Microeconomics: theory and applications

Fourth Edition

MICROECONOMICS

Theory and Applications

MICROECONOMICS

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MICROECONOMICS

Theory and

Applications

Fourth Edition

New York Oxford

OXFORD UNIVERSITY PRESS

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O x fo rd U n iv ersity P ress

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Library o f Congress Cataloging-in-Publication Data

Salvatore, Dominick.

Microeconomics: theory and applications / Dominick Salvatore.— 4th ed.

p. cm.

Includes indexes.

ISBN 0-19-513995-X

1. Microeconomics. I. Title.

HB172 .S I39 2002

338.5— dc21 2002068402

Printing number: 98765432 1

Printed in the United States of America

on acid-free paper

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f

BRIEF CONTENTS

%

Contents v ii

List of Examples and At The Frontier xxviii

Preface xxxiii

About the Author xli

Introduction to Microeconomics________________________________ 1

■ CHAPTER 1' Introduction 3

■ CHAPTER 2 Basic Demand and Supply Analysis 25

PART TWO

Theory of Consumer

Behavior and Demand 55

CHAPTER 3 ' Consumer Preferences and Choice 57

CHAPTER 4 ' Consumer Behavior and Individual Demand

CHAPTER 5 ' Market Demand and Elasticities 125

CHAPTER 6 Choice Under Uncertainty 160

88

PART THREE

Production, Costs,

and Competitive Markets 187

CHAPTER 7 ' Production Theory 189

CHAPTER 8 ’ Costs of Production 227

CHAPTER 9 ' Price and Output Under Perfect Competition 2 6 4

* Core Chapter

V

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v i Brief Contents

Imperfectly Competitive Markets 307

■ CHAPTER 10’ Price and Output Under Pure Monopoly 3 0 9

■ CHAPTER 11 Price and Output Under Monopolistic Competition

and Oligopoly 353

■ CHAPTER 12 Game Theory and Oligopolistic Behavior 39 9

■ CHAPTER 13 Market Structure, Efficiency, and Regulation 421

PART FIVE | Pricing and Employment of Inputs 453

■ CHAPTER 14' Input Price and Employment Under Perfect Competition 455

■ CHAPTER 15 Input Price and Employment Under Imperfect Competition 491

■ CHAPTER 16 Financial Microeconomics: Interest, Investment, and the Cost

of Capital 522

General Equilibrium,

Efficiency, and Public Goods 565

■ CHAPTER 17 General Equilibrium and Welfare Economics 567

■ CHAPTER 18 Externalities, Public Goods, and the Role of Government 6 0 5

■ CHAPTER 19 The Economics of Information 6 3 4

Appendix A Mathematical Appendix 657

Appendix B Answers to Selected Problems 668

Appendix C Glossary 699

Name Index 717

Subject Index 719

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CONTENTS

List of Examples and A t The Frontier xxviil

Preface xxxiii

About the Author xh

Introduction to Microeconomics 1

■ CHAPTER 1 Introduction 3

1.1 Wants and Scarcity 4

Can Human Wants Ever Be Fully Satisfied7 4

Scarcity: The Pervasive Economic Problem 4

Example 1-1 More Health Care Means Less of Other Goods

1.2 Functions of an Economic System 6

1.3 Microeconomic Theory and the Price System 7

The Circular Flow of Economic Activity 7

Determination and Function of Prices 8

Example 1-2 Drought in Kansas Sends Wheat Prices Soaring 10

What Role for the Government? 10

Example 1-3 Economic Inefficiencies Cause Collapse

of Communist Regimes 11

1.4 The Margin: The Key Unifying Concept in Microeconomics 12

The Crucial Importance of the Concept of the Margin 12

Example 1-4 Marginal Analysis in TV Advertising 13

Some Clarifications on the Use of the Margin 15

1.5 Specialization, Exchange, and the International Framework

of Microeconomics 16

Specialization and Exchange 16

The International Framework of Microeconomics 16

and Services 5

vii

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viii Contents

Example 1-5 Even the IBM PC and the Boeing 777

