C onsider your typical day. You wake up in the morning and pour your-
self juice from oranges grown in Florida and coffee from beans grown in
Brazil. Over breakfast, you watch a news program broadcast from New
York on your television made in Japan. You get dressed in clothes made of cotton
grown in Georgia and sewn in factories in Thailand. You drive to class in a car
made of parts manufactured in more than a dozen countries around the world.
Then you open up your economics textbook written by an author living in Mas-
sachusetts, published by a company located in Ohio, and printed on paper made
from trees grown in Oregon.
Every day, you rely on many people, most of whom you have never met, to
provide you with the goods and services that you enjoy. Such interdependence
is possible because people trade with one another. Those people providing you
goods and services are not acting out of generosity. Nor is some government
agency directing them to satisfy your desires. Instead, people provide you and
other consumers with the goods and services they produce because they get
something in return.
In subsequent chapters, we examine how our economy coordinates the activi-
ties of millions of people with varying tastes and abilities. As a starting point for
49
this analysis, here we consider the reasons for economic interdependence. One
of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make
everyone better off. In this chapter, we examine this principle more closely. What
exactly do people gain when they trade with one another? Why do people choose
to become interdependent?
The answers to these questions are key to understanding the modern global
economy. In most countries today, many goods and services consumed are
imported from abroad, and many goods and services produced are exported to
foreign customers. The analysis in this chapter explains interdependence not only
among individuals but also among nations. As we will see, the gains from trade
are much the same whether you are buying a haircut from your local barber or a
T-shirt made by a worker on the other side of the globe.
A PARABLE FOR THE MODERN ECONOMY

To understand why people choose to depend on others for goods and services and
how this choice improves their lives, let’s look at a simple economy. Imagine that
there are two goods in the world: meat and potatoes. And there are two people in
the world—a cattle rancher and a potato farmer—each of whom would like to eat
both meat and potatoes.
The gains from trade are most obvious if the rancher can produce only meat and
the farmer can produce only potatoes. In one scenario, the rancher and the farmer
could choose to have nothing to do with each other. But after several months
of eating beef roasted, boiled, broiled, and grilled, the rancher might decide that
self-sufficiency is not all it’s cracked up to be. The farmer, who has been eating
potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy to see
that trade would allow them to enjoy greater variety: Each could then have a steak
with a baked potato or a burger with fries.
Although this scene illustrates most simply how everyone can benefit from
trade, the gains would be similar if the rancher and the farmer were each capable
of producing the other good, but only at great cost. Suppose, for example, that
the potato farmer is able to raise cattle and produce meat, but that he is not very
good at it. Similarly, suppose that the cattle rancher is able to grow potatoes but
that her land is not very well suited for it. In this case, the farmer and the rancher
can each benefit by specializing in what he or she does best and then trading with
the other.
The gains from trade are less obvious, however, when one person is better at
producing every good. For example, suppose that the rancher is better at rais-
ing cattle and better at growing potatoes than the farmer. In this case, should the
rancher choose to remain self-sufficient? Or is there still reason for her to trade
with the farmer? To answer this question, we need to look more closely at the fac-
tors that affect such a decision.
PRODUCTION POSSIBILITIES
Suppose that the farmer and the rancher each work 8 hours per day and can
devote this time to growing potatoes, raising cattle, or a combination of the two.
The table in Figure 1 shows the amount of time each person requires to produce
1 ounce of each good. The farmer can produce an ounce of potatoes in 15 minutes
CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE 51
and an ounce of meat in 60 minutes. The rancher, who is more productive in both
activities, can produce an ounce of potatoes in 10 minutes and an ounce of meat
in 20 minutes. The last two columns in the table show the amounts of meat or
potatoes the farmer and rancher can produce if they work an 8-hour day produc-
ing only that good.
Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that the
farmer can produce. If the farmer devotes all 8 hours of his time to potatoes, he
produces 32 ounces of potatoes (measured on the horizontal axis) and no meat. If
he devotes all his time to meat, he produces 8 ounces of meat (measured on the
vertical axis) and no potatoes. If the farmer divides his time equally between the
two activities, spending 4 hours on each, he produces 16 ounces of potatoes and
4 ounces of meat. The figure shows these three possible outcomes and all others
in between.
This graph is the farmer’s production possibilities frontier. As we discussed in
Chapter 2, a production possibilities frontier shows the various mixes of output
that an economy can produce. It illustrates one of the Ten Principles of Economics
in Chapter 1: People face trade-offs. Here the farmer faces a trade-off between
producing meat and producing potatoes.
Panel (a) shows the production opportunities available to the farmer and the
rancher. Panel (b) shows the combinations of meat and potatoes that the farmer can
F I G U R E
1
produce. Panel (c) shows the combinations of meat and potatoes that the rancher
can produce. Both production possibilities frontiers are derived assuming that the The Production
farmer and rancher each work 8 hours per day. If there is no trade, each person’s Possibilities Frontier
production possibilities frontier is also his or her consumption possibilities frontier.
(a) Production Opportunities
Minutes Needed to Amount

Make 1 Ounce of: Produced in 8 Hours
Meat Potatoes Meat Potatoes
Farmer 60 min/oz 15 min/oz 8 oz 32 oz

Rancher 20 min/oz 10 min/oz 24 oz 48 oz
(b) The Farmer’s Production Possibilities Frontier (c) The Rancher’s Production Possibilities Frontier
Meat (ounces) Meat (ounces)
24
If there is no
trade, the rancher
chooses this
production and
If there is no consumption.
trade, the farmer
8 chooses this 12 B
production and
consumption.
4 A
0 16 32 0 24 48
Potatoes (ounces) Potatoes (ounces)
You may recall that the production possibilities frontier in Chapter 2 was
drawn bowed out. In that case, the rate at which society could trade one good for
the other depended on the amounts that were being produced. Here, however, the
farmer’s technology for producing meat and potatoes (as summarized in Figure 1)
allows him to switch between the two goods at a constant rate. Whenever the
farmer spends 1 hour less producing meat and 1 hour more producing potatoes,
he reduces his output of meat by 1 ounce and raises his output of potatoes by
4 ounces—and this is true regardless of how much he is already producing. As a
result, the production possibilities frontier is a straight line.
Panel (c) of Figure 1 shows the production possibilities frontier for the rancher.
If the rancher devotes all 8 hours of her time to potatoes, she produces 48 ounces of
potatoes and no meat. If she devotes all her time to meat, she produces 24 ounces
of meat and no potatoes. If the rancher divides her time equally, spending 4 hours
on each activity, she produces 24 ounces of potatoes and 12 ounces of meat. Once
again, the production possibilities frontier shows all the possible outcomes.
If the farmer and rancher choose to be self-sufficient rather than trade with
each other, then each consumes exactly what he or she produces. In this case, the
production possibilities frontier is also the consumption possibilities frontier. That
is, without trade, Figure 1 shows the possible combinations of meat and potatoes
that the farmer and rancher can each produce and then consume.
These production possibilities frontiers are useful in showing the trade-offs that
the farmer and rancher face, but they do not tell us what the farmer and rancher will
actually choose to do. To determine their choices, we need to know the tastes of the
farmer and the rancher. Let’s suppose they choose the combinations identified by
points A and B in Figure 1: The farmer produces and consumes 16 ounces of pota-
toes and 4 ounces of meat, while the rancher produces and consumes 24 ounces
of potatoes and 12 ounces of meat.
SPECIALIZATION AND TRADE

After several years of eating combination B, the rancher gets an idea and goes to
talk to the farmer:
Rancher: Farmer, my friend, have I got a deal for you! I know how to improve
life for both of us. I think you should stop producing meat altogether
and devote all your time to growing potatoes. According to my cal-
culations, if you work 8 hours a day growing potatoes, you’ll pro-
duce 32 ounces of potatoes. If you give me 15 of those 32 ounces,
I’ll give you 5 ounces of meat in return. In the end, you’ll get to eat
17 ounces of potatoes and 5 ounces of meat every day, instead of the
16 ounces of potatoes and 4 ounces of meat you now get. If you go
along with my plan, you’ll have more of both foods. [To illustrate her
point, the rancher shows the farmer panel (a) of Figure 2.]
Farmer: (sounding skeptical) That seems like a good deal for me. But I don’t
understand why you are offering it. If the deal is so good for me, it
can’t be good for you too.
Rancher: Oh, but it is! Suppose I spend 6 hours a day raising cattle and 2 hours
growing potatoes. Then I can produce 18 ounces of meat and 12
ounces of potatoes. After I give you 5 ounces of my meat in exchange
for 15 ounces of your potatoes, I’ll end up with 13 ounces of meat
and 27 ounces of potatoes, instead of the 12 ounces of meat and
The proposed trade between the farmer and the rancher offers each of them a
combination of meat and potatoes that would be impossible in the absence of trade.
F I G U R E 2
In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b),
the rancher gets to consume at point B* rather than point B. Trade allows each to
How Trade Expands
consume more meat and more potatoes.
the Set of Consump-
tion Opportunities
(a) The Farmer’s Production and Consumption (b) The Rancher’s Production and Consumption
Meat (ounces) Meat (ounces)
24 Rancher's
production
with trade Rancher's
consumption
18 with trade
Farmer's
consumption 13
B* Rancher's
with trade
8 Farmer's production and
production and B
12 consumption
consumption without trade
5 A* without trade
4
A Farmer's
production
with trade
0 32 0 12 24 27 48
16 17 Potatoes (ounces) Potatoes (ounces)
(c) The Gains from Trade: A Summary
Farmer Rancher
Meat Potatoes Meat Potatoes
Without Trade:
Production and Consumption 4 oz 16 oz 12 oz 24 oz
With Trade:
Production 0 oz 32 oz 18 oz 12 oz
Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz
Consumption 5 oz 17 oz 13 oz 27 oz
GAINS FROM TRADE:

Increase in Consumption +1 oz +1 oz +1 oz +3 oz
24 ounces of potatoes that I now get. So I will also consume more of

both foods than I do now. [She points out panel (b) of Figure 2.]
Farmer: I don’t know. . . . This sounds too good to be true.
Rancher: It’s really not as complicated as it first seems. Here—I’ve summa-
rized my proposal for you in a simple table. [The rancher shows the
farmer a copy of the table at the bottom of Figure 2.]
Farmer: (after pausing to study the table) These calculations seem correct, but
I am puzzled. How can this deal make us both better off?
Rancher: We can both benefit because trade allows each of us to specialize in
doing what we do best. You will spend more time growing potatoes
and less time raising cattle. I will spend more time raising cattle and
less time growing potatoes. As a result of specialization and trade,

each of us can consume more meat and more potatoes without work-
ing any more hours.
Q Q
UICK UIZ Draw an example of a production possibilities frontier for Robinson Crusoe,
a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this
frontier limit Crusoe’s consumption of coconuts and fish if he lives by himself? Does he
face the same limits if he can trade with natives on the island?
COMPARATIVE ADVANTAGE: THE DRIVING FORCE

OF SPECIALIZATION
The rancher’s explanation of the gains from trade, though correct, poses a puzzle:
If the rancher is better at both raising cattle and growing potatoes, how can the
farmer ever specialize in doing what he does best? The farmer doesn’t seem to do
anything best. To solve this puzzle, we need to look at the principle of comparative
advantage.
As a first step in developing this principle, consider the following question:
In our example, who can produce potatoes at a lower cost—the farmer or the
rancher? There are two possible answers, and in these two answers lie the solution
to our puzzle and the key to understanding the gains from trade.
A BSOLUTE A DVANTAGE
One way to answer the question about the cost of producing potatoes is to com-
absolute advantage pare the inputs required by the two producers. Economists use the term absolute
the ability to produce a advantage when comparing the productivity of one person, firm, or nation to that
good using fewer inputs of another. The producer that requires a smaller quantity of inputs to produce a
than another producer good is said to have an absolute advantage in producing that good.
In our example, time is the only input, so we can determine absolute advan-
tage by looking at how much time each type of production takes. The rancher
has an absolute advantage both in producing meat and in producing potatoes
because she requires less time than the farmer to produce a unit of either good.
The rancher needs to input only 20 minutes to produce an ounce of meat, whereas
the farmer needs 60 minutes. Similarly, the rancher needs only 10 minutes to pro-
duce an ounce of potatoes, whereas the farmer needs 15 minutes. Based on this
information, we can conclude that the rancher has the lower cost of producing
potatoes, if we measure cost by the quantity of inputs.
OPPORTUNITY COST AND COMPARATIVE A DVANTAGE

There is another way to look at the cost of producing potatoes. Rather than com-
paring inputs required, we can compare the opportunity costs. Recall from Chap-
opportunity cost ter 1 that the opportunity cost of some item is what we give up to get that item.
whatever must be given In our example, we assumed that the farmer and the rancher each spend 8 hours
up to obtain some item a day working. Time spent producing potatoes, therefore, takes away from time
available for producing meat. When reallocating time between the two goods,
the rancher and farmer give up units of one good to produce units of the other,
thereby moving along the production possibilities frontier. The opportunity cost
measures the trade-off between the two goods that each producer faces.
Let’s first consider the rancher’s opportunity cost. According to the table in
panel (a) of Figure 1, producing 1 ounce of potatoes takes 10 minutes of work.
When the rancher spends those 10 minutes producing potatoes, she spends
10 minutes less producing meat. Because the rancher needs 20 minutes to produce
1 ounce of meat, 10 minutes of work would yield 1⁄2 ounce of meat. Hence, the
rancher’s opportunity cost of producing 1 ounce of potatoes is 1⁄2 ounce of meat.
Now consider the farmer’s opportunity cost. Producing 1 ounce of potatoes
takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat,
15 minutes of work would yield 1⁄4 ounce of meat. Hence, the farmer’s opportunity
cost of 1 ounce of potatoes is 1⁄4 ounce of meat.
Table 1 shows the opportunity costs of meat and potatoes for the two produc-
ers. Notice that the opportunity cost of meat is the inverse of the opportunity
cost of potatoes. Because 1 ounce of potatoes costs the rancher 1⁄2 ounce of meat,
1 ounce of meat costs the rancher 2 ounces of potatoes. Similarly, because 1 ounce
of potatoes costs the farmer 1⁄4 ounce of meat, 1 ounce of meat costs the farmer
4 ounces of potatoes.
Economists use the term comparative advantage when describing the oppor- comparative advantage
tunity cost of two producers. The producer who gives up less of other goods to the ability to produce a
produce Good X has the smaller opportunity cost of producing Good X and is good at a lower oppor-
said to have a comparative advantage in producing it. In our example, the farmer tunity cost than another
has a lower opportunity cost of producing potatoes than the rancher: An ounce of producer
potatoes costs the farmer only 1⁄4 ounce of meat, but it costs the rancher 1⁄2 ounce
of meat. Conversely, the rancher has a lower opportunity cost of producing meat
than the farmer: An ounce of meat costs the rancher 2 ounces of potatoes, but it
costs the farmer 4 ounces of potatoes. Thus, the farmer has a comparative advan-
tage in growing potatoes, and the rancher has a comparative advantage in pro-
ducing meat.
Although it is possible for one person to have an absolute advantage in both
goods (as the rancher does in our example), it is impossible for one person to
have a comparative advantage in both goods. Because the opportunity cost of one
good is the inverse of the opportunity cost of the other, if a person’s opportunity
cost of one good is relatively high, the opportunity cost of the other good must
be relatively low. Comparative advantage reflects the relative opportunity cost.
Unless two people have exactly the same opportunity cost, one person will have a
comparative advantage in one good, and the other person will have a comparative
advantage in the other good.
COMPARATIVE A DVANTAGE AND TRADE

The gains from specialization and trade are based not on absolute advantage but
on comparative advantage. When each person specializes in producing the good
T A B L E
1
Opportunity Cost of:
The Opportunity Cost

1 oz of Meat 1 oz of Potatoes
of Meat and Potatoes
1
Farmer 4 oz potatoes ⁄4 oz meat
1
Rancher 2 oz potatoes ⁄2 oz meat
for which he or she has a comparative advantage, total production in the economy
rises. This increase in the size of the economic pie can be used to make everyone
better off.
In our example, the farmer spends more time growing potatoes, and the rancher
spends more time producing meat. As a result, the total production of potatoes
rises from 40 to 44 ounces, and the total production of meat rises from 16 to 18
ounces. The farmer and rancher share the benefits of this increased production.
We can also look at the gains from trade in terms of the price that each party
pays the other. Because the farmer and rancher have different opportunity costs,
they can both get a bargain. That is, each benefits from trade by obtaining a good
at a price that is lower than his or her opportunity cost of that good.
Consider the proposed deal from the viewpoint of the farmer. The farmer gets
5 ounces of meat in exchange for 15 ounces of potatoes. In other words, the farmer
buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is
lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes.
Thus, the farmer benefits from the deal because he gets to buy meat at a good price.
Now consider the deal from the rancher’s viewpoint. The rancher buys 15 ounces
of potatoes for a price of 5 ounces of meat. That is, the price of potatoes is 1⁄3 ounce
of meat. This price of potatoes is lower than her opportunity cost of an ounce of
potatoes, which is 1⁄2 ounce of meat. The rancher benefits because she gets to buy
potatoes at a good price.
The moral of the story of the farmer and the rancher should now be clear: Trade
can benefit everyone in society because it allows people to specialize in activities in which
they have a comparative advantage.
THE PRICE OF THE TRADE

The principle of comparative advantage establishes that there are gains from spe-
cialization and trade, but it leaves open a couple of related questions: What deter-
mines the price at which trade takes place? How are the gains from trade shared
between the trading parties? The precise answer to these questions is beyond the
scope of this chapter, but we can state one general rule: For both parties to gain from
trade, the price at which they trade must lie between the two opportunity costs.
In our example, the farmer and rancher agreed to trade at a rate of 3 ounces of
potatoes for each ounce of meat. This price is between the rancher’s opportunity
cost (2 ounces of potatoes per ounce of meat) and the farmer’s opportunity cost
(4 ounces of potatoes per ounce of meat). The price need not be exactly in the
middle for both parties to gain, but it must be somewhere between 2 and 4.
To see why the price has to be in this range, consider what would happen if it
were not. If the price of meat were below 2 ounces of potatoes, both the farmer
and the rancher would want to buy meat, because the price would be below their
opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes,
both would want to sell meat, because the price would be above their opportu-
nity costs. But there are only two members of this economy. They cannot both be
buyers of meat, nor can they both be sellers. Someone has to take the other side
of the deal.
A mutually advantageous trade can be struck at a price between 2 and 4. In this
price range, the rancher wants to sell meat to buy potatoes, and the farmer wants
to sell potatoes to buy meat. Each party can buy a good at a price that is lower
The Legacy of Adam Smith and David Ricardo
Economists have long un- Principles of Political Economy and Taxation, Ricardo developed the
derstood the gains from trade. Here is how the great economist principle of comparative advantage as we know it today. He consid-
Adam Smith put the argument: ered an example with two goods (wine and cloth) and two coun-
tries (England and Portugal). He showed that both countries can
It is a maxim of every prudent master of a family, never to attempt
gain by opening up trade and specializing based on comparative
to make at home what it will cost him more to make than to buy.
advantage.
The tailor does not attempt to make his own shoes, but buys them of
Ricardo’s theory is the starting point of modern international
the shoemaker. The shoemaker does not attempt to make his own
economics, but his defense of free trade was not a mere academic
clothes but employs a tailor. The farmer attempts to make neither
exercise. Ricardo put his beliefs to work as a member of the British
the one nor the other, but employs those different artificers. All of
Parliament, where he opposed the Corn Laws, which restricted the
them find it for their interest to employ their whole
import of grain.
industry in a way in which they have some advantage
The conclusions of Adam Smith and David Ricardo
over their neighbors, and to purchase with a part of its
on the gains from trade have held up well over time.
produce, or what is the same thing, with the price of
Although economists often disagree on questions of
part of it, whatever else they have occasion for.
policy, they are united in their support of free trade.
This quotation is from Smith’s 1776 book An Inquiry into Moreover, the central argument for free trade has not
the Nature and Causes of the Wealth of Nations, which changed much in the past two centuries. Even though
was a landmark in the analysis of trade and economic the field of economics has broadened its scope and
interdependence. refined its theories since the time of Smith and Ricardo,
Smith’s book inspired David Ricardo, a millionaire economists’ opposition to trade restrictions is still based
stockbroker, to become an economist. In his 1817 book David Ricardo largely on the principle of comparative advantage.
than his or her opportunity cost. In the end, both of them specialize in the good
for which he or she has a comparative advantage and are, as a result, better off.
QUICK QUIZ Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend
Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s opportunity cost
of catching one fish? What is Friday’s? Who has an absolute advantage in catching fish?
Who has a comparative advantage in catching fish?
APPLICATIONS OF COMPARATIVE ADVANTAGE

The principle of comparative advantage explains interdependence and the gains
from trade. Because interdependence is so prevalent in the modern world, the
principle of comparative advantage has many applications. Here are two exam-
ples, one fanciful and one of great practical importance.
SHOULD TIGER WOODS MOW HIS OWN LAWN?

Tiger Woods spends a lot of time walking around on grass. One of the most tal-
ented golfers of all time, he can hit a drive and sink a putt in a way that most
© JOHN AMIS/REUTERS/LANDOV
casual golfers only dream of doing. Most likely, he is talented at other activities
too. For example, let’s imagine that Woods can mow his lawn faster than anyone
else. But just because he can mow his lawn fast, does this mean he should?
To answer this question, we can use the concepts of opportunity cost and com-
parative advantage. Let’s say that Woods can mow his lawn in 2 hours. In that
same 2 hours, he could film a television commercial for Nike and earn $10,000. By
contrast, Forrest Gump, the boy next door, can mow Woods’s lawn in 4 hours. In
that same 4 hours, he could work at McDonald’s and earn $20.
In this example, Woods has an absolute advantage in mowing lawns because
he can do the work with a lower input of time. Yet because Woods’s opportunity
cost of mowing the lawn is $10,000 and Forrest’s opportunity cost is only $20, For-
rest has a comparative advantage in mowing lawns.
The gains from trade in this example are tremendous. Rather than mowing his
own lawn, Woods should make the commercial and hire Forrest to mow the lawn.
As long as Woods pays Forrest more than $20 and less than $10,000, both of them
are better off.
SHOULD THE UNITED STATES TRADE

WITH OTHER COUNTRIES?
Just as individuals can benefit from specialization and trade with one another, as
the farmer and rancher did, so can populations of people in different countries.
Many of the goods that Americans enjoy are produced abroad, and many of the
goods produced in the United States are sold abroad. Goods produced abroad
imports and sold domestically are called imports. Goods produced domestically and sold
goods produced abroad abroad are called exports.
and sold domestically To see how countries can benefit from trade, suppose there are two countries,
the United States and Japan, and two goods, food and cars. Imagine that the two
exports countries produce cars equally well: An American worker and a Japanese worker
goods produced domes-
can each produce one car per month. By contrast, because the United States has
tically and sold abroad
more and better land, it is better at producing food: A U.S. worker can produce
2 tons of food per month, whereas a Japanese worker can produce only 1 ton of
food per month.
The principle of comparative advantage states that each good should be pro-
duced by the country that has the smaller opportunity cost of producing that
good. Because the opportunity cost of a car is 2 tons of food in the United States
but only 1 ton of food in Japan, Japan has a comparative advantage in producing
cars. Japan should produce more cars than it wants for its own use and export
some of them to the United States. Similarly, because the opportunity cost of a ton
of food is 1 car in Japan but only 1⁄2 car in the United States, the United States has
a comparative advantage in producing food. The United States should produce
more food than it wants to consume and export some to Japan. Through special-
ization and trade, both countries can have more food and more cars.
In reality, of course, the issues involved in trade among nations are more com-
plex than this example suggests. Most important among these issues is that each
country has many citizens with different interests. International trade can make
some individuals worse off, even as it makes the country as a whole better off.
When the United States exports food and imports cars, the impact on an American
farmer is not the same as the impact on an American autoworker. Yet, contrary to
the opinions sometimes voiced by politicians and pundits, international trade is
not like war, in which some countries win and others lose. Trade allows all coun-
tries to achieve greater prosperity.
Q Q
UICK UIZ Suppose that a skilled brain surgeon also happens to be the world’s fastest
typist. Should she do her own typing or hire a secretary? Explain.
The Changing Face of International Trade

A decade ago, no one would have asked which nation has a compara-
tive advantage in slaying ogres. But technology is rapidly changing the
goods and services that are traded across national borders.
Ogre to Slay? Outsource games. These workers have strict quotas

It to Chinese and are supervised by bosses who equip
By David Barboza them with computers, software and Internet
connections to thrash online trolls, gnomes
Fuzhou, China—One of China’s newest and ogres.
factories operates here in the basement of As they grind through the games, they
an old warehouse. Posters of World of War- accumulate virtual currency that is valu-
craft and Magic Land hang above a corps able to game players around the world.
of young people glued to their computer The games allow players to trade currency
screens, pounding away at their keyboards to other players, who can then use it to buy
in the latest hustle for money. a 23-year-old gamer who works here in this better armor, amulets, magic spells and
The people working at this clandestine makeshift factory and goes by the online other accoutrements to climb to higher lev-
locale are “gold farmers.” Every day, in 12- code name Wandering. “I make about $250 els or create more powerful characters.
hour shifts, they “play” computer games by a month, which is pretty good compared The Internet is now filled with classified
killing onscreen monsters and winning bat- with the other jobs I’ve had. And I can play advertisements from small companies—
tles, harvesting artificial gold coins and other games all day.” many of them here in China—auctioning
virtual goods as rewards that, as it turns out, He and his comrades have created yet for real money their powerful figures, called
can be transformed into real cash. another new business out of cheap Chi- avatars. . . .
That is because, from Seoul to San Fran- nese labor. They are tapping into the fast- “It’s unimaginable how big this is,” says
PHOTO: © MARK RALSTON/AFP/GETTY IMAGES
cisco, affluent online gamers who lack the growing world of “massively multiplayer Chen Yu, 27, who employs 20 full-time gam-
time and patience to work their way up to online games,” which involve role players here in Fuzhou. “They say that in some
the higher levels of gamedom are willing to ing and often revolve around fantasy or of these popular games, 40 or 50 percent of
pay the young Chinese here to play the early warfare in medieval kingdoms or distant the players are actually Chinese farmers.”
rounds for them. galaxies. . . .
“For 12 hours a day, 7 days a week, my For the Chinese in game-playing facto-
colleagues and I are killing monsters,” said ries like these, though, it is not all fun and
Source: New York Times, December 9, 2005.

CONCLUSION
You should now understand more fully the benefits of living in an interdependent
economy. When Americans buy tube socks from China, when residents of Maine
drink orange juice from Florida, and when a homeowner hires the kid next door
to mow the lawn, the same economic forces are at work. The principle of compara-
tive advantage shows that trade can make everyone better off.
Having seen why interdependence is desirable, you might naturally ask how it
is possible. How do free societies coordinate the diverse activities of all the people
involved in their economies? What ensures that goods and services will get from
those who should be producing them to those who should be consuming them? In
a world with only two people, such as the rancher and the farmer, the answer is
simple: These two people can bargain and allocate resources between themselves.
In the real world with billions of people, the answer is less obvious. We take up
this issue in the next chapter, where we see that free societies allocate resources
through the market forces of supply and demand.
SUMMARY
• Each person consumes goods and services pro- to have a comparative advantage. The gains from
duced by many other people both in the United trade are based on comparative advantage, not
States and around the world. Interdependence absolute advantage.
and trade are desirable because they allow every-
one to enjoy a greater quantity and variety of
• Trade makes everyone better off because it allows
people to specialize in those activities in which
goods and services.
they have a comparative advantage.
• There are two ways to compare the ability of two • The principle of comparative advantage applies
people in producing a good. The person who can
to countries as well as to people. Economists use
produce the good with the smaller quantity of
the principle of comparative advantage to advo-
inputs is said to have an absolute advantage in pro-
cate free trade among countries.
ducing the good. The person who has the smaller
opportunity cost of producing the good is said
KEY CONCEPTS
absolute advantage, p. 54 comparative advantage, p. 55 exports, p. 58

opportunity cost, p. 54 imports, p. 58
1. Under what conditions is the production pos- 4. Is absolute advantage or comparative advantage
sibilities frontier linear rather than bowed out? more important for trade? Explain your reason-
2. Explain how absolute advantage and compara- ing using the example in your answer to Ques-
tive advantage differ. tion 3.
3. Give an example in which one person has 5. Will a nation tend to export or import goods for
an absolute advantage in doing something which it has a comparative advantage? Explain.
but another person has a comparative 6. Why do economists oppose policies that restrict
advantage. trade among nations?
1. Maria can read 20 pages of economics in an some time for their favorite activities: making
hour. She can also read 50 pages of sociology in pizza and brewing root beer. Pat takes 4 hours
an hour. She spends 5 hours per day studying. to brew a gallon of root beer and 2 hours to
a. Draw Maria’s production possibilities fron- make a pizza. Kris takes 6 hours to brew a gal-
tier for reading economics and sociology. lon of root beer and 4 hours to make a pizza.
b. What is Maria’s opportunity cost of reading a. What is each roommate’s opportunity cost
100 pages of sociology? of making a pizza? Who has the absolute
2. American and Japanese workers can each advantage in making pizza? Who has the
produce 4 cars a year. An American worker can comparative advantage in making pizza?
produce 10 tons of grain a year, whereas a Japa- b. If Pat and Kris trade foods with each other,
nese worker can produce 5 tons of grain a year. who will trade away pizza in exchange for
To keep things simple, assume that each country root beer?
has 100 million workers. c. The price of pizza can be expressed in terms
a. For this situation, construct a table analogous of gallons of root beer. What is the high-
to the table in Figure 1. est price at which pizza can be traded that
b. Graph the production possibilities frontier of would make both roommates better off?
the American and Japanese economies. What is the lowest price? Explain.
c. For the United States, what is the opportu- 4. Suppose that there are 10 million workers in
nity cost of a car? Of grain? For Japan, what Canada and that each of these workers can
is the opportunity cost of a car? Of grain? produce either 2 cars or 30 bushels of wheat in
Put this information in a table analogous to a year.
Table 1. a. What is the opportunity cost of producing a
d. Which country has an absolute advantage in car in Canada? What is the opportunity cost
producing cars? In producing grain? of producing a bushel of wheat in Canada?
e. Which country has a comparative advantage Explain the relationship between the oppor-
in producing cars? In producing grain? tunity costs of the two goods.
f. Without trade, half of each country’s workers b. Draw Canada’s production possibilities fron-
produce cars and half produce grain. What tier. If Canada chooses to consume 10 million
quantities of cars and grain does each coun- cars, how much wheat can it consume with-
try produce? out trade? Label this point on the production
g. Starting from a position without trade, give possibilities frontier.
an example in which trade makes each coun- c. Now suppose that the United States offers to
try better off. buy 10 million cars from Canada in exchange
3. Pat and Kris are roommates. They spend most for 20 bushels of wheat per car. If Canada
of their time studying (of course), but they leave continues to consume 10 million cars, how
much wheat does this deal allow Canada to numerical example and show it on your
consume? Label this point on your diagram. graph. Which country would benefit from
Should Canada accept the deal? trade? Explain.
5. England and Scotland both produce scones and c. Explain at what price of computers (in terms
sweaters. Suppose that an English worker can of shirts) the two countries might trade.
produce 50 scones per hour or 1 sweater per d. Suppose that China catches up with Ameri-
hour. Suppose that a Scottish worker can pro- can productivity so that a Chinese worker
duce 40 scones per hour or 2 sweaters per hour. can produce 100 shirts or 20 computers. What
a. Which country has the absolute advantage in pattern of trade would you predict now?
the production of each good? Which country How does this advance in Chinese produc-
has the comparative advantage? tivity affect the economic well-being of the
b. If England and Scotland decide to trade, citizens of the two countries?
which commodity will Scotland trade to 8. An average worker in Brazil can produce an
England? Explain. ounce of soybeans in 20 minutes and an ounce
c. If a Scottish worker could produce only 1 of coffee in 60 minutes, while an average worker
sweater per hour, would Scotland still gain in Peru can produce an ounce of soybeans in
from trade? Would England still gain from 50 minutes and an ounce of coffee in 75 minutes.
trade? Explain. a. Who has the absolute advantage in coffee?
6. The following table describes the production Explain.
possibilities of two cities in the country of b. Who has the comparative advantage in cof-
Baseballia: fee? Explain.
Pairs of Red Socks Pairs of White Socks
c. If the two countries specialize and trade with
per Worker per Hour per Worker per Hour each other, who will import coffee? Explain.
d. Assume that the two countries trade and that
Boston 3 3 the country importing coffee trades 2 ounces
Chicago 2 1 of soybeans for 1 ounce of coffee. Explain
why both countries will benefit from this
a. Without trade, what is the price of white trade.
socks (in terms of red socks) in Boston? What 9. Are the following statements true or false?
is the price in Chicago? Explain in each case.
b. Which city has an absolute advantage in the a. “Two countries can achieve gains from trade
production of each color sock? Which city even if one of the countries has an absolute
has a comparative advantage in the produc- advantage in the production of all goods.”
tion of each color sock? b. “Certain very talented people have a com-
c. If the cities trade with each other, which color parative advantage in everything they do.”
sock will each export? c. “If a certain trade is good for one person,
d. What is the range of prices at which trade can it can’t be good for the other one.”
occur? d. “If a certain trade is good for one person,
7. Suppose that in a year an American worker it is always good for the other one.”
can produce 100 shirts or 20 computers, while e. “If trade is good for a country, it must be
a Chinese worker can produce 100 shirts or good for everyone in the country.”
10 computers. 10. The United States exports corn and aircraft to
a. Graph the production possibilities curve the rest of the world, and it imports oil and
for the two countries. Suppose that without clothing from the rest of the world. Do you
trade the workers in each country spend half think this pattern of trade is consistent with the
their time producing each good. Identify this principle of comparative advantage? Why or
point in your graph. why not?
b. If these countries were open to trade, which
country would export shirts? Give a specific
CHAPTER # THE MARKET FORCES OF SUPPLY AND DEMAND 63
PART II
How Markets Work
4
CHAPTER
The Market Forces of Supply

and Demand
W hen a cold snap hits Florida, the price of orange juice rises in super-
markets throughout the country. When the weather turns warm in
New England every summer, the price of hotel rooms in the Carib-
bean plummets. When a war breaks out in the Middle East, the price of gasoline in
the United States rises, and the price of a used Cadillac falls. What do these events
have in common? They all show the workings of supply and demand.
Supply and demand are the two words economists use most often—and for good
reason. Supply and demand are the forces that make market economies work.
They determine the quantity of each good produced and the price at which it is
sold. If you want to know how any event or policy will affect the economy, you
must think first about how it will affect supply and demand.
This chapter introduces the theory of supply and demand. It considers how
buyers and sellers behave and how they interact with one another. It shows how
supply and demand determine prices in a market economy and how prices, in
turn, allocate the economy’s scarce resources.
65
66 PART II HOW MARKETS WORK
MARKETS AND COMPETITION

The terms supply and demand refer to the behavior of people as they interact with
one another in competitive markets. Before discussing how buyers and sellers
behave, let’s first consider more fully what we mean by the terms market and
competition.
WHAT IS A M ARKET?
market A market is a group of buyers and sellers of a particular good or service. The buy-
a group of buyers and ers as a group determine the demand for the product, and the sellers as a group
sellers of a particular determine the supply of the product.
good or service Markets take many forms. Sometimes markets are highly organized, such as
the markets for many agricultural commodities. In these markets, buyers and sell-
ers meet at a specific time and place, where an auctioneer helps set prices and
arrange sales.
More often, markets are less organized. For example, consider the market for
ice cream in a particular town. Buyers of ice cream do not meet together at any one
time. The sellers of ice cream are in different locations and offer somewhat differ-
ent products. There is no auctioneer calling out the price of ice cream. Each seller
posts a price for an ice-cream cone, and each buyer decides how much ice cream
to buy at each store. Nonetheless, these consumers and producers of ice cream are
closely connected. The ice-cream buyers are choosing from the various ice-cream
sellers to satisfy their hunger, and the ice-cream sellers are all trying to appeal
to the same ice-cream buyers to make their businesses successful. Even though
it is not organized, the group of ice-cream buyers and ice-cream sellers forms a
market.
WHAT IS COMPETITION?
The market for ice cream, like most markets in the economy, is highly competitive.
Each buyer knows that there are several sellers from which to choose, and each
seller is aware that his or her product is similar to that offered by other sellers. As
a result, the price of ice cream and the quantity of ice cream sold are not deter-
mined by any single buyer or seller. Rather, price and quantity are determined by
all buyers and sellers as they interact in the marketplace.
competitive market Economists use the term competitive market to describe a market in which
a market in which there there are so many buyers and so many sellers that each has a negligible impact
are many buyers and on the market price. Each seller of ice cream has limited control over the price
many sellers so that each because other sellers are offering similar products. A seller has little reason to
has a negligible impact charge less than the going price, and if he or she charges more, buyers will make
on the market price
their purchases elsewhere. Similarly, no single buyer of ice cream can influence
the price of ice cream because each buyer purchases only a small amount.
In this chapter, we assume that markets are perfectly competitive. To reach this
highest form of competition, a market must have two characteristics: (1) the goods
offered for sale are all exactly the same, and (2) the buyers and sellers are so
numerous that no single buyer or seller has any influence over the market price.
Because buyers and sellers in perfectly competitive markets must accept the price
the market determines, they are said to be price takers. At the market price, buyers
can buy all they want, and sellers can sell all they want.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 67
There are some markets in which the assumption of perfect competition applies
perfectly. In the wheat market, for example, there are thousands of farmers who
sell wheat and millions of consumers who use wheat and wheat products. Because
no single buyer or seller can influence the price of wheat, each takes the price as
given.
Not all goods and services, however, are sold in perfectly competitive markets.
Some markets have only one seller, and this seller sets the price. Such a seller is
called a monopoly. Your local cable television company, for instance, may be a
monopoly. Residents of your town probably have only one cable company from
which to buy this service. Still other markets fall between the extremes of perfect
competition and monopoly.
Despite the diversity of market types we find in the world, assuming perfect
competition is a useful simplification and, therefore, a natural place to start. Per-
fectly competitive markets are the easiest to analyze because everyone participat-
ing in the market takes the price as given by market conditions. Moreover, because
some degree of competition is present in most markets, many of the lessons that
we learn by studying supply and demand under perfect competition apply in
more complicated markets as well.
QUICK QUIZ What is a market? • What are the characteristics of a perfectly competitive
market?
DEMAND
We begin our study of markets by examining the behavior of buyers. To focus our
thinking, let’s keep in mind a particular good—ice cream.
THE DEMAND CURVE: THE R ELATIONSHIP BETWEEN

PRICE AND QUANTITY DEMANDED
The quantity demanded of any good is the amount of the good that buyers are quantity demanded
willing and able to purchase. As we will see, many things determine the quantity the amount of a good
demanded of any good, but when analyzing how markets work, one determinant that buyers are willing
plays a central role—the price of the good. If the price of ice cream rose to $20 per and able to purchase
scoop, you would buy less ice cream. You might buy frozen yogurt instead. If the
price of ice cream fell to $0.20 per scoop, you would buy more. This relationship
between price and quantity demanded is true for most goods in the economy and,
in fact, is so pervasive that economists call it the law of demand: Other things law of demand
equal, when the price of a good rises, the quantity demanded of the good falls, the claim that, other
and when the price falls, the quantity demanded rises. things equal, the quan-
The table in Figure 1 shows how many ice-cream cones Catherine buys each tity demanded of a
month at different prices of ice cream. If ice cream is free, Catherine eats 12 cones good falls when the
price of the good rises
per month. At $0.50 per cone, Catherine buys 10 cones each month. As the price
rises further, she buys fewer and fewer cones. When the price reaches $3.00, Cath- demand schedule
erine doesn’t buy any ice cream at all. This table is a demand schedule, a table that a table that shows the
shows the relationship between the price of a good and the quantity demanded, relationship between the
holding constant everything else that influences how much consumers of the good price of a good and the
want to buy. quantity demanded
1 F I G U R E Types of Graphs
The demand
demand
The pie
schedule is a table that shows the quantity demanded at each price.
chartcurve, which
in panel graphshow
(a) shows theU.S.
demand schedule,
national incomeillustrates
is derivedhow
fromthevarious
quantity
demanded
sources. ofbar
The thegraph
good in
changes as compares
panel (b) its price varies. Becauseincome
the average a lower
in price increases
four countries.
Catherine’s Demand the quantity
The demanded,
time-series graph in the demand
panel (c) showscurve
theslopes downward.
productivity of labor in U.S. businesses
Schedule and Demand from 1950 to 2000.
Curve
Price of Quantity of Price of
Ice-Cream Cone Cones Demanded Ice-Cream Cone
$3.00
$0.00 12 cones
0.50 10 2.50
1.00 8
1.50 6 1. A decrease 2.00
2.00 4 in price . . .
2.50 2
1.50
3.00 0
1.00
Demand curve
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. . . . increases quantity
of cones demanded.
The graph in Figure 1 uses the numbers from the table to illustrate the law
of demand. By convention, the price of ice cream is on the vertical axis, and the
quantity of ice cream demanded is on the horizontal axis. The downward-sloping
demand curve line relating price and quantity demanded is called the demand curve.
a graph of the relation-
ship between the price
of a good and the quan- M ARKET DEMAND VERSUS INDIVIDUAL DEMAND
tity demanded The demand curve in Figure 1 shows an individual’s demand for a product. To
analyze how markets work, we need to determine the market demand, the sum of
all the individual demands for a particular good or service.
The table in Figure 2 shows the demand schedules for ice cream of the two
individuals in this market—Catherine and Nicholas. At any price, Catherine’s
demand schedule tells us how much ice cream she buys, and Nicholas’s demand
schedule tells us how much ice cream he buys. The market demand at each price
is the sum of the two individual demands.
The graph in Figure 2 shows the demand curves that correspond to these
demand schedules. Notice that we sum the individual demand curves horizontally
to obtain the market demand curve. That is, to find the total quantity demanded
at any price, we add the individual quantities, which are found on the horizontal
axis of the individual demand curves. Because we are interested in analyzing how
markets function, we work most often with the market demand curve. The market
demand curve shows how the total quantity demanded of a good varies as the
The quantity demanded in a market is the sum of the quantities demanded by all the
buyers at each price. Thus, the market demand curve is found by adding horizontally
F I G U R E 2
the individual demand curves. At a price of $2.00, Catherine demands 4 ice-cream
cones, and Nicholas demands 3 ice-cream cones. The quantity demanded in the
Market Demand as
market at this price is 7 cones.
the Sum of Individual
Demands
Price of Ice-Cream Cone Catherine Nicholas Market
$0.00 12 + 7 = 19 cones
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1
Catherine's Demand + Nicholas's Demand = Market Demand

Price of Price of Price of
Ice-Cream Ice-Cream Ice-Cream
Cone Cone Cone
$3.00 $3.00 $3.00
2.50 2.50 2.50
2.00 2.00 2.00
1.50 1.50 1.50
1.00 1.00 1.00
DCatherine DMarket
0.50 0.50 DNicholas 0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 8 9 10 11 12 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
price of the good varies, while all the other factors that affect how much consum-
ers want to buy are held constant.
SHIFTS IN THE DEMAND CURVE

Because the market demand curve holds other things constant, it need not be
stable over time. If something happens to alter the quantity demanded at any
given price, the demand curve shifts. For example, suppose the American Medi-
cal Association discovered that people who regularly eat ice cream live longer,
healthier lives. The discovery would raise the demand for ice cream. At any given
price, buyers would now want to purchase a larger quantity of ice cream, and the
demand curve for ice cream would shift.
Figure 3 illustrates shifts in demand. Any change that increases the quantity
demanded at every price, such as our imaginary discovery by the American Medi-
cal Association, shifts the demand curve to the right and is called an increase in
demand. Any change that reduces the quantity demanded at every price shifts the
demand curve to the left and is called a decrease in demand.
There are many variables that can shift the demand curve. Here are the most
important.
3 F I G U R E
Price of
Ice-Cream
Cone
Shifts in the Demand Curve
Any change that raises the quantity
Increase
that buyers wish to purchase at any
in demand
given price shifts the demand curve to
the right. Any change that lowers the
quantity that buyers wish to purchase
at any given price shifts the demand
curve to the left. Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
Ice-Cream Cones
Income What would happen to your demand for ice cream if you lost your job
one summer? Most likely, it would fall. A lower income means that you have
less to spend in total, so you would have to spend less on some—and probably
most—goods. If the demand for a good falls when income falls, the good is called
normal good a normal good.
a good for which, other Not all goods are normal goods. If the demand for a good rises when income
things equal, an increase falls, the good is called an inferior good. An example of an inferior good might be
in income leads to an bus rides. As your income falls, you are less likely to buy a car or take a cab and
increase in demand
more likely to ride a bus.
inferior good
a good for which, other Prices of Related Goods Suppose that the price of frozen yogurt falls. The law
things equal, an increase of demand says that you will buy more frozen yogurt. At the same time, you will
in income leads to a probably buy less ice cream. Because ice cream and frozen yogurt are both cold,
decrease in demand sweet, creamy desserts, they satisfy similar desires. When a fall in the price of one
good reduces the demand for another good, the two goods are called substitutes.
substitutes Substitutes are often pairs of goods that are used in place of each other, such as
two goods for which an hot dogs and hamburgers, sweaters and sweatshirts, and movie tickets and video
increase in the price of rentals.
one leads to an increase Now suppose that the price of hot fudge falls. According to the law of demand, you
in the demand for the
will buy more hot fudge. Yet in this case, you will buy more ice cream as well because
other
ice cream and hot fudge are often used together. When a fall in the price of one
complements good raises the demand for another good, the two goods are called complements.
two goods for which an Complements are often pairs of goods that are used together, such as gasoline and
increase in the price of automobiles, computers and software, and peanut butter and jelly.
one leads to a decrease
in the demand for the Tastes The most obvious determinant of your demand is your tastes. If you like
other ice cream, you buy more of it. Economists normally do not try to explain peo-
ple’s tastes because tastes are based on historical and psychological forces that are
beyond the realm of economics. Economists do, however, examine what happens
when tastes change.
T A B L E 1
Variable A Change in This Variable . . .
Variables That Influence Buyers

Price of the good itself Represents a movement along
This table lists the variables that affect how much consumers
the demand curve
choose to buy of any good. Notice the special role that the price
Income Shifts the demand curve
of the good plays: A change in the good’s price represents a
Prices of related goods Shifts the demand curve
movement along the demand curve, whereas a change in one of
Tastes Shifts the demand curve
the other variables shifts the demand curve.
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
Expectations Your expectations about the future may affect your demand for
a good or service today. For example, if you expect to earn a higher income next
month, you may choose to save less now and spend more of your current income
buying ice cream. As another example, if you expect the price of ice cream to fall
tomorrow, you may be less willing to buy an ice-cream cone at today’s price.
Number of Buyers In addition to the preceding factors, which influence the

behavior of individual buyers, market demand depends on the number of these
buyers. If Peter were to join Catherine and Nicholas as another consumer of ice
cream, the quantity demanded in the market would be higher at every price, and
market demand would increase.
Summary The demand curve shows what happens to the quantity demanded of
a good when its price varies, holding constant all the other variables that influence
buyers. When one of these other variables changes, the demand curve shifts. Table
1 lists the variables that influence how much consumers choose to buy of a good.
If you have trouble remembering whether you need to shift or move along the
demand curve, it helps to recall a lesson from the appendix to Chapter 2. A curve
shifts when there is a change in a relevant variable that is not measured on either
axis. Because the price is on the vertical axis, a change in price represents a move-
ment along the demand curve. By contrast, income, the prices of related goods,
tastes, expectations, and the number of buyers are not measured on either axis, so
a change in one of these variables shifts the demand curve.
© ALEXANDER BECHER/DPA/LANDOV
TWO WAYS TO REDUCE THE QUANTITY

OF SMOKING DEMANDED
Public policymakers often want to reduce the amount that people smoke. There
are two ways that policy can attempt to achieve this goal.
One way to reduce smoking is to shift the demand curve for cigarettes and
other tobacco products. Public service announcements, mandatory health warn-
ings on cigarette packages, and the prohibition of cigarette advertising on televi-
sion are all policies aimed at reducing the quantity of cigarettes demanded at any WHAT IS THE BEST WAY TO
given price. If successful, these policies shift the demand curve for cigarettes to the STOP THIS?
left, as in panel (a) of Figure 4.
4 F I G U R E Types
If
curve
The pie
of Graphs
warnings on cigarette packages convince smokers to smoke less, the demand
forchart
cigarettes shifts
in panel to thehow
(a) shows left. U.S.
In panel (a), the
national demand
income curve shifts
is derived from D1
from various
to D2. At The
sources. a price
barof $2.00inper
graph pack,
panel (b) the quantity
compares thedemanded falls from
average income 20 to
in four 10 ciga-
countries.
Shifts in the Demand rettes
The per day, as
time-series reflected
graph by the
in panel shift from
(c) shows point A to point
the productivity B. By
of labor in contrast, if a tax
U.S. businesses
Curve versus Move- raises1950
from the price of cigarettes, the demand curve does not shift. Instead, we observe
to 2000.
ments along the a movement to a different point on the demand curve. In panel (b), when the price
Demand Curve rises from $2.00 to $4.00, the quantity demanded falls from 20 to 12 cigarettes per
day, as reflected by the movement from point A to point C.
(a) A Shift in the Demand Curve (b) A Movement along the Demand Curve
Price of Price of A tax that raises the

Cigarettes, A policy to discourage Cigarettes, price of cigarettes
per Pack smoking shifts the per Pack results in a movement
demand curve to the left. C along the demand curve.
$4.00
B A A
$2.00 2.00
D1 D1
D2
0 10 20 0 12 20
Number of Cigarettes Smoked per Day Number of Cigarettes Smoked per Day
Alternatively, policymakers can try to raise the price of cigarettes. If the gov-
ernment taxes the manufacture of cigarettes, for example, cigarette companies
pass much of this tax on to consumers in the form of higher prices. A higher price
encourages smokers to reduce the numbers of cigarettes they smoke. In this case,
the reduced amount of smoking does not represent a shift in the demand curve.
Instead, it represents a movement along the same demand curve to a point with a
higher price and lower quantity, as in panel (b) of Figure 4.
How much does the amount of smoking respond to changes in the price of
cigarettes? Economists have attempted to answer this question by studying what
happens when the tax on cigarettes changes. They have found that a 10 percent
increase in the price causes a 4 percent reduction in the quantity demanded. Teen-
agers are found to be especially sensitive to the price of cigarettes: A 10 percent
increase in the price causes a 12 percent drop in teenage smoking.
A related question is how the price of cigarettes affects the demand for illicit
drugs, such as marijuana. Opponents of cigarette taxes often argue that tobacco
and marijuana are substitutes so that high cigarette prices encourage marijuana
use. By contrast, many experts on substance abuse view tobacco as a “gateway
drug” leading the young to experiment with other harmful substances. Most stud-
ies of the data are consistent with this latter view: They find that lower cigarette
prices are associated with greater use of marijuana. In other words, tobacco and
marijuana appear to be complements rather than substitutes. ●
QUICK QUIZ Make up an example of a monthly demand schedule for pizza and graph
the implied demand curve. • Give an example of something that would shift this demand
curve, and briefly explain your reasoning. • Would a change in the price of pizza shift
this demand curve?
SUPPLY
We now turn to the other side of the market and examine the behavior of sellers.
Once again, to focus our thinking, let’s consider the market for ice cream.
THE SUPPLY CURVE: THE R ELATIONSHIP BETWEEN

PRICE AND QUANTITY SUPPLIED
The quantity supplied of any good or service is the amount that sellers are will- quantity supplied
ing and able to sell. There are many determinants of quantity supplied, but once the amount of a good
again, price plays a special role in our analysis. When the price of ice cream is high, that sellers are willing
selling ice cream is profitable, and so the quantity supplied is large. Sellers of ice and able to sell
cream work long hours, buy many ice-cream machines, and hire many workers.
By contrast, when the price of ice cream is low, the business is less profitable, and
so sellers produce less ice cream. At a low price, some sellers may even choose to
shut down, and their quantity supplied falls to zero. This relationship between
price and quantity supplied is called the law of supply: Other things equal, when law of supply
the price of a good rises, the quantity supplied of the good also rises, and when the claim that, other
the price falls, the quantity supplied falls as well. things equal, the quan-
The table in Figure 5 shows the quantity of ice-cream cones supplied each month tity supplied of a good
by Ben, an ice-cream seller, at various prices of ice cream. At a price below $1.00, rises when the price of
Ben does not supply any ice cream at all. As the price rises, he supplies a greater the good rises
and greater quantity. This is the supply schedule, a table that shows the rela-
supply schedule
tionship between the price of a good and the quantity supplied, holding constant a table that shows the
everything else that influences how much producers of the good want to sell. relationship between the
The graph in Figure 5 uses the numbers from the table to illustrate the law price of a good and the
of supply. The curve relating price and quantity supplied is called the supply quantity supplied
curve. The supply curve slopes upward because, other things equal, a higher price
means a greater quantity supplied. supply curve
a graph of the relation-
M ARKET SUPPLY VERSUS INDIVIDUAL SUPPLY ship between the price
of a good and the quan-
Just as market demand is the sum of the demands of all buyers, market supply is tity supplied
the sum of the supplies of all sellers. The table in Figure 6 shows the supply sched-
ules for the two ice-cream producers in the market—Ben and Jerry. At any price,
Ben’s supply schedule tells us the quantity of ice cream Ben supplies, and Jerry’s
supply schedule tells us the quantity of ice cream Jerry supplies. The market sup-
ply is the sum of the two individual supplies.
The graph in Figure 6 shows the supply curves that correspond to the supply
schedules. As with demand curves, we sum the individual supply curves horizon-
tally to obtain the market supply curve. That is, to find the total quantity supplied
at any price, we add the individual quantities, which are found on the horizontal
axis of the individual supply curves. The market supply curve shows how the
total quantity supplied varies as the price of the good varies, holding constant
5 F I G U R E Types
supply
of Graphs
The supply schedule is a table that shows the quantity supplied at each price. This
The piecurve, which
chart in graphs
panel the supply
(a) shows schedule,
how U.S. nationalillustrates
income ishow the quantity
derived supplied
from various
of the good
sources. Thechanges
bar graph as in
itspanel
price (b)
varies. Because
compares theaaverage
higher price increases
income in four the quantity
countries.
Ben’s Supply Schedule supplied, the supply
The time-series graphcurve slopes
in panel upward.
(c) shows the productivity of labor in U.S. businesses
and Supply Curve from 1950 to 2000.
Price of Quantity of Price of

Ice-Cream Cone Cones Supplied Ice-Cream
Cone
$3.00 Supply curve
$0.00 0 cones
0.50 0
2.50
1.00 1 1. An
1.50 2 increase
2.00 3 in price ... 2.00
2.50 4
3.00 5 1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
all the other factors beyond price that influence producers’ decisions about how
much to sell.
SHIFTS IN THE SUPPLY CURVE

Because the market supply curve holds other things constant, the curve shifts
when one of the factors changes. For example, suppose the price of sugar falls.
Sugar is an input into producing ice cream, so the fall in the price of sugar makes
selling ice cream more profitable. This raises the supply of ice cream: At any given
price, sellers are now willing to produce a larger quantity. The supply curve for
ice cream shifts to the right.
Figure 7 illustrates shifts in supply. Any change that raises quantity supplied at
every price, such as a fall in the price of sugar, shifts the supply curve to the right
and is called an increase in supply. Similarly, any change that reduces the quantity
supplied at every price shifts the supply curve to the left and is called a decrease in
supply.
There are many variables that can shift the supply curve. Here are some of the
most important.
Input Prices To produce their output of ice cream, sellers use various inputs:
cream, sugar, flavoring, ice-cream machines, the buildings in which the ice cream
is made, and the labor of workers to mix the ingredients and operate the machines.
F I G U R E
6
Price of Ice-Cream Cone Ben Jerry Market Market Supply as the Sum
of Individual Supplies
$0.00 0 + 0 = 0 cones The quantity supplied in a market is
0.50 0 0 0 the sum of the quantities supplied
1.00 1 0 1 by all the sellers at each price. Thus,
1.50 2 2 4 the market supply curve is found by
2.00 3 4 7 adding horizontally the individual
2.50 4 6 10 supply curves. At a price of $2.00,
3.00 5 8 13 Ben supplies 3 ice-cream cones, and
Jerry supplies 4 ice-cream cones. The
quantity supplied in the market at
this price is 7 cones.
Ben's Supply + Jerry's Supply = Market Supply

Price of Price of Price of
Ice-Cream S Ben Ice-Cream S Jerry Ice-Cream
Cone Cone Cone
$3.00 $3.00 $3.00
S Market
2.50 2.50 2.50
2.00 2.00 2.00
1.50 1.50 1.50
1.00 1.00 1.00
0.50 0.50 0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
Price of
F I G U R E 7
Ice-Cream Supply curve, S3
Supply
Cone
curve, S1 Shifts in the Supply Curve
Supply Any change that raises the quantity
Decrease curve, S2
that sellers wish to produce at any
in supply given price shifts the supply curve to
the right. Any change that lowers the
quantity that sellers wish to produce
at any given price shifts the supply
Increase
curve to the left.
in supply
0 Quantity of
Ice-Cream Cones
When the price of one or more of these inputs rises, producing ice cream is less
profitable, and firms supply less ice cream. If input prices rise substantially, a firm
might shut down and supply no ice cream at all. Thus, the supply of a good is
negatively related to the price of the inputs used to make the good.
Technology The technology for turning inputs into ice cream is another deter-
minant of supply. The invention of the mechanized ice-cream machine, for exam-
ple, reduced the amount of labor necessary to make ice cream. By reducing firms’
costs, the advance in technology raised the supply of ice cream.
Expectations The amount of ice cream a firm supplies today may depend on its
expectations about the future. For example, if a firm expects the price of ice cream
to rise in the future, it will put some of its current production into storage and
supply less to the market today.
Number of Sellers In addition to the preceding factors, which influence the

behavior of individual sellers, market supply depends on the number of these
sellers. If Ben or Jerry were to retire from the ice-cream business, the supply in the
market would fall.
Summary The supply curve shows what happens to the quantity supplied of a
good when its price varies, holding constant all the other variables that influence
sellers. When one of these other variables changes, the supply curve shifts. Table 2
lists the variables that influence how much producers choose to sell of a good.
Once again, to remember whether you need to shift or move along the supply
curve, keep in mind that a curve shifts only when there is a change in a relevant
variable that is not named on either axis. The price is on the vertical axis, so a change
in price represents a movement along the supply curve. By contrast, because input
prices, technology, expectations, and the number of sellers are not measured on
either axis, a change in one of these variables shifts the supply curve.
QUICK QUIZ Make up an example of a monthly supply schedule for pizza and graph the
implied supply curve. • Give an example of something that would shift this supply curve,
and briefly explain your reasoning. • Would a change in the price of pizza shift this sup-
ply curve?
2 T A B L E
Variable A Change in This Variable . . .
Variables That Influence Sellers

Price of the good itself Represents a movement along the supply curve
This table lists the variables that affect how much
Input prices Shifts the supply curve
producers choose to sell of any good. Notice the
Technology Shifts the supply curve
special role that the price of the good plays: A
Expectations Shifts the supply curve
change in the good’s price represents a movement
Number of sellers Shifts the supply curve
along the supply curve, whereas a change in one of
the other variables shifts the supply curve.
SUPPLY AND DEMAND TOGETHER

Having analyzed supply and demand separately, we now combine them to see
how they determine the price and quantity of a good sold in a market.
EQUILIBRIUM
Figure 8 shows the market supply curve and market demand curve together. equilibrium
Notice that there is one point at which the supply and demand curves intersect. a situation in which the
This point is called the market’s equilibrium. The price at this intersection is market price has reached
the level at which
called the equilibrium price, and the quantity is called the equilibrium quantity.
quantity supplied equals
Here the equilibrium price is $2.00 per cone, and the equilibrium quantity is 7 ice- quantity demanded
cream cones.
The dictionary defines the word equilibrium as a situation in which various equilibrium price
forces are in balance—and this also describes a market’s equilibrium. At the equi- the price that balances
librium price, the quantity of the good that buyers are willing and able to buy exactly quantity supplied and
balances the quantity that sellers are willing and able to sell. The equilibrium price is quantity demanded
sometimes called the market-clearing price because, at this price, everyone in the
market has been satisfied: Buyers have bought all they want to buy, and sellers equilibrium quantity
have sold all they want to sell. the quantity sup-
The actions of buyers and sellers naturally move markets toward the equilib- plied and the quantity
demanded at the equi-
rium of supply and demand. To see why, consider what happens when the mar-
librium price
ket price is not equal to the equilibrium price.
Suppose first that the market price is above the equilibrium price, as in panel surplus
(a) of Figure 9. At a price of $2.50 per cone, the quantity of the good supplied (10 a situation in which
cones) exceeds the quantity demanded (4 cones). There is a surplus of the good: quantity supplied is
Suppliers are unable to sell all they want at the going price. A surplus is sometimes greater than quantity
called a situation of excess supply. When there is a surplus in the ice-cream market, demanded
Price of
F I G U R E 8
Ice-Cream
Cone Supply
The Equilibrium of
Supply and Demand
The equilibrium is found
Equilibrium Equilibrium
where the supply and
price
$2.00
demand curves intersect.
At the equilibrium price, the
quantity supplied equals
the quantity demanded.
Here the equilibrium price
Demand is $2.00: At this price, 7 ice-
cream cones are supplied,
and 7 ice-cream cones are
demanded.
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Equilibrium
quantity
9 F I G U R E In panelof
Types (a),Graphs
equilibrium
The pie chart
there is a surplus. Because the market price of $2.50 is above the
price, the quantity
in panel (a) showssupplied
how U.S.(10 cones) income
national exceedsisthe quantity
derived fromdemanded
various
(4 cones).The
sources. Suppliers try to
bar graph increase
in panel (b) sales by cutting
compares the price
the average of a cone,
income and
in four this
countries.
Markets Not in moves the pricegraph
The time-series toward in its equilibrium
panel (c) showslevel. In panel (b), of
the productivity there is ainshortage.
labor U.S. businesses
Equilibrium Because
from 1950 the tomarket
2000. price of $1.50 is below the equilibrium price, the quantity
demanded (10 cones) exceeds the quantity supplied (4 cones). With too many buy-
ers chasing too few goods, suppliers can take advantage of the shortage by raising
the price. Hence, in both cases, the price adjustment moves the market toward the
equilibrium of supply and demand.
(a) Excess Supply (b) Excess Demand

Price of Price of
Ice-Cream Supply Ice-Cream Supply
Cone Surplus Cone
$2.50
2.00 $2.00
1.50
Shortage
Demand Demand
0 4 7 10 Quantity of 0 4 7 10 Quantity of
Quantity Quantity Ice-Cream Quantity Quantity Ice-Cream
demanded supplied Cones supplied demanded Cones
sellers of ice cream find their freezers increasingly full of ice cream they would
like to sell but cannot. They respond to the surplus by cutting their prices. Falling
prices, in turn, increase the quantity demanded and decrease the quantity sup-
plied. Prices continue to fall until the market reaches the equilibrium.
Suppose now that the market price is below the equilibrium price, as in panel
(b) of Figure 9. In this case, the price is $1.50 per cone, and the quantity of the
shortage good demanded exceeds the quantity supplied. There is a shortage of the good:
a situation in which Demanders are unable to buy all they want at the going price. A shortage is some-
quantity demanded is times called a situation of excess demand. When a shortage occurs in the ice-cream
greater than quantity market, buyers have to wait in long lines for a chance to buy one of the few cones
supplied available. With too many buyers chasing too few goods, sellers can respond to the
shortage by raising their prices without losing sales. As the price rises, the quan-
tity demanded falls, the quantity supplied rises, and the market once again moves
toward the equilibrium.
Thus, the activities of the many buyers and sellers automatically push the mar-
ket price toward the equilibrium price. Once the market reaches its equilibrium,
law of supply and
all buyers and sellers are satisfied, and there is no upward or downward pres-
demand
the claim that the price
sure on the price. How quickly equilibrium is reached varies from market to mar-
of any good adjusts to ket depending on how quickly prices adjust. In most free markets, surpluses and
bring the quantity sup- shortages are only temporary because prices eventually move toward their equi-
plied and the quantity librium levels. Indeed, this phenomenon is so pervasive that it is called the law of
demanded for that good supply and demand: The price of any good adjusts to bring the quantity supplied
into balance and quantity demanded for that good into balance.
CARTOON: NON-SEQUITUR © WILEY MILLER. DIST.

BY UNIVERSAL PRESS SYNDICATE. REPRINTED
WITH PERMISSION. ALL RIGHTS RESERVED.
THREE STEPS TO ANALYZING CHANGES IN EQUILIBRIUM

So far, we have seen how supply and demand together determine a market’s equi-
librium, which in turn determines the price and quantity of the good that buyers
purchase and sellers produce. The equilibrium price and quantity depend on the
position of the supply and demand curves. When some event shifts one of these
curves, the equilibrium in the market changes, resulting in a new price and a new
quantity exchanged between buyers and sellers.
When analyzing how some event affects the equilibrium in a market, we pro-
ceed in three steps. First, we decide whether the event shifts the supply curve,
the demand curve, or, in some cases, both curves. Second, we decide whether the
curve shifts to the right or to the left. Third, we use the supply-and-demand dia-
gram to compare the initial and the new equilibrium, which shows how the shift
affects the equilibrium price and quantity. Table 3 summarizes these three steps.
To see how this recipe is used, let’s consider various events that might affect the
market for ice cream.
Example: A Change in Market Equilibrium Due to a Shift in Demand Sup-

pose that one summer the weather is very hot. How does this event affect the
market for ice cream? To answer this question, let’s follow our three steps.
1. The hot weather affects the demand curve by changing people’s taste for
ice cream. That is, the weather changes the amount of ice cream that people 3 T A B L E
want to buy at any given price. The supply curve is unchanged because the
weather does not directly affect the firms that sell ice cream.
Three Steps for
2. Because hot weather makes people want to eat more ice cream, the demand
Analyzing Changes
curve shifts to the right. Figure 10 shows this increase in demand as the shift in Equilibrium
in the demand curve from D1 to D2. This shift indicates that the quantity of
ice cream demanded is higher at every price. 1. Decide whether the
3. As Figure 10 shows, the increase in demand raises the equilibrium price event shifts the supply
from $2.00 to $2.50 and the equilibrium quantity from 7 to 10 cones. In other or demand curve (or
perhaps both).
words, the hot weather increases the price of ice cream and the quantity of
2. Decide in which direction
ice cream sold.
the curve shifts.
3. Use the supply-and-
Shifts in Curves versus Movements along Curves Notice that when hot demand diagram to see
weather increases the demand for ice cream and drives up the price, the quan- how the shift changes
tity of ice cream that firms supply rises, even though the supply curve remains the equilibrium price and
the same. In this case, economists say there has been an increase in “quantity quantity.
supplied” but no change in “supply.”
10 F I G U R E
Price of
Ice-Cream 1. Hot weather increases
Cone
How an Increase in Demand the demand for ice cream . . .
Affects the Equilibrium
An event that raises quantity
demanded at any given price
shifts the demand curve to the Supply
right. The equilibrium price
and the equilibrium quantity $2.50 New equilibrium
both rise. Here an abnormally
hot summer causes buyers to 2.00
demand more ice cream. The 2. . . . resulting
demand curve shifts from D1 to Initial
in a higher equilibrium
D2, which causes the equilibrium price . . .
price to rise from $2.00 to $2.50 D2
and the equilibrium quantity to
rise from 7 to 10 cones.
D1
0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold.
Supply refers to the position of the supply curve, whereas the quantity supplied
refers to the amount suppliers wish to sell. In this example, supply does not change
because the weather does not alter firms’ desire to sell at any given price. Instead,
the hot weather alters consumers’ desire to buy at any given price and thereby
shifts the demand curve to the right. The increase in demand causes the equilib-
rium price to rise. When the price rises, the quantity supplied rises. This increase
in quantity supplied is represented by the movement along the supply curve.
To summarize, a shift in the supply curve is called a “change in supply,” and
a shift in the demand curve is called a “change in demand.” A movement along a
fixed supply curve is called a “change in the quantity supplied,” and a movement
along a fixed demand curve is called a “change in the quantity demanded.”
Example: A Change in Market Equilibrium Due to a Shift in Supply Suppose

that during another summer, a hurricane destroys part of the sugarcane crop and
drives up the price of sugar. How does this event affect the market for ice cream?
Once again, to answer this question, we follow our three steps.
1. The change in the price of sugar, an input into making ice cream, affects the
supply curve. By raising the costs of production, it reduces the amount of
ice cream that firms produce and sell at any given price. The demand curve
does not change because the higher cost of inputs does not directly affect the
amount of ice cream households wish to buy.
2. The supply curve shifts to the left because, at every price, the total amount
that firms are willing and able to sell is reduced. Figure 11 illustrates this
decrease in supply as a shift in the supply curve from S1 to S2.
Price of
F I G U R E 11
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . . How a Decrease in
S2
Supply Affects the
S1
Equilibrium
An event that reduces quan-
tity supplied at any given
New price shifts the supply curve
$2.50 equilibrium to the left. The equilibrium
price rises, and the equilib-
2.00 Initial equilibrium rium quantity falls. Here an
increase in the price of sugar
2. . . . resulting (an input) causes sellers to
in a higher
supply less ice cream. The
price of ice
supply curve shifts from S1
cream . . . Demand
to S2, which causes the equi-
librium price of ice cream to
rise from $2.00 to $2.50 and
the equilibrium quantity to
0 4 7 Quantity of
fall from 7 to 4 cones.
3. . . . and a lower Ice-Cream Cones
quantity sold.
3. As Figure 11 shows, the shift in the supply curve raises the equilibrium
price from $2.00 to $2.50 and lowers the equilibrium quantity from 7 to 4
cones. As a result of the sugar price increase, the price of ice cream rises,
and the quantity of ice cream sold falls.
Example: Shifts in Both Supply and Demand Now suppose that a heat wave
and a hurricane occur during the same summer. To analyze this combination of
events, we again follow our three steps.
1. We determine that both curves must shift. The hot weather affects the
demand curve because it alters the amount of ice cream that households
want to buy at any given price. At the same time, when the hurricane drives
up sugar prices, it alters the supply curve for ice cream because it changes
the amount of ice cream that firms want to sell at any given price.
2. The curves shift in the same directions as they did in our previous analysis:
The demand curve shifts to the right, and the supply curve shifts to the left.
Figure 12 illustrates these shifts.
3. As Figure 12 shows, two possible outcomes might result depending on the
relative size of the demand and supply shifts. In both cases, the equilibrium
price rises. In panel (a), where demand increases substantially while supply
falls just a little, the equilibrium quantity also rises. By contrast, in panel (b),
where supply falls substantially while demand rises just a little, the equilib-
rium quantity falls. Thus, these events certainly raise the price of ice cream,
but their impact on the amount of ice cream sold is ambiguous (that is, it
could go either way).
12 F I G U R E Here weofobserve
Types
outcomes
Graphsa simultaneous increase in demand and decrease in supply. Two
are in
The pie chart possible.
panel (a)Inshows
panel how
(a), the
U.S.equilibrium price rises
national income from Pfrom
is derived 1 to P2, and the
various
equilibrium
sources. Thequantity rises
bar graph in from
panelQ(b)
1 to Q2. In panel
compares the (b), the equilibrium
average pricecountries.
income in four again rises
A Shift in Both Supply fromtime-series
The P1 to P2, but the equilibrium
graph quantity
in panel (c) shows falls
the from Q1 toofQlabor
productivity 2. in U.S. businesses
and Demand from 1950 to 2000.
(a) Price Rises, Quantity Rises (b) Price Rises, Quantity Falls
Price of Price of
Ice-Cream Large Ice-Cream Small S2
Cone increase in Cone increase in
demand New demand S1
S2
equilibrium
S1
New
P2 P2 equilibrium
Large
Small decrease
decrease in supply
P1 D2 in supply P1
Initial D2
Initial equilibrium equilibrium
D1 D1
0 Q1 Q2 Quantity of 0 Q2 Q1 Quantity of
Ice-Cream Cones Ice-Cream Cones
Summary We have just seen three examples of how to use supply and demand
curves to analyze a change in equilibrium. Whenever an event shifts the supply
curve, the demand curve, or perhaps both curves, you can use these tools to pre-
dict how the event will alter the amount sold in equilibrium and the price at which
the good is sold. Table 4 shows the predicted outcome for any combination of
shifts in the two curves. To make sure you understand how to use the tools of sup-
ply and demand, pick a few entries in this table and make sure you can explain to
yourself why the table contains the prediction it does.
QUICK QUIZ On the appropriate diagram, show what happens to the market for pizza if
the price of tomatoes rises. • On a separate diagram, show what happens to the market
for pizza if the price of hamburgers falls.
4 T A B L E
No Change An Increase A Decrease
in Supply in Supply in Supply
What Happens to Price and Quantity
When Supply or Demand Shifts?
No Change P same P down P up
As a quick quiz, make sure you can explain at least
in Demand Q same Q up Q down
a few of the entries in this table using a supply-and-
demand diagram. An Increase P up P ambiguous P up
in Demand Q up Q up Q ambiguous
A Decrease P down P down P ambiguous

in Demand Q down Q ambiguous Q down
The Helium Market

This analysis illustrates how supply and demand interact.
As Demand Balloons, in the demand curve.] It is needed to make do with less. [A movement along the demand
Helium Is in Short Supply computer microchips, flat-panel displays, curve.] Large industrial manufacturers are
By Ana Campoy fiber optics and to operate magnetic reso- better able to weather the helium short-
nance imaging, or MRI, scans and welding age, taking steps like installing equipment
Syracuse University physicist Gianfranco machines. . . . that can recycle the gas. So it is the nation’s
Vidali spends most of his time studying how Glitches at some of the world’s biggest cash-strapped scientific community that is
molecules are made in outer space, but a helium-producing plants have put a further getting the worst of the crunch.
couple of months ago he abruptly dropped pinch on supplies in the past year. [Another Soaring helium expenses could shut the
his interstellar research to address an earthly leftward shift in the supply curve.] As supplies doors of some independent labs, many [of]
issue: the global shortage of helium. have tightened, prices have surged in recent which have produced important research
The airy element best known for float- months. For one New York laboratory, prices over the years, and slow down work at
ing party balloons and the Goodyear blimp have increased to $8 a liquid liter, from close bigger research centers. Helium is used in
is also the lifeblood of a widening world of to $4 at the end of the summer. [An increase research to find cures to deadly diseases,
scientific research. Mr. Vidali uses the gas, in the equilibrium price.] create new sources of energy and answer
which becomes the coldest liquid on earth The upshot: Helium users—from party questions about how the universe was
when pressurized, to recreate conditions planners to welding shops—are having to formed. . . .
similar to outer space. Without it, he can’t Experts predict this situation will eventu-
work. So when his helium supplier informed ally price out many helium users, who will
him it was cutting deliveries to his lab, Mr. find substitutes or modify their technology.
PHOTO: © LOUIE PSIHOYOS/SCIENCE FACTION/GETTY IMAGES
Vidali said, “it sent us into a panic mode.” Some party balloon businesses are filling bal-
Helium is found in varying concentra- loons with mixtures that contain less helium.
tions in the world’s natural-gas deposits, Some welders are using argon. Industrial
and is separated out in a special refining users are installing recovery systems. . . .
process. As with oil and natural gas, the Reem Jaafar, a researcher at CUNY, says
easiest-to-get helium supplies have been she will go into another area of physics if
tapped and are declining. [A leftward shift helium prices stay at their current levels. “If
in the supply curve.] Meanwhile, scientific you have a fixed amount in a grant, and you
research has rapidly multiplied the uses of have to spend it all on helium, you don’t
helium in the past 50 years. [A rightward shift have anything left over,” she says.
Source: The Wall Street Journal, December 5, 2007.
CONCLUSION: HOW PRICES ALLOCATE RESOURCES

This chapter has analyzed supply and demand in a single market. Although our
discussion has centered on the market for ice cream, the lessons learned here apply
in most other markets as well. Whenever you go to a store to buy something,
Price Increases after Natural Disasters

When a natural disaster such as a hurricane hits a region, basic com-
modities such as gasoline and bottled water experience increasing
demand and shrinking supply. These shifts in demand and supply
curves cause prices to rise, leading some people to complain about
“price gouging.” But, as journalist John Stossel argues in this opinion
piece, there is an upside to higher prices after a disaster strikes.
In Praise of Price Gouging the price gouger makes sure his water goes tradesmen to go to New Orleans. But in a
By John Stossel to those who really need it. free society, those tradesmen must be per-
The people the softheaded politicians suaded to leave their homes and families,
Politicians and the media are furious about think are cruelest are doing the most to leave their employers and customers, and
price increases in the wake of Hurricane help. Assuming the demand for bottled drive from say, Wisconsin, to take work
Katrina. They want gas stations and water water was going to go up, they bought a in New Orleans. If they can’t make more
sellers punished. lot of it, planning to resell it at a steep profit. money in Louisiana than Wisconsin, why
If you want to score points cracking If they hadn’t done that, that water would would they make the trip?
down on mean, greedy profiteers, pushing not have been available for the people who Some may be motivated by a desire
anti-”gouging” rules is a very good thing. But need it the most. to be heroic, but we can’t expect enough
if you’re one of the people the law “protects” Might the water have been provided by heroes to fill the need, week after week;
from “price gouging,” you won’t fare as well. volunteers? Certainly some people help oth- most will travel there for the same rea-
Consider this scenario: You are thirsty— ers out of benevolence. But we can’t count son most Americans go to work: to make
worried that your baby is going to become on benevolence. As Adam Smith wrote, “It money. Any tradesman who treks to a disas-
dehydrated. You find a store that’s open, is not from the benevolence of the butcher, ter area must get higher pay than he would
and the storeowner thinks it’s immoral to the brewer or the baker, that we can expect get in his hometown, or he won’t do the
take advantage of your distress, so he won’t our dinner, but from their regard to their trek. Limit him to what his New Orleans col-
charge you a dime more than he charged own interest.” leagues charged before the storm, and even
last week. But you can’t buy water from him. Consider the store owner’s perspective: a would-be hero may say, “the heck with it.”
It’s sold out. If he’s not going to make a big profit, why If he charges enough to justify his ven-
You continue on your quest, and finally open up the store at all? Staying in a disas- ture, he’s likely to be condemned morally
find that dreaded monster, the price gouger. ter area is dangerous and means giving up or legally by the very people he’s trying to
He offers a bottle of water that cost $1 last the opportunity to be with family in order help. But they just don’t understand basic
week at an “outrageous” price—say $20. to take care of the needs of strangers. Why economics. Force prices down, and you
You pay it to survive the disaster. take the risk? keep suppliers out. Let the market work,
You resent the price gouger. But if he Any number of services—roofing, for suppliers come—and competition brings
hadn’t demanded $20, he’d have been out example, carpentry, or tree removal—are prices as low as the challenges of the disas-
of water. It was the price gouger’s “exploita- in overwhelming demand after a disaster allow. Goods that were in short supply
tion” that saved your child. ter. When the time comes to rebuild New become available, even to the poor.
It saved her because people look out Orleans, it’s safe to predict a shortage of It’s the price “gougers” who bring the
for their own interests. Before you got to local carpenters: The city’s own population water, ship the gasoline, fix the roof, and
the water seller, other people did. At $1 a of carpenters won’t be enough. rebuild the cities. The price “gougers” save
bottle, they stocked up. At $20 a bottle, they If this were a totalitarian country, the lives.
bought more cautiously. By charging $20, government might just order a bunch of
Source: Townhall.com, September 7, 2005.

you are contributing to the demand for that item. Whenever you look for a job,
you are contributing to the supply of labor services. Because supply and demand
are such pervasive economic phenomena, the model of supply and demand is a
powerful tool for analysis. We will be using this model repeatedly in the follow-
ing chapters.
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity. Although it is still too early to
judge whether market outcomes are good or bad, in this chapter we have begun
to see how markets work. In any economic system, scarce resources have to be
allocated among competing uses. Market economies harness the forces of supply
and demand to serve that end. Supply and demand together determine the prices “Two dollars”
of the economy’s many different goods and services; prices in turn are the signals
that guide the allocation of resources.
For example, consider the allocation of beachfront land. Because the amount of
this land is limited, not everyone can enjoy the luxury of living by the beach. Who
gets this resource? The answer is whoever is willing and able to pay the price. The
price of beachfront land adjusts until the quantity of land demanded exactly bal-
ances the quantity supplied. Thus, in market economies, prices are the mechanism
for rationing scarce resources.
Similarly, prices determine who produces each good and how much is pro-
duced. For instance, consider farming. Because we need food to survive, it is
crucial that some people work on farms. What determines who is a farmer and
who is not? In a free society, there is no government planning agency making
this decision and ensuring an adequate supply of food. Instead, the allocation of
workers to farms is based on the job decisions of millions of workers. This decen-
tralized system works well because these decisions depend on prices. The prices
of food and the wages of farmworkers (the price of their labor) adjust to ensure
that enough people choose to be farmers.
If a person had never seen a market economy in action, the whole idea might
seem preposterous. Economies are enormous groups of people engaged in a mul-
titude of interdependent activities. What prevents decentralized decision making
from degenerating into chaos? What coordinates the actions of the millions of
people with their varying abilities and desires? What ensures that what needs to
be done is in fact done? The answer, in a word, is prices. If an invisible hand guides
market economies, as Adam Smith famously suggested, then the price system is “—and seventy-five cents.”
the baton that the invisible hand uses to conduct the economic orchestra.
SUMMARY
• Economists use the model of supply and demand falls, the quantity demanded rises. Therefore, the
to analyze competitive markets. In a competitive demand curve slopes downward.
market, there are many buyers and sellers, each
• In addition to price, other determinants of how
of whom has little or no influence on the market much consumers want to buy include income,
price. the prices of substitutes and complements, tastes,
• The demand curve shows how the quantity of a expectations, and the number of buyers. If one of
good demanded depends on the price. Accord- these factors changes, the demand curve shifts.
ing to the law of demand, as the price of a good
• The supply curve shows how the quantity of a below the equilibrium price, there is a shortage,
good supplied depends on the price. According which causes the market price to rise.
to the law of supply, as the price of a good rises,
the quantity supplied rises. Therefore, the supply • To analyze how any event influences a mar-
ket, we use the supply-and-demand diagram to
curve slopes upward.
examine how the event affects the equilibrium
• In addition to price, other determinants of how price and quantity. To do this, we follow three
much producers want to sell include input prices, steps. First, we decide whether the event shifts
technology, expectations, and the number of sell- the supply curve or the demand curve (or both).
ers. If one of these factors changes, the supply Second, we decide in which direction the curve
curve shifts. shifts. Third, we compare the new equilibrium
with the initial equilibrium.
• The intersection of the supply and demand curves
determines the market equilibrium. At the equi- • In market economies, prices are the signals that
librium price, the quantity demanded equals the guide economic decisions and thereby allocate
quantity supplied. scarce resources. For every good in the economy,
the price ensures that supply and demand are in
• The behavior of buyers and sellers naturally balance. The equilibrium price then determines
drives markets toward their equilibrium. When
how much of the good buyers choose to consume
the market price is above the equilibrium price,
and how much sellers choose to produce.
there is a surplus of the good, which causes the
market price to fall. When the market price is
KEY CONCEPTS
market, p. 66 inferior good, p. 70 equilibrium, p. 77

competitive market, p. 66 substitutes, p. 70 equilibrium price, p. 77
quantity demanded, p. 67 complements, p. 70 equilibrium quantity, p. 77
law of demand, p. 67 quantity supplied, p. 73 surplus, p. 77
demand schedule, p. 67 law of supply, p. 73 shortage, p. 78
demand curve, p. 68 supply schedule, p. 73 law of supply and demand, p. 78
normal good, p. 70 supply curve, p. 73
1. What is a competitive market? Briefly describe a a normal good? What happens to Popeye’s
type of market that is not perfectly competitive. demand curve for spinach?
2. What are the demand schedule and the demand 5. What are the supply schedule and the supply
curve and how are they related? Why does the curve and how are they related? Why does the
demand curve slope downward? supply curve slope upward?
3. Does a change in consumers’ tastes lead to a 6. Does a change in producers’ technology lead to
movement along the demand curve or a shift in a movement along the supply curve or a shift in
the demand curve? Does a change in price lead the supply curve? Does a change in price lead to
to a movement along the demand curve or a a movement along the supply curve or a shift in
shift in the demand curve? the supply curve?
4. Popeye’s income declines, and as a result, he 7. Define the equilibrium of a market. Describe
buys more spinach. Is spinach an inferior or the forces that move a market toward its
equilibrium.
8. Beer and pizza are complements because they quantity supplied, quantity demanded, and the
are often enjoyed together. When the price of price in the market for pizza?
beer rises, what happens to the supply, demand, 9. Describe the role of prices in market economies.
1. Explain each of the following statements using b. Suppose a technological advance reduces the
supply-and-demand diagrams. cost of manufacturing TV screens. Draw a
a. “When a cold snap hits Florida, the price of diagram to show what happens in the market
orange juice rises in supermarkets through- for TV screens.
out the country.” c. Draw two more diagrams to show how the
b. “When the weather turns warm in New Eng- change in the market for TV screens affects
land every summer, the price of hotel rooms the markets for DVDs and movie tickets.
in Caribbean resorts plummets.” 6. Over the past 20 years, technological advances
c. “When a war breaks out in the Middle East, have reduced the cost of computer chips.
the price of gasoline rises, and the price of a How do you think this affected the market
used Cadillac falls.” for computers? For computer software? For
2. “An increase in the demand for notebooks raises typewriters?
the quantity of notebooks demanded but not 7. Using supply-and-demand diagrams, show the
the quantity supplied.” Is this statement true or effect of the following events on the market for
false? Explain. sweatshirts.
3. Consider the market for minivans. For each a. A hurricane in South Carolina damages the
of the events listed here, identify which of the cotton crop.
determinants of demand or supply are affected. b. The price of leather jackets falls.
Also indicate whether demand or supply c. All colleges require morning exercise in
increases or decreases. Then draw a diagram appropriate attire.
to show the effect on the price and quantity of d. New knitting machines are invented.
minivans. 8. A survey shows an increase in drug use by
a. People decide to have more children. young people. In the ensuing debate, two
b. A strike by steelworkers raises steel prices. hypotheses are proposed:
c. Engineers develop new automated machin- • Reduced police efforts have increased the
ery for the production of minivans. availability of drugs on the street.
d. The price of sports utility vehicles rises. • Cutbacks in education efforts have decreased
e. A stock-market crash lowers people’s wealth. awareness of the dangers of drug addiction.
4. Identify the flaw in this analysis: “If more a. Use supply-and-demand diagrams to show
Americans go on a low-carb diet, the demand how each of these hypotheses could lead to
for bread will fall. The decrease in the demand an increase in quantity of drugs consumed.
for bread will cause the price of bread to fall. b. How could information on what has hap-
The lower price, however, will then increase the pened to the price of drugs help us to distin-
demand. In the new equilibrium, Americans guish between these explanations?
might end up consuming more bread than they 9. Suppose that in the year 2010 the number of
did initially.” births is temporarily high. How does this baby
5. Consider the markets for DVD movies, TV boom affect the price of babysitting services in
screens, and tickets at movie theaters. 2015 and 2025? (Hint: 5-year-olds need babysit-
a. For each pair, identify whether they are ters, whereas 15-year-olds can be babysitters.)
complements or substitutes: 10. Ketchup is a complement (as well as a condi-
• DVDs and TV screens ment) for hot dogs. If the price of hot dogs rises,
• DVDs and movie tickets what happens to the market for ketchup? For
• TV screens and movie tickets tomatoes? For tomato juice? For orange juice?
11. The market for pizza has the following demand Currently, the demand and supply schedules
and supply schedules: are as follows:
Price Quantity Demanded Quantity Supplied Price Quantity Demanded Quantity Supplied
$4 135 pizzas 26 pizzas $ 4 10,000 tickets 8,000 tickets

5 104 53 8 8,000 8,000
6 81 81 12 6,000 8,000
7 68 98 16 4,000 8,000
8 53 110 20 2,000 8,000
9 39 121
a. Draw the demand and supply curves. What
a. Graph the demand and supply curves. What is unusual about this supply curve? Why
is the equilibrium price and quantity in this might this be true?
market? b. What are the equilibrium price and quantity
b. If the actual price in this market were above of tickets?
the equilibrium price, what would drive the c. Your college plans to increase total enroll-
market toward the equilibrium? ment next year by 5,000 students. The
c. If the actual price in this market were below additional students will have the following
the equilibrium price, what would drive the demand schedule:
market toward the equilibrium?
Price Quantity Demanded
12. Consider the following events: Scientists reveal
that consumption of oranges decreases the risk
$ 4 4,000 tickets
of diabetes and, at the same time, farmers use 8 3,000
a new fertilizer that makes orange trees more 12 2,000
productive. Illustrate and explain what effect 16 1,000
these changes have on the equilibrium price and 20 0
quantity of oranges.
13. Because bagels and cream cheese are often eaten Now add the old demand schedule and the
together, they are complements. demand schedule for the new students to
a. We observe that both the equilibrium price of calculate the new demand schedule for the
cream cheese and the equilibrium quantity of entire college. What will be the new equilibrium
bagels have risen. What could be responsible price and quantity?
for this pattern—a fall in the price of flour 15. Market research has revealed the following
or a fall in the price of milk? Illustrate and information about the market for chocolate
explain your answer. bars: The demand schedule can be represented
b. Suppose instead that the equilibrium price of by the equation QD = 1,600 – 300P, where QD
cream cheese has risen but the equilibrium is the quantity demanded and P is the price.
quantity of bagels has fallen. What could The supply schedule can be represented by the
be responsible for this pattern—a rise in the equation QS = 1,400 + 700P, where QS is the
price of flour or a rise in the price of milk? quantity supplied. Calculate the equilibrium
Illustrate and explain your answer. price and quantity in the market for chocolate
14. Suppose that the price of basketball tickets at bars.
your college is determined by market forces.
5
CHAPTER
Elasticity and Its Application
I magine that some event drives up the price of gasoline in the United States.
It could be a war in the Middle East that disrupts the world supply of oil, a
booming Chinese economy that boosts the world demand for oil, or a new
tax on gasoline passed by Congress. How would U.S. consumers respond to the
higher price?
It is easy to answer this question in broad fashion: Consumers would buy less.
That is simply the law of demand we learned in the previous chapter. But you
might want a precise answer. By how much would consumption of gasoline fall?
This question can be answered using a concept called elasticity, which we develop
in this chapter.
Elasticity is a measure of how much buyers and sellers respond to changes in
market conditions. When studying how some event or policy affects a market,
we can discuss not only the direction of the effects but their magnitude as well.
Elasticity is useful in many applications, as we will see toward the end of this
chapter.
Before proceeding, however, you might be curious about the answer to the
gasoline question. Many studies have examined consumers’ response to gasoline
prices, and they typically find that the quantity demanded responds more in the
89
long run than it does in the short run. A 10 percent increase in gasoline prices
reduces gasoline consumption by about 2.5 percent after a year and about 6 percent
after five years. About half of the long-run reduction in quantity demanded arises
because people drive less and half because they switch to more fuel-efficient cars.
Both responses are reflected in the demand curve and its elasticity.
THE ELASTICITY OF DEMAND

When we introduced demand in Chapter 4, we noted that consumers usually buy
more of a good when its price is lower, when their incomes are higher, when the
prices of substitutes for the good are higher, or when the prices of complements of
the good are lower. Our discussion of demand was qualitative, not quantitative.
That is, we discussed the direction in which quantity demanded moves but not
the size of the change. To measure how much consumers respond to changes in
elasticity these variables, economists use the concept of elasticity.
a measure of the respon-
siveness of quantity
demanded or quantity
THE PRICE ELASTICITY OF DEMAND
supplied to one of its AND ITS DETERMINANTS
determinants
The law of demand states that a fall in the price of a good raises the quantity
price elasticity of demanded. The price elasticity of demand measures how much the quantity
demand demanded responds to a change in price. Demand for a good is said to be elastic
a measure of how much if the quantity demanded responds substantially to changes in the price. Demand
the quantity demanded is said to be inelastic if the quantity demanded responds only slightly to changes
of a good responds to in the price.
a change in the price of The price elasticity of demand for any good measures how willing consumers
that good, computed as are to buy less of the good as its price rises. Thus, the elasticity reflects the many
the percentage change economic, social, and psychological forces that shape consumer preferences. Based
in quantity demanded
on experience, however, we can state some general rules about what determines
divided by the percent-
age change in price
the price elasticity of demand.
Availability of Close Substitutes Goods with close substitutes tend to have

more elastic demand because it is easier for consumers to switch from that good
to others. For example, butter and margarine are easily substitutable. A small
increase in the price of butter, assuming the price of margarine is held fixed,
causes the quantity of butter sold to fall by a large amount. By contrast, because
eggs are a food without a close substitute, the demand for eggs is less elastic than
the demand for butter.
Necessities versus Luxuries Necessities tend to have inelastic demands, whereas

luxuries have elastic demands. When the price of a doctor’s visit rises, people will
not dramatically reduce the number of times they go to the doctor, although they
might go somewhat less often. By contrast, when the price of sailboats rises, the
quantity of sailboats demanded falls substantially. The reason is that most people
view doctor visits as a necessity and sailboats as a luxury. Of course, whether a
good is a necessity or a luxury depends not on the intrinsic properties of the good
but on the preferences of the buyer. For avid sailors with little concern over their
health, sailboats might be a necessity with inelastic demand and doctor visits a
luxury with elastic demand.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 91
Definition of the Market The elasticity of demand in any market depends on

how we draw the boundaries of the market. Narrowly defined markets tend to
have more elastic demand than broadly defined markets because it is easier to
find close substitutes for narrowly defined goods. For example, food, a broad cate-
gory, has a fairly inelastic demand because there are no good substitutes for food.
Ice cream, a narrower category, has a more elastic demand because it is easy to
substitute other desserts for ice cream. Vanilla ice cream, a very narrow category,
has a very elastic demand because other flavors of ice cream are almost perfect
substitutes for vanilla.
Time Horizon Goods tend to have more elastic demand over longer time hori-
zons. When the price of gasoline rises, the quantity of gasoline demanded falls
only slightly in the first few months. Over time, however, people buy more fuel-
efficient cars, switch to public transportation, and move closer to where they work.
Within several years, the quantity of gasoline demanded falls more substantially.
COMPUTING THE PRICE ELASTICITY OF DEMAND

Now that we have discussed the price elasticity of demand in general terms, let’s
be more precise about how it is measured. Economists compute the price elastic-
ity of demand as the percentage change in the quantity demanded divided by the
percentage change in the price. That is,
Percentage change in quantity demanded

Price elasticity of demand = .
Percentage change in price
For example, suppose that a 10 percent increase in the price of an ice-cream cone
causes the amount of ice cream you buy to fall by 20 percent. We calculate your
elasticity of demand as
20 percent
Price elasticity of demand = = 2.
10 percent
In this example, the elasticity is 2, reflecting that the change in the quantity
demanded is proportionately twice as large as the change in the price.
Because the quantity demanded of a good is negatively related to its price, the
percentage change in quantity will always have the opposite sign as the percent-
age change in price. In this example, the percentage change in price is a positive 10
percent (reflecting an increase), and the percentage change in quantity demanded
is a negative 20 percent (reflecting a decrease). For this reason, price elasticities of
demand are sometimes reported as negative numbers. In this book, we follow the
common practice of dropping the minus sign and reporting all price elasticities of
demand as positive numbers. (Mathematicians call this the absolute value.) With
this convention, a larger price elasticity implies a greater responsiveness of quan-
tity demanded to price.
THE MIDPOINT M ETHOD: A BETTER WAY TO CALCULATE

PERCENTAGE CHANGES AND ELASTICITIES
If you try calculating the price elasticity of demand between two points on a
demand curve, you will quickly notice an annoying problem: The elasticity from
point A to point B seems different from the elasticity from point B to point A. For
example, consider these numbers:
Point A: Price = $4 Quantity = 120

Point B: Price = $6 Quantity = 80
Going from point A to point B, the price rises by 50 percent, and the quantity falls
by 33 percent, indicating that the price elasticity of demand is 33/50, or 0.66. By
contrast, going from point B to point A, the price falls by 33 percent, and the quan-
tity rises by 50 percent, indicating that the price elasticity of demand is 50/33, or
1.5. This difference arises because the percentage changes are calculated from a
different base.
One way to avoid this problem is to use the midpoint method for calculating elas-
ticities. The standard procedure for computing a percentage change is to divide
the change by the initial level. By contrast, the midpoint method computes a per-
centage change by dividing the change by the midpoint (or average) of the initial
and final levels. For instance, $5 is the midpoint between $4 and $6. Therefore,
according to the midpoint method, a change from $4 to $6 is considered a 40 per-
cent rise because (6 – 4) / 5 × 100 = 40. Similarly, a change from $6 to $4 is con-
sidered a 40 percent fall.
Because the midpoint method gives the same answer regardless of the direction
of change, it is often used when calculating the price elasticity of demand between
two points. In our example, the midpoint between point A and point B is:
Midpoint: Price = $5 Quantity = 100
According to the midpoint method, when going from point A to point B, the price
rises by 40 percent, and the quantity falls by 40 percent. Similarly, when going
from point B to point A, the price falls by 40 percent, and the quantity rises by
40 percent. In both directions, the price elasticity of demand equals 1.
The following formula expresses the midpoint method for calculating the price
elasticity of demand between two points, denoted (Q1, P1) and (Q2, P2):
(Q2 – Q1) / [(Q2 + Q1) / 2]

Price elasticity of demand = .
(P2 – P1) / [(P2 + P1) / 2]
The numerator is the percentage change in quantity computed using the midpoint
method, and the denominator is the percentage change in price computed using
the midpoint method. If you ever need to calculate elasticities, you should use this
formula.
In this book, however, we rarely perform such calculations. For most of our
purposes, what elasticity represents—the responsiveness of quantity demanded
to a change in price—is more important than how it is calculated.
THE VARIETY OF DEMAND CURVES

Economists classify demand curves according to their elasticity. Demand is con-
sidered elastic when the elasticity is greater than 1, which means the quantity
moves proportionately more than the price. Demand is considered inelastic when
the elasticity is less than 1, which means the quantity moves proportionately less
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
F I G U R E 1
The Price Elasticity
of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0 (b) Inelastic Demand: Elasticity Is Less Than 1
Price Price
Demand
$5 $5
4 4
1. An 1. A 22% Demand
increase increase
in price . . . in price . . .
0 100 Quantity 0 90 100 Quantity

2. . . . leaves the quantity demanded unchanged. 2. . . . leads to an 11% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
1. A 22% Demand
increase
in price . . .
0 80 100 Quantity
2. . . . leads to a 22% decrease in quantity demanded.

(d) Elastic Demand: Elasticity Is Greater Than 1 (e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price Price
1. At any price
above $4, quantity
$5 demanded is zero.
4 Demand $4 Demand
1. A 22%
2. At exactly $4,
increase
consumers will
in price . . .
buy any quantity.
0 50 100 Quantity 0 Quantity

3. At a price below $4,
2. . . . leads to a 67% decrease in quantity demanded. quantity demanded is infinite.
than the price. If the elasticity is exactly 1, the quantity moves the same amount
proportionately as the price, and demand is said to have unit elasticity.
Because the price elasticity of demand measures how much quantity demanded
responds to changes in the price, it is closely related to the slope of the demand
curve. The following rule of thumb is a useful guide: The flatter the demand curve
that passes through a given point, the greater the price elasticity of demand. The
steeper the demand curve that passes through a given point, the smaller the price
elasticity of demand.
Figure 1 on the previous page shows five cases. In the extreme case of a zero
elasticity, shown in panel (a), demand is perfectly inelastic, and the demand curve
is vertical. In this case, regardless of the price, the quantity demanded stays the
same. As the elasticity rises, the demand curve gets flatter and flatter, as shown in
panels (b), (c), and (d). At the opposite extreme, shown in panel (e), demand is per-
fectly elastic. This occurs as the price elasticity of demand approaches infinity and
the demand curve becomes horizontal, reflecting the fact that very small changes
in the price lead to huge changes in the quantity demanded.
Finally, if you have trouble keeping straight the terms elastic and inelastic, here’s
a memory trick for you: Inelastic curves, such as in panel (a) of Figure 1, look like
the letter I. This is not a deep insight, but it might help on your next exam.
TOTAL R EVENUE AND THE PRICE

ELASTICITY OF DEMAND
When studying changes in supply or demand in a market, one variable we often
total revenue want to study is total revenue, the amount paid by buyers and received by sellers
the amount paid by buy- of the good. In any market, total revenue is P × Q, the price of the good times the
ers and received by sell- quantity of the good sold. We can show total revenue graphically, as in Figure 2.
ers of a good, computed The height of the box under the demand curve is P, and the width is Q. The area
as the price of the good of this box, P × Q, equals the total revenue in this market. In Figure 2, where P =
times the quantity sold
$4 and Q = 100, total revenue is $4 × 100, or $400.
How does total revenue change as one moves along the demand curve? The
answer depends on the price elasticity of demand. If demand is inelastic, as in
panel (a) of Figure 3, then an increase in the price causes an increase in total rev-
enue. Here an increase in price from $1 to $3 causes the quantity demanded to fall
from 100 to 80, so total revenue rises from $100 to $240. An increase in price raises
P × Q because the fall in Q is proportionately smaller than the rise in P.
We obtain the opposite result if demand is elastic: An increase in the price
causes a decrease in total revenue. In panel (b) of Figure 3, for instance, when
the price rises from $4 to $5, the quantity demanded falls from 50 to 20, so total
revenue falls from $200 to $100. Because demand is elastic, the reduction in the
quantity demanded is so great that it more than offsets the increase in the price.
That is, an increase in price reduces P × Q because the fall in Q is proportionately
greater than the rise in P.
Although the examples in this figure are extreme, they illustrate some general
rules:
• When demand is inelastic (a price elasticity less than 1), price and total
revenue move in the same direction.
• When demand is elastic (a price elasticity greater than 1), price and total
revenue move in opposite directions.
Price
F I G U R E 2
Total Revenue
The total amount paid by buy-
ers, and received as revenue by
sellers, equals the area of the box
under the demand curve, P × Q.
Here, at a price of $4, the quan-
$4
tity demanded is 100, and total
revenue is $400.
P Q $400
P
(revenue) Demand
0 100 Quantity
• If demand is unit elastic (a price elasticity exactly equal to 1), total revenue
remains constant when the price changes.
ELASTICITY AND TOTAL R EVENUE ALONG

A LINEAR DEMAND CURVE
Let’s examine how elasticity varies along a linear demand curve, as shown in Fig-
ure 4. We know that a straight line has a constant slope. Slope is defined as “rise
over run,” which here is the ratio of the change in price (“rise”) to the change in
quantity (“run”). This particular demand curve’s slope is constant because each $1
increase in price causes the same two-unit decrease in the quantity demanded.
Even though the slope of a linear demand curve is constant, the elasticity is not.
This is true because the slope is the ratio of changes in the two variables, whereas
the elasticity is the ratio of percentage changes in the two variables. You can see
this by looking at the table in Figure 4, which shows the demand schedule for the
linear demand curve in the graph. The table uses the midpoint method to calcu-
late the price elasticity of demand. At points with a low price and high quantity,
the demand curve is inelastic. At points with a high price and low quantity, the
demand curve is elastic.
The table also presents total revenue at each point on the demand curve. These
numbers illustrate the relationship between total revenue and elasticity. When the
price is $1, for instance, demand is inelastic, and a price increase to $2 raises total
revenue. When the price is $5, demand is elastic, and a price increase to $6 reduces
total revenue. Between $3 and $4, demand is exactly unit elastic, and total revenue
is the same at these two prices.
The linear demand curve illustrates that the price elasticity of demand need not
be the same at all points on a demand curve. A constant elasticity is possible, but
it is not always the case.
3 F I G U R E Types
depends
The
of Graphs
The impact of a price change on total revenue (the product of price and quantity)
on the
pie chart elasticity
in panel of demand.
(a) shows In panel
how U.S. (a), the
national demand
income curve from
is derived is inelastic.
variousIn
this case,The
sources. an increase
bar graphin in
the price(b)
panel leads to a decrease
compares in quantity
the average incomedemanded that is
in four countries.
How Total Revenue proportionately
The smaller,
time-series graph in so total(c)revenue
panel increases.
shows the Here an
productivity increase
of labor in the
in U.S. price from
businesses
Changes When Price $1 to 1950
from $3 causes the quantity demanded to fall from 100 to 80. Total revenue rises
to 2000.
Changes from $100 to $240. In panel (b), the demand curve is elastic. In this case, an increase
in the price leads to a decrease in quantity demanded that is proportionately larger,
so total revenue decreases. Here an increase in the price from $4 to $5 causes the
quantity demanded to fall from 50 to 20. Total revenue falls from $200 to $100.
(a) The Case of Inelastic Demand
Price Price
$3
Revenue $240
$1
Revenue $100 Demand Demand
0 100 Quantity 0 80 Quantity
(b) The Case of Elastic Demand
Price Price
$5
$4
Demand
Demand
Revenue $200 Revenue $100
0 50 Quantity 0 20 Quantity
Price
F I G U R E
4
Elasticity is
$7 larger
than 1.
Elasticity of a Linear Demand Curve
6 The slope of a linear demand curve is constant, but its elastic-
ity is not. The demand schedule in the table was used to cal-
5
culate the price elasticity of demand by the midpoint method.
Elasticity is
4 smaller At points with a low price and high quantity, the demand curve
than 1. is inelastic. At points with a high price and low quantity, the
3 demand curve is elastic.
2
0 2 4 6 8 10 12 14
Quantity
Percentage Percentage
Total Revenue Change Change
Price Quantity (Price × Quantity) in Price in Quantity Elasticity Description
$7 0 $ 0
15 200 13.0 Elastic
6 2 12
18 67 3.7 Elastic
5 4 20
22 40 1.8 Elastic
4 6 24
29 29 1.0 Unit elastic
3 8 24
40 22 0.6 Inelastic
2 10 20
67 18 0.3 Inelastic
1 12 12
200 15 0.1 Inelastic
0 14 0
OTHER DEMAND ELASTICITIES

In addition to the price elasticity of demand, economists use other elasticities to
describe the behavior of buyers in a market.
The Income Elasticity of Demand The income elasticity of demand measures income elasticity
how the quantity demanded changes as consumer income changes. It is calculated of demand
as the percentage change in quantity demanded divided by the percentage change a measure of how much
in income. That is, the quantity demanded
of a good responds to
a change in consumers’
Percentage change in quantity demanded
Income elasticity of demand = . income, computed as
Percentage change in income the percentage change
in quantity demanded
As we discussed in Chapter 4, most goods are normal goods: Higher income raises divided by the percent-
the quantity demanded. Because quantity demanded and income move in the age change in income
same direction, normal goods have positive income elasticities. A few goods, such
as bus rides, are inferior goods: Higher income lowers the quantity demanded.
Because quantity demanded and income move in opposite directions, inferior
goods have negative income elasticities.
Energy Demand
What would induce consumers to use less gasoline and electricity?
Real Energy Savers That kind of drop requires a big change in

Don’t Wear Cardigans. behavior. The authors found that households
Or Do They? had turned off air-conditioners in the middle
By Anna Bernasek of summer and had invested in new energy-
efficient appliances, among other things.
When oil and gas prices surged after Hur- High costs aren’t the only force that will
ricanes Katrina and Rita, President Bush influence consumers to cut back. Although
appealed to Americans to conserve energy. public appeals to save energy may be
He asked people to cut back on nonessential ridiculed by comedians on late-night
travel, for example, and to carpool to work. television—recall President Jimmy Carter’s
Then, in October, the White House started a when the price rises 10 percent, electric- cardigan sweater—the efforts can have a
campaign for energy conservation in Ameri- ity use falls roughly 3 percent. At the gas substantial impact.
can homes, dusting off some old ideas like pump, a 10 percent increase in price leads Professors Reiss and White found that to
switching to fluorescent light bulbs and to a decline of around 2 percent in demand. be true in San Diego. In February 2001, with
installing better insulation in attics. [Author’s note: It would be more precise to electricity prices capped, the state of Califor-
Some critics derided the program as a say that the price increase leads to a 2 per- nia began a campaign to have households
bizarre flashback from the 1970’s—a collec- cent decline in quantity demanded, because conserve electricity. It worked. “It was clear
tion of worn-out ideas that evoked feelings the change represents a movement along by about six months into 2001 that public
of deprivation and gloom. It will be a pity, the demand curve.] appeals were having a big impact,” Profes-
though, if an effective energy policy never Consumer behavior can change quickly sor White said. Such campaigns can have
gets off the ground. Much has been learned in a crisis. A study by Peter C. Reiss, a pro- significant effects on consumer behavior,
since the 70’s about what works and what fessor of economics at Stanford, and Mat- he said, if they offer a clear explanation of
doesn’t. . . . thew W. White, a professor of business and what people can do and how it will make
There are reasons for optimism. One is public policy at the Wharton School of the a difference.
that market forces can help provide solu- University of Pennsylvania, provides some Perhaps the most important reason for
tions: higher prices, on their own, can make recent evidence. In examining San Diego optimism is technology’s role in promoting
people cut back. Just how responsive con- households during the California electric- energy savings. From 1979 to 1985, in the
sumers are to price changes—what econo- ity crisis of 2000 and 2001, they found that aftermath of energy shortages, Americans
mists call the elasticity of demand—has use of electricity dropped surprisingly fast. reduced their oil consumption by 15 per-
been the focus of much research. Today, In the summer of 2000, within 60 days of cent. The single biggest factor was a shift
economists believe that they have devel- seeing monthly electric bills rise by about in car-buying habits. Americans found that
PHOTO: © DENNIS BRACK/LANDOV
oped a pretty good rule of thumb for energy $60—an increase of 130 percent—the driving fuel-efficient cars, instead of gas guz-
use. In the case of electricity, which is rela- average household cut its use of electricity zlers, didn’t stop them from going where
tively easy to measure, they have found that by 12 percent. they wanted to go.
Source: New York Times, November 13, 2005.

Even among normal goods, income elasticities vary substantially in size. Neces-
sities, such as food and clothing, tend to have small income elasticities because
consumers choose to buy some of these goods even when their incomes are low.
Luxuries, such as caviar and diamonds, tend to have large income elasticities
because consumers feel that they can do without these goods altogether if their
incomes are too low.
The Cross-Price Elasticity of Demand The cross-price elasticity of demand cross-price elasticity
measures how the quantity demanded of one good responds to a change in of demand
the price of another good. It is calculated as the percentage change in quantity a measure of how much
demanded of good 1 divided by the percentage change in the price of good 2. the quantity demanded
That is, of one good responds
to a change in the price
of another good, com-
Percentage change in quantity demanded of good 1
Cross-price elasticity of demand = . puted as the percent-
Percentage change in the price of good 2
age change in quantity
demanded of the first
Whether the cross-price elasticity is a positive or negative number depends on good divided by the
whether the two goods are substitutes or complements. As we discussed in Chap- percentage change in
ter 4, substitutes are goods that are typically used in place of one another, such the price of the second
as hamburgers and hot dogs. An increase in hot dog prices induces people to good
grill hamburgers instead. Because the price of hot dogs and the quantity of ham-
burgers demanded move in the same direction, the cross-price elasticity is posi-
tive. Conversely, complements are goods that are typically used together, such as
computers and software. In this case, the cross-price elasticity is negative, indicat-
ing that an increase in the price of computers reduces the quantity of software
demanded.
Q Q
UICK UIZ Define the price elasticity of demand. • Explain the relationship between
total revenue and the price elasticity of demand.
THE ELASTICITY OF SUPPLY

When we introduced supply in Chapter 4, we noted that producers of a good
offer to sell more of it when the price of the good rises. To turn from qualitative
to quantitative statements about quantity supplied, we once again use the concept
of elasticity.
THE PRICE ELASTICITY OF SUPPLY AND

ITS DETERMINANTS price elasticity
The law of supply states that higher prices raise the quantity supplied. The price of supply
elasticity of supply measures how much the quantity supplied responds to a measure of how much
the quantity supplied
changes in the price. Supply of a good is said to be elastic if the quantity supplied
of a good responds to
responds substantially to changes in the price. Supply is said to be inelastic if the
a change in the price of
quantity supplied responds only slightly to changes in the price. that good, computed as
The price elasticity of supply depends on the flexibility of sellers to change the the percentage change
amount of the good they produce. For example, beachfront land has an inelastic in quantity supplied
supply because it is almost impossible to produce more of it. By contrast, manu- divided by the percent-
factured goods, such as books, cars, and televisions, have elastic supplies because age change in price
firms that produce them can run their factories longer in response to a higher
price.
In most markets, a key determinant of the price elasticity of supply is the time
period being considered. Supply is usually more elastic in the long run than in the
short run. Over short periods of time, firms cannot easily change the size of their
factories to make more or less of a good. Thus, in the short run, the quantity sup-
plied is not very responsive to the price. By contrast, over longer periods, firms
can build new factories or close old ones. In addition, new firms can enter a mar-
ket, and old firms can shut down. Thus, in the long run, the quantity supplied can
respond substantially to price changes.
COMPUTING THE PRICE ELASTICITY OF SUPPLY

Now that we have a general understanding about the price elasticity of supply,
let’s be more precise. Economists compute the price elasticity of supply as the
percentage change in the quantity supplied divided by the percentage change in
the price. That is,
Percentage change in quantity supplied

Price elasticity of supply = .
Percentage change in price
For example, suppose that an increase in the price of milk from $2.85 to $3.15 a
gallon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons
per month. Using the midpoint method, we calculate the percentage change in
price as
Percentage change in price = (3.15 – 2.85) / 3.00 × 100 = 10 percent.
Similarly, we calculate the percentage change in quantity supplied as
Percentage change in quantity supplied = (11,000 – 9,000) / 10,000 × 100 = 20 percent.
In this case, the price elasticity of supply is
20 percent
Price elasticity of supply = = 2.0.
10 percent
In this example, the elasticity of 2 indicates that the quantity supplied changes
proportionately twice as much as the price.
THE VARIETY OF SUPPLY CURVES

Because the price elasticity of supply measures the responsiveness of quantity
supplied to the price, it is reflected in the appearance of the supply curve. Figure 5
shows five cases. In the extreme case of a zero elasticity, as shown in panel (a),
supply is perfectly inelastic, and the supply curve is vertical. In this case, the quan-
tity supplied is the same regardless of the price. As the elasticity rises, the sup-
ply curve gets flatter, which shows that the quantity supplied responds more
to changes in the price. At the opposite extreme, shown in panel (e), supply is
perfectly elastic. This occurs as the price elasticity of supply approaches infinity
and the supply curve becomes horizontal, meaning that very small changes in the
price lead to very large changes in the quantity supplied.
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
F I G U R E 5
The Price Elasticity
of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0 (b) Inelastic Supply: Elasticity Is Less Than 1
Price Price
Supply
Supply
$5 $5
4 4
1. An 1. A 22%
increase increase
in price . . . in price . . .
0 100 Quantity 0 100 110 Quantity
2. . . . leaves the quantity supplied unchanged. 2. . . . leads to a 10% increase in quantity supplied.
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .
0 100 125 Quantity
2. . . . leads to a 22% increase in quantity supplied.
(d) Elastic Supply: Elasticity Is Greater Than 1 (e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price Price
Supply 1. At any price

above $4, quantity
$5 supplied is infinite.
4 $4 Supply
1. A 22%
2. At exactly $4,
increase
producers will
in price . . .
supply any quantity.
0 100 200 Quantity 0 Quantity

3. At a price below $4,
2. . . . leads to a 67% increase in quantity supplied. quantity supplied is zero.
In some markets, the elasticity of supply is not constant but varies over the
supply curve. Figure 6 shows a typical case for an industry in which firms have
factories with a limited capacity for production. For low levels of quantity sup-
plied, the elasticity of supply is high, indicating that firms respond substantially
to changes in the price. In this region, firms have capacity for production that is
not being used, such as plants and equipment idle for all or part of the day. Small
increases in price make it profitable for firms to begin using this idle capacity. As
the quantity supplied rises, firms begin to reach capacity. Once capacity is fully
used, increasing production further requires the construction of new plants. To
induce firms to incur this extra expense, the price must rise substantially, so sup-
ply becomes less elastic.
Figure 6 presents a numerical example of this phenomenon. When the price
rises from $3 to $4 (a 29 percent increase, according to the midpoint method), the
quantity supplied rises from 100 to 200 (a 67 percent increase). Because quantity
supplied changes proportionately more than the price, the supply curve has elas-
ticity greater than 1. By contrast, when the price rises from $12 to $15 (a 22 percent
increase), the quantity supplied rises from 500 to 525 (a 5 percent increase). In this
case, quantity supplied moves proportionately less than the price, so the elasticity
is less than 1.
Q Q
UICK UIZ Define the price elasticity of supply. • Explain why the price elasticity of
supply might be different in the long run and in the short run.
THREE APPLICATIONS OF SUPPLY, DEMAND,

AND ELASTICITY
Can good news for farming be bad news for farmers? Why did OPEC fail to keep
the price of oil high? Does drug interdiction increase or decrease drug-related
crime? At first, these questions might seem to have little in common. Yet all three
6 F I G U R E
Price
$15
How the Price Elasticity of Supply Can Vary Elasticity is small
(less than 1).
Because firms often have a maximum capacity for
12
production, the elasticity of supply may be very high
at low levels of quantity supplied and very low at
high levels of quantity supplied. Here an increase in
price from $3 to $4 increases the quantity supplied
from 100 to 200. Because the 67 percent increase Elasticity is large
in quantity supplied (computed using the midpoint (greater than 1).
method) is larger than the 29 percent increase in
price, the supply curve is elastic in this range. By 4
contrast, when the price rises from $12 to $15, the 3
quantity supplied rises only from 500 to 525. Because
the 5 percent increase in quantity supplied is smaller
than the 22 percent increase in price, the supply
0 100 200 500 525 Quantity
curve is inelastic in this range.
questions are about markets, and all markets are subject to the forces of supply
and demand. Here we apply the versatile tools of supply, demand, and elasticity
to answer these seemingly complex questions.
CAN GOOD NEWS FOR FARMING BE

BAD NEWS FOR FARMERS?
Imagine yourself as a Kansas wheat farmer. Because you earn all your income
from selling wheat, you devote much effort to making your land as productive
as possible. You monitor weather and soil conditions, check your fields for pests
and disease, and study the latest advances in farm technology. You know that the
more wheat you grow, the more you will have to sell after the harvest, and the
higher will be your income and your standard of living.
One day, Kansas State University announces a major discovery. Researchers
in its agronomy department have devised a new hybrid of wheat that raises the
amount farmers can produce from each acre of land by 20 percent. How should
you react to this news? Does this discovery make you better off or worse off than
you were before?
Recall from Chapter 4 that we answer such questions in three steps. First, we
examine whether the supply or demand curve shifts. Second, we consider in
which direction the curve shifts. Third, we use the supply-and-demand diagram
to see how the market equilibrium changes.
In this case, the discovery of the new hybrid affects the supply curve. Because
the hybrid increases the amount of wheat that can be produced on each acre of
land, farmers are now willing to supply more wheat at any given price. In other
words, the supply curve shifts to the right. The demand curve remains the same
because consumers’ desire to buy wheat products at any given price is not affected
by the introduction of a new hybrid. Figure 7 shows an example of such a change.
When the supply curve shifts from S1 to S2, the quantity of wheat sold increases
from 100 to 110, and the price of wheat falls from $3 to $2.
Price of
F I G U R E 7
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . . An Increase in Supply in the Market for Wheat
to a large fall S1 When an advance in farm technology increases the
in price . . . S2
supply of wheat from S1 to S2, the price of wheat
$3 falls. Because the demand for wheat is inelastic,
the increase in the quantity sold from 100 to 110 is
2 proportionately smaller than the decrease in the price
from $3 to $2. As a result, farmers’ total revenue falls
from $300 ($3 × 100) to $220 ($2 × 110).
Demand
0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Does this discovery make farmers better off? As a first cut to answering this
question, consider what happens to the total revenue received by farmers. Farmers’
total revenue is P × Q, the price of the wheat times the quantity sold. The discov-
ery affects farmers in two conflicting ways. The hybrid allows farmers to produce
more wheat (Q rises), but now each bushel of wheat sells for less (P falls).
Whether total revenue rises or falls depends on the elasticity of demand. In
practice, the demand for basic foodstuffs such as wheat is usually inelastic because
these items are relatively inexpensive and have few good substitutes. When the
demand curve is inelastic, as it is in Figure 7, a decrease in price causes total rev-
enue to fall. You can see this in the figure: The price of wheat falls substantially,
whereas the quantity of wheat sold rises only slightly. Total revenue falls from
$300 to $220. Thus, the discovery of the new hybrid lowers the total revenue that
farmers receive from the sale of their crops.
If farmers are made worse off by the discovery of this new hybrid, one might
wonder why they adopt it. The answer goes to the heart of how competitive mar-
kets work. Because each farmer is only a small part of the market for wheat, he or
she takes the price of wheat as given. For any given price of wheat, it is better to
use the new hybrid to produce and sell more wheat. Yet when all farmers do this,
the supply of wheat increases, the price falls, and farmers are worse off.
Although this example may at first seem hypothetical, it helps to explain a
major change in the U.S. economy over the past century. Two hundred years ago,
most Americans lived on farms. Knowledge about farm methods was sufficiently
primitive that most Americans had to be farmers to produce enough food to feed
the nation’s population. Yet over time, advances in farm technology increased
the amount of food that each farmer could produce. This increase in food supply,
together with inelastic food demand, caused farm revenues to fall, which in turn
encouraged people to leave farming.
A few numbers show the magnitude of this historic change. As recently as 1950,
there were 10 million people working on farms in the United States, representing
17 percent of the labor force. Today, fewer than 3 million people work on farms,
or 2 percent of the labor force. This change coincided with tremendous advances
in farm productivity: Despite the 70 percent drop in the number of farmers, U.S.
farms now produce more than twice the output of crops and livestock that they
did in 1950.
REPRINTED WITH PERMISSION OF UNIVERSAL PRESS

CARTOON: DOONESBURY © 1972 G. B. TRUDEAU.
SYNDICATE. ALL RIGHTS RESERVED.

This analysis of the market for farm products also helps to explain a seeming
paradox of public policy: Certain farm programs try to help farmers by induc-
ing them not to plant crops on all of their land. The purpose of these programs
is to reduce the supply of farm products and thereby raise prices. With inelastic
demand for their products, farmers as a group receive greater total revenue if
they supply a smaller crop to the market. No single farmer would choose to leave
his land fallow on his own because each takes the market price as given. But if all
farmers do so together, each of them can be better off.
When analyzing the effects of farm technology or farm policy, it is important to
keep in mind that what is good for farmers is not necessarily good for society as a
whole. Improvement in farm technology can be bad for farmers because it makes
farmers increasingly unnecessary, but it is surely good for consumers who pay
less for food. Similarly, a policy aimed at reducing the supply of farm products
may raise the incomes of farmers, but it does so at the expense of consumers.
WHY DID OPEC FAIL TO K EEP

THE P RICE OF OIL H IGH?
Many of the most disruptive events for the world’s economies over the past sev-
eral decades have originated in the world market for oil. In the 1970s, members
of the Organization of Petroleum Exporting Countries (OPEC) decided to raise
the world price of oil to increase their incomes. These countries accomplished this
goal by jointly reducing the amount of oil they supplied. From 1973 to 1974, the
price of oil (adjusted for overall inflation) rose more than 50 percent. Then, a few
years later, OPEC did the same thing again. From 1979 to 1981, the price of oil
approximately doubled.
Yet OPEC found it difficult to maintain a high price. From 1982 to 1985, the
price of oil steadily declined about 10 percent per year. Dissatisfaction and disar-
ray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC
members completely broke down, and the price of oil plunged 45 percent. In 1990,
the price of oil (adjusted for overall inflation) was back to where it began in 1970,
and it stayed at that low level throughout most of the 1990s. (In the first decade
of the 21st century, the price of oil rose again, but the main driving force was not
OPEC supply restrictions but, rather, increased world demand, in part from a
large and rapidly growing Chinese economy.)
This OPEC episode of the 1970s and 1980s shows how supply and demand
can behave differently in the short run and in the long run. In the short run, both
the supply and demand for oil are relatively inelastic. Supply is inelastic because
the quantity of known oil reserves and the capacity for oil extraction cannot be
changed quickly. Demand is inelastic because buying habits do not respond
immediately to changes in price. Thus, as panel (a) of Figure 8 shows, the short-
run supply and demand curves are steep. When the supply of oil shifts from S1 to
S2, the price increase from P1 to P2 is large.
The situation is very different in the long run. Over long periods of time, pro-
ducers of oil outside OPEC respond to high prices by increasing oil exploration
and by building new extraction capacity. Consumers respond with greater con-
servation, for instance by replacing old inefficient cars with newer efficient ones.
Thus, as panel (b) of Figure 8 shows, the long-run supply and demand curves are
more elastic. In the long run, the shift in the supply curve from S1 to S2 causes a
much smaller increase in the price.
8 F I G U R E Types
The
of supply
When the
run, pie
Graphs
supply
chart
of oil falls, the response depends on the time horizon. In the short
and
in demand
panel (a) are relatively
shows inelastic,
how U.S. as income
national in panelis(a). Thus, from
derived whenvarious
the supply
curve shifts
sources. Thefrom S1 to Sin
bar graph 2, the price
panel rises substantially.
(b) compares By contrast,
the average income in infour
the long run,
countries.
A Reduction in Supply supply and demand
The time-series are
graph inrelatively
panel (c) elastic,
shows theas in panel (b). Inofthis
productivity case,
labor the same
in U.S. size
businesses
in the World Market shift
from in the to
1950 supply
2000.curve (S1 to S2) causes a smaller increase in the price.
for Oil
(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
Price of Oil Price of Oil

1. In the short run, when supply 1. In the long run,
and demand are inelastic, when supply and
a shift in supply . . . demand are elastic,
S2 a shift in supply . . .
S1
S2
S1
P2 2. . . . leads
2. . . . leads
to a small P2
to a large
increase P1
increase
P1 in price.
in price.
Demand
Demand
0 Quantity of Oil 0 Quantity of Oil
This analysis shows why OPEC succeeded in maintaining a high price of oil
only in the short run. When OPEC countries agreed to reduce their production
of oil, they shifted the supply curve to the left. Even though each OPEC member
sold less oil, the price rose by so much in the short run that OPEC incomes rose.
By contrast, in the long run, when supply and demand are more elastic, the same
reduction in supply, measured by the horizontal shift in the supply curve, caused
a smaller increase in the price. Thus, OPEC’s coordinated reduction in supply
proved less profitable in the long run. The cartel learned that raising prices is
easier in the short run than in the long run.
DOES DRUG INTERDICTION INCREASE OR

DECREASE DRUG-R ELATED CRIME?
A persistent problem facing our society is the use of illegal drugs, such as heroin,
cocaine, ecstasy, and crack. Drug use has several adverse effects. One is that drug
dependence can ruin the lives of drug users and their families. Another is that
drug addicts often turn to robbery and other violent crimes to obtain the money
needed to support their habit. To discourage the use of illegal drugs, the U.S. gov-
ernment devotes billions of dollars each year to reduce the flow of drugs into the
country. Let’s use the tools of supply and demand to examine this policy of drug
interdiction.
Suppose the government increases the number of federal agents devoted to

the war on drugs. What happens in the market for illegal drugs? As is usual,
we answer this question in three steps. First, we consider whether the supply or
demand curve shifts. Second, we consider the direction of the shift. Third, we see
how the shift affects the equilibrium price and quantity.
Although the purpose of drug interdiction is to reduce drug use, its direct
impact is on the sellers of drugs rather than the buyers. When the government
stops some drugs from entering the country and arrests more smugglers, it raises
the cost of selling drugs and, therefore, reduces the quantity of drugs supplied at
any given price. The demand for drugs—the amount buyers want at any given
price—is not changed. As panel (a) of Figure 9 shows, interdiction shifts the sup-
ply curve to the left from S1 to S2 and leaves the demand curve the same. The
equilibrium price of drugs rises from P1 to P2, and the equilibrium quantity falls
from Q1 to Q2. The fall in the equilibrium quantity shows that drug interdiction
does reduce drug use.
But what about the amount of drug-related crime? To answer this question,
consider the total amount that drug users pay for the drugs they buy. Because few
drug addicts are likely to break their destructive habits in response to a higher
price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure.
Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the
demand for drugs is inelastic, then the total amount paid by drug users rises, even
F I G U R E 9
as the amount of drug use falls. By contrast, drug education reduces the demand for
drugs from D1 to D2, as in panel (b). Because both price and quantity fall, the amount
Policies to Reduce
paid by drug users falls.
the Use of Illegal
Drugs
(a) Drug Interdiction (b) Drug Education
Price of Price of
Drugs Drugs 1. Drug education reduces
1. Drug interdiction reduces
the supply of drugs . . . the demand for drugs . . .
S2 Supply
S1
P2 P1
P1 P2
2. . . . which 2. . . . which
raises the reduces the
price . . . price . . . D1
Demand
D2
0 Q2 Q1 Quantity of Drugs 0 Q2 Q1 Quantity of Drugs
3. . . . and reduces 3. . . . and reduces

the quantity sold. the quantity sold.
If demand is inelastic, then an increase in price raises total revenue in the drug
market. That is, because drug interdiction raises the price of drugs proportionately
more than it reduces drug use, it raises the total amount of money that drug users
pay for drugs. Addicts who already had to steal to support their habits would
have an even greater need for quick cash. Thus, drug interdiction could increase
drug-related crime.
Because of this adverse effect of drug interdiction, some analysts argue for
alternative approaches to the drug problem. Rather than trying to reduce the sup-
ply of drugs, policymakers might try to reduce the demand by pursuing a policy
of drug education. Successful drug education has the effects shown in panel (b) of
Figure 9. The demand curve shifts to the left from D1 to D2. As a result, the equi-
librium quantity falls from Q1 to Q2, and the equilibrium price falls from P1 to P2.
Total revenue, which is price times quantity, also falls. Thus, in contrast to drug
interdiction, drug education can reduce both drug use and drug-related crime.
Advocates of drug interdiction might argue that the long-run effects of this
policy are different from the short-run effects because the elasticity of demand
depends on the time horizon. The demand for drugs is probably inelastic over
short periods because higher prices do not substantially affect drug use by estab-
lished addicts. But demand may be more elastic over longer periods because
higher prices would discourage experimentation with drugs among the young
and, over time, lead to fewer drug addicts. In this case, drug interdiction would
increase drug-related crime in the short run while decreasing it in the long run.
Q Q
UICK UIZ How might a drought that destroys half of all farm crops be good for farm-
ers? If such a drought is good for farmers, why don’t farmers destroy their own crops in
the absence of a drought?
CONCLUSION
According to an old quip, even a parrot can become an economist simply by learn-
ing to say “supply and demand.” These last two chapters should have convinced
you that there is much truth in this statement. The tools of supply and demand
allow you to analyze many of the most important events and policies that shape
the economy. You are now well on your way to becoming an economist (or at least
a well-educated parrot).
SUMMARY
• The price elasticity of demand measures how • The price elasticity of demand is calculated as
much the quantity demanded responds to the percentage change in quantity demanded
changes in the price. Demand tends to be more divided by the percentage change in price. If
elastic if close substitutes are available, if the quantity demanded moves proportionately less
good is a luxury rather than a necessity, if the than the price, then the elasticity is less than 1,
market is narrowly defined, or if buyers have and demand is said to be inelastic. If quantity
substantial time to react to a price change. demanded moves proportionately more than the
price, then the elasticity is greater than 1, and time horizon under consideration. In most mar-
demand is said to be elastic. kets, supply is more elastic in the long run than
in the short run.
• Total revenue, the total amount paid for a good,
equals the price of the good times the quantity • The price elasticity of supply is calculated as the
sold. For inelastic demand curves, total revenue percentage change in quantity supplied divided
rises as price rises. For elastic demand curves, by the percentage change in price. If quantity
total revenue falls as price rises. supplied moves proportionately less than the
price, then the elasticity is less than 1, and sup-
• The income elasticity of demand measures ply is said to be inelastic. If quantity supplied
how much the quantity demanded responds to
moves proportionately more than the price, then
changes in consumers’ income. The cross-price
the elasticity is greater than 1, and supply is said
elasticity of demand measures how much the
to be elastic.
quantity demanded of one good responds to
changes in the price of another good. • The tools of supply and demand can be applied
in many different kinds of markets. This chapter
• The price elasticity of supply measures how uses them to analyze the market for wheat, the
much the quantity supplied responds to changes
market for oil, and the market for illegal drugs.
in the price. This elasticity often depends on the
KEY CONCEPTS
elasticity, p. 90 income elasticity of price elasticity of supply, p. 99

price elasticity of demand, p. 90 demand, p. 97
total revenue, p. 93 cross-price elasticity of
demand, p. 99
1. Define the price elasticity of demand and the 6. If demand is elastic, how will an increase in
income elasticity of demand. price change total revenue? Explain.
2. List and explain the four determinants of the 7. What do we call a good whose income elasticity
price elasticity of demand discussed in the is less than 0?
chapter. 8. How is the price elasticity of supply calculated?
3. What is the main advantage of using the mid- Explain what it measures.
point method for calculating elasticity? 9. What is the price elasticity of supply of Picasso
4. If the elasticity is greater than 1, is demand paintings?
elastic or inelastic? If the elasticity equals 0, is 10. Is the price elasticity of supply usually larger in
demand perfectly elastic or perfectly inelastic? the short run or in the long run? Why?
5. On a supply-and-demand diagram, show 11. How did elasticity help explain why drug inter-
equilibrium price, equilibrium quantity, and the diction could reduce the supply of drugs, yet
total revenue received by producers. possibly increase drug-related crime?
1. For each of the following pairs of goods, which Billy: Demand increased, but supply was
good would you expect to have more elastic totally inelastic.
demand and why? Marian: Supply increased, but so did demand.
a. required textbooks or mystery novels Valerie: Supply decreased, but demand was
b. Beethoven recordings or classical music totally inelastic.
recordings in general
6. Suppose that your demand schedule for com-
c. subway rides during the next 6 months or
pact discs is as follows:
subway rides during the next 5 years
d. root beer or water Quantity Demanded Quantity Demanded
2. Suppose that business travelers and vacationers Price (income = $10,000) (income = $12,000)
have the following demand for airline tickets
from New York to Boston: $ 8 40 CDs 50 CDs
10 32 45
Quantity Demanded Quantity Demanded 12 24 30
Price (business travelers) (vacationers) 14 16 20
16 8 12
$150 2,100 tickets 1,000 tickets
200 2,000 800 a. Use the midpoint method to calculate your
250 1,900 600 price elasticity of demand as the price of
300 1,800 400 compact discs increases from $8 to $10 if
(i) your income is $10,000 and (ii) your
a. As the price of tickets rises from $200 to $250,
income is $12,000.
what is the price elasticity of demand for
b. Calculate your income elasticity of demand
(i) business travelers and (ii) vacationers?
as your income increases from $10,000 to
(Use the midpoint method in your
$12,000 if (i) the price is $12 and (ii) the price
calculations.)
is $16.
b. Why might vacationers have a different elas-
7. You have the following information about good
ticity from business travelers?
X and good Y:
3. Suppose the price elasticity of demand for heat-
• Income elasticity of demand for good
ing oil is 0.2 in the short run and 0.7 in the long
X: –3
run.
• Cross-price elasticity of demand for good
a. If the price of heating oil rises from $1.80 to
X with respect to the price of good Y: 2
$2.20 per gallon, what happens to the quan-
Would an increase in income and a decrease in
tity of heating oil demanded in the short run?
the price of good Y unambiguously decrease the
In the long run? (Use the midpoint method in
demand for good X? Why or why not?
your calculations.)
8. Maria has decided always to spend one-third of
b. Why might this elasticity depend on the time
her income on clothing.
horizon?
a. What is her income elasticity of clothing
4. A price change causes the quantity demanded
demand?
of a good to decrease by 30 percent, while the
b. What is her price elasticity of clothing
total revenue of that good increases by 15 per-
demand?
cent. Is the demand curve elastic or inelastic?
c. If Maria’s tastes change and she decides
Explain.
to spend only one-fourth of her income
5. The equilibrium price of coffee mugs rose
on clothing, how does her demand curve
sharply last month, but the equilibrium quan-
change? What is her income elasticity and
tity was the same as ever. Three people tried to
price elasticity now?
explain the situation. Which explanations could
be right? Explain your logic.
9. The New York Times reported (Feb. 17, 1996, a. What happens to the equilibrium price and
p. 25) that subway ridership declined after a fare quantity in each market?
increase: “There were nearly four million fewer b. Which product experiences a larger change
riders in December 1995, the first full month in price?
after the price of a token increased 25 cents to c. Which product experiences a larger change in
$1.50, than in the previous December, a 4.3 per- quantity?
cent decline.” d. What happens to total consumer spending on
a. Use these data to estimate the price elasticity each product?
of demand for subway rides. 14. Beachfront resorts have an inelastic supply, and
b. According to your estimate, what happens automobiles have an elastic supply. Suppose
to the Transit Authority’s revenue when the that a rise in population doubles the demand for
fare rises? both products (that is, the quantity demanded at
c. Why might your estimate of the elasticity be each price is twice what it was).
unreliable? a. What happens to the equilibrium price and
10. Two drivers—Tom and Jerry—each drive up to quantity in each market?
a gas station. Before looking at the price, each b. Which product experiences a larger change in
places an order. Tom says, “I’d like 10 gallons price?
of gas.” Jerry says, “I’d like $10 worth of gas.” c. Which product experiences a larger change in
What is each driver’s price elasticity of demand? quantity?
11. Consider public policy aimed at smoking. d. What happens to total consumer spending on
a. Studies indicate that the price elasticity each product?
of demand for cigarettes is about 0.4. If a 15. Several years ago, flooding along the Missouri
pack of cigarettes currently costs $2 and the and the Mississippi rivers destroyed thousands
government wants to reduce smoking by of acres of wheat.
20 percent, by how much should it increase a. Farmers whose crops were destroyed by the
the price? floods were much worse off, but farmers
b. If the government permanently increases whose crops were not destroyed benefited
the price of cigarettes, will the policy have a from the floods. Why?
larger effect on smoking 1 year from now or b. What information would you need about the
5 years from now? market for wheat to assess whether farmers
c. Studies also find that teenagers have a higher as a group were hurt or helped by the floods?
price elasticity than do adults. Why might 16. Explain why the following might be true: A
this be true? drought around the world raises the total rev-
12. You are the curator of a museum. The museum enue that farmers receive from the sale of grain,
is running short of funds, so you decide to but a drought only in Kansas reduces the total
increase revenue. Should you increase or revenue that Kansas farmers receive.
decrease the price of admission? Explain. 17. Suppose the demand curve for a product is Q =
13. Pharmaceutical drugs have an inelastic demand, 60/P. Compute the quantity demanded at prices
and computers have an elastic demand. Suppose of $1, $2, $3, $4, $5, and $6. Graph the demand
that technological advance doubles the supply curve. Use the midpoint method to calculate the
of both products (that is, the quantity supplied price elasticity of demand between $1 and $2
at each price is twice what it was). and between $5 and $6. How does this demand
curve compare to the linear demand curve?
6
CHAPTER
Supply, Demand, and

Government Policies
E conomists have two roles. As scientists, they develop and test theories to
explain the world around them. As policy advisers, they use their theories
to help change the world for the better. The focus of the preceding two
chapters has been scientific. We have seen how supply and demand determine the
price of a good and the quantity of the good sold. We have also seen how various
events shift supply and demand and thereby change the equilibrium price and
quantity.
This chapter offers our first look at policy. Here we analyze various types of
government policy using only the tools of supply and demand. As you will see,
the analysis yields some surprising insights. Policies often have effects that their
architects did not intend or anticipate.
We begin by considering policies that directly control prices. For example,
rent-control laws dictate a maximum rent that landlords may charge tenants.
Minimum-wage laws dictate the lowest wage that firms may pay workers. Price
controls are usually enacted when policymakers believe that the market price of a
good or service is unfair to buyers or sellers. Yet, as we will see, these policies can
generate inequities of their own.
113
After discussing price controls, we consider the impact of taxes. Policymakers

use taxes to raise revenue for public purposes and to influence market outcomes.
Although the prevalence of taxes in our economy is obvious, their effects are not.
For example, when the government levies a tax on the amount that firms pay their
workers, do the firms or the workers bear the burden of the tax? The answer is not
at all clear—until we apply the powerful tools of supply and demand.
CONTROLS ON PRICES
To see how price controls affect market outcomes, let’s look once again at the
market for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive
market free of government regulation, the price of ice cream adjusts to balance
supply and demand: At the equilibrium price, the quantity of ice cream that buy-
ers want to buy exactly equals the quantity that sellers want to sell. To be concrete,
suppose the equilibrium price is $3 per cone.
Not everyone may be happy with the outcome of this free-market process. Let’s
say the American Association of Ice-Cream Eaters complains that the $3 price is
too high for everyone to enjoy a cone a day (their recommended diet). Meanwhile,
the National Organization of Ice-Cream Makers complains that the $3 price—the
result of “cutthroat competition”—is too low and is depressing the incomes of its
members. Each of these groups lobbies the government to pass laws that alter the
market outcome by directly controlling the price of an ice-cream cone.
Because buyers of any good always want a lower price while sellers want a
higher price, the interests of the two groups conflict. If the Ice-Cream Eaters are
successful in their lobbying, the government imposes a legal maximum on the
price at which ice cream can be sold. Because the price is not allowed to rise above
price ceiling this level, the legislated maximum is called a price ceiling. By contrast, if the Ice-
a legal maximum on the Cream Makers are successful, the government imposes a legal minimum on the
price at which a good price. Because the price cannot fall below this level, the legislated minimum is
can be sold called a price floor. Let us consider the effects of these policies in turn.
price floor
a legal minimum on the HOW PRICE CEILINGS AFFECT M ARKET OUTCOMES
price at which a good
When the government, moved by the complaints and campaign contributions of
can be sold
the Ice-Cream Eaters, imposes a price ceiling on the market for ice cream, two
outcomes are possible. In panel (a) of Figure 1, the government imposes a price
ceiling of $4 per cone. In this case, because the price that balances supply and
demand ($3) is below the ceiling, the price ceiling is not binding. Market forces
naturally move the economy to the equilibrium, and the price ceiling has no effect
on the price or the quantity sold.
Panel (b) of Figure 1 shows the other, more interesting, possibility. In this case,
the government imposes a price ceiling of $2 per cone. Because the equilibrium
price of $3 is above the price ceiling, the ceiling is a binding constraint on the mar-
ket. The forces of supply and demand tend to move the price toward the equi-
librium price, but when the market price hits the ceiling, it can, by law, rise no
further. Thus, the market price equals the price ceiling. At this price, the quantity
of ice cream demanded (125 cones in the figure) exceeds the quantity supplied
(75 cones). There is a shortage of ice cream: 50 people who want to buy ice cream
at the going price are unable to do so.
CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES 115
In panel (a), the government imposes a price ceiling of $4. Because the price ceiling
is above the equilibrium price of $3, the price ceiling has no effect, and the market
F I G U R E 1
can reach the equilibrium of supply and demand. In this equilibrium, quantity sup-
plied and quantity demanded both equal 100 cones. In panel (b), the government
A Market with a
imposes a price ceiling of $2. Because the price ceiling is below the equilibrium price
Price Ceiling
of $3, the market price equals $2. At this price, 125 cones are demanded and only
75 are supplied, so there is a shortage of 50 cones.
(a) A Price Ceiling That Is Not Binding (b) A Price Ceiling That Is Binding
Price of Price of
Ice-Cream Ice-Cream
Cone Cone
Supply Supply
Equilibrium
$4 Price price
ceiling
3 $3
Equilibrium
price 2 Price
Shortage ceiling
Demand Demand
0 100 Quantity of 0 75 125 Quantity of

Equilibrium Ice-Cream Quantity Quantity Ice-Cream
quantity Cones supplied demanded Cones
When a shortage of ice cream develops because of this price ceiling, some
mechanism for rationing ice cream will naturally develop. The mechanism could
be long lines: Buyers who are willing to arrive early and wait in line get a cone, but
those unwilling to wait do not. Alternatively, sellers could ration ice cream accord-
ing to their own personal biases, selling it only to friends, relatives, or members
of their own racial or ethnic group. Notice that even though the price ceiling was
motivated by a desire to help buyers of ice cream, not all buyers benefit from the
policy. Some buyers do get to pay a lower price, although they may have to wait
in line to do so, but other buyers cannot get any ice cream at all.
This example in the market for ice cream shows a general result: When the gov-
ernment imposes a binding price ceiling on a competitive market, a shortage of the good
arises, and sellers must ration the scarce goods among the large number of potential buy-
ers. The rationing mechanisms that develop under price ceilings are rarely desir-
able. Long lines are inefficient because they waste buyers’ time. Discrimination
according to seller bias is both inefficient (because the good does not necessarily
go to the buyer who values it most highly) and potentially unfair. By contrast, the
rationing mechanism in a free, competitive market is both efficient and imper-
sonal. When the market for ice cream reaches its equilibrium, anyone who wants
to pay the market price can get a cone. Free markets ration goods with prices.
LINES AT THE GAS PUMP
As we discussed in the preceding chapter, in 1973 the Organization of Petroleum

Exporting Countries (OPEC) raised the price of crude oil in world oil markets.
Because crude oil is the major input used to make gasoline, the higher oil prices
reduced the supply of gasoline. Long lines at gas stations became commonplace,
and motorists often had to wait for hours to buy only a few gallons of gas.
What was responsible for the long gas lines? Most people blame OPEC. Surely,
if OPEC had not raised the price of crude oil, the shortage of gasoline would not
have occurred. Yet economists blame U.S. government regulations that limited
the price oil companies could charge for gasoline.
Figure 2 shows what happened. As shown in panel (a), before OPEC raised the
price of crude oil, the equilibrium price of gasoline, P1, was below the price ceil-
ing. The price regulation, therefore, had no effect. When the price of crude oil rose,
however, the situation changed. The increase in the price of crude oil raised the
cost of producing gasoline, and this reduced the supply of gasoline. As panel (b)
shows, the supply curve shifted to the left from S1 to S2. In an unregulated market,
this shift in supply would have raised the equilibrium price of gasoline from P1
to P2, and no shortage would have resulted. Instead, the price ceiling prevented
the price from rising to the equilibrium level. At the price ceiling, producers were
willing to sell QS, and consumers were willing to buy QD. Thus, the shift in supply
caused a severe shortage at the regulated price.
2 F I G U R E Panel (a)ofshows
Types
the
Graphs
The equilibrium
the gasoline market when the price ceiling is not binding because
pie chart in price,
panel P(a)
1, is below
shows theU.S.
how ceiling. Panelincome
national (b) shows the gasoline
is derived market
from various
after an increase
sources. in the price
The bar graph of crude
in panel oil (an input
(b) compares into making
the average gasoline)
income in fourshifts the
countries.
The Market for Gasoline supply curve to graph
The time-series the leftinfrom
panelS1(c)
toshows
S2. In an
theunregulated
productivitymarket,
of laborthe pricebusinesses
in U.S. would have
with a Price Ceiling risen from P
from 1950 to1 to P2. The price ceiling, however, prevents this from happening. At the
2000.
binding price ceiling, consumers are willing to buy QD, but producers of gasoline are
willing to sell only QS. The difference between quantity demanded and quantity sup-
plied, QD – QS, measures the gasoline shortage.
(a) The Price Ceiling on Gasoline Is Not Binding (b) The Price Ceiling on Gasoline Is Binding
Price of Price of S2
Gasoline Gasoline 2. . . . but when
supply falls . . .
Supply, S1 S1
1. Initially, P2
the price
ceiling
is not
binding . . . Price ceiling Price ceiling
P1 P1 3. . . . the price
4. . . . ceiling becomes
resulting binding . . .
in a
Demand shortage. Demand
0 Q1 Quantity of 0 QS QD Q1 Quantity of
Gasoline Gasoline
Eventually, the laws regulating the price of gasoline were repealed. Lawmakers
came to understand that they were partly responsible for the many hours Ameri-
cans lost waiting in line to buy gasoline. Today, when the price of crude oil changes,
the price of gasoline can adjust to bring supply and demand into equilibrium. ●
RENT CONTROL IN THE SHORT RUN

AND THE LONG RUN
One common example of a price ceiling is rent control. In many cities, the local
government places a ceiling on rents that landlords may charge their tenants. The
goal of this policy is to help the poor by making housing more affordable. Econo-
mists often criticize rent control, arguing that it is a highly inefficient way to help
the poor raise their standard of living. One economist called rent control “the best
way to destroy a city, other than bombing.”
The adverse effects of rent control are less apparent to the general population
because these effects occur over many years. In the short run, landlords have a
fixed number of apartments to rent, and they cannot adjust this number quickly
as market conditions change. Moreover, the number of people searching for hous-
ing in a city may not be highly responsive to rents in the short run because people
take time to adjust their housing arrangements. Therefore, the short-run supply
and demand for housing are relatively inelastic.
Panel (a) of Figure 3 shows the short-run effects of rent control on the hous-
ing market. As with any binding price ceiling, rent control causes a shortage. Yet
Panel (a) shows the short-run effects of rent control: Because the supply and demand
for apartments are relatively inelastic, the price ceiling imposed by a rent-control
F I G U R E 3
law causes only a small shortage of housing. Panel (b) shows the long-run effects of
rent control: Because the supply and demand for apartments are more elastic, rent
Rent Control in the
control causes a large shortage.
Short Run and in the
Long Run
(a) Rent Control in the Short Run (b) Rent Control in the Long Run
(supply and demand are inelastic) (supply and demand are elastic)
Rental Rental
Price of Price of
Apartment Supply Apartment
Supply
Controlled rent Controlled rent
Shortage Demand
Shortage
Demand
0 Quantity of 0 Quantity of
Apartments Apartments
because supply and demand are inelastic in the short run, the initial shortage
caused by rent control is small. The primary effect in the short run is to reduce
rents.
The long-run story is very different because the buyers and sellers of rental
housing respond more to market conditions as time passes. On the supply side,
landlords respond to low rents by not building new apartments and by failing to
maintain existing ones. On the demand side, low rents encourage people to find
their own apartments (rather than living with their parents or sharing apartments
with roommates) and induce more people to move into a city. Therefore, both
supply and demand are more elastic in the long run.
Panel (b) of Figure 3 illustrates the housing market in the long run. When rent
control depresses rents below the equilibrium level, the quantity of apartments
supplied falls substantially, and the quantity of apartments demanded rises sub-
stantially. The result is a large shortage of housing.
In cities with rent control, landlords use various mechanisms to ration housing.
Some landlords keep long waiting lists. Others give a preference to tenants with-
out children. Still others discriminate on the basis of race. Sometimes apartments
are allocated to those willing to offer under-the-table payments to building super-
intendents. In essence, these bribes bring the total price of an apartment (includ-
ing the bribe) closer to the equilibrium price.
To understand fully the effects of rent control, we have to remember one of the
Ten Principles of Economics from Chapter 1: People respond to incentives. In free
markets, landlords try to keep their buildings clean and safe because desirable
apartments command higher prices. By contrast, when rent control creates short-
ages and waiting lists, landlords lose their incentive to respond to tenants’ con-
cerns. Why should a landlord spend money to maintain and improve the property
when people are waiting to get in as it is? In the end, tenants get lower rents, but
they also get lower-quality housing.
Policymakers often react to the effects of rent control by imposing additional
regulations. For example, there are laws that make racial discrimination in hous-
ing illegal and require landlords to provide minimally adequate living conditions.
These laws, however, are difficult and costly to enforce. By contrast, when rent
control is eliminated and a market for housing is regulated by the forces of com-
petition, such laws are less necessary. In a free market, the price of housing adjusts
to eliminate the shortages that give rise to undesirable landlord behavior. ●
HOW PRICE FLOORS AFFECT M ARKET OUTCOMES

To examine the effects of another kind of government price control, let’s return
to the market for ice cream. Imagine now that the government is persuaded by
the pleas of the National Organization of Ice-Cream Makers. In this case, the
government might institute a price floor. Price floors, like price ceilings, are an
attempt by the government to maintain prices at other than equilibrium levels.
Whereas a price ceiling places a legal maximum on prices, a price floor places a
legal minimum.
When the government imposes a price floor on the ice-cream market, two out-
comes are possible. If the government imposes a price floor of $2 per cone when
the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 4. In this
case, because the equilibrium price is above the floor, the price floor is not bind-
ing. Market forces naturally move the economy to the equilibrium, and the price
floor has no effect.
In panel (a), the government imposes a price floor of $2. Because this is below the
equilibrium price of $3, the price floor has no effect. The market price adjusts to
F I G U R E 4
balance supply and demand. At the equilibrium, quantity supplied and quantity
demanded both equal 100 cones. In panel (b), the government imposes a price floor
A Market with
of $4, which is above the equilibrium price of $3. Therefore, the market price equals
a Price Floor
$4. Because 120 cones are supplied at this price and only 80 are demanded, there is
a surplus of 40 cones.
(a) A Price Floor That Is Not Binding (b) A Price Floor That Is Binding
Price of Price of
Ice-Cream Ice-Cream
Cone Supply Cone Supply
Surplus
Equilibrium
price $4
Price
floor
$3 3
Price
floor
2 Equilibrium
price
Demand Demand
0 100 Quantity of 0 80 120 Quantity of

Equilibrium Ice-Cream Quantity Quantity Ice-Cream
quantity Cones demanded supplied Cones
Panel (b) of Figure 4 shows what happens when the government imposes a
price floor of $4 per cone. In this case, because the equilibrium price of $3 is below
the floor, the price floor is a binding constraint on the market. The forces of sup-
ply and demand tend to move the price toward the equilibrium price, but when
the market price hits the floor, it can fall no further. The market price equals the
price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds
the quantity demanded (80 cones). Some people who want to sell ice cream at the
going price are unable to. Thus, a binding price floor causes a surplus.
Just as the shortages resulting from price ceilings can lead to undesirable ration-
ing mechanisms, so can the surpluses resulting from price floors. In the case of a
price floor, some sellers are unable to sell all they want at the market price. The
sellers who appeal to the personal biases of the buyers, perhaps due to racial or
familial ties, are better able to sell their goods than those who do not. By contrast,
in a free market, the price serves as the rationing mechanism, and sellers can sell
all they want at the equilibrium price.
THE MINIMUM WAGE
An important example of a price floor is the minimum wage. Minimum-wage

laws dictate the lowest price for labor that any employer may pay. The U.S. Con-
gress first instituted a minimum wage with the Fair Labor Standards Act of 1938
to ensure workers a minimally adequate standard of living. In 2007, the minimum
wage according to federal law was $5.15 per hour, and it was scheduled to increase
to $7.25 by 2010. (Some states mandate minimum wages above the federal level.)
Most European nations have minimum-wage laws as well; some, such as France
and the United Kingdom, have significantly higher minimums than the United
States.
To examine the effects of a minimum wage, we must consider the market for
labor. Panel (a) of Figure 5 shows the labor market, which, like all markets, is sub-
ject to the forces of supply and demand. Workers determine the supply of labor,
and firms determine the demand. If the government doesn’t intervene, the wage
normally adjusts to balance labor supply and labor demand.
Panel (b) of Figure 5 shows the labor market with a minimum wage. If the
minimum wage is above the equilibrium level, as it is here, the quantity of labor
supplied exceeds the quantity demanded. The result is unemployment. Thus, the
minimum wage raises the incomes of those workers who have jobs, but it lowers
the incomes of workers who cannot find jobs.
To fully understand the minimum wage, keep in mind that the economy con-
tains not a single labor market but many labor markets for different types of work-
ers. The impact of the minimum wage depends on the skill and experience of the
worker. Workers with high skills and much experience are not affected because
their equilibrium wages are well above the minimum. For these workers, the min-
imum wage is not binding.
The minimum wage has its greatest impact on the market for teenage labor.
The equilibrium wages of teenagers are low because teenagers are among the least
skilled and least experienced members of the labor force. In addition, teenagers
are often willing to accept a lower wage in exchange for on-the-job training. (Some
5 F I G U R E Panel (a)ofshows
Types
and labor
The pie
Graphs
chart
a labor market in which the wage adjusts to balance labor supply
demand. Panel
in panel (b) shows
(a) shows howthe impact
U.S. of aincome
national bindingis minimum wage.
derived from Because
various
the minimum
sources. wage
The bar is a price
graph floor,
in panel (b) it causes a the
compares surplus: Theincome
average quantityinof labor
four supplied
countries.
How the Minimum exceeds the quantity
The time-series graphdemanded.
in panel (c) The
shows result
the is unemployment.
Wage Affects the from 1950 to 2000.
Labor Market
(a) A Free Labor Market (b) A Labor Market with a Binding Minimum Wage
Wage Wage
Labor Labor
supply supply
Labor surplus
(unemployment)
Minimum
wage
Equilibrium
wage
Labor Labor
demand demand
0 Equilibrium Quantity of 0 Quantity Quantity Quantity of
employment Labor demanded supplied Labor
teenagers are willing to work as “interns” for no pay at all. Because internships
pay nothing, however, the minimum wage does not apply to them. If it did, these
jobs might not exist.) As a result, the minimum wage is more often binding for
teenagers than for other members of the labor force.
Many economists have studied how minimum-wage laws affect the teenage
labor market. These researchers compare the changes in the minimum wage over
time with the changes in teenage employment. Although there is some debate
about how much the minimum wage affects employment, the typical study finds
that a 10 percent increase in the minimum wage depresses teenage employ-
ment between 1 and 3 percent. In interpreting this estimate, note that a 10 per-
cent increase in the minimum wage does not raise the average wage of teenagers
by 10 percent. A change in the law does not directly affect those teenagers who
are already paid well above the minimum, and enforcement of minimum-wage
laws is not perfect. Thus, the estimated drop in employment of 1 to 3 percent is
significant.
In addition to altering the quantity of labor demanded, the minimum wage
alters the quantity supplied. Because the minimum wage raises the wage that
teenagers can earn, it increases the number of teenagers who choose to look for
jobs. Studies have found that a higher minimum wage influences which teenag-
ers are employed. When the minimum wage rises, some teenagers who are still
attending school choose to drop out and take jobs. These new dropouts displace
other teenagers who had already dropped out of school and who now become
unemployed.
The minimum wage is a frequent topic of debate. Economists are about evenly
divided on the issue. In a 2006 survey of PhD economists, 47 percent favored
eliminating the minimum wage, while 14 percent would maintain it at its current
level and 38 percent would increase it.
Advocates of the minimum wage view the policy as one way to raise the
income of the working poor. They correctly point out that workers who earn the
minimum wage can afford only a meager standard of living. In 2007, for instance,
when the minimum wage was $5.15 per hour, two adults working 40 hours a
week for every week of the year at minimum-wage jobs had a total annual income
of only $21,424, which was less than half of the median family income. Many
advocates of the minimum wage admit that it has some adverse effects, including
unemployment, but they believe that these effects are small and that, all things
considered, a higher minimum wage makes the poor better off.
Opponents of the minimum wage contend that it is not the best way to combat
poverty. They note that a high minimum wage causes unemployment, encour-
ages teenagers to drop out of school, and prevents some unskilled workers from
getting the on-the-job training they need. Moreover, opponents of the minimum
wage point out that it is a poorly targeted policy. Not all minimum-wage workers
are heads of households trying to help their families escape poverty. In fact, fewer
than a third of minimum-wage earners are in families with incomes below the
poverty line. Many are teenagers from middle-class homes working at part-time
jobs for extra spending money. ●
EVALUATING PRICE CONTROLS

One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity. This principle explains why
economists usually oppose price ceilings and price floors. To economists, prices
President Chavez versus the Market

Venezuela’s president has tried to replace market prices with his own.
Price Caps Ail Venezuelan His plight is becoming more common tale for the growing ranks of Latin American
Economy in Venezuela, with President Hugo Chávez populists pushing for a heavy government
By Peter Millard and Raul Gallegos meddling in the economy to advance his hand in the economy. . . . Mr. Chávez is
populist-leftist agenda as companies selling taking advantage of the country’s massive
CARACAS, VENEZUELA—After 21 years in price-regulated products watch their profits oil-revenue windfall to fund a governing
the milk business, Ismael Cárdenas Gil is disappear. While government controls have philosophy he has dubbed “socialism for the
throwing in the towel. slowed the growth of inflation, Venezuela’s 21st century.” His goal is to increase social
Mr. Cárdenas, who heads Alimentaria rate is still the highest in Latin America. The spending and curb inflation through a mix
Internacional, can no longer make a profit controls also have led to frequent product of price caps, a fixed exchange rate and fixed
selling imported powdered milk under shortages and the emergence of a thriving interest rates.
government-imposed price controls. As a black market. Some farmers and retailers But some Venezuelan businesses hurt by
result, he has cut back his imports to “practi- are skirting the rules or have stopped sell- the price controls are beginning to balk. Last
cally zero.” ing certain goods altogether rather than sell week, corn growers marched outside the
“The controls have been very harsh. The them at a loss. presidential palace, protesting government
numbers don’t work out to import milk and The problems facing Venezuelan busi- controls they say have dried up demand for
sell it here,” Mr. Cárdenas says. nesses and consumers serve as a cautionary their corn. While the farmers are getting a
are not the outcome of some haphazard process. Prices, they contend, are the result
of the millions of business and consumer decisions that lie behind the supply and
demand curves. Prices have the crucial job of balancing supply and demand and,
thereby, coordinating economic activity. When policymakers set prices by legal
decree, they obscure the signals that normally guide the allocation of society’s
resources.
Another one of the Ten Principles of Economics is that governments can some-
times improve market outcomes. Indeed, policymakers are led to control prices
because they view the market’s outcome as unfair. Price controls are often aimed
at helping the poor. For instance, rent-control laws try to make housing affordable
for everyone, and minimum-wage laws try to help people escape poverty.
Yet price controls often hurt those they are trying to help. Rent control may
keep rents low, but it also discourages landlords from maintaining their buildings
and makes housing hard to find. Minimum-wage laws may raise the incomes of
some workers, but they also cause other workers to be unemployed.
Helping those in need can be accomplished in ways other than controlling
prices. For instance, the government can make housing more affordable by paying
a fraction of the rent for poor families. Unlike rent control, such rent subsidies do
not reduce the quantity of housing supplied and, therefore, do not lead to housing
decent price, processors are refusing to buy The predominance of the state, Mr. fee prices by 60%. But Pedro Obediente, a
the corn because they can’t sell it at what Chávez says, aims to protect the poor major- retired university professor living in Cara-
they consider an acceptable markup. The ity from “greedy capitalists” and “specula- cas’s hilly suburbs, says he is still looking for
country’s largest food company, Alimen- tors.” He has threatened to expropriate his favorite brand. “I haven’t found Café El
tos Polar, has warned it may have to halt plants of those who shut down operations, Peñón, which is what I like,” he says, refer-
production of corn flour for such reasons. while government troops have seized stock- ring to one of the country’s largest roasting
In early December, coffee producers chal- piled grain to stop shortages. companies.
lenged the new price ceilings, paralyzing Mr. Cárdenas, the milk importer, has Businesses increasingly are finding ways
deliveries and causing an acute coffee short- responded to the regulations by cutting to get around the price caps, and some
age for weeks. his staff to a dozen employees, from 280 in stores violate the price controls outright. Top
As the world’s fifth-largest oil exporter— 2001. He is using his office space to start a cuts of beef can sell for 30% more than the
the state-run oil company supplies about construction company and is looking to government-set price in Caracas supermar-
15% of U.S. petroleum imports—Venezu- produce agricultural goods not included in kets. Some businesses have turned to selling
ela has amassed a hoard of cash that has the long list of price regulations. “We’re not more-expensive imported meat instead of
allowed it to import goods and sell them at idle,” he says. . . . the regulated local cuts; others refocus their
a loss through the state-run Mercal super- The coffee strike in December has been efforts on producing goods that fall outside
market chain, subsidizing Mr. Chávez’s pric- the most vocal so far. Roasters shut their the regulations. Milk producers, for instance,
ing policies. Enforcement of price controls plants after the government raised the price have boosted their output of unregulated
is being stepped up as Mr. Chávez readies of green coffee that farmers sell to roasters goods, such as yogurts and cheeses.
a December re-election bid. [Author’s note: by 100% while leaving processed-coffee
Chavez was reelected to a new six-year term prices unchanged. After weeks of protests,
that began January 2007.] the government agreed to raise retail cof-
Source: The Wall Street Journal, February 15, 2006.
shortages. Similarly, wage subsidies raise the living standards of the working poor
without discouraging firms from hiring them. An example of a wage subsidy is
the earned income tax credit, a government program that supplements the incomes
of low-wage workers.
Although these alternative policies are often better than price controls, they are
not perfect. Rent and wage subsidies cost the government money and, therefore,
require higher taxes. As we see in the next section, taxation has costs of its own.
QUICK QUIZ Define price ceiling and price floor and give an example of each. Which
leads to a shortage? Which leads to a surplus? Why?
TAXES
All governments—from the federal government in Washington, D.C., to the local
governments in small towns—use taxes to raise revenue for public projects, such
as roads, schools, and national defense. Because taxes are such an important pol-
icy instrument, and because they affect our lives in many ways, we return to the
study of taxes several times throughout this book. In this section, we begin our
study of how taxes affect the economy.
To set the stage for our analysis, imagine that a local government decides to
hold an annual ice-cream celebration—with a parade, fireworks, and speeches by
town officials. To raise revenue to pay for the event, the town decides to place a
$0.50 tax on the sale of ice-cream cones. When the plan is announced, our two lob-
bying groups swing into action. The American Association of Ice-Cream Eaters
claims that consumers of ice cream are having trouble making ends meet, and it
argues that sellers of ice cream should pay the tax. The National Organization of
Ice-Cream Makers claims that its members are struggling to survive in a competi-
tive market, and it argues that buyers of ice cream should pay the tax. The town
mayor, hoping to reach a compromise, suggests that half the tax be paid by the
buyers and half be paid by the sellers.
To analyze these proposals, we need to address a simple but subtle question:
When the government levies a tax on a good, who actually bears the burden of the
tax? The people buying the good? The people selling the good? Or if buyers and
sellers share the tax burden, what determines how the burden is divided? Can the
government simply legislate the division of the burden, as the mayor is suggest-
ing, or is the division determined by more fundamental market forces? The term
tax incidence tax incidence refers to how the burden of a tax is distributed among the various
the manner in which the people who make up the economy. As we will see, some surprising lessons about
burden of a tax is shared tax incidence can be learned by applying the tools of supply and demand.
among participants in a
market
HOW TAXES ON SELLERS AFFECT M ARKET OUTCOMES
We begin by considering a tax levied on sellers of a good. Suppose the local gov-
ernment passes a law requiring sellers of ice-cream cones to send $0.50 to the gov-
ernment for each cone they sell. How does this law affect the buyers and sellers of
ice cream? To answer this question, we can follow the three steps in Chapter 4 for
analyzing supply and demand: (1) We decide whether the law affects the supply
curve or demand curve. (2) We decide which way the curve shifts. (3) We examine
how the shift affects the equilibrium price and quantity.
Step One The immediate impact of the tax is on the sellers of ice cream. Because
the tax is not levied on buyers, the quantity of ice cream demanded at any given
price is the same; thus, the demand curve does not change. By contrast, the tax on
sellers makes the ice-cream business less profitable at any given price, so it shifts
the supply curve.
Step Two Because the tax on sellers raises the cost of producing and selling ice
cream, it reduces the quantity supplied at every price. The supply curve shifts to
the left (or, equivalently, upward).
We can, in this case, be precise about how much the curve shifts. For any mar-
ket price of ice cream, the effective price to sellers—the amount they get to keep
after paying the tax—is $0.50 lower. For example, if the market price of a cone
happened to be $2.00, the effective price received by sellers would be $1.50. What-
ever the market price, sellers will supply a quantity of ice cream as if the price
were $0.50 lower than it is. Put differently, to induce sellers to supply any given
quantity, the market price must now be $0.50 higher to compensate for the effect
of the tax. Thus, as shown in Figure 6, the supply curve shifts upward from S1 to S2
by the exact size of the tax ($0.50).
Price of
F I G U R E 6
Ice-Cream A tax on sellers
Price Cone Equilibrium S2 shifts the supply
buyers A Tax on Sellers
with tax curve upward
pay by the size of
When a tax of $0.50 is levied on
S1
$3.30
the tax ($0.50). sellers, the supply curve shifts
Tax ($0.50)
Price 3.00 up by $0.50 from S1 to S2. The
without 2.80 Equilibrium without tax equilibrium quantity falls from 100
tax to 90 cones. The price that buyers
pay rises from $3.00 to $3.30. The
Price
sellers price that sellers receive (after
receive paying the tax) falls from $3.00
to $2.80. Even though the tax is
Demand, D1 levied on sellers, buyers and sell-
ers share the burden of the tax.
Ice-Cream Cones
Step Three Having determined how the supply curve shifts, we can now com-
pare the initial and the new equilibriums. The figure shows that the equilibrium
price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from
100 to 90 cones. Because sellers sell less and buyers buy less in the new equilib-
rium, the tax reduces the size of the ice-cream market.
Implications We can now return to the question of tax incidence: Who pays the
tax? Although sellers send the entire tax to the government, buyers and sellers
share the burden. Because the market price rises from $3.00 to $3.30 when the tax
is introduced, buyers pay $0.30 more for each ice-cream cone than they did with-
out the tax. Thus, the tax makes buyers worse off. Sellers get a higher price ($3.30)
from buyers than they did previously, but the effective price after paying the tax
falls from $3.00 before the tax to $2.80 with the tax ($3.30 – $0.50 = $2.80). Thus,
the tax also makes sellers worse off.
To sum up, the analysis yields two lessons:
• Taxes discourage market activity. When a good is taxed, the quantity of the
good sold is smaller in the new equilibrium.
• Buyers and sellers share the burden of taxes. In the new equilibrium, buyers
pay more for the good, and sellers receive less.
HOW TAXES ON BUYERS AFFECT M ARKET OUTCOMES

Now consider a tax levied on buyers of a good. Suppose that our local govern-
ment passes a law requiring buyers of ice-cream cones to send $0.50 to the govern-
ment for each ice-cream cone they buy. What are the effects of this law? Again, we
apply our three steps.
Step One The initial impact of the tax is on the demand for ice cream. The sup-
ply curve is not affected because, for any given price of ice cream, sellers have the
same incentive to provide ice cream to the market. By contrast, buyers now have
to pay a tax to the government (as well as the price to the sellers) whenever they
buy ice cream. Thus, the tax shifts the demand curve for ice cream.
Step Two We next determine the direction of the shift. Because the tax on buy-
ers makes buying ice cream less attractive, buyers demand a smaller quantity of
ice cream at every price. As a result, the demand curve shifts to the left (or, equiv-
alently, downward), as shown in Figure 7.
Once again, we can be precise about the magnitude of the shift. Because of the
$0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher than
the market price (whatever the market price happens to be). For example, if the
market price of a cone happened to be $2.00, the effective price to buyers would
be $2.50. Because buyers look at their total cost including the tax, they demand a
quantity of ice cream as if the market price were $0.50 higher than it actually is.
In other words, to induce buyers to demand any given quantity, the market price
must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts
the demand curve downward from D1 to D2 by the exact size of the tax ($0.50).
Step Three Having determined how the demand curve shifts, we can now see
the effect of the tax by comparing the initial equilibrium and the new equilibrium.
You can see in the figure that the equilibrium price of ice cream falls from $3.00 to
$2.80 and the equilibrium quantity falls from 100 to 90 cones. Once again, the tax
on ice cream reduces the size of the ice-cream market. And once again, buyers and
sellers share the burden of the tax. Sellers get a lower price for their product; buy-
ers pay a lower market price to sellers than they did previously, but the effective
price (including the tax buyers have to pay) rises from $3.00 to $3.30.
7 F I G U R E
Price of
Ice-Cream
Price Cone Supply, S1
A Tax on Buyers buyers
When a tax of $0.50 is levied on pay
buyers, the demand curve shifts $3.30 Equilibrium without tax
Tax ($0.50)
down by $0.50 from D1 to D2. Price 3.00
2.80 A tax on buyers
The equilibrium quantity falls without
shifts the demand
from 100 to 90 cones. The price tax
curve downward
that sellers receive falls from by the size of
Price Equilibrium
$3.00 to $2.80. The price that sellers the tax ($0.50).
with tax
buyers pay (including the tax) receive
rises from $3.00 to $3.30. Even
though the tax is levied on buy-
D1
ers, buyers and sellers share the
burden of the tax. D2
Ice-Cream Cones
Implications If you compare Figures 6 and 7, you will notice a surprising con-
clusion: Taxes levied on sellers and taxes levied on buyers are equivalent. In both cases,
the tax places a wedge between the price that buyers pay and the price that sell-
ers receive. The wedge between the buyers’ price and the sellers’ price is the
same, regardless of whether the tax is levied on buyers or sellers. In either case,
the wedge shifts the relative position of the supply and demand curves. In the
new equilibrium, buyers and sellers share the burden of the tax. The only differ-
ence between taxes on sellers and taxes on buyers is who sends the money to the
government.
The equivalence of these two taxes is easy to understand if we imagine that the
government collects the $0.50 ice-cream tax in a bowl on the counter of each ice-
cream store. When the government levies the tax on sellers, the seller is required
to place $0.50 in the bowl after the sale of each cone. When the government levies
the tax on buyers, the buyer is required to place $0.50 in the bowl every time a
cone is bought. Whether the $0.50 goes directly from the buyer’s pocket into the
bowl, or indirectly from the buyer’s pocket into the seller’s hand and then into the
bowl, does not matter. Once the market reaches its new equilibrium, buyers and
sellers share the burden, regardless of how the tax is levied.
CAN CONGRESS DISTRIBUTE THE BURDEN

OF A PAYROLL TAX?
If you have ever received a paycheck, you probably noticed that taxes were
deducted from the amount you earned. One of these taxes is called FICA, an acro-
nym for the Federal Insurance Contributions Act. The federal government uses
the revenue from the FICA tax to pay for Social Security and Medicare, the income
support and healthcare programs for the elderly. FICA is an example of a payroll
tax, which is a tax on the wages that firms pay their workers. In 2008, the total
FICA tax for the typical worker was 15.3 percent of earnings.
Who do you think bears the burden of this payroll tax—firms or workers?
When Congress passed this legislation, it tried to mandate a division of the tax
burden. According to the law, half of the tax is paid by firms, and half is paid by
workers. That is, half of the tax is paid out of firms’ revenues, and half is deducted
from workers’ paychecks. The amount that shows up as a deduction on your pay
stub is the worker contribution.
Our analysis of tax incidence, however, shows that lawmakers cannot so eas-
ily dictate the distribution of a tax burden. To illustrate, we can analyze a payroll
tax as merely a tax on a good, where the good is labor and the price is the wage.
The key feature of the payroll tax is that it places a wedge between the wage that
firms pay and the wage that workers receive. Figure 8 shows the outcome. When
a payroll tax is enacted, the wage received by workers falls, and the wage paid
by firms rises. In the end, workers and firms share the burden of the tax, much as
the legislation requires. Yet this division of the tax burden between workers and
firms has nothing to do with the legislated division: The division of the burden in
Figure 8 is not necessarily fifty-fifty, and the same outcome would prevail if the
law levied the entire tax on workers or if it levied the entire tax on firms.
This example shows that the most basic lesson of tax incidence is often over-
looked in public debate. Lawmakers can decide whether a tax comes from the
buyer’s pocket or from the seller’s, but they cannot legislate the true burden of a
tax. Rather, tax incidence depends on the forces of supply and demand. ●
8 F I G U R E
Wage
A Payroll Tax Labor supply

A payroll tax places a wedge
between the wage that workers
receive and the wage that firms
Wage firms pay
pay. Comparing wages with and
without the tax, you can see Tax wedge
that workers and firms share the Wage without tax
tax burden. This division of the
tax burden between workers Wage workers
and firms does not depend on receive
whether the government levies
the tax on workers, levies the
tax on firms, or divides the tax Labor demand
equally between the two groups.
0 Quantity
of Labor
ELASTICITY AND TAX INCIDENCE

When a good is taxed, buyers and sellers of the good share the burden of the tax.
But how exactly is the tax burden divided? Only rarely will it be shared equally.
To see how the burden is divided, consider the impact of taxation in the two mar-
kets in Figure 9. In both cases, the figure shows the initial demand curve, the
initial supply curve, and a tax that drives a wedge between the amount paid by
buyers and the amount received by sellers. (Not drawn in either panel of the fig-
ure is the new supply or demand curve. Which curve shifts depends on whether
the tax is levied on buyers or sellers. As we have seen, this is irrelevant for the
incidence of the tax.) The difference in the two panels is the relative elasticity of
supply and demand.
Panel (a) of Figure 9 shows a tax in a market with very elastic supply and rela-
tively inelastic demand. That is, sellers are very responsive to changes in the price
of the good (so the supply curve is relatively flat), whereas buyers are not very
responsive (so the demand curve is relatively steep). When a tax is imposed on a
market with these elasticities, the price received by sellers does not fall much, so
sellers bear only a small burden. By contrast, the price paid by buyers rises sub-
stantially, indicating that buyers bear most of the burden of the tax.
Panel (b) of Figure 9 shows a tax in a market with relatively inelastic supply
and very elastic demand. In this case, sellers are not very responsive to changes
in the price (so the supply curve is steeper), whereas buyers are very responsive
(so the demand curve is flatter). The figure shows that when a tax is imposed, the
price paid by buyers does not rise much, but the price received by sellers falls
substantially. Thus, sellers bear most of the burden of the tax.
The two panels of Figure 9 show a general lesson about how the burden of a tax
is divided: A tax burden falls more heavily on the side of the market that is less elastic.
Why is this true? In essence, the elasticity measures the willingness of buyers or
(a) Elastic Supply, Inelastic Demand

F I G U R E 9
Price
1. When supply is more elastic How the Burden of a Tax
than demand . . . Is Divided
Price buyers pay In panel (a), the supply curve is
Supply elastic, and the demand curve is
inelastic. In this case, the price
received by sellers falls only
Tax slightly, while the price paid by
2. . . . the
buyers rises substantially. Thus,
incidence of the
Price without tax tax falls more
buyers bear most of the burden
heavily on of the tax. In panel (b), the supply
Price sellers consumers . . . curve is inelastic, and the demand
receive curve is elastic. In this case, the
price received by sellers falls
3. . . . than substantially, while the price paid
Demand
on producers. by buyers rises only slightly. Thus,
sellers bear most of the burden of
0 Quantity
the tax.
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay Supply
Price without tax 3. . . . than on

consumers.
Tax
2. . . . the Demand
Price sellers incidence of
receive the tax falls
more heavily
on producers . . .
0 Quantity
sellers to leave the market when conditions become unfavorable. A small elastic-
ity of demand means that buyers do not have good alternatives to consuming this
particular good. A small elasticity of supply means that sellers do not have good
alternatives to producing this particular good. When the good is taxed, the side
of the market with fewer good alternatives is less willing to leave the market and
must, therefore, bear more of the burden of the tax.
We can apply this logic to the payroll tax discussed in the previous case study.
Most labor economists believe that the supply of labor is much less elastic than the
demand. This means that workers, rather than firms, bear most of the burden of
the payroll tax. In other words, the distribution of the tax burden is not at all close
to the fifty-fifty split that lawmakers intended.
WHO PAYS THE LUXURY TAX?
In 1990, Congress adopted a new luxury tax on items such as yachts, private air-
planes, furs, jewelry, and expensive cars. The goal of the tax was to raise revenue
from those who could most easily afford to pay. Because only the rich could afford
© TURNER FORTE/THE IMAGE BANK/GETTY IMAGES to buy such extravagances, taxing luxuries seemed a logical way of taxing the
rich.
Yet, when the forces of supply and demand took over, the outcome was quite
different from what Congress intended. Consider, for example, the market for
yachts. The demand for yachts is quite elastic. A millionaire can easily not buy
a yacht; she can use the money to buy a bigger house, take a European vacation,
or leave a larger bequest to her heirs. By contrast, the supply of yachts is rela-
tively inelastic, at least in the short run. Yacht factories are not easily converted to
alternative uses, and workers who build yachts are not eager to change careers in
response to changing market conditions.
Our analysis makes a clear prediction in this case. With elastic demand and
inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax on
“IF THIS BOAT WERE ANY yachts places a burden largely on the firms and workers who build yachts because
MORE EXPENSIVE, WE’D BE they end up getting a significantly lower price for their product. The workers,
PLAYING GOLF.” however, are not wealthy. Thus, the burden of a luxury tax falls more on the mid-
dle class than on the rich.
The mistaken assumptions about the incidence of the luxury tax quickly became
apparent after the tax went into effect. Suppliers of luxuries made their congres-
sional representatives well aware of the economic hardship they experienced, and
Congress repealed most of the luxury tax in 1993. ●
Q Q
UICK UIZ In a supply-and-demand diagram, show how a tax on car buyers of $1,000
per car affects the quantity of cars sold and the price of cars. In another diagram, show
how a tax on car sellers of $1,000 per car affects the quantity of cars sold and the price
of cars. In both of your diagrams, show the change in the price paid by car buyers and
the change in the price received by car sellers.
CONCLUSION
The economy is governed by two kinds of laws: the laws of supply and demand
and the laws enacted by governments. In this chapter, we have begun to see how
these laws interact. Price controls and taxes are common in various markets in
the economy, and their effects are frequently debated in the press and among
policymakers. Even a little bit of economic knowledge can go a long way toward
understanding and evaluating these policies.
In subsequent chapters, we analyze many government policies in greater detail.
We will examine the effects of taxation more fully, and we will consider a broader
range of policies than we considered here. Yet the basic lessons of this chapter will
not change: When analyzing government policies, supply and demand are the
first and most useful tools of analysis.
SUMMARY
• A price ceiling is a legal maximum on the price • A tax on a good places a wedge between the price
of a good or service. An example is rent control. paid by buyers and the price received by sellers.
If the price ceiling is below the equilibrium price, When the market moves to the new equilibrium,
the quantity demanded exceeds the quantity buyers pay more for the good and sellers receive
supplied. Because of the resulting shortage, sell- less for it. In this sense, buyers and sellers share
ers must in some way ration the good or service the tax burden. The incidence of a tax (that is, the
among buyers. division of the tax burden) does not depend on
whether the tax is levied on buyers or sellers.
• A price floor is a legal minimum on the price of
a good or service. An example is the minimum • The incidence of a tax depends on the price elas-
wage. If the price floor is above the equilibrium ticities of supply and demand. Most of the burden
price, the quantity supplied exceeds the quan- falls on the side of the market that is less elastic
tity demanded. Because of the resulting surplus, because that side of the market can respond less
buyers’ demands for the good or service must in easily to the tax by changing the quantity bought
some way be rationed among sellers. or sold.
• When the government levies a tax on a good, the
equilibrium quantity of the good falls. That is, a
tax on a market shrinks the size of the market.
KEY CONCEPTS
price ceiling, p. 114 price floor, p. 114 tax incidence, p. 124
1. Give an example of a price ceiling and an size on sellers of the good. How does this
example of a price floor. change in tax policy affect the price that buyers
2. Which causes a shortage of a good—a price pay sellers for this good, the amount buyers are
ceiling or a price floor? Justify your answer out of pocket including the tax, the amount sell-
with a graph. ers receive net of the tax, and the quantity of the
3. What mechanisms allocate resources when the good sold?
price of a good is not allowed to bring supply 6. How does a tax on a good affect the price paid
and demand into equilibrium? by buyers, the price received by sellers, and the
4. Explain why economists usually oppose con- quantity sold?
trols on prices. 7. What determines how the burden of a tax is
5. Suppose the government removes a tax on divided between buyers and sellers? Why?
buyers of a good and levies a tax of the same
1. Lovers of classical music persuade Congress to 4. Suppose the federal government requires beer
impose a price ceiling of $40 per concert ticket. drinkers to pay a $2 tax on each case of beer
As a result of this policy, do more or fewer purchased. (In fact, both the federal and state
people attend classical music concerts? governments impose beer taxes of some sort.)
2. The government has decided that the free- a. Draw a supply-and-demand diagram of the
market price of cheese is too low. market for beer without the tax. Show the
a. Suppose the government imposes a binding price paid by consumers, the price received
price floor in the cheese market. Draw a by producers, and the quantity of beer sold.
supply-and-demand diagram to show the What is the difference between the price
effect of this policy on the price of cheese and paid by consumers and the price received by
the quantity of cheese sold. Is there a short- producers?
age or surplus of cheese? b. Now draw a supply-and-demand diagram
b. Farmers complain that the price floor has for the beer market with the tax. Show the
reduced their total revenue. Is this possible? price paid by consumers, the price received
Explain. by producers, and the quantity of beer sold.
c. In response to farmers’ complaints, the gov- What is the difference between the price
ernment agrees to purchase all the surplus paid by consumers and the price received
cheese at the price floor. Compared to the by producers? Has the quantity of beer sold
basic price floor, who benefits from this new increased or decreased?
policy? Who loses? 5. A senator wants to raise tax revenue and make
3. A recent study found that the demand and sup- workers better off. A staff member proposes
ply schedules for Frisbees are as follows: raising the payroll tax paid by firms and using
Price per Quantity Quantity
part of the extra revenue to reduce the payroll
Frisbee Demanded Supplied tax paid by workers. Would this accomplish the
senator’s goal? Explain.
$11 1 million Frisbees 15 million Frisbees 6. If the government places a $500 tax on luxury
10 2 12 cars, will the price paid by consumers rise by
9 4 9 more than $500, less than $500, or exactly $500?
8 6 6 Explain.
7 8 3 7. Congress and the president decide that the
6 10 1 United States should reduce air pollution by
a. What are the equilibrium price and quantity reducing its use of gasoline. They impose a $0.50
of Frisbees? tax for each gallon of gasoline sold.
b. Frisbee manufacturers persuade the gov- a. Should they impose this tax on producers or
ernment that Frisbee production improves consumers? Explain carefully using a supply-
scientists’ understanding of aerodynamics and-demand diagram.
and thus is important for national security. b. If the demand for gasoline were more elastic,
A concerned Congress votes to impose a would this tax be more effective or less
price floor $2 above the equilibrium price. effective in reducing the quantity of gasoline
What is the new market price? How many consumed? Explain with both words and a
Frisbees are sold? diagram.
c. Irate college students march on Washing- c. Are consumers of gasoline helped or hurt by
ton and demand a reduction in the price of this tax? Why?
Frisbees. An even more concerned Congress d. Are workers in the oil industry helped or
votes to repeal the price floor and impose a hurt by this tax? Why?
price ceiling $1 below the former price floor. 8. A case study in this chapter discusses the fed-
What is the new market price? How many eral minimum-wage law.
Frisbees are sold?
a. Suppose the minimum wage is above the program for tobacco farmers, which raises the
equilibrium wage in the market for unskilled price of tobacco above the equilibrium price.
labor. Using a supply-and-demand diagram a. How do these two programs affect cigarette
of the market for unskilled labor, show the consumption? Use a graph of the cigarette
market wage, the number of workers who are market in your answer.
employed, and the number of workers who b. What is the combined effect of these two
are unemployed. Also show the total wage programs on the price of cigarettes?
payments to unskilled workers. c. Cigarettes are also heavily taxed. What effect
b. Now suppose the secretary of labor proposes does this tax have on cigarette consumption?
an increase in the minimum wage. What 12. At Fenway Park, home of the Boston Red Sox,
effect would this increase have on employ- seating is limited to 34,000. Hence, the number
ment? Does the change in employment of tickets issued is fixed at that figure. (Assume
depend on the elasticity of demand, the elas- that all seats are equally desirable and are sold
ticity of supply, both elasticities, or neither? at the same price.) Seeing a golden opportunity
c. What effect would this increase in the mini- to raise revenue, the City of Boston levies a per
mum wage have on unemployment? Does ticket tax of $5 to be paid by the ticket buyer.
the change in unemployment depend on the Boston sports fans, a famously civic-minded lot,
elasticity of demand, the elasticity of supply, dutifully send in the $5 per ticket. Draw a well-
both elasticities, or neither? labeled graph showing the impact of the tax.
d. If the demand for unskilled labor were On whom does the tax burden fall—the team’s
inelastic, would the proposed increase in the owners, the fans, or both? Why?
minimum wage raise or lower total wage 13. A subsidy is the opposite of a tax. With a $0.50
payments to unskilled workers? Would your tax on the buyers of ice-cream cones, the gov-
answer change if the demand for unskilled ernment collects $0.50 for each cone purchased;
labor were elastic? with a $0.50 subsidy for the buyers of ice-cream
9. Consider the following policies, each of which is cones, the government pays buyers $0.50 for
aimed at reducing violent crime by reducing the each cone purchased.
use of guns. Illustrate each of these proposed a. Show the effect of a $0.50 per cone subsidy
policies in a supply-and-demand diagram of the on the demand curve for ice-cream cones, the
gun market. effective price paid by consumers, the effec-
a. a tax on gun buyers tive price received by sellers, and the quan-
b. a tax on gun sellers tity of cones sold.
c. a price floor on guns b. Do consumers gain or lose from this policy?
d. a tax on ammunition Do producers gain or lose? Does the govern-
10. In 2007, Rod Blagojevich, the governor of Illi- ment gain or lose?
nois, proposed a 3 percent payroll tax to finance 14. In the spring of 2008, Senators John McCain
some state health programs. The proposed and Hillary Clinton (who were then running for
legislation provided that the payroll tax “shall President) proposed a temporary elimination of
not be withheld from wages paid to employees the federal gasoline tax, effective only during
or otherwise be collected from employees or the summer of 2008, in order to help consumers
reduce the compensation paid to employees.” deal with high gasoline prices.
What do you think was the intent of this lan- a. During the summer, when gasoline demand
guage? Would the bill in fact have accomplished is high because of vacation driving, gasoline
this objective? refiners are operating near full capacity.
11. The U.S. government administers two programs What does this fact suggest about the price
that affect the market for cigarettes. Media elasticity of supply?
campaigns and labeling requirements are aimed b. In light of your answer to (a), who do you
at making the public aware of the dangers of predict would benefit from the temporary
cigarette smoking. At the same time, the Depart- gas tax holiday?
ment of Agriculture maintains a price-support
PART III
Markets and Welfare
7
CHAPTER
Consumers, Producers, and

the Efficiency of Markets
W hen consumers go to grocery stores to buy their turkeys for Thanks-

giving dinner, they may be disappointed that the price of turkey is
as high as it is. At the same time, when farmers bring to market the
turkeys they have raised, they wish the price of turkey were even higher. These
views are not surprising: Buyers always want to pay less, and sellers always want
to be paid more. But is there a “right price” for turkey from the standpoint of
society as a whole?
In previous chapters, we saw how, in market economies, the forces of supply
and demand determine the prices of goods and services and the quantities sold.
So far, however, we have described the way markets allocate scarce resources
without directly addressing the question of whether these market allocations are
desirable. In other words, our analysis has been positive (what is) rather than nor-
mative (what should be). We know that the price of turkey adjusts to ensure that
the quantity of turkey supplied equals the quantity of turkey demanded. But at welfare economics
this equilibrium, is the quantity of turkey produced and consumed too small, too the study of how the
large, or just right? allocation of resources
In this chapter, we take up the topic of welfare economics, the study of how affects economic
the allocation of resources affects economic well-being. We begin by examining well-being
137
138 PART III MARKETS AND WELFARE
the benefits that buyers and sellers receive from taking part in a market. We then
examine how society can make these benefits as large as possible. This analysis
leads to a profound conclusion: The equilibrium of supply and demand in a mar-
ket maximizes the total benefits received by buyers and sellers.
As you may recall from Chapter 1, one of the Ten Principles of Economics is that
markets are usually a good way to organize economic activity. The study of wel-
fare economics explains this principle more fully. It also answers our question
about the right price of turkey: The price that balances the supply and demand for
turkey is, in a particular sense, the best one because it maximizes the total welfare
of turkey consumers and turkey producers. No consumer or producer of turkeys
aims to achieve this goal, but their joint action directed by market prices moves
them toward a welfare-maximizing outcome, as if led by an invisible hand.
CONSUMER SURPLUS
We begin our study of welfare economics by looking at the benefits buyers receive
from participating in a market.
WILLINGNESS TO PAY
Imagine that you own a mint-condition recording of Elvis Presley’s first album.
Because you are not an Elvis Presley fan, you decide to sell it. One way to do so is
to hold an auction.
Four Elvis fans show up for your auction: John, Paul, George, and Ringo. Each
of them would like to own the album, but there is a limit to the amount that each
is willing to pay for it. Table 1 shows the maximum price that each of the four
willingness to pay possible buyers would pay. Each buyer’s maximum is called his willingness to
the maximum amount pay, and it measures how much that buyer values the good. Each buyer would be
that a buyer will pay for eager to buy the album at a price less than his willingness to pay, and he would
a good refuse to buy the album at a price greater than his willingness to pay. At a price
equal to his willingness to pay, the buyer would be indifferent about buying the
good: If the price is exactly the same as the value he places on the album, he would
be equally happy buying it or keeping his money.
To sell your album, you begin the bidding at a low price, say, $10. Because
all four buyers are willing to pay much more, the price rises quickly. The bid-
ding stops when John bids $80 (or slightly more). At this point, Paul, George, and
Ringo have dropped out of the bidding because they are unwilling to bid any
more than $80. John pays you $80 and gets the album. Note that the album has
gone to the buyer who values the album most highly.
1 T A B L E
Buyer Willingness to Pay
Four Possible Buyers’

John $100
Willingness to Pay
Paul 80
George 70
Ringo 50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 139
What benefit does John receive from buying the Elvis Presley album? In a
sense, John has found a real bargain: He is willing to pay $100 for the album but
pays only $80 for it. We say that John receives consumer surplus of $20. Consumer consumer surplus
surplus is the amount a buyer is willing to pay for a good minus the amount the the amount a buyer is
buyer actually pays for it. willing to pay for a good
Consumer surplus measures the benefit buyers receive from participating in minus the amount the
a market. In this example, John receives a $20 benefit from participating in the buyer actually pays for it
auction because he pays only $80 for a good he values at $100. Paul, George, and
Ringo get no consumer surplus from participating in the auction because they left
without the album and without paying anything.
Now consider a somewhat different example. Suppose that you had two identi-
cal Elvis Presley albums to sell. Again, you auction them off to the four possible
buyers. To keep things simple, we assume that both albums are to be sold for the
same price and that no buyer is interested in buying more than one album. There-
fore, the price rises until two buyers are left.
In this case, the bidding stops when John and Paul bid $70 (or slightly higher).
At this price, John and Paul are each happy to buy an album, and George and
Ringo are not willing to bid any higher. John and Paul each receive consumer sur-
plus equal to his willingness to pay minus the price. John’s consumer surplus is
$30, and Paul’s is $10. John’s consumer surplus is higher now than in the previous
example because he gets the same album but pays less for it. The total consumer
surplus in the market is $40.
USING THE DEMAND CURVE TO M EASURE

CONSUMER SURPLUS
Consumer surplus is closely related to the demand curve for a product. To see
how they are related, let’s continue our example and consider the demand curve
for this rare Elvis Presley album.
We begin by using the willingness to pay of the four possible buyers to find the
demand schedule for the album. The table in Figure 1 shows the demand sched-
ule that corresponds to Table 1. If the price is above $100, the quantity demanded
in the market is 0 because no buyer is willing to pay that much. If the price is
between $80 and $100, the quantity demanded is 1 because only John is willing to
pay such a high price. If the price is between $70 and $80, the quantity demanded
is 2 because both John and Paul are willing to pay the price. We can continue this
analysis for other prices as well. In this way, the demand schedule is derived from
the willingness to pay of the four possible buyers.
The graph in Figure 1 shows the demand curve that corresponds to this demand
schedule. Note the relationship between the height of the demand curve and the
buyers’ willingness to pay. At any quantity, the price given by the demand curve
shows the willingness to pay of the marginal buyer, the buyer who would leave the
market first if the price were any higher. At a quantity of 4 albums, for instance,
the demand curve has a height of $50, the price that Ringo (the marginal buyer)
is willing to pay for an album. At a quantity of 3 albums, the demand curve has
a height of $70, the price that George (who is now the marginal buyer) is willing
to pay.
Because the demand curve reflects buyers’ willingness to pay, we can also
use it to measure consumer surplus. Figure 2 uses the demand curve to compute
consumer surplus in our two examples. In panel (a), the price is $80 (or slightly
1 F I G U R E Types
The
of shows
The table Graphs
the demand schedule for the buyers in Table 1. The graph shows
the corresponding demand
pie chart in panel curve.
(a) shows howNote
U.S.that the height
national incomeof isthe demand
derived curve
from reflects
various
buyers’ willingness
sources. to pay.
The bar graph in panel (b) compares the average income in four countries.
The Demand Schedule The time-series graph in panel (c) shows the productivity of labor in U.S. businesses
and the Demand Curve from 1950 to 2000.
Quantity Price of
Price Buyers Demanded Album
$100 John’s willingness to pay

More than $100 None 0
$80 to $100 John 1
80 Paul’s willingness to pay
$70 to $80 John, Paul 2
$50 to $70 John, Paul, 3 70 George’s willingness to pay
George
$50 or less John, Paul, 4
50 Ringo’s willingness to pay
George, Ringo
Demand
0 1 2 3 4 Quantity of
Albums
above), and the quantity demanded is 1. Note that the area above the price and
below the demand curve equals $20. This amount is exactly the consumer surplus
we computed earlier when only 1 album is sold.
Panel (b) of Figure 2 shows consumer surplus when the price is $70 (or slightly
above). In this case, the area above the price and below the demand curve equals
the total area of the two rectangles: John’s consumer surplus at this price is $30
and Paul’s is $10. This area equals a total of $40. Once again, this amount is the
consumer surplus we computed earlier.
The lesson from this example holds for all demand curves: The area below the
demand curve and above the price measures the consumer surplus in a market. This is
true because the height of the demand curve measures the value buyers place on
the good, as measured by their willingness to pay for it. The difference between
this willingness to pay and the market price is each buyer’s consumer surplus.
Thus, the total area below the demand curve and above the price is the sum of the
consumer surplus of all buyers in the market for a good or service.
HOW A L OWER PRICE R AISES CONSUMER SURPLUS

Because buyers always want to pay less for the goods they buy, a lower price
makes buyers of a good better off. But how much does buyers’ well-being rise in
response to a lower price? We can use the concept of consumer surplus to answer
this question precisely.
Figure 3 shows a typical demand curve. You may notice that this curve grad-
ually slopes downward instead of taking discrete steps as in the previous two
In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel
(b), the price of the good is $70, and the consumer surplus is $40.
F I G U R E 2
Measuring Consumer
Surplus with the
Demand Curve
(a) Price = $80 (b) Price = $70
Price of Price of
Album Album
$100
$100 John’s consumer surplus ($30)
John’s consumer surplus ($20)
80
80
Paul’s consumer
70 surplus ($10)
70
Total
50 50 consumer
surplus ($40)
Demand
Demand
0 1 2 3 4 Quantity of 0 1 2 3 4 Quantity of
Albums Albums
figures. In a market with many buyers, the resulting steps from each buyer drop-
ping out are so small that they form, in essence, a smooth curve. Although this
curve has a different shape, the ideas we have just developed still apply: Con-
sumer surplus is the area above the price and below the demand curve. In panel
(a), consumer surplus at a price of P1 is the area of triangle ABC.
Now suppose that the price falls from P1 to P2, as shown in panel (b). The con-
sumer surplus now equals area ADF. The increase in consumer surplus attribut-
able to the lower price is the area BCFD.
This increase in consumer surplus is composed of two parts. First, those buy-
ers who were already buying Q1 of the good at the higher price P1 are better off
because they now pay less. The increase in consumer surplus of existing buy-
ers is the reduction in the amount they pay; it equals the area of the rectangle
BCED. Second, some new buyers enter the market because they are willing to
buy the good at the lower price. As a result, the quantity demanded in the market
increases from Q1 to Q2. The consumer surplus these newcomers receive is the
area of the triangle CEF.
WHAT DOES CONSUMER SURPLUS M EASURE?

Our goal in developing the concept of consumer surplus is to make judgments
about the desirability of market outcomes. Now that you have seen what consumer
surplus is, let’s consider whether it is a good measure of economic well-being.
Types
equals
The piethe
(a),Graphs
chart
the price is P1, the quantity demanded is Q1, and consumer surplus
area
in of the (a)
panel triangle
showsABC.how When the price
U.S. national falls from
income P1 to Pfrom
is derived 2, as various
in panel
(b), the quantity
sources. The bar demanded rises(b)
graph in panel from Q1 to Qthe
compares 2, and the consumer
average income insurplus rises to
four countries.
How the Price Affects the
The area of the triangle
time-series graph inADF.
panelThe
(c) increase
shows thein productivity
consumer surplus (area
of labor BCFD)
in U.S. occurs
businesses
Consumer Surplus in part
from because
1950 existing consumers now pay less (area BCED) and in part because
to 2000.
new consumers enter the market at the lower price (area CEF).
(a) Consumer Surplus at Price P1 (b) Consumer Surplus at Price P2

Price Price
A A
Initial
Consumer consumer
surplus surplus
C Consumer surplus
P1 P1
B C B to new consumers
F
P2
Demand D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Quantity 0 Q1 Q2 Quantity
Imagine that you are a policymaker trying to design a good economic system.
Would you care about the amount of consumer surplus? Consumer surplus, the
amount that buyers are willing to pay for a good minus the amount they actu-
ally pay for it, measures the benefit that buyers receive from a good as the buyers
themselves perceive it. Thus, consumer surplus is a good measure of economic well-
being if policymakers want to respect the preferences of buyers.
In some circumstances, policymakers might choose not to care about consumer
surplus because they do not respect the preferences that drive buyer behavior. For
example, drug addicts are willing to pay a high price for heroin. Yet we would
not say that addicts get a large benefit from being able to buy heroin at a low price
(even though addicts might say they do). From the standpoint of society, willing-
ness to pay in this instance is not a good measure of the buyers’ benefit, and con-
sumer surplus is not a good measure of economic well-being, because addicts are
not looking after their own best interests.
In most markets, however, consumer surplus does reflect economic well-being.
Economists normally assume that buyers are rational when they make decisions.
Rational people do the best they can to achieve their objectives, given their oppor-
tunities. Economists also normally assume that people’s preferences should be
respected. In this case, consumers are the best judges of how much benefit they
receive from the goods they buy.
QUICK QUIZ Draw a demand curve for turkey. In your diagram, show a price of turkey
and the consumer surplus at that price. Explain in words what this consumer surplus
measures.
PRODUCER SURPLUS
We now turn to the other side of the market and consider the benefits sellers
receive from participating in a market. As you will see, our analysis of sellers’
welfare is similar to our analysis of buyers’ welfare.
COST AND THE WILLINGNESS TO SELL

Imagine now that you are a homeowner and you want to get your house painted.
You turn to four sellers of painting services: Mary, Frida, Georgia, and Grandma.
Each painter is willing to do the work for you if the price is right. You decide to
take bids from the four painters and auction off the job to the painter who will do
the work for the lowest price.
Each painter is willing to take the job if the price she would receive exceeds
her cost of doing the work. Here the term cost should be interpreted as the paint- cost
ers’ opportunity cost: It includes the painters’ out-of-pocket expenses (for paint, the value of everything
brushes, and so on) as well as the value that the painters place on their own time. a seller must give up to
Table 2 shows each painter’s cost. Because a painter’s cost is the lowest price she produce a good
would accept for her work, cost is a measure of her willingness to sell her services.
Each painter would be eager to sell her services at a price greater than her cost,
and she would refuse to sell her services at a price less than her cost. At a price
exactly equal to her cost, she would be indifferent about selling her services: She
would be equally happy getting the job or using her time and energy for another
purpose.
When you take bids from the painters, the price might start high, but it quickly
falls as the painters compete for the job. Once Grandma has bid $600 (or slightly
less), she is the sole remaining bidder. Grandma is happy to do the job for this
price because her cost is only $500. Mary, Frida, and Georgia are unwilling to do
the job for less than $600. Note that the job goes to the painter who can do the
work at the lowest cost.
What benefit does Grandma receive from getting the job? Because she is willing
to do the work for $500 but gets $600 for doing it, we say that she receives producer
surplus of $100. Producer surplus is the amount a seller is paid minus the cost of producer surplus
production. Producer surplus measures the benefit sellers receive from participat- the amount a seller is
ing in a market. paid for a good minus
Now consider a somewhat different example. Suppose that you have two the seller’s cost of
houses that need painting. Again, you auction off the jobs to the four painters. To providing it
keep things simple, let’s assume that no painter is able to paint both houses and
that you will pay the same amount to paint each house. Therefore, the price falls
until two painters are left.
T A B L E
2
Seller Cost
The Costs of Four

Mary $900
Possible Sellers
Frida 800
Georgia 600
Grandma 500
In this case, the bidding stops when Georgia and Grandma each offer to do the
job for a price of $800 (or slightly less). Georgia and Grandma are willing to do the
work at this price, while Mary and Frida are not willing to bid a lower price. At a
price of $800, Grandma receives producer surplus of $300, and Georgia receives
producer surplus of $200. The total producer surplus in the market is $500.
USING THE SUPPLY CURVE TO M EASURE

PRODUCER SURPLUS
Just as consumer surplus is closely related to the demand curve, producer surplus
is closely related to the supply curve. To see how, let’s continue our example.
We begin by using the costs of the four painters to find the supply schedule
for painting services. The table in Figure 4 shows the supply schedule that corre-
sponds to the costs in Table 2. If the price is below $500, none of the four painters
is willing to do the job, so the quantity supplied is zero. If the price is between
$500 and $600, only Grandma is willing to do the job, so the quantity supplied is 1.
If the price is between $600 and $800, Grandma and Georgia are willing to do the
job, so the quantity supplied is 2, and so on. Thus, the supply schedule is derived
from the costs of the four painters.
The graph in Figure 4 shows the supply curve that corresponds to this supply
schedule. Note that the height of the supply curve is related to the sellers’ costs.
At any quantity, the price given by the supply curve shows the cost of the marginal
seller, the seller who would leave the market first if the price were any lower. At a
quantity of 4 houses, for instance, the supply curve has a height of $900, the cost
that Mary (the marginal seller) incurs to provide her painting services. At a quan-
4 F I G U R E Types
The
of shows
The table Graphs
the supply schedule for the sellers in Table 2. The graph shows
the corresponding supply
pie chart in panel curve.how
(a) shows NoteU.S.
thatnational
the height of the
income supply curve
is derived reflects
from various
sellers’ costs.
sources. The bar graph in panel (b) compares the average income in four countries.
The Supply Schedule The time-series graph in panel (c) shows the productivity of labor in U.S. businesses
and the Supply Curve from 1950 to 2000.
Quantity Price of
Price Sellers Supplied House
Painting Supply
$900 or more Mary, Frida, 4

Georgia, Grandma $900 Mary’s cost
$800 to $900 Frida, Georgia, 3 800 Frida’s cost
Grandma
$600 to $800 Georgia, Grandma 2
600 Georgia’s cost
$500 to $600 Grandma 1
Less than $500 None 0 500 Grandma’s cost
0 1 2 3 4 Quantity of
Houses Painted
tity of 3 houses, the supply curve has a height of $800, the cost that Frida (who is
now the marginal seller) incurs.
Because the supply curve reflects sellers’ costs, we can use it to measure pro-
ducer surplus. Figure 5 uses the supply curve to compute producer surplus in our
two examples. In panel (a), we assume that the price is $600. In this case, the quan-
tity supplied is 1. Note that the area below the price and above the supply curve
equals $100. This amount is exactly the producer surplus we computed earlier for
Grandma.
Panel (b) of Figure 5 shows producer surplus at a price of $800. In this case, the
area below the price and above the supply curve equals the total area of the two
rectangles. This area equals $500, the producer surplus we computed earlier for
Georgia and Grandma when two houses needed painting.
The lesson from this example applies to all supply curves: The area below the
price and above the supply curve measures the producer surplus in a market. The logic
is straightforward: The height of the supply curve measures sellers’ costs, and the
difference between the price and the cost of production is each seller’s producer
surplus. Thus, the total area is the sum of the producer surplus of all sellers.
HOW A HIGHER PRICE R AISES PRODUCER SURPLUS

You will not be surprised to hear that sellers always want to receive a higher price
for the goods they sell. But how much does sellers’ well-being rise in response to
In panel (a), the price of the good is $600, and the producer surplus is $100. In panel
(b), the price of the good is $800, and the producer surplus is $500.
F I G U R E
5
Measuring Producer
Surplus with the
Supply Curve
(a) Price = $600 (b) Price = $800
Price of Price of
House House
Supply Supply
Painting Painting
Total
producer
$900 $900 surplus ($500)
800 800
600 600 Georgia’s producer

500 500 surplus ($200)
Grandma’s producer
surplus ($100)
Grandma’s producer
surplus ($300)
0 1 2 3 4 0 1 2 3 4
Quantity of Quantity of
Houses Painted Houses Painted
a higher price? The concept of producer surplus offers a precise answer to this
question.
Figure 6 shows a typical upward-sloping supply curve that would arise in a
market with many sellers. Although this supply curve differs in shape from the
previous figure, we measure producer surplus in the same way: Producer surplus
is the area below the price and above the supply curve. In panel (a), the price is P1,
and producer surplus is the area of triangle ABC.
Panel (b) shows what happens when the price rises from P1 to P2. Producer sur-
plus now equals area ADF. This increase in producer surplus has two parts. First,
those sellers who were already selling Q1 of the good at the lower price P1 are
better off because they now get more for what they sell. The increase in producer
surplus for existing sellers equals the area of the rectangle BCED. Second, some
new sellers enter the market because they are willing to produce the good at the
higher price, resulting in an increase in the quantity supplied from Q1 to Q2. The
producer surplus of these newcomers is the area of the triangle CEF.
As this analysis shows, we use producer surplus to measure the well-being of
sellers in much the same way as we use consumer surplus to measure the well-
being of buyers. Because these two measures of economic welfare are so similar, it
is natural to use them together. And indeed, that is exactly what we do in the next
section.
QUICK QUIZ Draw a supply curve for turkey. In your diagram, show a price of turkey
and the producer surplus at that price. Explain in words what this producer surplus
measures.
6 F I G U R E Types
In panelof
the
The area
(a),Graphs
pie chart
the price is P1, the quantity supplied is Q1, and producer surplus equals
of theintriangle
panel (a)ABC. When
shows howthe price
U.S. rises income
national from P1istoderived
P2, as infrom
panel (b), the
various
quantity
sources. supplied rises from
The bar graph Q1 to
in panel (b)Qcompares
2, and thethe
producer
averagesurplus
income rises to the
in four area
countries.
How the Price Affects of the
The triangle ADF.
time-series graphThe increase
in panel (c) in producer
shows surplus (area
the productivity ofBCFD)
labor inoccurs in part
U.S. businesses
Producer Surplus because
from 1950existing producers now receive more (area BCED) and in part because new
to 2000.
producers enter the market at the higher price (area CEF).
(a) Producer Surplus at Price P1 (b) Producer Surplus at Price P2
Price Price
Supply Additional producer Supply
surplus to initial
producers
D E
P2 F
B B
P1 P1
C Initial C
Producer Producer surplus
surplus producer to new producers
surplus
A A
0 Q1 Quantity 0 Q1 Q2 Quantity
MARKET EFFICIENCY
Consumer surplus and producer surplus are the basic tools that economists use
to study the welfare of buyers and sellers in a market. These tools can help us
address a fundamental economic question: Is the allocation of resources deter-
mined by free markets desirable?
THE BENEVOLENT SOCIAL PLANNER

To evaluate market outcomes, we introduce into our analysis a new, hypotheti-
cal character called the benevolent social planner. The benevolent social planner
is an all-knowing, all-powerful, well-intentioned dictator. The planner wants to
maximize the economic well-being of everyone in society. What should this plan-
ner do? Should he just leave buyers and sellers at the equilibrium that they reach
naturally on their own? Or can he increase economic well-being by altering the
market outcome in some way?
To answer this question, the planner must first decide how to measure the eco-
nomic well-being of a society. One possible measure is the sum of consumer and
producer surplus, which we call total surplus. Consumer surplus is the benefit that
buyers receive from participating in a market, and producer surplus is the ben-
efit that sellers receive. It is therefore natural to use total surplus as a measure of
society’s economic well-being.
To better understand this measure of economic well-being, recall how we mea-
sure consumer and producer surplus. We define consumer surplus as
Consumer surplus = Value to buyers – Amount paid by buyers.
Similarly, we define producer surplus as
Producer surplus = Amount received by sellers – Cost to sellers.
When we add consumer and producer surplus together, we obtain
Total surplus = (Value to buyers – Amount paid by buyers)

+ (Amount received by sellers – Cost to sellers).
The amount paid by buyers equals the amount received by sellers, so the middle
two terms in this expression cancel each other. As a result, we can write total
surplus as
Total surplus = Value to buyers – Cost to sellers.
Total surplus in a market is the total value to buyers of the goods, as measured by
their willingness to pay, minus the total cost to sellers of providing those goods.
If an allocation of resources maximizes total surplus, we say that the alloca-
efficiency
tion exhibits efficiency. If an allocation is not efficient, then some of the potential the property of a
gains from trade among buyers and sellers are not being realized. For example, resource allocation of
an allocation is inefficient if a good is not being produced by the sellers with low- maximizing the total
est cost. In this case, moving production from a high-cost producer to a low-cost surplus received by all
producer will lower the total cost to sellers and raise total surplus. Similarly, an members of society
allocation is inefficient if a good is not being consumed by the buyers who value
it most highly. In this case, moving consumption of the good from a buyer with a
low valuation to a buyer with a high valuation will raise total surplus.
equality In addition to efficiency, the social planner might also care about equality—
the property of distribut- that is, whether the various buyers and sellers in the market have a similar level
ing economic prosperity of economic well-being. In essence, the gains from trade in a market are like a pie
uniformly among the to be shared among the market participants. The question of efficiency concerns
members of society whether the pie is as big as possible. The question of equality concerns how the
pie is sliced and how the portions are distributed among members of society. In
this chapter, we concentrate on efficiency as the social planner’s goal. Keep in
mind, however, that real policymakers often care about equality as well.
EVALUATING THE M ARKET EQUILIBRIUM

Figure 7 shows consumer and producer surplus when a market reaches the equi-
librium of supply and demand. Recall that consumer surplus equals the area
above the price and under the demand curve and producer surplus equals the
area below the price and above the supply curve. Thus, the total area between
the supply and demand curves up to the point of equilibrium represents the total
surplus in this market.
Is this equilibrium allocation of resources efficient? That is, does it maximize
total surplus? To answer this question, recall that when a market is in equilibrium,
the price determines which buyers and sellers participate in the market. Those
buyers who value the good more than the price (represented by the segment
AE on the demand curve) choose to buy the good; buyers who value it less than
the price (represented by the segment EB) do not. Similarly, those sellers whose
7 F I G U R E
Price A
Consumer and Producer Surplus D

in the Market Equilibrium Supply
Total surplus—the sum of consumer
and producer surplus—is the area
between the supply and demand Consumer
curves up to the equilibrium quantity. surplus
Equilibrium E
price
Producer
surplus
Demand
B
0 Equilibrium Quantity
quantity
costs are less than the price (represented by the segment CE on the supply curve)
choose to produce and sell the good; sellers whose costs are greater than the price
(represented by the segment ED) do not.
These observations lead to two insights about market outcomes:
1. Free markets allocate the supply of goods to the buyers who value them
most highly, as measured by their willingness to pay.
2. Free markets allocate the demand for goods to the sellers who can produce
them at the least cost.
Thus, given the quantity produced and sold in a market equilibrium, the social
planner cannot increase economic well-being by changing the allocation of con-
sumption among buyers or the allocation of production among sellers.
But can the social planner raise total economic well-being by increasing or
decreasing the quantity of the good? The answer is no, as stated in this third
insight about market outcomes:
3. Free markets produce the quantity of goods that maximizes the sum of con-
sumer and producer surplus.
Figure 8 illustrates why this is true. To interpret this figure, keep in mind that the
demand curve reflects the value to buyers and the supply curve reflects the cost
to sellers. At any quantity below the equilibrium level, such as Q1, the value to the
marginal buyer exceeds the cost to the marginal seller. As a result, increasing the
quantity produced and consumed raises total surplus. This continues to be true
until the quantity reaches the equilibrium level. Similarly, at any quantity beyond
the equilibrium level, such as Q2, the value to the marginal buyer is less than the
Price
F I G U R E
8
Supply
The Efficiency of the Equilibrium Quantity

At quantities less than the equilibrium quantity, such
as Q1, the value to buyers exceeds the cost to sell-
ers. At quantities greater than the equilibrium quan-
Value Cost tity, such as Q2, the cost to sellers exceeds the value
to to to buyers. Therefore, the market equilibrium maxi-
buyers sellers mizes the sum of producer and consumer surplus.
Cost Value
to to
sellers buyers Demand
0 Q1 Equilibrium Q2 Quantity
quantity
Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.
cost to the marginal seller. In this case, decreasing the quantity raises total surplus,
and this continues to be true until quantity falls to the equilibrium level. To maxi-
mize total surplus, the social planner would choose the quantity where the supply
and demand curves intersect.
Together, these three insights tell us that the market outcome makes the sum of
consumer and producer surplus as large as it can be. In other words, the equilib-
rium outcome is an efficient allocation of resources. The benevolent social planner
can, therefore, leave the market outcome just as he finds it. This policy of leaving
well enough alone goes by the French expression laissez faire, which literally trans-
lates to “allow them to do.”
Society is lucky that the planner doesn’t need to intervene. Although it has been
a useful exercise imagining what an all-knowing, all-powerful, well-intentioned
dictator would do, let’s face it: Such characters are hard to come by. Dictators are
rarely benevolent, and even if we found someone so virtuous, he would lack cru-
cial information.
Suppose our social planner tried to choose an efficient allocation of resources
on his own, instead of relying on market forces. To do so, he would need to know
the value of a particular good to every potential consumer in the market and the
cost of every potential producer. And he would need this information not only for
this market but for every one of the many thousands of markets in the economy.
The task is practically impossible, which explains why centrally planned econo-
mies never work very well.
The planner’s job becomes easy, however, once he takes on a partner: Adam
Smith’s invisible hand of the marketplace. The invisible hand takes all the infor-
mation about buyers and sellers into account and guides everyone in the market
to the best outcome as judged by the standard of economic efficiency. It is, truly, a
remarkable feat. That is why economists so often advocate free markets as the best
way to organize economic activity.
SHOULD THERE BE A MARKET IN ORGANS?

On April 12, 2001, the front page of the Boston Globe ran the headline “How a
Mother’s Love Helped Save Two Lives.” The newspaper told the story of Susan
Stephens, a woman whose son needed a kidney transplant. When the doctor
learned that the mother’s kidney was not compatible, he proposed a novel solu-
tion: If Stephens donated one of her kidneys to a stranger, her son would move
to the top of the kidney waiting list. The mother accepted the deal, and soon two
patients had the transplant they were waiting for.
The ingenuity of the doctor’s proposal and the nobility of the mother’s act can-
not be doubted. But the story raises some intriguing questions. If the mother could
trade a kidney for a kidney, would the hospital allow her to trade a kidney for an
expensive, experimental cancer treatment that she could not otherwise afford?
Should she be allowed to exchange her kidney for free tuition for her son at the
hospital’s medical school? Should she be able to sell her kidney so she can use the
cash to trade in her old Chevy for a new Lexus?
As a matter of public policy, our society makes it illegal for people to sell their
organs. In essence, in the market for organs, the government has imposed a price
ceiling of zero. The result, as with any binding price ceiling, is a shortage of the
good. The deal in the Stephens case did not fall under this prohibition because no
Ticket Scalping
To allocate resources efficiently, an economy must get goods—
including tickets to the Red Sox—to the consumers who value
them most highly.
Like It or Not, Scalping Is first three games and there was no joy in
a Force in the Free Market Mudville. Scalpers were unloading tickets
By Charles Stein for the fourth game for only slightly more
than face value. Tickets for a possible fifth
Chip Case devotes a class each year to the game were going for even less.
reselling of sports tickets. He has a section But the Red Sox rallied to win game four
in his economics textbook on the same in extra innings. By 2 that morning, said Case,
subject. top tickets for game five were already selling
But for Case, an economics professor at for more than $1,000 online. A bear market
Wellesley College, the sale and scalping of had become a bull market instantaneously.
sports tickets is more than an interesting As defenders of the free market, econo-
theoretical pursuit. Like Margaret Mead, he the sites devoted solely to ticket sales. But mists generally see nothing wrong with
has done plenty of firsthand research in the even in the pre-Internet era, the process scalping. “Consenting adults should be able
jungle, and he has the stories to prove it. worked, albeit more slowly. In 1984, the to make economic trades when they think
In 1984, Case waited in line for two man who bought Case’s tickets was a rich it is to their mutual advantage,” said Greg
nights on Causeway Street to get $11 tickets New Yorker whose son attended a Boston Mankiw, a Harvard economics professor
to one of the classic Celtics-Lakers champi- private school. The man called a friend at who recently stepped down as chairman of
onship series. The night before the climactic the school, who called someone else, who President Bush’s Council of Economic Advis-
seventh game, he was in the shower when eventually called Case. Where there is a will, ers. Mankiw has a section about scalping in
his daughter called out to him: “Dad, there’s there is a way. his own textbook.
a guy on the phone who wants to buy your Trading happens no matter how hard Teams could eliminate scalping alto-
Celtics tickets.” Case said he wasn’t selling. teams try to suppress it. The National Foot- gether by holding their own online auctions
“But Dad,” his daughter added, “he’s willing ball League gives some of its Super Bowl for desirable tickets. Case doesn’t expect
to pay at least $1,000 apiece for them.” tickets to its teams, and prohibits them from that to happen. “People would burn down
Case was selling. An hour later, a limo reselling. Yet many of those same tickets Fenway Park if the Red Sox charged $2,000
arrived at the house to pick up two tickets— wind up back on the secondary market. Last for a ticket,” he said. The team would be
one that belonged to Case and one to a season the league caught Minnesota Vikings accused of price gouging. Yet if you went
friend of his. The driver left behind $3,000. head coach Mike Tice selling his tickets to a online last week, you could find front-row
To Case and other economists, tickets California ticket agency. “I regret it,” Tice told Green Monster seats for the July 15 game
are a textbook case of the free market in Sports Illustrated afterward. Or at least he against the Yankees selling for more than
action. When supply is limited and demand regretted getting caught. $2,000. Go figure.
is not, prices rise and the people willing to Like any good market, the one for tickets Case will be at Fenway Park this Friday.
pay more will eventually get their hands on is remarkably sensitive to information. Case He is taking his father-in-law to the game.
the tickets. “As long as people can commu- has a story about that, too. He was in Ken- He paid a small fortune for the tickets online.
nicate, there will be trades,” said Case. more Square just before game four of last But he isn’t complaining. It’s the free market
In the age of the Internet, buyers and year’s playoff series between the Yankees at work.
PHOTO: © AP IMAGES
sellers can link up online, through eBay or and Red Sox. The Red Sox had dropped the
Source: Boston Globe, May 1, 2005.

cash changed hands.

Many economists believe that there would be large benefits to allowing a free
market in organs. People are born with two kidneys, but they usually need only
one. Meanwhile, a few people suffer from illnesses that leave them without any
working kidney. Despite the obvious gains from trade, the current situation is
dire: The typical patient has to wait several years for a kidney transplant, and
every year thousands of people die because a kidney cannot be found. If those
needing a kidney were allowed to buy one from those who have two, the price
would rise to balance supply and demand. Sellers would be better off with the
extra cash in their pockets. Buyers would be better off with the organ they need to
save their lives. The shortage of kidneys would disappear.
Such a market would lead to an efficient allocation of resources, but critics of
this plan worry about fairness. A market for organs, they argue, would benefit the
rich at the expense of the poor because organs would then be allocated to those
most willing and able to pay. But you can also question the fairness of the current
system. Now, most of us walk around with an extra organ that we don’t really
need, while some of our fellow citizens are dying to get one. Is that fair? ●
Q Q
UICK UIZ Draw the supply and demand for turkey. In the equilibrium, show producer
and consumer surplus. Explain why producing more turkeys would lower total surplus.
CONCLUSION: MARKET EFFICIENCY

AND MARKET FAILURE
This chapter introduced the basic tools of welfare economics—consumer and
producer surplus—and used them to evaluate the efficiency of free markets. We
showed that the forces of supply and demand allocate resources efficiently. That
is, even though each buyer and seller in a market is concerned only about his or
her own welfare, they are together led by an invisible hand to an equilibrium that
maximizes the total benefits to buyers and sellers.
A word of warning is in order. To conclude that markets are efficient, we made
several assumptions about how markets work. When these assumptions do not
hold, our conclusion that the market equilibrium is efficient may no longer be
true. As we close this chapter, let’s consider briefly two of the most important of
these assumptions.
First, our analysis assumed that markets are perfectly competitive. In the world,
however, competition is sometimes far from perfect. In some markets, a single
buyer or seller (or a small group of them) may be able to control market prices.
This ability to influence prices is called market power. Market power can cause
markets to be inefficient because it keeps the price and quantity away from the
equilibrium of supply and demand.
Second, our analysis assumed that the outcome in a market matters only to the
buyers and sellers in that market. Yet, in the world, the decisions of buyers and
sellers sometimes affect people who are not participants in the market at all. Pol-
lution is the classic example. The use of agricultural pesticides, for instance, affects
not only the manufacturers who make them and the farmers who use them, but
many others who breathe air or drink water that has been polluted with these pes-
ticides. Such side effects, called externalities, cause welfare in a market to depend
on more than just the value to the buyers and the cost to the sellers. Because buy-
The Miracle of the Market

An opinion columnist suggests that the next time you sit down for Thanksgiving
dinner, you should give thanks not only for the turkey on your plate but also for
the economic system in which you live.
Giving Thanks for the And yet, isn’t there something won- what is even more mind-boggling is this: No
“Invisible Hand” drous—something almost inexplicable—in one coordinated it.
By Jeff Jacoby the way your Thanksgiving weekend is No turkey czar sat in a command post
made possible by the skill and labor of vast somewhere, consulting a master plan and
Gratitude to the Almighty is the theme of numbers of total strangers? issuing orders. No one rode herd on all those
Thanksgiving, and has been ever since the To bring that turkey to the dining room people, forcing them to cooperate for your
Pilgrims of Plymouth brought in their first table, for example, required the efforts of benefit. And yet they did cooperate. When
good harvest. . . . Today, in millions of homes thousands of people—the poultry farmers you arrived at the supermarket, your turkey
across the nation, God will be thanked for who raised the birds, of course, but also the was there. You didn’t have to do anything
many gifts—for the feast on the table and feed distributors who supplied their nour- but show up to buy it. If that isn’t a miracle,
the company of loved ones, for health and ishment and the truckers who brought it what should we call it?
good fortune in the year gone by, for peace to the farm, not to mention the architect Adam Smith called it “the invisible
at home in a time of war, for the incalculable who designed the hatchery, the workmen hand”—the mysterious power that leads
privilege of having been born—or having who built it, and the technicians who keep innumerable people, each working for
become—American. it running. The bird had to be slaughtered his own gain, to promote ends that ben-
But it probably won’t occur to too many and defeathered and inspected and trans- efit many. Out of the seeming chaos of mil-
of us to give thanks for the fact that the local ported and unloaded and wrapped and lions of uncoordinated private transactions
supermarket had plenty of turkey for sale priced and displayed. The people who emerges the spontaneous order of the mar-
this week. Even the devout aren’t likely to accomplished those tasks were supported ket. Free human beings freely interact, and
thank God for airline schedules that made it in turn by armies of other people accom- the result is an array of goods and services
possible for some of those loved ones to fly plishing other tasks—from refining the more immense than the human mind can
home for Thanksgiving. Or for the arrival of gasoline that fueled the trucks to manu- comprehend. No dictator, no bureaucracy,
“Master and Commander” at the local movie facturing the plastic in which the meat was no supercomputer plans it in advance.
theater in time for the holiday weekend. Or packaged. Indeed, the more an economy is planned,
for that great cranberry-apple pie recipe in The activities of countless far-flung men the more it is plagued by shortages, disloca-
the food section of the newspaper. and women over the course of many months tion, and failure. . . .
Those things we take more or less for had to be intricately choreographed and pre- The social order of freedom, like the
granted. It hardly takes a miracle to explain cisely timed, so that when you showed up to wealth and the progress it makes possible,
why grocery stores stock up on turkey before buy a fresh Thanksgiving turkey, there would is an extraordinary gift from above. On this
Thanksgiving, or why Hollywood releases be one—or more likely, a few dozen— Thanksgiving Day and every day, may we be
big movies in time for big holidays. That’s waiting. The level of coordination that was grateful.
what they do. Where is God in that? required to pull it off is mind-boggling. But
Source: The Boston Globe, November 27, 2003.

ers and sellers do not consider these side effects when deciding how much to
consume and produce, the equilibrium in a market can be inefficient from the
standpoint of society as a whole.
Market power and externalities are examples of a general phenomenon called
market failure—the inability of some unregulated markets to allocate resources
efficiently. When markets fail, public policy can potentially remedy the problem
and increase economic efficiency. Microeconomists devote much effort to study-
ing when market failure is likely and what sorts of policies are best at correcting
market failures. As you continue your study of economics, you will see that the
tools of welfare economics developed here are readily adapted to that endeavor.
Despite the possibility of market failure, the invisible hand of the marketplace
is extraordinarily important. In many markets, the assumptions we made in this
chapter work well, and the conclusion of market efficiency applies directly. More-
over, we can use our analysis of welfare economics and market efficiency to shed
light on the effects of various government policies. In the next two chapters, we
apply the tools we have just developed to study two important policy issues—the
welfare effects of taxation and of international trade.
SUMMARY
• Consumer surplus equals buyers’ willingness to to be efficient. Policymakers are often concerned
pay for a good minus the amount they actually with the efficiency, as well as the equality, of eco-
pay, and it measures the benefit buyers get from nomic outcomes.
participating in a market. Consumer surplus
can be computed by finding the area below the
• The equilibrium of supply and demand maxi-
mizes the sum of consumer and producer sur-
demand curve and above the price.
plus. That is, the invisible hand of the marketplace
• Producer surplus equals the amount sellers leads buyers and sellers to allocate resources
receive for their goods minus their costs of pro- efficiently.
duction, and it measures the benefit sellers get
from participating in a market. Producer surplus
• Markets do not allocate resources efficiently in
the presence of market failures such as market
can be computed by finding the area below the
power or externalities.
price and above the supply curve.
• An allocation of resources that maximizes the
sum of consumer and producer surplus is said
KEY CONCEPTS
welfare economics, p. 137 cost, p. 143 equality, p. 148

willingness to pay, p. 138 producer surplus, p. 143
consumer surplus, p. 139 efficiency, p. 147
1. Explain how buyers’ willingness to pay, con- 4. What is efficiency? Is it the only goal of eco-
sumer surplus, and the demand curve are nomic policymakers?
related. 5. What does the invisible hand do?
2. Explain how sellers’ costs, producer surplus, 6. Name two types of market failure. Explain
and the supply curve are related. why each may cause market outcomes to be
3. In a supply-and-demand diagram, show pro- inefficient.
ducer and consumer surplus in the market
equilibrium.
1. Melissa buys an iPod for $120 and gets con- a. From this information, derive Bert’s demand
sumer surplus of $80. schedule. Graph his demand curve for
a. What is her willingness to pay? bottled water.
b. If she had bought the iPod on sale for $90, b. If the price of a bottle of water is $4, how
what would her consumer surplus have many bottles does Bert buy? How much
been? consumer surplus does Bert get from his
c. If the price of an iPod were $250, what would purchases? Show Bert’s consumer surplus
her consumer surplus have been? in your graph.
2. An early freeze in California sours the lemon c. If the price falls to $2, how does quantity
crop. Explain what happens to consumer sur- demanded change? How does Bert’s con-
plus in the market for lemons. Explain what sumer surplus change? Show these changes
happens to consumer surplus in the market in your graph.
for lemonade. Illustrate your answers with 5. Ernie owns a water pump. Because pumping
diagrams. large amounts of water is harder than pumping
3. Suppose the demand for French bread rises. small amounts, the cost of producing a bottle of
Explain what happens to producer surplus in water rises as he pumps more. Here is the cost
the market for French bread. Explain what hap- he incurs to produce each bottle of water:
pens to producer surplus in the market for flour.
Cost of first bottle $1
Illustrate your answers with diagrams. Cost of second bottle $3
4. It is a hot day, and Bert is thirsty. Here is the Cost of third bottle $5
value he places on a bottle of water: Cost of fourth bottle $7
Value of first bottle $7 a. From this information, derive Ernie’s supply
Value of second bottle $5
schedule. Graph his supply curve for bottled
Value of third bottle $3
water.
Value of fourth bottle $1
b. If the price of a bottle of water is $4, how There are four haircutting businesses with the
many bottles does Ernie produce and sell? following costs:
How much producer surplus does Ernie get
Firm A: $3 Firm B: $6 Firm C: $4 Firm D: $2
from these sales? Show Ernie’s producer
surplus in your graph. Each firm has the capacity to produce only
c. If the price rises to $6, how does quantity one haircut. For efficiency, how many haircuts
supplied change? How does Ernie’s producer should be given? Which businesses should cut
surplus change? Show these changes in your hair and which consumers should have their
graph. hair cut? How large is the maximum possible
6. Consider a market in which Bert from Problem total surplus?
4 is the buyer and Ernie from Problem 5 is the 9. Suppose a technological advance reduces the
seller. cost of making computers.
a. Use Ernie’s supply schedule and Bert’s a. Draw a supply-and-demand diagram to
demand schedule to find the quantity sup- show what happens to price, quantity, con-
plied and quantity demanded at prices of $2, sumer surplus, and producer surplus in the
$4, and $6. Which of these prices brings sup- market for computers.
ply and demand into equilibrium? b. Computers and adding machines are substi-
b. What are consumer surplus, producer sur- tutes. Use a supply-and-demand diagram to
plus, and total surplus in this equilibrium? show what happens to price, quantity, con-
c. If Ernie produced and Bert consumed one sumer surplus, and producer surplus in the
fewer bottle of water, what would happen market for adding machines. Should adding
to total surplus? machine producers be happy or sad about
d. If Ernie produced and Bert consumed one the technological advance in computers?
additional bottle of water, what would hap- c. Computers and software are complements.
pen to total surplus? Draw a supply-and-demand diagram to
7. The cost of producing flat-screen TVs has fallen show what happens to price, quantity, con-
over the past several decades. Let’s consider sumer surplus, and producer surplus in the
some implications of this fact. market for software. Should software pro-
a. Draw a supply-and-demand diagram to ducers be happy or sad about the technologi-
show the effect of falling production costs on cal advance in computers?
the price and quantity of flat-screen TVs sold. d. Does this analysis help explain why software
b. In your diagram, show what happens to con- producer Bill Gates is one of the world’s rich-
sumer surplus and producer surplus. est men?
c. Suppose the supply of flat-screen TVs is 10. Consider how health insurance affects the
very elastic. Who benefits most from falling quantity of healthcare services performed.
production costs—consumers or producers Suppose that the typical medical procedure
of these TVs? has a cost of $100, yet a person with health
8. There are four consumers willing to pay the insurance pays only $20 out of pocket. Her
following amounts for haircuts: insurance company pays the remaining $80.
(The insurance company recoups the $80
Jerry: $7 Oprah: $2 Ellen: $8 Phil: $5
through premiums, but the premium a person Given your analysis, why might the use of
pays does not depend on how many procedures care be viewed as “excessive”?
that person chooses to undertake.) d. What sort of policies might prevent this
a. Draw the demand curve in the market for excessive use?
medical care. (In your diagram, the hori- 11. The supply and demand for broccoli are
zontal axis should represent the number of described by the following equations:
medical procedures.) Show the quantity of
Supply: QS = 4P – 80
procedures demanded if each procedure has
Demand: QD = 100 – 2P.
a price of $100.
Q is in bushels, and P is in dollars per bushel.
b. On your diagram, show the quantity of pro-
cedures demanded if consumers pay only $20 a. Graph the supply curve and the demand
per procedure. If the cost of each procedure curve. What is the equilibrium price and
to society is truly $100, and if individuals quantity?
have health insurance as just described, will b. Calculate consumer surplus, producer sur-
the number of procedures performed maxi- plus, and total surplus at the equilibrium.
mize total surplus? Explain. c. If a dictator who hated broccoli were to ban
c. Economists often blame the health insurance the vegetable, who would bear the larger
system for excessive use of medical care. burden—the buyers or sellers of broccoli?
8
CHAPTER
Application: The Costs

of Taxation
T axes are often a source of heated political debate. In 1776, the anger of
the American colonists over British taxes sparked the American Revolu-
tion. More than two centuries later, the American political parties continue
to debate the proper size and shape of the tax system. Yet no one would deny
that some level of taxation is necessary. As Oliver Wendell Holmes Jr. once said,
“Taxes are what we pay for civilized society.”
Because taxation has such a major impact on the modern economy, we return
to the topic several times throughout this book as we expand the set of tools we
have at our disposal. We began our study of taxes in Chapter 6. There we saw how
a tax on a good affects its price and the quantity sold and how the forces of supply
and demand divide the burden of a tax between buyers and sellers. In this chap-
ter, we extend this analysis and look at how taxes affect welfare, the economic
well-being of participants in a market. In other words, we see how high the price
of civilized society can be.
The effects of taxes on welfare might at first seem obvious. The government
enacts taxes to raise revenue, and that revenue must come out of someone’s pocket.
As we saw in Chapter 6, both buyers and sellers are worse off when a good is
taxed: A tax raises the price buyers pay and lowers the price sellers receive. Yet to
159
understand more fully how taxes affect economic well-being, we must compare
the reduced welfare of buyers and sellers to the amount of revenue the govern-
ment raises. The tools of consumer and producer surplus allow us to make this
comparison. The analysis will show that the cost of taxes to buyers and sellers
exceeds the revenue raised by the government.
THE DEADWEIGHT LOSS OF TAXATION

We begin by recalling one of the surprising lessons from Chapter 6: The outcome
is the same whether a tax on a good is levied on buyers or sellers of the good.
When a tax is levied on buyers, the demand curve shifts downward by the size
of the tax; when it is levied on sellers, the supply curve shifts upward by that
amount. In either case, when the tax is enacted, the price paid by buyers rises, and
the price received by sellers falls. In the end, the elasticities of supply and demand
determine how the tax burden is distributed between producers and consumers.
This distribution is the same regardless of how it is levied.
Figure 1 shows these effects. To simplify our discussion, this figure does not
show a shift in either the supply or demand curve, although one curve must shift.
Which curve shifts depends on whether the tax is levied on sellers (the supply
curve shifts) or buyers (the demand curve shifts). In this chapter, we can keep the
analysis general and simplify the graphs by not bothering to show the shift. The
key result for our purposes here is that the tax places a wedge between the price
buyers pay and the price sellers receive. Because of this tax wedge, the quantity
sold falls below the level that would be sold without a tax. In other words, a tax on
a good causes the size of the market for the good to shrink. These results should
be familiar from Chapter 6.
1 F I G U R E
Price
The Effects of a Tax

A tax on a good places a wedge Supply
between the price that buyers pay
Price buyers
and the price that sellers receive. Size of tax
pay
The quantity of the good sold falls.
Price
without tax
Price sellers
receive
Demand
0 Quantity Quantity Quantity

with tax without tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 161
HOW A TAX AFFECTS M ARKET PARTICIPANTS

Let’s use the tools of welfare economics to measure the gains and losses from a
tax on a good. To do this, we must take into account how the tax affects buyers,
sellers, and the government. The benefit received by buyers in a market is mea-
sured by consumer surplus—the amount buyers are willing to pay for the good
minus the amount they actually pay for it. The benefit received by sellers in a
market is measured by producer surplus—the amount sellers receive for the good
minus their costs. These are precisely the measures of economic welfare we used
in Chapter 7.
What about the third interested party, the government? If T is the size of the tax
and Q is the quantity of the good sold, then the government gets total tax revenue
of T × Q. It can use this tax revenue to provide services, such as roads, police,
and public education, or to help the needy. Therefore, to analyze how taxes affect
economic well-being, we use the government’s tax revenue to measure the public
benefit from the tax. Keep in mind, however, that this benefit actually accrues not
to government but to those on whom the revenue is spent. “YOU KNOW, THE IDEA OF
Figure 2 shows that the government’s tax revenue is represented by the rect- TAXATION WITH REPRESENTA-
angle between the supply and demand curves. The height of this rectangle is the TION DOESN’T APPEAL TO ME
size of the tax, T, and the width of the rectangle is the quantity of the good sold, VERY MUCH, EITHER.”
Q. Because a rectangle’s area is its height times its width, this rectangle’s area is T
× Q, which equals the tax revenue.
Welfare without a Tax To see how a tax affects welfare, we begin by consider-
ing welfare before the government imposes a tax. Figure 3 shows the supply-and-
demand diagram and marks the key areas with the letters A through F.
Without a tax, the equilibrium price and quantity are found at the intersection
of the supply and demand curves. The price is P1, and the quantity sold is Q1.
Price
F I G U R E 2
Tax Revenue
Supply The tax revenue that the govern-
ment collects equals T × Q, the
Price buyers
Size of tax (T ) size of the tax T times the quantity
pay
sold Q. Thus, tax revenue equals
Tax
revenue the area of the rectangle between

(T Q ) the supply and demand curves.
Price sellers
receive
Quantity Demand
sold (Q)
0 Quantity Quantity Quantity

with tax without tax
3 F I G U R E Types
A tax onofa Graphs
Thethe
(by
good reduces consumer surplus (by the area B + C) and producer surplus
chartDin+panel
pie area (a) shows
E). Because thehow U.S.
fall in nationaland
producer income is derived
consumer from
surplus varioustax
exceeds
sources. (area
revenue B +graph
The bar in panel
D), the (b) compares
tax is said to imposethe average income
a deadweight + E).
in fourCcountries.
loss (area
How a Tax Affects The time-series graph in panel (c) shows the productivity of labor in U.S. businesses
Welfare from 1950 to 2000.
Without Tax With Tax Change
Consumer Surplus A+B+C A –(B + C)

Producer Surplus D+E+F F –(D + E)
Tax Revenue None B+D +(B + D)
Total Surplus A+B+C+D+E+F A+B+D+F –(C + E)
The area C + E shows the fall in total surplus and is the deadweight loss of the tax.
Price
A Supply
Price
buyers PB
pay
B
Price C
without tax P1
E
Price D
sellers PS
receive
F
Demand
0 Q2 Q1 Quantity
Because the demand curve reflects buyers’ willingness to pay, consumer surplus
is the area between the demand curve and the price, A + B + C. Similarly, because
the supply curve reflects sellers’ costs, producer surplus is the area between the
supply curve and the price, D + E + F. In this case, because there is no tax, tax
revenue equals zero.
Total surplus, the sum of consumer and producer surplus, equals the area A
+ B + C + D + E + F. In other words, as we saw in Chapter 7, total surplus is the
area between the supply and demand curves up to the equilibrium quantity. The
first column of the table in Figure 3 summarizes these conclusions.
Welfare with a Tax Now consider welfare after the tax is enacted. The price
paid by buyers rises from P1 to PB, so consumer surplus now equals only area A
(the area below the demand curve and above the buyer’s price). The price received
by sellers falls from P1 to PS, so producer surplus now equals only area F (the area
above the supply curve and below the seller’s price). The quantity sold falls from
Q1 to Q2, and the government collects tax revenue equal to the area B + D.
To compute total surplus with the tax, we add consumer surplus, producer
surplus, and tax revenue. Thus, we find that total surplus is area A + B + D + F.
The second column of the table summarizes these results.
Changes in Welfare We can now see the effects of the tax by comparing wel-
fare before and after the tax is enacted. The third column of the table in Figure 3
shows the changes. The tax causes consumer surplus to fall by the area B + C and
producer surplus to fall by the area D + E. Tax revenue rises by the area B + D.
Not surprisingly, the tax makes buyers and sellers worse off and the government
better off.
The change in total welfare includes the change in consumer surplus (which is
negative), the change in producer surplus (which is also negative), and the change
in tax revenue (which is positive). When we add these three pieces together, we
find that total surplus in the market falls by the area C + E. Thus, the losses to
buyers and sellers from a tax exceed the revenue raised by the government. The fall in
total surplus that results when a tax (or some other policy) distorts a market out-
come is called the deadweight loss. The area C + E measures the size of the dead- deadweight loss
weight loss. the fall in total surplus
To understand why taxes impose deadweight losses, recall one of the Ten Prin- that results from a
ciples of Economics in Chapter 1: People respond to incentives. In Chapter 7, we market distortion, such
saw that free markets normally allocate scarce resources efficiently. That is, the as a tax
equilibrium of supply and demand maximizes the total surplus of buyers and sell-
ers in a market. When a tax raises the price to buyers and lowers the price to sell-
ers, however, it gives buyers an incentive to consume less and sellers an incentive
to produce less than they would in the absence of the tax. As buyers and sellers
respond to these incentives, the size of the market shrinks below its optimum (as
shown in the figure by the movement from Q1 to Q2). Thus, because taxes distort
incentives, they cause markets to allocate resources inefficiently.
DEADWEIGHT L OSSES AND THE GAINS FROM TRADE

To gain some intuition for why taxes result in deadweight losses, consider an
example. Imagine that Joe cleans Jane’s house each week for $100. The opportu-
nity cost of Joe’s time is $80, and the value of a clean house to Jane is $120. Thus,
Joe and Jane each receive a $20 benefit from their deal. The total surplus of $40
measures the gains from trade in this particular transaction.
Now suppose that the government levies a $50 tax on the providers of cleaning
services. There is now no price that Jane can pay Joe that will leave both of them
better off after paying the tax. The most Jane would be willing to pay is $120, but
then Joe would be left with only $70 after paying the tax, which is less than his
$80 opportunity cost. Conversely, for Joe to receive his opportunity cost of $80,
Jane would need to pay $130, which is above the $120 value she places on a clean
house. As a result, Jane and Joe cancel their arrangement. Joe goes without the
income, and Jane lives in a dirtier house.
The tax has made Joe and Jane worse off by a total of $40 because they have
each lost $20 of surplus. But note that the government collects no revenue from
Joe and Jane because they decide to cancel their arrangement. The $40 is pure
deadweight loss: It is a loss to buyers and sellers in a market that is not offset by
an increase in government revenue. From this example, we can see the ultimate
source of deadweight losses: Taxes cause deadweight losses because they prevent buy-
ers and sellers from realizing some of the gains from trade.
4 F I G U R E
Price
The Deadweight Loss

When the government imposes a Lost gains Supply
tax on a good, the quantity sold falls from trade
PB
from Q1 to Q2. At every quantity
between Q1 and Q2, the potential Size of tax
gains from trade among buyers and Price
sellers are not realized. These lost without tax
gains from trade create the dead-
weight loss. PS
Cost to
Demand
Value to sellers
buyers
0 Q2 Q1 Quantity
Reduction in quantity due to the tax
The area of the triangle between the supply and demand curves (area C + E in
Figure 3) measures these losses. This conclusion can be seen more easily in Figure
4 by recalling that the demand curve reflects the value of the good to consumers
and that the supply curve reflects the costs of producers. When the tax raises the
price to buyers to PB and lowers the price to sellers to PS, the marginal buyers and
sellers leave the market, so the quantity sold falls from Q1 to Q2. Yet as the figure
shows, the value of the good to these buyers still exceeds the cost to these sellers.
At every quantity between Q1 and Q2, the situation is the same as in our example
with Joe and Jane. The gains from trade—the difference between buyers’ value
and sellers’ cost—are less than the tax. As a result, these trades are not made once
the tax is imposed. The deadweight loss is the surplus lost because the tax dis-
courages these mutually advantageous trades.
QUICK QUIZ Draw the supply and demand curves for cookies. If the government imposes
a tax on cookies, show what happens to the price paid by buyers, the price received by
sellers, and the quantity sold. In your diagram, show the deadweight loss from the tax.
Explain the meaning of the deadweight loss.
THE DETERMINANTS OF THE DEADWEIGHT LOSS

What determines whether the deadweight loss from a tax is large or small? The
answer is the price elasticities of supply and demand, which measure how much
the quantity supplied and quantity demanded respond to changes in the price.
Let’s consider first how the elasticity of supply affects the size of the dead-
weight loss. In the top two panels of Figure 5, the demand curve and the size of
the tax are the same. The only difference in these figures is the elasticity of the
supply curve. In panel (a), the supply curve is relatively inelastic: Quantity sup-
plied responds only slightly to changes in the price. In panel (b), the supply curve
is relatively elastic: Quantity supplied responds substantially to changes in the
price. Notice that the deadweight loss, the area of the triangle between the supply
and demand curves, is larger when the supply curve is more elastic.
Similarly, the bottom two panels of Figure 5 show how the elasticity of demand
affects the size of the deadweight loss. Here the supply curve and the size of the
In panels (a) and (b), the demand curve and the size of the tax are the same, but the
price elasticity of supply is different. Notice that the more elastic the supply curve,
F I G U R E 5
the larger the deadweight loss of the tax. In panels (c) and (d), the supply curve
and the size of the tax are the same, but the price elasticity of demand is different.
Tax Distortions and
Notice that the more elastic the demand curve, the larger the deadweight loss of
Elasticities
the tax.
(a) Inelastic Supply (b) Elastic Supply
Price Price
Supply When supply is relatively

elastic, the deadweight
loss of a tax is large.
When supply is Supply

relatively inelastic, Size
the deadweight loss of
of a tax is small. tax
Size of tax
Demand Demand
0 Quantity 0 Quantity
(c) Inelastic Demand (d) Elastic Demand
Price Price
Supply Supply
Size of tax
When demand is
relatively inelastic, Size
the deadweight loss of
of a tax is small. tax Demand
When demand is relatively

elastic, the deadweight
Demand loss of a tax is large.
0 Quantity 0 Quantity
tax are held constant. In panel (c), the demand curve is relatively inelastic, and the
deadweight loss is small. In panel (d), the demand curve is more elastic, and the
deadweight loss from the tax is larger.
The lesson from this figure is easy to explain. A tax has a deadweight loss
because it induces buyers and sellers to change their behavior. The tax raises the
price paid by buyers, so they consume less. At the same time, the tax lowers the
price received by sellers, so they produce less. Because of these changes in behav-
ior, the size of the market shrinks below the optimum. The elasticities of supply
and demand measure how much sellers and buyers respond to the changes in the
price and, therefore, determine how much the tax distorts the market outcome.
Hence, the greater the elasticities of supply and demand, the greater the deadweight loss
of a tax.
THE DEADWEIGHT LOSS DEBATE
Supply, demand, elasticity, deadweight loss—all this economic theory is enough

to make your head spin. But believe it or not, these ideas go to the heart of a pro-
found political question: How big should the government be? The debate hinges
on these concepts because the larger the deadweight loss of taxation, the larger
the cost of any government program. If taxation entails large deadweight losses,
then these losses are a strong argument for a leaner government that does less
and taxes less. But if taxes impose small deadweight losses, then government pro-
grams are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? Economists disagree on the
answer to this question. To see the nature of this disagreement, consider the most
important tax in the U.S. economy: the tax on labor. The Social Security tax, the
Medicare tax, and, to a large extent, the federal income tax are labor taxes. Many
state governments also tax labor earnings. A labor tax places a wedge between the
wage that firms pay and the wage that workers receive. For a typical worker, if all
forms of labor taxes are added together, the marginal tax rate on labor income—the
tax on the last dollar of earnings—is about 40 percent.
Although the size of the labor tax is easy to determine, the deadweight loss of
this tax is less straightforward. Economists disagree about whether this 40 percent
labor tax has a small or a large deadweight loss. This disagreement arises because
economists hold different views about the elasticity of labor supply.
Economists who argue that labor taxes do not greatly distort market outcomes
believe that labor supply is fairly inelastic. Most people, they claim, would work
full time regardless of the wage. If so, the labor supply curve is almost vertical,
and a tax on labor has a small deadweight loss.
Economists who argue that labor taxes are highly distorting believe that labor
supply is more elastic. While admitting that some groups of workers may supply
their labor inelastically, these economists claim that many other groups respond
more to incentives. Here are some examples:
• Many workers can adjust the number of hours they work—for instance,
by working overtime. The higher the wage, the more hours they choose to
work.
• Some families have second earners—often married women with children—
with some discretion over whether to do unpaid work at home or paid work
in the marketplace. When deciding whether to take a job, these second earn-
ers compare the benefits of being at home (including savings on the cost of
child care) with the wages they could earn.
• Many of the elderly can choose when to retire, and their decisions are partly
based on the wage. Once they are retired, the wage determines their incen-
tive to work part time.
© AP IMAGES
• Some people consider engaging in illegal economic activity, such as the drug
trade, or working at jobs that pay “under the table” to evade taxes. Econo-
mists call this the underground economy. In deciding whether to work in the
underground economy or at a legitimate job, these potential criminals com- “WHAT’S YOUR POSITION
pare what they can earn by breaking the law with the wage they can earn ON THE ELASTICITY OF LABOR
SUPPLY?”
legally.
In each of these cases, the quantity of labor supplied responds to the wage (the
price of labor). Thus, the decisions of these workers are distorted when their labor
earnings are taxed. Labor taxes encourage workers to work fewer hours, second
earners to stay at home, the elderly to retire early, and the unscrupulous to enter
the underground economy.
These two views of labor taxation persist to this day. Indeed, whenever you see
two political candidates debating whether the government should provide more
services or reduce the tax burden, keep in mind that part of the disagreement may
rest on different views about the elasticity of labor supply and the deadweight
loss of taxation. ●
QUICK QUIZ The demand for beer is more elastic than the demand for milk. Would a tax
on beer or a tax on milk have a larger deadweight loss? Why?
DEADWEIGHT LOSS AND TAX REVENUE

AS TAXES VARY
Taxes rarely stay the same for long periods of time. Policymakers in local, state,
and federal governments are always considering raising one tax or lowering
another. Here we consider what happens to the deadweight loss and tax revenue
when the size of a tax changes.
Figure 6 shows the effects of a small, medium, and large tax, holding constant
the market’s supply and demand curves. The deadweight loss—the reduction in
total surplus that results when the tax reduces the size of a market below the opti-
mum—equals the area of the triangle between the supply and demand curves. For
the small tax in panel (a), the area of the deadweight loss triangle is quite small.
But as the size of a tax rises in panels (b) and (c), the deadweight loss grows larger
and larger.
Indeed, the deadweight loss of a tax rises even more rapidly than the size of
the tax. This occurs because the deadweight loss is an area of a triangle, and the
area of a triangle depends on the square of its size. If we double the size of a tax,
for instance, the base and height of the triangle double, so the deadweight loss
rises by a factor of 4. If we triple the size of a tax, the base and height triple, so the
deadweight loss rises by a factor of 9.
The government’s tax revenue is the size of the tax times the amount of the
good sold. As the first three panels of Figure 6 show, tax revenue equals the area
6 F I G U R E Types
is
Thethepie
of Graphs
The deadweight
amount
chart in
loss is the reduction in total surplus due to the tax. Tax revenue
ofpanel
the tax (a)times
showsthe howamount of the good
U.S. national sold.
income In panelfrom
is derived (a), avarious
small
tax has aThe
sources. small deadweight
bar graph in panelloss and raises a small
(b) compares amount income
the average of revenue. In panel
in four (b),
countries.
How Deadweight Loss a
Thesomewhat larger
time-series graphtax in
has a larger
panel deadweight
(c) shows loss and raises
the productivity a larger
of labor in U.S.amount of
businesses
and Tax Revenue Vary revenue.
from 1950Into panel
2000. (c), a very large tax has a very large deadweight loss, but because
with the Size of a Tax it has reduced the size of the market so much, the tax raises only a small amount of
revenue. Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the
size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that
tax revenue first rises and then falls. This relationship is sometimes called the Laffer
curve.
(a) Small Tax (b) Medium Tax (c) Large Tax

Price Price Price
PB
Deadweight Deadweight
Deadweight loss loss
loss Supply PB
Supply Supply
Tax revenue
PB
Tax revenue Tax revenue
PS
Demand PS Demand Demand
PS
0 Q2 Q1 Quantity 0 Q2 Q1 Quantity 0 Q2 Q1 Quantity
(d) From panel (a) to panel (c), (e) From panel (a) to panel (c), tax
deadweight loss continually increases. revenue first increases, then decreases.
Deadweight Tax
Loss Revenue
Laffer curve
0 Tax Size 0 Tax Size
of the rectangle between the supply and demand curves. For the small tax in panel
(a), tax revenue is small. As the size of a tax increases from panel (a) to panel
(b), tax revenue grows. But as the size of the tax increases further from panel (b)
to panel (c), tax revenue falls because the higher tax drastically reduces the size
of the market. For a very large tax, no revenue would be raised because people
would stop buying and selling the good altogether.
The last two panels of Figure 6 summarize these results. In panel (d), we see
that as the size of a tax increases, its deadweight loss quickly gets larger. By con-
Henry George and the Land Tax
Is there an extreme. Because the elasticity of supply is zero, the

ideal tax? Henry George, the 19th-century American landowners bear the entire burden of the tax.
economist and social philosopher, thought so. In his Consider next the question of efficiency. As we
1879 book Progress and Poverty, George argued that just discussed, the deadweight loss of a tax depends
the government should raise all its revenue from a tax on the elasticities of supply and demand. Again, a tax
on land. This “single tax” was, he claimed, both equi- on land is an extreme case. Because supply is per-
table and efficient. George’s ideas won him a large fectly inelastic, a tax on land does not alter the mar-
political following, and in 1886, he lost a close race ket allocation. There is no deadweight loss, and the
for mayor of New York City (although he finished well government’s tax revenue exactly equals the loss of
ahead of Republican candidate Theodore Roosevelt). the landowners.
George’s proposal to tax land was motivated Although taxing land may look attractive in theory,
Henry George
largely by a concern over the distribution of eco- it is not as straightforward in practice as it may appear.
nomic well-being. He deplored the “shocking contrast For a tax on land not to distort economic incentives,
between monstrous wealth and debasing want” and thought land- it must be a tax on raw land. Yet the value of land often comes
owners benefited more than they should from the rapid growth in from improvements, such as clearing trees, providing sewers, and
the overall economy. building roads. Unlike the supply of raw land, the supply of improve-
George’s arguments for the land tax can be understood using ments has an elasticity greater than zero. If a land tax were imposed
the tools of modern economics. Consider first supply and demand on improvements, it would distort incentives. Landowners would
in the market for renting land. As immigration causes the popula- respond by devoting fewer resources to improving their land.
tion to rise and technological progress causes incomes to grow, the Today, few economists support George’s proposal for a single
demand for land rises over time. Yet because the amount of land tax on land. Not only is taxing improvements a potential problem,
is fixed, the supply is perfectly inelastic. Rapid increases in demand but the tax would not raise enough revenue to pay for the much
together with inelastic supply lead to large increases in the equilib- larger government we have today. Yet many of George’s arguments
rium rents on land so that economic growth makes rich landowners remain valid. Here is the assessment of the eminent economist Mil-
even richer. ton Friedman a century after George’s book: “In my opinion, the least
PHOTO: © CORBIS
Now consider the incidence of a tax on land. As we first saw in bad tax is the property tax on the unimproved value of land, the
Chapter 6, the burden of a tax falls more heavily on the side of the Henry George argument of many, many years ago.”
market that is less elastic. A tax on land takes this principle to an
trast, panel (e) shows that tax revenue first rises with the size of the tax, but as the
tax gets larger, the market shrinks so much that tax revenue starts to fall.
THE LAFFER CURVE AND SUPPLY-SIDE ECONOMICS

One day in 1974, economist Arthur Laffer sat in a Washington restaurant with
some prominent journalists and politicians. He took out a napkin and drew a
figure on it to show how tax rates affect tax revenue. It looked much like panel
(e) of our Figure 6. Laffer then suggested that the United States was on the
On the Way to France