Are Not All American! 17

1.6 Models, Methodology, and Value Judgments 18

Models and Methodology 18

Positive and Normative Analysis 19

At The Frontier Do Economists Ever Agree on Anything7 20

Summary 22

Key Terms 22

Review Questions 23

Problems 23

Internet Site Addresses 24

CHAPTER 2 Basic Demand and Supply Analysis 25

2.1 Market Analysis 25

2.2 Market Demand 26

Demand Schedule and Demand Curve 26

Changes in Demand 28

2.3 Market Supply 29

Supply Schedule and Supply Curve 29

Changes in Supply 30

2.4 When Is a Market in Equilibrium? 31

2.5 Adjustment to Changes in Demand and Supply:

Comparative Static Analysis 33

Adjustment to Changes in Demand 34

Adjustment to Changes in Supply 34

Example 2 -1 Changes in Demand and Supply and Coffee Prices 35

2.6 Domestic Demand and Supply, Imports, and Prices 37

Example 2 -2 The Large U.S. Automotive Trade Deficit Keeps U S

Auto Prices Down 38

2.7 Interfering with versus Working through the Market 39

Example 2 -3 Rent Control Harms the Housing Market 40

Example 2 -4 The Economics of U.S. Farm Support Programs 42

Example 2 -5 Working through the Market with an Excise Tax 44

Example 2 - 6 Fighting the Drug War by Reducing Demand

and Supply 46

At The Frontier Nonclearing Markets Theory 47

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Contents ix

PART TWO

Summary 48

Key Terms 49

Review Questions 50

Problems 50

A p p en d ix The Algebra of Demand, Supply, and Equilibrium 51

Market Equilibrium Algebraically 52

Shifts in Demand and Supply, and Equilibrium 53

The Effect of an Excise Tax 53

Internet Site Addresses 54

Theory of Consumer Behavior and Demand_____________55

a CHAPTER 3 Consumer Preferences and Choice 57

3.1 Utility Analysis 58

Total and Marginal Utility 58

Cardinal or Ordinal Utility7 60

Example 3 -1 Does Money Buy Happiness7 61

3.2 Consumer's Tastes: Indifference Curves 62

Indifference Curves—What Do They Show7 62

Characteristics of Indifference Curves 64

The Marginal Rate of Substitution 65

Some Special Types of Indifference Curves 66

Example 3 -2 How Ford Decided on the Characteristics

of Its Taurus 68

3.3 International Convergence of Tastes 69

Example 3 -3 Gillette Introduces the Sensor and Mach3 Razors—

Two Truly Global Products 69

3.4 The Consumer’s Income and Price Constraints: The Budget Line 70

Definition of the Budget Line 70

Changes in Income and Prices and the Budget Line 72

Example 3 -4 Time as a Constraint 74

3.5 Consumer’s Choice 74

Utility Maximization 75

Example 3 -5 Utility Maximization and Government

Warnings on Junk Food 76

Corner Solutions 78

Example 3 -6 Water Rationing in the West 79

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X Contents

Marginal Utility Approach to Utility Maximization 80

At The Frontier The Theory of Revealed Preference 82

Summary 84

Key Terms 85

Review Questions 85

Problems 86

Internet Site Addresses 8 7

■ CHAPTER 4 Consumer Behavior and Individual Demand 8 8

4.1 Changes in Income and the Engel Curve 89

Income-Consumption Curve and Engel Curve 89

Example 4 -1 Engel's Law After a Century 91

Normal and Inferior Goods 92

Example 4 -2 Many People Are Blowing Their Pension Money Long

Before Retirement 94

4.2 Changes in Price and the Individual Demand Curve 95

Example 4 -3 Higher Alcohol Prices Would Sharply Reduce Youth Alcohol

Use and Traffic Deaths 97

4.3 Substitution and Income Effects 98

How Are the Substitution and Income Effects Separated7 98

Example 4 -4 The Substitution and Income Effects

of a Gasoline Tax 101

Substitution and Income Effects for Inferior Goods 102

4.4 Substitution Between Domestic and Foreign Goods 104

Example 4 -5 What Is an "American” Car7 105

4.5 Some Applications of Indifference Curve Analysis 106

Is a Cash Subsidy Better Than Food Stamps7 106