Tax rates affect work effort. This proposition helps explain why the U.S.
economy differs from many others around the world.
U.S. Could Follow Europe’s mid-1990s, he says, the French tax rate rose lower taxes than the U.S., work more, and
High-Tax Path to 59 percent from 49 percent, while the U.S. the Italians, with the highest taxes, work the
Americans owe their economic edge over tax rate held at 40 percent. least. The difference in hours was narrower
Europeans in part to the fact that they work The result: The average French person of in the 1970s, when the difference in tax
more, a distinction often attributed to cul- working age logged 24.4 hours a week in the rates was smaller. . . .
tural differences: Americans want to con- early 1970s, one hour more than an Ameri- Europe’s larger lesson for the U.S. may be
sume more, while Europeans enjoy their can. By the mid-1990s, the French work- about the costs of failing to prepare for the
leisure more. week had shrunk to 17.5 hours, while the expense of the baby boomers’ retirement.
As late as the 1970s, though, the French U.S. workweek had grown to 25.9 hours. The White House budget office says Social
actually worked longer than Americans. Security and Medicare have promised to pay
The reason they now work one-third fewer out $18 trillion more than they will receive
Who Works Hardest? in revenue in coming decades. . . . Closing
hours has less to do with a yearning for the In countries with higher taxes, people
good life than it does with escalating taxes, that gap without any cuts in benefits would
tend to work less.
including payroll taxes, in Europe. But Amer- require a 7.1 percentage point increase in
Country Tax Rate Workweek the combined Social Security–Medicare pay-
icans can’t afford to be smug: The U.S. may
be headed in the same high-tax direction if roll tax, now at 15.3 percent. . . .
Italy 64% 16.5 hours “People would just stop working,” says
it doesn’t tackle the looming crisis in Social
France 59 17.5 Arthur Rolnick, research director of the Min-
Security and Medicare. . . .
Germany 59 19.3
Edward Prescott of the University of neapolis Fed. As the work force shrank, taxes
Canada 52 22.8
Minnesota says Europe’s higher taxes made would have to go up even more for the
U.K. 44 22.9
it more expensive to hire labor, even though remaining workers. . . .
U.S. 40 25.9
take-home pay may not have increased Japan 37 27.0 Alan Auerbach of the University of Cali-
much. The bigger the burden, the harder fornia at Berkeley says the system’s generos-
it is for employers to pay a salary that will ity will have to be curtailed and “the sooner,
entice someone to take a job rather than The relationship between work and tax the better.” Otherwise, American work hab-
stay on public assistance, go to school, or rates was similar for the seven major indus- its again could look like those of the French.
retire early. Between the early 1970s and trial countries. The Japanese, with even
Source: The Wall Street Journal, October 20, 2003.
downward-sloping side of this curve. Tax rates were so high, he argued, that
reducing them would actually raise tax revenue.
Most economists were skeptical of Laffer’s suggestion. The idea that a cut in
tax rates could raise tax revenue was correct as a matter of economic theory, but
there was more doubt about whether it would do so in practice. There was little
evidence for Laffer’s view that U.S. tax rates had in fact reached such extreme
levels.
Nonetheless, the Laffer curve (as it became known) captured the imagination of
Ronald Reagan. David Stockman, budget director in the first Reagan administra-
tion, offers the following story:
[Reagan] had once been on the Laffer curve himself. “I came into the Big Money
making pictures during World War II,” he would always say. At that time the
wartime income surtax hit 90 percent. “You could only make four pictures and
then you were in the top bracket,” he would continue. “So we all quit work-
ing after four pictures and went off to the country.” High tax rates caused less
work. Low tax rates caused more. His experience proved it.
When Reagan ran for president in 1980, he made cutting taxes part of his plat-
form. Reagan argued that taxes were so high that they were discouraging hard
work. He argued that lower taxes would give people the proper incentive to work,
which would raise economic well-being and perhaps even tax revenue. Because
the cut in tax rates was intended to encourage people to increase the quantity of
labor they supplied, the views of Laffer and Reagan became known as supply-side
economics.
Economists continue to debate Laffer’s argument. Many believe that subsequent
history refuted Laffer’s conjecture that lower tax rates would raise tax revenue.
Yet because history is open to alternative interpretations, other economists view
the events of the 1980s as more favorable to the supply-siders. To evaluate Laffer’s
hypothesis definitively, we would need to rerun history without the Reagan tax
cuts and see if tax revenues were higher or lower. Unfortunately, that experiment
is impossible.
Some economists take an intermediate position on this issue. They believe that
while an overall cut in tax rates normally reduces revenue, some taxpayers at
some times may find themselves on the wrong side of the Laffer curve. Other
things equal, a tax cut is more likely to raise tax revenue if the cut applies to
those taxpayers facing the highest tax rates. In addition, Laffer’s argument may be
more compelling when considering countries with much higher tax rates than the
United States. In Sweden in the early 1980s, for instance, the typical worker faced
a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial
disincentive to work. Studies have suggested that Sweden would indeed have
raised more tax revenue if it had lowered its tax rates.
Economists disagree about these issues in part because there is no consensus
about the size of the relevant elasticities. The more elastic that supply and demand
are in any market, the more taxes in that market distort behavior, and the more
likely it is that a tax cut will raise tax revenue. There is no debate, however, about
the general lesson: How much revenue the government gains or loses from a tax
change cannot be computed just by looking at tax rates. It also depends on how
the tax change affects people’s behavior. ●
Q Q
UICK UIZ If the government doubles the tax on gasoline, can you be sure that rev-
enue from the gasoline tax will rise? Can you be sure that the deadweight loss from the
gasoline tax will rise? Explain.
CONCLUSION
In this chapter we have used the tools developed in the previous chapter to fur-
ther our understanding of taxes. One of the Ten Principles of Economics discussed in
Chapter 1 is that markets are usually a good way to organize economic activity. In
Chapter 7, we used the concepts of producer and consumer surplus to make this
principle more precise. Here we have seen that when the government imposes
taxes on buyers or sellers of a good, society loses some of the benefits of market
efficiency. Taxes are costly to market participants not only because taxes transfer
resources from those participants to the government but also because they alter
incentives and distort market outcomes.
The analysis presented here and in Chapter 6 should give you a good basis for
understanding the economic impact of taxes, but this is not the end of the story.
Microeconomists study how best to design a tax system, including how to strike
the right balance between equality and efficiency. Macroeconomists study how
taxes influence the overall economy and how policymakers can use the tax sys-
tem to stabilize economic activity and to achieve more rapid economic growth. So
don’t be surprised that, as you continue your study of economics, the subject of
taxation comes up yet again.
SUMMARY
• A tax on a good reduces the welfare of buyers mizes total surplus. Because the elasticities of
and sellers of the good, and the reduction in supply and demand measure how much market
consumer and producer surplus usually exceeds participants respond to market conditions, larger
the revenue raised by the government. The fall elasticities imply larger deadweight losses.
in total surplus—the sum of consumer surplus,
producer surplus, and tax revenue—is called the
• As a tax grows larger, it distorts incentives more,
and its deadweight loss grows larger. Because a
deadweight loss of the tax.
tax reduces the size of the market, however, tax
• Taxes have deadweight losses because they revenue does not continually increase. It first
cause buyers to consume less and sellers to pro- rises with the size of a tax, but if a tax gets large
duce less, and these changes in behavior shrink enough, tax revenue starts to fall.
the size of the market below the level that maxi-
KEY CONCEPT
deadweight loss, p. 163
1. What happens to consumer and producer sur- 3. How do the elasticities of supply and demand
plus when the sale of a good is taxed? How does affect the deadweight loss of a tax? Why do they
the change in consumer and producer surplus have this effect?
compare to the tax revenue? Explain. 4. Why do experts disagree about whether labor
2. Draw a supply-and-demand diagram with a tax taxes have small or large deadweight losses?
on the sale of the good. Show the deadweight 5. What happens to the deadweight loss and tax
loss. Show the tax revenue. revenue when a tax is increased?
1. The market for pizza is characterized by a b. “A tax that raises no revenue for the govern-
downward-sloping demand curve and an ment cannot have any deadweight loss.”
upward-sloping supply curve. 3. Consider the market for rubber bands.
a. Draw the competitive market equilibrium. a. If this market has very elastic supply and
Label the price, quantity, consumer surplus, very inelastic demand, how would the
and producer surplus. Is there any dead- burden of a tax on rubber bands be shared
weight loss? Explain. between consumers and producers? Use the
b. Suppose that the government forces each tools of consumer surplus and producer sur-
pizzeria to pay a $1 tax on each pizza sold. plus in your answer.
Illustrate the effect of this tax on the pizza b. If this market has very inelastic supply and
market, being sure to label the consumer sur- very elastic demand, how would the burden
plus, producer surplus, government revenue, of a tax on rubber bands be shared between
and deadweight loss. How does each area consumers and producers? Contrast your
compare to the pre-tax case? answer with your answer to part (a).
c. If the tax were removed, pizza eaters and 4. The 19th-century economist Henry George
sellers would be better off, but the govern- argued that the government should levy a siz-
ment would lose tax revenue. Suppose able tax on land, the supply of which he took to
that consumers and producers voluntarily be completely inelastic.
transferred some of their gains to the govern- a. George believed that economic growth
ment. Could all parties (including the gov- increased the demand for land and made
ernment) be better off than they were with a rich landowners richer at the expense of the
tax? Explain using the labeled areas in your tenants who made up the demand side of the
graph. market. Show this argument on an appropri-
2. Evaluate the following two statements. Do you ately labeled diagram.
agree? Why or why not? b. Who bears the burden of a tax on land—the
a. “A tax that has no deadweight loss cannot owners of land or the tenants on the land?
raise any revenue for the government.” Explain.
c. Is the deadweight loss of this tax large or 9. Suppose the government currently raises $100
small? Explain. million through a 1-cent tax on widgets, and
d. Many cities and towns today levy taxes on another $100 million through a 10-cent tax on
the value of real estate. Why might the above gadgets. If the government doubled the tax rate
analysis of George’s land tax not apply to this on widgets and eliminated the tax on gadgets,
modern tax? would it raise more money than today, less
5. Suppose that the government imposes a tax on money, or the same amount of money? Explain.
heating oil. 10. This chapter analyzed the welfare effects of a tax
a. Would the deadweight loss from this tax on a good. Consider now the opposite policy.
likely be greater in the first year after it is Suppose that the government subsidizes a good:
imposed or in the fifth year? Explain. For each unit of the good sold, the government
b. Would the revenue collected from this tax pays $2 to the buyer. How does the subsidy
likely be greater in the first year after it is affect consumer surplus, producer surplus, tax
imposed or in the fifth year? Explain. revenue, and total surplus? Does a subsidy lead
6. After economics class one day, your friend sug- to a deadweight loss? Explain.
gests that taxing food would be a good way to 11. Hotel rooms in Smalltown go for $100, and 1,000
raise revenue because the demand for food is rooms are rented on a typical day.
quite inelastic. In what sense is taxing food a a. To raise revenue, the mayor decides to
“good” way to raise revenue? In what sense is it charge hotels a tax of $10 per rented room.
not a “good” way to raise revenue? After the tax is imposed, the going rate for
7. Daniel Patrick Moynihan, the late senator from hotel rooms rises to $108, and the number
New York, once introduced a bill that would of rooms rented falls to 900. Calculate the
levy a 10,000 percent tax on certain hollow- amount of revenue this tax raises for Small-
tipped bullets. town and the deadweight loss of the tax.
a. Do you expect that this tax would raise much (Hint: The area of a triangle is 1⁄2 × base ×
revenue? Why or why not? height.)
b. Even if the tax would raise no revenue, why b. The mayor now doubles the tax to $20. The
might Senator Moynihan have proposed it? price rises to $116, and the number of rooms
8. The government places a tax on the purchase of rented falls to 800. Calculate tax revenue
socks. and deadweight loss with this larger tax. Do
a. Illustrate the effect of this tax on equilibrium they double, more than double, or less than
price and quantity in the sock market. Iden- double? Explain.
tify the following areas both before and after 12. Suppose that a market is described by the fol-
the imposition of the tax: total spending by lowing supply and demand equations:
consumers, total revenue for producers, and
QS = 2P
government tax revenue.
QD = 300 – P
b. Does the price received by producers rise or
fall? Can you tell whether total receipts for a. Solve for the equilibrium price and the equi-
producers rise or fall? Explain. librium quantity.
c. Does the price paid by consumers rise or fall? b. Suppose that a tax of T is placed on buyers,
Can you tell whether total spending by con- so the new demand equation is
sumers rises or falls? Explain carefully. (Hint:
QD = 300 – (P + T).
Think about elasticity.) If total consumer
spending falls, does consumer surplus rise? Solve for the new equilibrium. What happens
Explain. to the price received by sellers, the price paid
by buyers, and the quantity sold?
c. Tax revenue is T × Q. Use your answer to ship for T between 0 and 300. (Hint: Looking
part (b) to solve for tax revenue as a function sideways, the base of the deadweight loss
of T. Graph this relationship for T between 0 triangle is T, and the height is the difference
and 300. between the quantity sold with the tax and
d. The deadweight loss of a tax is the area of the quantity sold without the tax.)
the triangle between the supply and demand e. The government now levies a tax on this
curves. Recalling that the area of a triangle good of $200 per unit. Is this a good policy?
is 1⁄2 × base × height, solve for deadweight Why or why not? Can you propose a better
loss as a function of T. Graph this relation- policy?
9
CHAPTER
Application: International
Trade
I f you check the labels on the clothes you are now wearing, you will probably
find that some of your clothes were made in another country. A century ago,
the textile and clothing industry was a major part of the U.S. economy, but
that is no longer the case. Faced with foreign competitors that can produce quality
goods at low cost, many U.S. firms have found it increasingly difficult to produce
and sell textiles and clothing at a profit. As a result, they have laid off their work-
ers and shut down their factories. Today, much of the textiles and clothing that
Americans consume are imported.
The story of the textile industry raises important questions for economic policy:
How does international trade affect economic well-being? Who gains and who
loses from free trade among countries, and how do the gains compare to the
losses?
Chapter 3 introduced the study of international trade by applying the principle
of comparative advantage. According to this principle, all countries can benefit
from trading with one another because trade allows each country to specialize in
doing what it does best. But the analysis in Chapter 3 was incomplete. It did not
177
explain how the international marketplace achieves these gains from trade or how
the gains are distributed among various economic participants.
We now return to the study of international trade and take up these questions.
Over the past several chapters, we have developed many tools for analyzing how
markets work: supply, demand, equilibrium, consumer surplus, producer sur-
plus, and so on. With these tools, we can learn more about how international trade
affects economic well-being.
THE DETERMINANTS OF TRADE

Consider the market for textiles. The textile market is well suited to examining
the gains and losses from international trade: Textiles are made in many countries
around the world, and there is much world trade in textiles. Moreover, the textile
market is one in which policymakers often consider (and sometimes implement)
trade restrictions to protect domestic producers from foreign competitors. We
examine here the textile market in the imaginary country of Isoland.
THE EQUILIBRIUM WITHOUT TRADE

As our story begins, the Isolandian textile market is isolated from the rest of the
world. By government decree, no one in Isoland is allowed to import or export
textiles, and the penalty for violating the decree is so large that no one dares try.
Because there is no international trade, the market for textiles in Isoland con-
sists solely of Isolandian buyers and sellers. As Figure 1 shows, the domestic price
adjusts to balance the quantity supplied by domestic sellers and the quantity
demanded by domestic buyers. The figure shows the consumer and producer sur-
plus in the equilibrium without trade. The sum of consumer and producer surplus
1 F I G U R E
Price of
Textiles
The Equilibrium without International Trade
Domestic
When an economy cannot trade in world markets, the
supply
price adjusts to balance domestic supply and demand.
This figure shows consumer and producer surplus in an Consumer
equilibrium without international trade for the textile surplus
market in the imaginary country of Isoland. Equilibrium
price Producer
surplus
Domestic
demand
0 Equilibrium Quantity of
quantity Textiles
CHAPTER 9 APPLICATION: INTERNATIONAL TRADE 179
measures the total benefits that buyers and sellers receive from participating in
the textile market.
Now suppose that, in an election upset, Isoland elects a new president. The
president campaigned on a platform of “change” and promised the voters bold
new ideas. Her first act is to assemble a team of economists to evaluate Isolandian
trade policy. She asks them to report on three questions:
• If the government allows Isolandians to import and export textiles, what will
happen to the price of textiles and the quantity of textiles sold in the domes-
tic textile market?
• Who will gain from free trade in textiles and who will lose, and will the
gains exceed the losses?
• Should a tariff (a tax on textile imports) be part of the new trade policy?
After reviewing supply and demand in their favorite textbook (this one, of course),
the Isolandian economics team begins its analysis.
THE WORLD PRICE AND COMPARATIVE A DVANTAGE

The first issue our economists take up is whether Isoland is likely to become a
textile importer or a textile exporter. In other words, if free trade is allowed, will
Isolandians end up buying or selling textiles in world markets?
To answer this question, the economists compare the current Isolandian price
of textiles to the price of textiles in other countries. We call the price prevailing
in world markets the world price. If the world price of textiles is higher than the world price
domestic price, then Isoland will export textiles once trade is permitted. Isolan- the price of a good that
dian textile producers will be eager to receive the higher prices available abroad prevails in the world
and will start selling their textiles to buyers in other countries. Conversely, if the market for that good
world price of textiles is lower than the domestic price, then Isoland will import
textiles. Because foreign sellers offer a better price, Isolandian textile consumers
will quickly start buying textiles from other countries.
In essence, comparing the world price and the domestic price before trade indi-
cates whether Isoland has a comparative advantage in producing textiles. The
domestic price reflects the opportunity cost of textiles: It tells us how much an Iso-
landian must give up to obtain one unit of textiles. If the domestic price is low, the
cost of producing textiles in Isoland is low, suggesting that Isoland has a compara-
tive advantage in producing textiles relative to the rest of the world. If the domes-
tic price is high, then the cost of producing textiles in Isoland is high, suggesting
that foreign countries have a comparative advantage in producing textiles.
As we saw in Chapter 3, trade among nations is ultimately based on compara-
tive advantage. That is, trade is beneficial because it allows each nation to special-
ize in doing what it does best. By comparing the world price and the domestic
price before trade, we can determine whether Isoland is better or worse at produc-
ing textiles than the rest of the world.
Q Q
UICK UIZ The country Autarka does not allow international trade. In Autarka, you can
buy a wool suit for 3 ounces of gold. Meanwhile, in neighboring countries, you can buy
the same suit for 2 ounces of gold. If Autarka were to allow free trade, would it import
or export wool suits? Why?
THE WINNERS AND LOSERS FROM TRADE

To analyze the welfare effects of free trade, the Isolandian economists begin with
the assumption that Isoland is a small economy compared to the rest of the world.
This small-economy assumption means that Isoland’s actions have little effect on
world markets. Specifically, any change in Isoland’s trade policy will not affect
the world price of textiles. The Isolandians are said to be price takers in the world
economy. That is, they take the world price of textiles as given. Isoland can be an
exporting country by selling textiles at this price or an importing country by buy-
ing textiles at this price.
The small-economy assumption is not necessary to analyze the gains and losses
from international trade. But the Isolandian economists know from experience
(and from reading Chapter 2 of this book) that making simplifying assumptions is
a key part of building a useful economic model. The assumption that Isoland is a
small economy simplifies the analysis, and the basic lessons do not change in the
more complicated case of a large economy.
THE GAINS AND L OSSES OF AN EXPORTING COUNTRY

Figure 2 shows the Isolandian textile market when the domestic equilibrium price
before trade is below the world price. Once trade is allowed, the domestic price
rises to equal the world price. No seller of textiles would accept less than the
world price, and no buyer would pay more than the world price.
2 F I G U R E
Before Trade After Trade Change
International Trade in an Exporting Consumer Surplus A+B A –B

Country Producer Surplus C B+C+D +(B + D)
Once trade is allowed, the domestic price Total Surplus A+B+C A+B+C+D +D
rises to equal the world price. The supply
curve shows the quantity of textiles pro- The area D shows the increase in total surplus
duced domestically, and the demand curve and represents the gains from trade.
shows the quantity consumed domestically.
Price of
Exports from Isoland equal the difference
Textiles
between the domestic quantity supplied
and the domestic quantity demanded at the Domestic
world price. Sellers are better off (producer Price supply
surplus rises from C to B + C + D), and buy- after A Exports
ers are worse off (consumer surplus falls from trade World
A + B to A). Total surplus rises by an amount B D price
equal to area D, indicating that trade raises Price
the economic well-being of the country as a before
C
whole. trade
Domestic
Exports demand
0 Domestic Domestic Quantity of

quantity quantity Textiles
demanded supplied
After the domestic price has risen to equal the world price, the domestic quantity
supplied differs from the domestic quantity demanded. The supply curve shows
the quantity of textiles supplied by Isolandian sellers. The demand curve shows
the quantity of textiles demanded by Isolandian buyers. Because the domestic
quantity supplied is greater than the domestic quantity demanded, Isoland sells
textiles to other countries. Thus, Isoland becomes a textile exporter.
Although domestic quantity supplied and domestic quantity demanded differ,
the textile market is still in equilibrium because there is now another participant
in the market: the rest of the world. One can view the horizontal line at the world
price as representing the rest of the world’s demand for textiles. This demand
curve is perfectly elastic because Isoland, as a small economy, can sell as many
textiles as it wants at the world price.
Now consider the gains and losses from opening up trade. Clearly, not every-
one benefits. Trade forces the domestic price to rise to the world price. Domestic
producers of textiles are better off because they can now sell textiles at a higher
price, but domestic consumers of textiles are worse off because they have to buy
textiles at a higher price.
To measure these gains and losses, we look at the changes in consumer and
producer surplus. Before trade is allowed, the price of textiles adjusts to balance
domestic supply and domestic demand. Consumer surplus, the area between the
demand curve and the before-trade price, is area A + B. Producer surplus, the
area between the supply curve and the before-trade price, is area C. Total surplus
before trade, the sum of consumer and producer surplus, is area A + B + C.
After trade is allowed, the domestic price rises to the world price. Consumer
surplus is reduced to area A (the area between the demand curve and the world
price). Producer surplus is increased to area B + C + D (the area between the
supply curve and the world price). Thus, total surplus with trade is area A + B
+ C + D.
These welfare calculations show who wins and who loses from trade in an
exporting country. Sellers benefit because producer surplus increases by the area
B + D. Buyers are worse off because consumer surplus decreases by the area B.
Because the gains of sellers exceed the losses of buyers by the area D, total surplus
in Isoland increases.
This analysis of an exporting country yields two conclusions:
• When a country allows trade and becomes an exporter of a good, domestic
producers of the good are better off, and domestic consumers of the good
are worse off.
• Trade raises the economic well-being of a nation in the sense that the gains
of the winners exceed the losses of the losers.
THE GAINS AND L OSSES OF AN IMPORTING COUNTRY

Now suppose that the domestic price before trade is above the world price. Once
again, after trade is allowed, the domestic price must equal the world price. As
Figure 3 shows, the domestic quantity supplied is less than the domestic quan-
tity demanded. The difference between the domestic quantity demanded and the
domestic quantity supplied is bought from other countries, and Isoland becomes
a textile importer.
In this case, the horizontal line at the world price represents the supply of the
rest of the world. This supply curve is perfectly elastic because Isoland is a small
economy and, therefore, can buy as many textiles as it wants at the world price.
3 F I G U R E
Before Trade After Trade Change
International Trade in an Consumer Surplus A A+B+D +(B + D)

Importing Country Producer Surplus B+C C –B
Once trade is allowed, the domestic price Total Surplus A+B+C A+B+C+D +D
falls to equal the world price. The supply
curve shows the amount produced domes- The area D shows the increase in total surplus
tically, and the demand curve shows the and represents the gains from trade.
amount consumed domestically. Imports
equal the difference between the domestic Price of
quantity demanded and the domestic quan- Textiles
tity supplied at the world price. Buyers are
better off (consumer surplus rises from A to Domestic
A + B + D), and sellers are worse off (pro- supply
ducer surplus falls from B + C to C). Total
surplus rises by an amount equal to area D, A
indicating that trade raises the economic Price
well-being of the country as a whole. before trade B D
Price World
after trade C price
Imports
Domestic
demand
0 Domestic Domestic Quantity of
quantity quantity Textiles
supplied demanded
Now consider the gains and losses from trade. Once again, not everyone ben-
efits. When trade forces the domestic price to fall, domestic consumers are better
off (they can now buy textiles at a lower price), and domestic producers are worse
off (they now have to sell textiles at a lower price). Changes in consumer and
producer surplus measure the size of the gains and losses. Before trade, consumer
surplus is area A, producer surplus is area B + C, and total surplus is area A + B
+ C. After trade is allowed, consumer surplus is area A + B + D, producer sur-
plus is area C, and total surplus is area A + B + C + D.
These welfare calculations show who wins and who loses from trade in an
importing country. Buyers benefit because consumer surplus increases by the area
B + D. Sellers are worse off because producer surplus falls by the area B. The gains
of buyers exceed the losses of sellers, and total surplus increases by the area D.
This analysis of an importing country yields two conclusions parallel to those
for an exporting country:
• When a country allows trade and becomes an importer of a good, domestic
consumers of the good are better off, and domestic producers of the good are
worse off.
• Trade raises the economic well-being of a nation in the sense that the gains
of the winners exceed the losses of the losers.
Having completed our analysis of trade, we can better understand one of the
Ten Principles of Economics in Chapter 1: Trade can make everyone better off. If Iso-
land opens its textile market to international trade, the change will create winners
and losers, regardless of whether Isoland ends up exporting or importing textiles.
In either case, however, the gains of the winners exceed the losses of the losers, so
the winners could compensate the losers and still be better off. In this sense, trade
can make everyone better off. But will trade make everyone better off? Probably
not. In practice, compensation for the losers from international trade is rare. With-
out such compensation, opening an economy to international trade is a policy that
expands the size of the economic pie, while perhaps leaving some participants in
the economy with a smaller slice.
We can now see why the debate over trade policy is often contentious. When-
ever a policy creates winners and losers, the stage is set for a political battle.
Nations sometimes fail to enjoy the gains from trade because the losers from free
trade are better organized than the winners. The losers may turn their cohesive-
ness into political clout, lobbying for trade restrictions such as tariffs or import
quotas.
THE EFFECTS OF A TARIFF

The Isolandian economists next consider the effects of a tariff—a tax on imported tariff
goods. The economists quickly realize that a tariff on textiles will have no effect a tax on goods pro-
if Isoland becomes a textile exporter. If no one in Isoland is interested in import- duced abroad and
ing textiles, a tax on textile imports is irrelevant. The tariff matters only if Isoland sold domestically
becomes a textile importer. Concentrating their attention on this case, the econo-
mists compare welfare with and without the tariff.
Figure 4 shows the Isolandian market for textiles. Under free trade, the domestic
price equals the world price. A tariff raises the price of imported textiles above the
world price by the amount of the tariff. Domestic suppliers of textiles, who com-
pete with suppliers of imported textiles, can now sell their textiles for the world
price plus the amount of the tariff. Thus, the price of textiles—both imported and
domestic—rises by the amount of the tariff and is, therefore, closer to the price
that would prevail without trade.
The change in price affects the behavior of domestic buyers and sellers. Because
the tariff raises the price of textiles, it reduces the domestic quantity demanded
from Q D1 to Q D2 and raises the domestic quantity supplied from Q S1 to Q S2. Thus, the
tariff reduces the quantity of imports and moves the domestic market closer to its equilib-
rium without trade.
Now consider the gains and losses from the tariff. Because the tariff raises the
domestic price, domestic sellers are better off, and domestic buyers are worse off.
In addition, the government raises revenue. To measure these gains and losses,
we look at the changes in consumer surplus, producer surplus, and government
revenue. These changes are summarized in the table in Figure 4.
Before the tariff, the domestic price equals the world price. Consumer surplus,
the area between the demand curve and the world price, is area A + B + C + D +
E + F. Producer surplus, the area between the supply curve and the world price,
is area G. Government revenue equals zero. Total surplus, the sum of consumer
surplus, producer surplus, and government revenue, is area A + B + C + D + E
+ F + G.
Once the government imposes a tariff, the domestic price exceeds the world
price by the amount of the tariff. Consumer surplus is now area A + B. Producer
4 F I G U R E Types
A tariff of
that pie
The would
Graphs
reduces
exist
chart
the quantity of imports and moves a market closer to the equilibrium
without
in panel (a) trade.
showsTotal surplus
how U.S. falls by
national an amount
income equalfrom
is derived to area D + F.
various
These two
sources. triangles
The represent
bar graph in panelthe
(b)deadweight
compares thelossaverage
from the tariff. in four countries.
income
The Effects of a Tariff The time-series graph in panel (c) shows the productivity of labor in U.S. businesses
from 1950 to 2000.
Before Tariff After Tariff Change
Consumer Surplus A+B+C+D+E+F A+B –(C + D + E + F)

Producer Surplus G C+G +C
Government Revenue None E +E
Total Surplus A+B+C+D+E+F+G A+B+C+E+G –(D + F)
The area D + F shows the fall in total surplus and represents the deadweight loss of the tariff.
Price of
Textiles
Domestic
supply
A
Equilibrium
without trade
B
Price
with tariff C Tariff
D E F
Price World
without tariff G Imports price
Domestic
with tariff
demand
0 Q1S Q2S Q2D Q1D Quantity of

Textiles
Imports
without tariff
surplus is area C + G. Government revenue, which is the quantity of after-tariff

imports times the size of the tariff, is the area E. Thus, total surplus with the tariff
is area A + B + C + E + G.
To determine the total welfare effects of the tariff, we add the change in con-
sumer surplus (which is negative), the change in producer surplus (positive), and
the change in government revenue (positive). We find that total surplus in the
market decreases by the area D + F. This fall in total surplus is called the dead-
weight loss of the tariff.
A tariff causes a deadweight loss simply because a tariff is a type of tax. Like
most taxes, it distorts incentives and pushes the allocation of scarce resources
Import Quotas: Another Way to Restrict Trade
Beyond tariffs, another way sets the license fee equal to the difference between the domestic
that nations sometimes restrict international trade is by putting lim- price and the world price. In this case, all the profit of license hold-
its on how much of a good can be imported. In this book, we will ers is paid to the government in license fees, and the import quota
not analyze such a policy, other than to point out the conclusion: works exactly like a tariff. Consumer surplus, producer surplus, and
Import quotas are much like tariffs. Both tariffs and import quotas government revenue are precisely the same under the two policies.
reduce the quantity of imports, raise the domestic price of the good, In practice, however, countries that restrict trade with import
decrease the welfare of domestic consumers, increase the welfare of quotas rarely do so by selling the import licenses. For example, the
domestic producers, and cause deadweight losses. U.S. government has at times pressured Japan to “voluntarily” limit
There is only one difference between these two types of trade the sale of Japanese cars in the United States. In this case, the Japa-
restriction: A tariff raises revenue for the government, whereas an nese government allocates the import licenses to Japanese firms,
import quota creates surplus for those who obtain the licenses to and the surplus from these licenses accrues to those firms. From the
import. The profit for the holder of an import license is the difference standpoint of U.S. welfare, this kind of import quota is worse than a
between the domestic price (at which he sells the imported good) U.S. tariff on imported cars. Both a tariff and an import quota raise
and the world price (at which he buys it). prices, restrict trade, and cause deadweight losses, but at least the
Tariffs and import quotas are even more similar if the govern- tariff produces revenue for the U.S. government rather than profit
ment charges a fee for the import licenses. Suppose the government for foreign producers.
away from the optimum. In this case, we can identify two effects. First, when
the tariff raises the domestic price of textiles above the world price, it encourages
domestic producers to increase production from Q S1 to Q S2. Even though the cost
of making these incremental units exceeds the cost of buying them at the world
price, the tariff makes it profitable for domestic producers to manufacture them
nonetheless. Second, when the tariff raises the price that domestic textile consum-
ers have to pay, it encourages them to reduce consumption of textiles from Q D1 to
Q D2 . Even though domestic consumers value these incremental units at more than
the world price, the tariff induces them to cut back their purchases. Area D rep-
resents the deadweight loss from the overproduction of textiles, and area F repre-
sents the deadweight loss from the underconsumption. The total deadweight loss
of the tariff is the sum of these two triangles.
THE LESSONS FOR TRADE POLICY

The team of Isolandian economists can now write to the new president:
Dear Madame President,
You asked us three questions about opening up trade. After much hard
work, we have the answers.
Question: If the government allows Isolandians to import and export textiles,

what will happen to the price of textiles and the quantity of textiles sold in the
domestic textile market?
Answer: Once trade is allowed, the Isolandian price of textiles will be driven
to equal the price prevailing around the world.
If the world price is now higher than the Isolandian price, our price will rise.
The higher price will reduce the amount of textiles Isolandians consume and
raise the amount of textiles that Isolandians produce. Isoland will, therefore,
become a textile exporter. This occurs because, in this case, Isoland has a com-
parative advantage in producing textiles.
Conversely, if the world price is now lower than the Isolandian price, our
price will fall. The lower price will raise the amount of textiles that Isolandians
consume and lower the amount of textiles that Isolandians produce. Isoland
will, therefore, become a textile importer. This occurs because, in this case,
other countries have a comparative advantage in producing textiles.
Question: Who will gain from free trade in textiles and who will lose, and
will the gains exceed the losses?
Answer: The answer depends on whether the price rises or falls when trade
is allowed. If the price rises, producers of textiles gain, and consumers of tex-
tiles lose. If the price falls, consumers gain, and producers lose. In both cases,
the gains are larger than the losses. Thus, free trade raises the total welfare of
Isolandians.
Question: Should a tariff be part of the new trade policy?
Answer: A tariff has an impact only if Isoland becomes a textile importer. In
this case, a tariff moves the economy closer to the no-trade equilibrium and,
like most taxes, has deadweight losses. Although a tariff improves the welfare
of domestic producers and raises revenue for the government, these gains are
more than offset by the losses suffered by consumers. The best policy, from the
standpoint of economic efficiency, would be to allow trade without a tariff.
We hope you find these answers helpful as you decide on your new policy.
Your faithful servants,

Isolandian economics team
OTHER BENEFITS OF INTERNATIONAL TRADE

The conclusions of the Isolandian economics team are based on the standard
analysis of international trade. Their analysis uses the most fundamental tools in
the economist’s toolbox: supply, demand, and producer and consumer surplus. It
shows that there are winners and losers when a nation opens itself up to trade, but
the gains to the winners exceed the losses of the losers.
The case for free trade can be made even stronger, however, because there are
several other economic benefits of trade beyond those emphasized in the standard
analysis. Here, in a nutshell, are some of these other benefits:
• Increased variety of goods. Goods produced in different countries are not
exactly the same. German beer, for instance, is not the same as American
beer. Free trade gives consumers in all countries greater variety from which
to choose.
Should the Winners from Free Trade

Compensate the Losers?
Political candidates often say that the government should help
those made worse off by international trade. In this opinion piece,
an economist makes the opposite case.
What to Expect When I doubt there’s a human being on earth In what morally relevant way, then,
You’re Free Trading who hasn’t benefited from the opportunity might displaced workers differ from dis-
By Steven E. Landsburg to trade freely with his neighbors. Imagine placed pharmacists or displaced landlords?
what your life would be like if you had to You might argue that pharmacists and land-
In the days before Tuesday’s Republi- grow your own food, make your own clothes lords have always faced cutthroat competi-
can presidential primary in Michigan, Mitt and rely on your grandmother’s home rem- tion and therefore knew what they were
Romney and John McCain battled over what edies for health care. Access to a trained getting into, while decades of tariffs and
the government owes to workers who lose physician might reduce the demand for quotas have led manufacturing workers
their jobs because of the foreign competi- grandma’s home remedies, but—especially to expect a modicum of protection. That
tion unleashed by free trade. Their rhetoric at her age—she’s still got plenty of reason expectation led them to develop certain
differed—Mr. Romney said he would “fight to be thankful for having a doctor. skills, and now it’s unfair to pull the rug out
for every single job,” while Mr. McCain said Some people suggest, however, that it from under them.
some jobs “are not coming back”—but makes sense to isolate the moral effects of a Once again, that argument does not
their proposed policies were remarkably single new trading opportunity or free trade mesh with our everyday instincts. For many
similar: educate and retrain the workers for agreement. Surely we have fellow citizens decades, schoolyard bullying has been a
new jobs. who are hurt by those agreements, at least profitable occupation. All across America,
All economists know that when Ameri- in the limited sense that they’d be better off bullies have built up skills so they can
can jobs are outsourced, Americans as in a world where trade flourishes, except in take advantage of that opportunity. If we
a group are net winners. What we lose this one instance. What do we owe those toughen the rules to make bullying unprof-
through lower wages is more than offset by fellow citizens? itable, must we compensate the bullies?
what we gain through lower prices. In other One way to think about that is to ask Bullying and protectionism have a lot
words, the winners can more than afford to what your moral instincts tell you in analo- in common. They both use force (either
compensate the losers. Does that mean they gous situations. Suppose, after years of buy- directly or through the power of the law)
ought to? Does it create a moral mandate for ing shampoo at your local pharmacy, you to enrich someone else at your involuntary
the taxpayer-subsidized retraining programs discover you can order the same shampoo expense. If you’re forced to pay $20 an hour
proposed by Mr. McCain and Mr. Romney? for less money on the Web. Do you have an to an American for goods you could have
Um, no. Even if you’ve just lost your job, obligation to compensate your pharmacist? bought from a Mexican for $5 an hour, you’re
there’s something fundamentally churlish If you move to a cheaper apartment, should being extorted. When a free trade agree-
about blaming the very phenomenon that’s you compensate your landlord? When you ment allows you to buy from the Mexican
elevated you above the subsistence level eat at McDonald’s, should you compensate after all, rejoice in your liberation—even if
since the day you were born. If the world the owners of the diner next door? Public Mr. McCain, Mr. Romney and the rest of the
owes you compensation for enduring the policy should not be designed to advance presidential candidates don’t want you to.
downside of trade, what do you owe the moral instincts that we all reject every day
world for enjoying the upside? of our lives.
Source: New York Times, January 16, 2008.

• Lower costs through economies of scale. Some goods can be produced at

low cost only if they are produced in large quantities—a phenomenon called
economies of scale. A firm in a small country cannot take full advantage of
economies of scale if it can sell only in a small domestic market. Free trade
gives firms access to larger world markets and allows them to realize econo-
mies of scale more fully.
• Increased competition. A company shielded from foreign competitors is
more likely to have market power, which in turn gives it the ability to raise
prices above competitive levels. This is a type of market failure. Opening
up trade fosters competition and gives the invisible hand a better chance to
work its magic.
• Enhanced flow of ideas. The transfer of technological advances around the
world is often thought to be linked to the trading of the goods that embody
those advances. The best way for a poor agricultural nation to learn about
the computer revolution, for instance, is to buy some computers from abroad
rather than trying to make them domestically.
Thus, free international trade increases variety for consumers, allows firms
to take advantage of economies of scale, makes markets more competitive, and
facilitates the spread of technology. If the Isolandian economists also took these
effects into account, their advice to their president would be even more forceful.
QUICK QUIZ Draw a supply and demand diagram for wool suits in the country of Autarka.
When trade is allowed, the price of a suit falls from 3 to 2 ounces of gold. In your dia-
gram, show the change in consumer surplus, the change in producer surplus, and the
change in total surplus. How would a tariff on suit imports alter these effects?
THE ARGUMENTS FOR RESTRICTING TRADE

The letter from the economics team starts to persuade the new president of Iso-
land to consider allowing trade in textiles. She notes that the domestic price is
now high compared to the world price. Free trade would, therefore, cause the
price of textiles to fall and hurt domestic textiles producers. Before implementing
the new policy, she asks Isolandian textile companies to comment on the econo-
mists’ advice.
Not surprisingly, the textile companies oppose free trade in textiles. They
PERMISSION OF UNITED FEATURE SYNDICATE, INC.

believe that the government should protect the domestic textile industry from for-
CARTOON: © BERRY’S WORLD REPRINTED BY

eign competition. Let’s consider some of the arguments they might give to sup-
port their position and how the economics team would respond.
THE JOBS A RGUMENT

Opponents of free trade often argue that trade with other countries destroys
domestic jobs. In our example, free trade in textiles would cause the price of tex-
“YOU LIKE PROTECTIONISM tiles to fall, reducing the quantity of textiles produced in Isoland and thus reducing
AS A ‘WORKING MAN.’ HOW employment in the Isolandian textile industry. Some Isolandian textile workers
ABOUT AS A CONSUMER?” would lose their jobs.
Offshore Outsourcing
If you buy a new computer and call the company for tech support, you
shouldn’t be surprised if you end up talking to someone in Bangalore,
India. In 2004, the author of this textbook, while an adviser to President
Bush, was asked about the movement of such jobs overseas. I replied
that the trend was “probably a plus for the economy in the long
run.” Most economists agreed, but some elected officials responded
differently.
The Economics of Progress Hastert’s ideal economy, where jobs do health of U.S. airlines, and the security of the
By George F. Will not disappear, existed almost everywhere jobs and pensions of most airline employ-
for almost everyone through almost all of ees, should he not applaud Delta for saving
It is difficult to say something perfectly, pre- human history. In, say, 12th-century France, $25 million a year by sending some reserva-
cisely false. But House Speaker Dennis Hast- the ox behind which a man plowed a field tion services to India?
ert did when participating in the bipartisan changed, but otherwise the plowman was Does Kerry really want to restrain the rise
piling-on against the president’s economic doing what generations of his ancestors had of health care costs? Does he oppose having
adviser, who imprudently said something done and what generations of his descen- X-rays analyzed in India at a fraction of the
sensible. dants were to do. Those were the good old U.S. cost?
John Kerry and John Edwards, who are days, before economic growth. . . . In November, Indiana Gov. Joseph Ker-
not speaking under oath and who know For the highly competent workforce of nan canceled a $15 million contract with a
that economic illiteracy has never been this wealthy nation, the loss of jobs is not firm in India to process state unemployment
a disqualification for high office, have led a zero-sum game: It is a trading up in social claims. The contract was given to a U.S. firm
the scrum against the chairman of the rewards. When the presidential candidates that will charge $23 million. Because of this
president’s Council of Economic Advisers, were recently in South Carolina, histrioni- 53 percent price increase, there will be 8
N. Gregory Mankiw, who said the arguments cally lamenting the loss of textile jobs, they million fewer state dollars for schools, hos-
for free trade apply to trade in services as surely noticed the huge BMW presence. It pitals, law enforcement, etc. And the benefit
well as manufactured goods. But the prize is the “offshoring” of German jobs because to Indiana is . . . what?
for the pithiest nonsense went to Hastert: Germany’s irrational labor laws, among other When Kernan made this gesture he
“An economy suffers when jobs disappear.” things, give America a comparative advan- probably was wearing something that was
So the economy suffered when automo- tage. Such economic calculation explains wholly or partly imported and that at one
biles caused the disappearance of the jobs of the manufacture of Mercedes-Benzes in Ala- time, before offshoring, would have been
most blacksmiths, buggy makers, operators bama, Hondas in Ohio, Toyotas in California. entirely made here. Such potential embar-
of livery stables, etc.? The economy did not As long as the American jobs going rassments are among the perils of making
seem to be suffering in 1999, when 33 mil- offshore were blue-collar jobs, the politi- moral grandstanding into an economic
lion jobs were wiped out—by an economic cal issue did not attain the heat it has now policy.
dynamism that created 35.7 million jobs. that white-collar job losses frighten a more
How many of the 4,500 U.S. jobs that IBM articulate, assertive social class. . . .
is planning to create this year will be made Kerry says offshoring is done by “Benedict
possible by sending 3,000 jobs overseas? Arnold CEOs.” But if he wants to improve the
Source: The Washington Post, Friday, February 20, 2004. Page A25. Copyright © 2004, The Washington Post Writers Group. Reprinted with permission.
Yet free trade creates jobs at the same time that it destroys them. When Isolan-
dians buy textiles from other countries, those countries obtain the resources to
buy other goods from Isoland. Isolandian workers would move from the textile
industry to those industries in which Isoland has a comparative advantage. The
transition may impose hardship on some workers in the short run, but it allows
Isolandians as a whole to enjoy a higher standard of living.
Opponents of trade are often skeptical that trade creates jobs. They might
respond that everything can be produced more cheaply abroad. Under free trade,
they might argue, Isolandians could not be profitably employed in any industry.
As Chapter 3 explains, however, the gains from trade are based on comparative
advantage, not absolute advantage. Even if one country is better than another
country at producing everything, each country can still gain from trading with the
other. Workers in each country will eventually find jobs in an industry in which
that country has a comparative advantage.
THE NATIONAL-SECURITY A RGUMENT

When an industry is threatened with competition from other countries, opponents
of free trade often argue that the industry is vital for national security. For exam-
ple, if Isoland were considering free trade in steel, domestic steel companies might
point out that steel is used to make guns and tanks. Free trade would allow Iso-
land to become dependent on foreign countries to supply steel. If a war later broke
out and the foreign supply was interrupted, Isoland might be unable to produce
enough steel and weapons to defend itself.
Economists acknowledge that protecting key industries may be appropri-
ate when there are legitimate concerns over national security. Yet they fear that
this argument may be used too quickly by producers eager to gain at consumers’
expense.
One should be wary of the national-security argument when it is made by rep-
resentatives of industry rather than the defense establishment. Companies have
an incentive to exaggerate their role in national defense to obtain protection from
foreign competition. A nation’s generals may see things very differently. Indeed,
when the military is a consumer of an industry’s output, it would benefit from
imports. Cheaper steel in Isoland, for example, would allow the Isolandian mili-
tary to accumulate a stockpile of weapons at lower cost.
THE INFANT-INDUSTRY A RGUMENT

New industries sometimes argue for temporary trade restrictions to help them
get started. After a period of protection, the argument goes, these industries will
mature and be able to compete with foreign firms.
Similarly, older industries sometimes argue that they need temporary protec-
tion to help them adjust to new conditions. For example, in 2002, President Bush
imposed temporary tariffs on imported steel. He said, “I decided that imports were
severely affecting our industry, an important industry.” The tariff, which lasted 20
months, offered “temporary relief so that the industry could restructure itself.”
Economists are often skeptical about such claims, largely because the infant-
industry argument is difficult to implement in practice. To apply protection suc-
cessfully, the government would need to decide which industries will eventually
be profitable and decide whether the benefits of establishing these industries
exceed the costs of this protection to consumers. Yet “picking winners” is extraor-
dinarily difficult. It is made even more difficult by the political process, which
often awards protection to those industries that are politically powerful. And once
a powerful industry is protected from foreign competition, the “temporary” pol-
icy is sometimes hard to remove.
In addition, many economists are skeptical about the infant-industry argu-
ment in principle. Suppose, for instance, that an industry is young and unable to
compete profitably against foreign rivals, but there is reason to believe that the
industry can be profitable in the long run. In this case, firm owners should be
willing to incur temporary losses to obtain the eventual profits. Protection is not
necessary for an infant industry to grow. History shows that start-up firms often
incur temporary losses and succeed in the long run, even without protection from
competition.
THE UNFAIR-COMPETITION A RGUMENT

A common argument is that free trade is desirable only if all countries play by
the same rules. If firms in different countries are subject to different laws and
regulations, then it is unfair (the argument goes) to expect the firms to compete
in the international marketplace. For instance, suppose that the government of
Neighborland subsidizes its textile industry by giving textile companies large tax
breaks. The Isolandian textile industry might argue that it should be protected
from this foreign competition because Neighborland is not competing fairly.
Would it, in fact, hurt Isoland to buy textiles from another country at a subsi-
dized price? Certainly, Isolandian textile producers would suffer, but Isolandian
textile consumers would benefit from the low price. The case for free trade is no
different: The gains of the consumers from buying at the low price would exceed
the losses of the producers. Neighborland’s subsidy to its textile industry may be
a bad policy, but it is the taxpayers of Neighborland who bear the burden. Isoland
can benefit from the opportunity to buy textiles at a subsidized price.
THE PROTECTION-AS-A-BARGAINING-CHIP A RGUMENT

Another argument for trade restrictions concerns the strategy of bargaining. Many
policymakers claim to support free trade but, at the same time, argue that trade
restrictions can be useful when we bargain with our trading partners. They claim
that the threat of a trade restriction can help remove a trade restriction already
imposed by a foreign government. For example, Isoland might threaten to impose
a tariff on textiles unless Neighborland removes its tariff on wheat. If Neighbor-
land responds to this threat by removing its tariff, the result can be freer trade.
The problem with this bargaining strategy is that the threat may not work. If
it doesn’t work, the country faces a choice between two bad options. It can carry
out its threat and implement the trade restriction, which would reduce its own
economic welfare. Or it can back down from its threat, which would cause it to
lose prestige in international affairs. Faced with this choice, the country would
probably wish that it had never made the threat in the first place.
Second Thoughts about Free Trade

Some economists worry about the impact of trade on the distribution of
income. Even if free trade enhances efficiency, it may reduce equality.
Trouble with Trade countries is a very good thing. Above all, it rower range of products at larger scale. The
By Paul Krugman offers backward economies their best hope result was an all-round, broadly shared rise
of moving up the income ladder. in productivity and wages.
While the United States has long imported But for American workers the story is By contrast, trade between countries at
oil and other raw materials from the third much less positive. In fact, it’s hard to avoid very different levels of economic develop-
world, we used to import manufactured the conclusion that growing U.S. trade ment tends to create large classes of losers
goods mainly from other rich countries like with third-world countries reduces the real as well as winners.
Canada, European nations and Japan. wages of many and perhaps most workers Although the outsourcing of some high-
But recently we crossed an important in this country. And that reality makes the tech jobs to India has made headlines, on
watershed: we now import more manufac- politics of trade very difficult. balance, highly educated workers in the
tured goods from the third world than from Let’s talk for a moment about the United States benefit from higher wages
other advanced economies. That is, a major- economics. and expanded job opportunities because of
ity of our industrial trade is now with coun- Trade between high-wage countries trade. For example, ThinkPad notebook com-
tries that are much poorer than we are and tends to be a modest win for all, or almost puters are now made by a Chinese company,
that pay their workers much lower wages. all, concerned. When a free-trade pact made Lenovo, but a lot of Lenovo’s research and
For the world economy as a whole— it possible to integrate the U.S. and Canadian development is conducted in North Carolina.
and especially for poorer nations—growing auto industries in the 1960s, each country’s But workers with less formal education
trade between high-wage and low-wage industry concentrated on producing a nar- either see their jobs shipped overseas or
TRADE AGREEMENTS AND THE WORLD

TRADE ORGANIZATION
A country can take one of two approaches to achieving free trade. It can take a uni-
lateral approach and remove its trade restrictions on its own. This is the approach
that Great Britain took in the 19th century and that Chile and South Korea have
taken in recent years. Alternatively, a country can take a multilateral approach and
reduce its trade restrictions while other countries do the same. In other words,
it can bargain with its trading partners in an attempt to reduce trade restrictions
around the world.
One important example of the multilateral approach is the North American
Free Trade Agreement (NAFTA), which in 1993 lowered trade barriers among the
United States, Mexico, and Canada. Another is the General Agreement on Tariffs
and Trade (GATT), which is a continuing series of negotiations among many of
the world’s countries with the goal of promoting free trade. The United States
find their wages driven down by the ripple The original “newly industrializing econo- ing to special interests that tends to be the
effect as other workers with similar qualifi- mies” exporting manufactured goods— editorial response to politicians who express
cations crowd into their industries and look South Korea, Taiwan, Hong Kong and skepticism about the benefits of free-trade
for employment to replace the jobs they lost Singapore—paid wages that were about agreements.
to foreign competition. And lower prices at 25 percent of U.S. levels in 1990. Since then, It’s often claimed that limits on trade
Wal-Mart aren’t sufficient compensation. however, the sources of our imports have benefit only a small number of Americans,
All this is textbook international eco- shifted to Mexico, where wages are only 11 while hurting the vast majority. That’s still
nomics: contrary to what people sometimes percent of the U.S. level, and China, where true of things like the import quota on sugar.
assert, economic theory says that free trade they’re only about 3 percent or 4 percent. But when it comes to manufactured goods,
normally makes a country richer, but it There are some qualifying aspects to this it’s at least arguable that the reverse is true.
doesn’t say that it’s normally good for every- story. For example, many of those made- The highly educated workers who clearly
one. Still, when the effects of third-world in-China goods contain components made benefit from growing trade with third-world
exports on U.S. wages first became an issue in Japan and other high-wage economies. economies are a minority, greatly outnum-
in the 1990s, a number of economists— Still, there’s little doubt that the pressure bered by those who probably lose.
myself included—looked at the data and of globalization on American wages has As I said, I’m not a protectionist. For the
concluded that any negative effects on U.S. increased. sake of the world as a whole, I hope that we
wages were modest. So am I arguing for protectionism? No. respond to the trouble with trade not by
The trouble now is that these effects Those who think that globalization is always shutting trade down, but by doing things
may no longer be as modest as they were, and everywhere a bad thing are wrong. On like strengthening the social safety net. But
because imports of manufactured goods the contrary, keeping world markets rela- those who are worried about trade have a
from the third world have grown dramati- tively open is crucial to the hopes of billions point, and deserve some respect.
cally—from just 2.5 percent of G.D.P. in of people.
1990 to 6 percent in 2006. But I am arguing for an end to the
And the biggest growth in imports has finger-wagging, the accusation either of not
come from countries with very low wages. understanding economics or of kowtow-
Source: New York Times, December 28, 2007.
helped to found GATT after World War II in response to the high tariffs imposed
during the Great Depression of the 1930s. Many economists believe that the high
tariffs contributed to the worldwide economic hardship of that period. GATT
has successfully reduced the average tariff among member countries from about
40 percent after World War II to about 5 percent today.
The rules established under GATT are now enforced by an international insti-
tution called the World Trade Organization (WTO). The WTO was established in
1995 and has its headquarters in Geneva, Switzerland. As of July 2007, 151 coun-
tries have joined the organization, accounting for more than 97 percent of world
trade. The functions of the WTO are to administer trade agreements, provide a
forum for negotiations, and handle disputes among member countries.
What are the pros and cons of the multilateral approach to free trade? One
advantage is that the multilateral approach has the potential to result in freer
trade than a unilateral approach because it can reduce trade restrictions abroad
as well as at home. If international negotiations fail, however, the result could be
more restricted trade than under a unilateral approach.
In addition, the multilateral approach may have a political advantage. In most

markets, producers are fewer and better organized than consumers—and thus
wield greater political influence. Reducing the Isolandian tariff on textiles, for
example, may be politically difficult if considered by itself. The textile compa-
nies would oppose free trade, and the buyers of textiles who would benefit are
so numerous that organizing their support would be difficult. Yet suppose that
Neighborland promises to reduce its tariff on wheat at the same time that Iso-
land reduces its tariff on textiles. In this case, the Isolandian wheat farmers, who
are also politically powerful, would back the agreement. Thus, the multilateral
approach to free trade can sometimes win political support when a unilateral
approach cannot. ●
Q Q
UICK UIZ The textile industry of Autarka advocates a ban on the import of wool
suits. Describe five arguments its lobbyists might make. Give a response to each of these
arguments.
CONCLUSION
Economists and the public often disagree about free trade. In December 2007, the
Los Angeles Times asked the American public, “Generally speaking, do you believe
that free international trade has helped or hurt the economy, or hasn’t it made a
difference to the economy one way or the other?” Only 27 percent of those polled
said free international trade helped, whereas 44 percent thought it hurt. (The rest
thought it made no difference or were unsure.) By contrast, most economists sup-
port free international trade. They view free trade as a way of allocating produc-
tion efficiently and raising living standards both at home and abroad.
Economists view the United States as an ongoing experiment that confirms
the virtues of free trade. Throughout its history, the United States has allowed
unrestricted trade among the states, and the country as a whole has benefited
from the specialization that trade allows. Florida grows oranges, Texas pumps oil,
California makes wine, and so on. Americans would not enjoy the high standard
of living they do today if people could consume only those goods and services
produced in their own states. The world could similarly benefit from free trade
among countries.
To better understand economists’ view of trade, let’s continue our parable.
Suppose that the president of Isoland, after reading the latest poll results, ignores
the advice of her economics team and decides not to allow free trade in textiles.
The country remains in the equilibrium without international trade.
Then, one day, some Isolandian inventor discovers a new way to make tex-
tiles at very low cost. The process is quite mysterious, however, and the inventor
insists on keeping it a secret. What is odd is that the inventor doesn’t need tradi-
tional inputs such as cotton or wool. The only material input he needs is wheat.
And even more oddly, to manufacture textiles from wheat, he hardly needs any
labor input at all.
The inventor is hailed as a genius. Because everyone buys clothing, the lower
cost of textiles allows all Isolandians to enjoy a higher standard of living. Work-
ers who had previously produced textiles experience some hardship when their
factories close, but eventually, they find work in other industries. Some become
farmers and grow the wheat that the inventor turns into textiles. Others enter new
industries that emerge as a result of higher Isolandian living standards. Everyone
understands that the displacement of workers in outmoded industries is an inevi-
table part of technological progress and economic growth.
After several years, a newspaper reporter decides to investigate this mysteri-
ous new textiles process. She sneaks into the inventor’s factory and learns that the
inventor is a fraud. The inventor has not been making textiles at all. Instead, he
has been smuggling wheat abroad in exchange for textiles from other countries.
The only thing that the inventor had discovered was the gains from international
trade.
When the truth is revealed, the government shuts down the inventor’s opera-
tion. The price of textiles rises, and workers return to jobs in textile factories. Living
standards in Isoland fall back to their former levels. The inventor is jailed and held
up to public ridicule. After all, he was no inventor. He was just an economist.
SUMMARY
• The effects of free trade can be determined by • A tariff—a tax on imports—moves a market
comparing the domestic price without trade to closer to the equilibrium that would exist with-
the world price. A low domestic price indicates out trade and, therefore, reduces the gains from
that the country has a comparative advantage trade. Although domestic producers are better
in producing the good and that the country will off and the government raises revenue, the losses
become an exporter. A high domestic price indi- to consumers exceed these gains.
cates that the rest of the world has a comparative
advantage in producing the good and that the • There are various arguments for restricting trade:
country will become an importer. protecting jobs, defending national security, help-
ing infant industries, preventing unfair competi-
• When a country allows trade and becomes an tion, and responding to foreign trade restrictions.
exporter of a good, producers of the good are Although some of these arguments have some
better off, and consumers of the good are worse merit in some cases, economists believe that free
off. When a country allows trade and becomes an trade is usually the better policy.
importer of a good, consumers are better off, and
producers are worse off. In both cases, the gains
from trade exceed the losses.
KEY CONCEPTS
world price, p. 179 tariff, p. 183
1. What does the domestic price that prevails with- plus with free trade? What is the change in total
out international trade tell us about a nation’s surplus?
comparative advantage? 4. Describe what a tariff is and its economic effects.
2. When does a country become an exporter of a 5. List five arguments often given to support trade
good? An importer? restrictions. How do economists respond to
3. Draw the supply-and-demand diagram for an these arguments?
importing country. What is consumer surplus 6. What is the difference between the unilateral
and producer surplus before trade is allowed? and multilateral approaches to achieving free
What is consumer surplus and producer sur- trade? Give an example of each.
1. Mexico represents a small part of the world 2. The world price of wine is below the price that
orange market. would prevail in Canada in the absence of trade.
a. Draw a diagram depicting the equilibrium in a. Assuming that Canadian imports of wine are
the Mexican orange market without interna- a small part of total world wine production,
tional trade. Identify the equilibrium price, draw a graph for the Canadian market for
equilibrium quantity, consumer surplus, and wine under free trade. Identify consumer sur-
producer surplus. plus, producer surplus, and total surplus in
b. Suppose that the world orange price is below an appropriate table.
the Mexican price before trade and that the b. Now suppose that an unusual shift of the
Mexican orange market is now opened to Gulf Stream leads to an unseasonably cold
trade. Identify the new equilibrium price, summer in Europe, destroying much of the
quantity consumed, quantity produced grape harvest there. What effect does this
domestically, and quantity imported. Also shock have on the world price of wine? Using
show the change in the surplus of domestic your graph and table from part (a), show the
consumers and producers. Has total surplus effect on consumer surplus, producer sur-
increased or decreased?
plus, and total surplus in Canada. Who are 6. Consider the arguments for restricting trade.
the winners and losers? Is Canada as a whole a. Assume you are a lobbyist for timber, an
better or worse off? established industry suffering from low-
3. Suppose that Congress imposes a tariff on priced foreign competition. Which two or
imported autos to protect the U.S. auto industry three of the five arguments do you think
from foreign competition. Assuming that the would be most persuasive to the average
United States is a price taker in the world auto member of Congress as to why he or she
market, show on a diagram: the change in the should support trade restrictions? Explain
quantity of imports, the loss to U.S. consum- your reasoning.
ers, the gain to U.S. manufacturers, government b. Now assume you are an astute student of
revenue, and the deadweight loss associated economics (hopefully not a hard assump-
with the tariff. The loss to consumers can be tion). Although all the arguments for restrict-
decomposed into three pieces: a gain to domes- ing trade have their shortcomings, name the
tic producers, revenue for the government, and two or three arguments that seem to make
a deadweight loss. Use your diagram to identify the most economic sense to you. For each,
these three pieces. describe the economic rationale for and
4. When China’s clothing industry expands, the against these arguments for trade restrictions.
increase in world supply lowers the world price 7. Senator Ernest Hollings once wrote that
of clothing. “consumers do not benefit from lower-priced
a. Draw an appropriate diagram to analyze imports. Glance through some mail-order cata-
how this change in price affects consumer logs and you’ll see that consumers pay exactly
surplus, producer surplus, and total surplus the same price for clothing whether it is U.S.-
in a nation that imports clothing, such as the made or imported.” Comment.
United States. 8. The nation of Textilia does not allow imports
b. Now draw an appropriate diagram to show of clothing. In its equilibrium without trade, a
how this change in price affects consumer T-shirt costs $20, and the equilibrium quantity is
surplus, producer surplus, and total surplus 3 million T-shirts. One day, after reading Adam
in a nation that exports clothing, such as the Smith’s The Wealth of Nations while on vacation,
Dominican Republic. the president decides to open the Textilian mar-
c. Compare your answers to parts (a) and (b). ket to international trade. The market price of
What are the similarities and what are the a T-shirt falls to the world price of $16. The
differences? Which country should be con- number of T-shirts consumed in Textilia rises
cerned about the expansion of the Chinese to 4 million, while the number of T-shirts pro-
textile industry? Which country should be duced declines to 1 million.
applauding it? Explain. a. Illustrate the situation just described in
5. Imagine that winemakers in the state of Wash- a graph. Your graph should show all the
ington petitioned the state government to tax numbers.
wines imported from California. They argue b. Calculate the change in consumer surplus,
that this tax would both raise tax revenue for producer surplus, and total surplus that
the state government and raise employment in results from opening up trade. (Hint: Recall
the Washington State wine industry. Do you that the area of a triangle is 1⁄2 × base ×
agree with these claims? Is it a good policy? height.)
9. China is a major producer of grains, such as b. Kawmin then opens the market to trade.
wheat, corn, and rice. In 2008 the Chinese Draw another graph to describe the new situ-
government, concerned that grain exports were ation in the jelly bean market. Calculate the
driving up food prices for domestic consumers, equilibrium price, quantities of consumption
imposed a tax on grain exports. and production, imports, consumer surplus,
a. Draw the graph that describes the market for producer surplus, and total surplus.
grain in an exporting country. Use this graph c. After awhile, the Czar of Kawmin responds
as the starting point to answer the following to the pleas of jelly bean producers by plac-
questions. ing a $1 per bag tariff on jelly bean imports.
b. How does an export tax affect domestic grain On a graph, show the effects of this tariff.
prices? Calculate the equilibrium price, quantities
c. How does it affect the welfare of domestic of consumption and production, imports,
consumers, the welfare of domestic produc- consumer surplus, producer surplus, govern-
ers, and government revenue? ment revenue, and total surplus.
d. What happens to total welfare in China, as d. What are the gains from opening up trade?
measured by the sum of consumer surplus, What are the deadweight losses from restrict-
producer surplus, and tax revenue? ing trade with the tariff? Give numerical
10. Consider a country that imports a good from answers.
abroad. For each of following statements, say 12. Assume the United States is an importer of tele-
whether it is true or false. Explain your answer. visions and there are no trade restrictions. U.S.
a. “The greater the elasticity of demand, the consumers buy 1 million televisions per year, of
greater the gains from trade.” which 400,000 are produced domestically and
b. “If demand is perfectly inelastic, there are no 600,000 are imported.
gains from trade.” a. Suppose that a technological advance among
c. “If demand is perfectly inelastic, consumers Japanese television manufacturers causes
do not benefit from trade.” the world price of televisions to fall by $100.
11. Kawmin is a small country that produces and Draw a graph to show how this change
consumes jelly beans. The world price of jelly affects the welfare of U.S. consumers and U.S.
beans is $1 per bag, and Kawmin’s domestic producers and how it affects total surplus in
demand and supply for jelly beans are governed the United States.
by the following equations: b. After the fall in price, consumers buy 1.2
million televisions, of which 200,000 are
Demand: QD = 8 – P
produced domestically and 1 million are
Supply: QS = P,
imported. Calculate the change in consumer
where P is in dollars per bag and Q is in bags of surplus, producer surplus, and total surplus
jelly beans. from the price reduction.
a. Draw a well-labeled graph of the situation in c. If the government responded by putting a
Kawmin if the nation does not allow trade. $100 tariff on imported televisions, what
Calculate the following (recalling that the would this do? Calculate the revenue that
area of a triangle is 1⁄2 × base × height): the would be raised and the deadweight loss.
equilibrium price and quantity, consumer Would it be a good policy from the stand-
surplus, producer surplus, and total surplus. point of U.S. welfare? Who might support
the policy?
d. Suppose that the fall in price is attributable steel, the quantity of steel produced, the quan-
not to technological advance but to a $100 per tity of steel consumed, and the quantity of steel
television subsidy from the Japanese govern- exported? How does it affect consumer surplus,
ment to Japanese industry. How would this producer surplus, government revenue, and
affect your analysis? total surplus? Is it a good policy from the stand-
13. Consider a small country that exports steel. Sup- point of economic efficiency? (Hint: The analysis
pose that a “pro-trade” government decides to of an export subsidy is similar to the analysis of
subsidize the export of steel by paying a certain a tariff.)
amount for each ton sold abroad. How does
this export subsidy affect the domestic price of
PART IV
The Economics of
the Public Sector
10
CHAPTER
Externalities
F irms that make and sell paper also create, as a by-product of the manufac-
turing process, a chemical called dioxin. Scientists believe that once dioxin
enters the environment, it raises the population’s risk of cancer, birth defects,
and other health problems.
Is the production and release of dioxin a problem for society? In Chapters 4
through 9, we examined how markets allocate scarce resources with the forces of
supply and demand, and we saw that the equilibrium of supply and demand is
typically an efficient allocation of resources. To use Adam Smith’s famous meta-
phor, the “invisible hand” of the marketplace leads self-interested buyers and sell-
ers in a market to maximize the total benefit that society derives from that market.
This insight is the basis for one of the Ten Principles of Economics in Chapter 1:
Markets are usually a good way to organize economic activity. Should we con-
clude, therefore, that the invisible hand prevents firms in the paper market from
emitting too much dioxin?
Markets do many things well, but they do not do everything well. In this chap-
ter, we begin our study of another of the Ten Principles of Economics: Government
action can sometimes improve upon market outcomes. We examine why mar-
kets sometimes fail to allocate resources efficiently, how government policies can
potentially improve the market’s allocation, and what kinds of policies are likely
to work best.
203
204 PART IV THE ECONOMICS OF THE PUBLIC SECTOR
The market failures examined in this chapter fall under a general category
externality called externalities. An externality arises when a person engages in an activity that
the uncompensated influences the well-being of a bystander and yet neither pays nor receives any
impact of one person’s compensation for that effect. If the impact on the bystander is adverse, it is called a
actions on the well-being negative externality. If it is beneficial, it is called a positive externality. In the presence
of a bystander of externalities, society’s interest in a market outcome extends beyond the well-
being of buyers and sellers who participate in the market to include the well-being
of bystanders who are affected indirectly. Because buyers and sellers neglect the
external effects of their actions when deciding how much to demand or supply,
the market equilibrium is not efficient when there are externalities. That is, the
equilibrium fails to maximize the total benefit to society as a whole. The release of
dioxin into the environment, for instance, is a negative externality. Self-interested
paper firms will not consider the full cost of the pollution they create in their
production process, and consumers of paper will not consider the full cost of the
pollution they contribute from their purchasing decisions. Therefore, the firms
will emit too much pollution unless the government prevents or discourages them
from doing so.
Externalities come in many varieties, as do the policy responses that try to deal
with the market failure. Here are some examples:
• The exhaust from automobiles is a negative externality because it creates
smog that other people have to breathe. As a result of this externality, driv-
ers tend to pollute too much. The federal government attempts to solve
this problem by setting emission standards for cars. It also taxes gasoline to
reduce the amount that people drive.
• Restored historic buildings convey a positive externality because people who
walk or ride by them can enjoy the beauty and the sense of history that these
buildings provide. Building owners do not get the full benefit of restoration
and, therefore, tend to discard older buildings too quickly. Many local gov-
ernments respond to this problem by regulating the destruction of historic
buildings and by providing tax breaks to owners who restore them.
• Barking dogs create a negative externality because neighbors are disturbed
by the noise. Dog owners do not bear the full cost of the noise and, therefore,
tend to take too few precautions to prevent their dogs from barking. Local
governments address this problem by making it illegal to “disturb the peace.”
• Research into new technologies provides a positive externality because it cre-
ates knowledge that other people can use. Because inventors cannot capture
the full benefits of their inventions, they tend to devote too few resources to
research. The federal government addresses this problem partially through
the patent system, which gives inventors exclusive use of their inventions for
a limited time.
In each of these cases, some decision maker fails to take account of the external
effects of his or her behavior. The government responds by trying to influence this
behavior to protect the interests of bystanders.
EXTERNALITIES AND MARKET INEFFICIENCY

In this section, we use the tools of welfare economics developed in Chapter 7 to
examine how externalities affect economic well-being. The analysis shows pre-
cisely why externalities cause markets to allocate resources inefficiently. Later in
CHAPTER 10 EXTERNALITIES 205
the chapter, we examine various ways in which private individuals and public
policymakers may remedy this type of market failure.
WELFARE ECONOMICS: A R ECAP

We begin by recalling the key lessons of welfare economics from Chapter 7.
To make our analysis concrete, we consider a specific market—the market for
aluminum. Figure 1 shows the supply and demand curves in the market for
aluminum.
As you should recall from Chapter 7, the supply and demand curves contain
important information about costs and benefits. The demand curve for aluminum
reflects the value of aluminum to consumers, as measured by the prices they are
willing to pay. At any given quantity, the height of the demand curve shows the
willingness to pay of the marginal buyer. In other words, it shows the value to the
consumer of the last unit of aluminum bought. Similarly, the supply curve reflects
the costs of producing aluminum. At any given quantity, the height of the supply
curve shows the cost of the marginal seller. In other words, it shows the cost to the
producer of the last unit of aluminum sold.
In the absence of government intervention, the price adjusts to balance the
supply and demand for aluminum. The quantity produced and consumed in the
market equilibrium, shown as QMARKET in Figure 1, is efficient in the sense that it
maximizes the sum of producer and consumer surplus. That is, the market allo-
cates resources in a way that maximizes the total value to the consumers who
buy and use aluminum minus the total costs to the producers who make and sell
aluminum.
NEGATIVE EXTERNALITIES
Now let’s suppose that aluminum factories emit pollution: For each unit of alu-
minum produced, a certain amount of smoke enters the atmosphere. Because this
Price of
F I G U R E 1
Aluminum Supply
(private cost)
The Market for Aluminum
The demand curve reflects the
value to buyers, and the supply
curve reflects the costs of sellers.
The equilibrium quantity, QMARKET,
Equilibrium
maximizes the total value to buy-
ers minus the total costs of sellers.
In the absence of externalities,
therefore, the market equilibrium
is efficient.
Demand
(private value)
0 QMARKET Quantity of
Aluminum
smoke creates a health risk for those who breathe the air, it is a negative external-
ity. How does this externality affect the efficiency of the market outcome?
Because of the externality, the cost to society of producing aluminum is larger
than the cost to the aluminum producers. For each unit of aluminum produced,
the social cost includes the private costs of the aluminum producers plus the costs
to those bystanders affected adversely by the pollution. Figure 2 shows the social
cost of producing aluminum. The social-cost curve is above the supply curve
because it takes into account the external costs imposed on society by aluminum
producers. The difference between these two curves reflects the cost of the pollu-
“ALL I CAN SAY IS THAT tion emitted.
IF BEING A LEADING MANU-
What quantity of aluminum should be produced? To answer this question,
FACTURER MEANS BEING A
we once again consider what a benevolent social planner would do. The planner
LEADING POLLUTER, SO BE IT.”
wants to maximize the total surplus derived from the market—the value to con-
sumers of aluminum minus the cost of producing aluminum. The planner under-
stands, however, that the cost of producing aluminum includes the external costs
of the pollution.
The planner would choose the level of aluminum production at which the
demand curve crosses the social-cost curve. This intersection determines the opti-
mal amount of aluminum from the standpoint of society as a whole. Below this
level of production, the value of the aluminum to consumers (as measured by the
height of the demand curve) exceeds the social cost of producing it (as measured
by the height of the social-cost curve). The planner does not produce more than
this level because the social cost of producing additional aluminum exceeds the
value to consumers.
Note that the equilibrium quantity of aluminum, QMARKET, is larger than the
socially optimal quantity, QOPTIMUM. This inefficiency occurs because the market
equilibrium reflects only the private costs of production. In the market equilib-
2 F I G U R E
Price of
Social cost (private cost
Aluminum
and external cost)
Pollution and the External
Social Optimum Cost
In the presence of a negative Supply
externality, such as pollu- (private cost)
tion, the social cost of the
good exceeds the private Optimum

cost. The optimal quantity,
QOPTIMUM, is therefore smaller Equilibrium
than the equilibrium quan-
tity, QMARKET.
Demand
(private value)
0 QOPTIMUM QMARKET Quantity of

Aluminum
rium, the marginal consumer values aluminum at less than the social cost of pro-
ducing it. That is, at QMARKET, the demand curve lies below the social-cost curve.
Thus, reducing aluminum production and consumption below the market equi-
librium level raises total economic well-being.
How can the social planner achieve the optimal outcome? One way would be
to tax aluminum producers for each ton of aluminum sold. The tax would shift
the supply curve for aluminum upward by the size of the tax. If the tax accurately
reflected the external cost of smoke released into the atmosphere, the new supply
curve would coincide with the social-cost curve. In the new market equilibrium,
aluminum producers would produce the socially optimal quantity of aluminum.
The use of such a tax is called internalizing the externality because it gives internalizing the
buyers and sellers in the market an incentive to take into account the external externality
effects of their actions. Aluminum producers would, in essence, take the costs of altering incentives so
pollution into account when deciding how much aluminum to supply because that people take account
the tax would make them pay for these external costs. And, because the market of the external effects of
their actions
price would reflect the tax on producers, consumers of aluminum would have an
incentive to use a smaller quantity. The policy is based on one of the Ten Principles
of Economics: People respond to incentives. Later in this chapter, we consider in
more detail how policymakers can deal with externalities.
POSITIVE EXTERNALITIES
Although some activities impose costs on third parties, others yield benefits. For
example, consider education. To a large extent, the benefit of education is pri-
vate: The consumer of education becomes a more productive worker and thus
reaps much of the benefit in the form of higher wages. Beyond these private ben-
efits, however, education also yields positive externalities. One externality is that
a more educated population leads to more informed voters, which means better
government for everyone. Another externality is that a more educated popula-
tion tends to mean lower crime rates. A third externality is that a more educated
population may encourage the development and dissemination of technologi-
cal advances, leading to higher productivity and wages for everyone. Because of
these three positive externalities, a person may prefer to have neighbors who are
well educated.
The analysis of positive externalities is similar to the analysis of negative exter-
nalities. As Figure 3 shows, the demand curve does not reflect the value to society
of the good. Because the social value is greater than the private value, the social-
value curve lies above the demand curve. The optimal quantity is found where
the social-value curve and the supply curve (which represents costs) intersect.
Hence, the socially optimal quantity is greater than the quantity determined by
the private market.
Once again, the government can correct the market failure by inducing market
participants to internalize the externality. The appropriate response in the case of
positive externalities is exactly the opposite to the case of negative externalities.
To move the market equilibrium closer to the social optimum, a positive exter-
nality requires a subsidy. In fact, that is exactly the policy the government fol-
lows: Education is heavily subsidized through public schools and government
scholarships.
To summarize: Negative externalities lead markets to produce a larger quantity than
is socially desirable. Positive externalities lead markets to produce a smaller quantity than
3 F I G U R E
Price of
Education
Supply
Education and the (private cost)
Social Optimum
In the presence of a posi-
tive externality, the social External
value of the good exceeds benefit Optimum
the private value. The Equilibrium
optimal quantity, QOPTIMUM,
is therefore larger than
the equilibrium quantity,
QMARKET.
Social value (private value
and external benefit)
Demand
(private value)
0 QMARKET QOPTIMUM Quantity of

Education
is socially desirable. To remedy the problem, the government can internalize the external-
ity by taxing goods that have negative externalities and subsidizing goods that have posi-
tive externalities.
TECHNOLOGY SPILLOVERS, INDUSTRIAL POLICY,

AND PATENT PROTECTION
A potentially important type of positive externality is called a technology spillover—

the impact of one firm’s research and production efforts on other firms’ access
to technological advance. For example, consider the market for industrial robots.
Robots are at the frontier of a rapidly changing technology. Whenever a firm
builds a robot, there is some chance that it will discover a new and better design.
This new design may benefit not only this firm but society as a whole because
the design will enter society’s pool of technological knowledge. That is, the new
design may have positive externalities for other producers in the economy.
In this case, the government can internalize the externality by subsidizing the
production of robots. If the government paid firms a subsidy for each robot pro-
duced, the supply curve would shift down by the amount of the subsidy, and this
shift would increase the equilibrium quantity of robots. To ensure that the market
equilibrium equals the social optimum, the subsidy should equal the value of the
technology spillover.
How large are technology spillovers, and what do they imply for public policy?
This is an important question because technological progress is the key to why liv-
ing standards rise over time. Yet it is also a difficult question on which economists
often disagree.
Some economists believe that technology spillovers are pervasive and that the
government should encourage those industries that yield the largest spillovers.
For instance, these economists argue that if making computer chips yields greater
spillovers than making potato chips, then the government should encourage the
production of computer chips relative to the production of potato chips. The U.S.
tax code does this in a limited way by offering special tax breaks for expendi-
tures on research and development. Some other nations go further by subsidizing
specific industries that supposedly offer large technology spillovers. Government
intervention in the economy that aims to promote technology-enhancing indus-
tries is sometimes called industrial policy.
Other economists are skeptical about industrial policy. Even if technology spill-
overs are common, the success of an industrial policy requires that the government
be able to measure the size of the spillovers from different markets. This measure-
ment problem is difficult at best. Moreover, without precise measurements, the
political system may end up subsidizing industries with the most political clout
rather than those that yield the largest positive externalities.
Another way to deal with technology spillovers is patent protection. The patent
laws protect the rights of inventors by giving them exclusive use of their inven-
tions for a period of time. When a firm makes a technological breakthrough, it can
patent the idea and capture much of the economic benefit for itself. The patent
internalizes the externality by giving the firm a property right over its invention. If
other firms want to use the new technology, they would have to obtain permission
from the inventing firm and pay it some royalty. Thus, the patent system gives
firms a greater incentive to engage in research and other activities that advance
technology. ●
QUICK QUIZ Give an example of a negative externality and a positive externality. Explain
why market outcomes are inefficient in the presence of these externalities.
PUBLIC POLICIES TOWARD EXTERNALITIES

We have discussed why externalities lead markets to allocate resources ineffi-
ciently but have mentioned only briefly how this inefficiency can be remedied. In
practice, both public policymakers and private individuals respond to externali-
ties in various ways. All of the remedies share the goal of moving the allocation of
resources closer to the social optimum.
This section considers governmental solutions. As a general matter, the govern-
ment can respond to externalities in one of two ways. Command-and-control policies
regulate behavior directly. Market-based policies provide incentives so that private
decision makers will choose to solve the problem on their own.
COMMAND-AND-CONTROL POLICIES: R EGULATION

The government can remedy an externality by making certain behaviors either
required or forbidden. For example, it is a crime to dump poisonous chemicals
into the water supply. In this case, the external costs to society far exceed the ben-
efits to the polluter. The government therefore institutes a command-and-control
policy that prohibits this act altogether.
In most cases of pollution, however, the situation is not this simple. Despite
the stated goals of some environmentalists, it would be impossible to prohibit
all polluting activity. For example, virtually all forms of transportation—even
the horse—produce some undesirable polluting by-products. But it would not be

sensible for the government to ban all transportation. Thus, instead of trying to
eradicate pollution entirely, society has to weigh the costs and benefits to decide
the kinds and quantities of pollution it will allow. In the United States, the Envi-
ronmental Protection Agency (EPA) is the government agency with the task of
developing and enforcing regulations aimed at protecting the environment.
Environmental regulations can take many forms. Sometimes the EPA dictates a
maximum level of pollution that a factory may emit. Other times the EPA requires
that firms adopt a particular technology to reduce emissions. In all cases, to design
good rules, the government regulators need to know the details about specific
industries and about the alternative technologies that those industries could
adopt. This information is often difficult for government regulators to obtain.
M ARKET-BASED POLICY 1: CORRECTIVE TAXES

AND SUBSIDIES
Instead of regulating behavior in response to an externality, the government can
use market-based policies to align private incentives with social efficiency. For
instance, as we saw earlier, the government can internalize the externality by tax-
ing activities that have negative externalities and subsidizing activities that have
positive externalities. Taxes enacted to deal with the effects of negative externali-
corrective tax ties are called corrective taxes. They are also called Pigovian taxes after economist
a tax designed to induce Arthur Pigou (1877–1959), an early advocate of their use. An ideal corrective tax
private decision makers would equal the external cost from an activity with negative externalities, and an
to take account of ideal corrective subsidy would equal the external benefit from an activity with
the social costs that positive externalities.
arise from a negative
Economists usually prefer corrective taxes to regulations as a way to deal with
externality
pollution because they can reduce pollution at a lower cost to society. To see why,
let us consider an example.
Suppose that two factories—a paper mill and a steel mill—are each dumping
500 tons of glop into a river each year. The EPA decides that it wants to reduce the
amount of pollution. It considers two solutions:
• Regulation: The EPA could tell each factory to reduce its pollution to
300 tons of glop per year.
• Corrective tax: The EPA could levy a tax on each factory of $50,000 for
each ton of glop it emits.
The regulation would dictate a level of pollution, whereas the tax would give fac-
tory owners an economic incentive to reduce pollution. Which solution do you
think is better?
Most economists prefer the tax. To explain this preference, they would first
point out that a tax is just as effective as a regulation in reducing the overall level
of pollution. The EPA can achieve whatever level of pollution it wants by setting
the tax at the appropriate level. The higher the tax, the larger the reduction in pol-
lution. If the tax is high enough, the factories will close down altogether, reducing
pollution to zero.
Although regulation and corrective taxes are both capable of reducing pollution,
the tax accomplishes this goal more efficiently. The regulation requires each factory
to reduce pollution by the same amount. An equal reduction, however, is not nec-
essarily the least expensive way to clean up the water. It is possible that the paper
mill can reduce pollution at lower cost than the steel mill. If so, the paper mill would
respond to the tax by reducing pollution substantially to avoid the tax, whereas the
steel mill would respond by reducing pollution less and paying the tax.
In essence, the corrective tax places a price on the right to pollute. Just as mar-
kets allocate goods to those buyers who value them most highly, a corrective tax
allocates pollution to those factories that face the highest cost of reducing it. What-
ever the level of pollution the EPA chooses, it can achieve this goal at the lowest
total cost using a tax.
Economists also argue that corrective taxes are better for the environment.
Under the command-and-control policy of regulation, the factories have no rea-
son to reduce emission further once they have reached the target of 300 tons of
glop. By contrast, the tax gives the factories an incentive to develop cleaner tech-
nologies because a cleaner technology would reduce the amount of tax the factory
has to pay.
Corrective taxes are unlike most other taxes. As we discussed in Chapter 8,
most taxes distort incentives and move the allocation of resources away from the
social optimum. The reduction in economic well-being—that is, in consumer and
producer surplus—exceeds the amount of revenue the government raises, result-
ing in a deadweight loss. By contrast, when externalities are present, society also
cares about the well-being of the bystanders who are affected. Corrective taxes
alter incentives to account for the presence of externalities and thereby move the
allocation of resources closer to the social optimum. Thus, while corrective taxes
raise revenue for the government, they also enhance economic efficiency.
WHY IS GASOLINE TAXED SO HEAVILY?

In many nations, gasoline is among the most heavily taxed goods. The gas tax can
be viewed as a corrective tax aimed at three negative externalities associated with
driving:
• Congestion: If you have ever been stuck in bumper-to-bumper traffic, you
have probably wished that there were fewer cars on the road. A gasoline tax
keeps congestion down by encouraging people to take public transportation,
carpool more often, and live closer to work.
• Accidents: Whenever people buy large cars or sport-utility vehicles, they may
make themselves safer but they certainly put their neighbors at risk. Accord-
ing to the National Highway Traffic Safety Administration, a person driv-
ing a typical car is five times as likely to die if hit by a sport-utility vehicle
than if hit by another car. The gas tax is an indirect way of making people
pay when their large, gas-guzzling vehicles impose risk on others, which in
turn makes them take this risk into account when choosing what vehicle to
purchase.
• Pollution: The burning of fossil fuels such as gasoline is widely believed to
be the cause of global warming. Experts disagree about how dangerous this
threat is, but there is no doubt that the gas tax reduces the threat by reducing
the use of gasoline.
So the gas tax, rather than causing deadweight losses like most taxes, actually
makes the economy work better. It means less traffic congestion, safer roads, and
a cleaner environment.
CARTOON: © 2005 JOHN TREVER, ALBUQUERQUE JOURNAL.

REPRINTED BY PERMISSION.
How high should the tax on gasoline be? Most European countries impose gas-
oline taxes that are much higher than those in the United States. Many observers
have suggested that the United States also should tax gasoline more heavily. A
2007 study published in the Journal of Economic Literature summarized the research
on the size of the various externalities associated with driving. It concluded that
the optimal corrective tax on gasoline was $2.10 per gallon, compared to the actual
tax in the United States of 40 cents.
The tax revenue from a gasoline tax could be used to lower taxes that distort
incentives and cause deadweight losses. In addition, some of the burdensome
government regulations that require automakers to produce more fuel-efficient
cars would prove unnecessary. This idea, however, has never proven politically
popular. ●
M ARKET-BASED POLICY 2: TRADABLE

POLLUTION PERMITS
Returning to our example of the paper mill and the steel mill, let us suppose that,
despite the advice of its economists, the EPA adopts the regulation and requires
each factory to reduce its pollution to 300 tons of glop per year. Then one day,
after the regulation is in place and both mills have complied, the two firms go to
the EPA with a proposal. The steel mill wants to increase its emission of glop by
100 tons. The paper mill has agreed to reduce its emission by the same amount if
the steel mill pays it $5 million. Should the EPA allow the two factories to make
this deal?
From the standpoint of economic efficiency, allowing the deal is good policy.
The deal must make the owners of the two factories better off because they are
voluntarily agreeing to it. Moreover, the deal does not have any external effects
because the total amount of pollution remains the same. Thus, social welfare is
enhanced by allowing the paper mill to sell its pollution rights to the steel mill.
The same logic applies to any voluntary transfer of the right to pollute from one
firm to another. If the EPA allows firms to make these deals, it will, in essence,
have created a new scarce resource: pollution permits. A market to trade these
permits will eventually develop, and that market will be governed by the forces
of supply and demand. The invisible hand will ensure that this new market allo-
cates the right to pollute efficiently. That is, the permits will end up in the hands
of those firms that value them most highly, as judged by their willingness to pay.
A firm’s willingness to pay, in turn, will depend on its cost of reducing pollution:
The more costly it is for a firm to cut back on pollution, the more it will be willing
to pay for a permit.
An advantage of allowing a market for pollution permits is that the initial allo-
cation of pollution permits among firms does not matter from the standpoint of
economic efficiency. Those firms that can reduce pollution at a low cost will sell
whatever permits they get, and firms that can reduce pollution only at a high
cost will buy whatever permits they need. As long as there is a free market for
the pollution rights, the final allocation will be efficient regardless of the initial
allocation.
Although reducing pollution using pollution permits may seem very different
from using corrective taxes, the two policies have much in common. In both cases,
firms pay for their pollution. With corrective taxes, polluting firms must pay a tax
to the government. With pollution permits, polluting firms must pay to buy the
permit. (Even firms that already own permits must pay to pollute: The opportu-
nity cost of polluting is what they could have received by selling their permits
on the open market.) Both corrective taxes and pollution permits internalize the
externality of pollution by making it costly for firms to pollute.
The similarity of the two policies can be seen by considering the market for
pollution. Both panels in Figure 4 show the demand curve for the right to pol-
lute. This curve shows that the lower the price of polluting, the more firms will
choose to pollute. In panel (a), the EPA uses a corrective tax to set a price for pollu-
tion. In this case, the supply curve for pollution rights is perfectly elastic (because
firms can pollute as much as they want by paying the tax), and the position of the
demand curve determines the quantity of pollution. In panel (b), the EPA sets a
quantity of pollution by issuing pollution permits. In this case, the supply curve
for pollution rights is perfectly inelastic (because the quantity of pollution is fixed
by the number of permits), and the position of the demand curve determines the
price of pollution. Hence, the EPA can achieve any point on a given demand curve
either by setting a price with a corrective tax or by setting a quantity with pollu-
tion permits.
In some circumstances, however, selling pollution permits may be better than
levying a corrective tax. Suppose the EPA wants no more than 600 tons of glop
dumped into the river. But because the EPA does not know the demand curve
for pollution, it is not sure what size tax would achieve that goal. In this case, it
can simply auction off 600 pollution permits. The auction price would yield the
appropriate size of the corrective tax.
The idea of the government auctioning off the right to pollute may at first
sound like a creature of some economist’s imagination. And in fact, that is how
the idea began. But increasingly, the EPA has used the system as a way to control
pollution. A notable success story has been the case of sulfur dioxide (SO2)—a
Types
demand
(a),Graphs
The pie chart
the EPA sets a price on pollution by levying a corrective tax, and the
curveindetermines the quantity
panel (a) shows how U.S.ofnational
pollution. In panel
income (b), the from
is derived EPA limits the
various
quantity
sources. of
Thepollution by in
bar graph limiting
panel the number ofthe
(b) compares pollution
averagepermits,
incomeand the countries.
in four demand
The Equivalence of curve determines
The time-series the price
graph of pollution.
in panel (c) shows The price and quantity
the productivity of laborof in
pollution are the
U.S. businesses
Corrective Taxes and same in thetotwo
from 1950 cases.
2000.
Pollution Permits
(a) Corrective Tax (b) Pollution Permits
Price of Price of Supply of
Pollution Pollution pollution permits
P Corrective P
tax
1. A corrective
tax sets the
price of Demand for Demand for
pollution . . . pollution rights pollution rights
0 Q Quantity of 0 Q Quantity of
Pollution Pollution
2. . . . which, together
with the demand curve, 2. . . . which, together 1. Pollution
determines the quantity with the demand curve, permits set
of pollution. determines the price the quantity
of pollution. of pollution . . .
leading cause of acid rain. In 1990, amendments to the Clean Air Act required
power plants to reduce SO2 emissions substantially. At the same time, the amend-
ments set up a system that allowed plants to trade their SO2 allowances. Although
initially both industry representatives and environmentalists were skeptical of the
proposal, over time the system has proved that it can reduce pollution with mini-
mal disruption. Pollution permits, like corrective taxes, are now widely viewed as
a cost-effective way to keep the environment clean.
OBJECTIONS TO THE ECONOMIC ANALYSIS OF POLLUTION

“We cannot give anyone the option of polluting for a fee.” This comment by for-
mer Senator Edmund Muskie reflects the view of some environmentalists. Clean
air and clean water, they argue, are fundamental human rights that should not
be debased by considering them in economic terms. How can you put a price on
clean air and clean water? The environment is so important, they claim, that we
should protect it as much as possible, regardless of the cost.
Economists have little sympathy for this type of argument. To economists, good
environmental policy begins by acknowledging the first of the Ten Principles of
Economics in Chapter 1: People face trade-offs. Certainly, clean air and clean water
have value. But their value must be compared to their opportunity cost—that
is, to what one must give up to obtain them. Eliminating all pollution is impos-
sible. Trying to eliminate all pollution would reverse many of the technological
advances that allow us to enjoy a high standard of living. Few people would be
willing to accept poor nutrition, inadequate medical care, or shoddy housing to

make the environment as clean as possible.
Economists argue that some environmental activists hurt their own cause by
not thinking in economic terms. A clean environment is a good like other goods.
Like all normal goods, it has a positive income elasticity: Rich countries can afford
a cleaner environment than poor ones and, therefore, usually have more rigorous
environmental protection. In addition, like most other goods, clean air and clean
water obey the law of demand: The lower the price of environmental protection,
the more the public will want. The economic approach of using pollution permits
and corrective taxes reduces the cost of environmental protection and should,
therefore, increase the public’s demand for a clean environment.
QUICK QUIZ A glue factory and a steel mill emit smoke containing a chemical that is
harmful if inhaled in large amounts. Describe three ways the town government might
respond to this externality. What are the pros and cons of each solution?
PRIVATE SOLUTIONS TO EXTERNALITIES

Although externalities tend to cause markets to be inefficient, government action
is not always needed to solve the problem. In some circumstances, people can
develop private solutions.
THE TYPES OF PRIVATE SOLUTIONS

Sometimes the problem of externalities is solved with moral codes and social
sanctions. Consider, for instance, why most people do not litter. Although there
are laws against littering, these laws are not vigorously enforced. Most people do
not litter just because it is the wrong thing to do. The Golden Rule taught to most
children says, “Do unto others as you would have them do unto you.” This moral
injunction tells us to take account of how our actions affect other people. In eco-
nomic terms, it tells us to internalize externalities.
Another private solution to externalities is charities, many of which are estab-
lished to deal with externalities. For example, the Sierra Club, whose goal is to
protect the environment, is a nonprofit organization funded with private dona-
tions. As another example, colleges and universities receive gifts from alumni, cor-
porations, and foundations in part because education has positive externalities for
society. The government encourages this private solution to externalities through
the tax system by allowing an income tax deduction for charitable donations.
The private market can often solve the problem of externalities by relying on
the self-interest of the relevant parties. Sometimes the solution takes the form of
integrating different types of businesses. For example, consider an apple grower
and a beekeeper who are located next to each other. Each business confers a posi-
tive externality on the other: By pollinating the flowers on the trees, the bees help
the orchard produce apples. At the same time, the bees use the nectar they get
from the apple trees to produce honey. Nonetheless, when the apple grower is
deciding how many trees to plant and the beekeeper is deciding how many bees
to keep, they neglect the positive externality. As a result, the apple grower plants
too few trees and the beekeeper keeps too few bees. These externalities could be
internalized if the beekeeper bought the apple orchard or if the apple grower
The Case for Taxing Carbon

An obscure economist proposes a way to deal with global
climate change.
One Answer to Global century. In his honor, economics textbooks a carbon tax would raise the tax burden on
Warming: A New Tax now call them “Pigovian taxes.” anyone who drives a car or uses electricity
By N. Gregory Mankiw Using a Pigovian tax to address global produced with fossil fuels, which means
warming is also an old idea. It was proposed just about everybody. Some might fear this
In the debate over global climate change, as far back as 1992 by Martin S. Feldstein on would be particularly hard on the poor and
there is a yawning gap that needs to be the editorial page of The Wall Street Journal. middle class.
bridged. The gap is not between environ- Once chief economist to Ronald Reagan, Mr. But Gilbert Metcalf, a professor of eco-
mentalists and industrialists, or between Feldstein has devoted much of his career to nomics at Tufts, has shown how revenue
Democrats and Republicans. It is between studying how high tax rates distort incentives from a carbon tax could be used to reduce
policy wonks and political consultants. and impede economic growth. But like most payroll taxes in a way that would leave the
Among policy wonks like me, there is other policy wonks, he appreciates that some distribution of total tax burden approxi-
a broad consensus. The scientists tell us taxes align private incentives with social mately unchanged. He proposes a tax of $15
that world temperatures are rising because costs and move us toward better outcomes. per metric ton of carbon dioxide, together
humans are emitting carbon into the atmo- Those vying for elected office, however, with a rebate of the federal payroll tax on
sphere. Basic economics tells us that when are reluctant to sign on to this agenda. Their the first $3,660 of earnings for each worker.
you tax something, you normally get less political consultants are no fans of taxes, The case for a carbon tax looks even
of it. So if we want to reduce global emis- Pigovian or otherwise. Republican consul- stronger after an examination of the other
sions of carbon, we need a global carbon tants advise using the word “tax” only if options on the table. Lawmakers in both
tax. QED. followed immediately by the word “cut.” political parties want to require carmakers to
The idea of using taxes to fix problems, Democratic consultants recommend the increase the fuel efficiency of the cars they
rather than merely raise government rev- word “tax” be followed by “on the rich.” sell. Passing the buck to auto companies has
enue, has a long history. The British econo- Yet this natural aversion to carbon taxes a lot of popular appeal.
mist Arthur Pigou advocated such corrective can be overcome if the revenue from the Increased fuel efficiency, however, is not
taxes to deal with pollution in the early 20th tax is used to reduce other taxes. By itself, free. Like a tax, the cost of complying with
bought the beehives: Both activities would then take place within the same firm,
and this single firm could choose the optimal number of trees and bees. Internal-
izing externalities is one reason that some firms are involved in different types of
businesses.
Another way for the private market to deal with external effects is for the inter-
ested parties to enter into a contract. In the foregoing example, a contract between
the apple grower and the beekeeper can solve the problem of too few trees and
too few bees. The contract can specify the number of trees, the number of bees,
and perhaps a payment from one party to the other. By setting the right number
of trees and bees, the contract can solve the inefficiency that normally arises from
these externalities and make both parties better off.
more stringent regulation will be passed allocated. If the government auctions them the United States. Using a historical baseline
on to consumers in the form of higher car off, then the price of a carbon allowance is to allocate allowances, as is often proposed,
prices. But the government will not raise any effectively a carbon tax. would reward the United States for having
revenue that it can use to cut other taxes to But the history of cap-and-trade systems been a leading cause of the problem.
compensate for these higher prices. (And suggests that the allowances would proba- But allocating carbon allowances based
don’t expect savings on gas to compen- bly be handed out to power companies and on population alone would create a system
sate consumers in a meaningful way: Any other carbon emitters, which would then in which the United States, with its higher
truly cost-effective increase in fuel efficiency be free to use them or sell them at mar- standard of living, would buy allowances
would already have been made.) ket prices. In this case, the prices of energy from China. American voters are not going
More important, enhancing fuel effi- products would rise as they would under a to embrace a system of higher energy prices,
ciency by itself is not the best way to reduce carbon tax, but the government would col- coupled with a large transfer of national
energy consumption. Fuel use depends lect no revenue to reduce other taxes and income to the Chinese. It would amount to
not only on the efficiency of the car fleet compensate consumers. a massive foreign aid program to one of the
but also on the daily decisions that people The international dimension of the world’s most rapidly growing economies.
make—how far from work they choose to problem also suggests the superiority of a A global carbon tax would be easier to
live and how often they carpool or use pub- carbon tax over cap-and-trade. Any long- negotiate. All governments require revenue
lic transportation. term approach to global climate change will for public purposes. The world’s nations
A carbon tax would provide incentives have to deal with the emerging economies could agree to use a carbon tax as one
for people to use less fuel in a multitude of China and India. By some reports, China is instrument to raise some of that revenue.
of ways. By contrast, merely having more now the world’s leading emitter of carbon, No money needs to change hands across
efficient cars encourages more driving. in large part simply because it has so many national borders. Each government could
Increased driving not only produces more people. The failure of the Kyoto treaty to keep the revenue from its tax and use it to
carbon but also exacerbates other problems, include these emerging economies is one finance spending or whatever form of tax
like accidents and road congestion. reason that, in 1997, the United States Sen- relief it considered best.
Another popular proposal to limit car- ate passed a resolution rejecting the Kyoto Convincing China of the virtues of a
bon emissions is a cap-and-trade system, approach by a vote of 95 to zero. carbon tax, however, may prove to be the
under which carbon emissions are limited Agreement on a truly global cap-and- easy part. The first and more difficult step is
and allowances are bought and sold in the trade system, however, is hard to imagine. to convince American voters, and therefore
marketplace. The effect of such a system China is unlikely to be persuaded to accept political consultants, that “tax” is not a four-
depends on how the carbon allowances are fewer carbon allowances per person than letter word.
Source: New York Times, September 16, 2007.
THE COASE THEOREM

How effective is the private market in dealing with externalities? A famous result,
called the Coase theorem after economist Ronald Coase, suggests that it can be Coase theorem
very effective in some circumstances. According to the Coase theorem, if private the proposition that
parties can bargain over the allocation of resources at no cost, then the private if private parties can
market will always solve the problem of externalities and allocate resources bargain without cost
efficiently. over the allocation of
resources, they can solve
To see how the Coase theorem works, consider an example. Suppose that Dick
the problem of externali-
owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets
ties on their own
a benefit from owning the dog, but the dog confers a negative externality on Jane.
Should Dick be forced to send Spot to the pound, or should Jane have to suffer
sleepless nights because of Spot’s barking?
Consider first what outcome is socially efficient. A social planner, considering
the two alternatives, would compare the benefit that Dick gets from the dog to
the cost that Jane bears from the barking. If the benefit exceeds the cost, it is effi-
cient for Dick to keep the dog and for Jane to live with the barking. Yet if the cost
exceeds the benefit, then Dick should get rid of the dog.
According to the Coase theorem, the private market will reach the efficient out-
come on its own. How? Jane can simply offer to pay Dick to get rid of the dog.
Dick will accept the deal if the amount of money Jane offers is greater than the
benefit of keeping the dog.
By bargaining over the price, Dick and Jane can always reach the efficient out-
come. For instance, suppose that Dick gets a $500 benefit from the dog and Jane
bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid
of the dog, and Dick will gladly accept. Both parties are better off than they were
before, and the efficient outcome is reached.
It is possible, of course, that Jane would not be willing to offer any price that
Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the
dog and Jane bears an $800 cost from the barking. In this case, Dick would turn
down any offer below $1,000, while Jane would not offer any amount above $800.
Therefore, Dick ends up keeping the dog. Given these costs and benefits, how-
ever, this outcome is efficient.
So far, we have assumed that Dick has the legal right to keep a barking dog.
In other words, we have assumed that Dick can keep Spot unless Jane pays him
enough to induce him to give up the dog voluntarily. But how different would the
outcome be if Jane had the legal right to peace and quiet?
According to the Coase theorem, the initial distribution of rights does not mat-
ter for the market’s ability to reach the efficient outcome. For instance, suppose
that Jane can legally compel Dick to get rid of the dog. Although having this right
works to Jane’s advantage, it probably will not change the outcome. In this case,
Dick can offer to pay Jane to allow him to keep the dog. If the benefit of the dog
to Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a
bargain in which Dick keeps the dog.
Although Dick and Jane can reach the efficient outcome regardless of how
rights are initially distributed, the distribution of rights is not irrelevant: It deter-
mines the distribution of economic well-being. Whether Dick has the right to a
barking dog or Jane the right to peace and quiet determines who pays whom in
the final bargain. But in either case, the two parties can bargain with each other
and solve the externality problem. Dick will end up keeping the dog only if the
benefit exceeds the cost.
To sum up: The Coase theorem says that private economic actors can solve the problem
of externalities among themselves. Whatever the initial distribution of rights, the inter-
ested parties can always reach a bargain in which everyone is better off and the outcome is
efficient.
WHY PRIVATE SOLUTIONS DO NOT A LWAYS WORK

Despite the appealing logic of the Coase theorem, private individuals on their
own often fail to resolve the problems caused by externalities. The Coase theorem
applies only when the interested parties have no trouble reaching and enforcing
an agreement. In the real world, however, bargaining does not always work, even
when a mutually beneficial agreement is possible.
Sometimes the interested parties fail to solve an externality problem because
of transaction costs, the costs that parties incur in the process of agreeing to and transaction costs
following through on a bargain. In our example, imagine that Dick and Jane speak the costs that parties
different languages so that, to reach an agreement, they need to hire a translator. incur in the process of
If the benefit of solving the barking problem is less than the cost of the transla- agreeing to and follow-
tor, Dick and Jane might choose to leave the problem unsolved. In more realistic ing through on a bargain
examples, the transaction costs are the expenses not of translators but of the law-
yers required to draft and enforce contracts.
At other times, bargaining simply breaks down. The recurrence of wars and
labor strikes shows that reaching agreement can be difficult and that failing to
reach agreement can be costly. The problem is often that each party tries to hold
out for a better deal. For example, suppose that Dick gets a $500 benefit from the
dog, and Jane bears an $800 cost from the barking. Although it is efficient for Jane
to pay Dick to get rid of the dog, there are many prices that could lead to this out-
come. Dick might demand $750, and Jane might offer only $550. As they haggle
over the price, the inefficient outcome with the barking dog persists.
Reaching an efficient bargain is especially difficult when the number of inter-
ested parties is large because coordinating everyone is costly. For example, con-
sider a factory that pollutes the water of a nearby lake. The pollution confers a
negative externality on the local fishermen. According to the Coase theorem, if the
pollution is inefficient, then the factory and the fishermen could reach a bargain
in which the fishermen pay the factory not to pollute. If there are many fishermen,
however, trying to coordinate them all to bargain with the factory may be almost
impossible.
When private bargaining does not work, the government can sometimes play a
role. The government is an institution designed for collective action. In this exam-
ple, the government can act on behalf of the fishermen, even when it is impractical
for the fishermen to act for themselves.
Q Q
UICK UIZ Give an example of a private solution to an externality. • What is the Coase
theorem? • Why are private economic participants sometimes unable to solve the prob-
lems caused by an externality?
CONCLUSION
The invisible hand is powerful but not omnipotent. A market’s equilibrium maxi-
mizes the sum of producer and consumer surplus. When the buyers and sellers
in the market are the only interested parties, this outcome is efficient from the
standpoint of society as a whole. But when there are external effects, such as pol-
lution, evaluating a market outcome requires taking into account the well-being
of third parties as well. In this case, the invisible hand of the marketplace may fail
to allocate resources efficiently.
In some cases, people can solve the problem of externalities on their own. The
Coase theorem suggests that the interested parties can bargain among themselves
and agree on an efficient solution. Sometimes, however, an efficient outcome can-
not be reached, perhaps because the large number of interested parties makes
bargaining difficult.
When people cannot solve the problem of externalities privately, the govern-
ment often steps in. Yet even with government intervention, society should not
abandon market forces entirely. Rather, the government can address the problem
by requiring decision makers to bear the full costs of their actions. Corrective taxes
on emissions and pollution permits, for instance, are designed to internalize the
externality of pollution. More and more, these are the policies of choice for those
interested in protecting the environment. Market forces, properly redirected, are
often the best remedy for market failure.
SUMMARY
• When a transaction between a buyer and seller of pollution permits. The result of this policy is
directly affects a third party, the effect is called largely the same as imposing corrective taxes on
an externality. If an activity yields negative exter- polluters.
nalities, such as pollution, the socially optimal
quantity in a market is less than the equilibrium
• Those affected by externalities can sometimes
solve the problem privately. For instance, when
quantity. If an activity yields positive externali-
one business imposes an externality on another
ties, such as technology spillovers, the socially
business, the two businesses can internalize the
optimal quantity is greater than the equilibrium
externality by merging. Alternatively, the inter-
quantity.
ested parties can solve the problem by negotiat-
• Governments pursue various policies to rem- ing a contract. According to the Coase theorem,
edy the inefficiencies caused by externalities. if people can bargain without cost, then they can
Sometimes the government prevents socially always reach an agreement in which resources
inefficient activity by regulating behavior. Other are allocated efficiently. In many cases, however,
times it internalizes an externality using correc- reaching a bargain among the many interested
tive taxes. Another public policy is to issue per- parties is difficult, so the Coase theorem does not
mits. For example, the government could protect apply.
the environment by issuing a limited number
KEY CONCEPTS
externality, p. 204 corrective tax, p. 210

internalizing the Coase theorem, p. 217
externality, p. 207 transaction costs, p. 219
1. Give an example of a negative externality and 5. List some of the ways that the problems caused
an example of a positive externality. by externalities can be solved without govern-
2. Draw a supply-and-demand diagram to explain ment intervention.
the effect of a negative externality that occurs as 6. Imagine that you are a nonsmoker sharing a
a result of a firm’s production process. room with a smoker. According to the Coase
3. In what way does the patent system help society theorem, what determines whether your room-
solve an externality problem? mate smokes in the room? Is this outcome effi-
4. What are corrective taxes? Why do economists cient? How do you and your roommate reach
prefer them to regulations as a way to protect this solution?
the environment from pollution?
1. There are two ways to protect your car from 4. It is rumored that the Swiss government sub-
theft. The Club makes it difficult for a car thief sidizes cattle farming and that the subsidy is
to take your car. Lojack makes it easier for the larger in areas with more tourist attractions.
police to catch the car thief who has stolen it. Can you think of a reason this policy might be
Which of these types of protection conveys efficient?
a negative externality on other car owners? 5. A local drama company proposes a new
Which conveys a positive externality? Do you neighborhood theater in San Francisco. Before
think there are any policy implications of your approving the permit, the city planner com-
analysis? pletes a study of the theater’s impact on the
2. Do you agree with the following statements? surrounding community.
Why or why not? a. One finding of the study is that theaters
a. “The benefits of corrective taxes as a way to attract traffic, which adversely affects the
reduce pollution have to be weighed against community. The city planner estimates that
the deadweight losses that these taxes cause.” the cost to the community from the extra
b. “When deciding whether to levy a correc- traffic is $5 per ticket. What kind of an exter-
tive tax on consumers or producers, the nality is this? Why?
government should be careful to levy the b. Graph the market for theater tickets, labeling
tax on the side of the market generating the the demand curve, the social-value curve,
externality.” the supply curve, the social-cost curve, the
3. Consider the market for fire extinguishers. market equilibrium level of output, and the
a. Why might fire extinguishers exhibit positive efficient level of output. Also show the per-
externalities? unit amount of the externality.
b. Draw a graph of the market for fire extin- c. Upon further review, the city planner uncov-
guishers, labeling the demand curve, the ers a second externality. Rehearsals for the
social-value curve, the supply curve, and the plays tend to run until late at night, with
social-cost curve. actors, stagehands, and other theater mem-
c. Indicate the market equilibrium level of out- bers coming and going at various hours. The
put and the efficient level of output. Give an planner has found that the increased foot
intuitive explanation for why these quantities traffic improves the safety of the surrounding
differ. streets, an estimated benefit to the commu-
d. If the external benefit is $10 per extinguisher, nity of $2 per ticket. What kind of externality
describe a government policy that would is this? Why?
yield the efficient outcome.
d. On a new graph, illustrate the market for theorem, how might Ringo and Luciano
theater tickets in the case of these two exter- reach an efficient outcome on their own?
nalities. Again, label the demand curve, the What might prevent them from reaching an
social-value curve, the supply curve, the efficient outcome?
social-cost curve, the market equilibrium 9. The Pristine River has two polluting firms on its
level of output, the efficient level of output, banks. Acme Industrial and Creative Chemicals
and the per-unit amount of both externalities. each dump 100 tons of glop into the river each
e. Describe a government policy that would year. The cost of reducing glop emissions per
result in an efficient outcome. ton equals $10 for Acme and $100 for Creative.
6. Greater consumption of alcohol leads to more The local government wants to reduce overall
motor vehicle accidents and, thus, imposes costs pollution from 200 tons to 50 tons.
on people who do not drink and drive. a. If the government knows the cost of reduc-
a. Illustrate the market for alcohol, labeling tion for each firm, what reductions will it
the demand curve, the social-value curve, impose to reach its overall goal? What will be
the supply curve, the social-cost curve, the the cost to each firm and the total cost to the
market equilibrium level of output, and the firms together?
efficient level of output. b. In a more typical situation, the government
b. On your graph, shade the area corresponding does not know the cost of pollution reduction
to the deadweight loss of the market equi- for each firm. If the government decides to
librium. (Hint: The deadweight loss occurs reach its overall goal by imposing uniform
because some units of alcohol are consumed reductions on the firms, calculate the reduc-
for which the social cost exceeds the social tion made by each firm, the cost to each firm,
value.) Explain. and the total cost to the firms together.
7. Many observers believe that the levels of pollu- c. Compare the total cost of pollution reduction
tion in our society are too high. in parts (a) and (b). If the government does
a. If society wishes to reduce overall pollution not know the cost of reduction for each firm,
by a certain amount, why is it efficient to is there still some way for it to reduce pollu-
have different amounts of reduction at differ- tion to 50 tons at the total cost you calculated
ent firms? in part (a)? Explain.
b. Command-and-control approaches often rely 10. Figure 4 shows that for any given demand
on uniform reductions among firms. Why curve for the right to pollute, the government
are these approaches generally unable to can achieve the same outcome either by set-
target the firms that should undertake bigger ting a price with a corrective tax or by setting a
reductions? quantity with pollution permits. Suppose there
c. Economists argue that appropriate corrective is a sharp improvement in the technology for
taxes or tradable pollution rights will result controlling pollution.
in efficient pollution reduction. How do a. Using graphs similar to those in Figure 4,
these approaches target the firms that should illustrate the effect of this development on
undertake bigger reductions? the demand for pollution rights.
8. Ringo loves playing rock-’n’-roll music at high b. What is the effect on the price and quantity
volume. Luciano loves opera and hates rock-’n’- of pollution under each regulatory system?
roll. Unfortunately, they are next-door neigh- Explain.
bors in an apartment building with paper-thin 11. Suppose that the government decides to issue
walls. tradable permits for a certain form of pollution.
a. What is the externality here? a. Does it matter for economic efficiency
b. What command-and-control policy might the whether the government distributes or auc-
landlord impose? Could such a policy lead to tions the permits?
an inefficient outcome? b. If the government chooses to distribute
c. Suppose the landlord lets the tenants do the permits, does the allocation of permits
whatever they want. According to the Coase among firms matter for efficiency?
12. There are three industrial firms in Happy b. For each unit of Negext produced, 4 units of
Valley. pollution are emitted, and each unit of pollu-
Initial Cost of Reducing
tion imposes a cost on society of $1. Compute
Firm Pollution Level Pollution by 1 Unit the total cost of pollution when the market
for Negext is in equilibrium. What is total
A 70 units $20 surplus from this market after taking into
B 80 units $25 account the cost of pollution?
C 50 units $10 c. Would banning Negext increase or decrease
welfare? Why?
The government wants to reduce pollution to d. Suppose that the government restricts emis-
120 units, so it gives each firm 40 tradable pollu- sions to 100 units of pollution. Graph the
tion permits. Negext market under this constraint. Find
a. Who sells permits and how many do they the new equilibrium price and quantity
sell? Who buys permits and how many do and show them on your graph. Compute
they buy? Briefly explain why the sellers how this policy affects consumer surplus,
and buyers are each willing to do so. What producer surplus, and the cost of pollution.
is the total cost of pollution reduction in this Would you recommend this policy? Why?
situation? e. Suppose that instead of restricting pollution,
b. How much higher would the costs of pollu- the government imposes a tax on producers
tion reduction be if the permits could not be equal to $4 for each unit of chemical pro-
traded? duced. Calculate the new equilibrium price
13. The market for a particular chemical, called and quantity, as well as consumer surplus,
Negext, is described by the following equations. producer surplus, tax revenue, and the cost
Demand is given by: of pollution. What is total surplus now?
QD = 100 – 5P Would you recommend this policy? Why?
f. New research finds the social cost of pollu-
Supply is given by: tion is really higher than $1. How would that
QS = 5P change the optimal policy response? Is there
where Q is measured as units of Negext and P some cost of pollution that would make it
is price in dollars per unit. sensible to ban Negext? If so, what is it?
a. Find the equilibrium price and quantity.
Compute consumer surplus, producer
surplus, and total surplus in the market
equilibrium.
11
CHAPTER
Public Goods and Common

Resources
A n old song lyric maintains that “the best things in life are free.” A moment’s
thought reveals a long list of goods that the songwriter could have had in
mind. Nature provides some of them, such as rivers, mountains, beaches,
lakes, and oceans. The government provides others, such as playgrounds, parks,
and parades. In each case, people do not pay a fee when they choose to enjoy the
benefit of the good.
Goods without prices provide a special challenge for economic analysis. Most
goods in our economy are allocated in markets, where buyers pay for what they
receive and sellers are paid for what they provide. For these goods, prices are the
signals that guide the decisions of buyers and sellers, and these decisions lead to an
efficient allocation of resources. When goods are available free of charge, however,
the market forces that normally allocate resources in our economy are absent.
In this chapter, we examine the problems that arise for the allocation of
resources when there are goods without market prices. Our analysis will shed
light on one of the Ten Principles of Economics in Chapter 1: Governments can some-
times improve market outcomes. When a good does not have a price attached to
it, private markets cannot ensure that the good is produced and consumed in
the proper amounts. In such cases, government policy can potentially remedy the
market failure and raise economic well-being.
225
THE DIFFERENT KINDS OF GOODS

How well do markets work in providing the goods that people want? The answer
to this question depends on the good being considered. As we discussed in Chap-
ter 7, a market can provide the efficient number of ice-cream cones: The price
of ice-cream cones adjusts to balance supply and demand, and this equilibrium
maximizes the sum of producer and consumer surplus. Yet as we discussed in
Chapter 10, the market cannot be counted on to prevent aluminum manufacturers
from polluting the air we breathe: Buyers and sellers in a market typically do not
take into account the external effects of their decisions. Thus, markets work well
when the good is ice cream, but they work badly when the good is clean air.
In thinking about the various goods in the economy, it is useful to group them
according to two characteristics:
excludability • Is the good excludable? That is, can people be prevented from using the
the property of a good good?
whereby a person can be • Is the good rival in consumption? That is, does one person’s use of the
prevented from using it good reduce another person’s ability to use it?
rivalry in consumption Using these two characteristics, Figure 1 divides goods into four categories:
the property of a good
1. Private goods are both excludable and rival in consumption. Consider an
whereby one person’s
use diminishes other
ice-cream cone, for example. An ice-cream cone is excludable because it is
people’s use possible to prevent someone from eating an ice-cream cone—you just don’t
give it to him. An ice-cream cone is rival in consumption because if one per-
private goods son eats an ice-cream cone, another person cannot eat the same cone. Most
goods that are both goods in the economy are private goods like ice-cream cones: You don’t
excludable and rival in get one unless you pay, and once you have it, you are the only person who
consumption benefits. When we analyzed supply and demand in Chapters 4, 5, and 6 and
the efficiency of markets in Chapters 7, 8, and 9, we implicitly assumed that
public goods goods were both excludable and rival in consumption.
goods that are neither 2. Public goods are neither excludable nor rival in consumption. That is, peo-
excludable nor rival in
ple cannot be prevented from using a public good, and one person’s use of a
consumption
public good does not reduce another person’s ability to use it. For example,
1 F I G U R E
Rival in consumption?
Yes No
Four Types of Goods Private Goods Natural Monopolies

Goods can be grouped into four
• Ice-cream cones • Fire protection
categories according to two charac- Yes
• Clothing • Cable TV
teristics: (1) A good is excludable if • Congested toll roads • Uncongested toll roads
people can be prevented from using
it. (2) A good is rival in consumption Excludable?
Common Resources Public Goods
if one person’s use of the good
diminishes other people’s use of • Fish in the ocean • Tornado siren
No
it. This diagram gives examples of • The environment • National defense
goods in each category. • Congested nontoll roads • Uncongested nontoll roads
CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES 227
a tornado siren in a small town is a public good. Once the siren sounds, it is
impossible to prevent any single person from hearing it (so it is not exclud-
able). Moreover, when one person gets the benefit of the warning, she does
not reduce the benefit to anyone else (so it is not rival in consumption).
3. Common resources are rival in consumption but not excludable. For exam- common resources
ple, fish in the ocean are rival in consumption: When one person catches goods that are rival in
fish, there are fewer fish for the next person to catch. Yet these fish are not consumption but not
an excludable good because, given the vast size of an ocean, it is difficult to excludable
stop fishermen from taking fish out of it.
4. When a good is excludable but not rival in consumption, it is an example of
a good produced by a natural monopoly. For instance, consider fire protection
in a small town. It is easy to exclude someone from using this good: The fire
department can just let his house burn down. Yet fire protection is not rival
in consumption: Once a town has paid for the fire department, the additional
cost of protecting one more house is small. (In Chapter 15, we give a more
complete definition of natural monopolies and study them in some detail.)
Although Figure 1 offers a clean separation of goods into four categories, the
boundary between the categories is sometimes fuzzy. Whether goods are exclud-
able or rival in consumption is often a matter of degree. Fish in an ocean may not
be excludable because monitoring fishing is so difficult, but a large enough coast
guard could make fish at least partly excludable. Similarly, although fish are gen-
erally rival in consumption, this would be less true if the population of fishermen
were small relative to the population of fish. (Think of North American fishing
waters before the arrival of European settlers.) For purposes of our analysis, how-
ever, it will be helpful to group goods into these four categories.
In this chapter, we examine goods that are not excludable: public goods and
common resources. Because people cannot be prevented from using these goods,
they are available to everyone free of charge. The study of public goods and com-
mon resources is closely related to the study of externalities. For both of these types
of goods, externalities arise because something of value has no price attached to it.
If one person were to provide a public good, such as a tornado siren, other people
would be better off. They would receive a benefit without paying for it—a posi-
tive externality. Similarly, when one person uses a common resource such as the
fish in the ocean, other people are worse off because there are fewer fish to catch.
They suffer a loss but are not compensated for it—a negative externality. Because
of these external effects, private decisions about consumption and production can
lead to an inefficient allocation of resources, and government intervention can
potentially raise economic well-being.
QUICK QUIZ Define public goods and common resources and give an example of each.
PUBLIC GOODS
To understand how public goods differ from other goods and the problems they
present for society, let’s consider an example: a fireworks display. This good is
not excludable because it is impossible to prevent someone from seeing fireworks,
and it is not rival in consumption because one person’s enjoyment of fireworks
does not reduce anyone else’s enjoyment of them.
THE FREE-R IDER PROBLEM

The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July.
Each of the town’s 500 residents places a $10 value on the experience for a total
benefit of $5,000. The cost of putting on a fireworks display is $1,000. Because the
$5,000 benefit exceeds the $1,000 cost, it is efficient for Smalltown to have a fire-
works display on the Fourth of July.
Would the private market produce the efficient outcome? Probably not. Imag-
ine that Ellen, a Smalltown entrepreneur, decided to put on a fireworks display.
Ellen would surely have trouble selling tickets to the event because her potential
customers would quickly figure out that they could see the fireworks even with-
out a ticket. Because fireworks are not excludable, people have an incentive to be
free rider free riders. A free rider is a person who receives the benefit of a good but does not
a person who receives pay for it. Because people would have an incentive to be free riders rather than
the benefit of a good ticket buyers, the market would fail to provide the efficient outcome.
but avoids paying for it One way to view this market failure is that it arises because of an externality.
If Ellen puts on the fireworks display, she confers an external benefit on those
who see the display without paying for it. When deciding whether to put on the
display, however, Ellen does not take the external benefits into account. Even
though the fireworks display is socially desirable, it is not profitable. As a result,
Ellen makes the privately rational but socially inefficient decision not to put on the
display.
Although the private market fails to supply the fireworks display demanded
by Smalltown residents, the solution to Smalltown’s problem is obvious: The local
government can sponsor a Fourth of July celebration. The town council can raise
everyone’s taxes by $2 and use the revenue to hire Ellen to produce the fireworks.
Everyone in Smalltown is better off by $8—the $10 in value from the fireworks
minus the $2 tax bill. Ellen can help Smalltown reach the efficient outcome as a
public employee even though she could not do so as a private entrepreneur.
The story of Smalltown is simplified but realistic. In fact, many local govern-
ments in the United States pay for fireworks on the Fourth of July. Moreover, the
story shows a general lesson about public goods: Because public goods are not
excludable, the free-rider problem prevents the private market from supplying
them. The government, however, can potentially remedy the problem. If the gov-
ernment decides that the total benefits of a public good exceed its costs, it can pro-
vide the public good, pay for it with tax revenue, and make everyone better off.
SOME IMPORTANT PUBLIC GOODS

There are many examples of public goods. Here we consider three of the most
important.
National Defense The defense of a country from foreign aggressors is a clas-

sic example of a public good. Once the country is defended, it is impossible to
prevent any single person from enjoying the benefit of this defense. Moreover,
when one person enjoys the benefit of national defense, he does not reduce the
benefit to anyone else. Thus, national defense is neither excludable nor rival in
consumption.
National defense is also one of the most expensive public goods. In 2007, the
U.S. federal government spent a total of $553 billion on national defense, more
than $1,800 per person. People disagree about whether this amount is too small or
too large, but almost no one doubts that some government spending for national
defense is necessary. Even economists who advocate small government agree that
the national defense is a public good the government should provide.
Basic Research Knowledge is created through research. In evaluating the

appropriate public policy toward knowledge creation, it is important to distin-
guish general knowledge from specific technological knowledge. Specific tech-
nological knowledge, such as the invention of a longer-lasting battery, a smaller
microchip, or a better digital music player, can be patented. The patent gives the
inventor the exclusive right to the knowledge he or she has created for a period of “I LIKE THE CONCEPT IF
time. Anyone else who wants to use the patented information must pay the inven- WE CAN DO IT WITH NO
NEW TAXES.”
tor for the right to do so. In other words, the patent makes the knowledge created
by the inventor excludable.
By contrast, general knowledge is a public good. For example, a mathematician
cannot patent a theorem. Once a theorem is proved, the knowledge is not exclud-
able: The theorem enters society’s general pool of knowledge that anyone can use
without charge. The theorem is also not rival in consumption: One person’s use of
the theorem does not prevent any other person from using the theorem.
Profit-seeking firms spend a lot on research trying to develop new products
that they can patent and sell, but they do not spend much on basic research. Their
incentive, instead, is to free ride on the general knowledge created by others. As a
result, in the absence of any public policy, society would devote too few resources
to creating new knowledge.
The government tries to provide the public good of general knowledge in vari-
ous ways. Government agencies, such as the National Institutes of Health and
the National Science Foundation, subsidize basic research in medicine, mathemat-
ics, physics, chemistry, biology, and even economics. Some people justify gov-
ernment funding of the space program on the grounds that it adds to society’s
pool of knowledge (although many scientists are skeptical of the scientific value of
manned space travel). Determining the appropriate level of government support
for these endeavors is difficult because the benefits are hard to measure. More-
over, the members of Congress who appropriate funds for research usually have
little expertise in science and, therefore, are not in the best position to judge what
lines of research will produce the largest benefits. So, while basic research is surely
a public good, we should not be surprised if the public sector fails to pay for the
right amount and the right kinds.
Fighting Poverty Many government programs are aimed at helping the poor.
The welfare system (officially called Temporary Assistance for Needy Families)
provides a small income for some poor families. Similarly, the Food Stamp pro-
gram subsidizes the purchase of food for those with low incomes, and various
government housing programs make shelter more affordable. These antipov-
erty programs are financed by taxes paid by families that are financially more
successful.
Economists disagree among themselves about what role the government should
play in fighting poverty. Although we discuss this debate more fully in Chapter
20, here we note one important argument: Advocates of antipoverty programs
claim that fighting poverty is a public good. Even if everyone prefers living in a
society without poverty, fighting poverty is not a “good” that private actions will
adequately provide.
To see why, suppose someone tried to organize a group of wealthy individuals

to try to eliminate poverty. They would be providing a public good. This good
would not be rival in consumption: One person’s enjoyment of living in a society
without poverty would not reduce anyone else’s enjoyment of it. The good would
not be excludable: Once poverty is eliminated, no one can be prevented from tak-
ing pleasure in this fact. As a result, there would be a tendency for people to free
ride on the generosity of others, enjoying the benefits of poverty elimination with-
out contributing to the cause.
Because of the free-rider problem, eliminating poverty through private charity
will probably not work. Yet government action can solve this problem. Taxing the
wealthy to raise the living standards of the poor can potentially make everyone
better off. The poor are better off because they now enjoy a higher standard of liv-
ing, and those paying the taxes are better off because they enjoy living in a society
with less poverty.
ARE LIGHTHOUSES PUBLIC GOODS?

Some goods can switch between being public goods and being private goods
depending on the circumstances. For example, a fireworks display is a public
good if performed in a town with many residents. Yet if performed at a private
amusement park, such as Walt Disney World, a fireworks display is more like a
private good because visitors to the park pay for admission.
Another example is a lighthouse. Economists have long used lighthouses as
an example of a public good. Lighthouses mark specific locations so that passing
ships can avoid treacherous waters. The benefit that the lighthouse provides to the
ship captain is neither excludable nor rival in consumption, so each captain has an
incentive to free ride by using the lighthouse to navigate without paying for the
service. Because of this free-rider problem, private markets usually fail to provide
the lighthouses that ship captains need. As a result, most lighthouses today are
operated by the government.
In some cases, however, lighthouses have been closer to private goods. On the
coast of England in the 19th century, for example, some lighthouses were pri-
vately owned and operated. Instead of trying to charge ship captains for the ser-
vice, however, the owner of the lighthouse charged the owner of the nearby port.
If the port owner did not pay, the lighthouse owner turned off the light, and ships
avoided that port.
In deciding whether something is a public good, one must determine who the
beneficiaries are and whether these beneficiaries can be excluded from using the
© WEHRLE/PREMIUM STOCK/JUPITERIMAGES
good. A free-rider problem arises when the number of beneficiaries is large and
exclusion of any one of them is impossible. If a lighthouse benefits many ship cap-
tains, it is a public good. Yet if it primarily benefits a single port owner, it is more
like a private good. ●
THE DIFFICULT JOB OF COST–BENEFIT ANALYSIS

So far we have seen that the government provides public goods because the pri-
vate market on its own will not produce an efficient quantity. Yet deciding that
the government must play a role is only the first step. The government must then
WHAT KIND OF GOOD IS THIS? determine what kinds of public goods to provide and in what quantities.
Suppose that the government is considering a public project, such as building a

new highway. To judge whether to build the highway, it must compare the total
benefits of all those who would use it to the costs of building and maintaining
it. To make this decision, the government might hire a team of economists and
engineers to conduct a study, called a cost–benefit analysis, the goal of which is cost–benefit analysis
to estimate the total costs and benefits of the project to society as a whole. a study that compares
Cost–benefit analysts have a tough job. Because the highway will be available the costs and benefits to
to everyone free of charge, there is no price with which to judge the value of the society of providing
highway. Simply asking people how much they would value the highway is not a public good
reliable: Quantifying benefits is difficult using the results from a questionnaire,
and respondents have little incentive to tell the truth. Those who would use the
highway have an incentive to exaggerate the benefit they receive to get the high-
way built. Those who would be harmed by the highway have an incentive to
exaggerate the costs to them to prevent the highway from being built.
The efficient provision of public goods is, therefore, intrinsically more difficult
than the efficient provision of private goods. When buyers of a private good enter
a market, they reveal the value they place on it through the prices they are willing
to pay. At the same time, sellers reveal their costs with the prices they are willing
to accept. The equilibrium is an efficient allocation of resources because it reflects
all this information. By contrast, cost–benefit analysts do not have any price sig-
nals to observe when evaluating whether the government should provide a public
good and how much to provide. Their findings on the costs and benefits of public
projects are rough approximations at best.
HOW MUCH IS A LIFE WORTH?

Imagine that you have been elected to serve as a member of your local town coun-
cil. The town engineer comes to you with a proposal: The town can spend $10,000
to build and operate a traffic light at a town intersection that now has only a
stop sign. The benefit of the traffic light is increased safety. The engineer esti-
mates, based on data from similar intersections, that the traffic light would reduce
the risk of a fatal traffic accident over the lifetime of the traffic light from 1.6 to
1.1 percent. Should you spend the money for the new light?
To answer this question, you turn to cost–benefit analysis. But you quickly
run into an obstacle: The costs and benefits must be measured in the same units
if you are to compare them meaningfully. The cost is measured in dollars, but
the benefit—the possibility of saving a person’s life—is not directly monetary. To
make your decision, you have to put a dollar value on a human life.
At first, you may be tempted to conclude that a human life is priceless. After all,
there is probably no amount of money that you could be paid to voluntarily give
up your life or that of a loved one. This suggests that a human life has an infinite
dollar value.
For the purposes of cost–benefit analysis, however, this answer leads to non-
sensical results. If we truly placed an infinite value on human life, we should place
traffic lights on every street corner, and we should all drive large cars loaded with
all the latest safety features. Yet traffic lights are not at every corner, and people
sometimes choose to pay less for smaller cars without safety options such as side-
impact air bags or antilock brakes. In both our public and private decisions, we
are at times willing to risk our lives to save some money.
Once we have accepted the idea that a person’s life has an implicit dollar value,
how can we determine what that value is? One approach, sometimes used by
courts to award damages in wrongful-death suits, is to look at the total amount of
money a person would have earned if he or she had lived. Economists are often
critical of this approach because it ignores other opportunity costs of losing one’s
life. It thus has the bizarre implication that the life of a retired or disabled person
has no value.
A better way to value human life is to look at the risks that people are volun-
tarily willing to take and how much they must be paid for taking them. Mortality
risk varies across jobs, for example. Construction workers in high-rise buildings
face greater risk of death on the job than office workers do. By comparing wages in
risky and less risky occupations, controlling for education, experience, and other
determinants of wages, economists can get some sense about what value people
put on their own lives. Studies using this approach conclude that the value of a
human life is about $10 million.
We can now return to our original example and respond to the town engineer.
The traffic light reduces the risk of fatality by 0.5 percentage points. Thus, the
expected benefit from installing the traffic light is 0.005 × $10 million, or $50,000.
This estimate of the benefit well exceeds the cost of $10,000, so you should approve
the project. ●
Q Q
UICK UIZ What is the free-rider problem? Why does the free-rider problem induce
the government to provide public goods? • How should the government decide whether
to provide a public good?
COMMON RESOURCES
Common resources, like public goods, are not excludable: They are available free
of charge to anyone who wants to use them. Common resources are, however,
rival in consumption: One person’s use of the common resource reduces other
people’s ability to use it. Thus, common resources give rise to a new problem.
Once the good is provided, policymakers need to be concerned about how much
it is used. This problem is best understood from the classic parable called the
Tragedy of the Tragedy of the Commons.
Commons
a parable that illustrates
why common resources
THE TRAGEDY OF THE COMMONS
are used more than Consider life in a small medieval town. Of the many economic activities that take
is desirable from the place in the town, one of the most important is raising sheep. Many of the town’s
standpoint of society families own flocks of sheep and support themselves by selling the sheep’s wool,
as a whole
which is used to make clothing.
As our story begins, the sheep spend much of their time grazing on the land sur-
rounding the town, called the Town Common. No family owns the land. Instead,
the town residents own the land collectively, and all the residents are allowed to
graze their sheep on it. Collective ownership works well because land is plentiful.
As long as everyone can get all the good grazing land they want, the Town Com-
mon is not rival in consumption, and allowing residents’ sheep to graze for free
causes no problems. Everyone in town is happy.
As the years pass, the population of the town grows, and so does the number
of sheep grazing on the Town Common. With a growing number of sheep and a
fixed amount of land, the land starts to lose its ability to replenish itself. Eventu-
ally, the land is grazed so heavily that it becomes barren. With no grass left on
the Town Common, raising sheep is impossible, and the town’s once prosperous
wool industry disappears. Many families lose their source of livelihood.
What causes the tragedy? Why do the shepherds allow the sheep population
to grow so large that it destroys the Town Common? The reason is that social and
private incentives differ. Avoiding the destruction of the grazing land depends on
the collective action of the shepherds. If the shepherds acted together, they could
reduce the sheep population to a size that the Town Common can support. Yet no
single family has an incentive to reduce the size of its own flock because each flock
represents only a small part of the problem.
In essence, the Tragedy of the Commons arises because of an externality. When
one family’s flock grazes on the common land, it reduces the quality of the land
available for other families. Because people neglect this negative externality when
deciding how many sheep to own, the result is an excessive number of sheep.
If the tragedy had been foreseen, the town could have solved the problem in
various ways. It could have regulated the number of sheep in each family’s flock,
internalized the externality by taxing sheep, or auctioned off a limited number
of sheep-grazing permits. That is, the medieval town could have dealt with the
problem of overgrazing in the way that modern society deals with the problem of
pollution.
In the case of land, however, there is a simpler solution. The town can divide
the land among town families. Each family can enclose its parcel of land with a
fence and then protect it from excessive grazing. In this way, the land becomes a
private good rather than a common resource. This outcome in fact occurred dur-
ing the enclosure movement in England in the 17th century.
The Tragedy of the Commons is a story with a general lesson: When one per-
son uses a common resource, he or she diminishes other people’s enjoyment of
it. Because of this negative externality, common resources tend to be used exces-
sively. The government can solve the problem by using regulation or taxes to
reduce consumption of the common resource. Alternatively, the government can
sometimes turn the common resource into a private good.
This lesson has been known for thousands of years. The ancient Greek philoso-
pher Aristotle pointed out the problem with common resources: “What is com-
mon to many is taken least care of, for all men have greater regard for what is their
own than for what they possess in common with others.”
SOME IMPORTANT COMMON R ESOURCES

There are many examples of common resources. In almost all cases, the same
problem arises as in the Tragedy of the Commons: Private decision makers use
the common resource too much. Governments often regulate behavior or impose
fees to mitigate the problem of overuse.
Clean Air and Water As we discussed in Chapter 10, markets do not adequately
protect the environment. Pollution is a negative externality that can be remedied
with regulations or with corrective taxes on polluting activities. One can view this
market failure as an example of a common-resource problem. Clean air and clean
The Bloomberg Plan

Many economists have advocated road pricing as a mechanism
to control traffic. Recently, they have convinced the mayor of
New York City.
Don’t Drive, He Said them—congestion pricing—got almost all or at least trot—just as quickly is borne out
By Elizabeth Kolbert the attention, much of it negative. The by the numbers; according to data collected
Mayor anticipated this—he referred to the by the New York Metropolitan Transporta-
Michael Bloomberg has always favored pricing proposal as “the elephant in the tion Council and analyzed by Bruce Schaller,
grand schemes. Last week, on Earth Day, the room”—and his decision to include it any- a Brooklyn-based consultant, the average
Mayor stood in the American Museum of way is perhaps the best reason to take the speed achieved by a vehicle travelling along
Natural History’s Hall of Ocean Life, beneath plan seriously. Forty-second Street between the hours
the blue whale, to lay out his vision for the The basic idea behind congestion pric- of 10 A.M. and 4 P.M. is 4.7 miles per hour.
city’s future. In an expansive speech, Bloom- ing is simple: make motorists pay to use On Thirty-fourth Street approaching the
berg described a New York that would, in the busiest streets. Under the Mayor’s pro- entrance to the Queens Midtown Tunnel,
2030, be both “greater” and “greener,” a posal, an invisible line would be drawn the average speed drops to 2.5 miles per
city with nearly a million more residents, as around Manhattan from Eighty-sixth Street hour.
well as cleaner water, new open space, and south to the Battery. Vehicles crossing this A few cities have tried congestion pricing,
zippier transportation. This bigger, better line on weekdays between 6 A.M. and 6 P.M. most notably Stockholm and London, and in
metropolis would be a leader in combatting would be charged a fee—eight dollars for most cases it has been a success. Stockholm
global warming; despite its increased popu- cars, twenty-one dollars for trucks. (Those imposed congestion pricing on a trial basis
lation, the New York of the future would pro- travelling only within the congestion zone last year; the program worked so well that
duce thirty percent less CO2, resulting, as the would pay half price, while taxis and livery voters opted to reinstitute it. Since the Lon-
Mayor put it, in “the most dramatic reduc- cabs would be exempt.) The fees would be don plan was introduced, in 2003, vehicle
tion in greenhouse gases ever achieved by assessed electronically and could be paid speeds in the city’s central business district
any American city.” either with a toll pass or over the phone or have increased by thirty-seven percent and
The printed version of Bloomberg’s the Internet. carbon-dioxide emissions from cars and
plan ran to a hundred and fifty-five full- Driving crosstown for lunch is an easy, if trucks have dropped by fifteen percent. The
color pages and contained a hundred and maddening, way to appreciate the scheme’s plan, which the newspapers initially derided
twenty-seven new initiatives. Just one of logic. The impression that one could walk— as “Kengestion”—after its main supporter,
water are common resources like open grazing land, and excessive pollution is
like excessive grazing. Environmental degradation is a modern Tragedy of the
Commons.
Congested Roads Roads can be either public goods or common resources. If a

road is not congested, then one person’s use does not affect anyone else. In this
case, use is not rival in consumption, and the road is a public good. Yet if a road
is congested, then use of that road yields a negative externality. When one person
drives on the road, it becomes more crowded, and other people must drive more
slowly. In this case, the road is a common resource.
London’s mayor, Ken Livingstone—has sued the country’s largest carbon emitters,
grown increasingly popular; in 2004, Living- offered what can only be described as a
stone was easily reelected, and now nearly tepid endorsement of the Mayor’s proposal,
two-thirds of Londoners say that they back saying, “We look forward to reviewing the
the scheme. Just three months ago, the plan.”
congestion zone was expanded westward As a matter of city planning, congestion
to include most of the boroughs of Kensing- pricing is a compelling idea; in the context
ton and Chelsea and Westminster. of climate change, it is much more than
The case against congestion pricing that. Any meaningful effort to address the
is often posed in egalitarian terms. “The problem will have to include incentives for
Mayor Bloomberg
middle class and the poor will not be able low-emitting activities (walking, biking, rid-
to pay these fees and the rich will,” State ing the subway) and costs for high-emitting
Assemblyman Richard Brodsky, of West- Meanwhile, it’s naïve to suppose that ones (flying, driving, sitting at home and
chester County, declared after listening to congestion isn’t itself costly. Sitting in traffic, cranking up the A.C.). These costs will incon-
the Mayor’s speech. In fact, the poor don’t, a plumber can’t plumb and a deliveryman venience some people—perhaps most
as a rule, drive in and out of Manhattan: can’t deliver. The value of time lost to con- people—and the burden will not always be
compare the cost of buying, insuring, and gestion delays in the city has been put at distributed with perfect fairness. But, as the
parking a car with the seventy-six dollars a five billion dollars annually. When expenses Mayor pointed out, New York, a flood-prone
month the M.T.A. charges for an unlimited- like wasted fuel, lost revenue, and the coastal city, is vulnerable to one of global
ride MetroCard. For those who do use cars increased cost of doing business are added warming’s most destructive—and most
to commute, eight dollars a day would, it’s in, that figure rises to thirteen billion dollars. certain—consequences: rising sea levels. If
true, quickly add up. And that is precisely The question, Bloomberg observed, is “not New Yorkers won’t change their behavior,
the point. Congestion pricing works only whether we want to pay but how do we then it’s hard to see why anyone in the rest
to the extent that it makes other choices— want to pay?” of the country or, for that matter, the world
changing the hours of one’s daily drive or, Many elements of the Mayor’s plan, should, either. The congestion problem will,
better yet, using mass transit—more attrac- including congestion pricing, will require in that case, find a different resolution. Who,
tive. One of the Mayor’s proposals is to put approval by the state legislature, which is after all, wants to drive into a city that’s
the money raised by congestion pricing— too bad, since, as a recent Times editorial under water?
an estimated four hundred million dollars a put it, Albany is a place where good poli-
year—toward improving subway and bus cies generally “go to die.” Even Governor
PHOTO: © AP IMAGES
service. Eliot Spitzer, who, as state attorney general,
Source: New Yorker, May 7, 2007.
One way for the government to address the problem of road congestion is to
charge drivers a toll. A toll is, in essence, a corrective tax on the externality of con-
gestion. Sometimes, as in the case of local roads, tolls are not a practical solution
because the cost of collecting them is too high. But the city of London has found
increasing tolls to be a very effective way to reduce congestion, and as the accom-
panying In The News box discusses, a similar plan is being considered for New
York City.
Sometimes congestion is a problem only at certain times of day. If a bridge is
heavily traveled only during rush hour, for instance, the congestion externality
is largest during this time. The efficient way to deal with these externalities is to
charge higher tolls during rush hour. This toll would provide an incentive for
drivers to alter their schedules, reducing traffic when congestion is greatest.
Another policy that responds to the problem of road congestion, discussed in
a case study in the previous chapter, is the tax on gasoline. Gasoline is a comple-
mentary good to driving: An increase in the price of gasoline tends to reduce the
quantity of driving demanded. Therefore, a gasoline tax reduces road congestion.
A gasoline tax, however, is an imperfect solution, because it affects other decisions
besides the amount of driving on congested roads. For example, the gasoline tax
discourages driving on uncongested roads, even though there is no congestion
externality for these roads.
Fish, Whales, and Other Wildlife Many species of animals are common
resources. Fish and whales, for instance, have commercial value, and anyone can
go to the ocean and catch whatever is available. Each person has little incentive
to maintain the species for the next year. Just as excessive grazing can destroy the
Town Common, excessive fishing and whaling can destroy commercially valu-
able marine populations.
The ocean remains one of the least regulated common resources. Two problems
prevent an easy solution. First, many countries have access to the oceans, so any
solution would require international cooperation among countries that hold dif-
ferent values. Second, because the oceans are so vast, enforcing any agreement is
difficult. As a result, fishing rights have been a frequent source of international
tension among normally friendly countries.
Within the United States, various laws aim to protect fish and other wildlife. For
example, the government charges for fishing and hunting licenses, and it restricts
the lengths of the fishing and hunting seasons. Fishermen are often required to
throw back small fish, and hunters can kill only a limited number of animals.
All these laws reduce the use of a common resource and help maintain animal
populations.
© IAN SANDERSON/PHOTOGRAPHER’S CHOICE/GETTY IMAGES
WHY THE COW IS NOT EXTINCT

Throughout history, many species of animals have been threatened with extinc-
tion. When Europeans first arrived in North America, more than 60 million buf-
falo roamed the continent. Yet hunting the buffalo was so popular during the 19th
century that by 1900 the animal’s population had fallen to about 400 before the
government stepped in to protect the species. In some African countries today,
the elephant faces a similar challenge, as poachers kill the animals for the ivory in
their tusks.
Yet not all animals with commercial value face this threat. The cow, for exam-
ple, is a valuable source of food, but no one worries that the cow will soon be
extinct. Indeed, the great demand for beef seems to ensure that the species will
continue to thrive.
Why is the commercial value of ivory a threat to the elephant, while the com-
“WILL THE MARKET mercial value of beef is a guardian of the cow? The reason is that elephants are a
PROTECT ME?” common resource, whereas cows are a private good. Elephants roam freely with-
out any owners. Each poacher has a strong incentive to kill as many elephants
as he can find. Because poachers are numerous, each poacher has only a slight
incentive to preserve the elephant population. By contrast, cattle live on ranches
that are privately owned. Each rancher makes great effort to maintain the cattle
population on his ranch because he reaps the benefit of these efforts.
Governments have tried to solve the elephant’s problem in two ways. Some
countries, such as Kenya, Tanzania, and Uganda, have made it illegal to kill ele-
phants and sell their ivory. Yet these laws have been hard to enforce, and ele-
phant populations have continued to dwindle. By contrast, other countries, such
as Botswana, Malawi, Namibia, and Zimbabwe, have made elephants a private
good by allowing people to kill elephants, but only those on their own property.
Landowners now have an incentive to preserve the species on their own land, and
as a result, elephant populations have started to rise. With private ownership and
the profit motive now on its side, the African elephant might someday be as safe
from extinction as the cow. ●
QUICK QUIZ Why do governments try to limit the use of common resources?
CONCLUSION: THE IMPORTANCE

OF PROPERTY RIGHTS
In this and the previous chapter, we have seen there are some “goods” that the
market does not provide adequately. Markets do not ensure that the air we breathe
is clean or that our country is defended from foreign aggressors. Instead, societies
rely on the government to protect the environment and to provide for the national
defense.
Although the problems we considered in these chapters arise in many differ-
ent markets, they share a common theme. In all cases, the market fails to allocate
resources efficiently because property rights are not well established. That is, some
item of value does not have an owner with the legal authority to control it. For
example, although no one doubts that the “good” of clean air or national defense
is valuable, no one has the right to attach a price to it and profit from its use. A
factory pollutes too much because no one charges the factory for the pollution
it emits. The market does not provide for national defense because no one can
charge those who are defended for the benefit they receive.
When the absence of property rights causes a market failure, the government
can potentially solve the problem. Sometimes, as in the sale of pollution permits,
the solution is for the government to help define property rights and thereby
unleash market forces. Other times, as in restricted hunting seasons, the solution
is for the government to regulate private behavior. Still other times, as in the pro-
vision of national defense, the solution is for the government to use tax revenue
to supply a good that the market fails to supply. In all cases, if the policy is well
planned and well run, it can make the allocation of resources more efficient and
thus raise economic well-being.
SUMMARY
• Goods differ in whether they are excludable and are not charged for their use of the public good,
whether they are rival in consumption. A good they have an incentive to free ride when the
is excludable if it is possible to prevent someone good is provided privately. Therefore, govern-
from using it. A good is rival in consumption if ments provide public goods, making their deci-
one person’s use of the good reduces other peo- sion about the quantity of each good based on
ple’s ability to use the same unit of the good. Mar- cost–benefit analysis.
kets work best for private goods, which are both
excludable and rival in consumption. Markets do
• Common resources are rival in consumption but
not excludable. Examples include common graz-
not work as well for other types of goods.
ing land, clean air, and congested roads. Because
• Public goods are neither rival in consumption people are not charged for their use of common
nor excludable. Examples of public goods include resources, they tend to use them excessively.
fireworks displays, national defense, and the cre- Therefore, governments use various methods to
ation of fundamental knowledge. Because people limit the use of common resources.
KEY CONCEPTS
excludability, p. 226 public goods, p. 226 cost–benefit analysis, p. 231

rivalry in consumption, p. 226 common resources, p. 227 Tragedy of the Commons, p. 232
private goods, p. 226 free rider, p. 228
1. Explain what is meant by a good being “exclud- 3. What is cost–benefit analysis of public goods?
able.” Explain what is meant by a good being Why is it important? Why is it hard?
“rival in consumption.” Is a slice of pizza 4. Define and give an example of a common
excludable? Is it rival in consumption? resource. Without government intervention,
2. Define and give an example of a public good. will people use this good too much or too little?
Can the private market provide this good on its Why?
own? Explain.
1. Think about the goods and services provided by • education

your local government. • rural roads
a. Using the classification in Figure 1, explain • city streets
which category each of the following goods b. Why do you think the government provides
falls into: items that are not public goods?
• police protection 2. Both public goods and common resources
• snow plowing involve externalities.
a. Are the externalities associated with public f. What does this example teach you about the
goods generally positive or negative? Use optimal provision of public goods?
examples in your answer. Is the free-market 5. Some economists argue that private firms will
quantity of public goods generally greater or not undertake the efficient amount of basic sci-
less than the efficient quantity? entific research.
b. Are the externalities associated with common a. Explain why this might be so. In your
resources generally positive or negative? Use answer, classify basic research in one of the
examples in your answer. Is the free-market categories shown in Figure 1.
use of common resources generally greater or b. What sort of policy has the United States
less than the efficient use? adopted in response to this problem?
3. Charlie loves watching Teletubbies on his local c. It is often argued that this policy increases
public TV station, but he never sends any the technological capability of American
money to support the station during its fund- producers relative to that of foreign firms. Is
raising drives. this argument consistent with your classifica-
a. What name do economists have for Charlie? tion of basic research in part (a)? (Hint: Can
b. How can the government solve the problem excludability apply to some potential benefi-
caused by people like Charlie? ciaries of a public good and not others?)
c. Can you think of ways the private market 6. There is often litter along highways but rarely
can solve this problem? How does the exis- in people’s yards. Provide an economic explana-
tence of cable TV alter the situation? tion for this fact.
4. Four roommates are planning to spend the 7. The village of Ectenia has ten residents. Villag-
weekend in their dorm room watching old mov- ers can earn income by either weaving baskets
ies, and they are debating how many to watch. or fishing. Because the lake has a limited num-
Here is their willingness to pay for each film: ber of fish, the more villagers fish, the less each
Orson Alfred Woody Ingmar
catches. In particular, if n households fish in
the lake, then each fishing household makes
First film $7 $5 $3 $2
an amount:
Second film 6 4 2 1 If = 12 – 2n
Third film 5 3 1 0
Fourth film 4 2 0 0 where If is daily income measured in dollars.
Fifth film 3 1 0 0 The income that a household makes by weaving
baskets is $2 a day.
a. Within the dorm room, is the showing of a
a. Assume that each household makes the deci-
movie a public good? Why or why not?
sion of whether to weave baskets or fish in
b. If it costs $8 to rent a movie, how many mov-
the lake independently. How many house-
ies should the roommates rent to maximize
holds do you expect to see fishing each day?
total surplus?
How many households do you expect to see
c. If they choose the optimal number from
weaving baskets? (Hint: Think about oppor-
part (b) and then split the cost of renting the
tunity cost.) Calculate the total income of the
movies equally, how much surplus does each
village in this equilibrium.
person obtain from watching the movies?
b. Show that, when 3 households fish in the
d. Is there any way to split the cost to ensure
lake, the total income of the village is larger
that everyone benefits? What practical prob-
than the one you found in part (a). What
lems does this solution raise?
prevented the villagers from reaching this
e. Suppose they agree in advance to choose the
higher-income allocation of resources when
efficient number and to split the cost of the
they acted independently?
movies equally. When Orson is asked his
c. If the villagers together decided to achieve
willingness to pay, will he have an incentive
the allocation in part (b), what kinds of rules
to tell the truth? If so, why? If not, what will
would they need to institute? If they wanted
he be tempted to say?
everyone to benefit equally in the new sys- 10. The federal government tests the safety of car
tem, what kind of tax and transfer system models and provides the test results free of
would they need? charge to the public. Do you think this informa-
d. What type of good is the fishery? What char- tion qualifies as a public good? Why or why
acteristics make it that type of good? not?
8. The Washington, D.C., Metro (subway) system 11. High-income people are willing to pay more
charges higher fares during rush hours than than lower-income people to avoid the risk
during the rest of the day. Why might it do this? of death. For example, they are more likely to
9. Timber companies in the United States cut pay for safety features on cars. Do you think
down many trees on publicly owned land and cost–benefit analysts should take this fact into
many trees on privately owned land. Discuss account when evaluating public projects? Con-
the likely efficiency of logging on each type of sider, for instance, a rich town and a poor town,
land in the absence of government regulation. both of which are considering the installation of
How do you think the government should regu- a traffic light. Should the rich town use a higher
late logging on publicly owned lands? Should dollar value for a human life in making this
similar regulations apply to privately owned decision? Why or why not?
land?
12
CHAPTER
The Design of the

Tax System
A l “Scarface” Capone, the notorious 1920s gangster and crime boss, was
never convicted for his many violent crimes. Yet eventually, he did go to
jail—for tax evasion. He had neglected to heed Ben Franklin’s observation
that “in this world nothing is certain but death and taxes.”
When Franklin made this claim in 1789, the average American paid less than
5 percent of his income in taxes, and that remained true for the next hundred years.
Over the course of the 20th century, however, taxes became ever more important
in the life of the typical U.S. citizen. Today, all taxes taken together—including
personal income taxes, corporate income taxes, payroll taxes, sales taxes, and
property taxes—use up about a third of the average American’s income. In many
European countries, the tax bite is even larger.
Taxes are inevitable because we as citizens expect the government to provide
us with various goods and services. The previous two chapters shed light on one
of the Ten Principles of Economics from Chapter 1: The government can sometimes
improve market outcomes. When the government remedies an externality (such
as air pollution), provides a public good (such as national defense), or regulates
the use of a common resource (such as fish in a public lake), it can raise economic
well-being. Yet these activities are costly. For the government to perform these
and its many other functions, it needs to raise revenue through taxation.
241
We began our study of taxation in earlier chapters, where we saw how a tax on
a good affects supply and demand for that good. In Chapter 6, we saw that a tax
reduces the quantity sold in a market, and we examined how the burden of a tax is
shared by buyers and sellers depending on the elasticities of supply and demand.
In Chapter 8, we examined how taxes affect economic well-being. We learned that
taxes cause deadweight losses: The reduction in consumer and producer surplus
resulting from a tax exceeds the revenue raised by the government.
In this chapter, we build on these lessons to discuss the design of a tax system.
We begin with a financial overview of the U.S. government. When thinking about
the tax system, it is useful to know some basic facts about how the U.S. govern-
ment raises and spends money. We then consider the fundamental principles of
taxation. Most people agree that taxes should impose as small a cost on society as
possible and that the burden of taxes should be distributed fairly. That is, the tax
system should be both efficient and equitable. As we will see, however, stating these
goals is easier than achieving them.
A FINANCIAL OVERVIEW OF
THE U.S. GOVERNMENT
How much of the nation’s income does the government take as taxes? Figure 1
shows government revenue, including federal, state, and local governments, as
a percentage of total income for the U.S. economy. It shows that the role of gov-
ernment has grown substantially over the past century. In 1902, the government
1 F I G U R E Types
ernments
The
of Graphs
This figure shows revenue of the federal government and of state and local gov-
as ainpercentage
pie chart panel (a) showsof gross
howdomestic product
U.S. national (GDP),
income which measures
is derived from various total
income inThe
sources. thebareconomy.
graph inIt panel
shows(b) that the government
compares plays
the average a large
income inrole
fourincountries.
the U.S.
Government Revenue economy
The and that
time-series graphits role has grown
in panel (c) showsoverthe
time.
as a Percentage of GDP from 1950 to 2000.
Source: Historical Statistics of the United States; Bureau of Economic Analysis; and author’s calculations.
Revenue as
Percent of 35%
GDP
30 Total government
25
State and local
20
15
10
Federal
5
0
1902 1913 1922 1929 1940 1950 1960 1970 1980 1990 2000
CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 243
T A B L E 1
Sweden 50% United States 28%
France 45 Japan 27
United Kingdom 37 Mexico 20 Total Government
Germany 36 Chile 19 Tax Revenue as a
Canada 36 China 15 Percentage of GDP
Brazil 30 India 14 Source: OECD, United Nations.
Russia 32 Data are for most recent year
available.
collected 7 percent of total income; in recent years, government has collected about
30 percent. In other words, as the economy’s income has grown, the government’s
revenue from taxation has grown even more.
Table 1 compares the tax burden for several major countries, as measured by
the government’s tax revenue as a percentage of the nation’s total income. The
United States is in the middle of the pack. The U.S. tax burden is low compared to
many European countries, but it is high compared to some other nations around
the world. Less economically developed countries, such as India, often have rela-
tively low tax burdens. This fact is consistent with the evidence in Figure 1 of a
growing tax burden over time: As a nation gets richer, the government typically
takes a larger share of income in taxes.
The overall size of government tells only part of the story. Behind the total
dollar figures lie thousands of individual decisions about taxes and spending.
To understand the government’s finances more fully, let’s look at how the total
breaks down into some broad categories.
THE FEDERAL GOVERNMENT

The U.S. federal government collects about two-thirds of the taxes in our econ-
omy. It raises this money in a number of ways, and it finds even more ways to
spend it.
Receipts Table 2 shows the receipts of the federal government in 2007.

Total receipts that year were $2,568 billion, a number so large that it is hard to
T A B L E 2
Amount Amount Percent
Tax (billions) per Person of Receipts
Receipts of the Federal
Government: 2007
Individual income taxes $1,163 $3,851 45%
Social insurance taxes 870 2,881 34 Source: Economic Report of the
Corporate income taxes 370 1,225 14 President, 2008, Table B-81.
Other 165 546 7
Total $2,568 $8,503 100%

comprehend. To bring this astronomical number down to earth, we can divide it

by the size of the U.S. population, which was about 302 million in 2007. We then
find that the average American paid $8,503 to the federal government.
The largest source of revenue for the federal government is the individual
income tax. As April 15 approaches each year, almost every American family fills
out a tax form to determine how much income tax it owes the government. Each
family is required to report its income from all sources: wages from working,
interest on savings, dividends from corporations in which it owns shares, profits
from any small businesses it operates, and so on. The family’s tax liability (how
much it owes) is then based on its total income.
A family’s income tax liability is not simply proportional to its income. Instead,
the law requires a more complicated calculation. Taxable income is computed as
total income minus an amount based on the number of dependents (primarily chil-
dren) and minus certain expenses that policymakers have deemed “deductible”
(such as mortgage interest payments, state and local tax payments, and charitable
giving). Then the tax liability is calculated from taxable income using a schedule
such as the one shown in Table 3.
This table presents the marginal tax rate—the tax rate applied to each additional
dollar of income. Because the marginal tax rate rises as income rises, higher-
income families pay a larger percentage of their income in taxes. Note that each
tax rate in the table applies only to income within the associated range, not to a
person’s entire income. For example, a person with an income of $1 million still
pays only 10 percent of the first $7,825. (Later in this chapter we discuss the con-
cept of marginal tax rate more fully.)
Almost as important to the federal government as the individual income tax
are payroll taxes. A payroll tax is a tax on the wages that a firm pays its workers.
Table 2 calls this revenue social insurance taxes because the revenue from these
taxes is earmarked to pay for Social Security and Medicare. Social Security is an
income-support program designed primarily to maintain the living standards of
the elderly. Medicare is the government health program for the elderly. Table 2
shows that the average American paid $2,881 in social insurance taxes in 2007.
Next in magnitude, but much smaller than either individual income taxes or
social insurance taxes, is the corporate income tax. A corporation is a business that
is set up as a separate legal entity. The government taxes each corporation based
on its profit—the amount the corporation receives for the goods or services it sells
minus the costs of producing those goods or services. Notice that corporate profits
3 T A B L E
On Taxable Income . . . The Tax Rate Is . . .
The Federal Income Tax Rates: 2007

Up to $7,825 10%
This table shows the marginal tax rates for an
From $7,825 to $31,850 15%
unmarried taxpayer. The taxes owed by a taxpayer
From $31,850 to $77,100 25%
depend on all the marginal tax rates up to his or
From $77,100 to $160,850 28%
her income level. For example, a taxpayer with
From $160,850 to $349,700 33%
income of $25,000 pays 10 percent of the first
Over $349,700 35%
$7,825 of income, and then 15 percent of the rest.
are, in essence, taxed twice. They are taxed once by the corporate income tax when
the corporation earns the profits; they are taxed a second time by the individual
income tax when the corporation uses its profits to pay dividends to its sharehold-
ers. In 2003, the tax rate on dividend income was reduced to 15 percent, in part to
compensate for this double taxation.
The last category, labeled “other” in Table 2, makes up 7 percent of receipts.
This category includes excise taxes, which are taxes on specific goods like gasoline,
cigarettes, and alcoholic beverages. It also includes various small items, such as
estate taxes and customs duties.
Spending Table 4 shows the spending of the federal government in 2007. Total
spending was $2,730 billion, or $9,040 per person. This table also shows how the
federal government’s spending was divided among major categories.
The largest category in Table 4 is Social Security, which represents mostly trans-
fer payments to the elderly. A transfer payment is a government payment not made
in exchange for a good or service. This category made up 21 percent of spending
by the federal government in 2007.
The second largest category of spending is national defense. This includes both
the salaries of military personnel and the purchases of military equipment such
as guns, fighter jets, and warships. Spending on national defense fluctuates over
time as international tensions and the political climate change. Not surprisingly,
spending on national defense rises substantially during wars. In part because of
the war in Iraq, defense spending rose from 17 to 20 percent of total federal spend-
ing from 2001 to 2007.
Health spending looms large in the federal budget. Medicare, the third cat-
egory in Table 4, is the government’s health plan for the elderly. The fifth category
in the table is other health spending, which includes Medicaid, the federal health
program for the poor, and spending on medical research, such as through the
National Institutes of Health. Total health spending makes up about a quarter of
the federal budget.
The fourth category in Table 4 is spending on income security, which includes
transfer payments to poor families. One program is Temporary Assistance for
Needy Families (TANF), often simply called “welfare.” Another is the Food
T A B L E 4
Category (billions) per Person of Spending
Spending of the Federal
Government: 2007
Social Security $ 586 $1,940 21%
National defense 553 1,831 20 Source: Economic Report of the
Medicare 375 1,242 14 President, 2008, Table B-81.
Income security 366 1,212 13
Health 266 881 10
Net interest 237 785 9
Other 347 1,149 13
Total $2,730 $9,040 100%

Stamp program, which gives poor families vouchers that they can use to buy food.
The federal government pays some of this money to state and local governments,
which administer the programs under federal guidelines.
Next on the list is net interest. When a person borrows from a bank, the bank
requires the borrower to pay interest for the loan. The same is true when the gov-
ernment borrows from the public. The more indebted the government, the larger
the amount it must spend in interest payments.
The “other” category in Table 4 consists of many less expensive functions of
government. It includes, for example, the federal court system, the space program,
and farm-support programs, as well as the salaries of members of Congress and
the president.
You might have noticed that total receipts of the federal government shown in
Table 2 fall short of total spending shown in Table 4 by $162 billion. In such a situ-
budget deficit ation, the government is said to run a budget deficit. When receipts exceed spend-
an excess of government ing, the government is said to run a budget surplus. The government finances a
spending over govern- budget deficit by borrowing from the public. That is, it sells government debt to
ment receipts the private sector, including both investors in the United States and those abroad.
When the government runs a budget surplus, it uses the excess receipts to reduce
budget surplus
its outstanding debts.
an excess of government
receipts over govern-
ment spending THE FISCAL CHALLENGE AHEAD
In 2007, the federal government ran a budget deficit of $162 billion. This excess
of government spending over government revenue is only the tip of an iceberg:
Long-term projections of the government’s budget show that, under current law,
the government will spend vastly more than it will receive in tax revenue in the
decades ahead. As a percentage of gross domestic product (the total income in the
economy), taxes are projected to be about constant. But government spending as
a percentage of GDP is projected to rise gradually but substantially over the next
several decades.
One reason for the rise in government spending is that Social Security and Medi-
care provide significant benefits for the elderly, who are a growing percentage of
the overall population. Over the past half century, medical advances and lifestyle
improvements have greatly increased life expectancy. In 1950, a man age 65 could
expect to live for another 13 years; now he can expect to live another 17 years. The
life expectancy of a 65-year-old woman has risen from 16 years in 1950 to 20 years
today. At the same time, people are having fewer children. In 1950, the typical
woman had three children. Today, the number is about two. As a result of smaller
families, the labor force is growing more slowly now than it has in the past.
Panel (a) of Figure 2 shows the demographic shift that is arising from the com-
bination of longer life expectancy and lower fertility. In 1950, the elderly popula-
tion equaled about 14 percent of the working-age population. Now the elderly are
about 21 percent of the working-age population, and that figure will rise to about
40 percent over the next 50 years. This means that there will be fewer workers pay-
ing taxes to support the government benefits that each elderly person receives.
A second, related trend that will affect government spending in the decades
ahead is the rising cost of healthcare. The government provides healthcare to the
elderly through the Medicare system and to the poor through Medicaid. As the
cost of healthcare increases, government spending on these programs will increase
as well.
Panel (a) shows the U.S. population age 65 and older as a percentage of the popula-
tion age 20 to 64. The growing elderly population will put increasing pressure on
F I G U R E 2
the government budget. Panel (b) shows government spending on Social Security,
Medicare, and Medicaid as a percentage of GDP. The projection for future years
The Demographic
assumes no change in current law. Unless changes in benefits are enacted, govern-
and Fiscal Challenge
ment spending on these programs will rise significantly and will require large tax
increases to pay for them.
Source: Congressional Budget Office.
(a) The growing elderly population (b) Government spending on

Population Percentage 20% Social Security, Medicare, and Medicaid
45%
age 65+ of GDP
(as Percentage
of Population 40
20 to 64) 15
35
30
10
25
Elderly population Government spending
20
5
15
10 0
1950 1970 1990 2010 2030 2050 2070 1950 1970 1990 2010 2030 2050 2070
Policymakers have proposed various ways to stem the rise in healthcare costs,
such as reducing the burden of lawsuits on the healthcare system, encouraging
more competition among healthcare providers, and promoting greater use of
information technology. Most health economists, however, believe that such mea-
sures will have only a limited impact. The main reason for rising healthcare costs
is medical advances that provide new, better, but often expensive ways to extend
and improve our lives.
Panel (b) of Figure 2 shows government spending on Social Security, Medicare,
and Medicaid as a percentage of GDP. Spending on these programs has risen from
less than 1 percent in 1950 to about 8 percent today. The combination of a growing
elderly population and rising healthcare costs is expected to continue and even
accelerate the trend.
How our society will handle these spending increases is an open question.
Simply increasing the budget deficit is not feasible. A budget deficit just pushes
the cost of government spending onto a future generation of taxpayers, who will
inherit a government with greater debts. In the long run, the government needs to
pay for what it spends.
Some economists believe that to pay for these commitments, we will need to
raise taxes substantially as a percentage of GDP. If so, the long-term trend we saw
in Figure 1 will continue. Spending on Social Security, Medicare, and Medicaid
is expected to rise by about 10 percentage points of GDP. Because taxes are now
30 percent of GDP, paying for these benefits would require approximately a one-
third increase in all taxes.
Other economists believe that such high tax rates would impose too great a cost
on younger workers. They believe that policymakers should reduce the promises
now being made to the elderly of the future and that, at the same time, people
should be encouraged to take a greater role caring for themselves as they age. This
might entail raising the normal retirement age, while giving people more incen-
tive to save during their working years to prepare for their own retirement and
health costs.
It is likely that the final resolution will involve a combination of measures.
No one can dispute that resolving this debate is one of the great challenges
ahead. ●
STATE AND L OCAL GOVERNMENT

State and local governments collect about 40 percent of all taxes paid. Let’s look at
how they obtain tax revenue and how they spend it.
Receipts Table 5 shows the receipts of U.S. state and local governments. Total
receipts for 2005 were $2,021 billion, or $6,827 per person. The table also shows
how this total is broken down into different kinds of taxes.
The two most important taxes for state and local governments are sales taxes
and property taxes. Sales taxes are levied as a percentage of the total amount spent
at retail stores. Every time a customer buys something, he or she pays the store-
keeper an extra amount that the storekeeper remits to the government. (Some
states exclude certain items that are considered necessities, such as food and cloth-
ing.) Property taxes are levied as a percentage of the estimated value of land and
structures and are paid by property owners. Together, these two taxes make up
more than a third of all receipts of state and local governments.
State and local governments also levy individual and corporate income taxes.
In many cases, state and local income taxes are similar to federal income taxes.
In other cases, they are quite different. For example, some states tax income from
wages less heavily than income earned in the form of interest and dividends.
Some states do not tax income at all.
State and local governments also receive substantial funds from the federal gov-
ernment. To some extent, the federal government’s policy of sharing its revenue
5 T A B L E
Tax (billions) per Person of Spending
Receipts of State and Local
Governments: 2005
Sales taxes $ 383 $1,294 19%
Source: Economic Report of the Property taxes 336 1,135 17
President, 2008, Table B-86. Individual income taxes 241 814 12
Corporate income taxes 43 145 2
From federal government 438 1,480 22
Other 580 1,959 28
Total $2,021 6,827 100%

T A B L E 6
Category (billions) per Person of Spending
Spending of State and
Local Governments: 2005
Education $ 689 $2,328 34%
Public welfare 367 1,240 18 Source: Economic Report of the
Highways 124 419 6 President, 2008, Table B-86.
Other 834 2,817 42
Total $2,014 $6,804 100%
with state governments redistributes funds from high-income states (who pay
more taxes) to low-income states (who receive more benefits). Often, these funds
are tied to specific programs that the federal government wants to subsidize.
Finally, state and local governments receive much of their receipts from vari-
ous sources included in the “other” category in Table 5. These include fees for
fishing and hunting licenses, tolls from roads and bridges, and fares for public
buses and subways.
Spending Table 6 shows the total spending of state and local governments in
2005 and its breakdown among the major categories.
By far the biggest single expenditure for state and local governments is educa-
tion. Local governments pay for the public schools, which educate most students
from kindergarten through high school. State governments contribute to the sup-
port of public universities. In 2005, education accounted for about a third of the
spending of state and local governments.
The second largest category of spending is for public welfare, which includes
transfer payments to the poor. This category includes some federal programs that
are administered by state and local governments. The next category is highways,
which includes the building of new roads and the maintenance of existing ones.
The large “other” category in Table 6 includes the many additional services pro-
vided by state and local governments, such as libraries, police, garbage removal,
fire protection, park maintenance, and snow removal.
QUICK QUIZ What are the two most important sources of tax revenue for the federal
government? • What are the two most important sources of tax revenue for state and
local governments?
TAXES AND EFFICIENCY

Now that we have seen how various levels of the U.S. government raise and spend
money, let’s consider how one might evaluate its tax policy and design a tax sys-
tem. The primary aim of a tax system is to raise revenue for the government, but
there are many ways to raise any given amount of money. When choosing among
the many alternative tax systems, policymakers have two objectives: efficiency
and equity.
One tax system is more efficient than another if it raises the same amount of
revenue at a smaller cost to taxpayers. What are the costs of taxes to taxpayers?
The most obvious cost is the tax payment itself. This transfer of money from the
taxpayer to the government is an inevitable feature of any tax system. Yet taxes
also impose two other costs, which a well-designed tax policy tries to avoid or, at
least, minimize:
• The deadweight losses that result when taxes distort the decisions that
people make
• The administrative burdens that taxpayers bear as they comply with the
tax laws
An efficient tax system is one that imposes small deadweight losses and small
administrative burdens.
DEADWEIGHT L OSSES
One of the Ten Principles of Economics is that people respond to incentives, and this
includes incentives provided by the tax system. If the government taxes ice cream,
people eat less ice cream and more frozen yogurt. If the government taxes hous-
ing, people live in smaller houses and spend more of their income on other things.
If the government taxes labor earnings, people work less and enjoy more leisure.
Because taxes distort incentives, they entail deadweight losses. As we first dis-
cussed in Chapter 8, the deadweight loss of a tax is the reduction in economic
well-being of taxpayers in excess of the amount of revenue raised by the govern-
ment. The deadweight loss is the inefficiency that a tax creates as people allocate
resources according to the tax incentive rather than the true costs and benefits of
the goods and services that they buy and sell.
To recall how taxes cause deadweight losses, consider an example. Suppose
that Joe places an $8 value on a pizza, and Jane places a $6 value on it. If there is
no tax on pizza, the price of pizza will reflect the cost of making it. Let’s suppose
that the price of pizza is $5, so both Joe and Jane choose to buy one. Both consum-
ers get some surplus of value over the amount paid. Joe gets consumer surplus of
$3, and Jane gets consumer surplus of $1. Total surplus is $4.
Now suppose that the government levies a $2 tax on pizza and the price of
CARTOON: BERRY’S WORLD REPRINTED BY PERMISSION

pizza rises to $7. Joe still buys a pizza, but now he has consumer surplus of only
$1. Jane now decides not to buy a pizza because its price is higher than its value
to her. The government collects tax revenue of $2 on Joe’s pizza. Total consumer
surplus has fallen by $3 (from $4 to $1). Because total surplus has fallen by more
OF UNITED FEATURE SYNDICATE, INC.
than the tax revenue, the tax has a deadweight loss. In this case, the deadweight
loss is $1.
Notice that the deadweight loss comes not from Joe, the person who pays the
tax, but from Jane, the person who doesn’t. The reduction of $2 in Joe’s surplus
exactly offsets the amount of revenue the government collects. The deadweight
“I WAS GONNA FIX THE PLACE loss arises because the tax causes Jane to alter her behavior. When the tax raises
UP, BUT IF I DID THE CITY the price of pizza, Jane is worse off, and yet there is no offsetting revenue to the
WOULD JUST RAISE MY TAXES!” government. This reduction in Jane’s welfare is the deadweight loss of the tax.
SHOULD INCOME OR CONSUMPTION BE TAXED?

When taxes induce people to change their behavior—such as inducing Jane to buy
less pizza—the taxes cause deadweight losses and make the allocation of resources
less efficient. As we have already seen, much government revenue comes from the
individual income tax. In a case study in Chapter 8, we discussed how this tax
discourages people from working as hard as they otherwise might. Another inef-
ficiency caused by this tax is that it discourages people from saving.
Consider a person 25 years old who is considering saving $100. If he puts this
money in a savings account that earns 8 percent and leaves it there, he would
have $2,172 when he retires at age 65. Yet if the government taxes one-fourth of
his interest income each year, the effective interest rate is only 6 percent. After 40
years of earning 6 percent, the $100 grows to only $1,029, less than half of what it
would have been without taxation. Thus, because interest income is taxed, saving
is much less attractive.
Some economists advocate eliminating the current tax system’s disincentive
toward saving by changing the basis of taxation. Rather than taxing the amount of
income that people earn, the government could tax the amount that people spend.
Under this proposal, all income that is saved would not be taxed until the saving
is later spent. This alternative system, called a consumption tax, would not distort
people’s saving decisions.
Various provisions of the current tax code already make the tax system a bit
like a consumption tax. Taxpayers can put a limited amount of their saving into
special accounts—such as Individual Retirement Accounts and 401(k) plans—that
escape taxation until the money is withdrawn at retirement. For people who do
most of their saving through these retirement accounts, their tax bill is, in effect,
based on their consumption rather than their income.
European countries tend to rely more on consumption taxes than does the United
States. Most of them raise a significant amount of government revenue through a
value-added tax, or a VAT. A VAT is like the retail sales tax that many U.S. states
use, but rather than collecting all of the tax at the retail level when the consumer
buys the final good, the government collects the tax in stages as the good is being
produced (that is, as value is added by firms along the chain of production).
Various U.S. policymakers have proposed that the tax code move further in
the direction of taxing consumption rather than income. In 2005, economist Alan
Greenspan, then Chairman of the Federal Reserve, offered this advice to a presi-
dential commission on tax reform: “As you know, many economists believe that
a consumption tax would be best from the perspective of promoting economic
growth—particularly if one were designing a tax system from scratch—because
a consumption tax is likely to encourage saving and capital formation. However,
getting from the current tax system to a consumption tax raises a challenging set
of transition issues.” ●
A DMINISTRATIVE BURDEN
If you ask the typical person on April 15 for an opinion about the tax system, you
might get an earful (perhaps peppered with expletives) about the headache of
filling out tax forms. The administrative burden of any tax system is part of the
inefficiency it creates. This burden includes not only the time spent in early April
filling out forms but also the time spent throughout the year keeping records
for tax purposes and the resources the government has to use to enforce the tax
laws.
Many taxpayers—especially those in higher tax brackets—hire tax lawyers
and accountants to help them with their taxes. These experts in the complex tax
laws fill out the tax forms for their clients and help them arrange their affairs in a
way that reduces the amount of taxes owed. This behavior is legal tax avoidance,
which is different from illegal tax evasion.
Critics of our tax system say that these advisers help their clients avoid taxes
by abusing some of the detailed provisions of the tax code, often dubbed “loop-
holes.” In some cases, loopholes are congressional mistakes: They arise from
ambiguities or omissions in the tax laws. More often, they arise because Congress
has chosen to give special treatment to specific types of behavior. For example,
the U.S. federal tax code gives preferential treatment to investors in municipal
bonds because Congress wanted to make it easier for state and local governments
to borrow money. To some extent, this provision benefits states and localities, and
to some extent, it benefits high-income taxpayers. Most loopholes are well known
by those in Congress who make tax policy, but what looks like a loophole to one
taxpayer may look like a justifiable tax deduction to another.
The resources devoted to complying with the tax laws are a type of deadweight
loss. The government gets only the amount of taxes paid. By contrast, the taxpayer
loses not only this amount but also the time and money spent documenting, com-
puting, and avoiding taxes.
The administrative burden of the tax system could be reduced by simplifying
the tax laws. Yet simplification is often politically difficult. Most people are ready
to simplify the tax code by eliminating the loopholes that benefit others, but few
are eager to give up the loopholes that benefit them. In the end, the complexity of
the tax law results from the political process as various taxpayers with their own
special interests lobby for their causes.
M ARGINAL TAX R ATES VERSUS AVERAGE TAX R ATES

When discussing the efficiency and equity of income taxes, economists distinguish
average tax rate between two notions of the tax rate: the average and the marginal. The average tax
total taxes paid divided rate is total taxes paid divided by total income. The marginal tax rate is the extra
by total income taxes paid on an additional dollar of income.
For example, suppose that the government taxes 20 percent of the first $50,000
marginal tax rate of income and 50 percent of all income above $50,000. Under this tax, a person who
the extra taxes paid on
makes $60,000 pays a tax of $15,000: 20 percent of the first $50,000 (0.20 × $50,000
an additional dollar of
income
= $10,000) plus 50 percent of the next $10,000 (0.50 × $10,000 = $5,000). For this
person, the average tax rate is $15,000 / $60,000, or 25 percent. But the marginal
tax rate is 50 percent. If the taxpayer earned an additional dollar of income, that
dollar would be subject to the 50 percent tax rate, so the amount the taxpayer
would owe to the government would rise by $0.50.
The marginal and average tax rates each contain a useful piece of information.
If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate
is more appropriate because it measures the fraction of income paid in taxes. By
contrast, if we are trying to gauge how much the tax system distorts incentives,
the marginal tax rate is more meaningful. One of the Ten Principles of Economics in
Chapter 1 is that rational people think at the margin. A corollary to this principle
is that the marginal tax rate measures how much the tax system discourages peo-
ple from working. If you are thinking of working an extra few hours, the marginal
tax rate determines how much the government takes of your additional earnings.
It is the marginal tax rate, therefore, that determines the deadweight loss of an
income tax.
LUMP-SUM TAXES
Suppose the government imposes a tax of $4,000 on everyone. That is, everyone
owes the same amount, regardless of earnings or any actions that a person might
take. Such a tax is called a lump-sum tax. lump-sum tax
A lump-sum tax shows clearly the difference between average and marginal a tax that is the same
tax rates. For a taxpayer with income of $20,000, the average tax rate of a $4,000 amount for every person
lump-sum tax is 20 percent; for a taxpayer with income of $40,000, the average tax
rate is 10 percent. For both taxpayers, the marginal tax rate is zero because no tax
is owed on an additional dollar of income.
A lump-sum tax is the most efficient tax possible. Because a person’s decisions
do not alter the amount owed, the tax does not distort incentives and, therefore,
does not cause deadweight losses. Because everyone can easily compute the
amount owed and because there is no benefit to hiring tax lawyers and accoun-
tants, the lump-sum tax imposes a minimal administrative burden on taxpayers.
If lump-sum taxes are so efficient, why do we rarely observe them in the real
world? The reason is that efficiency is only one goal of the tax system. A lump-
sum tax would take the same amount from the poor and the rich, an outcome most
people would view as unfair. To understand the tax systems that we observe, we
must therefore consider the other major goal of tax policy: equity.
Q Q
UICK UIZ What is meant by the efficiency of a tax system? • What can make a tax
system inefficient?
TAXES AND EQUITY

Ever since American colonists dumped imported tea into Boston harbor to protest
high British taxes, tax policy has generated some of the most heated debates in
American politics. The heat is rarely fueled by questions of efficiency. Instead, it
arises from disagreements over how the tax burden should be distributed. Senator
Russell Long once mimicked the public debate with this ditty:
Don’t tax you.
Don’t tax me.
Tax that fella behind the tree.
Of course, if we are to rely on the government to provide some of the goods and
services we want, taxes must fall on someone. In this section, we consider the
equity of a tax system. How should the burden of taxes be divided among the
population? How do we evaluate whether a tax system is fair? Everyone agrees
that the tax system should be equitable, but there is much disagreement about
what equity means and how the equity of a tax system can be judged.
THE BENEFITS PRINCIPLE

benefits principle One principle of taxation, called the benefits principle, states that people should
the idea that people pay taxes based on the benefits they receive from government services. This prin-
should pay taxes based ciple tries to make public goods similar to private goods. It seems fair that a per-
on the benefits they son who often goes to the movies pays more in total for movie tickets than a
receive from government person who rarely goes. Similarly, a person who gets great benefit from a public
services
good should pay more for it than a person who gets little benefit.
The gasoline tax, for instance, is sometimes justified using the benefits princi-
ple. In some states, revenues from the gasoline tax are used to build and maintain
roads. Because those who buy gasoline are the same people who use the roads, the
gasoline tax might be viewed as a fair way to pay for this government service.
The benefits principle can also be used to argue that wealthy citizens should
pay higher taxes than poorer ones. Why? Simply because the wealthy benefit
more from public services. Consider, for example, the benefits of police protection
from theft. Citizens with much to protect benefit more from police than do those
with less to protect. Therefore, according to the benefits principle, the wealthy
should contribute more than the poor to the cost of maintaining the police force.
The same argument can be used for many other public services, such as fire pro-
tection, national defense, and the court system.
It is even possible to use the benefits principle to argue for antipoverty pro-
grams funded by taxes on the wealthy. As we discussed in Chapter 11, people pre-
fer living in a society without poverty, suggesting that antipoverty programs are
a public good. If the wealthy place a greater dollar value on this public good than
members of the middle class do, perhaps just because the wealthy have more to
spend, then according to the benefits principle, they should be taxed more heavily
to pay for these programs.
THE A BILITY-TO-PAY PRINCIPLE

ability-to-pay principle Another way to evaluate the equity of a tax system is called the ability-to-pay
the idea that taxes principle, which states that taxes should be levied on a person according to how
should be levied on a well that person can shoulder the burden. This principle is sometimes justified by
person according to the claim that all citizens should make an “equal sacrifice” to support the govern-
how well that person ment. The magnitude of a person’s sacrifice, however, depends not only on the
can shoulder the burden size of his tax payment but also on his income and other circumstances. A $1,000
tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by
a rich one.
vertical equity The ability-to-pay principle leads to two corollary notions of equity: vertical
the idea that taxpayers equity and horizontal equity. Vertical equity states that taxpayers with a greater
with a greater ability to ability to pay taxes should contribute a larger amount. Horizontal equity states
pay taxes should pay that taxpayers with similar abilities to pay should contribute the same amount.
larger amounts
These notions of equity are widely accepted, but applying them to evaluate a tax
horizontal equity
system is rarely straightforward.
the idea that taxpayers
with similar abilities to Vertical Equity If taxes are based on ability to pay, then richer taxpayers should
pay taxes should pay the pay more than poorer taxpayers. But how much more should the rich pay? Much
same amount of the debate over tax policy concerns this question.
T A B L E
7
Proportional Tax Regressive Tax Progressive Tax
Three Tax Systems

Amount Percent Amount Percent Amount Percent
Income of Tax of Income of Tax of Income of Tax of Income
$ 50,000 $12,500 25% $15,000 30% $10,000 20%

100,000 25,000 25 25,000 25 25,000 25
200,000 50,000 25 40,000 20 60,000 30
Consider the three tax systems in Table 7. In each case, taxpayers with higher
incomes pay more. Yet the systems differ in how quickly taxes rise with income.
The first system is called proportional because all taxpayers pay the same fraction proportional tax
of income. The second system is called regressive because high-income taxpayers a tax for which high-
pay a smaller fraction of their income, even though they pay a larger amount. The income and low-income
third system is called progressive because high-income taxpayers pay a larger taxpayers pay the same
fraction of income
fraction of their income.
Which of these three tax systems is most fair? There is no obvious answer, and
regressive tax
economic theory does not offer any help in trying to find one. Equity, like beauty, a tax for which high-
is in the eye of the beholder. income taxpayers pay a
smaller fraction of their
HOW THE TAX BURDEN IS DISTRIBUTED income than do low-
income taxpayers
Much debate over tax policy concerns whether the wealthy pay their fair share.
progressive tax
There is no objective way to make this judgment. In evaluating the issue for your-
a tax for which high-
self, however, it is useful to know how much families with different incomes pay income taxpayers pay
under the current tax system. a larger fraction of their
Table 8 presents some data on how all federal taxes are distributed among income than do low-
income classes. To construct this table, families are ranked according to their income taxpayers
income and placed into five groups of equal size, called quintiles. The table also
presents data on the richest 1 percent of Americans.
The second column of the table shows the average income of each group. The
poorest one-fifth of families had average income of $15,900, and the richest one-
fifth had average income of $231,300. The richest 1 percent had average income of
over $1 million.
The next column of the table shows total taxes as a percentage of income. As
you can see, the U.S. federal tax system is progressive. The poorest fifth of families
paid 4.3 percent of their incomes in taxes, and the richest fifth paid 25.5 percent.
The top 1 percent paid 31.2 percent of their incomes.
The fourth and fifth columns compare the distribution of income and the dis-
tribution of taxes. The poorest quintile earns 4.0 percent of all income and pays 0.8
percent of all taxes. The richest quintile earns 55.1 percent of all income and pays
68.7 percent of all taxes. The richest 1 percent (which, remember, is 1⁄20 the size of
each quintile) earns 18.1 percent of all income and pays 27.6 percent of all taxes.
This table on taxes is a good starting point for understanding the burden of
government, but the picture it offers is incomplete. Although it includes all the
8 T A B L E
Taxes as a Percentage Percentage
Average Percentage of All of All
The Burden of Federal Taxes Quintile Income of Income Income Taxes
Source: Congressional Budget Office.
Figures are for 2005. Lowest $15,900 4.3% 4.0% 0.8%
Second 37,400 9.9 8.5 4.1
Middle 58,500 14.2 13.3 9.3
Fourth 85,200 17.4 19.8 16.9
Highest 231,300 25.5 55.1 68.7
Top 1% 1,558,500 31.2 18.1 27.6
taxes that flow from households to the federal government, it fails to include the
transfer payments, such as Social Security and welfare, that flow from the federal
government back to households.
Studies that include both taxes and transfers show even greater progressiv-
ity. The richest group of families still pays about one-quarter of its income to the
government, even after transfers are subtracted. By contrast, poor families typi-
cally receive more in transfers than they pay in taxes. The average tax rate of the
poorest quintile, rather than being 4.3 percent as in the table, is approximately
negative 30 percent. In other words, their income is about 30 percent higher than it
would be without government taxes and transfers. The lesson is clear: To under-
stand fully the progressivity of government policies, one must take account of
both what people pay and what they receive. ●
Horizontal Equity If taxes are based on ability to pay, then similar taxpayers
should pay similar amounts of taxes. But what determines if two taxpayers are
similar? Families differ in many ways. To evaluate whether a tax code is horizon-
tally equitable, one must determine which differences are relevant for a family’s
ability to pay and which differences are not.
Suppose the Smith and Jones families each have income of $80,000. The Smiths
have no children, but Mr. Smith has an illness that causes medical expenses of
$30,000. The Joneses are in good health, but they have four children. Two of the
Jones children are in college, generating tuition bills of $40,000. Would it be fair
for these two families to pay the same tax because they have the same income?
Would it be fair to give the Smiths a tax break to help them offset their high medi-
cal expenses? Would it be fair to give the Joneses a tax break to help them with
their tuition expenses?
There are no easy answers to these questions. In practice, the U.S. income
tax is filled with special provisions that alter a family’s tax based on its specific
circumstances.
TAX INCIDENCE AND TAX EQUITY

Tax incidence—the study of who bears the burden of taxes—is central to evaluat-
ing tax equity. As we first saw in Chapter 6, the person who bears the burden of
a tax is not always the person who gets the tax bill from the government. Because
taxes alter supply and demand, they alter equilibrium prices. As a result, they
affect people beyond those who, according to statute, actually pay the tax. When
evaluating the vertical and horizontal equity of any tax, it is important to take
these indirect effects into account.
Many discussions of tax equity ignore the indirect effects of taxes and are based
on what economists mockingly call the flypaper theory of tax incidence. According
to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it first
lands. This assumption, however, is rarely valid.
For example, a person not trained in economics might argue that a tax on expen-
sive fur coats is vertically equitable because most buyers of furs are wealthy. Yet if
these buyers can easily substitute other luxuries for furs, then a tax on furs might
only reduce the sale of furs. In the end, the burden of the tax will fall more on
those who make and sell furs than on those who buy them. Because most work-
ers who make furs are not wealthy, the equity of a fur tax could be quite different
from what the flypaper theory indicates.
WHO PAYS THE CORPORATE INCOME TAX?

The corporate income tax provides a good example of the importance of tax inci-
dence for tax policy. The corporate tax is popular among voters. After all, corpora-
tions are not people. Voters are always eager to have their taxes reduced and have
some impersonal corporation pick up the tab.
But before deciding that the corporate income tax is a good way for the govern-
ment to raise revenue, we should consider who bears the burden of the corporate
tax. This is a difficult question on which economists disagree, but one thing is
certain: People pay all taxes. When the government levies a tax on a corporation, the
corporation is more like a tax collector than a taxpayer. The burden of the tax ulti-
© BRIAN KERSEY/UPI/LANDOV
mately falls on people—the owners, customers, or workers of the corporation.
Many economists believe that workers and customers bear much of the burden
of the corporate income tax. To see why, consider an example. Suppose that the
U.S. government decides to raise the tax on the income earned by car companies.
At first, this tax hurts the owners of the car companies, who receive less profit.
But over time, these owners will respond to the tax. Because producing cars is less
profitable, they invest less in building new car factories. Instead, they invest their
wealth in other ways—for example, by buying larger houses or by building fac- THIS WORKER PAYS PART OF
tories in other industries or other countries. With fewer car factories, the supply THE CORPORATE INCOME TAX.
of cars declines, as does the demand for autoworkers. Thus, a tax on corporations
making cars causes the price of cars to rise and the wages of autoworkers to fall.
The corporate income tax shows how dangerous the flypaper theory of tax inci-
dence can be. The corporate income tax is popular in part because it appears to be
paid by rich corporations. Yet those who bear the ultimate burden of the tax—the
customers and workers of corporations—are often not rich. If the true incidence of
the corporate tax were more widely known, this tax might be less popular among
voters. ●
Q Q
UICK UIZ Explain the benefits principle and the ability-to-pay principle. • What are
vertical equity and horizontal equity? • Why is studying tax incidence important for
determining the equity of a tax system?
Questions and Answers about Tax Reform

The most recent attempt at major tax reform was in 2005, when
President Bush appointed a bipartisan advisory panel to study the
issue. This Q&A explains what the panel tried to achieve. Answers
are from Edward Lazear and James Poterba, the two economists
on the panel. Because Congress failed to adopt the panel’s
recommendations, the tax code is much the same now as it was
in 2005, and the issues the panel raised remain relevant.
Q: What should the goal of a tax system be? riddled with targeted incentives, phase-out on investment and shifts the tax system
A: A tax system should generate the rules, phantom tax rates, and complex and toward a consumption tax are much larger.
government’s required revenue with as sometimes inconsistent provisions that leave Q: How might tax reform promote eco-
little economic distortion as possible, while most taxpayers unable to understand the nomic growth?
distributing tax burdens fairly. It should not rules under which they are taxed, let alone A: A substantial body of economic
discourage work, saving or entrepreneur- able to complete their own tax return. research suggests that tax wedges between
ship more than is necessary, and it should Q: What should reform try to accomplish? the before-tax and the after-tax return on
not discourage individuals from acquiring A: Although many see simplification saving and investment are particularly detri-
the skills and education that will increase as the primary goal of tax reform, promot- mental to long-term economic growth. The
their productivity. It should not discourage ing economic growth is a more important current tax system taxes corporate income
investment, or favor investments in one objective. Even in the relatively short run, once at the corporate level and again at
asset over those in another. In short, an effi- the economic costs of a tax system that the investor level. The Treasury Department
cient tax system alters economic decision- slows growth are likely to exceed compli- estimates that, on average, the total tax bur-
making as little as possible. ance costs. U.S. households spend roughly den on a new corporate investment project
Q: What is wrong with the current 1% of GDP in complying with the income is 24%. By comparison, investments in the
system? tax system. Halving the costs of compliance non-corporate sector, which are taxed only
A: The more than 15,000 changes to the would be equivalent to raising GDP by one once, face a 17% tax burden. Investments
tax code in the last 19 years have under- half of one percent—no minor accomplish- in owner-occupied housing, which yield
mined many achievements of the 1986 tax ment. The increase in GDP that might result untaxed returns in the form of implicit rental
reform. They have created a tax code that is from a tax reform that reduces tax burdens income, are untaxed. Taxing different invest-
CONCLUSION: THE TRADE-OFF BETWEEN EQUITY

AND EFFICIENCY
Almost everyone agrees that equity and efficiency are the two most important
goals of the tax system. But often, these two goals conflict, especially when equity
is judged by the progressivity of the tax system. People disagree about tax policy
often because they attach different weights to these goals.
The recent history of tax policy shows how political leaders differ in their views
on equity and efficiency. When Ronald Reagan was elected president in 1980, the
marginal tax rate on the earnings of the richest Americans was 50 percent. On
interest income, the marginal tax rate was 70 percent. Reagan argued that such
ments differently distorts capital formation Productivity growth depends on invest- of taxable income. Both proposals replace
and slows growth. ment in human and physical capital. Invest- the current itemized deduction for interest
The Treasury Department estimates that ment in human capital means acquiring on a mortgage of up to $1 million, plus a
eliminating the tax burden on new invest- skills through formal education and learning $100,000 home equity loan, with a 15% tax
ment, for example by adopting a consump- on the job. Investment in physical capital credit on interest for loans up to 125% of an
tion tax, would eventually raise GDP by means adding to the stock of plant, equip- area’s median home price.
between 5% and 7%. GDP growth is essen- ment, technological know-how and other Employer-provided health insurance
tial to improving the standard of living for all intangibles that make workers productive. is currently untaxed regardless of its cost.
Americans, and it is closely tied to produc- Both proposals encourage investment in This encourages the purchase of excessively
tivity growth. The surest way to raise wages skills by reducing marginal tax rates on labor generous insurance policies. To preserve
is to raise productivity. supply for most earners. They encourage incentives for employers to provide families
Q: What specifically do you propose? investment in physical capital by reduc- with basic insurance coverage, both plans
A: The Tax Panel endorses two reform ing taxes on business investment. Treasury tax employer-provided health insurance,
proposals that would improve economic estimates that moving from the current but only on the amount of insurance valued
growth, simplify the tax code, and roughly structure to the Growth and Investment at more than $11,500 for a married couple
preserve the current distribution of tax bur- Tax would lower the average tax burden on and $5,000 for a single individual.
dens. Both would repeal the individual and all investment from 17% to 6%. This would Both plans eliminate the federal tax
corporate Alternative Minimum Tax. The first encourage new investment and significantly deduction for payments of state and local
is the Simplified Income Tax. It preserves the increase productivity and wage growth. income and property taxes.
income tax framework but cuts marginal Q: How do these proposals reduce tax Q: How about vertical equity?
rates to 15%, 25% and 33%. It provides for a rates without reducing tax revenue? A: The plans leave the burden of pay-
large amount of tax-free saving, consolidates A: Both proposals trim many of the ing for the work of government virtually
credits, and rationalizes the system of busi- deductions that currently narrow the unchanged. There is a very slight increase
ness taxation. The second reform proposal, income tax base, while retaining incen- in the burden carried by the rich, but the
the Growth and Investment Tax, builds on tives for charitable giving, homeownership standard of living of this group would still
the Simplified Income Tax system, and by and the purchase of health insurance. Both rise in the long run, as a result of the plans’
allowing full expensing of capital, shifts the proposals allow taxpayers a deduction for favorable effects on long-term economic
tax system toward a consumption tax base. charitable contributions in excess of 1% growth.
Source: Answers are excerpts from “A Golden Opportunity,” by Edward P. Lazear and James M. Poterba, The Wall Street Journal, November 1, 2005. More information on the tax
reform advisory panel can be found at http://www.taxreformpanel.gov/.
high tax rates greatly distorted economic incentives to work and save. In other
words, he claimed that these high tax rates cost too much in terms of economic
efficiency. Tax reform was, therefore, a high priority of his administration. Reagan
signed into law large cuts in tax rates in 1981 and then again in 1986. When
Reagan left office in 1989, the richest Americans faced a marginal tax rate of only
28 percent.
The pendulum of political debate swings both ways. When Bill Clinton ran for
president in 1992, he argued that the rich were not paying their fair share of taxes.
In other words, the low tax rates on the rich violated his view of vertical equity.
In 1993, President Clinton signed into law a bill that raised the tax rates on the
richest Americans to about 40 percent. When George W. Bush ran for president,
he reprised many of Reagan’s themes, and as president he reversed part of the
Clinton tax increase, reducing the highest tax rate to 35 percent. During the 2008
presidential campaign, Republican John McCain advocated making the Bush tax
cuts permanent, while Democrat Barack Obama proposed increasing the top mar-
ginal tax rate.
Economics alone cannot determine the best way to balance the goals of effi-
ciency and equity. This issue involves political philosophy as well as econom-
ics. But economists do have an important role in this debate: They can shed light
on the trade-offs that society inevitably faces when designing the tax system and
can help us avoid policies that sacrifice efficiency without any benefit in terms of
equity.
SUMMARY
• The U.S. government raises revenue using vari- lation. According to the benefits principle, it is
ous taxes. The most important taxes for the fed- fair for people to pay taxes based on the benefits
eral government are individual income taxes they receive from the government. According to
and payroll taxes for social insurance. The most the ability-to-pay principle, it is fair for people to
important taxes for state and local governments pay taxes based on their capability to handle the
are sales taxes and property taxes. financial burden. When evaluating the equity of
a tax system, it is important to remember a lesson
• The efficiency of a tax system refers to the costs from the study of tax incidence: The distribution
it imposes on taxpayers. There are two costs of
of tax burdens is not the same as the distribution
taxes beyond the transfer of resources from the
of tax bills.
taxpayer to the government. The first is the dead-
weight loss that arises as taxes alter incentives • When considering changes in the tax laws, policy-
and distort the allocation of resources. The sec- makers often face a trade-off between efficiency
ond is the administrative burden of complying and equity. Much of the debate over tax policy
with the tax laws. arises because people give different weights to
these two goals.
• The equity of a tax system concerns whether the
tax burden is distributed fairly among the popu-
KEY CONCEPTS
budget deficit, p. 246 lump-sum tax, p. 253 horizontal equity, p. 254

budget surplus, p. 246 benefits principle, p. 254 proportional tax, p. 255
average tax rate, p. 252 ability-to-pay principle, p. 254 regressive tax, p. 255
marginal tax rate, p. 252 vertical equity, p. 254 progressive tax, p. 255
1. Over the past century, has the government’s tax 6. What is the marginal tax rate on a lump-sum
revenue grown more or less slowly than the rest tax? How is this related to the efficiency of the
of the economy? tax?
2. What are the two most important sources of 7. Give two arguments why wealthy taxpayers
revenue for the U.S. federal government? should pay more taxes than poor taxpayers.
3. Explain how corporate profits are taxed twice. 8. What is the concept of horizontal equity and
4. Why is the burden of a tax to taxpayers greater why is it hard to apply?
than the revenue received by the government?
5. Why do some economists advocate taxing con-
sumption rather than income?
1. In a published source or on the Internet, find c. Looking at the combined expenditures of

out whether the U.S. federal government had the federal government and state and local
a budget deficit or surplus last year. What do governments, how have the relative shares
policymakers expect to happen over the next of transfer payments and purchases of goods
few years? (Hint: The website of the Congressio- and services changed over time?
nal Budget Office is http://www.cbo.gov.) 3. The chapter states that the elderly population in
2. The information in many of the tables in this the United States is growing more rapidly than
chapter can be found in the Economic Report of the total population. In particular, the number
the President, which appears annually. Using a of workers is rising slowly, while the number
recent issue of the report at your library or on of retirees is rising quickly. Concerned about
the Internet, answer the following questions the future of Social Security, some members of
and provide some numbers to support your Congress propose a “freeze” on the program.
answers. (Hint: The website of the Government a. If total expenditures were frozen, what
Printing Office is http://www.gpo.gov.) would happen to benefits per retiree? To tax
a. Figure 1 shows that government revenue as a payments per worker? (Assume that Social
percentage of total income has increased over Security taxes and receipts are balanced in
time. Is this increase primarily attributable to each year.)
changes in federal government revenue or in b. If benefits per retiree were frozen, what
state and local government revenue? would happen to total expenditures? To tax
b. Looking at the combined revenue of the payments per worker?
federal government and state and local gov- c. If tax payments per worker were frozen,
ernments, how has the composition of total what would happen to total expenditures?
revenue changed over time? Are personal To benefits per retiree?
income taxes more or less important? Social d. What do your answers to parts (a), (b), and
insurance taxes? Corporate profits taxes? (c) imply about the difficult decisions faced
by policymakers?
4. Suppose you are a typical person in the U.S. 9. Categorize each of the following funding
economy. You pay 4 percent of your income in schemes as examples of the benefits principle
a state income tax and 15.3 percent of your labor or the ability-to-pay principle.
earnings in federal payroll taxes (employer a. Visitors to many national parks pay an
and employee shares combined). You also pay entrance fee.
federal income taxes as in Table 3. How much b. Local property taxes support elementary and
tax of each type do you pay if you earn $20,000 secondary schools.
a year? Taking all taxes into account, what are c. An airport trust fund collects a tax on each
your average and marginal tax rates? What plane ticket sold and uses the money to
happens to your tax bill and to your average improve airports and the air traffic control
and marginal tax rates if your income rises to system.
$40,000? 10. Any income tax schedule embodies two types
5. Some states exclude necessities, such as food of tax rates: average tax rates and marginal tax
and clothing, from their sales tax. Other states rates.
do not. Discuss the merits of this exclusion. a. The average tax rate is defined as total taxes
Consider both efficiency and equity. paid divided by income. For the proportional
6. When someone owns an asset (such as a share tax system presented in Table 7, what are the
of stock) that rises in value, he has an “accrued” average tax rates for people earning $50,000,
capital gain. If he sells the asset, he “realizes” $100,000, and $200,000? What are the corre-
the gains that have previously accrued. Under sponding average tax rates in the regressive
the U.S. income tax, realized capital gains are and progressive tax systems?
taxed, but accrued gains are not. b. The marginal tax rate is defined as the extra
a. Explain how individuals’ behavior is affected taxes paid on additional income divided by
by this rule. the increase in income. Calculate the mar-
b. Some economists believe that cuts in capital ginal tax rate for the proportional tax system
gains tax rates, especially temporary ones, as income rises from $50,000 to $100,000.
can raise tax revenue. How might this be so? Calculate the marginal tax rate as income
c. Do you think it is a good rule to tax realized rises from $100,000 to $200,000. Calculate
but not accrued capital gains? Why or why the corresponding marginal tax rates for the
not? regressive and progressive tax systems.
7. Suppose that your state raises its sales tax from c. Describe the relationship between average
5 percent to 6 percent. The state revenue com- tax rates and marginal tax rates for each of
missioner forecasts a 20 percent increase in sales these three systems. In general, which rate
tax revenue. Is this plausible? Explain. is relevant for someone deciding whether to
8. The Tax Reform Act of 1986 eliminated the accept a job that pays slightly more than her
deductibility of interest payments on consumer current job? Which rate is relevant for judg-
debt (mostly credit cards and auto loans) but ing the vertical equity of a tax system?
maintained the deductibility of interest pay- 11. Use the data in Table 8 to answer these ques-
ments on mortgages and home equity loans. tions about the U.S. tax system:
What do you think happened to the relative a. For each quintile, compute the federal taxes
amounts of borrowing through consumer debt paid by the typical taxpayer.
and home equity debt? b. As a taxpayer moves from each quintile to
the next higher quintile, compute the change
in income and the change in taxes.
c. Use the information in part (b) to compute If the income tax base were broadened by
the marginal tax rate as a person moves from eliminating these deductions, tax rates could be
one quintile to the next. lowered, while raising the same amount of tax
d. For any given taxpayer, which is higher—the revenue.
marginal tax rate or the average tax rate? For each of these deductions, what would
e. What happens to the average tax rate and you expect the likely effect on taxpayer behavior
the marginal tax rate as income rises? Which to be? Discuss the pros and cons of each deduc-
changes more? tion from the standpoint of efficiency, vertical
12. Each of the following expenditures is a deduc- equity, and horizontal equity. Would you keep
tion for the purposes of calculating a person’s or eliminate the deduction?
federal income tax liability:
a. Mortgage interest
b. State and local taxes
c. Charitable contributions
PART V
Firm Behavior and the
Organization of Industry
13
CHAPTER
The Costs of Production
T he economy is made up of thousands of firms that produce the goods

and services you enjoy every day: General Motors produces automobiles,
General Electric produces lightbulbs, and General Mills produces break-
fast cereals. Some firms, such as these three, are large; they employ thousands
of workers and have thousands of stockholders who share in the firms’ profits.
Other firms, such as the local barbershop or candy store, are small; they employ
only a few workers and are owned by a single person or family.
In previous chapters, we used the supply curve to summarize firms’ produc-
tion decisions. According to the law of supply, firms are willing to produce and
sell a greater quantity of a good when the price of the good is higher, and this
response leads to a supply curve that slopes upward. For analyzing many ques-
tions, the law of supply is all you need to know about firm behavior.
In this chapter and the ones that follow, we examine firm behavior in more
detail. This topic will give you a better understanding of the decisions behind
the supply curve. In addition, it will introduce you to a part of economics called
industrial organization—the study of how firms’ decisions about prices and quanti-
ties depend on the market conditions they face. The town in which you live, for
instance, may have several pizzerias but only one cable television company. This
raises a key question: How does the number of firms affect the prices in a market
and the efficiency of the market outcome? The field of industrial organization
addresses exactly this question.
267
268 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
Before turning to these issues, we need to discuss the costs of production. All
firms, from Delta Air Lines to your local deli, incur costs as they make the goods
and services that they sell. As we will see in the coming chapters, a firm’s costs
are a key determinant of its production and pricing decisions. In this chapter, we
define some of the variables that economists use to measure a firm’s costs, and we
consider the relationships among these variables.
A word of warning: This topic is dry and technical. To be honest, one might
even call it boring. But this material provides a crucial foundation for the fascinat-
ing topics that follow.
WHAT ARE COSTS?

We begin our discussion of costs at Caroline’s Cookie Factory. Caroline, the owner
of the firm, buys flour, sugar, chocolate chips, and other cookie ingredients. She
also buys the mixers and ovens and hires workers to run this equipment. She then
sells the cookies to consumers. By examining some of the issues that Caroline
faces in her business, we can learn some lessons about costs that apply to all firms
in an economy.
TOTAL R EVENUE, TOTAL COST, AND PROFIT

We begin with the firm’s objective. To understand the decisions a firm makes, we
must understand what it is trying to do. It is conceivable that Caroline started her
firm because of an altruistic desire to provide the world with cookies or, perhaps,
out of love for the cookie business. More likely, Caroline started her business to
make money. Economists normally assume that the goal of a firm is to maximize
profit, and they find that this assumption works well in most cases.
What is a firm’s profit? The amount that the firm receives for the sale of its
total revenue output (cookies) is called its total revenue. The amount that the firm pays to buy
the amount a firm inputs (flour, sugar, workers, ovens, and so forth) is called its total cost. Caroline
receives for the sale of gets to keep any revenue that is not needed to cover costs. Profit is a firm’s total
its output revenue minus its total cost:
total cost
Profit = Total revenue – Total cost.
the market value of the
inputs a firm uses in
production Caroline’s objective is to make her firm’s profit as large as possible.
To see how a firm goes about maximizing profit, we must consider fully how to
profit measure its total revenue and its total cost. Total revenue is the easy part: It equals
total revenue minus the quantity of output the firm produces times the price at which it sells its output.
total cost If Caroline produces 10,000 cookies and sells them at $2 a cookie, her total revenue
is $20,000. By contrast, the measurement of a firm’s total cost is more subtle.
COSTS AS OPPORTUNITY COSTS

When measuring costs at Caroline’s Cookie Factory or any other firm, it is impor-
tant to keep in mind one of the Ten Principles of Economics from Chapter 1: The
cost of something is what you give up to get it. Recall that the opportunity cost of
an item refers to all those things that must be forgone to acquire that item. When
economists speak of a firm’s cost of production, they include all the opportunity
costs of making its output of goods and services.
CHAPTER 13 THE COSTS OF PRODUCTION 269
While some of a firm’s opportunity costs of production are obvious, others are
less so. When Caroline pays $1,000 for flour, that $1,000 is an opportunity cost
because Caroline can no longer use that $1,000 to buy something else. Similarly,
when Caroline hires workers to make the cookies, the wages she pays are part of
the firm’s costs. Because these opportunity costs require the firm to pay out some
money, they are called explicit costs. By contrast, some of a firm’s opportunity explicit costs
costs, called implicit costs, do not require a cash outlay. Imagine that Caroline input costs that require
is skilled with computers and could earn $100 per hour working as a program- an outlay of money by
mer. For every hour that Caroline works at her cookie factory, she gives up $100 the firm
in income, and this forgone income is also part of her costs. The total cost of
implicit costs
Caroline’s business is the sum of the explicit costs and the implicit costs.
input costs that do not
The distinction between explicit and implicit costs highlights an important dif- require an outlay of
ference between how economists and accountants analyze a business. Economists money by the firm
are interested in studying how firms make production and pricing decisions.
Because these decisions are based on both explicit and implicit costs, economists
include both when measuring a firm’s costs. By contrast, accountants have the job
of keeping track of the money that flows into and out of firms. As a result, they
measure the explicit costs but usually ignore the implicit costs.
The difference between economists and accountants is easy to see in the case
of Caroline’s Cookie Factory. When Caroline gives up the opportunity to earn
money as a computer programmer, her accountant will not count this as a cost of
her cookie business. Because no money flows out of the business to pay for this
cost, it never shows up on the accountant’s financial statements. An economist,
however, will count the forgone income as a cost because it will affect the deci-
sions that Caroline makes in her cookie business. For example, if Caroline’s wage
as a computer programmer rises from $100 to $500 per hour, she might decide that
running her cookie business is too costly and choose to shut down the factory to
become a full-time computer programmer.
THE COST OF CAPITAL AS AN OPPORTUNITY COST

An important implicit cost of almost every business is the opportunity cost of the
financial capital that has been invested in the business. Suppose, for instance, that
Caroline used $300,000 of her savings to buy her cookie factory from its previous
owner. If Caroline had instead left this money deposited in a savings account that
pays an interest rate of 5 percent, she would have earned $15,000 per year. To
own her cookie factory, therefore, Caroline has given up $15,000 a year in interest
income. This forgone $15,000 is one of the implicit opportunity costs of Caroline’s
business.
As we have already noted, economists and accountants treat costs differently,
and this is especially true in their treatment of the cost of capital. An economist
views the $15,000 in interest income that Caroline gives up every year as a cost of
her business, even though it is an implicit cost. Caroline’s accountant, however,
will not show this $15,000 as a cost because no money flows out of the business to
pay for it.
To further explore the difference between economists and accountants, let’s
change the example slightly. Suppose now that Caroline did not have the entire
$300,000 to buy the factory but, instead, used $100,000 of her own savings and
borrowed $200,000 from a bank at an interest rate of 5 percent. Caroline’s accoun-
tant, who only measures explicit costs, will now count the $10,000 interest paid on
the bank loan every year as a cost because this amount of money now flows out of
the firm. By contrast, according to an economist, the opportunity cost of owning

the business is still $15,000. The opportunity cost equals the interest on the bank
loan (an explicit cost of $10,000) plus the forgone interest on savings (an implicit
cost of $5,000).
ECONOMIC PROFIT VERSUS ACCOUNTING PROFIT

Now let’s return to the firm’s objective: profit. Because economists and accoun-
tants measure costs differently, they also measure profit differently. An econo-
economic profit mist measures a firm’s economic profit as the firm’s total revenue minus all the
total revenue minus total opportunity costs (explicit and implicit) of producing the goods and services sold.
cost, including both An accountant measures the firm’s accounting profit as the firm’s total revenue
explicit and implicit costs minus only the firm’s explicit costs.
Figure 1 summarizes this difference. Notice that because the accountant ignores
accounting profit
the implicit costs, accounting profit is usually larger than economic profit. For
total revenue minus total
a business to be profitable from an economist’s standpoint, total revenue must
explicit cost
cover all the opportunity costs, both explicit and implicit.
Economic profit is an important concept because it is what motivates the firms
that supply goods and services. As we will see, a firm making positive economic
profit will stay in business. It is covering all its opportunity costs and has some rev-
enue left to reward the firm owners. When a firm is making economic losses (that
is, when economic profits are negative), the business owners are failing to earn
enough revenue to cover all the costs of production. Unless conditions change,
the firm owners will eventually close down the business and exit the industry. To
understand business decisions, we need to keep an eye on economic profit.
Q Q
UICK UIZ Farmer McDonald gives banjo lessons for $20 an hour. One day, he spends
10 hours planting $100 worth of seeds on his farm. What opportunity cost has he incurred?
What cost would his accountant measure? If these seeds yield $200 worth of crops, does
McDonald earn an accounting profit? Does he earn an economic profit?
1 F I G U R E
How an Economist How an Accountant
Views a Firm Views a Firm
Economists versus Accountants
Economists include all opportunity
Economic
costs when analyzing a firm, whereas profit
accountants measure only explicit
Accounting
costs. Therefore, economic profit is
profit
smaller than accounting profit.
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
PRODUCTION AND COSTS

Firms incur costs when they buy inputs to produce the goods and services that
they plan to sell. In this section, we examine the link between a firm’s production
process and its total cost. Once again, we consider Caroline’s Cookie Factory.
In the analysis that follows, we make an important simplifying assumption:
We assume that the size of Caroline’s factory is fixed and that Caroline can vary
the quantity of cookies produced only by changing the number of workers she
employs. This assumption is realistic in the short run but not in the long run. That
is, Caroline cannot build a larger factory overnight, but she can do so over the
next year or two. This analysis, therefore, describes the production decisions that
Caroline faces in the short run. We examine the relationship between costs and
time horizon more fully later in the chapter.
THE PRODUCTION FUNCTION

Table 1 shows how the quantity of cookies produced per hour at Caroline’s fac-
tory depends on the number of workers. As you can see in the first two columns,
if there are no workers in the factory, Caroline produces no cookies. When there
is 1 worker, she produces 50 cookies. When there are 2 workers, she produces
production function
90 cookies and so on. Panel (a) of Figure 2 presents a graph of these two columns the relationship between
of numbers. The number of workers is on the horizontal axis, and the number quantity of inputs used
of cookies produced is on the vertical axis. This relationship between the quan- to make a good and the
tity of inputs (workers) and quantity of output (cookies) is called the production quantity of output of that
function. good
T A B L E
1
Output Total Cost
(quantity of of Inputs
cookies Marginal (cost of A Production Function
Number of produced Product Cost of Cost of factory + cost and Total Cost:
Workers per hour) of Labor Factory Workers of workers) Caroline’s Cookie
Factory
0 0 $30 $0 $30
50
1 50 30 10 40
40
2 90 30 20 50
30
3 120 30 30 60
20
4 140 30 40 70
10
5 150 30 50 80
5
6 155 30 60 90
2 F I G U R E Types
The
workers
of Graphs
production
hiredin
The pie chart
function in panel (a) shows the relationship between the number of
and the (a)
panel quantity
showsof output
how U.S. produced. Here the
national income number
is derived of workers
from various
hired (onThe
sources. the bar
horizontal
graph inaxis) is from
panel the first column
(b) compares in Table
the average 1, and
income in the
fourquantity of
countries.
Caroline’s Production output produced
The time-series (on the
graph vertical
in panel (c)axis)
showsis from the second of
the productivity column. The
labor in production
U.S. businesses
Function and Total-Cost function
from 1950gets flatter as the number of workers increases, which reflects diminishing
to 2000.
Curve marginal product. The total-cost curve in panel (b) shows the relationship between
the quantity of output produced and total cost of production. Here the quantity of
output produced (on the horizontal axis) is from the second column in Table 1, and
the total cost (on the vertical axis) is from the sixth column. The total-cost curve gets
steeper as the quantity of output increases because of diminishing marginal product.
(a) Production function (b) Total-cost curve
Quantity Total
of Output Cost
(cookies $90
per hour)
160 Production 80 Total-cost
function curve
140 70
120 60
100 50
80 40
60 30
40 20
20 10
0 1 2 3 4 5 6 Number of 0 20 40 60 80 100 120 140 160 Quantity

Workers Hired of Output
(cookies per hour)
One of the Ten Principles of Economics introduced in Chapter 1 is that rational

people think at the margin. As we will see in future chapters, this idea is the key
to understanding the decisions a firm makes about how many workers to hire
and how much output to produce. To take a step toward understanding these
decisions, the third column in the table gives the marginal product of a worker.
marginal product The marginal product of any input in the production process is the increase in
the increase in output the quantity of output obtained from one additional unit of that input. When the
that arises from an number of workers goes from 1 to 2, cookie production increases from 50 to 90, so
additional unit of input the marginal product of the second worker is 40 cookies. And when the number of
workers goes from 2 to 3, cookie production increases from 90 to 120, so the mar-
ginal product of the third worker is 30 cookies. In the table, the marginal product
is shown halfway between two rows because it represents the change in output as
the number of workers increases from one level to another.
Notice that as the number of workers increases, the marginal product declines.
The second worker has a marginal product of 40 cookies, the third worker has
a marginal product of 30 cookies, and the fourth worker has a marginal prod-
uct of 20 cookies. This property is called diminishing marginal product. At first, diminishing marginal
when only a few workers are hired, they have easy access to Caroline’s kitchen product
equipment. As the number of workers increases, additional workers have to share the property whereby
equipment and work in more crowded conditions. Eventually, the kitchen is so the marginal product
crowded that the workers start getting in each other’s way. Hence, as more and of an input declines as
the quantity of the input
more workers are hired, each additional worker contributes fewer additional
increases
cookies to total production.
Diminishing marginal product is also apparent in Figure 2. The production
function’s slope (“rise over run”) tells us the change in Caroline’s output of cook-
ies (“rise”) for each additional input of labor (“run”). That is, the slope of the
production function measures the marginal product of a worker. As the number
of workers increases, the marginal product declines, and the production function
becomes flatter.
FROM THEPRODUCTION FUNCTION

TO THE TOTAL-COST CURVE
The last three columns of Table 1 show Caroline’s cost of producing cookies. In
this example, the cost of Caroline’s factory is $30 per hour, and the cost of a worker
is $10 per hour. If she hires 1 worker, her total cost is $40 per hour. If she hires
2 workers, her total cost is $50 per hour, and so on. With this information, the table
now shows how the number of workers Caroline hires is related to the quantity of
cookies she produces and to her total cost of production.
Our goal in the next several chapters is to study firms’ production and pricing
decisions. For this purpose, the most important relationship in Table 1 is between
quantity produced (in the second column) and total costs (in the sixth column).
Panel (b) of Figure 2 graphs these two columns of data with the quantity pro-
duced on the horizontal axis and total cost on the vertical axis. This graph is called
the total-cost curve.
Now compare the total-cost curve in panel (b) with the production function
in panel (a). These two curves are opposite sides of the same coin. The total-cost
curve gets steeper as the amount produced rises, whereas the production func-
tion gets flatter as production rises. These changes in slope occur for the same
reason. High production of cookies means that Caroline’s kitchen is crowded with
many workers. Because the kitchen is crowded, each additional worker adds less
to production, reflecting diminishing marginal product. Therefore, the produc-
tion function is relatively flat. But now turn this logic around: When the kitchen
is crowded, producing an additional cookie requires a lot of additional labor and
is thus very costly. Therefore, when the quantity produced is large, the total-cost
curve is relatively steep.
Q Q
UICK UIZ If Farmer Jones plants no seeds on his farm, he gets no harvest. If he plants
1 bag of seeds, he gets 3 bushels of wheat. If he plants 2 bags, he gets 5 bushels. If he
plants 3 bags, he gets 6 bushels. A bag of seeds costs $100, and seeds are his only cost.
Use these data to graph the farmer’s production function and total-cost curve. Explain
their shapes.
THE VARIOUS MEASURES OF COST

Our analysis of Caroline’s Cookie Factory demonstrated how a firm’s total cost
reflects its production function. From data on a firm’s total cost, we can derive
several related measures of cost, which will turn out to be useful when we ana-
lyze production and pricing decisions in future chapters. To see how these related
measures are derived, we consider the example in Table 2. This table presents cost
data on Caroline’s neighbor—Conrad’s Coffee Shop.
The first column of the table shows the number of cups of coffee that Conrad
might produce, ranging from 0 to 10 cups per hour. The second column shows
Conrad’s total cost of producing coffee. Figure 3 plots Conrad’s total-cost curve.
The quantity of coffee (from the first column) is on the horizontal axis, and total
cost (from the second column) is on the vertical axis. Conrad’s total-cost curve
has a shape similar to Caroline’s. In particular, it becomes steeper as the quan-
tity produced rises, which (as we have discussed) reflects diminishing marginal
product.
fixed costs FIXED AND VARIABLE COSTS

costs that do not vary
with the quantity of Conrad’s total cost can be divided into two types. Some costs, called fixed costs,
output produced do not vary with the quantity of output produced. They are incurred even if the
2 T A B L E
Quantity
of Coffee Average Average Average
The Various Measures (cups per Total Fixed Variable Fixed Variable Total Marginal
of Cost: Conrad’s hour) Cost Cost Cost Cost Cost Cost Cost
Coffee Shop
0 $ 3.00 $3.00 $ 0.00 — — —
$0.30
1 3.30 3.00 0.30 $3.00 $0.30 $3.30
0.50
2 3.80 3.00 0.80 1.50 0.40 1.90
0.70
3 4.50 3.00 1.50 1.00 0.50 1.50
0.90
4 5.40 3.00 2.40 0.75 0.60 1.35
1.10
5 6.50 3.00 3.50 0.60 0.70 1.30
1.30
6 7.80 3.00 4.80 0.50 0.80 1.30
1.50
7 9.30 3.00 6.30 0.43 0.90 1.33
1.70
8 11.00 3.00 8.00 0.38 1.00 1.38
1.90
9 12.90 3.00 9.90 0.33 1.10 1.43
2.10
10 15.00 3.00 12.00 0.30 1.20 1.50
Total Cost
F I G U R E 3
$15.00 Total-cost curve
14.00 Conrad’s Total-Cost Curve
13.00 Here the quantity of output produced (on
12.00 the horizontal axis) is from the first column in
11.00 Table 2, and the total cost (on the vertical axis)
10.00 is from the second column. As in Figure 2, the
9.00 total-cost curve gets steeper as the quantity
of output increases because of diminishing
8.00
marginal product.
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(cups of coffee per hour)
firm produces nothing at all. Conrad’s fixed costs include any rent he pays because
this cost is the same regardless of how much coffee he produces. Similarly, if Con-
rad needs to hire a full-time bookkeeper to pay bills, regardless of the quantity of
coffee produced, the bookkeeper’s salary is a fixed cost. The third column in Table
2 shows Conrad’s fixed cost, which in this example is $3.00.
Some of the firm’s costs, called variable costs, change as the firm alters the variable costs
quantity of output produced. Conrad’s variable costs include the cost of coffee costs that vary with
beans, milk, sugar, and paper cups: The more cups of coffee Conrad makes, the the quantity of output
more of these items he needs to buy. Similarly, if Conrad has to hire more work- produced
ers to make more cups of coffee, the salaries of these workers are variable costs.
The fourth column of the table shows Conrad’s variable cost. The variable cost is
0 if he produces nothing, $0.30 if he produces 1 cup of coffee, $0.80 if he produces
2 cups, and so on.
A firm’s total cost is the sum of fixed and variable costs. In Table 2, total cost in
the second column equals fixed cost in the third column plus variable cost in the
fourth column.
AVERAGE AND M ARGINAL COST

As the owner of his firm, Conrad has to decide how much to produce. A key part
of this decision is how his costs will vary as he changes the level of production. In
making this decision, Conrad might ask his production supervisor the following
two questions about the cost of producing coffee:
• How much does it cost to make the typical cup of coffee?
• How much does it cost to increase production of coffee by 1 cup?
Although at first these two questions might seem to have the same answer, they
do not. Both answers will turn out to be important for understanding how firms
make production decisions.
To find the cost of the typical unit produced, we would divide the firm’s costs
by the quantity of output it produces. For example, if the firm produces 2 cups
of coffee per hour, its total cost is $3.80, and the cost of the typical cup is $3.80/2,
average total cost or $1.90. Total cost divided by the quantity of output is called average total cost.
total cost divided by Because total cost is the sum of fixed and variable costs, average total cost can be
the quantity of output expressed as the sum of average fixed cost and average variable cost. Average
fixed cost is the fixed cost divided by the quantity of output, and average variable
average fixed cost cost is the variable cost divided by the quantity of output.
fixed cost divided by
Although average total cost tells us the cost of the typical unit, it does not tell us
the quantity of output
how much total cost will change as the firm alters its level of production. The last
average variable cost column in Table 2 shows the amount that total cost rises when the firm increases
variable cost divided by production by 1 unit of output. This number is called marginal cost. For example,
the quantity of output if Conrad increases production from 2 to 3 cups, total cost rises from $3.80 to $4.50,
so the marginal cost of the third cup of coffee is $4.50 minus $3.80, or $0.70. In the
marginal cost table, the marginal cost appears halfway between two rows because it represents
the increase in total cost the change in total cost as quantity of output increases from one level to another.
that arises from an extra It may be helpful to express these definitions mathematically:
unit of production
Average total cost = Total cost/Quantity
ATC = TC/Q
and
Marginal cost = Change in total cost/Change in quantity
MC = ∆TC/∆Q.
Here ∆, the Greek letter delta, represents the change in a variable. These equations
show how average total cost and marginal cost are derived from total cost. Aver-
age total cost tells us the cost of a typical unit of output if total cost is divided evenly over
all the units produced. Marginal cost tells us the increase in total cost that arises from
producing an additional unit of output. As we will see more fully in the next chapter,
business managers like Conrad need to keep in mind the concepts of average total
cost and marginal cost when deciding how much of their product to supply to the
market.
COST CURVES AND THEIR SHAPES

Just as in previous chapters we found graphs of supply and demand useful when
analyzing the behavior of markets, we will find graphs of average and marginal
cost useful when analyzing the behavior of firms. Figure 4 graphs Conrad’s costs
using the data from Table 2. The horizontal axis measures the quantity the firm
produces, and the vertical axis measures marginal and average costs. The graph
shows four curves: average total cost (ATC), average fixed cost (AFC), average
variable cost (AVC), and marginal cost (MC).
The cost curves shown here for Conrad’s Coffee Shop have some features
that are common to the cost curves of many firms in the economy. Let’s examine
Costs
F I G U R E 4
$3.50
3.25
Conrad’s Average-Cost and
Marginal-Cost Curves
3.00 This figure shows the average
2.75 total cost (ATC), average fixed
cost (AFC), average variable cost
2.50
(AVC), and marginal cost (MC) for
2.25 Conrad’s Coffee Shop. All of these
MC
2.00 curves are obtained by graphing
the data in Table 2. These cost
1.75
curves show three features that
1.50 ATC are typical of many firms: (1) Mar-
1.25 AVC
ginal cost rises with the quantity
of output. (2) The average-total-
1.00
cost curve is U-shaped. (3) The
0.75 marginal-cost curve crosses the
0.50 average-total-cost curve at the
AFC minimum of average total cost.
0.25
0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(cups of coffee per hour)
three features in particular: the shape of the marginal-cost curve, the shape of the
average-total-cost curve, and the relationship between marginal and average total
cost.
Rising Marginal Cost Conrad’s marginal cost rises with the quantity of out-
put produced. This reflects the property of diminishing marginal product. When
Conrad produces a small quantity of coffee, he has few workers, and much of his
equipment is not used. Because he can easily put these idle resources to use, the
marginal product of an extra worker is large, and the marginal cost of an extra cup
of coffee is small. By contrast, when Conrad produces a large quantity of coffee,
his shop is crowded with workers, and most of his equipment is fully utilized.
Conrad can produce more coffee by adding workers, but these new workers have
to work in crowded conditions and may have to wait to use the equipment. There-
fore, when the quantity of coffee produced is already high, the marginal product
of an extra worker is low, and the marginal cost of an extra cup of coffee is large.
U-Shaped Average Total Cost Conrad’s average-total-cost curve is U-shaped,

as shown in Figure 4. To understand why, remember that average total cost is the
sum of average fixed cost and average variable cost. Average fixed cost always
declines as output rises because the fixed cost is spread over a larger number of
units. Average variable cost typically rises as output increases because of dimin-
ishing marginal product.
Average total cost reflects the shapes of both average fixed cost and average
variable cost. At very low levels of output, such as 1 or 2 cups per hour, average
total cost is very high. Even though average variable cost is low, average fixed cost
is high because the fixed cost is spread over only a few units. As output increases,
the fixed cost is spread more widely. Average fixed cost declines, rapidly at first
and then more slowly. As a result, average total cost also declines until the firm’s
output reaches 5 cups of coffee per hour, when average total cost is $1.30 per cup.
When the firm produces more than 6 cups per hour, however, the increase in aver-
age variable cost becomes the dominant force, and average total cost starts rising.
The tug of war between average fixed cost and average variable cost generates the
U-shape in average total cost.
The bottom of the U-shape occurs at the quantity that minimizes average total
efficient scale cost. This quantity is sometimes called the efficient scale of the firm. For Conrad,
the quantity of output the efficient scale is 5 or 6 cups of coffee per hour. If he produces more or less than
that minimizes average this amount, his average total cost rises above the minimum of $1.30. At lower
total cost levels of output, average total cost is higher than $1.30 because the fixed cost is
spread over so few units. At higher levels of output, average total cost is higher
than $1.30 because the marginal product of inputs has diminished significantly.
At the efficient scale, these two forces are balanced to yield the lowest average
total cost.
The Relationship between Marginal Cost and Average Total Cost If you
look at Figure 4 (or back at Table 2), you will see something that may be surprising
at first. Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising. This
feature of Conrad’s cost curves is not a coincidence from the particular numbers
used in the example: It is true for all firms.
To see why, consider an analogy. Average total cost is like your cumulative
grade point average. Marginal cost is like the grade in the next course you will
take. If your grade in your next course is less than your grade point average, your
grade point average will fall. If your grade in your next course is higher than
your grade point average, your grade point average will rise. The mathematics of
average and marginal costs is exactly the same as the mathematics of average and
marginal grades.
This relationship between average total cost and marginal cost has an important
corollary: The marginal-cost curve crosses the average-total-cost curve at its minimum.
Why? At low levels of output, marginal cost is below average total cost, so aver-
age total cost is falling. But after the two curves cross, marginal cost rises above
average total cost. For the reason we have just discussed, average total cost must
start to rise at this level of output. Hence, this point of intersection is the minimum
of average total cost. As you will see in the next chapter, minimum average total
cost plays a key role in the analysis of competitive firms.
TYPICAL COST CURVES

In the examples we have studied so far, the firms exhibit diminishing marginal
product and, therefore, rising marginal cost at all levels of output. This simplifying
assumption was useful because it allowed us to focus on the key features of cost
curves that will prove useful in analyzing firm behavior. Yet actual firms are usu-
ally more complicated than this. In many firms, marginal product does not start
to fall immediately after the first worker is hired. Depending on the production
process, the second or third worker might have a higher marginal product than
the first because a team of workers can divide tasks and work more productively
than a single worker. Firms exhibiting this pattern would experience increasing
marginal product for a while before diminishing marginal product set in.
Figure 5 shows the cost curves for such a firm, including average total cost
(ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost
(MC). At low levels of output, the firm experiences increasing marginal prod-
uct, and the marginal-cost curve falls. Eventually, the firm starts to experience
diminishing marginal product, and the marginal-cost curve starts to rise. This
combination of increasing then diminishing marginal product also makes the
average-variable-cost curve U-shaped.
Despite these differences from our previous example, the cost curves shown
here share the three properties that are most important to remember:
• Marginal cost eventually rises with the quantity of output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the average-total-cost curve at the minimum
of average total cost.
QUICK QUIZ Suppose Honda’s total cost of producing 4 cars is $225,000 and its
total cost of producing 5 cars is $250,000. What is the average total cost of producing
5 cars? What is the marginal cost of the fifth car? • Draw the marginal-cost curve and
the average-total-cost curve for a typical firm, and explain why these curves cross where
they do.
F I G U R E 5
Costs
Cost Curves for a Typical Firm
$3.00 Many firms experience increasing
marginal product before diminishing
marginal product. As a result, they
2.50
have cost curves shaped like those in
MC this figure. Notice that marginal cost
2.00 and average variable cost fall for a
while before starting to rise.
1.50
ATC
AVC
1.00
0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output
COSTS IN THE SHORT RUN AND IN THE LONG RUN

We noted earlier in this chapter that a firm’s costs might depend on the time
horizon under consideration. Let’s examine more precisely why this might be
the case.
THE R ELATIONSHIP BETWEEN SHORT-RUN

AND L ONG -RUN AVERAGE TOTAL COST
For many firms, the division of total costs between fixed and variable costs
depends on the time horizon. Consider, for instance, a car manufacturer such as
Ford Motor Company. Over a period of only a few months, Ford cannot adjust the
number or sizes of its car factories. The only way it can produce additional cars is
to hire more workers at the factories it already has. The cost of these factories is,
therefore, a fixed cost in the short run. By contrast, over a period of several years,
Ford can expand the size of its factories, build new factories, or close old ones.
Thus, the cost of its factories is a variable cost in the long run.
Because many decisions are fixed in the short run but variable in the long run,
a firm’s long-run cost curves differ from its short-run cost curves. Figure 6 shows
an example. The figure presents three short-run average-total-cost curves—for a
small, medium, and large factory. It also presents the long-run average-total-cost
curve. As the firm moves along the long-run curve, it is adjusting the size of the
factory to the quantity of production.
This graph shows how short-run and long-run costs are related. The long-run
average-total-cost curve is a much flatter U-shape than the short-run average-
total-cost curve. In addition, all the short-run curves lie on or above the long-run
6 F I G U R E
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
Average Total Cost in the Short ATC in long run
small factory medium factory large factory
and Long Runs
Because fixed costs are variable in
the long run, the average-total-cost
curve in the short run differs from the
average-total-cost curve in the long
$12,000
run.
10,000
Economies Constant
of returns to
scale scale Diseconomies
of
scale
0 1,000 1,200 Quantity of

Cars per Day
curve. These properties arise because firms have greater flexibility in the long run.
In essence, in the long run, the firm gets to choose which short-run curve it wants
to use. But in the short run, it has to use whatever short-run curve it has chosen in
the past.
The figure shows an example of how a change in production alters costs over
different time horizons. When Ford wants to increase production from 1,000 to
1,200 cars per day, it has no choice in the short run but to hire more workers at its
existing medium-sized factory. Because of diminishing marginal product, aver-
age total cost rises from $10,000 to $12,000 per car. In the long run, however, Ford
can expand both the size of the factory and its workforce, and average total cost
returns to $10,000.
How long does it take a firm to get to the long run? The answer depends on
the firm. It can take a year or longer for a major manufacturing firm, such as a car
company, to build a larger factory. By contrast, a person running a coffee shop can
buy another coffee maker within a few hours. There is, therefore, no single answer
to how long it takes a firm to adjust its production facilities.
ECONOMIES AND DISECONOMIES OF SCALE

The shape of the long-run average-total-cost curve conveys important informa-
tion about the production processes that a firm has available for manufacturing a
good. In particular, it tells us how costs vary with the scale—that is, the size—of a
firm’s operations. When long-run average total cost declines as output increases,
there are said to be economies of scale. When long-run average total cost rises as economies of scale
output increases, there are said to be diseconomies of scale. When long-run aver- the property whereby
age total cost does not vary with the level of output, there are said to be constant long-run average total
returns to scale. In this example, Ford has economies of scale at low levels of out- cost falls as the quantity
put, constant returns to scale at intermediate levels of output, and diseconomies of output increases
of scale at high levels of output.
diseconomies of scale
What might cause economies or diseconomies of scale? Economies of scale
the property whereby
often arise because higher production levels allow specialization among workers, long-run average total
which permits each worker to become better at a specific task. For instance, if cost rises as the quantity
Ford hires a large number of workers and produces a large number of cars, it can of output increases
reduce costs with modern assembly-line production. Diseconomies of scale can
arise because of coordination problems that are inherent in any large organization. constant returns
The more cars Ford produces, the more stretched the management team becomes, to scale
and the less effective the managers become at keeping costs down. the property whereby
This analysis shows why long-run average-total-cost curves are often U-shaped. long-run average total
At low levels of production, the firm benefits from increased size because it can cost stays the same as
take advantage of greater specialization. Coordination problems, meanwhile, are
changes
not yet acute. By contrast, at high levels of production, the benefits of specializa-
tion have already been realized, and coordination problems become more severe
as the firm grows larger. Thus, long-run average total cost is falling at low levels
of production because of increasing specialization and rising at high levels of pro-
duction because of increasing coordination problems.
QUICK QUIZ If Boeing produces 9 jets per month, its long-run total cost is $9.0 million
per month. If it produces 10 jets per month, its long-run total cost is $9.5 million per
month. Does Boeing exhibit economies or diseconomies of scale?
Lessons from a Pin Factory
“Jack of all trades, master of Smith reported that because of this specialization, the pin factory
none.” This well-known adage helps explain why firms sometimes produced thousands of pins per worker every day. He conjectured
experience economies of scale. A person who tries to do everything that if the workers had chosen to work separately, rather than as
usually ends up doing nothing very well. If a firm wants its work- a team of specialists, “they certainly could not each of them make
ers to be as productive as they can be, it is often best to give each twenty, perhaps not one pin a day.” In other words, because of
worker a limited task that he or she can master. But this is possible specialization, a large pin factory could achieve higher output per
only if a firm employs many workers and produces a large quantity worker and lower average cost per pin than a small pin factory.
of output. The specialization that Smith observed in the pin factory is
In his celebrated book An Inquiry into the Nature and Causes of prevalent in the modern economy. If you want to build a house, for
the Wealth of Nations, Adam Smith described a visit he made to a instance, you could try to do all the work yourself. But most people
pin factory. Smith was impressed by the specialization among the turn to a builder, who in turn hires carpenters, plumbers, electricians,
workers and the resulting economies of scale. He wrote, painters, and many other types of workers. These workers specialize
in particular jobs, and this allows them to become better at their
One man draws out the wire, another straightens it, a third cuts it, jobs than if they were generalists. Indeed, the use of specialization
a fourth points it, a fifth grinds it at the top for receiving the head; to achieve economies of scale is one reason modern societies are as
to make the head requires two or three distinct operations; to put it prosperous as they are.
on is a peculiar business; to whiten it is another; it is even a trade by
itself to put them into paper.
CONCLUSION
The purpose of this chapter has been to develop some tools that we can use to
study how firms make production and pricing decisions. You should now under-
stand what economists mean by the term costs and how costs vary with the quan-
tity of output a firm produces. To refresh your memory, Table 3 summarizes some
of the definitions we have encountered.
By themselves, a firm’s cost curves do not tell us what decisions the firm will
make. But they are an important component of that decision, as we will begin to
see in the next chapter.
T A B L E
3
Mathematical
Term Definition Description
The Many Types of
Cost: A Summary
Explicit costs Costs that require
an outlay of money by the firm
Implicit costs Costs that do not require

an outlay of money by the firm
Fixed costs Costs that do not vary with the FC

quantity of output produced
Variable costs Costs that vary with the VC

quantity of output produced
Total cost The market value of all the inputs TC = FC + VC

that a firm uses in production
Average fixed cost Fixed cost divided by AFC = FC / Q

Average variable cost Variable cost divided by AVC = VC / Q

Average total cost Total cost divided by ATC = TC / Q

Marginal cost The increase in total cost that arises MC = ∆TC / ∆Q

from an extra unit of production
SUMMARY
• The goal of firms is to maximize profit, which result, a firm’s total-cost curve gets steeper as the
equals total revenue minus total cost. quantity produced rises.
• When analyzing a firm’s behavior, it is important • A firm’s total costs can be divided between fixed
to include all the opportunity costs of production. costs and variable costs. Fixed costs are costs that
Some of the opportunity costs, such as the wages do not change when the firm alters the quantity
a firm pays its workers, are explicit. Other oppor- of output produced. Variable costs are costs that
tunity costs, such as the wages the firm owner change when the firm alters the quantity of out-
gives up by working in the firm rather than tak- put produced.
ing another job, are implicit.
• From a firm’s total cost, two related measures of
• A firm’s costs reflect its production process. A cost are derived. Average total cost is total cost
typical firm’s production function gets flatter as divided by the quantity of output. Marginal cost
the quantity of an input increases, displaying the is the amount by which total cost rises if output
property of diminishing marginal product. As a increases by 1 unit.
• When analyzing firm behavior, it is often useful • A firm’s costs often depend on the time horizon
to graph average total cost and marginal cost. For considered. In particular, many costs are fixed in
a typical firm, marginal cost rises with the quan- the short run but variable in the long run. As a
tity of output. Average total cost first falls as out- result, when the firm changes its level of produc-
put increases and then rises as output increases tion, average total cost may rise more in the short
further. The marginal-cost curve always crosses run than in the long run.
the average-total-cost curve at the minimum of
average total cost.
KEY CONCEPTS
total revenue, p. 268 production function, p. 271 average fixed cost, p. 276
total cost, p. 268 marginal product, p. 272 average variable cost, p. 276
profit, p. 268 diminishing marginal product, marginal cost, p. 276
explicit costs, p. 269 p. 273 efficient scale, p. 278
implicit costs, p. 269 fixed costs, p. 274 economies of scale, p. 281
economic profit, p. 270 variable costs, p. 275 diseconomies of scale, p. 281
accounting profit, p. 270 average total cost, p. 276 constant returns to scale, p. 281
1. What is the relationship between a firm’s total 5. Define total cost, average total cost, and marginal
revenue, profit, and total cost? cost. How are they related?
2. Give an example of an opportunity cost that 6. Draw the marginal-cost and average-total-cost
an accountant might not count as a cost. Why curves for a typical firm. Explain why the curves
would the accountant ignore this cost? have the shapes that they do and why they cross
3. What is marginal product, and what does it where they do.
mean if it is diminishing? 7. How and why does a firm’s average-total-cost
4. Draw a production function that exhibits curve differ in the short run and in the long run?
diminishing marginal product of labor. Draw 8. Define economies of scale and explain why they
the associated total-cost curve. (In both cases, be might arise. Define diseconomies of scale and
sure to label the axes.) Explain the shapes of the explain why they might arise.
two curves you have drawn.
1. This chapter discusses many types of costs: a. What is the marginal product of each hour
opportunity cost, total cost, fixed cost, vari- spent fishing?
able cost, average total cost, and marginal cost. b. Use these data to graph the fisherman’s pro-
Fill in the type of cost that best completes each duction function. Explain its shape.
sentence: c. The fisherman has a fixed cost of $10 (his
a. What you give up for taking some action is pole). The opportunity cost of his time is $5
called the ______. per hour. Graph the fisherman’s total-cost
b. _____ is falling when marginal cost is below curve. Explain its shape.
it and rising when marginal cost is above it. 4. Nimbus, Inc., makes brooms and then sells them
c. A cost that does not depend on the quantity door-to-door. Here is the relationship between
produced is a ______. the number of workers and Nimbus’s output in
d. In the ice-cream industry in the short run, a given day:
______ includes the cost of cream and sugar Average
but not the cost of the factory. Marginal Total Total Marginal
e. Profits equal total revenue less ______. Workers Output Product Cost Cost Cost
f. The cost of producing an extra unit of output
is the ______. 0 0 ___ ___
2. Your aunt is thinking about opening a hardware ___ ___
store. She estimates that it would cost $500,000 1 20 ___ ___
per year to rent the location and buy the stock. ___ ___
In addition, she would have to quit her $50,000 2 50 ___ ___
per year job as an accountant. ___ ___
a. Define opportunity cost. 3 90 ___ ___
___ ___
b. What is your aunt’s opportunity cost of
4 120 ___ ___
running a hardware store for a year? If your
___ ___
aunt thought she could sell $510,000 worth of 5 140 ___ ___
merchandise in a year, should she open the ___ ___
store? Explain. 6 150 ___ ___
3. A commercial fisherman notices the following ___ ___
relationship between hours spent fishing and 7 155 ___ ___
the quantity of fish caught:
a. Fill in the column of marginal products.
Quantity of Fish What pattern do you see? How might you
Hours (in pounds) explain it?
b. A worker costs $100 a day, and the firm has
0 hours 0 lb. fixed costs of $200. Use this information to fill
1 10
in the column for total cost.
2 18
c. Fill in the column for average total cost.
3 24
4 28
(Recall that ATC = TC/Q.) What pattern do
5 30 you see?
d. Now fill in the column for marginal cost. the information on variable cost. What is the
(Recall that MC = ∆TC/∆Q.) What pattern do relationship between these sets of numbers?
you see? Comment.
e. Compare the column for marginal product 7. You are thinking about setting up a lemonade
and the column for marginal cost. Explain the stand. The stand itself costs $200. The ingredi-
relationship. ents for each cup of lemonade cost $0.50.
f. Compare the column for average total cost a. What is your fixed cost of doing business?
and the column for marginal cost. Explain the What is your variable cost per cup?
relationship. b. Construct a table showing your total cost,
5. You are the Chief Financial Officer for a firm average total cost, and marginal cost for out-
that sells digital music players. Your firm has put levels varying from 0 to 10 gallons. (Hint:
the following average total cost schedule: There are 16 cups in a gallon.) Draw the three
Quantity Average Total Cost
cost curves.
8. Your cousin Vinnie owns a painting company
600 players $300
with fixed costs of $200 and the following
601 301 schedule for variable costs:
Quantity of
Your current level of production is 600 devices,
Houses Painted 1 2 3 4 5 6 7
all of which have been sold. Someone calls,
per Month
desperate to buy one of your music players. The
caller offers you $550 for it. Should you accept Variable Costs $10 $20 $40 $80 $160 $320 $640
the offer? Why or why not? Calculate average fixed cost, average variable
6. Consider the following cost information for a cost, and average total cost for each quan-
pizzeria: tity. What is the efficient scale of the painting
Quantity Total Cost Variable Cost company?
9. The city government is considering two tax
0 dozen pizzas $300 $ 0 proposals:
1 350 50 • A lump-sum tax of $300 on each producer of
2 390 90 hamburgers.
3 420 120 • A tax of $1 per burger, paid by producers of
4 450 150
hamburgers.
5 490 190
a. Which of the following curves—average fixed
6 540 240
cost, average variable cost, average total
a. What is the pizzeria’s fixed cost? cost, and marginal cost—would shift as a
b. Construct a table in which you calculate the result of the lump-sum tax? Why? Show this
marginal cost per dozen pizzas using the in a graph. Label the graph as precisely as
information on total cost. Also, calculate possible.
the marginal cost per dozen pizzas using
b. Which of these same four curves would shift 11. A firm has fixed cost of $100 and average vari-
as a result of the per-burger tax? Why? Show able cost of $5 × Q, where Q is the number of
this in a new graph. Label the graph as pre- units produced.
cisely as possible. a. Construct a table showing total cost for Q
10. Jane’s Juice Bar has the following cost schedules: from 0 to 10.
Quantity Variable Cost Total Cost
b. Graph the firm’s curves for marginal cost and
average total cost.
0 vats of juice $ 0 $ 30
c. How does marginal cost change with Q?
1 10 40 What does this suggest about the firm’s pro-
2 25 55 duction process?
3 45 75 12. Consider the following table of long-run total
4 70 100 costs for three different firms:
5 100 130
Quantity 1 2 3 4 5 6 7
6 135 165
a. Calculate average variable cost, average total Firm A $60 $70 $80 $90 $100 $110 $120
cost, and marginal cost for each quantity. Firm B 11 24 39 56 75 96 119
b. Graph all three curves. What is the rela- Firm C 21 34 49 66 85 106 129
tionship between the marginal-cost curve Does each of these firms experience economies
and the average-total-cost curve? Between of scale or diseconomies of scale?
the marginal-cost curve and the average-
variable-cost curve? Explain.
14
CHAPTER
Firms in Competitive
Markets
I f your local gas station raised its price for gasoline by 20 percent, it would see
a large drop in the amount of gasoline it sold. Its customers would quickly
switch to buying their gasoline at other gas stations. By contrast, if your local
water company raised the price of water by 20 percent, it would see only a small
decrease in the amount of water it sold. People might water their lawns less often
and buy more water-efficient showerheads, but they would be hard-pressed to
reduce water consumption greatly and would be unlikely to find another sup-
plier. The difference between the gasoline market and the water market is obvi-
ous: Many firms supply gasoline to the local market, but only one firm supplies
water. As you might expect, this difference in market structure shapes the pricing
and production decisions of the firms that operate in these markets.
In this chapter, we examine the behavior of competitive firms, such as your
local gas station. You may recall that a market is competitive if each buyer and
seller is small compared to the size of the market and, therefore, has little ability
to influence market prices. By contrast, if a firm can influence the market price of
the good it sells, it is said to have market power. Later in the book, we examine the
behavior of firms with market power, such as your local water company.
289
Our analysis of competitive firms in this chapter sheds light on the decisions
that lie behind the supply curve in a competitive market. Not surprisingly, we will
find that a market supply curve is tightly linked to firms’ costs of production. Less
obvious, however, is the question of which among a firm’s many types of cost—
fixed, variable, average, and marginal—are most relevant for its supply decisions.
We will see that all these measures of cost play important and interrelated roles.
WHAT IS A COMPETITIVE MARKET?

Our goal in this chapter is to examine how firms make production decisions in
competitive markets. As a background for this analysis, we begin by reviewing
what a competitive market is.
THE M EANING OF COMPETITION

competitive market A competitive market, sometimes called a perfectly competitive market, has two
a market with many buy- characteristics:
ers and sellers trading
identical products so that • There are many buyers and many sellers in the market.
each buyer and seller is a • The goods offered by the various sellers are largely the same.
price taker
As a result of these conditions, the actions of any single buyer or seller in the mar-
ket have a negligible impact on the market price. Each buyer and seller takes the
market price as given.
As an example, consider the market for milk. No single consumer of milk can
influence the price of milk because each buyer purchases a small amount relative
to the size of the market. Similarly, each dairy farmer has limited control over
the price because many other sellers are offering milk that is essentially identical.
Because each seller can sell all he wants at the going price, he has little reason to
charge less, and if he charges more, buyers will go elsewhere. Buyers and sellers
in competitive markets must accept the price the market determines and, there-
fore, are said to be price takers.
In addition to the foregoing two conditions for competition, there is a third
condition sometimes thought to characterize perfectly competitive markets:
• Firms can freely enter or exit the market.
If, for instance, anyone can decide to start a dairy farm, and if any existing dairy
farmer can decide to leave the dairy business, then the dairy industry would
satisfy this condition. Much of the analysis of competitive firms does not need
the assumption of free entry and exit because this condition is not necessary for
firms to be price takers. Yet, as we will see later in this chapter, if there is free
entry and exit in a competitive market, it is a powerful force shaping the long-run
equilibrium.
THE R EVENUE OF A COMPETITIVE FIRM

A firm in a competitive market, like most other firms in the economy, tries to
maximize profit (total revenue minus total cost). To see how it does this, we first
consider the revenue of a competitive firm. To keep matters concrete, let’s con-
sider a specific firm: the Vaca Family Dairy Farm.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 291
The Vaca Farm produces a quantity of milk, Q, and sells each unit at the market
price, P. The farm’s total revenue is P × Q. For example, if a gallon of milk sells for
$6 and the farm sells 1,000 gallons, its total revenue is $6,000.
Because the Vaca Farm is small compared to the world market for milk, it takes
the price as given by market conditions. This means, in particular, that the price
of milk does not depend on the number of gallons that the Vaca Farm produces
and sells. If the Vacas double the amount of milk they produce to 2,000 gallons,
the price of milk remains the same, and their total revenue doubles to $12,000. As
a result, total revenue is proportional to the amount of output.
Table 1 shows the revenue for the Vaca Family Dairy Farm. The first two col-
umns show the amount of output the farm produces and the price at which it sells
its output. The third column is the farm’s total revenue. The table assumes that the
price of milk is $6 a gallon, so total revenue is $6 times the number of gallons.
Just as the concepts of average and marginal were useful in the preceding chap-
ter when analyzing costs, they are also useful when analyzing revenue. To see
what these concepts tell us, consider these two questions:
• How much revenue does the farm receive for the typical gallon of milk?
• How much additional revenue does the farm receive if it increases produc-
tion of milk by 1 gallon?
The last two columns in Table 1 answer these questions.
The fourth column in the table shows average revenue, which is total revenue average revenue
(from the third column) divided by the amount of output (from the first column). total revenue divided
Average revenue tells us how much revenue a firm receives for the typical unit by the quantity sold
sold. In Table 1, you can see that average revenue equals $6, the price of a gallon
of milk. This illustrates a general lesson that applies not only to competitive firms
but to other firms as well. Average revenue is total revenue (P × Q) divided by the
quantity (Q). Therefore, for all firms, average revenue equals the price of the good.
T A B L E
1
Quantity Price Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR = P × Q) (AR = TR / Q) (MR = ∆TR / ∆Q)
Total, Average, and
Marginal Revenue for
1 gallon $6 $ 6 $6
a Competitive Firm
$6
2 6 12 6
6
3 6 18 6
6
4 6 24 6
6
5 6 30 6
6
6 6 36 6
6
7 6 42 6
6
8 6 48 6
marginal revenue The fifth column shows marginal revenue, which is the change in total rev-
the change in total revenue from the sale of each additional unit of output. In Table 1, marginal revenue
enue from an additional equals $6, the price of a gallon of milk. This result illustrates a lesson that applies
unit sold only to competitive firms. Total revenue is P × Q, and P is fixed for a competitive
firm. Therefore, when Q rises by 1 unit, total revenue rises by P dollars. For com-
petitive firms, marginal revenue equals the price of the good.
QUICK QUIZ When a competitive firm doubles the amount it sells, what happens to the
price of its output and its total revenue?
PROFIT MAXIMIZATION AND THE COMPETITIVE

FIRM’S SUPPLY CURVE
The goal of a competitive firm is to maximize profit, which equals total revenue
minus total cost. We have just discussed the firm’s revenue, and in the preced-
ing chapter, we discussed the firm’s costs. We are now ready to examine how a
competitive firm maximizes profit and how that decision determines its supply
curve.
A SIMPLE EXAMPLE OF PROFIT M AXIMIZATION

Let’s begin our analysis of the firm’s supply decision with the example in Table 2.
In the first column of the table is the number of gallons of milk the Vaca Family
Dairy Farm produces. The second column shows the farm’s total revenue, which
is $6 times the number of gallons. The third column shows the farm’s total cost.
Total cost includes fixed costs, which are $3 in this example, and variable costs,
which depend on the quantity produced.
The fourth column shows the farm’s profit, which is computed by subtracting
total cost from total revenue. If the farm produces nothing, it has a loss of $3 (its
fixed cost). If it produces 1 gallon, it has a profit of $1. If it produces 2 gallons, it
has a profit of $4 and so on. Because the Vaca family’s goal is to maximize profit,
it chooses to produce the quantity of milk that makes profit as large as possible. In
this example, profit is maximized when the farm produces 4 or 5 gallons of milk,
for a profit of $7.
There is another way to look at the Vaca Farm’s decision: The Vacas can find
the profit-maximizing quantity by comparing the marginal revenue and marginal
cost from each unit produced. The fifth and sixth columns in Table 2 compute
marginal revenue and marginal cost from the changes in total revenue and total
cost, and the last column shows the change in profit for each additional gallon
produced. The first gallon of milk the farm produces has a marginal revenue of
$6 and a marginal cost of $2; hence, producing that gallon increases profit by $4
(from –$3 to $1). The second gallon produced has a marginal revenue of $6 and a
marginal cost of $3, so that gallon increases profit by $3 (from $1 to $4). As long as
marginal revenue exceeds marginal cost, increasing the quantity produced raises
profit. Once the Vaca Farm has reached 5 gallons of milk, however, the situation
changes. The sixth gallon would have a marginal revenue of $6 and a marginal
cost of $7, so producing it would reduce profit by $1 (from $7 to $6). As a result,
the Vacas would not produce beyond 5 gallons.
One of the Ten Principles of Economics in Chapter 1 is that rational people think
at the margin. We now see how the Vaca Family Dairy Farm can apply this
T A B L E
2
Total Total Marginal Marginal Change
Quantity Revenue Cost Profit Revenue Cost in Profit
(Q) (TR) (TC) (TR – TC) (MR = ∆TR / ∆Q) (MC = ∆TC /∆Q) (MR – MC) Profit
Maximization:
A Numerical
0 gallons $ 0 $ 3 –$3
Example
$6 $2 $ 4
1 6 5 1
6 3 3
2 12 8 4
6 4 2
3 18 12 6
6 5 1
4 24 17 7
6 6 0
5 30 23 7
6 7 –1
6 36 30 6
6 8 –2
7 42 38 4
6 9 –3
8 48 47 1
principle. If marginal revenue is greater than marginal cost—as it is at 1, 2, or

3 gallons—the Vacas should increase the production of milk because it will put
more money in their pockets (marginal revenue) than it takes out (marginal cost).
If marginal revenue is less than marginal cost—as it is at 6, 7, or 8 gallons—the
Vacas should decrease production. If the Vacas think at the margin and make
incremental adjustments to the level of production, they are naturally led to pro-
duce the profit-maximizing quantity.
THE M ARGINAL-COST CURVE AND

THE FIRM’S SUPPLY DECISION
To extend this analysis of profit maximization, consider the cost curves in Figure
1. These cost curves have the three features that, as we discussed in the previ-
ous chapter, are thought to describe most firms: The marginal-cost curve (MC)
is upward sloping. The average-total-cost curve (ATC) is U-shaped. And the
marginal-cost curve crosses the average-total-cost curve at the minimum of aver-
age total cost. The figure also shows a horizontal line at the market price (P). The
price line is horizontal because the firm is a price taker: The price of the firm’s
output is the same regardless of the quantity that the firm decides to produce.
Keep in mind that, for a competitive firm, the firm’s price equals both its average
revenue (AR) and its marginal revenue (MR).
We can use Figure 1 to find the quantity of output that maximizes profit. Imag-
ine that the firm is producing at Q1. At this level of output, marginal revenue
is greater than marginal cost. That is, if the firm raised its level of production
and sales by 1 unit, the additional revenue (MR1) would exceed the additional
cost (MC1). Profit, which equals total revenue minus total cost, would increase.
1 F I G U R E Types
and
The pie
of Graphs
This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC),
the chart
average-variable-cost
in panel (a) showscurve
how(AVC). It also shows
U.S. national incomethe market price
is derived (P), which
from various
equals
sources.marginal
The barrevenue
graph in(MR) and
panel (b)average revenue
compares (AR). At
the average the quantity
income in four Q 1, mar-
countries.
Profit Maximization for ginal revenue MR
The time-series 1 exceeds
graph marginal
in panel costthe
(c) shows MCproductivity
1, so raising of
production increases
labor in U.S. profit.
businesses
a Competitive Firm At the1950
from quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing
to 2000.
production increases profit. The profit-maximizing quantity QMAX is found where the
horizontal price line intersects the marginal-cost curve.
Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
MC2
ATC
P = MR1 = MR2 P = AR = MR
AVC
MC1
0 Q1 QMAX Q2 Quantity
Hence, if marginal revenue is greater than marginal cost, as it is at Q1, the firm can
increase profit by increasing production.
A similar argument applies when output is at Q2. In this case, marginal cost is
greater than marginal revenue. If the firm reduced production by 1 unit, the costs
saved (MC2) would exceed the revenue lost (MR2). Therefore, if marginal revenue
is less than marginal cost, as it is at Q2, the firm can increase profit by reducing
production.
Where do these marginal adjustments to production end? Regardless of whether
the firm begins with production at a low level (such as Q1) or at a high level (such
as Q2), the firm will eventually adjust production until the quantity produced
reaches QMAX. This analysis yields three general rules for profit maximization:
• If marginal revenue is greater than marginal cost, the firm should increase
its output.
• If marginal cost is greater than marginal revenue, the firm should decrease
its output.
• At the profit-maximizing level of output, marginal revenue and marginal
cost are exactly equal.
These rules are the key to rational decision making by a profit-maximizing firm.
They apply not only to competitive firms but, as we will see in the next chapter, to
other types of firms as well.
We can now see how the competitive firm decides the quantity of its good to
supply to the market. Because a competitive firm is a price taker, its marginal rev-
enue equals the market price. For any given price, the competitive firm’s profit-
maximizing quantity of output is found by looking at the intersection of the price
with the marginal-cost curve. In Figure 1, that quantity of output is QMAX.
Suppose that the price prevailing in this market rises, perhaps because of an
increase in market demand. Figure 2 shows how a competitive firm responds to
the price increase. When the price is P1, the firm produces quantity Q1, the quantity
that equates marginal cost to the price. When the price rises to P2, the firm finds
that marginal revenue is now higher than marginal cost at the previous level of
output, so the firm increases production. The new profit-maximizing quantity is
Q2, at which marginal cost equals the new higher price. In essence, because the firm’s
marginal-cost curve determines the quantity of the good the firm is willing to supply at
any price, the marginal-cost curve is also the competitive firm’s supply curve. There are,
however, some caveats to that conclusion, which we examine next.
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN

So far, we have been analyzing the question of how much a competitive firm will
produce. In certain circumstances, however, the firm will decide to shut down
and not produce anything at all.
Here we should distinguish between a temporary shutdown of a firm and the
permanent exit of a firm from the market. A shutdown refers to a short-run decision
not to produce anything during a specific period of time because of current mar-
ket conditions. Exit refers to a long-run decision to leave the market. The short-run
and long-run decisions differ because most firms cannot avoid their fixed costs in
the short run but can do so in the long run. That is, a firm that shuts down tempo-
rarily still has to pay its fixed costs, whereas a firm that exits the market does not
have to pay any costs at all, fixed or variable.
Price
F I G U R E
2
MC Marginal Cost as the Competitive
P2
Firm’s Supply Curve
An increase in the price from P1 to P2
leads to an increase in the firm’s profit-
ATC maximizing quantity from Q1 to Q2. Because
P1 AVC the marginal-cost curve shows the quantity
supplied by the firm at any given price, it is
the firm’s supply curve.
0 Q1 Q2 Quantity
For example, consider the production decision that a farmer faces. The cost of
the land is one of the farmer’s fixed costs. If the farmer decides not to produce
any crops one season, the land lies fallow, and he cannot recover this cost. When
making the short-run decision whether to shut down for a season, the fixed cost
of land is said to be a sunk cost. By contrast, if the farmer decides to leave farming
altogether, he can sell the land. When making the long-run decision whether to
exit the market, the cost of land is not sunk. (We return to the issue of sunk costs
shortly.)
Now let’s consider what determines a firm’s shutdown decision. If the firm
shuts down, it loses all revenue from the sale of its product. At the same time, it
saves the variable costs of making its product (but must still pay the fixed costs).
Thus, the firm shuts down if the revenue that it would get from producing is less than its
variable costs of production.
A small bit of mathematics can make this shutdown criterion more useful. If TR
stands for total revenue and VC stands for variable costs, then the firm’s decision
can be written as
Shut down if TR < VC.
The firm shuts down if total revenue is less than variable cost. By dividing both
sides of this inequality by the quantity Q, we can write it as
Shut down if TR / Q < VC / Q.
The left side of the inequality, TR / Q, is total revenue P × Q divided by quantity

Q, which is average revenue, most simply expressed as the good’s price, P. The
right side of the inequality, VC / Q, is average variable cost, AVC. Therefore, the
firm’s shutdown criterion can be restated as
Shut down if P < AVC.
That is, a firm chooses to shut down if the price of the good is less than the average
variable cost of production. This criterion is intuitive: When choosing to produce,
the firm compares the price it receives for the typical unit to the average variable
cost that it must incur to produce the typical unit. If the price doesn’t cover the
average variable cost, the firm is better off stopping production altogether. The
firm will be losing money (since it still has to pay fixed costs), but it would lose
even more money staying open. The firm can reopen in the future if conditions
change so that price exceeds average variable cost.
We now have a full description of a competitive firm’s profit-maximizing strat-
egy. If the firm produces anything, it produces the quantity at which marginal
cost equals the price of the good. Yet if the price is less than average variable cost
at that quantity, the firm is better off shutting down and not producing anything.
These results are illustrated in Figure 3. The competitive firm’s short-run supply curve
is the portion of its marginal-cost curve that lies above average variable cost.
SPILT MILK AND OTHER SUNK COSTS

sunk cost
a cost that has already Sometime in your life you may have been told, “Don’t cry over spilt milk,” or
been committed and “Let bygones be bygones.” These adages hold a deep truth about rational decision
cannot be recovered making. Economists say that a cost is a sunk cost when it has already been com-
Costs
F I G U R E 3
1. In the short run, the MC The Competitive Firm’s
firm produces on the Short-Run Supply Curve
MC curve if P AVC,... In the short run, the competitive
firm’s supply curve is its marginal-
ATC cost curve (MC) above average
AVC variable cost (AVC). If the price falls
below average variable cost, the
firm is better off shutting down.
2. ...but
shuts down
if P AVC.
0 Quantity
mitted and cannot be recovered. Because nothing can be done about sunk costs,
you can ignore them when making decisions about various aspects of life, includ-
ing business strategy.
Our analysis of the firm’s shutdown decision is one example of the irrelevance
of sunk costs. We assume that the firm cannot recover its fixed costs by temporar-
ily stopping production. That is, regardless of the quantity of output supplied,
and even if it is zero, the firm still has to pay its fixed costs. As a result, the fixed
costs are sunk in the short run, and the firm can ignore them when deciding how
much to produce. The firm’s short-run supply curve is the part of the marginal-
cost curve that lies above average variable cost, and the size of the fixed cost does
not matter for this supply decision.
The irrelevance of sunk costs is also important when making personal deci-
sions. Imagine, for instance, that you place a $15 value on seeing a newly released
movie. You buy a ticket for $10, but before entering the theater, you lose the ticket.
Should you buy another ticket? Or should you now go home and refuse to pay a
total of $20 to see the movie? The answer is that you should buy another ticket.
The benefit of seeing the movie ($15) still exceeds the opportunity cost (the $10 for
the second ticket). The $10 you paid for the lost ticket is a sunk cost. As with spilt
milk, there is no point in crying about it.
NEAR-EMPTY RESTAURANTS AND OFF-SEASON

MINIATURE GOLF
Have you ever walked into a restaurant for lunch and found it almost empty?
Why, you might have asked, does the restaurant even bother to stay open? It
might seem that the revenue from the few customers could not possibly cover the
cost of running the restaurant.
In making the decision whether to open for lunch, a restaurant owner must
keep in mind the distinction between fixed and variable costs. Many of a res-
taurant’s costs—the rent, kitchen equipment, tables, plates, silverware, and so
on—are fixed. Shutting down during lunch would not reduce these costs. In other
words, these costs are sunk in the short run. When the owner is deciding whether
to serve lunch, only the variable costs—the price of the additional food and the
wages of the extra staff—are relevant. The owner shuts down the restaurant at
lunchtime only if the revenue from the few lunchtime customers fails to cover the
restaurant’s variable costs.
An operator of a miniature-golf course in a summer resort community faces a
similar decision. Because revenue varies substantially from season to season, the
STAYING OPEN CAN BE PROFIT-
ABLE, EVEN WITH MANY TABLES
firm must decide when to open and when to close. Once again, the fixed costs—
EMPTY.
the costs of buying the land and building the course—are irrelevant in making this
decision. The miniature-golf course should be open for business only during those
times of year when its revenue exceeds its variable costs. ●
THE FIRM’S L ONG-RUN DECISION

TO EXIT OR ENTER A M ARKET
A firm’s long-run decision to exit a market is similar to its shutdown decision. If
the firm exits, it will again lose all revenue from the sale of its product, but now
it will save not only its variable costs of production but also its fixed costs. Thus,
the firm exits the market if the revenue it would get from producing is less than its total
costs.
We can again make this criterion more useful by writing it mathematically. If
TR stands for total revenue, and TC stands for total cost, then the firm’s exit crite-
rion can be written as
Exit if TR < TC.
The firm exits if total revenue is less than total cost. By dividing both sides of this
inequality by quantity Q, we can write it as
Exit if TR / Q < TC / Q.
We can simplify this further by noting that TR / Q is average revenue, which

equals the price P, and that TC / Q is average total cost, ATC. Therefore, the firm’s
exit criterion is
Exit if P < ATC.
That is, a firm chooses to exit if the price of its good is less than the average total
cost of production.
PHOTO: © ANDERSEN ROSS/BRAND X
A parallel analysis applies to an entrepreneur who is considering starting a

firm. The firm will enter the market if such an action would be profitable, which
PICTURES/JUPITERIMAGES
occurs if the price of the good exceeds the average total cost of production. The
entry criterion is
Enter if P > ATC.
The criterion for entry is exactly the opposite of the criterion for exit.
We can now describe a competitive firm’s long-run profit-maximizing strategy.