Consumer Surplus Measures Unpaid Benefits 108

Benefits from Exchange 110

At The Frontier The Characteristics Approach

to Consumer Theory 112

Summary 115

Key Terms 116

Review Questions 116

Problems 117

Appendix Index Numbers and Changes in Consumer Welfare 118

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Contents x i

Expenditure, Laspeyres, and Paasche Indices 118

How Are Changes in Consumer Welfare Measured? 119

Example 4 -6 The Consumer Price Index, Inflation, and Changes

in the Standard of Living 121

Example 4 -7 Comparing the Standard of Living in Different

Countries 122

Internet Site Addresses 124

m CHAPTER 5 Market Demand and Elasticities 125

5.1 The Market Demand for a Commodity 125

Example 5-1 The Demand for Big Macs 127

5.2 Price Elasticity of Market Demand 129

Measuring the Price Elasticity of Demand 129

Price Elasticity Graphically 131

Price Elasticity and Total Expenditures 132

What Determines Price Elasticity7 133

Example 5 -2 The Price Elasticity for Clothing Increases with

Time 135

5.3 Income Elasticity of Demand 136

Example 5 -3 Transatlantic Air Travel Is a Luxury,

Flour Is an Inferior Good 138

5.4 Cross Elasticity of Demand 139

Example 5 -4 Margarine and Butter Are Substitutes, Cereals and Fresh Fish

Are Complements 140

5.5 Price and Income Elasticities of Imports and Exports 141

Example 5 -5 Price and Income Elasticities for Imports and Exports

in the Real World 142

5.6 Marginal Revenue and Elasticity 143

Demand, Total Revenue, and Marginal Revenue 143

Geometry of Marginal Revenue Determination 144

Marginal Revenue, Price, and Elasticity 146

Example 5 -6 The U.S. Consumer Demand for

Alcoholic Beverages 148

At The Frontier The Marketing Revolution with Micromarketing 149

Summary 151

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xii Contents

Key Terms 152

Review Questions 152

Problems 153

Appendix Empirical Estimation of Demand

by Regression Analysis 155

Example 5 -7 Estimating and Forecasting the U.S. Demand

for Electricity 157

Internet Site Addresses 159

■ CHAPTER 6 Choice Under Uncertainty 160

6.1 Risk and Uncertainty in Demand Choices 160

Example 6-1 The Risk Faced by Coca-Cola in Changing Its

Secret Formula 161

6.2 Measuring Risk 162

Probability Distributions 162

The Standard Deviation 164

Example 6 -2 Risk and Crime Deterrence 166

6.3 Utility Theory and Risk Aversion 167

Different Preferences Toward Risk 167

Maximizing Expected Utility 168

Example 6 -3 America's Gambling Craze 170

6.4 Insurance and Gambling 171

Why Do Some Individuals Buy Insurance’ 171

Why Do Some Individuals Gamble7 173

Example 6 -4 Gambling and Insuring by the Same Individual—

A Seeming Contradiction 174

6.5 Risk Aversion and Indifference Curves 175

Example 6 -5 Spreading Risks in the Choice of a Portfolio 177

6.6 Reducing Risk and Uncertainty 178

Gathering More Information 178

Diversification 179

Insurance 179

Example 6 -6 Some Disasters as Nondiversifiable Risks 180

At The Frontier Foreign Exchange Risks and Hedging 181

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Contents xiii

PART THREE

Summary 182

Key Terms 183

Review Questions 183

Problems 184

Internet Site Addresses 186

Production, Costs, and Competitive Markets__________187

■ CHAPTER 7 Production Theory 189

7.1 Relating Outputs to Inputs 190

Organization of Production 190

Classification of Inputs 191

7.2 Production with One Variable Input 192

Total, Average, and Marginal Product 192

The Geometry of Average and Marginal Product Curves 195

The Law of Diminishing Returns 196

Example 7-1 Economics—The Dismal Science Because

of Diminishing Returns 197

7.3 Production with Two Variable Inputs 198

What Do Isoquants Show7 198

Derivation of Total Product Curves from the Isoquant Map 199

7.4 The Shape of Isoquants 201