If the firm is in the market, it produces the quantity at which marginal cost equals
the price of the good. Yet if the price is less than average total cost at that quantity,
the firm chooses to exit (or not enter) the market. These results are illustrated in
Figure 4. The competitive firm’s long-run supply curve is the portion of its marginal-cost
curve that lies above average total cost.
M EASURING PROFIT IN OUR GRAPH FOR

THE COMPETITIVE FIRM
As we analyze exit and entry, it is useful to be able to analyze the firm’s profit in
more detail. Recall that profit equals total revenue (TR) minus total cost (TC):
Profit = TR – TC.
We can rewrite this definition by multiplying and dividing the right side by Q:
Profit = (TR / Q – TC / Q) × Q.
But note that TR / Q is average revenue, which is the price, P, and TC / Q is aver-
age total cost, ATC. Therefore,
Profit = (P – ATC) × Q.
This way of expressing the firm’s profit allows us to measure profit in our
graphs.
Panel (a) of Figure 5 shows a firm earning positive profit. As we have already
discussed, the firm maximizes profit by producing the quantity at which price
equals marginal cost. Now look at the shaded rectangle. The height of the rectangle
Costs
F I G U R E 4
MC The Competitive Firm’s
1. In the long run, the
firm produces on the Long-Run Supply Curve
MC curve if P ATC,... In the long run, the competitive
firm’s supply curve is its marginal-
ATC cost curve (MC) above average total
cost (ATC). If the price falls below
average total cost, the firm
is better off exiting the market.
2. ...but
exits if
P ATC.
0 Quantity
5 F I G U R E Types
The area
firm’s
The pie
ofofGraphs
profit.
the shaded box between price and average total cost represents the
chartThe height
in panel (a)ofshows
this box
howisU.S.
price minus average
national income istotal (P – ATC),
cost from
derived and
various
the widthThe
sources. of the
bar box is the
graph quantity
in panel of output the
(b) compares (Q).average
In panelincome
(a), price in is above
four average
countries.
Profit as the Area total cost, so thegraph
The time-series firm has positive
in panel profit.the
(c) shows In panel (b), price
productivity of islabor
less in
than
U.S.average total
businesses
between Price and cost, so thetofirm
from 1950 has losses.
2000.
Average Total Cost
(a) A Firm with Profits (b) A Firm with Losses
Price Price
MC ATC
Profit MC ATC
ATC P = AR = MR ATC
P P = AR = MR
Loss
0 Q Quantity 0 Q Quantity
(profit-maximizing quantity) (loss-minimizing quantity)
is P – ATC, the difference between price and average total cost. The width of
the rectangle is Q, the quantity produced. Therefore, the area of the rectangle is
(P – ATC) × Q, which is the firm’s profit.
Similarly, panel (b) of this figure shows a firm with losses (negative profit). In
this case, maximizing profit means minimizing losses, a task accomplished once
again by producing the quantity at which price equals marginal cost. Now con-
sider the shaded rectangle. The height of the rectangle is ATC – P, and the width
is Q. The area is (ATC – P) × Q, which is the firm’s loss. Because a firm in this situ-
ation is not making enough revenue to cover its average total cost, the firm would
choose in the long run to exit the market.
QUICK QUIZ How does a competitive firm determine its profit-maximizing level of out-
put? Explain. • When does a profit-maximizing competitive firm decide to shut down?
When does a profit-maximizing competitive firm decide to exit a market?
THE SUPPLY CURVE IN A COMPETITIVE MARKET

Now that we have examined the supply decision of a single firm, we can discuss
the supply curve for a market. There are two cases to consider. First, we examine
a market with a fixed number of firms. Second, we examine a market in which
the number of firms can change as old firms exit the market and new firms enter.
Both cases are important, for each applies over a specific time horizon. Over short
periods of time, it is often difficult for firms to enter and exit, so the assumption of
a fixed number of firms is appropriate. But over long periods of time, the number
of firms can adjust to changing market conditions.
THE SHORT RUN: M ARKET SUPPLY WITH

A FIXED NUMBER OF FIRMS
Consider first a market with 1,000 identical firms. For any given price, each firm
supplies a quantity of output so that its marginal cost equals the price, as shown
in panel (a) of Figure 6. That is, as long as price is above average variable cost,
each firm’s marginal-cost curve is its supply curve. The quantity of output sup-
plied to the market equals the sum of the quantities supplied by each of the 1,000
individual firms. Thus, to derive the market supply curve, we add the quantity
supplied by each firm in the market. As panel (b) of Figure 6 shows, because the
firms are identical, the quantity supplied to the market is 1,000 times the quantity
supplied by each firm.
THE L ONG RUN: M ARKET SUPPLY

WITH ENTRY AND EXIT
Now consider what happens if firms are able to enter or exit the market. Let’s sup-
pose that everyone has access to the same technology for producing the good and
access to the same markets to buy the inputs into production. Therefore, all firms
and all potential firms have the same cost curves.
In the short run, the number of firms in the market is fixed. As a result, the market
supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves,
F I G U R E 6
shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied
to the market is 1,000 times the quantity supplied by each firm.
Short-Run Market
Supply
(a) Individual Firm Supply (b) Market Supply
Price Price
MC Supply
$2.00 $2.00
1.00 1.00
0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)

Decisions about entry and exit in a market of this type depend on the incentives
facing the owners of existing firms and the entrepreneurs who could start new
firms. If firms already in the market are profitable, then new firms will have an
incentive to enter the market. This entry will expand the number of firms, increase
the quantity of the good supplied, and drive down prices and profits. Conversely,
if firms in the market are making losses, then some existing firms will exit the
market. Their exit will reduce the number of firms, decrease the quantity of the
good supplied, and drive up prices and profits. At the end of this process of entry and
exit, firms that remain in the market must be making zero economic profit.
Recall that we can write a firm’s profit as
This equation shows that an operating firm has zero profit if and only if the price
of the good equals the average total cost of producing that good. If price is above
average total cost, profit is positive, which encourages new firms to enter. If price
is less than average total cost, profit is negative, which encourages some firms to
exit. The process of entry and exit ends only when price and average total cost are driven
to equality.
This analysis has a surprising implication. We noted earlier in the chapter that
competitive firms maximize profits by choosing a quantity at which price equals
marginal cost. We just noted that free entry and exit force price to equal average
total cost. But if price is to equal both marginal cost and average total cost, these
two measures of cost must equal each other. Marginal cost and average total cost
are equal, however, only when the firm is operating at the minimum of average
total cost. Recall from the preceding chapter that the level of production with low-
est average total cost is called the firm’s efficient scale. Therefore, in the long-run
equilibrium of a competitive market with free entry and exit, firms must be operating at
their efficient scale.
Panel (a) of Figure 7 shows a firm in such a long-run equilibrium. In this fig-
ure, price P equals marginal cost MC, so the firm is profit-maximizing. Price also
equals average total cost ATC, so profits are zero. New firms have no incentive to
enter the market, and existing firms have no incentive to leave the market.
From this analysis of firm behavior, we can determine the long-run supply
curve for the market. In a market with free entry and exit, there is only one price
consistent with zero profit—the minimum of average total cost. As a result, the
long-run market supply curve must be horizontal at this price, as illustrated by
the perfectly elastic supply curve in panel (b) of Figure 7. Any price above this
level would generate profit, leading to entry and an increase in the total quantity
supplied. Any price below this level would generate losses, leading to exit and
a decrease in the total quantity supplied. Eventually, the number of firms in the
market adjusts so that price equals the minimum of average total cost, and there
are enough firms to satisfy all the demand at this price.
WHY DO COMPETITIVE FIRMS STAY IN BUSINESS

IF THEY M AKE ZERO PROFIT?
At first, it might seem odd that competitive firms earn zero profit in the long run.
After all, people start businesses to make a profit. If entry eventually drives profit
to zero, there might seem to be little reason to stay in business.
In the long run, firms will enter or exit the market until profit is driven to zero. As
a result, price equals the minimum of average total cost, as shown in panel (a). The
F I G U R E 7
number of firms adjusts to ensure that all demand is satisfied at this price. The long-
run market supply curve is horizontal at this price, as shown in panel (b).
Long-Run Market
Supply
(a) Firm’s Zero-Profit Condition (b) Market Supply
Price Price
MC
ATC
P = minimum ATC Supply
0 Quantity (firm) 0 Quantity (market)
To understand the zero-profit condition more fully, recall that profit equals
total revenue minus total cost and that total cost includes all the opportunity costs
of the firm. In particular, total cost includes the time and money that the firm own-
ers devote to the business. In the zero-profit equilibrium, the firm’s revenue must
compensate the owners for these opportunity costs.
Consider an example. Suppose that, to start his farm, a farmer had to invest $1
million, which otherwise he could have deposited in a bank to earn $50,000 a year
in interest. In addition, he had to give up another job that would have paid him
$30,000 a year. Then the farmer’s opportunity cost of farming includes both the “WE’RE A NONPROFIT
interest he could have earned and the forgone wages—a total of $80,000. Even if ORGANIZATION—WE
DON’T INTEND TO
his profit is driven to zero, his revenue from farming compensates him for these
BE, BUT WE ARE!”
opportunity costs.
Keep in mind that accountants and economists measure costs differently. As
we discussed in the previous chapter, accountants keep track of explicit costs but
not implicit costs. That is, they measure costs that require an outflow of money
CARTOON: © REPRINTED WITH SPECIAL PERMISSION
from the firm, but they do not include the opportunity costs of production that do
not involve an outflow of money. As a result, in the zero-profit equilibrium, eco-
nomic profit is zero, but accounting profit is positive. Our farmer’s accountant, for
instance, would conclude that the farmer earned an accounting profit of $80,000,
OF KING FEATURES SYNDICATE.
which is enough to keep the farmer in business.
A SHIFT IN DEMAND IN THE SHORT RUN

AND L ONG RUN
Now that we have a more complete understanding of how firms make supply
decisions, we can better explain how markets respond to changes in demand.
Because firms can enter and exit in the long run but not in the short run, the
response of a market to a change in demand depends on the time horizon. To see
this, let’s trace the effects of a shift in demand over time.
Suppose the market for milk begins in a long-run equilibrium. Firms are earn-
ing zero profit, so price equals the minimum of average total cost. Panel (a) of
Figure 8 shows the situation. The long-run equilibrium is point A, the quantity
sold in the market is Q1, and the price is P1.
Now suppose scientists discover that milk has miraculous health benefits. As a
result, the demand curve for milk shifts outward from D1 to D2, as in panel (b). The
short-run equilibrium moves from point A to point B; as a result, the quantity rises
from Q1 to Q2, and the price rises from P1 to P2. All of the existing firms respond
to the higher price by raising the amount produced. Because each firm’s supply
curve reflects its marginal-cost curve, how much they each increase production
is determined by the marginal-cost curve. In the new short-run equilibrium, the
price of milk exceeds average total cost, so the firms are making positive profit.
Over time, the profit in this market encourages new firms to enter. Some farm-
ers may switch to milk from other farm products, for example. As the number of
firms grows, the short-run supply curve shifts to the right from S1 to S2, as in panel
(c), and this shift causes the price of milk to fall. Eventually, the price is driven
back down to the minimum of average total cost, profits are zero, and firms stop
entering. Thus, the market reaches a new long-run equilibrium, point C. The price
of milk has returned to P1, but the quantity produced has risen to Q3. Each firm is
again producing at its efficient scale, but because more firms are in the dairy busi-
ness, the quantity of milk produced and sold is higher.
WHY THE L ONG-RUN SUPPLY CURVE

MIGHT SLOPE UPWARD
So far, we have seen that entry and exit can cause the long-run market supply
curve to be perfectly elastic. The essence of our analysis is that there are a large
number of potential entrants, each of which faces the same costs. As a result, the
long-run market supply curve is horizontal at the minimum of average total cost.
When the demand for the good increases, the long-run result is an increase in the
number of firms and in the total quantity supplied, without any change in the
price.
There are, however, two reasons that the long-run market supply curve might
slope upward. The first is that some resource used in production may be avail-
able only in limited quantities. For example, consider the market for farm prod-
ucts. Anyone can choose to buy land and start a farm, but the quantity of land is
limited. As more people become farmers, the price of farmland is bid up, which
raises the costs of all farmers in the market. Thus, an increase in demand for farm
products cannot induce an increase in quantity supplied without also inducing a
rise in farmers’ costs, which in turn means a rise in price. The result is a long-run
market supply curve that is upward sloping, even with free entry into farming.
A second reason for an upward-sloping supply curve is that firms may have
different costs. For example, consider the market for painters. Anyone can enter
the market for painting services, but not everyone has the same costs. Costs vary
in part because some people work faster than others and in part because some
people have better alternative uses of their time than others. For any given price,
those with lower costs are more likely to enter than those with higher costs. To
increase the quantity of painting services supplied, additional entrants must be
encouraged to enter the market. Because these new entrants have higher costs,
The market starts in a long-run equilibrium, shown as point A in panel (a). In this
equilibrium, each firm makes zero profit, and the price equals the minimum average
F I G U R E
8
total cost. Panel (b) shows what happens in the short run when demand rises from D1
to D2. The equilibrium goes from point A to point B, price rises from P1 to P2, and the
An Increase in
quantity sold in the market rises from Q1 to Q2. Because price now exceeds average
Demand in the Short
total cost, firms make profits, which over time encourage new firms to enter the mar-
Run and Long Run
ket. This entry shifts the short-run supply curve to the right from S1 to S2, as shown
in panel (c). In the new long-run equilibrium, point C, price has returned to P1 but the
quantity sold has increased to Q3. Profits are again zero, price is back to the minimum
of average total cost, but the market has more firms to satisfy the greater demand.
(a) Initial Condition

Market Firm
Price Price
1. A market begins in 2. …with the firm
long-run equilibrium… earning zero profit.
MC ATC
Short-run supply, S1
A
P1 Long-run P1
supply
Demand, D1
0 Q1 Quantity (market) 0 Quantity (firm)
(b) Short-Run Response

Market Firm
Price Price
3. But then an 4. …leading to
increase in demand short-run profits.
raises the price…
S1 MC ATC
B
P2 P2
A
P1 Long-run P1
supply
D2
D1
0 Q1 Q2 Quantity (market) 0 Quantity (firm)
(c) Long-Run Response

Market Firm
Price Price
5. When profits induce 6. …restoring long-
entry, supply increases run equilibrium.
S1 and the price falls,… MC
B ATC
S2
P2
A C
P1 Long-run P1
supply
D2
D1
0 Q1 Q2 Q3 Quantity (market) 0 Quantity (firm)

the price must rise to make entry profitable for them. Thus, the long-run market
supply curve for painting services slopes upward even with free entry into the
market.
Notice that if firms have different costs, some firms earn profit even in the long
run. In this case, the price in the market reflects the average total cost of the mar-
ginal firm—the firm that would exit the market if the price were any lower. This
firm earns zero profit, but firms with lower costs earn positive profit. Entry does
not eliminate this profit because would-be entrants have higher costs than firms
already in the market. Higher-cost firms will enter only if the price rises, making
the market profitable for them.
Thus, for these two reasons, a higher price may be necessary to induce a larger
quantity supplied, in which case the long-run supply curve is upward sloping
rather than horizontal. Nonetheless, the basic lesson about entry and exit remains
true. Because firms can enter and exit more easily in the long run than in the short run,
the long-run supply curve is typically more elastic than the short-run supply curve.
Q Q
UICK UIZ In the long run with free entry and exit, is the price in a market equal to
marginal cost, average total cost, both, or neither? Explain with a diagram.
CONCLUSION: BEHIND THE SUPPLY CURVE

We have been discussing the behavior of profit-maximizing firms that supply
goods in perfectly competitive markets. You may recall from Chapter 1 that one
of the Ten Principles of Economics is that rational people think at the margin. This
chapter has applied this idea to the competitive firm. Marginal analysis has given
us a theory of the supply curve in a competitive market and, as a result, a deeper
understanding of market outcomes.
We have learned that when you buy a good from a firm in a competitive mar-
ket, you can be assured that the price you pay is close to the cost of producing that
good. In particular, if firms are competitive and profit maximizing, the price of a
good equals the marginal cost of making that good. In addition, if firms can freely
enter and exit the market, the price also equals the lowest possible average total
cost of production.
Although we have assumed throughout this chapter that firms are price tak-
ers, many of the tools developed here are also useful for studying firms in less
competitive markets. We now turn to an examination of the behavior of firms
with market power. Marginal analysis will again be useful, but it will have quite
different implications.
SUMMARY
• Because a competitive firm is a price taker, its will choose to exit if the price is less than average
revenue is proportional to the amount of out- total cost.
put it produces. The price of the good equals
both the firm’s average revenue and its marginal
• In a market with free entry and exit, profits are
driven to zero in the long run. In this long-run
revenue.
equilibrium, all firms produce at the efficient
• To maximize profit, a firm chooses a quantity of scale, price equals the minimum of average total
output such that marginal revenue equals mar- cost, and the number of firms adjusts to satisfy
ginal cost. Because marginal revenue for a com- the quantity demanded at this price.
petitive firm equals the market price, the firm
chooses quantity so that price equals marginal
• Changes in demand have different effects over
different time horizons. In the short run, an
cost. Thus, the firm’s marginal-cost curve is its
increase in demand raises prices and leads to
supply curve.
profits, and a decrease in demand lowers prices
• In the short run when a firm cannot recover its and leads to losses. But if firms can freely enter
fixed costs, the firm will choose to shut down and exit the market, then in the long run, the
temporarily if the price of the good is less than number of firms adjusts to drive the market back
average variable cost. In the long run when the to the zero-profit equilibrium.
firm can recover both fixed and variable costs, it
KEY CONCEPTS
competitive market, p. 290 marginal revenue, p. 292 sunk cost, p. 296

average revenue, p. 291
1. What is meant by a competitive firm? 5. Under what conditions will a firm exit a mar-
2. Explain the difference between a firm’s revenue ket? Explain.
and its profit. Which do firms maximize? 6. Does a firm’s price equal marginal cost in the
3. Draw the cost curves for a typical firm. For a short run, in the long run, or both? Explain.
given price, explain how the firm chooses the 7. Does a firm’s price equal the minimum of aver-
level of output that maximizes profit. At that age total cost in the short run, in the long run,
level of output, show on your graph the total or both? Explain.
revenue of the firm. Show its total costs. 8. Are market supply curves typically more elastic
4. Under what conditions will a firm shut down in the short run or in the long run? Explain.
temporarily? Explain.
1. Many small boats are made of fiberglass, which 5. Ball Bearings Inc. faces costs of production as
is derived from crude oil. Suppose that the price follows:
of oil rises. Total Total
a. Using diagrams, show what happens to the Fixed Variable
cost curves of an individual boat-making Quantity Costs Costs
firm and to the market supply curve.
b. What happens to the profits of boat makers 0 $100 $ 0
in the short run? What happens to the num- 1 100 50
ber of boat makers in the long run? 2 100 70
2. You go out to the best restaurant in town and 3 100 90
order a lobster dinner for $40. After eating half 4 100 140
of the lobster, you realize that you are quite 5 100 200
full. Your date wants you to finish your din- 6 100 360
ner because you can’t take it home and because a. Calculate the company’s average fixed costs,
“you’ve already paid for it.” What should you average variable costs, average total costs,
do? Relate your answer to the material in this and marginal costs.
chapter. b. The price of a case of ball bearings is $50.
3. Bob’s lawn-mowing service is a profit- Seeing that she can’t make a profit, the Chief
maximizing, competitive firm. Bob mows Executive Officer (CEO) decides to shut down
lawns for $27 each. His total cost each day operations. What are the firm’s profits/
is $280, of which $30 is a fixed cost. He mows losses? Was this a wise decision? Explain.
10 lawns a day. What can you say about c. Vaguely remembering his introductory
Bob’s short-run decision regarding shutdown economics course, the Chief Financial Officer
and his long-run decision regarding exit? tells the CEO it is better to produce 1 case
4. Consider total cost and total revenue given in of ball bearings, because marginal revenue
the following table: equals marginal cost at that quantity. What
Quantity 0 1 2 3 4 5 6 7 are the firm’s profits/losses at that level
of production? Was this the best decision?
Total cost $8 9 10 11 13 19 27 37
Explain.
Total revenue $0 8 16 24 32 40 48 56
6. Suppose the book-printing industry is competi-
a. Calculate profit for each quantity. How much tive and begins in a long-run equilibrium.
should the firm produce to maximize profit? a. Draw a diagram describing the typical firm
b. Calculate marginal revenue and marginal in the industry.
cost for each quantity. Graph them. (Hint: b. Hi-Tech Printing Company invents a new
Put the points between whole numbers. For process that sharply reduces the cost of print-
example, the marginal cost between 2 and 3 ing books. What happens to Hi-Tech’s profits
should be graphed at 21⁄2.) At what quantity and the price of books in the short run when
do these curves cross? How does this relate Hi-Tech’s patent prevents other firms from
to your answer to part (a)? using the new technology?
c. Can you tell whether this firm is in a com- c. What happens in the long run when the pat-
petitive industry? If so, can you tell whether ent expires and other firms are free to use the
the industry is in a long-run equilibrium? technology?
7. A firm in a competitive market receives $500 in 11. An industry currently has 100 firms, all of which
total revenue and has marginal revenue of $10. have fixed costs of $16 and average variable cost
What is the average revenue, and how many as follows:
units were sold? Quantity Average Variable Cost
8. A profit-maximizing firm in a competitive mar-
ket is currently producing 100 units of output. It 1 $1
has average revenue of $10, average total cost of 2 2
$8, and fixed costs of $200. 3 3
a. What is profit? 4 4
b. What is marginal cost? 5 5
c. What is average variable cost? 6 6
d. Is the efficient scale of the firm more than,
a. Compute marginal cost and average total
less than, or exactly 100 units?
cost.
9. The market for fertilizer is perfectly competitive.
b. The price is currently $10. What is the total
Firms in the market are producing output, but
quantity supplied in the market?
are currently making economic losses.
c. As this market makes the transition to its
a. How does the price of fertilizer compare to
long-run equilibrium, will the price rise or
the average total cost, the average variable
fall? Will the quantity demanded rise or fall?
cost, and the marginal cost of producing
Will the quantity supplied by each firm rise
fertilizer?
or fall?
b. Draw two graphs, side by side, illustrating
d. Graph the long-run supply curve for this
the present situation for the typical firm and
market.
in the market.
12. Suppose there are 1,000 hot pretzel stands
c. Assuming there is no change in demand or
operating in New York City. Each stand has the
the firms’ cost curves, explain what will hap-
usual U-shaped average-total-cost curve. The
pen in the long run to the price of fertilizer,
market demand curve for pretzels slopes down-
marginal cost, average total cost, the quantity
ward, and the market for pretzels is in long-run
supplied by each firm, and the total quantity
competitive equilibrium.
supplied to the market.
a. Draw the current equilibrium, using graphs
10. Suppose that the U.S. textile industry is com-
for the entire market and for an individual
petitive, and there is no international trade in
pretzel stand.
textiles. In long-run equilibrium, the price per
b. The city decides to restrict the number of
unit of cloth is $30.
pretzel-stand licenses, reducing the number
a. Describe the equilibrium using graphs for the
of stands to only 800. What effect will this
entire market and for an individual producer.
action have on the market and on an individ-
Now suppose that textile producers in other
ual stand that is still operating? Draw graphs
countries are willing to sell large quantities of
to illustrate your answer.
cloth in the United States for only $25 per unit.
c. Suppose that the city decides to charge a fee
b. Assuming that U.S. textile producers have
for the 800 licenses, all of which are quickly
large fixed costs, what is the short-run effect
sold. How will the size of the fee affect the
of these imports on the quantity produced by
number of pretzels sold by an individual
an individual producer? What is the short-
stand? How will it affect the price of pretzels
run effect on profits? Illustrate your answer
in the city?
with a graph.
d. The city wants to raise as much revenue as
c. What is the long-run effect on the number of
possible, while ensuring that all 800 licenses
U.S. firms in the industry?
are sold. How high should the city set the
license fee? Show the answer on your graph.
13. Assume that the gold-mining industry is run equilibrium price in part (b)? Is it pos-
competitive. sible for the new long-run equilibrium price
a. Illustrate a long-run equilibrium using dia- to be above the original long-run equilibrium
grams for the gold market and for a represen- price? Explain.
tative gold mine. 14. Analyze the two following situations for firms
b. Suppose that an increase in jewelry demand in competitive markets:
induces a surge in the demand for gold. a. Suppose that TC = 100 + 15q, where TC is
Using your diagrams from part (a), show total cost and q is the quantity produced.
what happens in the short run to the gold What is the minimum price necessary for this
market and to each existing gold mine. firm to produce any output in the short run?
c. If the demand for gold remains high, what b. Suppose that MC = 4q, where MC is mar-
would happen to the price over time? Specifi- ginal cost. The perfectly competitive firm
cally, would the new long-run equilibrium maximizes profits by producing 10 units of
price be above, below, or equal to the short- output. At what price does it sell these units?
15
CHAPTER
Monopoly
I f you own a personal computer, it probably uses some version of Windows,

the operating system sold by the Microsoft Corporation. When Microsoft first
designed Windows many years ago, it applied for and received a copyright
from the government. The copyright gives Microsoft the exclusive right to make
and sell copies of the Windows operating system. If a person wants to buy a copy
of Windows, he or she has little choice but to give Microsoft the approximately
$100 that the firm has decided to charge for its product. Microsoft is said to have
a monopoly in the market for Windows.
Microsoft’s business decisions are not well described by the model of firm
behavior we developed in the previous chapter. In that chapter, we analyzed
competitive markets, in which there are many firms offering essentially identical
products, so each firm has little influence over the price it receives. By contrast,
a monopoly such as Microsoft has no close competitors and, therefore, has the
power to influence the market price of its product. While a competitive firm is a
price taker, a monopoly firm is a price maker.
In this chapter, we examine the implications of this market power. We will see
that market power alters the relationship between a firm’s costs and the price at
which it sells its product. A competitive firm takes the price of its output as given
by the market and then chooses the quantity it will supply so that price equals
marginal cost. By contrast, a monopoly charges a price that exceeds marginal cost.
311
This result is clearly true in the case of Microsoft’s Windows. The marginal cost of
Windows—the extra cost that Microsoft incurs by printing one more copy of the
program onto a CD—is only a few dollars. The market price of Windows is many
times marginal cost.
It is not surprising that monopolies charge high prices for their products.
Customers of monopolies might seem to have little choice but to pay whatever
the monopoly charges. But if so, why does a copy of Windows not cost $1,000?
Or $10,000? The reason is that if Microsoft sets the price that high, fewer people
would buy the product. People would buy fewer computers, switch to other oper-
ating systems, or make illegal copies. A monopoly firm can control the price of the
good it sells, but because a high price reduces the quantity that its customers buy,
the monopoly’s profits are not unlimited.
As we examine the production and pricing decisions of monopolies, we also
consider the implications of monopoly for society as a whole. Monopoly firms,
like competitive firms, aim to maximize profit. But this goal has very different
ramifications for competitive and monopoly firms. In competitive markets, self-
interested consumers and producers behave as if they are guided by an invisible
hand to promote general economic well-being. By contrast, because monopoly
firms are unchecked by competition, the outcome in a market with a monopoly is
often not in the best interest of society.
One of the Ten Principles of Economics in Chapter 1 is that governments can
sometimes improve market outcomes. The analysis in this chapter sheds more
light on this principle. As we examine the problems that monopolies raise for
society, we discuss the various ways in which government policymakers might
respond to these problems. The U.S. government, for example, keeps a close eye
on Microsoft’s business decisions. In 1994, it blocked Microsoft from buying Intuit,
a leading seller of personal finance software, on the grounds that combining the
two firms would concentrate too much market power. Similarly, in 1998, the U.S.
Department of Justice objected when Microsoft started integrating its Internet
browser into its Windows operating system, claiming that this addition would
extend the firm’s market power into new areas. To this day, Microsoft continues
to wrangle with antitrust regulators in the United States and abroad.
WHY MONOPOLIES ARISE

monopoly A firm is a monopoly if it is the sole seller of its product and if its product does
a firm that is the sole not have close substitutes. The fundamental cause of monopoly is barriers to entry:
seller of a product with- A monopoly remains the only seller in its market because other firms cannot
out close substitutes enter the market and compete with it. Barriers to entry, in turn, have three main
sources:
• Monopoly resources: A key resource required for production is owned by a
single firm.
• Government regulation: The government gives a single firm the exclusive right
to produce some good or service.
• The production process: A single firm can produce output at a lower cost than
can a larger number of producers.
Let’s briefly discuss each of these.
CHAPTER 15 MONOPOLY 313
MONOPOLY R ESOURCES
The simplest way for a monopoly to arise is for a single firm to own a key resource.
For example, consider the market for water in a small town in the Old West. If
dozens of town residents have working wells, the competitive model discussed in
the preceding chapter describes the behavior of sellers. As a result of the competi-
tion among water suppliers, the price of a gallon is driven to equal the marginal
cost of pumping an extra gallon. But if there is only one well in town and it is
impossible to get water from anywhere else, then the owner of the well has a
monopoly on water. Not surprisingly, the monopolist has much greater market
power than any single firm in a competitive market. In the case of a necessity like
water, the monopolist could command quite a high price, even if the marginal cost
of pumping an extra gallon is low. “RATHER THAN A MONOPOLY,
A classic example of market power arising from the ownership of a key WE LIKE TO CONSIDER
resource is DeBeers, the South African diamond company. Founded in 1888 by OURSELVES ‘THE ONLY GAME
Cecil Rhodes, an English businessman (and benefactor for the Rhodes scholar- IN TOWN.’”
ship), DeBeers has at times controlled up to 80 percent of the production from the
world’s diamond mines. Because its market share is less than 100 percent, DeBeers
is not exactly a monopoly, but the company has nonetheless exerted substantial
influence over the market price of diamonds.
Although exclusive ownership of a key resource is a potential cause of monop-
oly, in practice monopolies rarely arise for this reason. Economies are large, and
resources are owned by many people. Indeed, because many goods are traded
internationally, the natural scope of their markets is often worldwide. There are,
therefore, few examples of firms that own a resource for which there are no close
substitutes.
GOVERNMENT-CREATED MONOPOLIES
In many cases, monopolies arise because the government has given one person
or firm the exclusive right to sell some good or service. Sometimes the monopoly
arises from the sheer political clout of the would-be monopolist. Kings, for exam-
ple, once granted exclusive business licenses to their friends and allies. At other
times, the government grants a monopoly because doing so is viewed to be in the
public interest.
The patent and copyright laws are two important examples. When a pharma-
ceutical company discovers a new drug, it can apply to the government for a pat-
ent. If the government deems the drug to be truly original, it approves the patent,
which gives the company the exclusive right to manufacture and sell the drug
CARTOON: © FROM THE WALL STREET JOURNAL—
for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The
PERMISSION, CARTOON FEATURES SYNDICATE
copyright is a government guarantee that no one can print and sell the work with-
out the author’s permission. The copyright makes the novelist a monopolist in the
sale of her novel.
The effects of patent and copyright laws are easy to see. Because these laws
give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices
and earn higher profits, the laws also encourage some desirable behavior. Drug
companies are allowed to be monopolists in the drugs they discover to encour-
age research. Authors are allowed to be monopolists in the sale of their books to
encourage them to write more and better books.
Thus, the laws governing patents and copyrights have benefits and costs. The
benefits of the patent and copyright laws are the increased incentives for creative
activity. These benefits are offset, to some extent, by the costs of monopoly pric-
ing, which we examine fully later in this chapter.
NATURAL MONOPOLIES
natural monopoly An industry is a natural monopoly when a single firm can supply a good or ser-
a monopoly that arises vice to an entire market at a lower cost than could two or more firms. A natural
because a single firm can monopoly arises when there are economies of scale over the relevant range of
supply a good or service output. Figure 1 shows the average total costs of a firm with economies of scale.
to an entire market at a In this case, a single firm can produce any amount of output at least cost. That is,
smaller cost than could
for any given amount of output, a larger number of firms leads to less output per
two or more firms
firm and higher average total cost.
An example of a natural monopoly is the distribution of water. To provide
water to residents of a town, a firm must build a network of pipes throughout the
town. If two or more firms were to compete in the provision of this service, each
firm would have to pay the fixed cost of building a network. Thus, the average
total cost of water is lowest if a single firm serves the entire market.
We saw other examples of natural monopolies when we discussed public goods
and common resources in Chapter 11. We noted in passing that some goods are
excludable but not rival in consumption. An example is a bridge used so infre-
quently that it is never congested. The bridge is excludable because a toll collec-
tor can prevent someone from using it. The bridge is not rival in consumption
because use of the bridge by one person does not diminish the ability of others to
use it. Because there is a fixed cost of building the bridge and a negligible mar-
ginal cost of additional users, the average total cost of a trip across the bridge (the
total cost divided by the number of trips) falls as the number of trips rises. Hence,
the bridge is a natural monopoly.
1 F I G U R E
Cost
Economies of Scale as a Cause of Monopoly

When a firm’s average-total-cost curve continually
declines, the firm has what is called a natural monop-
oly. In this case, when production is divided among
more firms, each firm produces less, and average total
cost rises. As a result, a single firm can produce any
given amount at the smallest cost.
Average
total
cost
0 Quantity of Output
When a firm is a natural monopoly, it is less concerned about new entrants erod-
ing its monopoly power. Normally, a firm has trouble maintaining a monopoly
position without ownership of a key resource or protection from the government.
The monopolist’s profit attracts entrants into the market, and these entrants make
the market more competitive. By contrast, entering a market in which another
firm has a natural monopoly is unattractive. Would-be entrants know that they
cannot achieve the same low costs that the monopolist enjoys because, after entry,
each firm would have a smaller piece of the market.
In some cases, the size of the market is one determinant of whether an industry
is a natural monopoly. Again, consider a bridge across a river. When the popula-
tion is small, the bridge may be a natural monopoly. A single bridge can satisfy
the entire demand for trips across the river at lowest cost. Yet as the population
grows and the bridge becomes congested, satisfying the entire demand may
require two or more bridges across the same river. Thus, as a market expands, a
natural monopoly can evolve into a more competitive market.
Q Q
UICK UIZ What are the three reasons that a market might have a monopoly? • Give
two examples of monopolies and explain the reason for each.
HOW MONOPOLIES MAKE PRODUCTION

AND PRICING DECISIONS
Now that we know how monopolies arise, we can consider how a monopoly firm
decides how much of its product to make and what price to charge for it. The
analysis of monopoly behavior in this section is the starting point for evaluating
whether monopolies are desirable and what policies the government might pur-
sue in monopoly markets.
MONOPOLY VERSUS COMPETITION

The key difference between a competitive firm and a monopoly is the monopoly’s
ability to influence the price of its output. A competitive firm is small relative to
the market in which it operates and, therefore, has no power to influence the price
of its output. It takes the price as given by market conditions. By contrast, because
a monopoly is the sole producer in its market, it can alter the price of its good by
adjusting the quantity it supplies to the market.
One way to view this difference between a competitive firm and a monopoly
is to consider the demand curve that each firm faces. When we analyzed profit
maximization by competitive firms in the preceding chapter, we drew the market
price as a horizontal line. Because a competitive firm can sell as much or as little
as it wants at this price, the competitive firm faces a horizontal demand curve, as
in panel (a) of Figure 2. In effect, because the competitive firm sells a product with
many perfect substitutes (the products of all the other firms in its market), the
demand curve that any one firm faces is perfectly elastic.
By contrast, because a monopoly is the sole producer in its market, its demand
curve is the market demand curve. Thus, the monopolist’s demand curve slopes
downward for all the usual reasons, as in panel (b) of Figure 2. If the monopolist
raises the price of its good, consumers buy less of it. Looked at another way, if the
2 F I G U R E Types
Becauseofcompetitive
curves,
The
Graphs firms are price takers, they in effect face horizontal demand
pie as in panel
chart (a). (a)
in panel Because
showsahowmonopoly firm is income
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bar graph in panelmarket demandthe
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Monopoly Firms
(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve
Price Price
Demand
Demand
0 Quantity of Output 0 Quantity of Output
monopolist reduces the quantity of output it produces and sells, the price of its
output increases.
The market demand curve provides a constraint on a monopoly’s ability to
profit from its market power. A monopolist would prefer, if it were possible, to
charge a high price and sell a large quantity at that high price. The market demand
curve makes that outcome impossible. In particular, the market demand curve
describes the combinations of price and quantity that are available to a monopoly
firm. By adjusting the quantity produced (or equivalently, the price charged), the
monopolist can choose any point on the demand curve, but it cannot choose a
point off the demand curve.
What price and quantity of output will the monopolist choose? As with com-
petitive firms, we assume that the monopolist’s goal is to maximize profit. Because
the firm’s profit is total revenue minus total costs, our next task in explaining
monopoly behavior is to examine a monopolist’s revenue.
A MONOPOLY’S R EVENUE
Consider a town with a single producer of water. Table 1 shows how the monop-
oly’s revenue might depend on the amount of water produced.
The first two columns show the monopolist’s demand schedule. If the monopo-
list produces 1 gallon of water, it can sell that gallon for $10. If it produces 2 gal-
lons, it must lower the price to $9 to sell both gallons. If it produces 3 gallons, it
must lower the price to $8. And so on. If you graphed these two columns of num-
bers, you would get a typical downward-sloping demand curve.
T A B L E
1
Quantity
of Water Price Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR = P × Q) (AR = TR / Q) (MR = ∆TR / ∆Q) A Monopoly’s Total,
Average, and
Marginal Revenue
0 gallons $11 $ 0 —
$10
1 10 10 $10
8
2 9 18 9
6
3 8 24 8
4
4 7 28 7
2
5 6 30 6
0
6 5 30 5
–2
7 4 28 4
–4
8 3 24 3
The third column of the table presents the monopolist’s total revenue. It equals
the quantity sold (from the first column) times the price (from the second column).
The fourth column computes the firm’s average revenue, the amount of revenue the
firm receives per unit sold. We compute average revenue by taking the number
for total revenue in the third column and dividing it by the quantity of output
in the first column. As we discussed in the previous chapter, average revenue
always equals the price of the good. This is true for monopolists as well as for
competitive firms.
The last column of Table 1 computes the firm’s marginal revenue, the amount
of revenue that the firm receives for each additional unit of output. We compute
marginal revenue by taking the change in total revenue when output increases
by 1 unit. For example, when the firm is producing 3 gallons of water, it receives
total revenue of $24. Raising production to 4 gallons increases total revenue to $28.
Thus, marginal revenue from the sale of the fourth gallon is $28 minus $24, or $4.
Table 1 shows a result that is important for understanding monopoly behavior:
A monopolist’s marginal revenue is always less than the price of its good. For example,
if the firm raises production of water from 3 to 4 gallons, it will increase total
revenue by only $4, even though it will be able to sell each gallon for $7. For
a monopoly, marginal revenue is lower than price because a monopoly faces a
downward-sloping demand curve. To increase the amount sold, a monopoly firm
must lower the price it charges to all customers. Hence, to sell the fourth gallon of
water, the monopolist will get $1 less revenue for each of the first three gallons.
This $3 loss accounts for the difference between the price of the fourth gallon ($7)
and the marginal revenue of that fourth gallon ($4).
Marginal revenue for monopolies is very different from marginal revenue for
competitive firms. When a monopoly increases the amount it sells, this action has
two effects on total revenue (P × Q):
• The output effect: More output is sold, so Q is higher, which tends to increase
total revenue.
• The price effect: The price falls, so P is lower, which tends to decrease total
revenue.
Because a competitive firm can sell all it wants at the market price, there is no
price effect. When it increases production by 1 unit, it receives the market price for
that unit, and it does not receive any less for the units it was already selling. That
is, because the competitive firm is a price taker, its marginal revenue equals the
price of its good. By contrast, when a monopoly increases production by 1 unit, it
must reduce the price it charges for every unit it sells, and this cut in price reduces
revenue on the units it was already selling. As a result, a monopoly’s marginal
revenue is less than its price.
Figure 3 graphs the demand curve and the marginal-revenue curve for a
monopoly firm. (Because the firm’s price equals its average revenue, the demand
curve is also the average-revenue curve.) These two curves always start at the
same point on the vertical axis because the marginal revenue of the first unit sold
equals the price of the good. But for the reason we just discussed, the monopolist’s
marginal revenue on all units after the first is less than the price of the good. Thus,
a monopoly’s marginal-revenue curve lies below its demand curve.
You can see in the figure (as well as in Table 1) that marginal revenue can even
become negative. Marginal revenue is negative when the price effect on revenue is
greater than the output effect. In this case, when the firm produces an extra unit of
output, the price falls by enough to cause the firm’s total revenue to decline, even
though the firm is selling more units.
3 F I G U R E
Price
$11
Demand and Marginal-Revenue 10
Curves for a Monopoly 9
The demand curve shows how the quan- 8
tity affects the price of the good. The 7
marginal-revenue curve shows how the 6
firm’s revenue changes when the quantity 5
increases by 1 unit. Because the price on 4
all units sold must fall if the monopoly 3 Demand
2 Marginal (average
increases production, marginal revenue
1 revenue revenue)
is always less than the price.
0
1 1 2 3 4 5 6 7 8 Quantity of Water
2
3
4
PROFIT M AXIMIZATION
Now that we have considered the revenue of a monopoly firm, we are ready to
examine how such a firm maximizes profit. Recall from Chapter 1 that one of the
Ten Principles of Economics is that rational people think at the margin. This lesson
is as true for monopolists as it is for competitive firms. Here we apply the logic of
marginal analysis to the monopolist’s decision about how much to produce.
Figure 4 graphs the demand curve, the marginal-revenue curve, and the cost
curves for a monopoly firm. All these curves should seem familiar: The demand
and marginal-revenue curves are like those in Figure 3, and the cost curves are
like those we encountered in the last two chapters. These curves contain all the
information we need to determine the level of output that a profit-maximizing
monopolist will choose.
Suppose, first, that the firm is producing at a low level of output, such as Q1.
In this case, marginal cost is less than marginal revenue. If the firm increased
production by 1 unit, the additional revenue would exceed the additional costs,
and profit would rise. Thus, when marginal cost is less than marginal revenue, the
firm can increase profit by producing more units.
A similar argument applies at high levels of output, such as Q2. In this case,
marginal cost is greater than marginal revenue. If the firm reduced production
by 1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is
greater than marginal revenue, the firm can raise profit by reducing production.
In the end, the firm adjusts its level of production until the quantity reaches
QMAX, at which marginal revenue equals marginal cost. Thus, the monopolist’s profit-
maximizing quantity of output is determined by the intersection of the marginal-revenue
curve and the marginal-cost curve. In Figure 4, this intersection occurs at point A.
You might recall from the previous chapter that competitive firms also choose
the quantity of output at which marginal revenue equals marginal cost. In
Costs and
F I G U R E
4
Revenue 2. . . . and then the demand 1. The intersection of the
curve shows the price marginal-revenue curve
Profit Maximization for
consistent with this quantity. and the marginal-cost
curve determines the
a Monopoly
profit-maximizing A monopoly maximizes profit by
B
Monopoly quantity . . . choosing the quantity at which
price marginal revenue equals marginal
Average total cost cost (point A). It then uses the
A demand curve to find the price
that will induce consumers to buy
that quantity (point B).
Demand
Marginal
cost
Marginal revenue
0 Q1 QMAX Q2 Quantity
following this rule for profit maximization, competitive firms and monopolies are
alike. But there is also an important difference between these types of firms: The
marginal revenue of a competitive firm equals its price, whereas the marginal
revenue of a monopoly is less than its price. That is,
For a competitive firm: P = MR = MC.

For a monopoly firm: P > MR = MC.
The equality of marginal revenue and marginal cost at the profit-maximizing

quantity is the same for both types of firms. What differs is the relationship of the
price to marginal revenue and marginal cost.
How does the monopoly find the profit-maximizing price for its product? The
demand curve answers this question because the demand curve relates the amount
that customers are willing to pay to the quantity sold. Thus, after the monopoly
firm chooses the quantity of output that equates marginal revenue and marginal
cost, it uses the demand curve to find the highest price it can charge and sell that
quantity. In Figure 4, the profit-maximizing price is found at point B.
We can now see a key difference between markets with competitive firms and
markets with a monopoly firm: In competitive markets, price equals marginal cost. In
monopolized markets, price exceeds marginal cost. As we will see in a moment, this
finding is crucial to understanding the social cost of monopoly.
A MONOPOLY’S PROFIT
How much profit does a monopoly make? To see a monopoly firm’s profit in a
graph, recall that profit equals total revenue (TR) minus total costs (TC):
Profit = TR – TC.
Why a Monopoly Does Not Have a Supply Curve
You may have noticed that not a price taker. It is not meaningful to ask what such a firm would
we have analyzed the price in a monopoly market using the market produce at any price because the firm sets the price at the same time
demand curve and the firm’s cost curves. We have not made any it chooses the quantity to supply.
mention of the market supply curve. By contrast, when we analyzed Indeed, the monopolist’s decision about how much to supply
prices in competitive markets beginning in Chapter 4, the two most is impossible to separate from the demand curve it faces. The
important words were always supply and demand. shape of the demand curve determines the shape of the marginal-
What happened to the supply curve? Although monopoly firms revenue curve, which in turn determines the monopolist’s profit-
make decisions about what quantity to supply (in the way described maximizing quantity. In a competitive market, supply decisions can
in this chapter), a monopoly does not have a supply curve. A supply be analyzed without knowing the demand curve, but that is not true
curve tells us the quantity that firms choose to supply at any given in a monopoly market. Therefore, we never talk about a monopoly’s
price. This concept makes sense when we are analyzing competitive supply curve.
firms, which are price takers. But a monopoly firm is a price maker,
Costs and
F I G U R E 5
Revenue
The Monopolist’s Profit
The area of the box BCDE equals
Marginal cost the profit of the monopoly firm.
Monopoly E B The height of the box (BC) is price
price minus average total cost, which
Average total cost
equals profit per unit sold. The
Monopoly
profit width of the box (DC) is the num-
ber of units sold.
Average
total D C
cost
Demand
Marginal revenue
0 QMAX Quantity
We can rewrite this as
Profit = (TR/Q – TC/Q) × Q.
TR/Q is average revenue, which equals the price, P, and TC/Q is average total
cost, ATC. Therefore,
This equation for profit (which also holds for competitive firms) allows us to mea-
sure the monopolist’s profit in our graph.
Consider the shaded box in Figure 5. The height of the box (the segment BC)
is price minus average total cost, P – ATC, which is the profit on the typical unit
sold. The width of the box (the segment DC) is the quantity sold, QMAX. Therefore,
the area of this box is the monopoly firm’s total profit.
MONOPOLY DRUGS VERSUS GENERIC DRUGS
According to our analysis, prices are determined differently in monopolized mar-

kets and competitive markets. A natural place to test this theory is the market for
pharmaceutical drugs because this market takes on both market structures. When
a firm discovers a new drug, patent laws give the firm a monopoly on the sale of
that drug. But eventually, the firm’s patent runs out, and any company can make
and sell the drug. At that time, the market switches from being monopolistic to
being competitive.
What should happen to the price of a drug when the patent runs out? Figure 6
shows the market for a typical drug. In this figure, the marginal cost of producing
6 F I G U R E
Costs and
Revenue
The Market for Drugs
When a patent gives a firm a monop-
oly over the sale of a drug, the firm
charges the monopoly price, which
is well above the marginal cost of Price
making the drug. When the patent on during
a drug runs out, new firms enter the patent life
market, making it more competitive.
As a result, the price falls from the Price after
Marginal
monopoly price to marginal cost. patent
cost
expires
Marginal Demand
revenue
0 Monopoly Competitive Quantity

quantity quantity
the drug is constant. (This is approximately true for many drugs.) During the life
of the patent, the monopoly firm maximizes profit by producing the quantity at
which marginal revenue equals marginal cost and charging a price well above
marginal cost. But when the patent runs out, the profit from making the drug
should encourage new firms to enter the market. As the market becomes more
competitive, the price should fall to equal marginal cost.
Experience is, in fact, consistent with our theory. When the patent on a drug
expires, other companies quickly enter and begin selling so-called generic prod-
ucts that are chemically identical to the former monopolist’s brand-name product.
And just as our analysis predicts, the price of the competitively produced generic
drug is well below the price that the monopolist was charging.
The expiration of a patent, however, does not cause the monopolist to lose all its
market power. Some consumers remain loyal to the brand-name drug, perhaps out
of fear that the new generic drugs are not actually the same as the drug they have
been using for years. As a result, the former monopolist can continue to charge a
price at least somewhat above the price charged by its new competitors. ●
Q Q
UICK UIZ Explain how a monopolist chooses the quantity of output to produce and
the price to charge.
THE WELFARE COST OF MONOPOLIES

Is monopoly a good way to organize a market? We have seen that a monopoly,
in contrast to a competitive firm, charges a price above marginal cost. From the
standpoint of consumers, this high price makes monopoly undesirable. At the
same time, however, the monopoly is earning profit from charging this high price.
From the standpoint of the owners of the firm, the high price makes monopoly
very desirable. Is it possible that the benefits to the firm’s owners exceed the costs
imposed on consumers, making monopoly desirable from the standpoint of soci-
ety as a whole?
We can answer this question using the tools of welfare economics. Recall from
Chapter 7 that total surplus measures the economic well-being of buyers and
sellers in a market. Total surplus is the sum of consumer surplus and producer
surplus. Consumer surplus is consumers’ willingness to pay for a good minus
the amount they actually pay for it. Producer surplus is the amount producers
receive for a good minus their costs of producing it. In this case, there is a single
producer—the monopolist.
You can probably guess the result of this analysis. In Chapter 7, we concluded
that the equilibrium of supply and demand in a competitive market is not only a
natural outcome but also a desirable one. The invisible hand of the market leads
to an allocation of resources that makes total surplus as large as it can be. Because
a monopoly leads to an allocation of resources different from that in a compet-
itive market, the outcome must, in some way, fail to maximize total economic
well-being.
THE DEADWEIGHT L OSS

We begin by considering what the monopoly firm would do if it were run by
a benevolent social planner. The social planner cares not only about the profit
earned by the firm’s owners but also about the benefits received by the firm’s
consumers. The planner tries to maximize total surplus, which equals producer
surplus (profit) plus consumer surplus. Keep in mind that total surplus equals the
value of the good to consumers minus the costs of making the good incurred by
the monopoly producer.
Figure 7 analyzes how a benevolent social planner would choose the monopo-
ly’s level of output. The demand curve reflects the value of the good to consum-
ers, as measured by their willingness to pay for it. The marginal-cost curve reflects
the costs of the monopolist. Thus, the socially efficient quantity is found where the
demand curve and the marginal-cost curve intersect. Below this quantity, the value of
an extra unit to consumers exceeds the cost of providing it, so increasing output
would raise total surplus. Above this quantity, the cost of producing an extra unit
exceeds the value of that unit to consumers, so decreasing output would raise
total surplus. At the optimal quantity, the value of an extra unit to consumers
exactly equals the marginal cost of production.
If the social planner were running the monopoly, the firm could achieve this
efficient outcome by charging the price found at the intersection of the demand
and marginal-cost curves. Thus, like a competitive firm and unlike a profit-
maximizing monopoly, a social planner would charge a price equal to marginal
cost. Because this price would give consumers an accurate signal about the cost of
producing the good, consumers would buy the efficient quantity.
We can evaluate the welfare effects of monopoly by comparing the level of out-
put that the monopolist chooses to the level of output that a social planner would
choose. As we have seen, the monopolist chooses to produce and sell the quantity
of output at which the marginal-revenue and marginal-cost curves intersect; the
social planner would choose the quantity at which the demand and marginal-cost
curves intersect. Figure 8 shows the comparison. The monopolist produces less than
the socially efficient quantity of output.
7 F I G U R E
Price
Marginal cost
The Efficient Level of Output
A benevolent social planner who wanted
to maximize total surplus in the market
would choose the level of output where
the demand curve and marginal-cost Value
Cost
to
curve intersect. Below this level, the value to
buyers
of the good to the marginal buyer (as monopolist
reflected in the demand curve) exceeds
the marginal cost of making the good.
Above this level, the value to the marginal Demand
buyer is less than marginal cost. Cost Value (value to buyers)
to to
monopolist buyers
0 Quantity
Value to buyers Value to buyers

is greater than is less than
cost to seller. cost to seller.
Efficient
quantity
We can also view the inefficiency of monopoly in terms of the monopolist’s

price. Because the market demand curve describes a negative relationship between
the price and quantity of the good, a quantity that is inefficiently low is equiva-
lent to a price that is inefficiently high. When a monopolist charges a price above
marginal cost, some potential consumers value the good at more than its marginal
cost but less than the monopolist’s price. These consumers do not buy the good.
Because the value these consumers place on the good is greater than the cost of
providing it to them, this result is inefficient. Thus, monopoly pricing prevents
some mutually beneficial trades from taking place.
The inefficiency of monopoly can be measured with a deadweight loss triangle,
as illustrated in Figure 8. Because the demand curve reflects the value to con-
sumers and the marginal-cost curve reflects the costs to the monopoly producer,
the area of the deadweight loss triangle between the demand curve and the
marginal-cost curve equals the total surplus lost because of monopoly pricing.
It is the reduction in economic well-being that results from the monopoly’s use
of its market power.
The deadweight loss caused by monopoly is similar to the deadweight loss
caused by a tax. Indeed, a monopolist is like a private tax collector. As we saw
in Chapter 8, a tax on a good places a wedge between consumers’ willingness to
pay (as reflected in the demand curve) and producers’ costs (as reflected in the
supply curve). Because a monopoly exerts its market power by charging a price
above marginal cost, it places a similar wedge. In both cases, the wedge causes the
quantity sold to fall short of the social optimum. The difference between the two
Price
F I G U R E 8
Deadweight Marginal cost
loss The Inefficiency of Monopoly
Because a monopoly charges a
Monopoly price above marginal cost, not all
price consumers who value the good
at more than its cost buy it. Thus,
the quantity produced and sold by
a monopoly is below the socially
efficient level. The deadweight
loss is represented by the area of
the triangle between the demand
Marginal
revenue Demand curve (which reflects the value
of the good to consumers) and
the marginal-cost curve (which
reflects the costs of the monopoly
0 Monopoly Efficient Quantity producer).
quantity quantity
cases is that the government gets the revenue from a tax, whereas a private firm
gets the monopoly profit.
THE MONOPOLY’S PROFIT: A SOCIAL COST?

It is tempting to decry monopolies for “profiteering” at the expense of the pub-
lic. And indeed, a monopoly firm does earn a higher profit by virtue of its mar-
ket power. According to the economic analysis of monopoly, however, the firm’s
profit is not in itself necessarily a problem for society.
Welfare in a monopolized market, like all markets, includes the welfare of both
consumers and producers. Whenever a consumer pays an extra dollar to a pro-
ducer because of a monopoly price, the consumer is worse off by a dollar, and the
producer is better off by the same amount. This transfer from the consumers of the
good to the owners of the monopoly does not affect the market’s total surplus—
the sum of consumer and producer surplus. In other words, the monopoly profit
itself represents not a reduction in the size of the economic pie but merely a big-
ger slice for producers and a smaller slice for consumers. Unless consumers are
for some reason more deserving than producers—a normative judgment about
equity that goes beyond the realm of economic efficiency—the monopoly profit is
not a social problem.
The problem in a monopolized market arises because the firm produces and
sells a quantity of output below the level that maximizes total surplus. The dead-
weight loss measures how much the economic pie shrinks as a result. This inef-
ficiency is connected to the monopoly’s high price: Consumers buy fewer units
when the firm raises its price above marginal cost. But keep in mind that the profit
earned on the units that continue to be sold is not the problem. The problem stems
from the inefficiently low quantity of output. Put differently, if the high monopoly
price did not discourage some consumers from buying the good, it would raise
producer surplus by exactly the amount it reduced consumer surplus, leaving
total surplus the same as could be achieved by a benevolent social planner.
There is, however, a possible exception to this conclusion. Suppose that a
monopoly firm has to incur additional costs to maintain its monopoly position.
For example, a firm with a government-created monopoly might need to hire lob-
byists to convince lawmakers to continue its monopoly. In this case, the monopoly
may use up some of its monopoly profits paying for these additional costs. If so,
the social loss from monopoly includes both these costs and the deadweight loss
resulting from a price above marginal cost.
QUICK QUIZ How does a monopolist’s quantity of output compare to the quantity of
output that maximizes total surplus? How does this difference relate to the concept of
deadweight loss?
PRICE DISCRIMINATION
So far, we have been assuming that the monopoly firm charges the same price to
all customers. Yet in many cases, firms sell the same good to different customers
for different prices, even though the costs of producing for the two customers are
price discrimination the same. This practice is called price discrimination.
the business practice of Before discussing the behavior of a price-discriminating monopolist, we should
selling the same good note that price discrimination is not possible when a good is sold in a competi-
at different prices to tive market. In a competitive market, many firms are selling the same good at the
different customers market price. No firm is willing to charge a lower price to any customer because
the firm can sell all it wants at the market price. And if any firm tried to charge a
higher price to a customer, that customer would buy from another firm. For a firm
to price discriminate, it must have some market power.
A PARABLE ABOUT PRICING

To understand why a monopolist would price discriminate, let’s consider an
example. Imagine that you are the president of Readalot Publishing Company.
Readalot’s best-selling author has just written a new novel. To keep things
simple, let’s imagine that you pay the author a flat $2 million for the exclusive
rights to publish the book. Let’s also assume that the cost of printing the book is
zero. Readalot’s profit, therefore, is the revenue from selling the book minus the
$2 million it has paid to the author. Given these assumptions, how would you, as
Readalot’s president, decide the book’s price?
Your first step is to estimate the demand for the book. Readalot’s marketing
department tells you that the book will attract two types of readers. The book will
appeal to the author’s 100,000 die-hard fans who are willing to pay as much as
$30. In addition, the book will appeal to about 400,000 less enthusiastic readers
who will pay up to $5.
If Readalot charges a single price to all customers, what price maximizes
profit? There are two natural prices to consider: $30 is the highest price Readalot
can charge and still get the 100,000 die-hard fans, and $5 is the highest price it
can charge and still get the entire market of 500,000 potential readers. Solving
Readalot’s problem is a matter of simple arithmetic. At a price of $30, Readalot
sells 100,000 copies, has revenue of $3 million, and makes profit of $1 million. At
a price of $5, it sells 500,000 copies, has revenue of $2.5 million, and makes profit
of $500,000. Thus, Readalot maximizes profit by charging $30 and forgoing the
opportunity to sell to the 400,000 less enthusiastic readers.
Notice that Readalot’s decision causes a deadweight loss. There are 400,000
readers willing to pay $5 for the book, and the marginal cost of providing it to them
is zero. Thus, $2 million of total surplus is lost when Readalot charges the higher
price. This deadweight loss is the inefficiency that arises whenever a monopolist
charges a price above marginal cost.
Now suppose that Readalot’s marketing department makes a discovery: These
two groups of readers are in separate markets. The die-hard fans live in Australia,
and the other readers live in the United States. Moreover, it is hard for readers in
one country to buy books in the other.
In response to this discovery, Readalot can change its marketing strategy and
increase profits. To the 100,000 Australian readers, it can charge $30 for the book.
To the 400,000 American readers, it can charge $5 for the book. In this case, rev-
enue is $3 million in Australia and $2 million in the United States, for a total of $5
million. Profit is then $3 million, which is substantially greater than the $1 million
the company could earn charging the same $30 price to all customers. Not surpris-
ingly, Readalot chooses to follow this strategy of price discrimination.
The story of Readalot Publishing is hypothetical, but it describes accurately
the business practice of many publishing companies. Textbooks, for example, are
often sold at a lower price in Europe than in the United States. Even more impor-
tant is the price differential between hardcover books and paperbacks. When a
publisher has a new novel, it initially releases an expensive hardcover edition and
later releases a cheaper paperback edition. The difference in price between these
two editions far exceeds the difference in printing costs. The publisher’s goal is
just as in our example. By selling the hardcover to die-hard fans and the paperback
to less enthusiastic readers, the publisher price discriminates and raises its profit.
THE MORAL OF THE STORY

Like any parable, the story of Readalot Publishing is stylized. Yet also like any
parable, it teaches some general lessons. In this case, there are three lessons to be
learned about price discrimination.
The first and most obvious lesson is that price discrimination is a rational
strategy for a profit-maximizing monopolist. That is, by charging different prices
to different customers, a monopolist can increase its profit. In essence, a price-
discriminating monopolist charges each customer a price closer to his or her will-
ingness to pay, therefore selling more than is possible with a single price.
The second lesson is that price discrimination requires the ability to separate
customers according to their willingness to pay. In our example, customers were
separated geographically. But sometimes monopolists choose other differences,
such as age or income, to distinguish among customers.
A corollary to this second lesson is that certain market forces can prevent firms
from price discriminating. In particular, one such force is arbitrage, the process
of buying a good in one market at a low price and selling it in another market at
a higher price to profit from the price difference. In our example, if Australian
bookstores could buy the book in the United States and resell it to Australian
readers, the arbitrage would prevent Readalot from price discriminating, because
no Australian would buy the book at the higher price.
The third lesson from our parable is the most surprising: Price discrimination
can raise economic welfare. Recall that a deadweight loss arises when Readalot
charges a single $30 price because the 400,000 less enthusiastic readers do not
end up with the book, even though they value it at more than its marginal cost
of production. By contrast, when Readalot price discriminates, all readers get the
book, and the outcome is efficient. Thus, price discrimination can eliminate the
inefficiency inherent in monopoly pricing.
Note that in this example the increase in welfare from price discrimination
shows up as higher producer surplus rather than higher consumer surplus. Con-
sumers are no better off for having bought the book: The price they pay exactly
equals the value they place on the book, so they receive no consumer surplus.
The entire increase in total surplus from price discrimination accrues to Readalot
Publishing in the form of higher profit.
THE ANALYTICS OF PRICE DISCRIMINATION

Let’s consider a bit more formally how price discrimination affects economic wel-
fare. We begin by assuming that the monopolist can price discriminate perfectly.
Perfect price discrimination describes a situation in which the monopolist knows
exactly the willingness to pay of each customer and can charge each customer
a different price. In this case, the monopolist charges each customer exactly his
or her willingness to pay, and the monopolist gets the entire surplus in every
transaction.
Figure 9 shows producer and consumer surplus with and without price dis-
crimination. Without price discrimination, the firm charges a single price above
marginal cost, as shown in panel (a). Because some potential customers who value
the good at more than marginal cost do not buy it at this high price, the monopoly
causes a deadweight loss. Yet when a firm can perfectly price discriminate, as
shown in panel (b), each customer who values the good at more than marginal
cost buys the good and is charged his or her willingness to pay. All mutually
beneficial trades take place, there is no deadweight loss, and the entire surplus
derived from the market goes to the monopoly producer in the form of profit.
In reality, of course, price discrimination is not perfect. Customers do not walk
into stores with signs displaying their willingness to pay. Instead, firms price dis-
criminate by dividing customers into groups: young versus old, weekday versus
weekend shoppers, Americans versus Australians, and so on. Unlike those in our
parable of Readalot Publishing, customers within each group differ in their will-
ingness to pay for the product, making perfect price discrimination impossible.
How does this imperfect price discrimination affect welfare? The analysis of
these pricing schemes is quite complicated, and it turns out that there is no gen-
eral answer to this question. Compared to the monopoly outcome with a single
price, imperfect price discrimination can raise, lower, or leave unchanged total
surplus in a market. The only certain conclusion is that price discrimination raises
the monopoly’s profit; otherwise, the firm would choose to charge all customers
the same price.
Panel (a) shows a monopolist that charges the same price to all customers. Total
surplus in this market equals the sum of profit (producer surplus) and consumer
F I G U R E 9
surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because
consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing
Welfare with and
these two panels, you can see that perfect price discrimination raises profit, raises
without Price
total surplus, and lowers consumer surplus.
Discrimination
(a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination
Price Price
Consumer
surplus
Monopoly Deadweight
price loss
Profit
Profit
Marginal cost Marginal cost
Marginal
Demand Demand
revenue
0 Quantity sold Quantity 0 Quantity sold Quantity
EXAMPLES OF PRICE DISCRIMINATION

Firms in our economy use various business strategies aimed at charging different
prices to different customers. Now that we understand the economics of price
discrimination, let’s consider some examples.
Movie Tickets Many movie theaters charge a lower price for children and senior
citizens than for other patrons. This fact is hard to explain in a competitive mar-
ket. In a competitive market, price equals marginal cost, and the marginal cost
of providing a seat for a child or senior citizen is the same as the marginal cost
CARTOON: HAMILTON © UNIVERSAL PRESS SYNDICATE.
of providing a seat for anyone else. Yet the differential pricing is easily explained
REPRINTED WITH PERMISSION. ALL RIGHTS RESERVED.
if movie theaters have some local monopoly power and if children and senior
citizens have a lower willingness to pay for a ticket. In this case, movie theaters
raise their profit by price discriminating.
Airline Prices Seats on airplanes are sold at many different prices. Most airlines
charge a lower price for a round-trip ticket between two cities if the traveler stays
over a Saturday night. At first, this seems odd. Why should it matter to the airline
whether a passenger stays over a Saturday night? The reason is that this rule pro-
vides a way to separate business travelers and leisure travelers. A passenger on a “WOULD IT BOTHER YOU TO
business trip has a high willingness to pay and, most likely, does not want to stay HEAR HOW LITTLE I PAID FOR
over a Saturday night. By contrast, a passenger traveling for personal reasons has THIS FLIGHT?”
TKTS and Other Schemes

Economist Hal Varian discusses a dramatic example of price
discrimination.
The Dynamics of Pricing the plane takes off, a seat is worth next to
Tickets for Broadway nothing.
Shows In both industries, sellers use a variety
By Hal R. Varian of strategies to try to ensure that the seats
are sold to those who are willing to pay
Every night in New York, about 25,000 peo- the most.
ple, on average, attend Broadway shows. This phenomenon was examined
As avid theatergoers know, ticket prices recently by a Stanford economist, Phillip
have been rising inexorably. The top ticket Leslie, in an article, “Price Discrimination
PHOTO: © BRUCE GLIKAS/GETTY IMAGES
price for Broadway shows has risen 31 per- in Broadway Theater,” published in the
BARGAIN HUNTERS
cent since 1998. But the actual price paid autumn 2004 issue of the RAND Journal of
has gone up by only 24 percent. Economics.
The difference is a result of discounting. prices for students, and through the TKTS Mr. Leslie was able to collect detailed
Savvy fans know that there are deals avail- booth in Times Square. data on a 1996 Broadway play, “Seven Gui-
able for even the most popular shows, with Why so much discounting? The value of tars.” Over 140,000 people saw this play, and
the most popular discounts being offered a seat in a theater, like a seat on an airplane, they bought tickets in 17 price categories.
through coupons, two-for-one deals, special is highly perishable. Once the show starts or Some price variation was due to the qual-
a lower willingness to pay and is more likely to be willing to stay over a Saturday
night. Thus, the airlines can successfully price discriminate by charging a lower
price for passengers who stay over a Saturday night.
Discount Coupons Many companies offer discount coupons to the public in

newspapers and magazines. A buyer simply has to clip the coupon to get $0.50 off
his or her next purchase. Why do companies offer these coupons? Why don’t they
just cut the price of the product by $0.50?
The answer is that coupons allow companies to price discriminate. Companies
know that not all customers are willing to spend the time to clip coupons. More-
over, the willingness to clip coupons is related to the customer’s willingness to pay
for the good. A rich and busy executive is unlikely to spend her time clipping dis-
count coupons out of the newspaper, and she is probably willing to pay a higher
price for many goods. A person who is unemployed is more likely to clip coupons
and to have a lower willingness to pay. Thus, by charging a lower price only to
those customers who clip coupons, firms can successfully price discriminate.
ity of the seats—orchestra, mezzanine, Mr. Leslie’s goal was primarily to model Mr. Leslie uses some advanced econo-
balcony and so on—while other price dif- the behavior of the theatergoer. The audi- metric techniques to estimate the values
ferences were a result of various forms of ence for Broadway shows is highly diverse. that different income groups put on the
discounting. About 10 percent, according to a 1991 sur- various categories of tickets. He finds that
The combination of quality variation vey conducted by Broadway producers, had Broadway producers do a pretty good job,
and discounts led to widely varying ticket household incomes of $25,000 or $35,000 in general, at maximizing revenue. . . .
prices. The average difference of two tick- while an equal number had incomes over We are likely to see more and more
ets chosen at random on a given night was $150,000 (in 1990 dollars). goods and services sold using the same sort
about 40 percent of the average price. This The prices and discounting policy set of differential pricing. As more and more
is comparable to the price variation in airline by the producers of Broadway shows try to transactions become computer-mediated, it
tickets. . . . use this heterogeneity to get people to sort becomes easier for sellers to collect data, to
The ticket promotions also varied over themselves by their willingness to pay for experiment with pricing and to analyze the
the 199 performances of the show. Targeted tickets. results of those experiments.
direct mail was used early on, while two-for- You probably will not see Donald Trump This, of course, makes life more compli-
one tickets were not introduced until about waiting in line at TKTS; presumably, those cated for us consumers. The flip side is that
halfway through the run. in his income class do not mind paying full pricing variations make those good deals
The tickets offered for sale at the TKTS price. But a lot of students, unemployed more likely.
booth in Times Square are typically orches- actors and tourists do use TKTS. Last time I was in New York, I was pleased
tra seats, the best category of seats available. Yes, it is inconvenient to wait in line that I managed to get a ticket to “The Pro-
But the discounted tickets at TKTS tend to at TKTS. But that is the point. If it weren’t ducers” for half price. It almost made up for
be the lower-quality orchestra seats. They inconvenient, everyone would do it, and this the fact that I had to book my airline ticket
sell at a fixed discount of 50 percent, but are would result in substantially lower revenues two weeks in advance and stay over a Sat-
offered only for performances that day. for Broadway shows. urday night.
Financial Aid Many colleges and universities give financial aid to needy students.
One can view this policy as a type of price discrimination. Wealthy students have
greater financial resources and, therefore, a higher willingness to pay than needy
students. By charging high tuition and selectively offering financial aid, schools
in effect charge prices to customers based on the value they place on going to that
school. This behavior is similar to that of any price-discriminating monopolist.
Quantity Discounts So far in our examples of price discrimination, the monop-

olist charges different prices to different customers. Sometimes, however, monop-
olists price discriminate by charging different prices to the same customer for
different units that the customer buys. For example, many firms offer lower prices
to customers who buy large quantities. A bakery might charge $0.50 for each donut
but $5 for a dozen. This is a form of price discrimination because the customer pays
a higher price for the first unit bought than for the twelfth. Quantity discounts are
often a successful way of price discriminating because a customer’s willingness to
pay for an additional unit declines as the customer buys more units.
QUICK QUIZ Give two examples of price discrimination. • How does perfect price dis-
crimination affect consumer surplus, producer surplus, and total surplus?
PUBLIC POLICY TOWARD MONOPOLIES

We have seen that monopolies, in contrast to competitive markets, fail to allocate
resources efficiently. Monopolies produce less than the socially desirable quantity
of output and, as a result, charge prices above marginal cost. Policymakers in the
government can respond to the problem of monopoly in one of four ways:
• By trying to make monopolized industries more competitive
• By regulating the behavior of the monopolies
• By turning some private monopolies into public enterprises
• By doing nothing at all
INCREASING COMPETITION WITH ANTITRUST LAWS

If Coca-Cola and PepsiCo wanted to merge, the deal would be closely examined
by the federal government before it went into effect. The lawyers and economists
in the Department of Justice might well decide that a merger between these two
large soft drink companies would make the U.S. soft drink market substantially
less competitive and, as a result, would reduce the economic well-being of the
country as a whole. If so, the Department of Justice would challenge the merger in
court, and if the judge agreed, the two companies would not be allowed to merge.
It is precisely this kind of challenge that prevented software giant Microsoft from
buying Intuit in 1994.
The government derives this power over private industry from the antitrust
laws, a collection of statutes aimed at curbing monopoly power. The first and most
important of these laws was the Sherman Antitrust Act, which Congress passed
in 1890 to reduce the market power of the large and powerful “trusts” that were
viewed as dominating the economy at the time. The Clayton Antitrust Act, passed
in 1914, strengthened the government’s powers and authorized private lawsuits.
As the U.S. Supreme Court once put it, the antitrust laws are “a comprehensive
charter of economic liberty aimed at preserving free and unfettered competition
as the rule of trade.”
The antitrust laws give the government various ways to promote competition.
They allow the government to prevent mergers, such as our hypothetical merger
between Coca-Cola and PepsiCo. They also allow the government to break up
companies. For example, in 1984, the government split up AT&T, the large tele-
communications company, into eight smaller companies. Finally, the antitrust
laws prevent companies from coordinating their activities in ways that make mar-
CARTOON: © 2003 BY SIDNEY HARRIS
kets less competitive.

Antitrust laws have costs as well as benefits. Sometimes companies merge not
to reduce competition but to lower costs through more efficient joint production.
“BUT IF WE DO MERGE WITH
These benefits from mergers are sometimes called synergies. For example, many
AMALGAMATED, WE’LL HAVE U.S. banks have merged in recent years and, by combining operations, have been
ENOUGH RESOURCES TO FIGHT able to reduce administrative staff. If antitrust laws are to raise social welfare, the
THE ANTI-TRUST VIOLATION government must be able to determine which mergers are desirable and which
CAUSED BY THE MERGER.” are not. That is, it must be able to measure and compare the social benefit from
Airline Mergers
When firms consider merging, executives keep one eye on business
fundamentals and another eye on regulatory policy and politics.
Delta’s Merger Buzz May was reported by The Wall Street Journal. corporate costs and closing some hubs.
Stir the Industry Delta shares rose $2.46, or 18%. . . . Also, bigger airlines may have an edge in
Any big U.S. airline merger is sure to winning corporate accounts because they
Delta Air Lines Inc. is seriously considering a draw heavy regulatory scrutiny because of have broader route networks.
merger with either Northwest Airlines Corp. the impact on fares and competition. United Consolidation has taken on new urgency
or United Airlines parent UAL Corp., accord- and Delta are the second- and third-largest because carriers believe the chances of get-
ing to people close to the situation, a move carriers by traffic behind AMR Corp.’s Ameri- ting one or two big deals approved by anti-
that could spur a new round of industry can Airlines. Continental is No. 4, and North- trust authorities are better under the current
matchmaking as rising fuel costs hurt airline west is No. 5. Republican administration. Airline execu-
stocks. Still, a new round of industry consoli- tives and investors believe deals need to
At a meeting today, Delta’s board is dation would help airlines reduce excess be forged in the next 30 to 45 days to allow
expected to act on a proposal to give Chief capacity, raise fares and boost profit margins enough time for scrutiny before the new
Executive Officer Richard Anderson a green battered by oil’s rise to nearly $100 a barrel, administration takes office a year from now.
light to pursue formal merger discussions though it likely would lead to more grum-
with both Northwest and United. . . . bling from stressed passengers.
The market reacted enthusiastically yes- Merged airlines could save money by
terday after the news of a prospective deal combining computer systems, reducing
Source: The Wall Street Journal, January 11, 2008.
synergies to the social costs of reduced competition. Critics of the antitrust laws
are skeptical that the government can perform the necessary cost–benefit analysis
with sufficient accuracy.
R EGULATION
Another way the government deals with the problem of monopoly is by regulat-
ing the behavior of monopolists. This solution is common in the case of natu-
ral monopolies, such as water and electric companies. These companies are not
allowed to charge any price they want. Instead, government agencies regulate
their prices.
What price should the government set for a natural monopoly? This question
is not as easy as it might at first appear. One might conclude that the price should
equal the monopolist’s marginal cost. If price equals marginal cost, customers will
buy the quantity of the monopolist’s output that maximizes total surplus, and the
allocation of resources will be efficient.
Public Transport and Private Enterprise

In many cities, the mass transit system of buses and subways is a
monopoly run by the local government. But is this the best system?
Man with a Van more frequently at every hour of the day. “It
By John Tierney takes me an hour to get home if I use the
bus,” explains Cynthia Peters, a nurse born
Vincent Cummins looks out from his van in Trinidad. “When I’m working late, it’s very
with the wary eyes of a hardened criminal. It scary waiting in the dark for the bus and
is quiet this evening in downtown Brooklyn then walking the three blocks home. With
. . . too quiet. “Watch my back for me!” he Vincent’s van, I get home in less than half
barks into the microphone of his C.B. radio, an hour. He takes me right to the door and
addressing a fellow outlaw in a van who just waits until I get inside.”
drove by him on Livingston Street. He looks Cummins would prefer not to be an
left and right. No police cars in sight. None outlaw. A native of Barbados, he has been
of the usual unmarked cars, either. Cummins driving his van full time ever since an injury
pauses for a second—he has heard on the forced him to give up his job as a machinist.
C.B. that cops have just busted two other “I could be collecting disability,” he says, “but
drivers—but he can’t stop himself. “Watch it’s better to work.” He met Federal require-
my back!” he repeats into the radio as he ments to run an interstate van service, then
ruthlessly pulls over to the curb. spent years trying to get approval to operate
Five seconds later, evil triumphs. A in the city. His application, which included
VINCENT CUMMINS: OUTLAW
middle-aged woman with a shopping bag ENTREPRENEUR more than 900 supporting statements from
climbs into the van . . . and Cummins drives riders, business groups, and church leaders,
PHOTO: EVAN KAFKA
off with impunity! His new victim and the was approved by the City Taxi and Limou-
other passengers laugh when asked why way when you’re guaranteed a seat here for sine Commission as well as by the Depart-
they’re riding this illegal jitney. What fool $1? Unlike bus drivers, the van drivers make ment of Transportation. Mayor Giuliani
would pay $1.50 to stand on the bus or sub- change and accept bills, and the vans run supported him. But this summer the City
There are, however, two practical problems with marginal-cost pricing as a reg-
ulatory system. The first arises from the logic of cost curves. By definition, natural
monopolies have declining average total cost. As we first discussed in Chapter 13,
when average total cost is declining, marginal cost is less than average total cost.
This situation is illustrated in Figure 10, which shows a firm with a large fixed cost
and then constant marginal cost thereafter. If regulators were to set price equal to
marginal cost, that price must be less than the firm’s average total cost, and the
firm would lose money. Instead of charging such a low price, the monopoly firm
would just exit the industry.
Regulators can respond to this problem in various ways, none of which is per-
fect. One way is to subsidize the monopolist. In essence, the government picks
Council rejected his application for a license, Eventually though, New York’s politicians age private operators to make a long-term
as it has rejected most applications over the drove most private transit companies out of investment in regular service along a route,
past four years, which is why thousands of business by refusing to adjust the fare for the Brookings researchers recommend sell-
illegal drivers in Brooklyn and Queens are inflation. When the enterprises lost money ing them exclusive “curb rights” to pick up
dodging the police. in the 1920’s, Mayor John Hylan offered to passengers waiting at certain stops along
Council members claim they’re trying teach them efficient management. If the city the route. That way part-time opportunists
to prevent vans from causing accidents and ran the subway, he promised, it would make couldn’t swoop in to steal regular customers
traffic problems, although no one who rides money while preserving the nickel fare and from a long-term operator. But to encour-
the vans takes these protestations seriously. freeing New Yorkers from “serfdom” and age competition, at other corners along the
Vans with accredited and insured drivers like “dictatorship” of the “grasping transporta- route there should also be common stops
Cummins are no more dangerous or disruption monopolies.” But expenses soared as where passengers could be picked up by
tive than taxis. The only danger they pose is soon as government merged the private sys- any licensed jitney or bus.
to the public transit monopoly, whose union tems into a true monopoly. The fare, which Elements of this system already exist
leaders have successfully led the campaign remained a nickel through seven decades of where jitneys have informally established
against them. private transit, has risen 2,900 percent under their own stops separate from the regular
The van drivers have refuted two mod- public management—and today the Met- buses, but the City Council is trying to elimi-
ern urban myths: that mass transit must ropolitan Transportation Authority still man- nate these competitors. Besides denying
lose money and that it must be a public ages to lose about $2 per ride. Meanwhile, licenses to new drivers like Cummins, the
enterprise. Entrepreneurs like Cummins are a jitney driver can provide better service at Council has forbidden veteran drivers with
thriving today in other cities—Seoul and lower prices and still make a profit. licenses to operate on bus routes. Unless
Buenos Aires rely entirely on private, profit- “Transit could be profitable again if these restrictions are overturned in court—a
able bus companies—and they once made entrepreneurs are given a chance,” says suit on the drivers’ behalf has been filed by the
New York the world leader in mass transit. Daniel B. Klein, an economist at Santa Clara Institute for Justice, a public-interest law firm
The first horsecars and elevated trains were University in California and the co-author of in Washington—the vans can compete only
developed here by private companies. The Curb Rights, a new book from the Brookings by breaking the law. At this very moment,
first subway was partly financed with a loan Institution on mass transit. “Government has despite the best efforts of the police and
from the city, but it was otherwise a private demonstrated that it has no more business the Transport Workers Union, somewhere in
operation, built and run quite profitably producing transit than producing cornflakes. New York a serial predator like Cummins is
with the fare set at a nickel—the equivalent It should concentrate instead on establishing luring another unsuspecting victim. He may
of less than a dollar today. new rules to foster competition.” To encour- even be making change for a $5 bill.
Source: The New York Times Magazine, August 10, 1997, page 22. Copyright © 1997 by The New York Times Co. Reprinted by permission.
up the losses inherent in marginal-cost pricing. Yet to pay for the subsidy, the
government needs to raise money through taxation, which involves its own dead-
weight losses. Alternatively, the regulators can allow the monopolist to charge a
price higher than marginal cost. If the regulated price equals average total cost,
the monopolist earns exactly zero economic profit. Yet average-cost pricing leads
to deadweight losses because the monopolist’s price no longer reflects the mar-
ginal cost of producing the good. In essence, average-cost pricing is like a tax on
the good the monopolist is selling.
The second problem with marginal-cost pricing as a regulatory system (and
with average-cost pricing as well) is that it gives the monopolist no incentive to
reduce costs. Each firm in a competitive market tries to reduce its costs because
10 F I G U R E
Price
Marginal-Cost Pricing for

a Natural Monopoly
Because a natural monopoly has
declining average total cost,
marginal cost is less than average
total cost. Therefore, if regula-
Average total
tors require a natural monopoly to cost Average total cost
charge a price equal to marginal Loss
cost, price will be below average Regulated
price Marginal cost
total cost, and the monopoly will
lose money.
Demand
0 Quantity
lower costs mean higher profits. But if a regulated monopolist knows that regula-
tors will reduce prices whenever costs fall, the monopolist will not benefit from
lower costs. In practice, regulators deal with this problem by allowing monopo-
lists to keep some of the benefits from lower costs in the form of higher profit, a
practice that requires some departure from marginal-cost pricing.
PUBLIC OWNERSHIP
The third policy used by the government to deal with monopoly is public owner-
ship. That is, rather than regulating a natural monopoly that is run by a private
firm, the government can run the monopoly itself. This solution is common in
many European countries, where the government owns and operates utilities such
as telephone, water, and electric companies. In the United States, the government
runs the Postal Service. The delivery of ordinary first-class mail is often thought
to be a natural monopoly.
Economists usually prefer private to public ownership of natural monopolies.
The key issue is how the ownership of the firm affects the costs of production.
Private owners have an incentive to minimize costs as long as they reap part of
the benefit in the form of higher profit. If the firm’s managers are doing a bad job
of keeping costs down, the firm’s owners will fire them. By contrast, if the govern-
ment bureaucrats who run a monopoly do a bad job, the losers are the customers
and taxpayers, whose only recourse is the political system. The bureaucrats may
become a special-interest group and attempt to block cost-reducing reforms. Put
simply, as a way of ensuring that firms are well run, the voting booth is less reli-
able than the profit motive.
DOING NOTHING
Each of the foregoing policies aimed at reducing the problem of monopoly has
drawbacks. As a result, some economists argue that it is often best for the gov-
ernment not to try to remedy the inefficiencies of monopoly pricing. Here is the
assessment of economist George Stigler, who won the Nobel Prize for his work in
industrial organization:
A famous theorem in economics states that a competitive enterprise economy
will produce the largest possible income from a given stock of resources. No
real economy meets the exact conditions of the theorem, and all real economies
will fall short of the ideal economy—a difference called “market failure.” In
my view, however, the degree of “market failure” for the American economy
is much smaller than the “political failure” arising from the imperfections of
economic policies found in real political systems.
As this quotation makes clear, determining the proper role of the government in
the economy requires judgments about politics as well as economics.
Q Q
UICK UIZ Describe the ways policymakers can respond to the inefficiencies caused
by monopolies. List a potential problem with each of these policy responses.
CONCLUSION: THE PREVALENCE OF MONOPOLIES

This chapter has discussed the behavior of firms that have control over the prices
they charge. We have seen that these firms behave very differently from the com-
petitive firms studied in the previous chapter. Table 2 summarizes some of the
key similarities and differences between competitive and monopoly markets.
From the standpoint of public policy, a crucial result is that a monopolist pro-
duces less than the socially efficient quantity and charges a price above marginal
cost. As a result, a monopoly causes deadweight losses. In some cases, these
T A B L E
2
Competition Monopoly
Competition versus
Similarities
Monopoly: A Summary
Goal of firms Maximize profits Maximize profits
Comparison
Rule for maximizing MR = MC MR = MC
Can earn economic profits
in the short run? Yes Yes
Differences
Number of firms Many One
Marginal revenue MR = P MR < P
Price P = MC P > MC
Produces welfare-maximizing
level of output? Yes No
Entry in long run? Yes No
in long run? No Yes
Price discrimination
possible? No Yes
inefficiencies can be mitigated through price discrimination by the monopolist,

but other times, they call for policymakers to take an active role.
How prevalent are the problems of monopoly? There are two answers to this
question.
In one sense, monopolies are common. Most firms have some control over the
prices they charge. They are not forced to charge the market price for their goods
because their goods are not exactly the same as those offered by other firms. A
Ford Taurus is not the same as a Toyota Camry. Ben and Jerry’s ice cream is not
the same as Breyer’s. Each of these goods has a downward-sloping demand curve,
which gives each producer some degree of monopoly power.
Yet firms with substantial monopoly power are rare. Few goods are truly
unique. Most have substitutes that, even if not exactly the same, are similar. Ben
and Jerry can raise the price of their ice cream a little without losing all their sales,
but if they raise it very much, sales will fall substantially as their customers switch
to another brand.
In the end, monopoly power is a matter of degree. It is true that many firms
have some monopoly power. It is also true that their monopoly power is usually
limited. In such a situation, we will not go far wrong assuming that firms operate
in competitive markets, even if that is not precisely the case.
SUMMARY
• A monopoly is a firm that is the sole seller in its • A monopolist’s profit-maximizing level of output
market. A monopoly arises when a single firm is below the level that maximizes the sum of con-
owns a key resource, when the government gives sumer and producer surplus. That is, when the
a firm the exclusive right to produce a good, or monopoly charges a price above marginal cost,
when a single firm can supply the entire market some consumers who value the good more than
at a smaller cost than many firms could. its cost of production do not buy it. As a result,
monopoly causes deadweight losses similar to
• Because a monopoly is the sole producer in its the deadweight losses caused by taxes.
market, it faces a downward-sloping demand
curve for its product. When a monopoly increases • A monopolist often can raise its profits by charg-
production by 1 unit, it causes the price of its ing different prices for the same good based on
good to fall, which reduces the amount of rev- a buyer’s willingness to pay. This practice of
enue earned on all units produced. As a result, price discrimination can raise economic welfare
a monopoly’s marginal revenue is always below by getting the good to some consumers who oth-
the price of its good. erwise would not buy it. In the extreme case of
perfect price discrimination, the deadweight loss
• Like a competitive firm, a monopoly firm maxi- of monopoly is completely eliminated, and all
mizes profit by producing the quantity at which
the surplus in the market goes to the monopoly
marginal revenue equals marginal cost. The
producer. More generally, when price discrimi-
monopoly then chooses the price at which that
nation is imperfect, it can either raise or lower
quantity is demanded. Unlike a competitive firm,
welfare compared to the outcome with a single
a monopoly firm’s price exceeds its marginal rev-
monopoly price.
enue, so its price exceeds marginal cost.
• Policymakers can respond to the inefficiency of monopolist into a government-run enterprise. Or

monopoly behavior in four ways. They can use if the market failure is deemed small compared
the antitrust laws to try to make the industry to the inevitable imperfections of policies, they
more competitive. They can regulate the prices can do nothing at all.
that the monopoly charges. They can turn the
KEY CONCEPTS
monopoly, p. 312 natural monopoly, p. 314 price discrimination, p. 326
1. Give an example of a government-created surplus. Show the deadweight loss from the
monopoly. Is creating this monopoly necessarily monopoly. Explain your answer.
bad public policy? Explain. 6. Give two examples of price discrimination. In
2. Define natural monopoly. What does the size of a each case, explain why the monopolist chooses
market have to do with whether an industry is a to follow this business strategy.
natural monopoly? 7. What gives the government the power to
3. Why is a monopolist’s marginal revenue less regulate mergers between firms? From the
than the price of its good? Can marginal rev- standpoint of the welfare of society, give a good
enue ever be negative? Explain. reason and a bad reason that two firms might
4. Draw the demand, marginal-revenue, average- want to merge.
total-cost, and marginal-cost curves for a 8. Describe the two problems that arise when regu-
monopolist. Show the profit-maximizing level lators tell a natural monopoly that it must set a
of output, the profit-maximizing price, and the price equal to marginal cost.
amount of profit.
5. In your diagram from the previous question,
show the level of output that maximizes total
1. A publisher faces the following demand 2. Suppose that a natural monopolist was required
schedule for the next novel of one of its popular by law to charge average total cost. On a dia-
authors: gram, label the price charged and the dead-
Price Quantity Demanded
weight loss to society relative to marginal-cost
pricing.
$100 0 novels
3. Suppose the Clean Springs Water Company has
90 100,000 a monopoly on bottled water sales in California.
80 200,000 If the price of tap water increases, what is the
70 300,000 change in Clean Springs’ profit-maximizing lev-
60 400,000 els of output, price, and profit? Explain in words
50 500,000 and with a graph.
40 600,000 4. A small town is served by many competing
30 700,000 supermarkets, which have constant marginal
20 800,000 cost.
10 900,000
a. Using a diagram of the market for grocer-
0 1,000,000
ies, show the consumer surplus, producer
The author is paid $2 million to write the book, surplus, and total surplus.
and the marginal cost of publishing the book is b. Now suppose that the independent super-
a constant $10 per book. markets combine into one chain. Using a new
a. Compute total revenue, total cost, and profit diagram, show the new consumer surplus,
at each quantity. What quantity would a producer surplus, and total surplus. Relative
profit-maximizing publisher choose? What to the competitive market, what is the trans-
price would it charge? fer from consumers to producers? What is the
b. Compute marginal revenue. (Recall that deadweight loss?
MR = ∆TR / ∆Q.) How does marginal rev- 5. Johnny Rockabilly has just finished recording
enue compare to the price? Explain. his latest CD. His record company’s marketing
c. Graph the marginal-revenue, marginal-cost, department determines that the demand for the
and demand curves. At what quantity do the CD is as follows:
marginal-revenue and marginal-cost curves Price Number of CDs
cross? What does this signify?
d. In your graph, shade in the deadweight loss. $24 10,000
Explain in words what this means. 22 20,000
e. If the author were paid $3 million instead of 20 30,000
$2 million to write the book, how would this 18 40,000
affect the publisher’s decision regarding the 16 50,000
price to charge? Explain. 14 60,000
f. Suppose the publisher was not profit- The company can produce the CD with no fixed
maximizing but was concerned with maxi- cost and a variable cost of $5 per CD.
mizing economic efficiency. What price
would it charge for the book? How much
profit would it make at this price?
a. Find total revenue for quantity equal to curve and its cost curves, show the price and
10,000, 20,000, and so on. What is the mar- quantity combinations favored by each of the
ginal revenue for each 10,000 increase in the three partners. Explain.
quantity sold? 8. For many years, AT&T was a regulated monop-
b. What quantity of CDs would maximize oly, providing both local and long-distance
profit? What would the price be? What telephone service.
would the profit be? a. Explain why long-distance phone service was
c. If you were Johnny’s agent, what recording originally a natural monopoly.
fee would you advise Johnny to demand b. Over the past two decades, many companies
from the record company? Why? have launched communication satellites, each
6. A company is considering building a bridge of which can transmit a limited number of
across a river. The bridge would cost $2 million calls. How did the growing role of satellites
to build and nothing to maintain. The following change the cost structure of long-distance
table shows the company’s anticipated demand phone service?
over the lifetime of the bridge: After a lengthy legal battle with the govern-
Number of Crossings,
ment, AT&T agreed to compete with other
Price per Crossing in Thousands companies in the long-distance market. It also
agreed to spin off its local phone service into the
$8 0 “Baby Bells,” which remain highly regulated.
7 100 c. Why might it be efficient to have competition
6 200 in long-distance phone service and regulated
5 300 monopolies in local phone service?
4 400 9. Consider the relationship between monopoly
3 500 pricing and price elasticity of demand:
2 600 a. Explain why a monopolist will never pro-
1 700 duce a quantity at which the demand curve
0 800
is inelastic. (Hint: If demand is inelastic and
a. If the company were to build the bridge, the firm raises its price, what happens to total
what would be its profit-maximizing price? revenue and total costs?)
Would that be the efficient level of output? b. Draw a diagram for a monopolist, precisely
Why or why not? labeling the portion of the demand curve that
b. If the company is interested in maximiz- is inelastic. (Hint: The answer is related to the
ing profit, should it build the bridge? What marginal-revenue curve.)
would be its profit or loss? c. On your diagram, show the quantity and
c. If the government were to build the bridge, price that maximizes total revenue.
what price should it charge? 10. If the government wanted to encourage a
d. Should the government build the bridge? monopoly to produce the socially efficient quan-
Explain. tity, should it use a per-unit tax or a per-unit
7. Larry, Curly, and Moe run the only saloon in subsidy? Explain how this tax or subsidy would
town. Larry wants to sell as many drinks as achieve the socially efficient level of output.
possible without losing money. Curly wants the Among the various interested parties—the
saloon to bring in as much revenue as possible. monopoly firm, the monopoly’s consumers, and
Moe wants to make the largest possible profits. other taxpayers—who would support the policy
Using a single diagram of the saloon’s demand and who would oppose it?
11. You live in a town with 300 adults and 200 chil- a. Find the price and quantity that maximizes
dren, and you are thinking about putting on a the company’s profit.
play to entertain your neighbors and make some b. Find the price and quantity that would maxi-
money. A play has a fixed cost of $2,000, but mize social welfare.
selling an extra ticket has zero marginal cost. c. Calculate the deadweight loss from
Here are the demand schedules for your two monopoly.
types of customer: d. Suppose, in addition to the costs above, the
Price Adults Children
musician on the album has to be paid. The
company is considering four options:
$10 0 0
i. A flat fee of 2,000 cents
9 100 0 ii. 50 percent of the profits
8 200 0 iii. 150 cents per unit sold
7 300 0 iv. 50 percent of the revenue
6 300 0 For each option, calculate the profit-
5 300 100 maximizing price and quantity. Which,
4 300 200 if any, of these compensation schemes
3 300 200 would alter the deadweight loss from
2 300 200 monopoly? Explain.
1 300 200
13. Many schemes for price discriminating involve
0 300 200
some cost. For example, discount coupons take
a. To maximize profit, what price would you up the time and resources of both the buyer and
charge for an adult ticket? For a child’s the seller. This question considers the implica-
ticket? How much profit do you make? tions of costly price discrimination. To keep
b. The city council passes a law prohibiting you things simple, let’s assume that our monopo-
from charging different prices to different list’s production costs are simply proportional
customers. What price do you set for a ticket to output so that average total cost and marginal
now? How much profit do you make? cost are constant and equal to each other.
c. Who is worse off because of the law prohibit- a. Draw the cost, demand, and marginal-
ing price discrimination? Who is better off? revenue curves for the monopolist. Show
(If you can, quantify the changes in welfare.) the price the monopolist would charge
d. If the fixed cost of the play were $2,500 rather without price discrimination.
than $2,000, how would your answers to b. In your diagram, mark the area equal to the
parts (a), (b), and (c) change? monopolist’s profit and call it X. Mark the
12. Based on market research, a recording company area equal to consumer surplus and call it Y.
obtains the following information about the Mark the area equal to the deadweight loss
demand and production costs of its new CD: and call it Z.
c. Now suppose that the monopolist can per-
Price = 1,000 – 10Q fectly price discriminate. What is the monop-
Total Revenue = 1,000Q – 10Q2 olist’s profit? (Give your answer in terms of
Marginal Revenue = 1,000 – 20Q X, Y, and Z.)
Marginal Cost = 100 + 10Q d. What is the change in the monopolist’s
profit from price discrimination? What is the
where Q indicates the number of copies sold change in total surplus from price discrimi-
and P is the price in cents. nation? Which change is larger? Explain.
(Give your answer in terms of X, Y, and Z.)
e. Now suppose that there is some cost of price monopolist should price discriminate? (Give
discrimination. To model this cost, let’s your answer in terms of X, Y, Z, and C.)
assume that the monopolist has to pay a fixed g. Compare your answers to parts (e) and (f).
cost C to price discriminate. How would a How does the monopolist’s incentive to price
monopolist make the decision whether to pay discriminate differ from the social planner’s?
this fixed cost? (Give your answer in terms of Is it possible that the monopolist will price
X, Y, Z, and C.) discriminate even though it is not socially
f. How would a benevolent social planner, who desirable?
cares about total surplus, decide whether the
16
CHAPTER
Monopolistic Competition
Y ou walk into a bookstore to buy a book to read during your next vacation.
On the store’s shelves you find a Sue Grafton mystery, a Stephen King
thriller, a Danielle Steel romance, a David McCullough history, and many
other choices. When you pick out a book and buy it, what kind of market are you
participating in?
On the one hand, the market for books seems competitive. As you look over
the shelves at your bookstore, you find many authors and many publishers vying
for your attention. A buyer in this market has thousands of competing products
from which to choose. And because anyone can enter the industry by writing and
publishing a book, the book business is not very profitable. For every highly paid
novelist, there are hundreds of struggling ones.
On the other hand, the market for books seems monopolistic. Because each
book is unique, publishers have some latitude in choosing what price to charge.
The sellers in this market are price makers rather than price takers. And indeed,
the price of books greatly exceeds marginal cost. The price of a typical hardcover
novel, for instance, is about $25, whereas the cost of printing one additional copy
of the novel is less than $5.
The market for novels fits neither the competitive nor the monopoly model.
Instead, it is best described by the model of monopolistic competition, the subject
of this chapter. The term “monopolistic competition” might at first seem to be an
oxymoron, like “jumbo shrimp.” But as we will see, monopolistically competitive
345
industries are monopolistic in some ways and competitive in others. The model
describes not only the publishing industry but also the market for many other
goods and services.
BETWEEN MONOPOLY AND PERFECT COMPETITION

The previous two chapters analyzed markets with many competitive firms and
markets with a single monopoly firm. In Chapter 14, we saw that the price in a
perfectly competitive market always equals the marginal cost of production. We
also saw that, in the long run, entry and exit drive economic profit to zero, so the
price also equals average total cost. In Chapter 15, we saw how monopoly firms
can use their market power to keep prices above marginal cost, leading to a posi-
tive economic profit for the firm and a deadweight loss for society. Competition
and monopoly are extreme forms of market structure. Competition occurs when
there are many firms in a market offering essentially identical products; monop-
oly occurs when there is only one firm in a market.
Although the cases of perfect competition and monopoly illustrate some impor-
tant ideas about how markets work, most markets in the economy include ele-
ments of both these cases and, therefore, are not completely described by either of
them. The typical firm in the economy faces competition, but the competition is
not so rigorous as to make the firm a price taker like the firms analyzed in Chapter
14. The typical firm also has some degree of market power, but its market power
is not so great that the firm can be described exactly by the monopoly model pre-
sented in Chapter 15. In other words, many industries fall somewhere between
the polar cases of perfect competition and monopoly. Economists call this situa-
tion imperfect competition.
oligopoly One type of imperfectly competitive market is an oligopoly, which is a mar-
a market structure in ket with only a few sellers, each offering a product that is similar or identical to
which only a few sellers the products offered by other sellers. Economists measure a market’s domination
offer similar or identical by a small number of firms with a statistic called the concentration ratio, which is
products the percentage of total output in the market supplied by the four largest firms.
In the U.S. economy, most industries have a four-firm concentration ratio under
50 percent, but in some industries, the biggest firms play a more dominant role.
Highly concentrated industries include breakfast cereal (which has a concentra-
tion ratio of 83 percent), aircraft manufacturing (85 percent), electric lamp bulbs
(89 percent), household laundry equipment (90 percent), and cigarettes (99 per-
cent). These industries are best described as oligopolies.
monopolistic A second type of imperfectly competitive market is called monopolistic
competition competition. This describes a market structure in which there are many firms
a market structure in selling products that are similar but not identical. In a monopolistically competi-
which many firms sell tive market, each firm has a monopoly over the product it makes, but many other
products that are similar firms make similar products that compete for the same customers.
but not identical
To be more precise, monopolistic competition describes a market with the fol-
lowing attributes:
• Many sellers: There are many firms competing for the same group of
customers.
• Product differentiation: Each firm produces a product that is at least slightly
different from those of other firms. Thus, rather than being a price taker,
each firm faces a downward-sloping demand curve.
CHAPTER 16 MONOPOLISTIC COMPETITION 347
• Free entry and exit: Firms can enter or exit the market without restriction.
Thus, the number of firms in the market adjusts until economic profits are
driven to zero.
A moment’s thought reveals a long list of markets with these attributes: books,
music CDs, movies, computer games, restaurants, piano lessons, cookies, furni-
ture, and so on.
Monopolistic competition, like oligopoly, is a market structure that lies between
the extreme cases of competition and monopoly. But oligopoly and monopolistic
competition are quite different. Oligopoly departs from the perfectly competitive
ideal of Chapter 14 because there are only a few sellers in the market. The small
number of sellers makes rigorous competition less likely and strategic interactions
among them vitally important. By contrast, under monopolistic competition, there
are many sellers, each of which is small compared to the market. A monopolis-
tically competitive market departs from the perfectly competitive ideal because
each of the sellers offers a somewhat different product.
Figure 1 summarizes the four types of market structure. The first question to
ask about any market is how many firms there are. If there is only one firm, the
market is a monopoly. If there are only a few firms, the market is an oligopoly. If
there are many firms, we need to ask another question: Do the firms sell identi-
cal or differentiated products? If the many firms sell differentiated products, the
market is monopolistically competitive. If the many firms sell identical products,
the market is perfectly competitive.
Because reality is never as clear-cut as theory, at times you may find it hard
to decide what structure best describes a market. There is, for instance, no magic
number that separates “few” from “many” when counting the number of firms.
(Do the approximately dozen companies that now sell cars in the United States
make this market an oligopoly or more competitive? The answer is open to debate.)
Number of Firms?
F I G U R E 1
Many The Four Types of
firms Market Structure
Economists who study industrial
Type of Products? organization divide markets into
four types—monopoly, oligopoly,
monopolistic competition, and
One Few Differentiated Identical perfect competition.
firm firms products products
Monopolistic Perfect
Monopoly Oligopoly Competition Competition
(Chapter 15) (Chapter 17) (Chapter 16) (Chapter 14)
• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Cigarettes • Movies • Milk
Similarly, there is no sure way to determine when products are differentiated and
when they are identical. (Are different brands of milk really the same? Again, the
answer is debatable.) When analyzing actual markets, economists have to keep
in mind the lessons learned from studying all types of market structure and then
apply each lesson as it seems appropriate.
Now that we understand how economists define the various types of market
structure, we can continue our analysis of them. In the next chapter we analyze
oligopoly. In this chapter we examine monopolistic competition.
QUICK QUIZ Define oligopoly and monopolistic competition and give an example
of each.
COMPETITION WITH DIFFERENTIATED PRODUCTS

To understand monopolistically competitive markets, we first consider the deci-
sions facing an individual firm. We then examine what happens in the long run as
firms enter and exit the industry. Next, we compare the equilibrium under monop-
olistic competition to the equilibrium under perfect competition that we examined
in Chapter 14. Finally, we consider whether the outcome in a monopolistically
competitive market is desirable from the standpoint of society as a whole.
THE MONOPOLISTICALLY COMPETITIVE FIRM

IN THE SHORT RUN
Each firm in a monopolistically competitive market is, in many ways, like a monop-
oly. Because its product is different from those offered by other firms, it faces a
downward-sloping demand curve. (By contrast, a perfectly competitive firm faces
a horizontal demand curve at the market price.) Thus, the monopolistically com-
petitive firm follows a monopolist’s rule for profit maximization: It chooses to
produce the quantity at which marginal revenue equals marginal cost and then
uses its demand curve to find the price at which it can sell that quantity.
Figure 2 shows the cost, demand, and marginal-revenue curves for two typical
firms, each in a different monopolistically competitive industry. In both panels
of this figure, the profit-maximizing quantity is found at the intersection of the
marginal-revenue and marginal-cost curves. The two panels in this figure show
different outcomes for the firm’s profit. In panel (a), price exceeds average total
cost, so the firm makes a profit. In panel (b), price is below average total cost. In
this case, the firm is unable to make a positive profit, so the best the firm can do is
to minimize its losses.
All this should seem familiar. A monopolistically competitive firm chooses its
quantity and price just as a monopoly does. In the short run, these two types of
market structure are similar.
THE L ONG-RUN EQUILIBRIUM

The situations depicted in Figure 2 do not last long. When firms are making
profits, as in panel (a), new firms have an incentive to enter the market. This
entry increases the number of products from which customers can choose and,
Monopolistic competitors, like monopolists, maximize profit by producing the quan-

tity at which marginal revenue equals marginal cost. The firm in panel (a) makes a
F I G U R E 2
profit because, at this quantity, price is above average total cost. The firm in panel
(b) makes losses because, at this quantity, price is less than average total cost.
Monopolistic
Competitors in
the Short Run
(a) Firm Makes Profit (b) Firm Makes Losses
Price Price
MC MC
ATC
ATC Losses
Average
total cost
Price
Price
Average
total cost
Demand
Profit
MR
MR Demand
0 Profit- Quantity 0 Loss- Quantity

maximizing minimizing
quantity quantity
therefore, reduces the demand faced by each firm already in the market. In other
words, profit encourages entry, and entry shifts the demand curves faced by the
incumbent firms to the left. As the demand for incumbent firms’ products falls,
these firms experience declining profit.
Conversely, when firms are making losses, as in panel (b), firms in the mar-
ket have an incentive to exit. As firms exit, customers have fewer products from
which to choose. This decrease in the number of firms expands the demand faced
by those firms that stay in the market. In other words, losses encourage exit, and
exit shifts the demand curves of the remaining firms to the right. As the demand
for the remaining firms’ products rises, these firms experience rising profit (that
is, declining losses).
This process of entry and exit continues until the firms in the market are mak-
ing exactly zero economic profit. Figure 3 depicts the long-run equilibrium. Once
the market reaches this equilibrium, new firms have no incentive to enter, and
existing firms have no incentive to exit.
Notice that the demand curve in this figure just barely touches the average-
total-cost curve. Mathematically, we say the two curves are tangent to each other.
These two curves must be tangent once entry and exit have driven profit to zero.
Because profit per unit sold is the difference between price (found on the demand
curve) and average total cost, the maximum profit is zero only if these two curves
touch each other without crossing. Also note that this point of tangency occurs at
the same quantity where marginal revenue equals marginal cost. That these two
points line up is not a coincidence: It is required because this particular quantity
maximizes profit and the maximum profit is exactly zero in the long run.
To sum up, two characteristics describe the long-run equilibrium in a monopo-
listically competitive market:
3 F I G U R E
Price
MC
A Monopolistic Competitor
ATC
in the Long Run
In a monopolistically competitive
market, if firms are making profit, new
firms enter, and the demand curves for
the incumbent firms shift to the left.
Similarly, if firms are making losses, old P = ATC
firms exit, and the demand curves of
the remaining firms shift to the right.
Because of these shifts in demand,
a monopolistically competitive firm
eventually finds itself in the long-run Demand
equilibrium shown here. In this long-run MR
equilibrium, price equals average total 0
cost, and the firm earns zero profit. Profit-maximizing Quantity
quantity
• As in a monopoly market, price exceeds marginal cost. This conclusion arises

because profit maximization requires marginal revenue to equal marginal
cost and because the downward-sloping demand curve makes marginal
revenue less than the price.
• As in a competitive market, price equals average total cost. This conclusion
arises because free entry and exit drive economic profit to zero.
The second characteristic shows how monopolistic competition differs from
monopoly. Because a monopoly is the sole seller of a product without close sub-
stitutes, it can earn positive economic profit, even in the long run. By contrast,
because there is free entry into a monopolistically competitive market, the eco-
nomic profit of a firm in this type of market is driven to zero.
MONOPOLISTIC VERSUS PERFECT COMPETITION

Figure 4 compares the long-run equilibrium under monopolistic competition to
the long-run equilibrium under perfect competition. (Chapter 14 discussed the
equilibrium with perfect competition.) There are two noteworthy differences
between monopolistic and perfect competition: excess capacity and the markup.
Panel (a) shows the long-run equilibrium in a monopolistically competitive market,

and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two
F I G U R E 4
differences are notable. (1) The perfectly competitive firm produces at the efficient
scale, where average total cost is minimized. By contrast, the monopolistically
Monopolistic versus
competitive firm produces at less than the efficient scale. (2) Price equals marginal
Perfect Competition
cost under perfect competition, but price is above marginal cost under monopolistic
competition.
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm
Price Price
MC MC
ATC ATC
Markup
P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand
0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale
Excess capacity
Excess Capacity As we have just seen, entry and exit drive each firm in a
monopolistically competitive market to a point of tangency between its demand
and average-total-cost curves. Panel (a) of Figure 4 shows that the quantity of
output at this point is smaller than the quantity that minimizes average total cost.
Thus, under monopolistic competition, firms produce on the downward-sloping
portion of their average-total-cost curves. In this way, monopolistic competition
contrasts starkly with perfect competition. As panel (b) of Figure 4 shows, free
entry in competitive markets drives firms to produce at the minimum of average
total cost.
The quantity that minimizes average total cost is called the efficient scale of the
firm. In the long run, perfectly competitive firms produce at the efficient scale,
whereas monopolistically competitive firms produce below this level. Firms
are said to have excess capacity under monopolistic competition. In other words,
a monopolistically competitive firm, unlike a perfectly competitive firm, could
increase the quantity it produces and lower the average total cost of production.
The firm forgoes this opportunity because it would need to cut its price to sell the
additional output. It is more profitable for a monopolistic competitor to continue
operating with excess capacity.
Markup over Marginal Cost A second difference between perfect competition

and monopolistic competition is the relationship between price and marginal cost.
For a competitive firm, such as that shown in panel (b) of Figure 4, price equals
marginal cost. For a monopolistically competitive firm, such as that shown in panel
(a), price exceeds marginal cost because the firm always has some market power.
How is this markup over marginal cost consistent with free entry and zero
profit? The zero-profit condition ensures only that price equals average total cost.
It does not ensure that price equals marginal cost. Indeed, in the long-run equilib-
rium, monopolistically competitive firms operate on the declining portion of their
average-total-cost curves, so marginal cost is below average total cost. Thus, for
price to equal average total cost, price must be above marginal cost.
In this relationship between price and marginal cost, we see a key behavioral
difference between perfect competitors and monopolistic competitors. Imag-
ine that you were to ask a firm the following question: “Would you like to see
another customer come through your door ready to buy from you at your current
price?” A perfectly competitive firm would answer that it didn’t care. Because
price exactly equals marginal cost, the profit from an extra unit sold is zero. By
contrast, a monopolistically competitive firm is always eager to get another cus-
tomer. Because its price exceeds marginal cost, an extra unit sold at the posted
price means more profit.
According to an old quip, monopolistically competitive markets are those in
which sellers send Christmas cards to the buyers. Trying to attract more custom-
ers makes sense only if price exceeds marginal cost.
MONOPOLISTIC COMPETITION AND

THE WELFARE OF SOCIETY
Is the outcome in a monopolistically competitive market desirable from the stand-
point of society as a whole? Can policymakers improve on the market outcome? In
previous chapters we evaluated markets from the standpoint of efficiency—that

is, whether society is getting the most it can out of its scarce resources. We learned
that competitive markets lead to efficient outcomes, unless there are externalities,
and that monopoly markets lead to deadweight losses. Monopolistically competi-
tive markets are more complex than either of these polar cases, so evaluating wel-
fare in these markets is a more subtle exercise.
One source of inefficiency is the markup of price over marginal cost. Because
of the markup, some consumers who value the good at more than the marginal
cost of production (but less than the price) will be deterred from buying it. Thus,
a monopolistically competitive market has the normal deadweight loss of monop-
oly pricing.
Although this outcome is undesirable compared to the first-best outcome of
price equal to marginal cost, there is no easy way for policymakers to fix the prob-
lem. To enforce marginal-cost pricing, policymakers would need to regulate all
firms that produce differentiated products. Because such products are so com-
mon in the economy, the administrative burden of such regulation would be
overwhelming.
Moreover, regulating monopolistic competitors would entail all the problems
of regulating natural monopolies. In particular, because monopolistic competi-
tors are making zero profits already, requiring them to lower their prices to equal
marginal cost would cause them to make losses. To keep these firms in business,
the government would need to help them cover these losses. Rather than raise
taxes to pay for these subsidies, policymakers may decide it is better to live with
the inefficiency of monopolistic pricing.
Another way in which monopolistic competition may be socially inefficient is
that the number of firms in the market may not be “ideal.” That is, there may be
too much or too little entry. One way to think about this problem is in terms of
the externalities associated with entry. Whenever a new firm considers entering
the market with a new product, it considers only the profit it would make. Yet its
entry would also have two effects that are external to the firm:
• The product-variety externality: Because consumers get some consumer sur-
plus from the introduction of a new product, entry of a new firm conveys
a positive externality on consumers.
• The business-stealing externality: Because other firms lose customers and
profits from the entry of a new competitor, entry of a new firm imposes
a negative externality on existing firms.
Thus, in a monopolistically competitive market, there are positive and negative
externalities associated with the entry of new firms. Depending on which exter-
nality is larger, a monopolistically competitive market could have either too few
or too many products.
Both of these externalities are closely related to the conditions for monopolis-
tic competition. The product-variety externality arises because a new firm would
offer a product different from those of the existing firms. The business-stealing
externality arises because firms post a price above marginal cost and, therefore,
are always eager to sell additional units. Conversely, because perfectly competi-
tive firms produce identical goods and charge a price equal to marginal cost, nei-
ther of these externalities exists under perfect competition.
Insufficient Variety as a Market Failure

University of Pennsylvania economist Joel Waldfogel argues that, in
the presence of large fixed costs, the market may insufficiently service
customers with unusual preferences.
If the Shoe Doesn’t Fit ently. As Milton Friedman eloquently put it

By Joel Waldfogel in 1962, “the characteristic feature of action
through political channels is that it tends to
Last week, Nike unveiled a shoe designed require or enforce substantial conformity.
specifically for American Indians. The The great advantage of the market is that it
sneaker has both a native-theme design permits wide diversity. Each man can vote,
and—more importantly—a wider shape to as it were, for the color of tie he wants and
accommodate the distinctly shaped feet of get it; he does not have to see what color
American Indians. With diabetes and related the majority wants and then, if he is in the
conditions near epidemic levels in some minority, submit.” This is a wonderful argu-
tribes, American Indian leaders were happy ment. Except that for many products and for
to welcome this comfortable product. If many people, it’s wrong.
anything, what seems odd is that it took so Two simple conditions that prevail in
long. After all, free-market economists have many markets mean that individual taste
told us for decades that we should rely on the Market: Why You Can’t Always Get What alone doesn’t determine individual satisfac-
market decisions, not the government, to You Want. tion. These conditions are (1) big setup costs
meet our needs, because it’s the market that John Stuart Mill pointed out that vot- and (2) preferences that differ across groups;
satisfies everyone’s every desire. ing gives rise to a tyranny of the majority. If when they’re present, an individual’s satisfac-
And yet it turns out that it’s the Indians’ we vote on what color shirts to make—or tion is a function of how many people share
long wait for a good sneaker that’s typical. whether to make wide or narrow shoes— his or her tastes. In other words, in these
PHOTO: © AP IMAGES
For small groups with preferences outside then the majority gets what it prefers, and cases, markets share some of the objection-
the norm, the market often fails to deliver, the minority does not. The market, on the able features of government. They give big-
as I argue in my new book, The Tyranny of other hand, is supposed to work differ- ger groups more and better options.
In the end, we can conclude only that monopolistically competitive markets

do not have all the desirable welfare properties of perfectly competitive markets.
That is, the invisible hand does not ensure that total surplus is maximized under
monopolistic competition. Yet because the inefficiencies are subtle, hard to mea-
sure, and hard to fix, there is no easy way for public policy to improve the market
outcome.
Q Q
UICK UIZ List the three key attributes of monopolistic competition. • Draw and
explain a diagram to show the long-run equilibrium in a monopolistically competitive
market. How does this equilibrium differ from that in a perfectly competitive market?
In my research, I’ve discovered that this economist—showed why this was hap- lation, and with feet on average three sizes
phenomenon is widespread. Ten years ago, pening. Blacks and whites don’t listen to wider, they need different-sized shoes. If
I started studying radio-station listening the same radio stations. The black-targeted we had all voted in a national election on
patterns. I noticed that people listened to formats account for about two-thirds of whether the Ministry of Shoes should make
the radio more in metro areas of the United black listening and only 3 percent of white wide or typical-width shoes, we surely would
States with relatively large populations. listening. Similarly, the formats that attract have chosen the latter. That’s why Friedman
This is not terribly surprising. In larger cities, the largest white audiences, like country, condemned government allocation. And yet
more stations can attract enough listeners attract almost no blacks. This means that if the market made the same choice. If Nike’s
and advertising revenue to cover their costs you dropped Larry the Cable Guy and a few announcement looks like a solution to this
and stay on the air. With more to choose thousand of his friends from a helicopter problem of ignored minority preference,
from on the dial, residents tune in more. (with parachutes) into a metro area, you’d it really isn’t. The company took too many
So, in this situation of high fixed costs (each create more demand for country and per- years to bring the shoe on line, and accord-
station needs a following to keep broad- haps album-rock stations, which would ing to the Associated Press, the new sneaker
casting), people help one another by mak- be nice for white listeners. But the influx “represents less of a financial opportunity
ing more options viable. wouldn’t help black listeners at all. than a goodwill and branding effort.”
But who benefits whom? When I looked In this example, different population The tyranny of the market arises else-
at black and white listeners separately, I groups don’t help each other, but they don’t where. With drug development costs near $1
noticed something surprising. Blacks listen hurt each other, either. Sometimes, though, billion, if you are going to be sick, hope that
more in cities with larger black populations, the effect that groups have on each other your disease is common enough to attract
and whites listen more in cities with larger through the market is actually negative. the interest of drug makers. If you want to fly
white populations. Black listening does Industries like daily newspapers offer essen- from your town to Chicago, hope that your
not increase where there’s a higher white tially one product per market. Because the city is big enough to fill a plane every day.
population, and white listening does not paper can be pitched to appeal to one group When you’re not so lucky, you ben-
increase with a higher black population. or another, the larger one group is, the less efit when the government steps in on your
Which means that while overall people help the product is tailored to anyone else. This is behalf, with subsidies for research on drugs
each other by increasing the number of sta- the tyranny of the majority translated almost for rare diseases or for air service to small
tions on the dial, blacks do not help whites, literally from politics into markets. locales. For a generation, influential econo-
and whites do not help blacks. Similar pat- This brings us back to Nike’s new shoe. mists have argued for letting the market
terns arise for Hispanics and non-Hispanics. Foot Locker is full of options that fit me and decide a wide array of questions, to protect
A closer look at the data—necessary most other Americans. But American Indians your freedom to choose whatever you want.
only because I’m a middle-aged white make up just 1.5 percent of the U.S. popu- This is true—if everyone agrees with you.
Source: Slate, Thursday, October 4, 2007.
ADVERTISING
It is nearly impossible to go through a typical day in a modern economy without
being bombarded with advertising. Whether you are reading a newspaper, watch-
ing television, or driving down the highway, some firm will try to convince you
to buy its product. Such behavior is a natural feature of monopolistic competition
(as well as some oligopolistic industries). When firms sell differentiated products
and charge prices above marginal cost, each firm has an incentive to advertise to
attract more buyers to its particular product.
The amount of advertising varies substantially across products. Firms that sell
highly differentiated consumer goods, such as over-the-counter drugs, perfumes,
soft drinks, razor blades, breakfast cereals, and dog food, typically spend between
10 and 20 percent of revenue for advertising. Firms that sell industrial products,
such as drill presses and communications satellites, typically spend very little on
advertising. And firms that sell homogeneous products, such as wheat, peanuts,
or crude oil, spend nothing at all.
For the economy as a whole, about 2 percent of total firm revenue is spent on
advertising. This spending takes many forms, including commercials on televi-
sion and radio, space in newspapers and magazines, direct mail, the yellow pages,
billboards, and the Internet.
THE DEBATE OVER A DVERTISING

Is society wasting the resources it devotes to advertising? Or does advertising
serve a valuable purpose? Assessing the social value of advertising is difficult and
often generates heated argument among economists. Let’s consider both sides of
the debate.
The Critique of Advertising Critics of advertising argue that firms advertise to

manipulate people’s tastes. Much advertising is psychological rather than infor-
mational. Consider, for example, the typical television commercial for some brand
of soft drink. The commercial most likely does not tell the viewer about the prod-
uct’s price or quality. Instead, it might show a group of happy people at a party
on a beach on a beautiful sunny day. In their hands are cans of the soft drink. The
goal of the commercial is to convey a subconscious (if not subtle) message: “You
too can have many friends and be happy, if only you drink our product.” Critics
of advertising argue that such a commercial creates a desire that otherwise might
not exist.
Critics also argue that advertising impedes competition. Advertising often tries
to convince consumers that products are more different than they truly are. By
increasing the perception of product differentiation and fostering brand loyalty,
advertising makes buyers less concerned with price differences among similar
goods. With a less elastic demand curve, each firm charges a larger markup over
marginal cost.
The Defense of Advertising Defenders of advertising argue that firms use

advertising to provide information to customers. Advertising conveys the prices
of the goods offered for sale, the existence of new products, and the locations of
retail outlets. This information allows customers to make better choices about what
to buy and, thus, enhances the ability of markets to allocate resources efficiently.
Defenders also argue that advertising fosters competition. Because advertis-
ing allows customers to be more fully informed about all the firms in the market,
customers can more easily take advantage of price differences. Thus, each firm has
less market power. In addition, advertising allows new firms to enter more easily
because it gives entrants a means to attract customers from existing firms.
Over time, policymakers have come to accept the view that advertising can
make markets more competitive. One important example is the regulation of
advertising for certain professions, such as lawyers, doctors, and pharmacists. In
the past, these groups succeeded in getting state governments to prohibit advertis-
ing in their fields on the grounds that advertising was “unprofessional.” In recent
years, however, the courts have concluded that the primary effect of these restric-
tions on advertising was to curtail competition. They have, therefore, overturned
many of the laws that prohibit advertising by members of these professions.
ADVERTISING AND THE PRICE OF EYEGLASSES
What effect does advertising have on the price of a good? On the one hand,
advertising might make consumers view products as being more different than
they otherwise would. If so, it would make markets less competitive and firms’
demand curves less elastic, and this would lead firms to charge higher prices. On
the other hand, advertising might make it easier for consumers to find the firms
offering the best prices. In this case, it would make markets more competitive and
firms’ demand curves more elastic, which would lead to lower prices.
In an article published in the Journal of Law and Economics in 1972, economist
Lee Benham tested these two views of advertising. In the United States during the
1960s, the various state governments had vastly different rules about advertising
by optometrists. Some states allowed advertising for eyeglasses and eye examina-
tions. Many states, however, prohibited it. For example, the Florida law read as
follows:
It is unlawful for any person, firm, or corporation to . . . advertise either directly
or indirectly by any means whatsoever any definite or indefinite price or credit
terms on prescriptive or corrective lens, frames, complete prescriptive or cor-
rective glasses, or any optometric service. . . . This section is passed in the inter-
est of public health, safety, and welfare, and its provisions shall be liberally
construed to carry out its objects and purposes.
Professional optometrists enthusiastically endorsed these restrictions on
advertising.
Benham used the differences in state law as a natural experiment to test the
two views of advertising. The results were striking. In those states that prohibited
advertising, the average price paid for a pair of eyeglasses was $33. (This number
is not as low as it seems, for this price is from 1963, when all prices were much
lower than they are today. To convert 1963 prices into today’s dollars, you can
multiply them by about 7.) In states that did not restrict advertising, the average
price was $26. Thus, advertising reduced average prices by more than 20 percent.
In the market for eyeglasses, and probably in many other markets as well, adver-
tising fosters competition and leads to lower prices for consumers. ●
A DVERTISING AS A SIGNAL OF QUALITY

Many types of advertising contain little apparent information about the product
being advertised. Consider a firm introducing a new breakfast cereal. A typical
advertisement might have some highly paid actor eating the cereal and exclaim-
ing how wonderful it tastes. How much information does the advertisement really
provide?
The answer is more than you might think. Defenders of advertising argue that
even advertising that appears to contain little hard information may in fact tell
consumers something about product quality. The willingness of the firm to spend
a large amount of money on advertising can itself be a signal to consumers about
the quality of the product being offered.
Galbraith versus Hayek
Two great well-known critique of Galbraith in 1961, addressing

economists of the 20th century were John Kenneth specifically Galbraith’s view of advertising. Hayek
Galbraith and Frederic Hayek. They held very differ- observed that advertising was merely one example
PHOTOS: BOTTOM: © WIRGININGS/DPA/LANDOV. TOP: © STEVE HANSEN/TIME & LIFE PICTURES/GETTY IMAGES
ent views about advertising, which reflected their of a larger phenomenon: Our social environment
views about the capitalist system more broadly. creates many of our preferences. Literature, art, and
John Kenneth Galbraith’s most famous book music are all acquired tastes. A person’s demand
was The Affluent Society, published in 1958. In it, for hearing a Mozart concerto may have been cre-
he argued that corporations use advertising to created in a music appreciation class, but this fact does
ate demand for products that people otherwise do not make the desire less legitimate or the music
not want or need. The market system should not professor a sinister influence. Hayek concluded, “It
be applauded, he believed, for satisfying desires is because each individual producer thinks that the
that it has itself created. Galbraith was skeptical consumers can be persuaded to like his products
that economic growth was leading to higher levels John Kenneth Galbraith that he endeavors to influence them. But though
of well-being, because people’s aspirations were this effort is part of the influences which shape
being made to keep pace with their increased consumers’ taste, no producer can in any real sense
material prosperity. He worried that as advertising ‘determine’ them.”
and salesmanship artificially enhanced the desire These two economists disagreed about the
for private goods, public spending on such items as roles of advertising, markets, and government, but
better schools and better parks suffered. The result, they did have one thing in common: great acclaim.
according to Galbraith, was “private opulence and In 1974, Hayek won the Nobel Prize in economics.
public squalor.” Galbraith’s policy recommendation In 2000, President Clinton awarded Galbraith the
was clear: Increase the size of government. National Medal of Freedom. And even though their
Frederic Hayek’s most famous book was The books are now many decades old, they are still well
Road to Serfdom, published in 1944. It argued that worth reading. The issues that Hayek and Galbraith
an expansive government inevitably means a sac- addressed are timeless, and their insights apply as
rifice of personal freedoms. Hayek also wrote a Frederic Hayek well to our economy as to their own.
Consider the problem facing two firms—Post and Kellogg. Each company has
just come up with a recipe for a new cereal, which it would sell for $3 a box. To
keep things simple, let’s assume that the marginal cost of making cereal is zero, so
the $3 is all profit. Each company knows that if it spends $10 million on advertis-
ing, it will get 1 million consumers to try its new cereal. And each company knows
that if consumers like the cereal, they will buy it not once but many times.
First consider Post’s decision. Based on market research, Post knows that
its cereal is only mediocre. Although advertising would sell one box to each of
1 million consumers, the consumers would quickly learn that the cereal is not
very good and stop buying it. Post decides it is not worth paying $10 million in
advertising to get only $3 million in sales. So it does not bother to advertise. It

sends its cooks back to the test kitchen to find another recipe.
Kellogg, on the other hand, knows that its cereal is great. Each person who tries
it will buy a box a month for the next year. Thus, the $10 million in advertising
will bring in $36 million in sales. Advertising is profitable here because Kellogg
has a good product that consumers will buy repeatedly. Thus, Kellogg chooses to
advertise.
Now that we have considered the behavior of the two firms, let’s consider the
behavior of consumers. We began by asserting that consumers are inclined to try
a new cereal that they see advertised. But is this behavior rational? Should a con-
sumer try a new cereal just because the seller has chosen to advertise it?
In fact, it may be completely rational for consumers to try new products that
they see advertised. In our story, consumers decide to try Kellogg’s new cereal
because Kellogg advertises. Kellogg chooses to advertise because it knows that its
cereal is quite good, while Post chooses not to advertise because it knows that its
cereal is mediocre. By its willingness to spend money on advertising, Kellogg sig-
nals to consumers the quality of its cereal. Each consumer thinks, quite sensibly,
“Boy, if the Kellogg Company is willing to spend so much money advertising this
new cereal, it must be really good.”
What is most surprising about this theory of advertising is that the content of
the advertisement is irrelevant. Kellogg signals the quality of its product by its
willingness to spend money on advertising. What the advertisements say is not as
important as the fact that consumers know ads are expensive. By contrast, cheap
advertising cannot be effective at signaling quality to consumers. In our example,
if an advertising campaign cost less than $3 million, both Post and Kellogg would
use it to market their new cereals. Because both good and mediocre cereals would
be advertised, consumers could not infer the quality of a new cereal from the
fact that it is advertised. Over time, consumers would learn to ignore such cheap
advertising.
This theory can explain why firms pay famous actors large amounts of money
to make advertisements that, on the surface, appear to convey no information at
all. The information is not in the advertisement’s content but simply in its exis-
tence and expense.
BRAND NAMES
Advertising is closely related to the existence of brand names. In many markets,
there are two types of firms. Some firms sell products with widely recognized
brand names, while other firms sell generic substitutes. For example, in a typi-
cal drugstore, you can find Bayer aspirin on the shelf next to generic aspirin. In a
typical grocery store, you can find Pepsi next to less familiar colas. Most often, the
firm with the brand name spends more on advertising and charges a higher price
for its product.
Just as there is disagreement about the economics of advertising, there is dis-
agreement about the economics of brand names. Let’s consider both sides of the
debate.
Critics argue that brand names cause consumers to perceive differences that do
not really exist. In many cases, the generic good is almost indistinguishable from
the brand-name good. Consumers’ willingness to pay more for the brand-name

good, these critics assert, is a form of irrationality fostered by advertising. Econo-
mist Edward Chamberlin, one of the early developers of the theory of monopolis-
tic competition, concluded from this argument that brand names were bad for the
economy. He proposed that the government discourage their use by refusing to
enforce the exclusive trademarks that companies use to identify their products.
More recently, economists have defended brand names as a useful way for
consumers to ensure that the goods they buy are of high quality. There are two
related arguments. First, brand names provide consumers with information about
quality when quality cannot be easily judged in advance of purchase. Second,
brand names give firms an incentive to maintain high quality because firms have a
financial stake in maintaining the reputation of their brand names.
To see how these arguments work in practice, consider a famous brand name:
McDonald’s hamburgers. Imagine that you are driving through an unfamiliar
town and want to stop for lunch. You see a McDonald’s and a local restaurant
next to it. Which do you choose? The local restaurant may in fact offer better food
at lower prices, but you have no way of knowing that. By contrast, McDonald’s
offers a consistent product across many cities. Its brand name is useful to you as a
way of judging the quality of what you are about to buy.
The McDonald’s brand name also ensures that the company has an incen-
tive to maintain quality. For example, if some customers were to become ill from
bad food sold at a McDonald’s, the news would be disastrous for the company.
McDonald’s would lose much of the valuable reputation that it has built up with
years of expensive advertising. As a result, it would lose sales and profit not just
in the outlet that sold the bad food but in its many outlets throughout the country.
By contrast, if some customers were to become ill from bad food at a local restau-
rant, that restaurant might have to close down, but the lost profits would be much
smaller. Hence, McDonald’s has a greater incentive to ensure that its food is safe.
The debate over brand names thus centers on the question of whether consum-
ers are rational in preferring brand names to generic substitutes. Critics argue
that brand names are the result of an irrational consumer response to advertising.
Defenders argue that consumers have good reason to pay more for brand-name
products because they can be more confident in the quality of these products.
Q Q
UICK UIZ How might advertising make markets less competitive? How might it make
markets more competitive? • Give the arguments for and against brand names.
CONCLUSION
Monopolistic competition is true to its name: It is a hybrid of monopoly and
competition. Like a monopoly, each monopolistic competitor faces a downward-
sloping demand curve and, as a result, charges a price above marginal cost. As
in a perfectly competitive market, there are many firms, and entry and exit drive
the profit of each monopolistic competitor toward zero. Table 1 summarizes
these lessons.
Because monopolistically competitive firms produce differentiated products,
each firm advertises to attract customers to its own brand. To some extent, adver-
tising manipulates consumers’ tastes, promotes irrational brand loyalty, and
impedes competition. To a larger extent, advertising provides information, estab-
lishes brand names of reliable quality, and fosters competition.
The theory of monopolistic competition seems to describe many markets in the
economy. It is somewhat disappointing, therefore, that the theory does not yield
simple and compelling advice for public policy. From the standpoint of the eco-
nomic theorist, the allocation of resources in monopolistically competitive mar-
kets is not perfect. Yet from the standpoint of a practical policymaker, there may
be little that can be done to improve it.
T A B L E
1
Market Structure
Monopolistic
Perfect Monopolistic
Competition:
Competition Competition Monopoly
Between Perfect
Competition and
Features that all three market Monopoly
structures share
Goal of firms Maximize profits Maximize profits Maximize profits
Rule for maximizing MR = MC MR = MC MR = MC
in the short run? Yes Yes Yes
Features that monopolistic

competition shares with
monopoly
Price taker? Yes No No
Price P = MC P > MC P > MC
Produces welfare-maximizing
level of output? Yes No No
Features that monopolistic

competition shares with
competition
Number of firms Many Many One
Entry in long run? Yes Yes No
in long run? No No Yes
SUMMARY
• A monopolistically competitive market is charac- oly caused by the markup of price over marginal
terized by three attributes: many firms, differen- cost. In addition, the number of firms (and thus
tiated products, and free entry. the variety of products) can be too large or too
small. In practice, the ability of policymakers to
• The equilibrium in a monopolistically competi- correct these inefficiencies is limited.
tive market differs from that in a perfectly com-
petitive market in two related ways. First, each • The product differentiation inherent in monop-
firm in a monopolistically competitive market olistic competition leads to the use of advertis-
has excess capacity. That is, it operates on the ing and brand names. Critics of advertising and
downward-sloping portion of the average-total- brand names argue that firms use them to manip-
cost curve. Second, each firm charges a price ulate consumers’ tastes and to reduce competi-
above marginal cost. tion. Defenders of advertising and brand names
argue that firms use them to inform consumers
• Monopolistic competition does not have all the and to compete more vigorously on price and
desirable properties of perfect competition.
product quality.
There is the standard deadweight loss of monop-
KEY CONCEPTS
oligopoly, p. 346 monopolistic competition, p. 346
1. Describe the three attributes of monopolistic 4. Does a monopolistic competitor produce too
competition. How is monopolistic competi- much or too little output compared to the most
tion like monopoly? How is it like perfect efficient level? What practical considerations
competition? make it difficult for policymakers to solve this
2. Draw a diagram depicting a firm that is mak- problem?
ing a profit in a monopolistically competitive 5. How might advertising reduce economic well-
market. Now show what happens to this firm being? How might advertising increase eco-
as new firms enter the industry. nomic well-being?
3. Draw a diagram of the long-run equilibrium in 6. How might advertising with no apparent infor-
a monopolistically competitive market. How is mational content in fact convey information to
price related to average total cost? How is price consumers?
related to marginal cost? 7. Explain two benefits that might arise from the
existence of brand names.
1. Among monopoly, oligopoly, monopolistic bly be maximizing profit? If not, what should it
competition, and perfect competition, how do to increase profit? If the firm is profit maxi-
would you classify the markets for each of the mizing, is the firm in a long-run equilibrium?
following drinks? If not, what will happen to restore long-run
a. tap water equilibrium?
b. bottled water a. P < MC, P > ATC
c. cola b. P > MC, P < ATC
d. beer c. P = MC, P > ATC
2. Classify the following markets as perfectly d. P > MC, P = ATC
competitive, monopolistic, or monopolistically 6. Sparkle is one firm of many in the market for
competitive, and explain your answers. toothpaste, which is in long-run equilibrium.
a. wooden no. 2 pencils a. Draw a diagram showing Sparkle’s demand
b. copper curve, marginal-revenue curve, average-total-
c. local telephone service cost curve, and marginal-cost curve. Label
d. peanut butter Sparkle’s profit-maximizing output and
e. lipstick price.
3. For each of the following characteristics, say b. What is Sparkle’s profit? Explain.
whether it describes a perfectly competitive c. On your diagram, show the consumer sur-
firm, a monopolistically competitive firm, both, plus derived from the purchase of Sparkle
or neither. toothpaste. Also show the deadweight loss
a. Sells a product differentiated from that of its relative to the efficient level of output.
competitors d. If the government forced Sparkle to produce
b. Has marginal revenue less than price the efficient level of output, what would
c. Earns economic profit in the long run happen to the firm? What would happen to
d. Produces at minimum of average total cost in Sparkle’s customers?
the long run 7. For each of the following pairs of firms, explain
e. Equates marginal revenue and marginal cost which firm would be more likely to engage in
f. Charges a price above marginal cost advertising:
4. For each of the following characteristics, say a. a family-owned farm or a family-owned
whether it describes a monopoly firm, a monop- restaurant
olistically competitive firm, both, or neither. b. a manufacturer of forklifts or a manufacturer
a. Faces a downward-sloping demand curve of cars
b. Has marginal revenue less than price c. a company that invented a very comfortable
c. Faces the entry of new firms selling similar razor or a company that invented a less com-
products fortable razor
d. Earns economic profit in the long run 8. Sleek Sneakers Co. is one of many firms in the
e. Equates marginal revenue and marginal cost market for shoes.
f. Produces the socially efficient quantity of a. Assume that Sleek is currently earning short-
output run economic profits. On a correctly labeled
5. You are hired as the consultant to a monopo- diagram, show Sleek’s profit-maximizing
listically competitive firm. The firm reports the output and price, as well as the area repre-
following information about its price, marginal senting profit.
cost, and average total cost. Can the firm possi-
b. What happens to Sleek’s price, output, and c. Which company has the bigger incentive for
profit in the long run? Explain this change in careful quality control? Why?
words, and show it on a new diagram. 11. In a box in this chapter, economist Joel
c. Suppose that over time consumers become Waldfogel argues that a free market may fail
more focused on stylistic differences among to serve some customers in the presence of
shoe brands. How would this change in fixed costs. Let’s analyze this claim with an
attitudes affect each firm’s price elasticity example.
of demand? In the long run, how will this a. Suppose that there are N people who might
change in demand affect Sleek’s price, out- consume a product sold by a monopoly firm.
put, and profits? Each person has demand of q = 2 – P, so
d. At the profit-maximizing price you identified total demand for this product is Q = Nq =
in part (c), is Sleek’s demand curve elastic or 2N – NP, or P = 2 – Q/N. Graph this market
inelastic? Explain. demand curve.
9. Thirty years ago, the market for chicken was b. For this market demand curve, the equation
perfectly competitive. Then Frank Perdue began for marginal revenue is MR = 2 – 2Q/N. Add
marketing chicken under his name. this marginal revenue curve to your graph.
a. How do you suppose Perdue created a brand c. To keep things simple, suppose that the mar-
name for chicken? What did he gain from ginal cost of producing this product is zero.
doing so? What quantity would a profit-maximizing
b. What did society gain from having brand- monopolist produce? What price would it
name chicken? What did society lose? charge? Show this price on your graph.
10. The makers of Tylenol pain reliever do a lot of d. Ignoring for the moment the fixed costs,
advertising and have loyal customers. In con- calculate profits, consumer surplus, and
trast, the makers of generic acetaminophen do total surplus at this profit-maximizing price.
no advertising, and their customers shop only (These will be functions of N.)
for the lowest price. Assume that the marginal e. Suppose now that before making this prod-
costs of Tylenol and generic acetaminophen are uct, the firm has to pay fixed costs of research
the same and constant. and development equal to $3,000,000. How
a. Draw a diagram showing Tylenol’s demand, large does N need to be before the profit-
marginal-revenue, and marginal-cost curves. maximizing firm chooses to pay the fixed
Label Tylenol’s price and markup over mar- cost and produce this product? How large
ginal cost. does N need to be before it is socially efficient
b. Repeat part (a) for a producer of generic to pay the fixed cost?
acetaminophen. How do the diagrams differ? f. Discuss how this example relates to
Which company has the bigger markup? Waldfogel’s arguments about the inefficiency
Explain. of free markets.
17
CHAPTER
Oligopoly
I f you go to a store to buy tennis balls, you will probably come home with
one of four brands: Wilson, Penn, Dunlop, or Spalding. These four companies
make almost all the tennis balls sold in the United States. Together these firms
determine the quantity of tennis balls produced and, given the market demand
curve, the price at which tennis balls are sold.
The market for tennis balls is an example of an oligopoly. The essence of an oligopoly
oligopolistic market is that there are only a few sellers. As a result, the actions of a market structure in
any one seller in the market can have a large impact on the profits of all the other which only a few sellers
sellers. Oligopolistic firms are interdependent in a way that competitive firms are offer similar or identical
not. Our goal in this chapter is to see how this interdependence shapes the firms’ products
behavior and what problems it raises for public policy.
The analysis of oligopoly offers an opportunity to introduce game theory, the game theory
study of how people behave in strategic situations. By “strategic” we mean a situ- the study of how people
ation in which a person, when choosing among alternative courses of action, must behave in strategic
consider how others might respond to the action he takes. Strategic thinking is situations
crucial not only in checkers, chess, and tic-tac-toe but in many business decisions.
Because oligopolistic markets have only a small number of firms, each firm must
act strategically. Each firm knows that its profit depends not only on how much it
produces but also on how much the other firms produce. In making its production
decision, each firm in an oligopoly should consider how its decision might affect
the production decisions of all the other firms.
365
Game theory is not necessary for understanding competitive or monopoly mar-

kets. In a market that is either perfectly competitive or monopolistically competi-
tive, each firm is so small compared to the market that strategic interactions with
other firms are not important. In a monopolized market, strategic interactions are
absent because the market has only one firm. But, as we will see, game theory is
useful for understanding oligopolies and many other situations in which small
numbers of players are interacting with one another. Game theory helps explain
the strategies that people choose, whether they are playing tennis or selling tennis
balls.
MARKETS WITH ONLY A FEW SELLERS

Because an oligopolistic market has only a small group of sellers, a key feature of
oligopoly is the tension between cooperation and self-interest. The group of oli-
gopolists is best off cooperating and acting like a monopolist—producing a small
quantity of output and charging a price above marginal cost. Yet because each
oligopolist cares only about its own profit, there are powerful incentives at work
that hinder a group of firms from maintaining the monopoly outcome.
A DUOPOLY EXAMPLE
To understand the behavior of oligopolies, let’s consider an oligopoly with only
two members, called a duopoly. Duopoly is the simplest type of oligopoly. Oli-
gopolies with three or more members face the same problems as duopolies, so we
do not lose much by starting with the simpler case.
Imagine a town in which only two residents—Jack and Jill—own wells that pro-
duce water safe for drinking. Each Saturday, Jack and Jill decide how many gallons
of water to pump, bring the water to town, and sell it for whatever price the mar-
ket will bear. To keep things simple, suppose that Jack and Jill can pump as much
water as they want without cost. That is, the marginal cost of water equals zero.
Table 1 shows the town’s demand schedule for water. The first column shows
the total quantity demanded, and the second column shows the price. If the two
well owners sell a total of 10 gallons of water, water goes for $110 a gallon. If they
sell a total of 20 gallons, the price falls to $100 a gallon. And so on. If you graphed
these two columns of numbers, you would get a standard downward-sloping
demand curve.
The last column in Table 1 shows the total revenue from the sale of water.
It equals the quantity sold times the price. Because there is no cost to pumping
water, the total revenue of the two producers equals their total profit.
Let’s now consider how the organization of the town’s water industry affects
the price of water and the quantity of water sold.
COMPETITION, MONOPOLIES, AND CARTELS

Before considering the price and quantity of water that would result from the
duopoly of Jack and Jill, let’s discuss briefly what the outcome would be if the
water market were either perfectly competitive or monopolistic. These two polar
cases are natural benchmarks.
CHAPTER 17 OLIGOPOLY 367
T A B L E
1
Total Revenue
Quantity Price (and total profit)
The Demand Schedule
for Water
0 gallons $120 $ 0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0
If the market for water were perfectly competitive, the production decisions
of each firm would drive price equal to marginal cost. Because we have assumed
that the marginal cost of pumping additional water is zero, the equilibrium price
of water under perfect competition would be zero as well. The equilibrium quan-
tity would be 120 gallons. The price of water would reflect the cost of producing
it, and the efficient quantity of water would be produced and consumed.
Now consider how a monopoly would behave. Table 1 shows that total profit
is maximized at a quantity of 60 gallons and a price of $60 a gallon. A profit-
maximizing monopolist, therefore, would produce this quantity and charge this
price. As is standard for monopolies, price would exceed marginal cost. The result
would be inefficient, because the quantity of water produced and consumed
would fall short of the socially efficient level of 120 gallons.
What outcome should we expect from our duopolists? One possibility is that
Jack and Jill get together and agree on the quantity of water to produce and the
price to charge for it. Such an agreement among firms over production and price
is called collusion, and the group of firms acting in unison is called a cartel. Once collusion
a cartel is formed, the market is in effect served by a monopoly, and we can apply an agreement among
our analysis from Chapter 15. That is, if Jack and Jill were to collude, they would firms in a market about
agree on the monopoly outcome because that outcome maximizes the total profit quantities to produce or
that the producers can get from the market. Our two producers would produce prices to charge
a total of 60 gallons, which would be sold at a price of $60 a gallon. Once again,
cartel
price exceeds marginal cost, and the outcome is socially inefficient. a group of firms acting
A cartel must agree not only on the total level of production but also on the in unison
amount produced by each member. In our case, Jack and Jill must agree on how
to split between themselves the monopoly production of 60 gallons. Each member
of the cartel will want a larger share of the market because a larger market share
means larger profit. If Jack and Jill agreed to split the market equally, each would
produce 30 gallons, the price would be $60 a gallon, and each would get a profit
of $1,800.
THE EQUILIBRIUM FOR AN OLIGOPOLY

Oligopolists would like to form cartels and earn monopoly profits, but that is
often impossible. Squabbling among cartel members over how to divide the profit
in the market can make agreement among them difficult. In addition, antitrust
laws prohibit explicit agreements among oligopolists as a matter of public policy.
Even talking about pricing and production restrictions with competitors can be
a criminal offense. Let’s therefore consider what happens if Jack and Jill decide
separately how much water to produce.
At first, one might expect Jack and Jill to reach the monopoly outcome on their
own, because this outcome maximizes their joint profit. In the absence of a bind-
ing agreement, however, the monopoly outcome is unlikely. To see why, imagine
that Jack expects Jill to produce only 30 gallons (half of the monopoly quantity).
Jack would reason as follows:
“I could produce 30 gallons as well. In this case, a total of 60 gallons of water
would be sold at a price of $60 a gallon. My profit would be $1,800 (30 gallons ×
$60 a gallon). Alternatively, I could produce 40 gallons. In this case, a total of 70
gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000
(40 gallons × $50 a gallon). Even though total profit in the market would fall, my
profit would be higher, because I would have a larger share of the market.”
Of course, Jill might reason the same way. If so, Jack and Jill would each bring
40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40.
Thus, if the duopolists individually pursue their own self-interest when deciding
how much to produce, they produce a total quantity greater than the monopoly
quantity, charge a price lower than the monopoly price, and earn total profit less
than the monopoly profit.
Although the logic of self-interest increases the duopoly’s output above the
monopoly level, it does not push the duopolists to reach the competitive alloca-
tion. Consider what happens when each duopolist is producing 40 gallons. The
price is $40, and each duopolist makes a profit of $1,600. In this case, Jack’s self-
interested logic leads to a different conclusion:
“Right now, my profit is $1,600. Suppose I increase my production to 50 gal-
lons. In this case, a total of 90 gallons of water would be sold, and the price would
be $30 a gallon. Then my profit would be only $1,500. Rather than increasing pro-
duction and driving down the price, I am better off keeping my production at 40
gallons.”
The outcome in which Jack and Jill each produce 40 gallons looks like some sort
of equilibrium. In fact, this outcome is called a Nash equilibrium. (It is named after
economic theorist John Nash, whose life was portrayed in the book and movie
Nash equilibrium A Beautiful Mind.) A Nash equilibrium is a situation in which economic actors
a situation in which eco- interacting with one another each choose their best strategy given the strategies
nomic actors interacting the others have chosen. In this case, given that Jill is producing 40 gallons, the best
with one another each strategy for Jack is to produce 40 gallons. Similarly, given that Jack is producing 40
choose their best strat- gallons, the best strategy for Jill is to produce 40 gallons. Once they reach this Nash
egy given the strategies equilibrium, neither Jack nor Jill has an incentive to make a different decision.
that all the other actors
This example illustrates the tension between cooperation and self-interest. Oli-
have chosen
gopolists would be better off cooperating and reaching the monopoly outcome.
Yet because they pursue their own self-interest, they do not end up reaching the
monopoly outcome and maximizing their joint profit. Each oligopolist is tempted
to raise production and capture a larger share of the market. As each of them tries
to do this, total production rises, and the price falls.
At the same time, self-interest does not drive the market all the way to the
competitive outcome. Like monopolists, oligopolists are aware that increasing the
amount they produce reduces the price of their product, which in turn affects
profits. Therefore, they stop short of following the competitive firm’s rule of
producing up to the point where price equals marginal cost.
In summary, when firms in an oligopoly individually choose production to maximize
profit, they produce a quantity of output greater than the level produced by monopoly and
less than the level produced by competition. The oligopoly price is less than the monopoly
price but greater than the competitive price (which equals marginal cost).
HOW THE SIZE OF AN OLIGOPOLY AFFECTS

THE M ARKET OUTCOME
We can use the insights from this analysis of duopoly to discuss how the size of
an oligopoly is likely to affect the outcome in a market. Suppose, for instance,
that John and Joan suddenly discover water sources on their property and join
Jack and Jill in the water oligopoly. The demand schedule in Table 1 remains the
same, but now more producers are available to satisfy this demand. How would
an increase in the number of sellers from two to four affect the price and quantity
of water in the town?
If the sellers of water could form a cartel, they would once again try to maxi-
mize total profit by producing the monopoly quantity and charging the monopoly
price. Just as when there were only two sellers, the members of the cartel would
need to agree on production levels for each member and find some way to enforce
the agreement. As the cartel grows larger, however, this outcome is less likely.
Reaching and enforcing an agreement becomes more difficult as the size of the
group increases.
If the oligopolists do not form a cartel—perhaps because the antitrust laws pro-
hibit it—they must each decide on their own how much water to produce. To see
how the increase in the number of sellers affects the outcome, consider the deci-
sion facing each seller. At any time, each well owner has the option to raise pro-
duction by 1 gallon. In making this decision, the well owner weighs two effects:
• The output effect: Because price is above marginal cost, selling 1 more gallon
of water at the going price will raise profit.
• The price effect: Raising production will increase the total amount sold, which
will lower the price of water and lower the profit on all the other gallons sold.
If the output effect is larger than the price effect, the well owner will increase pro-
duction. If the price effect is larger than the output effect, the owner will not raise
production. (In fact, in this case, it is profitable to reduce production.) Each oli-
gopolist continues to increase production until these two marginal effects exactly
balance, taking the other firms’ production as given.
Now consider how the number of firms in the industry affects the marginal
analysis of each oligopolist. The larger the number of sellers, the less each seller
is concerned about its own impact on the market price. That is, as the oligopoly
grows in size, the magnitude of the price effect falls. When the oligopoly grows
very large, the price effect disappears altogether. That is, the production deci-
sion of an individual firm no longer affects the market price. In this extreme case,
each firm takes the market price as given when deciding how much to produce. It
increases production as long as price is above marginal cost.
We can now see that a large oligopoly is essentially a group of competitive

firms. A competitive firm considers only the output effect when deciding how
much to produce: Because a competitive firm is a price taker, the price effect is
absent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more and more like a competitive market. The price approaches marginal
cost, and the quantity produced approaches the socially efficient level.
This analysis of oligopoly offers a new perspective on the effects of interna-
tional trade. Imagine that Toyota and Honda are the only automakers in Japan,
Volkswagen and BMW are the only automakers in Germany, and Ford and Gen-
eral Motors are the only automakers in the United States. If these nations prohib-
ited international trade in autos, each would have an auto oligopoly with only
two members, and the market outcome would likely depart substantially from
the competitive ideal. With international trade, however, the car market is a world
market, and the oligopoly in this example has six members. Allowing free trade
increases the number of producers from which each consumer can choose, and
this increased competition keeps prices closer to marginal cost. Thus, the theory
of oligopoly provides another reason, in addition to the theory of comparative
advantage discussed in Chapter 3, why all countries can benefit from free trade.
Q Q
UICK UIZ If the members of an oligopoly could agree on a total quantity to produce,
what quantity would they choose? • If the oligopolists do not act together but instead
make production decisions individually, do they produce a total quantity more or less
than in your answer to the previous question? Why?
THE ECONOMICS OF COOPERATION

As we have seen, oligopolies would like to reach the monopoly outcome, but doing
so requires cooperation, which at times is difficult to establish and maintain. In
this section we look more closely at the problems that arise when cooperation
among actors is desirable but difficult. To analyze the economics of cooperation,
we need to learn a little about game theory.
prisoners’ dilemma In particular, we focus on an important “game” called the prisoners’ dilemma.
a particular “game” This game provides insight into why cooperation is difficult. Many times in life,
between two captured people fail to cooperate with one another even when cooperation would make
prisoners that illus- them all better off. An oligopoly is just one example. The story of the prisoners’
trates why cooperation dilemma contains a general lesson that applies to any group trying to maintain
is difficult to maintain
cooperation among its members.
even when it is mutually
beneficial
THE PRISONERS’ DILEMMA
The prisoners’ dilemma is a story about two criminals who have been captured by
the police. Let’s call them Bonnie and Clyde. The police have enough evidence to
convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so
that each would spend a year in jail. The police also suspect that the two criminals
have committed a bank robbery together, but they lack hard evidence to convict
them of this major crime. The police question Bonnie and Clyde in separate rooms,
and they offer each of them the following deal:
“Right now, we can lock you up for 1 year. If you confess to the bank robbery
and implicate your partner, however, we’ll give you immunity and you can go
free. Your partner will get 20 years in jail. But if you both confess to the crime, we
won’t need your testimony and we can avoid the cost of a trial, so you will each
get an intermediate sentence of 8 years.”
If Bonnie and Clyde, heartless bank robbers that they are, care only about their
own sentences, what would you expect them to do? Figure 1 shows their choices.
Each prisoner has two strategies: confess or remain silent. The sentence each pris-
oner gets depends on the strategy he or she chooses and the strategy chosen by his
or her partner in crime.
Consider first Bonnie’s decision. She reasons as follows: “I don’t know what
Clyde is going to do. If he remains silent, my best strategy is to confess, since then
I’ll go free rather than spending a year in jail. If he confesses, my best strategy is
still to confess, since then I’ll spend 8 years in jail rather than 20. So, regardless of
what Clyde does, I am better off confessing.”
In the language of game theory, a strategy is called a dominant strategy if dominant strategy
it is the best strategy for a player to follow regardless of the strategies pursued a strategy that is best
by other players. In this case, confessing is a dominant strategy for Bonnie. She for a player in a game
spends less time in jail if she confesses, regardless of whether Clyde confesses or regardless of the strate-
remains silent. gies chosen by the other
players
Now consider Clyde’s decision. He faces the same choices as Bonnie, and he
reasons in much the same way. Regardless of what Bonnie does, Clyde can reduce
his jail time by confessing. In other words, confessing is also a dominant strategy
for Clyde.
In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. Yet,
from their standpoint, this is a terrible outcome. If they had both remained silent,
both of them would have been better off, spending only 1 year in jail on the gun
charge. Because each pursues his or her own interests, the two prisoners together
reach an outcome that is worse for each of them.
You might have thought that Bonnie and Clyde would have foreseen this sit-
uation and planned ahead. But even with advanced planning, they would still
run into problems. Imagine that, before the police captured Bonnie and Clyde,
the two criminals had made a pact not to confess. Clearly, this agreement would
Bonnie’s Decision
F I G U R E 1
Confess Remain Silent
The Prisoners’ Dilemma
Bonnie gets 8 years Bonnie gets 20 years In this game between two crimi-
nals suspected of committing a
crime, the sentence that each
Confess receives depends both on his or
Clyde gets 8 years Clyde goes free her decision whether to confess
Clyde’s
or remain silent and on the deci-
Decision Bonnie goes free Bonnie gets 1 year sion made by the other.
Remain
Silent
Clyde gets 20 years Clyde gets 1 year

make them both better off if they both lived up to it, because they would each
spend only 1 year in jail. But would the two criminals in fact remain silent, simply
because they had agreed to? Once they are being questioned separately, the logic
of self-interest takes over and leads them to confess. Cooperation between the two
prisoners is difficult to maintain, because cooperation is individually irrational.
OLIGOPOLIES AS A PRISONERS’ DILEMMA

What does the prisoners’ dilemma have to do with markets and imperfect compe-
tition? It turns out that the game oligopolists play in trying to reach the monop-
oly outcome is similar to the game that the two prisoners play in the prisoners’
dilemma.
Consider again the choices facing Jack and Jill. After prolonged negotiation,
the two suppliers of water agree to keep production at 30 gallons, so that the price
will be kept high and together they will earn the maximum profit. After they
agree on production levels, however, each of them must decide whether to coop-
erate and live up to this agreement or to ignore it and produce at a higher level.
Figure 2 shows how the profits of the two producers depend on the strategies they
choose.
Suppose you are Jack. You might reason as follows: “I could keep production
low at 30 gallons as we agreed, or I could raise my production and sell 40 gallons.
If Jill lives up to the agreement and keeps her production at 30 gallons, then I earn
profit of $2,000 with high production and $1,800 with low production. In this case,
I am better off with high production. If Jill fails to live up to the agreement and
produces 40 gallons, then I earn $1,600 with high production and $1,500 with low
production. Once again, I am better off with high production. So, regardless of
what Jill chooses to do, I am better off reneging on our agreement and producing
at a high level.”
Producing 40 gallons is a dominant strategy for Jack. Of course, Jill reasons in
exactly the same way, and so both produce at the higher level of 40 gallons. The
result is the inferior outcome (from Jack and Jill’s standpoint) with low profits for
each of the two producers.
2 F I G U R E
Jack’s Decision
High production: 40 Gallons Low production: 30 Gallons

Jack and Jill’s
Oligopoly Game Jack gets Jack gets
In this game between Jack and $1,600 profit $1,500 profit
Jill, the profit that each earns from High production:
40 Gallons
selling water depends on both the Jill gets Jill gets
quantity he or she chooses to sell $1,600 profit $2,000 profit
Jill’s
and the quantity the other chooses
Decision Jack gets Jack gets
to sell.
$2,000 profit $1,800 profit
Low production:
30 Gallons
Jill gets Jill gets
$1,500 profit $1,800 profit
This example illustrates why oligopolies have trouble maintaining monopoly

profits. The monopoly outcome is jointly rational for the oligopoly, but each
oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in
the prisoners’ dilemma to confess, self-interest makes it difficult for the oligop-
oly to maintain the cooperative outcome with low production, high prices, and
monopoly profits.
OPEC AND THE WORLD OIL MARKET

Our story about the town’s market for water is fictional, but if we change water to
crude oil, and Jack and Jill to Iran and Iraq, the story is close to being true. Much
of the world’s oil is produced by a few countries, mostly in the Middle East. These
countries together make up an oligopoly. Their decisions about how much oil to
pump are much the same as Jack and Jill’s decisions about how much water to
pump.
The countries that produce most of the world’s oil have formed a cartel, called
the Organization of Petroleum Exporting Countries (OPEC). As originally formed
in 1960, OPEC included Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By 1973,
eight other nations had joined: Qatar, Indonesia, Libya, the United Arab Emir-
ates, Algeria, Nigeria, Ecuador, and Gabon. These countries control about three-
fourths of the world’s oil reserves. Like any cartel, OPEC tries to raise the price of
its product through a coordinated reduction in quantity produced. OPEC tries to
set production levels for each of the member countries.
The problem that OPEC faces is much the same as the problem that Jack and Jill
face in our story. The OPEC countries would like to maintain a high price of oil.
But each member of the cartel is tempted to increase its production to get a larger
share of the total profit. OPEC members frequently agree to reduce production
but then cheat on their agreements.
OPEC was most successful at maintaining cooperation and high prices in the
period from 1973 to 1985. The price of crude oil rose from $3 a barrel in 1972 to
$11 in 1974 and then to $35 in 1981. But in the mid-1980s, member countries began
arguing about production levels, and OPEC became ineffective at maintaining
cooperation. By 1986 the price of crude oil had fallen back to $13 a barrel.
In recent years, the members of OPEC have continued to meet regularly, but the
cartel has been less successful at reaching and enforcing agreements. Although the
price of oil rose significantly in 2007 and 2008, the primary cause was increased
demand in the world oil market, in part from a booming Chinese economy, rather
than restricted supply. While this lack of cooperation among OPEC nations has
reduced the profits of the oil-producing nations below what they might have been,
it has benefited consumers around the world. ●
OTHER EXAMPLES OF THE PRISONERS’ DILEMMA

We have seen how the prisoners’ dilemma can be used to understand the problem
facing oligopolies. The same logic applies to many other situations as well. Here
we consider two examples in which self-interest prevents cooperation and leads
to an inferior outcome for the parties involved.
Arms Races In the decades after World War II, the world’s two superpowers—
the United States and the Soviet Union—were engaged in a prolonged competi-
tion over military power. This topic motivated some of the early work on game
theory. The game theorists pointed out that an arms race is much like the prison-
ers’ dilemma.
To see this, consider the decisions of the United States and the Soviet Union
about whether to build new weapons or to disarm. Each country prefers to have
more arms than the other because a larger arsenal would give it more influence in
world affairs. But each country also prefers to live in a world safe from the other
country’s weapons.
Figure 3 shows the deadly game. If the Soviet Union chooses to arm, the United
States is better off doing the same to prevent the loss of power. If the Soviet Union
chooses to disarm, the United States is better off arming because doing so would
make it more powerful. For each country, arming is a dominant strategy. Thus,
each country chooses to continue the arms race, resulting in the inferior outcome
with both countries at risk.
Throughout the era of the Cold War, the United States and the Soviet Union
attempted to solve this problem through negotiation and agreements over arms
control. The problems that the two countries faced were similar to those that oli-
gopolists encounter in trying to maintain a cartel. Just as oligopolists argue over
production levels, the United States and the Soviet Union argued over the amount
of arms that each country would be allowed. And just as cartels have trouble
enforcing production levels, the United States and the Soviet Union each feared
that the other country would cheat on any agreement. In both arms races and
oligopolies, the relentless logic of self-interest drives the participants toward a
noncooperative outcome that is worse for each party.
Common Resources In Chapter 11 we saw that people tend to overuse common

resources. One can view this problem as an example of the prisoners’ dilemma.
Imagine that two oil companies—Exxon and Texaco—own adjacent oil fields.
Under the fields is a common pool of oil worth $12 million. Drilling a well to
recover the oil costs $1 million. If each company drills one well, each will get half
of the oil and earn a $5 million profit ($6 million in revenue minus $1 million in
costs).
3 F I G U R E
Decision of the United States (U.S.)
Arm Disarm
An Arms-Race Game
In this game between two coun- U.S. at risk U.S. at risk and weak
tries, the safety and power of each
country depend on both its decision Arm
whether to arm and the decision
made by the other country. Decision USSR at risk USSR safe and powerful
of the
Soviet Union U.S. safe and powerful U.S. safe
(USSR)
Disarm
USSR at risk and weak USSR safe

Because the pool of oil is a common resource, the companies will not use it
efficiently. Suppose that either company could drill a second well. If one company
has two of the three wells, that company gets two-thirds of the oil, which yields
a profit of $6 million. The other company gets one-third of the oil, for a profit of
$3 million. Yet if each company drills a second well, the two companies again split
the oil. In this case, each bears the cost of a second well, so profit is only $4 million
for each company.
Figure 4 shows the game. Drilling two wells is a dominant strategy for each
company. Once again, the self-interest of the two players leads them to an inferior
outcome.
THE PRISONERS’ DILEMMA AND THE WELFARE

OF SOCIETY
The prisoners’ dilemma describes many of life’s situations, and it shows that
cooperation can be difficult to maintain, even when cooperation would make both
players in the game better off. Clearly, this lack of cooperation is a problem for
those involved in these situations. But is lack of cooperation a problem from the
standpoint of society as a whole? The answer depends on the circumstances.
In some cases, the noncooperative equilibrium is bad for society as well as the
players. In the arms-race game in Figure 3, both the United States and the Soviet
Union end up at risk. In the common-resources game in Figure 4, the extra wells
dug by Texaco and Exxon are pure waste. In both cases, society would be better
off if the two players could reach the cooperative outcome.
By contrast, in the case of oligopolists trying to maintain monopoly profits,
lack of cooperation is desirable from the standpoint of society as a whole. The
monopoly outcome is good for the oligopolists, but it is bad for the consumers
of the product. As we first saw in Chapter 7, the competitive outcome is best for
society because it maximizes total surplus. When oligopolists fail to cooperate,
the quantity they produce is closer to this optimal level. Put differently, the invis-
ible hand guides markets to allocate resources efficiently only when markets are
Exxon’s Decision
F I G U R E 4
Drill Two Wells Drill One Well
A Common-Resources Game
Exxon gets $4 Exxon gets $3 In this game between firms
million profit million profit pumping oil from a common
Drill Two pool, the profit that each earns
Wells
Texaco gets $4 Texaco gets $6 depends on both the number of
million profit million profit wells it drills and the number of
Texaco’s
wells drilled by the other firm.
Decision Exxon gets $6 Exxon gets $5
million profit million profit
Drill One
Well
Texaco gets $3 Texaco gets $5
million profit million profit
competitive, and markets are competitive only when firms in the market fail to
cooperate with one another.
Similarly, consider the case of the police questioning two suspects. Lack of
cooperation between the suspects is desirable, for it allows the police to convict
more criminals. The prisoners’ dilemma is a dilemma for the prisoners, but it can
be a boon to everyone else.
WHY PEOPLE SOMETIMES COOPERATE

The prisoners’ dilemma shows that cooperation is difficult. But is it impossible?
Not all prisoners, when questioned by the police, decide to turn in their partners
in crime. Cartels sometimes manage to maintain collusive arrangements, despite
the incentive for individual members to defect. Very often, players can solve the
prisoners’ dilemma because they play the game not once but many times.
To see why cooperation is easier to enforce in repeated games, let’s return to
our duopolists, Jack and Jill, whose choices were given in Figure 2. Jack and Jill
would like to agree to maintain the monopoly outcome in which each produces 30
gallons. Yet, if Jack and Jill are to play this game only once, neither has any incen-
tive to live up to this agreement. Self-interest drives each of them to renege and
choose the dominant strategy of 40 gallons.
Now suppose that Jack and Jill know that they will play the same game every
week. When they make their initial agreement to keep production low, they can
also specify what happens if one party reneges. They might agree, for instance,
that once one of them reneges and produces 40 gallons, both of them will produce
40 gallons forever after. This penalty is easy to enforce, for if one party is produc-
ing at a high level, the other has every reason to do the same.
The threat of this penalty may be all that is needed to maintain cooperation.
Each person knows that defecting would raise his or her profit from $1,800 to
$2,000. But this benefit would last for only one week. Thereafter, profit would fall
to $1,600 and stay there. As long as the players care enough about future profits,
they will choose to forgo the one-time gain from defection. Thus, in a game of
repeated prisoners’ dilemma, the two players may well be able to reach the coop-
erative outcome.
THE PRISONERS’ DILEMMA TOURNAMENT

Imagine that you are playing a game of prisoners’ dilemma with a person being
“questioned” in a separate room. Moreover, imagine that you are going to play
not once but many times. Your score at the end of the game is the total number of
years in jail. You would like to make this score as small as possible. What strategy
would you play? Would you begin by confessing or remaining silent? How would
the other player’s actions affect your subsequent decisions about confessing?
Repeated prisoners’ dilemma is quite a complicated game. To encourage coop-
eration, players must penalize each other for not cooperating. Yet the strategy
described earlier for Jack and Jill’s water cartel—defect forever as soon as the
other player defects—is not very forgiving. In a game repeated many times, a
strategy that allows players to return to the cooperative outcome after a period of
noncooperation may be preferable.
To see what strategies work best, political scientist Robert Axelrod held a tour-
nament. People entered by sending computer programs designed to play repeated
Aumann and Schelling

In 2005, two prominent game theorists won the Nobel Prize.
Economic Work on “Game Game theory is the study of strategy and credible and possibly game-changing mes-
Theory” Wins Nobel Prize how people make decisions when interact- sage toward his enemy that he has no inten-
By Jon E. Hilsenrath ing in conflict with one another. In a game tion of retreating.
of chess, two players act not only based on Economists have since applied this idea
The Cold War was a period of conflict man- their own strategy, but also on expectations of “precommitment” to other areas, includ-
agement on a grand, frightening scale, and of how their opponent will behave and react. ing business. Some companies, for example,
two researchers who explained how individ- In the 1940s and 1950s, economists began might find it advantageous to build too
uals negotiate such conflict won the Nobel to see their models of individual behavior much capacity, to alert would-be competi-
Prize in economics for work that grew out needed to be less robotic and should reflect tors that entering a market will lead them
of the period. the kind of strategic dance found in games into a price war. . . .
Thomas Schelling, an 84-year-old retired like chess. Messrs. Schelling and Aumann both
University of Maryland professor who served The movement toward game theory came of age during the Cold War, when
long stints as an adviser to the U.S. govern- was driven in part by mathematicians like fears of a nuclear confrontation between
ment, has written on managing the U.S.- Mr. Aumann and an associate from his days the Soviet Union and the U.S. led scholars
Soviet buildup of nuclear arms and extended at the Massachusetts Institute of Technology to examine the motivations and decision-
his theories to subjects such as drug addic- named John Nash, whose life was portrayed making of both sides. . . .
tion, racial segregation and global warming. in the movie “A Beautiful Mind.” Mr. Nash Prof. Schelling extended his research
Robert Aumann, 75, a mathematician by won the economics prize with two others beyond the Cold War. For instance, his work
training and professor at Hebrew University in 1994. has shown how even small differences in
in Jerusalem, added analytical rigor to the While Messrs. Nash and Aumann used preferences between groups of people
field that both professors helped to create, math to give precise formulations to game could lead to large-scale segregation in cit-
which has come to be known in economics theory, Prof. Schelling sought to give it prac- ies. It also has described drug addiction as
as “game theory.” tical meaning. He explained, for instance, a game against oneself. Someone who is
The two will share the 10 million kronor how decision makers often find it advanta- trying to quit smoking, for instance, might
prize ($1.3 million) awarded by the Royal geous to limit their own options to get con- flush cigarettes down the toilet because
Swedish Academy of Sciences. Mr. Schelling cessions from an opponent. In some cases, he realizes that “some time late at night he
is an American citizen, and Mr. Aumann is an for instance, it might be wise for a general won’t be able to resist them.”
American and Israeli citizen. to burn bridges behind his troops to send a
Source: The Wall Street Journal, October 11, 2005.
prisoners’ dilemma. Each program then played the game against all the other pro-
grams. The “winner” was the program that received the fewest total years in jail.
The winner turned out to be a simple strategy called tit-for-tat. According to
tit-for-tat, a player should start by cooperating and then do whatever the other
player did last time. Thus, a tit-for-tat player cooperates until the other player
defects; she then defects until the other player cooperates again. In other words,
this strategy starts out friendly, penalizes unfriendly players, and forgives them if
warranted. To Axelrod’s surprise, this simple strategy did better than all the more
complicated strategies that people had sent in.
The tit-for-tat strategy has a long history. It is essentially the biblical strategy
of “an eye for an eye, a tooth for a tooth.” The prisoners’ dilemma tournament
suggests that this may be a good rule of thumb for playing some of the games of
life. ●
Q Q
UICK UIZ Tell the story of the prisoners’ dilemma. Write down a table showing
the prisoners’ choices and explain what outcome is likely. • What does the prisoners’
dilemma teach us about oligopolies?
PUBLIC POLICY TOWARD OLIGOPOLIES

One of the Ten Principles of Economics in Chapter 1 is that governments can some-
times improve market outcomes. This principle applies directly to oligopolistic
markets. As we have seen, cooperation among oligopolists is undesirable from the
standpoint of society as a whole, because it leads to production that is too low and
prices that are too high. To move the allocation of resources closer to the social
optimum, policymakers should try to induce firms in an oligopoly to compete
rather than cooperate. Let’s consider how policymakers do this and then examine
the controversies that arise in this area of public policy.
R ESTRAINT OF TRADE AND THE ANTITRUST LAWS

One way that policy discourages cooperation is through the common law. Nor-
mally, freedom of contract is an essential part of a market economy. Businesses
and households use contracts to arrange mutually advantageous trades. In doing
this, they rely on the court system to enforce contracts. Yet, for many centuries,
judges in England and the United States have deemed agreements among com-
petitors to reduce quantities and raise prices to be contrary to the public good.
They have therefore refused to enforce such agreements.
The Sherman Antitrust Act of 1890 codified and reinforced this policy:
Every contract, combination in the form of trust or otherwise, or conspiracy,
in restraint of trade or commerce among the several States, or with foreign
nations, is declared to be illegal. . . . Every person who shall monopolize, or
attempt to monopolize, or combine or conspire with any person or persons
to monopolize any part of the trade or commerce among the several States, or
with foreign nations, shall be deemed guilty of a misdemeanor, and on convic-
tion therefor, shall be punished by fine not exceeding fifty thousand dollars, or
by imprisonment not exceeding one year, or by both said punishments, in the
discretion of the court.
The Sherman Act elevated agreements among oligopolists from an unenforceable
contract to a criminal conspiracy.
The Clayton Act of 1914 further strengthened the antitrust laws. According to
this law, if a person could prove that he was damaged by an illegal arrangement
to restrain trade, that person could sue and recover three times the damages he
sustained. The purpose of this unusual rule of triple damages is to encourage pri-
vate lawsuits against conspiring oligopolists.
Today, both the U.S. Justice Department and private parties have the authority
to bring legal suits to enforce the antitrust laws. As we discussed in Chapter 15,
these laws are used to prevent mergers that would lead to excessive market power
in any single firm. In addition, these laws are used to prevent oligopolists from
acting together in ways that would make their markets less competitive.
AN ILLEGAL PHONE CALL

Firms in oligopolies have a strong incentive to collude in order to reduce pro-
duction, raise price, and increase profit. The great 18th-century economist Adam
Smith was well aware of this potential market failure. In The Wealth of Nations he
wrote, “People of the same trade seldom meet together, but the conversation ends
in a conspiracy against the public, or in some diversion to raise prices.”
To see a modern example of Smith’s observation, consider the following excerpt
of a phone conversation between two airline executives in the early 1980s. The call
was reported in the New York Times on February 24, 1983. Robert Crandall was
president of American Airlines, and Howard Putnam was president of Braniff
Airways.
Crandall: I think it’s dumb as hell . . . to sit here and pound the @#$% out of
each other and neither one of us making a #$%& dime.
Putnam: Do you have a suggestion for me?
Crandall: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent.
I’ll raise mine the next morning.
Putnam: Robert, we . . .
Crandall: You’ll make more money, and I will, too.
Putnam: We can’t talk about pricing!
Crandall: Oh @#$%, Howard. We can talk about any &*#@ thing we want to
talk about.
Putnam was right: The Sherman Antitrust Act prohibits competing executives
from even talking about fixing prices. When Putnam gave a tape of this conversa-
tion to the Justice Department, the Justice Department filed suit against Crandall.
Two years later, Crandall and the Justice Department reached a settlement in
which Crandall agreed to various restrictions on his business activities, including
his contacts with officials at other airlines. The Justice Department said that the
terms of settlement would “protect competition in the airline industry, by pre-
venting American and Crandall from any further attempts to monopolize passen-
ger airline service on any route through discussions with competitors about the
prices of airline services.” ●
CONTROVERSIES OVER ANTITRUST POLICY

Over time, much controversy has centered on what kinds of behavior the anti-
trust laws should prohibit. Most commentators agree that price-fixing agreements
among competing firms should be illegal. Yet the antitrust laws have been used
to condemn some business practices whose effects are not obvious. Here we con-
sider three examples.
Public Price Fixing

If a group of producers coordinates their prices in secret meetings,
they can be sent to jail for criminal violations of antitrust laws. But
what if they discuss the same topic in public?
Market Talk mon for a customer to volunteer information mile passenger revenue for the next quarter.
By Alistair Lindsay about a rival’s prices to obtain leverage: But a rival airline might use the announced
“You’ve quoted £100 per ton, but X is offering figure as a benchmark when setting its own
Most companies have antitrust compliance £95 and I’m going to them unless you can do fares for the next quarter.
policies. They typically—and quite rightly— better.” A company that receives this infor- As things stand, cartel authorities have
identify a number of things that officers mation obtains valuable intelligence about focused their efforts in such situations on
and employees should not do, on pain of what its rivals are charging, but it does not blocking mergers in markets where signal-
criminal liability, eye-watering fines and infringe cartel rules. . . . ing is prevalent, arguing that consolida-
unlimited damages actions. All make clear Companies also sometimes signal to tion in such markets can further dampen
that companies must not agree with their one another in their communications with competition by making coordination easier
competitors to fix prices. This is a bright-line investors, whether deliberately or not. A or more successful. However, they have
rule. But it raises an important question: Can competitor which informs the markets, say, not taken high-profile action alleging car-
companies coordinate price increases with- that it expects a price war to end in February tel infringements against companies for
out infringing the cartel rules? is providing relevant information to actual announcements made to investors.
In markets where competitors need to and potential owners of its stock. But of If there is no justification for a particu-
publish their prices to win business—for course its rivals read the same reports and lar announcement other than to signal to
example, many retail markets—it is perfectly can change their strategies accordingly. So a competitors, cartel authorities should seek
lawful to shadow a rival’s increases, so long statement to the market can serve as just as to intervene. For in this case the public
as each seller acts entirely independently much of a signal to competitors as a state- announcement is analytically the same as
in setting its charges. The very definition of ment made during a cartel meeting. . . . a private discussion directly with the rivals,
an oligopoly is a market involving a small Signaling through investor communi- and there is scope for consumers to be seri-
number of suppliers that set their own com- cations raises difficult questions for cartel ously harmed. But most announcements do
mercial strategies but take account of their enforcement. The enforcers want to pro- serve legitimate purposes, such as keeping
competitors. One competitor may emerge tect consumers from the adverse effects investors informed. In these cases, inter-
as a leader, with others taking their cue on of blatant signaling, but not at the price of vention by the cartel authorities seems too
when to raise prices and by how much. losing transparency in financial markets. For complex, given the disparate policy objec-
When prices are privately negotiated— example, it is highly relevant to an investor tives in play.
as in many industrials markets—it is com- to know an airline’s predicted growth of per-
Resale Price Maintenance One example of a controversial business practice is

resale price maintenance, also called fair trade. Imagine that Superduper Electronics
sells DVD players to retail stores for $300. If Superduper requires the retailers
to charge customers $350, it is said to engage in resale price maintenance. Any
retailer that charged less than $350 would violate its contract with Superduper.
At first, resale price maintenance might seem anticompetitive and, therefore,

detrimental to society. Like an agreement among members of a cartel, it prevents
the retailers from competing on price. For this reason, the courts have often viewed
resale price maintenance as a violation of the antitrust laws.
Yet some economists defend resale price maintenance on two grounds. First,
they deny that it is aimed at reducing competition. To the extent that Superduper
Electronics has any market power, it can exert that power through the wholesale
price, rather than through resale price maintenance. Moreover, Superduper has
no incentive to discourage competition among its retailers. Indeed, because a car-
tel of retailers sells less than a group of competitive retailers, Superduper would
be worse off if its retailers were a cartel.
Second, economists believe that resale price maintenance has a legitimate goal.
Superduper may want its retailers to provide customers a pleasant showroom and
a knowledgeable sales force. Yet, without resale price maintenance, some custom-
ers would take advantage of one store’s service to learn about the DVD player’s
special features and then buy the item at a discount retailer that does not provide
this service. To some extent, good service is a public good among the retailers
that sell Superduper products. As we discussed in Chapter 11, when one person
provides a public good, others are able to enjoy it without paying for it. In this
case, discount retailers would free ride on the service provided by other retailers,
leading to less service than is desirable. Resale price maintenance is one way for
Superduper to solve this free-rider problem.
The example of resale price maintenance illustrates an important principle:
Business practices that appear to reduce competition may in fact have legitimate purposes.
This principle makes the application of the antitrust laws all the more difficult.
The economists, lawyers, and judges in charge of enforcing these laws must deter-
mine what kinds of behavior public policy should prohibit as impeding competi-
tion and reducing economic well-being. Often that job is not easy.
Predatory Pricing Firms with market power normally use that power to raise
prices above the competitive level. But should policymakers ever be concerned
that firms with market power might charge prices that are too low? This question
is at the heart of a second debate over antitrust policy.
Imagine that a large airline, call it Coyote Air, has a monopoly on some route.
Then Roadrunner Express enters and takes 20 percent of the market, leaving Coy-
ote with 80 percent. In response to this competition, Coyote starts slashing its
fares. Some antitrust analysts argue that Coyote’s move could be anticompetitive:
The price cuts may be intended to drive Roadrunner out of the market so Coyote
can recapture its monopoly and raise prices again. Such behavior is called preda-
tory pricing.
Although predatory pricing is a common claim in antitrust suits, some econo-
mists are skeptical of this argument and believe that predatory pricing is rarely,
and perhaps never, a profitable business strategy. Why? For a price war to drive
out a rival, prices have to be driven below cost. Yet if Coyote starts selling cheap
tickets at a loss, it had better be ready to fly more planes, because low fares will
attract more customers. Roadrunner, meanwhile, can respond to Coyote’s preda-
tory move by cutting back on flights. As a result, Coyote ends up bearing more
than 80 percent of the losses, putting Roadrunner in a good position to survive the
price war. As in the old Roadrunner-Coyote cartoons, the predator suffers more
than the prey.
A Reversal of Policy
In 2007 the Supreme Court, by a slim majority, changed its view
of retail price maintenance.
Century-Old Ban Lifted on a “rule of reason,” to assess their impact on these services and other marketing practices
Minimum Retail Pricing competition. The new rule is considerably that could promote competition.
By Stephen Labaton more favorable to defendants. “In sum, it is a flawed antitrust doctrine
The decision was handed down on the that serves the interests of lawyers—by cre-
WASHINGTON, June 28—Striking down last day of the court’s term, which has been ating legal distinctions that operate as traps
an antitrust rule nearly a century old, the notable for overturning precedents and for for the unaware—more than the interests
Supreme Court ruled on Thursday that it victories for big businesses and antitrust of consumers—by requiring manufacturers
was not automatically unlawful for manu- defendants. It was also the latest of a series to choose second-best options to achieve
facturers and distributors to agree on mini- of antitrust decisions in recent years rejecting sound business objectives,” the court said
mum retail prices. per se rules that had prohibited various mar- in an opinion written by Justice Anthony M.
The decision will give producers signifi- keting agreements between companies. Kennedy and signed by Chief Justice John G.
cantly more, though not unlimited, power The Bush administration, along with Roberts Jr. and Justices Antonin Scalia, Clar-
to dictate retail prices and to restrict the economists of the Chicago school, had ence Thomas and Samuel A. Alito Jr.
flexibility of discounters. argued that the blanket prohibition against But in his dissent, portions of which he
Five justices, agreeing with the nation’s resale price maintenance agreements was read from the bench, Justice Stephen G.
major manufacturers, said the new rule archaic and counterproductive because, Breyer said that there was no compelling
could in some instances lead to more com- they said, some resale price agreements reason to overturn a century’s worth of
petition and better service. But four dissent- actually promote competition. Supreme Court decisions that had affirmed
ing justices agreed with 37 states and some For example, they said, such agree- the prohibition on resale maintenance
consumer groups that abandoning the ments can make it easier for a new producer agreements.
old rule could result in significantly higher by assuring retailers that they will be able “The only safe predictions to make about
prices and less competition for consumer to recoup their investments in helping to today’s decision are that it will likely raise the
and other goods. market the product. And some distributors price of goods at retail and that it will cre-
The court struck down the 96-year-old would be unfairly harmed by others, like ate considerable legal turbulence as lower
rule that resale price maintenance agree- Internet-based retailers, which could offer courts seek to develop workable principles,”
ments were an automatic, or per se, violation discounts because they would not have the he wrote. “I do not believe that the major-
of the Sherman Antitrust Act. In its place, the expense of product demonstrations or other ity has shown new or changed conditions
court instructed judges considering such specialized consumer services. sufficient to warrant overruling a decision of
agreements for possible antitrust violations A majority of the court agreed that the such long standing.”
to apply a case-by-case approach, known as flat ban on price agreements discouraged
Source: New York Times, June 29, 2007.
Economists continue to debate whether predatory pricing should be a concern

for antitrust policymakers. Various questions remain unresolved. Is predatory
pricing ever a profitable business strategy? If so, when? Are the courts capable of
telling which price cuts are competitive and thus good for consumers and which
are predatory? There are no simple answers.
Tying A third example of a controversial business practice is tying. Suppose that

Makemoney Movies produces two new films—Spiderman and Hamlet. If Make-
money offers theaters the two films together at a single price, rather than sepa-
rately, the studio is said to be tying its two products.
When the practice of tying movies was challenged in the courts, the Supreme
Court banned it. The court reasoned as follows: Imagine that Spiderman is a block-
buster, whereas Hamlet is an unprofitable art film. Then the studio could use the
high demand for Spiderman to force theaters to buy Hamlet. It seemed that the
studio could use tying as a mechanism for expanding its market power.
Many economists are skeptical of this argument. Imagine that theaters are will-
ing to pay $20,000 for Spiderman and nothing for Hamlet. Then the most that a
theater would pay for the two movies together is $20,000—the same as it would
pay for Spiderman by itself. Forcing the theater to accept a worthless movie as part
of the deal does not increase the theater’s willingness to pay. Makemoney cannot
increase its market power simply by bundling the two movies together.
Why, then, does tying exist? One possibility is that it is a form of price discrimi-
nation. Suppose there are two theaters. City Theater is willing to pay $15,000 for
Spiderman and $5,000 for Hamlet. Country Theater is just the opposite: It is willing
to pay $5,000 for Spiderman and $15,000 for Hamlet. If Makemoney charges sepa-
rate prices for the two films, its best strategy is to charge $15,000 for each film, and
each theater chooses to show only one film. Yet if Makemoney offers the two mov-
ies as a bundle, it can charge each theater $20,000 for the movies. Thus, if different
theaters value the films differently, tying may allow the studio to increase profit
by charging a combined price closer to the buyers’ total willingness to pay.
Tying remains a controversial business practice. The Supreme Court’s argu-
ment that tying allows a firm to extend its market power to other goods is not well
founded, at least in its simplest form. Yet economists have proposed more elabo-
rate theories for how tying can impede competition. Given our current economic
knowledge, it is unclear whether tying has adverse effects for society as a whole.
THE MICROSOFT CASE

The most important and controversial antitrust case in recent years has been the
U.S. government’s suit against the Microsoft Corporation, filed in 1998. Certainly,
the case did not lack drama. It pitted one of the world’s richest men (Bill Gates)
against one of the world’s most powerful regulatory agencies (the U.S. Justice
Department). Testifying for the government was a prominent economist (MIT
professor Franklin Fisher). Testifying for Microsoft was an equally prominent
economist (MIT professor Richard Schmalensee). At stake was the future of one of
the world’s most valuable companies (Microsoft) in one of the economy’s fastest-
growing industries (computer software).
A central issue in the Microsoft case involved tying—in particular, whether
Microsoft should be allowed to integrate its Internet browser into its Windows
operating system. The government claimed that Microsoft was bundling these
two products together to expand its market power in computer operating systems
into the unrelated market of Internet browsers. Allowing Microsoft to incorpo-
rate such products into its operating system, the government argued, would deter
other software companies from entering the market and offering new products.
Microsoft responded by pointing out that putting new features into old prod-
ucts is a natural part of technological progress. Cars today include CD players
and air conditioners, which were once sold separately, and cameras come with
built-in flashes. The same is true with operating systems. Over time, Microsoft
has added many features to Windows that were previously stand-alone products.
This has made computers more reliable and easier to use because consumers can
be confident that the pieces work together. The integration of Internet technology,
Microsoft argued, was the natural next step.
One point of disagreement concerned the extent of Microsoft’s market power.
Noting that more than 80 percent of new personal computers use a Microsoft oper-
ating system, the government argued that the company had substantial monopoly
© AP IMAGES
power, which it was trying to expand. Microsoft replied that the software mar-
ket is always changing and that Microsoft’s Windows was constantly being chal-
lenged by competitors, such as the Apple Mac and Linux operating systems. It
also argued that the low price it charged for Windows—about $50, or only 3 per-
cent of the price of a typical computer—was evidence that its market power was
“ME? A MONOPOLIST? NOW
JUST WAIT A MINUTE . . .”
severely limited.
Like many large antitrust suits, the Microsoft case became a legal morass. In
November 1999, after a long trial, Judge Penfield Jackson ruled that Microsoft had
great monopoly power and that it had illegally abused that power. In June 2000,
after hearings on possible remedies, he ordered that Microsoft be broken up into
two companies—one that sold the operating system and one that sold applica-
tions software. A year later, an appeals court overturned Jackson’s breakup order
and handed the case to a new judge. In September 2001, the Justice Department
announced that it no longer sought a breakup of the company and wanted to
settle the case quickly.
A settlement was finally reached in November 2002. Microsoft accepted some
restrictions on its business practices, and the government accepted that a browser
would remain part of the Windows operating system. But the settlement did not
end Microsoft’s antitrust troubles. In recent years, the company has contended
with several private antitrust suits, as well as suits brought by the European Union
alleging a variety of anticompetitive behaviors. ●
Q Q
UICK UIZ What kind of agreement is illegal for businesses to make? • Why are the
antitrust laws controversial?
CONCLUSION
Oligopolies would like to act like monopolies, but self-interest drives them toward
competition. Where oligopolies end up on this spectrum depends on the num-
ber of firms in the oligopoly and how cooperative the firms are. The story of the
prisoners’ dilemma shows why oligopolies can fail to maintain cooperation, even
when cooperation is in their best interest.
Policymakers regulate the behavior of oligopolists through the antitrust laws.
The proper scope of these laws is the subject of ongoing controversy. Although
price fixing among competing firms clearly reduces economic welfare and should
be illegal, some business practices that appear to reduce competition may have
legitimate if subtle purposes. As a result, policymakers need to be careful when
they use the substantial powers of the antitrust laws to place limits on firm
behavior.
SUMMARY
• Oligopolists maximize their total profits by form- tion, even when cooperation is in their mutual
ing a cartel and acting like a monopolist. Yet, if oli- interest. The logic of the prisoners’ dilemma
gopolists make decisions about production levels applies in many situations, including arms races,
individually, the result is a greater quantity and common-resource problems, and oligopolies.
a lower price than under the monopoly outcome.
The larger the number of firms in the oligopoly,
• Policymakers use the antitrust laws to prevent oli-
gopolies from engaging in behavior that reduces
the closer the quantity and price will be to the
competition. The application of these laws can
levels that would prevail under competition.
be controversial, because some behavior that can
• The prisoners’ dilemma shows that self-interest appear to reduce competition may in fact have
can prevent people from maintaining coopera- legitimate business purposes.
KEY CONCEPTS
oligopoly, p. 365 cartel, p. 367 dominant strategy, p. 371

game theory, p. 365 Nash equilibrium, p. 368
collusion, p. 367 prisoners’ dilemma, p. 370
1. If a group of sellers could form a cartel, what 5. What is the prisoners’ dilemma, and what does
quantity and price would they try to set? it have to do with oligopoly?
2. Compare the quantity and price of an oligopoly 6. Give two examples other than oligopoly to show
to those of a monopoly. how the prisoners’ dilemma helps to explain
3. Compare the quantity and price of an oligopoly behavior.
to those of a competitive market. 7. What kinds of behavior do the antitrust laws
4. How does the number of firms in an oligopoly prohibit?
affect the outcome in its market? 8. What is resale price maintenance, and why is it
controversial?
1. A large share of the world supply of diamonds 3. This chapter discusses companies that are oli-
comes from Russia and South Africa. Suppose gopolists in the market for the goods they sell.
that the marginal cost of mining diamonds Many of the same ideas apply to companies that
is constant at $1,000 per diamond, and the are oligopolists in the market for the inputs they
demand for diamonds is described by the fol- buy.
lowing schedule: a. If sellers who are oligopolists try to increase
Price Quantity
the price of goods they sell, what is the goal
of buyers who are oligopolists?
$8,000 5,000 diamonds
b. Major league baseball team owners have an
7,000 6,000 oligopoly in the market for baseball players.
6,000 7,000 What is the owners’ goal regarding players’
5,000 8,000 salaries? Why is this goal difficult to achieve?
4,000 9,000 c. Baseball players went on strike in 1994
3,000 10,000 because they would not accept the salary
2,000 11,000 cap that the owners wanted to impose. If the
1,000 12,000 owners were already colluding over salaries,
a. If there were many suppliers of diamonds, why did the owners feel the need for a salary
what would be the price and quantity? cap?
b. If there were only one supplier of diamonds, 4. Consider trade relations between the United
what would be the price and quantity? States and Mexico. Assume that the leaders of
c. If Russia and South Africa formed a cartel, the two countries believe the payoffs to alterna-
what would be the price and quantity? If tive trade policies are as follows:
the countries split the market evenly, what United States’ Decision
would be South Africa’s production and Low Tariffs High Tariffs
profit? What would happen to South Africa’s U.S. gains U.S. gains
profit if it increased its production by 1,000 Low
$25 billion $30 billion
while Russia stuck to the cartel agreement? Tariffs

Mexico gains Mexico gains
d. Use your answers to part (c) to explain why Mexico’s $25 billion $10 billion
cartel agreements are often not successful. Decision U.S. gains U.S. gains
$10 billion $20 billion
2. The New York Times (Nov. 30, 1993) reported High
that “the inability of OPEC to agree last week Tariffs
Mexico gains Mexico gains
to cut production has sent the oil market into $30 billion $20 billion
turmoil . . . [leading to] the lowest price for

domestic crude oil since June 1990.” a. What is the dominant strategy for the United
a. Why were the members of OPEC trying to States? For Mexico? Explain.
agree to cut production? b. Define Nash equilibrium. What is the Nash
b. Why do you suppose OPEC was unable to equilibrium for trade policy?
agree on cutting production? Why did the c. In 1993 the U.S. Congress ratified the North
oil market go into “turmoil” as a result? American Free Trade Agreement, in which
c. The newspaper also noted OPEC’s view the United States and Mexico agreed to
“that producing nations outside the organi- reduce trade barriers simultaneously. Do the
zation, like Norway and Britain, should do perceived payoffs shown here justify this
their share and cut production.” What does approach to trade policy? Explain.
the phrase “do their share” suggest about d. Based on your understanding of the gains
OPEC’s desired relationship with Norway from trade (discussed in Chapters 3 and
and Britain? 9), do you think that these payoffs actually
reflect a nation’s welfare under the four pos- b. What is the likely outcome? Explain your
sible outcomes? answer.
5. Synergy and Dynaco are the only two firms in c. If you get this classmate as your partner on a
a specific high-tech industry. They face the fol- series of projects throughout the year, rather
lowing payoff matrix as they decide upon the than only once, how might that change the
size of their research budget: outcome you predicted in part (b)?
d. Another classmate cares more about good
Synergy Decision
grades: He gets 50 units of happiness for a B,
Large Budget Small Budget
and 80 units of happiness from an A. If this
Synergy gains Synergy gains
$20 million zero
classmate were your partner (but your pref-
Large
Budget
erences were unchanged), how would your
Dynaco gains
$30 million
Dynaco gains
$70 million
answers to parts (a) and (b) change? Which
Dynaco’s
Decision Synergy gains Synergy gains
of the two classmates would you prefer as
$30 million $40 million a partner? Would he also want you as a
Small
Budget partner?
Dynaco gains Dynaco gains
zero $50 million 7. A case study in the chapter describes a phone
conversation between the presidents of Ameri-
a. Does Synergy have a dominant strategy? can Airlines and Braniff Airways. Let’s analyze
Explain. the game between the two companies. Suppose
b. Does Dynaco have a dominant strategy? that each company can charge either a high
Explain. price for tickets or a low price. If one company
c. Is there a Nash equilibrium for this scenario? charges $100, it earns low profits if the other
Explain. (Hint: Look closely at the definition company charges $100 also, and high profits if
of Nash equilibrium.) the other company charges $200. On the other
6. You and a classmate are assigned a project on hand, if the company charges $200, it earns
which you will receive one combined grade. very low profits if the other company charges
You each want to receive a good grade, but you $100, and medium profits if the other company
also want to avoid hard work. In particular, here charges $200 also.
is the situation: a. Draw the decision box for this game.
• If both of you work hard, you both get b. What is the Nash equilibrium in this game?
an A, which gives each of you 40 units of Explain.
happiness. c. Is there an outcome that would be better than
• If only one of you works hard, you both the Nash equilibrium for both airlines? How
get a B, which gives each of you 30 units of could it be achieved? Who would lose if it
happiness. were achieved?
• If neither of you works hard, you both get 8. Little Kona is a small coffee company that is
a D, which gives each of you 10 units of considering entering a market dominated by
happiness. Big Brew. Each company’s profit depends on
• Working hard costs 25 units of happiness. whether Little Kona enters and whether Big
a. Fill in the payoffs in the following decision Brew sets a high price or a low price:
box:
Big Brew
Your Decision High Price Low Price
Work Shirk Brew makes Brew makes

$3 million $1 million
You: You:
Enter
Kona makes Kona loses
Work
Little $2 million $1 million
Classmate: Classmate:
Kona Brew makes Brew makes
Classmate’s
$7 million $2 million
Decision
You: You: Don’t
Enter
Kona makes Kona makes
Shirk
zero zero
Classmate: Classmate:
a. Does either player in this game have a domi- Does either player have a dominant strategy? If
nant strategy? Jeff chooses a particular strategy (Left or Right)
b. Does your answer to part (a) help you figure and sticks with it, what will Steve do? Can you
out what the other player should do? What is think of a better strategy for Jeff to follow?
the Nash equilibrium? Is there only one? 10. Let’s return to the chapter’s discussion of Jack
c. Big Brew threatens Little Kona by saying, “If and Jill’s water duopoly. Suppose that Jack and
you enter, we’re going to set a low price, so Jill are at the duopoly’s Nash equilibrium (80
you had better stay out.” Do you think Little gallons) when a third person, John, discovers
Kona should believe the threat? Why or why a water source and joins the market as a third
not? producer.
d. If the two firms could collude and agree on a. Jack and Jill propose that the three of them
how to split the total profits, what outcome continue to produce a total of 80 gallons,
would they pick? splitting the market three ways. If John
9. Jeff and Steve are playing tennis. Every point agrees to this, how much profit will he make?
comes down to whether Steve guesses correctly b. After agreeing to the proposed deal, John is
whether Jeff will hit the ball to Steve’s left or considering increasing his production by 10
right. The outcomes are: gallons. If he does, and Jack and Jill stick to
the agreement, how much profit will John
Steve Guesses
make? What does this tell you about the pro-
Left Right
posed agreement?
Steve wins Steve loses
point point c. What is the Nash equilibrium for this market
Left with three producers? How does it compare
Jeff loses
point
Jeff wins
point
to the Nash equilibrium with two producers?
Jeff
Hits
Steve loses Steve wins
point point
Right
Jeff wins Jeff loses
point point
PART VI
The Economics
of Labor Markets
18
CHAPTER
The Markets for the Factors

of Production
W hen you finish school, your income will be determined largely by

what kind of job you take. If you become a computer programmer,
you will earn more than if you become a gas station attendant. This
fact is not surprising, but it is not obvious why it is true. No law requires that com-
puter programmers be paid more than gas station attendants. No ethical principle
says that programmers are more deserving. What then determines which job will
pay you the higher wage?
Your income, of course, is a small piece of a larger economic picture. In 2008, the
total income of all U.S. residents was about $14 trillion. People earned this income
in various ways. Workers earned about three-fourths of it in the form of wages
and fringe benefits. The rest went to landowners and to the owners of capital—the
economy’s stock of equipment and structures—in the form of rent, profit, and
interest. What determines how much goes to workers? To landowners? To the
owners of capital? Why do some workers earn higher wages than others, some
landowners higher rental income than others, and some capital owners greater
profit than others? Why, in particular, do computer programmers earn more than
gas station attendants?
391
392 PART VI THE ECONOMICS OF LABOR MARKETS
The answers to these questions, like most in economics, hinge on supply and
demand. The supply and demand for labor, land, and capital determine the prices
paid to workers, landowners, and capital owners. To understand why some peo-
ple have higher incomes than others, therefore, we need to look more deeply at
the markets for the services they provide. That is our job in this and the next two
chapters.
This chapter provides the basic theory for the analysis of factor markets. As
factors of production you may recall from Chapter 2, the factors of production are the inputs used to
the inputs used to pro- produce goods and services. Labor, land, and capital are the three most important
duce goods and services factors of production. When a computer firm produces a new software program, it
uses programmers’ time (labor), the physical space on which its offices are located
(land), and an office building and computer equipment (capital). Similarly, when
a gas station sells gas, it uses attendants’ time (labor), the physical space (land),
and the gas tanks and pumps (capital).
In many ways factor markets resemble the markets for goods and services we
analyzed in previous chapters, but in one important way they are different: The
demand for a factor of production is a derived demand. That is, a firm’s demand
for a factor of production is derived from its decision to supply a good in another
market. The demand for computer programmers is inseparably linked to the sup-
ply of computer software, and the demand for gas station attendants is insepara-
bly linked to the supply of gasoline.
In this chapter, we analyze factor demand by considering how a competitive,
profit-maximizing firm decides how much of any factor to buy. We begin our
analysis by examining the demand for labor. Labor is the most important factor of
production, because workers receive most of the total income earned in the U.S.
economy. Later in the chapter, we see that the lessons we learn about the labor
market also apply to the markets for the other factors of production.
The basic theory of factor markets developed in this chapter takes a large step
toward explaining how the income of the U.S. economy is distributed among
workers, landowners, and owners of capital. Chapter 19 builds on this analysis
to examine in more detail why some workers earn more than others. Chapter
20 examines how much income inequality results from the functioning of factor
markets and then considers what role the government should and does play in
altering the income distribution.
THE DEMAND FOR LABOR

Labor markets, like other markets in the economy, are governed by the forces of
supply and demand. This is illustrated in Figure 1. In panel (a), the supply and
demand for apples determine the price of apples. In panel (b), the supply and
demand for apple pickers determine the price, or wage, of apple pickers.
As we have already noted, labor markets are different from most other markets
because labor demand is a derived demand. Most labor services, rather than being
final goods ready to be enjoyed by consumers, are inputs into the production of
other goods. To understand labor demand, we need to focus on the firms that
hire the labor and use it to produce goods for sale. By examining the link between
the production of goods and the demand for labor to make those goods, we gain
insight into the determination of equilibrium wages.
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 393
The basic tools of supply and demand apply to goods and to labor services. Panel (a)
shows how the supply and demand for apples determine the price of apples. Panel
F I G U R E 1
(b) shows how the supply and demand for apple pickers determine the wage of
apple pickers.
The Versatility of
Supply and Demand
(a) The Market for Apples (b) The Market for Apple Pickers
Price of Wage of
Apples Apple
Pickers
Supply Supply
P W
Demand Demand
0 Q Quantity of 0 L Quantity of
Apples Apple Pickers
THE COMPETITIVE PROFIT-M AXIMIZING FIRM

Let’s look at how a typical firm, such as an apple producer, decides the quantity
of labor to demand. The firm owns an apple orchard and each week must decide
how many apple pickers to hire to harvest its crop. After the firm makes its hir-
ing decision, the workers pick as many apples as they can. The firm then sells the
apples, pays the workers, and keeps what is left as profit.
We make two assumptions about our firm. First, we assume that our firm is com-
petitive both in the market for apples (where the firm is a seller) and in the market
for apple pickers (where the firm is a buyer). A competitive firm is a price taker.
Because there are many other firms selling apples and hiring apple pickers, a single
firm has little influence over the price it gets for apples or the wage it pays apple
pickers. The firm takes the price and the wage as given by market conditions. It
only has to decide how many apples to sell and how many workers to hire.
Second, we assume that the firm is profit-maximizing. Thus, the firm does not
directly care about the number of workers it has or the number of apples it pro-
duces. It cares only about profit, which equals the total revenue from the sale of
apples minus the total cost of producing them. The firm’s supply of apples and its
demand for workers are derived from its primary goal of maximizing profit.
THE PRODUCTION FUNCTION AND THE M ARGINAL

PRODUCT OF LABOR
To make its hiring decision, the firm must consider how the size of its workforce
affects the amount of output produced. In other words, it must consider how the
1 T A B L E
How the Competitive Firm Decides

How Much Labor to Hire
Value of the
Marginal Product Marginal Product
Labor Output of Labor of Labor Wage Marginal Profit
L Q MPL = ∆Q / ∆L VMPL = P × MPL W ∆Profit = VMPL – W
0 workers 0 bushels
100 bushels $1,000 $500 $500
1 100
80 800 500 300
2 180
60 600 500 100
3 240
40 400 500 –100
4 280
20 200 500 –300
5 300
number of apple pickers affects the quantity of apples it can harvest and sell. Table 1
gives a numerical example. In the first column is the number of workers. In the
second column is the quantity of apples the workers harvest each week.
These two columns of numbers describe the firm’s ability to produce. Recall
production function that economists use the term production function to describe the relationship
the relationship between between the quantity of the inputs used in production and the quantity of output
the quantity of inputs from production. Here the “input” is the apple pickers and the “output” is the
used to make a good apples. The other inputs—the trees themselves, the land, the firm’s trucks and
and the quantity of tractors, and so on—are held fixed for now. This firm’s production function shows
output of that good
that if the firm hires 1 worker, that worker will pick 100 bushels of apples per
week. If the firm hires 2 workers, the 2 workers together will pick 180 bushels per
week. And so on.
marginal product Figure 2 graphs the data on labor and output presented in Table 1. The number
of labor of workers is on the horizontal axis, and the amount of output is on the vertical
the increase in the axis. This figure illustrates the production function.
amount of output from One of the Ten Principles of Economics introduced in Chapter 1 is that ratio-
an additional unit of nal people think at the margin. This idea is the key to understanding how firms
labor decide what quantity of labor to hire. To take a step toward this decision, the third
column in Table 1 gives the marginal product of labor, the increase in the amount
diminishing marginal
product
of output from an additional unit of labor. When the firm increases the number of
the property whereby workers from 1 to 2, for example, the amount of apples produced rises from 100 to
the marginal product 180 bushels. Therefore, the marginal product of the second worker is 80 bushels.
of an input declines as Notice that as the number of workers increases, the marginal product of labor
the quantity of the input declines. That is, the production process exhibits diminishing marginal product.
increases At first, when only a few workers are hired, they can pick the low-hanging fruit. As
Quantity
F I G U R E 2
of Apples
Production The Production Function
300 function
280 The production function is the rela-
tionship between the inputs into
240 production (apple pickers) and the
output from production (apples). As
the quantity of the input increases,
180
the production function gets flatter,
reflecting the property of diminish-
ing marginal product.
100
0 1 2 3 4 5 Quantity of
Apple Pickers
the number of workers increases, additional workers have to climb higher up the
ladders to find apples to pick. Hence, as more and more workers are hired, each
additional worker contributes less to the production of apples. For this reason, the
production function in Figure 2 becomes flatter as the number of workers rises.
THE VALUE OF THE M ARGINAL PRODUCT

AND THE DEMAND FOR LABOR
Our profit-maximizing firm is concerned more with money than with apples. As
a result, when deciding how many workers to hire to pick apples, the firm consid-
ers how much profit each worker would bring in. Because profit is total revenue
minus total cost, the profit from an additional worker is the worker’s contribution
to revenue minus the worker’s wage.
To find the worker’s contribution to revenue, we must convert the marginal
product of labor (which is measured in bushels of apples) into the value of the
marginal product (which is measured in dollars). We do this using the price of
apples. To continue our example, if a bushel of apples sells for $10 and if an addi-
tional worker produces 80 bushels of apples, then the worker produces $800 of
revenue.
The value of the marginal product of any input is the marginal product of that value of the marginal
input multiplied by the market price of the output. The fourth column in Table 1 product
shows the value of the marginal product of labor in our example, assuming the the marginal product of
price of apples is $10 per bushel. Because the market price is constant for a compet- an input times the price
itive firm while the marginal product declines with more workers, the value of the of the output
marginal product diminishes as the number of workers rises. Economists some-
times call this column of numbers the firm’s marginal revenue product: It is the extra
revenue the firm gets from hiring an additional unit of a factor of production.
Now consider how many workers the firm will hire. Suppose that the market
wage for apple pickers is $500 per week. In this case, as you can see in Table 1,
the first worker that the firm hires is profitable: The first worker yields $1,000 in
revenue, or $500 in profit. Similarly, the second worker yields $800 in additional
revenue, or $300 in profit. The third worker produces $600 in additional revenue,
or $100 in profit. After the third worker, however, hiring workers is unprofit-
able. The fourth worker would yield only $400 of additional revenue. Because the
worker’s wage is $500, hiring the fourth worker would mean a $100 reduction in
profit. Thus, the firm hires only 3 workers.
It is instructive to consider the firm’s decision graphically. Figure 3 graphs the
value of the marginal product. This curve slopes downward because the mar-
ginal product of labor diminishes as the number of workers rises. The figure also
includes a horizontal line at the market wage. To maximize profit, the firm hires
workers up to the point where these two curves cross. Below this level of employ-
ment, the value of the marginal product exceeds the wage, so hiring another
worker would increase profit. Above this level of employment, the value of the
marginal product is less than the wage, so the marginal worker is unprofitable.
Thus, a competitive, profit-maximizing firm hires workers up to the point where the value
of the marginal product of labor equals the wage.
Having explained the profit-maximizing hiring strategy for a competitive firm,
we can now offer a theory of labor demand. Recall that a firm’s labor-demand
curve tells us the quantity of labor that a firm demands at any given wage. We
have just seen in Figure 3 that the firm makes that decision by choosing the quan-
tity of labor at which the value of the marginal product equals the wage. As a
result, the value-of-marginal-product curve is the labor-demand curve for a competitive,
profit-maximizing firm.
3 F I G U R E
Value
of the
Marginal
The Value of the Marginal
Product
Product of Labor
This figure shows how the value of
the marginal product (the marginal
product times the price of the output)
depends on the number of workers. Market
The curve slopes downward because wage
of diminishing marginal product. For
a competitive, profit-maximizing firm,
this value-of-marginal-product curve is
also the firm’s labor-demand curve.
Value of marginal product
(demand curve for labor)
0 Profit-maximizing quantity Quantity of

Apple Pickers
Input Demand and Output Supply:

Two Sides of the Same Coin
In Chapter 14, we saw how with workers, so it is more costly to produce an additional bushel of
a competitive, profit-maximizing firm decides how much of its out- apples (MC rises).
put to sell: It chooses the quantity of output at which the price of the Now consider our criterion for profit maximization. We deter-
good equals the marginal cost of production. We have just seen how mined earlier that a profit-maximizing firm chooses the quantity of
such a firm decides how much labor to hire: It chooses the quantity labor so that the value of the marginal product (P × MPL) equals the
of labor at which the wage equals the value of the marginal prod- wage (W). We can write this mathematically as
uct. Because the production function links the quantity of inputs to
P × MPL = W.
the quantity of output, you should not be surprised to learn that the
firm’s decision about input demand is closely linked to its decision If we divide both sides of this equation by MPL, we obtain
about output supply. In fact, these two decisions are two sides of
P = W / MPL.
the same coin.
To see this relationship more fully, let’s consider how the mar- We just noted that W / MPL equals marginal cost, MC. Therefore, we
ginal product of labor (MPL) and marginal cost (MC) are related. Sup- can substitute to obtain
pose an additional worker costs $500 and has a marginal product of
P = MC.
50 bushels of apples. In this case, producing 50 more bushels costs
$500; the marginal cost of a bushel is $500 / 50, or $10. More gener- This equation states that the price of the firm’s output is equal to the
ally, if W is the wage, and an extra unit of labor produces MPL units of marginal cost of producing a unit of output. Thus, when a competitive
output, then the marginal cost of a unit of output is MC = W / MPL. firm hires labor up to the point at which the value of the marginal prod-
This analysis shows that diminishing marginal product is closely uct equals the wage, it also produces up to the point at which the price
related to increasing marginal cost. When our apple orchard grows equals marginal cost. Our analysis of labor demand in this chapter is
crowded with workers, each additional worker adds less to the pro- just another way of looking at the production decision we first saw
duction of apples (MPL falls). Similarly, when the apple firm is pro- in Chapter 14.
ducing a large quantity of apples, the orchard is already crowded
WHAT CAUSES THE LABOR-DEMAND CURVE TO SHIFT?

We now understand the labor-demand curve: It reflects the value of the marginal
product of labor. With this insight in mind, let’s consider a few of the things that
might cause the labor-demand curve to shift.
The Output Price The value of the marginal product is marginal product times
the price of the firm’s output. Thus, when the output price changes, the value of
the marginal product changes, and the labor-demand curve shifts. An increase in
the price of apples, for instance, raises the value of the marginal product of each
worker who picks apples and, therefore, increases labor demand from the firms
that supply apples. Conversely, a decrease in the price of apples reduces the value
of the marginal product and decreases labor demand.
Technological Change Between 1960 and 2000, the amount of output a typical
U.S. worker produced in an hour rose by 140 percent. Why? The most important
The Luddite Revolt
Over the long span of his-

tory, technological progress has been the worker’s friend. It has
increased productivity, labor demand, and wages. Yet there is no
doubt that workers sometimes see technological progress as a
threat to their standard of living.
One famous example occurred in England in the early 19th cen-
tury, when skilled knitters saw their jobs threatened by the inven-
tion and spread of machines that could produce textiles using less
skilled workers and at much lower cost. The displaced workers orga-
nized violent revolts against the new technology. They smashed the
weaving machines used in the wool and cotton mills and, in some
cases, set the homes of the mill owners on fire. Because the workers
claimed to be led by General Ned Ludd (who may have been a leg-
endary figure rather than a real person), they were called Luddites.
The Luddites wanted the British government to save their jobs
by restricting the spread of the new technology. Instead, the Parlia-

ment took action to stop the Luddites. Thousands of troops were The Luddites.
sent to suppress the Luddite riots, and the Parliament eventually
made destroying machines a capital crime. After a trial in York in
1813, seventeen men were hanged for the offense. Many others Today, the term Luddite refers to anyone who opposes techno-
were convicted and sent to Australia as prisoners. logical progress.
reason is technological progress: Scientists and engineers are constantly figur-

ing out new and better ways of doing things. This has profound implications for
the labor market. Technological advance typically raises the marginal product of
labor, which in turn increases the demand for labor and shifts the labor-demand
curve to the right.
It is also possible for technological change to reduce labor demand. The inven-
tion of a cheap industrial robot, for instance, could conceivably reduce the mar-
ginal product of labor, shifting the labor-demand curve to the left. Economists
call this labor-saving technological change. History suggests, however, that most
technological progress is instead labor-augmenting. Such technological advance
explains persistently rising employment in the face of rising wages: Even though
wages (adjusted for inflation) increased by 131 percent during the last four decades
of the 20th century, firms nonetheless increased by 80 percent the amount of labor
they employed.
The Supply of Other Factors The quantity available of one factor of production
can affect the marginal product of other factors. A fall in the supply of ladders, for
instance, will reduce the marginal product of apple pickers and thus the demand
for apple pickers. We consider this linkage among the factors of production more
fully later in the chapter.
Q Q
UICK UIZ Define marginal product of labor and value of the marginal product of
labor. • Describe how a competitive, profit-maximizing firm decides how many workers
to hire.
THE SUPPLY OF LABOR

Having analyzed labor demand in detail, let’s turn to the other side of the market
and consider labor supply. A formal model of labor supply is included in Chapter
21, where we develop the theory of household decision making. Here we discuss
briefly and informally the decisions that lie behind the labor-supply curve.
THE TRADE-OFF BETWEEN WORK AND LEISURE

One of the Ten Principles of Economics in Chapter 1 is that people face trade-offs.
Probably no trade-off is more obvious or more important in a person’s life than
the trade-off between work and leisure. The more hours you spend working, the
fewer hours you have to watch TV, enjoy dinner with friends, or pursue your
favorite hobby. The trade-off between labor and leisure lies behind the labor-
supply curve.
Another of the Ten Principles of Economics is that the cost of something is what
you give up to get it. What do you give up to get an hour of leisure? You give up
an hour of work, which in turn means an hour of wages. Thus, if your wage is $15
per hour, the opportunity cost of an hour of leisure is $15. And when you get a
raise to $20 per hour, the opportunity cost of enjoying leisure goes up.
The labor-supply curve reflects how workers’ decisions about the labor-leisure
trade-off respond to a change in that opportunity cost. An upward-sloping labor-
supply curve means that an increase in the wage induces workers to increase the
quantity of labor they supply. Because time is limited, more hours of work mean
that workers are enjoying less leisure. That is, workers respond to the increase in
the opportunity cost of leisure by taking less of it.
It is worth noting that the labor-supply curve need not be upward sloping.
Imagine you got that raise from $15 to $20 per hour. The opportunity cost of
leisure is now greater, but you are also richer than you were before. You might
decide that with your extra wealth you can now afford to enjoy more leisure. That
is, at the higher wage, you might choose to work fewer hours. If so, your labor- “I REALLY DIDN’T ENJOY
supply curve would slope backward. In Chapter 21, we discuss this possibility in WORKING FIVE DAYS A WEEK,
terms of conflicting effects on your labor-supply decision (called the income and FIFTY WEEKS A YEAR FOR
substitution effects). For now, we ignore the possibility of backward-sloping labor FORTY YEARS, BUT I NEEDED
supply and assume that the labor-supply curve is upward sloping. THE MONEY.”
WHAT CAUSES THE LABOR-SUPPLY CURVE TO SHIFT?

The labor-supply curve shifts whenever people change the amount they want to
work at a given wage. Let’s now consider some of the events that might cause
such a shift.
Changes in Tastes In 1950, 34 percent of women were employed at paid jobs

or looking for work. In 2000, the number had risen to 60 percent. There are many
explanations for this development, but one of them is changing tastes, or attitudes
toward work. A generation or two ago, it was the norm for women to stay at home
while raising children. Today, family sizes are smaller, and more mothers choose
to work. The result is an increase in the supply of labor.
Changes in Alternative Opportunities The supply of labor in any one labor

market depends on the opportunities available in other labor markets. If the wage
earned by pear pickers suddenly rises, some apple pickers may choose to switch
occupations, and the supply of labor in the market for apple pickers falls.
Immigration Movement of workers from region to region, or country to country,

is another important source of shifts in labor supply. When immigrants come to
the United States, for instance, the supply of labor in the United States increases,
and the supply of labor in the immigrants’ home countries falls. In fact, much of
the policy debate about immigration centers on its effect on labor supply and,
thereby, equilibrium wages in the labor market.
Q Q
UICK UIZ Who has a greater opportunity cost of enjoying leisure—a janitor or a brain
surgeon? Explain. Can this help explain why doctors work such long hours?
EQUILIBRIUM IN THE LABOR MARKET

So far we have established two facts about how wages are determined in competi-
tive labor markets:
• The wage adjusts to balance the supply and demand for labor.
• The wage equals the value of the marginal product of labor.
At first, it might seem surprising that the wage can do both of these things at once.
In fact, there is no real puzzle here, but understanding why there is no puzzle is
an important step to understanding wage determination.
Figure 4 shows the labor market in equilibrium. The wage and the quantity
of labor have adjusted to balance supply and demand. When the market is in
this equilibrium, each firm has bought as much labor as it finds profitable at the
equilibrium wage. That is, each firm has followed the rule for profit maximiza-
tion: It has hired workers until the value of the marginal product equals the wage.
Hence, the wage must equal the value of the marginal product of labor once it has
brought supply and demand into equilibrium.
This brings us to an important lesson: Any event that changes the supply or demand
for labor must change the equilibrium wage and the value of the marginal product by the
same amount because these must always be equal. To see how this works, let’s consider
some events that shift these curves.
SHIFTS IN LABOR SUPPLY

Suppose that immigration increases the number of workers willing to pick apples.
As Figure 5 shows, the supply of labor shifts to the right from S1 to S2. At the ini-
tial wage W1, the quantity of labor supplied now exceeds the quantity demanded.
Wage
F I G U R E 4
(price of
labor)
Supply Equilibrium in a Labor Market
Like all prices, the price of labor
(the wage) depends on supply and
demand. Because the demand
curve reflects the value of the
Equilibrium marginal product of labor, in
wage, W equilibrium workers receive the
value of their marginal contribu-
tion to the production of goods
and services.
Demand
0 Equilibrium Quantity of
employment, L Labor
This surplus of labor puts downward pressure on the wage of apple pickers, and
the fall in the wage from W1 to W2 in turn makes it profitable for firms to hire more
workers. As the number of workers employed in each apple orchard rises, the
marginal product of a worker falls, and so does the value of the marginal product.
In the new equilibrium, both the wage and the value of the marginal product of
labor are lower than they were before the influx of new workers.
Wage
F I G U R E
5
(price of 1. An increase in
Supply, S1 labor supply . . .
labor)
S2 A Shift in Labor Supply
When labor supply increases
from S1 to S2, perhaps
because of an immigration
W1
of new workers, the equilib-
rium wage falls from W1 to
W2. At this lower wage, firms
W2 hire more labor, so employ-
2. . . . reduces ment rises from L1 to L2. The
the wage . . . change in the wage reflects
a change in the value of the
Demand marginal product of labor:
With more workers, the
added output from an extra
0 L1 L2 Quantity of worker is smaller.
Labor
3. . . . and raises employment.
The Economics of Immigration

Here is an interview with Pia Orrenius, an economist at the Federal
Reserve Bank of Dallas who studies immigration.
Q: What can you tell us about the size of the Being in the workforce allows immi-
immigrant population in the United States? grants to interact with the rest of society.
A: Immigrants make up about 12 per- They learn the language faster, pay taxes
cent of the overall population, which means and become stakeholders.
about 36 million foreign-born live in the Q: Where do immigrants fit into the U.S.
United States. The commonly accepted esti- economy?
mate for the undocumented portion of the A: Our immigrants are diverse in eco-
foreign-born population is 11 million. Immi- nomic terms. We rely on immigrants for both
© COURTESY OF FEDERAL RESERVE BANK OF DALLAS,
grants come from all parts of the world, but high- and low-skilled jobs. Some immigrants
we’ve seen big changes in their origins. In the do medium-skilled work, but more than any-
Pia Orrenius
SOUTHWEST ECONOMY, MARCH/APRIL 2006.
1950s and 1960s, 75 percent of immigrants thing else they’re found on the low and the
were from Europe. Today, about 75 percent ment rates compared with other developed high ends of the education distribution.
are from Latin America and Asia. Inflows are countries. This is partly because we don’t set The economic effects are different
also much larger today, with 1 million to 2 high entry-level wages or have strict hiring depending on which group you’re talking
million newcomers entering each year. and firing rules. In this type of flexible sys- about. We have an extremely important
What’s interesting about the United tem, you have more job openings. You have group of high-skilled immigrants. We rely
States is how our economy has been able more opportunities. You also have lower on them to fill important, high-level jobs
to absorb immigrants and put them to entry-level wages, but immigrants at least in technology, science and research. About
work. U.S. immigrants have high employ- get their foot in the door. 40 percent of our Ph.D. scientists and engi-
An episode from Israel illustrates how a shift in labor supply can alter the equi-
librium in a labor market. During most of the 1980s, many thousands of Palestin-
ians regularly commuted from their homes in the Israeli-occupied West Bank and
Gaza Strip to jobs in Israel, primarily in the construction and agriculture indus-
tries. In 1988, however, political unrest in these occupied areas induced the Israeli
government to take steps that, as a by-product, reduced this supply of workers.
Curfews were imposed, work permits were checked more thoroughly, and a ban
on overnight stays of Palestinians in Israel was enforced more rigorously. The
economic impact of these steps was exactly as theory predicts: The number of
Palestinians with jobs in Israel fell by half, while those who continued to work
in Israel enjoyed wage increases of about 50 percent. With a reduced number of
Palestinian workers in Israel, the value of the marginal product of the remaining
workers was much higher.
neers were born in another country. We also Q: Does it matter whether the immigration wages of Americans, particularly the low-
employ many high-skilled immigrants in the is legal or not? skilled who lack a high school degree. The
health sector. A: If you’re making value judgments reason we worry about this is that real
High-skilled immigration has good eco- about immigrants, or if you’re discussing wages have been falling for low-skilled U.S.
nomic effects—it adds to GDP growth. It also national security, you probably need to dis- workers over the past 25 years or so.
has beneficial fiscal effects—the impact on tinguish between those who come legally The studies tend to show that not much
government finances is large and positive. and those who don’t. From an economic of the decline is due to inflows of immigrants.
People tend to focus on illegal or low-skilled perspective, however, it makes more sense The consensus seems to be that wages are
immigration when discussing immigrants to differentiate among immigrants of vari- about 1 to 3 percent lower today as a result
and often do not recognize the tremendous ous skill levels than it does to focus on legal of immigration. Some scholars find larger
contribution of high-skilled immigrants. status. effects for low-skilled workers. Still, labor
Q: What about the low-skilled The economic benefits of low-skilled economists think it’s a bit of a puzzle that
immigration? immigrants aren’t typically going to depend they haven’t been able to systematically
A: With low-skilled immigration, the eco- on how they entered the United States. identify larger adverse wage effects.
nomic benefits are there as well but have to Illegal immigrants may pay less in taxes, The reason may be the way the econ-
be balanced against the fiscal impact, which but they’re also eligible for fewer benefits. omy is constantly adjusting to the inflow
is likely negative. So being illegal doesn’t mean these immi- of immigrants. On a geographical basis, for
What makes the fiscal issue more dif- grants have a worse fiscal impact. In fact, a example, a large influx of immigrants into an
ficult is the distribution of the burden. The low-skilled illegal immigrant can create less area tends to encourage an inflow of capital
federal government reaps much of the rev- fiscal burden than a low-skilled legal immi- to put them to use. So you have a shift out
enue from immigrants who work and pay grant because the undocumented don’t in labor supply, but you also have a shift out
employment taxes. State and local govern- qualify for most benefits. in labor demand, and the wage effects are
ments realize less of that benefit and have Q: How does immigration affect jobs and ameliorated.
to pay more of the costs associated with earnings for the native-born population?
low-skilled immigration—usually health A: We focus a lot on that—for example,
care and educational expenses. exactly how immigration has affected the
Source: Southwest Economy, March/April 2006.
SHIFTS IN LABOR DEMAND

Now suppose that an increase in the popularity of apples causes their price to
rise. This price increase does not change the marginal product of labor for any
given number of workers, but it does raise the value of the marginal product. With
a higher price of apples, hiring more apple pickers is now profitable. As Figure
6 shows, when the demand for labor shifts to the right from D1 to D2, the equi-
librium wage rises from W1 to W2, and equilibrium employment rises from L1 to
L2. Once again, the wage and the value of the marginal product of labor move
together.
This analysis shows that prosperity for firms in an industry is often linked to
prosperity for workers in that industry. When the price of apples rises, apple pro-
ducers make greater profit, and apple pickers earn higher wages. When the price
6 F I G U R E
Wage
(price of Supply
labor)
A Shift in Labor Demand
When labor demand increases
from D1 to D2, perhaps because
of an increase in the price of W2
the firm’s output, the equilib-
rium wage rises from W1 to W2, 1. An increase in
and employment rises from L1 labor demand . . .
to L2. Again, the change in the W1
wage reflects a change in the 2. . . . increases
value of the marginal product the wage . . . D2
of labor: With a higher output
price, the added output from an
extra worker is more valuable. Demand, D1
0 L1 L2 Quantity of
Labor
3. . . . and increases employment.
of apples falls, apple producers earn smaller profit, and apple pickers earn lower
wages. This lesson is well known to workers in industries with highly volatile
prices. Workers in oil fields, for instance, know from experience that their earn-
ings are closely linked to the world price of crude oil.
From these examples, you should now have a good understanding of how
wages are set in competitive labor markets. Labor supply and labor demand
together determine the equilibrium wage, and shifts in the supply or demand
curve for labor cause the equilibrium wage to change. At the same time, profit
maximization by the firms that demand labor ensures that the equilibrium wage
always equals the value of the marginal product of labor.
PRODUCTIVITY AND WAGES
One of the Ten Principles of Economics in Chapter 1 is that our standard of liv-
ing depends on our ability to produce goods and services. We can now see how
this principle works in the market for labor. In particular, our analysis of labor
demand shows that wages equal productivity as measured by the value of the
marginal product of labor. Put simply, highly productive workers are highly paid,
and less productive workers are less highly paid.
This lesson is key to understanding why workers today are better off than
workers in previous generations. Table 2 presents some data on growth in pro-
ductivity and growth in real wages (that is, wages adjusted for inflation). From
1959 to 2006, productivity as measured by output per hour of work grew about
2.1 percent per year. Real wages grew at 2.0 percent—almost exactly the same
rate. With a growth rate of 2 percent per year, productivity and real wages double
about every 35 years.
T A B L E
2
Growth Rate Growth Rate
Time Period of Productivity of Real Wages
Productivity and
Wage Growth in the
1959–2006 2.1% 2.0%
United States
1959–1973 2.8 2.8
1973–1995 1.4 1.2
1995–2006 2.6 2.5
Source: Economic Report of the President 2008, Table B-49. Growth in productivity is measured
here as the annualized rate of change in output per hour in the nonfarm business sector. Growth
in real wages is measured as the annualized change in compensation per hour in the nonfarm
business sector divided by the implicit price deflator for that sector. These productivity data
measure average productivity—the quantity of output divided by the quantity of labor—rather
than marginal productivity, but average and marginal productivity are thought to move closely
together.
Productivity growth varies over time. Table 2 also shows the data for three
shorter periods that economists have identified as having very different pro-
ductivity experiences. Around 1973, the U.S. economy experienced a significant
slowdown in productivity growth that lasted until 1995. The cause of the produc-
tivity slowdown is not well understood, but the link between productivity and
real wages is exactly as standard theory predicts. The slowdown in productivity
growth from 2.8 to 1.4 percent per year coincided with a slowdown in real wage
growth from 2.8 to 1.2 percent per year.
Productivity growth picked up again around 1995, and many observers hailed
the arrival of the “new economy.” This productivity acceleration is most often
attributed to the spread of computers and information technology. As theory pre-
dicts, growth in real wages picked up as well. From 1995 to 2006, productivity
grew by 2.6 percent per year, and real wages grew by 2.5 percent per year.
The bottom line: Both theory and history confirm the close connection between
productivity and real wages. ●
Q Q
UICK UIZ How does an immigration of workers affect labor supply, labor demand,
the marginal product of labor, and the equilibrium wage?
THE OTHER FACTORS OF PRODUCTION:

LAND AND CAPITAL
We have seen how firms decide how much labor to hire and how these deci-
sions determine workers’ wages. At the same time that firms are hiring workers,
they are also deciding about other inputs to production. For example, our apple-
producing firm might have to choose the size of its apple orchard and the number
of ladders for its apple pickers. We can think of the firm’s factors of production as
falling into three categories: labor, land, and capital.
Monopsony
On the preceding pages, firm moves along the product’s demand curve, raising the price and
we built our analysis of the labor market with the tools of supply also its profits. Similarly, a monopsony firm in a labor market hires
and demand. In doing so, we assumed that the labor market was fewer workers than would a competitive firm; by reducing the num-
competitive. That is, we assumed that there were many buyers and ber of jobs available, the monopsony firm moves along the labor
sellers of labor, so each buyer or seller had a negligible effect on the supply curve, reducing the wage it pays and raising its profits. Thus,
wage. both monopolists and monopsonists reduce economic activity in
Yet imagine the labor market in a small town dominated by a a market below the socially optimal level. In both cases, the exis-
single large employer. That employer can exert a large influence on tence of market power distorts the outcome and causes deadweight
the going wage, and it may well use that market power to alter the losses.
outcome. Such a market in which there is a single buyer is called a This book does not present the formal model of monopsony
monopsony. because, in the world, monopsonies are rare. In most labor markets,
A monopsony (a market with one buyer) is in many ways similar workers have many possible employers, and firms compete with
to a monopoly (a market with one seller). Recall from Chapter 15 one another to attract workers. In this case, the model of supply and
that a monopoly firm produces less of the good than would a com- demand is the best one to use.
petitive firm; by reducing the quantity offered for sale, the monopoly
The meaning of the terms labor and land is clear, but the definition of capital is
capital somewhat tricky. Economists use the term capital to refer to the stock of equip-
the equipment and struc- ment and structures used for production. That is, the economy’s capital represents
tures used to produce the accumulation of goods produced in the past that are being used in the present
goods and services to produce new goods and services. For our apple firm, the capital stock includes
the ladders used to climb the trees, the trucks used to transport the apples, the
buildings used to store the apples, and even the trees themselves.
EQUILIBRIUM IN THE M ARKETS FOR LAND AND CAPITAL

What determines how much the owners of land and capital earn for their contri-
bution to the production process? Before answering this question, we need to dis-
tinguish between two prices: the purchase price and the rental price. The purchase
price of land or capital is the price a person pays to own that factor of production
indefinitely. The rental price is the price a person pays to use that factor for a lim-
ited period of time. It is important to keep this distinction in mind because, as we
will see, these prices are determined by somewhat different economic forces.
Having defined these terms, we can now apply the theory of factor demand that
we developed for the labor market to the markets for land and capital. Because
the wage is the rental price of labor, much of what we have learned about wage
determination applies also to the rental prices of land and capital. As Figure 7
illustrates, the rental price of land, shown in panel (a), and the rental price of
capital, shown in panel (b), are determined by supply and demand. Moreover, the
Supply and demand determine the compensation paid to the owners of land, as
shown in panel (a), and the compensation paid to the owners of capital, as shown in
F I G U R E 7
panel (b). The demand for each factor, in turn, depends on the value of the marginal
product of that factor.
The Markets for Land
and Capital
(a) The Market for Land (b) The Market for Capital
Rental Rental
Price of Price of
Land Supply Capital Supply
P P
Demand
Demand
0 Q Quantity of 0 Q Quantity of
Land Capital
demand for land and capital is determined just like the demand for labor. That is,
when our apple-producing firm is deciding how much land and how many lad-
ders to rent, it follows the same logic as when deciding how many workers to hire.
For both land and capital, the firm increases the quantity hired until the value of
the factor’s marginal product equals the factor’s price. Thus, the demand curve for
each factor reflects the marginal productivity of that factor.
We can now explain how much income goes to labor, how much goes to land-
owners, and how much goes to the owners of capital. As long as the firms using the
factors of production are competitive and profit-maximizing, each factor’s rental
price must equal the value of the marginal product for that factor. Labor, land, and
capital each earn the value of their marginal contribution to the production process.
Now consider the purchase price of land and capital. The rental price and the
purchase price are related: Buyers are willing to pay more for a piece of land or
capital if it produces a valuable stream of rental income. And as we have just seen,
the equilibrium rental income at any point in time equals the value of that factor’s
marginal product. Therefore, the equilibrium purchase price of a piece of land or
capital depends on both the current value of the marginal product and the value
of the marginal product expected to prevail in the future.
LINKAGES AMONG THE FACTORS OF PRODUCTION

We have seen that the price paid to any factor of production—labor, land, or
capital—equals the value of the marginal product of that factor. The marginal
product of any factor, in turn, depends on the quantity of that factor that is avail-
able. Because of diminishing marginal product, a factor in abundant supply has
What Is Capital Income?
Labor income is an easy the firm’s stockholders. A stockholder is a person who has bought a
concept to understand: It is the paycheck that workers get from their share in the ownership of the firm and, therefore, is entitled to share
employers. The income earned by capital, however, is less obvious. in the firm’s profits.
In our analysis, we have been implicitly assuming that house- A firm does not have to pay out all its earnings to households in
holds own the economy’s stock of capital—ladders, drill presses, the form of interest and dividends. Instead, it can retain some earn-
warehouses, and so on—and rent it to the firms that use it. Capital ings within the firm and use these earnings to buy additional capital.
income, in this case, is the rent that households receive for the use of Although these retained earnings are not paid to the firm’s stock-
their capital. This assumption simplified our analysis of how capital holders, the stockholders benefit from them nonetheless. Because
owners are compensated, but it is not entirely realistic. In fact, firms retained earnings increase the amount of capital the firm owns, they
usually own the capital they use, and, therefore, they receive the tend to increase future earnings and, thereby, the value of the firm’s
earnings from this capital. stock.
These earnings from capital, however, eventually are paid to These institutional details are interesting and important, but they
households. Some of the earnings are paid in the form of interest do not alter our conclusion about the income earned by the owners
to those households who have lent money to firms. Bondholders of capital. Capital is paid according to the value of its marginal prod-
and bank depositors are two examples of recipients of interest. Thus, uct, regardless of whether this income is transmitted to households
when you receive interest on your bank account, that income is part in the form of interest or dividends or whether it is kept within firms
of the economy’s capital income. as retained earnings.
In addition, some of the earnings from capital are paid to house-
holds in the form of dividends. Dividends are payments by a firm to
a low marginal product and thus a low price, and a factor in scarce supply has a
high marginal product and a high price. As a result, when the supply of a factor
falls, its equilibrium factor price rises.
When the supply of any factor changes, however, the effects are not limited
to the market for that factor. In most situations, factors of production are used
together in a way that makes the productivity of each factor dependent on the
quantities of the other factors available for use in the production process. As
a result, a change in the supply of any one factor alters the earnings of all the
factors.
For example, suppose a hurricane destroys many of the ladders that workers
use to pick apples from the orchards. What happens to the earnings of the vari-
ous factors of production? Most obviously, the supply of ladders falls, and, there-
fore, the equilibrium rental price of ladders rises. Those owners who were lucky
enough to avoid damage to their ladders now earn a higher return when they rent
out their ladders to the firms that produce apples.
Yet the effects of this event do not stop at the ladder market. Because there are
fewer ladders with which to work, the workers who pick apples have a smaller
marginal product. Thus, the reduction in the supply of ladders reduces the demand
for the labor of apple pickers, and this causes the equilibrium wage to fall.
This story shows a general lesson: An event that changes the supply of any fac-
tor of production can alter the earnings of all the factors. The change in earnings
of any factor can be found by analyzing the impact of the event on the value of the
marginal product of that factor.
THE ECONOMICS OF THE BLACK DEATH

In 14th-century Europe, the bubonic plague wiped out about one-third of the
population within a few years. This event, called the Black Death, provides a grisly
natural experiment to test the theory of factor markets that we have just devel-
oped. Consider the effects of the Black Death on those who were lucky enough to
survive. What do you think happened to the wages earned by workers and the
© BETTMANN/CORBIS
rents earned by landowners?
To answer this question, let’s examine the effects of a reduced population on
the marginal product of labor and the marginal product of land. With a smaller
supply of workers, the marginal product of labor rises. (This is diminishing mar-
ginal product working in reverse.) Thus, we would expect the Black Death to raise
wages. WORKERS WHO SURVIVED THE
Because land and labor are used together in production, a smaller supply of PLAGUE WERE LUCKY IN MORE
workers also affects the market for land, the other major factor of production in WAYS THAN ONE.
medieval Europe. With fewer workers available to farm the land, an additional
unit of land produced less additional output. In other words, the marginal prod-
uct of land fell. Thus, we would expect the Black Death to lower rents.
In fact, both predictions are consistent with the historical evidence. Wages
approximately doubled during this period, and rents declined 50 percent or more.
The Black Death led to economic prosperity for the peasant classes and reduced
incomes for the landed classes. ●
Q Q
UICK UIZ What determines the income of the owners of land and capital? • How
would an increase in the quantity of capital affect the incomes of those who already own
capital? How would it affect the incomes of workers?
CONCLUSION
This chapter explained how labor, land, and capital are compensated for the roles
they play in the production process. The theory developed here is called the neo-
classical theory of distribution. According to the neoclassical theory, the amount paid
to each factor of production depends on the supply and demand for that factor.
The demand, in turn, depends on that particular factor’s marginal productivity. In
equilibrium, each factor of production earns the value of its marginal contribution
to the production of goods and services.
The neoclassical theory of distribution is widely accepted. Most economists
begin with the neoclassical theory when trying to explain how the U.S. economy’s
$14 trillion of income is distributed among the economy’s various members. In the
following two chapters, we consider the distribution of income in more detail. As
you will see, the neoclassical theory provides the framework for this discussion.
Even at this point, you can use the theory to answer the question that began this
chapter: Why are computer programmers paid more than gas station attendants?
It is because programmers can produce a good of greater market value than can
gas station attendants. People are willing to pay dearly for a good computer game,
but they are willing to pay little to have their gas pumped and their windshield
washed. The wages of these workers reflect the market prices of the goods they
produce. If people suddenly got tired of using computers and decided to spend
more time driving, the prices of these goods would change, and so would the
equilibrium wages of these two groups of workers.
SUMMARY
• The economy’s income is distributed in the mar- respond to an increase in the wage by working
kets for the factors of production. The three most more hours and enjoying less leisure.
important factors of production are labor, land,
and capital.
• The price paid to each factor adjusts to balance
the supply and demand for that factor. Because
• The demand for factors, such as labor, is a factor demand reflects the value of the marginal
derived demand that comes from firms that use product of that factor, in equilibrium each factor
the factors to produce goods and services. Com- is compensated according to its marginal contri-
petitive, profit-maximizing firms hire each factor bution to the production of goods and services.
up to the point at which the value of the marginal
product of the factor equals its price.
• Because factors of production are used together,
the marginal product of any one factor depends
• The supply of labor arises from individuals’ on the quantities of all factors that are available.
trade-off between work and leisure. An upward- As a result, a change in the supply of one factor
sloping labor-supply curve means that people alters the equilibrium earnings of all the factors.
KEY CONCEPTS
factors of production, p. 392 diminishing marginal value of the marginal

production function, p. 394 product, p. 394 product, p. 395
marginal product of labor, p. 394 capital, p. 406
1. Explain how a firm’s production function is 4. Explain how the wage can adjust to balance the
related to its marginal product of labor, how a supply and demand for labor while simultane-
firm’s marginal product of labor is related to ously equaling the value of the marginal prod-
the value of its marginal product, and how a uct of labor.
firm’s value of marginal product is related to its 5. If the population of the United States suddenly
demand for labor. grew because of a large immigration, what
2. Give two examples of events that could shift the would happen to wages? What would happen
demand for labor, and explain why they do so. to the rents earned by the owners of land and
3. Give two examples of events that could shift the capital?
supply of labor, and explain why they do so.
1. Suppose that the president proposes a new law Number of Total

aimed at reducing healthcare costs: All Ameri- Robots Product
cans are required to eat one apple daily.
a. How would this apple-a-day law affect the 0 0 gallons
demand and equilibrium price of apples? 1 50
2 85
b. How would the law affect the marginal prod-
3 115
uct and the value of the marginal product of
4 140
apple pickers? 5 150
c. How would the law affect the demand and 6 155
equilibrium wage for apple pickers?
2. Show the effect of each of the following events a. In what kind of market structure does the
on the market for labor in the computer manu- firm sell its output? How can you tell?
facturing industry. b. In what kind of market structure does the
a. Congress buys personal computers for all firm rent robots? How can you tell?
U.S. college students. c. Calculate the marginal product and the value
b. More college students major in engineering of the marginal product for each additional
and computer science. robot.
c. Computer firms build new manufacturing d. How many robots should the firm rent?
plants. Explain.
3. Suppose that labor is the only input used by a 5. Your enterprising uncle opens a sandwich shop
perfectly competitive firm. The firm’s produc- that employs 7 people. The employees are paid
tion function is as follows: $6 per hour, and a sandwich sells for $3. If your
uncle is maximizing his profit, what is the value
Days of Labor Units of Output
of the marginal product of the last worker he
hired? What is that worker’s marginal product?
0 days 0 units
6. Suppose a freeze destroys part of the Florida
1 7
2 13
orange crop.
3 19 a. Explain what happens to the price of oranges
4 25 and the marginal product of orange pickers
5 28 as a result of the freeze. Can you say what
6 29 happens to the demand for orange pickers?
7 29 Why or why not?
b. Suppose the price of oranges doubles and the
a. Calculate the marginal product for each addi-
marginal product falls by 30 percent. What
tional worker.
happens to the equilibrium wage of orange
b. Each unit of output sells for $10. Calculate
pickers?
the value of the marginal product of each
c. Suppose the price of oranges rises by
worker.
30 percent and the marginal product falls by
c. Compute the demand schedule showing the
50 percent. What happens to the equilibrium
number of workers hired for all wages from
wage of orange pickers?
zero to $100 a day.
7. Leadbelly Co. sells pencils in a perfectly com-
d. Graph the firm’s demand curve.
petitive product market and hires workers in a
e. What happens to this demand curve if the
perfectly competitive labor market. Assume that
price of output rises from $10 to $12 per unit?
the market wage rate for workers is $150 per
4. Smiling Cow Dairy can sell all the milk it wants
day.
for $4 a gallon, and it can rent all the robots it
a. What rule should Leadbelly follow to hire the
wants to milk the cows at a capital rental price
profit-maximizing amount of labor?
of $100 a day. It faces the following production
schedule:
b. At the profit-maximizing level of output, the hour that the worker is employed by the
marginal product of the last worker hired firm. How does this law affect the marginal
is 30 boxes of pencils per day. Calculate the profit that a firm earns from each worker?
price of a box of pencils. How does the law affect the demand curve
c. Draw a diagram of the labor market for for labor? Draw your answer on a graph with
pencil workers (as in Figure 4 of this chapter) the cash wage on the vertical axis.
next to a diagram of the labor supply and b. If there is no change in labor supply, how
demand for Leadbelly Co. (as in Figure 3). would this law affect employment and
Label the equilibrium wage and quantity of wages?
labor for both the market and the firm. How c. Why might the labor-supply curve shift in
are these diagrams related? response to this law? Would this shift in
d. Suppose some pencil workers switch to jobs labor supply raise or lower the impact of the
in the growing computer industry. On the law on wages and employment?
side-by-side diagrams from part (c), show d. As Chapter 6 discussed, the wages of some
how this change affects the equilibrium wage workers, particularly the unskilled and inex-
and quantity of labor for both the pencil perienced, are kept above the equilibrium
market and for Leadbelly. How does this level by minimum-wage laws. What effect
change affect the marginal product of labor at would a fringe-benefit mandate have for
Leadbelly? these workers?
8. During the 1980s, 1990s, and the first decade of 10. This chapter has assumed that labor is supplied
the 21st century, the United States experienced by individual workers acting competitively. In
a significant inflow of capital from abroad. For some markets, however, the supply of labor is
example, Toyota, BMW, and other foreign car determined by a union of workers.
companies built auto plants in the United States. a. Explain why the situation faced by a labor
a. Using a diagram of the U.S. capital market, union may resemble the situation faced by a
show the effect of this inflow on the rental monopoly firm.
price of capital in the United States and on b. The goal of a monopoly firm is to maximize
the quantity of capital in use. profits. Is there an analogous goal for labor
b. Using a diagram of the U.S. labor market, unions?
show the effect of the capital inflow on the c. Now extend the analogy between monopoly
average wage paid to U.S. workers. firms and unions. How do you suppose
9. In recent years, some policymakers have pro- that the wage set by a union compares to
posed requiring firms to give workers certain the wage in a competitive market? How do
fringe benefits, such as health insurance. Let’s you suppose employment differs in the two
consider the effects of such a policy on the labor cases?
market. d. What other goals might unions have that
a. Suppose that a law required firms to give make unions different from monopoly firms?
each worker $3 of fringe benefits for every
19
CHAPTER
Earnings and Discrimination
I n the United States today, the typical physician earns about $200,000 a year, the
typical police officer about $50,000, and the typical farmworker about $20,000.
These examples illustrate the large differences in earnings that are so common
in our economy. The differences explain why some people live in mansions, ride
in limousines, and vacation on the French Riviera, while other people live in small
apartments, ride a bus, and vacation in their own backyards.
Why do earnings vary so much from person to person? Chapter 18, which
developed the basic neoclassical theory of the labor market, offers an answer to
this question. There we saw that wages are governed by labor supply and labor
demand. Labor demand, in turn, reflects the marginal productivity of labor. In
equilibrium, each worker is paid the value of his or her marginal contribution to
the economy’s production of goods and services.
This theory of the labor market, though widely accepted by economists, is only
the beginning of the story. To understand the wide variation in earnings that we
observe, we must go beyond this general framework and examine more precisely
what determines the supply and demand for different types of labor. That is our
goal in this chapter.
413
SOME DETERMINANTS OF EQUILIBRIUM WAGES

Workers differ from one another in many ways. Jobs also have differing charac-
teristics—both in terms of the wage they pay and in terms of their nonmonetary
attributes. In this section, we consider how the characteristics of jobs and workers
affect labor supply, labor demand, and equilibrium wages.
COMPENSATING DIFFERENTIALS
When a worker is deciding whether to take a job, the wage is only one of many
job attributes that the worker takes into account. Some jobs are easy, fun, and safe,
while others are hard, dull, and dangerous. The better the job as gauged by these
nonmonetary characteristics, the more people there are who are willing to do the
job at any given wage. In other words, the supply of labor for easy, fun, and safe
jobs is greater than the supply of labor for hard, dull, and dangerous jobs. As a
result, “good” jobs will tend to have lower equilibrium wages than “bad” jobs.
For example, imagine you are looking for a summer job in a local beach com-
munity. Two kinds of jobs are available. You can take a job as a beach-badge
checker, or you can take a job as a garbage collector. The beach-badge checkers
take leisurely strolls along the beach during the day and check to make sure the
tourists have bought the required beach permits. The garbage collectors wake up
before dawn to drive dirty, noisy trucks around town to pick up garbage. Which
compensating
job would you want? Most people would prefer the beach job if the wages were
differential the same. To induce people to become garbage collectors, the town has to offer
a difference in wages higher wages to garbage collectors than to beach-badge checkers.
that arises to offset the Economists use the term compensating differential to refer to a difference in
nonmonetary character- wages that arises from nonmonetary characteristics of different jobs. Compensat-
istics of different jobs ing differentials are prevalent in the economy. Here are some examples:
• Coal miners are paid more than other workers with similar levels of edu-
cation. Their higher wage compensates them for the dirty and dangerous
nature of coal mining, as well as the long-term health problems that coal
miners experience.
• Workers who work the night shift at factories are paid more than simi-
lar workers who work the day shift. The higher wage compensates them
for having to work at night and sleep during the day, a lifestyle that most
people find undesirable.