Characteristics of Isoquants 201

Economic Region of Production 203

Fixed-Proportions Production Functions 205

Example 7-2 Trading Traveling Time for Gasoline Consumption

on the Nation’s Highways 206

7.5 Constant, Increasing, and Decreasing Returns to Scale 207

Example 7-3 General Motors Decides Smaller Is Better 210

7.6 Technological Progress and International Competitiveness 211

Meaning and Importance of Innovations 211

Example 7-4 How Do Firms Get New Technology7 212

Innovations and the International Competitiveness of U S Firms 213

Example 7-5 How Xerox Lost and Regained, but Is Now Struggling

to Remain Internationally Competitive 214

Example 7-6 Score Card on American Industry 215

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xiv Contents

At The Frontier The New Computer-Aided Production Revolution

and the International Competitiveness of U S Firms 216

Summary 218

Key Terms 218

Review Questions 219

Problems 219

Appendix The Cobb-Douglas Production Function 221

The Formula 221

Illustration 221

Empirical Estimation 223

Example 7-7 Output Elasticity of Labor and Capital and Returns to Scale

in U.S. and Canadian Manufacturing 224

Internet Site Addresses 226

S CHAPTER 8 Costs of Production 227

8.1 The Nature of Production Costs 227

Example 8 -1 The Cost of Attending College 228

8.2 Cost in the Short Run 229

Total Costs 230

Per-Unit Costs 230

Geometry of Per-Unit Cost Curves 232

Example 8 -2 Per-Unit Cost Curves in Corn Production 235

8.3 Cost in the Long Run 236

Isocost Lines 236

Least-Cost Input Combination 238

Cost Minimization in the Long Run and in the Short Run 239

Example 8 -3 The Least-Cost Combination of Gasoline

and Driving Time 240

8.4 Expansion Path and Long-Run Cost Curves 241

Expansion Path and the Long-Run Total Cost Curve 242

Derivation of the Long-Run Average and Marginal Cost Curves 242

The Relationship between Short- and Long-Run Average

Cost Curves 245

Example 8 -4 Long-Run Average Cost Curve

in Electricity Generation 246

8.5 Shape of the Long-Run Average Cost Curve 247

Example 8 -5 The Shape of the Long-Run Average Cost Curves

in Various Industries 248

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Contents XV

Example 8 -6 The Minimum Efficient Scale in Various

U.S. Food Industries 249

8.6 Multiproduct Firms and Dynamic Changes in Costs 250

Economies of Scope 250

The Learning Curve 251

Example 8 - 7 The Learning Curve for the Lockheed L-1011 Aircraft

and for Semiconductors 253

At The Frontier Minimizing Costs Internationally—The New Economies

of Scale 254

Summary 256

Key Terms 257

Review Questions 257

Problems 258

Appendix Extensions and Uses of Production and Cost Analysis 259

Derivation of the Total Variable Cost Curve from the Total

Product Curve 259

Input Substitution in Production to Minimize Costs 261

Example 8 -8 The Elasticity of Substitution in Japanese

Manufacturing Industries 262

Input Prices and the Firm's Cost Curves 262

Internet Site Addresses 263

■ CHAPTER 9 Price and Output Under Perfect Competition 264

9.1 Market Structure: Perfect Competition 265

Example 9 -1 Competition in the New York Stock Market 266

9.2 Price Determination in the Market Period 267

9.3 Short-Run Equilibrium of the Firm 268

Total Approach: Maximizing the Positive Difference between Total Revenue

and Total Costs 269

Marginal Approach: Equating Marginal Revenue and Marginal Cost 269

Profit Maximization or Loss Minimization? 273

9.4 Short-Run Supply Curve and Equilibrium 274

Short-Run Supply Curve of the Firm and Industry 274

Example 9 -2 The Supply Curve of Petroleum from Tar Sands 276

Example 9 -3 The Short-Run World Supply Curve of Copper 278

Short-Run Equilibrium of the Industry and Firm 280

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