• Professors are paid less than lawyers and doctors, who have similar amounts

of education. Professors’ lower wages compensate them for the great intel-
lectual and personal satisfaction that their jobs offer. (Indeed, teaching
economics is so much fun that it is surprising that economics professors are
paid anything at all!)
“ON THE ONE HAND, I KNOW HUMAN CAPITAL

I COULD MAKE MORE MONEY
IF I LEFT PUBLIC SERVICE FOR
As we discussed in the previous chapter, the word capital usually refers to the
THE PRIVATE SECTOR, BUT, ON economy’s stock of equipment and structures. The capital stock includes the farm-
THE OTHER HAND, I COULDN’T er’s tractor, the manufacturer’s factory, and the teacher’s chalkboard. The essence
CHOP OFF HEADS.” of capital is that it is a factor of production that itself has been produced.
CHAPTER 19 EARNINGS AND DISCRIMINATION 415
There is another type of capital that, while less tangible than physical capital,
is just as important to the economy’s production. Human capital is the accumula- human capital
tion of investments in people. The most important type of human capital is educa- the accumulation of
tion. Like all forms of capital, education represents an expenditure of resources investments in people,
at one time to raise productivity in the future. But unlike an investment in other such as education and
on-the-job training
forms of capital, an investment in education is tied to a specific person, and this
linkage is what makes it human capital.
Not surprisingly, workers with more human capital on average earn more
than those with less human capital. College graduates in the United States, for
example, earn almost twice as much as those workers who end their education
with a high school diploma. This large difference has been documented in many
countries around the world. It tends to be even larger in less developed countries,
where educated workers are in scarce supply.
It is easy to see why education raises wages from the perspective of supply
and demand. Firms—the demanders of labor—are willing to pay more for the
highly educated because highly educated workers have higher marginal prod-
ucts. Workers—the suppliers of labor—are willing to pay the cost of becoming
educated only if there is a reward for doing so. In essence, the difference in wages
between highly educated workers and less educated workers may be considered
a compensating differential for the cost of becoming educated.
THE INCREASING VALUE OF SKILLS
“The rich get richer, and the poor get poorer.” Like many adages, this one is not
always true, but recently it has been. Many studies have documented that the
earnings gap between workers with high skills and workers with low skills has
increased over the past two decades.
Table 1 presents data on the average earnings of college graduates and of high
school graduates without any additional education. These data show the increase
in the financial reward from education. In 1980, a man on average earned 44 per-
cent more with a college degree than without one; by 2005, this figure had risen to
87 percent. For a woman, the reward for attending college rose from a 35 percent
increase in earnings to a 72 percent increase. The incentive to stay in school is as
great today as it has ever been.
Why has the gap in earnings between skilled and unskilled workers widened in
recent years? No one knows for sure, but economists have proposed two hypoth-
eses to explain this trend. Both hypotheses suggest that the demand for skilled
labor has risen over time relative to the demand for unskilled labor. The shift in
demand has led to a corresponding change in wages, which in turn has led to
greater inequality.
The first hypothesis is that international trade has altered the relative demand
for skilled and unskilled labor. In recent years, the amount of trade with other
countries has increased substantially. As a percentage of total U.S. production
of goods and services, imports have risen from 5 percent in 1970 to 16 percent in
2005, and exports have risen from 6 percent in 1970 to 11 percent in 2005. Because
unskilled labor is plentiful and cheap in many foreign countries, the United States
tends to import goods produced with unskilled labor and export goods produced
1 T A B L E
1980 2005
Average Annual Earn-

Men
ings by Educational
High school, no college $41,083 $40,112
Attainment
College graduates $59,196 $75,130
College graduates have
Percent extra for college grads +44% +87%
always earned more than
workers without the benefit Women
of college, but the salary High school, no college $24,775 $28,657
gap has grown even larger College graduates $33,452 $49,326
over the past few decades. Percent extra for college grads +35% +72%
Note: Earnings data are adjusted for inflation and are expressed in 2005
dollars. Data apply to full-time, year-round workers age 18 and over. Data for
college graduates exclude workers with additional schooling beyond college,
such as a master’s degree or PhD.
Source: U.S. Census Bureau and author’s calculations.
with skilled labor. Thus, when international trade expands, the domestic demand
for skilled labor rises, and the domestic demand for unskilled labor falls.
The second hypothesis is that changes in technology have altered the relative
demand for skilled and unskilled labor. Consider, for instance, the introduction
of computers. Computers raise the demand for skilled workers who can use the
new machines and reduce the demand for the unskilled workers whose jobs are
replaced by the computers. For example, many companies now rely more on com-
puter databases, and less on filing cabinets, to keep business records. This change
raises the demand for computer programmers and reduces the demand for filing
clerks. Thus, as more firms use computers, the demand for skilled labor rises, and
the demand for unskilled labor falls.
Economists have found it difficult to gauge the validity of these two hypothe-
ses. It is possible that both are true: Increasing international trade and technologi-
cal change may share responsibility for the increasing income inequality we have
observed in recent decades. ●
A BILITY, EFFORT, AND CHANCE

Why do major league baseball players get paid more than minor league players?
Certainly, the higher wage is not a compensating differential. Playing in the major
leagues is not a less pleasant job than playing in the minor leagues; in fact, the
opposite is true. The major leagues do not require more years of schooling or more
experience. To a large extent, players in the major leagues earn more just because
they have greater natural ability.
Natural ability is important for workers in all occupations. Because of heredity
and upbringing, people differ in their physical and mental attributes. Some peo-
ple are strong, others weak. Some people are smart, others less so. Some people
The Loss of Manufacturing Jobs

In the early 1940s, about one in three American workers worked in
manufacturing. Today, that figure is about one in ten. According to
former Secretary of Labor Robert Reich, the loss of manufacturing
jobs is not a reason to worry. But it is a reason to study hard.
Nice Work If You employment has dropped around the world, shapes, words, ideas. This kind of work usu-
Can Get It global industrial output has risen more than ally requires a college degree. . . .
By Robert B. Reich 30 percent. . . . A second growing category of work
Want to blame something? Blame new in America involves personal services.
It’s hard to listen to a politician or pundit knowledge. Knowledge created the elec- Computers and robots can’t do these jobs
these days without hearing that Amer- tronic gadgets and software that can now because they require care and attentive-
ica is “losing jobs” to poorer nations— do almost any routine task. This goes well ness. Workers in other nations can’t do them
manufacturing jobs to China, back-office beyond the factory floor. America also used because they must be done in person. Some
work to India, just about every job to Latin to have lots of elevator operators, telephone personal-service workers need education
America. This lament distracts our attention operators, bank tellers, and service-station beyond high school—nurses, physical ther-
from the larger challenge of preparing more attendants. Most have been replaced by apists, and medical technicians. But most
Americans for better jobs. . . . technology. . . . don’t, such as restaurant workers, cabbies,
It’s true that U.S. manufacturing employ- Any job that’s even slightly routine is dis- retail workers, security guards, and hospital
ment has been dropping for many years, appearing from the United States. But this attendants. In contrast to that of symbolic
but that’s not primarily due to foreigners doesn’t mean we are left with fewer jobs. analysts, the pay of most personal-service
taking these jobs. Factory jobs are vanish- It means only that we have fewer routine workers in the United States is stagnant
ing all over the world. . . . I recently toured jobs. . . . or declining. That’s because the supply of
a U.S. factory containing two employees Look closely at the economy today and personal-service workers is growing quickly,
and 400 computerized robots. The two live you find two growing categories of work— as more and more people who’d otherwise
people sat in front of computer screens and but only the first is commanding better pay have factory or routine service jobs join their
instructed the robots. In a few years this fac- and benefits. This category involves iden- ranks. Legal and undocumented immigrants
tory won’t have a single employee on site, tifying and solving new problems. Here, are also pouring into this sector.
except for an occasional visiting technician workers do R&D, design, and engineer- But America’s long-term problem isn’t
who repairs and upgrades the robots, like ing. Or they are responsible for high-level too few jobs. It’s the widening income gap
the gas man changing your meter. sales, marketing, and advertising. They’re between personal-service workers and sym-
Manufacturing is following the same composers, writers, and producers. They’re bolic analysts. The long-term solution is to
trend as agriculture. As productivity rises, lawyers, bankers, financiers, journalists, doc- help spur upward mobility by getting more
employment falls because fewer people tors, and management consultants. I call Americans a good education, including
are needed. In 1910, a third of Americans this “symbolic analysis” work because most access to college.
worked on farms. Now, fewer than 3 per- of it has to do with analyzing, manipulat-
cent do. Since 1995, even as manufacturing ing, and communicating through numbers,

are outgoing, others awkward in social situations. These and many other personal
characteristics determine how productive workers are and, therefore, play a role
in determining the wages they earn.
Closely related to ability is effort. Some people work hard, others are lazy. We
should not be surprised to find that those who work hard are more productive
and earn higher wages. To some extent, firms reward workers directly by pay-
ing people based on what they produce. Salespeople, for instance, are often paid
a percentage of the sales they make. At other times, hard work is rewarded less
directly in the form of a higher annual salary or a bonus.
Chance also plays a role in determining wages. If a person attended a trade
school to learn how to repair televisions with vacuum tubes and then found this
skill made obsolete by the invention of solid-state electronics, he or she would end
up earning a low wage compared to others with similar years of training. The low
wage of this worker is due to chance—a phenomenon that economists recognize
but do not shed much light on.
How important are ability, effort, and chance in determining wages? It is hard
to say because these factors are difficult to measure. But indirect evidence suggests
that they are very important. When labor economists study wages, they relate a
worker’s wage to those variables that can be measured, such as years of school-
ing, years of experience, age, and job characteristics. All these measured variables
affect a worker’s wage as theory predicts, but they account for less than half of
the variation in wages in our economy. Because so much of the variation in wages
is left unexplained, omitted variables, including ability, effort, and chance, must
play an important role.
THE BENEFITS OF BEAUTY

People differ in many ways. One difference is in how attractive they are. The
actress Keira Knightley, for instance, is a beautiful woman. In part for this reason,
her movies attract large audiences. Not surprisingly, the large audiences mean a
large income for Ms. Knightley.
How prevalent are the economic benefits of beauty? Labor economists Daniel
Hamermesh and Jeff Biddle tried to answer this question in a study published in
the December 1994 issue of the American Economic Review. Hamermesh and Biddle
examined data from surveys of individuals in the United States and Canada. The
interviewers who conducted the survey were asked to rate each respondent’s
physical appearance. Hamermesh and Biddle then examined how much the
wages of the respondents depended on the standard determinants—education,
experience, and so on—and how much they depended on physical appearance.
Hamermesh and Biddle found that beauty pays. People who are deemed more
attractive than average earn 5 percent more than people of average looks, and
© REUTERS/TONY MARSH/LANDOV
people of average looks earn 5 to 10 percent more than people considered less
attractive than average. Similar results were found for men and women.
What explains these differences in wages? There are several ways to interpret
the “beauty premium.”
One interpretation is that good looks are themselves a type of innate ability
determining productivity and wages. Some people are born with the physical
attributes of a movie star; other people are not. Good looks are useful in any job in
which workers present themselves to the public—such as acting, sales, and wait-
GOOD LOOKS PAY. ing on tables. In this case, an attractive worker is more valuable to the firm than
an unattractive worker. The firm’s willingness to pay more to attractive workers

reflects its customers’ preferences.
A second interpretation is that reported beauty is an indirect measure of other
types of ability. How attractive a person appears depends on more than just hered-
ity. It also depends on dress, hairstyle, personal demeanor, and other attributes
that a person can control. Perhaps a person who successfully projects an attractive
image in a survey interview is more likely to be an intelligent person who suc-
ceeds at other tasks as well.
A third interpretation is that the beauty premium is a type of discrimination, a
topic to which we return later. ●
AN A LTERNATIVE VIEW OF EDUCATION: SIGNALING

Earlier we discussed the human-capital view of education, according to which
schooling raises workers’ wages because it makes them more productive. Although
this view is widely accepted, some economists have proposed an alternative the-
ory, which emphasizes that firms use educational attainment as a way of sorting
between high-ability and low-ability workers. According to this alternative view,
when people earn a college degree, for instance, they do not become more pro-
ductive, but they do signal their high ability to prospective employers. Because it
is easier for high-ability people to earn a college degree than it is for low-ability
people, more high-ability people get college degrees. As a result, it is rational for
firms to interpret a college degree as a signal of ability.
The signaling theory of education is similar to the signaling theory of advertis-
ing discussed in Chapter 16. In the signaling theory of advertising, the advertise-
ment itself contains no real information, but the firm signals the quality of its
product to consumers by its willingness to spend money on advertising. In the
signaling theory of education, schooling has no real productivity benefit, but the
worker signals his innate productivity to employers by his willingness to spend
years at school. In both cases, an action is being taken not for its intrinsic ben-
efit but because the willingness to take that action conveys private information to
someone observing it.
Thus, we now have two views of education: the human-capital theory and the
signaling theory. Both views can explain why more educated workers tend to
earn more than less educated workers. According to the human-capital view, edu-
cation makes workers more productive; according to the signaling view, educa-
tion is correlated with natural ability. But the two views have radically different
predictions for the effects of policies that aim to increase educational attainment.
According to the human-capital view, increasing educational levels for all work-
ers would raise all workers’ productivity and thereby their wages. According to
the signaling view, education does not enhance productivity, so raising all work-
ers’ educational levels would not affect wages.
Most likely, truth lies somewhere between these two extremes. The benefits
to education are probably a combination of the productivity-enhancing effects of
human capital and the productivity-revealing effects of signaling. The open ques-
tion is the relative size of these two effects.
THE SUPERSTAR PHENOMENON

Although most actors earn little and often take jobs as waiters to support them-
selves, Johnny Depp earns millions of dollars for each film he makes. Similarly,
The Human Capital of Terrorists

Workers with more education are better at all kinds of tasks,
even those aimed at destruction.
Even for Shoe Bombers, in the same way they might analyze the day. Mr. Reid, the failed shoe bomber, had
Education and Success auto industry. But they defined the “success” only a high school degree. Would an older
Are Linked of terrorists by their ability to kill. terrorist with more education have tried to
By Austan Goolsbee They gathered data on Palestinian sui- light a match on his shoe (as Mr. Reid did)
cide bombers in Israel from 2000 to 2005 in plain view of the flight attendant and
The fifth anniversary of 9/11 passed with a and found that for terrorists, just like for other passengers who proceeded to thwart
great deal of hand-wringing over all the peo- regular workers, experience and educa- his plan? Would a better-educated terror-
ple who want to kill Americans. Especially tion improve productivity. Suicide bombers ist have been more discreet? We will never
worrisome is the apparent rise of terrorists who are older—in their late 20’s and early know.
whose origins seem far from fanatical. 30’s—and better educated are less likely to The research suggests, however, that
These terrorists are not desperately poor be caught on their missions and are more there may be a reason that the average age
uneducated people from the Middle East. A likely to kill large numbers of people at big- of the 9/11 hijackers (at least the ones for
surprisingly large share of them have col- ger, more difficult targets than younger and whom we have a birth date) was close to 26
lege and even graduate degrees. Increas- more poorly educated bombers. and that the supposed leader, Mohammed
ingly, they seem to be from Britain, like the Professor Benmelech and Dr. Berrebi Atta, was 33 with a graduate degree.
shoe bomber Richard C. Reid and most of compare a Who’s Who of the biggest suicide As Professor Benmelech put it in an
the suspects in the London Underground bombers to more typical bombers. Whereas interview: “It’s clear that there are some ter-
bombings and the liquid explosives plot. typical bombers were younger than 21 and rorist missions that require a certain level of
This has left the public wondering, Why about 18 percent of them had at least some skill to accomplish. The older terrorists with
are some educated people from Western college education, the average age of the better educations seem to be less likely to
countries so prone to fanaticism? most successful bombers was almost 26 and fail them. Perhaps it is not surprising, then,
Before trying to answer that question, 60 percent of them were college educated. that terrorist organizers assign them to
though, some economists argue that we Experience and education also affect the these more difficult missions.”
need to think about what makes a success- chances of being caught. Every additional Among Palestinian suicide bombers,
ful terrorist and they warn against extrapo- year of age reduces the chance by 12 per- the older and better-educated bombers are
lating from the terrorists we catch. It is a cent. Having more than a high school edu- assigned to targets in bigger cities where
problem economists typically refer to as cation cuts the chance by more than half. they can potentially kill greater numbers
“selection bias.” There are many examples where young of people. That same idea means that the
In their new study, “Attack Assignments or uneducated terrorists made stupid mis- terrorists assigned to attack the United
in Terror Organizations and the Productiv- takes that foiled them. Professor Benmelech States are probably different from the typi-
ity of Suicide Bombers,” two economists, recounts the case last April of a teenager cal terrorist. They will be drawn from people
Efraim Benmelech of Harvard University and from Nablus apprehended by Israeli soldiers whose skills make them better at evading
Claude Berrebi of the RAND Corporation, set before carrying out his bombing because security.
out to analyze the productivity of terrorists he was wearing an overcoat on a 95-degree
Source: New York Times, September 14, 2006.

while most people who play tennis do it for free as a hobby, Lindsay Davenport
earns millions on the pro tour. Depp and Davenport are superstars in their fields,
and their great public appeal is reflected in astronomical incomes.
Why do Depp and Davenport earn so much? It is not surprising that incomes
differ within occupations. Good carpenters earn more than mediocre carpenters,
and good plumbers earn more than mediocre plumbers. People vary in ability and
effort, and these differences lead to differences in income. Yet the best carpenters
and plumbers do not earn the many millions that are common among the best
actors and athletes. What explains the difference?
To understand the tremendous incomes of Depp and Davenport, we must
examine the special features of the markets in which they sell their services. Super-
stars arise in markets that have two characteristics:
• Every customer in the market wants to enjoy the good supplied by the best
producer.
• The good is produced with a technology that makes it possible for the best
producer to supply every customer at low cost.
If Johnny Depp is the best actor around, then everyone will want to see his next
movie; seeing twice as many movies by an actor half as talented is not a good
substitute. Moreover, it is possible for everyone to enjoy a performance by Johnny
Depp. Because it is easy to make multiple copies of a film, Depp can provide his
service to millions of people simultaneously. Similarly, because tennis games are
broadcast on television, millions of fans can enjoy the extraordinary athletic skills
of Lindsay Davenport.
We can now see why there are no superstar carpenters and plumbers. Other
things equal, everyone prefers to employ the best carpenter, but a carpenter,
unlike a movie actor, can provide his services to only a limited number of cus-
tomers. Although the best carpenter will be able to command a somewhat higher
wage than the average carpenter, the average carpenter will still be able to earn a
good living.
A BOVE-EQUILIBRIUM WAGES: MINIMUM-WAGE LAWS,

UNIONS, AND EFFICIENCY WAGES
Most analyses of wage differences among workers are based on the equilibrium
model of the labor market—that is, wages are assumed to adjust to balance labor
supply and labor demand. But this assumption does not always apply. For some
workers, wages are set above the level that brings supply and demand into equi-
librium. Let’s consider three reasons this might be so.
One reason for above-equilibrium wages is minimum-wage laws, as we first
saw in Chapter 6. Most workers in the economy are not affected by these laws
because their equilibrium wages are well above the legal minimum. But for some union
workers, especially the least skilled and experienced, minimum-wage laws raise a worker association that
bargains with employers
wages above the level they would earn in an unregulated labor market.
over wages and working
A second reason that wages might rise above their equilibrium level is the mar- conditions
ket power of labor unions. A union is a worker association that bargains with
employers over wages and working conditions. Unions often raise wages above strike
the level that would prevail without a union, perhaps because they can threaten to the organized withdrawal
withhold labor from the firm by calling a strike. Studies suggest that union work- of labor from a firm by a
ers earn about 10 to 20 percent more than similar nonunion workers. union
A third reason for above-equilibrium wages is suggested by the theory of

efficiency wages efficiency wages. This theory holds that a firm can find it profitable to pay high
above-equilibrium wages wages because doing so increases the productivity of its workers. In particular, high
paid by firms to increase wages may reduce worker turnover, increase worker effort, and raise the quality
worker productivity of workers who apply for jobs at the firm. If this theory is correct, then some firms
may choose to pay their workers more than they would normally earn.
Above-equilibrium wages, whether caused by minimum-wage laws, unions, or
efficiency wages, have similar effects on the labor market. In particular, pushing a
wage above the equilibrium level raises the quantity of labor supplied and reduces
the quantity of labor demanded. The result is a surplus of labor, or unemployment.
The study of unemployment and the public policies aimed to deal with it is usu-
ally considered a topic within macroeconomics, so it goes beyond the scope of this
chapter. But it would be a mistake to ignore these issues completely when analyz-
ing earnings. Although most wage differences can be understood while maintain-
ing the assumption of equilibrium in the labor market, above-equilibrium wages
play a role in some cases.
QUICK QUIZ Define compensating differential and give an example. • Give two reasons
more educated workers earn more than less educated workers.
THE ECONOMICS OF DISCRIMINATION

discrimination Another source of differences in wages is discrimination. Discrimination occurs
the offering of different when the marketplace offers different opportunities to similar individuals who
opportunities to similar differ only by race, ethnic group, sex, age, or other personal characteristics. Dis-
individuals who differ crimination reflects some people’s prejudice against certain groups in society.
only by race, ethnic Discrimination is an emotionally charged topic that often generates heated debate,
group, sex, age, or other
but economists try to study the topic objectively to separate myth from reality.
personal characteristics
M EASURING LABOR-M ARKET DISCRIMINATION

How much does discrimination in labor markets affect the earnings of different
groups of workers? This question is important, but answering it is not easy.
There is no doubt that different groups of workers earn substantially different
wages, as Table 2 demonstrates. The median black man in the United States is
paid 21 percent less than the median white man, and the median black woman
is paid 8 percent less than the median white woman. The differences by sex are
also significant. The median white woman is paid 23 percent less than the median
white man, and the median black woman is paid 10 percent less than the median
black man. Taken at face value, these differentials look like evidence that employ-
ers discriminate against blacks and women.
Yet there is a potential problem with this inference. Even in a labor market
free of discrimination, different people have different wages. People differ in the
amount of human capital they have and in the kinds of work they are able and
willing to do. The wage differences we observe in the economy are, to some extent,
attributable to the determinants of equilibrium wages we discussed in the preced-
ing section. Simply observing differences in wages among broad groups—whites
and blacks, men and women—does not prove that employers discriminate.
T A B L E
2
Percent Earnings Are
White Black Lower for Black Workers
Median Annual Earnings
by Race and Sex
Men $41,982 $32,976 21%
Women $32,173 $29,680 8%
Percent Earnings Are Lower

for Women Workers 23% 10%
Note: Earnings data are for the year 2005 and apply to full-time, year-round workers over age 14.
Source: U.S. Census Bureau.
Consider, for example, the role of human capital. Among male workers, whites
are about 75 percent more likely to have a college degree than blacks. Thus, at
least some of the difference between the wages of whites and the wages of blacks
can be traced to differences in educational attainment. Among white workers,
men and women are now about equally likely to have a college degree, but men
are about 11 percent more likely to earn a graduate or professional degree after
college, indicating that some of the wage differential between men and women is
also attributable to educational attainment.
Moreover, human capital may be more important in explaining wage differen-
tials than measures of years of schooling suggest. Historically, public schools in
predominantly black areas have been of lower quality—as measured by expendi-
ture, class size, and so on—than public schools in predominantly white areas. Sim-
ilarly, for many years, schools directed girls away from science and math courses,
even though these subjects may have had greater value in the marketplace than
some of the alternatives. If we could measure the quality as well as the quantity of
education, the differences in human capital among these groups would seem even
larger.
Human capital acquired in the form of job experience can also help explain
wage differences. In particular, women tend to have less job experience on aver-
age than men. One reason is that female labor-force participation has increased
over the past several decades. Because of this historic change, the average female
worker today is younger than the average male worker. In addition, women are
more likely to interrupt their careers to raise children. For both reasons, the expe-
rience of the average female worker is less than the experience of the average male
worker.
Yet another source of wage differences is compensating differentials. Men and
women do not always choose the same type of work, and this fact may help explain
some of the earnings differential between men and women. For example, women
are more likely to be secretaries, and men are more likely to be truck drivers. The
relative wages of secretaries and truck drivers depend in part on the working
conditions of each job. Because these nonmonetary aspects are hard to measure,
it is difficult to gauge the practical importance of compensating differentials in
explaining the wage differences that we observe.
In the end, the study of wage differences among groups does not establish any
clear conclusion about the prevalence of discrimination in U.S. labor markets.
Most economists believe that some of the observed wage differentials are attribut-
able to discrimination, but there is no consensus about how much. The only con-
clusion about which economists are in consensus is a negative one: Because the
differences in average wages among groups in part reflect differences in human
capital and job characteristics, they do not by themselves say anything about how
much discrimination there is in the labor market.
Of course, differences in human capital among groups of workers may them-
selves reflect discrimination. The less rigorous curriculums historically offered to
female students, for instance, can be considered a discriminatory practice. Simi-
larly, the inferior schools historically available to black students may be traced
to prejudice on the part of city councils and school boards. But this kind of dis-
crimination occurs long before the worker enters the labor market. In this case, the
disease is political, even if the symptom is economic.
IS EMILY MORE EMPLOYABLE THAN LAKISHA?
Although measuring the extent of discrimination from labor-market outcomes is

hard, some compelling evidence for the existence of such discrimination comes
from a creative “field experiment.” Economists Marianne Bertrand and Sendhil
Mullainathan answered more than 1,300 help-wanted ads run in Boston and Chi-
cago newspapers by sending in nearly 5,000 fake résumés. Half of the résumés had
names that were common in the African American community, such as Lakisha
Washington or Jamal Jones. The other half had names that were more common
among the white population, such as Emily Walsh and Greg Baker. Otherwise,
the résumés were similar. The results of this experiment were published in the
American Economic Review in September 2004.
The researchers found large differences in how employers responded to the
two groups of résumés. Job applicants with white names received about 50 per-
cent more calls from interested employers than applicants with African American
names. The study found that this discrimination occurred for all types of employ-
ers, including those who claimed to be an “Equal Opportunity Employer” in their
help-wanted ads. The researchers concluded that “racial discrimination is still a
prominent feature of the labor market.” ●
DISCRIMINATION BY EMPLOYERS
Let’s now turn from measurement to the economic forces that lie behind discrimi-
nation in labor markets. If one group in society receives a lower wage than another
group, even after controlling for human capital and job characteristics, who is to
blame for this differential?
The answer is not obvious. It might seem natural to blame employers for dis-
criminatory wage differences. After all, employers make the hiring decisions that
determine labor demand and wages. If some groups of workers earn lower wages
than they should, then it seems that employers are responsible. Yet many econ-
omists are skeptical of this easy answer. They believe that competitive, market
economies provide a natural antidote to employer discrimination. That antidote is
called the profit motive.
Imagine an economy in which workers are differentiated by their hair color.

Blondes and brunettes have the same skills, experience, and work ethic. Yet
because of discrimination, employers prefer not to hire workers with blonde hair.
Thus, the demand for blondes is lower than it otherwise would be. As a result,
blondes earn a lower wage than brunettes.
How long can this wage differential persist? In this economy, there is an easy
way for a firm to beat out its competitors: It can hire blonde workers. By hiring
blondes, a firm pays lower wages and thus has lower costs than firms that hire
brunettes. Over time, more and more “blonde” firms enter the market to take
advantage of this cost advantage. The existing “brunette” firms have higher costs
and, therefore, begin to lose money when faced with the new competitors. These
losses induce the brunette firms to go out of business. Eventually, the entry of
blonde firms and the exit of brunette firms cause the demand for blonde workers
to rise and the demand for brunette workers to fall. This process continues until
the wage differential disappears.
Put simply, business owners who care only about making money are at an
advantage when competing against those who also care about discriminating. As
a result, firms that do not discriminate tend to replace those that do. In this way,
competitive markets have a natural remedy for employer discrimination.
SEGREGATED STREETCARS AND THE PROFIT MOTIVE
In the early 20th century, streetcars in many southern cities were segregated by
race. White passengers sat in the front of the streetcars, and black passengers sat
in the back. What do you suppose caused and maintained this discriminatory
practice? And how was this practice viewed by the firms that ran the streetcars?
In a 1986 article in the Journal of Economic History, economic historian Jennifer
Roback looked at these questions. Roback found that the segregation of races on
streetcars was the result of laws that required such segregation. Before these laws
were passed, racial discrimination in seating was rare. It was far more common to
segregate smokers and nonsmokers.
Moreover, the firms that ran the streetcars often opposed the laws requiring
racial segregation. Providing separate seating for different races raised the firms’
costs and reduced their profit. One railroad company manager complained to the
city council that, under the segregation laws, “the company has to haul around a
good deal of empty space.”
Here is how Roback describes the situation in one southern city:
The railroad company did not initiate the segregation policy and was not at all
eager to abide by it. State legislation, public agitation, and a threat to arrest the
president of the railroad were all required to induce them to separate the races
on their cars. . . . There is no indication that the management was motivated
by belief in civil rights or racial equality. The evidence indicates their primary
motives were economic; separation was costly. . . . Officials of the company
may or may not have disliked blacks, but they were not willing to forgo the
profits necessary to indulge such prejudice.
The story of southern streetcars illustrates a general lesson: Business owners
are usually more interested in making profit than in discriminating against a par-
ticular group. When firms engage in discriminatory practices, the ultimate source
Gender Differences
Recent economic research is shedding light on why men
and women choose different career paths.
The Difference between neering jobs. As the authors observe, the Is there any evidence that the hypoth-
Men and Women, “standard economic explanations for such esis is true? Do men really prefer more com-
Revisited: It’s About occupational differences include prefer- petitive environments than women? One
Competition ences, ability and discrimination.” could cite anecdote after anecdote, but the
By Hal R. Varian To this list the authors add a new factor: authors took a much more direct approach:
attitudes toward competitive environments. they ran an experiment.
Gender differences are a topic of endless If men prefer more competitive environ- By using an experiment, the authors
discussion for parents, teachers and social ments than women, then there will be more were able to determine not only whether
scientists. . . . A noteworthy case in point men represented in areas where competi- men and women differ in their willingness
is a recent National Bureau of Economic tion is intense. to compete, but more important, whether
Research working paper by a Stanford econ- Of course, discussions of gender differ- they differ in their willingness to compete
omist, Muriel Niederle, and Lise Vesterlund, ences of any sort can only be statements conditioned on their actual performance.
a University of Pittsburgh economist, titled, about averages; it is clear that there are The economists asked 80 subjects,
“Do Women Shy Away From Competition? women who thrive in competitive envi- divided into groups of two women and
Do Men Compete Too Much?” ronments and men who do not. Further- two men, to add up sets of five two-digit
It is widely noted that women are not more, attitudes toward competition may numbers for five minutes. The subjects per-
well represented in high-paying corporate be ingrained or a result of factors like social formed the task first on a piece-rate basis
jobs, or in mathematics, science and engi- stereotyping. (50 cents for each correct answer) and then
of the discrimination often lies not with the firms themselves but elsewhere. In
this particular case, the streetcar companies segregated whites and blacks because
discriminatory laws, which the companies opposed, required them to do so. ●
DISCRIMINATION BY CUSTOMERS AND GOVERNMENTS

The profit motive is a strong force acting to eliminate discriminatory wage dif-
ferentials, but there are limits to its corrective abilities. Two important limiting
factors are customer preferences and government policies.
To see how customer preferences for discrimination can affect wages, consider
again our imaginary economy with blondes and brunettes. Suppose that restau-
rant owners discriminate against blondes when hiring waiters. As a result, blonde
waiters earn lower wages than brunette waiters. In this case, a restaurant can open
up with blonde waiters and charge lower prices. If customers care only about the
quality and price of their meals, the discriminatory firms will be driven out of
business, and the wage differential will disappear.
as a tournament (the person with the most women have a 38 percent lower probability maximizing perspective, high-performing
correct answers in each group received $2 of choosing the tournament compensation. women enter the tournament too rarely,
per correct answer, while other participants Why were the men much more likely and low-performing men enter the tourna-
received nothing). Note that a subject with to choose the tournament? Perhaps it was ment too often.” The low-performing men
a 25 percent chance of being a winner in the because they felt more confident about and the high-performing women are both
tournament received the same average pay- their abilities. The data support this hypoth- hurt by this behavior but, in this experiment
ment as in the piece-rate system. esis, with 75 percent of the men believing at least, the costs to the women who did not
All participants were told how many that they won their four-player tournament, choose the tournament when they should
problems they got right, but not their relative while 43 percent of the women thought have exceeded the costs to the men who
performance. After completing the two tasks, they were best in their group. should have avoided the tournament.
the subjects were asked to choose whether Though both groups were overcon- One should not read too much into
they preferred a piece-rate system or a tour- fident about their performance, the men one study. But if it is really true that women
nament for the third set of problems. were much more so. . . . The results of this choose occupations that involve less com-
There were several interesting findings experiment are consistent with the finding petition, then one may well ask why. Socio-
in this experiment. First, there were no dif- by a Berkeley finance professor, Terry Odean, biologists may suggest that such differences
ferences between men and women in their that men trade stocks excessively, appar- come from genetic propensities; sociolo-
performance under either compensation ently because they (wrongly) feel that they gists may argue for differences in social roles
system. Despite this, twice as many men have exceptional ability to pick winners. and expectations; developmental psycholo-
selected the tournament as women (75 per- Women trade less, but do better on aver- gists may emphasize child-rearing practices.
cent versus 35 percent). age, because they are more likely to follow Whatever the cause, Ms. Niederle and Ms.
Even if one accounts for performance a buy-and-hold strategy. Vesterlund have certainly raised a host of
by comparing only men and women with The authors summarized their experi- interesting and important questions.
the same number of correct answers, the mental results by saying, “From a payoff-
Source: New York Times, March 9, 2006.
On the other hand, it is possible that customers prefer being served by brunette
waiters. If this preference for discrimination is strong, the entry of blonde res-
taurants need not succeed in eliminating the wage differential between brunettes
and blondes. That is, if customers have discriminatory preferences, a competitive
market is consistent with a discriminatory wage differential. An economy with
such discrimination would contain two types of restaurants. Blonde restaurants
hire blondes, have lower costs, and charge lower prices. Brunette restaurants hire
brunettes, have higher costs, and charge higher prices. Customers who did not
care about the hair color of their waiters would be attracted to the lower prices at
the blonde restaurants. Bigoted customers would go to the brunette restaurants
and would pay for their discriminatory preference in the form of higher prices.
Another way for discrimination to persist in competitive markets is for the
government to mandate discriminatory practices. If, for instance, the government
passed a law stating that blondes could wash dishes in restaurants but could not
work as waiters, then a wage differential could persist in a competitive market.
The example of segregated streetcars in the foregoing case study is one example of
government-mandated discrimination. More recently, before South Africa aban-

doned its system of apartheid, blacks were prohibited from working in some jobs.
Discriminatory governments pass such laws to suppress the normal equalizing
force of free and competitive markets.
To sum up: Competitive markets contain a natural remedy for employer discrimina-
tion. The entry into the market of firms that care only about profit tends to eliminate
discriminatory wage differentials. These wage differentials persist in competitive markets
only when customers are willing to pay to maintain the discriminatory practice or when
the government mandates it.
DISCRIMINATION IN SPORTS
As we have seen, measuring discrimination is often difficult. To determine
whether one group of workers is discriminated against, a researcher must correct
for differences in the productivity between that group and other workers in the
economy. Yet in most firms, it is difficult to measure a particular worker’s contri-
bution to the production of goods and services.
One type of firm in which such corrections are easier is the sports team. Pro-
fessional teams have many objective measures of productivity. In baseball, for
instance, we can measure a player’s batting average, the frequency of home runs,
the number of stolen bases, and so on.
Studies of sports teams suggest that racial discrimination is, in fact, common
and that much of the blame lies with customers. One study, published in the Jour-
nal of Labor Economics in 1988, examined the salaries of basketball players and
found that black players earned 20 percent less than white players of comparable
ability. The study also found that attendance at basketball games was larger for
teams with a greater proportion of white players. One interpretation of these facts
is that, at least at the time of the study, customer discrimination made black play-
ers less profitable than white players for team owners. In the presence of such cus-
tomer discrimination, a discriminatory wage gap can persist, even if team owners
care only about profit.
A similar situation once existed for baseball players. A study using data from
the late 1960s showed that black players earned less than comparable white play-
ers. Moreover, fewer fans attended games pitched by blacks than games pitched
by whites, even though black pitchers had better records than white pitchers.
Studies of more recent salaries in baseball, however, have found no evidence of
discriminatory wage differentials.
Another study, published in the Quarterly Journal of Economics in 1990, exam-
ined the market prices of old baseball cards. This study found similar evidence of
discrimination. The cards of black hitters sold for 10 percent less than the cards
of comparable white hitters, and the cards of black pitchers sold for 13 percent
less than the cards of comparable white pitchers. These results suggest customer
discrimination among baseball fans. ●
QUICK QUIZ Why is it hard to establish whether a group of workers is being discrimi-
nated against? • Explain how profit-maximizing firms tend to eliminate discriminatory
wage differentials. • How might a discriminatory wage differential persist?
CONCLUSION
In competitive markets, workers earn a wage equal to the value of their marginal
contribution to the production of goods and services. There are, however, many
things that affect the value of the marginal product. Firms pay more for work-
ers who are more talented, more diligent, more experienced, and more educated
because these workers are more productive. Firms pay less to those workers
against whom customers discriminate because these workers contribute less to
revenue.
The theory of the labor market we have developed in the last two chapters
explains why some workers earn higher wages than other workers. The theory
does not say that the resulting distribution of income is equal, fair, or desirable in
any way. That is the topic we take up in Chapter 20.
SUMMARY
• Workers earn different wages for many reasons. • Wages are sometimes pushed above the level
To some extent, wage differentials compensate that brings supply and demand into balance.
workers for job attributes. Other things equal, Three reasons for above-equilibrium wages are
workers in hard, unpleasant jobs are paid more minimum-wage laws, unions, and efficiency
than workers in easy, pleasant jobs. wages.
• Workers with more human capital are paid more • Some differences in earnings are attributable to
than workers with less human capital. The return discrimination based on race, sex, or other fac-
to accumulating human capital is high and has tors. Measuring the amount of discrimination
increased over the past two decades. is difficult, however, because one must cor-
rect for differences in human capital and job
• Although years of education, experience, and job characteristics.
characteristics affect earnings as theory predicts,
there is much variation in earnings that cannot • Competitive markets tend to limit the impact of
be explained by things that economists can mea- discrimination on wages. If the wages of a group
sure. The unexplained variation in earnings is of workers are lower than those of another group
largely attributable to natural ability, effort, and for reasons not related to marginal productiv-
chance. ity, then nondiscriminatory firms will be more
profitable than discriminatory firms. Profit-
• Some economists have suggested that more edu- maximizing behavior, therefore, can reduce dis-
cated workers earn higher wages not because
criminatory wage differentials. Discrimination
education raises productivity but because work-
persists in competitive markets, however, if cus-
ers with high natural ability use education as a
tomers are willing to pay more to discriminatory
way to signal their high ability to employers. If
firms or if the government passes laws requiring
this signaling theory is correct, then increasing
firms to discriminate.
the educational attainment of all workers would
not raise the overall level of wages.
KEY CONCEPTS
compensating differential, p. 414 union, p. 421 efficiency wages, p. 422

human capital, p. 415 strike, p. 421 discrimination, p. 422
1. Why are coal miners paid more than other 6. What difficulties arise in deciding whether a
workers with similar amounts of education? group of workers has a lower wage because of
2. In what sense is education a type of capital? discrimination?
3. How might education raise a worker’s wage 7. Do the forces of economic competition tend to
without raising the worker’s productivity? exacerbate or ameliorate discrimination based
4. What conditions lead to economic superstars? on race?
Would you expect to see superstars in dentistry? 8. Give an example of how discrimination might
In music? Explain. persist in a competitive market.
5. Give three reasons a worker’s wage might
be above the level that balances supply and
demand.
1. College students sometimes work as summer education). Why might this be so? Some studies
interns for private firms or the government. have also found that experience at the same job
Many of these positions pay little or nothing. (called job tenure) has an extra positive influence
a. What is the opportunity cost of taking such on wages. Explain.
a job? 4. At some colleges and universities, economics
b. Explain why students are willing to take professors receive higher salaries than profes-
these jobs. sors in some other fields.
c. If you were to compare the earnings later in a. Why might this be true?
life of workers who had worked as interns b. Some other colleges and universities have a
and those who had taken summer jobs that policy of paying equal salaries to professors
paid more, what would you expect to find? in all fields. At some of these schools, eco-
2. As explained in Chapter 6, a minimum-wage nomics professors have lighter teaching loads
law distorts the market for low-wage labor. To than professors in some other fields. What
reduce this distortion, some economists advo- role do the differences in teaching loads
cate a two-tiered minimum-wage system, with play?
a regular minimum wage for adult workers 5. Imagine that someone were to offer you a
and a lower, “subminimum” wage for teenage choice: You could spend 4 years studying at the
workers. Give two reasons a single minimum world’s best university, but you would have
wage might distort the labor market for teen- to keep your attendance there a secret. Or you
age workers more than it would the market for could be awarded an official degree from the
adult workers. world’s best university, but you couldn’t actu-
3. A basic finding of labor economics is that work- ally attend. Which choice do you think would
ers who have more experience in the labor force enhance your future earnings more? What does
are paid more than workers who have less expe- your answer say about the debate over signaling
rience (holding constant the amount of formal versus human capital in the role of education?
6. When recording devices were first invented 9. Suppose that all young women were channeled
almost 100 years ago, musicians could suddenly into careers as secretaries, nurses, and teachers;
supply their music to large audiences at low at the same time, young men were encouraged
cost. How do you suppose this development to consider these three careers and many others
affected the income of the best musicians? How as well.
do you suppose it affected the income of aver- a. Draw a diagram showing the combined labor
age musicians? market for secretaries, nurses, and teachers.
7. A current debate in education is whether teach- Draw a diagram showing the combined labor
ers should be paid on a standard pay scale market for all other fields. In which market is
based solely upon their years of training and the wage higher? Do men or women receive
teaching experience, or whether part of their higher wages on average?
salary should be based upon their performance b. Now suppose that society changed and
(called “merit pay”). encouraged both young women and young
a. Why might merit pay be desirable? men to consider a wide range of careers.
b. Who might be opposed to a system of merit Over time, what effect would this change
pay? have on the wages in the two markets you
c. What is a potential challenge of merit pay? illustrated in part (a)? What effect would the
d. A related issue: Why might a school district change have on the average wages of men
decide to pay teachers significantly more and women?
than the salaries offered by surrounding 10. Economist June O’Neill has argued that “until
districts? family roles are more equal, women are not
8. When Alan Greenspan (who would later likely to have the same pattern of market work
become chairman of the Federal Reserve) ran and earnings as men.” What does she mean
an economic consulting firm in the 1960s, he by the “pattern” of market work? How do
primarily hired female economists. He once told these characteristics of jobs and careers affect
the New York Times, “I always valued men and earnings?
women equally, and I found that because others 11. This chapter considers the economics of dis-
did not, good women economists were cheaper crimination by employers, customers, and
than men.” Is Greenspan’s behavior profit- governments. Now consider discrimination by
maximizing? Is it admirable or despicable? If workers. Suppose that some brunette work-
more employers were like Greenspan, what ers did not like working with blonde workers.
would happen to the wage differential between Do you think this worker discrimination could
men and women? Why might other economic explain lower wages for blonde workers? If such
consulting firms at the time not have followed a wage differential existed, what would a profit-
Greenspan’s business strategy? maximizing entrepreneur do? If there were
many such entrepreneurs, what would happen
over time?
20
CHAPTER
Income Inequality
and Poverty
“
T he only difference between the rich and other people,” Mary Colum once
said to Ernest Hemingway, “is that the rich have more money.” Maybe
so. But this claim leaves many questions unanswered. The gap between
rich and poor is a fascinating and important topic of study—for the comfortable
rich, for the struggling poor, and for the aspiring and worried middle class.
From the previous two chapters, you should have some understanding about
why different people have different incomes. A person’s earnings depend on the
supply and demand for that person’s labor, which in turn depend on natural abil-
ity, human capital, compensating differentials, discrimination, and so on. Because
labor earnings make up about three-fourths of the total income in the U.S. econ-
omy, the factors that determine wages are also largely responsible for determining
how the economy’s total income is distributed among the various members of
society. In other words, they determine who is rich and who is poor.
In this chapter, we discuss the distribution of income—a topic that raises some
fundamental questions about the role of economic policy. One of the Ten Principles
of Economics in Chapter 1 is that governments can sometimes improve market out-
comes. This possibility is particularly important when considering the distribu-
tion of income. The invisible hand of the marketplace acts to allocate resources
433
efficiently, but it does not necessarily ensure that resources are allocated fairly. As
a result, many economists—though not all—believe that the government should
redistribute income to achieve greater equality. In doing so, however, the govern-
ment runs into another of the Ten Principles of Economics: People face trade-offs.
When the government enacts policies to make the distribution of income more
equal, it distorts incentives, alters behavior, and makes the allocation of resources
less efficient.
Our discussion of the distribution of income proceeds in three steps. First, we
assess how much inequality there is in our society. Second, we consider some
different views about what role the government should play in altering the dis-
tribution of income. Third, we discuss various public policies aimed at helping
society’s poorest members.
THE MEASUREMENT OF INEQUALITY

We begin our study of the distribution of income by addressing four questions of
measurement:
• How much inequality is there in our society?
• How many people live in poverty?
• What problems arise in measuring the amount of inequality?
• How often do people move among income classes?
These measurement questions are the natural starting point from which to discuss
public policies aimed at changing the distribution of income.
U.S. INCOME INEQUALITY

Imagine that you lined up all the families in the economy according to their annual
income. Then you divided the families into five equal groups: the bottom fifth, the
“AS FAR AS I’M CONCERNED,
THEY CAN DO WHAT THEY
second fifth, the middle fifth, the fourth fifth, and the top fifth. Table 1 shows the
WANT WITH THE MINIMUM
income ranges for each of these groups, as well as for the top 5 percent. You can
WAGE, JUST AS LONG AS THEY use this table to find where your family lies in the income distribution.
KEEP THEIR HANDS OFF THE For examining differences in the income distribution over time, economists
MAXIMUM WAGE.” find it useful to present the income data as in Table 2. This table shows the share
1 T A B L E

Group Annual Family Income CARTOON: © 2002 THE NEW YORKER COLLECTION
The Distribution of
Bottom Fifth Under $25,616
Income in the United
Second Fifth $25,616–$45,021
States: 2005
Middle Fifth $45,021–$68,304
Fourth Fifth $68,304–$103,100
Top Fifth $103,100 and over
Top 5 percent $184,500 and over
Source: U.S. Bureau of the Census.

CHAPTER 20 INCOME INEQUALITY AND POVERTY 435
T A B L E 2
Bottom Second Middle Fourth Top Top
Year Fifth Fifth Fifth Fifth Fifth 5%
Income Inequality in
the United States
2005 4.0% 9.6% 15.3% 22.9% 48.1% 21.1%
This table shows the
2000 4.3 9.8 15.5 22.8 47.4 20.8
percentage of total before-tax
1990 4.6 10.8 16.6 23.8 44.3 17.4
income received by families
1980 5.2 11.5 17.5 24.3 41.5 15.3
in each fifth of the income
1970 5.5 12.2 17.6 23.8 40.9 15.6
distribution and by those
1960 4.8 12.2 17.8 24.0 41.3 15.9
families in the top 5 percent.
1950 4.5 12.0 17.4 23.4 42.7 17.3
1935 4.1 9.2 14.1 20.9 51.7 26.5
Source: U.S. Bureau of the Census.
of total income that each group of families received in selected years. In 2005, the
bottom fifth of all families received 4.0 percent of all income, and the top fifth of
all families received 48.1 percent of all income. In other words, even though the
top and bottom fifths include the same number of families, the top fifth has about
twelve times as much income as the bottom fifth.
The last column in the table shows the share of total income received by the
very richest families. In 2005, the top 5 percent of families received 21.1 percent of
total income, which was greater than the total income of the poorest 40 percent.
Table 2 also shows the distribution of income in various years beginning in
1935. At first glance, the distribution of income appears to have been remarkably
stable over time. Throughout the past several decades, the bottom fifth of families
has received about 4 to 5 percent of income, while the top fifth has received about
40 to 50 percent of income. Closer inspection of the table reveals some trends in
the degree of inequality. From 1935 to 1970, the distribution gradually became
more equal. The share of the bottom fifth rose from 4.1 to 5.5 percent, and the
share of the top fifth fell from 51.7 percent to 40.9 percent. In more recent years,
this trend has reversed itself. From 1970 to 2005, the share of the bottom fifth fell
from 5.5 percent to 4.0 percent, and the share of the top fifth rose from 40.9 to 48.1
percent.
In Chapter 19, we discussed some explanations for this recent rise in inequality.
Increases in international trade with low-wage countries and changes in technol-
ogy have tended to reduce the demand for unskilled labor and raise the demand
for skilled labor. As a result, the wages of unskilled workers have fallen relative
to the wages of skilled workers, and this change in relative wages has increased
inequality in family incomes.
INEQUALITY AROUND THE WORLD

How does the amount of inequality in the United States compare to that in other
countries? This question is interesting, but answering it is problematic. For some
countries, data are not available. Even when they are, not every country collects
data in the same way; for example, some countries collect data on individual
incomes, whereas other countries collect data on family incomes, and still others
collect data on expenditure rather than income. As a result, whenever we find a
difference between two countries, we can never be sure whether it reflects a true
difference in the economies or merely a difference in the way data are collected.
With this warning in mind, consider Figure 1, which compares inequality in
twelve countries. The inequality measure is the ratio of the income received by
the richest tenth of the population to the income of the poorest tenth. The most
equality is found in Japan, where the top tenth receives 4.5 times as much income
as the bottom tenth. The least equality is found in Brazil, where the top group
receives 51.3 times as much income as the bottom group. Although all countries
have significant disparities between rich and poor, the degree of inequality varies
substantially around the world.
When countries are ranked by inequality, the United States ends up around
the middle of the pack. The United States has more income inequality than other
economically advanced countries, such as Japan, Germany, and Canada. But the
United States has a more equal income distribution than many developing coun-
tries, such as South Africa, Brazil, and Mexico.
1 F I G U R E Types
the
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THE POVERTY R ATE

A commonly used gauge of the distribution of income is the poverty rate. The
poverty rate is the percentage of the population whose family income falls below poverty rate
an absolute level called the poverty line. The poverty line is set by the federal gov- the percentage of the
ernment at roughly three times the cost of providing an adequate diet. This line population whose family
is adjusted every year to account for changes in the level of prices, and it depends income falls below an
on family size. absolute level called the
poverty line
To get some idea about what the poverty rate tells us, consider the data for
2005. In that year, the median family had an income of $56,194, and the poverty
poverty line
line for a family of four was $19,971. The poverty rate was 12.6 percent. In other an absolute level of
words, 12.6 percent of the population were members of families with incomes income set by the fed-
below the poverty line for their family size. eral government for each
Figure 2 shows the poverty rate since 1959, when the official data begin. You family size below which
can see that the poverty rate fell from 22.4 percent in 1959 to a low of 11.1 percent a family is deemed to be
in 1973. This decline is not surprising, because average income in the economy in poverty
(adjusted for inflation) rose more than 50 percent during this period. Because
the poverty line is an absolute rather than a relative standard, more families are
pushed above the poverty line as economic growth pushes the entire income dis-
tribution upward. As John F. Kennedy once put it, a rising tide lifts all boats.
Since the early 1970s, however, the economy’s rising tide has left some boats
behind. Despite continued growth in average income, the poverty rate has not
declined below the level reached in 1973. This lack of progress in reducing pov-
erty in recent decades is closely related to the increasing inequality we saw in
Table 2. Although economic growth has raised the income of the typical family,
the increase in inequality has prevented the poorest families from sharing in this
greater economic prosperity.
Percent of the
F I G U R E
2
Population
below Poverty
The Poverty Rate
Line
The poverty rate shows
25% the percentage of
the population with
20% incomes below an
Poverty rate absolute level called
15% the poverty line.
Source: U.S. Bureau of
10%
the Census.
5%
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
3 T A B L E
Group Poverty Rate
Who Is Poor?
All persons 12.6%
This table shows that the
White, not Hispanic 8.3
poverty rate varies greatly
Black 24.9
among different groups
Hispanic 21.8
within the population.
Asian 11.1
Children (under age 18) 17.6
Elderly (over age 64) 10.1
Married-couple families 5.9
Female household, no spouse present 31.1
Source: U.S. Bureau of the Census. Data are for 2005.
Poverty is an economic malady that affects all groups within the population,
but it does not affect all groups with equal frequency. Table 3 shows the poverty
rates for several groups, and it reveals three striking facts:
• Poverty is correlated with race. Blacks and Hispanics are about three times
more likely to live in poverty than are whites.
• Poverty is correlated with age. Children are more likely than average to
be members of poor families, and the elderly are less likely than average
to be poor.
• Poverty is correlated with family composition. Families headed by a female
adult and without a spouse present are about five times as likely to live in
poverty as a family headed by a married couple.
These three facts have described U.S. society for many years, and they show which
people are most likely to be poor. These effects also work together: Among black
and Hispanic children in female-headed households, about half live in poverty.
PROBLEMS IN M EASURING INEQUALITY

Although data on the income distribution and the poverty rate help to give us
some idea about the degree of inequality in our society, interpreting these data is
not always straightforward. The data are based on households’ annual incomes.
What people care about, however, is not their incomes but their ability to maintain
a good standard of living. For at least three reasons, data on the income distribution
and the poverty rate give an incomplete picture of inequality in living standards.
In-Kind Transfers Measurements of the distribution of income and the poverty

rate are based on families’ money income. Through various government programs,
however, the poor receive many nonmonetary items, including food stamps, hous-
in-kind transfers ing vouchers, and medical services. Transfers to the poor given in the form of goods
transfers to the poor and services rather than cash are called in-kind transfers. Standard measurements
given in the form of of the degree of inequality do not take account of these in-kind transfers.
goods and services Because in-kind transfers are received mostly by the poorest members of soci-
rather than cash ety, the failure to include in-kind transfers as part of income greatly affects the
measured poverty rate. According to a study by the Census Bureau, if in-kind

transfers were included in income at their market value, the number of families in
poverty would be about 10 percent lower than the standard data indicate.
The Economic Life Cycle Incomes vary predictably over people’s lives. A young
worker, especially one in school, has a low income. Income rises as the worker
gains maturity and experience, peaks at around age 50, and then falls sharply
when the worker retires at around age 65. This regular pattern of income variation
is called the life cycle. life cycle
Because people can borrow and save to smooth out life cycle changes in income, the regular pattern of
their standard of living in any year depends more on lifetime income than on that income variation over
year’s income. The young often borrow, perhaps to go to school or to buy a house, a person’s life
and then repay these loans later when their incomes rise. People have their highest
saving rates when they are middle-aged. Because people can save in anticipation
of retirement, the large declines in incomes at retirement need not lead to similar
declines in the standard of living. This normal life cycle pattern causes inequal-
ity in the distribution of annual income, but it does not necessarily represent true
inequality in living standards.
Transitory versus Permanent Income Incomes vary over people’s lives not
only because of predictable life cycle variation but also because of random and
transitory forces. One year a frost kills off the Florida orange crop, and Florida
orange growers see their incomes fall temporarily. At the same time, the Flor-
ida frost drives up the price of oranges, and California orange growers see their
incomes temporarily rise. The next year the reverse might happen.
Just as people can borrow and lend to smooth out life cycle variation in income,
they can also borrow and lend to smooth out transitory variation in income. To
the extent that a family saves in good years and borrows (or depletes its savings)
in bad years, transitory changes in income need not affect its standard of living.
A family’s ability to buy goods and services depends largely on its permanent permanent income
income, which is its normal, or average, income. a person’s normal
To gauge inequality of living standards, the distribution of permanent income income
is more relevant than the distribution of annual income. Many economists believe
that people base their consumption on their permanent income; as a result, inequal-
ity in consumption is one gauge of inequality of permanent income. Because
permanent income and consumption are less affected by transitory changes in
income, they are more equally distributed than is current income.
ALTERNATIVE MEASURES OF INEQUALITY
A recent study by Michael Cox and Richard Alm of the Federal Reserve Bank of
Dallas shows how different measures of inequality lead to dramatically differ-
ent results. Cox and Alm compared American households in the top fifth of the
income distribution to those in the bottom fifth to see how far apart they are. They
used data from 2006 and reported some of their results in an article in the New
York Times on February 10, 2008.
According to Cox and Alm, the richest fifth of U.S. households has an average
income of $149,963, while the poorest fifth has an average income of $9,974. Thus,
the top group has about 15 times as much income as the bottom group.
The gap between rich and poor shrinks a bit if taxes are taken into account.
Because the tax system is progressive, the top group pays a higher percentage of
its income in taxes than does the bottom group. Cox and Alm find that the richest
fifth has 14 times as much after-tax income as the poorest fifth.
The gap shrinks more substantially if one looks at consumption rather than
income. Households having an unusually good year are more likely to be in the
top group and are likely to save a high fraction out of their incomes. Households
having an unusually bad year are more likely to be in the bottom group and are
more likely to consume out of their savings. According to Cox and Alms, the con-
sumption of the richest fifth is only 3.9 times as much as the consumption of the
poorest fifth.
The consumption gap becomes smaller still if one corrects for differences in the
number of people in the household. Because larger families are more likely to have
two earners, they are more likely to find themselves near the top of the income
distribution. But they also have more mouths to feed. Cox and Alms report that
households in the top fifth have an average of 3.1 people, while those in the bot-
tom fifth have an average of 1.7 people. As a result, consumption per person in the
richest fifth of households is only 2.1 times as much as consumption per person in
the poorest fifth.
These data show that inequality in material standards of living is much smaller
than inequality in annual income. ●
ECONOMIC MOBILITY
People sometimes speak of “the rich” and “the poor” as if these groups consisted
of the same families year after year. In fact, this is not at all the case. Economic
mobility, the movement of people among income classes, is substantial in the
U.S. economy. Movements up the income ladder can be due to good luck or hard
work, and movements down the ladder can be due to bad luck or laziness. Some
of this mobility reflects transitory variation in income, while some reflects more
persistent changes in income.
Because economic mobility is so great, many of those below the poverty line are
there only temporarily. Poverty is a long-term problem for relatively few families.
In a typical 10-year period, about one in four families falls below the poverty line
in at least 1 year. Yet fewer than 3 percent of families are poor for 8 or more years.
Because it is likely that the temporarily poor and the persistently poor face dif-
ferent problems, policies that aim to combat poverty need to distinguish between
these groups.
Another way to gauge economic mobility is the persistence of economic suc-
cess from generation to generation. Economists who have studied this topic find
that having an above-average income carries over from parents to children, but
the persistence is far from perfect, indicating substantial mobility among income
classes. If a father earns 20 percent above his generation’s average income, his son
will most likely earn 8 percent above his generation’s average income. There is
only a small correlation between the income of a grandfather and the income of a
grandson.
One result of this great economic mobility is that the U.S. economy is filled
with self-made millionaires (as well as with heirs who squandered the fortunes
they inherited). According to one study, about four of five millionaires made their
money on their own, often by starting and building a business or by climbing the
corporate ladder. Only one in five millionaires inherited their fortunes.
What to Make of Rising Inequality

An economist offers his perspective on the rise in U.S. income
inequality.
Incomes and Inequality: account for about three-quarters of the modern world. Even if more money makes
What the Numbers Don’t observed rise in income inequality for men people happier, it appears to do so at a
Tell Us and 69 to 95 percent of the observed rise declining rate, which places a natural check
By Tyler Cowen in income inequality for women (“Increas- on the inequality of happiness.
ing Residual Wage Inequality: Composi- Studies of personal happiness, based on
The growing inequality in wealth and tion Effects, Noisy Data, or Rising Demand questionnaires and self-reporting, indicate
income has led many people to question for Skill?” The American Economic Review, that the inequality of happiness is not grow-
whether the contemporary American econ- June 2006). In other words, rising income ing over time in the United States. Further-
omy is rigged in favor of the rich. While there inequality is not just a result of unfairness or more, the United States has an inequality
is little doubt that the gap between the bad public policy. . . . of happiness roughly comparable to that
wealthy and everybody else has widened in In any case, income is not the only—or of Sweden or Denmark, two nations with
recent years, the situation is not as unfair as even the most—important measure of strongly egalitarian reputations. (See the
some of the numbers seem to imply. inequality. For instance, inequality of con- symposium in Journal of Happiness Studies,
Much of the measured growth in income sumption—the difference between what December 2005.) American society offers
inequality has resulted from natural demo- the poor consume and what the rich good opportunities for people to be happy,
graphic trends. In general, there is more consume—does not show a significant even if not everyone becomes rich.
income inequality among older populations upward trend (Dirk Krueger and Fabrizio If we look at leisure, from 1965 to 2003,
than among younger populations, if only Perri, “Does Income Inequality Lead to Con- less-educated groups experienced a big-
because older people have had more time sumption Inequality?” The Review of Eco- ger boost in free time than more-educated
to experience rising or falling fortunes. nomic Studies, January 2006). Consumption, groups (Mark Aguiar and Erik Hurst, “Mea-
Furthermore, more-educated groups of course, is not an ideal indicator of well- suring Trends in Leisure: The Allocation of
show greater income inequality than less- being; a high or steady level of purchases Time Over Five Decades,” Federal Reserve
educated groups. Uneducated people are may reflect growing debt, and the ease of Bank of Boston Working Paper). In other
more likely to be clustered in a tight range of buying a big-screen TV does not reflect a words, the high earners are working hard for
relatively low incomes. But the educated will comparable ease in buying good health their money and perhaps they are having
include a greater range of highly motivated care. less fun. . . .
breadwinners and relaxed bohemians, and Happiness, possibly the most relevant The broader philosophical question is
a greater range of winning and losing inves- variable for a study of inequality, is also the why we should worry about inequality—
tors. A result is a greater variety of incomes. hardest to measure. Nonetheless, inequal- of any kind—much at all. Life is not a race
Since the United States is growing older and ity of happiness is usually less marked than against fellow human beings. . . . We should
also more educated, income inequality will inequality of income, at least in wealthy continue to improve opportunities for
naturally rise. societies. A man earning $500,000 a year lower-income people, but inequality as a
Thomas Lemieux, professor of econom- is not usually 10 times as happy as a man major and chronic American problem has
ics at the University of British Columbia, earning $50,000 a year. The $50,000 earner been overstated.
estimates that these demographic effects still enjoys most of the conveniences of the

QUICK QUIZ What does the poverty rate measure? • Describe three potential problems
in interpreting the measured poverty rate.
THE POLITICAL PHILOSOPHY OF

REDISTRIBUTING INCOME
We have just seen how the economy’s income is distributed and have considered
some of the problems in interpreting measured inequality. This discussion was
positive in the sense that it merely described the world as it is. We now turn to the
normative question facing policymakers: What should the government do about
economic inequality?
This question is not just about economics. Economic analysis alone cannot
tell us whether policymakers should try to make our society more egalitarian.
Our views on this question are, to a large extent, a matter of political philosophy.
Yet because the government’s role in redistributing income is central to so many
debates over economic policy, here we digress from economic science to consider
a bit of political philosophy.
UTILITARIANISM
utilitarianism A prominent school of thought in political philosophy is utilitarianism. The
the political philosophy founders of utilitarianism are the English philosophers Jeremy Bentham (1748–
according to which the 1832) and John Stuart Mill (1806–1873). To a large extent, the goal of utilitarians is
government should to apply the logic of individual decision making to questions concerning morality
choose policies to maxi- and public policy.
mize the total utility of
The starting point of utilitarianism is the notion of utility—the level of happi-
everyone in society
ness or satisfaction that a person receives from his or her circumstances. Utility is
utility a measure of well-being and, according to utilitarians, is the ultimate objective of
a measure of happiness all public and private actions. The proper goal of the government, they claim, is to
or satisfaction maximize the sum of utility achieved by everyone in society.
The utilitarian case for redistributing income is based on the assumption of
diminishing marginal utility. It seems reasonable that an extra dollar of income
provides a poor person with more additional utility than an extra dollar would
provide to a rich person. In other words, as a person’s income rises, the extra well-
being derived from an additional dollar of income falls. This plausible assump-
tion, together with the utilitarian goal of maximizing total utility, implies that the
government should try to achieve a more equal distribution of income.
The argument is simple. Imagine that Peter and Paul are the same, except
that Peter earns $80,000 and Paul earns $20,000. In this case, taking a dollar from
Peter to pay Paul will reduce Peter’s utility and raise Paul’s utility. But because
of diminishing marginal utility, Peter’s utility falls by less than Paul’s utility rises.
Thus, this redistribution of income raises total utility, which is the utilitarian’s
objective.
At first, this utilitarian argument might seem to imply that the government
should continue to redistribute income until everyone in society has exactly the
same income. Indeed, that would be the case if the total amount of income—
$100,000 in our example—were fixed. But in fact, it is not. Utilitarians reject
complete equalization of incomes because they accept one of the Ten Principles of
Economics presented in Chapter 1: People respond to incentives.
To take from Peter to pay Paul, the government must pursue policies that redis-
tribute income. The U.S. federal income tax and welfare system are examples.
Under these policies, people with high incomes pay high taxes, and people with
low incomes receive income transfers. Yet if the government takes away addi-
tional income a person might earn through higher income taxes or reduced trans-
fers, both Peter and Paul have less incentive to work hard. As they work less,
society’s income falls, and so does total utility. The utilitarian government has to
balance the gains from greater equality against the losses from distorted incen-
tives. To maximize total utility, therefore, the government stops short of making
society fully egalitarian.
A famous parable sheds light on the utilitarian’s logic. Imagine that Peter and
Paul are thirsty travelers trapped at different places in the desert. Peter’s oasis
has much water; Paul’s has little. If the government could transfer water from
one oasis to the other without cost, it would maximize total utility from water by
equalizing the amount in the two places. But suppose that the government has
only a leaky bucket. As it tries to move water from one place to the other, some of
the water is lost in transit. In this case, a utilitarian government might still try to
move some water from Peter to Paul, depending on the size of Paul’s thirst and
the size of the bucket’s leak. But with only a leaky bucket at its disposal, a utilitar-
ian government will stop short of trying to reach complete equality.
LIBERALISM
A second way of thinking about inequality might be called liberalism. Philoso- liberalism
pher John Rawls develops this view in his book A Theory of Justice. This book was the political philosophy
first published in 1971, and it quickly became a classic in political philosophy. according to which the
Rawls begins with the premise that a society’s institutions, laws, and policies government should
should be just. He then takes up the natural question: How can we, the members choose policies deemed
just, as evaluated by
of society, ever agree on what justice means? It might seem that every person’s
an impartial observer
point of view is inevitably based on his or her particular circumstances—whether
behind a “veil of
he or she is talented or less talented, diligent or lazy, educated or less educated, ignorance”
born to a wealthy family or a poor one. Could we ever objectively determine what
a just society would be?
To answer this question, Rawls proposes the following thought experiment.
Imagine that before any of us is born, we all get together for a meeting to design
the rules that govern society. At this point, we are all ignorant about the station in
life each of us will end up filling. In Rawls’s words, we are sitting in an “original
position” behind a “veil of ignorance.” In this original position, Rawls argues, we
can choose a just set of rules for society because we must consider how those rules
will affect every person. As Rawls puts it, “Since all are similarly situated and no
one is able to design principles to favor his particular conditions, the principles of
justice are the result of fair agreement or bargain.” Designing public policies and
institutions in this way allows us to be objective about what policies are just.
Rawls then considers what public policy designed behind this veil of ignorance
would try to achieve. In particular, he considers what income distribution a per-
son would consider fair if that person did not know whether he or she would end
up at the top, bottom, or middle of the distribution. Rawls argues that a person in
the original position would be especially concerned about the possibility of being
at the bottom of the income distribution. In designing public policies, therefore,
we should aim to raise the welfare of the worst-off person in society. That is,
rather than maximizing the sum of everyone’s utility, as a utilitarian would do,
maximin criterion Rawls would maximize the minimum utility. Rawls’s rule is called the maximin
the claim that the gov- criterion.
ernment should aim to Because the maximin criterion emphasizes the least fortunate person in soci-
maximize the well-being ety, it justifies public policies aimed at equalizing the distribution of income. By
of the worst-off person transferring income from the rich to the poor, society raises the well-being of the
in society
least fortunate. The maximin criterion would not, however, lead to a completely
egalitarian society. If the government promised to equalize incomes completely,
people would have no incentive to work hard, society’s total income would
fall substantially, and the least fortunate person would be worse off. Thus, the
maximin criterion still allows disparities in income because such disparities can
improve incentives and thereby raise society’s ability to help the poor. Nonethe-
less, because Rawls’s philosophy puts weight on only the least fortunate members
of society, it calls for more income redistribution than does utilitarianism.
Rawls’s views are controversial, but the thought experiment he proposes has
much appeal. In particular, this thought experiment allows us to consider the
social insurance redistribution of income as a form of social insurance. That is, from the perspec-
government policy tive of the original position behind the veil of ignorance, income redistribution is
aimed at protecting like an insurance policy. Homeowners buy fire insurance to protect themselves
people against the risk from the risk of their house burning down. Similarly, when we as a society choose
of adverse events policies that tax the rich to supplement the incomes of the poor, we are all insur-
ing ourselves against the possibility that we might have been a member of a poor
family. Because people dislike risk, we should be happy to have been born into a
society that provides us this insurance.
It is not at all clear, however, that rational people behind the veil of ignorance
would truly be so averse to risk as to follow the maximin criterion. Indeed, because
a person in the original position might end up anywhere in the distribution of
outcomes, he or she might treat all possible outcomes equally when designing
public policies. In this case, the best policy behind the veil of ignorance would be
to maximize the average utility of members of society, and the resulting notion of
justice would be more utilitarian than Rawlsian.
LIBERTARIANISM
libertarianism A third view of inequality is called libertarianism. The two views we have consid-
the political philosophy ered so far—utilitarianism and liberalism—both view the total income of society
according to which the as a shared resource that a social planner can freely redistribute to achieve some
government should pun- social goal. By contrast, libertarians argue that society itself earns no income—
ish crimes and enforce only individual members of society earn income. According to libertarians, the
voluntary agreements
government should not take from some individuals and give to others to achieve
but not redistribute
income
any particular distribution of income.
For instance, philosopher Robert Nozick writes the following in his famous
1974 book Anarchy, State, and Utopia:
We are not in the position of children who have been given portions of pie by
someone who now makes last minute adjustments to rectify careless cutting.
There is no central distribution, no person or group entitled to control all the
resources, jointly deciding how they are to be doled out. What each person
gets, he gets from others who give to him in exchange for something, or as a
gift. In a free society, diverse persons control different resources, and new hold-
ings arise out of the voluntary exchanges and actions of persons.
Whereas utilitarians and liberals try to judge what amount of inequality is desir-
able in a society, Nozick denies the validity of this very question.
The libertarian alternative to evaluating economic outcomes is to evaluate the
process by which these outcomes arise. When the distribution of income is achieved
unfairly—for instance, when one person steals from another—the government has
the right and duty to remedy the problem. But as long as the process determining
the distribution of income is just, the resulting distribution is fair, no matter how
unequal.
Nozick criticizes Rawls’s liberalism by drawing an analogy between the dis-
tribution of income in society and the distribution of grades in a course. Suppose
you were asked to judge the fairness of the grades in the economics course you are
now taking. Would you imagine yourself behind a veil of ignorance and choose
a grade distribution without knowing the talents and efforts of each student? Or
would you ensure that the process of assigning grades to students is fair without
regard for whether the resulting distribution is equal or unequal? For the case of
grades at least, the libertarian emphasis on process over outcomes is compelling.
Libertarians conclude that equality of opportunities is more important than
equality of incomes. They believe that the government should enforce individual
rights to ensure that everyone has the same opportunity to use his or her talents
and achieve success. Once these rules of the game are established, the government
has no reason to alter the resulting distribution of income.
Q Q
UICK UIZ Pam earns more than Pauline. Someone proposes taxing Pam to supple-
ment Pauline’s income. How would a utilitarian, a liberal, and a libertarian evaluate this
proposal?
POLICIES TO REDUCE POVERTY

As we have just seen, political philosophers hold various views about what role
the government should take in altering the distribution of income. Political debate
among the larger population of voters reflects a similar disagreement. Despite
these continuing debates, most people believe that, at the very least, the govern-
ment should try to help those most in need. According to a popular metaphor,
the government should provide a “safety net” to prevent any citizen from falling
too far.
Poverty is one of the most difficult problems that policymakers face. Poor fami-
lies are more likely than the overall population to experience homelessness, drug
dependence, health problems, teenage pregnancy, illiteracy, unemployment, and
low educational attainment. Members of poor families are both more likely to
commit crimes and more likely to be victims of crimes. Although it is hard to
separate the causes of poverty from the effects, there is no doubt that poverty is
associated with various economic and social ills.
Suppose that you were a policymaker in the government, and your goal was
to reduce the number of people living in poverty. How would you achieve this
goal? Here we examine some of the policy options that you might consider. Each
of these options helps some people escape poverty, but none of them is perfect,
and deciding upon the best combination to use is not easy.
MINIMUM-WAGE LAWS
Laws setting a minimum wage that employers can pay workers are a perennial
source of debate. Advocates view the minimum wage as a way of helping the
working poor without any cost to the government. Critics view it as hurting those
it is intended to help.
The minimum wage is easily understood using the tools of supply and demand,
as we first saw in Chapter 6. For workers with low levels of skill and experience,
a high minimum wage forces the wage above the level that balances supply and
demand. It therefore raises the cost of labor to firms and reduces the quantity
of labor that those firms demand. The result is higher unemployment among
those groups of workers affected by the minimum wage. Although those workers
who remain employed benefit from a higher wage, those who might have been
employed at a lower wage are worse off.
The magnitude of these effects depends crucially on the elasticity of demand.
Advocates of a high minimum wage argue that the demand for unskilled labor
is relatively inelastic so that a high minimum wage depresses employment only
slightly. Critics of the minimum wage argue that labor demand is more elastic,
especially in the long run when firms can adjust employment and production
more fully. They also note that many minimum-wage workers are teenagers from
middle-class families so that a high minimum wage is imperfectly targeted as a
policy for helping the poor.
WELFARE
One way to raise the living standards of the poor is for the government to supple-
ment their incomes. The primary way the government does this is through the
welfare welfare system. Welfare is a broad term that encompasses various government
government programs programs. Temporary Assistance for Needy Families (TANF) is a program that
that supplement the assists families with children and no adult able to support the family. In a typical
incomes of the needy family receiving such assistance, the father is absent, and the mother is at home
raising small children. Another welfare program is Supplemental Security Income
(SSI), which provides assistance to the poor who are sick or disabled. Note that
for both of these welfare programs, a poor person cannot qualify for assistance
simply by having a low income. He or she must also establish some additional
“need,” such as small children or a disability.
A common criticism of welfare programs is that they create incentives for
people to become “needy.” For example, these programs may encourage families
to break up, for many families qualify for financial assistance only if the father
is absent. The programs may also encourage illegitimate births, for many poor,
single women qualify for assistance only if they have children. Because poor,
single mothers are such a large part of the poverty problem and because welfare
programs seem to raise the number of poor, single mothers, critics of the welfare
system assert that these policies exacerbate the very problems they are supposed
to cure. As a result of these arguments, the welfare system was revised in a 1996
law that limited the amount of time recipients could stay on welfare.
How severe are these potential problems with the welfare system? No one
knows for sure. Proponents of the welfare system point out that being a poor,
single mother on welfare is a difficult existence at best, and they are skeptical that
many people would be encouraged to pursue such a life if it were not thrust upon
them. Moreover, trends over time do not support the view that the decline of the
two-parent family is largely a symptom of the welfare system, as the system’s
critics sometimes claim. Since the early 1970s, welfare benefits (adjusted for infla-
tion) have declined, yet the percentage of children living with only one parent
has risen.
NEGATIVE INCOME TAX

Whenever the government chooses a system to collect taxes, it affects the dis-
tribution of income. This is clearly true in the case of a progressive income tax,
whereby high-income families pay a larger percentage of their income in taxes
than do low-income families. As we discussed in Chapter 12, equity across income
groups is an important criterion in the design of a tax system.
Many economists have advocated supplementing the income of the poor using
a negative income tax. According to this policy, every family would report its negative income tax
income to the government. High-income families would pay a tax based on their a tax system that collects
incomes. Low-income families would receive a subsidy. In other words, they revenue from high-
would “pay” a “negative tax.” income households and
For example, suppose the government used the following formula to compute gives subsidies to low-
income households
a family’s tax liability:
Taxes owed = (1⁄3 of income) – $10,000.
In this case, a family that earned $60,000 would pay $10,000 in taxes, and a fam-
ily that earned $90,000 would pay $20,000 in taxes. A family that earned $30,000
would owe nothing. And a family that earned $15,000 would “owe” –$5,000. In
other words, the government would send this family a check for $5,000.
Under a negative income tax, poor families would receive financial assistance
without having to demonstrate need. The only qualification required to receive
assistance would be a low income. Depending on one’s point of view, this feature
can be either an advantage or a disadvantage. On the one hand, a negative income
tax does not encourage illegitimate births and the breakup of families, as critics
of the welfare system believe current policy does. On the other hand, a negative
income tax would subsidize not only the unfortunate but also those who are sim-
ply lazy and, in some people’s eyes, undeserving of government support.
One actual tax provision that works much like a negative income tax is the
Earned Income Tax Credit (EITC). This credit allows poor working families to
receive income tax refunds greater than the taxes they paid during the year.
Because the Earned Income Tax Credit applies only to the working poor, it does not
discourage recipients from working, as other antipoverty programs are claimed
to do. For the same reason, however, it also does not help alleviate poverty due to
unemployment, sickness, or other inability to work.
IN-K IND TRANSFERS

Another way to help the poor is to provide them directly with some of the goods
and services they need to raise their living standards. For example, charities pro-
vide the needy with food, shelter, and toys at Christmas. The government gives
Child Labor
What is the best way to reduce the use of child labor around the world?
Research Changes Ideas When he started working on child labor

about Children and Work issues six years ago, Professor Edmonds said
By Virginia Postrel in an interview, “[T]he conventional view
was that child labor really wasn’t about pov-
When Americans think about child labor in erty.” Children’s work, many policy makers
poor countries, they rarely picture girls fetch- believed, “reflected perhaps parental cal-
ing water or boys tending livestock. Yet most lousness or a lack of education for parents
of the 211 million children, ages 5 to 14, who about the benefits of educating your child.”
work worldwide are not in factories. They are So policies to curb child labor focused on
working in agriculture—from 92 percent in educating parents about why their children
Vietnam to 63 percent in Guatemala—and should not work and banning children’s
most are not paid directly. Global Economy,” published in the Winter employment to remove the temptation.
“Contrary to popular perception in high- 2005 Journal of Economic Perspectives. Recent research, however, casts doubt
income countries, most working children Their article surveys what is known about on the cultural explanation. “In every con-
PHOTO: © GETTY IMAGES
are employed by their parents rather than child labor. Research over the past several text that I’ve looked at things, child labor
in manufacturing establishments or other years, by these economists and others, has seems to be almost entirely about poverty.
forms of wage employment,” two Dart- begun to erode some popular beliefs about I wouldn’t say it’s only about poverty, but
mouth economists, Eric V. Edmonds and why children work, what they do and when it’s got a lot to do with poverty,” Professor
Nina Pavcnik, wrote in “Child Labor in the they are likely to leave work for school. Edmonds said.
poor families food stamps, which are government vouchers that can be used to buy
food at stores; the stores then redeem the vouchers for money. The government
also gives many poor people healthcare through a program called Medicaid.
Is it better to help the poor with these in-kind transfers or with direct cash pay-
ments? There is no clear answer.
Advocates of in-kind transfers argue that such transfers ensure that the poor
get what they need most. Among the poorest members of society, alcohol and
drug addiction is more common than it is in society as a whole. By providing the
poor with food and shelter, society can be more confident that it is not helping to
support such addictions. This is one reason in-kind transfers are more politically
popular than cash payments to the poor.
Advocates of cash payments, on the other hand, argue that in-kind transfers
are inefficient and disrespectful. The government does not know what goods and
services the poor need most. Many of the poor are ordinary people down on their
luck. Despite their misfortune, they are in the best position to decide how to raise
their own living standards. Rather than giving the poor in-kind transfers of goods
As families’ incomes increase, children “Child labor does not appear to vary with “Instead, it looks like what households
tend to stop working and, where schools per capita expenditure until households can did was, with rising income, they purchased
are available, they go to school. If family meet their food needs, and it then declines substitutes for child labor. They used more
incomes drop, children are more likely to dramatically,” Professor Edmonds wrote. fertilizers. There was more mechanization,
return to work. During this same period, Vietnam more purchasing of tools,” he said, adding,
Some of the best data, and the most repealed its policy against exporting rice. “It was the opposite of what I expected to
noteworthy results, come from Vietnam, That opened a big new market for Vietnam- find coming in.” . . .
which tracked about 3,000 households from ese farmers—the country went from almost The results from Vietnam suggest that
1993 to 1998. This was a period of rapid no exports to being one of the world’s top families do not want their children to work.
economic growth, in which gross domestic rice exporters—and significantly raised the Parents pull their children out of work when
product rose about 9 percent a year. price of rice. they can afford to, even when the wages
In a paper published in the Winter 2005 This change, along with the family sur- children could earn are rising. Poverty, not
Journal of Human Resources, “Does Child vey data, allowed Professors Edmonds and culture, appears to be the fundamental
Labor Decline With Improving Economic Pavcnik to examine what happens when problem. . . .
Status?” Professor Edmonds found that child household incomes rise but children’s labor “Most child labor policy even today is
labor dropped by nearly 30 percent over also becomes more valuable. Their paper, directed at trying to get kids into unemploy-
this five-year period. Rising incomes explain “The Effect of Trade Liberalization on Child ment—to limit working opportunities for
about 60 percent of that shift. Labor,” was published in the March 2005 kids,” he said in the interview. But, “if house-
The effects were greatest for families Journal of International Economics. holds are already in a situation where they
escaping poverty. For those who crossed In the interview, Professor Edmonds don’t want their children to be working, but
the official poverty line, earning enough to said he expected that the booming market they’re forced to because of their circum-
pay for adequate food and basic necessities, for rice would lead more children to work stance, taking additional steps to prevent
higher incomes accounted for 80 percent of in agriculture, if only on their own families’ the kids from working is punishing the poor-
the drop in child labor. In 1993, 58 percent farms, because the value of their labor had est for being poor.”
of the population fell below the poverty line, risen substantially. But that was not what
compared with 33 percent five years later. happened.
Source: New York Times, July 14, 2005.
and services that they may not want, it may be better to give them cash and allow
them to buy what they think they need most.
ANTIPOVERTY PROGRAMS AND WORK INCENTIVES

Many policies aimed at helping the poor can have the unintended effect of dis-
couraging the poor from escaping poverty on their own. To see why, consider the
following example. Suppose that a family needs an income of $15,000 to maintain
a reasonable standard of living. And suppose that, out of concern for the poor, the
government promises to guarantee every family that income. Whatever a family
earns, the government makes up the difference between that income and $15,000.
What effect would you expect this policy to have?
The incentive effects of this policy are obvious: Any person who would make
under $15,000 by working has little incentive to find and keep a job. For every
dollar that the person would earn, the government would reduce the income
supplement by a dollar. In effect, the government taxes 100 percent of additional
earnings. An effective marginal tax rate of 100 percent is surely a policy with a
large deadweight loss.
The adverse effects of this high effective tax rate can persist over time. A per-
son discouraged from working loses the on-the-job training that a job might offer.
In addition, his or her children miss the lessons learned by observing a parent
with a full-time job, and this may adversely affect their own ability to find and
hold a job.
Although the antipoverty program we have been discussing is hypothetical,
it is not as unrealistic as might first appear. Welfare, Medicaid, food stamps, and
the Earned Income Tax Credit are all programs aimed at helping the poor, and
they are all tied to family income. As a family’s income rises, the family becomes
ineligible for these programs. When all these programs are taken together, it is
common for families to face effective marginal tax rates that are very high. Some-
times the effective marginal tax rates even exceed 100 percent so that poor families
are worse off when they earn more. By trying to help the poor, the government
discourages those families from working. According to critics of antipoverty pro-
grams, these programs alter work attitudes and create a “culture of poverty.”
It might seem that there is an easy solution to this problem: Reduce benefits to
poor families more gradually as their incomes rise. For example, if a poor fam-
ily loses 30 cents of benefits for every dollar it earns, then it faces an effective
marginal tax rate of 30 percent. Although this effective tax reduces work effort to
some extent, it does not eliminate the incentive to work completely.
The problem with this solution is that it greatly increases the cost of programs
to combat poverty. If benefits are phased out gradually as a poor family’s income
rises, then families just above the poverty level will also be eligible for substan-
tial benefits. The more gradual the phase-out, the more families are eligible, and
the more the program costs. Thus, policymakers face a trade-off between burden-
ing the poor with high effective marginal tax rates and burdening taxpayers with
costly programs to reduce poverty.
There are various other ways to reduce the work disincentive of antipoverty
programs. One is to require any person collecting benefits to accept a govern-
ment-provided job—a system sometimes called workfare. Another possibility is to
provide benefits for only a limited period of time. This route was taken in the 1996
welfare reform bill, which imposed a 5-year lifetime limit on welfare recipients.
When President Clinton signed the bill, he explained his policy as follows: “Wel-
fare should be a second chance, not a way of life.”
How has the reform worked? The debate over the bill persists to this day, but
there is no doubt that its passage was followed by a large decrease in the welfare
rolls and a large increase in employment among those groups traditionally on
welfare. In a 2003 study, economist Rebecca Blank, a prominent expert on the
welfare system, summarized the experience as follows:
This nation transformed its assistance programs to poor families with children
from cash-assistance oriented programs aimed at providing income support, to
work-assistance programs aimed at encouraging and supporting work. Critics
can argue that the changes have left us with an inadequate safety net, in which
an increasing number of families will be unable to return for assistance due to
time limits, past sanctions, and limited state funds. Meanwhile, work require-
ments force women into unstable, difficult work situations with low wages and
inadequate support for child care, healthcare or other family needs. Supporters
can argue that the system has now worked for seven years. Due to a mix of eco-
nomic good fortune and well-designed policies, a substantial number of women
who would previously have been receiving welfare are now in employment
building a record of experience and demonstrating to their children the impor-
tance of work preparation. Dire predictions about deep poverty and greatly
increased homelessness have not come to pass. Even if the work-support sys-
tem is far from perfect, it may be preferable to the poorly-functioning AFDC
[Aid to Families with Dependent Children] welfare system of the past.
QUICK QUIZ List three policies aimed at helping the poor, and discuss the pros and cons
of each.
CONCLUSION
People have long reflected on the distribution of income in society. Plato, the
ancient Greek philosopher, concluded that in an ideal society the income of the
richest person would be no more than four times the income of the poorest per-
son. Although the measurement of inequality is difficult, it is clear that our society
has much more inequality than Plato recommended.
One of the Ten Principles of Economics discussed in Chapter 1 is that govern-
ments can sometimes improve market outcomes. There is little consensus, how-
ever, about how this principle should be applied to the distribution of income.
Philosophers and policymakers today do not agree on how much income inequal-
ity is desirable, or even whether public policy should aim to alter the distribution
of income. Much of public debate reflects this disagreement. Whenever taxes are
raised, for instance, lawmakers argue over how much of the tax hike should fall
on the rich, the middle class, and the poor.
Another of the Ten Principles of Economics is that people face trade-offs. This
principle is important to keep in mind when thinking about economic inequal-
ity. Policies that penalize the successful and reward the unsuccessful reduce the
incentive to succeed. Thus, policymakers face a trade-off between equality and
efficiency. The more equally the pie is divided, the smaller the pie becomes. This
is the one lesson concerning the distribution of income about which almost every-
one agrees.
SUMMARY
• Data on the distribution of income show a wide ety. Liberals (such as John Rawls) would deter-
disparity in our society. The richest fifth of fami- mine the distribution of income as if we were
lies earns more than ten times as much income as behind a “veil of ignorance” that prevented us
the poorest fifth. from knowing our own stations in life. Libertari-
ans (such as Robert Nozick) would have the gov-
• Because in-kind transfers, the economic life cycle, ernment enforce individual rights to ensure a fair
transitory income, and economic mobility are so
process but then not be concerned about inequal-
important for understanding variation in income,
ity in the resulting distribution of income.
it is difficult to gauge the degree of inequality
in our society using data on the distribution of • Various policies aim to help the poor—minimum-
income in a single year. When these other factors wage laws, welfare, negative income taxes, and
are taken into account, they tend to suggest that in-kind transfers. While these policies help some
economic well-being is more equally distributed families escape poverty, they also have unin-
than is annual income. tended side effects. Because financial assistance
declines as income rises, the poor often face very
• Political philosophers differ in their views about high effective marginal tax rates, which discour-
the role of government in altering the distribu-
age poor families from escaping poverty on their
tion of income. Utilitarians (such as John Stuart
own.
Mill) would choose the distribution of income to
maximize the sum of utility of everyone in soci-
KEY CONCEPTS
poverty rate, p. 437 utilitarianism, p. 442 libertarianism, p. 444

poverty line, p. 437 utility, p. 442 welfare, p. 446
in-kind transfers, p. 438 liberalism, p. 443 negative income tax, p. 447
life cycle, p. 439 maximin criterion, p. 444
permanent income, p. 439 social insurance, p. 444
1. Does the richest fifth of the U.S. population earn 5. How would a utilitarian, a liberal, and a liber-
closer to two, four, or ten times the income of tarian determine how much income inequality
the poorest fifth? is permissible?
2. How does the extent of income inequality in the 6. What are the pros and cons of in-kind (rather
United States compare to that of other nations than cash) transfers to the poor?
around the world? 7. Describe how antipoverty programs can dis-
3. What groups in the U.S. population are most courage the poor from working. How might you
likely to live in poverty? reduce this disincentive? What are the disadvan-
4. When gauging the amount of inequality, why tages of your proposed policy?
do transitory and life cycle variations in income
cause difficulties?
1. Table 2 shows that income inequality in the 6. The chapter uses the analogy of a “leaky
United States has increased since 1970. Some bucket” to explain one constraint on the redistri-
factors contributing to this increase were dis- bution of income.
cussed in Chapter 19. What are they? a. What elements of the U.S. system for redis-
2. Table 3 shows that the percentage of children tributing income create the leaks in the
in families with income below the poverty line bucket? Be specific.
far exceeds the percentage of the elderly in such b. Do you think that Republicans or Demo-
families. How might the allocation of govern- crats generally believe that the bucket used
ment money across different social programs for redistributing income is leakier? How
have contributed to this phenomenon? (Hint: does that belief affect their views about the
See Chapter 12.) amount of income redistribution that the
3. Economists often view life cycle variation in government should undertake?
income as one form of transitory variation in 7. Suppose there are two possible income distribu-
income around people’s lifetime, or permanent, tions in a society of ten people. In the first dis-
income. In this sense, how does your current tribution, nine people have incomes of $30,000
income compare to your permanent income? and one person has an income of $10,000. In the
Do you think your current income accurately second distribution, all ten people have incomes
reflects your standard of living? of $25,000.
4. The chapter discusses the importance of eco- a. If the society had the first income distribu-
nomic mobility. tion, what would be the utilitarian argument
a. What policies might the government pur- for redistributing income?
sue to increase economic mobility within a b. Which income distribution would Rawls
generation? consider more equitable? Explain.
b. What policies might the government pur- c. Which income distribution would Nozick
sue to increase economic mobility across consider more equitable? Explain.
generations? 8. The poverty rate would be substantially lower
c. Do you think we should reduce spending on if the market value of in-kind transfers were
current welfare programs to increase spend- added to family income. The largest in-kind
ing on programs that enhance economic transfer is Medicaid, the government health pro-
mobility? What are some of the advantages gram for the poor. Let’s say the program costs
and disadvantages of doing so? $7,000 per recipient family.
5. Consider two communities. In one community, a. If the government gave each recipient family
ten families have incomes of $100,000 each and a $7,000 check instead of enrolling them in
ten families have incomes of $20,000 each. In the the Medicaid program, do you think that
other community, ten families have incomes of most of these families would spend that
$200,000 each and ten families have incomes of money to purchase health insurance? Why?
$22,000 each. (Recall that the poverty level for a family of
a. In which community is the distribution of four is about $20,000.)
income more unequal? In which community b. How does your answer to part (a) affect your
is the problem of poverty likely to be worse? view about whether we should determine
b. Which distribution of income would Rawls the poverty rate by valuing in-kind transfers
prefer? Explain. at the price the government pays for them?
c. Which distribution of income do you prefer? Explain.
Explain. c. How does your answer to part (a) affect your
d. Why might someone have the opposite view about whether we should provide assis-
preference? tance to the poor in the form of cash transfers
or in-kind transfers? Explain.
9. Consider two of the income security programs point). What do you think is the effect of this
in the United States: Temporary Assistance for program on the labor supply of low-income
Needy Families (TANF) and the Earned Income individuals? Explain.
Tax Credit (EITC). c. What are the disadvantages of eliminating
a. When a woman with children and very low TANF and allocating the savings to the
income earns an extra dollar, she receives less EITC?
in TANF benefits. What do you think is the 10. John and Jeremy are utilitarians. John believes
effect of this feature of TANF on the labor that labor supply is highly elastic, whereas Jer-
supply of low-income women? Explain. emy believes that labor supply is quite inelastic.
b. The EITC provides greater benefits as low- How do you suppose their views about income
income workers earn more income (up to a redistribution differ?
PART VII
Topics for Further Study
21
CHAPTER
The Theory of
Consumer Choice
W hen you walk into a store, you are confronted with thousands of
goods that you might buy. Because your financial resources are lim-
ited, however, you cannot buy everything that you want. You there-
fore consider the prices of the various goods offered for sale and buy a bundle of
goods that, given your resources, best suits your needs and desires.
In this chapter, we develop a theory that describes how consumers make deci-
sions about what to buy. Thus far in this book, we have summarized consumers’
decisions with the demand curve. As we have seen, the demand curve for a good
reflects consumers’ willingness to pay for it. When the price of a good rises, con-
sumers are willing to pay for fewer units, so the quantity demanded falls. We now
look more deeply at the decisions that lie behind the demand curve. The theory of
consumer choice presented in this chapter provides a more complete understand-
ing of demand, just as the theory of the competitive firm in Chapter 14 provides a
more complete understanding of supply.
One of the Ten Principles of Economics discussed in Chapter 1 is that people
face trade-offs. The theory of consumer choice examines the trade-offs that people
face in their role as consumers. When a consumer buys more of one good, he can
afford less of other goods. When he spends more time enjoying leisure and less
time working, he has lower income and can afford less consumption. When he
457
458 PART VII TOPICS FOR FURTHER STUDY
spends more of his income in the present and saves less of it, he must accept a
lower level of consumption in the future. The theory of consumer choice examines
how consumers facing these trade-offs make decisions and how they respond to
changes in their environment.
After developing the basic theory of consumer choice, we apply it to three ques-
tions about household decisions. In particular, we ask:
• Do all demand curves slope downward?
• How do wages affect labor supply?
• How do interest rates affect household saving?
At first, these questions might seem unrelated. But as we will see, we can use the
theory of consumer choice to address each of them.
THE BUDGET CONSTRAINT: WHAT

THE CONSUMER CAN AFFORD
Most people would like to increase the quantity or quality of the goods they
consume—to take longer vacations, drive fancier cars, or eat at better restaurants.
People consume less than they desire because their spending is constrained, or lim-
ited, by their income. We begin our study of consumer choice by examining this
link between income and spending.
To keep things simple, we examine the decision facing a consumer who buys
only two goods: pizza and Pepsi. Of course, real people buy thousands of dif-
ferent kinds of goods. Assuming there are only two goods greatly simplifies the
problem without altering the basic insights about consumer choice.
We first consider how the consumer’s income constrains the amount he spends
on pizza and Pepsi. Suppose the consumer has an income of $1,000 per month and
he spends his entire income on pizza and Pepsi. The price of a pizza is $10, and the
price of a pint of Pepsi is $2.
The table in Figure 1 shows some of the many combinations of pizza and Pepsi
that the consumer can buy. The first row in the table shows that if the consumer
spends all his income on pizza, he can eat 100 pizzas during the month, but he
would not be able to buy any Pepsi at all. The second row shows another possible
consumption bundle: 90 pizzas and 50 pints of Pepsi. And so on. Each consump-
tion bundle in the table costs exactly $1,000.
The graph in Figure 1 illustrates the consumption bundles that the consumer
can choose. The vertical axis measures the number of pints of Pepsi, and the hori-
zontal axis measures the number of pizzas. Three points are marked on this fig-
ure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point
B, the consumer buys no pizza and consumes 500 pints of Pepsi. At point C, the
consumer buys 50 pizzas and 250 pints of Pepsi. Point C, which is exactly at the
middle of the line from A to B, is the point at which the consumer spends an equal
amount ($500) on pizza and Pepsi. These are only three of the many combinations
of pizza and Pepsi that the consumer can choose. All the points on the line from A
budget constraint to B are possible. This line, called the budget constraint, shows the consumption
the limit on the con- bundles that the consumer can afford. In this case, it shows the trade-off between
sumption bundles that pizza and Pepsi that the consumer faces.
a consumer can afford The slope of the budget constraint measures the rate at which the consumer can
trade one good for the other. Recall that the slope between two points is calculated
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 459
The budget constraint shows the various bundles of goods that the consumer can
buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The
F I G U R E 1
table and graph show what the consumer can afford if his income is $1,000, the price
of pizza is $10, and the price of Pepsi is $2.
The Consumer’s
Budget Constraint
Number Pints Spending Spending Total Quantity
of Pizzas of Pepsi on Pizza on Pepsi Spending of Pepsi
B
100 0 $1,000 $ 0 $1,000 500
90 50 900 100 1,000
80 100 800 200 1,000
70 150 700 300 1,000
60 200 600 400 1,000
50 250 500 500 1,000
C
40 300 400 600 1,000 250
30 350 300 700 1,000
20 400 200 800 1,000 Consumer’s
10 450 100 900 1,000 budget constraint
0 500 0 1,000 1,000
A
0 50 100 Quantity
of Pizza
as the change in the vertical distance divided by the change in the horizontal dis-
tance (“rise over run”). From point A to point B, the vertical distance is 500 pints,
and the horizontal distance is 100 pizzas. Thus, the slope is 5 pints per pizza.
(Actually, because the budget constraint slopes downward, the slope is a negative
number. But for our purposes, we can ignore the minus sign.)
Notice that the slope of the budget constraint equals the relative price of the two
goods—the price of one good compared to the price of the other. A pizza costs
5 times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints
of Pepsi. The budget constraint’s slope of 5 reflects the trade-off the market is
offering the consumer: 1 pizza for 5 pints of Pepsi.
Q Q
UICK UIZ Draw the budget constraint for a person with income of $1,000 if the price
of Pepsi is $5 and the price of pizza is $10. What is the slope of this budget constraint?
PREFERENCES: WHAT THE CONSUMER WANTS

Our goal in this chapter is to see how consumers make choices. The budget
constraint is one piece of the analysis: It shows the combinations of goods the
consumer can afford given his income and the prices of the goods. The consum-
er’s choices, however, depend not only on his budget constraint but also on his
preferences regarding the two goods. Therefore, the consumer’s preferences are
the next piece of our analysis.
R EPRESENTING PREFERENCES WITH

INDIFFERENCE CURVES
The consumer’s preferences allow him to choose among different bundles of pizza
and Pepsi. If you offer the consumer two different bundles, he chooses the bundle
that best suits his tastes. If the two bundles suit his tastes equally well, we say that
the consumer is indifferent between the two bundles.
Just as we have represented the consumer’s budget constraint graphically,
we can also represent his preferences graphically. We do this with indifference
indifference curve curves. An indifference curve shows the bundles of consumption that make the
a curve that shows con- consumer equally happy. In this case, the indifference curves show the combina-
sumption bundles that tions of pizza and Pepsi with which the consumer is equally satisfied.
give the consumer the Figure 2 shows two of the consumer’s many indifference curves. The consumer
same level of satisfaction
is indifferent among combinations A, B, and C because they are all on the same
curve. Not surprisingly, if the consumer’s consumption of pizza is reduced, say,
from point A to point B, consumption of Pepsi must increase to keep him equally
happy. If consumption of pizza is reduced again, from point B to point C, the
amount of Pepsi consumed must increase yet again.
The slope at any point on an indifference curve equals the rate at which the
consumer is willing to substitute one good for the other. This rate is called the
marginal rate of marginal rate of substitution (MRS). In this case, the marginal rate of substitution
substitution measures how much Pepsi the consumer requires to be compensated for a one-
the rate at which a con- unit reduction in pizza consumption. Notice that because the indifference curves
sumer is willing to trade are not straight lines, the marginal rate of substitution is not the same at all points
one good for another
on a given indifference curve. The rate at which a consumer is willing to trade one
good for the other depends on the amounts of the goods he is already consuming.
That is, the rate at which a consumer is willing to trade pizza for Pepsi depends
on whether he is hungrier or thirstier, which in turn depends on how much pizza
and Pepsi he is consuming.
The consumer is equally happy at all points on any given indifference curve, but
he prefers some indifference curves to others. Because he prefers more consump-
tion to less, higher indifference curves are preferred to lower ones. In Figure 2,
any point on curve I2 is preferred to any point on curve I1.
2 F I G U R E
Quantity
of Pepsi
The Consumer’s Preferences C
The consumer’s preferences are represented with
indifference curves, which show the combinations
of pizza and Pepsi that make the consumer equally
satisfied. Because the consumer prefers more of a
good, points on a higher indifference curve (I2 here) B D
are preferred to points on a lower indifference MRS I2
curve (I1). The marginal rate of substitution (MRS) 1
shows the rate at which the consumer is willing to Indifference
A
curve, I 1
trade Pepsi for pizza. It measures the quantity of
Pepsi the consumer must be given in exchange for 0 Quantity
1 pizza. of Pizza
A consumer’s set of indifference curves gives a complete ranking of the consum-

er’s preferences. That is, we can use the indifference curves to rank any two bundles
of goods. For example, the indifference curves tell us that point D is preferred to
point A because point D is on a higher indifference curve than point A. (That con-
clusion may be obvious, however, because point D offers the consumer both more
pizza and more Pepsi.) The indifference curves also tell us that point D is preferred
to point C because point D is on a higher indifference curve. Even though point D
has less Pepsi than point C, it has more than enough extra pizza to make the con-
sumer prefer it. By seeing which point is on the higher indifference curve, we can
use the set of indifference curves to rank any combination of pizza and Pepsi.
FOUR PROPERTIES OF INDIFFERENCE CURVES

Because indifference curves represent a consumer’s preferences, they have certain
properties that reflect those preferences. Here we consider four properties that
describe most indifference curves:
• Property 1: Higher indifference curves are preferred to lower ones. People usually
prefer to consume more goods rather than less. This preference for greater
quantities is reflected in the indifference curves. As Figure 2 shows, higher
indifference curves represent larger quantities of goods than lower indiffer-
ence curves. Thus, the consumer prefers being on higher indifference curves.
• Property 2: Indifference curves are downward sloping. The slope of an indiffer-
ence curve reflects the rate at which the consumer is willing to substitute one
good for the other. In most cases, the consumer likes both goods. Therefore,
if the quantity of one good is reduced, the quantity of the other good must
increase for the consumer to be equally happy. For this reason, most indiffer-
ence curves slope downward.
• Property 3: Indifference curves do not cross. To see why this is true, suppose
that two indifference curves did cross, as in Figure 3. Then, because point A
is on the same indifference curve as point B, the two points would make the
consumer equally happy. In addition, because point B is on the same indif-
ference curve as point C, these two points would make the consumer equally
Quantity
F I G U R E 3
of Pepsi
The Impossibility of Intersecting
C Indifference Curves
A situation like this can never happen. According
A to these indifference curves, the consumer would
be equally satisfied at points A, B, and C, even
though point C has more of both goods than
B point A.
0 Quantity
of Pizza
happy. But these conclusions imply that points A and C would also make
the consumer equally happy, even though point C has more of both goods.
This contradicts our assumption that the consumer always prefers more of
both goods to less. Thus, indifference curves cannot cross.
• Property 4: Indifference curves are bowed inward. The slope of an indifference
curve is the marginal rate of substitution—the rate at which the consumer
is willing to trade off one good for the other. The marginal rate of substitu-
tion (MRS) usually depends on the amount of each good the consumer is
currently consuming. In particular, because people are more willing to trade
away goods that they have in abundance and less willing to trade away
goods of which they have little, the indifference curves are bowed inward.
As an example, consider Figure 4. At point A, because the consumer has a
lot of Pepsi and only a little pizza, he is very hungry but not very thirsty. To
induce the consumer to give up 1 pizza, he has to be given 6 pints of Pepsi:
The marginal rate of substitution is 6 pints per pizza. By contrast, at point
B, the consumer has little Pepsi and a lot of pizza, so he is very thirsty but
not very hungry. At this point, he would be willing to give up 1 pizza to get
1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza. Thus,
the bowed shape of the indifference curve reflects the consumer’s greater
willingness to give up a good that he already has in large quantity.
TWO EXTREME EXAMPLES OF INDIFFERENCE CURVES

The shape of an indifference curve tells us about the consumer’s willingness to
trade one good for the other. When the goods are easy to substitute for each other,
the indifference curves are less bowed; when the goods are hard to substitute,
4 F I G U R E
Quantity
of Pepsi
Bowed Indifference Curves 14
Indifference curves are usually
bowed inward. This shape implies
that the marginal rate of sub-
MRS = 6
stitution (MRS) depends on the
quantity of the two goods the
consumer is consuming. At point 8
A
A, the consumer has little pizza 1
and much Pepsi, so he requires a
lot of extra Pepsi to induce him
to give up one of the pizzas: The
marginal rate of substitution is 6 4
MRS = 1 B
pints of Pepsi per pizza. At point 3
1
B, the consumer has much pizza Indifference
and little Pepsi, so he requires curve
only a little extra Pepsi to induce
him to give up one of the pizzas: 0 2 3 6 7 Quantity
of Pizza
The marginal rate of substitution
is 1 pint of Pepsi per pizza.
the indifference curves are very bowed. To see why this is true, let’s consider the
extreme cases.
Perfect Substitutes Suppose that someone offered you bundles of nickels and
dimes. How would you rank the different bundles?
Most likely, you would care only about the total monetary value of each bun-
dle. If so, you would always be willing to trade 2 nickels for 1 dime, regardless of
the number of nickels and dimes in the bundle. Your marginal rate of substitution
between nickels and dimes would be a fixed number—2.
We can represent your preferences over nickels and dimes with the indiffer-
ence curves in panel (a) of Figure 5. Because the marginal rate of substitution is
constant, the indifference curves are straight lines. In this extreme case of straight
indifference curves, we say that the two goods are perfect substitutes. perfect substitutes
two goods with straight-
Perfect Complements Suppose now that someone offered you bundles of line indifference curves
shoes. Some of the shoes fit your left foot, others your right foot. How would you
rank these different bundles?
In this case, you might care only about the number of pairs of shoes. In other
words, you would judge a bundle based on the number of pairs you could assem-
ble from it. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting
1 more right shoe has no value if there is no left shoe to go with it.
We can represent your preferences for right and left shoes with the indifference
curves in panel (b) of Figure 5. In this case, a bundle with 5 left shoes and 5 right
shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also just
as good as a bundle with 7 left shoes and 5 right shoes. The indifference curves,
When two goods are easily substitutable, such as nickels and dimes, the indifference
curves are straight lines, as shown in panel (a). When two goods are strongly comple-
F I G U R E 5
mentary, such as left shoes and right shoes, the indifference curves are right angles,
as shown in panel (b).
Perfect Substitutes
and Perfect
Complements
(a) Perfect Substitutes (b) Perfect Complements
Nickels Left
Shoes
6
4
I2
7
5 I1
2
I1 I2 I3
0 1 2 3 Dimes 0 5 7 Right Shoes
therefore, are right angles. In this extreme case of right-angle indifference curves,
perfect complements we say that the two goods are perfect complements.
two goods with right- In the real world, of course, most goods are neither perfect substitutes (like
angle indifference curves nickels and dimes) nor perfect complements (like right shoes and left shoes).
More typically, the indifference curves are bowed inward, but not so bowed as to
become right angles.
QUICK QUIZ Draw some indifference curves for pizza and Pepsi. Explain the four prop-
erties of these indifference curves.
OPTIMIZATION: WHAT THE CONSUMER CHOOSES

The goal of this chapter is to understand how a consumer makes choices. We have
the two pieces necessary for this analysis: the consumer’s budget constraint (how
much he can afford to spend) and the consumer’s preferences (what he wants to
spend it on). Now we put these two pieces together and consider the consumer’s
decision about what to buy.
THE CONSUMER’S OPTIMAL CHOICES

Consider once again our pizza and Pepsi example. The consumer would like to
end up with the best possible combination of pizza and Pepsi for him—that is, the
combination on his highest possible indifference curve. But the consumer must
also end up on or below his budget constraint, which measures the total resources
available to him.
Figure 6 shows the consumer’s budget constraint and three of his many indif-
ference curves. The highest indifference curve that the consumer can reach (I2 in
the figure) is the one that just barely touches his budget constraint. The point at
6 F I G U R E
Quantity
of Pepsi
The Consumer’s Optimum
The consumer chooses the point on his budget
Optimum
constraint that lies on the highest indifference
curve. At this point, called the optimum, the mar- B
ginal rate of substitution equals the relative price A
of the two goods. Here the highest indifference
curve the consumer can reach is I2. The consumer I3
prefers point A, which lies on indifference curve
I2
I3, but the consumer cannot afford this bundle of I1
pizza and Pepsi. By contrast, point B is affordable,
but because it lies on a lower indifference curve, Budget constraint
the consumer does not prefer it. 0 Quantity
of Pizza
Utility: An Alternative Way to Describe

Preferences and Optimization
We have used indifference MRS = PX / PY .
curves to represent the consumer’s preferences. Another common
Because the marginal rate of substitution equals the ratio of mar-
way to represent preferences is with the concept of utility. Utility is
ginal utilities, we can write this condition for optimization as
an abstract measure of the satisfaction or happiness that a consumer
receives from a bundle of goods. Economists say that a consumer MUX / MUY = PX / PY .
prefers one bundle of goods to another if one provides more utility
than the other. Now rearrange this expression to become
Indifference curves and utility are closely related. Because the
MUX / PX = MUY / PY .
consumer prefers points on higher indifference curves, bundles of
goods on higher indifference curves provide higher utility. Because This equation has a simple interpretation: At the optimum, the mar-
the consumer is equally happy with all points on the same indiffer- ginal utility per dollar spent on good X equals the marginal utility
ence curve, all these bundles provide the same utility. You can think per dollar spent on good Y. (Why? If this equality did not hold, the
of an indifference curve as an “equal-utility” curve. consumer could increase utility by spending less on the good that
The marginal utility of any good is the increase in utility that the provided lower marginal utility per dollar and more on the good that
consumer gets from an additional unit of that good. Most goods provided higher marginal utility per dollar.)
are assumed to exhibit diminishing marginal utility: The more of the When economists discuss the theory of consumer choice, they
good the consumer already has, the lower the marginal utility pro- might express the theory using different words. One economist
vided by an extra unit of that good. might say that the goal of the consumer is to maximize utility.
The marginal rate of substitution between two goods depends Another economist might say that the goal of the consumer is to
on their marginal utilities. For example, if the marginal utility of good end up on the highest possible indifference curve. The first econo-
X is twice the marginal utility of good Y, then a person would need mist would conclude that at the consumer’s optimum, the marginal
2 units of good Y to compensate for losing 1 unit of good X, and the utility per dollar is the same for all goods, whereas the second would
marginal rate of substitution equals 2. More generally, the marginal conclude that the indifference curve is tangent to the budget con-
rate of substitution (and thus the slope of the indifference curve) straint. In essence, these are two ways of saying the same thing.
equals the marginal utility of one good divided by the marginal util-
ity of the other good.
Utility analysis provides another way to describe consumer opti-
mization. Recall that at the consumer’s optimum, the marginal rate
of substitution equals the ratio of prices. That is,
which this indifference curve and the budget constraint touch is called the opti-
mum. The consumer would prefer point A, but he cannot afford that point because
it lies above his budget constraint. The consumer can afford point B, but that point
is on a lower indifference curve and, therefore, provides the consumer less satis-
faction. The optimum represents the best combination of pizza and Pepsi avail-
able to the consumer.
Notice that, at the optimum, the slope of the indifference curve equals the
slope of the budget constraint. We say that the indifference curve is tangent to
the budget constraint. The slope of the indifference curve is the marginal rate of
substitution between pizza and Pepsi, and the slope of the budget constraint is the
relative price of pizza and Pepsi. Thus, the consumer chooses consumption of the two
goods so that the marginal rate of substitution equals the relative price.
In Chapter 7, we saw how market prices reflect the marginal value that con-
sumers place on goods. This analysis of consumer choice shows the same result
in another way. In making his consumption choices, the consumer takes as given
the relative price of the two goods and then chooses an optimum at which his
marginal rate of substitution equals this relative price. The relative price is the rate
at which the market is willing to trade one good for the other, whereas the mar-
ginal rate of substitution is the rate at which the consumer is willing to trade one
good for the other. At the consumer’s optimum, the consumer’s valuation of the
two goods (as measured by the marginal rate of substitution) equals the market’s
valuation (as measured by the relative price). As a result of this consumer optimi-
zation, market prices of different goods reflect the value that consumers place on
those goods.
HOW CHANGES IN INCOME AFFECT

THE CONSUMER’S CHOICES
Now that we have seen how the consumer makes a consumption decision, let’s
examine how this decision responds to changes in the consumer’s income. To be
specific, suppose that income increases. With higher income, the consumer can
afford more of both goods. The increase in income, therefore, shifts the budget
constraint outward, as in Figure 7. Because the relative price of the two goods has
not changed, the slope of the new budget constraint is the same as the slope of the
initial budget constraint. That is, an increase in income leads to a parallel shift in
the budget constraint.
7 F I G U R E
Quantity
of Pepsi New budget constraint
An Increase in Income
When the consumer’s
income rises, the budget 1. An increase in income shifts the
constraint shifts out. If both budget constraint outward . . .
goods are normal goods,
the consumer responds New optimum
to the increase in income
by buying more of both of 3. . . . and
Pepsi
them. Here the consumer Initial
consumption.
buys more pizza and more optimum I2
Pepsi.
Initial
budget
I1
constraint
0 Quantity
of Pizza
2. . . . raising pizza consumption . . .
The expanded budget constraint allows the consumer to choose a better com-
bination of pizza and Pepsi, one that is on a higher indifference curve. Given the
shift in the budget constraint and the consumer’s preferences as represented by
his indifference curves, the consumer’s optimum moves from the point labeled
“initial optimum” to the point labeled “new optimum.”
Notice that, in Figure 7, the consumer chooses to consume more Pepsi and
more pizza. Although the logic of the model does not require increased consump-
tion of both goods in response to increased income, this situation is the most com-
mon one. As you may recall from Chapter 4, if a consumer wants more of a good
when his income rises, economists call it a normal good. The indifference curves normal good
in Figure 7 are drawn under the assumption that both pizza and Pepsi are normal a good for which an
goods. increase in income raises
Figure 8 shows an example in which an increase in income induces the con- the quantity demanded
sumer to buy more pizza but less Pepsi. If a consumer buys less of a good when
his income rises, economists call it an inferior good. Figure 8 is drawn under the inferior good
assumption that pizza is a normal good and Pepsi is an inferior good. a good for which an
Although most goods are normal goods, there are some inferior goods in the increase in income
world. One example is bus rides. As income increases, consumers are more likely reduces the quantity
to own cars or take a taxi and less likely to ride a bus. Bus rides, therefore, are an demanded
inferior good.
HOW CHANGES IN PRICES AFFECT

THE CONSUMER’S CHOICES
Let’s now use this model of consumer choice to consider how a change in the price
of one of the goods alters the consumer’s choices. Suppose, in particular, that the
Quantity
F I G U R E 8
of Pepsi New budget constraint
An Inferior Good
A good is an inferior good if
the consumer buys less of it
when his income rises. Here
Pepsi is an inferior good:
1. When an increase in income shifts the When the consumer’s income
3. . . . but budget constraint outward . . .
Pepsi
Initial increases and the budget
optimum constraint shifts outward, the
consumption
falls, making consumer buys more pizza
New optimum but less Pepsi.
Pepsi an
inferior good.
Initial
budget I1 I2
constraint
0 Quantity
of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .
price of Pepsi falls from $2 to $1 per pint. It is no surprise that the lower price
expands the consumer’s set of buying opportunities. In other words, a fall in the
price of any good shifts the budget constraint outward.
Figure 9 considers more specifically how the fall in price affects the budget con-
straint. If the consumer spends his entire $1,000 income on pizza, then the price of
Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the consumer
spends his entire income of $1,000 on Pepsi, he can now buy 1,000 rather than
only 500 pints. Thus, the end point of the budget constraint moves from point B to
point D.
Notice that in this case the outward shift in the budget constraint changes its
slope. (This differs from what happened previously when prices stayed the same
but the consumer’s income changed.) As we have discussed, the slope of the bud-
income effect get constraint reflects the relative price of pizza and Pepsi. Because the price of
the change in consump- Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the con-
tion that results when a sumer can now trade a pizza for 10 rather than 5 pints of Pepsi. As a result, the
price change moves the new budget constraint has a steeper slope.
consumer to a higher or How such a change in the budget constraint alters the consumption of both
lower indifference curve
goods depends on the consumer’s preferences. For the indifference curves drawn
in this figure, the consumer buys more Pepsi and less pizza.
substitution effect
the change in consump-
tion that results when a INCOME AND SUBSTITUTION EFFECTS
price change moves the
consumer along a given The impact of a change in the price of a good on consumption can be decomposed
indifference curve to a into two effects: an income effect and a substitution effect. To see what these two
point with a new mar- effects are, consider how our consumer might respond when he learns that the
ginal rate of substitution price of Pepsi has fallen. He might reason in the following ways:
9 F I G U R E
Quantity
of Pepsi
A Change in Price New budget constraint
When the price of Pepsi 1,000 D
falls, the consumer’s budget
constraint shifts outward and
changes slope. The consumer
moves from the initial opti-
mum to the new optimum, New optimum
which changes his purchases 1. A fall in the price of Pepsi rotates
B
of both pizza and Pepsi. In 500 the budget constraint outward . . .
this case, the quantity of 3. . . . and
Pepsi consumed rises, and raising Pepsi Initial optimum
the quantity of pizza con- consumption.
sumed falls. Initial I2
budget I1
constraint
A
0 100 Quantity
of Pizza
2. . . . reducing pizza consumption . . .
• “Great news! Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I can buy both
more pizza and more Pepsi.” (This is the income effect.)
• “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every
pizza that I give up. Because pizza is now relatively more expensive, I
should buy less pizza and more Pepsi.” (This is the substitution effect.)
Which statement do you find more compelling?
In fact, both of these statements make sense. The decrease in the price of Pepsi
makes the consumer better off. If pizza and Pepsi are both normal goods, the con-
sumer will want to spread this improvement in his purchasing power over both
goods. This income effect tends to make the consumer buy more pizza and more
Pepsi. Yet at the same time, consumption of Pepsi has become less expensive rela-
tive to consumption of pizza. This substitution effect tends to make the consumer
choose less pizza and more Pepsi.
Now consider the result of these two effects working at the same time. The
consumer certainly buys more Pepsi because the income and substitution effects
both act to raise purchases of Pepsi. But it is ambiguous whether the consumer
buys more pizza because the income and substitution effects work in opposite
directions. This conclusion is summarized in Table 1.
We can interpret the income and substitution effects using indifference curves.
The income effect is the change in consumption that results from the movement to a higher
indifference curve. The substitution effect is the change in consumption that results from
being at a point on an indifference curve with a different marginal rate of substitution.
Figure 10 shows graphically how to decompose the change in the consumer’s
decision into the income effect and the substitution effect. When the price of Pepsi
falls, the consumer moves from the initial optimum, point A, to the new optimum,
point C. We can view this change as occurring in two steps. First, the consumer
moves along the initial indifference curve, I1, from point A to point B. The consumer
is equally happy at these two points, but at point B, the marginal rate of substi-
tution reflects the new relative price. (The dashed line through point B reflects
the new relative price by being parallel to the new budget constraint.) Next, the
T A B L E
1
Good Income Effect Substitution Effect Total Effect
Income and Substitution

Pepsi Consumer is richer, Pepsi is relatively Income and substitution
Effects When the Price
so he buys more Pepsi. cheaper, so consumer effects act in same
of Pepsi Falls
buys more Pepsi. direction, so consumer
buys more Pepsi.
Pizza Consumer is richer, Pizza is relatively Income and substitution
so he buys more pizza. more expensive, effects act in opposite
so consumer buys directions, so the
less pizza. total effect on pizza
consumption is
ambiguous.
10 F I G U R E
Quantity
of Pepsi
Income and Substitution
Effects New budget constraint
The effect of a change in price can
be broken down into an income
effect and a substitution effect. The
substitution effect—the movement
along an indifference curve to a C New optimum
point with a different marginal rate Income
of substitution—is shown here as effect B
Initial optimum
the change from point A to point Initial
B along indifference curve I1. The Substitution
effect budget
income effect—the shift to a higher constraint A
indifference curve—is shown here I2
as the change from point B on
indifference curve I1 to point C on I1
indifference curve I2.
0 Quantity
Substitution effect of Pizza
Income effect
consumer shifts to the higher indifference curve, I2, by moving from point B to
point C. Even though point B and point C are on different indifference curves, they
have the same marginal rate of substitution. That is, the slope of the indifference
curve I1 at point B equals the slope of the indifference curve I2 at point C.
Although the consumer never actually chooses point B, this hypothetical point
is useful to clarify the two effects that determine the consumer’s decision. Notice
that the change from point A to point B represents a pure change in the mar-
ginal rate of substitution without any change in the consumer’s welfare. Similarly,
the change from point B to point C represents a pure change in welfare without
any change in the marginal rate of substitution. Thus, the movement from A to B
shows the substitution effect, and the movement from B to C shows the income
effect.
DERIVING THE DEMAND CURVE

We have just seen how changes in the price of a good alter the consumer’s budget
constraint and, therefore, the quantities of the two goods that he chooses to buy.
The demand curve for any good reflects these consumption decisions. Recall that
a demand curve shows the quantity demanded of a good for any given price. We
can view a consumer’s demand curve as a summary of the optimal decisions that
arise from his budget constraint and indifference curves.
For example, Figure 11 considers the demand for Pepsi. Panel (a) shows that
when the price of a pint falls from $2 to $1, the consumer’s budget constraint shifts
outward. Because of both income and substitution effects, the consumer increases
Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s opti-
mum moves from point A to point B, and the quantity of Pepsi consumed rises from
F I G U R E 11
250 to 750 pints. The demand curve in panel (b) reflects this relationship between
the price and the quantity demanded.
Deriving the
Demand Curve
(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi
Quantity Price of
of Pepsi Pepsi
New budget constraint
B A
750 $2
I2
B
1
A
250 Demand
I1
0 Initial budget Quantity 0 250 750 Quantity

constraint of Pizza of Pepsi
his purchases of Pepsi from 250 to 750 pints. Panel (b) shows the demand curve
that results from this consumer’s decisions. In this way, the theory of consumer
choice provides the theoretical foundation for the consumer’s demand curve.
It may be comforting to know that the demand curve arises naturally from the
theory of consumer choice, but this exercise by itself does not justify developing
the theory. There is no need for a rigorous, analytic framework just to establish
that people respond to changes in prices. The theory of consumer choice is, how-
ever, useful in studying various decisions that people make as they go about their
lives, as we see in the next section.
Q Q
UICK UIZ Draw a budget constraint and indifference curves for pizza and Pepsi.
Show what happens to the budget constraint and the consumer’s optimum when the
price of pizza rises. In your diagram, decompose the change into an income effect and a
substitution effect.
THREE APPLICATIONS
Now that we have developed the basic theory of consumer choice, let’s use it to
shed light on three questions about how the economy works. These three ques-
tions might at first seem unrelated. But because each question involves household
decision making, we can address it with the model of consumer behavior we have
just developed.
DO A LL DEMAND CURVES SLOPE DOWNWARD?

Normally, when the price of a good rises, people buy less of it. This usual behav-
ior, called the law of demand, is reflected in the downward slope of the demand
curve.
As a matter of economic theory, however, demand curves can sometimes slope
upward. In other words, consumers can sometimes violate the law of demand
and buy more of a good when the price rises. To see how this can happen, consider
Figure 12. In this example, the consumer buys two goods—meat and potatoes.
Initially, the consumer’s budget constraint is the line from point A to point B. The
optimum is point C. When the price of potatoes rises, the budget constraint shifts
inward and is now the line from point A to point D. The optimum is now point
E. Notice that a rise in the price of potatoes has led the consumer to buy a larger
quantity of potatoes.
Why is the consumer responding in a seemingly perverse way? In this exam-
ple, potatoes are a strongly inferior good. When the price of potatoes rises, the
consumer is poorer. The income effect makes the consumer want to buy less meat
and more potatoes. At the same time, because the potatoes have become more
expensive relative to meat, the substitution effect makes the consumer want to
buy more meat and less potatoes. In this particular case, however, the income
effect is so strong that it exceeds the substitution effect. In the end, the consumer
responds to the higher price of potatoes by buying less meat and more potatoes.
Giffen good Economists use the term Giffen good to describe a good that violates the law
a good for which an of demand. (The term is named for economist Robert Giffen, who first noted this
increase in the price possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior
raises the quantity goods for which the income effect dominates the substitution effect. Therefore,
demanded they have demand curves that slope upward.
12 F I G U R E
Quantity of
Potatoes Initial budget constraint
A Giffen Good B
In this example, when the
price of potatoes rises, the
consumer’s optimum shifts
from point C to point E.
Optimum with high
In this case, the consumer
price of potatoes
responds to a higher price
Optimum with low
of potatoes by buying less D price of potatoes
meat and more potatoes. E
2. . . . which 1. An increase in the price of
increases C potatoes rotates the budget
potato constraint inward . . .
consumption
if potatoes I1
are a Giffen New budget I2
good. constraint
0 A Quantity
of Meat
THE SEARCH FOR GIFFEN GOODS

Have any actual Giffen goods ever been observed? Some historians suggest that
potatoes were a Giffen good during the Irish potato famine of the 19th century.
Potatoes were such a large part of people’s diet that when the price of potatoes
rose, it had a large income effect. People responded to their reduced living stan-
dard by cutting back on the luxury of meat and buying more of the staple food
of potatoes. Thus, it is argued that a higher price of potatoes actually raised the
quantity of potatoes demanded.
A recent study by Robert Jensen and Nolan Miller has produced similar but
more concrete evidence for the existence of Giffen goods. These two economists
conducted a field experiment for 5 months in the Chinese province of Hunan.
They gave randomly selected households vouchers that subsidized the purchase
of rice, a staple in local diets, and used surveys to measure how consumption
of rice responded to changes in the price. They found strong evidence that poor
households exhibited Giffen behavior. Lowering the price of rice with the subsidy
voucher caused households to reduce their consumption of rice, and removing
the subsidy had the opposite effect. Jensen and Miller wrote, “To the best of our
knowledge, this is the first rigorous empirical evidence of Giffen behavior.”
Thus, the theory of consumer choice allows demand curves to slope upward,
and sometimes that strange phenomenon actually occurs. As a result, the law of
demand we first saw in Chapter 4 is not completely reliable. It is safe to say, how-
ever, that Giffen goods are very rare. ●
HOW DO WAGES AFFECT LABOR SUPPLY?

So far, we have used the theory of consumer choice to analyze how a person allo-
cates income between two goods. We can use the same theory to analyze how a
person allocates time. People spend some of their time enjoying leisure and some
of it working so they can afford to buy consumption goods. The essence of the
time-allocation problem is the trade-off between leisure and consumption.
Consider the decision facing Sally, a freelance software designer. Sally is awake
for 100 hours per week. She spends some of this time enjoying leisure—riding
her bike, watching television, and studying economics. She spends the rest of this
time developing software at her computer. For every hour she works developing
software, she earns $50, which she spends on consumption goods—food, clothing,
and music downloads. Her wage ($50) reflects the trade-off Sally faces between
leisure and consumption. For every hour of leisure she gives up, she works one
more hour and gets $50 of consumption.
Figure 13 shows Sally’s budget constraint. If she spends all 100 hours enjoying
leisure, she has no consumption. If she spends all 100 hours working, she earns a
weekly consumption of $5,000 but has no time for leisure. If she works a normal 40-
hour week, she enjoys 60 hours of leisure and has weekly consumption of $2,000.
Figure 13 uses indifference curves to represent Sally’s preferences for consump-
tion and leisure. Here consumption and leisure are the two “goods” between
which Sally is choosing. Because Sally always prefers more leisure and more
consumption, she prefers points on higher indifference curves to points on lower
ones. At a wage of $50 per hour, Sally chooses a combination of consumption and
leisure represented by the point labeled “optimum.” This is the point on the bud-
get constraint that is on the highest possible indifference curve, I2.
13 F I G U R E
Consumption
The Work-Leisure Decision $5,000

This figure shows Sally’s budget
constraint for deciding how much
to work, her indifference curves
for consumption and leisure, and
her optimum. Optimum
I3
2,000
I2
I1
0 60 100 Hours of Leisure
Now consider what happens when Sally’s wage increases from $50 to $60 per
hour. Figure 14 shows two possible outcomes. In each case, the budget constraint,
shown in the left graphs, shifts outward from BC1 to BC2. In the process, the budget
constraint becomes steeper, reflecting the change in relative price: At the higher
wage, Sally earns more consumption for every hour of leisure that she gives up.
Sally’s preferences, as represented by her indifference curves, determine how
her choice regarding consumption and leisure responds to the higher wage. In
both panels, consumption rises. Yet the response of leisure to the change in the
wage is different in the two cases. In panel (a), Sally responds to the higher wage
by enjoying less leisure. In panel (b), Sally responds by enjoying more leisure.
Sally’s decision between leisure and consumption determines her supply of
labor because the more leisure she enjoys, the less time she has left to work. In
each panel of Figure 14, the right graph shows the labor-supply curve implied
by Sally’s decision. In panel (a), a higher wage induces Sally to enjoy less leisure
and work more, so the labor-supply curve slopes upward. In panel (b), a higher
wage induces Sally to enjoy more leisure and work less, so the labor-supply curve
slopes “backward.”
At first, the backward-sloping labor-supply curve is puzzling. Why would a
person respond to a higher wage by working less? The answer comes from con-
sidering the income and substitution effects of a higher wage.
Consider first the substitution effect. When Sally’s wage rises, leisure becomes
more costly relative to consumption, and this encourages Sally to substitute away
from leisure and toward consumption. In other words, the substitution effect
induces Sally to work harder in response to higher wages, which tends to make
the labor-supply curve slope upward.
Now consider the income effect. When Sally’s wage rises, she moves to a higher
indifference curve. She is now better off than she was. As long as consumption
and leisure are both normal goods, she tends to want to use this increase in well-
being to enjoy both higher consumption and greater leisure. In other words, the
The two panels of this figure show how a person might respond to an increase in the
wage. The graphs on the left show the consumer’s initial budget constraint, BC1, and
F I G U R E 14
new budget constraint, BC2, as well as the consumer’s optimal choices over con-
sumption and leisure. The graphs on the right show the resulting labor-supply curve.
An Increase
Because hours worked equal total hours available minus hours of leisure, any change
in the Wage
in leisure implies an opposite change in the quantity of labor supplied. In panel (a),
when the wage rises, consumption rises and leisure falls, resulting in a labor-supply
curve that slopes upward. In panel (b), when the wage rises, both consumption and
leisure rise, resulting in a labor-supply curve that slopes backward.
(a) For a person with these preferences . . . . . . the labor supply curve slopes upward.
Consumption Wage
Labor
supply
1. When the wage rises . . .
BC1
BC2 I 2
I1
0 Hours of 0 Hours of Labor
2. . . . hours of leisure decrease . . . Leisure 3. . . . and hours of labor increase. Supplied
(b) For a person with these preferences . . . . . . the labor supply curve slopes backward.
Consumption Wage
BC2
1. When the wage rises . . .
Labor
BC1 supply
I2
I1
0 Hours of 0 Hours of Labor

2. . . . hours of leisure increase . . . Leisure 3. . . . and hours of labor decrease. Supplied
income effect induces her to work less, which tends to make the labor-supply
curve slope backward.
In the end, economic theory does not give a clear prediction about whether an
increase in the wage induces Sally to work more or less. If the substitution effect
is greater than the income effect for Sally, she works more. If the income effect is
greater than the substitution effect, she works less. The labor-supply curve, there-
fore, could be either upward or backward sloping.
INCOME EFFECTS ON LABOR SUPPLY: HISTORICAL

TRENDS, LOTTERY WINNERS, AND THE CARNEGIE
CONJECTURE
The idea of a backward-sloping labor-supply curve might at first seem like a mere
theoretical curiosity, but in fact, it is not. Evidence indicates that the labor-supply
curve, considered over long periods, does in fact slope backward. A hundred
years ago, many people worked six days a week. Today, five-day workweeks are
the norm. At the same time that the length of the workweek has been falling, the
wage of the typical worker (adjusted for inflation) has been rising.
Here is how economists explain this historical pattern: Over time, advances in
technology raise workers’ productivity and, thereby, the demand for labor. The
increase in labor demand raises equilibrium wages. As wages rise, so does the
reward for working. Yet rather than responding to this increased incentive by
working more, most workers choose to take part of their greater prosperity in the
form of more leisure. In other words, the income effect of higher wages dominates
the substitution effect.
Further evidence that the income effect on labor supply is strong comes from
a very different kind of data: winners of lotteries. Winners of large prizes in the
lottery see large increases in their incomes and, as a result, large outward shifts in
their budget constraints. Because the winners’ wages have not changed, however,
the slopes of their budget constraints remain the same. There is, therefore, no sub-
stitution effect. By examining the behavior of lottery winners, we can isolate the
© AP IMAGES
income effect on labor supply.

The results from studies of lottery winners are striking. Of those winners who
win more than $50,000, almost 25 percent quit working within a year, and another
“NO MORE 9 TO 5 FOR ME.” 9 percent reduce the number of hours they work. Of those winners who win more
than $1 million, almost 40 percent stop working. The income effect on labor sup-
ply of winning such a large prize is substantial.
Similar results were found in a 1993 study, published in the Quarterly Journal of
Economics, of how receiving a bequest affects a person’s labor supply. The study
found that a single person who inherits more than $150,000 is four times as likely
to stop working as a single person who inherits less than $25,000. This finding
would not have surprised the 19th-century industrialist Andrew Carnegie. Carn-
egie warned that “the parent who leaves his son enormous wealth generally dead-
ens the talents and energies of the son, and tempts him to lead a less useful and
less worthy life than he otherwise would.” That is, Carnegie viewed the income
effect on labor supply to be substantial and, from his paternalistic perspective,
regrettable. During his life and at his death, Carnegie gave much of his vast for-
tune to charity. ●
HOW DO INTEREST R ATES AFFECT HOUSEHOLD SAVING?

An important decision that every person faces is how much income to consume
today and how much to save for the future. We can use the theory of consumer
choice to analyze how people make this decision and how the amount they save
depends on the interest rate their savings will earn.
Consider the decision facing Sam, a worker planning for retirement. To keep
things simple, let’s divide Sam’s life into two periods. In the first period, Sam is
young and working. In the second period, he is old and retired. When young, Sam
earns $100,000. He divides this income between current consumption and saving.
When he is old, Sam will consume what he has saved, including the interest that
his savings have earned.
Suppose the interest rate is 10 percent. Then for every dollar that Sam saves
when young, he can consume $1.10 when old. We can view “consumption when
young” and “consumption when old” as the two goods that Sam must choose
between. The interest rate determines the relative price of these two goods.
Figure 15 shows Sam’s budget constraint. If he saves nothing, he consumes
$100,000 when young and nothing when old. If he saves everything, he consumes
nothing when young and $110,000 when old. The budget constraint shows these
and all the intermediate possibilities.
Figure 15 uses indifference curves to represent Sam’s preferences for consump-
tion in the two periods. Because Sam prefers more consumption in both periods,
he prefers points on higher indifference curves to points on lower ones. Given
his preferences, Sam chooses the optimal combination of consumption in both
periods of life, which is the point on the budget constraint that is on the highest
possible indifference curve. At this optimum, Sam consumes $50,000 when young
and $55,000 when old.
Consumption Budget
F I G U R E 15
when Old constraint
$110,000 The Consumption-Saving
Decision
This figure shows the budget
constraint for a person deciding
how much to consume in the two
periods of his life, the indifference
curves representing his prefer-
55,000 Optimum
ences, and the optimum.
I3
I2
I1
0 $50,000 100,000 Consumption

when Young
Now consider what happens when the interest rate increases from 10 percent
to 20 percent. Figure 16 shows two possible outcomes. In both cases, the budget
constraint shifts outward and becomes steeper. At the new higher interest rate,
Sam gets more consumption when old for every dollar of consumption that he
gives up when young.
The two panels show the results given different preferences by Sam. In both
cases, consumption when old rises. Yet the response of consumption when young
to the change in the interest rate is different in the two cases. In panel (a), Sam
responds to the higher interest rate by consuming less when young. In panel (b),
Sam responds by consuming more when young.
Sam’s saving is his income when young minus the amount he consumes when
young. In panel (a), consumption when young falls when the interest rate rises, so
saving must rise. In panel (b), Sam consumes more when young, so saving must
fall.
The case shown in panel (b) might at first seem odd: Sam responds to an
increase in the return to saving by saving less. Yet this behavior is not as peculiar
as it might seem. We can understand it by considering the income and substitu-
tion effects of a higher interest rate.
Consider first the substitution effect. When the interest rate rises, consumption
when old becomes less costly relative to consumption when young. Therefore, the
substitution effect induces Sam to consume more when old and less when young.
In other words, the substitution effect induces Sam to save more.
Now consider the income effect. When the interest rate rises, Sam moves to a
higher indifference curve. He is now better off than he was. As long as consump-
16 F I G U R E Types
In both of
In panel
The
Graphs
panels,
pie chart
an increase in the interest rate shifts the budget constraint outward.
(a), consumption when young
in panel (a) shows falls,
how U.S. and consumption
national when old
income is derived fromrises. The
various
result is an
sources. The increase
bar graphin saving when
in panel young. In panel
(b) compares (b), consumption
the average in both
income in four periods
countries.
An Increase in the rises.time-series
The The result graph
is a decrease
in panelin(c)saving
showswhen young.
the productivity of labor in U.S. businesses
Interest Rate from 1950 to 2000.
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption Consumption
when Old BC 2 when Old BC 2
1. A higher interest rate rotates
1. A higher interest rate rotates the budget constraint outward . . .
the budget constraint outward . . .
BC 1
BC 1
I2
I2
I1
I1
0 Consumption 0 Consumption
2. . . . resulting in lower when Young 2. . . . resulting in higher when Young
consumption when young consumption when young
and, thus, higher saving. and, thus, lower saving.
tion in both periods consists of normal goods, he tends to want to use this increase
in well-being to enjoy higher consumption in both periods. In other words, the
income effect induces him to save less.
The result depends on both the income and substitution effects. If the substi-
tution effect of a higher interest rate is greater than the income effect, Sam saves
more. If the income effect is greater than the substitution effect, Sam saves less.
Thus, the theory of consumer choice says that an increase in the interest rate could
either encourage or discourage saving.
Although this ambiguous result is interesting from the standpoint of economic
theory, it is disappointing from the standpoint of economic policy. It turns out
that an important issue in tax policy hinges in part on how saving responds to
interest rates. Some economists have advocated reducing the taxation of inter-
est and other capital income, arguing that such a policy change would raise the
after-tax interest rate that savers can earn and would thereby encourage people to
save more. Other economists have argued that because of offsetting income and
substitution effects, such a tax change might not increase saving and could even
reduce it. Unfortunately, research has not led to a consensus about how interest
rates affect saving. As a result, there remains disagreement among economists
about whether changes in tax policy aimed to encourage saving would, in fact,
have the intended effect.
QUICK QUIZ Explain how an increase in the wage can potentially decrease the amount
that a person wants to work.
CONCLUSION: DO PEOPLE REALLY THINK THIS WAY?

The theory of consumer choice describes how people make decisions. As we have
seen, it has broad applicability. It can explain how a person chooses between pizza
and Pepsi, work and leisure, consumption and saving, and on and on.
At this point, however, you might be tempted to treat the theory of consumer
choice with some skepticism. After all, you are a consumer. You decide what to
buy every time you walk into a store. And you know that you do not decide by
writing down budget constraints and indifference curves. Doesn’t this knowledge
about your own decision making provide evidence against the theory?
The answer is no. The theory of consumer choice does not try to present a literal
account of how people make decisions. It is a model. And as we first discussed in
Chapter 2, models are not intended to be completely realistic.
The best way to view the theory of consumer choice is as a metaphor for how
consumers make decisions. No consumer (except an occasional economist) goes
through the explicit optimization envisioned in the theory. Yet consumers are
aware that their choices are constrained by their financial resources. And given
those constraints, they do the best they can to achieve the highest level of satisfac-
tion. The theory of consumer choice tries to describe this implicit, psychological
process in a way that permits explicit, economic analysis.
Just as the proof of the pudding is in the eating, the test of a theory is in its
applications. In the last section of this chapter, we applied the theory of consumer
choice to three practical issues about the economy. If you take more advanced
courses in economics, you will see that this theory provides the framework for
much additional analysis.
SUMMARY
• A consumer’s budget constraint shows the pos- • When the price of a good falls, the impact on
sible combinations of different goods he can buy the consumer’s choices can be broken down into
given his income and the prices of the goods. The an income effect and a substitution effect. The
slope of the budget constraint equals the relative income effect is the change in consumption that
price of the goods. arises because a lower price makes the consumer
better off. The substitution effect is the change in
• The consumer’s indifference curves represent
his preferences. An indifference curve shows the consumption that arises because a price change
various bundles of goods that make the consumer encourages greater consumption of the good
equally happy. Points on higher indifference that has become relatively cheaper. The income
curves are preferred to points on lower indiffer- effect is reflected in the movement from a lower
ence curves. The slope of an indifference curve to a higher indifference curve, whereas the sub-
at any point is the consumer’s marginal rate of stitution effect is reflected by a movement along
substitution—the rate at which the consumer is an indifference curve to a point with a different
willing to trade one good for the other. slope.
• The consumer optimizes by choosing the point • The theory of consumer choice can be applied in
on his budget constraint that lies on the highest many situations. It explains why demand curves
indifference curve. At this point, the slope of the can potentially slope upward, why higher wages
indifference curve (the marginal rate of substi- could either increase or decrease the quantity
tution between the goods) equals the slope of of labor supplied, and why higher interest rates
the budget constraint (the relative price of the could either increase or decrease saving.
goods).
KEY CONCEPTS
budget constraint, p. 458 perfect substitutes, p. 463 income effect, p. 468

indifference curve, p. 460 perfect complements, p. 464 substitution effect, p. 468
marginal rate of normal good, p. 467 Giffen good, p. 472
substitution, p. 460 inferior good, p. 467
1. A consumer has income of $3,000. Wine costs $3 stitution. What does the marginal rate of substi-
per glass, and cheese costs $6 per pound. Draw tution tell us?
the consumer’s budget constraint. What is the 4. Show a consumer’s budget constraint and indif-
slope of this budget constraint? ference curves for wine and cheese. Show the
2. Draw a consumer’s indifference curves for wine optimal consumption choice. If the price of wine
and cheese. Describe and explain four properties is $3 per glass and the price of cheese is $6 per
of these indifference curves. pound, what is the marginal rate of substitution
3. Pick a point on an indifference curve for wine at this optimum?
and cheese and show the marginal rate of sub-
5. A person who consumes wine and cheese gets glass. For a consumer with a constant income
a raise, so his income increases from $3,000 to of $3,000, show what happens to consumption
$4,000. Show what happens if both wine and of wine and cheese. Decompose the change into
cheese are normal goods. Now show what hap- income and substitution effects.
pens if cheese is an inferior good. 7. Can an increase in the price of cheese possibly
6. The price of cheese rises from $6 to $10 per induce a consumer to buy more cheese? Explain.
pound, while the price of wine remains $3 per
1. Jennifer divides her income between coffee and b. Now suppose that all prices increase by
croissants (both of which are normal goods). An 10 percent in year 2 and that Jim’s salary
early frost in Brazil causes a large increase in the increases by 10 percent as well. Draw Jim’s
price of coffee in the United States. new budget constraint. How would Jim’s
a. Show the effect of the frost on Jennifer’s bud- optimal combination of milk and cookies in
get constraint. year 2 compare to his optimal combination in
b. Show the effect of the frost on Jennifer’s year 1?
optimal consumption bundle assuming that 5. A college student has two options for meals: eat-
the substitution effect outweighs the income ing at the dining hall for $6 per meal, or eating
effect for croissants. a Cup O’ Soup for $1.50 per meal. His weekly
c. Show the effect of the frost on Jennifer’s food budget is $60.
optimal consumption bundle assuming that a. Draw the budget constraint showing the
the income effect outweighs the substitution trade-off between dining hall meals and
effect for croissants. Cups O’ Soup. Assuming that he spends
2. Compare the following two pairs of goods: equal amounts on both goods, draw an indif-
• Coke and Pepsi ference curve showing the optimum choice.
• Skis and ski bindings Label the optimum as point A.
a. In which case are the two goods comple- b. Suppose the price of a Cup O’ Soup now
ments? In which case are they substitutes? rises to $2. Using your diagram from part
b. In which case do you expect the indifference (a), show the consequences of this change in
curves to be fairly straight? In which case do price. Assume that our student now spends
you expect the indifference curves to be very only 30 percent of his income on dining hall
bowed? meals. Label the new optimum as point B.
c. In which case will the consumer respond c. What happened to the quantity of Cups
more to a change in the relative price of the O’ Soup consumed as a result of this price
two goods? change? What does this result say about the
3. Mario consumes only cheese and crackers. income and substitution effects? Explain.
a. Could cheese and crackers both be inferior d. Use points A and B to draw a demand curve
goods for Mario? Explain. for Cup O’ Soup. What is this type of good
b. Suppose that cheese is a normal good for called?
Mario while crackers are an inferior good. 6. Consider your decision about how many hours
If the price of cheese falls, what happens to to work.
Mario’s consumption of crackers? What hap- a. Draw your budget constraint assuming that
pens to his consumption of cheese? Explain. you pay no taxes on your income. On the
4. Jim buys only milk and cookies. same diagram, draw another budget con-
a. In year 1, Jim earns $100, milk costs $2 per straint assuming that you pay 15 percent tax.
quart, and cookies cost $4 per dozen. Draw b. Show how the tax might lead to more hours
Jim’s budget constraint. of work, fewer hours, or the same number of
hours. Explain.
7. Sarah is awake for 100 hours per week. Using c. We observe that, as societies get richer and
one diagram, show Sarah’s budget constraints wages rise, people typically have fewer chil-
if she earns $6 per hour, $8 per hour, and $10 dren. Is this fact consistent with this model?
per hour. Now draw indifference curves such Explain.
that Sarah’s labor-supply curve is upward slop- 12. Economist George Stigler once wrote that,
ing when the wage is between $6 and $8 per according to consumer theory, “if consumers do
hour, and backward sloping when the wage is not buy less of a commodity when their incomes
between $8 and $10 per hour. rise, they will surely buy less when the price of
8. Draw the indifference curve for someone decid- the commodity rises.” Explain this statement
ing how to allocate time between work and using the concepts of income and substitution
leisure. Suppose the wage increases. Is it pos- effects.
sible that the person’s consumption would fall? 13. The welfare system provides income to some
Is this plausible? Discuss. (Hint: Think about needy families. Typically, the maximum pay-
income and substitution effects.) ment goes to families that earn no income; then,
9. Suppose you take a job that pays $30,000 and set as families begin to earn income, the welfare
some of this income aside in a savings account payment declines gradually and eventually
that pays an annual interest rate of 5 percent. disappears. Let’s consider the possible effects of
Use a diagram with a budget constraint and this program on a family’s labor supply.
indifference curves to show how your consump- a. Draw a budget constraint for a family assum-
tion changes in each of the following situations. ing that the welfare system did not exist. On
To keep things simple, assume that you pay no the same diagram, draw a budget constraint
taxes on your income. that reflects the existence of the welfare
a. Your salary increases to $40,000. system.
b. The interest rate on your bank account rises b. Adding indifference curves to your diagram,
to 8 percent. show how the welfare system could reduce
10. As discussed in the text, we can divide an the number of hours worked by the family.
individual’s life into two hypothetical periods: Explain, with reference to both the income
“young” and “old.” Suppose the individual and substitution effects.
earns income only when young and saves some c. Using your diagram from part (b), show the
of that income to consume when old. If the effect of the welfare system on the well-being
interest rate on savings falls, can you tell what of the family.
happens to consumption when young? Can you 14. Five consumers have the following marginal
tell what happens to consumption when old? utility of apples and pears:
Explain. Marginal Utility Marginal Utility
11. Consider a couple’s decision about how many of Apples of Pears
children to have. Assume that over a lifetime a
couple has 200,000 hours of time to either work Jerry 12 6
or raise children. The wage is $10 per hour. George 6 6
Raising a child takes 20,000 hours of time. Elaine 6 3
a. Draw the budget constraint showing the Kramer 3 6
trade-off between lifetime consumption and Newman 12 3
number of children. (Ignore the fact that
The price of an apple is $2, and the price of a
children come only in whole numbers!) Show
pear is $1. Which, if any, of these consumers are
indifference curves and an optimum choice.
optimizing over their choice of fruit? For those
b. Suppose the wage increases to $12 per hour.
who are not, how should they change their
Show how the budget constraint shifts. Using
spending?
income and substitution effects, discuss the
impact of the change on number of children
and lifetime consumption.
22
CHAPTER
Frontiers of Microeconomics
E conomics is a study of the choices that people make and the resulting inter-
actions they have with one another. This study has many facets, as we have
seen in the preceding chapters. Yet it would be a mistake to think that all
the facets we have seen make up a finished jewel, perfect and unchanging. Like
all scientists, economists are always on the lookout for new areas to study and
new phenomena to explain. This final chapter on microeconomics offers an assort-
ment of three topics at the discipline’s frontier to see how economists are trying to
expand their understanding of human behavior and society.
The first topic is the economics of asymmetric information. Many times in life,
some people are better informed than others, and this difference in information
can affect the choices they make and how they deal with one another. Thinking
about this asymmetry can shed light on many aspects of the world, from the mar-
ket for used cars to the custom of gift giving.
The second topic we examine in this chapter is political economy. Throughout
this book, we have seen many examples where markets fail and government
policy can potentially improve matters. But “potentially” is a needed qualifier:
Whether this potential is realized depends on how well our political institutions
work. The field of political economy uses the tools of economics to understand the
functioning of government.
The third topic in this chapter is behavioral economics. This field brings some of
the insights from psychology into the study of economic issues. It offers a view of
483
human behavior that is more subtle and complex than that found in conventional
economic theory, but this view may also be more realistic.
This chapter covers a lot of ground. To do so, it offers not a full helping of these
three topics but, instead, a taste of each. One goal is to show a few of the directions
economists are heading in their effort to expand knowledge of how the economy
works. Another goal is to whet your appetite for more courses in economics.
ASYMMETRIC INFORMATION
“I know something you don’t know.” This statement is a common taunt among
children, but it also conveys a deep truth about how people sometimes interact
with one another. Many times in life, one person knows more about what is going
on than another. A difference in access to relevant knowledge is called an informa-
tion asymmetry.
Examples abound. A worker knows more than his employer about how much
effort he puts into his job. A seller of a used car knows more than the buyer about
the car’s condition. The first is an example of a hidden action, whereas the second
is an example of a hidden characteristic. In each case, the uninformed party (the
employer, the car buyer) would like to know the relevant information, but the
informed party (the worker, the car seller) may have an incentive to conceal it.
Because asymmetric information is so prevalent, economists have devoted
much effort in recent decades to studying its effects. And indeed, the 2001 Nobel
Prize in Economics was awarded to three economists (George Akerlof, Michael
Spence, and Joseph Stiglitz) for their pioneering work on this topic. Let’s discuss
some of the insights that this study has revealed.
HIDDEN ACTIONS: PRINCIPALS, AGENTS,

AND MORAL H AZARD
moral hazard Moral hazard is a problem that arises when one person, called the agent, is per-
the tendency of a performing some task on behalf of another person, called the principal. If the prin-
son who is imperfectly cipal cannot perfectly monitor the agent’s behavior, the agent tends to undertake
monitored to engage in less effort than the principal considers desirable. The phrase moral hazard refers to
dishonest or otherwise the risk, or “hazard,” of inappropriate or otherwise “immoral” behavior by the
undesirable behavior
agent. In such a situation, the principal tries various ways to encourage the agent
to act more responsibly.
agent
a person who is per- The employment relationship is the classic example. The employer is the prin-
forming an act for cipal, and the worker is the agent. The moral-hazard problem is the temptation
another person, of imperfectly monitored workers to shirk their responsibilities. Employers can
called the principal respond to this problem in various ways:
principal • Better monitoring. Parents hiring nannies have been known to plant hidden
a person for whom video cameras in their homes to record the nanny’s behavior when the par-
another person, called ents are away. The aim is to catch irresponsible behavior.
the agent, is performing • High wages. According to efficiency-wage theories (discussed in Chapter 19),
some act some employers may choose to pay their workers a wage above the level
that equilibrates supply and demand in the labor market. A worker who
earns an above-equilibrium wage is less likely to shirk because, if he is
caught and fired, he might not be able to find another high-paying job.
CHAPTER 22 FRONTIERS OF MICROECONOMICS 485
• Delayed payment. Firms can delay part of a worker’s compensation, so if the

worker is caught shirking and is fired, he suffers a larger penalty. One exam-
ple of delayed compensation is the year-end bonus. Similarly, a firm may
choose to pay its workers more later in their lives. Thus, the wage increases
that workers get as they age may reflect not just the benefits of experience
but also a response to moral hazard.
Employers can use any combination of these various mechanisms to reduce the
problem of moral hazard.
There are also many examples of moral hazard beyond the workplace. A hom-
eowner with fire insurance will likely buy too few fire extinguishers because
the homeowner bears the cost of the extinguisher while the insurance company
receives much of the benefit. A family may live near a river with a high risk of
flooding because the family enjoys the scenic views, while the government bears
the cost of disaster relief after a flood. Many regulations are aimed at addressing
the problem: An insurance company may require homeowners to buy fire extin-
guishers, and the government may prohibit building homes on land with high
risk of flooding. But the insurance company does not have perfect information
about how cautious homeowners are, and the government does not have perfect
information about the risk that families undertake when choosing where to live.
As a result, the problem of moral hazard persists.
HIDDEN CHARACTERISTICS: A DVERSE SELECTION

AND THE L EMONS P ROBLEM
Adverse selection is a problem that arises in markets in which the seller knows adverse selection
more about the attributes of the good being sold than the buyer does. In such the tendency for the mix
a situation, the buyer runs the risk of being sold a good of low quality. That is, of unobserved attributes
the “selection” of goods sold may be “adverse” from the standpoint of the unin- to become undesirable
formed buyer. from the standpoint of
an uninformed party
The classic example of adverse selection is the market for used cars. Sellers of
used cars know their vehicles’ defects while buyers often do not. Because owners
of the worst cars are more likely to sell them than are the owners of the best cars,
buyers are apprehensive about getting a “lemon.” As a result, many people avoid
buying vehicles in the used car market. This lemons problem can explain why a
used car only a few weeks old sells for thousands of dollars less than a new car
of the same type. A buyer of the used car might surmise that the seller is getting
rid of the car quickly because the seller knows something about it that the buyer
does not.
A second example of adverse selection occurs in the labor market. According
to another efficiency-wage theory, workers vary in their abilities, and they may
know their own abilities better than do the firms that hire them. When a firm cuts
the wage it pays, the more talented workers are more likely to quit, knowing they
are better able to find other employment. Conversely, a firm may choose to pay an
above-equilibrium wage to attract a better mix of workers.
A third example of adverse selection occurs in markets for insurance. For exam-
ple, buyers of health insurance know more about their own health problems than
do insurance companies. Because people with greater hidden health problems
are more likely to buy health insurance than are other people, the price of health
insurance reflects the costs of a sicker-than-average person. As a result, people
Corporate Management
Much production in the The corporation’s board of directors is responsible for hiring
modern economy takes place within corporations. Like other firms, and firing the top management. The board monitors the managers’
corporations buy inputs in markets for the factors of production and performance, and it designs their compensation packages. These
sell their output in markets for goods and services. Also like other packages often include incentives aimed at aligning the interest of
firms, they are guided in their decisions by the objective of profit shareholders with the interest of management. Managers might be
maximization. But a large corporation has to deal with some issues given bonuses based on performance or options to buy the compa-
that do not arise in, say, a small family-owned business. ny’s stock, which are more valuable if the company performs well.
What is distinctive about a corporation? From a legal standpoint, Note, however, that the directors are themselves agents of the
a corporation is an organization that is granted a charter recogniz- shareholders. The existence of a board overseeing management
ing it as a separate legal entity, with its own rights and responsi- only shifts the principal-agent problem. The issue then becomes
bilities distinct from those of its owners and employees. From an how to ensure that the board of directors fulfills its own legal obliga-
economic standpoint, the most important feature of the corporate tion of acting in the best interest of the shareholders. If the directors
form of organization is the separation of ownership and control. One become too friendly with management, they may not provide the
group of people, called the shareholders, own the corporation and required oversight.
share in its profits. Another group of people, called the managers, The corporation’s principal-agent problem became big news
are employed by the corporation to make decisions about how to around 2005. The top managers of several prominent companies,
deploy the corporation’s resources. such as Enron, Tyco, and WorldCom, were found to be engaging
The separation of ownership and control creates a principal- in activities that enriched themselves at the expense of their share-
agent problem. In this case, the shareholders are the principals, and holders. In these cases, the actions were so extreme as to be crimi-
the managers are the agents. The chief executive officer and other nal, and the corporate managers were not just fired but also sent
managers, who are in the best position to know the available busi- to prison. Some shareholders sued directors for failing to monitor
ness opportunities, are charged with the task of maximizing profits management sufficiently.
for the shareholders. But ensuring that they carry out this task is not Fortunately, criminal activity by corporate managers is rare. But
always easy. The managers may have goals of their own, such as in some ways, it is only the tip of the iceberg. Whenever ownership
taking life easy, having a plush office and a private jet, throwing lav- and control are separated, as they are in most large corporations,
ish parties, or presiding over a large business empire. The managers’ there is an inevitable tension between the interests of shareholders
goals may not always coincide with the goal of profit maximization. and the interests of management.
in average health may be discouraged from buying health insurance by the high
price.
When markets suffer from adverse selection, the invisible hand does not neces-
sarily work its magic. In the used car market, owners of good cars may choose to
keep them rather than sell them at the low price that skeptical buyers are willing to
pay. In the labor market, wages may be stuck above the level that balances supply
and demand, resulting in unemployment. In insurance markets, buyers with low
risk may choose to remain uninsured because the policies they are offered fail to
reflect their true characteristics. Advocates of government-provided health insur-
ance sometimes point to the problem of adverse selection as one reason not to trust
the private market to provide the right amount of health insurance on its own.
SIGNALING TO CONVEY PRIVATE INFORMATION

Although asymmetric information is sometimes a motivation for public policy, it
also motivates some individual behavior that otherwise might be hard to explain.
Markets respond to problems of asymmetric information in many ways. One of
them is signaling, which refers to actions taken by an informed party for the sole signaling
purpose of credibly revealing his private information. an action taken by an
We have seen examples of signaling in previous chapters. As we saw in Chap- informed party to reveal
ter 16, firms may spend money on advertising to signal to potential customers that private information to
they have high-quality products. As we saw in Chapter 20, students may earn col- an uninformed party
lege degrees to signal to potential employers that they are high-ability individu-
als. Recall that the signaling theory of education contrasts with the human-capital
theory, which asserts that education increases a person’s productivity, rather than
merely conveying information about innate talent. These two examples of signal-
ing (advertising, education) may seem very different, but below the surface, they
are much the same: In both cases, the informed party (the firm, the student) is
using the signal to convince the uninformed party (the customer, the employer)
that the informed party is offering something of high quality.
What does it take for an action to be an effective signal? Obviously, it must
be costly. If a signal were free, everyone would use it, and it would convey no
information. For the same reason, there is another requirement: The signal must
be less costly, or more beneficial, to the person with the higher-quality product.
Otherwise, everyone would have the same incentive to use the signal, and the
signal would reveal nothing.
Consider again our two examples. In the advertising case, a firm with a good
product reaps a larger benefit from advertising because customers who try the
product once are more likely to become repeat customers. Thus, it is rational for
the firm with a good product to pay for the cost of the signal (advertising), and it
is rational for the customer to use the signal as a piece of information about the
product’s quality. In the education case, a talented person can get through school
more easily than a less talented one. Thus, it is rational for the talented person to
pay for the cost of the signal (education), and it is rational for the employer to use
the signal as a piece of information about the person’s talent.
The world is replete with instances of signaling. Magazine ads sometimes
include the phrase “as seen on TV.” Why does a firm selling a product in a maga-
zine choose to stress this fact? One possibility is that the firm is trying to convey
its willingness to pay for an expensive signal (a spot on television) in the hope that
you will infer that its product is of high quality. For the same reason, graduates of
elite schools are always sure to put that fact on their résumés.
GIFTS AS SIGNALS
A man is debating what to give his girlfriend for her birthday. “I know,” he says
to himself, “I’ll give her cash. After all, I don’t know her tastes as well as she
does, and with cash, she can buy anything she wants.” But when he hands her the
money, she is offended. Convinced he doesn’t really love her, she breaks off the
relationship.
What’s the economics behind this story?
In some ways, gift giving is a strange custom. As the man in our story suggests,
people typically know their own preferences better than others do, so we might
expect everyone to prefer cash to in-kind transfers. If your employer substituted

merchandise of his choosing for your paycheck, you would likely object to this
means of payment. But your reaction is very different when someone who (you
hope) loves you does the same thing.
One interpretation of gift giving is that it reflects asymmetric information and
signaling. The man in our story has private information that the girlfriend would
like to know: Does he really love her? Choosing a good gift for her is a signal of his
love. Certainly, the act of picking out a gift, rather than giving cash, has the right
characteristics to be a signal. It is costly (it takes time), and its cost depends on pri-
vate information (how much he loves her). If he really loves her, choosing a good
gift is easy because he is thinking about her all the time. If he doesn’t love her,
finding the right gift is more difficult. Thus, giving a gift that suits the girlfriend is
© TONY METAXAS/ASIA IMAGES/GETTY IMAGES
one way for him to convey the private information of his love for her. Giving cash
shows that he isn’t even bothering to try.
The signaling theory of gift giving is consistent with another observation: Peo-
ple care most about the custom when the strength of affection is most in question.
Thus, giving cash to a girlfriend or boyfriend is usually a bad move. But when col-
lege students receive a check from their parents, they are less often offended. The
parents’ love is less likely to be in doubt, so the recipient probably won’t interpret
the cash gift as a signal of lack of affection. ●
SCREENING TO INDUCE INFORMATION R EVELATION

“NOW WE’LL SEE HOW MUCH When an informed party takes actions to reveal his private information, the phe-
HE LOVES ME.” nomenon is called signaling. When an uninformed party takes actions to induce
the informed party to reveal private information, the phenomenon is called
screening screening.
an action taken by an Some screening is common sense. A person buying a used car may ask that it
uninformed party to be checked by an auto mechanic before the sale. A seller who refuses this request
induce an informed party reveals his private information that the car is a lemon. The buyer may decide to
to reveal information offer a lower price or to look for another car.
Other examples of screening are more subtle. For example, consider a firm that
sells car insurance. The firm would like to charge a low premium to safe drivers
and a high premium to risky drivers. But how can it tell them apart? Drivers know
whether they are safe or risky, but the risky ones won’t admit it. A driver’s history
is one piece of information (which insurance companies in fact use), but because
of the intrinsic randomness of car accidents, history is an imperfect indicator of
future risks.
The insurance company might be able to sort out the two kinds of drivers by
offering different insurance policies that would induce them to separate them-
selves. One policy would have a high premium and cover the full cost of any acci-
dents that occur. Another policy would have low premiums but would have, say,
a $1,000 deductible. (That is, the driver would be responsible for the first $1,000 of
damage, and the insurance company would cover the remaining risk.) Notice that
the deductible is more of a burden for risky drivers because they are more likely to
have an accident. Thus, with a large enough deductible, the low-premium policy
with a deductible would attract the safe drivers, while the high-premium policy
without a deductible would attract the risky drivers. Faced with these two poli-
cies, the two kinds of drivers would reveal their private information by choosing
different insurance policies.
ASYMMETRIC INFORMATION AND PUBLIC POLICY

We have examined two kinds of asymmetric information: moral hazard and
adverse selection. And we have seen how individuals may respond to the prob-
lem with signaling or screening. Now let’s consider what the study of asymmetric
information suggests about the proper scope of public policy.
The tension between market success and market failure is central in microeco-
nomics. We learned in Chapter 7 that the equilibrium of supply and demand is
efficient in the sense that it maximizes the total surplus that society can obtain in
a market. Adam Smith’s invisible hand seemed to reign supreme. This conclu-
sion was then tempered with the study of externalities (Chapter 10), public goods
(Chapter 11), imperfect competition (Chapters 15 through 17), and poverty (Chap-
ter 20). These examples of market failure showed that government can sometimes
improve market outcomes.
The study of asymmetric information gives us a new reason to be wary of
markets. When some people know more than others, the market may fail to put
resources to their best use. People with high-quality used cars may have trou-
ble selling them because buyers will be afraid of getting a lemon. People with
few health problems may have trouble getting low-cost health insurance because
insurance companies lump them together with those who have significant (but
hidden) health problems.
Although asymmetric information may call for government action in some
cases, three facts complicate the issue. First, as we have seen, the private market
can sometimes deal with information asymmetries on its own using a combina-
tion of signaling and screening. Second, the government rarely has more informa-
tion than the private parties. Even if the market’s allocation of resources is not
first-best, it may be second-best. That is, when there are information asymmetries,
policymakers may find it hard to improve upon the market’s admittedly imper-
fect outcome. Third, the government is itself an imperfect institution—a topic we
take up in the next section.
QUICK QUIZ A person who buys a life insurance policy pays a certain amount per year
and receives for his family a much larger payment in the event of his death. Would you
expect buyers of life insurance to have higher or lower death rates than the average per-
son? How might this be an example of moral hazard? Of adverse selection? How might
a life insurance company deal with these problems?
POLITICAL ECONOMY
As we have seen, markets left on their own do not always reach a desirable allo-
cation of resources. When we judge the market’s outcome to be either inefficient
or inequitable, there may be a role for the government to step in and improve the
situation. Yet before we embrace an activist government, we need to consider one political economy
more fact: The government is also an imperfect institution. The field of political the study of government
economy (sometimes called the field of public choice) applies the methods of eco- using the analytic meth-
nomics to study how government works. ods of economics
THE CONDORCET VOTING PARADOX

Most advanced societies rely on democratic principles to set government policy.
When a city is deciding between two locations to build a new park, for example,
we have a simple way to choose: The majority gets its way. Yet for most policy
issues, the number of possible outcomes far exceeds two. A new park, for instance,
could be placed in many possible locations. In this case, as the 18th-century French
political theorist Marquis de Condorcet famously noted, democracy might run
into some problems trying to choose the best outcome.
For example, suppose there are three possible outcomes, labeled A, B, and C,
and there are three voter types with the preferences shown in Table 1. The mayor
of our town wants to aggregate these individual preferences into preferences for
society as a whole. How should she do it?
At first, she might try some pairwise votes. If she asks voters to choose first
between B and C, voter types 1 and 2 will vote for B, giving B the majority. If she
then asks voters to choose between A and B, voter types 1 and 3 will vote for A,
giving A the majority. Observing that A beats B, and B beats C, the mayor might
conclude that A is the voters’ clear choice.
But wait: Suppose the mayor then asks voters to choose between A and C. In
this case, voter types 2 and 3 vote for C, giving C the majority. That is, under pair-
wise majority voting, A beats B, B beats C, and C beats A. Normally, we expect
preferences to exhibit a property called transitivity: If A is preferred to B, and B
Condorcet paradox is preferred to C, then we would expect A to be preferred to C. The Condorcet
the failure of majority paradox is that democratic outcomes do not always obey this property. Pairwise
rule to produce transitive voting might produce transitive preferences for society in some cases, but as our
preferences for society example in the table shows, it cannot be counted on to do so.
One implication of the Condorcet paradox is that the order which things are
voted on can affect the result. If the mayor suggests choosing first between A and
B and then comparing the winner to C, the town ends up choosing C. But if the
voters choose first between B and C and then compare the winner to A, the town
ends up with A. And if the voters choose first between A and C and then compare
the winner to B, the town ends up with B.
The Condorcet paradox teaches two lessons. The narrow lesson is that when
there are more than two options, setting the agenda (that is, deciding the order
which items are voted on) can have a powerful influence over the outcome of a
democratic election. The broad lesson is that majority voting by itself does not tell
us what outcome a society really wants.
1 T A B L E
Voter Type
The Condorcet Paradox

Type 1 Type 2 Type 3
If voters have these prefer-
ences over outcomes A,
B, and C, then in pairwise Percent of Electorate 35 45 20
majority voting, A beats B, First choice A B C
B beats C, and C beats A. Second choice B C A
Third choice C A B
A RROW’S IMPOSSIBILITY THEOREM

Since political theorists first noticed Condorcet’s paradox, they have spent much
energy studying existing voting systems and proposing new ones. For example,
as an alternative to pairwise majority voting, the mayor of our town could ask
each voter to rank the possible outcomes. For each voter, we could give 1 point
for last place, 2 points for second to last, 3 points for third to last, and so on. The
outcome that receives the most total points wins. With the preferences in Table 1,
outcome B is the winner. (You can do the arithmetic yourself.) This voting method
is called a Borda count for the 18th-century French mathematician and political
theorist who devised it. It is often used in polls that rank sports teams.
Is there a perfect voting system? Economist Kenneth Arrow took up this ques-
tion in his 1951 book Social Choice and Individual Values. Arrow started by defining
what a perfect voting system would be. He assumes that individuals in society
have preferences over the various possible outcomes: A, B, C, and so on. He then
assumes that society wants a voting system to choose among these outcomes that
satisfies several properties:
• Unanimity: If everyone prefers A to B, then A should beat B.
• Transitivity: If A beats B, and B beats C, then A should beat C.
• Independence of irrelevant alternatives: The ranking between any two out-
comes A and B should not depend on whether some third outcome C is also
available.
• No dictators: There is no person who always gets his way, regardless of
everyone else’s preferences.
These all seem like desirable properties of a voting system. Yet Arrow proved,
mathematically and incontrovertibly, that no voting system can satisfy all these prop-
erties. This amazing result is called Arrow’s impossibility theorem. Arrow’s impossibility
The mathematics needed to prove Arrow’s theorem is beyond the scope of this theorem
book, but we can get some sense of why the theorem is true from a couple of a mathematical result
examples. We have already seen the problem with the method of majority rule. showing that, under cer-
The Condorcet paradox shows that majority rule fails to produce a ranking of tain assumed conditions,
there is no scheme for
outcomes that always satisfies transitivity.
aggregating individual
As another example, the Borda count fails to satisfy the independence of irrel- preferences into a valid
evant alternatives. Recall that, using the preferences in Table 1, outcome B wins set of social preferences
with a Borda count. But suppose that suddenly C disappears as an alternative.
If the Borda count method is applied only to outcomes A and B, then A wins.
(Once again, you can do the arithmetic on your own.) Thus, eliminating alter-
native C changes the ranking between A and B. This change occurs because the
result of the Borda count depends on the number of points that A and B receive,
and the number of points depends on whether the irrelevant alternative, C, is also
available.
Arrow’s impossibility theorem is a deep and disturbing result. It doesn’t say
that we should abandon democracy as a form of government. But it does say that,
no matter what voting system society adopts for aggregating the preferences of its
members, in some way it will be flawed as a mechanism for social choice.
THE M EDIAN VOTER IS K ING

Despite Arrow’s theorem, voting is how most societies choose their leaders and
public policies, often by majority rule. The next step in studying government is
to examine how governments run by majority rule work. That is, in a democratic
society, who determines what policy is chosen? In some cases, the theory of demo-
cratic government yields a surprisingly simple answer.
Let’s consider an example. Imagine that society is deciding how much money
to spend on some public good, such as the army or the national parks. Each voter
has his own most preferred budget, and he always prefers outcomes closer to his
most preferred value to outcomes farther away. Thus, we can line up voters from
those who prefer the smallest budget to those who prefer the largest. Figure 1 is
an example. Here there are 100 voters, and the budget size varies from zero to $20
billion. Given these preferences, what outcome would you expect democracy to
produce?
median voter theorem According to a famous result called the median voter theorem, majority rule
a mathematical result will produce the outcome most preferred by the median voter. The median voter is
showing that if voters are the voter exactly in the middle of the distribution. In this example, if you take the
choosing a point along line of voters ordered by their preferred budgets and count 50 voters from either
a line and each voter end of the line, you will find that the median voter wants a budget of $10 billion.
wants the point closest By contrast, the average preferred outcome (calculated by adding the preferred
to his most preferred
outcomes and dividing by the number of voters) is $9 billion, and the modal out-
point, then majority
come (the one preferred by the greatest number of voters) is $15 billion.
rule will pick the most
preferred point of the The median voter rules the day because his preferred outcome beats any other
median voter proposal in a two-way race. In our example, more than half the voters want $10
billion or more, and more than half want $10 billion or less. If someone proposes,
say, $8 billion instead of $10 billion, everyone who prefers $10 billion or more will
vote with the median voter. Similarly, if someone proposes $12 billion instead
of $10 billion, everyone who wants $10 billion or less will vote with the median
voter. In either case, the median voter has more than half the voters on his side.
1 F I G U R E
Number of
People
35 35
The Median Voter Theorem:
An Example
This bar chart shows how 100 30
voters’ most preferred budgets 25
are distributed over five options, 25
ranging from zero to $20 billion. 20
If society makes its choice by 20
majority rule, the median voter 15
(who here prefers $10 billion) 15
determines the outcome.
10
5
5
0 $0 $5 $10 $15 $20 Preferred Size of

Budget (in billions)
What about the Condorcet voting paradox? It turns out that when the voters
are picking a point along a line and each voter aims for his own most preferred
point, the Condorcet paradox cannot arise. The median voter’s most preferred
outcome beats all comers.
One implication of the median voter theorem is that if two political parties are
each trying to maximize their chance of election, they will both move their posi-
tions toward the median voter. Suppose, for example, that the Democratic Party
advocates a budget of $15 billion, while the Republican Party advocates a budget
of $10 billion. The Democratic position is more popular in the sense that $15 billion
has more proponents than any other single choice. Nonetheless, the Republicans
get more than 50 percent of the vote: They will attract the 20 voters who want $10
billion, the 15 voters who want $5 billion, and the 25 voters who want zero. If the
Democrats want to win, they will move their platform toward the median voter.
Thus, this theory can explain why the parties in a two-party system are similar to
each other: They are both moving toward the median voter.
Another implication of the median voter theorem is that minority views are not
given much weight. Imagine that 40 percent of the population want a lot of money
spent on the national parks, and 60 percent want nothing spent. In this case, the
median voter’s preference is zero, regardless of the intensity of the minority’s
view. Such is the logic of democracy. Rather than reaching a compromise that
takes into account everyone’s preferences, majority rule looks only to the person
in the exact middle of the distribution.
POLITICIANS A RE PEOPLE TOO

When economists study consumer behavior, they assume that consumers buy the
bundle of goods and services that gives them the greatest level of satisfaction.
When economists study firm behavior, they assume that firms produce the quan-
tity of goods and services that yields the greatest level of profits. What should
they assume when they study people involved in the practice of politics?
Politicians also have objectives. It would be nice to assume that political lead-
ers are always looking out for the well-being of society as a whole, that they are
aiming for an optimal combination of efficiency and equality. Nice, perhaps, but
not realistic. Self-interest is as powerful a motive for political actors as it is for con-
sumers and firm owners. Some politicians are motivated by a desire for reelection
and are willing to sacrifice the national interest when doing so solidifies their base
of voters. Other politicians are motivated by simple greed. If you have any doubt,
you should look at the world’s poor nations, where corruption among govern-
CARTOON: © WWW.CARTOONSTOCK.COM/CHRIS WILDT
ment officials is a common impediment to economic development.

This book is not the place to develop a theory of political behavior. But when
thinking about economic policy, remember that this policy is made not by a benev-
olent king but by real people with their own all-too-human desires. Sometimes they
are motivated to further the national interest, but sometimes they are motivated
by their own political and financial ambitions. We shouldn’t be surprised when
economic policy fails to resemble the ideals derived in economics textbooks.
Q Q
UICK UIZ A public school district is voting on the school budget and the resulting
student-teacher ratio. A poll finds that 20 percent of the voters want a ratio of 9:1, 25
percent want a ratio of 10:1, 15 percent want a ratio of 11:1, and 40 percent want a ratio
of 12:1. What outcome would you expect the district to end up with? Explain.
Farm Policy and Politics

What motivates politicians? Humorist Dave Barry offers an answer
with his analysis of the Farm Security Act of 2002.
Farmer on the Dole The purpose of the Farm Security Act But that is NOTHING compared with
By Dave Barry is to provide farmers with “price stabil- how generous you’re about to get, tax-
ity.” What do we mean by “price stability”? payers! Thanks to the Farm Security Act,
If you’re like most American taxpayers, you We mean: your money. You have already over the next 10 years, you’ll be providing
often wake up in the middle of the night in been very generous about this: Last year farmers with 70 percent MORE stability, for
a cold sweat and ask yourself: “Am I doing alone, you gave more than $20 billion worth a total of $180 billion. At this rate, in a few
enough to support mohair producers?” of price stability to farmers. Since 1996, years farmers will be so stable that they’ll
I am pleased to report that you are, you’ve given more than a million dollars have to huddle in their root cellars for fear of
thanks to bold action taken recently by the apiece to more than 1,000 lucky recipients, being struck by bales of taxpayer-supplied
United States Congress (motto: “Hey, it’s not many of which are actually big agribusi- cash raining down on the Heartland states
OUR money!”). I am referring to the 2002 nesses. Some of the “farmers” you’ve sent from Air Force bombers.
Farm Security Act, which recently emerged your money to are billionaires, such as Perhaps you are asking yourself: “Wait a
from the legislative process very much the Ted Turner and Charles Schwab, as well minute! Isn’t this kind of like, I don’t know
way a steaming wad of processed vegas major corporations, such as Chevron, . . . welfare?”
etation emerges from the digestive tract of DuPont and John Hancock Mutual Life No, it is not. Welfare is when the govern-
a cow. Insurance. ment gives money to people who produce
BEHAVIORAL ECONOMICS
Economics is a study of human behavior, but it is not the only field that can make
that claim. The social science of psychology also sheds light on the choices that
people make in their lives. The fields of economics and psychology usually pro-
ceed independently, in part because they address a different range of questions.
behavioral economics But recently, a field called behavioral economics has emerged in which econo-
the subfield of econom- mists are making use of basic psychological insights. Let’s consider some of these
ics that integrates the insights here.
insights of psychology
PEOPLE A REN’T A LWAYS R ATIONAL

Economic theory is populated by a particular species of organism, sometimes
called Homo economicus. Members of this species are always rational. As firm
managers, they maximize profits. As consumers, they maximize utility (or equiva-
lently, pick the point on the highest indifference curve). Given the constraints they
face, they rationally weigh all the costs and benefits and always choose the best
possible course of action.
nothing. Whereas the farm-money recipi- tary purpose, and so . . . you are STILL pay- be, but there will be no lentils or chickpeas
ents produce something that is critical to ing people to produce it! And thanks to the tonight, and all because we taxpayers were
our nation: votes. Powerful congresspersons Farm Security Act, you will continue to pay too shortsighted to fork over millions of dol-
from both parties, as well as President Bush, millions and millions of dollars, every year, to lars in support for domestic lentil and chick-
believe that if they dump enough of your mohair producers! pea producers, who thus were forced to
money on farm states, the farm states will As I say, this is for National Security. If compete in the market like everybody else,
re-elect them, thus enabling them to con- terrorists, God forbid, ever manage to con- and . . . HEY, COME BACK HERE!”
tinue the vital work of dumping your money struct a giant time machine and transport Yes, that would be a horrible world, all
on the farm states. So as we see, it’s not wel- the United States back to 1941, and we right. And that is why I totally support the
fare at all! It’s bribery. have to fight World War II again, WE WILL Farm Security Act. I hope you agree with
But let us not forget the element of BE READY. me, though I realize that some of you may
National Security. This is where your mohair You will also be thrilled, as a taxpayer, not; in fact, some of you may be so angry
comes in. As you know, “mohair” is the hair to learn that the Farm Security Act provides about this column that you’ve decided to
of any animal whose name begins with new subsidies for producers of lentils and never read anything by me again.
“mo,” such as moose, mouse, mongoose or chickpeas. And not a moment too soon. Well, guess what: I don’t care! Thanks
moray eel. This nation has become far too dependent to the Humor Security Act recently passed
No, wait, sorry. “Mohair” is actually wool on imported lentils and chickpeas. Try to by Congress, I’ll be getting huge sums of
made from the hair of a goat. During WWII, picture the horror of living in a world in money from the federal government to con-
mohair was used to make military uniforms, which foreigners, in foreign countries, sud- tinue grinding out these columns, year after
so it was considered to be a strategic mate- denly cut off our lentil and chickpea supply. year, even if nobody wants to read them!
rial, and Congress decided that you, the Imagine how you would feel if you had to No, that would be stupid.
taxpayer, should pay people to produce it. look your small child in the eye and say,
But of course today mohair has no vital mili- “I’m sorry, little Billy or Suzy as the case may
Source: Boston Globe Magazine, June 30, 2002.
Real people, however, are Homo sapiens. Although in many ways they resemble
the rational, calculating people assumed in economic theory, they are far more
complex. They can be forgetful, impulsive, confused, emotional, and shortsighted.
These imperfections of human reasoning are the bread and butter of psycholo-
gists, but until recently, economists have neglected them.
Herbert Simon, one of the first social scientists to work at the boundary of eco-
nomics and psychology, suggested that humans should be viewed not as ratio-
nal maximizers but as satisficers. Rather than always choosing the best course of
action, they make decisions that are merely good enough. Similarly, other econo-
mists have suggested that humans are only “near rational” or that they exhibit
“bounded rationality.”
Studies of human decision making have tried to detect systematic mistakes that
people make. Here are a few of the findings:
• People are overconfident. Imagine that you were asked some numerical ques-
tions, such as the number of African countries in the United Nations, the
height of the tallest mountain in North America, and so on. Instead of being
asked for a single estimate, however, you were asked to give a 90 percent
confidence interval—a range such that you were 90 percent confident the
true number falls within it. When psychologists run experiments like this,
they find that most people give ranges that are too small: The true number
falls within their intervals far less than 90 percent of the time. That is, most
people are too sure of their own abilities.
• People give too much weight to a small number of vivid observations. Imagine that
you are thinking about buying a car of brand X. To learn about its reliabil-
ity, you read Consumer Reports, which has surveyed 1,000 owners of car X.
Then you run into a friend who owns car X, and she tells you that her car is
a lemon. How do you treat your friend’s observation? If you think rationally,
you will realize that she has only increased your sample size from 1,000 to
1,001, which does not provide much new information. But because your
friend’s story is so vivid, you may be tempted to give it more weight in your
decision making than you should.
• People are reluctant to change their minds. People tend to interpret evidence to
confirm beliefs they already hold. In one study, subjects were asked to read
and evaluate a research report on whether capital punishment deters crime.
After reading the report, those who initially favored the death penalty said
they were surer in their view, and those who initially opposed the death
penalty also said they were surer in their view. The two groups interpreted
the same evidence in exactly opposite ways.
Think about decisions you have made in your own life. Do you exhibit some of
these traits?
A hotly debated issue is whether deviations from rationality are important for
understanding economic phenomena. An intriguing example arises in the study
of 401(k) plans, the tax-advantaged retirement savings accounts that some firms
offer their workers. In some firms, workers can choose to participate in the plan
by filling out a simple form. In other firms, workers are automatically enrolled
and can opt out of the plan by filling out a simple form. It turns out many more
workers participate in the second case than in the first. If workers were perfectly
rational maximizers, they would choose the optimal amount of retirement sav-
ing, regardless of the default offered by their employer. In fact, workers’ behavior
appears to exhibit substantial inertia. Understanding their behavior seems easier
once we abandon the model of rational man.
Why, you might ask, is economics built on the rationality assumption when
psychology and common sense cast doubt on it? One answer is that the assump-
tion, even if not exactly true, may be true enough that it yields reasonably accu-
rate models of behavior. For example, when we studied the differences between
competitive and monopoly firms, the assumption that firms rationally maximize
profit yielded many important and valid insights. Incorporating complex psy-
chological deviations from rationality into the story might have added realism,
but it also would have muddied the waters and made those insights harder to
find. Recall from Chapter 2 that economic models are not meant to replicate real-
ity but are supposed to show the essence of the problem at hand as an aid to
understanding.
Another reason economists so often assume rationality may be that economists
are themselves not rational maximizers. Like most people, they are overconfident,
and they are reluctant to change their minds. Their choice among alternative theo-
ries of human behavior may exhibit excessive inertia. Moreover, economists may
be content with a theory that is not perfect but is good enough. The model of
rational man may be the theory of choice for a satisficing social scientist.
PEOPLE CARE ABOUT FAIRNESS

Another insight about human behavior is best illustrated with an experiment
called the ultimatum game. The game works like this: Two volunteers (who are
otherwise strangers to each other) are told that they are going to play a game and
could win a total of $100. Before they play, they learn the rules. The game begins
with a coin toss, which is used to assign the volunteers to the roles of player A
and player B. Player A’s job is to propose a division of the $100 prize between
himself and the other player. After player A makes his proposal, player B decides
whether to accept or reject it. If he accepts it, both players are paid according to the
proposal. If player B rejects the proposal, both players walk away with nothing. In
either case, the game then ends.
Before proceeding, stop and think about what you would do in this situation.
If you were player A, what division of the $100 would you propose? If you were
player B, what proposals would you accept?
Conventional economic theory assumes in this situation that people are ratio-
nal wealth-maximizers. This assumption leads to a simple prediction: Player A
should propose that he gets $99 and player B gets $1, and player B should accept
the proposal. After all, once the proposal is made, player B is better off accepting
it as long as he gets something out of it. Moreover, because player A knows that
accepting the proposal is in player B’s interest, player A has no reason to offer him
more than $1. In the language of game theory (discussed in Chapter 17), the 99-1
split is the Nash equilibrium.
Yet when experimental economists ask real people to play the ultimatum game,
the results differ from this prediction. People in player B’s role usually reject pro-
posals that give them only $1 or a similarly small amount. Anticipating this, peo-
ple in the role of player A usually propose giving player B much more than $1.
Some people will offer a 50-50 split, but it is more common for player A to propose
giving player B an amount such as $30 or $40, keeping the larger share for himself.
In this case, player B usually accepts the proposal.
What’s going on here? The natural interpretation is that people are driven in
part by some innate sense of fairness. A 99-1 split seems so wildly unfair to many
people that they reject it, even to their own detriment. By contrast, a 70-30 split is
still unfair, but it is not so unfair that it induces people to abandon their normal
self-interest.
Throughout our study of household and firm behavior, the innate sense of fair-
ness has not played any role. But the results of the ultimatum game suggest that
perhaps it should. For example, in Chapters 18 and 19, we discussed how wages
were determined by labor supply and labor demand. Some economists have sug-
gested that the perceived fairness of what a firm pays its workers should also
enter the picture. Thus, when a firm has an especially profitable year, workers
(like player B) may expect to be paid a fair share of the prize, even if the standard
equilibrium does not dictate it. The firm (like player A) might well decide to give
workers more than the equilibrium wage for fear that the workers might other-
wise try to punish the firm with reduced effort, strikes, or even vandalism.
PEOPLE A RE INCONSISTENT OVER TIME

Imagine some dreary task, such as doing your laundry, shoveling snow off your
driveway, or filling out your income tax forms. Now consider the following
questions:
This Is Your Brain on Economics

Research is increasingly focused on the intersection of economics
and neuroscience.
Enter the Neuro- in the laboratory. Furthermore, people are

Economists: Why especially afraid of ambiguous risks with
Do Investors Do unknown odds. This may help explain why
What They Do? so many investors are reluctant to seek out
By Tyler Cowen foreign stock markets, even when they could
diversify their portfolios at low cost.
Las Vegas uses flashing lights and ringing If one truth shines through, it is that
bells to create an illusion of reward and to people are not consistent or fully rational
encourage risk taking. Insurance company decision makers. Peter L. Bossaerts, an eco-
offices present a more somber mood to nomics professor at the California Institute
PHOTO: © LOUIE PSIHOYOS/SCIENCE FACTION/GETTY IMAGES
remind us of our mortality. Every marketer of Technology, has found that brains assess
knows that context and presentation influ- risk and return separately, rather than mak-
ence our decisions. prospective benefits and enjoy the feeling ing a single calculation of what economists
For the first time, economists are study- of risk. All of us are familiar with the giddy call expected utility.
ing these phenomena scientifically. The excitement that accompanies a triumph. Researchers can see on the screen how
economists are using a new technology Camelia Kuhnen and Brian Knutson, two people compartmentalize their choices
that allows them to trace the activity of researchers at Stanford University, have into different parts of their brains. This
neurons inside the brain and thereby study found that people are more likely to take a may not always sound like economics but
how emotions influence our choices, includ- foolish risk when their brains show this kind neuro-economists start with the insight—
ing economic choices like gambles and of activation. borrowed from the economist Friedrich
investments. But when people think about costs, they Hayek—that resources are scarce within
For instance, when humans are in a use different brain modules and become the brain and must be allocated to compet-
“positive arousal state,” they think about more anxious. They play it too safe, at least ing uses. Whether in economies or brains,
1. Would you prefer (A) to spend 50 minutes doing the task right now or (B)
to spend 60 minutes doing the task tomorrow?
2. Would you prefer (A) to spend 50 minutes doing the task in 90 days or (B)
to spend 60 minutes doing the task in 91 days?
When asked questions like these, many people choose B to question 1 and A to
question 2. When looking ahead to the future (as in question 2), they minimize the
amount of time spent on the dreary task. But faced with the prospect of doing the
task immediately (as in question 1), they choose to put it off.
In some ways, this behavior is not surprising: Everyone procrastinates from
time to time. But from the standpoint of the theory of rational man, it is puzzling.
Suppose that, in response to question 2, a person chooses to spend 50 minutes in
well-functioning systems should not be More ambitiously, future research may if one part of the brain is active at a par-
expected to exhibit centralized command try to determine when a short-term price ticular moment, how is that incorporated
and control. bubble will collapse. Does the market tide into a person’s broader method for making
Neuro-economics is just getting started. turn when people stop smiling, adjust to decisions?
The first major empirical paper was pub- their adrenalin levels or make different kinds The number of people scanned in any
lished in 2001 by Kevin McCabe, Daniel of eye contact? study is typically small, if only because
Houser, Lee Ryan, Vernon Smith and Theo- Not all of neuro-economics uses brain the hookups cost about $500 an hour and
dore Trouard, all economics professors. A scans. Andrew W. Lo, a professor at the require access to an expensive machine.
neuro-economics laboratory at Cal Tech, Sloan School of Management at the Mas- Furthermore, the setting may matter. Per-
led by Colin F. Camerer, a math prodigy and sachusetts Institute of Technology, applied haps we cannot equate choices made
now an economics professor, has assem- polygraph-like techniques to securities on the New York Stock Exchange trading
bled the foremost group of interdisciplinary traders to show that anxiety and fear affect floor with choices made under a hospital
researchers. Many of the early entrants, who market behavior. Measuring eye move- scanner, where the subject must lie on his
have learned neurology as well as econom- ments, which is easy and cheap, helps the back, remain motionless and endure a loud
ics, continue to dominate the field. researcher ascertain what is on a subject’s whirring, all the while calculating a trading
Investors are becoming interested in mind. Other researchers have opened up strategy.
the money-making potential of these ideas. monkey skulls to measure individual neu- That said, neuro-economics will make
Imagine training traders to set their emo- rons; monkey neurons fire in proportion to huge strides as technology allows research-
tions aside or testing their objectivity in the amount and probability of rewards. But ers to identify more brain regions and read
advance with brain scans. Futuristic devices do most economists care? Are phrases like brains more accurately and at lower cost. It
might monitor their emotions on the trad- “nucleus accumbens”—referring to a sub- is a growth area in a profession that knows
ing floor or in a bargaining session and cortical nucleus of the brain associated with human feelings matter, but does not always
instruct them how to compensate for pos- reward—welcome in a profession caught know what to do with them.
sible mistakes. up in interest rates and money supply? Skep- What is the next step? Perhaps neuro-
Are the best traders most adept at read- tics question whether neuro-economics economics should turn its attention to
ing the minds of others? Or is trading skill explains real-world phenomena. political economy. Do people use the same
correlated with traits like the ability to calcu- The neuro-economists admit that their part of their brains to vote as to trade? Is vot-
late and ignore the surrounding caldron of endeavor is in its infancy. It is difficult to ing governed by fear, disgust or perhaps the
human emotions? identify brain modules and their roles. Even desire to gain something new and exciting?
Source: New York Times, April 20, 2006.
90 days. Then, when the 90th day arrives, we allow him to change his mind. In
effect, he then faces question 1, so he opts for doing the task the next day. But why
should the mere passage of time affect the choices he makes?
Many times in life, people make plans for themselves, but then they fail to fol-
low through. A smoker promises himself that he will quit, but within a few hours
of smoking his last cigarette, he craves another and breaks his promise. A per-
son trying to lose weight promises that he will stop eating dessert, but when the
waiter brings the dessert cart, the promise is forgotten. In both cases, the desire for
instant gratification induces the decision maker to abandon his past plans.
Some economists believe that the consumption-saving decision is an impor-
tant instance in which people exhibit this inconsistency over time. For many peo-
ple, spending provides a type of instant gratification. Saving, like passing up the
cigarette or the dessert, requires a sacrifice in the present for a reward in the dis-
tant future. And just as many smokers wish they could quit and many overweight
individuals wish they ate less, many consumers wish they saved more of their
income. According to one survey, 76 percent of Americans said they were not sav-
ing enough for retirement.
An implication of this inconsistency over time is that people should try to find
ways to commit their future selves to following through on their plans. A smoker
trying to quit may throw away his cigarettes, and a person on a diet may put a
lock on the refrigerator. What can a person who saves too little do? He should find
some way to lock up his money before he spends it. Some retirement accounts,
such as 401(k) plans, do exactly that. A worker can agree to have some money
taken out of his paycheck before he ever sees it. The money is deposited in an
account that can be used before retirement only with a penalty. Perhaps that is one
reason these retirement accounts are so popular: They protect people from their
own desires for instant gratification.
Q Q
UICK UIZ Describe at least three ways in which human decision making differs from
that of the rational individual of conventional economic theory.
CONCLUSION
This chapter has examined the frontier of microeconomics. You may have noticed
that we have sketched out ideas rather than fully developing them. This is no acci-
dent. One reason is that you might study these topics in more detail in advanced
courses. Another reason is that these topics remain active areas of research and,
therefore, are still being fleshed out.
To see how these topics fit into the broader picture, recall the Ten Principles of
Economics from Chapter 1. One principle states that markets are usually a good
way to organize economic activity. Another principle states that governments can
sometimes improve market outcomes. As you study economics, you can more
fully appreciate the truth of these principles as well as the caveats that go with
them. The study of asymmetric information should make you more wary of mar-
ket outcomes. The study of political economy should make you more wary of
government solutions. And the study of behavioral economics should make you
wary of any institution that relies on human decision making, including both the
market and the government.
If there is a unifying theme to these topics, it is that life is messy. Information
is imperfect, government is imperfect, and people are imperfect. Of course, you
knew this long before you started studying economics, but economists need to
understand these imperfections as precisely as they can if they are to explain, and
perhaps even improve, the world around them.
SUMMARY
• In many economic transactions, information voting system will be perfect. In many situations,
is asymmetric. When there are hidden actions, democratic institutions will produce the outcome
principals may be concerned that agents suffer desired by the median voter, regardless of the
from the problem of moral hazard. When there preferences of the rest of the electorate. More-
are hidden characteristics, buyers may be con- over, the individuals who set government policy
cerned about the problem of adverse selection may be motivated by self-interest rather than the
among the sellers. Private markets sometimes national interest.
deal with asymmetric information with signaling
and screening.
• The study of psychology and economics reveals
that human decision making is more complex
• Although government policy can sometimes than is assumed in conventional economic the-
improve market outcomes, governments are ory. People are not always rational, they care
themselves imperfect institutions. The Con- about the fairness of economic outcomes (even to
dorcet paradox shows that majority rule fails to their own detriment), and they can be inconsis-
produce transitive preferences for society, and tent over time.
Arrow’s impossibility theorem shows that no
KEY CONCEPTS
moral hazard, p. 484 screening, p. 488 median voter theorem, p. 492

agent, p. 484 political economy, p. 489 behavioral economics, p. 494
principal, p. 484 Condorcet paradox, p. 490
adverse selection, p. 485 Arrow’s impossibility
signaling, p. 487 theorem, p. 491
1. What is moral hazard? List three things an 5. Explain why majority rule respects the prefer-
employer might do to reduce the severity of this ences of the median voter rather than the aver-
problem. age voter.
2. What is adverse selection? Give an example of 6. Describe the ultimatum game. What outcome
a market in which adverse selection might be a from this game would conventional economic
problem. theory predict? Do experiments confirm this
3. Define signaling and screening and give an prediction? Explain.
example of each.
4. What unusual property of voting did Condorcet
notice?
1. Each of the following situations involves moral 6. Ken walks into an ice-cream parlor.
hazard. In each case, identify the principal and
Waiter: “We have vanilla and chocolate
the agent, and explain why there is asymmetric
today.”
information. How does the action described
Ken: “I’ll take vanilla.”
reduce the problem of moral hazard?
Waiter: “I almost forgot. We also have
a. Landlords require tenants to pay security
strawberry.”
deposits.
Ken: “In that case, I’ll take chocolate.”
b. Firms compensate top executives with
options to buy company stock at a given What standard property of decision making
price in the future. is Ken violating? (Hint: Reread the section on
c. Car insurance companies offer discounts to Arrow’s impossibility theorem.)
customers who install antitheft devices in 7. Three friends are choosing a restaurant for
their cars. dinner. Here are their preferences:
2. Suppose that the Live-Long-and-Prosper Health Rachel Ross Joey
Insurance Company charges $5,000 annually for
a family insurance policy. The company’s presi- First choice Italian Italian Chinese
dent suggests that the company raise the annual Second choice Chinese Chinese Mexican
price to $6,000 to increase its profits. If the Third choice Mexican Mexican French
firm followed this suggestion, what economic Fourth choice French French Italian
problem might arise? Would the firm’s pool of
customers tend to become more or less healthy a. If the three friends use a Borda count to make
on average? Would the company’s profits neces- their decision, where do they go to eat?
sarily increase? b. On their way to their chosen restaurant, they
3. A case study in this chapter describes how a see that the Mexican and French restaurants
boyfriend can signal to a girlfriend that he loves are closed, so they use a Borda count again
her by giving an appropriate gift. Do you think to decide between the remaining two restau-
saying “I love you” can also serve as a signal? rants. Where do they decide to go now?
Why or why not? c. How do your answers to parts (a) and (b)
4. Some AIDS activists believe that health insur- relate to Arrow’s impossibility theorem?
ance companies should not be allowed to ask 8. Three friends are choosing a TV show to watch.
applicants if they are infected with the HIV Here are their preferences:
virus that causes AIDS. Would this rule help or Chandler Phoebe Monica
hurt those who are HIV-positive? Would it help
or hurt those who are not HIV-positive? Would First choice Lost Heroes Scrubs
it exacerbate or mitigate the problem of adverse Second choice Heroes Scrubs Lost
selection in the market for health insurance? Third choice Scrubs Lost Heroes
Do you think it would increase or decrease the a. If the three friends try using a Borda count to
number of people without health insurance? make their choice, what would happen?
In your opinion, would this be a good policy? b. Monica suggests a vote by majority rule. She
Explain your answers to each question. proposes that first they choose between Lost
5. The government is considering two ways to and Heroes, and then they choose between the
help the needy: giving them cash or giving them winner of the first vote and Scrubs. If they all
free meals at soup kitchens. Give an argument vote their preferences honestly, what out-
for giving cash. Give an argument, based on come would occur?
asymmetric information, for why the soup c. Should Chandler agree to Monica’s sugges-
kitchen may be better than the cash handout. tion? What voting system would he prefer?
d. Phoebe and Monica convince Chandler to go • The ordering of athletes should be transi-
along with Monica’s proposal. In round one, tive: If athlete A is ranked above athlete B,
Chandler dishonestly says he prefers Heroes and athlete B is ranked above athlete C, then
over Lost. Why might he do this? athlete A must rank above athlete C.
9. Five roommates are planning to spend the • If athlete A beats athlete B in all three races,
weekend in their dorm room watching mov- athlete A should rank higher than athlete B.
ies, and they are debating how many movies to • The rank ordering of any two athletes should
watch. Here is their willingness to pay: not depend on whether a third athlete drops
Quentin Spike Ridley Martin Steven
out of the competition just before the final
ranking.
First film $7 $5 $4 $2 $1
According to Arrow’s theorem, there are only
Second film 6 4 2 1 0 three ways to rank the athletes that satisfy these
Third film 5 3 1 0 0 properties. What are they? Are these desirable?
Fourth film 3 1 0 0 0 Why or why not? Can you think of a better
Fifth film 1 0 0 0 0 ranking scheme? Which of the three properties
above does your scheme not satisfy?
A video costs $8 to rent, which the roommates
11. Why might a political party in a two-party
split equally, so each pays $1.60 per movie.
system choose not to move toward the median
a. What is the efficient number of movies to
voter? (Hint: Think about abstentions from vot-
watch (that is, the number that maximizes
ing and political contributions.)
total surplus)?
12. Two ice-cream stands are deciding where to
b. From the standpoint of each roommate, what
locate along a 1-mile beach. The people are
is the preferred number of movies?
uniformly located along the beach, and each
c. What is the preference of the median
person sitting on the beach buys exactly 1 ice-
roommate?
cream cone per day from the nearest stand. Each
d. If the roommates held a vote on the efficient
ice-cream seller wants the maximum number of
outcome versus the median voter’s prefer-
customers. Where along the beach will the two
ence, how would each person vote? Which
stands locate?
outcome would get a majority?
13. Explain why the following reactions might
e. If one of the roommates proposed a different
reflect some deviation from rationality.
number of movies, could his proposal beat
a. After a widely reported earthquake in Califor-
the winner from part (d) in a vote?
nia, many people call their insurance com-
f. Can majority rule be counted on to reach
pany to apply for earthquake insurance.
efficient outcomes in the provision of public
b. In January, many fitness clubs offer special
goods?
annual membership fees to attract custom-
10. A group of athletes are competing in a multi-
ers who have made New Year’s resolutions
day triathlon. They have a running race on day
to exercise more. Even when these member-
one, a swimming race on day two, and a biking
ships are costly, many of these new custom-
race on day three. You know the order in which
ers seldom visit the gym to work out.
the athletes finish each of the three components.
From this information, you are asked to rank
the athletes in the overall competition. You are
given the following conditions:
Glossary
ability-to-pay principle the idea that budget constraint the limit on the competitive market a market with
taxes should be levied on a person consumption bundles that a consumer many buyers and sellers trading iden-
according to how well that person can can afford tical products so that each buyer and
shoulder the burden budget deficit an excess of govern- seller is a price taker
absolute advantage the ability to ment spending over government complements two goods for
produce a good using fewer inputs receipts which an increase in the price of one
than another producer budget surplus an excess of gov- leads to a decrease in the demand
accounting profit total revenue ernment receipts over government for the other
minus total explicit cost spending Condorcet paradox the failure of
adverse selection the tendency for business cycle fluctuations in eco- majority rule to produce transitive
the mix of unobserved attributes to nomic activity, such as employment preferences for society
become undesirable from the stand- and production constant returns to scale the prop-
point of an uninformed party erty whereby long-run average total
agent a person who is performing cost stays the same as the quantity of
capital the equipment and structures
an act for another person, called the output changes
used to produce goods and services
principal consumer surplus the amount a
cartel a group of firms acting in
Arrow’s impossibility theorem a buyer is willing to pay for a good
unison
mathematical result showing that, minus the amount the buyer actually
circular-flow diagram a visual pays for it
under certain assumed conditions,
model of the economy that shows how
there is no scheme for aggregating corrective tax a tax designed to
dollars flow through markets among
individual preferences into a valid set induce private decision makers
households and firms
of social preferences to take account of the social
Coase theorem the proposition that costs that arise from a negative
average fixed cost fixed cost divided
if private parties can bargain without externality
by the quantity of output
cost over the allocation of resources,
average revenue total revenue cost the value of everything a seller
they can solve the problem of exter-
divided by the quantity sold must give up to produce a good
nalities on their own
average tax rate total taxes paid cost–benefit analysis a study that
collusion an agreement among firms
divided by total income compares the costs and benefits to
in a market about quantities to pro-
society of providing a public good
average total cost total cost divided duce or prices to charge
by the quantity of output cross-price elasticity of demand a
common resources goods that
measure of how much the quantity
average variable cost variable cost are rival in consumption but not
demanded of one good responds to a
divided by the quantity of output excludable
change in the price of another good,
comparative advantage the ability to computed as the percentage change in
behavioral economics the subfield of produce a good at a lower opportunity quantity demanded of the first good
economics that integrates the insights cost than another producer divided by the percentage change in
of psychology compensating differential a differ- the price of the second good
benefits principle the idea that ence in wages that arises to offset the
people should pay taxes based on the nonmonetary characteristics of differ-
deadweight loss the fall in total
benefits they receive from government ent jobs
surplus that results from a market
services distortion, such as a tax
505
506 GLOSSARY
demand curve a graph of the rela- equilibrium price the price that bal- income elasticity of demand a
tionship between the price of a good ances quantity supplied and quantity measure of how much the quan-
and the quantity demanded demanded tity demanded of a good responds
demand schedule a table that shows equilibrium quantity the quantity to a change in consumers’ income,
the relationship between the price of a supplied and the quantity demanded computed as the percentage change
good and the quantity demanded at the equilibrium price in quantity demanded divided by the
percentage change in income
diminishing marginal product the excludability the property of a good
property whereby the marginal prod- whereby a person can be prevented indifference curve a curve that
uct of an input declines as the quantity from using it shows consumption bundles that
of the input increases give the consumer the same level of
explicit costs input costs that require
satisfaction
discrimination the offering of differ- an outlay of money by the firm
ent opportunities to similar individu- inferior good a good for which,
exports goods produced domesti-
als who differ only by race, ethnic other things equal, an increase in
cally and sold abroad
group, sex, age, or other personal income leads to a decrease in demand
externality the uncompensated
characteristics inflation an increase in the overall
impact of one person’s actions on the
diseconomies of scale the prop- level of prices in the economy
well-being of a bystander
erty whereby long-run average total in-kind transfers transfers to the
cost rises as the quantity of output poor given in the form of goods and
increases factors of production the inputs services rather than cash
used to produce goods and services
dominant strategy a strategy that is internalizing the externality altering
best for a player in a game regardless fixed costs costs that do not vary incentives so that people take account
of the strategies chosen by the other with the quantity of output produced of the external effects of their actions
players free rider a person who receives the
benefit of a good but avoids paying law of demand the claim that, other
for it things equal, the quantity demanded
economic profit total revenue minus
total cost, including both explicit and of a good falls when the price of the
implicit costs game theory the study of how good rises
economics the study of how society people behave in strategic situations law of supply the claim that, other
manages its scarce resources Giffen good a good for which an things equal, the quantity supplied
increase in the price raises the quantity of a good rises when the price of the
economies of scale the property
demanded good rises
whereby long-run average total cost
falls as the quantity of output increases law of supply and demand the claim
that the price of any good adjusts to
efficiency the property of society horizontal equity the idea that
bring the quantity supplied and the
getting the most it can from its scarce taxpayers with similar abilities to pay
quantity demanded for that good into
resources taxes should pay the same amount
balance
efficiency wages above-equilibrium human capital the knowledge and
liberalism the political philosophy
wages paid by firms to increase skills that workers acquire through
according to which the government
worker productivity education, training, and experience
should choose policies deemed just,
efficient scale the quantity of output as evaluated by an impartial observer
that minimizes average total cost implicit costs input costs that do not behind a “veil of ignorance”
elasticity a measure of the responsive- require an outlay of money by the firm libertarianism the political philoso-
ness of quantity demanded or quantity imports goods produced abroad and phy according to which the govern-
supplied to one of its determinants sold domestically ment should punish crimes and
equality the property of distributing incentive something that induces a enforce voluntary agreements but not
economic prosperity uniformly among person to act redistribute income
the members of society life cycle the regular pattern of
income effect the change in con-
equilibrium a situation in which the sumption that results when a price income variation over a person’s life
market price has reached the level at change moves the consumer to a lump-sum tax a tax that is the same
which quantity supplied equals quan- higher or lower indifference curve amount for every person
tity demanded
GLOSSARY 507
macroeconomics the study of monopolistic competition a mar- poverty line an absolute level of
economy-wide phenomena, including ket structure in which many firms income set by the federal government
inflation, unemployment, and eco- sell products that are similar but not for each family size below which a
nomic growth identical family is deemed to be in poverty
marginal changes small incremental monopoly a firm that is the sole poverty rate the percentage of the
adjustments to a plan of action seller of a product without close population whose family income falls
marginal cost the increase in total substitutes below an absolute level called the
cost that arises from an extra unit of moral hazard the tendency of a poverty line
production person who is imperfectly monitored price ceiling a legal maximum on
marginal product the increase in to engage in dishonest or otherwise the price at which a good can be sold
output that arises from an additional undesirable behavior price discrimination the business
unit of input practice of selling the same good at
marginal product of labor the different prices to different customers
Nash equilibrium a situation in
increase in the amount of output from which economic factors interacting price elasticity of demand a measure
an additional unit of labor with one another each choose their of how much the quantity demanded
marginal rate of substitution the best strategy given the strategies that of a good responds to a change in
rate at which a consumer is willing to all the other factors have chosen the price of that good, computed as
trade one good for another the percentage change in quantity
natural monopoly a monopoly that
demanded divided by the percentage
marginal revenue the change in total arises because a single firm can supply
change in price
revenue from an additional unit sold a good or service to an entire market
at a smaller cost than could two or price elasticity of supply a measure
marginal tax rate the extra taxes paid
more firms of how much the quantity supplied
on an additional dollar of income
of a good responds to a change in
market a group of buyers and sellers negative income tax a tax system the price of that good, computed as
of a particular good or service that collects revenue from high-income the percentage change in quantity
households and gives subsidies to supplied divided by the percentage
market economy an economy that
low-income households change in price
allocates resources through the decen-
tralized decisions of many firms and normal good a good for which, other price floor a legal minimum on the
households as they interact in markets things equal, an increase in income price at which a good can be sold
for goods and services leads to an increase in demand
principal a person for whom another
market failure a situation in which a normative statements claims that person, called the agent, is performing
market left on its own fails to allocate attempt to prescribe how the world some act
resources efficiently should be
prisoners’ dilemma a particular
market power the ability of a single oligopoly a market structure in “game” between two captured prison-
economic actor (or small group of which only a few sellers offer similar ers that illustrates why cooperation is
actors) to have a substantial influence or identical products difficult to maintain even when it is
on market prices opportunity cost whatever must be mutually beneficial
maximin criterion the claim that the given up to obtain some item
private goods goods that are both
government should aim to maximize excludable and rival in consumption
the well-being of the worst-off person perfect complements two goods
in society producer surplus the amount a seller
with right-angle indifference curves is paid for a good minus the seller’s
median voter theorem a mathemati- perfect substitutes two goods with cost of providing it
cal result showing that if voters are straight-line indifference curves
choosing a point along a line and each production function the relationship
permanent income a person’s nor- between the quantity of inputs used
voter wants the point closest to his
mal income to make a good and the quantity of
most preferred point, then majority
rule will pick the most preferred point political economy the study of gov- output of that good
of the median voter ernment using the analytic methods of production possibilities frontier a
economics graph that shows the combinations of
microeconomics the study of how
households and firms make decisions positive statements claims that output that the economy can possibly
and how they interact in markets attempt to describe the world as it is produce given the available factors of
production and the available produc-
tion technology
508 GLOSSARY
productivity the quantity of goods signaling an action taken by an Tragedy of the Commons a parable
and services produced from each unit informed party to reveal private infor- that illustrates why common resources
of labor input mation to an uninformed party are used more than is desirable from
profit total revenue minus total cost social insurance government policy the standpoint of society as a whole
aimed at protecting people against the transaction costs the costs that par-
progressive tax a tax for which high-
risk of adverse events ties incur in the process of agreeing to
income taxpayers pay a larger fraction
of their income than do low-income strike the organized withdrawal of and following through on a bargain
taxpayers labor from a firm by a union
property rights the ability of an substitutes two goods for which an union a worker association that
individual to own and exercise control increase in the price of one leads to an bargains with employers over wages,
over scarce resources increase in the demand for the other benefits, and working conditions
proportional tax a tax for which substitution effect the change in utilitarianism the political philoso-
high-income and low-income taxpay- consumption that results when a phy according to which the gov-
ers pay the same fraction of income price change moves the consumer ernment should choose policies to
along a given indifference curve to maximize the total utility of everyone
public goods goods that are neither a point with a new marginal rate of in society
excludable nor rival in consumption substitution utility a measure of happiness or
sunk cost a cost that has already satisfaction
quantity demanded the amount of a been committed and cannot be
good that buyers are willing and able recovered
to purchase value of the marginal product the
supply curve a graph of the relation- marginal product of an input times the
quantity supplied the amount of a ship between the price of a good and price of the output
good that sellers are willing and able the quantity supplied
variable costs costs that vary with
to sell supply schedule a table that shows
the quantity of output produced
the relationship between the price of a
good and the quantity supplied vertical equity the idea that taxpay-
rational people people who ers with a greater ability to pay taxes
systematically and purposefully do surplus a situation in which quan-
should pay larger amounts
the best they can to achieve their tity supplied is greater than quantity
objectives demanded
regressive tax a tax for which welfare government programs that
high-income taxpayers pay a smaller tariff a tax on goods produced supplement the incomes of the needy
fraction of their income than do low- abroad and sold domestically welfare economics the study of
income taxpayers tax incidence the manner in which how the allocation of resources affects
rivalry in consumption the property the burden of a tax is shared among economic well-being
of a good whereby one person’s use participants in a market willingness to pay the maximum
diminishes other people’s use total cost the market value of the amount that a buyer will pay for a
inputs a firm uses in production good
scarcity the limited nature of total revenue (for firm) the amount world price the price of a good that
society’s resources a firm receives for the sale of its output prevails in the world market for that
good
screening an action taken by an total revenue (in a market) the
uninformed party to induce an amount paid by buyers and received
informed party to reveal information by sellers of a good, computed as the
shortage a situation in which quan- price of the good times the quantity
tity demanded is greater than quantity sold
supplied
Index
Note: Page numbers in boldface refer to public price fixing, 380 neuro-economics, 498–499
pages where key terms are defined. resale price maintenance, 380–381 psychology of savings, 499–500
Sherman Antitrust Act, 378 Belichick, Bill, 33
tying, 383 Benefits principle, 254
A Arbitrage, 327–328 Benham, Lee, 357
Ability, wages and, 416, 418 Arms race, as prisoners’ dilemma, Benmelech, Efraim, 420
Ability-to-pay principle, 254 373–374 Bentham, Jeremy, 442
Absolute advantage, 54 Arrow, Kenneth, 491 Bernasek, Anna, 98
Absolute value, 91 Arrow’s impossibility theorem, 491, 491 Berrebi, Claude, 420
Accidents, associated with driving, 211 Assumptions, 23 Bertrand, Marianne, 424
Accountants, vs. economists and oppor- Asymmetric information, 484–489 Biddle, Jeff, 418
tunity costs, 269 adverse selection, 485–486 Black Death, 409
Accounting profit, 270 moral hazard, 484–485 Blacks
Adverse selection, 485, 485–486 public policy and, 489 poverty and, 438
Advertising, 355–360 screening to induce information revela-
Blank, Rebecca, 450–451
brand names, 359–360 tion, 488
Bloomberg, Michael, 234–235
critique of, 356 signaling to convey information, 487–488
Borda count, 491
defense of, 356–357 AT&T, 332
Bossaerts, Peter, 498
Galbraith vs. Hayek on, 358 Auerbach, Alan, 170
Botswana
price of eyeglasses and, 357 Aumann, Robert, 377
elephant poaching, 237
signaling theory of, 419, 487 Automobile industry
as sign of quality, 357–359 adverse selection and, 485
Bounded rationality, 495
Affluent Society, The (Galbraith), 358 safety laws, 7–8 Brand names, 359–360
Agent, 484 Average fixed cost, 276, 283 Braniff Airways, 379
Agriculture Average fixed cost curve, 277, 279 Brazil
price controls in Venezuela, 122–123 Average revenue, 291 income inequality in, 436
price stability policy, 494–495 tax burden in, 243
Average tax rate, 252
supply, demand and elasticity, Average total cost, 276, 283 Broadway shows and price discrimina-
103–105 related to marginal cost, 278 tion, 330–331
Airline industry, price discrimination in short-run vs. long-run, 280–281 Brodsky, Richard, 235
in, 329–330 Average total cost (ATC) curve, 277, Broken window fallacy, 15
Akerlof, George, 484 278, 279 Budget constraint, 458
Alkire, Caroline, 37 Average variable cost, 276, 283 consumer choice and, 458–459
Alm, Richard, 439–440 Average variable cost (AVC) curve, 277, Budget deficit, 246
American Airlines, 379 279 growing healthcare costs and elderly
Anarchy, State, and Utopia (Nozick), 444 Axelrod, Robert, 376–377 population, 246–248
Antipoverty programs, 445–451 size of, 246
fighting, as public good, 229–230 Budget surplus, 246
in-kind transfers and, 447–449 B Bush, George W.
minimum-wage laws, 446 Ball, Laurence, 509 tax cuts under, 259–260
negative income tax, 447 Barboza, David, 59 Business cycle, 15
welfare and, 446–447 Bar graph, 40–41 Buyers. See also Customers
work incentives and, 449–451 Barriers to entry, sources of, 312 number of, and shifts in demand, 71
Antitrust laws, 332–333, 378–384 Barry, Dave, 494=495 taxes on, effect on market outcome, 125–127
Clayton Antitrust Act, 378–379 Beauty, wages and, 418–419
controversies over, 379–383
Microsoft case, 383–384
Behavioral economics, 494, 494–500 C
deviations from rationality, 495–496
oligopolies and, 378–379 fairness and, 497 Camerer, Colin F., 499
predatory pricing, 381–382 inconsistency over time, 497–500 Campoy, Ana, 83
509
510 INDEX
Canada Comparative advantage, 54–59, 55 interest rates and household savings,

income inequality in, 436 absolute advantage, 54 477–479
labor tax, 170 applications of, 57–59 marginal rate of substitution, 460
multilateral approach to free trade, opportunity cost and, 54–55 optimization and. See Optimization
192–193 trade and, 55–56 perfect complements, 463–464
NAFTA, 192 world price and, 179 perfect substitutes, 463
tax burden in, 243 Compensating differentials, 414, 423 preferences, 459–464
Cap-and-trade system, 217 Competition price changes and, 467–468
Capital, 406 imperfect, 346 . See also Monopolistic substitution effect, 468–470
cost of, as opportunity cost, 269–270 competition; Oligopoly Consumer surplus, 138–142, 139
equilibrium in markets for, 406–407 markets and, 66–67 efficiency and, 148–149
human, 414–416, 415 perfect, 66–67 equilibrium and, 148–150
Capital income, 408 perfect vs. monopolistic, 351–352, 361 as measure of economic well-being,
Capone, Al, 241 unfair-competition argument for trade 141–142
Carbon tax, 216–217 restriction, 191 measuring with demand curve, 139–140
Carnegie, Andrew, 476 Competitive firms raising of, by lowering price, 140–141
Cartel, 367. See also Organization of labor demand of, 393–396 willingness to pay, 138–139
Petroleum Exporting Countries long-run decision to exit or enter market, Consumption. See also Consumer choice
298–299 rival in, 226
(OPEC)
OPEC as, 373 marginal-cost curve and supply decision, Consumption tax, 251
public price fixing, 380 293–295 Cooperation
reasons for cooperation, 376 measuring profit graphically, 299–300 prisoners’ dilemma and, 370–378
Cause and effect, 46–48 vs. monopoly, 315–316, 337 reasons for, 376
Centrally planned economies, 9, 150. profit maximization, 292–295 Coordinate system, 41–46
revenue of, 290–292 Coordination problems, diseconomies of
See also specific countries
short-run decision to shut down, 295–297 scale and, 281
Chamberlin, Edward, 360
sunk costs and, 296–298 Copyright laws, 314
Chance, wages and, 416, 418 supply decision of, 293–295
Chávez, Hugo, 122–123 Corporate income tax, 244–245
Competitive markets, 66, 290, 290–306, burden of, 257
Child labor, poverty and, 448–449 347–348. See also Price takers
Chile, unilateral approach to free Corporations, moral hazard and,
characteristics of, 290 484–485, 486
trade, 192 demand shifts in long and short run,
China Corrective tax, 210
303–306 gas tax as, 211–212
cap-and-trade system, 217 firms in. See Competitive firms
carbon tax, 217 Correlation, positive and negative, 42
market supply with entry and exit,
free trade and wages, 193 Cost-benefit analysis, 231
301–302
game-playing factories, 59 Cost curves, 277–279
market supply with fixed number of
income inequality in, 436 shape of, 276–278
firms, 301
“Permanent Normal Trade Relations” total-cost, production function and,
supply curve in, 300–306
status for, 194 272–273
upward sloping long-run supply curve
Choice. See Consumer choice; typical, 278–279
in, 304–306
Optimization Cost(s), 143
zero economic profit and, 302–303
Circular-flow diagram, 24, 24–25 economies of scale and. See Diseconomies
Complements, 70
of scale; Economies of scale
Clayton Antitrust Act, 332, 378–379 cross-price elasticity of demand, 99
explicit, 269, 283
Clean Air Act, 37, 214 perfect, 463–464
fixed, 274, 276, 283
Clean air and water, as common Concentration ratio, 346 implicit, 269, 283
resource, 233–234 Condorcet, Marquis de, 490 marginal. See Marginal cost
Clinton, Bill, 450 Condorcet paradox, 490, 490 measures of, 274–279
taxes, 259–260 Congestion opportunity. See Opportunity cost
Coase, Ronald, 217 common resource and, 234–236 producer surplus and, 143–144
Coase theorem, 217, 217–219 congestion pricing, 234–235 production and, 271–273
Collusion, 367 gasoline tax and, 211 in short- and long-run, 280–281
Colum, Mary, 433 toll roads and, 235 social, 206–207
Command-and-control policy, 209–210 Congestion pricing, 234–235 sunk, 296, 296–297
Common resources, 227, 232–237 Congressional Budget Office, 31 total, 268, 276, 283
clean air and water, 233–234 Constant returns to scale, 281 transaction, 219
congested roads and, 234–236 Consumer choice, 457–479 variable, 275, 276, 283
importance of property rights, 237 budget constraints, 458–459 Council of Economic Advisers, 31, 32–33
prisoners’ dilemma and, 374–375 consumer’s optimal choices, 464–466 Cowen, Tyler, 441, 498–499
Tragedy of the Commons, 232–233 demand curve derivation, 470–471 Cox, Michael, 439–440
wildlife as, 236 Giffen goods, 472–473 Crandall, Robert, 379
Communism, collapse in Soviet Union income changes and, 466–467 Cross-price elasticity of demand, 99, 99
and Eastern Europe, 8–9 income effect and, 468–470
INDEX 511
Cummins, Vincent, 334–335 income, 97, 99 green, 37

Curves, 42–44. See also specific curves price, 90, 90–99 as policy adviser, 30–33
movement along, 43–44 Demand schedule, 67 as scientist, 22–30
shifts of, 43–44 Derived demand, 392 Edmonds, Eric V., 448–449
slope of, 44–46 Developed countries Education. See also Human capital
Customers, labor-market discrimination, free trade and wages, 192–193 cost of college, 5–6
426–428 Developing countries as human capital view of, 415–416
free trade and wages, 192–193 as positive externality, 207
Diminishing marginal product, 273, 394 signaling theory of, 419, 487
D Diminishing marginal utility, utilitarian- state and local spending for, 249
Davies, Kert, 37 ism and, 442 terrorists and, 420
Deadweight loss, 160–172, 163 Discount coupons, 330 wages and, 415–416
changes in welfare and, 161–163 Discrimination, 422 Edwards, John, 189
determinants of, 164–167 by customers and governments, 426–428 Efficiency, 5, 147, 147–154
elasticity and, 164–166 by employers, 424–426 government intervention and, 11–12
gains from trade, 163–164 in labor market, 422–428 market equilibrium and, 148–152
labor tax, 166–167 price. See Price discrimination market failure and, 152, 154
of monopoly, 323–325 profit motive and, 424–426 market for human organs and, 150, 152
of tariff, 184–185 in sports, 428 monopoly and, 323–325
tax effects on market participants and, Diseconomies of scale, 281 production possibilities frontier and,
161–163 26–27
Distribution, neoclassical theory of, 409
of taxes, 250 taxes and, 249–253
Dividends, 408
tax revenue and, 167–171 ticket scalping and, 151
Dominant strategy, 371
DeBeers, 313 total surplus and, 147–148
Double taxation, 245
Deficits Efficiency wages, 422
Drug interdiction, supply, demand and
budget. See Budget deficit Efficient scale, 278, 302, 352
elasticity, 106–108
Demand, 67–72. See also Equilibrium Effort, wages and, 416, 418
changes in, 79
Duopoly, 366
Einstein, Albert, 22
decrease in, 69, 70 Elastic demand, 90, 93
elastic, 90, 93 E Elasticity, 89–108, 90
elasticity of. See Demand elasticity applications of, 102–108
Earned Income Tax Credit (EITC), 123,
equilibrium of supply and demand, deadweight loss and, 164–166
447
77–82 of demand. See Demand elasticity
excess, 78
Economic growth
production possibilities frontier and, 28 income elasticity of demand, 97, 99
expectations and, 71 of supply, 99–102
income changes, 70 Economic mobility, 440
tax incidence, 128–130
increase in, 69, 70 Economic models, 23–28. See also specific
Elastic supply, 100, 101
individual, 68–69 models
Electricity
inelastic, 90, 93 Economic profit, 270
price elasticity of demand, 98
for labor. See Labor demand market entry and, 301–302
Elephant
law of, 67 Economic Report of the President, 31
as common resource, 236–237
market, 68–69 Economics, 4
Employers, labor-market discrimination
number of buyers and, 71 environmental, 37
reasons for studying, 14–15
by, 424–426
perfectly elastic, 93, 94
Economic welfare Employment
perfectly inelastic, 93, 94
moral hazard, 484–485
price of related goods and, 70 advertising and, 356–357
outsourcing, 187, 189, 192
reducing smoking, 71–72 consumer surplus as measure of, 141–142
relationship between price and quantity externalities and, 205–209 England. See Great Britain; United
demanded, 67–68 gains and losses from international trade, Kingdom
shifts in long and short run, in competi- 180–183 Enron, 486
tive markets, 303–306 monopolies and, 322–326 Entry/exit into industry
taste and, 70 monopolistic competition and, 352–354 barriers to entry, 312–315
Demand curve, 42–44, 67–71, 68 tax effect on, 161–163 competitive markets and, 290
derivation of, 470–471 Economies long-run decision to, 298–299
measuring consumer surplus using, centrally planned, 9 market supply in long run with,
139–140 market, 9–10 301–302
price elasticity of demand and, 92–94 Economies of scale, 281 monopolistic competition and, 347
shifts in, 69–71, 303–306 international trade and, 188 Environmental Defense, 37
slope of, 472 monopoly and, 314–315 Environmental economics, 37
Demand elasticity, 90–99 Economist Environmental Protection Agency (EPA),
applications of, 102–108 vs. accountants and opportunity costs, 37, 210, 212–214
cross-price elasticity of demand, 99 269 Equality, 5, 148
deadweight loss and, 164–166 disagreement among, 34–36 government intervention and, 12
512 INDEX
Equilibrium, 77, 77–82 Fair Labor Standards Act, 119 prisoners’ dilemma, 370–378
analyzing changes in, 79–82 Fairness, behavioral economics and, 497 reasons for cooperation, 376
efficiency and, 148–152 Fair trade, 380–381 tit-for-tat strategy, 377–378
in labor market, 400–404 Farming Gasoline. See Oil industry
in markets for land and capital, 406–407 farm subsidies, 494–495 Gas tax
monopolistic competition in long-run, supply, demand and elasticity, 103–105 benefits principle and, 254
348–351 Farm Security Act, 494–495 as corrective tax, 211–212
Nash equilibrium, 368–369 Federal government, 243–248 road congestion and, 211, 234–236
for oligopoly, 368–369 budget of. See Budget entries Gates, Bill, 383–384
without international trade, 178–179 receipts, 243–245 Gender. See also Women
Equilibrium price, 77 spending, 245–246 competitive work environments, 426–427
Equilibrium quantity, 77 Federal Reserve System (Fed), 31 labor-market discrimination based on,
Equity Feldstein, Martin, 216 422–423
horizontal, 254 FICA (Federal Insurance Contribution General Agreement on Tariffs and Trade
taxes and, 253–260 Act), 127 (GATT), 192–193
vertical, 254 Financial aid, 331 George, Henry, 169
Excess capacity of monopolistic competi- Firms Germany
tion, 351–352 in circular-flow diagram, 24–25 income inequality in, 436
Excise taxes, 245 competitive. See Competitive firms inflation in, 13
Excludability, 226 labor demand of. See Labor demand labor tax, 170
Expectations monopolistically competitive. See outsourcing, 189
shifts in demand and, 71 Monopolistic competition tax burden in, 243
shifts in supply curve related to, 76 monopoly. See Monopoly Giffen, Robert, 472
Experience number of, and market structure, 347 Giffen good, 472
terrorists and, 420 Fisher, Franklin, 383 Gifts, as signals, 487–488
Explicit costs, 269, 283 Fixed costs, 274, 283 Goods, 70
Exports, 58. See also International trade average, 276 complements, 70
gains and losses of exporting countries, Flows, international. See Exports; excludability of, 226
180–181 Imports; International trade Giffen, 472
Externalities, 11, 152, 203–219, 204 Food Stamp program, 229, 245, 448 inferior, 70, 467
carbon tax, 216–217 Ford, Gerald, 13 markets for, 24–25
Coase theorem, 217–219 401(k) plans, 251 normal, 467
command-and-control policy, 209–210 default enrollment for, 496, 500 price of related, and demand, 70
corrective taxes and subsidies, 210–212 private, 226
France
free-rider problem, 228 public, 226, 226–230
labor tax and, 170
gas tax and, 211–212 rivalry of, 226
tax burden in, 243
importance of property rights and, 237 substitutes, 70, 90
Franklin, Benjamin, 241
internalizing, 207 Goolsbee, Austan, 9, 420
Free rider, 228
market inefficiency and, 204–209 Goulder, Lawrence, 37
Free trade, 57
monopolistic competition and market Government
benefits of, 192–194
entry, 353 benefits of, 10–12
multilateral approach, 192–194
negative, 204, 205–207 . See also Pollution federal, 243–248
multilateral approach to, 192–194
positive, 204, 207–208 labor-market discrimination, 426–428
outsourcing, 187, 189, 192
private solutions to, 215–219 local, 242, 248–249
unilateral approach, 192
public policies toward, 209–215 monopolies created by, 313–314
wages and, 192–193
technology spillovers and, 208–209 Government policy. See also Public policy
tradable pollution permits, 212–214
Friedman, Milton, 354
for externalities, 209–215
Tragedy of the Commons, 232–233 price ceilings, 114–118
transaction costs and, 219 G price floors, 118–123
Gains from trade Government spending
F comparative advantage, 54–59 budget deficit and challenges ahead,
deadweight losses and, 163–164 246–248
Factor markets, 392–409 by federal government, 245–246
of exporting countries, 180–181
for labor. See Labor entries Graphs, 40–48
of importing countries, 181–183
Factors of production, 24–25, 392. See also cause and effect, 46–48
production possibilities frontier, 50–54
Capital; Labor curves and, 42–44
specialization, 55–56
demand for labor, 392–399 measuring profit by, 299–300
Galbraith, John Kenneth, 358
equilibrium in labor market, 400–405 of single variable, 40–41
land and capital, 405–409
Gallegos, Raul, 122–123
Game-playing factories, 59 slope of, 44–46
linkages among, 407–409 of two variables, 41–42
neoclassical theory of distribution, 409 Game theory, 365, 370–378
dominant strategy, 371 Great Britain
productivity and wages, 404–405 unilateral approach to free trade, 192
supply of labor, 399–400 Noble Prize and, 377
INDEX 513
Green economists, 37 Income effect, 468, 468–470 Inputs. See Factors of production; specific
Greenpeace, 37 interest rates, 478–479 factors of production
Greenspan, Alan, 251 labor supply and, 476 An Inquiry into the Nature and Causes
“Guns and butter” tradeoff, 4 Income elasticity of demand, 97, 97, 99 of the Wealth of Nations (Smith), 10,
Income inequality, 433–451. See also 57, 282
Poverty Insurance
H economic mobility, 440 adverse selection, 485–486
Hamermesh, Daniel, 418 poverty rate and, 437–439 moral hazard, 485
Hastert, Dennis, 189 problems in measuring, 438–440 screening and, 488
Hayek, Frederic, 358 redistributing income, 442–445 social. See Social insurance; Social
Hayek, Friedrich, 498 rise in, 435, 439–440, 441 Security; Welfare programs
Healthcare costs in United States, 434–435, 436 Interest, 408
budget deficit and, 246–248 worldwide, 435–436 Interest rate(s)
Helium market, 83 Income redistribution, 442–445 household savings and, 477–479
Hemingway, Ernest, 433 liberalism, 443–444 income effect, 478–479
Hilsenrath, Jon E., 377 libertarianism, 444–445 substitution effect, 478–479
Hispanics, poverty rate and, 438 maximin criterion, 444 Internalizing the externality, 207
Holmes, Oliver Wendell, Jr., 159 utilitarianism and, 442–443 International trade, 177–195
Hong Kong Income tax. See also Tax entries benefits of, 186, 188
free trade and wages, 193 negative, 447 comparative advantage. See Comparative
Horizontal equity, 254, 254, 256 India advantage
Households income inequality in, 436 determinants of, 178–179
in circular-flow diagram, 24–25 tax burden in, 243 effect of tariff on, 183–185
decisions faced by, 3 Indifference curve, 460, 460–464 equilibrium without, 178–179
Houser, Daniel, 499 income effect, 469–470 free trade, 192–194
perfect complements, 463–464 gains and losses of exporting countries,
Housing
perfect substitutes, 463 180–181
rent control, 117–118, 122–123
preferences and, 460–461 gains and losses of importing countries,
Human capital, 414–416, 415
properties of, 461–462 181–183
education as, 415–416
substitution effect, 469–470 multilateral approach to free trade,
Individual demand, 68–69 192–194
I vs. market demand, 68–69 outsourcing, 187, 189, 192
Immigration Individual income tax. See also Tax restriction on. See Trade restrictions
economic effect of, 402–403 entries trade agreements and trade organiza-
size of immigration population, 402 as revenue source for federal govern- tions, 192–195
Immigration, changes in and labor ment, 244 trade policy and, 185–186
supply, 400 Individual Retirement Accounts (IRA), of United States, 58–59
251 world price and, 179
Imperfect competition, 346. See also
Monopolistic competition; Oligopoly Individual supply, vs. market supply, Intuit, 312, 332
Implicit cost, 269, 283 73–74 Invisible hand, 10–11, 150, 153
cost of capital as, 269–270 Industrial organization, 267–268 Israel, labor supply shift in, 402
Import quota, 36 Industrial policy, 209 Italy
compared to tariff, 185 Industries. See specific industries labor tax, 170
Imports, 58. See also International Inefficiency
trade externalities and, 204–209 J
gains and losses of importing monopolistic competition and, 353
Inelastic demand, 90, 93 Jackson, Penfield, 384
countries, 181–183
Inelastic supply, 100, 101 Jacoby, Jeff, 153
Incentives, 7, 7–8
Inequality James, LeBron, 7
brand names, 360
alternative measures of, 439–440 Japan
incentive pay, 9
income inequality in, 436
Income Infant-industry argument for trade
labor tax, 170
capital, 408 restriction, 190–191
Jobs argument for trade restriction,
consumer choice and, 466–467 Inferior good, 70, 467
distribution of tax burden and, income change and, 466–467
188–190
255–256 income elasticity of demand, 97, 99
incentive pay, 9 Inflation, 12, 13–14 K
life cycle, 439 tradeoff with unemployment, 14–15
Kennedy, John F., 437
permanent, 439 Information, asymmetric. See Kenya
shifts in demand and, 70 Asymmetric information elephant poaching, 237
tax rate and, 244 In-kind transfers, 438 Kernan, Joseph, 189
Income distribution. See Income inequal- measuring inequality and, 438–439
Kerry, John, 189
ity; Income redistribution; Poverty reducing poverty and, 447–449
514 INDEX
Keynes, John Maynard, 31 Lindsay, Alistair, 380 definition of, and price elasticity of
Knutson, Brian, 498 Livingstone, Ken, 235 demand, 91
Kolbert, Elizabeth, 234–235 Local government for factors of production, 24–25
Krugman, Paul, 192–193 receipts of, 242, 248–249 for goods and services, 24–25
Kuhnen, Camelia, 498 spending, 249 structure, 347–348
Kyoto treaty, 217 Long, Russell, 253 Market-based policy, 210–215
Long run Market demand, 68–69
costs in, 280–281 vs. individual demand, 68–69
L decision to exit or enter market, 298–299 Market economy, 9
Labor demand shifts in, 303–306 Market efficiency. See Efficiency
jobs argument for trade restriction, market supply with entry and exit, Market failure, 11. See also Externalities
188–190 301–302 efficiency and, 154
marginal product. See Marginal product rent control in, 117–118 insufficient variety as, 354–355
of labor Long run equilibrium, monopolistic Market power, 11, 152, 154
taxes on, 166–167, 170 competition, 348–351 Market structure
Labor demand, 392–399 Losses concentration ratio and, 346
competitive profit-maximizing firm, deadweight. See Deadweight loss overview of types, 347–348
393–396 of exporting countries, 180–181 Market supply
as derived demand, 392 of importing countries, 181–183 in competitive markets. See Competitive
minimum wage and, 120–121 Luddites, 398 markets
output price and, 397 Lump-sum tax, 253 vs. individual supply, 73–74
production function and marginal prod- Luxuries Markup, over marginal cost in monopo-
uct of labor, 393–395 income elasticity of demand, 99 listic competition, 352
shifts in, 397–399, 403–404 price elasticity of demand and, 90 Mass transit system, public vs. private,
technology and, 397–398 Luxury tax, 130 334–335
value of marginal product and, 395–396
Maximin criterion, 444, 444
Labor market McCabe, Kevin, 499
equilibrium in, 400–404 M McCain, John, 187, 260
immigration and economic effect, Macroeconomics, 28, 28–30 McDonald’s, 360
402–403 Malawi
loss of manufacturing jobs, 417
McTeer, Robert D., Jr., 14–15
elephant poaching, 237 Median voter theorem, 491–493, 492
minimum wage and, 119–121 Manufacturing jobs, loss of, 417
monopsony and, 406 Medicare/Medicaid, 244, 245, 448
Marginal benefit, 6 spending on and growing deficit,
productivity and wages, 404–405
Marginal changes, 6 246–248
Labor-market discrimination, 422–428 Marginal cost, 6, 276, 283
by customers and governments, 426–428 Medicare tax, 166, 170
marginal-cost pricing for natural monop- Metcalf, Gilbert, 216
by employers, 424–426
oly, 335–336 Mexico
measuring, 422–424
marginal product of labor and, 397 free trade and wages, 193
in sports, 428
markup over, in monopolistic competi- income inequality in, 436
Labor supply tion, 352
income effect and, 476 living standard in, 12
related to average total cost, 278 multilateral approach to free trade,
shifts in, 399–400, 400–402 rising, 277
wages and, 473–476 192–193
Marginal cost curve, 277, 279 Microeconomics, 28, 28–30
Labor tax firm’s supply decision and, 293–295
deadweight loss of, 166–167 Microsoft Corporation, 311–312, 332
Marginal product, 272, 394 antitrust suit against, 383–384
in various countries, 170
diminishing, 273, 394–395
Laffer, Arthur, 169–171 Midpoint method, for calculating price
value of, 395–396
Laffer curve, 171 elasticity of demand, 91–92
Marginal product of labor
Laissez-faire policy, 150 Mill, John Stuart, 354, 442
diminishing, 394–395
Land market, equilibrium in, 406–407 Miller, Peter, 122–123
marginal cost and, 397
Landsburg, Steven, 187 production function and, 393–395
Minimum wage
Land tax, 169 opponents/advocates of, 121
value of, demand for labor and, 395–396
Law of demand, 67 as price floor, 119–121
Marginal rate of substitution, 460,
Law of supply, 73 teenage employment and, 120–121
465–466
Law of supply and demand, 78 Minimum-wage laws, 421
marginal utility and, 465
reducing poverty and, 446
Leslie, Phillip, 330–331 Marginal revenue, 292
Liberalism, 443 Money supply
of monopoly, 317–318
inflation and, 13–14
income redistribution, 443–444 Marginal revenue product, 395
Libertarianism, 444 Monopolistic competition, 345–361, 346
Marginal tax rate, 244, 252, 252–253
advertising and, 355–360
income redistribution, 444–445 Marginal utility, preferences and, 465 characteristics of, 346–347
Life cycle, 439 Market(s), 66. See also specific markets excess capacity, 351–352
Lighthouses, as public good, 230 competitive. See Competitive markets long-run equilibrium, 348–351
INDEX 515
markup over marginal cost, 352 Negative correlation, 42 income effect and, 468–470
number of firms, 347 Negative externality, 204, 205–207 price changes and, 467–468
vs. perfect competition, 351–352, 361 Negative income tax, 447 substitution effect, 468–470
in short run, 348–349 poverty reduction and, 447 utility and, 465
welfare of society and, 352–354 Neoclassical theory of distribution, 409 Optimum, 465
Monopoly, 67, 311–338, 312, 347–348 Neuroeconomics, 498–499 Ordered pair, 41
antitrust laws, 332–333 Newton, Isaac, 22 Organization of Petroleum Exporting
barriers to entry and, 312–315 Niederle, Muriel, 426–427 Countries (OPEC)
vs. competitive firm, 315–316, 337, 361 Nigeria failure to keep oil prices high,
deadweight loss, 323–325 income inequality in, 436 105–106
economies of scale and, 314–315 living standard in, 12 formation of, 373
efficiency and, 323–325 nations in, 373
Nike, 354, 355
government-created, 313–314 oil price increases and price ceiling,
Normal good, 70, 467
lack of supply curve for, 320 116–117
income change and, 464–465
natural, 314, 314–315 world oil market and, 373
income elasticity of demand, 97, 99
number of firms, 347 Organs (human), market for, 150, 152
Normative statements, 30, 30–31
prevalence of, 338 Origin, of graph, 41
price and, 315–316, 317
North American Free Trade Agreement
(NAFTA), 192 Orrenius, Pia, 402–403
price discrimination. See Price Output effect, on oligopoly, 369
discrimination Nozick, Robert, 444–445
Output price, labor demand and, 397
profit maximization, 319–320
Outsourcing, 187, 189, 192
profit of, 319–321, 325–326 O
public ownership of, 336
reasons for, 312–315
Obama, Barack, 260 P
regulation, 333–336 Observation, 22–23
Oceans, as common resource, 236 Patent, 314, 321–322
resources and, 313
Oil industry Patent protection, 209
revenue of, 316–318
OPEC and keeping oil prices high, Pavcnik, Nina, 448–449
welfare costs of, 322–326
105–106 Payroll tax, 244
Monopsony, 406
OPEC and world oil market, 373 burden of, 127
Moral hazard, 484, 484–485
price ceilings and lines at pump, 116–117 Peltzman, Sam, 7–8
Movie industry, movie tickets as price
Oligopoly, 365, 365–384 Perception, vs. reality, 35–36
discrimination, 329
antitrust laws, 378–384 Perfect competition, 66–67
Mullainathan, Sendhil, 424 vs. monopolistic competition,
characteristics of, 346
Muskie, Edmund, 214 351–352, 361
competition and monopoly and, 366–367
concentration ratio, 346 number of firms, 347
N duopoly example, 366 Perfect complements, 464
Nader, Ralph, 7 equilibrium, 368–369 Perfectly elastic demand, 93, 94
NAFTA, 192
examples of, 346 Perfectly elastic supply, 100, 101
game theory and, 370–378 Perfectly inelastic demand, 93, 94
Namibia
number of firms, 347 Perfectly inelastic supply, 100, 101
elephant poaching, 237
OPEC as cartel, 373 Perfect price discrimination, 328
Nash, John, 368 predatory pricing, 381–382
Nash equilibrium, 368, 368–369 Perfect substitutes, 463
prisoners’ dilemma and, 372–373 Permanent income, 439
National defense public policy toward, 378–384
federal spending for, 245 Pharmaceutical drugs, monopoly vs.
public price fixing, 380
as public good, 228–229 generic drugs, 321–322
reasons for cooperation, 376
spending on, 228–229 Pie chart, 40
resale price maintenance, 380–381
National Highway Traffic Safety Pigou, Arthur, 216
size of, and market outcome, 369–370
Administration, 211 tying, 383
Pigovian taxes, 210, 216
National Institutes of Health, 229, 245 Omitted variable, causality and, 46–47 Political economy, 489, 489–493
National Science Foundation, 229 Arrow’s impossibility theorem, 491
OPEC. See Organization of Petroleum
National security argument for trade Condorcet paradox, 490
Exporting Countries (OPEC)
restriction, 190 median voter theorem, 491–493
Opportunity cost, 6, 54 politician’s behavior, 493
Natural disasters accountants vs. economists view of, 269
prices and, 84 Pollution. See also Externalities
comparative advantage and, 54–55
carbon tax, 216–217
Natural monopoly, 227, 314, 314–315, cost of capital as, 269–270
clean air and water as common resource,
334–335 explicit and implicit costs, 269
233–234
Natural resources production possibilities frontier and, 27
corrective taxes and, 210–212, 216
monopolies and, 313 Optimization, 464–471 as negative externality, 206–207
prisoners’ dilemma and, 374–375 consumer’s optimal choices, 464–466
regulation and, 209–210
Necessities, price elasticity of demand demand curve derivation, 470–471
tradable pollution permits, 212–214
and, 90 income changes and, 466–467
Positive correlation, 42
516 INDEX
Positive externality, 204, 207–208 Price effect, on oligopoly, 369 market entry/exit and, 301–302
technology spillovers, industrial policy Price elasticity of demand, 90, 90–99 measuring profit graphically, 299–300
and patent protection, 208–209 computing, 91–92 monopolistic competition, 350–351
Positive statements, 30, 30–31 cross-price elasticity of demand, 99 of monopoly, 319–321, 325–326
Postrel, Virginia, 448–449 demand curve and, 93, 94 Profit maximization
Poverty, 445–451 determinants of, 90–91 by competitive firms, 292–295
antipoverty programs and work incen- midpoint method for, 91–92 labor demand of competitive firms and,
tives, 449–451 total revenue and, 94–95 393–396
child labor and, 448–449 Price elasticity of supply, 99, 99–102 monopolistic competition and, 348–349
fighting, as public good, 229–230 computing, 100 monopoly, 319–320
in-kind transfers and, 438–439, 447–449 determinants of, 99–100 Progress and Poverty (George), 169
life cycle and, 439 supply curves and, 100–102 Progressive tax, 255
measuring, 438–440 Price fixing Property rights, 10, 10–11
minimum-wage laws, 4446 public price fixing and cartels, 380 importance of, and public goods, 237
negative income tax, 447 Price floor, 114, 118–123 over technology, 209
policies to reduce, 445–451 binding, 119 Property tax, 248
race, age and family composition, 438 evaluation of, 121–123 Proportional tax, 255
welfare and, 446–447 minimum wage as, 119–121 Protection-as-a-bargaining-chip argu-
Poverty line, 437 not binding, 119 ment for trade restriction, 191
Poverty rate, 437, 437–439 Price gougers, 84 Public good, 226, 226–230
Predatory pricing, 381–382 Price makers. See Monopoly antipoverty programs, 229–230
Preferences Price takers, 66, 180, 290. See also basic research as, 229
consumer choice and, 459–464 Competitive markets cost-benefit analysis, 230–231
insufficient variety, 354–355 Pricing free-rider problem, 228
marginal rate of substitution, 460 predatory pricing, 381–382 importance of property rights, 237
utility and, 465 tying, 383 lighthouses as, 230
Prescott, Edward, 170 Principal, 484 national defense as, 228–229
Price Principles of Political Economy and Taxation value of human life and, 231–232
advertising effect on, 357 (Ricardo), 57 Public ownership of monopoly, 336
consumer choice and, 467–468 Prisoners’ dilemma, 370, 370–378 Public policy. See also Antitrust laws;
equilibrium, 77 examples of, 373–375 Government policy; Regulation
higher prices, raising producer surplus, oligopoly as, 372–373 asymmetric information and, 489
145–146 reasons for cooperation, 376 externalities, 209–215
income effect and, 468–470 tit-for-tat strategy, 377–378 monopolies and, 332–337
input prices and supply, 74, 76 welfare of society and, 375–376 for oligopoly, 378–384
lower prices, to raise consumer surplus, Private goods, 226 Putnam, Howard, 379
140–141 Producer surplus, 143, 143–146
monopolistic competition and, 350–351
monopoly and, 315–316, 317
cost and willingness to sell, 143–144 Q
efficiency and, 148–149
natural disasters and, 84 equilibrium and, 148–150 Quality
output, and labor demand, 397 measuring with supply curve, 144–145 advertising as sign of, 357–359
purchase, for land or capital, 406–407 raising of, by higher prices, 145–146 Quantity, equilibrium, 77
quantity demanded and, 67–68 Production Quantity demanded, 67
quantity supplied and, 73 costs and, 271–273 change in, 80
relative, 459, 466 factors of. See Capital; Factors of produc- price and, 67–68
rental, for land or capital, 406–407 tion; Labor entries Quantity discounts, 331
shortage and, 78 Quantity supplied, 73
Production function, 271, 271–273, 394
substitution effect, 468–470 change in, 80
marginal product of labor and, 393–395
surplus and, 77–78 price and, 73
total-cost curve and, 272–273
willingness to pay, 138–139 Quotas, import, 185
Production possibilities frontier, 25–28,
world, 179
26
Price ceiling, 114, 114–118
binding, 114–115
gains from trade, 50–54 R
Productivity, 12
evaluation of, 121–123 Race
standard of living and, 13
lines at gas pump, 116–117 discrimination in sports and, 428
wages and, 404–405
not binding, 114–115 labor-market discrimination based on,
rationing and, 115
Products
422–424
advertising as sign of quality of, 357–359
rent control, 117–118 poverty and, 438
brand names, 359–360
Venezuela, 122–123 streetcar segregation and, 425–426
Price discrimination, 326, 326–331 Profit, 268
accounting, 270
Rationality, deviations from, 495–496
analytics of, 328–329 Rational people, 6
discrimination and, 424–426
examples of, 329–331 Rationing, price ceiling and, 115–118
economic, 270
perfect, 328 Rawls, John, 443
INDEX 517
Reagan, Ronald, 34 Scientific method, 22–23 Specialization

taxes, 171, 258–259 Screening, 488 economies of scale and, 281, 282
Reality, perception versus, 35–36 Segregation, streetcars and profit trade and, 52–54
Regressive tax, 255 motive, 425–426 Spence, Michael, 484
Regulation Sellers Spitzer, Eliot, 235
of externalities, 209–210 number of, and shifts in supply curve Sports, labor-market discrimination in, 428
monopoly, 333–336 related to, 76 Standard of living
Reich, Robert B., 417 taxes on, effect on market outcome, determinants of, 12–13
Reiss, Peter C., 98 124–125 State government
Relative price Services, markets for, 24–25 receipts of, 242, 248–249
budget constraint and, 459, 466 Shaw, George Bernard, 34 spending, 249
Rent control, 36 Sherman Antitrust Act, 332, 378 Stein, Charles, 151
in short and long run, 117–118 Shortage, 78 Stewart, Wayne, 33
Rent subsidies, 122–123 price ceiling, 114–115, 117, 118 Stigler, George, 337
Resale price maintenance, 380–381 Short run Stiglitz, Joseph, 484
Research, basic, as public good, 229 competitive firm’s decision to shutdown, Stockman, David, 171
Resources 295–296 Stossel, John, 84
common, 227, 232–237 costs in, 280–281 Strike, 421
monopolies and, 313 demand shifts in, 303–305 Substitutes, 70
prisoners’ dilemma and, 374–375 market supply with fixed number of cross-price elasticity of demand, 99
scarcity of, 3 firms, 301 marginal rate of substitution, 460
Revenue monopolistically competitive firm in, perfect, 463
average, 291 348–349 price elasticity of demand and, 90
of competitive firms, 290–292 rent control in, 117–118 Substitution effect, 468, 468–470
marginal, 292 Shutdown, short-run decision to, interest rates and, 478–479
of monopoly, 316–318 295–297 wages and, 474, 476
tax, and deadweight loss, 167–171 Sierra Club, 215 Sunk cost, 296, 296–297
total. See Total revenue Signaling, 487 Supplemental Security Income (SSI), 446
Reverse causality, 47–48 advertising as, 419, 487 Supply, 73–76. See also Equilibrium
Rhodes, Cecil, 313 to convey information, 487–488 changes in, 80–81
Ricardo, David, 57 education as, 419, 487 decrease in, 74, 75
Rivalry in consumption, 226 gifts as, 487–488 elastic, 100, 101
Road congestion Simon, Herbert, 495 elasticity of, 99–102
common resource and, 234–236 Singapore equilibrium of supply and demand,
congestion pricing, 234–235 free trade and wages, 193 77–82
gasoline tax and, 211, 235–236 Slope, 44–46 excess, 77–78
toll roads and, 235 Smith, Adam, 10, 11, 57, 84, 153, expectations and, 76
Road to Serfdom, The (Hayek), 358 282, 379 increase in, 74, 75
Roback, Jennifer, 425–426 Smith, Vernon, 499 individual, 73–74
Rolnick, Arthur, 170 Smoking, reducing, 71–72 inelastic, 100, 101
Romer, David, 32–33 Social Choice and Individual Values input prices and, 74, 76
Romney, Mitt, 187 (Arrow), 491 of labor. See Labor supply
Russia Social costs, of externalities, 206–207 law of, 73
income inequality in, 436 Social insurance, 444 marginal-cost curve and firm’s supply
tax burden in, 243 decision, 293–295
Social insurance tax, 244
Ryan, Lee, 499 market, 73–74
Social Security
number of sellers, 76
federal spending for, 245–246
perfectly elastic, 100, 101
spending on and growing deficit,
S 246–248
perfectly inelastic, 100, 101
Sales tax, 248 relationship between price and quantity
taxes for, 166, 170, 244
Satisficers, 495 supplied, 73
Society
Saving technology and, 76
decisions faced by, 3
interest rates and household, 477–479 Supply and demand, law of, 78
monopolistic competition and welfare
psychology of, 499–500 of, 352–354
Supply curve, 73, 73–76
tax disincentive toward, 251 in competitive market, 300–306
prisoners’ dilemma and welfare of,
Scarcity, 3 lack of, for monopoly, 320
375–376
Scatterplot, 41 long-run, upward-sloping, 304–306
South Africa, income inequality in, 436
measuring producer surplus with,
Schaller, Bruce, 234 South Korea
144–145
Schelling, Thomas, 377 free trade and wages, 193
price elasticity of supply, 100–102
Schmalensee, Richard, 383 unilateral approach to free trade, 192
shifts in, 74–76, 80
Scientific judgment, differences among Soviet Union, Cold War and arms race, shifts in vs. movement along, 79–80
economists in, 34 373–374
518 INDEX
Supply elasticity, 99–102 sales, 248 Trade restrictions

applications of, 102–108 on sellers, effect on market outcome, effects of tariff, 183–185
deadweight loss and, 164–166 124–125 import quotas, 185
Supply schedule, 73 social insurance, 244 infant-industry argument, 190–191
Supply-side economics, 171 tariff, 184–185 jobs argument for, 188–190
Surplus, 77 tax reform in 2005, 258–259 national security argument, 190
consumer. See Consumer surplus value-added, 251 protection-as-a-bargaining-chip
price floor, 119, 120 vertical equity, 254–255 argument, 191
producer. See Producer surplus Tax incidence, 124 tariffs, 36, 183–185
total surplus and efficiency, 147–148 elasticity and, 128–130 unfair-competition argument, 191
Sweden flypaper theory of, 257 Traffic
tax rate in, 171, 243 tax equity and, 256–257 congestion and common resource,
Synergies, 332 Tax liability, 244 234–236
Tax rate congestion pricing, 234–235
average, 252 Tragedy of the Commons, 232,
T marginal, 244, 252, 252–253 232–233
Taiwan Technology Transaction costs, 219
free trade and wages, 193 earnings between skilled and unskilled Transfer payment, 245, 249
Tanzania workers and, 416 Transitivity, 490
elephant poaching, 237 labor demand and changes in, 397–398 Transportation
Tariffs, 183 productivity and, 405 incentive pay for bus drivers, 9
compared to import quotas, 185 supply curve shifts and, 76 Transport Workers Union, 335
deadweight loss of, 184–185 Technology spillovers, 208–209 Trouard, Theodore, 499
effects of, 183–185 Teenage employment, minimum wage Truman, Harry, 31
Tastes. See also Preferences and, 120–121 Tyco, 486
changes in and labor supply, 400 Temporary Assistance for Needy Tying, 383
shifts in demand and, 70 Families (TANF), 229, 245, 446 Tyranny of the Market, The (Waldfogel),
Taxes, 123–130, 159–172 Terrorist 354
ability-to-pay principle, 254–255 education and experience, 420
administrative burden of, 251–252 Textile industry, 177
avoidance, 252 Theory, 22–23 U
benefits principle, 254 A Theory of Justice (Rawls), 443 Uganda
on buyers, effect on market outcomes, Ticket scalping, 151 elephant poaching, 237
125–127 Tierney, John, 334–335 Underground economy, 167
carbon tax, 216–217 Unemployment
Time horizon. See also Long run; Short
consumption tax, 251 minimum-wage laws and, 121,
run
corporate income tax, 244–245, 257 446
price elasticity of demand and, 91
corrective, 210
price elasticity of supply and, 100 Unfair-competition argument for
cuts under G. W. Bush, 259–260
Time-series graph, 41 trade restriction, 191
cuts under Reagan, 171
Tit-for-tat strategy, 377–378 Unions, 421
deadweight loss of, 161–163, 167–172, 250
Toll roads, 235 wages and, 421–422
distribution of tax burden, 255–256
double taxation, 245 Total cost, 268, 283 United Kingdom
average, 276, 277, 278 income inequality in, 436
efficiency and, 249–253
Total-cost curve, production function labor tax, 170
equity and, 253–260
and, 272–273 tax burden in, 243
excise, 245
gas tax, 211–212, 234–236, 254 Total revenue, 94, 268 United States
horizontal equity, 254, 256 along linear demand curve, 95–97 cap-and-trade system, 217
incidence, 124, 128–130 price elasticity of demand and, 94–95 carbon tax, 217
on labor, 166–167, 170 Total surplus, efficiency and, 147–148 Cold War and arms race, 373–374
Laffer curve and supply-side economics, Tradable permits, 37 income inequality in, 434–435, 436
169–171 Tradable pollution permits, 212–214, 217 international trade and, 58–59
labor tax, 170
on land, 169 Trade
loopholes, 252 living standard in, 12
benefits of, 8
lump-sum tax, 253 multilateral approach to free trade,
comparative advantage and, 55–56
luxury, 130 192–193
gains from. See Gains from trade
payroll, 127, 244 NAFTA, 192
international. See International trade;
progressive, 255 tax burden in, 243
Trade restrictions
property, 248 specialization and, 52–54 Unsafe at Any Speed (Nader), 7
proportional, 255 Tradeoffs, 4–5 U.S. Postal Service, 336
regressive, 255 policy decisions and, 31 Utilitarianism, 442, 442–443
revenue from, and deadweight loss, production possibilities frontier and, 27 Utility, 442
167–171 between work and leisure, 399 preferences and, 465
INDEX 519
V discrimination. See Labor-market

discrimination
White, Matthew W., 98
Wildlife, as common resource, 236
Value education and, 415–416 Will, George F., 189
of the marginal product, 395 efficiency, 422 Willingness to pay, 138, 138–139
Value-added tax, 251 equilibrium, determinants of, 414–422 Willingness to sell, producer surplus
Values, differences among economists free trade and, 192–193 and, 143–144
in, 34–35 gender and, 422–424 Windows operating system, 311–312, 384
Variable costs, 275, 283 human capital and, 414–416
Women
average, 276 immigration and, 402–403
competitive work environments, 426–427
Variables income effect, 474
education and wages, 422–423
graphs of single, 40–41 labor market equilibrium and, 400–404
labor-market discrimination based on,
graphs of two, 41–42 labor supply and, 473–476
422–423
omitted, causality and, 46–47 loss of manufacturing jobs and, 417
Work, tradeoff between leisure and,
Varian, Hal R., 330–331, 426–427 minimum, 119–121, 421
473–476
Vedantam, Shankar, 32–33 minimum-wage laws, 446
moral hazard and, 484–485
Workfare, 450
Venezuela
productivity and, 404–405 Work incentives, antipoverty programs
price controls, 122–123
race and, 422–424 and, 449–451
Vertical equity, 254, 254–255
signaling and, 419 WorldCom, 486
Vesterlund, Lise, 426–427
substitution effect, 474, 476 World price, 179
Vietnam, child labor and poverty
superstar phenomenon, 419, 421 World Trade Organization (WTO), 193
in, 448
unions and, 421–422
Voting
Arrow’s impossibility theorem, 491 Wage subsidies, 123 X
Condorcet paradox, 490 Waldfogel, Joel, 354–355
Water, clean, as common resource, x-coordinate, 41
median voter theorem, 491–493
233–234
Wealth of Nations, The (Smith), 11 Y
W The Wealth of Nations (Smith), 282, 379 y-coordinate, 41
Wages Welfare, 446
ability, effort and chance, 416, 418 Welfare economics, 137, 205
adverse selection, 485 Welfare programs Z
beauty and, 418–419 federal spending for, 245–246 Zimbabwe
Black Death and, 409 reducing poverty and, 446–447 elephant poaching, 237
compensating differentials, 414 reform, 450–451
work incentives and, 449–451
SUGGESTIONS for
SUMMER READING
IF YOU ENJOYED THE ECONOMICS COURSE THAT YOU
HAVE JUST FINISHED, YOU MIGHT LIKE TO READ MORE ABOUT
ECONOMIC ISSUES IN THE FOLLOWING BOOKS.
WILLIAM BREIT AND BARRY T. HIRSCH WILLIAM EASTERLY

Lives of the Laureates The Elusive Quest for Growth: Economists’
(Cambridge, MA: MIT Press, 2004) Adventures and Misadventures in the Tropics
(Cambridge, MA: MIT Press, 2001)
Eighteen winners of the Nobel Prize in Economics
offer autobiographical essays about their lives A former World Bank economist examines the many
and work. attempts to help the world’s poorest nations and
why these attempts have so often failed.
PAUL COLLIER
The Bottom Billion: Why the Poorest Countries MILTON FRIEDMAN
Are Failing and What Can Be Done About It Capitalism and Freedom
(New York: Oxford University Press, 2007) (Chicago: University of Chicago Press, 1962)
A former research director at the World Bank offers In this classic book, one of the most important econ-
his insights into how to help the world’s poor. omists of the 20th century argues that society should
rely less on the government and more on
the free market.
AVINASH DIXIT AND BARRY NALEBUFF
Thinking Strategically: A Competitive Edge
in Business, Politics, and Everyday Life ALAN GREENSPAN
(New York: Norton, 1991) The Age of Turbulence: Adventures
in a New World
This introduction to game theory discusses how
(New York: Penguin Press, 2007)
all people—from corporate executives to criminals
under arrest—should and do make strategic An economist, former Fed chairman, and
decisions. Washington insider looks back on his fascinating
life and offers insights on the world economy.

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FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

THE ECONOMICS OF LABOR MARKETS

TOPICS FOR FURTHER STUDY

Microeconomics FIF TH EDITION

Senior Frontlist Buyer, Manufacturing:

Cengage Learning products are represented in Canada by

For your course and learning solutions, visit academic.cengage.com

Printed in the United States of America

N. Gregory Mankiw is professor of economics at Harvard University. As a stu-

PART I INTRODUCTION 1 PART V FIRM BEHAVIOR AND THE

“Economics is a study of mankind in the ordinary business of life.” So wrote

Product Support Website

To order the study guide, visit www.ichapters.com.

Ready to apply chapter concepts to the real world?

John Crooker, University of Central Francis Kemegue, Bryant University

Syed Ahmed, Cameron University Bruce Brown, California State

Craig Depken, University of North William Mertens, University of

Joanne Guo, Dyson College of Pace Nitin V. Paranjpe, Wayne State

The accuracy of a textbook is critically important. I am responsible for any

Joel Dalafave, Bucks County Francis Kemegue, Bryant University

Preface: To the Student ix How the Economy as a Whole Works 12

How People Make Decisions 4 The Economist as Scientist 22

Why Economists Disagree 34

Let’s Get Going 36

CHAPTER 5 Taxes 123

The Elasticity of Supply 99

Three Applications of Supply, Demand, and

CHAPTER 6 Consumer Surplus 138

The Deadweight Loss of Taxation 160 Conclusion 194

Deadweight Loss and Tax Revenue as Taxes Vary 167

Common Resources 232

Conclusion: The Importance of Property Rights 237

Public Policy toward Oligopolies 378

How Do Interest Rates Affect Household Saving? 477

Conclusion: Do People Really Think This Way? 479

PART VII Asymmetric Information 484

Ten Principles of Economics

HOW PEOPLE MAKE DECISIONS

PRINCIPLE 1: PEOPLE FACE TRADE-OFFS

PRINCIPLE 2: THE COST OF SOMETHING

PRINCIPLE 3: R ATIONAL PEOPLE THINK AT THE M ARGIN

PRINCIPLE 4: PEOPLE R ESPOND TO INCENTIVES

HOW PEOPLE INTERACT

PRINCIPLE 5: TRADE CAN M AKE EVERYONE BETTER OFF

PRINCIPLE 6: M ARKETS A RE USUALLY A GOOD WAY

Source: Slate.com, March 16, 2006.

Communist countries worked on the premise that government officials were in

PRINCIPLE 7: GOVERNMENTS CAN SOMETIMES

by making illegal copies. We all rely on government-provided police and courts to

Adam Smith and the Invisible Hand

HOW THE ECONOMY AS A WHOLE WORKS

PRINCIPLE 8: A COUNTRY’S STANDARD

PRINCIPLE 9: PRICES R ISE WHEN THE GOVERNMENT

Why You Should Study Economics

PRINCIPLE 10: SOCIETY FACES A SHORT-RUN TRADE-OFF

Source: The Wall Street Journal, June 4, 2003.

How to Read This Book

How People Interact

How the Economy as a Whole Works

scarcity, p. 3 marginal changes, p. 6 market power, p. 12